Monetary policy refers to the use of interest rates, money supply and exchange rate to influence macroeconomic objectives.
Interest rate can be defined as the cost of borrowing or the benefits of savings. A rise in interest rate will make borrowing more expensive and create more incentive to save which reduces overall spending in an economy.
Money supply is the amount of money in an economy at a particular time. If there is an increase in money supply in an economy as a result of reduced interest rate, it will increase consumption and investment expenditure in the country.
Exchange rate is the price of one currency measured in terms of another currency. An increase in money supply as a result of a fall in interest rate will lead to an increase in importation thereby demanding foreign currency. This might lead to the currency being devalued in the long run.
Monetary policy can be used in 2 different ways just like Fiscal policy to increase demand, they are:
Expansionary Monetary Policy: this seeks to increase economic activity by increasing money supply which is achieved by a decrease in interest rates. This encourages firms to borrow and invest in their business and employ more people to increase their output.
Contractionary Monetary policy: this seeks reduce economic activity within an economy by reducing money supply achieved through an increase in interest rates. It can be used to reduce the threat of inflation and can also hinder economic growth and cause an increase in unemployment.
Impacts of monetary policy on macroeconomic aims
Economic Growth: with lower interest rate, it makes it very easy to achieve economic growth as reduced cost of borrowing will ensure that there is increased spending for firms and individuals which increases consumer spending and investment in businesses. This move will guarantee an increase in output and infrastructures within the economy.
Inflation: economic growth stimulated by lower interest rates will result in higher consumption and investment expenditure. This will increase the productive capacity of the economy and firms will benefit from economies of scale without having to increase prices of goods and services.
Low unemployment: Lower interest rates ensures creation of jobs as more firms would have the capacity to expand as a result of increased spending power of consumers within the economy.
Balance of International payment: a lower exchange rate through government intervention in the foreign exchange market will tend to improve the international competitiveness of the country which will help set a favorable balance of payment.