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Monetary and Supply-Side Policy: Question 6

Syllabus 4.3

Structured 9 marks

Kestrion's central bank cuts its main policy interest rate from 6% to 3.5% per year, aiming to boost spending and reduce unemployment. A small manufacturing firm in Kestrion has an outstanding bank loan of $60,000 at a variable interest rate that moves in line with the policy rate.

(a) Explain why cutting the interest rate is classified as a monetary policy measure rather than a fiscal policy measure. [2]

(b) Calculate the fall in the firm's monthly interest cost caused by the cut in the interest rate from 6% to 3.5%. [4]

(c) Explain how the cut in the interest rate is expected to help reduce unemployment in Kestrion. [3]

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Worked solution

Part (a): Why an interest rate cut is monetary policy

Cutting the interest rate changes the price of borrowing and the reward for saving. It is one of the three instruments of monetary policy, alongside changes in the money supply and the exchange rate, and is carried out through the central bank. This is different from fiscal policy, which works through changes in government spending and taxation.

Part (b): Calculating the fall in monthly interest cost

At the original rate of 6%, the annual interest on the $60,000 loan is: 0.06×60,000=3,6000.06 \times 60{,}000 = 3{,}600 so the annual cost is $3,600, which is $300 a month (3,600÷12=3003{,}600 \div 12 = 300).

At the new rate of 3.5%, the annual interest on the same loan is: 0.035×60,000=2,1000.035 \times 60{,}000 = 2{,}100 so the annual cost is $2,100, which is $175 a month (2,100÷12=1752{,}100 \div 12 = 175).

The fall in monthly interest cost is: 300−175=125300 - 175 = 125

So the interest rate cut reduces the firm’s monthly interest cost by 125\boxed{125}, i.e. $125 a month.

Part (c): Explaining the effect on unemployment

A lower interest rate reduces the cost of borrowing and lowers the reward from saving. Households are more willing to borrow and spend rather than save, and firms (like the manufacturing firm above, whose loan repayments have just fallen) find it cheaper to borrow for new investment. As consumer spending and firm investment both rise, total demand for goods and services in Kestrion’s economy increases. To meet this higher demand, firms typically need to produce more, which usually means taking on extra workers, so unemployment is expected to fall.

Final answers

  • (a) An interest rate cut is a monetary policy measure, made through the interest rate (one of the three monetary instruments), not through government spending or taxation.
  • (b) The firm’s monthly interest cost falls by $125.
  • (c) Cheaper borrowing and lower reward for saving raise spending and investment, increasing demand and encouraging firms to hire more workers, which helps reduce unemployment.