Governments influence the economy of a country by varying the money supply in the economy through the increase or decrease of interest rates of borrowing. Monetary policy is the process by which a monetary authority of a country controls the supply of money in the economy to attain a target rate of interest. It is used to attain growth and stability of the economy through stabilization of prices and lowering of unemployment. Expansionary monetary policy increases the total money supply in the economy, while contractionary monetary policy decreases the total money supply in the economy.
Expansionary monetary policy may be used to help reduce the unemployment rate in recession periods. Through lowering of interest rates, which is a characteristic of expansionary monetary policy, the size of the money supply increases. This is because of increased borrowing. Buying of Treasury bonds by the Treasury from investors also increases money in the supply. The increased money supply in the economy stimulates business investments. These business investments in turn create employment opportunities for the unemployed. The purchasing power of the people increases, pulling the economy from recession.
On the other hand, expansionary monetary policy can be harmful to the economy. A delicate balance has to be maintained among economic, creation of employment, price stabilization and inflation. Increased money supply in the economy boosts economic growth through increased business investments, creation of employment and enhanced purchasing power. However, it also causes high rate of inflation, which is undesirable trend because it erodes the gains already attained by the expansionary monetary policy. High wage rate increases consumer demand, causing demand pull inflation. It also leads to high cost of production inputs, resulting in cost push inflation.
Contractionary monetary policy helps the economy during high inflationary rate. If applied, it reduces the size of money supply in the economy, thereby raising the interest rates. This pushes the demand and the cost of production to desirable levels. This reduces the rate of inflation.
Contractionary monetary policy, however, can be counterproductive. If applied during recession periods, it accelerates the recession to depression. High interest rates leave little money in circulation in the already suppressed economy. Business investments contract and people are laid off. This leads to low household income, no savings and, consequently, low purchasing power.