Monetary Policy Mind Map Minor
What is Monetary Policy
Disclaimer - Multiple resources were used in the making of this mind map!
Aims of Monetary Policy
Types of Monetary Policy
A demand-side policy using changes in the money supply or interest rates to achieve economic objectives relating to output, employment and inflation.
In an economy, there is a vast array of different interest rates. Advertisements offering low mortgage rates or “competitive financing” are examples of the interest rates offered by private profit-making businesses, such as commercial banks. Although banks are regulated by the government, they are mainly free to set these rates themselves.
The Creation of Money by Commercial Banks → Commercial banks can actually create money. They do this through a process known as “credit creation”. In this way, they can have a significant effect on the money supply in an economy.
The Equilibrium Nominal Interest Rate → Interest rates are often referred to as the price of money, but more accurately they are the opportunity cost of holding/spending money. The nominal rate of interest is the rate of interest available in the money market, not allowing for inflation. If the rate of interest is adjusted for inflation, then we call it the real rate of interest.
The Central Bank → An institution charged with conducting monetary and exchange rate policy, regulating behavior of commercial banks, and providing banking services to the government and commercial banks.
When we talk about interest rates as a tool of monetary policy we are talking about the base rate (discount rate or prime rate) that is set by a country’s central bank. The central bank is not a private profit-making bank but is essentially the government’s bank and the ultimate authority in control of the money supply in an economy. In some countries the government controls the central bank, but in most industrialized countries these days the central bank is an independent body with the primary responsibility of maintaining a low and stable rate of inflation in the economy. Changes in the central bank’s base rate ultimately impact upon all borrowing and lending in the economy and are an important signal of a country’s monetary policy. Even though the central bank may be largely independent we usually consider its activities as part of government monetary policy.
Credit creation occurs when commercial banks lend money to customers, either individuals or businesses. They do this by making loans based upon the deposits that customers have made with them. However, it is not simply the case of someone depositing $100,000 dollars and a bank lending that $100,000 to someone else because if this happened there would be no money being created. The fact is that when commercial banks receive deposits, they lend out a multiple of the deposit value. They lend out more than they get, which is known as the money (or banking credit) multiplier. This multiplier is related to a minimum reserve requirement, which is a percentage of the deposits that commercial banks are legally required to hold in reserve by the central bank, so that they can meet the cash requirements of their depositors.
Tools Used by the Government to Control the Money Supply → There are a number of methods that the central bank may use to affect the size of the money supply, and thus the interest rate.
The Difference Between Nominal and Real Interest Rates → As stated earlier, the nominal rate of interest is the rate of interest available in the money market, not allowing for inflation. If the rate of interest is adjusted for inflation, then we call it the real rate of interest. So, to calculate the real rate of interest from a nominal rate of interest, we simply need to subtract the inflation rate from the nominal rate.
Open market operations → Open market operations involve the buying and selling of government securities in the open market by the central bank. A government security is a bond, usually issued by the central bank, that offers interest on the nominal value of the bond. They are redeemable after a given number of years. They are considered to be very low-risk, since they are guaranteed by the government.
Changes in the central bank minimum lending rate → The minimum lending rate is also known as the base rate, discount rate or refinancing rate. The minimum lending rate is the rate of interest which the central bank charges on loans and advances to commercial banks. It operates as the base rate for the banking system, influencing the interest rates charged on bank loans, mortgages and credit transactions throughout the economy. The central bank has control over the level of the minimum lending rate and so they can raise or lower it as they wish.
Minimum reserve requirements → The minimum reserve requirement is the percentage of the deposits that commercial banks are legally required to hold in reserve by the central bank, so that they can meet the cash requirements of their depositors. There is a clear relationship between the minimum reserve requirement and the size of the money multiplier in that the larger the minimum reserve requirement, the smaller the money multiplier and vice versa.
Quantitative easing → Quantitative easing (QE) involves the introduction of new money into the money supply by a central bank. The aim is, obviously, to expand the economy and so it is a form of expansionary monetary policy. It has become a common form of monetary policy following the economic crisis of 2008. After the crisis, many countries trying to increase AD using lower interest rates found that even though interest rates were very low, AD was not increasing because low consumer and business confidence were preventing consumers and producers from increasing their borrowing. Another means of increasing the money supply had to be implemented and this was QE. The process is quite simple. The central bank injects new money directly into the economy by purchasing assets, mostly securities, from commercial banks and other financial institutions with newly created electronic cash. This will have a number of expansionary effects, including:
The size of the money multiplier can be calculated using the equation: 
It will lower interest rates, and this will reduce the debt of people and firms who have previously borrowed money; this should increase consumer and business confidence.
