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Monetary Policy, Inflation and Growth

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Essay title: Monetary Policy, Inflation and Growth

Monetary policy is the government or central bank process of managing money supply to achieve specific goals, such as constraining inflation, maintaining an exchange rate, achieving full employment or economic growth. Monetary policy can involve changing certain interest rates, either directly or indirectly through open market operations, setting reserve requirements, or trading in foreign exchange markets. It must be universally agreed that low and stable inflation is a primary and essential goal for monetary policy, in large part because economists believe that it brings stability to financial systems and fosters sustainable economic growth over the longer run.Although, monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy has the goal of raising interest rates to combat inflation.(12)- (3)

Inflation is an increase in the money supply or an increase in prices. The two most obvious versions of this, each held by some economists to be "real" inflation, are for prices of goods and services in the currency in question to rise, or for the money supply to increase. Price inflation is closely related to "cost of living" measurement, where a "basket" of goods is used as a standard and the prices of the goods are compared at two intervals and adjusting for changes in the intrinsic basket. But, technically, this is not raw inflation; it is an attempt to determine real-life value of money compared to the members of the society in question, adding other factors like increased expectations. Raw inflation measurement does not adjust for expectations, but directly measures the change in the price of goods. There are different measurements of price inflation, depending on the basket of goods selected. The most common measures are of consumer inflation, producer inflation and GDP deflators, or price indexes. The last measures inflation in the entire economy. General price inflation is a fall in the purchasing power of money within an economy, as compared to currency devaluation which is the fall of the market value of a currency between economies. The extent to which these two phenomena are related is open to economic debate, though the comparison of a currency to foreign currencies is based on investor demand for currencies, and therefore must at least partially be a matter of perception. Both of these are often caused by money being added to an economy, either as printed currency or as virtual money lent to banks or other entities. This is called currency inflation, and can cause price inflation or currency devaluation. But, because the general amount of wealth gradually changes in an economy (as long-lasting things are created, new technologies invented, et cetera), a small amount of currency inflation need not cause price inflation. (6)- (9)

Economic growth is the increase in the value of goods and services produced by an economy. It is generally considered to be an increase in the wealth, or more precisely the income, of a nation or entity. It is conventionally measured as the percent rate of increase in real gross domestic product, or GDP. Growth is usually calculated in real terms, i.e. inflation-adjusted terms, in order to net out the effect of inflation on the price of the goods and services produced. In economics, "economic growth" or "economic growth theory" typically refers to growth of potential output, i.e., production at "full employment," rather than growth of aggregate demand or observed output. The short-run variation of economic growth is termed the business cycle, and almost all economies experience periodic recessions. Explaining and preventing these fluctuations is one of the main focuses of macroeconomics. A statistical relationship called Okun's law relates the growth rate of an economy to the level of unemployment. On a Keynesian view, growth varies because of changes in aggregate demand, causing firms to produce more or less goods and for sale and hence altering the size of the economy. The contrasting real business cycle model suggests that in the short run growth depends on a series of shocks to the productivity of the economy, e.g. an oil price rise making the economy generally less productive and reducing growth. The long-run path of economic growth is one of the central questions of economics; in spite of the problems of measurement, an increase in GDP of a country is generally taken as an increase in the standard of living of its inhabitants. Over long periods of time, even small rates of annual growth can have large effects through compounding. A growth rate of 2.5% per annum will

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