Monetary policy

Monetary policy is the process by which the monetary authority of a country, typically the central bank or currency board, controls either the cost of very short-term borrowing or the monetary base, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.[1][2][3]

Further goals of a monetary policy are usually to contribute to the stability of gross domestic product, to achieve and maintain low unemployment, and to maintain predictable exchange rates with other currencies.

Monetary economics provides insight into how to craft an optimal monetary policy. In developed countries, monetary policy has generally been formed separately from fiscal policy, which refers to taxation, government spending, and associated borrowing.[4]

Monetary policy is referred to as being either expansionary or contractionary. Expansionary policy is when a monetary authority uses its tools to stimulate the economy. An expansionary policy maintains short-term interest rates at a lower than usual rate or increases the total supply of money in the economy more rapidly than usual. It is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that less expensive credit will entice businesses into expanding. This increases aggregate demand (the overall demand for all goods and services in an economy), which boosts short-term growth as measured by gross domestic product (GDP) growth. Expansionary monetary policy usually diminishes the value of the currency relative to other currencies (the exchange rate).[5]

The opposite of expansionary monetary policy is contractionary monetary policy, which maintains short-term interest rates higher than usual or which slows the rate of growth in the money supply or even shrinks it. This slows short-term economic growth and lessens inflation. Contractionary monetary policy can lead to increased unemployment and depressed borrowing and spending by consumers and businesses, which can eventually result in an economic recession if implemented too vigorously.[6]

History

Monetary policy is associated with interest rates and availability of credit. Instruments of monetary policy have included short-term interest rates and bank reserves through the monetary base.[7] For many centuries there were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print paper money to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy during this time. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seigniorage, or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price.

Paper money originated from promissory notes called "jiaozi" in 7th century China. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The successive Yuan Dynasty was the first government to use paper currency as the predominant circulating medium. In the later course of the dynasty, facing massive shortages of specie to fund war and their rule in China, they began printing paper money without restrictions, resulting in hyperinflation.

With the creation of the Bank of England in 1694,[8] which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established.[9] The goal of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged, both their own borrowers, and other banks who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates. The gold standard is a system under which the price of the national currency is measured in units of gold bars and is kept constant by the government's promise to buy or sell gold at a fixed price in terms of the base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of commodity price level targeting. Nowadays this type of monetary policy is no longer used by any country.[10]

During the period 1870–1920, the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913.[11] By this point the role of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the marginal revolution in economics, which demonstrated how people would change a decision based on a change in the economic trade-offs.

Monetarist economists long contended that the money-supply growth could affect the macroeconomy. These included Milton Friedman who early in his career advocated that government budget deficits during recessions be financed in equal amount by money creation to help to stimulate aggregate demand for output.[12] Later he advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable output growth.[13] However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979, it was found to be impractical, because of the highly unstable relationship between monetary aggregates and other macroeconomic variables.[14] Even Milton Friedman later acknowledged that direct money supply targeting was less successful than he had hoped.[15]

Therefore, monetary decisions today take into account a wider range of factors, such as:

Monetary policy instruments

Conventional instrument

The central bank influences interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. Central banks have three main tools of monetary policy: open market operations, the discount rate and the reserve requirements.

An important tool with which a central bank can affect the monetary base is open market operations, if its country has a well developed market for its government bonds. This entails managing the quantity of money in circulation through the buying and selling of various financial instruments, such as treasury bills, company bonds, or foreign currencies, in exchange for money on deposit at the central bank. Those deposits are convertible to currency, so all of these purchases or sales result in more or less base currency entering or leaving market circulation. For example, if the central bank wishes to lower interest rates (executing expansionary monetary policy), it purchases government debt, thereby increasing the amount of cash in circulation or crediting banks' reserve accounts. Commercial banks then have more money to lend, so they reduce lending rates, making loans less expensive. Cheaper credit card interest rates boost consumer spending. Additionally, when business loans are more affordable, companies can expand to keep up with consumer demand. They ultimately hire more workers, whose incomes rise, which in its turn also increases the demand. This tool is usually enough to stimulate demand and drive economic growth to a healthy rate. Usually, the short-term goal of open market operations is to achieve a specific short-term interest rate target. In other instances, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example, in the case of the United States the Federal Reserve targets the federal funds rate, the rate at which member banks lend to one another overnight; however, the monetary policy of China is to target the exchange rate between the Chinese renminbi and a basket of foreign currencies.

If the open market operations do not lead to the desired effects, a second tool can be used: the central bank can increase or decrease the interest rate it charges on discounts or overdrafts (loans from the central bank to commercial banks, see discount window). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy.

A third alternative is to change the reserve requirements. The reserve requirement refers to the proportion of total liabilities that banks must keep on hand overnight, either in its vaults or at the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. Lowering the reserve requirement frees up funds for banks to increase loans or buy other profitable assets. This is expansionary because it creates credit. However, even though this tool immediately increases liquidity, central banks rarely change the reserve requirement because doing so frequently adds uncertainty to banks’ planning. The use of open market operations is therefore preferred.

