What is monetary policy?

Monetary policy is how a central bank uses interest rates and the supply of money to pursue goals such as stable prices and high employment. It matters because it affects borrowing costs, savings returns and the pace of the whole economy.

How it works

The main tool is the policy interest rate. Raising it makes loans costlier, so borrowing and spending slow and inflation tends to ease. Lowering it makes loans cheaper, so borrowing and spending pick up. Buying or selling assets adds or removes money in the system.

The effects arrive with a delay of months or even years, which is the difficulty. A bank must act on a forecast, and the feedback it uses, such as measured inflation, reflects choices made earlier. Acting too late or too hard can overshoot, so policy is a balancing loop with a lag, which tends to oscillate if it is too aggressive.

Example

Say inflation is 6 percent against a target of 2 percent. The bank raises its rate from 2 to 4 percent. Higher loan costs reduce monthly borrowing by, say, 5 percent over the next year, and inflation slides to 4 percent. A further rise to 5 percent, followed by a pause, brings it to 2.5 percent. If the bank had waited for inflation to hit 2 percent before easing, it would have overshot. All figures are an illustration.

How to model it in Machinations

Create a Register for the policy rate set by a Lever, and a Register for inflation. Connect the rate to borrowing through a state connection with a Delay of several steps, and borrowing to a Pool of demand that raises inflation. Add a Register for the gap between inflation and target that adjusts the rate. Play with different Delay lengths and chart inflation to see how lag leads to oscillation.