The cause-effect chain which makes monetary policy effective is as follows:

1. Changes in the supply of money from the central banking system cause changes in interest rates. The greater the supply of money, the lower interest rates will be.

2. Changes in interest rates affect aggregate demand. A fall in interest rates makes borrowing cheaper, increasing both expenditure and investment, and therefore also increasing aggregate demand.

3. Changes in aggregate demand affect levels of employment, output, and prices. The higher the aggregate demand, the more people will be employed, the greater output will be, and the higher prices will rise (unless output increases at a higher rate than aggregate demand, in which case further controls may be necessary).

The aim of monetary policy is to achieve high employment and maintain sustainable levels of growth without high inflation. Monetary policy is controlled by a central bank increasing or decreasing the money supply and cutting or raising interest rates. The principal alternative is fiscal policy, which involves the government changing the level of taxation. Monetary policy is much more flexible and faster to implement than fiscal policy. When compared with governments, central banks are also relatively free from political pressure, and likely to focus on the long-term health of the economy rather than immediate expediency.