Monetary Policy
Brief History of Modern Monetary Policy
Monetary Policy has been considered a pseudo scientific discipline for the past 150 years. Monetary policy is associated with interest rates and credit. For centuries there were only two forms of monetary policy which were decisions about coinage and decisions to print paper money to create credit. Even though interest rates are now thought of as part of monetary authority, they are not generally coordinated with the other forms of monetary policy. Monetary policy was seen as an executive decision and was in the hands of the authority with seigniorage or the power to coin. In the past 50 years there have been rapid changes in the macroeconomic and microeconomic theories that have affected monetary policy. It has grown from simply increasing the monetary supply to keep up with both population growth and economic activity. Monetary supply must now include the following factors:
- Short term/long term interest rates
- Exchange rates
- Credit quality
- Velocity of money through the economy
- Government v. private sector spending/savings
- equities and bonds
- Financial derivatives such as options, swaps, future contracts, ect.
- International capital flows of money on large scales
Overview of Monetary Policy
Monetary Policy is the process by which the government, central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets. Monetary Policy deals with the relationship between the total money supply in the economy and the interest rate (price at which money can be borrowed). A monetary authority has the ability to alter the money supply (increase or decrease) and thus influence the interest rate, to achieve policy goals. Monetary Policy uses a variety of tools to control either the total money supply or the interest rate to influence exchange rates, economic growth, inflation and unemployment.
2 General Policies
- Expansionary Policy** Increase the total supply of money in the economy
- also used to decrease the interest rate
- used to combat unemployment in a recession by lowering interest rates
- also used to decrease the interest rate
- Contractionary Policy** Decreases the total supply of money in the economy
- used to raise interest rates to combat inflation
- also to cool an overheated economy
- used to raise interest rates to combat inflation
Monetary Policy Descriptions
- Tight - intended to reduce inflation
- Neutral - If it is intended neither spur growth nor combat inflation
- Accommodative - if the interest rate set by the central monetary authority is intended to spur economic growth
Monetary Policy Tools
Open Market Operations (Monetary Base)
This is the process of buying and selling federal treasuries in the fixed income market. The central bank will conduct either an open market purchase or an open market sale. An open market purchase is an accommodative policy acting to stimulate the economy. When the central bank purchases the securities they do so using their currency, this introduces more cash into the economy. This transaction lowers interest rates and helps to lower the cost of borrowing. When a central bank takes a restrictive stance they will conduct an open market purchase, by issuing treasury securities for cash. This withdraws money from the economy and raises short term interest rates. In any open market operation the quantity of the purchase or sale is large. The size of the transaction ensures the market moves to the economic stance of the central bank.
- Directly changes the total amount of money circulating in the economy
Reserve Requirements
Reserves are the amount of currency held by the bank relative to its deposits. When the required reserve ratio increases, required reserves increase and hence the quantity of reserves demanded increases for any given interest rate. Increasing the reserve requirements helps to remove money from the economy. When the reserve requirements increase, the short-term interest rates will increase.
- The monetary authority can change the size of the total money supply
Discount Window Lending
The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions.
- The monetary authority can change the size of the total money supply
Interest Rates
The contraction/expansion of the money supply can be achieved indirectly by increasing/decreasing the nominal interest rate.
- Expanding or contracting money supply
How Monetary Policy Works
Essentially, all types of monetary policy involve modifying the amount of base currency in circulation. This is done through open market operations (mentioned in the previous section).
There are 7 broad policies:
- Inflation Targeting
- Price Level Targeting
- Monetary Aggregates
- Fixed Exchange Rate
- Gold Standard
- Mixed Policy
- Managed Float
1. Inflation Targeting
| Monetary Policy | Target Market Variable |
Long Term Objective |
|---|---|---|
| Inflation targeting |
Interest rate on overnight debt |
A given rate of change in the CPI |
Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index (CPI), 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. The interest rate target is maintained for a specific duration (monthly, quarterly, yearly) using open market operations.
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 target inflation.
2. Price Level Targeting
| Monetary Policy | Target Market Variable | Long Term Objective |
|---|---|---|
| Price level targeting |
Interest rate on overnight debt |
A specific CPI number |
Price level targeting is similar to inflation targeting except that the CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.
3. Monetary Aggregates
| Monetary Policy | Target Market Variable |
Long Term Objective |
|---|---|---|
| Monetary Aggregates |
The growth in money supply |
A given rate of change in the CPI |
This approach is based on the constant growth in the money supply. While most monetary policy focuses on a price signal, this approach is focused on monetary quantities. This approach is also known as Monetarism.
4. Fixed Exchange Rates
| Monetary Policy | Target Market Variable |
Long Term Objective |
|---|---|---|
| Fixed Exchange Rate |
The spot price of the currency |
The spot price of the currency |
This policy is based on maintaining a fixed exchange with a foreign currency.
1. Fiat Fixed Rates
the monetary authority declares a fixed exchange rate but does not buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (import/export licenses and capital controls).
2. Fixed Convertibility
Currency is bought and sold by the monetary authority on a daily basis to achieve the target exchange rate.