Unconventional monetary policy at the zero bound

Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are concerns about deflation or deflation is occurring, are referred to as unconventional monetary policy. These include credit easing, quantitative easing, forward guidance, and signaling.[16] In credit easing, a central bank purchases private sector assets to improve liquidity and improve access to credit. Signaling can be used to lower market expectations for lower interest rates in the future. For example, during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for an "extended period", and the Bank of Canada made a "conditional commitment" to keep rates at the lower bound of 25 basis points (0.25%) until the end of the second quarter of 2010.

Further heterodox monetary policy proposals include the idea of helicopter money whereby central banks would create money without assets as counterpart in their balance sheet. The money created could be distributed directly to the population as a citizen's dividend. This option has been increasingly discussed since March 2016 after the ECB's president Mario Draghi said he found the concept "very interesting".[17]

Nominal anchors

A nominal anchor for monetary policy is a single variable or device which the central bank uses to pin down expectations of private agents about the nominal price level or its path or about what the central bank might do with respect to achieving that path. Monetary regimes combine long-run nominal anchoring with flexibility in the short run. Nominal variables used as anchors primarily include exchange rate targets, money supply targets, and inflation targets with interest rate policy.[18]

Types

In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assets (usually government obligations). These open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions.

Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short-term interest rates and the exchange rate.

The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy: Target Market Variable: Long Term Objective:
Inflation Targeting Interest rate on overnight debt A given rate of change in the CPI
Price Level Targeting Interest rate on overnight debt A specific CPI number
Monetary Aggregates The growth in money supply A given rate of change in the CPI
Fixed Exchange Rate The spot price of the currency The spot price of the currency
Gold Standard The spot price of gold Low inflation as measured by the gold price
Mixed Policy Usually interest rates Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange-rate regimes. A fixed exchange rate is also an exchange-rate regime; The gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating the exchange rate unless the management of the relevant foreign currencies is tracking exactly the same variables (such as a harmonized consumer price index).

Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition such as the Consumer Price Index, 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 overnight rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.

As the Fisher effect model explains, the equation linking inflation with interest rates is the following:

π = i - r

where π is the inflation rate, i is the home nominal interest rate set by the central bank, and r is the real interest rate. Using i as an anchor, central banks can influence π. Central banks can choose to maintain a fixed interest rate at all times, or just temporarily. The duration of this policy varies, because of the simplicity associated with changing the nominal interest rate.

The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.[18]

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 inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.[19]

The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It has been used in Australia, Brazil, Canada, Chile, Colombia, the Czech Republic, Hungary, New Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

Price level targeting

Price level targeting is a monetary policy that is similar to inflation targeting except that CPI growth in one year over or under the long term price level target is offset in subsequent years such that a targeted price-level is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the current and future years.

Uncertainty in price levels can create uncertainty around price and wage setting activity for firms and workers, and undermines any information that can be gained from relative prices, as it is more difficult for firms to determine if a change in the price of a good or service is because of inflation or other factors, such as an increase in the efficiency of factors of production, if inflation is high and volatile. An increase in inflation also leads to a decrease in the demand for money, as it reduces the incentive to hold money and increases transaction costs and shoe leather costs.

Monetary aggregates/money supply targeting

In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the US this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

Central banks might choose to set a money supply growth target as a nominal anchor to keep prices stable in the long term. The quantity theory, is a long run model, which links price levels to money supply and demand. Using this equation, we can rearrange to see the following:

π = μ − g,

where π is the inflation rate, μ is the money supply growth rate and g is the real output growth rate. This equation suggests that controlling the money supply’s growth rate can ultimately lead to price stability in the long run. To use this nominal anchor, a central bank would need to set μ equal to a constant and commit to maintaining this target.

However, the money supply growth rate is considered a weak policy, because it is not stably related to the real output growth, As a result, a higher output growth rate will result in a too low level of inflation. A low output growth rate will result in inflation that would be higher than the desired level.[18]

While monetary policy typically focuses on a price signal of one form or another, this approach is focused on monetary quantities. As these quantities could have a role on the economy and business cycles depending on the households' risk aversion level, money is sometimes explicitly added in the central bank's reaction function.[20] Recently, however, central banks are shifting away from policies that focus on money supply targeting, because of the uncertainty that real output growth introduces. Some central banks, like the ECB, are choosing to combine money supply anchor with other targets.

Nominal income/NGDP targeting

Related to money targeting, nominal income targeting (also called Nominal GDP or NGDP targeting), originally proposed by James Meade (1978) and James Tobin (1980), was advocated by Scott Sumner and reinforced by the market monetarist school of thought.

Central banks do not implement this monetary policy explicitly. However, numerous studies shown that such a monetary policy targeting better matches welfare optimizing monetary policy compared to more standard monetary policy targeting.[21]

Fixed exchange rate targeting

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.

Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).

Theoretically, using relative purchasing power parity (PPP), the rate of depreciation of the home country’s currency must equal the inflation differential:

rate of depreciation = home inflation rate – foreign inflation rate,

which implies that

home inflation rate = foreign inflation rate + rate of depreciation.

The anchor variable is the rate of depreciation. Therefore, the rate of inflation at home must equal the rate of inflation in the foreign country plus the rate of depreciation of the exchange rate of the home country currency, relative to the other.

With a strict fixed exchange rate or a peg, the rate of depreciation of the exchange rate is set equal to zero. In the case of a crawling peg, the rate of depreciation is set equal to a constant. With a limited flexible band, the rate of depreciation is allowed to fluctuate within a given range.

