- As mentioned briefly before, monetary policy aims to achieve several macroeconomic objectives that contribute to a stable and prosperous economy, including:
- Low and stable inflation
- Low unemployment
- Reducing business cycle fluctuations
- Promoting a stable environment for long-term growth
- Achieving external balance
Low and Stable Inflation
Inflation Targeting
Inflation Targeting
A strategy where central banks set a specific inflation rate as their primary goal and adjust monetary policies respectively to meet the goal.
The Bank of England targets an inflation rate of 2%. If inflation rises above this target, the bank may increase interest rates to reduce spending and bring inflation back to the target level.
Inflation targeting has become an important aspect for central banks, as:
- It brings stability to the economic environment of the country, allowing investors and consumers to be more confident in their economic decision making.
- Provides a better coordination of fiscal policy with monetary policy, as the set inflation rate goal allows governments to better plan its fiscal policy to work well with the monetary policy.
However, inflation targeting has disadvantages as well.
By focusing solely on controlling inflation, central banks might be forced to adopt policies, such as:
- Raising interest rates, which could negatively affect other parts of the economy by:
- increasing unemployment
- slowing down economic growth
Why is Low Inflation Important?
- Price Stability: Stable prices prevent the decrease of purchasing power.
- Economic Confidence: Predictable inflation encourages investment and consumption.
- Avoiding Hyperinflation: High inflation can lead to economic instability and loss of confidence in the currency.
Low Unemployment
- Monetary policy can help reduce the cyclical unemployment by stimulating economic activity.
- Lower Interest Rates: Reduce borrowing costs for businesses and consumers.
- Due to this, firms are incentivised to invest in new projects, creating jobs.
- With an increase in employment, more consumers spend more, boosting demand for goods and services, increasing aggregate demand.
During the 2008 financial crisis, central banks worldwide lowered interest rates to near zero to encourage spending and reduce unemployment.
NoteMonetary policy alone cannot achieve full employment. Structural issues, such as skill mismatches, require supply-side interventions.
Reducing Business Cycle Fluctuations
The business cycle consists of periodic economic expansion and contraction of the economy. By using monetary policy, the central banks aim to make this fluctuations smoother, and reduce the disruptions it might bring.
- During Recessions: Lower interest rates to stimulate spending and investment, to push an expansion of the economy.
- During Booms: Raise interest rates to prevent overheating and inflation, hence contracting the economy.
In 2015, the U.S. Federal Reserve gradually increased interest rates as the economy recovered from the recession, aiming to prevent excessive inflation.
NoteStudents often confuse the roles of fiscal and monetary policy. Remember, monetary policy is controlled by the central bank, not the government.
Promoting a Stable Environment for Long-Term Growth
Economic stability fosters confidence among investors and consumers, encouraging long-term growth.
- A stable economic environment fosters investor and consumer confidence, which in turn encourages long-term capital investment and promotes sustainable economic growth.
- Having predictable interest rates provides consumers and investors a wealth of confidence, also encouraging investment in physical and human capital.
- Furthermore, stability attracts foreign investment and supports innovation.
Achieving External Balance
- External balance is where a country’s export earnings are roughly equal to its import expenditure for a long period of time.
- The central bank is able to heavily influence the currency exchange rates due to the close relationship it has with interest rates.
Exchange rates and balance of payments with its impacts will be discussed in 4.5 and 4.6.
ExampleIn 2016, the UK lowered interest rates following the Brexit vote, leading to a depreciation of the pound. This made UK exports more competitive globally.
NoteAchieving external balance is challenging. A weaker currency can boost exports but also increase the cost of imports, potentially leading to inflation.
