The functioning of monetary policy
The central bank is the sole issuer of banknotes and sets the reserve requirements for the commercial banks, which means that it is the monopoly supplier of the monetary base. This lets the central bank set the conditions under which banks can borrow from it, which then affects the conditions in the interbank money market.
A change in the monetary policy interest rates set by the central bank triggers a number of mechanisms and influences the activity of participants in the economy. Ultimately this then affects developments in economic variables such as output or prices. This mechanism is known as the monetary policy transmission mechanism. Although the general operation of this mechanism is well understood, its essence remains very complex.
The neutrality of money
The principle of the long-run neutrality of money underlies all standard macroeconomic thinking and theoretical frameworks. Incomes or the level of employment in the economy are, in the long term, essentially determined by real factors related to supply, such as technology, population growth or the preferences of participants in the economy.
Changes in the amount of money are felt in the economy in the short term through relative prices, as some prices such as wages are stickier than others, but some prices such as those of consumption goods are more flexible. This means that the prices of consumer goods rise faster than wages when the amount of money in the economy increases. Purchasing power consequently declines for a time.
In the long run, after the economy has adapted, a change in the quantity of money in the economy will be reflected in a change in the general level of prices, but it will not cause permanent changes in real variables such as real output or unemployment.
Inflation as a monetary phenomenon
A central bank can only contribute to increasing the potential for growth in the economy in the long run by maintaining an environment of stable prices. It cannot contribute to long-term economic growth by expanding the money supply or by keeping short-term interest rates at a level that is inconsistent with price stability. It can only influence the general level of prices.
Ultimately, inflation is a monetary phenomenon. A range of empirical research results have shown that prolonged periods of high inflation are typically associated with rapid growth in the amount of money, because of asset purchases for example. While other factors, such as variations in aggregate demand, technological changes or commodity price shocks, can affect price developments over shorter horizons, their effects can be offset over time by a change in monetary policy.