Central banks implement monetary policy by manipulation of money supply in an economy. Money supply affects the rates of interest and inflation, which are key determinants of issues such as employment and consumption (Brezina, 2011). Monetary policies can be contractionary or expansionary. Expansionary monetary policies aim to stimulate and speed up economic growth. On the contrary, contractionary policies restrict economic growth. By implementing an expansionary monetary policy, interest rates are lowered, and unemployment is reduced. Interest rates are reduced to attract businesses towards credit so that they can expand. Also, the gross domestic product (GDP) increases as well as spending by consumers. Prices go high, and there is increased potential real output (Samuelson, 2010). Such a policy increases the amount of money circulating in an economy.
On the other hand, a contractionary monetary policy reduces the money supply in a specific economy. As a result, both nominal output and consumer spending reduce. The capital available in an economy reduces, which leads to a reduction in prices and real output. Consumption by individuals, investments, spending by a government, and the imports made slowdown in their growth (Samuelson, 2010). Interest rates increase, and this encourages saving instead of consumption. Changes in the money supply have real effects on the monetary transmission mechanism as well. The effects are on nominal money stock or the rate of interest. As a result, real aspects, such as employment, are affected. In a conventional framework of monetary transmission, changes in the money supply lead to changes in the rates of interest in the money market. There are changes in the rates of bank loans, and this may impact decisions to invest. Rates in deposit may impact the choice between consumption now or in the days to come.
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Monetary policy can be applied to stabilize output and smooth business cycles effectively. For example, if a country is experiencing high rates of unemployment, expansionary monetary policy can be implemented to increase the growth of the economy and expand economic activities. An expansionary policy reduces the rates of interest, and this would promote the spending of money (Brezina, 2011). This leads to more money supply to promote investment as well as spending. Reduced interests allow businesses to secure loans under terms that are convenient to increase production and increased spending on consumer goods. However, an increase in the money supply can cause high inflation. As a consequence, the cost of conducting business and living increases. A contractionary policy can be used to increase the rates of interest hence reduce inflation to the desired level conducive for business activities.
The role of monetary policy and its impact on macroeconomy is associated with a financial accelerator, which has implications on the economy. Changes in monetary policy can trigger big economy-related shocks. For example, small changes in the prime rate can make businesses and consumers to reduce spending even though increment could be small. Financial accelerators, in most cases, emerge from the credit market and, in the end, work through to affect the whole economy (Brezina, 2011). A financial accelerator can cause and accelerate a positive or negative shock in a macroeconomy. When the expansion period of the business cycle closes, credit is tightened. As a result, weak companies and consumers are often ignored, and credit is offered to only strong companies. However, as these companies encounter challenges related to less purchasing by consumers, they also become less favorable. The loop continues until when most of the credit is ejected out of the economy. This leads to massive economic pain.
References
Brezina, C. (2011). Understanding the Federal Reserve and monetary policy . The Rosen Publishing Group.
Samuelson, P. A. (2010). Economics . Tata McGraw-Hill Education.