The lower interest rates will cause exchange rates to fall, which will make exports less expensive and imports more expensive, and should lead to an increase in (X-M), thus increasing AD.
It will increase the reserves of commercial banks as they sell securities. This will increase their liquidity and encourage them to lend more to households and firms, increasing consumption and investment and so increasing AD.
The supply of money in an economy, as we know, is controlled by the central bank, through its monetary policy, and is generally considered to be fixed at any given time. Thus it is usually shown as a perfectly inelastic supply curve. Because it is controlled by the central bank, and not affected by the nominal interest rate, the supply will be constant at QM, even if the nominal interest rate shifts from i1 to i2.
The money market is where the demand and supply of money come together to determine the equilibrium nominal rate of interest. As with any market the equilibrium is where the demand equals supply and so in this case, it is where the demand for money equals the supply of money.
The equilibrium nominal rate of interest is at ie, where SM is equal to DM. If the central bank adopted a contractionary monetary policy, using any of the tools we have covered, then the money supply would fall from Qe to Q1 and the new equilibrium nominal rate of interest would be i1. If the central bank adopted an expansionary monetary policy, then the money supply would increase from Qe to Q2 and the new equilibrium nominal rate of interest would be i2.
If a consumer, firm, or the government holds/spends money, then they forgo other things that the money could have been used for, i.e. saving or investment. If nominal interest rates are high, then they are giving up a large return on their savings and investment and so they will hold/demand less money. If nominal interest rates are low, then the opportunity cost of spending/holding money will be less and so they will hold/demand more money. This explains why the demand curve for money is downward sloping.
The real rate of interest = nominal rate of interest - inflation rate.
Expansionary Monetary Policy
Contractionary Monetary Policy
Refers to a monetary policy aimed at increasing aggregate demand through a decrease in interest rates; also referred to as easy monetary policy.
Refers to a policy employed by the central bank involving an increase in interest rates and aimed at decreasing aggregate demand and thus inflationary pressures. Referred to also as tight monetary policy.
Expand open market operations (sell securities) → If the central bank wishes to reduce the money supply (a contractionary monetary policy) then they will sell more government securities to institutions, which will have the effect of reducing the money that commercial banks have to lend. This fall in supply will increase the cost of borrowing and so increase interest rates, the price of money.
Real-world example: As reported by Dhaka Tribune, in 2018, Bangladesh Bank announced plans to issue a contractionary monetary policy in an effort to control the supply of credits and inflation and ultimately maintain economic stability in the country. As the economic situation changed in subsequent years, the bank converted to a monetary policy focused on expansion. (another example)
Increase the minimum reserve requirements → This means that if governments wish to reduce the money supply (a contractionary monetary policy) then they should increase the minimum reserve requirement. This will reduce the ability of the banks to create credit and so will reduce the money supply. This in turn will increase interest rates and thus lower AD as consumption and investment fall.
Diagram: If the government follows a successful contractionary monetary policy, then there will be a shift in aggregate demand from AD1 to AD2. This will have a number of economic outcomes. There will be a reduction in the inflationary gap previously caused by inflationary pressure as the average price level falls from P to P1. However, there will be a decrease in real output, from Y to Y1, which will mean a decrease in national income, an decrease in economic growth, and very probably, an increase in unemployment.
Raise the minimum lending rate → If the central bank is implementing a contractionary monetary policy, then they will raise the minimum lending rate. When this happens, commercial banks and other financial institutions, such as building societies, will increase their lending rates and also their interest rates paid to people who save. This will be likely to discourage consumers and businesses from borrowing more money and will also encourage consumers to save more. This will reduce consumption and investment and so reduce AD.
Contractionary: The quantity of loanable funds at the banks is reduced from S2 to S1, and so the interest rate rises from i2 to i1. The increase in interest rates will lower AD as consumption and investment fall.
Expand open market operations (buy securities) → If the central bank wishes to increase the money supply (an expansionary monetary policy) then they will buy back their own securities from institutions, which will have the effect of increasing the money that commercial banks have to lend. This increase in supply will reduce the cost of borrowing and so decrease interest rates, the price of money.
