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Monetary policy is the financial policy of managing the money supply
to achieve specific goals—such as reducing inflation or achieving full
employment or more well-being. Almost always, special institutions (like the European Central Bank or the Federal
Reserve) exist which have the task of maintaining the monetary policy of a country or transnational entity, independently of
government. In general, these institutions are called central banks and typically serve a role of supervising the smooth operation of the
financial system as well as monetary policy. Globally, the Bank for International Settlements plays a role in standardizing policy and also
informally called the central bank for the central banks, though it sets no monetary policy of its own.
The primary tool of monetary policy is usually a short term interest rate. In the case of the US for example, the Federal Reserve targets the Fed Funds rate, the rate at which member banks
lend to one another overnight. Monetary policy is also often expressed by the central bank trying to target or manipulate the
exchange rate with major trading partners.
History of Monetary Policy
Before there was money, there was the barter system, where items were exchanged
directly for other items. There was no monetary policy because there was no money.
The first 'money' was effectively the raw commodities of wheat, barley, etc. Later, gold, silver, ivory, amber, or other precious materials made trade more convenient. Monetary policy consisted of the
populace regarding a particular commodity as having equal value to any other set of goods. However, there were problems with
using gold and silver; the purity was questionable and therefore the value debatable.
To solve this, governments adopted the technology of minting coins of known purity and
size. This allowed the markets to more consistently set the value of goods and services. Minting coins was effectively the first
government monetary policy, since it allowed for more free flows of money through the economy (it increased the 'velocity' of the
money supply). This drastically improved economic growth. Governments today regulate the velocity of money by many means, only the most basic
of which is printing and coining currency.
The latest development in the 'technology' of money is the advent of 'fiat
currency'. This uses the concept that money is worth whatever anyone thinks it is worth, so the government prints a limited
supply of it and everyone accepts that that is money. This allows the money supply to grow and shrink as the government desires
it to do, in accordance with the government's monetary policy.
Important to mention here is that alongside the development of money came the development of credit systems. Credit is borrowing and repaying loans. Credit is possible in a barter system, as well as any other
system. The amount of credit available in an economy drastically influences the amount of money available that economy. Thus,
monetary policy is intricately tied to the availablity of credit. Governments can and do act as both borrower and lender to banks
and individuals to either add or subtract money from the economy, which is the goal of monetary policy.
The advancement of monetary policy as an engineering discipline has been quite rapid in the last 150 years, and it has
increased especially rapidly in the last 50 years. Monetary policy has grown from simply increasing the monetary supply enough to
keep up with both population growth and economic activity. It now encompasses (and must respond to) such diverse factors as:
- short term interest rates;
- long term interest rates;
- velocity of money through the economy;
- exchange rates;
- ;
- bonds and equities (corporate ownership
and debt);
- government versus private sector spending/savings;
- international capital flows
of money on large scales;
- options, futures, financial derivatives
like swaps, swaptions, and more complex
contracts.
A small but vocal group of people advocate for a return to the gold standard (the elimination of the 'fiat currency'). Their
argument is bascially that monetary policy is fraught with risk and these risks will result in drastic harm to the populace
should monetary policy fail.
Most economists disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply,
and throw away 100 years of advancement in monetary policy. The complex financial transactions that make big business (especially
international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different
people/companies that specialize in monitoring and using risk; they can turn any financial risk into a known dollar amount and
therefore make business predictable and more profitable for everyone involved.
Trends in Central Banking
In the 1980s, bankers began to become convinced that a central bank independent of the rest of government is the best way to
ensure an optimal monetary policy, and those central banks which did not have independence began to gain it. This is to avoid
overt manipulation of the tools of monetary policies to effect political goals, re-electing the current government for example.
Independence typically means that the members of the committee which conducts monetary policy have long, fixed terms. Obviously,
this is a somewhat limited independence. Independence has not stunted a thriving crop of conspiracy theories about the true
motives of a given action of monetary policy.
In the 1990s banks began adopting formal, public inflation targets. The goal of which is to make the outcomes, if not the
process, of monetary policy more transparent. That is, a central bank may have an inflation target of 2% for a given year, if
inflation turns out to be 5%, then the central bank will typically have to submit an explanation. The Bank of England exemplifies
both these trends. It became independent of government in 1996(?) and also adopted an inflation target in 1998(??).
