Monetary Policy

Definition of monetary policy

The government of every country has its policies to support the interconnected system between money, loans and banking or a nation’s financial system in general terms. One of the most powerful government policies is Monetary policy, a set of actions used by a country’s central bank to adjust the supply of money in the economy, usually through changing the official cash rate, to achieve economic growth while keeping inflation in check.

When central banks lower interest rates, monetary policy is easing. When they raise interest rates, monetary policy is tightening.

Types of monetary policy

Monetary policies are either expansionary or contractionary depending on the level of growth or stagnation within the economy.

Contractionary monetary policy (or tight monetary policy)

Central banks use the contractionary monetary policies to combat the rising inflation by:

• Increasing the interest rates to limit the amount of money circulating in the economy.

• Increasing reserve requirements held by banks to reduce the funds available for lending to businesses and consumers.

• Selling assets such as Treasury notes in the open market to lower the market price of such assets and increase their yields.

Expansionary monetary policy (or Loose monetary policy)

During times of slowdown or recession, expansionary monetary policies are used by central banks to stimulate economic growth by boosting aggregate demand.

• Lowering interest rates, which give banks greater access to cash that can be lent in the market.

• Reducing required reserves held by banks to allow banks to lend a higher proportion of their capital to consumers and businesses.

• Purchasing debt instruments such as Treasury bonds on the open market to inject capital directly into the economy.

Goals of monetary policy

Inflation

• The contractionary monetary policy is used to ease inflation when prices rise too quickly and to prevent the economy from overheating by reducing the money supply circulating within the economy.

• Whereas the expansionary monetary policy can stimulate economic growth with an increase of money in circulation.

Unemployment

The expansionary monetary policy can address unemployment by stimulating economic activity, which leads to job creation by:

• Lowering interest rates, which leads to lower borrowing costs, higher consumer demands, increased production levels and ultimately a need for more workers.

• Purchasing government securities and other financial assets to inject liquidity into the economy and encourage investment, which can lead to an increase in economic activity and job creation.

Exchange rates

The exchange rate between domestic and foreign currencies can be affected by monetary policy. With an increase in money supply (expansionary monetary policy), the domestic currency becomes cheaper than its foreign exchange.

Unconventional monetary policy

During the Global Financial Crisis (GFC) of 2007-2008, those standard monetary policies proved its inefficiency. The U.S. Federal Reserve (Fed) dropped the interest rates to near zero by December 2008, but the economy was still in a severe recession. Hence, central banks around the world have adopted non-traditional monetary tools such as quantitative easing (QE), forward guidance, and negative interest rates to combat economic collapse and prevent further destabilisation.

Forward guidance

Forward guidance refers to the central bank’s communication of its future intentions regarding the monetary policy. It lets the general public know the future path of the policy interest rate and other aspects of monetary policy. For instance, the central bank commits not to increase interest rates until a certain date or until a specific set of economic conditions are met (e.g. until inflation or unemployment reach certain levels).

Quantitative Easing (QE)

Quantitative easing involves the purchase of large quantities of a wide range of government bonds and other financial assets from the private sector to increase the money supply and lower long-term interest rates of risk-free assets (government bonds) and ultimately reduce borrowing costs.

In the early 1990s, Japan underwent a long period of slow growth and deflation, the Bank of Japan (BoJ) implemented its Quantitative easing program, which included not just buying government bonds, but also purchasing corporate bonds, exchange-traded funds (ETFs), and real estate investment trusts (REITs). While BoJ’s Quantitative easing helped prevent a complete collapse, the country’s long-term issues, such as an aging population and low productivity growth, limited the impact of the policy.

Negative interest rates

Negative interest rates are truly unconventional and hard to imagine in real life. It implies that instead of earning interest, people would be charged by their banks to deposit money. Prior to the Global financial crisis, nobody thought the policy interest rates could be negative. As it turned out, some countries adopted the policy to boost lending to businesses and households, stimulate investment and fight deflation.

In 2014, the European Central Bank (ECB) took the unprecedented steps of introducing negative interest rates on the deposits that commercial banks held with the central bank. While the policy aimed to encourage banks to lend rather than hold cash at the central bank, it also potentially lowered the banks’ profitability and undermined the financial system liquidity and stability. The ECB later complemented this policy with QE and other methods to further stimulate the economy.

Pitfalls of monetary policy

Monetary policy, while maintaining a powerful tool in managing the economy, still faces a number of significant hurdles and limitations. Some key pitfalls include:

Time lag

Monetary policy involves a chain of events. Therefore, there is a time lag between when the central bank recognises and implements the policy until the time its effects are felt and impact the economy. As a result, monetary policy has little effect in the immediate future.

Zero lower bound

During the period of great recession, with very low or even zero interest rates, traditional monetary tools such as adjusting policy interest rates further would not perhaps stimulate investments or economic growth. Instead, central banks may resort to unconventional tools including quantitative easing or negative interest rates, but these often come with their own risks (e.g. asset bubbles).

Excess reserve

Banks are often required to hold a minimum level of reserves if they choose to hold an excessive amount of reserves due to their fear of the contracting economy, then the expansionary monetary policy may not work well. Banks might be reluctant to lend, businesses and individuals might not want to borrow much in a recession, which further deepens the slow growth of the economy.

Japan experienced this situation for nearly a decade from the 1990s to early 2000s. Despite the country’s highly expansionary monetary policy with federal fund rates of 0%, Japan still underwent an extremely slow growth into the mid-2000s.

References

Brown, T & Foreman, C 2022, UH Macroeconomics 2022, OpenStax, Houston, TX, pp. 709-185.

Federal Reserve n.d., Monetary Policy: What Are Its Goals? How Does It Work?, Federal Reserve, available at <https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm>.

Koshy, M n.d., Monetary Policy: Stabilizing Prices and Output, International Monetary Fund, available at <https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Monetary-Policy>.

Haksar, V. and Kopp, E., 2020. What are negative interest rates?, International Monetary Fund, available at <https://www.imf.org/en/Publications/fandd/issues/2020/03/what-are-negative-interest-rates-basics>.

Reserve Bank of Australia n.d, Unconventional Monetary Policy, Reserve Bank of Australia, available at <https://www.rba.gov.au/education/resources/explainers/unconventional-monetary-policy.html>.