What this lesson teaches
I can describe monetary policy measures: changes in interest rates, money supply and the exchange rate.
Syllabus K343, 4.3.2. Monetary policy measures: changes in: interest rate, money supply, foreign exchange rate
Make a guess
A central bank wants to help the economy out of a recession. Should it raise or cut interest rates?
- Leave them, because interest rates do not affect spending.
- Raise them, so that savers earn more and feel richer.
- Cut them, so borrowing is cheaper and spending rises.
Show the answer
Cut them, so borrowing is cheaper and spending rises.
Lower rates cut loan repayments and make saving less rewarding, so households and firms spend and invest more.
A central bank can change the interest rate, the money supply or the exchange rate, and each changes how much households and firms spend.
Monetary policy uses three measures. The central bank can change the interest rate, the money supply or the foreign exchange rate. Each one changes how much households and firms spend.
Interest rate. The interest rate is the cost of borrowing and the reward for saving. When it rises, loans for homes, cars and machines cost more each month, so households and firms borrow and spend less. Saving earns more, so some people save instead of spending. A cut works the other way: cheaper loans encourage spending and investment.
Money supply. The central bank can make it easier or harder for commercial banks to lend. For example, it can change the share of deposits banks must keep in reserve. When banks lend more, more money is spent on goods and services. When they lend less, spending falls.
Exchange rate. A central bank can buy or sell its own currency to change its value. A stronger currency makes imports cheaper and exports dearer for foreign buyers; a weaker one does the opposite. Singapore's central bank is the Monetary Authority of Singapore (MAS). It uses the exchange rate as its main measure, because imports make up so much of what Singapore buys.
- Lower interest rates
- Raise borrowing, spending, growth and jobs.
- Higher interest rates
- Reduce spending and inflation.
- Stronger currency
- Cheaper imports, lower inflation; dearer exports.
- Singapore
- MAS uses the exchange rate as its main monetary tool.
Worked example: How a rise in interest rates reaches a household
Interest rates rose around the world in 2022, and home loan rates in Singapore rose too. Suppose a family owes $500,000 on a floating-rate home loan.
- Suppose the rate rises from 1.5% to 4% a year.
- Yearly interest rises from $500,000 x 1.5% = $7,500 to $500,000 x 4% = $20,000.
- The family has $12,500 less a year to spend on other things, so it cuts back on meals out, holidays and new furniture.
- When many families do this, total demand falls, which is how higher interest rates slow inflation.
Watch out for this
Raising interest rates is a way to boost economic growth.
Higher interest rates reduce borrowing and spending, so they slow growth. They are used to reduce inflation. Lower rates are used to boost growth.
Check your understanding
Prices are rising too fast. Which exchange rate move would help a central bank slow inflation?
- Let the currency depreciate, so exports grow
- Hold the currency fixed and cut interest rates to lift spending
- Let the currency appreciate, so imports cost less
Show the answer
Let the currency appreciate, so imports cost less
Right. A stronger currency makes imported goods and inputs cheaper, which slows the rise in prices.
Check your understanding
A family owes $400,000 on a home loan. The interest rate rises from 2% to 3.5% a year. By how much does its yearly interest rise?
- $6,000
- $14,000
- $1.50
- $600
Show the answer
$6,000
Right. Interest rises from $8,000 (2%) to $14,000 (3.5%), an increase of $6,000.