Please create a response to the following statment. What monetary policy are you

Question

Please create a response to the following statment.

What monetary policy are you referring to? I see you mention making minor changes to interest rates is the easiest way to influence economic cycle, but both an expansionary monetary policy and a contractionary monetary policy make changes to interest rates. An expansionary monetary policy decreases interest rates to increase the real GDP and contractionary policy increases rates to reduce inflation. I was unable to find what the potential GDP is compared to the real GDP, that would help decide if the real GDP needed to be increased using an expansionary monetary policy.

Explanation / Answer

Monetary policy refers to the policy initiatives taken up by the central bank (Federal Reserve in the USA) to help the economy grow and achieve stability as well. It is not only about interest rate change, but also it involves change in money supply using open market operations as well as quantitative easing in the economy. Besides, the reserve requirements are another ploy, that is used by the central banks to apply the monetary policy. The focus of the monetary policy is to drive the economy to achieve the potential GDP level. It is the GDP level, that is achieved at full employment level. If a central bank finds that real GDP in the economy is less than the potential level of GDP, then expansionary monetary policy is applied. As a part of it, money supply is increased and interest rate lowers. It increases the spending, supply increases and new jobs are created. It pushes the real GDP to be at the potential level of GDP. The potential level of GDP can also be identified using the Okun’s law that establishes the relationship between the increase in unemployment rate and decrease from a potential level of GDP.
  

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