Monetary policy is the policy adopted by the
monetary authority
In finance and economics, a monetary authority is the entity that manages a country’s currency and money supply, often with the objective of controlling inflation, interest rates, real GDP or unemployment rate. With its monetary tools, a m ...
of a nation to control either the
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
payable for
very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circul ...
, often as an attempt to reduce
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...
or the
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
, to ensure
price stability Price stability is a goal of monetary and fiscal policy aiming to support sustainable rates of economic activity. Policy is set to maintain a very low rate of inflation or deflation. For example, the European Central Bank (ECB) describes price s ...
and general trust of the value and stability of the nation's currency.
Monetary policy is a modification of the supply of money, i.e.
"printing" more money, or decreasing the money supply by changing interest rates or removing
excess reserves
Excess reserves are bank reserves held by a bank in excess of a reserve requirement for it set by a central bank.
In the United States, bank reserves for a commercial bank are represented by its cash holdings and any credit balance in an account ...
. This is in contrast to
fiscal policy
In economics and political science, fiscal policy is the use of government revenue collection (taxes or tax cuts) and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variab ...
, which relies on
tax
A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer (an individual or legal entity) by a governmental organization in order to fund government spending and various public expenditures (regional, local, or n ...
ation,
government spending, and
government borrowing as methods for a government to manage business cycle phenomena such as
recession
In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
s.
Further purposes of a monetary policy are usually to contribute to the stability of
gross domestic product
Gross domestic product (GDP) is a money, monetary Measurement in economics, measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjec ...
, to achieve and maintain low
unemployment
Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work during the refere ...
, and to maintain predictable
exchange rates
In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...
with other
currencies
A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins.
A more general def ...
.
Monetary economics
Monetary economics is the branch of economics that studies the different competing theories of money: it provides a framework for analyzing money and considers its functions (such as medium of exchange, store of value and unit of account), and ...
can provide insight into crafting optimal monetary policy. In
developed countries
A developed country (or industrialized country, high-income country, more economically developed country (MEDC), advanced country) is a sovereign state that has a high quality of life, developed economy and advanced technological infrastruct ...
, monetary policy is generally formed separately from fiscal policy.
Monetary policy is referred to as being either expansionary or contractionary.
Expansionary policy occurs when a monetary authority uses its procedures to stimulate the economy. An expansionary policy maintains short-term interest rates at a lower than usual rate or increases the total
supply of money in the economy more rapidly than usual. It is traditionally used to try to reduce
unemployment
Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for work during the refere ...
during a
recession
In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
by decreasing
interest rates in the hope that less expensive credit will entice businesses into borrowing more money and thereby expanding. This would increase
aggregate demand (the overall demand for all goods and services in an economy), which would increase short-term growth as measured by increase of
gross domestic product
Gross domestic product (GDP) is a money, monetary Measurement in economics, measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjec ...
(GDP). Expansionary monetary policy, by increasing the amount of currency in circulation, usually diminishes the value of the currency relative to other currencies (the
exchange rate
In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...
), in which case foreign purchasers will be able to purchase more with their currency in the country with the devalued currency.
Contractionary policy maintains short-term interest rates greater than usual, slows the rate of growth of the money supply, or even decreases it to slow short-term economic growth and lessen
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...
. Contractionary policy can result in increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an
economic recession
In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
if implemented too vigorously.
History
Monetary policy is associated with
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
s and availability of
credit
Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt) ...
. Instruments of monetary policy have included short-term interest rates and bank reserves through the
monetary base.
For many centuries there were only two forms of monetary policy: altering coinage or the printing of
paper money
A banknote—also called a bill (North American English), paper money, or simply a note—is a type of negotiable promissory note, made by a bank or other licensed authority, payable to the bearer on demand.
Banknotes were originally issued ...
.
Interest rates, while now thought of as part of
monetary authority
In finance and economics, a monetary authority is the entity that manages a country’s currency and money supply, often with the objective of controlling inflation, interest rates, real GDP or unemployment rate. With its monetary tools, a m ...
, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was considered as an executive decision, and was generally implemented by the authority with
seigniorage
Seigniorage , also spelled seignorage or seigneurage (from the Old French ''seigneuriage'', "right of the lord (''seigneur'') to mint money"), is the difference between the value of money and the cost to produce and distribute it. The term can be ...
(the power to coin). With the advent of larger trading networks came the ability to define the currency value in terms of gold or silver, and the price of the local currency in terms of foreign currencies. This official price could be enforced by law, even if it varied from the market price.
Paper money originated from
promissory notes
A promissory note, sometimes referred to as a note payable, is a legal instrument (more particularly, a financing instrument and a debt instrument), in which one party (the ''maker'' or ''issuer'') promises in writing to pay a determinate sum of ...
termed "
jiaozi
''Jiaozi'' (; ; pinyin: jiǎozi) are Chinese dumplings commonly eaten in China and other parts of East Asia. ''Jiaozi'' are folded to resemble Chinese sycee and have great cultural significance attached to them within China. ''Jiaozi'' are ...
" in 7th century
China
China, officially the People's Republic of China (PRC), is a country in East Asia. It is the world's most populous country, with a population exceeding 1.4 billion, slightly ahead of India. China spans the equivalent of five time zones and ...
. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The succeeding
Yuan Dynasty
The Yuan dynasty (), officially the Great Yuan (; xng, , , literally "Great Yuan State"), was a Mongol-led imperial dynasty of China and a successor state to the Mongol Empire after its division. It was established by Kublai, the fifth ...
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 maintain their rule, they began printing paper money without restrictions, resulting in
hyperinflation
In economics, hyperinflation is a very high and typically accelerating inflation. It quickly erodes the real value of the local currency, as the prices of all goods increase. This causes people to minimize their holdings in that currency as t ...
.
With the creation of the
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 to act as the English Government's banker, and still one of the bankers for the Government of ...
in 1694, which was granted the authority to print notes backed by gold, the idea of monetary policy as independent of executive action began to be established.
The purpose 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 national banks by industrializing nations was associated then with the desire to maintain the currency's relationship to the
gold standard
A gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. The gold standard was the basis for the international monetary system from the 1870s to the early 1920s, and from the la ...
, and to trade in a narrow
currency band
A currency band is a range of values for the exchange rate for a country’s currency which the country’s central bank acts to keep the exchange rate within.
The central bank selects a range, or "band", of values at which to set their currenc ...
with other gold-backed currencies. To accomplish this end, national banks as part of the gold standard began setting the interest rates that they charged both their own borrowers and other banks which required money for liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates.
The gold standard is a system by which the price of the national currency is fixed vis-a-vis the value of gold, and is kept constant by the government's promise to buy or sell gold at a fixed price in terms of the base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of commodity price level targeting.
