Monetary policy

Monetary policy

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Monetary policy is the process by which the monetary authority
Monetary authority
Monetary authority is a generic term in finance and economics for the entity which controls the money supply of a given currency, and has the right to set interest rates, and other parameters which control the cost and availability of money...

 of a country controls the supply of money, often targeting a rate of interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....

 for the purpose of promoting economic
Economy
An economy consists of the economic system of a country or other area; the labor, capital and land resources; and the manufacturing, trade, distribution, and consumption of goods and services of that area...

 growth and stability. The official goals usually include relatively stable prices and low unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

. Monetary theory provides insight into how to craft optimal monetary policy.
It is referred to as either being expansionary
Expansionary monetary policy
In economics, expansionary policies are fiscal policies, like higher spending and tax cuts, that encourage economic growth. In turn, an expansionary monetary policy is monetary policy that seeks to increase the size of the money supply...

 or contractionary
Contractionary monetary policy
Contractionary monetary policy is monetary policy that seeks to reduce the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry....

, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

 in a recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

 by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 in hopes of avoiding the resulting distortions and deterioration of asset values.

Monetary policy differs from fiscal policy
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

, which refers to taxation
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...

, government spending
Government spending
Government spending includes all government consumption, investment but excludes transfer payments made by a state. Government acquisition of goods and services for current use to directly satisfy individual or collective needs of the members of the community is classed as government final...

, and associated borrowing.

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. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

, inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

, exchange rates with other currencies and unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...

.

A policy is referred to as contractionary
Contractionary monetary policy
Contractionary monetary policy is monetary policy that seeks to reduce the size of the money supply. In most nations, monetary policy is controlled by either a central bank or a finance ministry....

 if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary
Expansionary monetary policy
In economics, expansionary policies are fiscal policies, like higher spending and tax cuts, that encourage economic growth. In turn, an expansionary monetary policy is monetary policy that seeks to increase the size of the money supply...

 policy increases the size of the money supply more rapidly, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.

There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base
Monetary base
In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...

; and increasing reserve requirement
Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...

s. All have the effect of contracting the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

. Even prior to the 1970s, the Bretton Woods system
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...

 still ensured that most nations would form the two policies separately.

Within almost all modern nations, special institutions (such as the Federal Reserve System
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...

 in the United States, the Bank of England
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...

, the European Central Bank
European Central Bank
The European Central Bank is the institution of the European Union that administers the monetary policy of the 17 EU Eurozone member states. It is thus one of the world's most important central banks. The bank was established by the Treaty of Amsterdam in 1998, and is headquartered in Frankfurt,...

, the People's Bank of China
People's Bank of China
The People's Bank of China is the central bank of the People's Republic of China with the power to control monetary policy and regulate financial institutions in mainland China...

, and the Bank of Japan
Bank of Japan
is the central bank of Japan. The Bank is often called for short. It has its headquarters in Chuo, Tokyo.-History:Like most modern Japanese institutions, the Bank of Japan was founded after the Meiji Restoration...

) exist which have the task of executing the monetary policy and often independently of the executive
Executive (government)
Executive branch of Government is the part of government that has sole authority and responsibility for the daily administration of the state bureaucracy. The division of power into separate branches of government is central to the idea of the separation of powers.In many countries, the term...

. In general, these institutions are called central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

s and often have other responsibilities such as supervising the smooth operation of the financial system.

The primary tool of monetary policy is open market operation
Open market operation
Open market operations is the buying and selling of government bonds on the open market by a central bank. It is the primary means of implementing monetary policy by a central bank. The usual aim of open market operations is to control the short term interest rate and the supply of base money in...

s. 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. 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. 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
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...

, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

 between the Chinese renminbi
Renminbi
The Renminbi is the official currency of the People's Republic of China . Renminbi is legal tender in mainland China, but not in Hong Kong or Macau. It is issued by the People's Bank of China, the monetary authority of the PRC...

 and a basket of foreign currencies.

