Monetary Policy

Elements of monetary policy

Evolution of objectives

Conflicts of objectives

Monetary policy and aggregate demand

Lags in monetary policy

Monetary and fiscal policies

BIBLIOGRAPHY

In its broadest sense, monetary policy includes all actions of governments, central banks, and other public authorities that influence the quantity of money and bank credit. It therefore embraces policies relating to such things as choice of the nation’s monetary standard; determination of the value of the monetary unit in terms of a metal or foreign currencies; determination of the types and amounts of the government’s own monetary issues; establishment of a central banking system and determination of its powers and rules for its operation; and policies concerning the establishment and regulation of commercial banks and other related financial institutions. A few even extend the meaning of monetary policy to include official actions affecting not only the quantity of money but also its rate of expenditure, thus embracing government tax, expenditure, lending, and debt management policies.

It has become customary, however, to define monetary policy in a more restricted sense and to exclude from it choices relating to the broad legal and institutional framework of the monetary and banking system. This narrower concept will be employed here. Monetary policy in this sense refers to regulation of the supply of money and bank credit for the promotion of selected objectives.

Elements of monetary policy

Like all economic policies, monetary policy has three interrelated elements: selection of objectives, implementation, and at least an implicit theory of the relationships between actions and effects. All three elements present problems of choice and are continuing subjects of controversy.

Monetary policy can be directed toward achieving many different objectives. For example, the supply of money can be regulated to provide the government with cheap or even costless funds, to maintain interest rates at some selected level, to regulate the exchange rate on the nation’s currency, to protect the nation’s gold and other international reserves, to stabilize domestic price levels, to promote continuously high levels of employment, and so on. Such multiple objectives are unlikely to be fully compatible at all times. Rational policy making therefore requires identification of the various objectives, analysis of the extent to which they are or can be made compatible, and choices from among those that conflict with one another. A later section will stress changes in the objectives of monetary policy and some of the problems of reconciling them.

The role played by monetary policy in promoting selected economic objectives depends greatly on the nature of the economic system and on attitudes toward the use of other methods of regulation. This role is usually secondary in economies characterized by government operation of most economic enterprises and government control of resource allocation, distribution of output, and prices of in-puts and outputs. Even in these economies monetary policy is not trivial. An excessive supply of money can create excessive demand and inflationary pressures, which are evidenced in black markets, hoarding, and bare shelves. On the other hand, a deficient supply of money can impede the flow of production and trade. Yet the major function of monetary policy in such economies is that of passive accommodation, that is, to provide the amount of money needed to facilitate the operation of other government controls; it is not to serve as a prime regulator.

Monetary policy usually plays a more positive regulatory role in economic systems that rely heavily on market forces to organize and direct processes of production and distribution. In such economies, decisions of business firms relating to rates of output, amounts of labor employed, rates of capital formation, and so on, are strongly influenced by relationships between costs and actual and prospective demands for output. If aggregate demands are deficient, firms will not find it profitable to employ all available labor, to utilize fully existing capacity, or to purchase all the new capital goods that could be produced. On the other hand, excessive aggregate demands for output are inflationary. A major function of monetary policy, therefore, is to regulate the behavior of aggregate demand for output in order to elicit a more favorable performance by the economy. This function is shared with fiscal policy in many countries and in many different combinations or “mixes.” Although the deliberate use of fiscal policy for this purpose has increased considerably in recent decades, monetary policy continues to be a major instrument.

Primary responsibility for administering monetary policies is usually entrusted to central banks, although there are varying degrees of government control of central banks and their policies. Central banks regulate the money supply and influence the supply of credit in two principal separate but closely related capacities: as controllers of their own issues of money and as regulators of the amount of money created by commercial banks. Both are important, but their relative importance depends in part on the stage of financial development of the country and on the types of money employed. In countries where bank deposits have not yet come to be widely used, notes issued by the central bank often constitute a major part of the money supply. In such cases the central bank may regulate the money supply largely by controlling directly its own note issues. However, in countries that have reached a later stage of financial development, central bank notes constitute a smaller part of the money supply; deposits at commercial banks are the major component, and the actions of commercial banks directly account for a large part of the fluctuations of the money supply. In such countries, the central bank is primarily a regulator of the commercial banks, although control of its own money creation remains important and is a part of the process.

The terms “monetary policy” and “credit policy” are often used interchangeably or with only slightly different shades of meaning. This has come about primarily because in most modern systems the creation and destruction of money by central and commercial banks are so closely intertwined with their expansion and contraction of credit. They typically create and issue money (currency and deposits) by making loans or purchasing securities, usually debt obligations. Thus, one side of the transaction is the issue of money; the other is the provision of funds to borrowers or sellers of securities, which tends to lower interest rates. Central and commercial banks typically withdraw money (currency and deposits) by decreasing their outstanding loans or by selling securities, usually debt obligations. Thus there is both a decrease in the supply of money and a decrease in the funds available to borrowers and to purchasers of the securities sold by the banks, which tends to increase interest rates.

Those who speak of monetary policy tend to focus on the behavior of the stock of money, while those who speak of credit policy tend to focus on the quantity of loan funds available from the central and commercial banks. Such differences in focus need not lead to differences in either analysis or conclusions. Yet they sometimes do. Those who focus on the stock of money are more likely to stress “real balance effects” on both consumption and investment spending, while those who focus on credit are likely to put more stress on the direct effects on interest rates, the availability of funds, and investment. Monetary theory has made considerable progress in reconciling and integrating these approaches, but much remains to be done.

The third element in monetary policy is at least an implicit theory of the relationships between actions and effects. If its actions are to promote its objectives, the monetary authority needs some theory as to the nature, direction, magnitude, and timing of the responses. The relevant responses are numerous and on several levels. For example, they include the response of the supply of money and credit; the response of aggregate demand for output; and the responses of real output, employment, and prices. There are still disagreements among both economists and central bankers on many of these theoretical and empirical issues, and these disagreements underlie many continuing controversies over the proper nature and scope of monetary policy. Some of these will be treated in a later section.

