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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 regulatory authority of a country that determines the scope and impact of the key drivers of the economic activity in that country. Activities which are integral to monetary policy consists of management of money supply and interest rates which are aimed at achieving macroeconomic objectives like 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.

BREAKING DOWN '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.

The monetary policy impacts the important facets of the economy, which include attempts to achieve stability/rise in gross domestic product (GDP) growth rate, maintain low rates of unemployment, support overall economic or sector specific growth, and maintain foreign exchange rates in a predictable range. Monetary policy is different from fiscal policy as the former relates to borrowing, consumption and spending by individuals and private businesses, while the latter refers to taxes, government borrowing and spending.

Types of Monetary Policies

At a broader 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 expansionary policy which is aimed at bumping up the economic growth and expanding the overall economic activity in the region. 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 higher consumer spending on a variety of goods and services, and an increased money supply in the market. Since capital is now available at low rates, both businesses and individuals can take loans on convenient terms. With easy funding, businesses and corporates make investments in manufacturing units, projects and other business-related activities that help in increasing the employment. Individuals not only get jobs thereby leading to reduction in unemployment, they also get higher disposable income which is used to make all kinds of purchases and investments. It includes big ticket purchases like property on loan and an increased spending on everyday needs. The lower interest rates aid such spending activity as more utility is derived from spending on goods and services than the benefits achieved from saving. As more money comes into circulation in the market, the overall economic activity is boosted which helps a country come out of the slowdown or recession. 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.

However, increased money supply and higher growth rates often lead to higher inflation. With prices rising for everyday essentials like energy, food, commodities, and other goods and services, it starts impacting the overall cost of living, cost of doing business and every other facet of the economy. A need then arises to contain the rate of growth and inflation which is achieved by the contractionary monetary policy. By increasing the interest rates, it aims to bring down inflation, reduce money supply in the market, make borrowing costlier, make spending unfavorable, and promote money saving. The contractionary monetary policy can slow the 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.

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 long-running financial crisis of 2008, the standard tools of traditional monetary policy may no longer remain effective in controlling the economic factors to achieve the desired goals. New and exceptional measures, like quantitative easing, may then be employed to bump up economic growth and drive demand. In the post-2008 period, the U.S. Fed loaded its balance sheet with trillions of dollars in treasury notes and mortgage-backed securities. Regulators of other leading economies across the globe followed suit, with Bank of England, the European Central Bank and the Bank of Japan pursuing similar policies. The effect of quantitative easing is to raise the price of securities, therefore lowering their yields, as well as to increase total money supply.

Tools to Implement Monetary Policy

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

The most popular option is to tweak the interest rates which has a cascading effect on the overall economy. For example, it may involve tweaking the specific interest rates that the central bank charges on overdrafts that the commercial banks take from the central bank. When commercial banks can borrow from central banks at lower rates, they have more liquidity and credit which they can make available to the economy by offering loans to their customers at cheaper rates. If such rates are high, the commercial banks will borrow less and limited money will be available in the economy.

Second option used by monetary authorities is to change the reserve requirements, which refer to the funds that banks must retain as a proportion of the deposits made by their customers. Lowering this reserve requirement releases more capital for the banks using which they can increase the funds available for offering loans or to buy other profitable assets. Increasing this reserve requirement has a reverse effect that helps in containing the money supply.

Authorities also use a third option called open market operations to expand or contract the money supply in the country’s banking system. It involves buying and selling of government securities like bonds or foreign currencies in the open market. Buying of government debt increases the amount of cash in circulation and credits the reserve accounts of the banks. With banks having more money available in their reserves, they have the liberty as well as competitive pressure to decrease the lending rates which makes borrowing cheaper and helps stimulate the economy. Selling government debt pulls the money out of the market, and eventually leads to tightening of money supply.

Additionally, monetary authorities may draft policies and use methods to selectively target specific factors for specific purpose. For example, if the nation’s currency (like US dollar) is getting weaker compared to a particular currency (like Chinese yuan), the monetary authority may tweak the federal funds rate to reduce the money supply and make dollar-denominated credit costlier. It also leads to higher returns getting generated from dollar-denominated assets. Both these factors result in higher demand for dollar which makes it stronger against other currencies. Such measures are important for the export-import business of a country, and may make or break the country’s foreign trade.

U.S. Federal Reserve

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, and since 2009 has served as a bank regulator. Its core role is to be the lender of last resort, providing banks with liquidity in order to prevent the bank failures and or panics in the financial services sector.  

Importance of Credibility of Monetary Authority

The 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 eligible authorities.

The monetary policy has a long-lasting impact on a nation’s economy. 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 the 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 authority’s working. It may vary from the government, judiciary or political parties having a limited role to only appointing the key members of the authority, and may extend to force them to announce populist measures (like when elections are approaching).

While developed nations have little or no interference in the working of monetary authority of the country, many underdeveloped and developing countries face the problem of such political interference. If a central bank announces a particular policy that talks about measures to put curbs on the increasing inflation, the inflation may continue to remain high if common public have no or little trust of the authority. While making investment decisions based on the announced monetary policy, one should also consider the credibility of the authority.

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