Monetary policy

Monetary policy involves changing either the price of money – its interest rate – or the quantity of money, in order to control inflation and stabilise the value of money. Keeping the value of money stable has long been an objective of governments, and later of independent central banks.

Monetary policy is a counter-cyclical policy in that it works to moderate changes in aggregate demand - with policy being loosened when aggregate demand is growing slowly or not at all, and tightened when aggregate demand is growing too quickly for the current capacity of the economy.

Short and long run

The use of monetary policy is regarded as a short term policy in that it is generally accepted that 'money is neutral' in its long term impact. It we take a long range range view of an economy through time, the value of money and the quantity of money may change without having an impact on economic growth, or employment levels. Growth and employment levels in the long term are determined more by the availability, quality, and efficiency of factors of production, and factor productivity, than by the price or availability of money.

However, in the short run it is accepted that changes in monetary conditions - interest rates and the quantity of money - can have a direct and significant effect on economic growth and jobs. Hence, governments and monetary authorities do not have long range targets for the value of money - only that the supply of money and its growth should be controlled and pegged closely to the economy's ability to grow in the medium term - namely, close to the economy's trend rate of growth.

While most central banks do not have specific long term targets - other than to achieve monetary stability - they will set short term 'tactical' targets, for example, the Bank of England's daily operations are designed to achieve a specific interest rate or exchange rate1.

How does monetary policy work?

In 'normal' economic circumstances, monetary authorities use monetary policy to influence the demand for money, which then influences aggregate demand and the real economy and the rate of inflation.

Open market operations

The conventional method by which this is accomplished is by central banks manipulating the rate of interest through a process called open market operations (OMO). While this operates differently in different countries (or monetary areas such as the Eurozone) the basics of OMO are similar.

If a central bank wishes interest rates to fall to stimulate economy activity, it will enter the money market and purchase existing government securities (Treasury bonds or bills) from the banking sector. This transaction injects money into the financial sector which means that, as with all assets, an increase in supply drives down price - hence, in this case interest rates fall.

To engineer an increase in rates, the central bank will sell securities to the banking sector, which soaks up money and creates a shortage, which drives up its price - interest rates. Most central banks will have a regular time at which they undertake OMO, and it is usually on at least a weekly basis.

Changes in rates then work their way to other 'market' rates, such as the rate at which banks lend to each other, and eventually on to rates which affect households and individuals, including mortgage rates, and credit card rates. This reinforces the idea that monetary policy is short term given that the 'time horizon' is measured in hours and days.

However, interest rates can fall to such a low level that less conventional methods are required.

The monetary transmission mechanism

The ‘monetary transmission mechanism’ shows how interest rates work their way through the economy, affecting asset prices, confidence, exchange rates, and finally on to the price level. The transmission mechanism highlights the 'interest rate channel' through which monetary policy operates on the rest of the economy.

Monetary transmission mechanism

Expansionary monetary policy will shift the aggregate demand curve to the right, and contractionary policy will shift it to the left.

Monetary policy

Monetary aggregates

Most central banks use at least two measures of the money supply - a narrow measure and a broad measure.

In the UK, the measures are:

  1. MO, which is the narrow measure consisting of notes and coin in circulation (which is over 99% of the total) and bankers' operational balances at the Bank of England.
  2. The broader measure, M4 consists of the private sector's holdings of cash, and sterling deposits held by the private sector at both banks and building societies.

There are three basic measures in the US, including:

  1. The monetary base - the sum of currency in circulation and reserve balances - deposits held by banks and other depository institutions in their accounts at the Federal Reserve.
  2. M1, which is the sum of currency held by the public and transaction deposits at depository institutions, such as commercial banks, savings banks, and credit unions.
  3. M2, which is M1 plus savings deposits, small-denomination time deposits - which are issued in amounts of less than $100,000 - and retail money market mutual fund shares.

Video on macro-economic policies

Quantitative easing - QE

As a result of very low interest rates central banks have looked to pump money directly into the economy when growth has slowed or when economies enter a recession. QE - officially called Asset Purchasing (AP) - involves the purchase of government bonds which lowers the interest rates (or yield) on these bonds.

The effect is to push interest rates down on other loans, such a mortgages. This makes it cheaper to borrow money, which encourages spending.

QE also works by stimulating asset prices - holders of bonds may now wish to invest in these other assets, which pushes up their prices. Asset holders across the economy may now feel more confident to spend money, which increases aggregate demand.

Aggregate demand

Aggregate demand and the AD curve.

Aggregate demand
Fiscal policy

How can fiscal policy influence aggregate demand?

Fiscal policy
Supply-side policy

How effective is supply-side policy?

Supply-side policy

1. Gray, S, Talbot, N - Monetary Operations - The Bank of England, viewed March 3, 2021.v

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