Evolution of objectives

Monetary policy, in the modern sense of deliberate and continuous management of the money supply to promote selected social and economic objectives, is largely a product of the twentieth century, especially the decades since World War i. In the earlier period, when most countries were on either a gold or a bimetallic standard, the primary and overriding objective of monetary policy was to maintain redeemability of the nation’s money in the primary metal, both domestically and internationally. A decline of the nation’s metallic reserves to dangerously low levels, or any other threat to redeemability, became a signal for monetary and credit restriction, whatever might be its other economic effects. When redeemability seemed secure, monetary policy was used to promote other objectives—to deal with panics, crises, and other credit stringencies and even to expand money somewhat when business was depressed. But such intervention was sporadic rather than continuous and its purposes limited rather than ambitious. The international gold standard of the pre-1914 period was not purely automatic, but it was managed only marginally.

Many forces have contributed to the change and growth of monetary policy since World War i. One set of forces includes the breakdown of the international gold standard and other changes and crises in monetary systems—inflation during and following World War I and the long period of suspension of gold redeemability in most countries, the changed and insecure nature of the gold and gold exchange standards re-established in the 1920s, the renewed breakdown of gold standards during the great depression of the 1930s, and world-wide inflation during and following World War n. All these had profound effects on attitudes toward monetary policy. Both countries that had too little gold and those that had too much shifted to the view that the state of their gold reserves was no longer an adequate guide to policy and that new objectives and guides should be developed. Monetary actions became increasingly less sporadic and limited and more continuous and ambitious in scope.

The objectives of monetary policy have also been powerfully influenced by changes in attitudes concerning the responsibilities of central banks and governments for the performance of the economy. The 1920s witnessed growing demands that some central agency reduce instability of price levels and business activity. These demands were strengthened immeasurably by the economic catastrophe of the 1930s and by fears that World War n would be followed by another world-wide depression. Within a few years after that war the governments of almost all Western nations had formally assumed responsibility for promoting continuously high levels of employment and output. And within a few more years almost all of these governments had signified their intentions to promote economic growth. Monetary policy is required, in some cases by government and in others by the force of public opinion and pressure, to contribute to such objectives.

Although often phrased in different terms, it is now common for monetary authorities to state four major or basic objectives of monetary policy: (1) continuously high levels of employment and output, (2) the highest sustainable rate of economic growth, (3) relatively stable domestic price levels, and (4) maintenance of a stable exchange rate for the nation’s currency and protection of its international reserve position. In some countries monetary policy is also influenced by other considerations, such as a desire to maintain low interest rates to facilitate government finance or other favored types of economic activity.

Conflicts of objectives

Some of the most basic problems of monetary policy relate to the compatibility of such multiple objectives. Can all these be achieved simultaneously and to an acceptable degree even if a nation has precise control of the behavior of aggregate demand for output? Of course, the answer depends in part on the ambitiousness of the goals; perfection in all respects is hardly to be expected.

The answer also depends to an important extent on the responses of output, employment, money wage rates, and prices to changes in aggregate demand. The most favorable case is that in which the supply of output is completely elastic at existing price levels up to the point of “full employment” and capacity output. In such cases, increases of demand would elicit only increases in output until the economy reached its maximum capacity to produce. Price inflation would appear only when demand became excessive relative to productive capacity.

Problems of reconciling objectives relating to output, employment, and price level stability arise, however, when the supply of output does not respond in such a favorable manner to increases of demand—when prices rise before the economy has neared its capacity to produce. Even in the face of considerable amounts of unemployment, average money wage rates may rise faster than average output per man-hour, thereby tending to raise costs of production. And for this, or other reasons, business firms may raise the prices of their products even though considerable amounts of excess capacity persist. Under such conditions it may be impossible to achieve all objectives, to acceptable degrees, solely by controlling aggregate demand. Levels of demand sufficient to elicit “full employment” and capacity output may bring inflation, while levels of demand low enough to assure stability of price levels may leave large amounts of unemployment and unused capacity.

Because of such difficulties, many economists and other observers have come to believe that objectives relating to output, employment, and price levels can be reconciled satisfactorily only if regulation of aggregate demand through monetary and fiscal policies is supplemented by measures designed to elicit more favorable responses by the economy. These measures are of several types, which can only be listed here: (1) reform of wage-making processes in order to avoid inflationary increases of money wage rates, (2) decrease of monopoly power in industry, and (3) increase of regional and occupational mobility of labor.

The above discussion related to possible conflicts among a nation’s multiple domestic objectives. One, or more, of these domestic objectives may also conflict with the nation’s international objectives of maintaining a stable exchange rate for its currency and of protecting its international reserve position. Fortunately, domestic and international objectives do not always conflict. For example, a nation may have a deficit in its balance of payments primarily because of excessive domestic demands and rising prices. In such cases, restrictive monetary policies may be appropriate for both domestic and international reasons. On the other hand, a nation may have a surplus in its balance of payments primarily because of unemployment and depressed output and incomes at home, which depress its demands for imports. In this case an expansionary monetary policy will promote both its domestic and international objectives.

Cases do arise, however, in which domestic objectives and the objectives of maintaining stable exchange rates and a balance in international payments come into conflict. For example, a nation may have a large and persistent surplus in its balance of payments while demands for its output are so large as to bring actual or threatened inflation. An expansionary monetary policy, aimed at reducing the surplus in its balance of payments, would increase inflationary pressures at home; while a restrictive policy, aimed at inhibiting domestic inflation, would continue, and perhaps even increase, the surplus in its balance of payments. A nation faced with this situation may be compelled to sacrifice its domestic objective of preventing inflation or to increase the exchange rate on its currency in order to decrease the value of its exports relative to its imports.

