Monetary policy refers to the actions taken by a nation’s central bank to influence the availability and cost of money and credit to promote a healthy economy.
Monetary policy can be broadly classified as either expansionary or contractionary.
Monetary policy consists of the management of money supply and interest rates, aimed at achieving macroeconomic objectives such as 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.
Monetary policy tools include open market operations, direct lending to banks, bank reserve requirements, unconventional emergency lending programs, and managing market expectations (subject to the central bank’s credibility).
Monetary authorities are typically given policy mandates, to achieve a stable rise in the gross domestic product (GDP), maintain low rates of unemployment, and maintain foreign exchange rates and inflation rates in a predictable range.
Monetary policy can be used in combination with or as an alternative to fiscal policy, which uses taxes, government borrowing, and spending to manage the economy.
In the United States, the Federal Reserve establishes monetary policy.
It tries to make sure the money supply grows neither too quickly, causing excessive inflation, nor too slowly, hampering economic growth.
Ideally, inflation is around 2% annually, which keeps prices stable. The Fed also tries to keep unemployment low, below 5%.
Its primary tools for influencing the money supply are the forward guidance, discount rate, the reserve requirement, open market operations, and large scale asset purchases (LSAPs)
Almost all monetary policy is now conducted through open market operations, which involve the buying and selling of government bonds on the secondary market.
Through these open market operations (which expand or contract the money supply), central banks can effectively set the short-term interest rate, which has long been regarded as the primary instrument of modern monetary policy.
After the Great Financial Crisis, the Federal Reserve also sought to influence longer-term interest rates by purchasing a range of longer-term instruments (such as mortgage-backed securities) through a policy known as “QE” or quantitative easing.
What are the central banks’ goals when conducting monetary policy?
Central bankers typically have many goals in conducting monetary policy:
- They wish to maintain economic growth at the highest sustainable level
- They hope to keep unemployment to an absolute minimum.
- They seek to keep inflation low.
- They hope to maintain interest rates at reasonable levels (so as not to discourage investment)
- They aim to keep exchange rates stable.
- They promote the stability of the financial system and seek to minimize systemic risks
Although central bankers would, ideally, like to achieve all of these goals simultaneously, there is now a broad consensus that a primary objective must be to stabilize the price level.
One strategy for achieving this goal is inflation targeting, which requires that central bankers raise interest rates (by slowing money growth) when inflation begins to rise above a target level—such as 2 percent—and that they lower interest rates (by accelerating money growth) when inflation threatens to fall below that target.
In recent years, central banks are reconsidering their role in fostering financial stability
Should financial stability be an explicit central bank goal on a par with other objectives such as price stability and sustainable economic growth?
Financial stability is defined as “a condition whereby the financial system is able to withstand shocks without giving way to cumulative processes, which impair the allocation of savings to investment opportunities and the processing of payments in the economy”.
Financial instability is a situation characterized by these three basic criteria:
- some important sets of financial asset prices seem to have diverged sharply from fundamentals; and/or
- market functioning and credit availability, domestically and perhaps internationally, have been significantly distorted; with the result that
- aggregate spending deviates (or is likely to deviate) significantly, either above or below, from the economy’s ability to produce.
The Federal Reserve created the Division of Financial Stability which identifies and analyzes potential threats to financial stability; monitors financial markets, institutions, and structures; and assesses and recommends policy alternatives to address these threats.