Monetary Policy

Monetary policy is the process by which governments and central banks manipulate the quantity of money in the economy to achieve certain macroeconomic and political objectives. The targets are usually: - economic growth, changes in the rate of inflation, higher level of employment, and adjustment of the exchange rate. Monetary policy is categorized into two types: contractionary and expansionary. Contractionary (or “tight”) monetary policy aims to reduce the amount of money circulating through the economy, and reduce short-term economic growth in exchange for higher (hoped-for) long-term growth.

Expansionary (“loose”) policy, on the other hand, aims to increase the money supply and increase short-term economic activity at the expense of long-term economic activity.

 What are the Tools of Monetary Policy?

1. Interest Rates

The tools used in monetary policy  hinge on manipulating variables that either directly or indirectly change interest rates. The most common monetary-policy instrument entails decisions by the Federal Reserve to change interest rates.  Here is how it works. If the Fed believes that the economy is overheating (if the supply of money is outpacing production of goods), it will raise interest rates and bring money supply down to what it perceives to be the “equilibrium” level. By the same token, if the Fed believes economic growth is outpacing money supply (causing deflation/ less inflation), it will reduce interest rates. When interest rates are lower, it’s cheaper for individuals to take out loans to start new businesses or buy goods and services. It also discourages them from keeping their money in a bank account, because they would make less interest.

Occasionally, a central bank will also reduce interest rates to alleviate the economic impact of a major political event, as the Fed did immediately after September 11, 2001. Generally, the Fed is calculating that short-term economic stability, and immediately re-establishing credibility in economic institutions (banks and businesses) is supremely important.

2. Monetary Base

The monetary base is the amount of money circulating the economy. The government can adjust the monetary base through open-market operations, specifically the sale and purchase of bonds in the bond market.

3. Reserve Requirements and Discount Window

The government can exert regulatory control on the amount of reserves as a proportion of total assets that banks must hold. This number is called the “reserve requirement.” The private incentives of banks mean that they want to keep reserves as low as possible, so that they can loan out as much money as possible. If reserves at a bank drop too much, however, a run on a bank could mean that the bank does not have enough reserves to meet the demands of its depositors. Were that to happen, the bank would go bankrupt, and other depositors would lose most of their money, go bankrupt themselves, causing other banks to go bankrupt, etc. A banking contagion was a major causal factor of the Great Depression.

The actual reserve in the local bank, however, is essentially a loan from the central bank, which has ultimate monetary authority. Restricting or expanding the size of this loan as a percentage of the bank’s total loan portfolio, then, amounts to another potent instrument of Fed policy.

Why does Raising Rates Cool Down the Economy?

Rational investors price transactions by opportunity cost. In buying something, a rational investor believes that the asset will have greater yield than other assets. High interest rates mean a higher opportunity cost of spending money, because the consumer sacrifices higher guaranteed return. Lower interest rates equal a lower opportunity cost of consuming, instead of saving.

What is Inflation, and Why Would a Drop in Demand Slow the Rate of Inflation?

Inflation, most simply, is “a higher price for the same thing.” More technically, it is the rate of increase in the money supply beyond the rate of increase in the supply of goods. According to economic theory, predictable inflation should have minimal economic impact, whether it’s high or low. In practice, medium and high rates of inflation portend higher future rates of inflation, discouraging investment and increasing overall uncertainty. High, variable inflation means that the central bank is failing its prime directive of maintaining credibility in the currency. It discourages individuals from holding money (crimping consumption) and makes the pricing of bonds much more difficult.

Since inflation is a function of the money supply relative to actual production, inflation can come from sources other than central banks. Many experts would argue that hedge funds, with substantial credibility among banks and the ability to use massive amounts of leverage, have much more influence on monetary policy than central banks do (unless central banks begin printing money on a massive scale, which is an entirely different story.) 

More on Inflation

Academically speaking, inflation relates to the money supply as follows:

 M * V = P * T

M = total amount of money available in the economy for circulation.

V = velocity of circulation. A good way to conceptualize this is “the amount of times a dollar bill changes hands over a specific period of time.”

P = price level of the economy for a specific period.

T = “the real value” of aggregate transactions.

Assuming T and V stay constant, an increase in the money supply will increase prices. This means that the government can use open market policy or change the reserve requirement to tweak M, so that P will change. Increasing interest rates has the effect of reducing M, because most people tend to deposit funds to receive the higher rates of interest. This is the most common method of combating inflation.

Another variable monitored by a central bank is the value of the currency relative to other currencies (the exchange rate). Certain countries have fixed exchange rate regimes where the currency is not allowed to appreciate or depreciate out of a certain band. This is also known as a “dirty float,” and is very popular with developing economies that want their currencies to be freely traded up to a point, but do not wish to expose themselves to sudden disturbances in international currency markets, which are much larger than the developing economies themselves.

Other countries whose central banks lack the credibility or track record of the established currencies simply peg their currency to the dollar. Essentially, they outsource monetary policy to the United States. This makes their currency more credible, at the price of operating on a monetary policy geared to the well-being of the US economy, not the economy of the small, dollar-pegging one.

The major FX currencies (US dollar, euro, yen, British pound, most developed-economy currencies) operate on an “unmanaged float,” in which international markets entirely determine the exchange rate for the given currency.