Considered by most countries to be even more serious is the situation in which there is a large and persistent deficit in the balance of payments combined with actual or threatened excess unemployment at home. Employing expansionary monetary and fiscal policies to increase domestic demand and eradicate excess unemployment would tend to widen the deficit in the nation’s balance of payments and to drain away its international reserves. But employing restrictive policies to eradicate the deficit in its balance of payments would increase unemployment at home. The nation may be forced to sacrifice its domestic objectives relating to employment, output, and growth or to lower the exchange rate on its currency.

Because of such conflicts, many economists have become critical of arrangements under which ex-change rates remain fixed over long periods of time. They see little merit in stable exchange rates as such and would alter them whenever they conflict with important economic objectives. However, their prescriptions vary widely. For example, some favor stability of exchange rates most of the time with adjustments only in case of “fundamental disequilibrium.” Others favor continuously flexible exchange rates, with or without official intervention to influence their behavior. The entire field of ex-change rate policy remains highly controversial. [SeeInternational monetary economics, article Onexchange rates.]

Monetary policy and aggregate demand

The preceding sections dealt with some of the problems that would be encountered in promoting multiple economic objectives simultaneously, even if the monetary authority possessed precise control over the behavior of aggregate demand for output. But it is unsafe to assume without analysis that the monetary authority, or even the monetary authority together with the fiscal authorities, can control aggregate demand precisely. The monetary authority has no direct control over aggregate demand for output or over any of its major components, such as demands for consumption, for investment or capital formation, for government use, or for export. Its powers are largely confined to regulation of the supply of money and credit. Even at this level its controls may lack precision. Presumably the central bank can accurately control its own creation and destruction of money; but its control of the creation and destruction of money and credit by the commercial banking system, exercised largely through its control over the reserve position of the banks, may be less accurate. And even if the monetary authority has precise control of the money supply, aggregate demand for output may not respond in a uniform or precisely predictable manner; the income velocity, or rate of expenditure, of money may fluctuate. Thus there are many links in the chain of causation from central bank action to the reaction of aggregate demand and many possibilities of slippage.

The effectiveness of monetary policy as a regulator of aggregate demand does not depend on the existence of some fixed relationship between the supply of money and aggregate demand. It requires only that changes in the money supply influence aggregate demand in the desired direction and in a predictable way and that the monetary authority have power to change the money supply to the extent required to offset adverse variations in the income velocity of money. However, the possibility of control of aggregate demand does suffer to the extent that changes in money supply fail to affect aggregate demand, that the power of the monetary authority to change the money supply is limited, and that the relationship between the money supply and aggregate demand is unpredictable.

Few economists doubt the ability of monetary policy, in the absence of strong cyclical forces, to regulate effectively the secular behavior of both the money supply and aggregate demand for output. Secular changes in the velocity of money are usually gradual and can be allowed for in determining the appropriate rate of change of the money supply. There is much less agreement, however, concerning the effectiveness of monetary policy alone for offsetting cyclical forces and stabilizing aggregate demand over the various phases of the business cycle.

Monetary policy meets its most severe test in dealing with the strong forces that cause recessions or depressions. Consider the extreme case in which an economy has slipped into a severe depression with widespread unemployment and unused capacity. Under such conditions businessmen are likely to view the future pessimistically and to see few opportunities for investment in capital facilities that promise favorable rates of return. Their demand functions for output to be used for capital formation may be so low that only extremely low interest—rates, perhaps rates approaching zero, would induce them to invest enough to lift the economy back toward full-employment levels.

But monetary policy may be incapable of depressing interest rates, and especially long-term rates, to such low levels. The monetary authority may encounter difficulties in increasing the money supply under such conditions because the banks prefer to hold excess reserves rather than lend and take risks. Interest rates, and especially long-term rates, may fall only sluggishly, even in the face of large increases in the money supply. One reason for this is the fear of default by borrowers under depression conditions. John Maynard Keynes suggested another reason—his famous “liquidity trap.” He argued that there was some long-term rate of interest, not far below that previously prevailing, that the public considered “normal,” in the sense that it would again prevail. No one would hold securities at lower yields because of fear of capital losses when interest rates returned to their normal levels. Below this normal rate the public would increase its holdings of money balances indefinitely rather than lend at a lower rate.

Thus monetary policy may be incapable of lowering interest rates enough to offset the decline of investment demand functions, and recovery may be delayed until something increases the expected profitability of private investment or until the government adopts expansionary fiscal policies.

In how many cases would a well-conceived and well-executed monetary policy prove incapable of dealing with depressive forces? On this there is still lack of agreement among economists. Some have argued that experience during the great depression proved the ineffectiveness of monetary policy. This experience is hardly relevant to the present question, however, because the monetary policies of that period were hardly exemplary. To protect gold standards or for other reasons, many countries actually followed deflationary monetary policies for a considerable period. Expansionary policies were in many cases initiated only after a long delay, during which excess capacity had be-come widespread, expectations had deteriorated, and the entire financial system had come under serious strain. It may well be that in this and other recessions an ambitious expansionary monetary policy introduced promptly after the downturn would have proved effective in arresting the decline of aggregate demand. However, many economists—including some who are optimists about the effectiveness of monetary policy—believe that monetary policy alone may not be potent enough to offset strong depressive forces and that expansionary fiscal policies should also be employed under such conditions.

It is generally conceded that well-conceived monetary policies can be more effective in restricting increases in aggregate demand during the prosperity phases of business cycles. However, such prosperity periods are usually characterized by increases in aggregate demand relative to the money supply. This increase in the income velocity of money, or “economizing of money balances relative to expenditures,” reflects several forces that usually accompany prosperity—greater optimism on the part of both households and business firms concerning their future receipts of income, which decreases the amounts of money held against contingencies; more profitable opportunities for investing idle balances held by business firms; and rising interest rates. Theorists have tended to stress, perhaps to overstress, the role played by rising interest rates. The rise of investment demand during prosperity tends to raise interest rates, and the rise of rates is accentuated by a restrictive monetary policy. In turn, the availability of higher yields on other assets induces both business firms and households to economize their holdings of money balances that yield no interest.

