Monetary policy

Public finance
Policies Agricultural Economic Energy Industrial Investment Social Trade Fiscal Monetary Policy mix
Fiscal policy Budget policy Debt internal Deficit / surplus Finance ministry Fiscal union Revenue Spending deficit Tax
Monetary policy Bank reserves requirements Discount window Gold reserves Interest rate Monetary authority central bank currency board Monetary base Monetary (currency) union Money supply
Trade policy Balance of trade Free trade Gains from trade Non-tariff barrier Protectionism Tariff Trade bloc Trade creation Trade diversion Trade / commerce ministry
Revenue Spending Non-tax revenue Tax revenue Discretionary spending Mandatory spending
Optimum Balanced budget Economic growth Price stability
Reform Fiscal adjustment Monetary reform
Portal
v t e

Part of a series on
Macroeconomics
Basic concepts Aggregate demand Aggregate supply Business cycle Deflation Demand shock Disinflation Effective demand Expectations Adaptive Rational Financial crisis Growth Inflation Demand-pull Cost-push Interest rate Investment Liquidity trap Measures of national income and output GDP GNI NNI Microfoundations Money Endogenous Money creation Demand for money Liquidity preference Money supply National accounts SNA Nominal rigidity Price level Recession Shrinkflation Stagflation Supply shock Saving Unemployment
Policies Fiscal Monetary Commercial Central bank Universal basic income
Models IS–LM AD–AS Keynesian cross Multiplier Accelerator Phillips curve Arrow–Debreu Harrod–Domar Solow–Swan Ramsey–Cass–Koopmans Overlapping generations General equilibrium DSGE Endogenous growth Matching theory Mundell–Fleming Overshooting NAIRU
Related fields Econometrics Economic statistics Monetary economics Development economics International economics
Schools Mainstream Keynesian Neo- New Monetarism New classical Real business-cycle theory Stockholm Supply-side New neoclassical synthesis Saltwater and freshwater Heterodox Austrian Chartalism Modern monetary theory Ecological Post-Keynesian Circuitism Disequilibrium Marxian Market monetarism
People François Quesnay Adam Smith Thomas Robert Malthus Karl Marx Léon Walras Knut Wicksell Irving Fisher Wesley Clair Mitchell John Maynard Keynes Alvin Hansen Michał Kalecki Gunnar Myrdal Simon Kuznets Joan Robinson Friedrich Hayek John Hicks Richard Stone Hyman Minsky Milton Friedman Paul Samuelson Lawrence Klein Edmund Phelps Robert Lucas Jr. Edward C. Prescott Peter Diamond William Nordhaus Joseph Stiglitz Thomas J. Sargent Paul Krugman N. Gregory Mankiw
See also Macroeconomic model Publications in macroeconomics Economics Applied Microeconomics Political economy Mathematical economics
Money portal  Business portal
v t e

Monetary policy is the policy adopted by the

The tools of monetary policy vary from central bank to central bank, depending on the country's stage of development, institutional structure, tradition and political system. Interest rate targeting is generally the primary tool, being obtained either directly via administratively changing the central bank's own interest rates or indirectly via

Monetary policy affects the economy through

How best to conduct monetary policy is an active and debated research area, drawing on fields like monetary economics as well as other subfields within macroeconomics.

History

Issuing coins and paper money

Monetary policy has evolved over the centuries, along with the development of a money economy. Historians, economists, anthropologists and numismatics do not agree on the origins of money. In the West the common point of view is that coins were first used in

Paper money originated from

With the creation of the Bank of England in 1694,^[7] which was granted the authority to print notes backed by gold, the idea of monetary policy as independent of executive action^[how?] began to be established.^[8] The purpose of monetary policy was to maintain the value of the coinage, print notes which would trade at par to specie, and prevent coins from leaving circulation. During the period 1870–1920, the industrialized nations established central banking systems, with one of the last being the Federal Reserve in 1913.^[9] By this time the role of the central bank as the "lender of last resort" was established. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of appreciation for the marginal revolution in economics, which demonstrated that people would change their decisions based on changes in their opportunity costs.

The establishment of national banks by industrializing nations was associated then with the desire to maintain the currency's relationship to the gold standard, and to trade in a narrow currency band with other gold-backed currencies. To accomplish this end, central banks as part of the gold standard began setting the interest rates that they charged both their own borrowers and other banks which required money for liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates.