Nowadays this type of monetary policy is no longer used by any country.
During the period 1870–1920, the industrialized nations established central banking systems, with one of the last being the
Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
in 1913.
By this time the role of the central bank as the "
lender of last resort
A lender of last resort (LOLR) is the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market when other faci ...
" was established. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of appreciation for the
marginal revolution in economics, which demonstrated that people would change their decisions based on changes in their economic trade-offs.
Monetarist economists long contended that the money-supply growth could affect the macroeconomy. These included
Milton Friedman
Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...
who early in his career advocated that
government budget deficit
The government budget balance, also alternatively referred to as general government balance, public budget balance, or public fiscal balance, is the overall difference between government revenues and spending. A positive balance is called a ''g ...
s during recessions be financed in equal amount by
money creation to help to stimulate
aggregate demand for production. Later he advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable production growth. However, when U.S.
Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
Chairman
Paul Volcker
Paul Adolph Volcker Jr. (September 5, 1927 – December 8, 2019) was an American economist who served as the 12th chairman of the Federal Reserve from 1979 to 1987. During his tenure as chairman, Volcker was widely credited with having ended th ...
tried this policy, starting in October 1979, it was found to be impractical, because of the unstable relationship between monetary aggregates and other macroeconomic variables. Even Milton Friedman later acknowledged that direct money supplying was less successful than he had hoped.
Therefore, monetary decisions presently take into account a wider range of factors, such as:
* short-term
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
s;
* long-term interest rates;
* velocity of money through the economy;
*
exchange rate
In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...
s;
*
credit quality
A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaultin ...
;
*
bonds and
equities
In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
(debt and corporate ownership);
* government versus private sector spending and savings;
* international
capital flow
In economics, capital goods or capital are "those durable produced goods that are in turn used as productive inputs for further production" of goods and services. At the macroeconomic level, "the nation's capital stock includes buildings, eq ...
s of money on large scales;
* financial
derivatives
The derivative of a function is the rate of change of the function's output relative to its input value.
Derivative may also refer to:
In mathematics and economics
* Brzozowski derivative in the theory of formal languages
* Formal derivative, an ...
such as
options,
swaps, and
futures contract
In finance, a futures contract (sometimes called a futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset ...
s
File:BankofFinlandSuomenPankkiFinlandsBank.jpg, The Bank of Finland, in Helsinki
Helsinki ( or ; ; sv, Helsingfors, ) is the Capital city, capital, primate city, primate, and List of cities and towns in Finland, most populous city of Finland. Located on the shore of the Gulf of Finland, it is the seat of the region of U ...
, established in 1812.
File:Basel - Bank für internationalen Zahlungsausgleich3.jpg, The headquarters of the Bank for International Settlements
The Bank for International Settlements (BIS) is an international financial institution owned by central banks that "fosters international monetary and financial cooperation and serves as a bank for central banks".
The BIS carries out its work thr ...
, in Basel
, french: link=no, Bâlois(e), it, Basilese
, neighboring_municipalities= Allschwil (BL), Hégenheim (FR-68), Binningen (BL), Birsfelden (BL), Bottmingen (BL), Huningue (FR-68), Münchenstein (BL), Muttenz (BL), Reinach (BL), Riehen (BS ...
(Switzerland
). Swiss law does not designate a ''capital'' as such, but the federal parliament and government are installed in Bern, while other federal institutions, such as the federal courts, are in other cities (Bellinzona, Lausanne, Luzern, Neuchâtel ...
).
File:RBI-Tower.jpg, The Reserve Bank of India
The Reserve Bank of India, chiefly known as RBI, is India's central bank and regulatory body responsible for regulation of the Indian banking system. It is under the ownership of Ministry of Finance, Government of India. It is responsible f ...
(established in 1935) Headquarters in Mumbai
Mumbai (, ; also known as Bombay — the official name until 1995) is the capital city of the Indian state of Maharashtra and the ''de facto'' financial centre of India. According to the United Nations, as of 2018, Mumbai is the second- ...
.
File:Central Bank of Brazil.jpg, The Central Bank of Brazil
The Central Bank of Brazil ( pt, Banco Central do Brasil) is Brazil's central bank. It was established on Thursday, 31 December 1964, a New Year's Eve.
The bank is not linked to any ministry, currently being autonomous. Like other central banks ...
(established in 1964) in Brasília
Brasília (; ) is the federal capital of Brazil and seat of government of the Federal District. The city is located at the top of the Brazilian highlands in the country's Central-West region. It was founded by President Juscelino Kubitsche ...
.
File:Banco de España (Madrid) 06.jpg, The Bank of Spain (established in 1782) in Madrid
Madrid ( , ) is the capital and most populous city of Spain. The city has almost 3.4 million inhabitants and a metropolitan area population of approximately 6.7 million. It is the second-largest city in the European Union (EU), and ...
.
Monetary policy instruments
The main
monetary policy instruments available to central banks are
open market operation, bank
reserve requirement
Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the centra ...
,
interest rate policy, re-lending and re-discount (including using the
term repurchase market), and
credit policy (often coordinated with
trade policy
A commercial policy (also referred to as a trade policy or international trade policy) is a government's policy governing international trade. Commercial policy is an all encompassing term that is used to cover topics which involve international t ...
). While
capital adequacy
A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital a ...
is important, it is defined and regulated by the Bank for International Settlements, and central banks in practice generally do not apply stricter rules.
Conventional instrument
The
central bank
A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union,
and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...
influences
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
s by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank.
Central banks have three main methods of monetary policy:
open market operations, the
discount rate and the
reserve requirement
Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the centra ...
s.
Key Interest rates & refinancing operations
By far the most visible and obvious power of many modern central banks is to influence market interest rates; contrary to popular belief, they rarely "set" rates to a fixed number. Although the mechanism differs from country to country, most use a similar mechanism based on a central bank's ability to create as much
fiat money
Fiat money (from la, fiat, "let it be done") is a type of currency that is not backed by any commodity such as gold or silver. It is typically designated by the issuing government to be legal tender. Throughout history, fiat money was sometime ...
as required.
The mechanism to move the market towards a 'target rate' (whichever specific rate is used) is generally to lend money or borrow money in theoretically unlimited quantities until the targeted market rate is sufficiently close to the target. Central banks may do so by lending money to and borrowing money from (taking deposits from) a limited number of qualified banks, or by purchasing and selling bonds. As an example of how this functions, the
Bank of Canada sets a target
overnight rate
The overnight rate is generally the interest rate that large banks use to borrow and lend from one another in the overnight market. In some countries (the United States, for example), the overnight rate may be the rate targeted by the central ban ...
, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of the band are unlimited. Other central banks use similar mechanisms.
