Monetary policy and the business cycle are two important aspects of a market economy that can have unintended negative effects. Governments can influence the business cycle through monetary policy, but loose policies can result in rampant inflation and a contraction in the economy.
An economy is a vast conglomeration of individuals, companies, regulations, government policies and phenomena. Two important aspects of a market economy are monetary policy and the business cycle. The first represents government policies on money supply and interest rates, while the second is a naturally occurring cycle of stages, from boom to peak, bust to trough. While a market economy naturally goes through each stage, governments can influence the business cycle through the use of monetary policy, hence a direct relationship between the two. Unfortunately, monetary policy and the business cycle can have unintended negative effects.
Market economies rely primarily on individuals and businesses residing in the general location to move resources between users. Growth occurs naturally as demand for goods or services increases for specific items. Inflation, which is classically defined as too many dollars chasing too few goods, can occur because of growth. This may correct itself once suppliers are able to increase the supply side of the economic equation. Monetary policy and the business cycle tend to start their relationship in the boom phase.
Governments may decide to induce growth through the use of a central bank or other economic agency to set monetary policy. By increasing the money supply through low bank retention rates and low interest rates, growth can begin due to the ease of access to money. Businesses can expand and individuals have the ability to buy more or more goods than before established policies. A difficulty arises, however, because unnatural inflation can result from loose monetary policy and the business cycle starts to peak earlier. An early spike in the growth stage means that businesses cannot expand and prices can rise on products due to lower supply and stable demand or higher due to rising monetary levels for individuals to purchase goods.
The result of loose monetary policy and rampant inflation can result in a government that needs to tighten monetary policy. The only way to complete this is to reverse loose monetary policies, which means high bank retention rates for cash held and higher interest rates for loans. The result is less money in the general market economy, through which individuals and companies can acquire resources or goods, respectively. Here, monetary policy and the business cycle can result in a contraction that starts when supply and demand fall. Businesses may start liquidating, and individuals will not have the same purchasing power as fewer dollars restrict their ability to buy luxuries – items not needed – in the economy.
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