Such increases of velocity—induced in part, but only in part, by restrictive monetary policy—do constitute a slippage in the operation of monetary policy. This does not mean that monetary policy is rendered ineffective; it means only that larger restrictive actions are required to achieve any specified amount of restriction of aggregate demand. Of course, the monetary authority may be unable or unwilling to restrict money to the required extent. For example, it may be inhibited by inadequacy of the control instruments currently at its disposal, fear that further restriction would precipitate a recession, dislike of high interest rates, or charges that credit restriction discriminates against both new and small business firms. However, these are not limitations on the capability of monetary policy to restrict aggregate demand. They are only considerations affecting the willingness of the monetary authority to use its powers of restriction.

Lags in monetary policy

The effectiveness of monetary policy as a countercyclical instrument depends heavily on the quickness of policy action and the quickness of response of the economy. Ideally, policy actions would be taken as soon as adverse developments appeared, or even in anticipation of such developments; and there would be an immediate and full response of aggregate demand and of such policy objectives as employment and output. Under such ideal conditions a high degree of stability might be maintained continuously. In practice, of course, such ideal performance is not realized. Economists have long recognized three lags in monetary policy: (1) the recognition lag—the interval between the time when a need for action develops and the time the need is recognized; (2) the administrative lag—the interval between recognition and the actual policy action; and (3) the operational lag—the interval between policy action and the time that the policy objectives, such as output and employment, respond fully.

Both the length and significance of these lags depend heavily on the reliability of economic forecasting. If developments could be reliably forecast well in advance, the first two lags could be eliminated and actions could be taken soon enough to allow for the operational lag. But when economic forecasting is unreliable the monetary authority is likely to wait until a development appears before taking action to deal with it. In such cases the length of the operational lag becomes highly important for countercyclical policy. Those who favor flexible countercyclical monetary policies implicitly assume that the operational lag is rather short, that all or most of the effects of a monetary action will be achieved within a few months or a year. [See Prediction and forecasting, economic.]

This view has been challenged by some economists, notably by Milton Friedman. These economists contend that the responses to a given monetary action are distributed over time and that the full effects are realized only after a lag of considerably more than a year. Because of this, monetary actions taken to counter cyclical fluctuations may actually produce, or at least accentuate, these fluctuations. For example, expansionary policy actions taken to counter recession may have little effect for several months and then achieve their full expansionary effects on aggregate demand only when the economy is in its next boom phase. And actions taken to restrict aggregate demand during a boom may in fact precipitate and accentuate an ensuing depression.

For this and other reasons, members of this school oppose flexible countercyclical monetary policies. They believe that a greater degree of stability will be achieved by a monetary policy aimed at a steady growth of the money supply, regardless of cyclical conditions. This growth should be at an annual rate approximating the growth rate of real gross national product.

This whole question, which is obviously crucial for countercyclical monetary policy, remains unresolved and controversial. Friedman’s theoretical and statistical arguments have been strongly challenged but not wholly refuted. Much more research is needed on both the magnitude and timing of responses to monetary policy actions. The same applies to the various types of fiscal policy actions.

Monetary and fiscal policies

Nations face complex problems in determining the relative roles to be played by monetary policies and by the various types of government expenditure and tax policies in promoting the economic objectives described earlier. Only a few of the considerations determining these relative roles can be mentioned here. One is, of course, the whole set of cultural, institutional, and political conditions determining the actual availability of these policy instruments. For example, in some countries it is in fact acceptable to use government tax and expenditure policies in a timely and flexible manner. Other governments are not yet in this position. Still others may find it possible to reduce taxes or increase expenditures to support aggregate demand but not to restrict it by fiscal measures. There can also be comparable differences in the actual availability of monetary policy instruments.

Also relevant are judgments concerning the relative effectiveness of monetary and fiscal policies in achieving some desired behavior of aggregate demand. For example, an expansionary fiscal policy may be judged to be necessary to promote quick recovery from depression conditions but to be no more effective than monetary policy in restricting increases of demand.

The optimum mix of monetary and fiscal policies also depends in part on the nature of economic objectives and on their relative priorities. Suppose that it is possible to achieve some selected level of aggregate demand with various combinations of monetary and fiscal policies—with, say, some restrictive fiscal policy and some expansionary monetary policy or with some expansionary fiscal policy and some restrictive monetary policy. This level of aggregate demand can reflect various combinations of consumption and capital formation. If the objective is only to achieve some selected level of total output and employment, without regard to the distribution of output between consumption and capital formation, many different combinations of monetary and fiscal policies may be equally acceptable. But this may cease to be true if promotion of economic growth through a higher rate of capital formation is also an objective. For this purpose a restrictive fiscal policy and an easy monetary policy may be most appropriate. Large taxes relative to government expenditures for current purposes can be used to force the nation to consume a smaller part, and to save a larger part, of its total income; and an easy monetary policy, instituted to lower interest rates, can encourage the use of savings for capital formation.

A somewhat different case is that in which a nation wishes to raise aggregate demand for its output while it faces an undesired deficit in its balance of payments. Both expansionary fiscal policies and expansionary monetary policies tend to increase the deficit in the balance of payments to the extent that they succeed in raising aggregate demand, which in turn increases imports. But an expansionary monetary policy, which lowers interest rates, will also tend to increase capital outflows or at least to reduce capital inflows. In such a situation, an optimum policy mix may require more expansionary fiscal policies to raise domestic demand, together with a less expansionary monetary policy to support interest rates and attract capital inflows or at least to retard capital outflows.

