Monetary Policy

You might have noticed a relatively recent post-pandemic price hike, which the Bank of England aimed to slow down by increasing interest rates to 0.5% in February 2022.2  This is an example of monetary policy. Monetary policy, in essence, is the strategic manipulation of the money supply by a country's central bank to steer the economy. It employs an array of instruments to achieve specific objectives, such as controlling inflation or fostering economic growth. In this article, we'll explore the definition, instruments, and objectives of monetary policy, and analyse diverse types of policies complemented by real-world examples to enhance your understanding.

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Contents
Table of contents

    Monetary policy definition

    Monetary policy refers to the actions taken by a central bank to control the supply of money and interest rates in an economy, aiming to achieve macroeconomic goals such as stable inflation, low unemployment, and economic growth. These actions can involve adjusting interest rates, buying or selling government securities, or changing reserve requirements for commercial banks.


    Monetary policy is the set of actions and strategies employed by a central bank to regulate the money supply, interest rates, and credit availability in an economy, with the objective of promoting sustainable economic growth, price stability, and low unemployment.

    Take the case of Brazil in 2015. The country was facing high inflation, which was eroding people's purchasing power and destabilizing the economy. In response, the Central Bank of Brazil raised its benchmark interest rate, the Selic, to a record high of 14.25%. This move made borrowing more expensive, thus discouraging excessive spending and reducing the money supply in the economy. Over time, this policy helped to ease inflationary pressures in Brazil.1

    Monetary Policy UK

    Before 1997, the Treasury Department in the government along with the Bank of England were responsible for setting monetary policy. However, since 1997 the Bank of England is in charge of the operational tasks and in charge of the nation’s monetary policy, and the Treasury only sets a ‘target’.

    It is important to distinguish the Bank of England from other banks like Barclays or HSBC.

    The Bank of England is a central bank that has the authority to change the interest rates and exchange rates and make changes to the money supply. Banks like Barclays or HSBC are commercial banks whose main operations are conducted to make a profit for their owners.

    The Bank of England, a central bank, controls the banking system and implements the monetary policy on behalf of the government.

    To better understand the functions of banks check our explanations on the Functions of Central Banks and Commercial Banks.

    Monetary policy objectives

    Monetary policy serves several key objectives designed to foster a healthy and stable economy. One of the most prominent objectives is price stability. Central banks use monetary policy to control inflation (a general increase in prices) or deflation (a general decrease in prices). Maintaining a low and steady rate of inflation is crucial for economic stability. High inflation can erode purchasing power, while deflation can lead to decreased economic activity. For instance, the European Central Bank aims for inflation rates of "below, but close to, 2% over the medium term" to ensure price stability within the Eurozone.

    Another vital objective of monetary policy is economic growth. Central banks aim to manage the money supply to create economic conditions that promote sustainable growth. This can involve stimulating growth during economic downturns with expansionary policy or slowing down overheating economies with contractionary measures. Additionally, monetary policy also seeks to promote full employment and maintain long-term interest rates at a moderate level. The U.S. Federal Reserve, for instance, is mandated by Congress to promote maximum employment, stable prices, and moderate long-term interest rates - a directive known as the "dual mandate".

    Instruments of monetary policy

    Monetary policy wields a variety of tools that central banks use to regulate economic growth, control inflation, and stabilize the financial system. These instruments are the levers that central banks can pull to impact the cost and availability of money in an economy. In this section, we'll delve into the primary monetary policy instruments and their applications in real-world scenarios.

    Open Market Operations

    Open market operations involve the buying and selling of government securities by a central bank. When a central bank wants to increase the money supply (expansionary policy), it buys government securities, pumping money into the economy. Conversely, to decrease the money supply (contractionary policy), it sells these securities, pulling money out of the economy. For example, the U.S. Federal Reserve regularly uses open market operations to adjust the federal funds rate, which influences other interest rates and ultimately affects spending and investment decisions.

    Discount Rate

    The discount rate is the interest rate at which a central bank lends money to commercial banks. If the central bank wants to expand the money supply, it can lower the discount rate, making it cheaper for banks to borrow money. This encourages lending and stimulates economic activity. On the other hand, raising the discount rate can slow economic activity by making borrowing more expensive. The Bank of England, for instance, has used adjustments to its discount rate (known as the Bank Rate) to manage inflation and stabilize the economy.

    Reserve Requirements

    Reserve requirements refer to the minimum amount of reserves a bank must hold against its liabilities, typically expressed as a percentage of bank deposits. By adjusting this ratio, a central bank can influence the amount of money a bank can lend. If the central bank lowers the reserve requirement, banks can lend more, increasing the money supply. Conversely, raising the reserve requirement decreases the money supply by reducing the amount of money banks can lend. An example of this is the People's Bank of China, which frequently adjusts reserve requirements to manage liquidity in the Chinese banking system.

