An expansionary monetary policy decreases the interest rate in order to increase the size of money supply. A contractionary monetary policy increases the interest rate to reduce the size of money supply.

The idea behind the concept of neutral rate of interest is that there might be a rate of interest that neither deliberately seeks to stimulate aggregate demand and growth nor deliberately seeks to weaken growth from its current level. In other words, a neutral rate of interest would be one that encourages a rate of growth of demand close to the estimated trend rate of growth of real GDP.

The neutral rate is a useful method of measuring the stance of monetary policy. It has two components:

Neutral rate = Trend growth + Inflation target

When the neutral rate is reached, the state of equilibrium is attained, implying that the economy is now well-balanced and the price level is stable.

Certainly there can be no such thing as an exact measure of the neutral rate, and it will differ from country to country.

A demand shock is a sudden surprise event that increases or decreases demand. If inflation is caused by an unexpected increase in aggregate demand, a contractionary monetary policy might be appropriate, to cause inflation to fall. However, if inflation is caused by a supply shock such as a sudden increase in oil price, a contractionary monetary policy might make the situation worse.

Limitations of Monetary Policy

Central banks cannot control the money supply. This is because:

• They cannot control the amount of money that households and corporations put in banks on deposit.
• They cannot control the willingness of banks to create money by expanding credit.

In quantitative easing (QE), a central bank buys any financial assets to inject money into the economy. It is different from the traditional policy of buying or selling government bonds to keep market interest rates at a specified target value. Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional money in order to increase their capital reserves.