Monetary Policy is defined as: measures taken by the central bank and treasury to strengthen the economy and minimize cyclical fluctuations through the availability and cost of credit, budgetary and tax policies, and other financial factors and comprising credit control and fiscal policy.
In other words, Monetary Policy is the sum of decisions taken by the monetary authority of a country, usually the central bank, in order to influence the economy and achieve its objectives.
Central banks influence the economy mainly by manipulating money supply (the total amount of money available in the economy at a certain point in time). They do it by “printing” more money or changing the conditions at which commercial banks can access to funds coming from the central bank, making it more or less expensive the act of borrowing.
All these actions, as said before, are made in order to achieve the goals that have been set by the monetary authorities, which usually are to ensure price stability, or to target a specific level for inflation (a level that is considered enough, not too high and neither too low).
Other specific goals might be related to the stabilization of the gross domestic product, to achieve and maintain a low level of unemployment, or to maintain exchange rates with respect to other currencies that are stable and predictable.
When the central bank decides to intervene, it can do it usually by adopting two different kind of approaches, the monetary policy implemented may be expansionary or contractionary.
It is considered expansionary when the monetary authority has the objective to stimulate the economy.
Central banks adopt this kind of approach when there is an excessive increase in unemployment or when the economy is facing a recession. It is implemented by using the tools that are available to the central bank at that moment in time and that are more suitable to stimulate the economy.
These measures usually include things like rapidly increasing the total supply of money in the economy (printing more money).
On the other hand, the contractionary monetary policy is implemented when the economy is going too fast and there is the risk of a great increase in inflation. Therefore, the central bank uses its tools to slow short-term economic growth, usually by increasing short-term interest rates.
The decision to adopt one strategy or the other is taken by studying monetary economics, that studies the different competing theories of money and tries to help the craft of the best monetary policy possible.
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Monetary Policy Instruments
As said in the introduction, central banks implement monetary policy and influence the economy by using the instruments that are available to them. There is not a universal set of tools available to central banks, in fact, they depend on the characteristics and peculiarities that every central bank has, and also on the role it has in a specific economy.
However, they are usually divided into two main groups, the conventional instruments, and the unconventional instruments.
Conventional Monetary Policy Instruments
The conventional instruments of monetary policy are tools that the central bank uses to influence interest rates, by expanding or contracting the monetary base, which is the sum of the money that circulates in the economy plus the money that is deposited at the central bank.
These tools are:
- Open market operations: The central bank operates in financial markets by buying or selling assets, usually government bonds, in order to increase or decrease the amount of money in circulation. If for example, the central banks want to increase the amount of money in circulation in the economy, it can do that by purchasing government bonds, which is government debt. The increase in money in circulation means that commercial banks will have more money available for their lending activity so that they will reduce lending rates making loans less expensive.
- The discount rate: Central banks can increase or decrease the interest rate that they charge to borrow at their discount window, loans from the central bank to commercial banks. If the interest rate on this kind of loans is low enough, commercial banks can expand their balance sheets by using liquidity borrowed from the central banks, and therefore they can loan more to businesses and consumers. This mechanism should help to stimulate economic activity and economic growth.
- Reserve requirements: This last tool of conventional monetary policy is based on the rule that commercial banks must keep a certain minimum portion of their deposit liabilities as reserves, either in its vaults or at the central bank. Lowering the portion required allows banks to loan more money to businesses and consumers, therefore it should have an expansionary effect on the economy. On the contrary, if the central bank wants to “slow down” the economy, an increase in the minimum reserve ratio required makes the money available to commercial banks for their lending activities smaller, therefore decreasing their ability to create new credit.
Unconventional Monetary Policy
When talking about unconventional monetary policy, we refer to measures adopted by central banks, usually after the 2008 financial crisis, when the new environment (interest rate near 0%) and the complex situation faced by the policymakers led them to look for more efficient mechanisms of transmission of monetary policy’s impulses, because the traditional measures, in that situation, were not considered effective enough.
This brought them to move their focus from the typical interest rates’ regulatory action, toward alternative unconventional measures.
In fact, conventional monetary policy measures were considered inadequate mainly because, given that interest rates were near zero, it would have been hard to further cut them with the aim of making money cheaper and therefore to stimulate the economy.
In order to pin down the expectations of private agents about what the central banks want to do and what wants to achieve with the measures that it wants to adopt, central banks use nominal anchors.
This can have also an effect of reassuring businesses, consumers and other agents that make transactions in the economy about what the central bank wants to do in the medium-long term.
It could, therefore, help to mitigate certain situations of fear and anxiety that usually are harmful to the economy.
There are different nominal anchors, one that is probably the best known is inflation targeting, which consists of the central bank announcing to the public that it intends to follow an explicit target for the inflation rate for the medium term.
This nominal anchor is pretty common, for example, the European Central Bank has the objective to keep inflation around 2%.
Other widely used nominal anchors are price level targeting, monetary aggregates, and nominal income target.
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