By fixing the rate of depreciation, PPP theory concludes that the home country’s inflation rate must depend on the foreign country‘s.

Countries may decide to use a fixed exchange rate monetary regime in order to take advantage of price stability and control inflation. In practice, more than half of nation’s monetary regimes use fixed exchange rate anchoring.[18]

These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.

In practice

Nominal anchors are possible with various exchange rate regimes.

Type of Nominal Anchor Compatible Exchange Rate Regimes
Exchange Rate Target Currency Union/Countries without own currency, Pegs/Bands/Crawls, Managed Floating
Money Supply Target Managed Floating, Freely Floating
Inflation Target (+ Interest Rate Policy) Managed Floating, Freely Floating

Following the collapse of Bretton Woods, nominal anchoring has grown in importance for monetary policy makers and inflation reduction. Particularly, governments sought to use anchoring in order to curtail rapid and high inflation during the 1970s and 1980s. By the 1990s, countries began to explicitly set credible nominal anchors. In addition, many countries chose a mix of more than one target, as well as implicit targets. As a result, global inflation rates have, on average, decreased gradually since the 1970s and central banks have gained credibility and increasing independence.

The Global Financial Crisis of 2008 has sparked controversy over the use and flexibility of inflation nominal anchoring. Many economists argue that inflation targets are currently set too low by many monetary regimes. During the crisis, many inflation anchoring countries reached the lower bound of zero rates, resulting in inflation rates decreasing to almost zero or even deflation.[18]

Implications

The anchors discussed in this article suggest that keeping inflation at the desired level is feasible by setting a target interest rate, money supply growth rate, price level, or rate of depreciation. However, these anchors are only valid if a central bank commits to maintaining them. This, in turn, requires that the central bank abandons their monetary policy autonomy in the long run. Should a central bank use one of these anchors to maintain a target inflation rate, they would have to forfeit using other policies. Using these anchors may prove more complicated for certain exchange rate regimes. Freely floating or managed floating regimes, have more options to affect their inflation, because they enjoy more flexibility than a pegged currency or a country without a currency. The latter regimes would have to implement an exchange rate target to influence their inflation, as none of the other instruments are available to them.

Credibility

The short-term effects of monetary policy can be influenced by the degree to which announcements of new policy are deemed credible.[22] In particular, when an anti-inflation policy is announced by a central bank, in the absence of credibility in the eyes of the public inflationary expectations will not drop, and the short-run effect of the announcement and a subsequent sustained anti-inflation policy is likely to be a combination of somewhat lower inflation and higher unemployment (see Phillips curve#NAIRU and rational expectations). But if the policy announcement is deemed credible, inflationary expectations will drop commensurately with the announced policy intent, and inflation is likely to come down more quickly and without so much of a cost in terms of unemployment.

Thus there can be an advantage to having the central bank be independent of the political authority, to shield it from the prospect of political pressure to reverse the direction of the policy. But even with a seemingly independent central bank, a central bank whose hands are not tied to the anti-inflation policy might be deemed as not fully credible; in this case there is an advantage to be had by the central bank being in some way bound to follow through on its policy pronouncements, lending it credibility.

Contexts

In international economics

Optimal monetary policy in international economics is concerned with the question of how monetary policy should be conducted in interdependent open economies. The classical view holds that international macroeconomic interdependence is only relevant if it affects domestic output gaps and inflation, and monetary policy prescriptions can abstract from openness without harm.[23] This view rests on two implicit assumptions: a high responsiveness of import prices to the exchange rate, i.e. producer currency pricing (PCP), and frictionless international financial markets supporting the efficiency of flexible price allocation.[24][25] The violation or distortion of these assumptions found in empirical research is the subject of a substantial part of the international optimal monetary policy literature. The policy trade-offs specific to this international perspective are threefold:[26]

First, research suggests only a weak reflection of exchange rate movements in import prices, lending credibility to the opposed theory of local currency pricing (LCP).[27] The consequence is a departure from the classical view in the form of a trade-off between output gaps and misalignments in international relative prices, shifting monetary policy to CPI inflation control and real exchange rate stabilization.

Second, another specificity of international optimal monetary policy is the issue of strategic interactions and competitive devaluations, which is due to cross-border spillovers in quantities and prices.[28] Therein, the national authorities of different countries face incentives to manipulate the terms of trade to increase national welfare in the absence of international policy coordination. Even though the gains of international policy coordination might be small, such gains may become very relevant if balanced against incentives for international noncooperation.[24]

Third, open economies face policy trade-offs if asset market distortions prevent global efficient allocation. Even though the real exchange rate absorbs shocks in current and expected fundamentals, its adjustment does not necessarily result in a desirable allocation and may even exacerbate the misallocation of consumption and employment at both the domestic and global level. This is because, relative to the case of complete markets, both the Phillips curve and the loss function include a welfare-relevant measure of cross-country imbalances. Consequently, this results in domestic goals, e.g. output gaps or inflation, being traded-off against the stabilization of external variables such as the terms of trade or the demand gap. Hence, the optimal monetary policy in this case consists of redressing demand imbalances and/or correcting international relative prices at the cost of some inflation.[29]

Corsetti, Dedola and Leduc (2011)[26] summarize the status quo of research on international monetary policy prescriptions: "Optimal monetary policy thus should target a combination of inward-looking variables such as output gap and inflation, with currency misalignment and cross-country demand misallocation, by leaning against the wind of misaligned exchange rates and international imbalances." This is main factor in country money status.

