Explain how interest rates can be used by a central bank to increase AD (9 marks)

Monetary policy is the use by the central bank of interest rates, money supply and the exchange rate to regulate the level of economic activity in the economy. Expansionary monetary policy is monetary policy designed to stimulate growth in aggregate demand, for example by cutting the base rate of interest. If the central bank (eg the Bank of England in the UK) cuts the base rate of interest commercial banks will do so too as they base their interest rates on the base rate. Lower interest rates will reduce the cost of borrowing credit for consumers whilst also reducing the return on savings, reducing the opportunity cost of borrowing and increasing the opportunity cost of saving. This will encourage households to borrow and spend more credit, increasing consumption, which accounts for roughly 60% of AD in the UK. It will also encourage firms to borrow and spend too, for the same reasons, increasing investment, another component of AD. Thus, a cut in interest rates will lead to an increase in AD as shown below from AD to AD1, increasing real GDP growth from Y to Y1 and demand-pull inflation from P to P1. [AD/AS diagram with shift to right in AD would be shown on whiteboard with title, labeled axes and dotted lines]