2.1.6.2 Economic effects of monetary policy
The Central bank tries to maintain price stability through
controlling the level of money supply. Thus, monetary policy plays a
stabilizing role in influencing economic growth through a number of channels.
However, the scope of such a role may be limited by the concurrent pursuit of
other primary objectives of monetary policy, the nature
of monetary policy transmission mechanism, and by
other factors, including the uncertainty facing policy makers and the
stance of economic policies.
In addition, the concurrent target of intermediate goals may
have implications on the attainment of the ultimate objective of achieving
sustainable growth. The contribution of monetary policy maker to sustainable
growth is the maintenance of price stability.
Since sustained increase in price levels is adjudged
substantially to be a monetary phenomenon, monetary policy uses its
tools to effectively check money supply with a view to maintaining
price stability in the medium to long term.
Theory and empirical evidence in the literature
suggest that sustainable long term growth is associated with
lower price levels. In other words, high inflation is damaging to long-run
economic performance and welfare.
Monetary policy has far reaching impact on
financing conditions in the economy, not just the costs, but also the
availability of credit, banks' willingness to assume specific risks, etc.
It also influences expectations about the future direction of
economic activity and inflation, thus affecting the prices of goods, asset
prices, exchange rates as well as consumption and investment.
A monetary policy decision that cuts interest
rate, for example, lowers the cost of borrowing, resulting
in higher investment activity and the purchase of consumer
durables.
The expectation that economic activity will strengthen may
also prompt banks to ease lending policy, which in turn enables
business and households to boost spending.
In a low interest-rate regime, stocks become more attractive
to buy, raising households' financial assets. This may also contribute to
higher consumer spending, and makes companies' investment projects
more attractive.
Low interest rates also tend to cause currency to
depreciate because the demand for domestic goods rises when
imported goods become more expensive. The combination of these
factors raises output and employment as well as investment and consumer
spending.
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