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Monetary policy
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Monetary policy

Monetary policy is the financial policy of managing the money supply to achieve specific goals—such as reducing inflation or achieving full employment or more well-being. Almost always, special institutions (like the European Central Bank or the 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 typically serve a role of supervising the smooth operation of the financial system as well as monetary policy. Globally, the Bank for International Settlements plays a role in standardizing policy and also informally called the central bank for the central banks, though it sets no monetary policy of its own.

The primary tool of monetary policy is usually a short term interest rate. In the case of the US for example, the Federal Reserve targets the Fed Funds rate, the rate at which member banks lend to one another overnight. Monetary policy is also often expressed by the central bank trying to target or manipulate the exchange rate with major trading partners.

Table of contents
1 History of Monetary Policy
2 Trends in Central Banking
3 Types of Monetary Policy
4 Currency Boards
5 Monetary Policy Theory

History of Monetary Policy

Before there was money, there was the barter system, where items were exchanged directly for other items. There was no monetary policy because there was no money.

The first 'money' was effectively the raw commodities of wheat, barley, etc. Later, gold, silver, ivory, amber, or other precious materials made trade more convenient. Monetary policy consisted of the populace regarding a particular commodity as having equal value to any other set of goods. However, there were problems with using gold and silver; the purity was questionable and therefore the value debatable.

To solve this, governments adopted the technology of minting coins of known purity and size. This allowed the markets to more consistently set the value of goods and services. Minting coins was effectively the first government monetary policy, since it allowed for more free flows of money through the economy (it increased the 'velocity' of the money supply). This drastically improved economic growth. Governments today regulate the velocity of money by many means, only the most basic of which is printing and coining currency.

The latest development in the 'technology' of money is the advent of 'fiat currency'. This uses the concept that money is worth whatever anyone thinks it is worth, so the government prints a limited supply of it and everyone accepts that that is money. This allows the money supply to grow and shrink as the government desires it to do, in accordance with the government's monetary policy.

Important to mention here is that alongside the development of money came the development of credit systems. Credit is borrowing and repaying loans. Credit is possible in a barter system, as well as any other system. The amount of credit available in an economy drastically influences the amount of money available that economy. Thus, monetary policy is intricately tied to the availablity of credit. Governments can and do act as both borrower and lender to banks and individuals to either add or subtract money from the economy, which is the goal of monetary policy.

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:

A small but vocal group of people advocate for a return to the gold standard (the elimination of the 'fiat currency'). 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 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 nations 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, re-electing the current government for example. 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. The goal of which is to make 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, 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 modifies the liquidity of base money and this impacts on 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

Inflation Targeting

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 eachother 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 commitee.

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

This monetary policy approach was pioneered initially in New Zealand. It is currently used in Australia, New Zealand, Sweden 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.

This type of policy is used by the European Central Bank.

Monetary Aggregates

In the 1980s several countries used an approached based on a constant growth in the money supply. Such schemes were refined to include different classes of money and credit (M0, M1 etc). Most such monetary policies were ultimately abandoned.

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 responsiblitity for monetary policy to a foreign government.

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

Gold Standard

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.

Mixed Policy

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.

Currency Boards

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.

This type of policy is used by China and Malaysia which have fixed exchange rates with the US dollar.

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.

See also: