Monetary policy
Monetary policy is one of the measures that can be used to achieve financial stability. Monetary policy can also be thought of as the demand side of the economy. As a tool for monitoring a country’s economy, monetary policy has to do with drafting, announcement, and implementation of a plan of actions established by a country’s central bank. These actions can also come from the currency board or any other monetary authority with such competence to determine the amount of money available in an economy and the means through which new money is made available. When we speak of monetary policy, we refer to actions that manage interest rates and money supply in an economy for the purpose of achieving macroeconomic goals such as liquidity, growth, consumption, and inflation control.
Monetary policy can be applied in two broad categories; these are expansionary and contractionary monetary policy. In the case of Lalaland, expansionary monetary policy is the most suitable choice. According to the country’s rates of inflation, unemployment, and economic growth, it is clear that the country requires a boost that will spur economic growth. By so doing, the rate of unemployment goes down while the rate of inflation goes up.
Expansionary policy is referred to as so because it is aimed at encouraging the growth of aggregate demand, which is the sum of investment, private consumption, imports, and government spending. Among the four elements, the monetary policy aims at influencing investment and private spending. Private consumption is directly influenced by the injection of new money into the economy. By so doing, the government then pushes commercial banks to lower interest rates, which then encourages lending, thus pushing up the level of investment as businesses spend on capital goods.
Monetary policy affects the number of loanable funds available and interest rates as well. This effect can, in turn, influence several components that make up aggregate demand. Expansionary monetary policy is one of the economic tools that can be used to get a country’s GDP to grow at its projected potential.
Monetary policies to stimulate economic growth
In encouraging economic activity in Lalaland, there are a number of policies that can be implemented to ensure higher liquidity in the economy. Increasing the supply of money leads to lower borrowing costs and interest rates in the hope that this will boost investment and consumption.
Interest rates are one of the items that the central bank uses when looking to apply expansionary monetary policies. The central bank lowers the discount rates when interest rates are high. Lower discount rates allow commercial banks to borrow from the central bank on a short-term basis to cover liquidity deficiencies. By reducing the discount rate, the central bank will make it cheaper for consumers and corporations to borrow funds. As the interest rate declines, savings accounts, and government bonds become less lucrative, thus turning the attention of savers and investors towards risk assets.
If interest rates are low and the central bank does not have as much room for lower discount rates, it then turns to the purchase of government securities in a concept known as quantitative easing (QE). This method will stimulate the economy since it reduces the number of government securities circulating in the marketplace. This creates a situation where there is an increase of money with a subsequent decrease in securities available, thus creating a demand for the existing ones, which lowers interest rates and encourages more investors to take risks.
The central bank can also strengthen loan activity when there is no incentive to take loans by changing the reserve ratio for commercial banks. Banks tend to hold back on money lending in a recession or anticipation of one. During times of economic uncertainty, central banks respond to this by encouraging borrowing by banks. To increase the capacity of commercial banks to give out loans, the central bank lowers their reserve ratio, which allows them a lower requirement of the money they should have in reserves when issuing out loans.
Changes in macroeconomic variables
The type of monetary policy chosen by a central bank determines the way the economy functions and touches on four main macroeconomic variables; economic growth, inflation, the balance of payments, and unemployment. All these are influenced in one way or another by monetary policy that intends to boost economic activity. Expansionary monetary policy is expected to encourage economic growth as the commercial sector acquires more liquidity. Businesses have more channels through which to get new money for expansion. Inflation is increased by expansionary monetary policy as such policy essentially injects money into the economy for purchase of the same amount of goods. Since production is not able to absorb the sudden flow of money, prices of goods and services go up. The balance of payments for a country is affected negatively when it comes to expansionary monetary policy as it creates a deficit. Since the economy has been funneled with extra liquidity, which increases the number of imports but does not necessarily increase the number of exports, this method of economic stimulation will lead to a decrease in unemployment rates. The rate of unemployment goes down as business as well as consumer spending goes higher. More people can secure jobs in industries that did not have job creation capacity, thus improving the number of non-disabled citizens in gainful employment.
While central banks have direct influence over the money supply and the environment of bank lending, they can also influence economic activity indirectly. Public announcements by the central bank are essential when it comes to the speculative business of the markets. Investors that predict correctly what the central bank’s future policies shall affect the economy can make substantial profits from the resulting investment.