Any change in the central back policy or the bank reserves, which is made to influence the interest rates and thus the investment, employment or production, is called the monetary policy. If the monetary authority wants to increase production, they need to increase the bank reserves. The bank then expands the money supply, which in turn reduces the interest rates. Monetary policy is one of the tools that a national Government uses to influence the economy. In alignment with its political objectives, it uses its authority to control the supply and availability of money to further impact its desired level of economic activity. The policy is usually done by the Central Bank of the country.
The monetary policy has undergone a change from past days to now. The modern central banking especially in the U.S. comes after the post-depression era. The 1930's Government led by the economist John Keynes found that it was due to the shortage of money supply and credit availability that the depression came about. This discovery that money supply affects the economy led the Government to influence the supply into more favorable circumstances called a monetary policy. At this time, many nations created "central banks," as a form of monetary authority. This meant that instead of accepting whatever happened to the money supply, they would influence the amount of money available in the market. This, in turn, would have an effect on credit and economic activity. The modern monetary policy, unlike the olden times does not have gold as its principal standard.
In olden times, governments would issue precious coins with their stamp. The worth of the currency depended on the value of the metal used in the coins. So, a country's worth was dependent on the amount of gold and silver reserves it had in its treasury. Paper currency led to a further problem since countries just needed to have large hordes of paper currency in their treasury to prove their credit worthiness. Paper money was backed by a "promise to pay" upon demand. When god became the "defacto" standard of the world, a gold standard was developed where nations kept sufficient gold to keep to his "promise to pay." In the U.S., the gold standard was withdrawn in 1968, and the Federal Reserve ha since then controlled the amount of money and credit in the U.S. economy. By this, it maintains the purchasing power of the U.S. dollar against the currencies of other countries. 1
What is the effectiveness of a monetary policy? There are narrow and broad money supplies. Narrow money supply means the money in circulation, while broad money supply means term deposits and mutual funds. Although economists vary about the effectiveness of a monetary policy it is a fact that in extreme circumstances, it has been an instrument of force. In countries like Russia and Brazil, printing presses work hard to produce a large amount of money for the Government's operations. Thus, the money supply expands rapidly and the currency becomes worthless as against the goods and services it can buy. This results in a high inflation.2
1. Monetary Policy. Retrieved at http://www.finpipe.com/monpol.htm. Accessed on April 22, 2004
2. Monetary Policy. Retrieved at http://www.finpipe.com/monpol.htm. Accessed on April 22, 2004
In other countries like Germany, which had the same "hyper-inflation," the monetary policy is now controlled and stable so that the inflation is low level and such occurrences are prevented. The Bank of Canada, for example, in the 1990's brought about a monetary policy that in turn targeted a negative inflation, between 0%-3%. Along with the effectiveness of monetary policy, the timing and its impact on economy are crucial. This is so because the investor puts in his money only on the basis of the real reasons behind a policy. The availability of money and credit is a key factor that determines his level of investment. 3
The main case of inflation target is the political economy of central banking: the incentives, and the process by which the monetary policy is set. Paper economy creates a sort of temptation to bring inflation on the unsuspecting public. Further, both the extremes of following a monetary policy by rules or by discretion are inadmissible. No straight forward rule exists to set a monetary policy. Only a rule like behavior increases predictability to ensure that expectations are consistent with the inflation target. An explicit inflation target would also set the central bank to be in line with the monetary policy announced. Constrained discretion will allow a bank to implement an optimal monetary policy. An inflation target is not related to inflation. 4
3. Monetary Policy. Retrieved at http://www.finpipe.com/monpol.htm. Accessed on April 22, 2004
4. Economic Policy. Retrieved at http://www.digitaleconomist.com/policy_4020.html. Accessed on April 22, 2004
Changes in commodity and oil prices or changes in the exchange rate or indirect taxes may affect inflation. The central bank chooses a target by which time inflation should be brought under control. Since inflation is measured over a twelve month period, any unexpected changes in the economy will remain over this period, so the central bank should start thinking about the monetary policy to regulate inflation at least 2 years in advance. This emphasizes the need for forecasting which probability distributions, not estimate points are. A transparent monetary policy means that the news should be of development of the economy, not in the announcements of the central bank. Transparency should lead to a predictable policy. 5
Let us see the simple reasons why we have a monetary policy. The invention of money has increased the ability of the people to spend their energy on what they do best and then trade this for any surplus from someone else. Thus, the standard of living of everyone rises. But to recognize that money is valuable, it must be accepted by everyone, within the society, it must be convenient, a reliable standard of value, and must be effective when stored. Monetary policy needs these standards. To achieve this, the total amount of money available in the society must be kept consistent with the total amount of goods and services produced in the society. Otherwise, the buying power of money either rises or falls which is called as inflation or deflation respectively. 6
5. Economic Policy. Retrieved at http://www.digitaleconomist.com/policy_4020.html. Accessed on April 22, 2004
6. The Impact of monetary policy on people. Reserve Bank of New Zealand. May 1997 Retrieved at http://www.rbnz.govt.nz/monpol/about/0092822.html. Accessed on April 22, 2004
If this happens, money as a reliable standard is accepted and its value falls and the benefits are lost. In certain situations, even social evils result, as in the case of Germany in 1920. Further, currencies also become worthless. The Reserve Bank Act states that the Reserve Bank must manage its monetary policy through stability in its prices. This helps the economy perform better. Price stability needs to be there to protect the income and savings of people, encourage investment, employment, growth and exports. Inflation imposes unfair costs on people who have limited means. Large companies and the rich people have a chance to avoid inflation or even gain from it. The Reserve Bank through its monetary policy creates a just society. 7
As an example, in the 1970's, New Zealand had a high inflation. Unemployment also increased. In mid-1984, New Zealand went through a process of deregulation. In 1985, the monetary policy was changed to focus just on bringing down inflation. This combination of factors meant the prices fell, and after the market crash in 1987, unemployment rose. This trend continued till 1991, after which inflation reached the targeted 0%-2%. The Reserve Bank then began, to ease the monetary policy to maintain price stability. Employment increased, the living standard rose, and GDP began to grow rapidly. Monetary policy does not focus on inflation alone; it stimulates the economic activity by adjusting according to the prevailing mood. 8
7. The Impact of monetary policy on people. Reserve Bank of New Zealand. May 1997 Retrieved at http://www.rbnz.govt.nz/monpol/about/0092822.html. Accessed on April 22, 2004
8. The Impact of monetary policy on people. Reserve Bank of New Zealand. May 1997 Retrieved at http://www.rbnz.govt.nz/monpol/about/0092822.html. Accessed on April 22, 2004
Let us further see how monetary policies are affected. Since monetary policy is the use of interest rates and the level of money supply to control the economy, it can be done to reflate or deflate the economy. If it is seen that inflation is falling and will easily meet the target, then interest rates can be cut. Reducing interest rates will promote firms and people to borrow more money. It will also give people who have taken out mortgages to give more towards their mortgage payment every month. Thus, the level of consumption and spending or investment will also rise in the economy, which in turn, will lead to increased growth and employment.
Reflationary policies are therefore to cut interest rates and allowing the money supply to increase. If the monetary policy shows that inflation is rising and will exceed…