These are but a few of the many considerations that determine the relative roles of monetary and fiscal policies. These relative roles have changed markedly in recent decades and are likely to continue to change with changes in the nature and relative priorities of economic objectives, with changes in attitudes toward the flexible use of fiscal policies for stabilization purposes, and with changes in our knowledge concerning the magnitudes and timing of responses to various types of both monetary and fiscal actions.

Lester V. Chandler

[See alsoFiscal policyand Money.]

BIBLIOGRAPHY

Commission on Money and Credit 1961 Money and Credit: Their Influence on Jobs, Prices and Growth. Englewood Cliffs, N.J.: Prentice-Hall.

Culbertson, J. M. 1960 Friedman on the Lag in Effect of Monetary Policy. Journal of Political Economy 68: 617–621.

Culbertson, J. M. 1961 The Lag in Effect of Monetary Policy: Reply. Journal of Political Economy 69:467–477.

Friedman, Milton 1961 The Lag in Effect of Monetary Policy. Journal of Political Economy 69:447–466.

Great Britain, Committee on the Working of the Monetary System 1959 Report. Papers by Command, Cmnd. 827. London: H. M. Stationery Office. → Known as the Radcliffe Report.

Scammell, W. M. (1957) 1962 International Monetary Policy. 2d ed. London: Macmillan; New York: St. Martins.

Yeager, Leland B. (editor) 1962 In Search of a Monetary Constitution. Cambridge, Mass.: Harvard Univ. Press.

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Policy, Monetary

A FEW BASICS

THE CENTRAL BANK

CONTROLLING MONEY, CREDIT, AND INTEREST RATES

MONETARY POLICY OBJECTIVES

THE POLICY FRAMEWORK

THE FUTURE OF MONEY AND MONETARY POLICY

BIBLIOGRAPHY

Monetary policy is the management of money, credit, and interest rates by a country’s central bank. Unfortunately, this short definition is clearly inadequate. What is money? What is credit? What is an interest rate? What is a central bank and how does it control them? And, most importantly, why should anyone care? The purpose of this entry is to answer these questions (for more detail, see the relevant chapters of Stephen G. Cecchetti [2006]).

A FEW BASICS

Money is an asset that is generally accepted as payment for goods and services or repayment of debt; money acts as a unit of account, and serves as a store of value. That is, people use money to pay for things (it is a means of payment); quote prices in dollars, euros, yen, or the units of our currency (it is a unit of account); and use money to move purchasing power over time (it is a store of value). Credit is the borrowing and lending of resources. Some people have more resources than they currently need (they are savers) while others have profitable opportunities that they cannot fund (they are investors). Credit flows from the savers to the investors. And an interest rate is the cost of borrowing and the reward for lending. Since lenders could have done something else with their resources, they require compensation—interest is rent paid by borrowers.

THE CENTRAL BANK

The U.S. Federal Reserve System, the Bank of Japan, and the Bank of England are all central banks. Nearly every country in the world has a central bank. It is easiest to understand a central bank by looking at what it does (for a history of money and central banks, see Glyn Davies [2002]). A modern central bank both provides an array of services to commercial banks (it is the bankers’ bank) and manages the government’s finances (it is the government’s bank). While not universally true, we will assume that only banks and governments have accounts at central banks. As the bank for bankers, the central bank holds deposit accounts and operates a system for interbank payments that enables commercial banks (the ones the public uses) to transfer balances in these accounts to one another. The central bank is also in a unique position to provide loans to commercial banks during times of crisis—more on this shortly.

Like any individual or business, the government needs a bank to make and receive payments. So, the central bank keeps an account for the government. When the government wants to make or receive a payment, it needs a bank just like the rest of us. The central bank does that job. In addition, the government gives the central bank the right to print money—that is the paper currency that people use in everyday life.

At its most basic level, printing money is a very profitable business. A $100 bill costs only a few cents to print, but it can be exchanged for $100 worth of goods and services. It is logical then that national governments create a monopoly on printing money and use the revenue it generates to benefit the general public. Also, government officials know that losing control of the money printing presses means losing control of inflation.

CONTROLLING MONEY, CREDIT, AND INTEREST RATES

The fact that the central bank has the license to issue money makes it unique. If individuals want to make a purchase, they need to have the resources to do it. So, for example, someone using a debit card to purchase groceries will have to have sufficient balances in a commercial bank account to cover it. If the grocery purchaser does not have sufficient resources of his own, he will need the financial assistance of someone who is willing to make him a loan. The central bank is different. If the central bank wants to buy something—say a government-issued bond—it can just create the liabilities to do it. Essentially it can issue the money. Importantly, the central bank can expand the size of its balance sheet at will. No one else can do this.

The central bank uses its ability to expand (and contract) its assets and liabilities to implement monetary policy. Figure 1 is a simple version of the central bank’s balance sheet, stripped of a number of incidental items (like buildings and gold). When looking at any balance sheet, the most important thing to remember is that assets equal liabilities, so any change in one side must be matched by a change in the other. When a central bank purchases a government security, increasing its assets, this is normally matched by an increase in commercial bank reserve liabilities. Banks hold these reserves both because they are required by law and in order to make interbank payments.

At its technical, day-to-day level, monetary policy is all about buying and selling securities to control the quantity of reserves in the commercial banking system. Modern central banks, like the Federal Reserve or the European Central Bank, use their monopoly over the supply of commercial bank reserves to control an interest rate of their choosing. In some, like the Reserve Bank of Australia, it is the deposit rate the central bank pays commercial banks on the balances in their reserve account. In the United States, it is the federal funds rate —the rate banks charge each other for overnight loans of reserves. The Federal Reserve decides on its target for the federal funds, and then buys and sells securities to set the supply of reserves to hit this target. Twenty-first century monetary policy is not about controlling the quantity of money or its growth rate; it is about interest rates. (For a technical discussion of the use and the abandonment of money

as a target, see Laurence Meyer [2001a]. For a detailed discussion of the monetary policy of the European Central Bank, see Otmar Issing et al. [2001]).

