HOME
        TheInfoList






Monetary policy is policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often as an attempt to reduce inflation or the interest rate to ensure price stability and general trust of the value and stability of the nation's currency.[1][2][3]

Unlike fiscal policy, which relies on taxation, government spending, and government borrowing,[4] as methods for a government to manage business cycle phenomena such as recessions, 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.

Further purposes of a monetary policy are usually to contribute to the stability of gross domestic product, to achieve and maintain low unemployment, and to maintain predictable exchange rates with other currencies.

Monetary economics can provide insight into crafting optimal monetary policy. In developed countries, 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 during a recession 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 (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 which case foreign purchasers will be able to purchase more with their currency in the country with the devalued currency.[5]

Contractionary monetary 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. Contractionary monetary policy can result in increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an economic recession if implemented too vigorously.[6]

History

Monetary policy is associated with interest rates and availability of credit. Instruments of monetary policy have included short-term interest rates and bank reserves through the monetary base.[7] For many centuries there were only two forms of monetary policy: altering coinage or the printing of paper money. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was considered as an executive decision, and was generally implemented by the authority with seigniorage (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 termed "jiaozi" in 7th century China. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The succeeding Yuan Dynasty 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.

With the creation of the Bank of England in 1694,[8] which was granted the authority to print notes backed by gold, the idea of monetary policy as independent of executive action[how?] began to be established.[9] 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, and to trade in a narrow currency band 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.[10]

During the period 1870–1920, the industrialized nations established central banking systems, with one of the last being the Federal Reserve in 1913.[11] By this time the role of the central bank as the "lender of last resort" 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 who early in his career advocated that government budget deficits during recessions be financed in equal amount by money creation to help to stimulate aggregate demand for production.[12] 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.[13] However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the unstable relationship between monetary aggregates and other macroeconomic variables.[14] Even Milton Friedman later acknowledged that direct money supplying was less successful than he had hoped.[15]

Therefore, monetary decisions presently take into account a wider range of factors, such as:

Monetary policy instruments

Conventional instrument

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

An important method

Monetary policy is policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often as an attempt to reduce inflation or the interest rate to ensure price stability and general trust of the value and stability of the nation's currency.[1][2][3]

Unlike fiscal policy, which relies on taxation, government spending, and government borrowing,[4] as methods for a government to manage business cycle phenomena such as recessions, 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.

Further purposes of a monetary policy are usually to contribute to the stability of gross domestic product, to achieve and maintain low unemployment, and to maintain predictable exchange rates with other currencies.

Monetary economics can provide insight into crafting optimal monetary policy. In developed countries, 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 during a recession 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 (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 which case foreign purchasers will be able to purchase more with their currency in the country with the devalued currency.[5]

Contractionary monetary 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. Contractionary monetary policy can result in increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an economic recession if implemented too vigorously.[6]