In developing countries

Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in developing countries are mostly not independent of the government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt dollarization. This can avoid interference from the government and may lead to the adoption of monetary policy as carried out in the anchor nation. Recent attempts at liberalizing and reform of financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required to implement monetary policy frameworks by the relevant central banks.

Trends

Transparency

Beginning with New Zealand in 1990, central banks began adopting formal, public inflation targets with the goal of making the outcomes, if not the process, of monetary policy more transparent. In other words, a central bank may have an inflation target of 2% for a given year, and 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 through the Bank of England Act 1998 and adopted an inflation target of 2.5% RPI, revised to 2% of CPI in 2003.[30] The success of inflation targeting in the United Kingdom has been attributed to the Bank of England's focus on transparency.[31] The Bank of England has been a leader in producing innovative ways of communicating information to the public, especially through its Inflation Report, which have been emulated by many other central banks.[32]

The European Central Bank adopted, in 1998, a definition of price stability within the Eurozone as inflation of under 2% HICP. In 2003, this was revised to inflation below, but close to, 2% over the medium term. Since then, the target of 2% has become common for other major central banks, including the Federal Reserve (since January 2012) and Bank of Japan (since January 2013).[33]

Effect on business cycles

There continues to be some debate about whether monetary policy can (or should) smooth business cycles. A central conjecture of Keynesian economics is that the central bank can stimulate aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral, as in the neoclassical model). However, some economists from the new classical school contend that central banks cannot affect business cycles.[34]

Behavioral monetary policy

Conventional macroeconomic models assume that all agents in an economy are fully rational. A rational agent has clear preferences, models uncertainty via expected values of variables or functions of variables, and always chooses to perform the action with the optimal expected outcome for itself among all feasible actions – they maximize their utility. Monetary policy analysis and decisions hence traditionally rely on this New Classical approach.[35][36][37] [38] However, as studied by the field of behavioral economics that takes into account the concept of bounded rationality, people often deviate from the way that these neoclassical theories assume.[38][39] Humans are generally not able to react fully rational to the world around them[37] – they do not make decisions in the rational way commonly envisioned in standard macroeconomic models. People have time limitations, cognitive biases, care about issues like fairness and equity and follow rules of thumb (heuristics).[39]

This has implications for the conduct of monetary policy. Monetary policy is the final outcome of a complex interaction between monetary institutions, central banker preferences and policy rules, and hence human decision-making plays an important role.[36] It is more and more recognized that the standard rational approach does not provide an optimal foundation for monetary policy actions. These models fail to address important human anomalies and behavioral drivers that explain monetary policy decisions.[40][36][37]

An example of a behavioral bias that characterizes the behavior of central bankers is loss aversion: for every monetary policy choice, losses loom larger than gains, and both are evaluated with respect to the status quo.[36] One result of loss aversion is that when gains and losses are symmetric or nearly so, risk aversion may set in. Loss aversion can be found in multiple contexts in monetary policy. The "hard fought" battle against the Great Inflation, for instance, might cause a bias against policies that risk greater inflation.[40] Another common finding in behavioral studies is that individuals regularly offer estimates of their own ability, competence, or judgments that far exceed an objective assessment: they are overconfident. Central bank policymakers may fall victim to overconfidence in managing the macroeconomy in terms of timing, magnitude, and even the qualitative impact of interventions. Overconfidence can result in actions of the central bank that are either "too little" or "too much". When policymakers believe their actions will have larger effects than objective analysis would indicate, this results in too little intervention. Overconfidence can, for instance, cause problems when relying on interest rates to gauge the stance of monetary policy: low rates might mean that policy is easy, but they could also signal a weak economy.[40]

These are examples of how behavioral phenomena may have a substantial influence on monetary policy.[38] Monetary policy analyses should thus account for the fact that policymakers (or central bankers) are individuals and prone to biases and temptations that can sensibly influence their ultimate choices in the setting of macroeconomic and/or interest rate targets.[36]

See also

US specific:

