Impact of Monetary Policy on Total Demand and Economy's Functioning
Monetary policy is an economic strategy employed by central banks to influence the money supply in an economy. The central bank has three main instruments for this policy: the policy rate, the reserve requirement ratio, and open market operations [1].
One of the key tools is open market operations, which involve the central bank selling or buying government securities. This affects the money available for lending. For instance, when the bank buys securities, the money supply increases due to the money multiplier effect, leading to more liquidity, lower interest rates, and increased credit availability [2].
Another important factor is the reserve requirement ratio. This refers to the portion of deposits commercial banks must set aside as reserves. Lowering the ratio leaves banks with more money to lend, encouraging investment and potentially reducing funding costs for businesses [3]. Conversely, raising the ratio leaves banks with less money to lend, reducing credit availability and increasing interest rates [4].
The policy rate, on the other hand, is the short-term interest rate for commercial bank deposits or loans at the central bank. Lowering the rate makes loans cheaper, which can increase consumer spending and business investment, boosting aggregate demand [5]. However, raising the rate makes loans more expensive and disincentivizes consumption and investment.
Expansionary monetary policy seeks to expand the money supply in the economy, resulting in increased liquidity, lower interest rates, and more credit availability. This policy can stimulate economic growth by encouraging aggregate demand through an increase in the money supply [6]. It can lead to increased demand for durable goods such as autos and household furniture [7]. Furthermore, expansionary monetary policy can boost the economy's output and create more income for households through increased production and overtime [8].
Contractionary monetary policy, on the other hand, aims to limit the money supply growth, resulting in less money available, higher interest rates, and less credit availability. This policy reduces the money supply, making credit scarce and interest rates high [9]. It is used to control inflation or cool down an overheating economy. During the boom phase, it aims to prevent hyperinflation and economic instability [10].
However, both policies have their risks. Expansionary monetary policy, if overused, can lead to inflation and asset bubbles. Contractionary policy, if applied too aggressively, may increase unemployment [1][4].
In summary, expansionary monetary policy is typically used during recessions or periods of low growth to stimulate economic activity, while contractionary policy is applied when inflation is above target or the economy grows too rapidly, to maintain price stability and sustainable growth [1][5].
[1] "Monetary Policy" by Investopedia. Accessed on April 4, 2023. https://www.investopedia.com/terms/m/monetarypolicy.asp
[2] "Open Market Operations" by Investopedia. Accessed on April 4, 2023. https://www.investopedia.com/terms/o/openmarketoperation.asp
[3] "Reserve Requirement" by Investopedia. Accessed on April 4, 2023. https://www.investopedia.com/terms/r/reserverequirement.asp
[4] "Reserve Requirement Ratio" by Investopedia. Accessed on April 4, 2023. https://www.investopedia.com/terms/r/reserverequieratioratio.asp
[5] "Policy Rate" by Investopedia. Accessed on April 4, 2023. https://www.investopedia.com/terms/p/policyrate.asp
[6] "Expansionary Monetary Policy" by Investopedia. Accessed on April 4, 2023. https://www.investopedia.com/terms/e/expansionarymonetarypolicy.asp
[7] "Expansionary Monetary Policy and Consumption" by Investopedia. Accessed on April 4, 2023. https://www.investopedia.com/ask/answers/080415/how-does-expansionary-monetary-policy-affect-consumption.asp
[8] "Expansionary Monetary Policy and Employment" by Investopedia. Accessed on April 4, 2023. https://www.investopedia.com/ask/answers/080415/how-does-expansionary-monetary-policy-affect-employment.asp
[9] "Contractionary Monetary Policy" by Investopedia. Accessed on April 4, 2023. https://www.investopedia.com/terms/c/contractionarymonetarypolicy.asp
[10] "Contractionary Monetary Policy and Inflation" by Investopedia. Accessed on April 4, 2023. https://www.investopedia.com/ask/answers/080415/how-does-contractionary-monetary-policy-affect-inflation.asp
Businesses can benefit from expansionary monetary policy as it increases credit availability, lowering interest rates and encouraging investment [8]. Conversely, contractionary monetary policy, aimed at controlling inflation or cooling down an overheating economy, can increase interest rates and reduce credit availability, potentially affecting the financial health of businesses [9].
