Monetary Policy and Its Effects on the Economy


Monetary policy involves the management of the money supply in a country’s economy. This is carried by the central banks, government, and monetary authority. In the United States of America, the Federal Reserve is responsible for monitoring and managing the money supply. The money supply is carried to help a government achieve goals in economic development and economic growth.

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According to Thomas (4), monetary policy involves measures that are implemented by the central bank to influence credit availability, interest rates levels as well as money supply. It is responsible for ensuring that it is responsible for the employment rates, interest rates as well as the prices of goods and services in the economy. The essay looks at how the monetary policy works and the detrimental effects caused by a failed monetary policy in a country’s economy. Some of the effects include inflation, low investments, and inability to export, reduced imports, and recession.

How a monetary policy works

Monitory policy controls the functioning of the economy through the contractionary monetary policy and the expansionary monetary policy (Baumol and Blinder 654). By expansionary policy, it means that the central bank lowers the interest rates and in the contractionary policy, the interest rates are increased. The components of aggregate demand net exports and investment are more sensitive to the changes in monetary policy.

When the expansionary monetary policy is carried, the rate of interest rates is lowered. The low-interest rates allow busy businessmen other investment bodies to increase the tithe investment low interest rate encourages investment that has effects on the multiplier effects, which’s to increase in the rate of employment and the general nationals output (Baumol and Blinder 654). On the other hand to contraction of the national bank reserves and the money supplied, the interest rates are increased by the central bank. This leads to low inveinvestmentnding pulling down the aggregate demand through the multiplier effects mechanism. This causes low output and reduces cent employment rate.

When the expenditure is low, the GDP of a country is raised. In general, monetary policy effects on aggregate demand are determined by how the interest rates are sensitive. It also depends on how investment spending responds to the interest rates and the effects of the expenditure multiplier effects (Baumol and Blinder 656). Gwartney (300) notes that when lenders and borrowers forecast using the expectations of the expansionary and contractionary monetary policies

The role of the monetary policy

According to Lloyd (5) inflation is defined as the continuous or persistent increase in the price levels of commodities in a given general economy. Because of the role played by the federal bank in the implementation of monetary policy in regulating the money supply, failed monetary policy leads to inflation. This is necessitated by the fast growth of goods and services aggregate expenditure. This is caused by an increase in the money supply in the economy, which is the job of monetary policies. When inflation is high the purchasing power of the people is reduced due to increased prices.

The quick expansion of the money supplied in an economy has a direct effect on the growth of expenditure. Lloyd (5) explains that if the money supplied in the economy increases rapidly, then national expenditures increase at the same rate leading to inflation. This occurs when the central bank’s monetary policy is not able to control the money supply. Excess money in the economy can result from money laundering, corruption, or the acts of cartels. Another cause that is related to the central banks is when the banks expand the money supplied at excessive rates (Lloyd 6).

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A failed monetary policy can lead to high unemployment rates. When the central bank increases the interest rates, the rates of investment in spending is reduced. This is because the multiplier effect hurts the aggregate demand. With the investment growth being low because few companies and investors are willing to invest, the rate of job creation is reduced. This automatically leads to unemployment in the economy. When the aggregate demand is low, the real GDP becomes low.

According to Baumol and Blinder (701) when the central bank initiates monetary policy to reduce inflation, the rate of unemployment rises. This occurs in the short run period but continued influence drives the rate of unemployment to much higher. When the aggregate demand is pulled down by a falling monetary policy the multiplier effect mechanism responds. When the output is reduced than the rate o unemployment increases.

The expansionary policy influences how the lenders and borrowers operate (Gwartney 300). When the expansionary rates are made the interest rates low. This affects the lending and borrowing ability of lenders and borrowers. This reduces the number of a number of an institution willing to lend money at low-interest rates. This affects the investment plan of an economy leading to unemployment.

Failed monetary can lead to the inability of a country to export goods. This is because monetary policy influences the net demand for foreign demand (Thomas 541). When the real income and nominal incomes rise due to expansionary acts of the monetary policy, it leads to increase demand in financial assets by foreign markets. It also leads to a decline in “demand for foreign financial assets” (Lloyd 541).with the increase in the demand for the U.S dollars; it leads to its appreciation in other foreign markets. This raises the value of the dollar in terms of foreign currencies. This makes the US goods expensive reducing the ability to export goods and services in the foreign markets.

This reduces exports while the rate of imports is increased. This reduces trade surplus hence the aggregate demand declines. Monetary policy is responsible for the international capital flows that alternatively affect the exchange rate as well as net exports (Lloyd 541).

When the interest rates are increased by the Federal Reserve’s financial assets demand increases. Goods become expensive to foreigners; this lowers the aggregate demand leading to a decrease in GDP. This can also lead to inflation and employment rates increase. When the currency drops or losses value in a foreign country, demand for foreign currency increases respectively. This causes a decrease in the exchange rates in that country which affects the ability to import goods and services.

Impacts of the monetary policy on the economy

Monetary policy that can be implemented because of a forecasted monetary lag can have adverse effects on the economy. Impact lag occurs between the times when the federal or central bank implements policy when they begin to have a positive influence on the GDP. During this period interest rates are affected that in turn affect the investment spending and other investments that depend on interest rates. This subsequently affects the consumption expenditures that depend mostly on interest rates (Lloyd 556).

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All these have a lag that affects the GDP of an economy. When the expansionary policies are not implemented there is a likelihood that inflation and high rates of employment would persist. It is recommendable that monetary policy should be appropriately implemented to avoid effects like inflation, high rates of unemployment, decreased GDP, low investments, ability to export as well as low exchange rates.


In conclusion monetary policy involves the control and management of money supply, interest rates as well as foreign market exchange rates. The central bank, monetary body, and the Federal Reserve are the various bodies that implement monetary policy. Monetary policy operates through the expansionary policy and the contractionary policy. There regulate the interest rates where one increases the interest rate why the other reduce the interest rates.

These affect the GDP and expenditures spending in a country. When the interest rates are low investment spending is stimulated leading to an increase in job creation, while the increase in interest cause investment to decrease because business cannot get loans at high-interest rates. Failed monetary policy has detrimental effects on the economy. It causes high inflation rates and increased employment rates.

This is because the money supplied in the economy leads to an increase in national expenditures. When the purchasing power of a country is low then GDP reduces. Monetary policy can also have effects on the ability to exports goods. This arises when the country’s currency becomes high in the foreign market because of contractionary effects. A decrease in exports leads to a low GDP growth rate that may cause unemployment. Low investments due to increased interest rates reduce the rate of investment leading to unemployment

Works Cited

Baumol, William J, and Alan S. Blinder. Economics: Principles and Policy. Mason, OH: South-Western/Cengage Learning, 2009. Print.

Gwartney, James D. Economics: Private and Public Choice. Australia: South-Western Cengage Learning, 2009. Print.

Lloyd, Thomas. Money, Banking, and Financial Markets. Mason (OH: South-Western, 2006. Print.

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