Question

Changes in the interest rate affect various kinds of economic activity and thereby, over time, inflation. Explain how monetary policy works and what are transmission channels through which the monetary policy affects economic activity and the inflation?

Answer 1

Monetary policy uses interest rate as effective tool to affect the economic activities taking place in the economy with a target to control the inflation and overall economic growth. If the inflation rate is high, then contractionary monetary policy is used to affect the economic activities. In this regard, the interest rates are increased and the different transmission channels are used to affect the economic activities. The first such channel is the bank credit lending to the households and firms. Higher interest rates, discourage the households and firms to go for borrowings. As a result, the ugly spending is eliminated and the inflation rate is controlled. The second channel is the reserve requirement to be maintained by the Banks. With higher reserve ratios set as a part of monetary policy, the banks have less funds to lend. As a result, the interest rates are raised by the banks that again discourage the borrowings. It curbs the ugly spending and aggregate demand comes down. So, inflation is brought down within the target range. On a similar note, the monetary policy uses money supply as another channel and implements the reduction in money supply by selling government securities in the open market. With less money available in the economy, interest rates in the money market and or with the banks increases. So, inflation rate is controlled.
When a monetary policy wants to stimulate the economy and try to boost the demand, then uses expansionary monetary policy and lowers the interest rates. Above channels again work in favor to increase the spending and aggregate demand is increased.