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Monetary Policy and Central Banking

March 28, 2019

Central banks play a crucial role in ensuring economic and financial
stability. They conduct monetary policy to achieve low and stable
inflation. In the wake of the global financial crisis, central banks
have expanded their toolkits to deal with risks to financial stability
and to manage volatile exchange rates. Central banks need clear policy
frameworks to achieve their objectives. Operational processes tailored
to each country’s circumstances enhance the effectiveness of the
central banks’ policies. The IMF supports countries around the world by
providing policy advice and technical assistance.

Monetary policy

A key role of central banks is to conduct monetary policy to achieve price stability (low and stable inflation) and to help manage economic fluctuations. The policy frameworks within which central banks operate have been subject to major changes over recent decades.

Since the late 1980s, inflation targeting has emerged as the leading framework for monetary policy. Central banks in Canada, the euro area, the United Kingdom, New Zealand, and elsewhere have introduced an explicit inflation target. Many low-income countries are also making a transition from targeting a monetary aggregate (a measure of the volume of money in circulation) to an inflation targeting framework.

Central banks conduct monetary policy by adjusting the supply of money, generally through open market operations. For instance, a central bank may reduce the amount of money by selling government bonds under a “sale and repurchase” agreement, thereby taking in money from commercial banks. The purpose of such open market operations is to steer short-term interest rates, which in turn influence longer-term rates and overall economic activity. In many countries, especially low-income countries, the monetary transmission mechanism is not as effective as it is in advanced economies. Before moving from monetary to inflation targeting, countries should develop a framework to enable the central bank to target short-term interest rates (paper).

Following the global financial crisis, central banks in advanced economies eased monetary policy by reducing interest rates until short-term rates came close to zero, which limited the option to cut policy rates further (i.e., limited conventional monetary options). With the danger of deflation rising, central banks undertook unconventional monetary policies, including buying long-term bonds (especially in the United States, the United Kingdom, the euro area, and Japan) with the aim of further lowering long term rates and loosening monetary conditions (paper). Some central banks even took short-term rates below zero.

Foreign exchange regimes and policies

The choice of a monetary framework is closely linked to the choice of an exchange rate regime. A country that has a fixed exchange rate will have limited scope for an independent monetary policy compared with one that has a more flexible exchange rate. Although some countries do not fix the exchange rate, they still try to manage its level, which could involve a tradeoff with the objective of price stability. A fully flexible exchange rate regime supports an effective inflation targeting framework.

Macroprudential policy

The global financial crisis showed that countries need to contain risks to the financial system as a whole with dedicated financial policies. Many central banks that also have a mandate to promote financial stability have upgraded their financial stability functions, including by establishing macroprudential policy frameworks. Macroprudential policy needs a strong institutional foundation to work effectively. Central banks are well placed to conduct macroprudential policy because they have the capacity to analyze systemic risk. In addition, they are often relatively independent and autonomous. In many countries, legislators have assigned the macroprudential mandate to the central bank or to a dedicated committee within the central bank. Regardless of the model used to implement macroprudential policy, the institutional setup should be strong enough to counter opposition from the financial industry and political pressures and to establish the legitimacy and accountability of macroprudential policy. It needs to ensure that policymakers are given clear objectives and the necessary legal powers, and to foster cooperation on the part of other supervisory and regulatory agencies (see further Key Aspects of Macroprudential Policy). A dedicated policy process and is needed to operationalize this new policy function, by mapping an analysis of systemic vulnerabilities into macroprudential policy action (Staff Guidance Note on Macroprudential Policy).

How the IMF supports effective central bank frameworks

The IMF promotes effective central bank frameworks through multilateral surveillance, policy papers and research, bilateral dialogue with its member countries, and the collection of data for policy analysis and research.

The IMF has provided policy advice on how to avoid potential side effects from the implementation of and exit from unconventional monetary policy (paper), and established principles for evolving monetary policy regimes in low income countries (paper).

The Fund has also examined interactions between monetary and macroprudential policy (paper), and provided principles for the establishment of well-functioning macroprudential frameworks (guidance note).

The IMF is in regular dialogue with member country central banks through bilateral surveillance (Article IV consultation), FSAPs and technical assistance:

In its Article IV consultations, the IMF provides advice on monetary policy action to achieve low and stable inflation, as well as on establishing effective monetary policy and macroprudential policy frameworks.

The Financial Sector Assessment Program (FSAP) provides member countries with an evaluation of their financial systems and in-depth advice on policy frameworks to contain and manage financial stability risks, including the macroprudential policy framework, which is now often covered in dedicated technical notes (see for example Finland, Netherlands, and Romania).

Country programs supported by an IMF arrangement often include measures to strengthen monetary policy and central bank governance.

In order to inform policy development and research, the IMF is also engaged with its members to develop and maintain databases:

The IMF has for some time kept track of countries’ monetary policy arrangements (AREAER), as well as central banks’ legal frameworks (CBLD), and their monetary operations and instruments (MOID).

The IMF has recently launched a new annual survey of macroprudential measures and institutions. This survey will support IMF advice and policymakers around the world, by providing details on the design of macroprudential measures, and enabling comparisons across countries and over time

The IMF also compiled a comprehensive historical database of macroprudential measures (iMaPP) that integrates the latest survey information and allows for an assessment of the quantitative effects of macroprudential instruments (paper). This database is now being used by IMF economists to measure policy effects, and it is also available to researchers around the world.