Monetary Policy

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Monetary policy is the government or central bank process of managing the money supply to achieve specific goals—such as constraining inflation, maintaining an exchange rate, achieving full employment, or economic growth. Monetary policy can involve changing certain interest rates, either directly or indirectly through open market operations, setting reserve requirements, or trading in foreign exchange markets.^[1] Historically, when the gold standard was the measure of currency valuation, the primary goal of monetary policy was to protect the central bank's gold reserves, generally achieved by adjusting interest rates to control the money supply. In the mid-twentieth century, however, escalating inflation led to the adoption of Monetarist policies, developed by economists such as Milton Friedman, over the previously held Keynesian approach. Friedman argued that government control over the money supply was effective in influencing the economy, and thus monetary policy became a tool for governments to manage the economic health of the country. However, this also proved not entirely successful.

The economic system of human society can be likened to a human body that has suffered ill-health, including the collapse of several banking systems, currencies, with out of control inflation, and catastrophic depressions. As humankind develops greater maturity and a peaceful world of harmony and co-prosperity is established, the economic system will enjoy greater health and effective monetary policies will be developed and implemented successfully.

Overview

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. The use of monetary policy is dated to the late nineteenth century where it was used to maintain the gold standard.

Monetary policy uses a variety of tools to control one or both of these to influence outcomes like economic growth, inflation, exchange rates with other currencies, and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks tied to a central bank, the monetary authority has the ability to alter the interest rate and the money supply in order to achieve policy goals.

A policy is referred to as "contractionary" if it reduces the size of the money supply or raises the interest rate. An "expansionary" policy increases the size of the money supply, or decreases the interest rate. Further monetary policies can be described as "accomodative" if the interest set by the central monetary authority is intended to spur economic growth, "neutral" if it is intended to neither spur growth or combat inflation, or "tight" if intended to reduce inflation or "cool" an economy.

There are several monetary policy tools available to achieve these ends. Increasing interest rates, reducing the monetary base, or increasing reserve requirements all have the effect of contracting the money supply. If reversed, these actions expand the money supply. A fourth primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies, or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation.

The short term goal of open market operations is often to achieve a specific short term interest rate target. In some instances monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency. In the case of the United States, the Federal Reserve targets the federal funds rate, which marks the rate at which member banks lend to one another overnight. The monetary policy of China, however, is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.

Within almost all modern nations, special institutions (such as the Bank of England, the European Central Bank, or the Federal Reserve System) exist which have the task of executing the monetary policy independently of the executive. In general, these institutions are called central banks and often have other responsibilities, such as supervising the operations of the financial system.

"The first and most important lesson that history teaches about what monetary policy can do—and it is a lesson of the most profound importance—is that monetary policy can prevent money itself from being a major source of economic disturbance."^[2]

History

Monetary policy is associated with currency and credit. For many centuries there were only two forms of monetary policy: Decisions about coinage and the decision to print paper money. Interest rates were not generally coordinated with the other responsibility of an authority with "seniorage," or the power to coin. With the advent of larger trading networks came the ability to set price levels between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price.

With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action was established.^[3] Early goals of monetary policy were to maintain the value of coinage, print notes, and prevent coins from leaving circulation. The establishment of central banks by industrial nations was associated with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold backed currencies. To accomplish this end, central banks began setting the interest rates that they charged to both borrowers and banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates.

During the 1870-1920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913.^[4] By this point, the concept of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, that there existed a business cycle, and that economic theory had begun to understand the relationship of interest rates to that cycle.

Contemporary monetary policies take into account a multitude of diverse factors including short and long term interest rates, the velocity of money through the economy, exchange rates, bonds and equities (corporate ownership and debt), international capital flows, and financial derivatives including options, swaps, and futures contracts.

Types

In practice, all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency is called open market operations.

Constant market transactions by the monetary authority modify the liquidity of currency and this impacts other market variables such as short term interest rates, the exchange rate, and the domestic price of spot market commodities such as gold. Open market operations are undertaken with the objective of stabilizing one of these market variables.