The target rates are generally short-term rates. The actual rate that borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity and other factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of
inverted yield curve
In finance, an inverted yield curve happens when a yield curve graph of typically government bonds inverts in the opposite direction and the shorter term US Treasury bonds are offering a higher yield than the long-term Treasury bonds. Long ...
s, even below the short-term rate. Many central banks have one primary "headline" rate that is quoted as the "central bank rate". In practice, they will have other tools and rates that are used, but only one that is rigorously targeted and enforced.
"The rate at which the central bank lends money can indeed be chosen at will by the central bank; this is the rate that makes the financial headlines." Henry C.K. Liu explains further that "the U.S. central-bank lending rate is known as the
Fed funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances ...
. The Fed sets a target for the Fed funds rate, which its
Open Market Committee tries to match by lending or borrowing in the
money market
The money market is a component of the economy that provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less.
As short-term securities became a commodity, the money market became a compon ...
... a fiat money system set by command of the central bank. The Fed is the head of the central-bank because the U.S. dollar is the key reserve currency for international trade. The global money market is a USA dollar market. All other currencies markets revolve around the U.S. dollar market." Accordingly, the U.S. situation is not typical of central banks in general.
Typically a central bank controls certain types of
short-term interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
s. These influence the
stock- and
bond market
The bond market (also debt market or credit market) is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, bu ...
s as well as
mortgage
A mortgage loan or simply mortgage (), in civil law jurisdicions known also as a hypothec loan, is a loan used either by purchasers of real property to raise funds to buy real estate, or by existing property owners to raise funds for any ...
and other interest rates. The European Central Bank, for example, announces its interest rate at the meeting of its Governing Council; in the case of the U.S. Federal Reserve, the
Federal Reserve Board of Governors
The Board of Governors of the Federal Reserve System, commonly known as the Federal Reserve Board, is the main governing body of the Federal Reserve System. It is charged with overseeing the Federal Reserve Banks and with helping implement the mon ...
. Both the Federal Reserve and the ECB are composed of one or more central bodies that are responsible for the main decisions about interest rates and the size and type of open market operations, and several branches to execute its policies. In the case of the Federal Reserve, they are the local Federal Reserve Banks; for the ECB they are the national central banks.
A typical central bank has several interest rates or monetary policy tools it can set to influence markets.
*
Marginal lending rate – a fixed rate for institutions to borrow money from the central bank. (In the USA this is called the
discount rate).
* Main refinancing rate – the publicly visible interest rate the central bank announces. It is also known as ''minimum bid rate'' and serves as a bidding floor for refinancing loans. (In the USA this is called the
federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances a ...
).
* Deposit rate, generally consisting of
interest on reserves and sometimes also
interest on excess reserves
Excess reserves are bank reserves held by a bank in excess of a reserve requirement for it set by a central bank.
In the United States, bank reserves for a commercial bank are represented by its cash holdings and any credit balance in an account ...
– the rates parties receive for deposits at the central bank.
These rates directly affect the rates in the money market, the market for short-term loans.
Some central banks (e.g. in Denmark, Sweden and the Eurozone) are currently applying
negative interest rates
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
.
Open market operations
Through
open market operations, a central bank influences the money supply in an economy. Each time it buys
securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
(such as a
government bond
A government bond or sovereign bond is a form of bond issued by a government to support public spending. It generally includes a commitment to pay periodic interest, called coupon payments'','' and to repay the face value on the maturity dat ...
or treasury bill), it in effect
creates money. The central bank exchanges money for the security, increasing the
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circul ...
while lowering the supply of the specific security. Conversely, selling of securities by the central bank reduces the money supply.
Open market operations usually take the form of:
* Buying or selling securities ("
direct operations") to achieve an interest rate target in the interbank market .
* Temporary lending of money for
collateral
Collateral may refer to:
Business and finance
* Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan
* Marketing collateral, in marketing and sales
Arts, entertainment, and media
* ''Collate ...
securities ("Reverse Operations" or "
repurchase operations", otherwise known as the "repo" market). These operations are carried out on a regular basis, where fixed
maturity loans (of one week and one month for the ECB) are auctioned off.
*
Foreign exchange
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all as ...
operations such as
foreign exchange swap
In finance, a foreign exchange swap, forex swap, or FX swap is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward) and may use foreign exchange derivatives. ...
s.
These interventions can also influence the
foreign exchange market and thus the exchange rate. For example, the
People's Bank of China
The People's Bank of China (officially PBC or informally PBOC; ) is the central bank of the People's Republic of China, responsible for carrying out monetary policy and regulation of financial institutions in mainland China, as determined by ...
and the
Bank of Japan have on occasion bought several hundred billions of
U.S. Treasuries, presumably in order to stop the decline of the
U.S. dollar
The United States dollar ( symbol: $; code: USD; also abbreviated US$ or U.S. Dollar, to distinguish it from other dollar-denominated currencies; referred to as the dollar, U.S. dollar, American dollar, or colloquially buck) is the officia ...
versus the
renminbi and the
yen
The is the official currency of Japan. It is the third-most traded currency in the foreign exchange market, after the United States dollar (US$) and the euro. It is also widely used as a third reserve currency after the US dollar and the e ...
.
Reserve requirements
Historically,
bank reserves
Bank reserves are a commercial bank's cash holdings physically held by the bank, and deposits held in the bank's account with the central bank. Under the fractional-reserve banking system used in most countries, central banks typically set mini ...
have formed only a small fraction of
deposits
A deposit account is a bank account maintained by a financial institution in which a customer can deposit and withdraw money. Deposit accounts can be savings accounts, current accounts or any of several other types of accounts explained below.
...
, a system called
fractional-reserve banking
Fractional-reserve banking is the system of banking operating in almost all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserve, ...
. Banks would hold only a small percentage of their assets in the form of cash
reserves as insurance against bank runs. Over time this process has been regulated and insured by central banks. Such legal
reserve requirement
Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the centra ...
s were introduced in the 19th century as an attempt to reduce the risk of banks overextending themselves and suffering from
bank runs, as this could lead to knock-on effects on other overextended banks. ''See also
money multiplier.''
As the early 20th century
gold standard
A gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. The gold standard was the basis for the international monetary system from the 1870s to the early 1920s, and from the la ...
was undermined by inflation and the late 20th-century fiat
dollar hegemony evolved, and as banks proliferated and engaged in more complex transactions and were able to profit from dealings globally on a moment's notice, these practices became mandatory, if only to ensure that there was some limit on the ballooning of money supply.
A number of central banks have since abolished their reserve requirements over the last few decades, beginning with the Reserve Bank of New Zealand in 1985 and continuing with the Federal Reserve in 2020. For the respective banking systems, bank capital requirements provide a check on the growth of the money supply.
