3.5
Monetary policy
How a central bank uses interest rates and other tools to manage aggregate demand, how the effect travels through the economy, and when it works well or poorly.
Level and scope checked against the Economics guide (course first assessed 2022; October 2022 update), pp. 20–21, 41–42, on 10 Nov 2026. AI-assisted check, not reviewed by a teacher.
Contents
- 1Learning objectives and review status
- 2HL learning objectivesHL
- 3What monetary policy is for
- 4How commercial banks create moneyHL
- 5Tools of monetary policyHL
- 6Interest rates and the money marketHL
- 7Expansionary and contractionary policy
- 8The transmission mechanism
- 9Real and nominal interest rates
- 10Strengths and constraints
- 11Practice and feedback: 10 marks
- 12Practice and feedback: 15 marks
- 13Practice and feedback: 4 marks
- 14Practice and feedback: 4 marks
- 15Practice and feedback: 4 marks
- 16Practice and feedback: 10 marksHL
- 17Practice and feedback: 4 marksHL
- 18Paper 2 practice set: Inflation and interest rates in Nordavia
- 19Sources and review status
1Learning objectives and review status
- State the goals of monetary policy and say what an inflation target is for.
- Explain how a change in the policy interest rate reaches aggregate demand through consumption, investment and net exports.
- Draw AD/AS diagrams of expansionary and contractionary monetary policy and interpret the change in the price level.
- Calculate a real interest rate from a nominal rate and an inflation rate or a price index.
- Evaluate monetary policy using its strengths, its constraints and a dated real-world example.
2HL learning objectivesHL only
- explain how commercial banks create money, how the four tools of monetary policy work and how the money market determines the equilibrium interest rate.
3What monetary policy is for
is a form of demand management. The changes interest rates, the money supply or credit conditions in order to influence , and through it output, employment and the price level.
In most economies its main instrument is the : the rate the central bank sets for its dealings with commercial banks. Changes in it feed through to the interest rates that banks charge borrowers and pay savers.
Monetary policy has five goals. The first is the central one in most economies.
- A low and stable rate of inflation. When prices rise slowly and predictably, money keeps its purchasing power and households and firms can plan, save and invest with confidence. Many central banks work to an explicit , commonly 2%; the Bank of Japan, for example, set a target of 2% in January 2013. The central bank raises its policy rate when it forecasts inflation above the target and lowers it when it forecasts inflation below. A public target also steers expectations: people who expect inflation of 2% build about 2% into wage claims and prices, which helps to keep inflation there.
- Low unemployment. When aggregate demand is too low, firms cut output and jobs. Lower interest rates raise spending, so firms produce more and employ more workers. This reduces unemployment caused by weak demand. It does not reduce unemployment caused by a mismatch of skills or by the time it takes to find a job.
- Smaller fluctuations in the business cycle. The central bank tightens policy when demand grows faster than the economy's capacity and loosens it when demand is weak. Leaning against the cycle in this way makes booms and recessions smaller than they would otherwise be.
- A stable environment for long-term growth. Low, predictable inflation and interest rates reduce the uncertainty around long-term decisions. Firms are more willing to invest in capital when they can judge future prices, costs and borrowing costs, and investment raises the economy's productive capacity.
- External balance. Interest rates affect the exchange rate and spending on imports, so monetary policy influences the balance between what a country pays to the rest of the world and what it receives. A central bank may, for example, raise interest rates to stop a rapid fall in its currency, which would make imports dearer and add to inflation.
The goals can pull in different directions. Raising interest rates to lower inflation also lowers output and raises unemployment in the short run, so the central bank has to decide which goal comes first. Where there is an inflation target, the target does.
Check your understanding
Key terms
- Monetary policy
- Action by a central bank to influence interest rates, the money supply and credit conditions in order to manage aggregate demand and achieve macroeconomic objectives, especially low and stable inflation.
- Central bank
- The institution that conducts a country's monetary policy, acts as banker to commercial banks and the government, and acts as lender of last resort to the banking system.
- Policy interest rate
- The interest rate a central bank sets to steer short-term interest rates in the economy, known by names such as base rate, refinancing rate, discount rate or minimum lending rate; changes in it feed through to the rates commercial banks charge borrowers and pay savers.
- Inflation targeting
- A monetary-policy framework in which the central bank publicly commits to keeping inflation close to a stated target rate and adjusts policy to steer expected inflation towards it.
- Central bank independence
- The degree to which a central bank sets monetary policy free from direct political control, usually to a mandate such as an inflation target.
- Aggregate demand (AD)
- The total planned spending on an economy's goods and services at each average price level: AD = C + I + G + (X − M).
4How commercial banks create moneyHL only
Most of the money in a modern economy is not notes and coins but bank deposits. When a commercial bank makes a loan, it does not hand over money it already holds. It credits the borrower's account with a new deposit. That deposit is new money, which the borrower can spend: . When loans are repaid, the deposits disappear and money is destroyed.
