IB Economics SL — Demand Management: Monetary Policy: Notes, Questions & Solutions

IB Economics SL — Demand Management: Monetary Policy: Notes, Questions & Solutions

Monetary policy is the use of interest rates and money supply, typically controlled by a central bank, to influence aggregate demand and achieve macroeconomic objectives such as low inflation and low unemployment.

Key points

• A cut in the policy interest rate lowers borrowing costs, encouraging consumption and investment, which raises AD.

• Monetary policy is usually set independently of government by a central bank, reducing political interference.

• Quantitative easing is an unconventional tool used when interest rates are already very low.

• Monetary policy affects AD, so its diagrammatic effect is identical to a rightward shift shown in aggregate demand and aggregate supply.

Practice questions

1. Explain the transmission mechanism from an interest rate cut to higher aggregate demand. (Lower interest rates reduce the cost of borrowing and the return on saving, encouraging households and firms to spend and invest more, which raises AD).

2. What is expansionary monetary policy generally used to combat? (Rising unemployment or a recession, by stimulating aggregate demand).

3. Name one risk of using expansionary monetary policy for too long. (It can cause demand-pull inflation if AD rises faster than the economy’s productive capacity).

4. Why is monetary policy often set by an independent central bank rather than the government directly? (To reduce the risk of politically motivated decisions, such as cutting rates before an election regardless of economic conditions).

5. What is quantitative easing and when is it typically used? (A central bank buying financial assets to inject money into the economy, typically used when interest rates are already near zero).

 

Written by sortmyprep | Reviewed by IB Teacher | Last updated: September 15, 2026