Monetary Policy

Monetary policy refers to the strategies employed by a central bank to regulate the money supply within an economy, aiming to influence macroeconomic variables such as output, national income, inflation, and unemployment. Central banks, like the Federal Reserve in the United States or the Bank of England in the UK, play a key role in this process by either expanding or contracting the amount of money available in the economy. There are two primary types of monetary policy: expansionary, which increases the money supply to stimulate economic activity, and contractionary, which reduces the money supply to curb inflation or stabilize the economy.

The effectiveness of monetary policy often hinges on economic theories such as Keynesianism and Monetarism, which offer differing perspectives on how the economy reacts to changes in the money supply. Central banks utilize various tools to implement monetary policy, including open market operations, discount rates, and reserve requirements. These tools allow them to fine-tune the economy, targeting objectives such as stable growth, low inflation, and full employment. However, the influence of central banks may be challenged by the dynamics of global credit markets, raising questions about their ability to maintain economic stability. Overall, monetary policy is a critical aspect of economic management, balancing the need for growth with the risks of inflation and market volatility.

Published in: 2021

By: Duffy, Francis

Subject Terms

Monetary Policy

Monetary policy sets the upward limit of money in the form of cash, demand depots, time deposits, and equities allowed to circulate in the economy at large. It is the preserve of a central bank and can be used to either expand or contract economic activity. The goal in either case is to induce a macroeconomic change in output, national income, inflation or unemployment in both the short and near term. Over the last sixty years, the precepts and fundamentals of such major schools of economic thought as Keynesianism and Monetarism have entered into its formulation with limited success, occasioning a shift in recent years towards a far more pragmatic reliance on interest rates to achieve short-term goals.

Keywords Bank Reserves; Business Cycle; Central Bank; Contractionary Monetary Policy; Discount Rate; Expansionary Monetary Policy; Gross Domestic Product; Inflation; Keynesian Economic; Monetarism; Monetary Policy Targets; Money Supply; Moral Suasion; Open Market Operations

Economics > Monetary Policy

Overview

For every economic 'boom' there is an ensuing 'bust.' History is full of examples of pendulum-like swings in our collective fortunes. Indeed, expansions and contractions in national output and income have occurred with such regularity that economists consider them phases of a quasi-natural 'business cycle.' During the 'Roaring Twenties' and the 'Great Depression' of the 1930s, this cycle played itself out in extremis, raising fundamental questions about the desirability of unbridled, unregulated free-markets. Left to its own devices, the marketplace was perhaps not as ideal an engine of economic growth as earlier proponents claimed. How, though, can any one institution exert a moderating influence on what is essentially a set of daily transaction numbering in the trillions? A command economy where centralized authorities set both production quotas and prices certainly might. But wild swings aside, free markets' singular virtue — the efficient allocation of resources — would be sacrificed. Was this really worth the prolonged period of social, political and economic upheaval it would take to implement? Considering the comparatively modest outcomes being sought — more stable growth in productive capacity and national wealth — no. But how do we go about fine-tuning free markets without unduly constricting them?

The answer to this perplexing question lies in your wallet. Look closely at the face side of any bank note there; it is printed for all to see. Be it a $1, $5, $10, $20, $50 or $100, every dollar bill says it's a "Federal Reserve Note" that's 'legal tender for all debts, private and public.' Every pound sterling note tells citizens of the United Kingdom "The Bank of England promises to pay the bearer the sum of…." Euros offer a slightly more cryptic assurance in the form of the printed initials of the European Central Bank in five different languages — BCE, ECB, EZB, EKT and EKP — along with the signature of the bank's president. All those trillions of daily transactions entail an exchange of money. For that money to hold any value, its supply must be limited. If it isn't, everyone can readily obtain all they need and more and it becomes worthless as a medium of exchange. People in such circumstances will only part with goods or services for other goods or services. To acquire a new linen shirt, for example, you might have to give the weaver a bag of potatoes you grew. Whoever controls the amount of money circulating in a national economy thus affects its performance. And that would be its issuer; a central bank, like the Federal Reserve.

