Monetary Policy Explained
Monetary Policy is the government’s process of controlling the supply of money in the country. This process is typically administered by the country’s monetary policy makers like the Treasury in Britain and the Federal Reserve in America. Alongside fiscal policy, monetary policy is one of the two most powerful tools at the government’s disposal in achieving set economic goals like inflation and GDP growth. These goals are often set by the government and it is up to the monetary policy administrators achieve those targets.
Although there are several instruments used in setting monetary policy, the most important tool in determining monetary policy is manipulation of interest rates. In layman terms, the interest rate is the rate where money can be borrowed or supplied in the economy. The monetary policy administrators will set the interest rate at the macro level which affects the banks and financial institutions. The macro level interest rate will then be used by these players in the financial industry to set micro level interest rates which will affect the general public. By setting the interest rates are a certain level, policy makers try to affect change in the country’s economy. This is the essence of monetary policy and is practiced by all countries in the world.
As said, monetary policy is an important tool in the management of a country’s economy. This is because monetary policy can be expansionary or contractionary. You may be surprised as to why a government would want to contract its economy but is actually happens more often than not. A contractionary monetary policy is used when the economic growth of a country is too fast or overheating causing price instabilities and high inflation. This phenomenon was recently encountered by China where years of double digit GDP growth has caused massive inflation in the country. Therefore, the country had no choice but to use a contractionary monetary policy to rein in economic growth to cool down the economy and return consumer prices to normalcy
On the other hand, the countries like Japan, American and the Euro have been aggressively pursuing an expansionary monetary policy to counter the effects of the global financial crisis. These countries are facing massive unemployment numbers and a lack of business or job creation. An expansionary monetary policy is used to spur business growth as the cost of borrowing money is lower through the lowering of interest rates.
Using monetary policy as a tool to control the economy has been a hallmark of Keynesian economics for over a hundred years. However, if there is a systemic breakdown in the global economy, then monetary policy by itself may not be enough to stimulate growth as evidenced by the current state of the global economy.