Monetary policy and inflation

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  • Monetary Policy controlling inflation
    • Decrease the money supply, inflation goes down in the medium run.
    • The mechanism through which this works is that if the money supply is higher, there is more money in circulation chasing the same amount of goods. The law of supply and demand says that the amount of money required for the goods must now go up.
    • Increase the money supply, inflation goes up in the medium run.
    • Monetary policy increases or decreases the money supply through open market operations - the buying and selling of government bonds.
    • Higher interest rates deter consumers and businesses from borrowing and encourage them to save.
    • Business investment may also fall, as the cost of borrowing funds will increase. Some planned investment projects will now become unprofitable and, as a result, aggregate demand will fall
    • Monetary policy can control the growth of demand through an increase in interest rates and a contraction in the real money supply.
    • Higher interest rates reduce aggregate demand in three ways;
      • Increasing the rate of saving (the opportunity cost of spending has increased)
      • Discouraging borrowing by both households and companies
      • The rise in mortgage interest payments will reduce homeowners' real 'effective' disposable income and their ability to spend. Increased mortgage costs will also reduce market demand in the housing market


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