A central bank never expands or contracts the money supply without a reason. It may want to stimulate a sluggish economy, to cool off an overheating one, or to simply maintain a steady rate of growth at full employment. How it goes about this depends in turn on the macroeconomic theory a central bank subscribes to. These decisions, along with the economic reasoning behind them make up Monetary Policy. When the money stock is increased over a period of time, the central bank is said to be pursing an expansionary monetary policy; when it's decreased, a contractionary monetary policy. Even though it is vested with wide-ranging statutory powers, a central bank does so not as a regulator so much as a bank with enormous assets at its disposal.

Executing Monetary Policy

Exactly how does a central bank control the money supply in a modern economy? Well, for starts, unlike commercial banks, its national government is a central bank's major customer. All its receipts and disbursements go through demand deposit accounts there. Yearly cash inflows and outflows of hundreds of billions of dollars pass through these accounts, some of which can be temporarily held as short-term treasury bonds with the potential to be sold to cover future government payments if needs be. By law, what's more, every commercial bank must keep a percentage of its demand deposits in non-interest bearing accounts at the Central Bank. These 'required reserves' ensure that financial institutions will have the funds necessary to withdrawals during a so-called 'run' on the banks when customers fear their funds may disappear if a bank goes belly up. Central banks of other countries carry out foreign exchange transactions, buying their currencies when a surplus lowers its value against another currency too much or, conversely, selling their currencies when a shortage raises it too much.

Controlling the Money Supply

A central bank, then, has a considerable amount of capital to buy government securities with. Whenever it thinks a lessening of the money supply is warranted, a central bank can sell some of its bond holdings to commercial banks at below par. Since the purchase can be redeemed at par, commercial banks stand to profit and so buy the securities using funds it would otherwise loan out. With fewer loans tendered, the amount of new deposits made by borrowers shrinks, lowering the money supply.

To increase this supply, alternatively, it buys government securities from commercial banks above par. Enough institutions find this incentive a good reason to sell; the payout from this transaction can be loaned out to customers. They in turn deposit said funds, raising the money supply. Called open market operations, the funds earned never actually leave the Central Bank, for it credits commercial banks' reserve accounts when it buys bonds and debits it when it sells them. Any amount added to its reserves above its minimum requirements can be lent out. Any amount subtracted below this requirement must be offset by a deposit usually by the close of business.

Borrowing Practices of Banks

More often than not, banks borrow what they need to maintain their minimum reserve requirement either from other banks through the aegis of a central bank or else directly from it. In the former instance, the interest rate charged is set by supply and demand; in the latter it is set by the Central Bank and remains fixed until an increase or decrease is deemed appropriate (Arestis & Sawyer 2004). A higher fixed rate raises the costs of borrowing, a lower one decreases it. Commercial and inter-bank loan rates adjust accordingly as lenders seek to protect their profit margins. Called the discount rate in the U.S. and the bank rate in the U.K., doubts about its effectiveness have led many central banks in developed countries to use it sparingly.

This rate must be set below existing short-term interest rates to motivate banks to borrow from the Central Bank instead of open credit markets. If set too far below or above prevailing commercial rates, the credit markets suffer in general; auto, mortgage, and credit card lenders that fuel consumer spending suffer in particular. Having to go hat-in-hand to a central bank for a loan, moreover, carries with it a certain stigma, so most banks refrain from doing so unless they have no other option. Given the size and liquidity of modern day credit markets, they typically don't, so the discount rate these days serves a more limited but still vital role as a backstop for banks suffering acute liquidity problems.

Reserve Requirements

A central bank, finally, can always raise or lower the commercial banks' reserve requirements (Handa, 2000). A powerful instrument of monetary policy, any such change is also the bluntest such instrument. For, a very small percentage increase or decrease here translates into very large sums of loanable funds, so any upward or downward movement has sudden and far-reaching economic consequences. It's also a fairly dramatic move; one that signals the potential seriousness of current conditions to financial markets driven by expectations of future events. Central banks in countries with stable, well-developed banking systems therefore tend to use it very sparingly.

