What is Monetary Policy?
According to the Grant (2000), Monetary policy can be defined as the attempts to manipulate either the rate of interest or the money supply so as to bring about desired changes in the economy. It aims to maintain price stability, full employment and economic growth.
The Monetary Policy can adjust the supply of money and the rates of interest in the economy. It deals with both the lending and borrowing rates of interest for commercial banks.
Controlling interest rates
It is also important to consider the effects of changing interest rates at a micro-level. Cutting interest rates will encourage people (and firms) to borrow more money. It will also give people who have mortgages more money to spend. The combination of these effects will increase the levels of consumption and investment. Since consumption and investment are two key factors of aggregate demand, cutting interest rates can result in increasing economic growth. In contrast, if the economy is growing too fast, causing inflation, government may choose to increase the interest rate, slowing the economy.
Changing money supply
Changes in the supply of money are not the only factor that influences the equilibrium interest rate and they can shift money demand. The demand for money depends on both the interest rate and the volume of transactions, and the level of aggregate output (income) can be a rough measure of the volume of transaction. In addition, the relationship between money demand and level of aggregate output (income) is positive. Consequently, changing that changing money supply can conduct the level of economic activity.
The central bank and monetary policy
The central bank can affect the interest rate by changing the quantity of money supplied. If it increases the quantity of money, the interest rate falls; if it decreases the quantity of money, the interest rate rises.
The reasons that the central bank might want to change the interest rate, a low interest rate can active spending, particularly in investment; a high interest rate can reduce spending. By changing the interest rate, the central bank can change aggregate output (income).
Expansionary Policy
Any government policy aimed at activating aggregate output (income) is said to be expansionary. The effect of these policies would be to encourage more spending and raise the level of economic activity.
Expansionary fiscal policy
Government purchases and net taxes are the two tools of government fiscal policy. It can be used in various different ways. The government can influence the level of economic activity either by increasing government purchases or by reducing net taxes.
It may be used to try to raise the level of economic activity when the economy in a recession, in this case it is called fiscal expansionary policy.
An expansionary fiscal policy could include:
1. Cutting the lower, basic or higher rates of tax,
2. Increasing the level of government expenditure,
Governments may choose to use expansionary fiscal policy in times of recession or a general downturn in economic activity. In this situation they will use their fiscal policy to give a boost to the economy. They may do this by lowering taxes in some forms or by increasing the level of government expenditure. This will encourage people to spend more.
Alternatively they could lower taxes. This will raise people's disposable income; therefore encourage them to spend more. The level of demand can rise and help encourage economic growth in either way in the economy
According to the Dobson and Palfreman (1999), in the 1950s and 1960s fiscal policy was seen as the most important way of controlling the economy-governments were influenced by Keynes’s view that level of spending in the economy determined the level of output and employment.
Crowding-out effect
The tendency for increases in government spending to cause reductions in private investment spending is called the crowding-out effect. In some particular conditions, planned investment spending is partially crowded out by the higher interest rate.
Otherwise, the crowding-out effect depends on the interest sensitivity of planned investment spending to changes in the interest rate. When a higher interest rate reduces planned investment spending, crowding out happens. Generally, investment depends on factors of the interest rate, however, sometime, investment may be quite insensitive to changes in the interest rate. If planned investment does not fall when the interest rate rises, there is no crowding-out effect.
Expansionary monetary policy
Monetary policies are ones that use the level of the money supply and interest rates to influence the level of economic activity. The government may want to use their monetary policy to boost economic activity if the economy is in a recession.
Government may choose to use expansionary monetary policy when economy is in a downturn. This would mean:
-
Reducing the level of interest rates
- Increasing the rate of growth of the money supply
Figure 2
Contractionary policy
In contrast, when the economy is growing too fast, government or firms may choose to use the contractionary policy to slow down the economy growth. The contractionay policy aims at reducing aggregate output (income), it can be used to fight inflation.
Fiscal policy or monetary policy
The issue whether fiscal or monetary policy is more effective in shifting aggregate demand has been being debated between the Keynesian and monetarist for a long time.
Extreme Keynesians support that only fiscal policy is effective, while extreme monetarists convinced that only monetary policy is effective. Research has shown that both two points of view are too extreme; both fiscal and monetary policy affects aggregate demand.
When fiscal and monetary policies are used together. For example, in expansionary policy, policy aimed at increasing output and employment.
Figure 3
Simply, expansionary fiscal occurred with expansionary monetary policy could mean that aggregate demand would be shifted to the further right. Prices would depend on the slope of the aggregate supply curve. This is illustrated in Figure3, where aggregate demand shift from AD0 to AD1, aggregate supply (AS) is moving up, the price level rises from P0 to P1, and output rises from Y0 to Y1. Consequently, expansionary fiscal and monetary policy working together are more effective than either working independently
Conclusion
In conclusion, it appears that government macroeconomic policy should be used carefully and with a well understanding of the consequences of the policies in the short and long run.
Fiscal policies can have long-run effects on saving, investment, the trade balance and growth. Monetary policy can ultimately determine the level of prices and affect the inflation rate. The debate about which particular tool is most appropriate will continue, whereas most economists recognizes the advantages of using fiscal and monetary policy to prevent the recession in our economy or extreme inflation.
