The functioning of monetary policy

The central bank is the sole issuer of banknotes and bank reserves, which means that it is the monopoly supplier of the monetary base. Therefore, it can also set the conditions on which banks borrow from the central bank and thus influence the conditions of the interbank money market.

In the short run, a change in the money market interest rates induced by the central bank triggers a number of mechanisms and influences the activity of economic agents. Ultimately, the change will influence developments in economic variables such as output or prices. This mechanism is known as the monetary policy transmission mechanism. Although the broad features of this mechanism are well understood, its essence remains very complex and there is no consensus on its detailed functioning.

Neutrality of money

The principle of the long-run neutrality of money underlies all standard macroeconomic thinking and theoretical frameworks. In the economy real income or the level of employment are, in the long term, essentially determined by real factors related to supply, such as technology, population growth or the preferences of economic agents.

In the long run, after all adjustments in the economy have worked through, 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 induce permanent changes in real variables such as real output or unemployment.

Inflation – a monetary phenomenon

In the long run, a central bank can only contribute to increasing the growth potential of the economy by maintaining an environment of stable prices. It cannot contribute to economic growth by expanding the money supply or by keeping short-term interest rates at a level inconsistent with price stability. It can only influence the general level of prices.

Ultimately, inflation is a monetary phenomenon. According to various empirical research results, prolonged periods of high inflation are typically associated with high monetary growth. While other factors, such as variations in aggregate demand, technological changes or commodity price shocks, can influence price developments over shorter horizons, over time their effects can be offset by a change in monetary policy.

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