The Effects of Monetary Policy on the Economy

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The Effects of Monetary Policy on the Economy
Central banks are the national authorities responsible for providing currency and implementing monetary policy. Monetary policy is a set of actions through which the monetary authority determines the conditions under which it supplies the money that circulates in the economy. Monetary policy therefore has an effect on short-term interest rates. Setting monetary policy goals has been a defining issue for economists and public opinion since the consolidation of central banks as the entities responsible for providing the economies with domestic currency and for implementing monetary policy. Parallel with academic progress and experience in this matter, the understanding of monetary policy has advanced significantly over the last few decades. Currently, it is clear that in both academic circles and among the world’s monetary authorities, monetary policy’s best contribution to sustained growth is to foster price stability. For that reason, in recent years, the central banks of many countries, including Mexico, have reoriented their monetary policy objectives, setting price stability as their main goal. This goal has been formalized, in most cases, by establishing low-level inflation targets. The central bank does not control prices directly because these are determined by the supply and demand of many goods and services. Nevertheless, through monetary policy the central bank can influence the price-determination process and thus attain its inflation target. The latter suggests the extreme need for the monetary authority to identify the effects that its actions have on the general economy and, particularly, on the price-determination process. The study of the channels by which these effects take place is known as the monetary policy transmission mechanism. Flow Chart 1 details this mechanism in general terms.

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Flow Chart.1 Monetary Policy Transmission Mechanism

Interest rate channel

Credit channel Aggregate...
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