Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Setting the interest rate: Impacts through monetary policy
Monetary policy is when policy makers (usually the central bank) use the money supply to influence the economy. (For a detailed look at monetary policy, check out Chapter 10.) Here we look at how monetary policy impacts on aggregate demand, including expansionary and contractionary policies, as we do for fiscal policy in the preceding section. Again, changes in monetary policy ‘shock’ the AD–AS system and cause the price level, real GDP and unemployment to change.

The central bank is a powerful institution because it has a monopoly over the creation of new money: it can create money out of thin air by simply printing more! Central banks typically use their ability to change the money supply in order to affect the interest rate in an economy. To see how, you need to understand how the money market works.

The money market is like any other market: the price of money is determined by supply and demand. When you think of the interest rate as the price of holding money, you can see exactly what we mean by the ‘price’ of money.

Holding money is great: it allows you to purchase goods and services easily. Economists say that money is very liquid (no doubt you’ve noticed how it drips away when you go shopping!). But this liquidity comes at a cost: money doesn’t give you any return. The £10 note you’re carrying around with you will still be a £10 note tomorrow, next year

and so on. In fact, if inflation is positive (which it usually is) your money buys less and less the longer you hold onto it. In addition, if instead of holding the money you deposit it in a savings account, you’d earn a return equal to the interest rate. Therefore, by holding money you’re giving up the opportunity to earn a return on it.


The (nominal) interest rate is the opportunity cost of holding money. This important observation means that when the interest rate is high, the demand for money is low: people don’t want to hold very much cash. As the interest rate falls, people become more willing to hold larger amounts of cash. The money demand curve in Figure 9-8 represents this effect.

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Figure 9-8: The demand for money.

As the interest rate falls, so too does the opportunity cost of holding money, which means that people demand more money. Because the central bank can choose the supply of money in an economy, it can effectively set the interest rate by varying the money supply (see Figure 9-9). The central bank sets the money supply equal to M_S, which determines the interest rate in equilibrium (equal to i₀ in Figure 9-9).

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Figure 9-9: Equilibrium in the money market.