Monday, October 8, 2007

Effect of Economic Growth on Monetary Policy

Reader Qu. Discuss the impact if an increase in domestic demand on the country's economy and the strategy that is used by your country in order to stabilize domestic demand?

If there is an increase in domestic demand it will be likely to influence Monetary policy and, to a lesser extent, fiscal policy

In the UK, the main tool for stabilising domestic demand is Monetary Policy. Monetary policy is controlled by the MPC, which is part of the Bank of England. They have a target for inflation of CPI = 2% +/-1. Therefore, an increase in domestic demand is likely to impact on their decisions when setting interest rates.

Each month the MPC try to predict future inflationary pressure. If inflation is likely to increase above the target then they will need to increase interest rates to reduce demand. An increase in domestic demand is likely to increase the risk of inflationary pressure, unless the economy is below full capacity. Therefore, a rise in domestic demand will probably cause interest rates to rise.

The MPC look at over 30 statistics to try and get the best indication of inflationary pressures. Domestic demand is one of the most important.

If the increase in domestic demand is very significant, governments may also use fiscal policy. Fiscal policy can be used to deflate the economy through high taxes and lower spending.


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