Banks cannot create money without limit. They lend only to borrowers they expect to repay, at interest rates that make lending profitable. They must meet regulations on how much capital and how many liquid assets they hold, and in some countries a . And the central bank's interest rate affects how much households and firms want to borrow in the first place.
Many textbooks describe the process the other way round, in rounds. A bank receives a deposit, keeps a required fraction as reserves and lends the rest. The loan is spent and redeposited in the banking system, part of it is lent again, and so on. Each round is smaller than the one before, and total deposits can grow to at most 1 ÷ (required reserve ratio) times the original deposit. This ratio is the money multiplier.
| Round | New deposit ($) | Kept as reserves ($) | Lent out ($) |
|---|---|---|---|
| 1 | 1,000 | 100 | 900 |
| 2 | 900 | 90 | 810 |
| 3 | 810 | 81 | 729 |
| All rounds (maximum) | 10,000 | 1,000 | 9,000 |
The figures are invented. Money multiplier = 1 ÷ 0.1 = 10, so total deposits can reach at most 10 × $1,000 = $10,000. The maximum is reached only if banks lend every dollar they are allowed to and all of it is redeposited.
This model shows how a reserve requirement can limit lending in principle. The Bank of England's 2014 article “Money creation in the modern economy” explains that in practice the causation runs the other way: lending creates the deposit, and banks obtain the reserves they need afterwards. Central banks therefore influence money creation mainly through the interest rate rather than through a fixed quantity of reserves.
A reserve requirement of zero makes the same point. The US Federal Reserve set its reserve requirement to zero from 26 March 2020. With a ratio of zero the multiplier formula sets no limit at all, so the limits on money creation must lie elsewhere: in the profitability and risk of lending, in regulation, and in the demand for loans at the interest rate the central bank sets.
Check your understanding
Key terms
- Money creation by commercial banksHL
- When a commercial bank makes a loan, it credits the borrower's account with a new deposit, so lending creates new money; repaying loans removes it. Profitability, regulation and the central bank's interest rate limit how much banks create.
- Minimum reserve requirementHL
- The minimum proportion of their deposits that commercial banks must hold as reserves at the central bank or as cash. In the simple textbook model, raising it limits how much lending, and so deposit creation, a given amount of reserves can support.
5Tools of monetary policyHL only
Central banks have four main tools. All of them work by changing the cost or availability of credit.
- Changes in the central bank's minimum lending rate. Also called the base rate, discount rate or refinancing rate: the . This is the main tool in most economies. When it rises, commercial banks pay more for funds from the central bank, so they raise the rates they charge borrowers and pay savers, and borrowing and money creation slow down. A cut does the opposite.
- Open market operations. The central bank buys or sells government bonds in the open market. When it buys bonds it pays with newly created reserves, so the reserves of commercial banks and the deposits of the sellers rise; banks can lend more, the money supply grows and interest rates are pushed down. When it sells bonds, the buyers' payments withdraw reserves and deposits from the banking system, the money supply shrinks and interest rates are pushed up. See .
- Minimum reserve requirements. In the simple textbook model, raising the share of deposits that banks must hold as reserves limits how much lending a given amount of reserves can support, and lowering it does the opposite. Some central banks no longer rely on this tool: the US Federal Reserve set its requirement to zero from 26 March 2020. Others still set a positive requirement. See .
- Quantitative easing. Large-scale purchases of bonds, paid for with newly created reserves and used when the policy rate is already close to zero. The purchases raise bond prices and lower longer-term interest rates, which makes borrowing cheaper and supports spending. See .
Check your understanding
Key terms
- Open market operationsHL
- The buying and selling of government bonds by the central bank to change the reserves of commercial banks and so influence the money supply and interest rates.
- Minimum reserve requirementHL
- The minimum proportion of their deposits that commercial banks must hold as reserves at the central bank or as cash. In the simple textbook model, raising it limits how much lending, and so deposit creation, a given amount of reserves can support.
- Quantitative easingHL
- Large-scale purchases of financial assets, usually government bonds, by a central bank using newly created reserves. It aims to lower longer-term interest rates and support spending when the policy rate is already very low.
- Quantitative tighteningHL
- The reversal of quantitative easing, in which a central bank reduces its holdings of bonds by letting them mature without replacing them or by selling them.
6Interest rates and the money marketHL only
In the money-market model, the interest rate is the price of money. The (Ms) is drawn as a vertical line because it is set by the central bank, not by the interest rate. The (Md) slopes downward: the higher the interest rate, the greater the opportunity cost of holding money instead of interest-bearing assets, so people hold less of it.
The is where Md meets Ms. If the central bank increases the money supply, Ms shifts right and the equilibrium interest rate falls. If it reduces the money supply, Ms shifts left and the interest rate rises.
The rate moves because people adjust what they hold. After an increase in the money supply, people have more money than they want to hold at the old interest rate. They use the excess to buy bonds and other interest-bearing assets. The extra demand raises bond prices, and because a bond pays a fixed sum each year, a higher price means a lower rate of return. Interest rates fall until people are willing to hold the larger quantity of money. A fall in the money supply works in reverse: people sell bonds to obtain money, bond prices fall and interest rates rise.
