Monetary Policy Term Paper

Monetary Policy

Benjamin M. Friedman

NBER Working Paper No. 8057
Issued in December 2000
NBER Program(s):Monetary Economics

Monetary policy is one of the two principal means (the other being fiscal policy) by which government authorities in a market economy regularly influence the pace and direction of overall economic activity, importantly including not only the level of aggregate output and employment but also the general rate at which prices rise or fall. The ability of central banks to carry out monetary policy stems from their monopoly position as suppliers of their own liabilities, which banks in turn need (either as legally required reserves or as balances for settling interbank claims) in order to create the money and credit used in everyday economic transactions. Important developments both in research and in the actual conduct of monetary policy in recent decades have revolved around the choice of a short-term interest rate versus a reserve quantity as the central bank's direct operating instrument, whether to use some measure of money as an intermediate target, whether to constrain the central bank to follow some fairly simple policy rule, what degree of political independence a central bank should have, and whether to target inflation. Some key areas of ongoing research in this area, as of the beginning of the 21st century, are whether the behavioral process by which monetary policy affects nonfinancial economic activity centers more on money or on credit, quantitative measurement of whatever is the mechanism at work, the trade-off between price inflation and real aspects of economic activity like output and employment, and just why it is that the public in most industrialized countries is as averse to inflation as is apparently the case.

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Document Object Identifier (DOI): 10.3386/w8057

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Monetary policy sets the upward limit of money in the form of cash, demand depots, time deposits, and equities allowed to circulate in the economy at large. It is the preserve of a central bank and can be used to either expand or contract economic activity. The goal in either case is to induce a macroeconomic change in output, national income, inflation or unemployment in both the short and near term. Over the last sixty years, the precepts and fundamentals of such major schools of economic thought as Keynesianism and Monetarism have entered into its formulation with limited success, occasioning a shift in recent years towards a far more pragmatic reliance on interest rates to achieve short-term goals.

Keywords Bank Reserves; Business Cycle; Central Bank; Contractionary Monetary Policy; Discount Rate; Expansionary Monetary Policy; Gross Domestic Product; Inflation; Keynesian Economic; Monetarism; Monetary Policy Targets; Money Supply; Moral Suasion; Open Market Operations

Economics: Monetary Policy


For every economic 'boom' there is an ensuing 'bust.' History is full of examples of pendulum-like swings in our collective fortunes. Indeed, expansions and contractions in national output and income have occurred with such regularity that economists consider them phases of a quasi-natural 'business cycle.' During the 'Roaring Twenties' and the 'Great Depression' of the 1930s, this cycle played itself out in extremis, raising fundamental questions about the desirability of unbridled, unregulated free-markets. Left to its own devices, the marketplace was perhaps not as ideal an engine of economic growth as earlier proponents claimed. How, though, can any one institution exert a moderating influence on what is essentially a set of daily transaction numbering in the trillions? A command economy where centralized authorities set both production quotas and prices certainly might. But wild swings aside, free markets' singular virtue — the efficient allocation of resources — would be sacrificed. Was this really worth the prolonged period of social, political and economic upheaval it would take to implement? Considering the comparatively modest outcomes being sought — more stable growth in productive capacity and national wealth — no. But how do we go about fine-tuning free markets without unduly constricting them?

The answer to this perplexing question lies in your wallet. Look closely at the face side of any bank note there; it is printed for all to see. Be it a $1, $5, $10, $20, $50 or $100, every dollar bill says it's a "Federal Reserve Note" that's 'legal tender for all debts, private and public.' Every pound sterling note tells citizens of the United Kingdom "The Bank of England promises to pay the bearer the sum of…." Euros offer a slightly more cryptic assurance in the form of the printed initials of the European Central Bank in five different languages — BCE, ECB, EZB, EKT and EKP — along with the signature of the bank's president. All those trillions of daily transactions entail an exchange of money. For that money to hold any value, its supply must be limited. If it isn't, everyone can readily obtain all they need and more and it becomes worthless as a medium of exchange. People in such circumstances will only part with goods or services for other goods or services. To acquire a new linen shirt, for example, you might have to give the weaver a bag of potatoes you grew. Whoever controls the amount of money circulating in a national economy thus affects its performance. And that would be its issuer; a central bank, like the Federal Reserve.

