Macro 2

Monetary policy is a tool used by the central bank, currency board or other regulatory committee to manage money supply in the economy in order to achieve a desirable growth. The central bank controls the money supply by increasing and decreasing the cost of money and the rate of interest.

Monetary policy can either be expansionary or contractionary in nature. Under an expansionary policy, policy makers increase the money supply in the system by lowering interest rates. This is done mainly to boost economic growth and decrease level of unemployment.

On the other hand, in contractionary policy, the cost of money is made dearer by increasing the rate of interest, which in turn helps in reducing the money supply in the system and combat inflation. Thus, while expansionary policy is followed to boost the economic growth, a contractionary policy is adopted to deal with an overheated economy situation.
Suitability of the Monetary Policy in Stabilizing the Economy
  * Because of the impact monetary policy has on financing conditions in the economy (not just the costs, but also the availability of credit or banks’ willingness to assume specific risks) but also because of its influence on expectations about economic activity and inflation, monetary policy can affect the prices of goods, asset prices, exchange rates as well as consumption and investment.
  *   Interest rate cuts, for example, lower the cost of borrowing, which results in higher investment activity and the purchase of consumer durables.  The expectation that economic activity will strengthen may also prompt banks to ease lending policy, which in turn enables businesses and households to boost spending.  In a low interest-rate environment, shares become a more attractive buy, raising households’ financial assets. This may also contribute to higher consumer spending, and makes companies’ investment projects more attractive.  Lower interest rates also tend to cause currencies to...