The Impact of Monetary Policy on The Economy

A country's central bank uses a set of instruments called monetary policy. This policy is used to control money supply, boost the economic growth, and implement measures like adjusting interest rates and altering bank reserve requirements. It also used to control economic turbulence and achieve price stability (price stability means low and stable inflation).

Central banks modify monetary policy by adjusting the amount of money supply. This usually happens through buying or selling securities in the open market. Short-term interest rates are impacted by open market operations, which in turn affect longer-term rates and economic activity. Monetary policy is easing when the central bank reduces the interest rate and it is tightening when the central bank increases the interest rate. Thus, the effects of monetary policy on the economic activities are as follows:

When the interest rates decrease, financial institutions can obtain funds at low interest rates. This authorizes them to decrease their lending rates on loans to firms and households. Given the interdependence among different financial markets, the decline is not only in the financial institutions' lending rates but also in the interest rates at which companies borrow directly from the market, such as in the form of corporate bond issuance. In this case, companies find it simpler to obtain operating capital (which are funds that are used for the payment of wages and input costs) and fixed investment funds (which are funds are used for constructions). While households find it simpler to borrow money. Thus, firms' and households' economic activity picks up, and in turn they stimulates the economy. Upward pressure on prices is also generated in turn. The monetary policy measures that are aimed to stimulate the economy are called Monetary Easing.

When the interest rates rise, financial institutions borrow money at higher costs. They raise their lending rates on loans to firms and households. Firms and households find it difficult to borrow funds, which makes their economic activity inactive. This exerts downward pressure on prices. The monetary policy measures that are aimed to overheat the economy are called Monetary Tightening.

Most economists agree that the output which is usually measured by gross domestic product (GDP) is fixed on the long term, so any changes in money supply can cause changes in prices. But in the short term, changes in money supply can affect the actual production of goods and services because prices and wages do not adjust immediately. Monetary policy is considered as a meaningful policy tool since it achieves two objectives which are both inflation and growth.

Recession hinders the process of undertaking new projects, and it decreases the research and development operations. An economic downturn leads to descent in demand for company’s products as customer’s incomes decrease. Thus, the return to investment will be decreased. Recessions are periods that may lead companies to economize toward “core” products and production techniques. Therefore, they may be less likely to try new techniques that authorize them to increase production. As a result, during recession employees are less able to use all of their skills and there is no need to “up skill” current worker or hire new workers (Irons, 2009), so the demand for labor is reduced and there will be a large percentage of unemployed people.

Monetary policymaker must balance between price and output objectives. Indeed, even central banks like the European Central Bank (ECB) its only target is inflation, but it generally admits that it also pays attention to stabilizing output and keeping the economy near full employment.

Most of the economists believe that monetary policy should be managed by a central bank or some similar institution that is independent from the elected government. This belief comes from the academic researches that emphasizes the problem of time inconsistency. Monetary policymakers who are less independent from the government would promise to keep down the inflation expectations among consumers and businesses. But later, in response to subsequent developments, they might find it hard to resist expanding the money supply, this lead to “inflation surprise.” This surprise would at first boost output, by making labor relatively cheap. But people would soon recognize this “inflation bias” and ratchet up their expectations of price increases, making it difficult for policymakers ever to achieve low inflation.