Monetary policy and the role of central banks

Monetary instruments

• Interest rates: the central bank sets its policy (base) rate, which affects rates on loans, mortgages and savings across the economy.
• Asset purchases (quantitative easing, QE): the central bank creates money to buy government bonds and other assets, raising bond prices, lowering long-term interest rates and increasing the money supply.
• Changes in lending criteria: rules on how much banks can lend and to whom (for example loan-to-value limits on mortgages).
• Reserve asset (liquidity) requirements: the share of deposits banks must hold as liquid reserves; a higher requirement reduces lending.

How an interest rate cut works

Lower rates make borrowing cheaper and saving less rewarding, so consumption rises; mortgage payments fall, raising disposable income; investment projects become more profitable; asset prices rise (wealth effect); the currency tends to depreciate, boosting net exports. AD shifts right. The Bank of England explains that raising Bank Rate makes loans dearer and saving more rewarding, so demand and spending fall (Bank of England, 2026).

The role of central banks

• Implementing monetary policy: setting interest rates and running QE. In the UK, Bank Rate is decided by a nine-member Monetary Policy Committee (Bank of England, 2026).
• Achieving an inflation target: for example, the UK target is 2% CPI inflation. In February 2024 the Bank held Bank Rate at 5.25% when twelve-month CPI inflation had fallen to 4.0% in December 2023 (Bank of England, February 2024).
• Banker to the government: managing its accounts and helping it borrow.
• Banker to the banks and lender of last resort: holding banks' reserves and lending to banks in a crisis to prevent a collapse of the financial system.

Strengths and weaknesses

Strengths: decisions can be made quickly and changed often; an independent central bank is credible and free of election pressures; it affects the whole economy.

Weaknesses: time lags of up to about two years for full effect; it is a blunt tool, hitting all regions and sectors; it may not work if confidence is very low or rates are already near zero (people and firms may not borrow even if credit is cheap); higher rates hurt borrowers and can raise the exchange rate, hitting exporters; QE may inflate asset prices and widen wealth inequality.

Worked example

Inflation is well above target. Explain how the central bank might respond and the likely effect.

1. It raises the policy interest rate.
2. Borrowing becomes dearer and saving more attractive, so C and I fall; mortgage payments rise, cutting disposable income; the currency may appreciate, reducing net exports.
3. AD shifts left, reducing demand-pull pressure, so inflation falls, though growth slows and unemployment may rise.

Answer: Higher interest rates reduce AD and bring inflation back towards target.

Check yourself

1. Quantitative easing involves the central bank
   • raising interest rates
   • creating money to buy government bonds and other assets
   • raising taxes
   • selling foreign currency
   Show answer

   creating money to buy government bonds and other assets. QE raises the money supply and lowers long-term interest rates.

2. Acting as 'lender of last resort' means the central bank
   • lends to households who are refused mortgages
   • lends to foreign governments
   • sets the inflation target
   • lends to banks in a crisis when they cannot borrow elsewhere
   Show answer

   lends to banks in a crisis when they cannot borrow elsewhere. It prevents bank runs spreading through the system.

3. A cut in interest rates is most likely to
   • raise the exchange rate
   • raise consumption and investment
   • increase saving
   • reduce house prices
   Show answer

   raise consumption and investment. Cheaper borrowing encourages spending.

4. If the central bank raises banks' reserve (liquidity) requirements, the most likely effect is
   • more bank lending
   • lower interest rates
   • less bank lending and lower AD
   • a rise in government spending
   Show answer

   less bank lending and lower AD. Banks must hold more reserves, so they can lend less.

5. Why might cutting interest rates fail to boost AD in a deep recession?
   • Confidence is so low that households and firms do not want to borrow
   • Interest rates have no effect on borrowing
   • It always raises taxes
   • It reduces the money supply
   Show answer

   Confidence is so low that households and firms do not want to borrow. Cheap credit does not help if no one wants to borrow.

6. According to the Bank of England, how many members sit on its Monetary Policy Committee?
   • Five
   • Twelve
   • Nine
   • Three
   Show answer

   Nine. Five internal and four external members (Bank of England, 2026).

7. In February 2024 Bank Rate was 5.25% and the latest CPI inflation (December 2023) was 4.0%. Find the approximate real interest rate in %.
   Show answer

   1.25 %. 5.25 - 4.0 = 1.25%: a positive real rate, which restrains demand.

8. Distinguish between fiscal policy and monetary policy.
   Show answer

   Fiscal policy uses government spending and taxation, decided by the government; monetary policy uses interest rates, the money supply and credit, usually set by the central bank.. Fiscal = G and T by government; monetary = interest rates, money and credit by the central bank.

Practise with instant feedback Print this lesson

Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2 (June 2018)
• Bank of England: Inflation and interest rates FAQs (updated 4 February 2026)
• Bank of England: Monetary Policy Summary, February 2024

Last updated 8 November 2026. Spotted a mistake? Tell us.