Check your understanding
Key terms
- Money supply
- The total quantity of money in an economy, mainly notes and coins plus bank deposits, which the central bank influences mainly through interest rates.
- Demand for moneyHL
- The quantity of money people and firms wish to hold. It slopes downward against the interest rate because a higher rate raises the opportunity cost of holding money rather than interest-bearing assets.
- Equilibrium interest rateHL
- The interest rate at which the demand for money equals the money supply.
7Expansionary and contractionary policy
(tight) policy raises interest rates to reduce aggregate demand. It is used when the economy is in an and demand-pull inflation is above target. (loose) policy lowers interest rates to raise aggregate demand. It is used when the economy is in a , with unemployment above its natural rate.
| Feature | Expansionary (loose) | Contractionary (tight) |
|---|---|---|
| Used when | Deflationary gap: real GDP below full employment output | Inflationary gap: real GDP above full employment output |
| Policy interest rate | Lowered | Raised |
| Consumption, investment and net exports | Rise | Fall |
| Aggregate demand | Shifts right | Shifts left |
| Real GDP | Rises towards full employment output | Falls towards full employment output |
| Price level | Higher than it would otherwise be | Lower than it would otherwise be |
Contractionary monetary policy: AD shifts left from AD1 to AD2. The average price level falls and Real GDP falls. The inflationary gap almost closes: Y₂ ends just above potential output (Y₂ ≈ Yf), so a small inflationary gap remains.
- Average price level
- FallsP₁ to P₂
- Real GDP
- FallsY₁ to Y₂
- Output gap
- The inflationary gap almost closes: Y₂ ends just above potential output (Y₂ ≈ Yf), so a small inflationary gap remains.
Look at what the slope of SRAS does. When SRAS is flatter, as when the economy has spare capacity, more of a change in AD shows up as a change in real GDP. When it is steeper, close to capacity, more of it shows up in the price level. This is why the same policy change can have different effects at different points in the business cycle. A flatter SRAS is still not the Keynesian AS curve. On the horizontal section of that curve, an increase in AD raises real GDP with no rise in the price level at all.
Check your understanding
Key terms
- Contractionary monetary policy
- Monetary policy that raises interest rates or reduces the money supply to reduce aggregate demand, typically used to close an inflationary gap and reduce demand-pull inflation.
- Expansionary monetary policy
- Monetary policy that lowers interest rates or increases the money supply to raise aggregate demand, typically used to close a deflationary (recessionary) gap.
- Inflationary gap
- The situation in which real GDP is above potential output, so that demand pressure tends to push up the price level.
- Deflationary (recessionary) gap
- The situation in which real GDP is below potential output, with resources (especially labour) unemployed.
- Demand-pull inflation
- Inflation caused by aggregate demand growing faster than the economy's capacity to produce, pulling up the average price level.
- Disinflation
- A fall in the rate of inflation. The average price level is still rising, but more slowly than before.
- Deflation
- A sustained fall in the average price level over time, which means a negative rate of inflation. It is not the same as disinflation, where prices keep rising but more slowly.
8The transmission mechanism
The is the chain of cause and effect from the central bank's decision to the economy. Each link has a reason, and an explanation is complete only when every link is stated. Select any node or link below to read its explanation.
The chain, step by step
- 1
increasesPolicy interest rate
The central bank raises its policy rate.
Full explanation: Policy interest rate
The central bank raises the interest rate it sets for its dealings with commercial banks. This is the decision that starts the chain.
Central banks usually do this when they judge that aggregate demand is growing faster than the economy can sustain, threatening inflation above target.
Concepts:
- leads to commercial bank rates (passed on): Commercial banks borrow from the central bank and from each other at rates linked to the policy rate, so a rise in it raises their cost of funds, which they pass on to customers.
- leads to exchange rate (attracts inflows): Higher domestic interest rates raise the return on the country's financial assets relative to those abroad, increasing demand for the currency.
- 2
increasesCommercial bank rates
Banks raise the rates they charge borrowers and pay savers.
Full explanation: Commercial bank rates
Commercial banks' own cost of funds rises, so they pass the increase on to the interest rates on loans, mortgages, credit cards and savings accounts.
Concepts:
- leads to cost of borrowing (raises): Higher lending rates mean every unit borrowed costs more interest.
- leads to reward for saving (raises): Banks compete for deposits by raising the rates they pay to savers.
- 3
increasesCost of borrowing
Loans, mortgages and credit become more expensive.
Full explanation: Cost of borrowing
Households and firms that borrow now pay more interest. Existing borrowers on variable rates face higher repayments, which leaves them less disposable income to spend.
Concepts:
- leads to consumption (c) (reduces): Credit-financed purchases become more expensive, and higher repayments on existing variable-rate debt reduce disposable income.
- leads to investment (i) (reduces): Projects whose expected return no longer exceeds the higher cost of finance are postponed or cancelled.
- 4
increasesReward for saving
Saving earns a higher return.
