Impact of Monetary Policy on Total Demand and Economy's Functioning
Monetary policy, a powerful tool wielded by central banks, plays a significant role in managing the economy. This policy affects the economy through its effects on the money supply and liquidity, interest rates, credit, asset prices, exchange rates, and economic actors' expectations.
Expansionary Monetary Policy
Expansionary monetary policy aims to stimulate economic growth by increasing the money supply in the economy. This results in increased liquidity, lower interest rates, and more credit availability.
When the central bank lowers interest rates or increases the money supply through means such as Quantitative Easing (QE) or by depreciating the exchange rate, it encourages borrowing and spending by firms and consumers. This boosts consumption (C) and investment (I), components of aggregate demand (AD = C + I + G + (X - M)). The increased demand raises economic output and employment but potentially risks higher inflation if overused.
Contractionary Monetary Policy
Contractionary monetary policy, on the other hand, aims to slow economic growth and reduce inflation. The central bank achieves this by raising interest rates, reducing the money supply, or implementing measures like selling government securities.
During contractionary monetary policy, an increase in interest rates makes borrowing more expensive, which lowers consumption and investment, shifting the AD curve to the left. This can slow economic growth and increase unemployment but helps reduce inflation. Selling government securities reduces the money supply, making credits scarce, tightening liquidity, and pushing interest rates up, thereby reducing aggregate demand.
Here's a summary of the effects of both types of monetary policy:
| Policy Type | Mechanism | Aggregate Demand Effect | Economic Outcomes | |----------------------|------------------------------------------------|---------------------------------|--------------------------------------------------------------| | Expansionary | Lower interest rates, increase money supply, QE, depreciate exchange rate | Shifts AD right (↑C, ↑I, possibly ↑X) | Higher output and employment, increased inflation risk | | Contractionary | Raise interest rates, reduce money supply, stop QE, appreciate exchange rate | Shifts AD left (↓C, ↓I, possibly ↓X) | Slower growth, lower inflation, possibly higher unemployment |
The central bank uses a combination of raising interest rates, selling government securities, and raising the reserve requirement ratio to pursue contractionary monetary policy. Lowering the reserve requirement ratio, on the other hand, allows commercial banks to lend more, resulting in increased credit availability.
In summary, monetary policy is an essential tool for central banks to manage economic cycles: expansionary policies counteract recessions by stimulating demand, while contractionary policies restrain excessive growth and inflation. By understanding the mechanisms behind these policies, we can better appreciate the central bank's role in maintaining a balanced and stable economy.
[1] "Expansionary Monetary Policy." Investopedia, Investopedia, 16 Feb. 2021, https://www.investopedia.com/terms/e/expansionarymonetarypolicy.asp.
[3] "Monetary Policy." Investopedia, Investopedia, 16 Feb. 2021, https://www.investopedia.com/terms/m/monetarypolicy.asp.
[5] "Contractionary Monetary Policy." Investopedia, Investopedia, 16 Feb. 2021, https://www.investopedia.com/terms/c/contractionarymonetarypolicy.asp.
In the context of the economy, expansionary monetary policy involves increasing the money supply, lowering interest rates, and encouraging borrowing, which can be achieved through quantitative easing or depreciating the exchange rate, all serving to boost business activities and finance growth. On the contrary, contractionary monetary policy aims to slow economic growth and reduce inflation by raising interest rates, reducing the money supply, or implementing measures like selling government securities, which can adversely affect the financial sector and overall business activity.
