Monetary policy: Definition from Answers.com

The central agency that conducts monetary policy in the United States is the Federal Reserve System (the Fed). It was founded by Congress in 1913 under the Federal Reserve Act. The Fed is a highly independent agency that is insulated from day-to-day political pressures, accountable only to the Congress. It is a federal system, consisting of the Board of Governors, twelve regional Federal Reserve Banks (FRBs) and their twenty-five branches, the Federal Open Market Committee (FOMC), the Federal Advisory Council and other advisory and working committees, and more than 4,000 member banks, mostly national banks. By law, all federally chartered banks, i.e., national banks, are automatic members of the system. State-chartered banks may elect to become members.

The seven-member Board of Governors, headquartered in Washington, D.C., is the central agency of the Fed, overseeing the entire operation of U.S. monetary policy. The FRBs are the operating arms of the system and are located in twelve major cities around the nation. The twelve-member FOMC is the most important policy-making entity of the system. The voting members of the committee are the seven members of the board, the president of the FRB of New York, and four of the other eleven FRB presidents, serving one year on a rotating basis. The other seven nonvoting FRB presidents still attend the meetings and participate fully in policy deliberations.

Monetary Policy and the Economy

Being one of the most influential government policies, monetary policy aims at affecting the economy through the Fed's management of money and interest rates. As generally accepted concepts, the narrowest definition of money is M1, which includes currency, checking account deposits, and traveler's checks. Time deposits, savings deposits, money market deposits, and other financial assets can be added to M1 to define other monetary measures such as M2 and M3. Interest rates are simply the costs of borrowing. The Fed conducts monetary policy through reserves, which are the portion of the deposits that banks and other depository institutions are required to hold either as cash in their vaults, called vault cash, or as deposits with their home FRBs. Excess reserves are the reserves in excess of the amount required. These additional funds can be transacted in the reserves market (the federal funds market) to allow overnight borrowing between depository institutions to meet short-term needs in reserves. The rate at which such private borrowings are charged is the federal funds rate.

Monetary policy is closely linked with the reserves market. With its policy tools, the Fed can control the reserves available in the market, affect the federal funds rate, and subsequently trigger a chain of reactions that influence other short-term interests rates, foreign-exchange rates, long-term interest rates, and the amount of money and credit in the economy. These changes will then bring about adjustments in consumption, affect saving and investment decisions, and eventually influence employment, output, and prices.

Goals of Monetary Policy

The long-term goals of monetary policy are to promote full employment, stable prices, and moderate long-term interest rates. Most economists think price stability should be the primary objective, since a stable level of prices is key to sustained output and employment, as well as to maintaining moderate long-term interest rates. Relatively speaking, it is easier for central banks to control inflation (i.e., the continual rise in the price level) than to influence employment directly, because the latter is affected by such real factors as technology and consumer tastes. Moreover, historical evidence indicates a strong positive correlation between inflation and the amount of money.

While the financial markets react quickly to changes in monetary policy, it generally takes months or even years for such policy to affect employment and growth, and thus to reach the Fed's long-term goals. The Fed, therefore, needs to be forward-looking and to make timely policy adjustments based on forecasted as well as actual data on such variables as wages and prices, inflation, unemployment, output growth, foreign trade, interest rates, exchange rates, money and credit, conditions in the markets for bonds and stocks, and so on.

Implementation of Monetary Policy

Since the early 1980s, the Fed has been relying on the overnight federal funds rate as the guide to its position in monetary policy. The Fed has at its disposal three major monetary policy tools:

Reserve Requirements Under the Monetary Control Act of 1980, all depository institutions, including commercial banks, savings and loans, and others, are subject to the same reserve requirements, regardless of their Fed member status. As of March 1999, the basic structure of reserve requirements is 3 percent for all checkable deposits up to $46.5 million and 10 percent for the amount above $46.5 million. No reserves are required for time deposits (data from Federal Reserve Bank of Minneapolis, 1999).

Reserve requirement affects the so-called multiple money creation. Suppose, for example, the reserve requirement ratio is 10 percent. A bank that receives a $100 deposit (bank 1) can lend out $90. Bank 1 can then issue a $90 check to a borrower, who deposits it in bank 2, which can then lend out $81. As it continues, the process will eventually involve a total of $1,000 ($100 + $90 + $81 + $72.9 … $1,000) in deposits. The initial deposit of $100 is thus multiplied 10 times. With a lower (higher) ratio, the multiple involved is larger (smaller), and more (less) reserves can be created.

