Monetary Policy essay
Monetary policy refers to the use of interest rates and the level of money supply to manage the economy. Monetary policy may be used to increase the level of economic activity (reflationary policies) or to decrease the level of economic activity (deflationary policies). A relationship therefore exists between monetary supply and the rate of interest. Economic theories have been suggested as to the extent of this relationship. Nevertheless, the monetary authorities may use various monetary policy measures to stimulate economic activity in the country.
The Monetary authorities can establish either the level of money supply or the rate of interest, not both. If the demand for money (liquidity preference) does not change, any change in the supply for money will alter the interest rate. (Refer to monetary policy 1)The diagram supplied shows that an increase in the money supply from MS to MS1 will cause a fall in the interest rate from R to R1. Assuming the monetary authorities fixed the supply of money. A change (increase or decrease) in the demand for money (liquidity preference) will effect a change in the interest rate. The diagram supplied shows that a decrease in the demand for money (L to L1) will reduce the interest rate from R to R1. (Refer to monetary policy 2). Read more…