The gold standard is a system by which the price of the national currency is fixed vis-a-vis the value of gold, and is kept constant by the government's promise to buy or sell gold at a fixed price in terms of the base currency. The gold standard might be regarded as a special case of "fixed exchange rate" policy, or as a special type of commodity price level targeting. However, the policies required to maintain the gold standard might be harmful to employment and general economic activity and probably exacerbated the Great Depression in the 1930s in many countries, leading eventually to the demise of the gold standards and efforts to create a more adequate monetary framework internationally after World War II.^[10] Nowadays the gold standard is no longer used by any country.^[11]

Fixed exchange rates prevailing

In 1944, the Bretton Woods system was established, which created the International Monetary Fund and introduced a fixed exchange rate system linking the currencies of most industrialized nations to the US dollar, which as the only currency in the system would be directly convertible to gold.^[12] During the following decades the system secured stable exchange rates internationally, but the system broke down during the 1970s when the dollar increasingly came to be viewed as overvalued. In 1971, the dollar's convertibility into gold was suspended. Attempts to revive the fixed exchange rates failed, and by 1973 the major currencies began to float against each other.^[13] In Europe, various attempts were made to establish a regional fixed exchange rate system via the European Monetary System, leading eventually to the Economic and Monetary Union of the European Union and the introduction of the currency euro.

Money supply targets

The Global Financial Crisis of 2008 sparked controversy over the use and flexibility of the inflation targeting employed. Many economists argued that the actual inflation targets decided upon were set too low by many monetary regimes. During the crisis, many inflation-anchoring countries reached the lower bound of zero rates, resulting in inflation rates decreasing to almost zero or even deflation.[19]

As of 2023, the central banks of all G7 member countries can be said to follow an inflation target, including the European Central Bank and the Federal Reserve, who have adopted the main elements of inflation targeting without officially calling themselves inflation targeters.^[18] In emerging countries fixed exchange rate regimes are still the most common monetary policy.^[20]

• 
  The Bank of Finland, in Helsinki, established in 1812.
• 
  The headquarters of the Bank for International Settlements, in Basel (Switzerland).
• 
  The Reserve Bank of India (established in 1935) Headquarters in Mumbai.
• 
  The Central Bank of Brazil (established in 1964) in Brasília.
• 
  The Bank of Spain (established in 1782) in Madrid.

Monetary policy instruments

The instruments available to central banks for conducting monetary policy vary from country to country, depending on the country's stage of development, institutional structure and political system.

For most central banks in advanced economies, their main monetary policy instrument is a short-term interest rate.

The concrete implementation mechanism used to adjust short-term interest rates differs from central bank to central bank.[25] The "policy rate" itself, i.e. the main interest rate which the central bank uses to communicate its policy, may be either an administered rate (i.e. set directly by the central bank) or a market interest rate which the central bank influences only indirectly.^[22] By setting administered rates that commercial banks and possibly other financial institutions will receive for their deposits in the central bank, respectively pay for loans from the central bank, the central monetary authority can create a band (or "corridor") within which market interbank short-term interest rates will typically move. Depending on the specific details, the resulting specific market interest rate may either be created by open market operations by the central bank (a so-called "corridor system") or in practice equal the administered rate (a "floor system", practised by the Federal Reserve^[26] among others).^[22][27]

As an example of how this functions, the Bank of Canada sets a target overnight rate, and a band of plus or minus 0.25%. Qualified banks borrow from each other within this band, but never above or below, because the central bank will always lend to them at the top of the band, and take deposits at the bottom of the band; in principle, the capacity to borrow and lend at the extremes of the band are unlimited.^[28]

The target rates are generally short-term rates. The actual rate that borrowers and lenders receive on the market will depend on (perceived) credit risk, maturity and other factors. For example, a central bank might set a target rate for overnight lending of 4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases of inverted yield curves, even below the short-term rate.

Many central banks have one primary "headline" rate that is quoted as the "central bank rate". In practice, they will have other tools and rates that are used, but only one that is rigorously targeted and enforced. A typical central bank consequently has several interest rates or monetary policy tools it can use to influence markets.

• Marginal lending rate – a fixed rate for institutions to borrow money from the central bank. (In the USA this is called the discount rate).
• Main refinancing rate – the publicly visible interest rate the central bank announces. It is also known as minimum bid rate and serves as a bidding floor for refinancing loans. (In the USA this is called the federal funds rate).
• Deposit rate, generally consisting of interest on reserves – the rates parties receive for deposits at the central bank.

Open market operations

Through open market operations, a central bank may influence the level of interest rates, the exchange rate and/or the money supply in an economy. Open market operations can influence interest rates by expanding or contracting the monetary base, which consists of currency in circulation and banks' reserves on deposit at the central bank. Each time a central bank buys securities (such as a government bond or treasury bill), it in effect creates money. The central bank exchanges money for the security, increasing the monetary base while lowering the supply of the specific security. Conversely, selling of securities by the central bank reduces the monetary base.

