Having discussed the instrument and objectives of monetary policy, it remains to describe how policy influences the economy. This topic can usefully be divided up between the effects on economic activity, covered in this section, and the effects on inflation, covered in the final section.
In describing the processes by which monetary policy affects the economy, it should be kept in mind that they are far from being purely mechanical in their operation. Predictions about the effects of a policy action are, like economic forecasts generally, always subject to uncertainty. The task of policy is to make decisions on the basis of the best available information, recognising that these uncertainties exist.
The general principle that short-term interest rates affect aggregate demand and activity is illustrated in Graph 4. The pattern illustrated in the graph is that important changes in trend for a broad measure of demand have generally been preceded by significant changes in the level of short-term interest rates. Substantial rises in interest rates, designed to restrain inflationary booms, have been followed by contractions in demand. Conversely, substantial interest rate reductions have been followed by periods of significantly faster growth. In responding to cyclical developments and inflationary pressures, monetary policy has had a powerful influence on aggregate demand and economic activity.
We can identify several mechanisms through which these effects can occur, broadly grouped under five headings.
Governments liable to make the wrong decisions – influence by political pressure groups, they spend on inefficient projects which lead to inefficient outcome.
Personal Freedom. Government intervention is taking away individuals decision on how to spend and act. Economic intervention, takes some personal freedom away.
Market is best at deciding how and when to produce.
When we relate this situation with the concept of unemployment then we can say that in case of long run increase in demand will give maximum benefit to the company or the industry when the economy has a starting point when the employment level in the economy is full. This is known as inflationary gap. Inflation is least expected in the deflationary conditions when there is an unemployment equilibrium. Hence inflation may only increase when there is high or full level of employment in the industry. When there is full level of employment in the industry then there is very little chances of increasing money supply to increase the national output. Hence when money supply in increased then there is a modest scenario of inflation.
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