Answer to Question #82460 in Macroeconomics for lamanda

Question

Discuss to what extend should monetary policy be used to fine-tune the economy?

Answer 1

Monetary policy is used in tandem with the fiscal policy of the state to regulate the economy. Monetary policy affects the supply and demand of money and thus, depending on the specific need, it allows to achieve a balance between the amount of money in circulation and the amount of goods and services produced (the monetarist approach).

As we know the economy is characterized by cyclicality, the period of recession alternates with a period of growth and vice versa. In this regard, in order to stimulate the economy in the state, measures should be taken to saturate in sufficient quantity of “cheap money” (a decrease in the reserve requirement, a reduction in the discount rate, the purchase of government securities). The increase in the mandatory reserve ratio, the increase in the discount rate, the sale of government securities will be restrictive for the economy, hence the name “expensive money policy”.

It should be noted that in the monetary policy there are a number of shortcomings: the amount of money in circulation can be smoothed by the velocity of money circulation; in the long run, there is a decrease in efficiency in contrast to the short term; the possibility of a situation arising when the interest rate ceases to react to the amount of money - the so-called "liquidity trap".

Despite a number of shortcomings, monetary policy, thanks to its flexibility and efficiency, continues to be effective in the mechanism of "fine-tuning" the economy. The most important thing is that this mechanism should be managed by an understanding "operator" and its course should not go against state fiscal policy.