What Is the Relationship between Monetary Policy and the Business Cycle?

An economy is a vast conglomerate of individuals, businesses, regulations, government policy, and phenomena. Two important aspects of a market economy are monetary policy and the business cycle. The first represents government policies regarding money supply and interest rates, while the second is a naturally occurring cycle of stages, from growth to peak to contraction to trough. While a market economy naturally goes through each stage, governments can influence the business cycle through the use of monetary policy, hence a direct relationship between the two. Unfortunately, monetary policy and the business cycle can have unintended negative effects.

Market economies primarily rely on the individuals and businesses that reside in the general locale to move resources among users. Growth occurs naturally as demand for goods or services increase for specific items. Inflation, which is classically defined as too many dollars chasing to few goods, may occur due to growth. This may rectify itself once suppliers can increase the supply side of the economics equation, however. Monetary policy and the business cycle tend to start their relationship in the growth stage.

Governments may decide to induce growth through the use of a central bank or other economic agency that sets monetary policy. By increasing the money supply through low bank retention rates and low interest rates, growth can begin due to the ease of accessing money. Businesses can expand, and individuals have the ability to purchase more goods or more expensive goods than before the policies set in. A difficulty arises, however, because unnatural inflation can result through loose monetary policy, and the business cycle begins to peak early. An early peak in the growth stage means companies cannot expand, and prices may rise on goods due to lower supply and stable or higher demand due to increased money levels for individuals to purchase goods.

The result of a loose monetary policy and rampant inflation can result in a government needing to tighten monetary policy. The only way to complete this is to reverse the loose monetary policies, meaning high bank retention rates for money held and higher interest rates for loans. The result is less money in the overall market economy by which individuals and businesses can purchase resources or goods, respectively. Here, monetary policy and the business cycle may result in a contraction beginning as supply and demand fall. Companies may begin to liquidate, and individuals will not have the same purchasing power as fewer dollars restrict their ability to purchase luxury — non-necessary items — in the economy.