Monetary policy entails manipulating the supply of money to influence interest rates. The present paper examines how the monetary policy affects the macroeconomy.
The monetary policy affects the macroeconomy through its influence on interest rates that in turn affect the monetary transmission processes.
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Monetary policy affects the monetary transmission process and the economy through its influence on the interest rate and the related interest rate effects (Harcourt & Kriesler, 2013). Interest rate alterations change the marginal cost of borrowing, which leads to saving and investment changes that ultimately lead to further aggregate demand changes. A change in average interest rates also affects the cash flows of creditors and debtors. A change in the monetary policy alters the supply of money, which in turn alters the interest rates in the money market for a given demand for money. In turn, interbank rates and policy alterations cause changes in the rates of bank loans for borrowers and deposit rates. Bank loan rate alterations influence investment decisions. In turn, this influences the decisions regarding current and later consumption (Harcourt & Kriesler, 2013).
Monetary policy also affects the domestic prices (real estate, the stock market, and bond prices). Interest rate alterations that the monetary policy causes influence asset price levels in the economy. High-interest rates in the short term may cause bond prices to decrease. An easy monetary policy may lead to high equity prices, which increases businesses’ market price relative to their capital’s replacement expenses. In turn, this decreases effective cost of capital as new equities have a high price compared to the price of real equipment and factory (Harcourt & Kriesler, 2013). The monetary policy, thus, indirectly affects investment spending through the expense of capital.
Another impact of the monetary policy is on the exchange rate. A tight monetary policy leads to high-interest rates for a floating exchange rate, which leads to a high demand for local assets and increases the nominal and the real exchange rate. The increase in the exchange rate can reduce the demand for local products that are priced higher than foreign products. The increase in the exchange rate can also influence the debt-to-assist rates and net worth, which may lead to significant modifications to borrowing and spending (Harcourt & Kriesler, 2013).
The monetary policy also affects the availability of credit. The monetary policy can change the presence of credit, which in turn affects aggregate demand, particularly for private markets with poorly developed credit or those that do not operate freely. The monetary policy can directly influence credit availability through its influence on the value of assets of lenders and borrowers. Monetary policy changes cause asset price changes, which affects the value of bank loan collateral. In turn, this alters the borrowers’ access to credit (Harcourt & Kriesler, 2013).
Monetary policy can be used to stabilize output and smooth business cycles by using a flexible inflation targeting system that stabilizes medium-term inflation near a low target followed by measured policy reactions. The policy can attain average inflation equal to a specific inflation target and an adequate balance between the variability in output gap and inflation (Galí, 2015). The objective is to maintain stable prices, which promote a stable environment that contributes to economic growth.
The financial accelerator effect is used as the basis for monetary transmission mechanism, particularly the credit channel (bank lending channel and the balance sheet channel) (Ćorić, 2011). The monetary policy measures can affect aggregate economic activity through the monetary policy credit channel. Alterations in monetary policy affect the balance sheet of companies in the economy, which affects the companies’ borrowing that in turn affects the aggregate economic activity (Ćorić, 2011). For instance, interest rate increases may cause the market worth of illiquid assets of companies to reduce because the market will refund returns from those assets through a higher interest rate in future (Ćorić, 2011). High-interest rates may also increase the indebtedness of companies and lead to variable interest rates for corporate loans (Ćorić, 2011).
Regarding the bank lending channel, alteration in the supply of loan through the monetary policy can affect aggregate economic activity. Tight monetary policies decrease the ability of banks to lend, which leads to low loan supply, tight lending conditions, and low economic activity (Ćorić, 2011).
References
Ćorić, B. (2011). The financial accelerator effect: concept and challenges. Financial theory and practice , 35 (2), 171-196.
Harcourt, G. C., & Kriesler, P. (Eds.). (2013). The Oxford handbook of post-Keynesian economics, volume 2: Critiques and methodology . Oxford University Press.
Galí, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications . Princeton University Press.