The
People's Bank of China
The People's Bank of China (officially PBC or informally PBOC; ) is the central bank of the People's Republic of China, responsible for carrying out monetary policy and regulation of financial institutions in mainland China, as determined by ...
retains (and uses) more powers over reserves because the
yuan that it manages is a non-
convertible currency
Convertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Convertibility is an important factor in international trade, where instruments valued in different currencies mus ...
.
Loan activity by banks plays a fundamental role in determining the money supply. The central-bank money after aggregate settlement – "final money" – can take only one of two forms:
* physical cash, which is rarely used in wholesale financial markets,
* central-bank money which is rarely used by the people
The currency component of the money supply is far smaller than the deposit component. Currency, bank reserves and institutional loan agreements together make up the monetary base, called
M1, M2 and M3. The Federal Reserve Bank stopped publishing M3 and counting it as part of the money supply in 2006.
Credit guidance
Central banks can directly or indirectly influence the allocation of bank lending in certain sectors of the economy by applying quotas, limits or differentiated interest rates. This allows the central bank to control both the quantity of lending and its allocation towards certain strategic sectors of the economy, for example to support the national industrial policy, or to environmental investment such as housing renovation.
The
Bank of Japan used to apply such policy ("window guidance") between 1962 and 1991. The
Banque de France
The Bank of France ( French: ''Banque de France''), headquartered in Paris, is the central bank of France. Founded in 1800, it began as a private institution for managing state debts and issuing notes. It is responsible for the accounts of the ...
also widely used credit guidance during the post-war period of 1948 until 1973 .
The European Central Bank's ongoing TLTROs operations can also be described as form of credit guidance insofar as the level of interest rate ultimately paid by banks is differentiated according to the volume of lending made by commercial banks at the end of the maintenance period. If commercial banks achieve a certain lending performance threshold, they get a discount interest rate, that is lower than the standard key interest rate. For this reason, some economists have described the TLTROs as a
"dual interest rates" policy. China is also applying a form of dual rate policy.
Exchange requirements
To influence the money supply, some central banks may require that some or all foreign exchange receipts (generally from exports) be exchanged for the local currency. The rate that is used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is generally used in countries with non-convertible currencies or partially convertible currencies. The recipient of the local currency may be allowed to freely dispose of the funds, required to hold the funds with the central bank for some period of time, or allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or use the foreign exchange may be otherwise limited.
In this method, money supply is increased by the central bank when it purchases the foreign currency by issuing (selling) the local currency. The central bank may subsequently reduce the money supply by various means, including selling bonds or foreign exchange interventions.
Collateral policy
In some countries, central banks may have other tools that work indirectly to limit lending practices and otherwise restrict or regulate capital markets. For example, a central bank may regulate
margin lending, whereby individuals or companies may borrow against pledged securities. The margin requirement establishes a minimum ratio of the value of the securities to the amount borrowed.
Central banks often have requirements for the quality of assets that may be held by financial institutions; these requirements may act as a limit on the amount of risk and leverage created by the financial system. These requirements may be direct, such as requiring certain assets to bear certain minimum
credit rating
A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.
...
s, or indirect, by the central bank lending to counter-parties only when security of a certain quality is pledged as
collateral
Collateral may refer to:
Business and finance
* Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan
* Marketing collateral, in marketing and sales
Arts, entertainment, and media
* ''Collate ...
.
Forward guidance
Forward guidance is a communication practice whereby the central bank announces its forecasts and future intentions to increase market expectations of future levels of
interest rates.
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 (QE) is a monetary policy action whereby a central bank purchases predetermined amounts of government bonds or other financial assets in order to stimulate economic activity. Quantitative easing is a novel form of monetary pol ...
,
forward guidance Forward guidance is a tool used by a central bank to exercise its power in monetary policy in order to influence, with their own forecasts, market expectations of future levels of interest rates.
Communication about the likely future course of mon ...
, and
signalling
In signal processing, a signal is a function that conveys information about a phenomenon. Any quantity that can vary over space or time can be used as a signal to share messages between observers. The ''IEEE Transactions on Signal Processing'' ...
. In credit easing, a central bank purchases private sector assets to improve liquidity and improve access to credit. Signaling can be used to lower market expectations for lower interest rates in the future. For example, during the credit crisis of 2008, the
US Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
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.
Helicopter money
Further heterodox monetary policy proposals include the idea of
helicopter money
Helicopter money is a proposed unconventional monetary policy, sometimes suggested as an alternative to quantitative easing (QE) when the economy is in a liquidity trap (when interest rates near zero and the economy remains in recession). Altho ...
whereby central banks would create money without assets as counterpart in their balance sheet. The money created could be distributed directly to the population as a citizen's dividend. Virtues of such money shock include the decrease of household risk aversion and the increase in demand, boosting both inflation and the
output gap. This option has been increasingly discussed since March 2016 after the ECB's president
Mario Draghi
Mario Draghi (; born 3 September 1947) is an Italian economist, academic, banker and civil servant who served as prime minister of Italy from February 2021 to October 2022. Prior to his appointment as prime minister, he served as President of ...
said he found the concept "very interesting". The idea was also promoted by prominent former central bankers
Stanley Fischer and
Philipp Hildebrand in a paper published by
BlackRock
BlackRock, Inc. is an American multi-national investment company based in New York City. Founded in 1988, initially as a risk management and fixed income institutional asset manager, BlackRock is the world's largest asset manager, with trill ...
, and in France by economists
Philippe Martin and Xavier Ragot from the French Council for Economic Analysis, a think tank attached to the Prime minister's office.
Some have envisaged the use of what Milton Friedman once called "
helicopter money
Helicopter money is a proposed unconventional monetary policy, sometimes suggested as an alternative to quantitative easing (QE) when the economy is in a liquidity trap (when interest rates near zero and the economy remains in recession). Altho ...
" whereby the central bank would make direct transfers to citizens in order to lift inflation up to the central bank's intended target. Such policy option could be particularly effective at the zero lower bound.
Nominal anchors
A nominal anchor for monetary policy is a single variable or device which the central bank uses to pin down expectations of private agents about the nominal price level or its path or about what the central bank might do with respect to achieving that path. Monetary regimes combine long-run nominal anchoring with flexibility in the short run. Nominal variables used as anchors primarily include exchange rate targets, money supply targets, and inflation targets with interest rate policy.
[Feenstra, Robert C., and Alan M. Taylor. International Macroeconomics. New York: Worth, 2012. 100-05.]
Types
In practice, to implement any type of monetary policy the main tool used is modifying the amount of
base money
In economics, the monetary base (also base money, money base, high-powered money, reserve money, outside money, central bank money or, in the UK, narrow money) in a country is the total amount of money created by the central bank. This include ...
in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These
open market operations
In macroeconomics, an open market operation (OMO) is an activity by a central bank to give (or take) liquidity in its currency to (or from) a bank or a group of banks. The central bank can either buy or sell government bonds (or other financial a ...
change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The
multiplier effect
In macroeconomics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable.
