Policy of interest rates or money supply
Monetary policy is the policy adopted by the monetary authority of a nation to affect monetary and other financial conditions to accomplish broader objectives like high employment and price stability (normally interpreted as a low and stable rate of inflation). Further purposes of a monetary policy may be to contribute to economic stability or to maintain predictable exchange rates with other currencies. Today most central banks in developed countries conduct their monetary policy within an inflation targeting framework, whereas the monetary policies of most developing countries' central banks target some kind of a fixed exchange rate system. A third monetary policy strategy, targeting the money supply, was widely followed during the 1980s, but has diminished in popularity since then, though it is still the official strategy in a number of emerging economies.
The tools of monetary policy vary from central bank to central bank, depending on the country's stage of development, institutional structure, tradition and political system. Interest-rate targeting is generally the primary tool, being obtained either directly via administratively changing the central bank's own interest rates or indirectly via open market operations. Interest rates affect general economic activity and consequently employment and inflation via a number of different channels, known collectively as the monetary transmission mechanism, and are also an important determinant of the exchange rate. Other policy tools include communication strategies like forward guidance and in some countries the setting of reserve requirements. Monetary policy is often referred to as being either expansionary (stimulating economic activity and consequently employment and inflation) or contractionary (dampening economic activity, hence decreasing employment and inflation).
Monetary policy affects the economy through financial channels like interest rates, exchange rates and prices of financial assets. This is in contrast to fiscal policy, which relies on changes in taxation and government spending as methods for a government to manage business cycle phenomena such as recessions. In developed countries, monetary policy is generally formed separately from fiscal policy, modern central banks in developed economies being independent of direct government control and directives.
How best to conduct monetary policy is an active and debated research area, drawing on fields like monetary economics as well as other subfields within macroeconomics.
History.
Issuing coin.
Monetary policy has evolved over the centuries, along with the development of a money economy. Historians, economists, anthropologists and numismatics do not agree on the origins of money. In the West the common point of view is that coins were first used in ancient Lydia in the 8th century BCE, whereas some date the origins to ancient China. The earliest predecessors to monetary policy seem to be those of debasement, where the government would melt coins down and mix them with cheaper metals. The practice was widespread in the late Roman Empire, but reached its perfection in western Europe in the late Middle Ages.
For many centuries there were only two forms of monetary policy: altering coinage or the printing of paper money. 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 considered as an executive decision, and was generally implemented by the authority with seigniorage (the power to coin). With the advent of larger trading networks came the ability to define the currency value in terms of gold or silver, and the price of the local currency in terms of foreign currencies. This official price could be enforced by law, even if it varied from the market price.
Paper money originated from promissory notes termed "jiaozi" in 7th-century China. Jiaozi did not replace metallic currency, and were used alongside the copper coins. The succeeding 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 maintain their rule, they began printing paper money without restrictions, resulting in hyperinflation.
Central banks and the gold standard.
With the creation of the Bank of England in 1694, which was granted the authority to print notes backed by gold, the idea of monetary policy as independent of executive action began to be established. The purpose 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. During the period 1870–1920, the industrialized nations established central banking systems, with one of the last being the Federal Reserve in 1913. By this time the role of the central bank as the "lender of last resort" was established. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of appreciation for the marginal revolution in economics, which demonstrated that people would change their decisions based on changes in their opportunity costs.
The establishment of national banks by industrializing nations was associated then with the desire to maintain the currency's relationship to the gold standard, and to trade in a narrow currency 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 which required money for liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates.
The gold standard is a system by which the price of the national currency is fixed vis-a-vis the value of gold, 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. However, the policies required to maintain the gold standard might be harmful to employment and general economic activity and probably exacerbated the Great Depression in the 1930s in many countries, leading eventually to the demise of the gold standards and efforts to create a more adequate monetary framework internationally after World War II. Nowadays the gold standard is no longer used by any country.
Fixed exchange rates prevailing.
In 1944, the Bretton Woods system was established, which created the International Monetary Fund and introduced a fixed exchange rate system linking the currencies of most industrialized nations to the US dollar, which as the only currency in the system would be directly convertible to gold. During the following decades the system secured stable exchange rates internationally, but the system broke down during the 1970s when the dollar increasingly came to be viewed as overvalued. In 1971, the dollar's convertibility into gold was suspended. Attempts to revive the fixed exchange rates failed, and by 1973 the major currencies began to float against each other. In Europe, various attempts were made to establish a regional fixed exchange rate system via the European Monetary System, leading eventually to the Economic and Monetary Union of the European Union and the introduction of the currency euro.
