Monetary Policy: Controlling Inflation and Economic Growth

Monetary Policy

Monetary policy involves actions taken by a central bank or regulatory committee to control the money supply and influence interest rates. These actions include modifying interest rates, buying or selling government bonds, and adjusting bank reserve requirements.

Types of Monetary Policy

Expansionary Monetary Policy

Expansionary monetary policy increases the money supply to lower unemployment, encourage borrowing and consumer spending, and stimulate economic growth.

Contractionary Monetary Policy

Contractionary monetary policy slows or decreases the money supply to control inflation. While necessary at times, it can slow economic growth, increase unemployment, and reduce borrowing and spending.

Example: The Federal Reserve in the 1980s

To combat nearly 15% inflation, the Federal Reserve raised its benchmark interest rate to 20%. This led to a recession but successfully curbed inflation.

Tools of Monetary Policy

• Open Market Operations: Buying short-term government bonds expands the money supply, while selling them contracts it.
• Benchmark Interest Rates: Rates like LIBOR and the Fed funds rate influence the cost of borrowing. Lower rates encourage borrowing and investment, while higher rates discourage them.
• Reserve Requirements: Higher reserve requirements for banks restrict lending and control inflation.

Fiscal Policy

Fiscal policies are government tools used to improve economic performance by adjusting tax rates and government spending.