Anatomy of Monetary Policy

To manage ‘national economy‘, the governments execute ‘political maneuverings’ like, Fiscal(Taxes) and Monetary policy (Interest rates), Trade, Revenue Spending and Reforms. Central Banks (Federal Reserve, BOE, ECB, BOJ, RBA, RBI, BOC) are responsible for most of these activities. The Central Banks sets the discount (interest rate banks charge among themselves) and prime interest rates (base interest rate charged to consumers for borrowing money)for lending money in the open market.

‘Monetary Policy’ decisions -‘Transmission Effect’ of Interest rate on economy , Illustration by ECB.

The simplest explanation of inflation is ‘more dollars chasing few goods’, therefore this high inflation increases the price wholesalers and businesses ask for most of the ‘things’ (resources). Inflation is a result of GDP growth, loose monetary policies in plain English is, “cheap money result from low discount and prime interest rates”. And, it can artificially increase inflation. To answer question, “Why central banks use ‘monetary tightening’?”, is to central banks typically try to restrict (tighten) economic growth by making money (credit) more expensive to borrow. This helps to control the rate of inflation.

Effects of Monetary Policies: Rate increases make borrowing less attractive therefore It affects all types of borrowing (aka credit) including personal loans, mortgages and interest rates on credit cards. Weirdly, this increase makes saving more attractive.

Fiscal policy on the other hand, is about collection or revenues from taxes and spending those revenues. Governments changes the levels of taxation and spending, it has direct effect on  ‘aggregate demand’ and the ‘level of economic activity (GDP)’.

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