Monetary Policy Strategy
[see Borio (2001), section I]
Monetary authorities (central bank and/or government) have the responsibility for achieving certain goals or final objectives. Historically, macroeconomic goals may have included items such as highest possible long-term economic growth or lowest unemployment. In recent years, however, responding to new insights from macroeconomic theory, central bank mandates have de jure or de facto been increasingly focused on price stability. In some cases this goes as far as setting explicit numerical targets for inflation to be attained over specific time horizons (inflation targeting).
For an economist, in theory, monetary policy strategy can be extremely simple. We can postulate a policy objective function (for example, stabilize inflation and/or output). We can also write down several mathematical equations as a dynamic model of the economy. Optimal monetary policy is then reduced to the mathematical derivation of an optimal policy rule, which sets the value of the policy instrument as a function of available information. However, there are many and varied reasons why such an optimal control theory approach to monetary policy is unlikely to be satisfactory.
In more general terms, the pursuit of final goals of monetary policy rests on a series of choices regarding the information set used as a basis for short-term and longer-term policy adjustments, including the weights and specific roles attached to various economic variables. This subsumes issues such as the choice of exchange rate regime, intermediate target variables, forecasting, and indices of the thrust of monetary policy or overall conditions in the monetary sphere. The variables playing a role at the strategic level are generally not under the close control of the authorities and the corresponding policy decisions usually pertain to horizons longer than one month.
What monetary policy can and cannot do [see ECB (2004) Chapter 3]
The way in which monetary policy exerts its influence on the economy can be explained as follows. The central bank is the sole issuer of banknotes and sole provider of bank reserves, i.e. it is the monopoly supplier of the monetary base. By virtue of this monopoly, the central bank is able to influence money market conditions and steer short-term interest rates. In the short run, a change in money market interest rates induced by the central bank sets in motion a number of mechanisms and actions by economic agents, ultimately influencing developments in economic variables such as output or prices. This process – also known as the monetary policy transmission mechanism – is complex and, while its broad features are understood, there is no unique and undisputed view of all the aspects involved.
However, it is a widely accepted proposition in the economic profession that, in the long run, i.e. after all adjustments in the economy have worked through, a change in the quantity of money in the economy (all other things being equal) will be reflected in a change in the general level of prices and will not induce permanent changes in real variables such as real output or unemployment. A change in the quantity of money in circulation ultimately represents a change in the unit of account (and thereby of the general price level) which leaves all other variables unchanged, in much the same way as changing the standard unit used to measure distance (e.g. switching from kilometres to miles) would not alter the actual distance between two locations.
This general principle, referred to as “the long-run neutrality” of money, underlies all standard macroeconomic thinking and theoretical frameworks. Real income or the level of employment in the economy are, in the long run, essentially determined by real (supply-side) factors. These are technology, population growth, the preferences of economic agents and all aspects of the institutional framework of the economy (notably property rights, tax policy, welfare policies and other regulations determining the flexibility of markets and incentives to supply labour and capital and to invest in human capital). In the long run, the central bank cannot influence economic growth by changing the money supply. Related to this is the assertion that inflation is ultimately a monetary phenomenon Indeed, prolonged periods of high inflation are typically associated with high monetary growth. While other factors (such as variations in aggregate demand, technological changes or commodity price shocks) can influence price developments over shorter horizons, over time their effects can be offset by some degree of adjustment of the money stock. In this sense, the longer-term trends of prices or inflation can be controlled by central banks. The close association between the growth of money and inflation in the economy and the long-run neutrality of monetary policy have been confirmed by a very large number of economic studies, covering various periods and countries. At the same time, both empirical and theoretical research has confirmed that the costs of inflation (and deflation) are substantial and it is today widely acknowledged that price stability contributes to increasing economic welfare and the growth potential of an economy.
...
Channels of monetary transmission
The process through which monetary policy decisions affect the economy in general, and the price level in particular, is known as the transmission mechanism of monetary policy. The individual links through which monetary policy impulses (typically) proceed are known as transmission channels.
The main channels of monetary policy transmission are set out in a simplified, schematic form in the lefthand part of Chart 3.1.
... starts with a change in official interest rates...
The (long) chain of cause and effect linking monetary policy decisions with the price level starts with a change in the official interest rates set by the central bank on its own operations. In these operations, the central bank typically provides funds to banks (see Chapter 4 for a detailed description of the Eurosystem’s monetary policy instruments). The banking system demands money issued by the central bank (“base money”) to meet the public demand for currency, to clear interbank balances and to meet the requirements for minimum reserves that have to be deposited with the central bank. Given its monopoly over the creation of base money, the central bank can fully determine the interest rates on its operations. Since the central bank thereby affects the funding cost of liquidity for banks, banks need to pass on these costs when lending to their customers.
...affecting market interest rates...
Through this process, the central bank can exert a dominant influence on money market conditions and thereby steer money market interest rates. Changes in money market rates in turn affect other interest rates, albeit to varying degrees. For example, changes in money market rates have an impact on the interest rates set by banks on short-term loans and deposits. In addition, expectations of future official interest rate changes affect longer-term market interest rates, since these reflect expectations of the future evolution of short-term interest rates. However, the impact of money market rate changes on interest rates at very long maturities (e.g. 10-year government bond yields, long-term bank lending rates) is less direct. Those rates depend to a large extent on market expectations for long-term growth and inflation trends in the economy. In other words, changes in the central bank’s off icial rates do not normally affect these longer-term rates unless they were to lead to a change in market expectations concerning long term economic trends.
...and asset prices...
