Introduction to Monetary Policy

Monetary policy is a set of tools used by a country’s central bank to manage the overall money supply and promote economic growth. The main goal is to achieve maximum employment while keeping inflation in check.

Central banks like the Federal Reserve in the US have control over monetary policy.

Monetary policy works through controlling interest rates and the money supply.

The main tools include setting interest rates, buying/selling government bonds, and changing reserve requirements for banks.

Why Economies Need Central Banks

Central banks serve several important functions:

As the lender of last resort, the central bank provides emergency loans to banks during financial crises. As such the central bank can help provide liquidity as needed and prevent an economic meltdown.

Managing inflation – it’s the job of the central bank to understand where price pressures are stemming from and help promote price stability.

Stabilizing currency exchange rates – The cost of a nation’s goods and services may remain stable over time, but should its exchange rate, or the value of its currency change, that can have significant impact on demand. A strengthening currency makes locally produced goods more expensive to foreign buyers. A weakening currency makes goods cheaper for foreign buyers. The central bank is charged with maintaining the stability of its currency by keeping inflation under control.

Supervising and regulating banks – The central bank must ensure the health of its financial system by making sure that banks and lenders are sufficiently well-capitalized to remain afloat. Bank failures can have a significant economic impact by creating panic among savers.

Providing liquidity to the financial system – A successful economy is one in which both domestic and foreign players have confidence to transact and invest. That means that the central bank must ensure that banks can get money when they need it and have overall confidence in other members of the system so that transactions can occur without fear of loss of capital.

Without central banks, economies would likely experience more frequent and severe booms and busts.

How Does Monetary Policy Work?

Monetary policy works through several channels, intended to reduce or increase demand for money by raising or lowering the cost of borrowing via the rate of interest. Interest rates affect borrowing costs for consumers and businesses. Lower interest rates stimulate spending and investment while higher rates slow the economy. Policy is typically expansionary during recessions and contractionary during inflationary periods. The level of interest rates affects the supply and demand for money. Changes in money supply impact overall economic activity. Often, the effects are not immediate but work their way through the economy over time. Economists refer to the lag of monetary policy in affecting the economy.

Inflation – Merits and Demerits

Inflation refers to an increase in the general level of prices of goods and services over time.

On the one hand, rising prices can stimulate economic activity, especially during recessions. Rising prices also has the impact of reducing existing debt burdens for borrowers.

In the other hand, inflation has the negative effect of eroding purchasing power for consumers. In other words, when prices are rising, it takes more money to buy the same item. At the same time, wages rarely keep pace with the cost of goods. Inflation also makes it difficult for businesses and investors to make solid plans.

Central banks aim to keep inflation low but positive (around 2%) rather than zero. Most have a target to operate around. When prices fall, usually in a downturn, the result can be a spiral lower in economic activity with lack of incentive to borrow or invest.

Types of Monetary Policy Instruments

Central banks have several policy tools:

Interest rates – The main tool used to control borrowing costs through a policy announcement. The central bank typically targets the cost of borrowing at a very short maturity. However, by setting a daily rate of interest, which is often the rate at which the bank offers liquidity to the banking system, the cost of borrowing is transmitted across the yield curve. The yield curve represents the cost of money for fixed periods of time. One of the drawbacks of monetary policy is that although the central bank can set day-to-day rates, it has limited effect on the yield curve through time, which is set by market participants.

While changing interest rates may directly affect the economy and is easy to implement, the central bank may be challenged by the absolute level of interest rates. Lowering an absolutely low cost of borrowing, even to zero in order to stimulate the economy has proven to have limited effectiveness. On the other hand, raising the cost of borrowing when the absolute rate of interest is already high might serve to increase demand for the currency causing demand from other countries to fall sharply.

Open market operations – Buying/selling government bonds. This is commonly referred to as quantitative tightening (QT) or easing (QE) and is often associated with changing the money supply in order to stimulate demand when room to lower the cost of borrowing is limited.

True, quantitative easing can stimulate an economy quickly during crises, but it can be a riskier strategy because it is harder to reverse its effects.

Reserve requirements – The central bank can determine how much cash banks must hold in relation to how much they can lend out. This provides the central bank with a direct control over money supply. However, if borrowers don’t bite when banks’ reserve requirements are low, there is not a lot the central bank can do using this method to effectively stimulate the economy.

Forward guidance – By clearly and consistently communicating future policy intentions the central bank can influence expectations without changing rates. This is often referred to as ‘jawboning’ or ‘talking the market’.  The initiative can have positive effects, especially at economic turning points. The central bank can highlight specific events that investors might be less focused on to explain why it may be forced to act or even not act going forward. Since several central bank members may speak publicly, there may be occasions when the public is confused by the message. Forward guidance may be effective but exerts less direct control over the economy.

The choice or combination of which policy tools to draw upon depends on the severity of economic conditions and policy goals at the time.

Independence and mandate of central bank

Central banks aim to be forward-looking and proactive in using monetary policy tools to support economic stability and growth while keeping inflation under control. Most central banks tend to be independent of political controls and operate around a mandate with specific targets or objectives. The exact timing and mix of instruments can vary significantly between central banks and over time.

Monetary policy is a powerful tool used by central banks to manage economies. It works through interest rates and money supply changes to stimulate or slow economic activity as needed. While effective, it has limitations and risks if misused. Understanding monetary policy helps investors anticipate economic trends and make better investment decisions.

Summary

The choice of policy weapon and mix of approach depends on the specific economic situation and goals at the time. Interest rate adjustments tend to be the primary tool, but central banks may combine multiple approaches for maximum effect. The decision-making process involves committees of central bank officials discussing and agreeing on policy actions.