Monetary policy is a short-term management of the interest rates in order to meet domestic policy objectives. The monetary policy takes the form of targets of cash rates and affects the economy in short-term.
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Interest rates affect the overall demand and supply. Monetary policy entails altering the base interest rates to regulate the growth of overall demand, supply of money and price inflation.
It operates by influencing the rate of demand for money. For example, changes in the interest rates for short periods influence the spending and saving process for businesses and households. Monetary policy are nowadays more effective in regulating inflation than there before.
It is more effective because it is more predictable and systematic. Nowadays, monetary policy anticipates the inflation at approximately 2% target and responds accordingly to readjust any alteration. Thus, households and businesses expect monetary policy to absorb shocks that can spur inflation from targets.
For example during the recent economic recession, low interest rates offered by financial institutions encouraged borrowing. Low interest rates offered by American banks were the one that enticed many Americans to take mortgages loans.
However, after a short period, the interest rates escalated and many borrowers were unable to service their loans or raise monthly installments for their mortgages.
The increased interest rates in loans offered to Americans resulted in many people and financial institutions becoming bankrupt, a condition that resulted to a very severe economic downturn that spread from the U.S. to other parts of the world (Dean 72).
The model of potential output is an important factor in policymaking. The principal of potential growth has a long history. The new model believes that given enough time, the economy will eventually readjust to the right level.
The period that the economy takes to readjust to its normal output level depends on the flexibility or inflexibility of prices, employment level and expectations. However, the condition worsens when there is a significant uncertainty in the preliminary data.
The duty of policymakers is regulating the uncertainty to enhance stabilization in the economy. The Federal Reserve has the mandate in ensuring price stability, as well as supporting maximum employment.
These two duties require fostering an environmental that supports sustainable growth. However, this was not the case in the recent economic crisis that resulted to collapsing of many large financial institutions in the United States of America.
Following the continuous improvement in GDP between 1990-2007 that increased employment opportunities and ensured modest inflation, the policy makers forgot to regulate the resultant booming growth.
The failure of the policymakers to put appropriate measures in place resulted to fraudulent activities, where personnel in financial institutions engaged in unethical behaviors of giving credits and mortgages to borrowers who could not service their loans or pay monthly installments for their mortgages.
This condition resulted in many people losing their properties and a collapse of many financial institutions in the United States of America. Then resultant economic downtown spread worldwide because of the interrelatedness of the world economy through greater trade integrations and liberalization.
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If the policymakers had regulated the growth of the economy and ensured sustainable growth that will offer price stability and maximum employment, the 2007 recession could not have occurred.
The principal of macroeconomic theory is to ensure sustainable growth that promotes maximum employment and stable prices and modest inflation. The modern economic theory ensures that the national economy is prosperous.
Economists are required to make forecasts about short-term and medium behavior in suitable aggregates that entail, consumption, public spending, investment and foreign trade.
Then the predictions then input in a standard model to illustrate the presumed working of the national economy. The results should show equilibrium between the level of employment and output before comparison with anticipated targets.
Any shortfall will result to further estimations will appropriate adjustment of essential parameters. After realizing the anticipated results, the policymakers communicate to appropriate decision makers who then respond accordingly through manipulating the government budget to accommodate the proposed changes (Foldvary 123).
The Fiscal Policy is very important in ensuring sustainable growth. Federal government uses the fiscal policy in regulating employment and inflation level.
For instance, there is creation of budget deficits in instances when aggregate demand is likely to fall short of the normal level needed to maintain full employment. During this period, the federal government uses stimulus packages to spur economic growth through increasing government spending, as well as reducing the interest rates.
The use of government spending and reduce of interest rates increase employment opportunities. In addition, the reduction of interest rates means that commodities are cheaper to purchase, which promote spending process. This results in the booming of the economy.
On the other hand, federal government creates surplus in instances, where the aggregate demand exceeds full-employment targets. When aggregate demand exceeds targeted full employment, it prompts price inflation. The creation of budget surplus entails a reduction in government spending and a rise in interests’ rates.
When government spending reduces, it means that there is creation of fewer job opportunities and thus people have lesser to spend. The rise of interest rates reduces spending and encourages saving a condition that helps to bring down the high rate of inflation (Fletcher 56).
Therefore, the Federal Reserve should be very sensitive in monitoring the economy to avoid high rate of unemployment by introducing stimulant packages to spur economic activities.
On the other hand, Federal Reserve should intervene accordingly when the economy is booming to arrest any potential inflation (McAfee 78).
There can be more than one theory that tries to explain the economy. However, the economists will either use one of the theories in enacting appropriate policies.
However, policy makers can borrow from different theories in formulating appropriate policies if the different theories adopted have converging views pertaining to the proposed policy.
The monetary policy and fiscal policy, which are founded on the Keynesian economic theory, has been very instrumental in ensuring sustainability in economic growth, through regulating aggregate demand and employment level.
The monetary policy changes the interest rates to affect the money demand accordingly. The alteration of the interest rates affects the aggregate demand in a short span through influencing the spending and saving processes.
On the other hand, the fiscal policy regulates the economic growth by increasing or decreasing government spending and interest rates. When the economy is booming, the Federal Reserve uses budget surplus to regulate employment level, prices and inflation rate.
However, during instances of recession, the Federal Reserve uses budget deficit to spar economic activity through by offering stimulus packages and reducing the interest rates.
Economic packages increase the employment level. Conversely, reduced interest rates encourages spending which is essential in spurring economy activities.
Dean, Ben. The Housing Bubble. Prentice Hall: New York.2010, print
Fletcher, John. House Prices Pumped Up: Rising Rates and Mortgages. Colin: New York. 2009 print.
Foldvary, Evans. The Monetary and Fiscal Policy. The Gutenberg Press: Berkeley.2007, print.
McAfee, Lewis. The Keynesians Economic Theory. Prentice Hall: New. 2009, print