Notes and references

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  2. ^ "Monetary Policy". Federal Reserve Board. January 3, 2006.
  3. ^ "Monetary and Exchange Rate Policies". Handbook of Development Economics, Elsevier. 2010.
  4. ^ "B.M. Friedman, [http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B7MRM-4MT09VJ-29C&_rdoc=21&_hierId=151000134&_refWorkId=21&_explode=151000131,151000134&_fmt=high&_orig=na&_docanchor=&_idxType=SC&view=c&_ct=28&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=7da5a6660c91a413b09f7cd3742de540 "Monetary Policy," Abstract.". International Encyclopedia of the Social & Behavioral Sciences. 2001. pp. 9976–9984.
  5. ^ Expansionary Monetary Policy: Definition, Purpose, Tools. The Balance.
  6. ^ Contractionary Monetary Policy: Definition, Examples. The Balance.
  7. ^ Bordo, Michael D., 2008. "monetary policy, history of," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract and pre-publication copy.
  8. ^ "History of the Bank of England - Bank of England".
  9. ^ "Bank of England founded 1694". BBC. March 31, 2006.
  10. ^ Abdel-Monem, Tarik. "What is The Gold Standard?". University of Iowa Center for The Center for International Finance and Development. Archived from the original on 2009-11-21.
  11. ^ "Federal Reserve Act". Federal Reserve Board. May 14, 2003.
  12. ^ Friedman, Milton (1948). "A Monetary and Fiscal Framework for Economic Stability" (PDF). American Economic Review. 38 (3): 245–264. Archived from the original (PDF) on 2011-10-07.
  13. ^ Friedman, Milton (1960). A Program for Monetary Stability. Fordham University Press.
  14. ^ Bernanke, Ben (2006). "Monetary Aggregates and Monetary Policy at the Federal Reserve: A Historical Perspective". Federal Reserve.
  15. ^ Nelson, Edward (2007). "Milton Friedman and U.S. Monetary History: 1961–2006" (PDF). Federal Reserve Bank of St. Louis Review (89 (3)): 171.
  16. ^ Roubini, Nouriel (January 14, 2016). "Troubled Global Economy". Time Magazine. time.com. Retrieved 5 February 2016.
  17. ^ "Permanent QE and helicopter money | Bruegel". bruegel.org. Retrieved 2016-10-06.
  18. ^ a b c d e Feenstra, Robert C., and Alan M. Taylor. International Macroeconomics. New York: Worth, 2012. 100-05.
  19. ^ Orphanides, Athanasios. Taylor rules (Abstract). The New Palgrave Dictionary of Economics, 2nd Edition. v. 8. pp. 200–04.
  20. ^ Benchimol, J., Fourçans, A. (2012), Money and risk in a DSGE framework: A Bayesian application to the Eurozone, Journal of Macroeconomics, vol. 34, pp. 95–111.
  21. ^ https://www3.nd.edu/~esims1/GLS_JEDC_WEB.pdf
  22. ^ Finn E. Kydland; Edward C. Prescott (June 1977). "Rules Rather than Discretion: The Inconsistency of Optimal Plans" (PDF). Journal of Political Economy. 85 (3): 473–492. CiteSeerX 10.1.1.603.6853. doi:10.1086/260580. JSTOR 1830193.
  23. ^ Cf. Clarida, R., Galí, J., Gertler, M. (2002). A simple framework for international policy analysis. Journal of Monetary Economics, 49(4), pp. 879–904.
  24. ^ a b Corsetti, G., Pesenti, P. (2005). International dimensions of optimal monetary policy. Journal of Monetary Economics, 52(2), pp. 281–305.
  25. ^ Devereux, M.B., Engel, C. (2003). Monetary policy in the open economy revisited: Price setting and exchange rate flexibility. Review of Economic Studies, 70(4), pp. 765–783.
  26. ^ a b Cf. Corsetti, G., Dedola, L., Leduc, S. (2011). Optimal Monetary Policy in Open Economies. In B.M. Friedman and M. Woodford (Eds.). Handbook of Monetary Economics, vol. III. Amsterdam: Elsevier.
  27. ^ Gopinath, G., Rigobon, R. (2008). Sticky borders. Quarterly Journal of Economics, 123(2), pp. 531–575.
  28. ^ Cf. Persson, T., Tabellini, G. (1995). Double-edged incentives: Institutions and policy coordination. In G. Grossman and K. Rogoff. Handbook of International Economics, vol. III. Amsterdam: Elsevier.
  29. ^ "Cf. Corsetti, G., Dedola, L., Leduc, S. (2011). Demand imbalances, real exchange rate misalignments and monetary policy. Draft version, December 2011" (PDF). wisc.edu.
  30. ^ "Monetary Policy Framework". Bank of England. Retrieved 19 January 2016.
  31. ^ "Targeting Inflation: The United Kingdom in Retrospect" (PDF). IMF. Retrieved 31 October 2016.
  32. ^ "Inflation Targeting Has Been A Successful Monetary Policy Strategy". National Bureau of Economic Research. Retrieved 31 October 2016.
  33. ^ Noyer, Christian (12 January 2016). "Thoughts on the zero lower bound in relation with monetary and financial stability". Bank for International Settlements. Retrieved 18 January 2016.
  34. ^ Seidman, Laurence (Fall 2007). "Reply to: "The New Classical Counter-Revolution: False Path or Illuminating Complement?"". Eastern Economic Journal. 33 (4): 563–565. JSTOR 20642378. (Subscription required (help)).
  35. ^ Cuthbertson, K., Nitzsche, D. and Hyde, S.(2008). Monetary policy and behavioral finance. Journal of Economic Surveys, 21(5), pp. 935-969.
  36. ^ a b c d e Favaretto, F. and Masciandaro, D. (2016). Doves, hawks and pigeons: Behavioral monetary policy and interest rate inertia. Journal of Financial Stability, 27, pp. 50-58.
  37. ^ a b c Hommes, C., Massaro, D. and Weber, M. (2015). Monetary Policy under Behavioral Expectations: Theory and Experiment. Tinbergen Institute Discussion Paper.
  38. ^ a b c Rustamli, N. and Abbas, G. (2014). Monetary policy: psychology and expectations. Academic Views, January 2014.
  39. ^ a b Yellen, J.L. (2007). Implications of Behavioral Economics for Monetary Policy. Federal Reserve Bank of Boston Conference: "Implications of Behavioral Economics for Economic Policy".
  40. ^ a b c Calabria, M. (2016). Behavioral Economics and Fed Policymaking. Cato Journal, 36(3), pp. 573-587.

