Monetary Policy involves the country’s central bank controlling the interest rate and money supply. Monetary policy affects Aggregate Demand (AD), and an expansionary monetary policy increases AD, while a contractionary monetary policy decreases AD.
The goals of monetary policy are to promote employment, stabilize prices and control long-term interest rates, thereby supporting conditions for long-term economic growth and maximum employment.
Expansionary Monetary Policy
This policy requires a decrease in interest rate and/or increase in money supply. It is used when the economy is in a recession and unemployment is high.
Since people make most big purchases (homes, cars, washing machines) on finance, a lower interest rate would encourage spending/consumption.
A lower interest rate could also make savings look less attractive. This will encourage consumer consumption.
Investment will increase as firms will find it more profitable to invest or borrow money. It will become cheaper for businesses to borrow money.
4. Exchange Rate
A lower interest rate could lead to a depreciation in the exchange rate, making exports more attractive than imports.
Contractionary Monetary Policy
This policy requires an increase in interest rate and/or decrease in money supply. It is used when the economic growth is unstable and inflation is high.
Uncontrollable inflation could result in an increase in the interest rate, which could lower Aggregate Demand.
With a higher interest rate, savings will become more attractive.
Consumption will fall as borrowing costs will rise.
4. Lower Investment
Investment will fall as firms will find it more expensive to borrow.
Central Banks have the ability to change interest rates whenever they want. The timing on the change is crucial. The head of the Central Bank plays a very important role in the economy.
Problems with Monetary Policy
- Consumption and investment are not only dependent on the interest rate.
- If the interest rate is near zero, it can’t be reduced any more, making it a useless tool.
- Monetary policy is characterized by time lags, where the effect is only felt several months later.
- Firms and households can borrow from anywhere in the world.
- Under a fixed exchange rate, a change in the interest rate would pressure on the exchange rate.