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QuestionHow does monetary policy affect economic activity and prices?

Answer

In general, the effects of monetary policy on economic activity, through a decline or a rise in (real) interest rates, are as follows.

When interest rates decline, financial institutions can procure funds at low interest rates. This enables them to reduce their lending rates on loans to firms and households. Given the linkage between various financial markets, there is a decline in not only financial institutions' lending rates but also interest rates at which firms borrow directly from the market, such as in the form of corporate bond issuance.

In this situation, firms find it easier to procure working capital (funds needed for the payment of salaries and input costs) and fixed investment funds (funds needed for construction of factories, stores, etc.), and households also find it easier to borrow funds, such as for purchasing housing.

As a result, firms' and households' economic activity picks up, and this stimulates the economy. Upward pressure on prices is also generated in turn.

Such monetary policy measures, aimed at stimulating the economy, are called monetary easing.

On the other hand, when interest rates rise, financial institutions must procure funds at higher interest rates, and raise their lending rates on loans to firms and households. Firms and households find it difficult to borrow funds, which makes their economic activity sluggish. This, in turn, contains overheating of the economy and exerts downward pressure on prices.

Such monetary policy measures, aimed at containing an overheating of the economy, are called monetary tightening.