Full explanation: Reward for saving
A higher return raises the opportunity cost of spending now rather than later, so some households choose to save more of their income.
Concepts:
- leads to consumption (c) (reduces): A higher return on saving raises the opportunity cost of spending now, so households save more and consume less.
- 5
increasesExchange rate
Higher returns attract financial inflows, so the currency tends to appreciate.
Full explanation: Exchange rate
Relatively higher interest rates make the country's financial assets more attractive to foreign savers. Demand for the currency rises and the currency tends to appreciate.
How much this happens depends on interest rates elsewhere and on expectations, so this link is less predictable than the domestic ones.
Concepts:
- leads to net exports (x − m) (reduces): An appreciation makes exports less price-competitive abroad and imports cheaper at home.
- 6
decreasesInvestment (I)
Fewer investment projects are worth financing.
Full explanation: Investment (I)
A project goes ahead only if its expected return exceeds the cost of financing it. A higher interest rate raises that cost, so marginal projects are postponed or cancelled.
The interest rate is also the opportunity cost of using retained profits, so investment falls even for firms that do not borrow.
Residential investment, the building of new homes, tends to fall too, because higher mortgage rates reduce demand for new housing.
Concepts:
- leads to aggregate demand (I is part of AD): Investment is a component of AD. It is often the most interest-sensitive component.
- 7
decreasesConsumption (C)
Households spend less, especially on goods bought on credit.
Full explanation: Consumption (C)
Spending on durable goods that are often bought with credit, such as cars and furniture, is most sensitive to interest rates. (Building new homes counts as investment, not consumption, and is also sensitive to mortgage rates.)
Lower asset prices (for example, house prices) can also reduce consumption through a negative .
Concepts:
- leads to aggregate demand (C is part of AD): Consumption is the largest component of aggregate demand in most economies, so a fall in it reduces AD.
- 8
decreasesNet exports (X − M)
A stronger currency makes exports dearer abroad and imports cheaper at home.
Full explanation: Net exports (X − M)
After an appreciation, exports cost more in foreign currency and imports cost less in domestic currency. Export volumes tend to fall and import volumes to rise, so net exports fall.
Concepts:
- leads to aggregate demand ((X − M) is part of AD): A fall in net exports reduces the foreign component of aggregate demand.
- 9
decreasesAggregate demand
Lower C, I and (X − M) shift AD to the left.
Full explanation: Aggregate demand
Because AD = C + I + G + (X − M), falls in its components shift the AD curve to the left. In the AD–AS model the economy moves down along SRAS to a new equilibrium, with a lower price level and lower real GDP than before the shift.
Concepts:
Show this on the AD–AS diagram- leads to demand-pull inflation (eases): With AD shifted left, the equilibrium price level is lower than it would otherwise have been, so demand-pull inflationary pressure eases. The rate of inflation falls (disinflation); the price level itself need not fall.
- 10
decreasesDemand-pull inflation
With less demand pressing on capacity, inflationary pressure eases.
Full explanation: Demand-pull inflation
With less spending pressing against the economy's productive capacity, firms face less pressure to raise prices. The rate of slows.
On the AD/AS diagram this is the fall from P₁ to P₂. The diagram compares two equilibria with everything else held constant, so P₂ is a price level lower than it would have been without the policy. With prices rising to begin with, the result is : prices still rise, but more slowly. , a sustained fall in the price level, is a different outcome and is not what the policy aims for.
Concepts:
How a rise in interest rates reduces inflationary pressure
The transmission mechanism of contractionary monetary policy, from the central bank's decision to its effect on demand-pull inflation, with the considerations that weaken or delay each link.
Select a node or a link label to see the reasoning behind it.
The chain for a rise in the policy rate has two stages. First, commercial banks pass the rise on: their own cost of funds is higher, so they raise the rates they charge on loans and pay on deposits. Second, the higher rates change spending through three components of aggregate demand.
- Consumption. Borrowing to buy durable goods costs more, so households buy fewer of them. Saving earns more, which raises the opportunity cost of spending now, so some households save a larger share of their income. Borrowers with variable-rate loans make higher repayments and have less left to spend. Higher rates also lower the prices of assets such as houses and shares, and households that feel less wealthy spend less (the ). falls.
- Investment. A firm invests when the expected return on a project exceeds the cost of financing it. Higher rates raise that cost, so projects that were only just worthwhile are postponed or cancelled. falls.
- Net exports. Higher returns on the country's financial assets attract savers from abroad. They need the currency to buy the assets, so demand for it rises and the rises. Exports become dearer in foreign currency and imports cheaper at home, so fall.
With consumption, investment and net exports lower, aggregate demand shifts left, real GDP falls and demand-pull pressure on prices eases. A cut in the policy rate runs the same chain in reverse: cheaper borrowing, a smaller reward for saving and a weaker currency raise consumption, investment and net exports, and aggregate demand shifts right.
Check your understanding
Using an AD/AS diagram, explain how an increase in the central bank's policy interest rate could reduce demand-pull inflation.
