According to European Central Bank, the basic objective of monetary policy is to improve price stability and achieve a high level of employment in the economy. Monetary policy also serves as a tool to stimulate economic growth during recessions and reduce price inflation.
Monetary policies stabilize prices by regulating the long- and short-term interest rates in the economy. The price at which money is lent, or the interest rate, is determined by the monetary policy adopted by the country's financial institutions and activities in financial markets. Monetary policies usually set a target for consumer price inflation to encourage strong and sustainable growth in the economy, according to the Bank of Australia.
Controlling the level of inflation in an economy not only improves economic prosperity, but it also protects the welfare of the people. According to the Bank of Canada, the rate of inflation rises when the demand for a country's currency is strong. As a result, central banks raise interest rates to lower inflation and absorb economic slack until there is price stability.
According to European Central Bank, inflation is directly influenced by the monetary growth of the economy, as well as factors such as variations in aggregate demand, technological changes or commodity price shocks.