How does monetary policy impact the economy?

Monetary policy impacts the economy primarily through the regulation of the money supply and interest rates. Central banks, such as the Federal Reserve in the United States, utilize various tools to control how much money is circulating in the economy and at what cost borrowing takes place (interest rates).

When a central bank increases the money supply, it often lowers interest rates, making it cheaper for consumers and businesses to borrow. This generally leads to increased spending and investment, stimulating economic growth. Conversely, if the central bank tightens the money supply and raises interest rates, borrowing costs increase, which can cool down an overheating economy and help quell inflation.

This mechanism of influencing economic activity through monetary policy is crucial because it helps maintain stable prices and promotes maximum employment. Neither price controls, government funding for public services, nor adjusting tariffs directly influences the money supply or interest rates in the way monetary policy does, making the latter the correct answer regarding how monetary policy shapes the economy.