Every country has a central bank, well, about 99% of all nations have one. Central banks control interest rates on money and thus, determine the price (or exchange rate) of money – to a certain extent.
Central banks have the power to regulate the amount of money in the economy. Think of the economy as a stadium full of money. When there is too much money in the stadium, it falls over the edges and people walking by can pick it up and run away with it; this is inflation.
Higher interest rates fill the stadium (bank) up with money, lower interest rates induce spending and help to empty the stadium (the economy).
So, to counteract (so much money spills out over the edges that it basically turns into useless pieces of paper) banks tamper with their base rates (interest rates) in an attempt to control the amount of money being injected into the economy.
It’s imperative when talking about monetary policy that we know the concept of interest rates and GDP inside and out.
Say a bank used to charge a 10% interest rate, but there was too much borrowing going on; nobody was spending any money because they could invest almost everything they earned and make a crap-ton. This high interest rate however was hurting businesses all over the nation because well, nobody was spending money. So, the bank lowers their interest rate to 5%, causing people to withdraw their savings, and start investing – this is monetary policy.
How does this affect GDP? Well, if banks are charging say, a 50% interest rate (this would never happen) then 100% of the economy would be saving money, and very little spending would be occurring, basically only on the necessities. There would be no spending on luxury goods, and little spending on entertainment because everyone would be conscious on saving their money. This would result in a ton of businesses closing down. So, to counteract this, the banks lower their interest rate to 5% to induce more spending in the economy.
We always want our economies to balance as much as possible (or, to reach equilibrium) even though it almost never happens, and when it does balance, it doesn’t stay there for long. To put this in other words, think back to the football stadium. If the central bank’s base rate is 50%, the stadium will be overflowing with money because everyone is saving. Conversely, if the lower the base rate to 5%, suddenly there is no money trickling over the edges and the stadium is now half-full – a sustainable amount.
What is it used for?
There are two main reasons why central banks carry out monetary policy. Detailed below are the two reasons and the methods used to achieve them:
Expansionary monetary policy – This is when the central bank lowers interest rates in the economy in order to encourage borrowing and discourage saving. The purpose of this is to increase the aggregate demand in the economy and boost spending. This will eventually create economic growth. Expansionary monetary policy is mainly used in a recession when demand for goods and services is low and people aren’t spending.
Contractionary monetary policy – This is when the central bank increases interest rates in the economy in order to reduce the amount of spending. The purpose of this method is to decrease the aggregate demand in the economy so that prices don’t rise too fast. Inflation is an issue in most countries and contractionary monetary policy is one way of dealing with it. This policy is often used in times of economic growth where the demand for goods and services is very high.
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