Monetary policy

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Monetary policy is the government or central bank process of managing money supply to achieve goals?such as constraining inflation, maintaining an exchange rate, achieving full employment or economic growth. Monetary policy can involve admending certain interest rates, directly or indirectly through open market operations, setting reserve requirements, or trading in foreign exchange markets.

Monetary policy lies on the relationship between the rates of interest in an economy, ie the price at which money can be borrowed and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the interest rate and the money supply in order to achieve policy goals.

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A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate, the growth of demand is then under control. For instance, during the late 80s, interest rates went up to 15% as the excessive growth in the economy and contributed to the recession of the early 90s.

Higher interest rates keep aggregate demand lower in 3 ways:

Households and companies are discouraged to borrow money
The rate of saving is increased, ie. the opportunity cost of spending has increased.
Mortgage interest payments go up and the real disposable income and will be reduced and their ability to spend is lowered. Increase in mortgage costs will reduce demand in housing market.

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Besides, investment may fall as well, since the cost of borrowing will increase. Planned investment might become now unprofitable. Thus lower the aggregate demand.

An expansionary policy increases the size of the money supply, or decreases the interest rate. Further monetary policies are described as accommodative if the interest set by the central monetary authority is intended to spur economic growth, neutral if it is intended to neither spur growth or combat inflation, or tight if intended to reduce inflation or "cool" an economy. A rise in real interest rates should be able to reduece the demand for lending and the growth of broad money would then be reduced.

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