It is important to note that some central banks decide to use their ability to control the size of their balance sheet to target something other than interest rates. The natural alternative is the exchange value of their currency—that is, the value of the number of dollars it takes to purchase the currency issued by another central bank. But, by the beginning of the twenty-first century, this had become increasingly rare. A central bank cannot control the total quantity of money and credit in the economy directly, and no modern central bank tries.

Finally, in addition to the size of their balance sheet, central banks have two additional tools. During times of financial stress, the central bank stands ready to provide loans to banks that are illiquid (so they cannot make payments) but still solvent (so their net worth is positive). Policymakers set interest rates on these loans. When the lending is done properly, this eliminates financial systemwide panics. In addition, central banks in many countries are given the power to set requirements governing how banks hold their assets. So, for example, they may require a certain level of reserve deposits, or prohibit the holding of common stock.

MONETARY POLICY OBJECTIVES

The central bank is part of the government. Whenever an agency of the government involves itself in the economy, people need to ask why. What makes individuals incapable of doing what they have entrusted to the government? In the case of national defense and pollution regulation, the reasons are obvious. Most people will not voluntarily contribute their resources to the army, nor will a country’s citizens spontaneously clean up their own air.

The rationale for the existence of a central bank is equally clear. While economic and financial systems may be fairly stable most of the time, when left on their own they are prone to episodes of extreme volatility. In the absence of a central bank, economic systems tend to be extremely unstable. The historical record is filled with examples of failure, such as the Great Depression of the 1930s, when the American banking system collapsed and economic activity plummeted.

Central bankers adjust interest rates to reduce the volatility of the economic and financial systems by pursuing a number of objectives. The three most important are: (1) low and stable inflation; (2) high and stable real growth, together with high employment; and (3) stable financial markets. Let’s look at each of these in turn.

The rationale for keeping the economy inflation-free is straightforward. Standards, everyone agrees, should be standard. A pound should always weigh a pound, a measuring cup should always hold a cup, a yardstick should always measure a yard, and one dollar should always have the same purchasing power. Maintaining price stability enhances money’s usefulness both as a unit of account and as a store of value.

Prices are central to everything that happens in a market-based economy. They provide the information individuals and firms need to ensure that resources are allocated to their best uses. When a seller can raise the price of a product, that is supposed to signal that demand has increased, so producing more is worthwhile. Inflation degrades the information content of prices, reducing the efficient operation of the economy.

Turning to growth, central bankers work to dampen the fluctuations of the business cycle. Booms are good; recessions are not. In recessions, people lose their jobs and businesses fail. Without a steady income, people struggle to make their auto, credit card, and mortgage payments. Consumers pull back, hurting businesses that rely on them to buy products. Reduced sales lead to more layoffs, and so on. The longer the downturn goes on, the worse it gets.

Finally, there is financial stability. The financial system is like plumbing: when it works, it is taken for granted, but when it does not work, watch out. If people lose faith in banks and financial markets, they will rush to low-risk alternatives, and the flow of resources from savers to borrowers will stop. Getting a car loan or a home mortgage becomes impossible, as does selling a bond to maintain or expand a business. When the financial system collapses, economic activity also collapses.

THE POLICY FRAMEWORK

Central banks use their ability to control their balance sheet to manipulate short-term interest rates in order to keep inflation low and stable, the growth high and stable, and the financial system stable. But what makes monetary policymakers successful? Today, there is a clear consensus that to succeed a central bank must be: (1) independent of political pressure; (2) accountable to the public; (3) transparent in its policy actions; and (4) clear in its communications with financial markets and the public.

Independence is the most important of these elements. Successful monetary policy requires a long time horizon. The impact of today’s decisions will not be felt for a while—not for several years, in most instances. Democratically elected politicians are not a patient bunch; their time horizon extends only to the next election. Politicians are encouraged to do everything they can for their constituents before the next election—including manipulating interest rates to bring short-term prosperity at the expense of long-term stability. The temptation to forsake long-term goals for short-term gains is simply impossible to resist. Given the ability to choose, politicians will keep interest rates too low, raising output and employment quickly (before the election), but resulting in inflation later (after the election).

Knowing these tendencies, governments have moved responsibility for monetary policy into a separate, largely apolitical, institution. To insulate policymakers from the daily pressures faced by politicians, governments must give central bankers control over their budgets, authority to make irreversible decisions, and long-term appointments.

There is a major problem with central bank independence: It is inconsistent with representative democracy. Politicians answer to the voters; by design, independent central bankers do not. How can people have faith in the financial system if there are no checks on what the central bankers are doing? The economy will not operate efficiently unless policymakers are trusted to do the right thing.

The solution to this problem is twofold. First, politicians establish the goals for the independent central bankers, and second, monetary policymakers publicly report their progress in achieving those goals. Explicit goals foster accountability and disclosure requirements create transparency. While central bankers are powerful, elected representatives tell them what to do and then monitor their progress.

The institutional means for assuring accountability and transparency differ from one country to the next. In some countries, such as the United Kingdom and Chile, the government establishes an explicit numerical target for inflation. In others, such as the United States, the central bank is asked to deliver price stability as one of a number of objectives (for a discussion of the structure of central bank objectives, see Laurence Meyer [2001b]).

THE FUTURE OF MONEY AND MONETARY POLICY

In the early 1980s, nearly two out of three of the countries in the world were experiencing inflation in excess of 10 percent per year. In the early twenty-first century, this is one in six. Two decades ago nearly one country in three was contracting. By 2005, five in six countries were growing at a rate in excess of 2 percent per year. But not only has inflation been lower and output higher, both inflation and output appear to be more stable. And careful empirical analysis shows that monetary policy is a likely source of this low, stable inflation and high, stable growth (see Cecchetti, Flores-Lagunes and Krause [2006]).