Applications

Objectives of Monetary Policy

Monetary policy always has a short-term and a near-term objective. In the best of economic times, they're one in the same: Maintain steady growth in output, low inflation and full employment. In worsening times, they typically differ: Either stimulate further growth in output, or control rising inflation or reduce unemployment. Here, the decision might be made to reign in spiraling prices in the near-term but add payroll jobs to the economy in the far-term. Or, it could be same priorities in reverse order. Equally, another objective all together, such as increasing output by encouraging investments in labor-saving technologies, might be pursued instead. In developing countries such as China and India, the objective can be as basic as expanding productive capacity in and of itself.

Influences of Economic Theory on Monetary Policy

Any decision is firmly rooted in economic theory, for monetary policy affects aggregate supply and demand. Central bankers not well-versed in the fundamentals of macroeconomics would simply be too ill-equipped to use monetary policy to good effect. For, be it Keynesian, Monetarist, New Classical or the like, economic theory links possible causes and effects, bringing a coherency to any analysis and a degree of predictability about the likely short and near-term outcomes of any one decision (Handa, 2000). Central bankers find it especially useful in choosing which macroeconomic fundamental to seek improvements in: Gross Domestic Product (GDP), aggregate demand, inflation, employment, etc.. Each can be likened to a lever that can be pushed or pulled by expanding or contracting the money supply until the economic data signals the desired change has occurred.

GDP is a broad measure of national income derived from overall economic output. Sustained growth here buoys economic activity in general.
Aggregate demand is a measure of total spending.
Inflation occurs whenever demand exceeds supply pushing prices higher; if inflation spreads through the economy it can take on a life of its own and end up reducing real purchasing power.
Unemployment, meanwhile, occurs whenever the supply of labor more than meets current demand. The more unemployment there is, the less the national income available to purchase goods and services, depressing both aggregate demand and overall economic output.

Keynesian Economics vs. Monetarism

Of these, Keynesian Economics and Monetarism put forth the most diametrically opposed views. The main point of contention between the two centers on the all important role prices play in influencing aggregate demand.

Keynesians contend that some nominal prices must be more inelastic than others; otherwise price increases would be uniform and simultaneous. If they are, any addition to the money stock would simply cause a proportionate increase in output and employment. Such is not the case, they claim. And fortunately so, for the propensity of prices to not move in lock-step means an increase in either investment, consumption or government expenditures will increase output. The temporary differential in price hikes leaves incrementally more money that can be spent at any given time (Johnson, 1962). This increase, importantly, will be greater than the increase in spending that precipitated it. Whatever inflation a swift influx of cash into the economy might trigger, more importantly, will be muted in the short run precisely because individual prices rise at different rates. As a by-product of stimulating growth in output at fuller employment, therefore, a certain amount of inflation is acceptable.
Monetarists, on the other hand, insist that markets must be left alone and prices in particular allowed to freely adjust to changing conditions in supply and demand just as early classical economists said they should. One and only one form of monetary policy permits this, they caution. And that is a very steady series of small expansions in the money supply; just enough to essentially keep pace with a growing population and naturally rising output (Friedman, 1977). Fixed yearly increases in the money stock, however, effectively leave a drop in wages as the sole remedy for any downturn in the business cycle. Growth in output temporarily slows or turns negative as unemployment trends upward but inflation crucially remains in check. Eventually, monetarists predict, markets will return to equilibrium and an economically-sound supply-side recovery will bring about a non-inflationary wage hike.

Shortfalls of Keynesianism & Monetarism

For all their theoretical import, both Keynesianism and Monetarism, ironically, have failed to explain, much less ameriolerate, some very real macroeconomic shocks. The high inflation and high interest-rate 'stagflation' of the 1970s confounded Keynesians, largely because it fell outside the pale of what they considered theoretically possible. Monetarist-inspired counter-measures undertaken by central banks in the early 1980s led to such a severe recession that they were soon abandoned. Adjustments in basic assumptions to both theories have since led to their reformulation by 'New Classical' economists and 'New Keynesians.' The former reject the Keynesian notion accepted by many monetarists that output rises or falls in response to anticipated changes in the money supply. They also hold that markets adjust quickly to shifts in demand and supply, and that business cycles are on the whole beneficial. Like their forbearers, 'New Keynesians' disagree with the 'New Classical' economists about the speed at which markets adjust to disequilibrium, especially with regard to prices and wages. "New Keynesians' broke new ground, though, by offering reasons why prices respond sluggishly. Administrative costs of frequent changes are too prohibitive, they maintain, and the inverse proposition — that prices everywhere increase simultaneously — is simply too far-fetched.

