• Varun Mittal

What is monetary policy and how does it affect interest rates?

The four main macroeconomic objectives — economic growth, stable prices, unemployment, and the balance of payments – were discussed in my previous post. In this article, I will address how governments can interfere to influence these goals. The policy I will be focusing on today is how to influence an economy's interest rates, which is often accomplished through monetary policy.

A government's monetary policy can be defined as an action taken to impact the cost of money or the quantity of money in circulation. Monetary policy is used to effectively control the interest rate, the money supply in the economy, and the exchange rate. Most currencies are floating or tied to another currency; therefore, governments rarely have direct influence over the exchange rate. Furthermore, most economies delegate monetary policy to a specific council or committee, such as the Federal Reserve in the United States or the Monetary Policy Committee in the United Kingdom.

To influence the interest rate, the monetary policy committee would lower the base rate first (known as the federal fund rate in the U.S.). This is the rate at which the central bank lends money to commercial banks, which are the banks that ordinary people use, and it is also used as a benchmark for interest rates. This would then send a signal to those commercial banks to lower their interest rates. Banks are not compelled to do so; rather, it serves as a signal that this is the proper course of action. As a result, commercial banks' interest rates would be reduced. This means that consumers can now borr

ow money at a lower cost. As a result of receiving less from savings, people are more likely to spend money, resulting in increased consumer spending. This would increase an economy's Aggregate Demand (AD). This leads to an increase in economic growth, as indicated in the graph to our right, but it also leads to an increase in inflation. As a result, monetary policy can be an effective tool for boosting economic growth.

Furthermore, because borrowing money is becoming more affordable, we may see an increase in company borrowing and spending. As investment is a component of AD, this would result in a rise in AD and an increase in the economy's Aggregate Supply (AS). Depending on the investment, this could be in the long-run (LR) or the short-run (SR). Assume the money was spent on capital equipment. In that instance, it is more likely to improve the LRAS, whereas it is more likely to improve the SRAS if it is spent on developing economies of scale. As a result, raising the base rate could aid in lowering inflation and achieving more significant economic growth.

When you consider what boosting the base rate does, you will notice that it has the opposite effect. Commercial banks will boost their rates if the base/federal funds rate is raised. As a result, borrowing becomes more expensive and saving becomes more lucrative. People begin to spend less, and we witness a decrease in consumer expenditure, which leads to a decrease in AD. This would result in a drop in an economy's GDP, lowering inflation. It has the potential to prevent and stop inflation before it spirals out of control. There would be reduced business expenditures as well; however, AD and AS would change by a smaller amount to reflect this.

To wrap up this article, changing the base / federal fund rate can be a powerful weapon for influencing the economy. However, it is predicated on the idea that individuals would spend and that no external economic shock will alter spending patterns. Watch for my next article, in which I will describe how the government intervenes in the money supply.