Monetary Policy Essay -- Expansionary and Contractionary Policy

Introduction Monetary policy is among the many tools used by a national government to manipulate its financial system. Monetary policy refers to the method used by the financial authority of any country to control the supply and availability of money (Woelfel, 1994). It is often targeted at interest rates to achieve lay down objectives directed towards economic growth and stability (Woelfel, 1994). Monetary policy rests on the link between interest rates in an economy, that is, the relationship between interest rates and the total money supply. It employs a variety of methods to control outcomes like inflation, economic growth, currency exchange rates and unemployment. Monetary policy can either be expansionary policy in which case there is a rapid increase in the total money in circulation in the economy, or contractionary policy in which case there is a slow increase or decrease in the total amount of money in circulation in the economy (Woelfel, 1994). The description of monetary policy takes the following approach; accommodative if the intention of the set interest rates is to stimulate economic growth, neutral if the intention is neither to fight inflation nor to stimulate economic growth and tight if the intention is to decrease inflation (Woelfel, 1994). These can be achieved through various tools including raising reserve requirements, increasing interest rates by fiat, and decreasing the monetary base, depending on the intended results (Woelfel, 1994). Monetary policy is always intended to either increase or decrease the amount of money in circulation in the economy. Reducing interest rates encourages borrowing thus increases the amount of money in circulation. It is however challenging when the interest rates are... ...ood of increased tax on their savings (Goodfriend, 2000). It is therefore fundamental for central banks to promise the public that it will maintain some elements of quantitative easing even as the economy recovers in order to gain public trust. Besides adjustments on tax and expenditure instruments takes a longer period thus may only be effective in neutralizing the zero bound in the long run but not short term effect as required in this case. The signaling Channel This channel unlike the others capitalizes on shaping the publics expectations through visible signal about central bank’s future policy intentions. This channel is more of a visible sign for central governments commitment to maintain zero policy rates for longer duration. This channel requires central banks to show a remarkable willingness to break from the previous conventional monetary policies.