Implement Quantitative Easing: Quantitative easing (QE) involves the introduction of new money into the money supply by a central bank. The aim is, obviously, to expand the economy and so it is a form of expansionary monetary policy. Many countries trying to increase AD through the use of lower interest rates find that even though interest rates are very low, AD is not increasing because low consumer and business confidence is preventing consumers and producers from increasing their borrowing. Therefore, in order to increase the money supply they started implementing quantitative easing, which consists of the central bank injecting new money directly into the economy by purchasing assets, mostly securities, from commercial banks and other financial institutions with newly created electronic cash.
Reduce the minimum reserve requirements → In the same way, if they wish to increase the money supply (an expansionary monetary policy) then they should reduce the minimum reserve requirement. This will increase the ability of the banks to create credit and so will increase the money supply. This in turn will lower interest rates and thus increase AD as consumption and investment rise.
Real-word example: Declining oil prices from 2014 through the second quarter of 2016 caused many economies to slow down. The benchmark West Texas intermediate crude dipped briefly below $30 US a barrel. If the U.S. dollar continues to rocket skyward, oil could drop as low as $20 US, according to analysts. Canada was hit especially hard in the first half of 2016, with almost one-third of its entire economy based in the energy sector. This caused bank profits to decline, making Canadian banks vulnerable to failure. To combat these low oil prices, Canada enacted an expansionary monetary policy by reducing interest rates within the country. The expansionary policy was targeted to boost economic growth domestically. However, the policy also meant a decrease in net interest margins for Canadian banks, squeezing bank profits.
Lower the minimum lending rate → If the central bank is implementing an expansionary monetary policy, then they will lower the minimum lending rate. When this happens, commercial banks and other financial institutions, such as building societies, will lower their lending rates and also their interest rates paid to people who save. This will be likely to encourage consumers and businesses to borrow more money and will also discourage consumers from saving. This will increase consumption and investment and so increase AD.
Diagram: If the government follows a successful expansionary monetary policy, then there will be a shift in aggregate demand from AD1 to AD2. This will have a number of economic outcomes. There will be inflationary pressure as the average price level rises from P1 to P2. However, there will be an increase in real output, from Y1 to Y2, which will mean an increase in national income, an increase in economic growth, and very probably, a decrease in unemployment.
Expansionary: The quantity of loanable funds at the banks is increased from S1 to S2, and so the interest rate falls from i2 to i1. The decrease in interest rates will increase AD as consumption and investment rise.
Reduce business cycle fluctuations
Real-world example: Canada’s business cycle at the start of 2018 looked very promising but issues like the building trade war with the US and China, especially since Canada relies on imports and ships exports to both countries, along with a combination of high household debt, rising interest rates and slowing wage growth, shows the Canadian economy facing certain troubles in the future.
To achieve an external balance between export revenue and import expenditure → Balance of trade (BOT) is the difference between the value of a country's imports and exports for a given period and is the largest component of a country's balance of payments (BOP).
A low unemployment rate
Real-world example: Unemployment for Singaporeans continued to rise as the pace of employment growth slowed in the second quarter of this year, amid trade tensions and global uncertainties. The unemployment rate for Singaporeans rose for the third consecutive quarter to 3.3 per cent in June, up from 3.2 per cent in March. This is after seasonal variations were taken into account.
The maintenance of a low and stable rate of inflation
This macroeconomic objective is usually tied in with “inflation targeting”, where the central bank sets a specific medium-term target inflation rate as a goal, for example, 2%.
In certain countries, central banks focus just on inflation and are guided by the objective to achieve an explicit or implicit inflation target rate because a healthy amount of inflation is actually good for the economy. So inflation targeting becomes their main objective rather than focusing on the maintenance of both full employment and a low rate of inflation because there is usually a conflict between full employment and a manageable average price level or a lower rate of inflation, therefore in many countries, central banks just need to focus on maintaining the inflation rate or achieving an explicit or implicit inflation rate target, known as inflation targeting.
Real-world example: Inflation in the US grew worse in February amid the escalating crisis in Ukraine and price pressures that became more entrenched. The consumer price index, which measures a wide-ranging basket of goods and services, increased 7.9% over the past 12 months, due to increases in gas, grocery, and shelter prices that contributed to the rising inflation rate.
Promote a stable economic environment for long-term growth → Economic stability is the absence of excessive fluctuations in the macroeconomy. An economy with fairly constant output growth and low and stable inflation would be considered economically stable.
Solutions
Benefits
Causes
Drawbacks
Cost-push inflation → Inflation that is a result of increased production costs (typically because of rising money wages or rising commodity prices) and illustrated by a leftward shift of the SRAS curve.
Demand-pull inflation → Inflation that is caused by increases in aggregate demand.