    Types of monetary policy

    In economics, monetary policy takes on two primary forms, each with its distinct objectives and tools. These are expansionary and contractionary monetary policies. Let's explore these two types, understanding their aims, the situations in which they're typically used, and their potential effects on an economy.

    Expansionary monetary policy

    Whereas fiscal policy can affect aggregate demand by using government spending, monetary policy can affect aggregate demand by changing interest rates, exchange, and money supply.

    Let’s briefly look at the aggregate demand formula:

    \(AD=C+G+I+(X-M)\)

    As we said, fiscal policy can affect AD through government spending (G). Monetary policy can affect other components of the AD primarily the components of Consumption (C), Investments (I), and Net Exports (X-M) (changes in Net exports can happen due to exchange rate changes).

    Refresh your knowledge on this topic in our explanation of Fiscal Policy.

    In expansionary monetary policy, the central bank decreases interest rates to inject more income into the circular flow of income and to stimulate aggregate demand.

    Here the central bank is encouraging consumption (C), borrowing, and investment(I) spending and discouraging savings as the cost of borrowing loans and credits has become cheaper. Exports (X-M) also increase as other countries find it cheaper to buy the country’s goods and services since interest rate reduction causes the exchange rate to depreciate relative to other currencies.

    This exchange rate change makes exports more internationally price competitive as it is easier to buy your country's goods and services while simultaneously making imports less competitive.

    We can use a graph to illustrate the effects of the enactment of expansionary monetary policy. Check Figure 1 below.

    Expansionary Monetary Policy StudySmarter OriginalsFigure 1. Expansionary Monetary Policy, StudySmarter Originals

    Let’s suppose the Bank of England with the MPC committee has decided to reduce interest rates to encourage more borrowings, investment, and consumption as the cost of borrowing money has become cheaper and more attractive for households and firms.

    There is also a need to find new markets to export British-made goods and services ever since the advent of Brexit. Hence, the intention is to increase overall exports and remain competitive in the global economy.

    With these changes in mind, considering that consumption, investments, and net exports, components of aggregate demand will increase, it will then shift the AD curve outward (to the right) from AD1 to AD2. The size of the shift depends on the size of the multiplier effect.

    To learn how to calculate the multiplier check our explanation on the Aggregate Demand Curve.

    As the economy sees an increase in aggregate demand, shown by the movement from point A to point B, real output increases from Y1 to Y2 and we also see a price level increase of P1 to P2. The extent to which both price level and real GDP increase depend on the slope of the long-run aggregate supply curve (LRAS).

    To learn more about the different types of supply curves check our explanation on the Aggregate Supply.

    In this scenario, the implementation of expansionary monetary policy will increase the overall real output (real GDP) and increase the availability of jobs which will simultaneously results in increased employment levels.

    Contractionary monetary policy

    When using a contractionary monetary policy, the government increases interest rates to decrease the level of aggregate demand in the economy. The implementation of contractionary monetary policy can be a result if the economy sees too strong growth that ends up causing high inflation levels.

    When the central bank increases its interest rates, the cost of borrowing loans and credits for households and firms increases. This will in short term discourage consumption; borrowings, investments, and imports are likely to increase. Imports will rise as the exchange rate will appreciate which will, in turn, discourage other countries to buy goods and services as the currency has become more expensive. This change will make exports less competitive and imports more competitive.

    Let’s assume the Bank of England has decided to increase interest rates. This, in turn, increased the cost of borrowing loans and credits which will discourage households’ consumption and firms’ investment as well as increase imports (that will likely result in a budget deficit). All of these components of aggregate demand will decrease and we can illustrate a representation of this change below in Figure 2.

    Contractionary monetary policy StudySmarter OriginalsFigure 2. Contractionary monetary policy, StudySmarter Originals

    A decrease in these components, which are some of the key components of aggregate demand, will cause the aggregate demand curve to shift inward (to the left) from AD1 to AD2. This also causes real output to decrease from Y1 to Y2 and general price levels fall from P1 to P2.

    A decrease in real output and a decrease in price levels due to a contractionary monetary policy can cause recessions in the long run, as the main goal initially was to control inflation. The likelihood of the recession occurring can increase due to the multiplier effect as well. This in the end causes the economy to move from point A at an operating level to point B.