A central bank never expands or contracts the money supply without a reason. It may want to stimulate a sluggish economy, to cool off an overheating one, or to simply maintain a steady rate of growth at full employment. How it goes about this depends in turn on the macroeconomic theory a central bank subscribes to. These decisions, along with the economic reasoning behind them make up Monetary Policy. When the money stock is increased over a period of time, the central bank is said to be pursing an expansionary monetary policy; when it's decreased, a contractionary monetary policy. Even though it is vested with wide-ranging statutory powers, a central bank does so not as a regulator so much as a bank with enormous assets at its disposal.

Executing Monetary Policy

Exactly how does a central bank control the money supply in a modern economy? Well, for starts, unlike commercial banks, its national government is a central bank's major customer. All its receipts and disbursements go through demand deposit accounts there. Yearly cash inflows and outflows of hundreds of billions of dollars pass through these accounts, some of which can be temporarily held as short-term treasury bonds with the potential to be sold to cover future government payments if needs be. By law, what's more, every commercial bank must keep a percentage of its demand deposits in non-interest bearing accounts at the Central Bank. These 'required reserves' ensure that financial institutions will have the funds necessary to withdrawals during a so-called 'run' on the banks when customers fear their funds may disappear if a bank goes belly up. Central banks of other countries carry out foreign exchange transactions, buying their currencies when a surplus lowers its value against another currency too much or, conversely, selling their currencies when a shortage raises it too much.

Controlling the Money Supply

A central bank, then, has a considerable amount of capital to buy government securities with. Whenever it thinks a lessening of the money supply is warranted, a central bank can sell some of its bond holdings to commercial banks at below par. Since the purchase can be redeemed at par, commercial banks stand to profit and so buy the securities using funds it would otherwise loan out. With fewer loans tendered, the amount of new deposits made by borrowers shrinks, lowering the money supply.

To increase this supply, alternatively, it buys government securities from commercial banks above par. Enough institutions find this incentive a good reason to sell; the payout from this transaction can be loaned out to customers. They in turn deposit said funds, raising the money supply. Called open market operations, the funds earned never actually leave the Central Bank, for it credits commercial banks' reserve accounts when it buys bonds and debits it when it sells them. Any amount added to its reserves above its minimum requirements can be lent out. Any amount subtracted below this requirement must be offset by a deposit usually by the close of business.

Borrowing Practices of Banks

More often than not, banks borrow what they need to maintain their minimum reserve requirement either from other banks through the aegis of a central bank or else directly from it. In the former instance, the interest rate charged is set by supply and demand; in the latter it is set by the Central Bank and remains fixed until an increase or decrease is deemed appropriate (Arestis & Sawyer 2004). A higher fixed rate raises the costs of borrowing, a lower one decreases it. Commercial and inter-bank loan rates adjust accordingly as lenders seek to protect their profit margins. Called the discount rate in the U.S. and the bank rate in the U.K., doubts about its effectiveness have led many central banks in developed countries to use it sparingly.

This rate must be set below existing short-term interest rates to motivate banks to borrow from the Central Bank instead of open credit markets. If set too far below or above prevailing commercial rates, the credit markets suffer in general; auto, mortgage, and credit card lenders that fuel consumer spending suffer in particular. Having to go hat-in-hand to a central bank for a loan, moreover, carries with it a certain stigma, so most banks refrain from doing so unless they have no other option. Given the size and liquidity of modern day credit markets, they typically don't, so the discount rate these days serves a more limited but still vital role as a backstop for banks suffering acute liquidity problems.

Reserve Requirements

A central bank, finally, can always raise or lower the commercial banks' reserve requirements (Handa, 2000). A powerful instrument of monetary policy, any such change is also the bluntest such instrument. For, a very small percentage increase or decrease here translates into very large sums of loanable funds, so any upward or downward movement has sudden and far-reaching economic consequences. It's also a fairly dramatic move; one that signals the potential seriousness of current conditions to financial markets driven by expectations of future events. Central banks in countries with stable, well-developed banking systems therefore tend to use it very sparingly.


Objectives of Monetary Policy

Monetary policy always has a short-term and a near-term objective. In the best of economic times, they're one in the same: Maintain steady growth in output, low inflation and full employment. In worsening times, they typically differ: Either stimulate further growth in output, or control rising inflation or reduce unemployment. Here, the decision might be made to reign in spiraling prices in the near-term but add payroll jobs to the economy in the far-term. Or, it could be same priorities in reverse order. Equally, another objective all together, such as increasing output by encouraging investments in labor-saving technologies, might be pursued instead....

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