Of course, each of these theories is far more complicated and the similarities and differences between are more numerous than this brief overview suggests. Considering the thoughtfulness that has gone into each, it thus might come as a surprise to learn that in regards to monetary policy at least, theory today has given way to more practical consideration. In the deliberations of many central banks over the last two decades, essentially, interest rates have emerged as the policy target of choice. Why rely on them as opposed to output, inflation, or unemployment? Well, rises and falls in the cost of capital play themselves out in greater or less growth in GDP, prices and employment. A central bank, what is more, can use interest rates proactively and in an incremental fashion to make the very fine adjustments innately cautious central bankers prefer with the means available to them. Ultimately, though, by targeting interest rates, they may run afoul of the same risks they run targeting output or inflation, and that is the inherent unpredictability of future events. No amount of experience or collective wisdom and certainly no forecasting model guarantees the right decision will be made at the most opportune moment. For, how can you expect 'the unexpected'? Then too, central bankers can misread current conditions all together or address the wrong underlying cause when problems arise. And what if the economy doesn't respond as it has in the past?

Viewpoints

Decreasing Influence of Central Banks?

Doubts of late have surfaced about just how much influence a central bank can actually exert given the ready availability of funds on the world's fast-growing credit markets. If a bank can freely borrow funds from private sources, at prices comparable to or less than it can from a central bank, then the latter's financial influence wanes. Given how global bond and equity markets show every sign of continuing their current rate of expansion, the possibility exists that this might indeed happen. Mergers and acquisitions among banks themselves have brought about a market concentration unparalleled in scale and scope. 'Mega-banks' can draw on combined assets in ways that were unimaginable thirty years ago. There is also a growing body of sentiment to the effect that markets, not central banks, should be the ultimate arbitrator of monetary policy. The fact that economic theorists of every stripe have yet to prove a casual link between the two in the long run certainly bolsters such arguments. And in the short run, investor expectations of what monetary policy a central bank will pursue has long been considered by many economists as more important than the policy it pursues (Blackburn & Christensen, 1989). Clearly, too, considering the targets and tools available to them, central banks' emphasis on interest-rates is a comparatively unobtrusive use of its very real powers. Does this mean its future monetary policy will be dictated more by the marketplace than in years hence?

Probably not, for the absence of the steadying influence of a central bank leads invariably to greater economic instability. It can also be argued that the prolonged period of relative growth in output and national income enjoyed by the industrialized world may not have been so sustained nor so impressive had they been absent. The argument that private equity and bond markets may increasingly erode central banks' 'power of the purse,' moreover, does not sufficiently factor in the penchant of modern day governments for deficit spending and the volatility of floating foreign exchange rates. Enormous debts are being underwritten and serviced by central banks these days. Government receipts from taxes, import duties and the like further swell the transaction balances available as short-term credit. Add to this the ballooning foreign exchange transactions being generated by the globalization also passing through central banks. No single commercial bank, much less the world's top twenty banks combined, process anywhere near the same volume. Nor are central bankers likely to abrogate their right to set reserve requirements or regulate other aspects of the banking system any time soon. The mere idea goes against the grain of everything they believe in. A diminished role for central banks in monetary matters, lastly, is the by-product of a fairly prosperous two decades in the world's richest nations. The true import of a central bank during such economic 'good times' is less appreciated simply because business, investors and households have less cause for alarm. With the next economic shock or protracted downturn in the business cycle, the idea will suddenly seem much less prudent.

Terms & Concepts

Business Cycle: Aggregate economic activity that follows a four-phased pattern (expansion, peak, contraction, and trough) usually over a three to five year period.

Central Bank: Controls the amount of money in circulation. The principal depository institution for the national government, it also has legal powers to regulate the activities of other banks.

Bank Reserves: A legally proscribed percentage of a commercial bank's demand deposits that must be held in a non-interest bearing account at a central bank to cover unexpectedly high customer withdrawals.