External links

Bank of Canada

The Bank of Canada (or BoC) (French: Banque du Canada) is a Crown corporation and Canada's central bank. Chartered in 1934 under the Bank of Canada Act, it is responsible for formulating Canada's monetary policy, and for the promotion of a safe, sound financial system within Canada. The Bank of Canada is the sole issuing authority of Canadian banknotes, provides banking services and money management for the government, and loans money to Canadian financial institutions.The Bank of Canada headquarters are located at the Bank of Canada Building, 234 Wellington Street in the nation's capital, Ottawa. The building also used to house the Bank of Canada Museum, which opened in December, 1980 and temporarily closed in 2013. As of July 2017, the museum is now located at 30 Bank Street, Ottawa, Ontario, but is connected to the main buildings through the Bank of Canada's underground meeting rooms.

Central Bank of Brazil

The Central Bank of Brazil (Portuguese: Banco Central do Brasil) is Brazil's central bank. It was established on December 31, 1964.

The Central Bank is linked with the Ministry of the Economy. Like other central banks, the Brazilian central bank is the principal monetary authority of the country. It received this authority when it was founded by three different institutions: the Bureau of Currency and Credit (SUMOC), the Bank of Brazil (BB), and the National Treasury.

One of the main instruments of Brazil's monetary policy is the Banco Central do Brasil's overnight rate, called the SELIC rate. It is managed by Monetary Policy Committee (COPOM) of the bank.The bank is active in promoting financial inclusion policy and is a leading member of the Alliance for Financial Inclusion. It is also one of the original 17 regulatory institutions to make specific national commitments to financial inclusion under the Maya Declaration. during the 2011 Global Policy Forum in Mexico.

Federal Reserve

The Federal Reserve System (also known as the Federal Reserve or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics (particularly the panic of 1907) led to the desire for central control of the monetary system in order to alleviate financial crises. Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System.The U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. The first two objectives are sometimes referred to as the Federal Reserve's dual mandate. Its duties have expanded over the years, and currently also include supervising and regulating banks, maintaining the stability of the financial system, and providing financial services to depository institutions, the U.S. government, and foreign official institutions. The Fed conducts research into the economy and provides numerous publications, such as the Beige Book and the FRED database.

The Federal Reserve System is composed of several layers. It is governed by the presidentially appointed board of governors or Federal Reserve Board (FRB). Twelve regional Federal Reserve Banks, located in cities throughout the nation, regulate and oversee privately owned commercial banks. Nationally chartered commercial banks are required to hold stock in, and can elect some of the board members of, the Federal Reserve Bank of their region. The Federal Open Market Committee (FOMC) sets monetary policy. It consists of all seven members of the board of governors and the twelve regional Federal Reserve Bank presidents, though only five bank presidents vote at a time (the president of the New York Fed and four others who rotate through one-year voting terms). There are also various advisory councils. Thus, the Federal Reserve System has both public and private components. It has a structure unique among central banks, and is also unusual in that the United States Department of the Treasury, an entity outside of the central bank, prints the currency used.The federal government sets the salaries of the board's seven governors. The federal government receives all the system's annual profits, after a statutory dividend of 6% on member banks' capital investment is paid, and an account surplus is maintained. In 2015, the Federal Reserve earned net income of $100.2 billion and transferred $97.7 billion to the U.S. Treasury. Although an instrument of the US Government, the Federal Reserve System considers itself "an independent central bank because its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government, it does not receive funding appropriated by the Congress, and the terms of the members of the board of governors span multiple presidential and congressional terms."

Fiscal policy

In economics and political science, fiscal policy is the use of government revenue collection (mainly taxes) and expenditure (spending) to influence the economy. According to Keynesian economics, when the government changes the levels of taxation and government spending, it influences aggregate demand and the level of economic activity. Fiscal policy is often used to stabilize the economy over the course of the business cycle.Changes in the level and composition of taxation and government spending can affect the following macroeconomic variables, amongst others:

Aggregate demand and the level of economic activity;

Saving and investment;

Income distribution.Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by an executive under laws of a legislature, whereas monetary policy deals with the money supply and interest rates and is often administered by a central bank.

Governor of the Bank of England

The Governor of the Bank of England is the most senior position in the Bank of England. It is nominally a civil service post, but the appointment tends to be from within the bank, with the incumbent grooming his or her successor. The Governor of the Bank of England is also Chairman of the Monetary Policy Committee, with a major role in guiding national economic and monetary policy, and is therefore one of the most important public officials in the United Kingdom.

According to the original charter of 27 July 1694 the bank's affairs would be supervised by a Governor, a Deputy Governor, and 24 directors. In its current incarnation, the Bank's Court of Directors has 12 (or up to 14) members, of whom five are various designated executives of the Bank.The 120th and current Governor is the Canadian Mark Carney, appointed in 2013. He is the first non-Briton to be appointed to the post, but made a commitment to the Prime Minister to take up British citizenship.

