4.4 Monetary Policy

2026 📋 Syllabus Objectives

By the end of this topic, you should be able to:

  • 4.4.1 Define money supply and monetary policy, including changes in interest rates, money supply, and foreign exchange rates
  • 4.4.2 Explain the measures of monetary policy — changes in interest rates, money supply, and foreign exchange rates
  • 4.4.3 Explain how monetary policy measures may help the government achieve its macroeconomic aims

4.4.1 What is Monetary Policy?

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Defining Monetary Policy

Monetary policy refers to the decisions a government makes about the money supply, interest rates, and exchange rates in order to influence the total amount of spending in the economy — this total spending is called aggregate demand (AD).

Think of it this way: if the government wants people to spend more money (to boost the economy), it can make borrowing cheaper. If it wants people to spend less (to cool down rising prices), it can make borrowing more expensive. These are examples of monetary policy in action.

Monetary policy is carried out by a country's central bank — a special government institution that manages money and banking on behalf of the government. Examples include:

  • The Bank of England in the United Kingdom
  • The Federal Reserve in the United States
  • The European Central Bank in the Eurozone

💡 Important note: Controlling the money supply and exchange rates can be quite difficult in practice. Because of this, governments usually rely most heavily on interest rates as their main monetary policy tool.

Defining Money Supply

The money supply is the total amount of money available in an economy at any given time. It is made up of:

  • Notes and coins — the physical cash you can hold in your hand
  • Bank accounts — money stored digitally in banks (current accounts, savings accounts)

So when economists talk about the money supply, they do not just mean cash — they mean all forms of money, including what's sitting in people's bank accounts.

4.4.2 Monetary Policy Measures

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There are three main tools (also called instruments) of monetary policy:

  1. Changes in interest rates
  2. Changes in the money supply
  3. Changes in the foreign exchange rate

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