Central bankers’ success can be traced to their ability to control interest rates. And their ability to manipulate interest rates relies on their control of the size of their balance sheet. This, in turn, requires that banks and individuals actually demand central bank liabilities. That is, people have to want to hold the currency issued by central banks, and commercial banks have to demand reserves. Won’t the day come when no one wants this stuff anymore? And when that happens, won’t monetary policy disappear?

The answer is almost surely no. While it is true that the creation of a secure and anonymous substitute for paper currency will ultimately cause dollar bills and euro notes to disappear, reserves are different. The central bank operates an interbank payments system based on reserves. It does this to ensure that, even during periods of crisis, banks can continue to make payments. And to ensure that commercial banks use their payments system, the central bank offers cheap access to this system—that is, it subsidizes the cost of the system’s operation. So long as banks want reserves, there will be monetary policy (for a discussion of the challenges facing monetary policy makers, see Gordon Sellon and Chairmaine Buskas [1999] and Laurence Meyer [2001c]).

SEE ALSO Business Cycles, Real; Inflation; Policy, Fiscal; Treasury View, The; Unemployment

BIBLIOGRAPHY

Cecchetti, Stephen G. 2006. Money, Banking, and Financial Markets. New York: McGraw Hill–Irwin.

Cecchetti, Stephen G., Alfonso Flores-Lagunes, and Stefan Krause. 2006. Has Monetary Policy Become More Efficient? A Cross-Country Analysis. Economic Journal 116 (4): 408–433.

Davies, Glyn. 2002. The History of Money from Ancient Times to the Present Day. 3rd ed. Cardiff, U.K.: University of Wales Press.

Issing, Otmar, Ignazio Angeloni, Vitor Gaspar, and Oreste Tristani. 2001. Monetary Policy in the Euro Area: Strategy and Decision-Making at the European Central Bank. Cambridge, U.K.: Cambridge University Press.

Meyer, Laurence H. 2001a. Does Money Matter? The 2001 Homer Jones Memorial Lecture, Washington University, Saint Louis, Missouri, March 28. http://www.federalreserve.gov/boarddocs/speeches/2001/20010328/default.htm.

Meyer, Laurence H. 2001b. Inflation Targets and Inflation Targeting. Remarks at the University of California at San Diego Economics Roundtable, San Diego, California, July 17. http://www.federalreserve.gov/boarddocs/speeches/2001/20010328/default.htm./boarddocs/speeches/2001/20010717/default.htm.

Meyer, Laurence H. 2001c. The Future of Money and of Monetary Policy. Remarks at the Distinguished Lecture Program, Swarthmore College, Swarthmore, Pennsylvania, December 5. http://www.federalreserve.gov/boarddocs/speeches/2001/20011205/default.htm.

Sellon, Gordon H., Jr., and Chairmaine R. Buskas, eds. 1999. New Challenges for Monetary Policy: A Symposium Sponsored by the Federal Reserve Bank of Kansas City. Kansas City, MO: Federal Reserve Bank of Kansas City.

Stephen G. Cecchetti

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MONETARY POLICY

The central agency that conducts monetary policy in the United States is the Federal Reserve System (the Fed). It was founded by the U.S. Congress in 1913 under the Federal Reserve Act. The Fed is a highly independent agency that is insulated from day-to-day political pressures, accountable only to Congress. It is a federal system, consisting of a board of governors, twelve regional Federal Reserve Banks (FRBs) and their twenty-five branches, the Federal Open Market Committee (FOMC), the Federal Advisory Council and other advisory and working committees, and 2,900 member banks, mostly national banks. By law, all federally chartered banks, that is, national banks, are automatic members of the system. State-chartered banks may elect to become members.

The seven-member board of governors, headquartered in Washington, D.C., is the core agency of the Fed, overseeing the entire operation of U.S. monetary policy. The FRBs are the operating arms of the system and are located in twelve major cities, one in each of the twelve Federal Reserve Districts around the nation. The twelve-member FOMC is the most important policy-making entity of the system. The voting members of the committee are the seven members of the board, the president of the FRB of New York, and four of the other eleven FRB presidents, each serving one year on a rotating basis. The other seven nonvoting FRB presidents still attend the meetings and participate fully in policy deliberations.

MONETARY POLICY AND THE ECONOMY

Being one of the most influential government policies, monetary policy aims at affecting the economy through the Fed's management of money and interest rates. The narrowest definition of money is M1, which includes currency, checking account deposits, and traveler's checks. Time deposits, savings deposits, money market deposits, and other financial assets can be added to M1 to define other monetary measures, such as M2 and M3. Interest rates are simply the costs of borrowing. The Fed conducts monetary policy through bank reserves, which are the portion of the deposits that banks and other depository institutions are required to hold either as vault cash or as deposits with their home FRBs. Excess reserves are the reserves in excess of the amount required. These additional funds can be transacted in the reserves market (the federal funds market) to allow overnight borrowing between depository institutions to meet short-term needs in reserves. The rate at which such private borrowings are charged is the federal funds rate.

Monetary policy is closely linked with the reserves market. With its policy tools, the Fed can control the reserves available in the market, affect the federal funds rate, and subsequently trigger a chain of reactions that influence other short-term interest rates, foreign-exchange rates, long-term interest rates, and the amount of money and credit in the economy. These changes will then bring about adjustments in consumption, affect saving and investment decisions, and eventually influence employment, output, and prices.

GOALS OF MONETARY POLICY

The long-term goals of monetary policy are to promote full employment and stable prices and to moderate long-term interest rates. Most economists believe price stability should be the primary objective, since a stable level of prices is key to sustained output and employment, as well as to maintaining moderate long-term interest rates. Relatively speaking, it is easier for central banks to control inflation (i.e., the continual rise in the price level) than to influence employment directly, because the latter is affected by such real factors as technology and consumer tastes. Moreover, historical evidence indicates a strong positive correlation between inflation and the amount of money.