The other primary means of conducting monetary policy include: (i) Discount window
Discount window
The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions...

 lending (lender of last resort
Lender of last resort
A lender of last resort is an institution willing to extend credit when no one else will. The term refers especially to a reserve financial institution, most often the central bank of a country, intended to avoid bankruptcy of banks or other institutions deemed systemically important or 'too big to...

); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market).

Theory


Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy.

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. 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 which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (to achieve policy goals).

It is important for policymakers to make credible announcements. If private agents (consumer
Consumer
Consumer is a broad label for any individuals or households that use goods generated within the economy. The concept of a consumer occurs in different contexts, so that the usage and significance of the term may vary.-Economics and marketing:...

s and firm
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...

s) believe that policymakers are committed to lowering inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

, they will anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely different matter; compare for instance rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

 with adaptive expectations
Adaptive expectations
In economics, adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past...

). 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 (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation
Demand pull inflation
Demand-pull inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as "too much money chasing...

 because employees are receiving a smaller wage and there is no cost push inflation
Cost push inflation
Cost-push inflation is a type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available.Inflation originating from increase in cost is known as cost-push inflation or supply side inflation A situation that has been often...

 because employers are paying out less in wages.

To achieve this low level of inflation, policymakers must have credible announcements; that is, 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
Demand pull inflation
Demand-pull inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as "too much money chasing...

) and a firm's costs (cost push inflation
Cost push inflation
Cost-push inflation is a type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available.Inflation originating from increase in cost is known as cost-push inflation or supply side inflation A situation that has been often...

), so inflation rises. Hence, if a policymaker's announcements regarding monetary policy are not credible, policy will not have the desired effect.

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
Marginal cost
In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good...

 of inflation); however, assuming private agents have rational expectations
Rational expectations
Rational expectations is a hypothesis in economics which states that agents' predictions of the future value of economically relevant variables are not systematically wrong in that all errors are random. An alternative formulation is that rational expectations are model-consistent expectations, in...

, 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. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);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 targets (for example, larger budgets, a wage bonus for the head of the bank) to increase their reputation and signal a strong commitment to a policy goal. Reputation is an important element in monetary policy implementation. But the idea of reputation should not be confused with commitment.

While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation). Reputation plays a crucial role in determining how much markets would believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from his or her ideology, professional background, public statements, etc.

In fact it has been argued that to prevent some pathologies related to the time inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessary tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations.

Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with central banks. The reliability with which a central bank keeps its promises is also a common definition. While everyone most likely agrees a central bank should not lie to the public, wide disagreement exists on how a central bank can best serve the public interest. Therefore, lack of definition can lead people to believe they are supporting one particular policy of credibility when they are really supporting another.

History of monetary policy


Monetary policy is associated with interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

s and availabilility of credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...

. Instruments of monetary policy have included short-term interest rates and bank reserves through the monetary base
Monetary base
In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...

.
For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money
Paper Money
Paper Money is the second album by the band Montrose. It was released in 1974 and was the band's last album to feature Sammy Hagar as lead vocalist.-History:...

 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 during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage
Seigniorage
Seigniorage can have the following two meanings:* Seigniorage derived from specie—metal coins, is a tax, added to the total price of a coin , that a customer of the mint had to pay to the mint, and that was sent to the sovereign of the political area.* Seigniorage derived from notes is more...

, or the power to coin. With the advent of larger trading networks came 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.

Paper money called "jiaozi
Jiaozi (currency)
Jiaozi is a form of banknote which appeared around 10th century in the Sichuan capital of Chengdu, China. Most numismatists generally regard it as the first paper money in history, a development of the Chinese Song Dynasty ....

" originated from promissory notes in 7th century China
China
Chinese civilization may refer to:* China for more general discussion of the country.* Chinese culture* Greater China, the transnational community of ethnic Chinese.* History of China* Sinosphere, the area historically affected by Chinese culture...

. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The successive Yuan Dynasty
Yuan Dynasty
The Yuan Dynasty , or Great Yuan Empire was a ruling dynasty founded by the Mongol leader Kublai Khan, who ruled most of present-day China, all of modern Mongolia and its surrounding areas, lasting officially from 1271 to 1368. It is considered both as a division of the Mongol Empire and as an...

 was the first government to use paper currency as the predominant circulating medium. In the later course of the dynasty, facing massive shortages of specie to fund war and their rule in China, they began printing paper money without restrictions, resulting in hyperinflation
Hyperinflation
In economics, hyperinflation is inflation that is very high or out of control. While the real values of the specific economic items generally stay the same in terms of relatively stable foreign currencies, in hyperinflationary conditions the general price level within a specific economy increases...

.

With the creation of the Bank of England
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...

 in 1694, 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
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of 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.

During the 1870-1920 period, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913. By this point the role 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
Marginal Revolution
Marginal Revolution is a blog focused on economics run by economists Tyler Cowen and Alex Tabarrok, both of whom teach at George Mason University. The blog's slogan is "Small steps toward a much better world." The site is updated daily and focuses on current events and newly released reports or books...

 in economics, which demonstrated how people would change a decision based on a change in the economic trade-offs.

Monetarist economists long contended that the money-supply growth could affect the macroeconomy. These included Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

 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
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 for output. 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. However, when U.S. Federal Reserve Chairman Paul Volcker
Paul Volcker
Paul Adolph Volcker, Jr. is an American economist. He was the Chairman of the Federal Reserve under United States Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987. He is widely credited with ending the high levels of inflation seen in the United States in the 1970s and...

 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. Even Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

 acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times
Financial Times
The Financial Times is an international business newspaper. It is a morning daily newspaper published in London and printed in 24 cities around the world. Its primary rival is the Wall Street Journal, published in New York City....

 on June 7, 2003. Therefore, monetary decisions today take into account a wider range of factors, such as:
  • short term interest rates;
  • long term interest rates;
  • velocity of money through the economy;
  • exchange rate
    Exchange rate
    In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

    s;
  • credit quality;
  • bonds
    Bond (finance)
    In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

     and equities (corporate ownership and debt);
  • government versus private sector spending/savings;
  • international capital flows of money on large scales;
  • financial derivatives
    Derivative (finance)
    A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

     such as option
    Option (finance)
    In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...

    s, swaps
    Swap (finance)
    In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...

    , futures contract
    Futures contract
    In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

    s, etc.


A small but vocal group of people, primarily libertarians and Constitutionalists, 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 basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail. Others see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society (including all governments) to be perpetually in debt.

In fact, many 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 can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved. Some have claimed that these arguments lost credibility in the global financial crisis of 2008-2009.

Trends in central banking


The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...

 in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirement
Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...

s. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). 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
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...

 is floating. If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange
Foreign exchange reserves
Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...

. 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. But even in the case of a pure floating exchange rate
Floating exchange rate
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....

, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile.

Accordingly, the management of the exchange rate will influence domestic monetary conditions. 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 (to counteract appreciation of the exchange rate), 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 market
Foreign exchange market
The foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...

s 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
Executive (government)
Executive branch of Government is the part of government that has sole authority and responsibility for the daily administration of the state bureaucracy. The division of power into separate branches of government is central to the idea of the separation of powers.In many countries, the term...

 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.

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. In other words, 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% RPI (now 2% of CPI).

The debate rages on about whether monetary policy can smooth business cycles or not. A central conjecture of Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 is that the central bank can stimulate aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

 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, as in the neoclassical model
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...

). There is also the Austrian school of economics, which includes Friedrich von Hayek and Ludwig von Mises
Ludwig von Mises
Ludwig Heinrich Edler von Mises was an Austrian economist, philosopher, and classical liberal who had a significant influence on the modern Libertarian movement and the "Austrian School" of economic thought.-Biography:-Early life:...

