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Monetary policy theory is the result of a government, central bank, or other head organization setting rules that affect an economy. The different types of theory are rather simplistic in definition, though quite difficult in actual application. Theories include tight, loose, and government spending, with each type having a specific focus as a monetary policy theory. The purpose of these theories is to control the economy, inducing growth during sluggish periods or cooling off an economy in order to stave off inflation. Economists generally make recommendations for the policy-setting organization on how to set monetary policy.
A tight monetary policy theory has high interest rates, high bank reserve rates, and other means to reduce the amount of money in an economy. High interest rates make it more costly to loan money between individuals and businesses. Setting high bank reserve rates requires financial institutions to retain more cash in their coffers. This reduces the amount of money available for investment. In short, less money in a market reduces the opportunity for growth and slows growth-induced inflation.
A central bank can induce growth in an economy by operating under a loose monetary policy, which includes factors that are the opposite of a tight economy. Lowering interest rates, for example, allows the cost of loans to go down, increasing the frequency of making loans. The same goes for low bank reserve rates. Less money kept in various financial institutions means these organizations can invest more money into projects that often result in economic growth. These policies are meant to encourage growth and spending by consumers and businesses, all of which should lead to economic growth.
Another type of monetary policy theory is government intervention into a free market. This theory dictates government action when the current free market economy goes soft, meaning little economic activity from consumers and businesses. Here, governments intervene by purchasing excess products; the purpose is to grease the economic skids and keep the economy growing and moving along. This theory is not always effective. The reason behind the lack of impact from this monetary policy comes from other factors outside of the government’s control in terms of creating economic demand.
Economics is rarely a one-and-done situation. Economists usually have differing opinions on how to maintain economic growth. A review of past monetary policy theory to determine what works is standard. Changes or adjustments can create a new policy meant to grow the economy under current conditions.
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