Monetary Policy

What is Monetary Policy?

• Monetary policy refers to the actions undertaken by a central bank such as the Bank of England to manage money supply and interest rates in order to achieve macroeconomic objectives like inflation, economic growth, and unemployment.
• Monetary policy is implemented through various tools including, but not limited to, open market operations, changing reserve requirements, and changing discount rates.

Types of Monetary Policy

• Contractionary Monetary Policy: This policy is pursued when an economy is in an inflationary gap where actual output is higher than potential output. A central bank will increase interest rates and decrease money supply to cool down the economy.
• Expansionary Monetary Policy: This policy is executed when an economy is in recession with high unemployment. A central bank will lower the interest rates and increase money supply to stimulate economic growth and reduce unemployment.

Key Instruments of Monetary Policy

• Interest rate: The rate at which the central bank lends money to commercial banks. Changes in interest rate affect the cost of borrowing, rate of return on savings, inflation, and overall economic growth.
• Open market operations: These operations involve the purchase or sale of government bonds to manipulate the level of money supply.
• Reserve requirements: Central banks may alter the amount of funds that banks need to hold in reserve. Increasing the reserve requirements decreases the money supply, while decreasing it achieves the opposite.

Advantages of Monetary Policy

• Monetary policy is typically administered by the central bank, which gives it a level of flexibility and independence from government.
• It enjoys a shorter inside lag (the time it takes for policy to be implemented) in comparison to fiscal policy.
• It has a direct impact on interest rates, which affects investment, consumption, and net export levels.

Disadvantages of Monetary Policy

• It suffers from an outside lag, meaning the time between policy implementation and real impact on the economy can be long.
• Monetary policy may be less effective in a liquidity trap, where changing interest rates has minimal effect on consumer spending and investment.
• It might worsen income inequality as those with high levels of debt benefit more from rate cuts than those without.

Note: Understanding monetary policy can give you insights into central banking functions and it’s direct effect on the economy. When revising, remember to focus on its purpose, instruments, advantages, and disadvantages.