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What Is the Relationship Between Monetary Policy and Economic Growth?

The Federal Reserve is part of the US government's system to maintain economic stability or foster growth.
Increases in the interest rate are used to decrease the amount of money in circulation at a given time.
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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 16 September 2014
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The relationship between monetary policy and economic growth is mainly the manner in which the judicious application of monetary policy can be used to foster or facilitate the growth of the economy. Monetary policies include all of the tools used by the financial regulatory authority of a country to guide economic growth in that country. Such financial regulatory authorities are usually the apex bank in the country, which may be the central bank, the federal reserve bank, or simply the financial top authority. The link between monetary policy and economic growth can be seen in the manner in which monetary policies, such as decisions to increase interest rates or the reverse of the same, can be used to maintain stability in the economy.

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Increases in the interest rate are used to decrease the rate of demand for goods and other consumables. They are also used to decrease the amount of money supply in the economy at a given point in time. The connection between monetary policy and economic growth is the fact that monetary policies are designed and applied at calculated points in the business cycle to remove unwanted economic factors like persistent inflation. It is also used to control the economy through a reduction in negative economic trends like excessive spending, which often lead to an overheating of the economy and consequent crashes or recessions. In that sense, it may be said that monetary policy and economic growth are related by the manner in which well-applied monetary policies serve as catalysts for sustained economic growth.

For example, when there is a boom in the economy and people are cashing in on the easy availability of cash and credit to make a lot of purchases, it puts a lot of strain on the economy as the various businesses strive to keep up with the excessive consumerism. Most times, the rate of production and supply are not equal to the level of demand, causing an imbalance in the economy that is capable of derailing it. The ideal type of economy should not have any imbalances where the supply far exceeds the demand or the demand is more than can be handled by the available supply. Neither one is desirable, as either could act as an inhibitor of proper economic growth. As such, the financial regulatory authorities usually try to maintain a healthy balance by constantly analyzing economic trends with a view to finding out if it is necessary to increase or decrease the interest rate.

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