Monetary Policies

Monetary policy are demand-side policies, which target the aggregate demand of an economy by influencing interest rates and controlling the money supply.  

The central bank is an independant organization, which is responsible for adjusting the base interest rate of an economy. Their primary objective is to hit the target inflation rate (usually 2%).

How does interest policy work?

• Expansionary: (decrease in IR)
• Consumption increases - less incentive to save due to lower returns & demand for mortgages increases due to lower interest payments
• Investment increases - more incentive to invest into capital due to lower cost of borrowing

• Contractionary: (increase in IR) 
• Consumption decreases - more incentive to save due to higher returns & demand for mortgages decreases due to higher interest payments
• Investment decreases - less incentive to invest into capital due to higher cost of borrowing

Advantages of using monetary policies:

1. affect consumption & investment ( both large components of AD)
2. Not affected by politics
3. faster than other demand-side policies
4. can affect AS as well as AD
5. easily reversible

Disadvantages :

1. Money supply policy can get out of control leading to stronger/uncontrollable inflation

2. Time lag - need long time to implement (usually 18 months)

3. useful for demand-pull inflation, but ineffective when controlling cost-push inflation

4. Interest rates cannot fall below 0

5. Reaction may not be as expected

Depends on:

• initial level of economic activity
• level of consumer/business confidence - if confidence low than even if interest rates decreases businesses/consumer will not necessarily spend more/save less
• size of multiplyer 
• level of change in interest rates - huge change=huge affect/small change=small affect
• Other factors expansionary monetary policy impaired by contractionary fiscal policy

Real life example :

USA central bank plans to increase interest rates from 0.75% to 1%