Open market operations usually take the form of:

• Buying or selling securities ("direct operations").
• Temporary lending of money for collateral securities ("Reverse Operations" or "repurchase operations", otherwise known as the "repo" market). These operations are carried out on a regular basis, where fixed maturity loans (of one week and one month for the ECB) are auctioned off.
• Foreign exchange operations such as foreign exchange swaps.

Forward guidance

Forward guidance is a communication practice whereby the central bank announces its forecasts and future intentions to influence market expectations of future levels of

Historically,

A number of central banks have since abolished their reserve requirements over the last few decades, beginning with the Reserve Bank of New Zealand in 1985 and continuing with the Federal Reserve in 2020. For the respective banking systems, bank capital requirements provide a check on the growth of the money supply.

The

The currency component of the money supply is far smaller than the deposit component. Currency, bank reserves and institutional loan agreements together make up the monetary base, called M1, M2 and M3. The Federal Reserve Bank stopped publishing M3 and counting it as part of the money supply in 2006.^[31]

Credit guidance

Central banks can directly or indirectly influence the allocation of bank lending in certain sectors of the economy by applying quotas, limits or differentiated interest rates.^[32][33] This allows the central bank to control both the quantity of lending and its allocation towards certain strategic sectors of the economy, for example to support the national industrial policy, or to environmental investment such as housing renovation.^[34][35][36]

The Bank of Japan used to apply such policy ("window guidance") between 1962 and 1991.^[37][38] The Banque de France also widely used credit guidance during the post-war period of 1948 until 1973 .^[39]

The European Central Bank's ongoing TLTROs operations can also be described as form of credit guidance insofar as the level of interest rate ultimately paid by banks is differentiated according to the volume of lending made by commercial banks at the end of the maintenance period. If commercial banks achieve a certain lending performance threshold, they get a discount interest rate, that is lower than the standard key interest rate. For this reason, some economists have described the TLTROs as a "dual interest rates" policy.^[40][41]

China is also applying a form of dual rate policy.^[42][43]

Exchange requirements

To influence the money supply, some central banks may require that some or all foreign exchange receipts (generally from exports) be exchanged for the local currency. The rate that is used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is generally used in countries with non-convertible currencies or partially convertible currencies. The recipient of the local currency may be allowed to freely dispose of the funds, required to hold the funds with the central bank for some period of time, or allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or use the foreign exchange may be otherwise limited.

In this method, money supply is increased by the central bank when it purchases the foreign currency by issuing (selling) the local currency. The central bank may subsequently reduce the money supply by various means, including selling bonds or foreign exchange interventions.

Collateral policy

In some countries, central banks may have other tools that work indirectly to limit lending practices and otherwise restrict or regulate capital markets. For example, a central bank may regulate

Central banks often have requirements for the quality of assets that may be held by financial institutions; these requirements may act as a limit on the amount of risk and leverage created by the financial system. These requirements may be direct, such as requiring certain assets to bear certain minimum credit ratings, or indirect, by the central bank lending to counter-parties only when security of a certain quality is pledged as collateral.

Unconventional monetary policy at the zero bound

Other forms of monetary policy, particularly used when interest rates are at or near 0% and there are concerns about deflation or deflation is occurring, are referred to as unconventional monetary policy. These include

Further similar monetary policy proposals include the idea of helicopter money whereby central banks would create money without assets as counterpart in their balance sheet. The money created could be distributed directly to the population as a citizen's dividend. Virtues of such money shocks include the decrease of household risk aversion and the increase in demand, boosting both inflation and the output gap. This option has been increasingly discussed since March 2016 after the ECB's president Mario Draghi said he found the concept "very interesting".^[45] The idea was also promoted by prominent former central bankers Stanley Fischer and Philipp Hildebrand in a paper published by BlackRock,^[46] and in France by economists Philippe Martin and Xavier Ragot from the French Council for Economic Analysis, a think tank attached to the Prime minister's office.^[47]

Some have envisaged the use of what Milton Friedman once called "helicopter money" whereby the central bank would make direct transfers to citizens^[48] in order to lift inflation up to the central bank's intended target. Such policy option could be particularly effective at the zero lower bound.^[49]

Nominal anchors

Central banks typically use a nominal anchor to pin down expectations of private agents about the nominal price level or its path or about what the central bank might do with respect to achieving that path. A nominal anchor is a variable that is thought to bear a stable relationship to the price level or the rate of inflation over some period of time. The adoption of a nominal anchor is intended to stabilize inflation expectations, which may, in turn, help stabilize actual inflation. Nominal variables historically used as anchors include the

Empirically, some researchers suggest that central banks' policies can be described by a simple method called the Taylor rule, according to which central banks adjust their policy interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.^[51]

Inflation targeting