What Affects Monetary Policy

The single biggest factor affecting monetary policy is the state of the economy, specifically the level of inflation, which increases monetary policy restrictions when high and decreases them when low, as seen in the case of the US Federal Reserve, which raised interest rates by 2.25% between 2015 and 2018 to combat an inflation rate of 2.1% (Bureau of Labor Statistics).

Main Factors

• Inflation rate — a high inflation rate increases monetary policy restrictions, as central banks try to reduce money supply and curb price growth, with the European Central Bank raising interest rates by 0.5% in 2011 to combat an inflation rate of 3% (European Central Bank), while a low inflation rate decreases restrictions, as seen in Japan, where the Bank of Japan has maintained negative interest rates since 2016 to combat deflation, with an inflation rate of -0.1% (Bank of Japan).
• Economic growth — a high growth rate increases monetary policy restrictions, as central banks try to prevent overheating, with the Bank of England raising interest rates by 0.25% in 2017 to combat a growth rate of 1.7% (Office for National Statistics), while a low growth rate decreases restrictions, as seen in the eurozone, where the European Central Bank has maintained quantitative easing since 2015 to combat a growth rate of 0.2% (Eurostat).
• Unemployment rate — a high unemployment rate decreases monetary policy restrictions, as central banks try to stimulate job creation, with the US Federal Reserve maintaining near-zero interest rates between 2009 and 2015 to combat an unemployment rate of 10% (Bureau of Labor Statistics), while a low unemployment rate increases restrictions, as seen in the US, where the Federal Reserve raised interest rates by 2.25% between 2015 and 2018 to combat an unemployment rate of 3.9% (Bureau of Labor Statistics).
• Exchange rate — a high exchange rate decreases monetary policy restrictions, as a strong currency reduces import prices and inflation, with the Swiss National Bank intervening in the foreign exchange market in 2011 to combat an exchange rate of 1.05 CHF/EUR (Swiss National Bank), while a low exchange rate increases restrictions, as seen in the UK, where the Bank of England raised interest rates by 0.25% in 2017 to combat an exchange rate of 1.30 GBP/USD (Bank of England).
• Fiscal policy — an expansionary fiscal policy increases monetary policy restrictions, as central banks try to offset the stimulative effects of government spending, with the US Federal Reserve raising interest rates by 2.25% between 2015 and 2018 to combat a fiscal deficit of 3.8% of GDP (Congressional Budget Office), while a contractionary fiscal policy decreases restrictions, as seen in Germany, where the European Central Bank has maintained quantitative easing since 2015 to combat a fiscal surplus of 1.2% of GDP (German Federal Statistical Office).
• Financial stability — a high level of financial instability increases monetary policy restrictions, as central banks try to prevent systemic risk, with the US Federal Reserve providing $1.5 trillion in emergency loans to banks in 2008 to combat a financial instability index of 1.5 (Federal Reserve), while a low level of financial instability decreases restrictions, as seen in Canada, where the Bank of Canada has maintained low interest rates since 2015 to combat a financial instability index of 0.5 (Bank of Canada).
• Global economic trends — a high level of global economic uncertainty increases monetary policy restrictions, as central banks try to insulate their economies, with the Bank of Japan maintaining negative interest rates since 2016 to combat a global economic uncertainty index of 120 (Chicago Booth), while a low level of global economic uncertainty decreases restrictions, as seen in Australia, where the Reserve Bank of Australia has maintained low interest rates since 2015 to combat a global economic uncertainty index of 80 (Chicago Booth).

How They Interact

The interaction between inflation rate and unemployment rate is particularly significant, as a high inflation rate and low unemployment rate can lead to a situation known as stagflation, where monetary policy restrictions are increased to combat inflation, but this can also lead to higher unemployment, as seen in the US in the 1970s, where the Federal Reserve raised interest rates by 10% to combat an inflation rate of 14.8% and an unemployment rate of 7.5% (Bureau of Labor Statistics).

• The interaction between exchange rate and fiscal policy is also important, as a high exchange rate and expansionary fiscal policy can lead to a situation known as twin deficits, where a large trade deficit and fiscal deficit can lead to a decrease in the value of the currency, as seen in the US, where the trade deficit increased by $100 billion and the fiscal deficit increased by $500 billion between 2017 and 2018 (US Census Bureau and Congressional Budget Office).
• The interaction between financial stability and global economic trends is also significant, as a high level of financial instability and global economic uncertainty can lead to a situation known as financial contagion, where a crisis in one country can spread to other countries, as seen in the 2008 global financial crisis, where the failure of Lehman Brothers led to a global credit crunch and a decline in economic activity (International Monetary Fund).

Controllable vs Uncontrollable

The controllable factors are fiscal policy, which is controlled by governments, and monetary policy itself, which is controlled by central banks, as seen in the case of the US Federal Reserve, which is controlled by the Federal Open Market Committee (Federal Reserve).

• The uncontrollable factors are global economic trends, which are influenced by a wide range of factors, including economic activity in other countries, and financial stability, which is influenced by a range of factors, including the stability of the financial system and the level of debt in the economy, as seen in the case of the 2008 global financial crisis, where the failure of Lehman Brothers led to a global credit crunch and a decline in economic activity (International Monetary Fund).
• Other factors, such as inflation rate and unemployment rate, can be influenced by both controllable and uncontrollable factors, as seen in the case of the US, where the Federal Reserve has used monetary policy to combat inflation and unemployment, but has also been influenced by global economic trends and financial stability (Bureau of Labor Statistics and Federal Reserve).