Monetary Policy

Updated: Nov 2, 2016

The Basics of Monetary Policy

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The topic of monetary policy is a very real part of the everyday life of people all over the world, but unfortunately, the people responsible for it – the world’s central bankers and economic ministers – seem to have a difficult time discussing it in anything other than the murky terms of hard economics that most ordinary people have a hard time understanding. For example, here’s a passage from The Federal Reserve System Purpose & Functions, a guide for the American public published by the US Federal Reserve Board:

“Often, a slowing of employment is accompanied by lessened pressures on prices, and moving to counter the weakening of the labor market by easing policy does not have adverse inflationary effects. Sometimes, however, upward pressures on prices are developing as output and employment are softening—especially when an adverse supply shock, such as a spike in energy prices, has occurred. Then, an attempt to restrain inflation pressures would compound the weakness in the economy or an attempt to reverse employment losses would aggravate inflation.”

Good grief. All of that means, “Addressing a problem in one part of the economy sometimes creates problems in another part.” Monetary policy may indeed be an extremely delicate and difficult job to do well, but it is not really that difficult to understand or explain. But of course, the central banks and treasuries around the world are staffed with economics and finance graduates, not journalists or communications majors; which is probably for the best, but still leaves the average person a little confused about what, exactly, his government is doing to his money.

The Fundamental Goal of Monetary Policy is Control of Prices

“Monetary policy,” defined in as few words as possible, means “Managing the supply and movement of a nation’s money to keep the prices of goods and services from changing too rapidly or by too great a degree.” Every part of the economy – jobs, business productivity, consumer buying power, the credit or debt of the government – in one way or another is connected to prices, which are since the entire world now operates on a fiat money system, actually expressions of the value of the nation’s currency.

There are two basic ways in which governments can control money supply and movement: by manipulation of the physical supply of money, and by controlling the flow of the money supply through the banking system. In most financial systems (the Eurozone, in which a common currency is shared by many countries, is a bit of an exception), the central bank serves as a bridge between the government’s treasury and the country’s banking system; the central bank is the government’s bank, and at the same time serves as “a bank for banks.” The actual supply of money is controlled by the treasury; the central bank controls its release into the financial system and also manipulates the movement of money already in the financial system.

Prices are of course related to the supply of money; when there is too much money, prices become inflated, because the value of one unit of currency relative to goods or services decreases. When there is too little currency, prices deflate. In the case of inflation, it is the consumer (demand side) that suffers the negative effects, because they are able to purchase less for the same amount of currency; in the case of deflation, the opposite problem occurs, and it is the producer (supply side) that is negatively affected. Governments aspire to prevent either problem from occurring because inflation or deflation affects spending, which eventually has an impact on production, employment, and even tax revenues. Maintaining absolutely stable prices – with no inflation or deflation – is practically impossible, so governments aim to control price inflation within a reasonable range; the ideal target differs from country to country depending on particular economic circumstances, but is usually around 2%. Thus in most places, monetary policy amounts to “a series of actions taken by the government to maintain prices at about a 2% rate of inflation”, and there are several ways in which they attempt to do that.

Instruments of Monetary Policy

Increasing the money supply

This is the most drastic and risky method of exercising monetary policy, which is perhaps why the US government has given it the friendly-sounding name “quantitative easing”, or QE. QE simply means printing more money; the obvious risk to taking this step is that increasing the physical supply of money causes inflation. The basic idea behind QE is that providing more money for banks to loan and consumers and businesses to spend, the increase in economic activity will more than offset the inflationary effect of a greater money supply.

Central bank interest rates

These take two basic forms. Lending rates are interest rates charged by the central bank to commercial and retail banks for short-term (usually overnight) loans. Deposit rates are interest paid to banks on short-term deposits to the central bank. Banks are required to maintain reserves of funds against the deposits of their customers. At the end of each business day, the transactions a bank has made that day will usually leave it with a deficit or a surplus with respect to its required reserve, meaning that the bank will either have to borrow to make up the difference, or can deposit the extra amount with the central bank, paying or earning interest as the case may be.

Interest rates set by government monetary authorities affect the flow of money in a couple different ways. First, the lending rate usually serves as a benchmark for commercial and retail loan rates; a decrease in interest rates usually creates greater demand for loans, which moves money out of the financial system into the market. Second, the deposit rate is used to manipulate the supply of money in the financial system, and as a consequence, the money’s value relative to other currencies. If the deposit rate is decreased, banks are either less likely to deposit their surplus funds, instead of lending them to other banks or to customers or will earn less – i.e., take less money out of the government account to put into the financial system – if they do deposit their surplus. Decreasing the deposit rate hypothetically weakens the value of the currency because more money will remain in the financial system.

Market operations

Principally, the sale of government bonds and other securities in the financial markets. Bonds and treasury bills are basically fixed-term loans to the government which has the effect of removing money from the financial system, though of course it usually appears again elsewhere in the form of government spending. In the US and other developed economies, government securities are usually the primary means by which monetary policy is exercised on a day-to-day basis. 


 

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