Because of the impact it has on financing conditions in the economy – but also because of its impact on expectations – monetary policy can affect other financial variables such as asset prices (e.g. stock market prices) and exchange rates.
...affecting credit, savings and investment decisions...
Changes in interest rates and financial asset prices in turn affect the saving, spending and investment decisions of households and firms. For example, all other things being equal, higher interest rates tend to make it less attractive for households or companies to take out loans in order to finance their consumption or investment. Higher interest rates also make it more attractive for households to save their current income rather than spend it, since the return on their savings is increased. Furthermore, changes in official interest rates may also affect the supply of credit. For example, following an increase in interest rates, the risk that some borrowers cannot safely pay back their loans may increase to a level such that banks will not grant a loan to these borrowers. As a consequence, such borrowers, households or firms, would be forced to postpone their consumption or investment plans.
Finally, movements in asset prices may affect consumption and investment via income and wealth effects. For example, as equity prices rise, share-owning households become wealthier and may choose to increase their consumption. Conversely, when equity prices fall, households may well reduce consumption. An additional way in which asset prices can impact on aggregate demand is via the value of collateral that allows borrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks. Lending decisions are often influenced to a large extent by the amount of collateral. If the value of collateral falls then loans will become more expensive and may even be difficult to obtain at all, with the result that spending will fall.
...leading to a change in aggregate demand and prices...
As a consequence of changes in consumption and investment, the level of domestic demand for goods and services relative to domestic supply will change. When demand exceeds supply, all other things being equal, upward pressure on prices is likely to result. Moreover, changes in aggregate demand may translate into tighter or looser conditions in labour and intermediate product markets, and these in turn can affect wage and price-setting in the respective market.
Effects of exchange rate changes on prices
Changes in the exchange rate will normally affect inflation in three ways. First, exchange rate movements may directly affect the domestic price of imported goods. If the exchange rate appreciates, the price of imported goods tends to fall, thus helping to reduce inflation directly, insofar as these products are directly used in consumption. Second, if these imports are used as inputs into the production process, lower prices for inputs might, over time, feed through into lower prices for final goods. Third, exchange rate developments may also have an effect via their impact on the competitiveness of domestically produced goods on international markets. If an appreciation in the exchange rate makes domestically produced goods less competitive in terms of their price on world markets, this tends to constrain external demand and thus reduce overall demand pressure in the economy. All other things being equal, an appreciation of the exchange rate would thus tend to reduce inflationary pressures. The strength of exchange rate effects depends on how open the economy is to international trade. Exchange rate effects are in general less important for a large, relatively closed currency area like the euro area than for a small open economy. Clearly, financial asset prices depend on many other factors in addition to monetary policy, and changes in the exchange rate are also often dominated by these factors.
Anchoring inflation expectations
Other channels through which monetary policy can influence price developments mainly work by influencing the private sector’s longer-term expectations. If a central bank enjoys a high degree of credibility in pursuing its objective, monetary policy can exert a powerful direct influence on price developments by guiding economic agents’ expectations of future inflation and thereby influencing their wage and price-setting behaviour. The credibility of a central bank to maintain price stability in a lasting manner is crucial in this respect. Only if economic agents believe in the central bank’s ability and commitment to maintain price stability will inflation expectations remain firmly anchored to price stability. This, in turn, will influence wage and price-setting in the economy given that, in an environment of price stability, wage and price-setters will not have to adjust their prices upwards for fear of higher inflation in the future. In this respect, credibility facilitates the task of monetary policy.
Transmission is characterised by long, variable and uncertain time lags...
The dynamic process outlined above involves a number of different mechanisms and actions by economic agents at various stages of the process. As a result, monetary policy action usually takes a considerable time to affect price developments. Furthermore, the size and strength of the different effects can vary according to the state of the economy, which makes the precise impact difficult to estimate. Taken together, central banks typically see themselves confronted with long, variable and uncertain lags in the conduct of monetary policy.
...and is influenced by exogenous shocks
Identifying the transmission mechanism of monetary policy is complicated by the fact that, in practice, economic developments are continuously influenced by shocks from a large variety of sources. For instance, changes in oil or other commodity prices or in administered prices can have a short-term, direct impact on inflation. Similarly, developments in the world economy or in fiscal policies may influence aggregate demand and thereby price developments. Furthermore, financial asset prices and exchange rates depend on many other factors in addition to monetary policy. Monetary policy therefore needs not only to monitor the transmission of monetary policy changes but also to take into account all other developments relevant for future inflation in order to avoid these having any impact on longer-term inflation trends and expectations in a way that is inconsistent with price stability. The required path of monetary policy is always dependent on the nature, size and duration of the shocks hitting the economy, and it is a permanent challenge for the central bank to understand which factors are driving price trends in order to find the appropriate monetary policy reaction.
INTERNET
- Bernanke, B.S., T. Laubach, F.S. Mishkin, A.S. Posen, Inflation Targeting: Lessons from the International Experience. Princeton Univ. Press, 1999.
- Mishkin, F.S., ‘International experiences with different monetary policy regimes,’ Journal of Monetary Economics, vol.43 (3) June 1999: 579-605.
- Bundesbank, "Monetary policy strategies in the countries of the European Union," Deutsche Bundesbank Monthly Report, January 1998: 33-47. Survey of monetary policy strategies in EU countries in the run-up to the formulation of a single monetary policy for the euro area.
- Bernanke, B. and F. Mishkin, "Central bank behavior and the strategy of monetary policy: Observations from six industrialized countries," in O.J. Blanchard, S. