Monetary policy is one of the main instruments of macroeconomics. It is based on the ability of the Central bank to control the money supply, which leads to changes in interest rates and the exchange rate, and therefore in the amount of investment, which influences directly the national output. This method of controlling the economy centres on adjusting the amount of money in circulation in the economy and so the level of spending and economic activity.
Monetary policy was first used as a means of control in the 1950s, but has been more widely used since the 1970s. The Central Bank plays a major role in the implementation of a nation's monetary policy. In some countries (for example, Germany) the Central Bank operates monetary policy independent of government policy. However, the UK's Central Bank, the Bank of England, implements monetary policy on behalf of the government.
Monetary policy has three main aspects:
· Controlling the money supply
· Controlling interest rates
· Managing the exchange rate
The aim of the authorities when controlling the money supply is to limit the amount borrowed (and spent afterwards) by businesses and individuals during a inflationary period. It is hoped in this way to limit the level of overall demand in the economy and thus to remove or reduce inflationary pressure. During a recession monetary policy is aimed at increasing the money supply to encourage spendings.
Monetary policy is often referred to as either expansionary or contractionary. Expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will encourage businesses into expanding. Contractionary policy is intended to slow inflation in hopes of avoiding deterioration of asset values.
Moreover, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if it is intended to reduce inflation. There are several monetary policy tools to achieve these objectives.