Monetary policy is strongly supported by the Chicago school of economics and is a demand side policy designed to improve the economy by adjusting interest rates and money demand. In the modern world were fiscal policy is used increasingly less monetary policy, as controlled by the central bank, has become the preferred way to make short term improvements to the economy.
First of all lets examine the tools of monetary policy and see how the work. Interest rates and money supply are controlled by the central bank to avoid opportunities for seigniorage, the government overprinting money to finance its debt or pushing interest rates lower when it wants to borrow money because this would lead to inflation the former by making currency worthless and the latter by increasing consumptions through making loans cheaper. When the government wants to pursue an expansionary monetary policy in an attempt to combat unemployment and increase growth it reduces interest rates. The way this mechanism works is by the reduced interest rates increasing peoples ability to borrow money as doing so has become cheaper while at the same time it reduces desirability for saving money as the interest on savings accounts becomes smaller thus the opportunity cost of not saving is also reduced. This causes aggregate demand to increase thus increasing growth and reducing unemployment however at the cost of inflation as illustrated in the following diagram.
The way increasing money supply helps when pursuing an expansionary monetary policy is because more money being printed means that more is readily available so the printing of money reinforces the drop in interest rates while makes money more widely available increasing spending even further.
When pursuing a contractionary monetary policy in order to reduce inflation the central bank will increase interest rates and reduce the money supply. The increased interest rates act as a disincentive for consumption because the increase the cost of getting a loan and make the opportunity cost of not saving significantly greater. At the same time the reduced money supply reinforces this upward pressure on the interest rate while making money scarcer and aiding the downward trend in demand as seen in the following diagram.
Despite the fact that this policy is quite good for short term fixes it does have numerous shortcomings. Firstly it can only work in the short term because if an expansionary monetary policy is pursued for too long it will lead to inflation and if a contractionary monetary policy is used for too long it will lead to stunted growth and unemployment. Moreover a great problem with this policy is the so called time lag, by the time the government has picked up on the problem, whether its unemployment or inflation to the time that it designs and finally implements the policy there is a significant time interval which will mean that the problem is no longer the same thus making the policy less effective or even potentially harmful for the economy. In addition to the above monetary policy can not be applied as a preventative measure which creates the problem of how to prevent unexpected inflation. This problem however is solved by supply side policies. These policies aim to increase the overall productive capacity of the economy by improving the quality of its resources. For example investing money in your educational system counts as a supply side policy because it aims at improving the quality of your labour. These policies work in the long term because overall the economy is better off because now unemployment shocks are going to be smaller as the economy has a significantly higher equilibrium than before and the same goes for inflation and growth as seen in the following diagram.
Overall we see that monetary policy works well as a short term fix in the economy but should be aided by supply side policies in order to have any effectiveness in the long run.