Interest rate

An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited or borrowed.

It is defined as the proportion of an amount loaned which a lender charges as interest to the borrower, normally expressed as an annual percentage. It is the rate a bank or other lender charges to borrow its money, or the rate a bank pays its savers for keeping money in an account.Annual interest rate is the rate over a period of one year. Other interest rates apply over different periods, such as a month or a day, but they are usually annualised.

Macroeconomics

Macroeconomics (from the Greek prefix makro- meaning "large" + economics) is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies.Macroeconomists study aggregated indicators such as GDP, unemployment rates, national income, price indices, and the interrelations among the different sectors of the economy to better understand how the whole economy functions. They also develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade, and international finance.

While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by governments to assist in the development and evaluation of economic policy.

Macroeconomics and microeconomics, a pair of terms coined by Ragnar Frisch, are the two most general fields in economics. In contrast to macroeconomics, microeconomics is the branch of economics that studies the behavior of individuals and firms in making decisions and the interactions among these individuals and firms in narrowly-defined markets.

Monetarism

Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on national output in the short run and on price levels over longer periods. Monetarists assert that the objectives of monetary policy are best met by targeting the growth rate of the money supply rather than by engaging in discretionary monetary policy.Monetarism today is mainly associated with the work of Milton Friedman, who was among the generation of economists to accept Keynesian economics and then criticise Keynes's theory of fighting economic downturns using fiscal policy (government spending). Friedman and Anna Schwartz wrote an influential book, A Monetary History of the United States, 1867–1960, and argued "inflation is always and everywhere a monetary phenomenon."

Though he opposed the existence of the Federal Reserve, Friedman advocated, given its existence, a central bank policy aimed at keeping the growth of the money supply at a rate commensurate with the growth in productivity and demand for goods.

Monetary Policy Committee

The Monetary Policy Committee (MPC) is a committee of the Bank of England, which meets for three and a half days, eight times a year, to decide the official interest rate in the United Kingdom (the Bank of England Base Rate).

It is also responsible for directing other aspects of the government's monetary policy framework, such as quantitative easing and forward guidance. The Committee comprises nine members, including the Governor (from 2013 Mark Carney), and is responsible primarily for keeping the Consumer Price Index (CPI) measure of inflation close to a target set by the government (2% per year as of 2016). Its secondary aim – to support growth and employment – was reinforced in March 2013.

Announced on 6 May 1997, only five days after that year's General Election, and officially given operational responsibility for setting interest rates in the Bank of England Act 1998, the Committee was designed to be independent of political interference and thus to add credibility to interest rate decisions. Each member has one vote, for which they are held to account: full minutes of each meeting are published alongside the Committee's monetary policy decisions, and members are regularly called before the Treasury Select Committee, as well as speaking to wider audiences at events during the year.

Monetary Policy Report to the Congress

The Monetary Policy Report to the Congress is a semi-annual report prepared by the Board of Governors of the Federal Reserve and presented to the Congress of the United States. The Chairman of the Board of Governors is called on to offer oral testimony about the report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services to the House of Representatives.

Monetary Policy Reports are mandated by the Humphrey-Hawkins Full Employment Act of 1978, which required the Federal Reserve to formally report on its activities to Congress. The Monetary Policy Reports were previously referred to as Humphrey-Hawkins reports.

The Monetary Policy Report is delivered twice a year, in February and July, and reports the basic state of the United States economy and its financial welfare. Each report contains two sections. The first section summarizes past policy decisions and their predicted economic impact. The second section focuses on recent financial and economic developments.

Monetary economics

Monetary economics is the branch of economics that studies the different competing theories of money. It provides a framework for analyzing money and considers its functions, such as medium of exchange, store of value and unit of account. It considers how money, for example fiat currency, can gain acceptance purely because of its convenience as a public good. It examines the effects of monetary systems, including regulation of money and associated financial institutions and international aspects.The discipline has historically prefigured, and remains integrally linked to, macroeconomics. Modern analysis has attempted to provide microfoundations for the demand for money and to distinguish valid nominal and real monetary relationships for micro or macro uses, including their influence on the aggregate demand for output. Its methods include deriving and testing the implications of money as a substitute for other assets and as based on explicit frictions.

Monetary policy of the United States

Monetary policy concerns the actions of a central bank or other regulatory authorities that determine the size and rate of growth of the money supply. For example, in the United States, the Federal Reserve is in charge of monetary policy, and implements it primarily by performing operations that influence short-term interest rates.

Money creation

Money creation is the process by which the money supply of a country, or of an economic or monetary region, is increased. In most modern economies, most of the money supply is in the form of bank deposits. Central banks monitor the amount of money in the economy by measuring the so-called monetary aggregates.

Open market operation

An open market operation (OMO) is an activity by a central bank to give (or take) liquidity in its currency to (or from) a bank or a group of banks. The central bank can either buy or sell government bonds in the open market (this is where the name was historically derived from) or, in what is now mostly the preferred solution, enter into a repo or secured lending transaction with a commercial bank: the central bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as collateral. A central bank uses OMO as the primary means of implementing monetary policy. The usual aim of open market operations is—aside from supplying commercial banks with liquidity and sometimes taking surplus liquidity from commercial banks—to manipulate the short-term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply, in effect expanding money or contracting the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.