For example, suppose variable ''x''
changes by ''k'' units, which causes an ...
of
fractional reserve banking amplifies the effects of these actions on the
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circul ...
, which includes bank deposits as well as base money.
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.
The different types of policy are also called monetary regimes, in parallel to
exchange-rate regime
An exchange rate regime is a way a monetary authority of a country or currency union manages the currency about other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many ...
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 the 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
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...
, under a particular definition such as the
Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the central bank
interest rate
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
target. The interest rate used is generally the
overnight rate
The overnight rate is generally the interest rate that large banks use to borrow and lend from one another in the overnight market. In some countries (the United States, for example), the overnight rate may be the rate targeted by the central ban ...
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.
As the
Fisher effect
In economics, the Fisher effect is the tendency for nominal interest rates to change to follow the inflation rate. It is named after the economist Irving Fisher, who first observed and explained this relationship. Fisher proposed that the real i ...
model explains, the equation linking inflation with interest rates is the following:
:π = ''i – r''
where π is the inflation rate, ''i'' is the home nominal interest rate set by the central bank, and ''r'' is the real interest rate. Using ''i'' as an anchor, central banks can influence π.
Central banks can choose to maintain a fixed interest rate at all times, or just temporarily. The duration of this policy varies, because of the simplicity associated with changing the nominal interest rate.
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 trend
*all the economic indicators that are the subject of economic forecasting
**see also: econometrics
*general trends in the economy, see: economic history
Economic history is the academic learning of economies or economic events of the past. R ...
s 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
The Taylor rule is a monetary policy targeting rule. The rule was proposed in 1992 by American economist John B. Taylor for central banks to use to stabilize economic activity by appropriately setting short-term interest rates.
The rule consider ...
adjusts the interest rate in response to changes in the inflation rate and the
output gap. The rule was proposed by
John B. Taylor
John Brian Taylor (born December 8, 1946) 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.
He taught at Columbia Univer ...
of
Stanford University
Stanford University, officially Leland Stanford Junior University, is a private research university in Stanford, California. The campus occupies , among the largest in the United States, and enrolls over 17,000 students. Stanford is consider ...
.
The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It has been used in
Australia
Australia, officially the Commonwealth of Australia, is a Sovereign state, sovereign country comprising the mainland of the Australia (continent), Australian continent, the island of Tasmania, and numerous List of islands of Australia, sma ...
,
Brazil
Brazil ( pt, Brasil; ), officially the Federative Republic of Brazil (Portuguese: ), is the largest country in both South America and Latin America. At and with over 217 million people, Brazil is the world's fifth-largest country by area ...
,
Canada
Canada is a country in North America. Its ten provinces and three territories extend from the Atlantic Ocean to the Pacific Ocean and northward into the Arctic Ocean, covering over , making it the world's second-largest country by tot ...
,
Chile
Chile, officially the Republic of Chile, is a country in the western part of South America. It is the southernmost country in the world, and the closest to Antarctica, occupying a long and narrow strip of land between the Andes to the east a ...
,
Colombia
Colombia (, ; ), officially the Republic of Colombia, is a country in South America with insular regions in North America—near Nicaragua's Caribbean coast—as well as in the Pacific Ocean. The Colombian mainland is bordered by the Car ...
, the
Czech Republic
The Czech Republic, or simply Czechia, is a landlocked country in Central Europe. Historically known as Bohemia, it is bordered by Austria to the south, Germany to the west, Poland to the northeast, and Slovakia to the southeast. The ...
,
Hungary
Hungary ( hu, Magyarország ) is a landlocked country in Central Europe. Spanning of the Carpathian Basin, it is bordered by Slovakia to the north, Ukraine to the northeast, Romania to the east and southeast, Serbia to the south, Croatia a ...
,
New Zealand
New Zealand ( mi, Aotearoa ) is an island country in the southwestern Pacific Ocean. It consists of two main landmasses—the North Island () and the South Island ()—and over 700 smaller islands. It is the sixth-largest island count ...
,
Norway
Norway, officially the Kingdom of Norway, is a Nordic country in Northern Europe, the mainland territory of which comprises the western and northernmost portion of the Scandinavian Peninsula. The remote Arctic island of Jan Mayen and t ...
,
Iceland
Iceland ( is, Ísland; ) is a Nordic island country in the North Atlantic Ocean and in the Arctic Ocean. Iceland is the most sparsely populated country in Europe. Iceland's capital and largest city is Reykjavík, which (along with its s ...
,
India
India, officially the Republic of India (Hindi: ), is a country in South Asia. It is the seventh-largest country by area, the second-most populous country, and the most populous democracy in the world. Bounded by the Indian Ocean on the so ...
,
Philippines
The Philippines (; fil, Pilipinas, links=no), officially the Republic of the Philippines ( fil, Republika ng Pilipinas, links=no),
* bik, Republika kan Filipinas
* ceb, Republika sa Pilipinas
* cbk, República de Filipinas
* hil, Republ ...
,
Poland
Poland, officially the Republic of Poland, is a country in Central Europe. It is divided into 16 administrative provinces called voivodeships, covering an area of . Poland has a population of over 38 million and is the fifth-most populous ...
,
Sweden
Sweden, formally the Kingdom of Sweden,The United Nations Group of Experts on Geographical Names states that the country's formal name is the Kingdom of SwedenUNGEGN World Geographical Names, Sweden./ref> is a Nordic country located on ...
,
South Africa
South Africa, officially the Republic of South Africa (RSA), is the southernmost country in Africa. It is bounded to the south by of coastline that stretch along the South Atlantic and Indian Oceans; to the north by the neighbouring countri ...
,
Turkey
Turkey ( tr, Türkiye ), officially the Republic of Türkiye ( tr, Türkiye Cumhuriyeti, links=no ), is a list of transcontinental countries, transcontinental country located mainly on the Anatolia, Anatolian Peninsula in Western Asia, with ...
, and the
United Kingdom
The United Kingdom of Great Britain and Northern Ireland, commonly known as the United Kingdom (UK) or Britain, is a country in Europe, off the north-western coast of the continental mainland. It comprises England, Scotland, Wales and North ...
.
Price level targeting
Price level targeting is a monetary policy that 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 trend 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.