's arguments, but most economists fall into either the Keynesian or neoclassical camps on this issue.

Developing countries


Developing countries may have problems establishing an effective operating monetary policy. 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
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

 tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization
Dollarization
Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency.The biggest economies to have...

. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation.

Recent attempts at liberalizing and reforming financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria
Nigeria
Nigeria , officially the Federal Republic of Nigeria, is a federal constitutional republic comprising 36 states and its Federal Capital Territory, Abuja. The country is located in West Africa and shares land borders with the Republic of Benin in the west, Chad and Cameroon in the east, and Niger in...

 and elsewhere) are gradually providing the latitude required to implement monetary policy frameworks by the relevant central banks.

Types of monetary policy


In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions.

Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.

The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.


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 regime
Exchange rate regime
The exchange-rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many of the same factors....

s. 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 exactly the same variables (such as a harmonized consumer price index).

Inflation targeting



Under this policy approach the target is to keep inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

, under a particular definition such as Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...

, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...

 target. The interest rate used is generally the interbank rate at which banks lend to each other overnight 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 made 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. For example, one simple method of inflation targeting called the Taylor rule
Taylor rule
In economics, a Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the...

 adjusts the interest rate in response to changes in the inflation rate and the output gap
Output gap
The GDP gap or the output gap is the difference between potential GDP and actual GDP or actual output. The calculation for the output gap is Y*–Y where Y* is actual output and Y is potential output...

. The rule was proposed by John B. Taylor
John B. Taylor
John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution....

 of Stanford University
Stanford University
The Leland Stanford Junior University, commonly referred to as Stanford University or Stanford, is a private research university on an campus located near Palo Alto, California. It is situated in the northwestern Santa Clara Valley on the San Francisco Peninsula, approximately northwest of San...

.

The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia
Australia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...

, Brazil
Brazil
Brazil , officially the Federative Republic of Brazil , is the largest country in South America. It is the world's fifth largest country, both by geographical area and by population with over 192 million people...

, Canada
Canada
Canada is a North American country consisting of ten provinces and three territories. Located in the northern part of the continent, it extends from the Atlantic Ocean in the east to the Pacific Ocean in the west, and northward into the Arctic Ocean...

, Chile
Chile
Chile ,officially the Republic of Chile , is a country in South America occupying a long, narrow coastal strip between the Andes mountains to the east and the Pacific Ocean to the west. It borders Peru to the north, Bolivia to the northeast, Argentina to the east, and the Drake Passage in the far...

, Colombia
Colombia
Colombia, officially the Republic of Colombia , is a unitary constitutional republic comprising thirty-two departments. The country is located in northwestern South America, bordered to the east by Venezuela and Brazil; to the south by Ecuador and Peru; to the north by the Caribbean Sea; to the...

, the Czech Republic
Czech Republic
The Czech Republic is a landlocked country in Central Europe. The country is bordered by Poland to the northeast, Slovakia to the east, Austria to the south, and Germany to the west and northwest....

, Hungary
Hungary
Hungary , officially the Republic of Hungary , is a landlocked country in Central Europe. It is situated in the Carpathian Basin and is bordered by Slovakia to the north, Ukraine and Romania to the east, Serbia and Croatia to the south, Slovenia to the southwest and Austria to the west. The...

, New Zealand
New Zealand
New Zealand is an island country in the south-western Pacific Ocean comprising two main landmasses and numerous smaller islands. The country is situated some east of Australia across the Tasman Sea, and roughly south of the Pacific island nations of New Caledonia, Fiji, and Tonga...

, Norway
Norway
Norway , officially the Kingdom of Norway, is a Nordic unitary constitutional monarchy whose territory comprises the western portion of the Scandinavian Peninsula, Jan Mayen, and the Arctic archipelago of Svalbard and Bouvet Island. Norway has a total area of and a population of about 4.9 million...

