Monetary policy

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Monetary policy is the process by which the monetary authority of a country, like the central bank or currency board, controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.[1][2][3]


Monetary economics provides insight into how to craft optimal monetary policy. Since the 1970s, monetary policy has generally been formed separately from fiscal policy, which refers to taxation, government spending, and associated borrowing.[4]

Monetary policy is referred to as either being expansionary or contractionary. Expansionary policy is when a monetary authority uses its tools to stimulate the economy. An expansionary policy increases the total supply of money in the economy more rapidly than usual. It is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Also, this increases the aggregate demand (the overall demand for all goods and services in an economy), which boosts growth as measured by gross domestic product (GDP). Expansionary monetary policy usually diminishes the value of the currency, thereby decreasing the exchange rate.[5]

The opposite of expansionary monetary policy is contractionary monetary policy, which slows the rate of growth in the money supply or even shrinks it. This slows economic growth to prevent inflation. Contractionary monetary policy can lead to increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an economic recession; it should hence be well managed and conducted with care.[6]




With the creation of the Bank of England in 1694,[8] 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.[9] 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-backed 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 maintenance of a gold standard required almost monthly adjustments of interest rates. The gold standard is a system under which the price of the national currency is measured in units of gold bars and is kept constant by the government's promise to buy or sell gold at a fixed price in terms of the base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of commodity price level targeting. Nowadays this type of monetary policy is no longer used by any country.[10]


Monetarist economists long contended that the money-supply growth could affect the macroeconomy. These included Milton Friedman who early in his career advocated that government budget deficits during recessions be financed in equal amount by money creation to help to stimulate aggregate demand for output.[12] Later he advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth.[13] However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables.[14] Even Milton Friedman later acknowledged that direct money supply targeting was less successful than he had hoped.[15]



Traditional tools[edit]

The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. Central banks have three main tools of monetary policy: open market operations, the discount rate and the reserve requirements.

The most commonly used tool by which the central bank can affect the monetary base is by open market operations. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies, in exchange for money on deposit at the central bank. Those deposits are convertible to currency, so all of these purchases or sales result in more or less base currency entering or leaving market circulation. For example, if the central bank wishes to lower interest rates (executing expansionary monetary policy), it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Commercial banks then have more money to lend, so they reduce lending rates, making loans less expensive. Cheaper credit card interest rates boost consumer spending. Additionally, when business loans are more affordable, companies can expand to keep up with consumer demand. They ultimately hire more workers, whose incomes rise, which in its turn also increases the demand. This tool is usually enough to stimulate demand and drive economic growth to a healthy rate. Usually, the short-term goal of open market operations is to achieve a specific short-term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.

If the open market operations do not lead to the desired effects, a second tool can be used: the central bank can lower the interest rate it charges on discounts or overdrafts (loans from the central bank to commercial banks, see discount window). 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.

A third alternative is to change the reserve requirements. The reserve requirement refers to the proportion of total assets that banks must keep on hand overnight, either in its vaults or at 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. Lowering the reserve requirement frees up funds for banks to increase loans or buy other profitable assets. This is expansionary because it creates credit. However, even though this tool immediately increases liquidity, central banks rarely change the reserve requirement because it is expensive and requires a lot of new policies and procedures, disrupting member banks. The use of open market operations is therefore preferred.

Other: Unconventional monetary policy at the zero bound[edit]


Further heterodox monetary policy proposals include the idea of helicopter money whereby central banks would create money without assets as counterpart in their balance sheet. The money created could be distributed directly to the population as a citizen's dividend. This option has been increasingly discussed since March 2016 after the ECB's president Mario Draghi said he found the concept "very interesting".[17]

Nominal anchors[edit]






Monetary Policy: Target Market Variable: Long Term Objective:
Price Level Targeting Interest rate on overnight debt A specific CPI number
Mixed Policy Usually interest rates Usually unemployment + CPI change



Inflation targeting/inflation and interest rate targets[edit]

Main article: Inflation targeting



As the Fisher Effect model explains, the equation linking inflation with interest rates (both foreign and abroad) is the following:

Π = i - r

Where π is the inflation at home, i is the home interest rate set by the central bank, and r is the real world interest rate. Using i as an anchor, central banks can influence π. However, a necessary assumption for this equation to hold, is that the world real interest rate is constant. Central banks can choose to maintain a fixed interest rates at all times, or to keep a constant interest rate until the real world interest rate changes. The duration of this policy varies, because of the simplicity associated with changing the nominal interest rate.




Price level targeting[edit]



Monetary aggregates/money supply targeting[edit]


This approach is also sometimes called monetarism.

Central banks might choose to set a money supply growth target as a nominal anchor to keep prices stable in the long term. The quantity theory, is a long run model, which links price levels to money supply and demand. Using this equation, we can rearrange to see the following:

Π = μ − g

Where π is the inflation, μ is the money supply growth rate and g is the real output growth. This equation suggests that controlling the money supply’s growth rate can ultimately lead to price stability in the long run. To use this nominal anchor, a central bank would need to set μ equal to a constant and commit to maintaining this target.

However, the money supply growth rate is considered a weak policy, because there is no way to target real output growth, As a result, a higher output growth rate will result in a too low level of inflation. A low output growth rate will result in inflation that would be higher than the desired level.[18]

While monetary policy typically focuses on a price signal of one form or another, this approach is focused on monetary quantities. As these quantities could have a role on the economy and business cycles depending on the households' risk aversion level, money is sometimes explicitly added in the central bank's reaction function.[22] Recently, however, central banks are shifting away from policies that focus on money supply targeting, because of the uncertainty that real output growth introduces. Some central banks, like the ECB, are choosing to combine money supply anchor with other targets.

Fixed exchange rate targeting[edit]






Theoretically, using Relative PPP, the rate of depreciation must equal the inflation differential.

(E(H/F) )/ (EH/F) =ΠHF

which implies that:

ΠH = (E(H/F) )/ (EH/F) +ΠF

where the subscript "H" denotes the home country and "F" indicates the foreign country. The anchor variable is the rate of depreciation, (E(H/F) )/ (EH/F) . Therefore, the rate of inflation at home must equal the rate of inflation in the foreign country plus the rate of depreciation of the exchange rate of home’s currency, relative to the other.

With a strict fixed exchange rate or a peg, the rate of depreciation of the exchange rate is set equal to zero, such as in currency unions. In the case of a crawling peg, the rate is set equal to constant. With a limited flexible band, the rate of depreciation is allowed to fluctuate within a given range.

By fixing the rate of depreciation, PPP theory concludes that the home country’s inflation rate must depend on the foreign country. For example, a two percent increase in inflation at home raises the foreign country’s inflation by two percent. Countries may decide to use a fixed exchange rate monetary regime in order to take advantage of price stability and control inflation. In practice, more than half of nation’s monetary regimes use fixed exchange rate anchoring.[18]


In practice[edit]

Nominal anchors are possible with various exchange rate regimes.

Type of Nominal Anchor Compatible Exchange Rate Regimes
Money Supply Target Managed Floating, Freely Floating

Following the collapse of Bretton Woods, nominal anchoring has grown in importance for monetary policy makers and inflation reduction. Particularly, governments sought to use anchoring in order to curtail rapid and high inflation during the 1970s and 1980s. By the 1990s, countries began to explicitly set credible nominal anchors. In addition, many countries chose a mix of more than one target, as well as implicit targets. As a result, global inflation rates have, on average, decreased gradually since the 1970s and central banks have gained credibility and increasing independence.

The Global Financial Crisis of 2008 has sparked controversy over the use and flexibility of inflation nominal anchoring. Many economists argue that inflation targets are currently set too low by many monetary regimes. During the crisis, many inflation anchoring countries reached the lower bound of zero rates, resulting in inflation rates decreasing to almost zero or even deflation.[18]


The anchors discussed in this article suggest that keeping inflation at the desired level is feasible by setting a target interest rate, money supply growth rate, price level, or rate of depreciation. However, these anchors are only valid if a central bank commits to maintaining them. This, in turn, requires that the central bank abandons their monetary policy autonomy in the long run. Should a central bank use one of these anchors to maintain a target inflation rate, they would have to forfeit using other policies. On that note, it is important to mention that using these anchors may prove more complicated for certain exchange rate regimes. Freely floating or managed floating regimes, have more options to affect their inflation, because they enjoy more flexibility than a pegged currency or a country without a currency. The latter regimes would have to implement an exchange rate target to influence their inflation, as none of the other instruments are available to them.