While the financial markets react quickly to changes in monetary policy, it generally takes months or even years for such policy to affect employment and growth, and thus to reach the Fed's long-term goals. The Fed, therefore, needs to be forward-looking and to make timely policy adjustments based on forecasted as well as actual data on such variables as wages and prices, inflation, unemployment, output growth, foreign trade, interest rates, exchange rates, money and credit, and conditions in the markets for bonds and stocks.

IMPLEMENTATION OF MONETARY POLICY

Since the early 1980s, the Fed has been relying on the overnight federal funds rate as the guide to its position in monetary policy. The Fed has at its disposal three major monetary policy tools: reserve requirements, the discount rate, and open-market operations.

Reserve Requirements

Under the Monetary Control Act of 1980, all depository institutions, including commercial banks and savings and loans, are subject to the same reserve requirements, regardless of their Fed member status. As of October 2005, the structure of reserve requirements was 0 percent for all checkable deposits up to $7 million (the exemption), 3 percent for such deposits from above $7 million to $47.6 million (the low-reserve tranche), and 10 percent for the amount above $47.6 million. Both the exemption and the low-reserve tranche are subject to annual adjustment by statute to reflect changes in reservable liabilities at all depository institutions. No reserves are required for nonpersonal time deposits and Eurocurrency liabilities.

Reserve requirements affect the so-called multiple money creation. Suppose, for example, the reserve requirement ratio is 10 percent. A bank that receives a $100 deposit (Bank 1) can lend out $90. Bank 1 can then issue a $90 check to a borrower, who deposits it in Bank 2, which can then lend out $81. As it continues, the process will eventually involve a total of $1,000 ($100 + $90 + $81 + $72.9 + … = $1,000) in deposits. The initial deposit of $100 is thus multiplied ten times. With a lower (higher) ratio, the multiple involved is larger (smaller), and more (fewer) reserves can be created.

Reserve requirements are not used as often as the other policy tools. Since funds grow in multiples, it is difficult to administer small adjustments in reserves with this tool. Also, banks always have the option of entering the federal funds market for reserves, further limiting the role of reserve requirements. Except for the yearly adjustments of the exemption and the low-reserve tranche, the last change in the reserve requirements was in April 1992, when the upper ratio was reduced from 12 to 10 percent.

The Discount Rate

Banks and other depository institutions may acquire loans through the discount window at their home FRB to meet their short-term needs against, for example, unexpected large withdrawals of deposits. The interest rate charged on such loans is the discount rate. A reduction of the rate encourages more borrowing, and through money creation, bank deposits increase and reserves increase. A rate hike works in the opposite direction. Since it is more efficient, however, to adjust reserves through open-market operations (discussed below), the amount of discount window lending has been unimportant, accounting for only a small fraction of total reserves. Perhaps a more meaningful function served by the discount rate is to signal the Fed's stance on monetary policy, similar to the role of the federal funds rate.

By law, each FRB sets its discount rate every two weeks, subject to the approval of the board of governors. The gradual nationalization of the credit market over the years, however, has resulted in a uniform discount rate. A major revision in the discount window programs took effect in January 2003 to enhance the Fed's lending function. The FRBs began to offer three discount window programs to depository institutions: the primary credit program for financially sound institutions, the secondary credit program for institutions not eligible for primary credit, and the seasonal credit program for small depository institutions that have seasonal fluctuations in funding needs.

Discount-rate adjustments, usually going hand in hand with changes in the federal funds rate, have been dictated by cyclical conditions of the economy, and the frequency of adjustments has varied. For instance, the discount rate moved up from a low of 3 percent in May 1994 to 6 percent in January 2001 to counter possible overheating and inflation from the robust economic growth since the mid-1990s. The rate was then lowered twelve times, to a bare 0.75 percent in two years, to help the economy recover from its 2001 recession. From June 2004 to September 2005, the primary (4.75 percent) and secondary (5.25 percent) credit rates were both raised 11 times to cool off the economy and especially the overheated housing market.

Open-Market Operations

The most important and flexible tool of monetary policy is open-market operations, that is, trading U.S. government securities in the open market. In 2004 the Fed made $7.55 trillion of purchases and $7.51 trillion of sales of Treasury securities (mostly short-term Treasury bills). As of June 2005, the Fed held $721.92 billion of U.S. Treasury securities, roughly 9.2 percent of the total federal debt outstanding.

The FOMC directs open-market operations (and also advises about reserve requirements and discount-rate policies). The day-to-day operations are determined and executed by the Domestic Trading Desk (the Desk) at the FRB of New York. Since 1980 the FOMC has met regularly eight times a year in Washington, D.C. At each of these meetings, it votes on an intermeeting target federal funds rate, based on the current and prospective conditions of the economy. Until the next meeting, the Desk will manage reserve conditions through open-market operations to maintain the federal funds rate around the given target level. When buying securities from a bank, the Fed makes the payment by increasing the bank's reserves at the Fed. More reserves will then be available in the federal funds market and the federal funds rate falls. By selling securities to a bank, the Fed receives payment in reserves from the bank. Supply of reserves falls and the funds rate rises.

The Fed has two basic approaches in running open-market operations. When a shortage or surplus in reserves is likely to persist, the Fed may undertake outright purchases or sales, creating a long-term impact on the supply of reserves. Nevertheless, many reserve movements are temporary. The Fed can then take a defensive position and engage in transactions that impose only temporary effects on the level of reserves. A repurchase agreement (a repo) allows the Fed to purchase securities with the agreement that the seller will buy back them within a short period, sometimes overnight and mostly within seven days. The repo creates a temporary increase in reserves, which vanishes when the term expires. If the Fed wishes to drain reserves temporarily from the banking system, it can adopt a matched sale-purchase transaction (a reverse repo), under which the buyer agrees to sell the securities back to the Fed, usually in fewer than seven days.

see also Federal Reserve System ; International Monetary Fund ; Macroeconomics/Microeconomics

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Edward Wei-Te Hsieh

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