What Is Monetary Policy?

Definition

Monetary policy is the actions of a central bank, such as the Federal Reserve in the United States, aimed at controlling the money supply and interest rates to promote economic growth, stability, and low inflation, as first described by Milton Friedman in his 1968 paper "The Role of Monetary Policy."

How It Works

The central bank uses several mechanisms to implement monetary policy, including setting reserve requirements for commercial banks, which determines the percentage of deposits that must be held in reserve rather than being lent out, and open market operations, where the central bank buys or sells government securities to increase or decrease the money supply. For instance, when the Federal Reserve buys government securities, it injects liquidity into the economy, which can lead to lower interest rates and increased borrowing, as seen in the quantitative easing program implemented during the 2008 financial crisis, which involved the purchase of $1.7 trillion in mortgage-backed securities (Federal Reserve). The central bank can also use discount rates, which are the interest rates at which commercial banks borrow from the central bank, to influence the prime lending rate, as Ricardo's comparative advantage model (1817) suggests that lower interest rates can lead to increased borrowing and economic growth.

The effectiveness of monetary policy depends on various factors, including the money multiplier, which is the ratio of the money supply to the monetary base, and the velocity of money, which is the rate at which money is spent and respent in the economy. According to the Taylor rule (1993), a central bank should adjust the interest rate in response to changes in inflation and output, with a 1% increase in inflation corresponding to a 1.5% increase in the interest rate. The money supply can be measured using M1, which includes currency and demand deposits, or M2, which includes M1 plus savings deposits and money market securities, with the M2 money supply being approximately $15.3 trillion in the United States (Federal Reserve).

Monetary policy can also have international implications, as changes in interest rates and exchange rates can affect trade and investment. For example, a country with a high interest rate may attract foreign investors, causing its currency to appreciate, as seen in the case of the Swiss franc, which has historically been considered a safe-haven currency and has appreciated in times of economic uncertainty. The exchange rate is the price of one currency in terms of another, and it can be influenced by monetary policy, as a higher interest rate can lead to an appreciation of the currency, making exports more expensive and potentially reducing trade.

Key Components

• Interest rates: the central bank sets interest rates to influence borrowing and spending, with higher interest rates reducing borrowing and lower interest rates increasing borrowing, as seen in the 2008 financial crisis when the Federal Reserve lowered the federal funds rate to near zero.
• Reserve requirements: the central bank sets reserve requirements to determine the amount of deposits that commercial banks must hold in reserve, with higher reserve requirements reducing the amount of loans that can be made, as seen in the case of the Chinese central bank, which has used reserve requirements to control credit growth.
• Open market operations: the central bank buys or sells government securities to increase or decrease the money supply, with the purchase of securities injecting liquidity into the economy and the sale of securities reducing liquidity, as seen in the quantitative easing program implemented by the Federal Reserve.
• Discount rates: the central bank sets discount rates to influence the prime lending rate, with lower discount rates reducing the prime lending rate and increasing borrowing, as seen in the case of the European Central Bank, which has used negative interest rates to stimulate borrowing.
• Money supply: the central bank aims to control the money supply to promote economic growth and stability, with a growing money supply potentially leading to inflation and a shrinking money supply potentially leading to deflation, as seen in the case of Japan, which has struggled with deflation in recent years.
• Inflation targeting: the central bank sets an inflation target, usually around 2%, to guide monetary policy decisions, with the goal of keeping inflation low and stable, as seen in the case of the Bank of England, which has an inflation target of 2%.

Common Misconceptions

• Myth: Monetary policy is only used in times of economic crisis — Fact: Monetary policy is used continuously to promote economic growth and stability, as seen in the regular meetings of the Federal Reserve's Federal Open Market Committee.
• Myth: The central bank can control inflation by simply printing more money — Fact: Excessive money printing can lead to hyperinflation, as seen in the case of Zimbabwe, which experienced hyperinflation in the early 2000s, with inflation reaching 89.7 sextillion percent (International Monetary Fund).
• Myth: Monetary policy has no impact on employment — Fact: Monetary policy can influence employment by affecting aggregate demand, as seen in the case of the United States, where the unemployment rate fell from 10% in 2009 to 3.5% in 2019, partly due to the expansionary monetary policy implemented by the Federal Reserve.
• Myth: The central bank can set interest rates arbitrarily — Fact: Interest rates are influenced by market forces, such as inflation expectations and global economic conditions, as seen in the case of the German bund, which has a negative yield due to market expectations of low inflation and economic growth.

In Practice

In 2013, the Bank of Japan implemented a massive monetary stimulus program, known as Abenomics, aimed at ending deflation and promoting economic growth. The program involved increasing the money supply by 2% annually, setting a 2% inflation target, and implementing negative interest rates, with the goal of increasing borrowing and spending. As a result, the Japanese economy experienced a period of growth, with the GDP growth rate increasing from -0.1% in 2012 to 1.7% in 2013, and the unemployment rate falling from 4.3% in 2012 to 3.5% in 2013 (World Bank). The program also led to an increase in exports, with the value of Japanese exports increasing by 10% in 2013, and a depreciation of the yen, which made Japanese goods more competitive in the global market. However, the program also had its challenges, including a significant increase in the Japanese government's debt-to-GDP ratio, which rose from 226% in 2012 to 238% in 2013 (International Monetary Fund).