Reserve requirements are not used as often as the other policy tools (discussed below). Since funds grow in multiples, it is difficult to administer small adjustments in reserves with this tool. Also, banks always have the option of entering the federal funds market for reserves, further limiting the role of reserve requirements. As of March 1999, the last change in the reserve requirements was in April 1992, when the upper ratio was reduced from 12 percent to 10 percent. However, the amount of deposits against which the 3 percent requirement applies does change relatively more often.

The Discount Rate Banks may acquire loans through the "discount window" at their home FRB. The most important credit available through the window is the adjustment credit, which helps depository institutions meet their short-term needs against, for example, unexpected large withdrawals of deposits. The interest rate charged on such loans is the basic discount rate and is the focus of discount policy. A lower-rate encourages more borrowing. Through money creation, bank deposits increase and reserves increase. A rate hike works in the opposite direction. However, since it is more efficient to adjust reserves through open-market operations (discussed below), the amount of discount window lending has been unimportant, accounting for only a small fraction of total reserves. Perhaps a more meaningful function served by the discount rate is to signal the Fed's stance on monetary policy, similar to the role of the federal funds rate.

By law, each FRB sets its discount rate every two weeks, subject to the approval of the Board of Governors. However, the gradual nationalization of the credit market over the years has resulted in a uniform discount rate. Its adjustments have been dictated by the cyclical conditions in the economy, and the frequency of adjustments has varied. In the 1990s, for example, the Fed cut the rate seven times—from 7 percent to 3 percent— during the recession from December 1990 to July 1992. Later, from May 1994 to February 1995, the rate was raised four times—from 3 percent to5.25 percent—to counter possible economic overheating and inflation. In January 1996, the rate was lowered to 5 percent and it stayed there for the next thirty-two months, during which the U.S. economy experienced a solid and consistent growth with only minor inflation. From October to November 1998, the Fed cut the rate twice, first to 4.75 percent and then to 4.5 percent, anticipating the threat from the global financial crisis that had began in Asia in mid-1997 (data from "United States Monetary Policy," 1999).

Open-Market Operations The most important and flexible tool of monetary policy is open-market operations (i.e., trading U.S. government securities in the open market). In 1997, the Fed made $3.62 trillion of purchases and $3.58 trillion of sales of Treasury securities (mostly short-term Treasury bills). As of September 1998, the Fed held $458.13 billion of Treasury securities, roughly 8.25 percent of the total Federal debt outstanding (data from Fisher et al., 1998; Treasury Bulletin, 1998).

The FOMC directs open-market operations (and also advises about reserve requirements and discount-rate policies). The day-to-day operations are determined and executed by the Domestic Trading Desk (the Desk) at the FRB of New York. Since 1980, the FOMC has met regularly eight times a year in Washington, D.C. At each of these meetings, it votes on an intermeeting target federal funds rate, based on the current and prospective conditions of the economy. Until the next meeting, the Desk will manage reserve conditions through open-market operations to maintain the federal funds rate around the given target level. When buying securities from a bank, the Fed makes the payment by increasing the bank's reserves at the Fed. More reserves will then be available in the federal funds market and the federal funds rate falls. By selling securities to a bank, the Fed receives payment in reserves from the bank. Supply of reserves falls and the funds rate rises.

The Fed has two basic approaches in running open-market operations. When a shortage or surplus in reserves is likely to persist, the Fed may undertake outright purchases or sales, creating a long-term impact on the supply of reserves. However, many reserve movements are temporary. The Fed can then take a defensive position and engage in transactions that only impose temporary effects on the level of reserves. A repurchase agreement (a repo) allows the Fed to purchase securities with the agreement that the seller will buy back them within a short time period, sometimes overnight and mostly within seven days. The repo creates a temporary increase in reserves, which vanishes when the term expires. If the Fed wishes to drain reserves temporarily from the banking system, it can adopt a matched sale-purchase transaction (a reverse repo), under which the buyer agrees to sell the securities back to the Fed, usually in less than seven days.

Bibliography

The Federal Reserve System: Purposes and Functions. (1994). Washington, DC: Board of Governors of the Federal Reserve System.

Ferguson, Jr., Roger W. Remarks by Governor Roger W. Ferguson, Jr.: The Making of Monetary Policy. Federal Reserve Board Speech. At www.bog.frb.fed.us/boarddocs/speeches/current/19990115.html. 1999.