Contractionary Monetary Policy: Deliberate action taken over time by a central bank to reduce the stock of money in circulation.

Discount Rate: The interest charged by the Federal Reserve on the overnight loans it makes to commercial banks.

Expansionary Monetary Policy: Deliberate action taken over time by a central bank to expand the stock of money in circulation.

Gross Domestic Product: The total amount of consumer spending, planned private investments, government outlays and net exports.

Inflation: Technically, any rise in price caused by demand exceeding supply. A certain amount of inflation is considered natural. Real purchasing power, however, falls when prices in general begin to rise at a rate greater than 2 or 3 percent per year and systemic inflation takes on a life of its own.

Keynesian Economics: An economic school of thought that believes a higher level of inflation is preferable to an unacceptably high rate of unemployment in the short run.

Monetarism: A school of economic thought that believes the only means of influencing economic activity in the short term lies in controlling the quantity of money in circulation. Doing this causes prices to rise or fall until market equilibrium is reestablished.

Monetary Policy Targets: A predetermined rise or fall in one of several key economic indicators that signals whether or not a monetary policy is having its intended effect.

Money Supply: In its most liquid form, all readily available funds such as cash, checking account and savings account deposits. Funds held in a financial instrument of some kind are also included in the broader sense of the term.

Moral Suasion: The indirect influence over markets and financial institutions that central bankers use to persuade rather than force.

Open Market Operations: Adjustments to the money supply made through the purchase or sale of government securities to commercial banks by a central bank.

Bibliography

Arestis, P., & Sawyer, M. (2004). On the effectiveness of monetary policy and of fiscal policy. Review of Social Economy, 62, 441-463. Retrieved September 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=15544673&site=ehost-live

Blackburn, K., & Christensen, M. (1989). Monetary policy and policy credibility: Theories and evidence. Journal of Economic Literature, 27, 1-45. Retrieved September 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5291215&site=ehost-live

Friedman, B. (1977). The inefficiency of short-run monetary targets for monetary policy. Brookings Papers on Economic Activity, , 293-335. Retrieved September 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=7073214&site=ehost-live

Gray, C. (2013). Responding to a Monetary Superpower: Investigating the Behavioral Spillovers of U.S. Monetary Policy. Atlantic Economic Journal, 41, 173-184. doi:10.1007/s11293-012-9352-0 Retrieved November 27, 2013 from EBSCO online database Business Source Complete with Full Text:http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87819787&site=ehost-live

Handa, J. (2000). Chapter eleven: The central bank: Goals, tools and guides for monetary policy. In Monetary economics (pp. 252-283). Oxfordshire, UK: Routledge. Retrieved September 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17413044&site=ehost-live

Handa, J. (2000). Chapter twelve: The central bank: Targets, conflicts, independence and the time consistency of policies. In Monetary economics (pp. 284-327). Oxfordshire, UK: Routledge. Retrieved September 25, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17413052&site=ehost-live

Johnson, H. (1962). Monetary theory and policy. American Economic Review, 52, 335. Retrieved September 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=8746533&site=ehost-live

Warsh, K. M. (2013). THE CONDUCT OF MONETARY POLICY. CATO Journal, 33, 359-363. Retrieved November 27, 2013 from EBSCO online database Business Source Complete with Full Text:http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90430858&site=ehost-live

Vasile, P. (2013). MONETARY POLICY RULES FOR EUROPEAN MONETARY UNION ACCEDING COUNTRIES. Studies In Business & Economics, 8, 108-122. Retrieved November 27, 2013 from EBSCO online database Business Source Complete with Full Text:http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91964970&site=ehost-live

Monetary Policy

On this Page

Subject Terms

Monetary Policy

Economics > Monetary Policy

Overview

Executing Monetary Policy

Controlling the Money Supply

Borrowing Practices of Banks

Reserve Requirements

Applications

Objectives of Monetary Policy

Influences of Economic Theory on Monetary Policy

Keynesian Economics vs. Monetarism

Shortfalls of Keynesianism & Monetarism

Viewpoints

Decreasing Influence of Central Banks?

Terms & Concepts

Bibliography

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