The distinction between the various types of monetary policy lies primarily with the market variable that open market operations are used to "target," targeting being the process of achieving relative stability in the target variable.

The different types of policy are also called "monetary regimes," in parallel to "exchange rate regimes." A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level, or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables, such as a harmonized consumer price index (CPI).

Monetary Policy:	Target Market Variable:	Long Term Objective:
Inflation Targeting	Interest rate on overnight debt	A given rate of change in the CPI
Price Level Targeting	Interest rate on overnight debt	A specific CPI number
Monetary Aggregates	The growth in money supply	A given rate of change in the CPI
Fixed Exchange Rate	The spot price of the currency	The spot price of the currency
Gold Standard	The spot price of gold	Low inflation as measured by the gold price
Mixed Policy	Usually interest rates	Usually unemployment + CPI change

Inflation targeting

Under this policy approach, the target is to keep inflation, under a particular definition such as consumer price index (CPI), at a particular level.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other over night for cash flow purposes. Depending on the country, this particular interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.

Changes to the interest rate target are done in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target.

This monetary policy approach was pioneered in New Zealand, and continues to be used in the Eurozone (European Union countries that have adopted the euro), Australia, Canada, New Zealand, Sweden, South Africa, Norway, and the United Kingdom.

Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years, such that over time the price level on aggregate does not move.

Something like price level targeting was tried in the 1930s, by Sweden, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operated monetary policy based absolutely on a price level target.

Monetary aggregates

In the 1980s, several countries used an approach based on a constant growth in the money supply—an approach known as monetarism. This approach was refined to include different classes of money and credit (M0, M1, and so forth). Whilst most monetary policy focuses on a price signal of one form or another this approach is focused on monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. Currency is bought and sold by the central bank on a daily basis to achieve the target exchange rate. This policy somewhat abdicates responsibility for monetary policy to a foreign government.

This type of policy was used by China. The Chinese yuan was managed such that its exchange rate with the United States dollar was fixed.

Gold standard

The gold standard is a system in which the price of the national currency as measured in units of gold is kept constant by the daily buying and selling of base currency. This process is called open market operations.

The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index." This type of monetary policy is no longer used anywhere in the world, although a form of gold standard, known as the Bretton Woods system, was used widely across the world prior to 1971. Its major advantages were simplicity and transparency.

Mixed policy

In practice, a mixed policy approach is most like "inflation targeting." However some consideration is also given to other goals such as economic growth, unemployment, and asset bubbles. This type of policy was used by the Federal Reserve in 1998.

Tools of monetary policy

Tools of monetary policy aim to affect levels of aggregate demand and can often influence economic decisions and behavior within the financial sector and across international borders. In order to reach a point of financial and economic stability, tools of monetary policy including changes in the monetary base, changes in reserve requirements, discount window lending, and alterations to the interest rate may be employed.

Monetary base

Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. The central bank would buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base. Note that open market operations are a relatively small part of the total volume in the bond market, thus the central bank is not able to directly influence interest rates through this method, although interest rates will be changed by the shift in money supply.

Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply.

Discount window lending

Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. The loaned funds represent an expansion in the monetary base. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply.

Interest rates

Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can only directly set the discount rate; it engages in open market operations to alter the federal funds rate. This rate has some effect on other market interest rates, but there is no direct, definite relationship. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts, or other financial assets. By altering the interest rate(s) under its control, a monetary authority can affect the money supply.

Trends in central banking

A central bank influences interest rates by expanding or contracting a country’s monetary base which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is through open market operations, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation. Alternatively, a central bank can lower the interest rate on discounts or overdrafts. If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets.

A central bank can only operate a truly independent monetary policy when the exchange rate is floating.^[5] If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa.

Accordingly, the management of the exchange rate will influence domestic monetary conditions. In order to maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange, base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate.