Uncertainty in price levels can create uncertainty around
price
A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the ...
and
wage
A wage is payment made by an employer to an employee for work done in a specific period of time. Some examples of wage payments include compensatory payments such as ''minimum wage'', '' prevailing wage'', and ''yearly bonuses,'' and remune ...
setting activity for firms and workers, and undermines any
information
Information is an abstract concept that refers to that which has the power to inform. At the most fundamental level information pertains to the interpretation of that which may be sensed. Any natural process that is not completely random ...
that can be gained from
relative price
A relative price is the price of a commodity such as a good or service in terms of another; i.e., the ratio of two prices. A relative price may be expressed in terms of a ratio between the prices of any two goods or the ratio between the price o ...
s, as it is more difficult for firms to determine if a change in the
price
A price is the (usually not negative) quantity of payment or compensation given by one party to another in return for goods or services. In some situations, the price of production has a different name. If the product is a "good" in the ...
of a
good
In most contexts, the concept of good denotes the conduct that should be preferred when posed with a choice between possible actions. Good is generally considered to be the opposite of evil and is of interest in the study of ethics, morality, ph ...
or
service is because of
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...
or other factors, such as an increase in the
efficiency of
factors of production
In economics, factors of production, resources, or inputs are what is used in the production process to produce output—that is, goods and services. The utilized amounts of the various inputs determine the quantity of output according to the rel ...
, if
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...
is high and
volatile. An increase in
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...
also leads to a decrease in the
demand for money
In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable ...
, as it reduces the
incentive
In general, incentives are anything that persuade a person to alter their behaviour. It is emphasised that incentives matter by the basic law of economists and the laws of behaviour, which state that higher incentives amount to greater levels of ...
to hold money and increases
transaction cost
In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike pro ...
s and
shoe leather cost Metaphorically, shoe leather cost is the cost of time and effort (or opportunity costs of time and effort) that people expend by holding less cash in order to reduce the inflation tax that they pay on cash holdings when there is high inflation. The ...
s.
Monetary aggregates/money supply targeting
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 US this approach to monetary policy was discontinued with the selection of
Alan Greenspan
Alan Greenspan (born March 6, 1926) is an American economist who served as the 13th chairman of the Federal Reserve from 1987 to 2006. He works as a private adviser and provides consulting for firms through his company, Greenspan Associates LLC. ...
as
Fed Chairman.
This approach is also sometimes called
monetarism
Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on nation ...
.
Central banks might choose to set a money supply growth target as a nominal anchor to keep prices stable in the long term. The quantity theory is a long run model, which links price levels to money supply and demand. Using this equation, we can rearrange to see the following:
:π = μ − g,
where π is the inflation rate, μ is the money supply growth rate and g is the real output growth rate. This equation suggests that controlling the money supply's growth rate can ultimately lead to price stability in the long run. To use this nominal anchor, a central bank would need to set μ equal to a constant and commit to maintaining this target.
However, targeting the money supply growth rate is considered a weak policy, because it is not stably related to the real output growth, As a result, a higher output growth rate will result in a too low level of inflation. A low output growth rate will result in inflation that would be higher than the desired level.
While monetary policy typically focuses on a
price signal
A price signal is information conveyed to consumers and producers, via the prices offered or requested for, and the amount requested or offered of a product or service, which provides a signal to increase or decrease quantity supplied or quantit ...
of one form or another, this approach is focused on monetary quantities. As these quantities could have a role in the economy and business cycles depending on the households' risk aversion level, money is sometimes explicitly added in the central bank's reaction function. After the 1980s, however, central banks have shifted away from policies that focus on money supply targeting, because of the uncertainty that real output growth introduces. Some central banks, like the ECB, have chosen to combine a money supply anchor with other targets.
Nominal income/NGDP targeting
Related to money targeting,
nominal income target
A nominal income target is a monetary policy target. Such targets are adopted by central banks to manage national economic activity. Nominal aggregates are not adjusted for inflation. Nominal income aggregates that can serve as targets include no ...
ing (also called Nominal GDP or NGDP targeting), originally proposed by
James Meade
James Edward Meade, (23 June 1907 – 22 December 1995) was a British economist and winner of the 1977 Nobel Memorial Prize in Economic Sciences jointly with the Swedish economist Bertil Ohlin for their "pathbreaking contribution to the ...
(1978) and
James Tobin
James Tobin (March 5, 1918 – March 11, 2002) was an American economist who served on the Council of Economic Advisers and consulted with the Board of Governors of the Federal Reserve System, and taught at Harvard and Yale Universities. He d ...
(1980), was advocated by
Scott Sumner
Scott B. Sumner (born 1955) is an American economist. He is the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University, a Research Fellow at the Independent Institute, and professor who teaches at Bentley ...
and reinforced by the
market monetarist
Market monetarism is a school of macroeconomic thought that advocates that central banks target the level of nominal income instead of inflation, unemployment, or other measures of economic activity, including in times of shocks such as the burs ...
school of thought.
Central banks do not implement this monetary policy explicitly. However, numerous studies shown that such a monetary policy targeting better matches central bank losses and welfare optimizing monetary policy compared to more standard monetary policy targeting.
Fixed exchange rate targeting
This policy is based on maintaining a
fixed exchange rate
A fixed exchange rate, often called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another m ...
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 controls are residency-based measures such as transaction taxes, other limits, or outright prohibitions that a nation's government can use to regulate flows from capital markets into and out of the country's capital account. These measure ...
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
Currency substitution is the use of a foreign currency in parallel to or instead of a domestic currency. The process is also known as dollarization or euroization when the foreign currency is the dollar or the euro, respectively.
Currency subs ...
, 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).
Theoretically, using
relative purchasing power parity
Relative Purchasing Power Parity is an economic theory which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is ...
(PPP), the rate of depreciation of the home country's currency must equal the inflation differential:
:rate of depreciation = home inflation rate – foreign inflation rate,
which implies that
:home inflation rate = foreign inflation rate + rate of depreciation.
The anchor variable is the rate of depreciation. Therefore, the rate of inflation at home must equal the rate of inflation in the foreign country plus the rate of depreciation of the exchange rate of the home country currency, relative to the other.
With a strict fixed exchange rate or a peg, the rate of depreciation of the exchange rate is set equal to zero. In the case of a
crawling peg
In macroeconomics, crawling peg is an exchange rate regime that allows Currency appreciation and depreciation, depreciation or appreciation to happen gradually. It is usually seen as a part of a fixed exchange rate regime.
The system is a method ...
, the rate of depreciation is set equal to a constant. With a limited flexible band, the rate of depreciation is allowed to fluctuate within a given range.
By fixing the rate of depreciation, PPP theory concludes that the home country's inflation rate must depend on the foreign country's.
Countries may decide to use a fixed exchange rate monetary regime in order to take advantage of price stability and control inflation. In practice, more than half of nations’ monetary regimes use fixed exchange rate anchoring.
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 and other economic factors.
In practice
Nominal anchors are possible with various exchange rate regimes.
