Central banks can use interest rates to change inflation rates. This is because the interest rate affects two determinants of aggregate demand (AD): Consumer Spending (C) and Investment (I).
Therefore, a change in C and I will cause a shift in AD, leading to a change in price levels.
- The central banks can use two types of monetary policy:
- Expansionary Monetary Policy
- Contractionary Monetary Policy
Expansionary Monetary Policy
Expansionary monetary policy, also sometimes referred as easy monetary policy, is used by central banks when an economy is having a deflationary gap and it is producing below the potential output.
- Observing the New Classical model, the economy currently produces at $Y_{rec}$, at the price level $PL_1$.
- As $Y_{rec}< Y_p$, the economy is in a deflationary gap, and is producing below its potential output level.
- Therefore, central banks implement expansionary monetary policy by decreasing the interest rates to encourage individuals to increase their spending and investments.
- This is because keeping money in savings does not provide high returns anymore.
- Due to this, the AD shifts from $AD_1$ to $AD_2$, increasing the total output ($Y_{rec} \rightarrow Y_p$) . This also causes the price level to increase to $PL_2$.
- With this, the deflationary gap is removed and the economy returns to its full-employment level of output.
- The same theory applies to the Keynesian model, where by decreasing the interest rates, the aggregate demand increases from $AD_1$ to $AD_2$.
- This increases the total output from $Y_{rec}$ to $Y_p$ and the price level from $PL_1$ to $PL_2$.
Contractionary Monetary Policy
Sometimes also referred to as tight monetary policy, it is implemented by the central bank when an economy is at an inflationary gap and is producing above its potential output.
- Observing the New Classical model, the economy currently produces at $Y_{infl}$, at the price level $PL_1$. Since $Y_{infl}>Y_p$, the economy is in an inflationary gap, and is producing above its potential output level.
- Therefore, the central banks can implement a contractionary monetary policy by increasing the interest rates to encourage individuals to decrease their spending and investments.
- This is because placing money in savings in the bank now provides higher returns.
- This causes the AD to decrease from $AD_1$ to $AD_2$ which decreases the total output and the price level to $PL_2$.
- With this, the inflationary gap is removed.
- The same theory applies to the Keynesian model, where increasing the interest rates causes the aggregate demand to decrease from $AD_1$ to $AD_2$.
- This decreases the total output from $Y_{infl}$ to $Y_p$.
Ratchet Effect
However, the Keynesian model assumes that the prices on the way down are sticky or inflexible because wages and prices are often slow to adjust downward due to contracts, worker resistance, and menu costs. This means that Figure 4 would not be a correct representation of what would happen in Keynesian economics.
- Figure 5 is a more realistic representation of the effects that a contractionary monetary policy would have in the Keynesian model.
- Essentially, when the central bank increases the interest rates, the aggregate demand decreases from $AD_1$ to $AD_2$.
- Yet the price level stays at $PL_1$. This is known as the Ratchet Effect.
Expansionary Monetary Policy in the United Kingdom
Background:
In late 2024, the United Kingdom faced a recessionary gap, characterised by stagnant economic growth, declining consumer confidence, and rising unemployment. The Bank of England (BoE) responded with expansionary monetary policy measures to stimulate the economy and close the output gap.
Policy Measures:
In November 2024, the BoE reduced the Bank Rate by 0.25 percentage points, bringing it down to 4.75%. This marked the third rate cut since August 2024 in response to weak economic performance. The objective was to lower borrowing costs, thereby encouraging consumer spending and business investment.
Possible Impacts:
- Increased Borrowing: Lower interest rates reduce the cost of borrowing, making loans and mortgages more affordable. This could lead to increased household consumption and business expansion.
- Currency Depreciation: A reduction in interest rates typically weakens the pound, making UK exports more competitive. However, it also increases import prices, potentially leading to a higher cost of living.
- Asset Price Inflation: Cheaper borrowing could result in increased demand for real estate and stocks, potentially inflating asset bubbles.
- Potential for Higher Inflation: While inflation remained moderate at 2.5% in December 2024, there were concerns that continued rate cuts could lead to demand-pull inflation in 2025.
Challenges:
Despite the rate cuts, concerns persisted about rising energy prices and increased household bills, which could offset the stimulative effects of the policy. Additionally, the global economic environment, influenced by trade tensions and geopolitical risks, posed challenges to the UK’s recovery.
Questions:
- Explain how a reduction in the Bank Rate can help close a recessionary gap.
- Discuss the potential limitations of expansionary monetary policy in stimulating economic growth.
Contractionary Monetary Policy in Japan
Background:
By early 2024, Japan was experiencing high inflation, with the core consumer inflation rate reaching 3.0% in December 2023, surpassing the Bank of Japan's (BoJ) 2% target for nearly three years. The weak yen, rising import costs, and strong wage growth further fuelled inflationary pressures.
Policy Measures:
In January 2024, the BoJ raised short-term interest rates to 0.5%, marking a shift from its previous ultra-loose monetary policy stance. The central bank also scaled back its government bond purchases, signalling a move toward monetary tightening.
Possible Impacts:
- Reduced Borrowing and Spending: Higher interest rates increase the cost of borrowing, discouraging consumer spending and business investment, which could slow aggregate demand.
- Yen Appreciation: An increase in interest rates strengthens the yen, making imports cheaper but reducing the competitiveness of Japanese exports.
- Stock Market Volatility: Higher interest rates tend to reduce corporate profitability, leading to stock market corrections.
- Potential for Economic Slowdown: While inflation may be controlled, higher rates could stifle economic growth, particularly in an economy with high public debt.
Challenges:
The BoJ faced the difficult task of balancing inflation control while ensuring that higher interest rates did not harm economic growth. Additionally, external factors, such as U.S. interest rate hikes, global supply chain disruptions, and Chinese economic slowdowns, added uncertainty to Japan’s economic outlook.
Questions:
- Explain how an increase in short-term interest rates can help close an inflationary gap.
- Discuss the potential risks associated with implementing contractionary monetary policy in an economy experiencing wage growth.