, Iceland
Iceland
Iceland , described as the Republic of Iceland, is a Nordic and European island country in the North Atlantic Ocean, on the Mid-Atlantic Ridge. Iceland also refers to the main island of the country, which contains almost all the population and almost all the land area. The country has a population...

, India
India
India , officially the Republic of India , is a country in South Asia. It is the seventh-largest country by geographical area, the second-most populous country with over 1.2 billion people, and the most populous democracy in the world...

, Philippines
Philippines
The Philippines , officially known as the Republic of the Philippines , is a country in Southeast Asia in the western Pacific Ocean. To its north across the Luzon Strait lies Taiwan. West across the South China Sea sits Vietnam...

, Poland
Poland
Poland , officially the Republic of Poland , is a country in Central Europe bordered by Germany to the west; the Czech Republic and Slovakia to the south; Ukraine, Belarus and Lithuania to the east; and the Baltic Sea and Kaliningrad Oblast, a Russian exclave, to the north...

, Sweden
Sweden
Sweden , officially the Kingdom of Sweden , is a Nordic country on the Scandinavian Peninsula in Northern Europe. Sweden borders with Norway and Finland and is connected to Denmark by a bridge-tunnel across the Öresund....

, South Africa
South Africa
The Republic of South Africa is a country in southern Africa. Located at the southern tip of Africa, it is divided into nine provinces, with of coastline on the Atlantic and Indian oceans...

, Turkey
Turkey
Turkey , known officially as the Republic of Turkey , is a Eurasian country located in Western Asia and in East Thrace in Southeastern Europe...

, and the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...

.

Price level targeting


Price level targeting is similar to inflation targeting except that CPI growth in one year over or under the long term price level target is offset in subsequent years such that a targeted price-level is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the current and future years.

Monetary aggregates


In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...

 as Fed Chairman.

This approach is also sometimes called monetarism
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

.

While 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
Fixed exchange rate
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.A fixed exchange rate is usually used to...

 with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital control
Capital control
Capital controls are measures such as transaction taxes and other limits or outright prohibitions, which a nation's government can use to regulate the flows into and out of the country's capital account....

s, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.

Under dollarization
Dollarization
Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency.The biggest economies to have...

, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).

These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels
Credit channel
The credit channel mechanism of monetary policy describes the theory that a central bank's policy changes affect the amount of credit that banks issue to firms and consumers for purchases, which in turn affects the real economy....

 and other economic factors.

Gold standard


The gold standard
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of 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.

The minimal gold standard would be a long-term commitment to tighten monetary policy enough to prevent the price of gold from permanently rising above parity. A full gold standard would be a commitment to sell unlimited amounts of gold at parity and maintain a reserve of gold sufficient to redeem the entire monetary base.

Today this type of monetary policy is no longer used by any country, although the gold standard was widely used across the world between the mid-19th century through 1971. Its major advantages were simplicity and transparency. The gold standard was abandoned during the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

, as countries sought to reinvigorate their economies by increasing their money supply. The Bretton Woods system
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...

, which was a modified gold standard, replaced it in the aftermath of World War II
World War II
World War II, or the Second World War , was a global conflict lasting from 1939 to 1945, involving most of the world's nations—including all of the great powers—eventually forming two opposing military alliances: the Allies and the Axis...

. However, this system too broke down during the Nixon shock
Nixon Shock
The Nixon Shock was a series of economic measures taken by U.S. President Richard Nixon in 1971 including unilaterally cancelling the direct convertibility of the United States dollar to gold that essentially ended the existing Bretton Woods system of international financial exchange.-Background:By...

 of 1971.

