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What Is the Relationship between Monetary Policy and Interest Rates?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 03 September 2016
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The relationship between monetary policy and interest rates is the fact that the manipulation of interest rates is a type of monetary policy that is utilized by the monetary policy maker in an economy to achieve a desired outcome in the economy. Monetary policy and interest rates are macroeconomic principles that are generally targeted toward the general economy in a country. A country's central or top bank is the entity that is vested with the responsibility of pushing monetary policies in a country. The purpose for applying monetary policy and interest rates depends on the type of outcome the apex bank is trying to achieve in the economy.

One of the aims for applying monetary policy and interest rate is to encourage the consumption of more services and goods by consumers. This may be due to the consequences of a pronounced drop in the general level of consumption in the economy. Some of the effects include a reduction in the aggregate Gross Domestic Product (GDP) and an increase in unemployment caused by the shedding of workers by employers in compensation for the reduction in the demand for their goods and services. Where this is the case, the central bank will utilize monetary policy and interest rates to stimulate an increase in general consumption by consumers.

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A reduction in the level of interest rates by the central bank will lead to a reduction in the interest charged to borrowers for borrowing money from banks. It will also lead to a lowering of the standards required to qualify for a loan or line of credit. As such, consumers will be able to access the necessary funds that will enable them to make purchases like buying homes, cars and other products as well as services. This will not only encourage economic activity, but it will also lead to a decrease in the level of unemployment as the producers and manufacturers hire more employees to keep up with the increase in the level of demand.

When the central bank wants to slow the rate of economic activity in the economy, it will increase the interest rates, increasing the expenses for consumers to obtain the finance with which to make purchases. It also will cause the banks to tighten their requirements for granting loans and credit, further making it harder for consumers to qualify for such means of financing their consumption. As such, monetary policy and interest rates are simply part of the tools used to control the economy.

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donasmrs
Post 3

Sometimes I see countries' Central Banks trying to fix their economic problems without touching the interest rates. I have no idea why they do this, it's so illogical. Adjusting the interest rate is the easiest and most effective way to stabilize an economy. It's a vital component of monetary policy like the article emphasized.

bluedolphin
Post 2

@fBoyle-- The relationship between these depend on the type of monetary policy.

If we have a contractionary monetary policy (also called "tight" or "restrictive"), interest rates will be raised to reduce money supply. An economy needs a contractionary policy when the inflation is too high (possibly due to rapid economic growth). So the Central Bank will raise interest rates to discourage people from lending. When lending is reduced, capital or money in the market will go down, also reducing inflation.

If we have an expansionary monetary policy (also called "easy"), then the Central Bank will reduce interest rates to increase money supply. This is the opposite of contractionary policy. Low interest rates will increase lending and will add capital to the market, also increasing the inflation rate.

fBoyle
Post 1

Can someone explain to me the relationship between monetary policy, interest rates and money supply? I have homework on this and I don't understand anything.

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