As part of their monetary policy, the central bank adopts one of the monetary anchor options as their monetary anchor and commits to stabilize the price based on that to achieve the policy goals. The monetary policy goals are to maintain stable prices and low unemployment rate. These two goals ultimately serve the main goal of achieving economic prosperity and welfare of a nation.
Whichever monetary anchor the central bank chooses to proceed with, to maintain a certain target, it has the several tools at its disposal such as interest rates, open market operations, and reserve requirement. The usage of these tools define whether a policy is expansionary or contractionary.
When the central bank performs any actions that increases the total supply of money in the economy more rapidly than usual, for example by lowering interest rates in the hope that easy credit will entice business into expanding or make property investment more attractive, then the policy is known as an expansionary policy. Also increasing the monetary base through open market operations and decreasing reserve requirements are actions that represent an expansionary policy.
When the central bank performs any actions that decreases the money supply or increases it more slowly than usual, for example by increasing interest rates in order to cut consumption by reducing people’s desire to borrow money and increasing the opportunity cost of not saving money, then the policy is known as an contractionary policy. Also reducing the monetary base through open market operations and increasing reserve requirements are actions that support the same goal.
The expansionary policy is applied to combat low inflation rate and the contractionary policy is applied to combat higher level of inflation rate, compared to their target range. In Australia, the inflation target range is 2 to 3 per cent, on average, over the medium term, whereas the Canadian target range is 1 to 3 per cent.
Inflation targeting was pioneered in New Zealand in 1990 and since then it has been adopted by Canada, Sweden, Spain, Australia, Brazil and South Africa, among other countries.
So what we know from this is that the money supply is determined by the workings of the economy and a way to control the economy is by tweaking monetary policy tools. So when the interest rates rises, the government want us to take time-out from purchases and investments, because the inflation rate is high and our currency value is lowering. When the interest rates lowers, the government wants us to jump in and make some noise, because the inflation rate is low and our currency value is increasing.