The study of a business cycle that is the fluctuations in the economic activities and market conditions of an economy over a period of time constitutes what macroeconomic policy is all about (Sims, 1990). Macroeconomic policies are designed in such a way that they affect the overall economic performance of the country as a whole.
Macroeconomic policy however has been defined by many economists, it can be defined as a set of rules and regulations set up by the government of an economy and these rules and regulations are used to control or regulate the main (aggregate) indicators of the economy. Such aggregate indicators include: interest rate, inflation, money supply and so on (Baumol and Blinder, 2009). Macroeconomic policy can also be defined as a number of policies that control the money supply of a country.
Macroeconomic policies are designed in such a way that they affect the overall performance of the economy as a whole. There are two main types of macroeconomic policy: the monetary policy and the fiscal policy.
Monetary policy is concerned with how the central banks make decisions that involve changes in the cost and availability of money (Evans, 2004). Here, the change in cost of money refers to the rate of interest. In the long-run, a change in monetary policy affects the inflation rate but doesn’t affect the real growth rate but in the short-run, a change in monetary policy affects both output and prices.
MONETARY POLICY AND INFLATION
There is a link between monetary policy and inflation rate; economists call this lint the monetary transmission mechanism. The monetary transmission mechanism is defined as a process through which a change in interest rate affects inflation rate. Rummel (2012) defined the monetary transmission mechanism as changes in monetary policy variables that affect inflation and output. According to Loayza and Schmidit-Habbel (2002), the monetary policy transmission policy channels assume that the central banks pursue an expansionary monetary policy. This involves either increasing the its monetary aggregates or reducing its policy interests. This mechanism consists of three main stages; a summary of these stages is shown in the chart below:
STAGE ONE STAGE TWO STAGE THREE
This stage shows how asset prices are seen as very important in discussion that involve interest rates and monetary policy (Mishkin, 2001). Also it shows that a change in the original or official interest rate set by the monetary policy committee has an effect on other interest rates. This causes banks and other financial institutions to react to this change by changing their loans and saving rates. These changes affect the asset prices (share price, price of gilt-edged securities and so on). These changes also affect the expectations of both individuals and firms; they could either become more confident or less confident of the future of the economy.
The second stage explains how all the changes that occur in the market affect the spending pattern of consumers and firms, this in turn affects the general aggregate demand. Household demand is affected because changes in interest rates affect savings, which indirectly affect spending. For households or firms that have acquired debt in the past (mortgage), changes in rates may affect repayments, and hence individuals have more (or less) cash after servicing their debts. Changes in rates affect the cash-flow of firms and households (Mishkin, 2001). Also an n increase in interest rates reduces the aggregate demand and because these increases affect consumers, they will be forced to cut back on their expenses/spending.
This however has an international effect, in the sense that there will be a corresponding change in imports and exports in response to the changes that affect the exchange rates.