Contractionary Monetary Policy → The goal of contractionary monetary policy is to reduce inflation by limiting the amount of active money circulating in the economy, through increasing interest rates and decreasing bond prices.
Reduced Inflation → The inflation level is the main target of a contractionary monetary policy. By reducing the money supply in the economy, policymakers are looking to reduce inflation and stabilize the prices in the economy.
This helps reduce spending because when there is less money to go around: those who have money want to keep it and save it, instead of spending it. It also means there is less available credit, which can reduce spending. Reducing spending is important during inflation because it helps halt economic growth and, in turn, the rate of inflation.
Time lags → Although they are quick to change, monetary policies still take time to have an effect on the economy. It may take a number of months before there is a noticeable effect on aggregate demand. In that time, economic factors may have changed and the policy may not be appropriate.
Slows down economic growth → Reducing the money supply usually slows down economic growth. As the money supply in the economy decreases, individuals and businesses generally halt major investments and capital expenditures, and companies slow down their production.
Low consumer and business confidence → Even though interest rates are reduced, the effect on expenditure may be very much dampened by low consumer and business confidence. This is especially the case if the economy is in a deep recession.
Increased unemployment → An unwanted side effect of a contractionary monetary policy is a rise in unemployment. The economic slowdown and lower production cause companies to hire fewer employees. Therefore, unemployment in the economy increases.
Solutions
Benefits
Causes
Drawbacks
Structural unemployment → A kind of long-term unemployment that arises from a number of factors including: technological change; changes in the patterns of demand for different labor skills; changes in the geographical location of industries; labor market rigidities.
Frictional unemployment → Unemployment of individuals who are in-between jobs, as people quit to find a better job or to move to a different location.
Cyclical (demand-deficient) unemployment → Unemployment that is a result of a decrease in aggregate demand and thus of economic activity; it occurs in a recession.
Seasonal unemployment → Unemployment that arises when people are out of work because their usual job is out of season, for example, agricultural workers during winter months.
Expansionary monetary policy → The goal of expansionary monetary policy is to increase aggregate demand and economic growth through cutting interest rates.
Lower Interest Rates → Lower interest rates mean that the cost of borrowing is lower. When it’s easier to borrow money, people spend more money and invest more. This increases aggregate demand and GDP and decreases cyclical unemployment.
In addition, when interest rates are lower, exchange rates are also lower, and an economy’s exports are more competitive.
Decreased unemployment (a “trade-off”) → The stimulation of capital investments creates additional jobs in the economy. Therefore, an expansionary monetary policy generally reduces unemployment.
Sometimes policymakers may also introduce specific initiatives that target particular areas of the economy in order to reduce unemployment and increase output. Examples of these unique initiatives include streamlining the approval process for government projects that create jobs, giving businesses cash incentives for hiring workers, and paying businesses to train workers to fill specific positions.
Ineffectiveness when interest rates are low → Expansionary monetary policy through cuts in the rate of interest cannot be used for ever. Eventually interest rates will start to approach zero and there will be no room left for further cuts.
Time lags → Although they are quick to change, monetary policies still take time to have an effect on the economy. It may take a number of months before there is a noticeable effect on aggregate demand. In that time, economic factors may have changed and the policy may not be appropriate.
Increased inflation (a “trade-off”) → The injection of additional money into the economy increases inflation levels. It can be both advantageous and disadvantageous to the economy. The excessive increase in the money supply may result in unsustainable inflation levels. On the other hand, the inflation increase may prevent possible deflation, which can be more damaging than reasonable inflation.
Solutions
Benefits
Causes
Drawbacks
Fluctuations in the business cycle are caused by the forces of aggregate supply and aggregate demand, such as the movement of the gross domestic product GDP, the availability of capital, and expectations about the future. The cycle is generally separated into four distinct segments, recovery (expansion), boom, recession (contraction), and trough.
Expansionary Monetary Policy (during a recession) → The goal of expansionary monetary policy is to increase aggregate demand and economic growth through cutting interest rates.
Contractionary Monetary Policy (during a boom) → The goal of contractionary monetary policy is to reduce inflation by limiting the amount of active money circulating in the economy, through increasing interest rates and decreasing bond prices.
(EMP) Lower Interest Rates → Lower interest rates mean that the cost of borrowing is lower. When it’s easier to borrow money, people spend more money and invest more. This increases aggregate demand and GDP and decreases cyclical unemployment.
(CMP) Reduced Inflation → The inflation level is the main target of a contractionary monetary policy. By reducing the money supply in the economy, policymakers are looking to reduce inflation and stabilize the prices in the economy.
