Science Fair Project Encyclopedia
Monetary policy is the process of managing a nation's money supply to achieve specific goals—such as constraining inflation, achieving full employment or more well-being. Monetary policy can involve setting interest rates, margin requirements , capitalization standards for banks or even acting as the lender of last resort or through negotiated agreements with other governments.
Any monetary action can be classified as either contractionary or expansionary. Contractionary actions seek to reduce the size of the money supply. Expansionary actions seek to increase the size of the money supply. Note that there are different monetary policy tools available to achieve these ends. Increasing interest rates by fiat, reducing the monetary base or increasing required reserves all have the effect of contracting the money supply. On each of the same policy tools, the opposite actions have the opposite effects and are expansionary.
Since the mid 1980s in most nations it has generally been formulated independently of Fiscal Policy.
Within almost all modern nations special institutions (like the European Central Bank or the US Federal Reserve) exist which have the task of maintaining the monetary policy of a country or transnational entity independently of executive government. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system.
The 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. Usually the short term goal of open market operations is to achieve a specific short term interest rate target. However monetary policy might entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold instead of targeting interest rates.
History of Monetary Policy
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 to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seniorage , or the power to coin. With the advent of larger trading networks the ability to set the price 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, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established. The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold back currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenence of a gold standard required almost monthly adjustments of interest rates. At the time it was not understood that this had a significant effect on the whole economy.
During the 1870-1920 period the industrialized nations set up central banking systems, with one of the last being the American Federal Reserve in 1913. By this point the understanding 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, in no small part because of the marginal revolution in economics, which focused on how many more, or how many fewer, people would make a decision based on a change in the economic trade offs. It also became clear that there was a business cycle, and economic theory began understanding the relationship of interest rates to that cycle.
The advancement of monetary policy as an engineering discipline has been quite rapid in the last 150 years, and it has increased especially rapidly in the last 50 years. Monetary policy has grown from simply increasing the monetary supply enough to keep up with both population growth and economic activity. It now encompasses (and must respond to) such diverse factors as:
- short term interest rates;
- long term interest rates;
- velocity of money through the economy;
- exchange rates;
- credit quality ;
- bonds and equities (corporate ownership and debt);
- government versus private sector spending/savings;
- international capital flows of money on large scales;
- options, futures contracts, financial derivatives like swaps, swaptions, and more complex contracts.
A small but vocal group of people advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is bascially that monetary policy is fraught with risk and 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 throw away 100 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, shifting risk to different people/companies that specialize in monitoring and using risk; they can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved.
Trends in Central Banking
In the 1980s, many economists began to believe that making a nation's central bank independent of the rest of executive government is the best way to ensure an optimal monetary policy, and those central banks which did not have independence began to gain it. This is to avoid overt manipulation of the tools of monetary policies to effect political goals, such as re-electing the current government. Independence typically means that the members of the committee which conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited independence. Independence has not stunted a thriving crop of conspiracy theories about the true motives of a given action of monetary policy.
In the 1990s central banks began adopting formal, public inflation targets with the goal of making the outcomes, if not the process, of monetary policy more transparent. That is, a central bank may have an inflation target of 2% for a given year, and if inflation turns out to be 5%, 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%.
Types of Monetary Policy
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 base money 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 stabilising 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.
|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|
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 requires fixed regime towards other countries on the gold standard and a floating regime towards those that are not. Targeting Inflation, the price level or other monetary aggregates requires floating exchange rate.
Under this policy approach Inflation is defined as the rate of change in the CPI. It requires that a basket of consumer prices is monitored and from these prices a CPI (Consumer Price Index) defined.
For example the target might be to keep increases in the CPI index between 2 and 3% per year. The specific Inflation rate objective is achieved through periodic adjustments to an interest rate target. The interest rate target generally refers to the interest 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.
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 operates monetary policy based on a price level target.
In the 1980s several countries used an approached based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). This approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.
This approach is also sometimes called monetarism.
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. Base money 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.
The gold standard is a system in which the price of the national currency as measured in unit 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".
Today this type of monetary policy is not used anywhere in the world, although a form of gold standard was used widely across the world prior to 1971. For details see the Bretton Woods system. Its major advantages were simplicity and transparency.
A mixed policy approach is usually in practice most like "inflation targeting". However consideration is also given to other goals such as unemployment and market bubbles.
This type of policy is used by the United States.
Monetary Policy Tools
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. In the United States, the Federal Reserve can use open market operations to change the monetary base. The Federal Reserve would buy/sell bonds in exchange for hard currency. When the Federal Reserve 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 Federal Reserve is not able to influence interest rates through this method.
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. Banks only maintain a small portion of their assets as cash available for immediate withdrawl; the rest is invested in illiquid assets like mortages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availablilty 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 lended funds represent an expansion in the monetary base. By calling in exisiting loans or extending new loans, the monetary authority can directly change the size of the money supply.
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 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.
Main article: currency board
A currency board is a central bank whose monetary policy is a special case. In this case, the country has decided to base its currency off another, larger currency. Typically this happens after a long, unsuccessful fight against inflation. The currency board in question will no longer issue fiat money but instead will only issue one unit of local currency for each unit of foreign currency it has 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 currency reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawback is that the country no longer has the ability to set monetary policy according to other domestic considerations.
Hong Kong operates a currency board, as does Bulgaria. Argentina abandoned this policy 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.
A gold standard is a special case of a currency board where the value of the national currency is linked to the value of gold instead of a foreign currency.
Monetary reform movements seek to alter the mechanisms used in such policy.
Monetary Policy Theory
It is important for policymakers to make credible announcements regarding their monetary policies. If private agents (consumers and firms) 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 behaviour between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is not demand pull inflation because employees are receiving a smaller wage and there is not cost push inflation because employers are paying out less in wages.
However, to achieve this low level of inflation, policymakers must have credible announcements, i.e. 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), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy 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 causes a rise in inflation. Therefore, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behaviour) and so there is higher inflation (without the benefit of increased output). Hence, 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). Hence, private agents know that inflation will be low because it is set by an independent body. Central banks can be given incentives to meet their targets (e.g. larger budgets, a wage bonus for the head of the bank). A policymaker with a reputation for low inflation policy can make credible announcements because private agents will expect future behavior to reflect the past.
- Contractionary monetary policy
- Currency devaluation
- Expansionary monetary policy
- Monetary base
- Monetary policy of the EU
- Monetary policy of the USA
- Monetary policy of Sweden
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