What is Monetary Policy?

Monetary policy consists of the process of drafting, announcing, and implementing the plan of actions taken by the central bank, currency board, or other competent monetary authority of a country that controls the quantity of money in an economy and the channels by which new money is supplied. Monetary policy consists of management of money supply and interest rates, aimed at achieving macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity. These are achieved by actions such as modifying the interest rate, buying or selling government bonds, regulating foreign exchange rates, and changing the amount of money banks are required to maintain as reserves. Some view the role of the International Monetary Fund as this.

Key Takeaways

  • Monetary policy is how a central bank or other agency governs the supply of money and interest rates in an economy in order to influence output, employment, and prices.
  • Monetary policy can be broadly classified as either expansionary or contractionary.
  • Monetary policy tools include open market operations, direct lending to banks, bank reserve requirements, unconventional emergency lending programs, and managing market expectations (subject to the central bank's credibility).
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Monetary Policy

Understanding Monetary Policy

Economists, analysts, investors, and financial experts across the globe eagerly await the monetary policy reports and outcome of the meetings involving monetary policy decision-making. Such developments have a long lasting impact on the overall economy, as well as on specific industry sector or market.

Monetary policy is formulated based on inputs gathered from a variety of sources. For instance, the monetary authority may look at macroeconomic numbers like GDP and inflation, industry/sector-specific growth rates and associated figures, geopolitical developments in the international markets (like oil embargo or trade tariffs), concerns raised by groups representing industries and businesses, survey results from organizations of repute, and inputs from the government and other credible sources.

Monetary authorities are typically given policy mandates, to achieve stable rise in gross domestic product (GDP), maintain low rates of unemployment, and maintain foreign exchange and inflation rates in a predictable range. Monetary policy can be used in combination with or as an alternative to fiscal policy, which uses to taxes, government borrowing, and spending to manage the economy.

The Federal Reserve Bank is in charge of monetary policy in the United States. The Federal Reserve has what is commonly referred to as a "dual mandate": to achieve maximum employment (with around 5 percent unemployment) and stable prices (with 2 to 3 percent inflation). It is the Fed's responsibility to balance economic growth and inflation. In addition, it aims to keep long-term interest rates relatively low. Its core role is to be the lender of last resort, providing banks with liquidity and serve as a bank regulator, in order to prevent the bank failures and panics in the financial services sector.

Types of Monetary Policies

At a broad level, monetary policies are categorized as expansionary or contractionary.

If a country is facing a high unemployment rate during a slowdown or a recession, the monetary authority can opt for an expansionary policy aimed at increasing economic growth and expanding economic activity. As a part of expansionary monetary policy, the monetary authority often lowers the interest rates through various measures that make money saving relatively unfavorable and promotes spending. It leads to an increased money supply in the market, with the hope of boosting investment and consumer spending. Lower interest rates mean that businesses and individuals can take loans on convenient terms to expand productive activities and spend more on big ticket consumer goods. An example of this expansionary approach is the low to zero interest rates maintained by many leading economies across the globe since the 2008 financial crisis. (For related reading, see "What Are Some Examples of Expansionary Monetary Policy?")

However, increased money supply can lead to higher inflation, raising the cost of living and cost of doing business. Contractionary monetary policy, by increasing interest rates and slowing the growth of the money supply, aims to bring down inflation. This can slow economic growth and increase unemployment, but is often required to tame inflation. In the early 1980s when inflation hit record highs and was hovering in the double digit range of around 15 percent, the Federal Reserve raised its benchmark interest rate to a record 20 percent. Though the high rates resulted in a recession, it managed to bring back the inflation to the desired range of 3 to 4 percent over the next few years.

Tools to Implement Monetary Policy

Central banks use a number of tools to shape and implement monetary policy. 

First is the buying and selling of short term bonds on the open market using newly created bank reserves. This is known as open market operations. Open market operations traditionally target short term interest rates such as the federal funds rate. The central bank adds money into the banking system by buying assets (or removes in by selling assets), and banks respond by loaning the money more easily at lower rates (or more dearly, at higher rates), until the central bank's interest rate target is met. Open market operations can also target specific increases in the money supply in order to get the banks to loan funds more easily, by purchasing a specified quantity of assets; this is known as quantitative easing.

The second option used by monetary authorities is to change the interest rates and/or the required collateral that the central bank demands for emergency direct loans to banks in its role as lender-of-last-resort. In the U.S. this rate is known as the discount rate. Charging higher rates and requiring more collateral, will mean that banks have to be more cautious with their own lending or risk failure and is an example of contractionary monetary policy. Conversely, lending to banks at lower rates and at looser collateral requirements will enable banks to make riskier loans at lower rates and run with lower reserves, and is expansionary.

Authorities also use a third option, the reserve requirements, which refer to the funds that banks must retain as a proportion of the deposits made by their customers in order to ensure that they are able to meet their liabilities. Lowering this reserve requirement releases more capital for the banks to offer loans or to buy other assets. Increasing the reserve requirement has a reverse effect, curtailing bank lending and slowing growth of the money supply.

In addition to the standard expansionary and contractionary monetary policies, unconventional monetary policy has also gained tremendous popularity in recent times. During periods of extreme economic crisis, like the financial crisis of 2008, the U.S. Fed loaded its balance sheet with trillions of dollars in treasury notes and mortgage-backed securities by introducing news lending and asset purchase programs that combined aspects of discount lending, open market operations, and quantitative easing. Monetary authorities of other leading economies across the globe followed suit, with the Bank of England, the European Central Bank and the Bank of Japan pursuing similar policies.

Lastly, in addition to direct influence over the money supply and bank lending environment, central banks have a powerful tool in their ability to shape market expectations by their public announcements about the central bank's own future policies. Central banks statements and policy announcements move markets, and investors who guess right about what the central banks will do can profit handsomely. Some central bankers choose to be deliberately opaque to market participants in the belief that this will maximize the effectiveness of monetary policy shifts by making them unpredictable and not "baked-in" to market prices in advance. Others choose the opposite: to be more open and predictable in the hopes that they can shape and stabilize market expectations in order to curb volatile market swings that can result from unexpected policy shifts.

However, the policy announcements are effective only to the extent of the credibility of the authority which is responsible for drafting, announcing, and implementing the necessary measures. In an ideal world, such monetary authorities should work completely independent of influence from the government, political pressure, or any other policy-making authorities. In reality, governments across the globe may have varying levels of interference with the monetary authority’s working. It may vary from the government, judiciary, or political parties having a role limited to only appointing the key members of the authority, or may extend to forcing them to announce populist measures (to influence an approaching election for example). If a central bank announces a particular policy to put curbs on increasing inflation, the inflation may continue to remain high if common public have no or little trust in the authority. While making investment decisions based on the announced monetary policy, one should also consider the credibility of the authority.