(EMP) Decreased unemployment (a “trade-off”) → The stimulation of capital investments creates additional jobs in the economy. Therefore, an expansionary monetary policy generally reduces unemployment.
(EMP & CMP) It is relatively quick to put into place → In most countries, the interest rate is set by the central bank and can be altered quickly, when it is felt to be necessary.
(EMP) An absence of “crowding out” → As mentioned earlier, expansionary fiscal policy involving increased government borrowing may lead to higher interest rates and a “crowding out” of private investment. This is not the case with monetary policy, where interest rates are simply lowered.
(EMP & CMP) There is no political intervention → Because the interest rate is normally adjusted by the central bank, there do not have to be political processes that are gone through before the rate can be changed. This is the opposite of fiscal policy. Also, because the central bank is usually independent, and not under the control of the government in power, it can implement policies, such as increased interest rates, that may be politically unpopular. However, this strength is somewhat theoretical. In many countries, although the central bank is said to be independent, there is no doubt that governments influence their decisions, often for political aims as opposed to economic aims.
(EMP) Stimulation of economic growth → An expansionary monetary policy reduces the cost of borrowing. Therefore, consumers tend to spend more while businesses are encouraged to make larger capital investments.
(EMP & CMP) The ability to make small changes → Because interest rates may be adjusted by as little as one quarter of one percent, it is possible to be more precise than fiscal policy and to set more exact targets - for example, an inflation target of 2%. Monetary policy enables more fine-tuning of the economy. The fine tuning is also helped by the speed of implementation and lack of political involvement that have already been mentioned.
(EMP) Currency devaluation → The higher money supply reduces the value of the local currency. The devaluation is beneficial to the economy’s export ability because exports become cheaper and more attractive to foreign countries.
Sometimes policymakers may also introduce specific initiatives that target particular areas of the economy in order to reduce unemployment and increase output. Examples of these unique initiatives include streamlining the approval process for government projects that create jobs, giving businesses cash incentives for hiring workers, and paying businesses to train workers to fill specific positions.
In addition, when interest rates are lower, exchange rates are also lower, and an economy’s exports are more competitive.
This helps reduce spending because when there is less money to go around: those who have money want to keep it and save it, instead of spending it. It also means there is less available credit, which can reduce spending. Reducing spending is important during inflation because it helps halt economic growth and, in turn, the rate of inflation.
(CMP) Low consumer and business confidence → Even though interest rates are reduced, the effect on expenditure may be very much dampened by low consumer and business confidence. This is especially the case if the economy is in a deep recession.
(CMP) Slows down economic growth → Reducing the money supply usually slows down economic growth. As the money supply in the economy decreases, individuals and businesses generally halt major investments and capital expenditures, and companies slow down their production.
(EMP) Increased inflation (a “trade-off”) → The injection of additional money into the economy increases inflation levels. It can be both advantageous and disadvantageous to the economy. The excessive increase in the money supply may result in unsustainable inflation levels. On the other hand, the inflation increase may prevent possible deflation, which can be more damaging than reasonable inflation.
(CMP) Increased unemployment → An unwanted side effect of a contractionary monetary policy is a rise in unemployment. The economic slowdown and lower production cause companies to hire fewer employees. Therefore, unemployment in the economy increases.
(EMP) Ineffectiveness when interest rates are low → Expansionary monetary policy through cuts in the rate of interest cannot be used for ever. Eventually interest rates will start to approach zero and there will be no room left for further cuts.
(EMP & CMP) Time lags → Although they are quick to change, monetary policies still take time to have an effect on the economy. It may take a number of months before there is a noticeable effect on aggregate demand. In that time, economic factors may have changed and the policy may not be appropriate.
A country's importing and exporting activity can influence its GDP, its exchange rate, and its level of inflation and interest rates.
A rising level of imports and a growing trade deficit can have a negative effect on a country's exchange rate.
A country that imports more goods and services than it exports in terms of value has a trade deficit while a country that exports more goods and services than it imports has a trade surplus.
Solutions
Benefits
Causes
Drawbacks
Cause of an unstable economic environment can originate from both the aggregate demand and aggregate supply side of an economy.