The gold standard induces deflation, as the economy usually grows faster than the supply of gold. When an economy grows faster than its money supply, the same amount of money is used to execute a larger number of transactions. The only way to make this possible is to lower the nominal cost of each transaction, which means that prices of goods and services fall, and each unit of money increases in value. Absent precautionary measures, deflation would tend to increase the ratio of the real value of nominal debts to physical assets over time. For example, during deflation, nominal debt and the monthly nominal cost of a fixed-rate home mortgage stays the same, even while the dollar value of the house falls, and the value of the dollars required to pay the mortgage goes up. Mainstream economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 considers such deflation to be a major disadvantage of the gold standard. Unsustainable (i.e. excessive) deflation can cause problems during recession
Recession
In economics, a recession is a business cycle contraction, a general slowdown in economic activity. During recessions, many macroeconomic indicators vary in a similar way...

s and financial crisis
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...

 lengthening the amount of time an economy spends in recession. William Jennings Bryan
William Jennings Bryan
William Jennings Bryan was an American politician in the late-19th and early-20th centuries. He was a dominant force in the liberal wing of the Democratic Party, standing three times as its candidate for President of the United States...

 rose to national prominence when he built his historic (though unsuccessful) 1896 presidential campaign around the argument that deflation caused by the gold standard made it harder for everyday citizens to start new businesses, expand their farms, or build new homes.

Policy of various nations

  • Australia - Inflation targeting
  • Brazil - Inflation targeting
  • Canada - Inflation targeting
  • Chile - Inflation targeting
  • China - Monetary targeting and targets a currency basket
  • Czech Republic - Inflation targeting
  • Colombia - Inflation targeting
  • Hong Kong - Currency board (fixed to US dollar)
  • India - Multiple indicator approach
  • New Zealand - Inflation targeting
  • Norway - Inflation targeting
  • Singapore - Exchange rate targeting
  • South Africa - Inflation targeting
  • Switzerland - Inflation targeting
  • Turkey - Inflation targeting
  • United Kingdom - Inflation targeting, alongside secondary targets on 'output and employment'.
  • United States - Mixed policy dedicated to maximum employment and stable prices (and since the 1980s it is well described by the "Taylor rule
    Taylor rule
    In economics, a Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the...

    ," which maintains that the Fed funds rate responds to shocks in inflation and output)

Monetary base


Monetary policy can be implemented by changing the size of the monetary base
Monetary base
In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...

. Central banks use open market operations to change the monetary base. The central bank buys or sells reserve assets (usually financial instruments such as bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

) in exchange for money on deposit at the central bank. Those deposits are convertible to currency. Together such currency and deposits constitute the monetary base which is the general liabilities of the central bank in its own monetary unit. Usually other banks can use base money as a fractional reserve and expand the circulating money supply by a larger amount.

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. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.

Discount window lending


Discount window lending is where the commercial banks, and other depository institutions, are able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below short term market rates (T-bills). This enables the institutions to vary credit conditions (i.e., the amount of money they have to loan out), thereby affecting the money supply. It is of note that the Discount Window is the only instrument which the Central Banks do not have total control over.

By affecting the money supply, it is theorized, that monetary policy can establish ranges for inflation, unemployment, interest rates ,and economic growth. A stable financial environment is created in which savings and investment can occur, allowing for the growth of the economy as a whole.

Interest rates



The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rate
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...

s.
Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate
Discount rate
The discount rate can mean*an interest rate a central bank charges depository institutions that borrow reserves from it, for example for the use of the Federal Reserve's discount window....

, as well as achieve the desired Federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...

 by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool — open market operations; one must choose which one to control.

In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.

Currency board


A currency board is a monetary arrangement that pegs the monetary base of one country to another, the anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are threefold:
  1. To import monetary credibility of the anchor nation;
  2. To maintain a fixed exchange rate with the anchor nation;
  3. To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization).

In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened (and it would be a more complicated to run than a simple single-currency currency board). A gold standard
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of 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.