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Key terms
- Transmission mechanism
- The chain of cause and effect through which a change in the central bank's policy rate affects borrowing, spending, aggregate demand and, eventually, output and the price level.
- Consumption (C)
- Spending by households on goods and services.
- Investment (I)
- Spending by firms on capital goods such as machinery, equipment and buildings, together with new housing and changes in stocks.
- Net exports (X − M)
- The value of exports minus the value of imports.
- Exchange rate
- The price of one currency expressed in terms of another currency.
- Wealth effect
- A change in consumption caused by a change in the value of households' assets, such as housing or shares.
9Real and nominal interest rates
The is the rate actually quoted. The adjusts it for inflation and measures the true cost of borrowing and the true reward for saving:
The real rate matters for policy. If inflation rises while the nominal rate is unchanged, the real rate falls, so policy has effectively become looser. To tighten policy in real terms, a central bank must raise the nominal rate by more than any rise in inflation.
The same reasoning applies when prices fall. With deflation the rate of inflation is negative, so the real rate is higher than the nominal rate: a nominal rate of 1% with prices falling by 2% a year is a real rate of 3% (invented figures). Borrowing is then dearer in real terms than the quoted rate suggests.
Check your understanding
The figures are invented. (i) A bank charges a nominal interest rate of 6.5% on business loans. The inflation rate is 2.3%. Calculate the real interest rate. [2] (ii) In another country the consumer price index rises from 200 to 215 over a year, and savings accounts pay a nominal interest rate of 3%. Calculate the real interest rate on savings. [2]
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Key terms
- Nominal interest rate
- The stated interest rate, not adjusted for inflation.
- Real interest rate
- The interest rate adjusted for inflation: approximately the nominal interest rate minus the rate of inflation. It measures the true cost of borrowing and the true return on saving.
10Strengths and constraints
Evaluating monetary policy means weighing how well it reaches its goals against its limits in particular circumstances.
How well monetary policy works also differs between the goals it is aimed at.
- Low and stable inflation. This is its main use and where it is strongest. Against demand-pull inflation a higher interest rate lowers aggregate demand and so removes the cause. Against cost-push inflation it is costly, because it can lower inflation only by cutting output and employment further.
- Low unemployment. A cut in interest rates can reduce cyclical unemployment by raising aggregate demand, provided confidence is high enough for cheaper credit to raise borrowing. It cannot reduce structural or frictional unemployment, which do not come from a lack of demand. Once the economy is at full employment output, further cuts raise prices and not employment.
- Growth. A cut can raise actual growth in the short run when there is spare capacity, weakly when confidence is low or rates are already near zero. Its contribution to long-term growth is indirect: low, stable inflation encourages investment, but changes in interest rates do not themselves raise productive capacity, and a long period of high rates reduces investment.
Check your understanding
Check your understanding
Using real-world examples, evaluate the effectiveness of raising interest rates as a way of reducing inflation.
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Key terms
- Time lag
- The delay between a policy decision and its full effect on spending, output and prices.
- Consumer and business confidence
- How optimistic households and firms are about future incomes, sales and economic conditions. Confidence affects how strongly spending responds to interest rates.
- Cost-push inflation
- Inflation caused by rising costs of production, such as wages or imported raw materials, which shift short-run aggregate supply to the left.
- Central bank independence
- The degree to which a central bank sets monetary policy free from direct political control, usually to a mandate such as an inflation target.
11Practice and feedback: 10 marks
12Practice and feedback: 15 marks
13Practice and feedback: 4 marks
14Practice and feedback: 4 marks
15Practice and feedback: 4 marks
16Practice and feedback: 10 marksHL only
17Practice and feedback: 4 marksHL only
18Paper 2 practice set: Inflation and interest rates in Nordavia
This set has 9 parts worth 40 marks in all, and the whole set should take about 100 minutes. Every part uses the texts and data below. Answer each part in its writing workspace before you open the feedback under it.
Text A: Prices are rising at the fastest rate for thirty years
Paragraph 1: Nordavia's economy grew strongly in Year 1 as consumer confidence and bank lending surged. Unemployment fell to 3.1% in Year 2, well below the 4.5% that the central bank estimates to be the natural rate of unemployment, and firms report that they cannot find enough workers. Economists describe the result as demand-pull inflation. About one third of the rise in prices, however, is explained by a jump in the world price of natural gas, which Nordavia imports.
Paragraph 2: The Central Bank of Nordavia has an inflation target of 2%. During Year 2 it raised its interest rate in steps from 2.0% to 6.0%. It expects the full effect on spending to take between 12 and 18 months.
Text B: The housing squeeze
Paragraph 1: About 70% of mortgages in Nordavia have a variable interest rate, and household debt is equal to 140% of annual household income. The monthly repayment on a typical mortgage has risen by 900 kronor (NKr 900), and sales of houses have fallen.
Paragraph 2: Rents in the capital city rose by 15% in Year 2, to an average of NKr 1,150 a month. The city council responded by imposing a maximum rent of NKr 1,000 a month. The landlords' association estimates that at this rent tenants want to rent 260,000 apartments but only 220,000 will be offered, and it reports that some owners are converting apartments into offices.