    Examples of monetary policy

    Monetary policy, a tool used by central banks, plays a pivotal role in shaping a country's economic trajectory. It involves strategies and measures that manipulate the money supply and interest rates to achieve specific economic objectives. Here, we'll delve into three real-world examples of monetary policy in action, showcasing different instruments used across the globe.

    Federal Reserve's Response to the 2008 Financial Crisis (USA)

    In the face of the 2008 financial crisis, the U.S. Federal Reserve employed an expansionary monetary policy to stimulate economic growth. It lowered the federal funds rate to near zero, making it cheaper for businesses and consumers to borrow money. The Fed also implemented quantitative easing, buying trillions of dollars in Treasury securities to inject more money into the economy.3

    European Central Bank's Negative Interest Rates (Eurozone)

    In 2014, to combat deflation and stimulate economic growth, the European Central Bank (ECB) introduced negative interest rates. This unconventional policy was designed to encourage banks to lend more money, as they would be charged for keeping excess reserves at the ECB. This decision marked one of the first instances of a major central bank applying a negative interest rate policy.4

    Bank of Japan's Yield Curve Control (Japan)

    The Bank of Japan (BoJ) introduced an innovative monetary policy in 2016 known as Yield Curve Control (YCC). This policy aimed to keep 10-year government bond yields around zero to control long-term interest rates directly. By doing so, the BoJ intended to encourage spending and investment, stimulate inflation, and promote economic growth.

    One example of monetary policy implementations includes interest rate changes. The Bank of England can either increase or decrease them to achieve its macroeconomic objective of keeping inflation in check.5

    Monetary policy vs fiscal policy

    Monetary Policy involves using interest rates and other monetary tools to influence the level of consumer spending and aggregate demand. Monetary policy aims to stabilize the economic cycle: keeping inflation low and avoiding recessions.

    Fiscal policy, often associated with Keynesian economic theory, is a section of the government's overall economic policy that aims to achieve its economic objectives through fiscal instruments such as taxation, public spending, and a budgetary position.

    Check out our explanation to learn more about Fiscal Policy.

    Monetary Policy - Key takeaways

    • Monetary policy is when the government uses interest rates and manipulation in the money supply to change the level of aggregate demand in the economy.
    • A monetary policy instrument is a tool that a central bank of a nation can use to control and influence the money supply, interest rates, and exchange rate to achieve a monetary objective.
    • The main monetary policy instrument that the Bank of England uses is the Bank Rate.
    • In expansionary monetary policy, the central bank decreases interest rates to inject more income into the circular flow of income and increase the level of aggregate demand in the economy.
    • In contractionary monetary policy, interest rates are increased with the intention of decreasing the level of aggregate demand in the economy.

    References

    1. Alonso Soto, Silvio Cascione, Brazil inflation ends 2015 above target, cenbank vows action, Reuters, 2015, https://www.reuters.com/article/us-brazil-economy-inflation-idUSKBN0UM2IO20160108
    2. Bank of England - Monetary Policy Summary, February 2022.
    3. John Weinberg, The Great Recession and Its Aftermath, 2013, https://www.federalreservehistory.org/essays/great-recession-and-its-aftermath
    4. Grégory CLAEYS, Bruegel, What Are the Effects of the ECB’s Negative Interest Rate Policy?, Monetary Dialogue Papers, June 2021, https://www.europarl.europa.eu/cmsdata/235691/02.%20BRUEGEL_formatted.pdf
    5. Leika Kihara, Explainer: How does Japan's yield curve control work?, Reuters, 2023, https://www.reuters.com/markets/asia/how-does-japans-yield-curve-control-work-2023-04-10/
    Frequently Asked Questions about Monetary Policy

    What is monetary policy?

    Monetary policy is a policy the government uses that consists of manipulating interest rates and altering the money supply in an economy to change the level of aggregate demand and achieve its overall macroeconomic objectives.

    Why do governments use monetary policy?

    The monetary policy enables governments to control inflation in times of high levels of economic growth but also promote consumption when the economy enters a recession 

    How does monetary policy affect the economy?

    Expansionary and contractionary Monetary Policies enable the governments to influence components of aggregate demand and the overall economy. For example, increasing economic growth through low interest rates or controlling inflation levels through high interest rates.

    What are the instruments of monetary policy?

    Interest rates, open market operations, and reserve requirements are some examples. 

    What is an example of monetary policy?

    The Central Bank buying or selling government securities.

    Test your knowledge with multiple choice flashcards

    Central banks were founded as for-profit organisations with the goal of promoting financial market stability. True or false?

    What are the secondary functions of the central bank?

    Independent central banks get their own separate rights, allowing them to join international accords without the permission of the government. True or false?

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