Quantitative easing

Quantitative easing (QE), also known as large-scale asset purchases, is an expansionary monetary policy whereby a central bank buys predetermined amounts of government bonds or other financial assets in order to stimulate the economy and increase liquidity. An unconventional form of monetary policy, it is usually used when inflation is very low or negative, and standard expansionary monetary policy has become ineffective. A central bank implements quantitative easing by buying specified amounts of financial assets from commercial banks and other financial institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously lowering short term interest rates which increases the money supply. This differs from the more usual policy of buying or selling short-term government bonds to keep interbank interest rates at a specified target value.

Expansionary monetary policy to stimulate the economy typically involves the central bank buying short-term government bonds to lower short-term market interest rates. However, when short-term interest rates reach or approach zero, this method can no longer work. In such circumstances, monetary authorities may then use quantitative easing to further stimulate the economy, by buying specified quantities of financial assets without reference to interest rates, and by buying riskier or of longer maturity assets (other than short-term government bonds), thereby lowering interest rates further out on the yield curve.

Quantitative easing can help ensure that inflation does not fall below a target. Risks include the policy being more effective than intended in acting against deflation (leading to higher inflation in the longer term, due to increased money supply), or not being effective enough if banks remain reluctant to lend and potential borrowers are unwilling to borrow. According to the International Monetary Fund, the U.S. Federal Reserve System, and various economists, quantitative easing undertaken since the global financial crisis of 2007–08 has mitigated some of the economic problems since the crisis.

Reserve Bank of India

The Reserve Bank of India (RBI) is India's central banking institution, which controls the issuance and supply of the Indian rupee. Until the Monetary Policy Committee was established in 2016, it also controlled monetary policy in India. It commenced its operations on 1 April 1935 in accordance with the Reserve Bank of India Act, 1934. The original share capital was divided into shares of 100 each fully paid, which were initially owned entirely by private shareholders. Following India's independence on 15 August 1947, the RBI was nationalised on 1 January 1949.The RBI plays an important part in the Development Strategy of the Government of India. It is a member bank of the Asian Clearing Union. The general superintendence and direction of the RBI is entrusted with the 21-member central board of directors: the governor; four deputy governors; two finance ministry representatives (usually the Economic Affairs Secretary and the Financial Services Secretary); ten government-nominated directors to represent important elements of India's economy; and four directors to represent local boards headquartered at Mumbai, Kolkata, Chennai and the capital New Delhi. Each of these local boards consists of five members who represent regional interests, the interests of co-operative and indigenous banks.

The central bank was an independent apex monetary authority which regulates banks and provides important financial services like storing of foreign exchange reserves, control of inflation, monetary policy report till August 2016. A central bank is known by different names in different countries. The functions of a central bank vary from country to country and are autonomous or quasi-autonomous body and perform or through another agency vital monetary functions in the country. A central bank is a vital financial apex institution of an economy and the key objects of central banks may differ from country to country still they perform activities and functions with the goal of maintaining economic stability and growth of an economy.The bank is also active in promoting financial inclusion policy and is a leading member of the Alliance for Financial Inclusion (AFI). The bank is often referred to by the name Mint Street. RBI is also known as banker's bank.

Reserve requirement

The reserve requirement (or cash reserve ratio) is a central bank regulation employed by most, but not all, of the world's central banks, that sets the minimum amount of reserves that must be held by a commercial bank. The minimum reserve is generally determined by the central bank to be no less than a specified percentage of the amount of deposit liabilities the commercial bank owes to its customers. The commercial bank's reserves normally consist of cash owned by the bank and stored physically in the bank vault (vault cash), plus the amount of the commercial bank's balance in that bank's account with the central bank.

The required reserve ratio is sometimes used as a tool in monetary policy, influencing the country's borrowing and interest rates by changing the amount of funds available for banks to make loans with. Western central banks rarely increase the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they generally prefer to use open market operations (buying and selling government-issued bonds) to implement their monetary policy. The People's Bank of China uses changes in reserve requirements as an inflation-fighting tool, and raised the reserve requirement ten times in 2007 and eleven times since the beginning of 2010.

An institution that holds reserves in excess of the required amount is said to hold excess reserves.

United States House Committee on Financial Services

The United States House Committee on Financial Services, also referred to as the House Banking Committee and formerly known as the Committee on Banking and Currency, is the committee of the United States House of Representatives that oversees the entire financial services industry, including the securities, insurance, banking and housing industries. The Financial Services Committee also oversees the work of the Federal Reserve, the United States Department of the Treasury, the U.S. Securities and Exchange Commission and other financial services regulators. It is currently chaired by Democrat Maxine Waters from California. Waters was elected as chair of the committee, and assumed office on January 3, 2019.

Zero interest-rate policy

Zero interest-rate policy (ZIRP) is a macroeconomic concept describing conditions with a very low nominal interest rate, such as those in contemporary Japan and December 2008 through December 2015 in the United States. ZIRP is considered to be an unconventional monetary policy instrument and can be associated with slow economic growth, deflation, and deleverage.

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