Text C: A strong krona
Paragraph 1: Higher interest rates have attracted financial investment from abroad, and there was an appreciation of the krona of 8% against the euro in Year 2. Exporters of furniture and timber complain that they are losing orders.
Paragraph 2: The central bank points out that a stronger krona makes imported goods and raw materials cheaper. Its forecast (Table 1) shows inflation falling in Year 3, but it also shows slower growth and higher unemployment.
| Item | Year 1 | Year 2 | Year 3 (central bank forecast) |
|---|---|---|---|
| Consumer price index (CPI) | 125.0 | 135.0 | 140.4 |
| Central bank interest rate at the end of the year (%) | 2.0 | 6.0 | 6.0 |
| Real GDP growth (%) | 4.5 | 3.0 | 0.8 |
| Unemployment rate (%) | 3.4 | 3.1 | 4.6 |
| Exchange rate (euros per krona) | 0.100 | 0.108 | not forecast |
Define the term demand-pull inflation indicated in bold in the text (Text A, paragraph 1).
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Define the term appreciation indicated in bold in the text (Text C, paragraph 1).
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Using information from Table 1, calculate the rate of inflation in Nordavia in Year 2 and the rate of inflation forecast for Year 3.
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Using information from Table 1 and your answer to part (b)(i), calculate the real interest rate in Nordavia at the end of Year 2.
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Using an AD/AS diagram, explain how the increase in the interest rate is expected to reduce inflationary pressure in Nordavia (Text A, paragraph 2).
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Using a demand and supply diagram, explain the effect of the maximum rent on the market for rented apartments in the capital city (Text B, paragraph 2).
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Using an exchange rate diagram, explain how higher interest rates in Nordavia caused the krona to appreciate (Text C, paragraph 1).
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Using information from Text C, explain two ways in which the appreciation of the krona could help to reduce inflation in Nordavia.
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Using information from the text/data and your knowledge of economics, evaluate the effectiveness of higher interest rates as a way of reducing inflation in Nordavia.
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19Sources and review status
Written with AI assistance. The sources below were consulted on ; each entry says what it was used for and what it does not cover. Not reviewed by a teacher. Not approved as a finished revision resource.
Not yet checked against any source: the money-market diagram.
Sources consulted
Diploma Programme Economics guide (course first assessed 2022; October 2022 update; cover reads "First assessment 2024")
International Baccalaureate. IB curriculum document, learner's own copy, 10 Nov 2026. Printed pp. 20-21 (syllabus outline) and the topic tables on the printed pages recorded on each syllabus node; assessment outline pp. 60-65; command terms pp. 74-75. PDF page = printed page + 6.
Used for: Topic titles, the scope of each topic and SL/HL level, the assessment format and the command terms, as recorded on each syllabus node.
Limits: Read from the learner's own PDF, which is not redistributed. The IB's online copy could not be opened by automated access (HTTP 403 on 11 November 2026), so this copy was not compared with it. It sets what must be taught; it does not explain the economics. AI-assisted reading, not checked by a teacher.
Monetary Policy: Stabilizing Prices and Output
IMF Finance & Development, Back to Basics (Koshy Mathai). Reference, read in full, 11 Nov 2026. Whole article, dated 15 June 2021
Used for: Goals of monetary policy; open market operations and the short-term policy rate; transmission through interest-rate, balance-sheet, bank-lending, exchange-rate and expectations channels; inflation targeting; central bank independence; quantitative and credit easing after 2008.
Limits: Gives no lag durations and no diagram.
Price Stability Target of 2 Percent and Quantitative and Qualitative Monetary Easing
Bank of Japan. Real-world source, read in full, 11 Nov 2026. Outline of monetary policy page
Used for: The 2% CPI target set in January 2013.
Limits: Gives no inflation data.
Bank of England (database). Real-world source, read in full, 11 Nov 2026. Table of changes
Used for: Dates and levels of Bank Rate changes from March 2020 onward.
Limits: A table of decisions with no commentary.
Federal Reserve issues FOMC statement
Board of Governors of the Federal Reserve System. Real-world source, read in full, 11 Nov 2026. Statement, 26 July 2023
Used for: The federal funds target range raised to 5-1/4 to 5-1/2 percent.
Limits: One decision; no outcome data.
Money creation in the modern economy (Quarterly Bulletin 2014 Q1)
Bank of England (Michael McLeay, Amar Radia and Ryland Thomas). Reference, read in full, 11 Nov 2026. Published 14 March 2014. Abstract on the publication page; full article is the linked PDF, Quarterly Bulletin 2014 Q1, pp. 14-27 (overview p. 14; limits on money creation pp. 17-20; QE pp. 21-25).
Used for: Commercial banks create money when they lend: a loan creates a matching deposit. Banks do not simply lend out deposits, and the money-multiplier account runs the wrong way round. Limits on money creation: banks' own profitability and risk, regulation, repayment by households and firms, and ultimately monetary policy through interest rates. How quantitative easing creates broad money. Bank deposits were 97% of broad money at the time of writing. That most money is created by commercial banks making loans, that banks do not simply lend out deposits or multiply up central-bank money, and that monetary policy is the ultimate limit.