In international economics[edit]

Optimal monetary policy in international economics is concerned with the question of how monetary policy should be conducted in interdependent open economies. The classical view holds that international macroeconomic interdependence is only relevant if it affects domestic output gaps and inflation, and monetary policy prescriptions can abstract from openness without harm.[23] This view rests on two implicit assumptions: a high responsiveness of import prices to the exchange rate, i.e. producer currency pricing (PCP), and frictionless international financial markets supporting the efficiency of flexible price allocation.[24][25] The violation or distortion of these assumptions found in empirical research is the subject of a substantial part of the international optimal monetary policy literature. The policy trade-offs specific to this international perspective are threefold:[26]

First, research suggests only a weak reflection of exchange rate movements in import prices, lending credibility to the opposed theory of local currency pricing (LCP).[27] The consequence is a departure from the classical view in the form of a trade-off between output gaps and misalignments in international relative prices, shifting monetary policy to CPI inflation control and real exchange rate stabilization.




In developing countries[edit]





Effect on business cycles[edit]


Behavioral monetary policy[edit]

Conventional macroeconomic models assume that all agents in an economy are fully rational. A rational agent has clear preferences, models uncertainty via expected values of variables or functions of variables, and always chooses to perform the action with the optimal expected outcome for itself among all feasible actions – they maximize their utility. Monetary policy analysis and decisions hence traditionally rely on this New Classical approach.[33][34][35] [36] However, as studied by the field of behavioral economics that takes into account the concept of bounded rationality, people often deviate from the way that these neoclassical theories assume.[36][37] Humans are generally not able to react fully rational to the world around them[35] – they do not make decisions in the rational way commonly envisioned in standard macroeconomic models. People have time limitations, cognitive biases, care about issues like fairness and equity and follow rules of thumb (heuristics).[37]

This has implications for the conduct of monetary policy. Monetary policy is the final outcome of a complex interaction between monetary institutions, central banker preferences and policy rules, and hence human decision-making plays an important role.[34] It is more and more recognized that the standard rational approach does not provide an optimal foundation for monetary policy actions. These models fail to address important human anomalies and behavioral drivers that explain monetary policy decisions.[38][34][35]


These are examples of how behavioral phenomena may have a substantial influence on monetary policy.[36] Monetary policy analyses should thus account for the fact that policymakers (or central bankers) are individuals and prone to biases and temptations that can sensibly influence their ultimate choices in the setting of macroeconomic and/or interest rate targets.[34]

See also[edit]

Notes and references[edit]

  12. ^ Friedman, Milton (1948). "A Monetary and Fiscal Framework for Economic Stability" (PDF). American Economic Review. 38 (3): 245–264. 
  15. ^ Nelson, Edward (2007). "Milton Friedman and U.S. Monetary History: 1961–2006" (PDF). Federal Reserve Bank of St. Louis Review (89 (3)): 171. 
  20. ^ Enria, Frank (4 February 2014). "Disclosure of Accommodative Monetary Policy meaning.". USA: Frank Enria. 
  32. ^ Seidman, Laurence (Fall 2007). "Reply to: "The New Classical Counter-Revolution: False Path or Illuminating Complement?"". Eastern Economic Journal. 33 (4): 563–565. JSTOR 20642378. (subscription required (help)). 
  33. ^ Cuthbertson, K., Nitzsche, D. and Hyde, S.(2008). Monetary policy and behavioral finance. Journal of Economic Surveys, 21(5), pp. 935-969.
  34. ^ a b c d e Favaretto, F. and Masciandaro, D. (2016). Doves, hawks and pigeons: Behavioral monetary policy and interest rate inertia. Journal of Financial Stability, 27, pp. 50-58.
  35. ^ a b c Hommes, C., Massaro, D. and Weber, M. (2015). Monetary Policy under Behavioral Expectations: Theory and Experiment. Tinbergen Institute Discussion Paper.
  36. ^ a b c Rustamli, N. and Abbas, G. (2014). Monetary policy: psychology and expectations. Academic Views, January 2014.
  37. ^ a b Yellen, J.L. (2007). Implications of Behavioral Economics for Monetary Policy. Federal Reserve Bank of Boston Conference: "Implications of Behavioral Economics for Economic Policy".
  38. ^ a b c Calabria, M. (2016). Behavioral Economics and Fed Policymaking. Cato Journal, 36(3), pp. 573-587.

External links[edit]