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Monetary policy is used to manipulate the economy, often involving changes to the money supply and interest rates. Central banks use business cycle analysis to determine if inflation is rising, and may reduce the money supply or increase interest rates to combat it. The relationship between monetary policy and the economy is established through these corrective measures.
The relationship between monetary policy and economics is the fact that monetary policy is a tool used for the manipulation of the economy in order to achieve certain expected results. Monetary policies usually involve factors such as an increase or decrease in the total money supply in the economy at any given time and an upward or downward revision of interest rates. Usually, central banks or federal reserve banks are responsible for such changes, which are usually based on some indicator of the economy.
An example of the relationship between monetary policy and the economy is a situation where an analysis of several business cycles reveals the fact that there is an inflationary trend. Business cycles are simply the periods used to divide the duration of business activities with the aim of serving as a point of reference for economists and other associated parties. For monetary policy purposes, a business cycle can be quarterly, annual, or based on the aggregate collection of economic activity over a four-year period. An analysis of the business cycle will show if there is any type of inflation or if the economy is sluggish. Where inflation is seen to rise over several business cycles, the central bank will introduce monetary policies aimed at reducing inflation.
Usually, inflation is fueled by an overactive economy where the rate of consumption exceeds the rate of production and supply. This trend leads to a situation where too much money will chase too many goods, causing the prices of those products to rise in response. In order to address these negative trends, the central bank may decide to reduce the amount of money in circulation in the economy. The purpose of this reduction is to reduce the rate of demand and consumption, thus leading to a corresponding decline in demand-driven inflation. This establishes a link between monetary policy and the economy, as monetary policy aims to correct a perceived anomaly in the economy.
One of the ways the central bank can reduce the amount of money in the economy is through interest rate hikes. The rationale is that rising interest rates will result in a drop in demand for loans and other forms of credit due to prohibitive interest rates. It will also lead to more savings in banks and lower expenses due to a related increase in interest paid on savings in the bank. The reverse is the case in case of lackluster activity in the economy. Hoping to encourage spending and boost economic activity, the central bank will cut interest rates, which also shows a link between monetary policy and the economy.
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