.Discuss the extent to which monetary policy is an effective means of reducing inflation.
The government uses three main economic policies to influence the economic activity to achieve their macroeconomic policy objectives. Monetary Policy is one of these. Monetary Policy involves changes in the base rate of interest to influence the rate of growth of aggregate demand, the money supply and ultimately price inflation.
Monetarist economists believe that monetary policy is a more powerful weapon than fiscal policy in controlling inflation. Monetary policy also involves changes in the value of the exchange rate since fluctuations in the currency also impact on macroeconomic activity, incomes, output and prices.
Changes in short term interest rates affect the spending and savings behaviour of households and businesses over time and therefore feed through the circular flow of income and spending. The transmission mechanism of monetary policy works with variable time lags depending on the interest elasticity of demand for different goods and services e.g. the demand for interest-sensitive consumer goods and services bought on credit or the demand for capital investment from private sector businesses. Because of the time lags involved in setting an appropriate level of short-term interest rates, the Bank of England sets nominal interest rates on the basis of hitting the inflation target over a two year forecasting horizon.
Inflation is defined as a sustained rise in the general price level. This is a very general definition. When the 'inflation figures' come out once a month and are quoted on the news, the newsreaders give certain percentage 'rates of inflation'. These are annual percentage changes in certain indices. The Retail Price Index (RPI) is the most famous, but the government prefer to quote the RPIX for reasons that will soon be explained. There are other, less quoted, measures that need to be considered too.
Monetary Policies have a great role to...