Fisher, Peter R., Cheng, Virginia, Hilton, Spence, and Tulpan, Ted (1998). "Open Market Operations During 1997." Federal Reserve Bulletin July: 517-532.

"Interest Rates and Monetary Policy." San Francisco: Federal Reserve Bank of San Francisco. At www.sf.frb.org/econrsrch/wklylfr/el97-18.html. 1997.

Mishkin, Frederic S. (1998). The Economics of Money, Banking, and Financial Markets, 5th ed. New York: Addison-Wesley.

Treasury Bulletin. (1998). December. Washington, DC: U.S. Department of Treasury.

"United States Monetary Policy." Federal Reserve Bank of Minneapolis. At [woodrow.mpls.frb.fed.us/info/policy]. 1999.

[Article by: EDWARD WEI-TE HSIEH]

This article may contain too much repetition or redundant language. Please help improve it to fix this issue. (September 2009)

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Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.^[1] Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation.^[2]

Overview

A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.

There are several monetary policy tools available to achieve these ends: increasing interest rates by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of contracting the money supply; and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from fiscal policy. Even prior to the 1970s, the Bretton Woods system still ensured that most nations would form the two policies separately.

Within almost all modern nations, special institutions (such as the Bank of England, the European Central Bank, Reserve Bank of India, the Federal Reserve System in the United States, the Bank of Japan, the Bank of Canada or the Reserve Bank of Australia) exist which have the task of executing the monetary policy and often independently of the executive. In general, these institutions are called central banks and often have other responsibilities such as supervising the smooth operation of the financial system.

The primary tool of monetary policy is open market operations. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation.

Usually, the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.

The other primary means of conducting monetary policy include: (i) Discount window lending (lender of last resort); (ii) Fractional deposit lending (changes in the reserve requirement); (iii) Moral suasion (cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (talking monetary policy with the market).

Theory

Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy.[1] Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like economic growth, inflation, exchange rates with other currencies and unemployment. Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the gold standard. A policy is referred to as contractionary if it reduces the size of the money supply or raises the interest rate. An expansionary policy increases the size of the money supply, or decreases the interest rate. Furthermore, monetary policies are described as follows: accommodative, if the interest rate set by the central monetary authority is intended to create economic growth; neutral, if it is intended neither to create growth nor combat inflation; or tight if intended to reduce inflation.

It is important for policymakers to make credible announcements and degrade interest rates as they are non-important and irrelevant in regarding to monetary policies. If private agents (consumers and firms) believe that policymakers are committed to lowering inflation, they will anticipate future prices to be lower than otherwise (how those expectations are formed is an entirely different matter; compare for instance rational expectations with 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 behavior between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is no demand pull inflation because employees are receiving a smaller wage and there is no cost push inflation because employers are paying out less in wages.

In order to achieve this low level of inflation, policymakers must have credible announcements; that is, 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.

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. Consequently, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behavior);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 (for example, larger budgets, a wage bonus for the head of the bank) in order to increase their reputation and signal a strong commitment to a policy goal. Reputation is an important element in monetary policy implementation. But the idea of reputation should not be confused with commitment. While a central bank might have a favorable reputation due to good performance in conducting monetary policy, the same central bank might not have chosen any particular form of commitment (such as targeting a certain range for inflation). Reputation plays a crucial role in determining how much would markets believe the announcement of a particular commitment to a policy goal but both concepts should not be assimilated. Also, note that under rational expectations, it is not necessary for the policymaker to have established its reputation through past policy actions; as an example, the reputation of the head of the central bank might be derived entirely from his or her ideology, professional background, public statements, etc. In fact it has been argued (add citation to Kenneth Rogoff, 1985. "The Optimal Commitment to an Intermediate Monetary Target" in 'Quarterly Journal of Economics' #100, pp. 1169-1189) that in order to prevent some pathologies related to the time-inconsistency of monetary policy implementation (in particular excessive inflation), the head of a central bank should have a larger distaste for inflation than the rest of the economy on average. Hence the reputation of a particular central bank is not necessary tied to past performance, but rather to particular institutional arrangements that the markets can use to form inflation expectations. Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is believed to be the most beneficial. For example, capability to serve the public interest is one definition of credibility often associated with central banks. The reliability with which a central bank keeps its promises is also a common definition. While everyone most likely agrees a central bank should not lie to the public, wide disagreement exists on how a central bank can best serve the public interest. Therefore, lack of definition can lead people to believe they are supporting one particular policy of credibility when they are really supporting another.^[3]

History of monetary policy

Monetary policy is primarily associated with interest rate and credit. For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price.