Money supply targets.
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 production. Later he advocated simply increasing the monetary supply at a low, constant rate, as the best way of maintaining low inflation and stable production growth. During the 1970s inflation rose in many countries caused by the 1970s energy crisis, and several central banks turned to a money supply target in an attempt to reduce inflation. 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 unstable relationship between monetary aggregates and other macroeconomic variables, and similar results prevailed in other countries. Even Milton Friedman later acknowledged that direct money supplying was less successful than he had hoped.
Inflation targeting.
In 1990, New Zealand as the first country ever adopted an official inflation target as the basis of its monetary policy. The idea is that the central bank tries to adjust interest rates in order to steer the country's inflation rate towards the official target instead of following indirect objectives like exchange rate stability or money supply growth, the purpose of which is normally also ultimately to obtain low and stable inflation. The strategy was generally considered to work well, and central banks in most developed countries have over the years adapted a similar strategy.
The Global Financial Crisis of 2008 sparked controversy over the use and flexibility of the inflation targeting employed. Many economists argued that the actual inflation targets decided upon were 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.
As of 2023, the central banks of all G7 member countries can be said to follow an inflation target, including the European Central Bank and the Federal Reserve, who have adopted the main elements of inflation targeting without officially calling themselves inflation targeters. In emerging countries fixed exchange rate regimes are still the most common monetary policy.
Monetary policy instruments.
The instruments available to central banks for conducting monetary policy vary from country to country, depending on the country's stage of development, institutional structure and political system. The main monetary policy instruments available to central banks are interest rate policy, i.e. setting (administered) interest rates directly, open market operations, forward guidance and other communication activities, bank reserve requirements, and re-lending and re-discount (including using the term repurchase market). While capital adequacy is important, it is defined and regulated by the Bank for International Settlements, and central banks in practice generally do not apply stricter rules.
Expansionary policy occurs when a monetary authority uses its instruments to stimulate the economy. An expansionary policy decreases short-term interest rates, affecting broader financial conditions to encourage spending on goods and services, in turn leading to increased employment. By affecting the exchange rate, it may also stimulate net export. Contractionary policy works in the opposite direction: Increasing interest rates will depress borrowing and spending by consumers and businesses, dampening inflationary pressure in the economy together with employment.
Key interest rates.
For most central banks in advanced economies, their main monetary policy instrument is a short-term interest rate. For monetary policy frameworks operating under an exchange rate anchor, adjusting interest rates are, together with direct intervention in the foreign exchange market (i.e. open market operations), important tools to maintain the desired exchange rate. For central banks targeting inflation directly, adjusting interest rates are crucial for the monetary transmission mechanism which ultimately affects inflation. Changes in the central bank policy rates normally affect the interest rates that banks and other lenders charge on loans to firms and households.
Higher interest rates reduce inflation by reducing aggregate consumption of goods and services by several causal paths. Higher borrowing costs can cause a cash shortage for companies, which then reduce direct spending on goods and services to reduce costs. They also tend to reduce spending on labor, which in turn reduces household income and then household spending on goods and services. Interest rate changes also affect asset prices like stock prices and house prices. Though unless they are selling or taking out new loans their cash flow is unaffected, asset owners feel less wealthy (the wealth effect) and reduce spending.
Rising interest rates also have smaller secondary effects, which decrease supply and tend to increase inflation (or cause it to decrease more slowly than it otherwise would. On the individual side, rising mortgage rates disincentivize wealthy homeowners from downsizing or moving to a new home if they have an existing mortgage that is locked in at a low fixed rate. On the business side, lower investment and spending may result in lower supply of new homes and other goods and services.
Firms experiencing high borrowing costs are also less willing or able to borrow or spend money on investment in new or expanding business. International interest rate differentials also affect exchange rates, and consequently exports and imports. Consumption, investment, and net exports are all important components of aggregate demand. Stimulating or suppressing the overall demand for goods and services in the economy will tend to increase respectively diminish inflation.
The concrete implementation mechanism used to adjust short-term interest rates differs from central