Limits: Describes the United Kingdom in 2014; the 97% figure is dated. It is an explanatory article by Bank staff, not a statement of IB syllabus scope.
Principles of Macroeconomics 3e: 14.4 How Banks Create Money
OpenStax, Rice University. Reference, read in full, 11 Nov 2026. Section 14.4
Used for: The textbook account: money creation by a single bank and by the banking system through lending; money multiplier = 1 / reserve requirement, with a worked example; cautions about the multiplier.
Limits: This is the deposit-multiplier account that the Bank of England article describes as a misconception of how money is created in practice; cite both and say so. University-level US textbook: its wording, examples and diagrams are not IB wording and it is not an authority for IB scope or SL/HL level.
Board of Governors of the Federal Reserve System. Real-world source, read in full, 11 Nov 2026. Policy Tools: Reserve Requirements; page last updated 26 November 2025
Used for: On 15 March 2020 the Board announced that reserve requirement ratios would be reduced to zero percent, effective 26 March 2020. Reserve requirement ratios reduced to zero percent, announced 15 March 2020 and effective 26 March 2020, for all depository institutions.
Limits: The page does not give the reason for the change. US only; other central banks still set positive requirements.
Principles of Macroeconomics 3e: 15.3 How a Central Bank Executes Monetary Policy
OpenStax, Rice University. Reference, read in full, 11 Nov 2026. Section 15.3
Used for: Open market operations, the discount rate, reserve requirements, interest on reserve balances and quantitative easing; states that US reserve requirements were cut to 0% in March 2020 and that the Fed now operates with ample reserves.
Limits: Federal Reserve practice only. University-level US textbook: its wording, examples and diagrams are not IB wording and it is not an authority for IB scope or SL/HL level.
Bank of England. Real-world source, read in full, 11 Nov 2026. Whole page (explainer and timeline)
Used for: QE is the purchase of bonds paid for with newly created central bank reserves, to lower longer-term interest rates. The Bank first used QE in March 2009, bought £895 billion of bonds in total (£875 billion gilts, £20 billion corporate bonds), last increased QE in November 2020, and began reducing the stock (quantitative tightening) in February 2022.
Limits: UK only. States the Bank's own account of its policy; it does not measure the effect of QE on output or inflation.
Bank of England. Real-world source, read in full, 11 Nov 2026. Explainer page
Used for: Start of QE in March 2009, the GBP 895 billion total (GBP 875bn gilts, GBP 20bn corporate bonds), the last increase in November 2020, the February 2022 decision to start reducing the stock and how QE lowers long-term rates.
Limits: The Bank's own account of the mechanism; it does not give the current stock.
Bank of England announces gilt market operation
Bank of England. Real-world source, read in full, 11 Nov 2026. News release, 28 September 2022
Used for: Temporary purchases of long-dated gilts to 14 October 2022, the financial-stability reason, and the postponement of gilt sales with the GBP 80bn reduction target unchanged.
Limits: The release does not mention the fiscal announcement that preceded the market move; the causal link is the standard reading, not stated in the source.
Principles of Macroeconomics 3e: 15.4 Monetary Policy and Economic Outcomes
OpenStax, Rice University. Reference, read in full, 11 Nov 2026. Section 15.4
Used for: Expansionary (loose) and contractionary (tight) monetary policy; the effect on interest rates in a loanable-funds diagram; the effect on aggregate demand in an AD/AS diagram.
Limits: Uses the loanable-funds market, NOT the money-market (money demand and money supply) diagram of the IB guide. Lists quantitative easing as an objective but does not explain it in the body. University-level US textbook: its wording, examples and diagrams are not IB wording and it is not an authority for IB scope or SL/HL level.
Consumer price inflation, UK: October 2022
UK Office for National Statistics. Real-world source, read in full, 11 Nov 2026. Statistical bulletin, main points
Used for: CPI at 11.1% in the 12 months to October 2022, the largest contributions and the estimate of inflation without the Energy Price Guarantee.
Limits: The 'without EPG' figure is an indicative ONS estimate.
Consumer price inflation, UK: May 2024
UK Office for National Statistics. Real-world source, read in full, 11 Nov 2026. Statistical bulletin, main points
Used for: CPI at 2.0% in the 12 months to May 2024 with core and services rates.
Limits: One month; services inflation remained well above target.
The Transmission of Monetary Policy
Reserve Bank of Australia. Reference, read in full, 11 Nov 2026. Explainer: two stages of transmission; channels; lags
Used for: Two stages (policy rate to other interest rates, then interest rates to activity and inflation); the saving-and-investment, cash-flow, asset-price and wealth, and exchange-rate channels; an estimate that the maximum effect takes about one to two years, with considerable uncertainty.
Limits: Describes Australia (for example the importance of variable-rate mortgages for the cash-flow channel).
What are interest rates and what is the difference between nominal and real interest rates?