Stock market crashes (e.g. 1929 Stock market crash)
Black swan events (e.g. major natural disaster, coronavirus outbreak 2020)
Change in confidence levels (e.g. worries after 9/11)
Labor market unrest (e.g. The Winter of discontent in the 1970s)
Changing interest rates (rise in interest rates around 2005-07)
Erratic leadership (e.g. Trump’s trade war with China)
Changing commodity prices (especially oil, e.g. 1974 oil price shock)
Monetary Policies → A demand-side policy using changes in the money supply or interest rates to achieve economic objectives relating to output, employment and inflation. Monetary Policies such as Expansionary and Contractionary may be used (more information has been previously mentioned)
(EMP) Decreased unemployment (a “trade-off”) → The stimulation of capital investments creates additional jobs in the economy. Therefore, an expansionary monetary policy generally reduces unemployment.
(EMP) Low consumer and business confidence → Even though interest rates are reduced, the effect on expenditure may be very much dampened by low consumer and business confidence. This is especially the case if the economy is in a deep recession. This drawback goes hand in hand with the solution implemented by central banks known as quantitative easing.
(EMP) An absence of “crowding out” → As mentioned earlier, expansionary fiscal policy involving increased government borrowing may lead to higher interest rates and a “crowding out” of private investment. This is not the case with monetary policy, where interest rates are simply lowered.
(EMP) Currency devaluation → The higher money supply reduces the value of the local currency. The devaluation is beneficial to the economy’s export ability because exports become cheaper and more attractive to foreign countries.
(EMP) Lower Interest Rates → Lower interest rates mean that the cost of borrowing is lower. When it’s easier to borrow money, people spend more money and invest more. This increases aggregate demand and GDP and decreases cyclical unemployment.
(EMP) Stimulation of economic growth → An expansionary monetary policy reduces the cost of borrowing. Therefore, consumers tend to spend more while businesses are encouraged to make larger capital investments.
(CMP) Reduced Inflation → The inflation level is the main target of a contractionary monetary policy. By reducing the money supply in the economy, policymakers are looking to reduce inflation and stabilize the prices in the economy.
(EMP & CMP) It is relatively quick to put into place → In most countries, the interest rate is set by the central bank and can be altered quickly, when it is felt to be necessary.
(EMP & CMP) There is no political intervention → Because the interest rate is normally adjusted by the central bank, there do not have to be political processes that are gone through before the rate can be changed. This is the opposite of fiscal policy. Also, because the central bank is usually independent, and not under the control of the government in power, it can implement policies, such as increased interest rates, that may be politically unpopular. However, this strength is somewhat theoretical. In many countries, although the central bank is said to be independent, there is no doubt that governments influence their decisions, often for political aims as opposed to economic aims.
(EMP & CMP) The ability to make small changes → Because interest rates may be adjusted by as little as one quarter of one percent, it is possible to be more precise than fiscal policy and to set more exact targets - for example, an inflation target of 2%. Monetary policy enables more fine-tuning of the economy. The fine tuning is also helped by the speed of implementation and lack of political involvement that have already been mentioned.
Sometimes policymakers may also introduce specific initiatives that target particular areas of the economy in order to reduce unemployment and increase output. Examples of these unique initiatives include streamlining the approval process for government projects that create jobs, giving businesses cash incentives for hiring workers, and paying businesses to train workers to fill specific positions.
In addition, when interest rates are lower, exchange rates are also lower, and an economy’s exports are more competitive.
This helps reduce spending because when there is less money to go around: those who have money want to keep it and save it, instead of spending it. It also means there is less available credit, which can reduce spending. Reducing spending is important during inflation because it helps halt economic growth and, in turn, the rate of inflation.
(CMP) Slows down economic growth → Reducing the money supply usually slows down economic growth. As the money supply in the economy decreases, individuals and businesses generally halt major investments and capital expenditures, and companies slow down their production.
(EMP) Increased inflation (a “trade-off”) → The injection of additional money into the economy increases inflation levels. It can be both advantageous and disadvantageous to the economy. The excessive increase in the money supply may result in unsustainable inflation levels. On the other hand, the inflation increase may prevent possible deflation, which can be more damaging than reasonable inflation.
(CMP) Increased unemployment → An unwanted side effect of a contractionary monetary policy is a rise in unemployment. The economic slowdown and lower production cause companies to hire fewer employees. Therefore, unemployment in the economy increases.
(EMP) Ineffectiveness when interest rates are low → Expansionary monetary policy through cuts in the rate of interest cannot be used for ever. Eventually interest rates will start to approach zero and there will be no room left for further cuts.
(EMP & CMP) Time lags → Although they are quick to change, monetary policies still take time to have an effect on the economy. It may take a number of months before there is a noticeable effect on aggregate demand. In that time, economic factors may have changed and the policy may not be appropriate.