Monetary policy

Monetary policy

Monetary policy relates to the control of some measure (or measures) of the money supply and/or the level and structure of interest rates. In recent years, much greater emphasis has been placed on monetary policy within a government’s policy package.
This is because broad consensus has emerged that suggest that price stability is an essential pre-condition for achieving the central economic objective of high and stable levels of growth and employment. Monetary policy is viewed as the preferred policy choice for influencing prices.
Although traditionally the choice of monetary policy over fiscal policy as the main policy tool was viewed as a matter of ideological choice, nowadays it is seen more as a pragmatic solution. As it is widely recognized that high and variable inflation harms long-term growth and employment, policymakers have tended to focus on those policies that appear to be most successful in dampening inflationary pressures.
Price stability, therefore, has become a key element of economic strategy, and monetary policy is widely accepted as the most appropriate type of policy to influence prices and price expectations.
The preference for using monetary policy over other types of policy relates to two main factors – the role of the monetary authorities (central banks) as sole issuers of banknotes and bank reserves (known as the monetary base) and the long run neutrality of money.
The central bank is the monopoly supplier of the monetary base and as a consequence can determine the conditions at which banks borrow from the central bank. The central bank can influence liquidity in the short-term money markets and so can determine the conditions at which banks buy and sell short-term wholesale funds. By influencing short-term money market rates, the central bank influences the price of liquidity in the financial system and this ultimately can impact on various economic variables such as output or prices.

In long run a change in the quantity of money in the economy will be reflected in a change in the general level of prices but it will have no permanent influence on real variables such as the level of (real) output or unemployment. This is known as the long-run neutrality of money. The argument goes that real income or the level of unemployment are, in the long term, determined solely real factors, such as technology, population growth or the preferences of economic agents. Inflation is therefore solely a monetary phenomenon.
As a consequence in the long run:
 A central bank can only contribute to raising the growth potential of the economy maintaining an environment of stable prices.
 Economic growth cannot be increased though monetary expansion (increased money supply) or keeping short-term interest rates at levels inconsistent with price stability.
In the past it has been noted that long periods of high inflation are usually related to high monetary growth. While various other factors (such as variations in aggregate demand, technological changes or commodity price shocks) can influence price developments over the short period, over time these influences can be offset a change in monetary policy.
 Monetary policy functions of a central bank
The most important function of any central bank is to undertake monetary control operations. Typically, these operations aim to administer the amount of money (money supply) in the economy and differ according to the monetary policy objectives they intend to achieve.
Monetary policy objectives
Monetary policy is one of the main policy tools used to influence interest rates, inflation and credit availability through changes in the supply of money (or liquidity) available in the economy. It is important to recognize that monetary policy constitutes only one element of an economic policy package and can be combined with a variety of other types of policy (e.g., fiscal policy) to achieve stated economic objectives.
Historically, monetary policy has, to a certain extent, been subservient to fiscal and other policies involved in managing the macro-economy, but nowadays it can be regarded as the main policy tool used to achieve various stated economic policy objectives (or goals).
The main objectives of economic (and monetary) policy include:
i. High employment – often cited as a major goal of economic policy. Having a high level of unemployment results in the economy having idle resources that result in lower levels of production and income, lower growth and possible social unrest. However, this does not necessarily mean that zero unemployment is a preferred policy goal. A certain level of unemployment is often felt to be necessary for the efficient operation of a dynamic economy. It will take people a period of time to switch between jobs, or to retrain for new jobs, and so on – so even near full employment there maybe people switching jobs who are temporarily out of work. This is known as frictional unemployment.
In addition, unemployment may be a consequence of mismatch in skills between workers and what employers want – known as structural unemployment. (Typically, although structural unemployment is undesirable monetary policy cannot alleviate this type of unemployment). The goal of high employment, therefore, does not aim to achieve zero unemployment but seeks to obtain a level above zero that is consistent with matching the demand and supply of labour. This level is known as the natural rate of unemployment. (Note, however, that there is much debate as to what is the appropriate natural level of unemployment – usually a figure of around 4% is cited as the appropriate level)
ii. Price stability – considered an essential objective of economic policy, given the general wish to avoid the costs associated with inflation. Price stability is viewed as desirable because a rising price level creates uncertainty in the economy and this can adversely affect economic growth. Many economists (but no means all) argue that low inflation is a necessary prerequisite for achieving sustainable economic growth.
iii. Stable economic growth – provides for the increases over time in the living standards of the population. The goal of steady economic growth is closely related to that of high employment because firms are more likely to invest when unemployment is high and firms have idle production they are unlikely to want to invest in building more plants and factories. The rate of economic growth should be at least comparable to the rates experienced similar nations.
iv. Interest rate stability – a desirable economic objective because volatility in interest rates creates uncertainty about the future and this can adversely impact on business and consumer investment decisions (such as the purchase of a house). Expected higher interest levels deter investment because they reduce the present value of future cash flows to investors and increase the cost of finance for borrowers.
v. Financial market stability – also an important objective of the monetary authorities. A collapse of financial markets can have major adverse effects on an economy. The US Wall Street Crash in 1929 resulted in a fall of manufacturing output 50 percent and an increase in unemployment to 25 to 30 percent of the US work force 1932. (Over 11,000 banks closed over this period.)
Note that financial market stability is influenced stability of interest rates because increases in interest rates can lead to a decrease in the value of bonds and other investments resulting in losses in the holders of such securities.
vi. Stability in foreign exchange markets – has become a policy goal of increasing importance especially in the light of greater international trade in goods, services and capital. A rise in the value of a currency makes exports more expensive, whereas a decline in the value of a currency leads to domestic inflation. Extreme adverse movements in a currency can therefore have a severe impact on exporting industries and can also have serious inflationary consequences if the economy is open and relatively dependent on imported goods. Ensuring the stability of foreign exchange markets is therefore seen as an appropriate goal of economic policy.
At first glance it may appear that all these policy objectives are consistent with one another, however conflicts do arise. The objective of price stability can conflict with the objectives of interest rate stability and full employment (at least in the short-run) because as an economy grows and unemployment declines, this may result in inflationary pressures forcing up interest rates. If the monetary authorities do not let interest rates increase this could fuel inflationary pressures, yet if they do increase rates then unemployment may occur. These sorts of conflicts create difficulties for the authorities in conducting monetary and other macroeconomic policy.
Typically, the most important long-term monetary target of a central bank is price stability that implies low and stable inflation levels. Such a long-term goal can only be attained setting short-term operational targets. Operational targets are usually necessary to achieve a particular level of interest rates, commercial banks‟ reserves or exchange rates. Often they are complemented intermediate targets such as a certain level of long-term interest rates or broad money growth (monetary aggregates). In choosing the intermediate targets, policymakers should take into account the stability of money demand and the controllability of the money aggregate. The chosen target should also be a good indicator of the effect of the monetary policy decision on the price stability target.

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