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Monetary policy is the process by which the Government , Central Bank , or monetary authority manages the Supply of Money , or trading in Foreign Exchange Market s.1 Monetary Theory provides insight into how to craft optimal monetary policy. Monetary policy is generally referred to as either being an Expansionary Policy , or a Contractionary Policy , where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat Unemployment in a Recession by lowering Interest Rates , while contractionary policy has the goal of raising Interest Rates to combat Inflation (or cool an otherwise overheated economy). Monetary policy should be contrasted with Fiscal Policy , which refers to government borrowing, spending and taxation. OVERVIEW Monetary policy rests on the relationship between the rates of interest in an economy, that is the price at which money can be borrowed, and the total supply of money. Monetary policy uses a variety of tools to control one or both of these, to influence outcomes like Economic Growth , Inflation , exchange rates with other currencies and Unemployment . Where currency is under a monopoly of issuance, or where there is a regulated system of issuing currency through banks which are tied to a central bank, the monetary authority has the ability to alter the money supply and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary policy as such comes from the late 19th century, where it was used to maintain the Gold Standard . A policy is referred to as Contractionary if it reduces the size of the money supply or raises the interest rate. An Expansionary policy increases the size of the money supply, or decreases the interest rate. Further monetary policies are described as accommodative if the interest rate set by the central monetary authority is intended to spur economic growth, neutral if it is intended to neither spur growth nor combat inflation, or tight if intended to reduce inflation. There are several monetary policy tools available to achieve these ends. Increasing interest rates by fiat, reducing the Monetary Base , and increasing Reserve Requirement s all have the effect of contracting the Money Supply , and, if reversed, expand the money supply. Since the 1970s, monetary policy has generally been formed separately from Fiscal Policy . And even prior to the 1970s, the Bretton Woods System still ensured that most nations would form the two policies separately. Within almost all modern nations, special institutions (such as the Bank Of England , the European Central Bank or the Federal Reserve System in the United States) exist which have the task of executing the monetary policy and oftentimes independently of the Executive . In general, these institutions are called Central Bank s and often have other responsibilities such as supervising the smooth operation of the financial system. The primary tool of monetary policy is Open Market Operation s. This entails managing the quantity of money in circulation through the buying and selling of various credit instruments, foreign currencies or commodities. All of these purchases or sales result in more or less base currency entering or leaving market circulation. Usually the short term goal of open market operations is to achieve a specific short term interest rate target. In other instances, however, monetary policy might instead entail the targeting of a specific exchange rate relative to some foreign currency or else relative to gold. For example in the case of the USA the Federal Reserve targets the Federal Funds Rate , the rate at which member banks lend to one another overnight. However the monetary policy of China is to target the Exchange Rate between the Chinese Renminbi and a basket of foreign currencies. The other primary means of conducting monetary policy include: (i) Discount window lending (i.e. lender of last resort); (ii) Fractional deposit lending (i.e. changes in the reserve requirement); (iii) Moral suasion (i.e. cajoling certain market players to achieve specified outcomes); (iv) "Open mouth operations" (i.e. talking monetary policy with the market). HISTORY OF MONETARY POLICY Monetary policy is associated with to create credit. Interest rates, while now thought of as part of monetary authority, were not generally coordinated with the other forms of monetary policy. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with Segniorage , or the power to coin. With the advent of larger trading networks came the ability to set the price between gold and silver, and the price of the local currency to foreign currencies. This official price could be enforced by law, even if it varied from the market price. With the creation of the Bank Of England in 1694 , which acquired the responsibility to print notes and back them with gold, the idea of monetary policy as independent of executive action began to be established.2 The goal 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. The establishment of central banks by industrializing nations was associated then with the desire to maintain the nation's peg to the Gold Standard , and to trade in a narrow Band with other gold back 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 who required liquidity. The maintenance of a gold standard required almost monthly adjustments of interest rates. During the 1870-1920 period the industrialized nations set up central banking systems, with one of the last being the Federal Reserve in 1913 .3 By this point the understanding of the central bank as the "lender of last resort" was understood. It was also increasingly understood that interest rates had an effect on the entire economy, in no small part because of the Marginal Revolution in economics, which focused on how many more, or how many fewer, people would make a decision based on a change in the economic trade-offs. It also became clear that there was a Business Cycle , and economic theory began understanding the relationship of interest rates to that cycle. (Nevertheless, steering a whole economy by influencing the interest rate has often been described as trying to steer an oil tanker with a canoe paddle.) The advancement of monetary policy as a pseudo scientific discipline has been quite rapid in the last 150 years, and it has increased especially rapidly in the last 50 years. Monetary policy has grown from simply increasing the monetary supply enough to keep up with both population growth and economic activity. It must now take into account such diverse factors as:
A small but vocal group of people advocate for a return to the gold standard (the elimination of the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is basically that monetary policy is fraught with risk and these risks will result in drastic harm to the populace should monetary policy fail. Most economists disagree with returning to a gold standard. They argue that doing so would drastically limit the money supply, and throw away 100 years of advancement in monetary policy. The sometimes complex financial transactions that make big business (especially international business) easier and safer would be much more difficult if not impossible. Moreover, shifting risk to different people/companies that specialize in monitoring and using risk can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved. TRENDS IN CENTRAL BANKING The central bank influences interest rates by expanding or contracting the monetary base, which consists of Currency in circulation and banks' reserves on deposit at the central bank. The primary way that the central bank can affect the monetary base is by Open Market Operations or sales and purchases of second hand government debt, or by changing the Reserve Requirement s. If the central bank wishes to lower interest rates, it purchases government debt, thereby increasing the amount of cash in circulation or crediting Banks' Reserve Accounts . Alternatively, it can lower the interest rate on discounts or overdrafts (basically loans to banks secured by suitable collateral, specified by the central bank). If the interest rate on such transactions is sufficiently low, commercial banks can borrow from the central bank to meet reserve requirements and use the additional liquidity to expand their balance sheets, increasing the credit available to the economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to increase loans or buy other profitable assets. |
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