European Central Bank. Reference, read in full, 11 Nov 2026. Explainer dated 25 May 2016
Used for: Nominal rate as the rate actually agreed and paid; real interest rate = nominal interest rate - inflation, with a worked example (2.5% nominal, 3% inflation, real return of -0.5%).
Limits: Uses actual inflation and the simple subtraction; it does not mention expected inflation or the exact compounding formula.
Principles of Macroeconomics 3e: 15.5 Pitfalls for Monetary Policy
OpenStax, Rice University. Reference, read in full, 11 Nov 2026. Section 15.5
Used for: Limits of monetary policy: long and variable lags, excess reserves, unpredictable velocity, the unemployment-inflation choice, asset bubbles, and the zero lower bound.
Limits: US episodes. University-level US textbook: its wording, examples and diagrams are not IB wording and it is not an authority for IB scope or SL/HL level.
Bank of England. Real-world source, read in full, 11 Nov 2026. Monetary Policy Summary
Used for: The 7-2 vote to raise Bank Rate by 0.75 percentage points to 3%, the September CPI figure, the projected peak, labour-market tightness and the GDP projection.
Limits: Projections made at the time, conditioned on market rates; the projected long recession did not occur as forecast.
Changes in the Monetary Policy Framework
Bank of Japan. Real-world source, read in full, 11 Nov 2026. Statement of 19 March 2024, sections 1 and (1)-(3)
Used for: End of the negative interest rate policy and yield curve control, the new 0 to 0.1% call-rate guideline, end of ETF and J-REIT purchases, continued JGB purchases.
Limits: PDF text extracted locally. A decision statement; it contains no evaluation of the earlier policy's effects.
Reserve Bank of Australia. Reference, read in full, 11 Nov 2026. Explainer: demand-pull; cost-push; inflation expectations
Used for: Demand-pull and cost-push inflation, each with a graph of aggregate demand and supply, and the role of inflation expectations.
Limits: The graphs are not labelled as IB AD/AS diagrams.
Principles of Macroeconomics 3e: 16.1 How the Foreign Exchange Market Works
OpenStax, Rice University. Reference, read in full, 11 Nov 2026. Section 16.1
Used for: The exchange rate as the price of one currency in terms of another; who demands and supplies a currency; appreciation and depreciation; who gains and loses from a stronger or weaker currency.
Limits: No currency-conversion calculation in the IB format. University-level US textbook: its wording, examples and diagrams are not IB wording and it is not an authority for IB scope or SL/HL level.
Principles of Macroeconomics 3e: 9.1 Tracking Inflation
OpenStax, Rice University. Reference, read in full, 11 Nov 2026. Section 9.1
Used for: Inflation as a general rise in the price level; pricing a basket of goods; index numbers with a base year; the inflation rate as the percentage change in the index, with a worked example.
Limits: The basket example is illustrative. University-level US textbook: its wording, examples and diagrams are not IB wording and it is not an authority for IB scope or SL/HL level.
Principles of Microeconomics 3e: 3.4 Price Ceilings and Price Floors
OpenStax, Rice University. Reference, read in full, 11 Nov 2026. Section 3.4
Used for: Definitions of price ceiling and price floor; a binding ceiling creates a shortage and a binding floor a surplus; rent control, EU farm price supports and the minimum wage as examples.
Limits: Does not cover indirect taxes or subsidies as policy tools, and has no welfare-area or stakeholder calculations. University-level US textbook: its wording, examples and diagrams are not IB wording and it is not an authority for IB scope or SL/HL level.
Principles of Macroeconomics 3e: 16.2 Demand and Supply Shifts in Foreign Exchange Markets
OpenStax, Rice University. Reference, read in full, 11 Nov 2026. Section 16.2
Used for: Determinants of exchange rates: expectations of future rates, differences in rates of return, relative inflation; purchasing power parity as a long-run anchor.
Limits: Does not list trade flows, remittances or central bank intervention as separate determinants. University-level US textbook: its wording, examples and diagrams are not IB wording and it is not an authority for IB scope or SL/HL level.
Exchange Rates and the Australian Economy
Reserve Bank of Australia. Reference, read in full, 11 Nov 2026. Explainer: effects of a depreciation on trade, activity and inflation
Used for: A depreciation makes exports cheaper abroad and imports dearer; net exports fall at first and rise later (the page names this the J-curve); effects on activity and employment; higher import prices raise inflation.
Limits: Does not state the Marshall-Lerner condition and does not discuss fixed or managed exchange rates.
Principles of Macroeconomics 3e: 16.3 Macroeconomic Effects of Exchange Rates
OpenStax, Rice University. Reference, read in full, 11 Nov 2026. Section 16.3
Used for: Exchange-rate changes alter the incentive to export and import and therefore aggregate demand; depreciation raises the burden of foreign-currency debt (Thailand 1997-98).
Limits: Does not explain the effect on inflation through import prices. University-level US textbook: its wording, examples and diagrams are not IB wording and it is not an authority for IB scope or SL/HL level.