With the creation of the Bank of England in 1694, which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established.^[4] The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates.

During the 1870-1920 period the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913.^[5] By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which focused on how many more, or how many fewer, people would make a decision based on a change in the economic trade-offs. It also became clear that there was a business cycle, and economic theory began understanding the relationship of interest rates to that cycle. (Nevertheless, steering a whole economy by influencing the interest rate has often been described as trying to steer an oil tanker with a canoe paddle.) Research by Cass Business School has also suggested that perhaps it is the central bank policies of expansionary and contractionary policies that are causing the economic cycle; evidence can be found by looking at the lack of cycles in economies before central banking policies existed.

Monetarist macroeconomists have sometimes advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth.^[6] However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables.^[7] Even Milton Friedman acknowledged that money supply targeting was less successful than he had hoped, in an interview with the Financial Times on June 7, 2003.^[8]^[9]^[10] Therefore, monetary decisions today take into account a wider range of factors, such as:

short term interest rates;
long term interest rates;
velocity of money through the economy;
exchange rates;
credit quality;
bonds and equities (corporate ownership and debt);
government versus private sector spending/savings;
international capital flows of money on large scales;
financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail. Others see another problem with our current monetary policy. The problem for them is not that our money has nothing physical to define its value, but that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes all but a small proportion of society (including all governments) to be perpetually in debt.

In fact, many 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 sometimes 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 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

The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by open market operations or sales and purchases of second hand government debt, or by changing the reserve requirements. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets.

A central bank can only operate a truly independent monetary policy when the exchange rate is floating.^[11] If the exchange rate is pegged or managed in any way, the central bank will have to purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on the monetary base analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the case of a pure floating exchange rate, central banks and monetary authorities can at best "lean against the wind" in a world where capital is mobile.

Accordingly, the management of the exchange rate will influence domestic monetary conditions. In order to maintain its monetary policy target, the central bank will have to sterilize or offset its foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase, the central bank must also sell government debt to contract the monetary base by an equal amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to lose control of domestic monetary policy when it is also managing the exchange rate.

In the 1980s, many economists began to believe that making a nation's central bank independent of the rest of executive 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, such as re-electing the current government. Independence typically means that the members of the committee which conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited independence.

In the 1990s, central banks began adopting formal, public inflation targets with the goal of making the outcomes, if not the process, of monetary policy more transparent. In other words, a central bank may have an inflation target of 2% for a given year, and 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 through the Bank of England Act 1998 and adopted an inflation target of 2.5% RPI (now 2% of CPI).

The debate rages on about whether monetary policy can smooth business cycles or not. A central conjecture of Keynesian economics is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral, as in the neoclassical model). There is also the Austrian school of economics, which includes Friedrich von Hayek and Ludwig von Mises's arguments, but most economists fall into either the Keynesian or neoclassical camps on this issue.

Developing countries

Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in a developing country is not independent of government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. Such forms of monetary institutions thus essentially tie the hands of the government from interference and, it is hoped, that such policies will import the monetary policy of the anchor nation.

Recent attempts at liberalizing and reforming the financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required in order to implement monetary policy frameworks by the relevant central banks.

Types of monetary policy

In practice, all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations.

Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.

The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy:	Target Market Variable:	Long Term Objective:
Inflation Targeting	Interest rate on overnight debt	A given rate of change in the CPI
Price Level Targeting	Interest rate on overnight debt	A specific CPI number
Monetary Aggregates	The growth in money supply	A given rate of change in the CPI
Fixed Exchange Rate	The spot price of the currency	The spot price of the currency
Gold Standard	The spot price of gold	Low inflation as measured by the gold price
Mixed Policy	Usually interest rates	Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonized consumer price index).

Inflation targeting

Main article: Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.

Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.^[12]

The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Canada, Chile, Colombia, the Eurozone, New Zealand, Norway, Iceland, Philippines, Poland, Sweden, South Africa, Turkey, 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.

Something similar to price level targeting was tried by Sweden in the 1930s, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operates monetary policy based on a price level target.

Monetary aggregates

In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.

Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).

These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.

Gold standard

Main article: Gold standard

The gold standard is a system in which the price of the national currency as measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationals. (i.e. open market operations, cf. above). The selling of gold is very important for economic growth and stability.

The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".

Today this type of monetary policy is not used anywhere in the world,^{[citation needed]} although a form of gold standard was used widely across the world prior to 1971. For details see the Bretton Woods system. Its major advantages were simplicity and transparency.

