Erratic increase or decrease in prices of commodities or other items, if continued unabated for a substantial period, can be a source of imbalance in the economy. While framing monetary policies, the fundamental objective of central banks all over the world is to maintain price stability. Now, price stability is directly related to demand and supply of the products besides the available money supply. By using monetary policy tools, the central banks ensure that money supply is controlled in a manner such that the aim of sustainable economy is achieved (sustainable economy = maximum employment + stable prices + growth).
How does a central bank control money supply in the market? Consider a hypothetical situation in which an economy is doing great and it is growing faster. When an economy grows too fast and there is too much growth, it can lead to inflation (more money in the market> people consuming more> higher prices> inflation). As we know, inflation is not healthy for any economy, so the central bank will try to curb it by using monetary tools. Thus, if inflation is an imminent danger, central bank will hike interest rates so that there is decrease in money supply (if interest rates are hiked, people will save more and spend less so that they can get better returns on their investments). If less money is available in the market, people will consume less and demand will decrease. A decrease in demand will lead to decrease in supply and general pricing of the products, respectively. By doing this, the central banks hope to bring back the economy to stable level.
On the flip side, consider the situation where an economy is in a slump and the central bank wants to promote better employment and higher growth. To do so, it will reduce interest rates which leads to more money supply into the market. When interest rates are decreased, the banks can give loans to consumers at a lower rate. People and businesses borrow more money thereby, boosting their spending and investment capacity. In a low-interest scenario, buying stocks, or for that matter, any type of investment becomes more attractive. Similarly, with low-interest rates, the value of currency decreases and the imports become expensive while the demand in domestic market increases (with more money in pocket, people consume more). Therefore, the overall sentiment in the domestic market becomes positive, and to meet increased demands, companies invest more, and more job opportunities are created.
One noteworthy point here is that interest rates invariably affect the currency exchange value. Suppose the interest rates are increased by the banks in USA, then the yields (profits) of assets in US dollars will be more promising, which will encourage investors in foreign markets to bid higher for these assets. Now, this will increase the value of US dollar which will lead to lower cost of imports for US inhabitants. However, for the people outside USA, prices of the goods exported from the USA will increase.
Well, do you get the drift, how small changes in the monetary policy affects the subtle relationship between financial instruments. Sometimes, even rumors or unexpected situations in a country can cause a drop in the financial market. In such situations investors lose confidence in their investments and to avoid further losses, quickly withdraw it. Most of the spending decisions, be it related to buying stocks of a blue-chip company or purchasing a toothpaste, are impacted by small changes in monetary policies. Lower the interest rates, and market sentiment changes and acquires positive note: people start spending and investing more. Just like lowering of house loan rates encourages housing demands, lower interest rates favor investments.
