What this lesson teaches
I can explain fiscal, monetary and supply-side policy and judge how well each works.
Syllabus 8843, 3.2.3(b). Macroeconomic Policies: Policy measures and their effectiveness in achieving macroeconomic objectives:; Fiscal policy - How discretionary fiscal policy can influence the level of economic activities and living standards through government spending and taxation; Supply-side policies - How supply-side policies can improve quantity, quality and mobility of factors of production to increase the productive capacity of an economy and hence affect living standards; Monetary policy - How monetary policy can influence the level of economic activities and living standards through the management of exchange rates (case of Singapore) and interest rates
Make a guess
The US Federal Reserve raises interest rates sharply. What happens to the US dollar?
- It tends to strengthen as money flows in.
- It weakens, because borrowing in US dollars becomes dearer.
- Nothing, because interest rates only affect borrowing.
Show the answer
It tends to strengthen as money flows in.
Higher rates attract short-term capital from abroad. Demand for the dollar rises, so it appreciates against other currencies.
In most economies, central banks cut interest rates to raise spending and raise them to curb inflation.
Most central banks, such as the US Federal Reserve (Fed) and the European Central Bank (ECB), use interest rates as their main monetary tool.
A lower interest rate makes borrowing cheaper and saving less attractive, so households spend more on big items and firms invest more. C and I rise, so AD shifts right.
Put these in order
A central bank cuts its interest rate. Put the chain to higher real GDP in order.
- Real GDP rises, by more than the first rise in spending.
- Consumption and investment rise.
- The central bank cuts its policy interest rate.
- Aggregate demand shifts right.
- Borrowing becomes cheaper for households and firms.
Show the answer
- The central bank cuts its policy interest rate. Banks follow by lowering the rates they charge on loans.
- Borrowing becomes cheaper for households and firms. Cheaper loans make big purchases and new machines more affordable, while saving earns less.
- Consumption and investment rise. C and I are parts of AD, so total planned spending rises at every price level.
- Aggregate demand shifts right. Firms get more orders, so they raise output and hire workers, and the multiplier spreads the effect.
- Real GDP rises, by more than the first rise in spending.
A higher interest rate does the opposite, reducing AD to bring inflation down. After inflation surged in 2021 and 2022, the Fed raised its policy rate from near zero in March 2022 to 5.25-5.50% by July 2023. The ECB raised rates from July 2022, its first rise in 11 years. Both began cutting in 2024 as inflation eased.
Interest rates also move the exchange rate. Higher rates attract short-term capital from abroad, often called hot money, so demand for the currency rises and it appreciates. That makes imports cheaper, which helps bring inflation down, but it hurts exporters. In 2022 money flowed into US dollar assets, and many currencies, including the Japanese yen, weakened sharply against the US dollar.
Central banks face different problems. The Bank of Japan kept rates below zero for years to fight weak demand and very low inflation, and raised them only in March 2024, for the first time in 17 years. China's central bank cut rates in 2024 to support weak spending.
Singapore does not use interest rates this way. Because its economy is small and open, with capital flowing freely, its interest rates largely follow global rates. MAS uses the exchange rate instead.
- Rate cut
- Cheaper borrowing: C and I rise.
- Hot money
- Higher rates draw in short-term capital, so the currency appreciates.
- Fed
- Near zero in March 2022 to 5.25-5.50% by July 2023; cuts from 2024.
- Singapore
- Rates follow global rates; MAS uses the exchange rate.
Worked example: A cheaper loan makes expansion worthwhile
A central bank cuts its policy rate. Banks lower rates on new business loans. A firm with strong expected sales can now afford to borrow to expand.
- Lower rates cut the cost of borrowing.
- The firm's expansion is now profitable, so it invests.
- Investment raises AD and creates jobs.
- Firms expecting weak sales may still not invest.
Watch out for this
MAS sets Singapore's interest rates to control inflation.
MAS uses the exchange rate. Singapore's interest rates largely follow global rates.
Check your understanding
A central bank raises interest rates. What is the likely effect?
- Borrowing falls, so C and I fall and AD shifts left.
- AD shifts right, because savers earn more interest and spend it.
- AS shifts right, because firms' borrowing costs are passed on.
Show the answer
Borrowing falls, so C and I fall and AD shifts left.
Right. Higher rates make borrowing dearer and saving more attractive.