In the 1980s, many economists began to believe that making a nation's central bank independent of the rest of executive government proved the best way to ensure an optimal monetary policy. Central banks which did not have independence began to gain it and avoided the manipulation of monetary policies to dictate certain political goals, such as re-electing the current government.

In the 1990s, central banks began adopting formal, public inflation targets with the goal of making the outcomes of monetary policy more transparent. That is, a central bank may have an inflation target of 2 percent for a given year, and if inflation turns out to be 5 percent, then the central bank will typically have to submit an explanation. The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998, and adopted an inflation target of 2.5 percent.

Currency board

A currency board is a monetary authority which is required to maintain an exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target. Currency boards have advantages for "small," "open" economies which would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.

A currency board may opt to no longer issue fiat money but instead solely issue a set number of units of local currency for each unit of foreign currency contained in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners.

Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board pegged to the German Deutschmark in 1992, after gaining independence, and this policy is seen as a mainstay of that country's subsequent economic success. Argentina abandoned its currency board in January 2002, after a severe recession. This emphasized the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders.

Policymaking

It is important for policymakers to make credible announcements regarding their monetary policies. If private agents (consumers and businesses) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower (adaptive expectations). If an employee expects prices to be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of lower wages is reflected in wage-setting behavior between employees and employers, and since wages are in fact lower there is exists no "demand pull" inflation as employees are receiving a smaller wage, and no "cost push" inflation as employers pay out less in wages.

To achieve a low level of inflation, policymakers must have "credible" announcements, meaning private agents must believe that these announcements will reflect actual future policy. If an announcement about low-level inflation targets is made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), and cause inflation to rise. Therefore, if a policy maker's announcements regarding monetary policy are not credible, monetary policies will not have the desired effect.

However, if policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist monetary policy where the marginal benefit of increasing economic output outweighs the marginal cost of inflation. However, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents know that if they anticipate low inflation, an expansionist policy will be adopted that will ultimately cause a rise in inflation. Therefore, private agents will expect high levels of inflation. This anticipation is fulfilled through adaptive expectations, or wage-setting behavior, and results in higher inflation without the benefit of increased output. Therefore, unless credible announcements can be made, expansionary monetary policy will fail.

Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets but no output targets. Private agents can therefore know that inflation will be low because it is set by an independent body. Central banks can also be given incentives to meet their targets. A policymaker with a reputation for low inflation policy can make credible announcements because private agents will expect future behavior to reflect the past.

Controversies

A small but vocal group of people have advocated for a return to the gold standard and the elimination of the dollar's fiat currency status and even of the Federal Reserve. These arguments are based on the idea that monetary policy is fraught with risk and that these risks will result in drastic harm to the populace should monetary policy fail.

Most economists disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and disregard one hundred years of advancement in monetary policy. The sometimes complex financial transactions that make big business, especially international business, easier and safer would be much more difficult if not impossible. Moreover, by shifting risk to different people or companies that specialize in monitoring and using risk, these transactions can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved.

Other critics of monetary policy question whether monetary policy can smooth business cycles or not. A central conjecture of Keynesian economics is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral).

Other criticisms include economists who believe certain developing countries to have problems operating monetary policy effectively. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, central banks in developing countries have had a poor record in managing monetary policy.

Notes

References

ISBN links support NWE through referral fees

• Friedman, Milton, and Anna Jacobson Schwartz. 1971. Monetary History of the United States, 1867-1960. Princeton, NJ: Princeton University Press. ISBN 0691003548.
• Matthews, Kent, and Philip M. Booth. 2006. Issues in Monetary Policy: The Relationship Between Money and the Financial Markets. John Wiley & Sons. ISBN 0470018194.
• Walsh, Carl E. 2003. Monetary Theory and Policy. The MIT Press. ISBN 0262232316.
• Woodford, Michael. 2003. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton, NJ: Princeton University Press. ISBN 0691010498.

External Links

All links retrieved November 9, 2022.

• Monetary Policy The Concise Encyclopedia of Economics.
• Monetary Policy Rule Home Page Stanford University, Monetary Policy Database.