Following the collapse of Bretton Woods, nominal anchoring has grown in importance for monetary policy makers and inflation reduction. Particularly, governments sought to use anchoring in order to curtail rapid and high inflation during the 1970s and 1980s. By the 1990s, countries began to explicitly set credible nominal anchors. In addition, many countries chose a mix of more than one target, as well as implicit targets. As a result, after the 1970s global inflation rates, on average, decreased gradually and central banks gained credibility and increasing independence.
The Global Financial Crisis of 2008 sparked controversy over the use and flexibility of inflation nominal anchoring. Many economists argued that inflation targets were set too low by many monetary regimes. During the crisis, many inflation-anchoring countries reached the lower bound of zero rates, resulting in inflation rates decreasing to almost zero or even deflation.
Implications
The anchors discussed in this article suggest that keeping inflation at the desired level is feasible by setting a target interest rate, money supply growth rate, price level, or rate of depreciation. However, these anchors are only valid if a central bank commits to maintaining them. This, in turn, requires that the central bank abandon their monetary policy autonomy in the long run. Should a central bank use one of these anchors to maintain a target inflation rate, they would have to forfeit using other policies. Using these anchors may prove more complicated for certain exchange rate regimes. Freely floating or managed floating regimes have more options to affect their inflation, because they enjoy more flexibility than a pegged currency or a country without a currency. The latter regimes would have to implement an exchange rate target to influence their inflation, as none of the other instruments are available to them.
Credibility
The short-term effects of monetary policy can be influenced by the degree to which announcements of new policy are deemed
credible
Credibility comprises the objective and subjective components of the believability of a source or message. Credibility dates back to Aristotle theory of Rhetoric. Aristotle defines rhetoric as the ability to see what is possibly persuasive in ...
. In particular, when an anti-inflation policy is announced by a central bank, in the absence of credibility in the eyes of the public
inflationary expectations will not drop, and the short-run effect of the announcement and a subsequent sustained anti-inflation policy is likely to be a combination of somewhat lower inflation and higher unemployment (see
Phillips curve § NAIRU and rational expectations). But if the policy announcement is deemed credible, inflationary expectations will drop commensurately with the announced policy intent, and inflation is likely to come down more quickly and without so much of a cost in terms of unemployment.
Thus there can be an advantage to having the central bank be independent of the political authority, to shield it from the prospect of political pressure to reverse the direction of the policy. But even with a seemingly independent central bank, a central bank whose hands are not tied to the anti-inflation policy might be deemed as not fully credible; in this case there is an advantage to be had by the central bank being in some way bound to follow through on its policy pronouncements, lending it credibility.
There is very strong consensus among economists that an independent central bank can run a more credible monetary policy, making market expectations more responsive to signals from the central bank.
Contexts
In international economics
Optimal monetary policy in international economics is concerned with the question of how monetary policy should be conducted in interdependent open economies. The
classical view holds that international macroeconomic interdependence is only relevant if it affects domestic
output gaps and inflation, and monetary policy prescriptions can abstract from openness without harm. This view rests on two implicit assumptions: a high responsiveness of import prices to the exchange rate, i.e. producer currency pricing (PCP), and frictionless international financial markets supporting the efficiency of flexible price allocation.
[Corsetti, G., Pesenti, P. (2005). International dimensions of optimal monetary policy. ''Journal of Monetary Economics'', 52(2), pp. 281–305.] The violation or distortion of these assumptions found in empirical research is the subject of a substantial part of the international optimal monetary policy literature. The policy trade-offs specific to this international perspective are threefold:
First, research suggests only a weak reflection of exchange rate movements in import prices, lending credibility to the opposed theory of local currency pricing (LCP). The consequence is a departure from the classical view in the form of a trade-off between output gaps and misalignments in international relative prices, shifting monetary policy to CPI inflation control and real exchange rate stabilization.
Second, another specificity of international optimal monetary policy is the issue of strategic interactions and competitive devaluations, which is due to cross-border spillovers in quantities and prices. Therein, the national authorities of different countries face incentives to manipulate the
terms of trade
The terms of trade (TOT) is the relative price of exports in terms of imports and is defined as the ratio of export prices to import prices. It can be interpreted as the amount of import goods an economy can purchase per unit of export goods.
An i ...
to increase national welfare in the absence of international policy coordination. Even though the gains of international policy coordination might be small, such gains may become very relevant if balanced against incentives for international noncooperation.
Third, open economies face policy trade-offs if asset market distortions prevent global efficient allocation. Even though the real exchange rate absorbs shocks in current and expected fundamentals, its adjustment does not necessarily result in a desirable allocation and may even exacerbate the misallocation of consumption and employment at both the domestic and global level. This is because, relative to the case of complete markets, both the Phillips curve and the loss function include a welfare-relevant measure of cross-country imbalances. Consequently, this results in domestic goals, e.g.
output gaps or inflation, being traded-off against the stabilization of external variables such as the terms of trade or the demand gap. Hence, the optimal monetary policy in this case consists of redressing demand imbalances and/or correcting international relative prices at the cost of some inflation.
Corsetti, Dedola and Leduc (2011)
summarize the status quo of research on international monetary policy prescriptions: "Optimal monetary policy thus should target a combination of inward-looking variables such as output gap and inflation, with currency misalignment and cross-country demand misallocation, by leaning against the wind of misaligned exchange rates and international imbalances." This is main factor in country money status.
In 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 tax by expanding the base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authorities in developing countries are mostly not independent of the government, so good monetary policy takes a backseat to the political desires of the government or is 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
Currency substitution is the use of a foreign currency in parallel to or instead of a domestic currency. The process is also known as dollarization or euroization when the foreign currency is the dollar or the euro, respectively.
Currency subs ...
. This can avoid interference from the government and may lead to the adoption of monetary policy as carried out in the anchor nation. Recent attempts at liberalizing and reform of financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required to implement monetary policy frameworks by the relevant central banks.
Trends
Transparency
Beginning with New Zealand in 1990, 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
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 to act as the English Government's banker, and still one of the bankers for the Government of ...
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, revised to 2% of CPI in 2003. The success of inflation targeting in the United Kingdom has been attributed to the Bank of England's focus on transparency.
The Bank of England has been a leader in producing innovative ways of communicating information to the public, especially through its Inflation Report, which have been emulated by many other central banks.
The
European Central Bank
The European Central Bank (ECB) is the prime component of the monetary Eurosystem and the European System of Central Banks (ESCB) as well as one of seven institutions of the European Union. It is one of the world's most important centr ...
adopted, in 1998, a definition of
price stability Price stability is a goal of monetary and fiscal policy aiming to support sustainable rates of economic activity. Policy is set to maintain a very low rate of inflation or deflation. For example, the European Central Bank (ECB) describes price s ...
within the
Eurozone
The euro area, commonly called eurozone (EZ), is a currency union of 19 member states of the European Union (EU) that have adopted the euro (€) as their primary currency and sole legal tender, and have thus fully implemented EMU policies ...
as inflation of under 2%
HICP The Harmonised Index of Consumer Prices (HICP) is an indicator of inflation and price stability for the European Central Bank (ECB). It is a consumer price index which is compiled according to a methodology that has been harmonised across EU countr ...
