A1.4.1. Monetary Policy
Monetary policy is a tool used by national governments to control the supply and availability of money and credit and thereby to affect overall economic activity in a country. Monetary policy is premised on the theory that changes in a country’s money supply—the total amount of money in the economy—will have direct and far-reaching effects on that country’s economy.
In highly simplified terms, monetary policy assumes that growth in the money supply increases the amount of available credit, which in turn causes interest rates to decline. Lower interest rates stimulate economic activity by reducing the cost of borrowing and encouraging business investment. Unemployment goes down, and personal income and consumer spending rises. However, all this extra money sloshing around in the economy leads to rising inflation—the rate at which the prices of goods and services increase. While some inflation is normal, excessive inflation erodes purchasing power, discourages investment, and provokes increases in interest rates. The outcome is the worst of both worlds: high prices and an economic downturn.
Conversely, slow or negative growth in a country’s money supply leads to slower economic growth, higher interest rates, and higher unemployment, but the reduced supply of money tends to foster low inflation.
Rarely, inflation can fall so much that it turns into deflation, which is an overall decrease in the prices of goods and services acro