3.Fixed Exchange Rates Maintained by a Currency Board
Every unit of local currency must be backed by a unit of foreign currency (correct for the exchange rate). This ensures that the local currency does not inflate without being backed by a hard currency.
4. Dollarisation
The U.S. dollar is used freely as the medium for exchange either exclusively or in parallel with the local currency.
5. Gold Standard
| Monetary Policy |
Target Market Variable |
Long Term Objective |
|---|---|---|
| Gold standard |
the spot price of gold |
low inflation as measured by the gold price |
The price of the national currency is measured in units of gold bars. This monetary policy was popular prior to 1971 with the Bretton Woods System.
6. Mixed Policy
| Monetary Policy | Target Market Variable |
Long Term Objective |
|---|---|---|
| Mixed policy |
Usually interest rates |
usually unemployment & CPI change |
A mixed policy approach is most like inflation targeting. However some consideration is also given to other goals such as economic growth, asset bubbles and unemployment.
7. Managed Float
The objective of a managed float is to control the volatility of the domestic currency. The pegged exchange rate is accompanied by an elaborate system of capital controls.
Background on Bank of England
The Bank of England is the central bank of the United Kingdom and was founded in 1694. It stands at the center of the United Kingdom's financial system where it is committed to promoting and maintaining monetary and financial stability. The Bank of England is responsible for printing notes and banking them with gold. Also, the Bank of England's Monetary Policy Committee makes interest rate decisions. The decision to allow the Monetary Policy Committee to make the interest rate decision became in effect in 1997. The Bank of England manages the United Kingdom's foreign exchange and gold reserves.
Bank of England Monetary Policy Committee
The Bank of England Monetary Policy Committee meets once a month on a Wednesday or a Thursday, normally following the first Monday of the month. There are nine members on the committee. Each member has one vote of equal weight, which means only one person can vote once. The Governor chairs the meeting and is the last to cast a vote. The Governor's vote can act as a tiebreaker if need be. Each member can be either appointed or re-appointed into office. There is also a member of the Treasury that must attend the meeting but only as a non-voting observer.
How Interest Rate Decisions are Made
Interest rate decisions are announced at noon right after the meeting. Decisions are made by data relevant to the United Kingdom and the world economy. The Bank of England Monetary Policy Committee's economists and regional representatives presents this data. The non-voting member from the Treasury can also give information to help the decision making process.
Two Goals of Monetary Policy Committee
There are two goals of the Monetary Policy Committee. Decisions are made with a primary aim of price stability, defined by the government's inflation. The government Budget helps to define the inflation rate. Currently the United Kingdom inflation rate is 2%, which is a goal set by the Bank of England. The Bank of England attempts to maintain this target inflation rate through changes in interest rates and the money supply. The secondary aim of the Monetary Policy Committee is to support the government's economic policies and to target for growth and employment.
Bank of England Act
In 1998 the Bank of England created the Bank of England Act. This Act stated that the Bank's Governor must write an open letter of explanation to the Chancellor if the inflation exceeds the target by more than one percentage point in either direction. On April 17, 2007 Mervyn King wrote the first open letter to Gordon Brown because inflation reached 3.1%, which was one point beyond the target of 2%. This open letter procedure demonstrates the goal of the Bank of England to become more transparent in its policies. While the Bank of England shares its target inflation rate and announces publicly if the actual inflation rate differs from the target rate, the Federal Reserve of the United States acts in a more private manner generally never sharring a target rate. This Act was a bold move by the Bank of England as it paved the way for a more open and accepting central bank.
Structure of the Committee
Governor of Bank: Mervyn King
Term in Office: July 1, 2003- June 30, 2008
Deputy Governor of Monetary Stability: Rachel Lomax
Term in Office: July 1, 2003- June 30, 2008
Deputy Governor of Financial Stability: Sir John Gieve
Term in Office: January 16, 2006- January 15, 2011
Chief Economist: Charles Bean
Term in Office: June 1, 2007- May 31, 2010 (Fourth Term)
Executive Director of Market Operations: Paul Tucker
Term in Office: June 1, 2005- May 31, 2008 (Second Term)
Committee Member: Kate Barker
Term in Office: June 1, 2007- May 31, 2010 (Third Term)
Committee Member: Prof. Tim Besley
Term in Office: September 1, 2006- August 31, 2009
Committee Member: Prof. David Blanchflower
Term in Office: June 1, 2006- May 31, 2008
Committee Member: Dr. Andrew Sentence
Term in Office: October 1, 2006- May 31, 2008
What Will Inflation Rates Be Like Be In the Future?
The following graph is from the Bank of England's website. It depicts various outcomes for CPI inflation in the future. The starting point is the second quarter of 2007 where the inflation rate is 2%. The graph holds true if economic conditions are identical to today. The Monetary Policy Committee's best guess is that inflation over the next three years will lie within the darkest part. The bands widen as the time horizon is extended, signifying the increasing uncertainty about outcomes. If the Monetary Policy Committee's predictions are correct, the inflation rate should stay within 2% to 2009.
More Information on Bank of England's Monetary Policy Committee: http://www.bankofengland.co.uk/monetarypolicy/index.htm