. In 2003, this was revised to inflation below, but close to, 2% over the medium term. Since then, the target of 2% has become common for other major central banks, including the
Federal Reserve
The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
(since January 2012) and
Bank of Japan (since January 2013).
Effect on business cycles
There continues to be some debate about whether monetary policy can (or should) smooth
business cycles
Business cycles are intervals of expansion followed by recession in economic activity. These changes have implications for the welfare of the broad population as well as for private institutions. Typically business cycles are measured by examini ...
. A central conjecture of
Keynesian economics
Keynesian economics ( ; sometimes Keynesianism, named after British economist John Maynard Keynes) are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output a ...
is that the central bank can stimulate
aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral, as in the
neoclassical model). However, some economists from the
new classical school
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundat ...
contend that central banks cannot affect business cycles.
Behavioral monetary policy
Conventional macroeconomic models assume that all agents in an economy are fully rational. A
rational agent
A rational agent or rational being is a person or entity that always aims to perform optimal actions based on given premises and information. A rational agent can be anything that makes decisions, typically a person, firm, machine, or software.
Th ...
has clear preferences, models uncertainty via expected values of variables or functions of variables, and always chooses to perform the action with the optimal expected outcome for itself among all feasible actions – they maximize their
utility
As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosoph ...
. Monetary policy analysis and decisions hence traditionally rely on this
New Classical
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundat ...
approach.
However, as studied by the field of
behavioral economics that takes into account the concept of
bounded rationality, people often deviate from the way that these neoclassical theories assume.
Humans are generally not able to react fully rational to the world around them
– they do not make decisions in the rational way commonly envisioned in standard macroeconomic models. People have time limitations,
cognitive biases
A cognitive bias is a systematic pattern of deviation from norm or rationality in judgment. Individuals create their own "subjective reality" from their perception of the input. An individual's construction of reality, not the objective input, m ...
, care about issues like fairness and equity and follow rules of thumb (
heuristics
A heuristic (; ), or heuristic technique, is any approach to problem solving or self-discovery that employs a practical method that is not guaranteed to be optimal, perfect, or rational, but is nevertheless sufficient for reaching an immediate, ...
).
This has implications for the conduct of monetary policy. Monetary policy is the final outcome of a complex interaction between monetary institutions, central banker preferences and policy rules, and hence human decision-making plays an important role.
It is more and more recognized that the standard rational approach does not provide an optimal foundation for monetary policy actions. These models fail to address important human anomalies and behavioral drivers that explain monetary policy decisions.
An example of a behavioral bias that characterizes the behavior of central bankers is
loss aversion
Loss aversion is the tendency to prefer avoiding losses to acquiring equivalent gains. The principle is prominent in the domain of economics. What distinguishes loss aversion from risk aversion is that the utility of a monetary payoff depends o ...
: for every monetary policy choice, losses loom larger than gains, and both are evaluated with respect to the status quo.
One result of loss aversion is that when gains and losses are symmetric or nearly so, risk aversion may set in. Loss aversion can be found in multiple contexts in monetary policy. The "hard fought" battle against the Great Inflation, for instance, might cause a bias against policies that risk greater inflation.
Another common finding in behavioral studies is that individuals regularly offer estimates of their own ability, competence, or judgments that far exceed an objective assessment: they are overconfident. Central bank policymakers may fall victim to
overconfidence in managing the macroeconomy in terms of timing, magnitude, and even the qualitative impact of interventions. Overconfidence can result in actions of the central bank that are either "too little" or "too much". When policymakers believe their actions will have larger effects than objective analysis would indicate, this results in too little intervention. Overconfidence can, for instance, cause problems when relying on interest rates to gauge the stance of monetary policy: low rates might mean that policy is easy, but they could also signal a weak economy.
These are examples of how behavioral phenomena may have a substantial influence on monetary policy. Monetary policy analyses should thus account for the fact that policymakers (or central bankers) are individuals and prone to biases and temptations that can sensibly influence their ultimate choices in the setting of macroeconomic and/or interest rate targets.
See also
*
Economic policy
*
Fiscal policy
In economics and political science, fiscal policy is the use of government revenue collection (taxes or tax cuts) and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variab ...
*
Forward guidance Forward guidance is a tool used by a central bank to exercise its power in monetary policy in order to influence, with their own forecasts, market expectations of future levels of interest rates.
Communication about the likely future course of mon ...
*
Interaction between monetary and fiscal policies
*
Interest on excess reserves
Excess reserves are bank reserves held by a bank in excess of a reserve requirement for it set by a central bank.
In the United States, bank reserves for a commercial bank are represented by its cash holdings and any credit balance in an account ...
*
Macroeconomic model
A macroeconomic model is an analytical tool designed to describe the operation of the problems of economy of a country or a region. These models are usually designed to examine the comparative statics and dynamics of aggregate quantities such a ...
*
Monetary conditions index
In macroeconomics, a monetary conditions index (MCI) is an index number calculated from a linear combination of a small number of economy-wide financial variables deemed relevant for monetary policy. These variables always include a short-run inte ...
*
Monetary system
A monetary system is a system by which a government provides money in a country's economy. Modern monetary systems usually consist of the national treasury, the mint, the central banks and commercial banks.
Commodity money system
A commodity m ...
*
Monetary reform
Monetary reform is any movement or theory that proposes a system of supplying money and financing the economy that is different from the current system.
Monetary reformers may advocate any of the following, among other proposals:
* A return t ...
*
Monetary transmission mechanism
The monetary transmission mechanism is the process by which asset prices and general economic conditions are affected as a result of monetary policy decisions. Such decisions are intended to influence the aggregate demand, interest rates, and amo ...
*
Negative interest on excess reserves
Negative interest on excess reserves is an instrument of unconventional monetary policy applied by central banks to encourage lending by making it costly for commercial banks to hold their excess reserves at central banks so they will lend more re ...
*
Gold standard
A gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. The gold standard was the basis for the international monetary system from the 1870s to the early 1920s, and from the la ...
US specific:
*
Greenspan put
The Greenspan put was a monetary policy response to financial crises that Alan Greenspan, former chair of the Federal Reserve, exercised beginning with the crash of 1987. Successful in addressing various crises, it became controversial as it l ...
*
Free silver
References
External links
*
*Mankiw, N. Gregory, and Ricardo Reis. 2018. "Friedman's Presidential Address in the Evolution of Macroeconomic Thought." ''Journal of Economic Perspectives'' 32(1): 81–96.
Bank for International Settlements
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Public finance