Discuss The Effectiveness Of The Monetary Policy i

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Discuss the effectiveness of the monetary policy in increasing AD (25 Marks) The monetary policy involves changes in the base rate of interest to influence the growth of aggregate demand, the money supply and price inflation. Monetary policy works by changing the rate of growth of demand for money. Changes in short term interest rates affect the spending and savings behaviour of households and businesses and therefore feed through the circular flow of income and spending. Monetary policy influences the decisions that we make about how much we save, borrow and spend. There are several ways in which changes in interest rates influence aggregate demand, one of the main changes are through the housing market & house prices. For example higher interest rates increase the cost of mortgages and eventually reduce the demand for most types of housing. This will slow down the growth of household wealth and put a squeeze on equity withdrawal (consumers borrowing off the back of rising house prices) which adds directly to consumer spending and can fuel inflation. Another situation where the monetary policy increases AD is through disposable incomes of mortgage payers. For example, if interest rates increase, the income of homeowners who have variable-rate mortgages will fall – leading to a decline in their effective purchasing power. The effects of a rate change are greater when the level of existing mortgage debt is high, leading to a rise in debt-servicing burdens for home-owners. On the other hand, a rise in interest rates boosts the disposable income of people who have paid off their mortgage and who have positive net savings in bank and building society accounts. Consumer demand for credit would also increase Aggregate Demand, as higher interest rates increase the cost of servicing debt on credit cards and should lead to a deceleration in the growth of retail sales and

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