The currency board in question will no longer issue fiat money
Fiat money
Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...

 but instead will only issue a set number of units of local currency for each unit of foreign currency it has in its vault
Bank vault
A bank vault is a secure space where money, valuables, records, and documents can be stored. It is intended to protect their contents from theft, unauthorized use, fire, natural disasters, and other threats, just like a safe...

. The surplus on the balance of payments
Balance of payments
Balance of payments accounts are an accounting record of all monetary transactions between a country and the rest of the world.These transactions include payments for the country's exports and imports of goods, services, financial capital, and financial transfers...

 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
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves
Foreign exchange reserves
Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...

 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
Hong Kong
Hong Kong is one of two Special Administrative Regions of the People's Republic of China , the other being Macau. A city-state situated on China's south coast and enclosed by the Pearl River Delta and South China Sea, it is renowned for its expansive skyline and deep natural harbour...

 operates a currency board, as does Bulgaria
Bulgaria
Bulgaria , officially the Republic of Bulgaria , is a parliamentary democracy within a unitary constitutional republic in Southeast Europe. The country borders Romania to the north, Serbia and Macedonia to the west, Greece and Turkey to the south, as well as the Black Sea to the east...

. Estonia
Estonia
Estonia , officially the Republic of Estonia , is a state in the Baltic region of Northern Europe. It is bordered to the north by the Gulf of Finland, to the west by the Baltic Sea, to the south by Latvia , and to the east by Lake Peipsi and the Russian Federation . Across the Baltic Sea lies...

 established a currency board pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a mainstay of that country's subsequent economic success (see Economy of Estonia
Economy of Estonia
Estonia is a member of the European Union and the eurozone and is an advanced economy, according to the IMF.Before the Second World War Estonia's economy was based on agriculture, but there was a significant knowledge sector and a growing industrial sector, similar to Finland...

 for a detailed description of the Estonian currency board). Argentina
Argentina
Argentina , officially the Argentine Republic , is the second largest country in South America by land area, after Brazil. It is constituted as a federation of 23 provinces and an autonomous city, Buenos Aires...

 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
Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...

 by foreign exchange traders. Following the signing of the Dayton Peace Agreement in 1995, Bosnia and Herzegovina established a currency board pegged to the Deutschmark (since 2002 replaced by the Euro).

Currency boards have advantages for small, open economies that would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.

Unconventional monetary policy at the zero bound



Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are concerns about deflation or deflation is occurring, are referred to as unconventional monetary policy. These include credit easing, quantitative easing
Quantitative easing
Quantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...

, and signaling
Signalling (economics)
In economics, more precisely in contract theory, signalling is the idea that one party credibly conveys some information about itself to another party...

. In credit easing, a central bank purchases private sector assets, in order to improve liquidity and improve access to credit. Signaling can be used to lower market expectations for future interest rates. For example, during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for an “extended period”, and the Bank of Canada made a “conditional commitment” to keep rates at the lower bound of 25 basis points (0.25%) until the end of the second quarter of 2010.

See also

  • Fiscal policy
    Fiscal policy
    In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....

  • Macroeconomic model
  • Monetary conditions index
    Monetary conditions index
    In macroeconomics, a Monetary Conditions Index is an index number calculated from a linear combination of a small number of economy-wide financial variables deemed relevant for monetary policy...

  • Monetary economics
  • Quantitative easing
    Quantitative easing
    Quantitative easing is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank buys financial assets to inject a pre-determined quantity of money into the economy...

  • Interaction between monetary and fiscal policies
    Interaction between monetary and fiscal policies
    Fiscal policy and monetary policy are the two tools used by the State to achieve its macroeconomic objectives. While the main objective of fiscal policy is to increase the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates...



US specific:
  • Greenspan put
    Greenspan put
    The "Greenspan Put" refers to the monetary policy approach that Alan Greenspan, the former Chairman of the United States Federal Reserve Board, and other Fed members exercised from the late 1987 to 2000....


External links