Question: To what extent can monetary policy be used to control inflation?
Monetary policy is the manipulation of monetary variables (interest rate and money supply) by the MPC to influence AD and inflation.
If inflation is below target then the monetary authorities will use a loose monetary policy and cut interest rates to increase AD. Multiplier effects make AD rise further and, eventually, real GDP and the price level rises.
Monetary policy works through a number of mechanisms including, for example, consumption, investment and the housing market.
For instance, a fall in interest rates means the cost of borrowing falls so consumers take out more loans and buy more credit-bought items. Furthermore, the return on savings falls so saving becomes less attractive and consumption becomes more attractive. Consumption rises, AD rises, the price level rises and real GDP rises.
Also, a lower interest rate means savings generates a lower return so more investment projects become profitable. Moreover, a fall in interest rates means the cost of borrowing falls, investment becomes cheaper so firms take out more loans and invest more. Investment rises, AD rises, the price level rises and real GDP rises.
Moreover, lower interest rates means mortgages are cheaper so demand for houses rise and house prices rise. As house prices rise, homeowners’ wealth rises inducing a wealth effect. A homeowner can borrow more against the higher value of their home and increase consumption (equity withdrawal). Consumption rises, AD rises, the price level rises and real GDP rises.
However, the effectiveness of monetary policy depends on a number of factors.
For example, monetary policy’s effectiveness depends on the magnitude of the change in interest rates. Monetary policy is more effective the larger the change in interest rates. A larger fall in interest rates means AD rises a lot, the price level rises a lot and real GDP rises a lot. Moreover, the shift in AD depends upon the size of the multiplier. Monetary policy is more effective the larger the multiplier.
Additionally, an interest rate drop will not affect investment if investment is interest inelastic because investment does not respond to interest rates. An interest rate drop affects investment if investment is interest elastic because investment responds to interest rates.
Moreover, monetary policy’s effectiveness depends on the elasticity of the LRAS curve. Monetary policy is more effective in raising real GDP the more elastic is LRAS. Conversely, monetary policy is more effective in raising inflation the more inelastic is LRAS. If LRAS is elastic there is a lot of spare capacity, a loose monetary policy boosts AD, real GDP rises a lot but the price level rises a little bit (or maybe stays the same).