Types of Monetary Policy
Inflation Targeting
Inflation targeting is generally a system in which a CPI (Consumer Price Index) is defined and its rate of change is managed. For example the target might be to
keep CPI growth between 2 and 3% per year. The target is achieved through a short-term interest rate target that is adjusted periodically. The interest rate target is achieved on a daily basis by
the buying and selling of base currency, normally in exchange for government bonds.
This type of policy is used in Australia, New Zealand, Sweden and the United Kingdom.
Price Level Targeting
Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such
that over time the price level on aggregate does not move.
This type of policy is used by the European Central
Bank.
Monetary Aggregates
In the 1980s several countries used an approached based on a constant growth in the money supply. Such schemes were refined to
include different classes of money (M0, M1 etc). Most such systems were ultimately abandoned.
Fixed Exchange Rate
This policy is based on maintaining a fixed exchange rate with a foreign currency. Base money is bought and sold by the
central bank on a daily basis to achieve the target exchange rate. This policy somewhat abdicates responsiblitity for monetary
policy to a foreign government.
This type of policy is used by China. The Chinese yuan is managed such that its
exhange rate with the United States dollar is fixed.
Gold Standard
The gold standard is a system in which the price of the national
currency as measured in unit of gold is kept constant by the daily buying and selling of base currency. This process is called
open market operations.
The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy.
This type of policy is not used anywhere in the world, although it was widely in earlier centuries.
Mixed Policy
A mixed policy approach is usually in practice most like "inflation targeting". However consideration is also given to other
goals such as unemployment and market bubbles.
This type of policy is used by the United States.
Currency Boards
A currency board is a central bank whose monetary policy is a special case. In this case, the country has decided to base its
currency off another, larger currency. Typically this happens after a long, unsuccessful fight against inflation. The currency
board in question will no longer issue fiat money but instead will only issue
one unit of local currency for each unit of foreign currency it has in its vault. The virtue of this system is that questions of
currency stability no longer apply. The drawback is that the country no longer has the ability to set monetary policy according
to other domestic considerations.
A gold standard is a special case of a currency board where the value
of the national currency is linked to the value of gold instead of a foreign currency.
Monetary reform movements seek to alter the mechanisms used in
such policy.
Monetary Policy Theory
It is important for policymakers to make credible announcements regarding their monetary policies. If private agents (consumers and firms) believe that policymakers are
committed to lowering inflation, they will anticipate future prices to be lower
(adaptive expectations). If an employee expects prices to
be high in the future, he or she will draw up a wage contract with a high wage to match these prices. Hence, the expectation of
lower wages is reflected in wage-setting behaviour between employees and employers (lower wages since prices are expected to be
lower) and since wages are in fact lower there is not demand
pull inflation because employees are receiving a smaller wage and there is not cost push inflation because employers are paying out less in wages.
However, to achieve this low level of inflation, policymakers must have credible announcements, i.e. private agents
must believe that these announcements will reflect actual future policy. If an announcement about low-level inflation targets is
made but not believed by private agents, wage-setting will anticipate high-level inflation and so wages will be higher and
inflation will rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs (cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding monetary
policy are not credible, policy will not have the desired effect.
However, if policymakers believe that private agents anticipate low inflation, they have an incentive to adopt an expansionist
monetary policy (where the marginal benefit of increasing economic output outweighs the marginal cost of inflation). However, assuming private agents have rational expectations, they know that policymakers have this incentive. Hence, private agents
know that if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in inflation. Therefore,
(unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This
anticipation is fulfilled through adaptive expectation (wage-setting behaviour) and so there is higher inflation (without the
benefit of increased output). Hence, unless credible announcements can be made, expansionary monetary policy will fail.
Announcements can be made credible in various ways. One is to establish an independent central bank with low inflation targets
(but no output targets). Hence, private agents know that inflation will be low because it is set by an independent body. Central
banks can be given incentives to meet their targets (e.g. larger budgets, a wage bonus for the head of the bank) A policymaker
with a reputation for low inflation policy can make credible announcements because private agents will expect future behavior to
reflect the past.
See also:
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