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The relationship between monetary policy and the economy is the fact that monetary policy is a tool used for the manipulation of the economy in order to achieve certain expected results. Monetary policies usually involve factors like an increase or decrease in the total supply of money in the economy at any one time and an upward or downward review of interest rates. Usually, the central banks or federal reserve banks are responsible for such changes, which are normally based on certain indicators in the economy.
An example of the relationship between monetary policy and the economy is a situation where an analysis of several business cycles reveals the fact that there is an inflationary trend. Business cycles are simply stated periods are used to divide the length of business activities with the aim of serving as a kind of reference point for economists and other associated parties. For the purpose of monetary policies, a business cycle may be quarterly, annually or based on the aggregate compilation of economic activities over a period of four years. An analysis of the business cycle will show if there is any type of inflation or if the economy is slow. Where there is a show of rising inflation over several business cycles, the central bank will introduce monetary policies aimed at reducing the inflation.
Usually, inflation is fueled by an overactive economy in which the rate of consumption exceeds the rate of production and supply. This trend leads to a situation where too much money will be chasing after too little goods, causing the prices of such commodities to go up in response. In order to address such negative trends, the central bank might decide to reduce the amount of money in circulation in the economy. The purpose for this reduction is to curtail the rate of demand and consumption, thereby leading to a corresponding fall in inflation that is fueled by the demand. This establishes a link between monetary policy and the economy, since the monetary policy is aimed at correcting a perceived anomaly in the economy.
One of the methods by which the central bank can reduce the amount of money in the economy is through increases in the interest rates. The logic is that increasing the interest rates will lead to a fall in demand for loans and other forms of credit as a result of the prohibitive interest rates. It will also lead to more savings in the banks and less spending due to a correlative increase in the interest paid on savings in the bank. The reverse is the case in the event of lackluster activities in the economy. With the hope of encouraging spending and increasing economic activities, the central bank will reduce interest rates, which also shows a link between monetary policy and the economy.