5.3.1—Monetary policy

Monetary policy uses interest rates, money and credit conditions, or the exchange rate to influence aggregate demand and the price level. In many economies the central bank, not the finance ministry, sets the policy instrument.

A lower policy rate can reduce borrowing costs, raise asset prices and weaken the exchange rate, encouraging consumption and investment. The strength and timing depend on confidence, debt, banks and expectations.

If the central bank cuts rates and households refinance cheaper mortgages, disposable income and consumption may rise; if banks are unwilling to lend, the transmission is weaker.

Changing the policy rate does not mechanically change inflation immediately, and monetary policy cannot remove a physical supply shortage.