Monetary policy
Monetary policy is the financial policy of managing the money supply to achieve specific goals—such as reducing inflation or achieving full employment or more well-being. Almost always, special institutions (like the European Central Bank or the Federal Reserve) exist which have the task of maintaining the monetary policy of a country or transnational entity, independently of government. In general, these institutions are called central banks and typically serve a role of supervising the smooth operation of the financial system as well as monetary policy. Globally, the Bank for International Settlements plays a role in standardizing policy and also informally called the central bank for the central banks, though it sets no monetary policy of its own.The primary tool of monetary policy is usually a short term interest rate. In the case of the US for example, the Federal Reserve targets the Fed Funds rate, the rate at which member banks lend to one another overnight. Monetary policy is also often expressed by the central bank trying to target or manipulate the exchange rate with major trading partners.
In the 1990s banks began adopting formal, public inflation targets. The goal of which is to make the outcomes, if not the process, of monetary policy more transparent. That is, a central bank may have an inflation target of 2% for a given year, 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 in 1996(?) and also adopted an inflation target in 1998(??).
Inflation targeting is generally a system in which a CPI (Consumer Price Index) is defined and its rate of change is managed. For example the target might be to keep CPI growth between 2 and 3% per year. The target is achieved through a short-term interest rate target that is adjusted periodically. The interest rate target is achieved on a daily basis by the buying and selling of base currency, normally in exchange for government bonds.
This type of policy is used in Australia, New Zealand, Sweden and the United Kingdom.
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.
This type of policy is used by the European Central Bank.
In the 1980s several countries used an approached based on a constant growth in the money supply. Such schemes were refined to include different classes of money (M0, M1 etc). Most such systems were ultimately abandoned.
This policy is based on maintaining a fixed exchange rate with a foreign currency. Base money is bought and sold by the central bank on a daily basis to achieve the target exchange rate. This policy somewhat abdicates responsiblitity for monetary policy to a foreign government.
This type of policy is used by China. The Chinese yuan is managed such that its exhange rate with the United States dollar is fixed.
The gold standard is a system in which the price of the national currency as measured in unit of gold is kept constant by the daily buying and selling of base currency.
The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy.
This type of policy is not used anywhere in the world, although it was widely in earlier centuries.
A mixed policy approach is usually in practice most like "inflation targeting". However consideration is also given to other goals such as unemployment and market bubbles.
This type of policy is used by the United States.
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.
Monetary reform movements seek to alter the mechanisms used in such policy.
It is important for policymakers to make credible announcements regarding their monetary policies. If private agents (consumers and firms) believe that policymakers are committed to low inflation, they will anticipate future prices to be lower (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 behaviour between employees and employers (lower wages since prices are expected to be lower) and since wages are in fact lower there is not demand pull inflation because employees are receiving a smaller wage and there is not cost push inflation because employers are paying out less in wages.
However, to achieve this low level of inflation, policymakers must have credible announcements, i.e. 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.
However, 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. Therefore, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behaviour) and 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 (e.g. larger budgets, a wage bonus for the head of the bank) A policymaker with a reputation for low inflation policy can make credible announcements because private agents will expect future behavior to reflect the past.
Trends in Central Banking
In the 1980s, bankers began to become convinced that a central bank independent of the rest of 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, re-electing the current government for example. Independence typically means that the members of the committee which conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited independence. Independence has not stunted a thriving crop of conspiracy theories about the true motives of a given action of monetary policy.Types of Monetary Policy
Inflation Targeting
Price Level Targeting
Monetary Aggregates
Fixed Exchange Rate
Gold Standard
Mixed Policy
Currency Boards
A currency board is a central bank whose monetary policy is a special case. In this case, the country has decided to base its currency off another, larger currency. Typically this happens after a long, unsuccessful fight against inflation. The currency board in question will no longer issue fiat money but instead will only issue one unit of local currency for each unit of foreign currency it has in its vault. The virtue of this system is that questions of currency stability no longer apply. The drawback is that the country no longer has the ability to set monetary policy according to other domestic considerations.Monetary Policy Theory