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In: Economics

How does the monetary policy affect inflation?

How does the monetary policy affect inflation?

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Expert Solution

Answer) Inflation pertains to a general rise in price levels due to an increase in the quantity of money; the growth of the money stock rises quickly than the level of productivity in the economy. The precise nature of price rises is the subject of much economic debate, but the word inflation narrowly refers to a monetary phenomenon in this context.

Central banks today mainly use inflation targeting in the injunction to keep economic growth steady and prices stable.

Most modern central banks target the rate of inflation in a country as their primary metric for monetary policy - usually at a rate of 2-3% annual inflation. If prices increase faster than that, central banks tighten monetary policy by raising interest rates or other hawkish policies. Higher interest rates make borrowing more valuable, reducing both consumption and investment, both of which rely heavily on credit. Likewise, if inflation falls and economic output decreases, the central bank will reduce interest rates and make borrowing cheaper, along with several other possible expansionary policy tools.

As a strategy, inflation targeting views the primary goal of the central bank as retaining price stability. All of the tools of monetary policy that a central bank has, including open market operations and discount lending, can be utilized in a general policy of inflation targeting. Inflation targeting can be contrasted to techniques of central banks aimed at other measures of economic performance as their primary objectives, such as targeting currency exchange rates, the unemployment rate, or the rate of nominal Gross Domestic Product (GDP) growth.


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