Policy of various nations

Australia - Inflation targeting
Brazil - Inflation targeting
Canada - Inflation targeting
Chile - Inflation targeting
China - Monetary targeting and targets a currency basket
Eurozone - Inflation targeting
Hong Kong - Currency board (fixed to US dollar)
India - Inflation targeting
New Zealand - Inflation targeting
Norway - Inflation targeting
Singapore - Exchange rate targeting
South Africa - Inflation targeting
Switzerland - Inflation targeting ^[13]
Turkey - Inflation targeting
United Kingdom^[14] - Inflation targeting, alongside secondary targets on 'output and employment'.
United States^[15] - Mixed policy (and since the 1980s it is well fitted/described by the "Taylor rule" which shows that the Fed funds rate responds to shocks in inflation and output)
Further information: Monetary policy of the USA

Monetary policy tools

Monetary base

Monetary policy can be implemented by changing the size of the monetary base. This directly changes the total amount of money circulating in the economy. A central bank can use open market operations to change the monetary base. The central bank would buy/sell bonds in exchange for hard currency. When the central bank disburses/collects this hard currency payment, it alters the amount of currency in the economy, thus altering the monetary base.

Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.

Discount window lending

Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans or extending new loans, the monetary authority can directly change the size of the money supply.

Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool — open market operations; one must choose which one to control.

In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.

Currency board

Main article: currency board

A currency board is a monetary arrangement which pegs the monetary base of a country to that of an anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are three-fold:

To import monetary credibility of the anchor nation;
To maintain a fixed exchange rate with the anchor nation;
To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization).

In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened (and it would be a more complicated to run than a simple single-currency currency board). 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.

The currency board in question will no longer issue fiat money but instead will only issue a set number of units of local currency for each unit of foreign currency it has in its vault. The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank. The virtue of this system is that questions of currency stability no longer apply. The drawbacks are that the country no longer has the ability to set monetary policy according to other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a country's terms of trade, irrespective of economic differences between it and its trading partners.

Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a mainstay of that country's subsequent economic success (see Economy of Estonia for a detailed description of the Estonian currency board). Argentina abandoned its currency board in January 2002 after a severe recession. This emphasized the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders. Following the signing of the Dayton Peace Agreement in 1995, Bosnia and Herzegovina established a currency board pegged to the Deutschmark (since 2002 replaced by the Euro).

Currency boards have advantages for small, open economies which would find independent monetary policy difficult to sustain. They can also form a credible commitment to low inflation.

References

^ "Monetary Policy". Federal Reserve Board. January 3, 2006. http://www.federalreserve.gov/policy.htm.
^ B.M. Friedman "Monetary Policy," International Encyclopedia of the Social & Behavioral Sciences, 2001, pp. 9976-9984. Abstract.
^ Forder, James. ""Credibility" in Context: Do Central Bankers and Economists Interpret the Term Differently?" (December 2004). [1]
^ "Bank of England founded 1694". BBC. March 31, 2006. http://www.bbc.co.uk/history/timelines/britain/stu_eng_bank.shtml.
^ "Federal Reserve Act". Federal Reserve Board. May 14, 2003. http://www.federalreserve.gov/generalinfo/fract/.
^ Milton Friedman (1960), A Program for Monetary Stability. Fordham University Press.
^ Ben Bernanke (2006), 'Monetary Aggregates and Monetary Policy at the Federal Reserve: A Historical Perspective'.
^ Edward Nelson (2007), 'Milton Friedman and U.S. Monetary History: 1961-2006', Federal Reserve Bank of St. Louis Review 89 (3), page 171.
^ Blog: Favorite Friedman quotes
^ Wikiquote
^ "Exchange Rates". The Library of Economics and Liberty. March 31, 2006. http://www.econlib.org/library/ENC/ExchangeRates.html.
^ Athanasios Orphanides (2008). "Taylor rules," The New Palgrave Dictionary of Economics, 2nd Edition. v. 8, pp. 200-04.Abstract.
^ http://www.bos.frb.org/economic/neer/neer2002/neer202l.pdf
^ "Monetary Policy Framework". Bank Of England. 2006. http://www.bankofengland.co.uk/monetarypolicy/framework.htm.
^ "U.S. Monetary Policy: An Introduction". Federal Bank of San Francisco. 2004. http://www.frbsf.org/publications/federalreserve/monetary/.

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Monetary policy

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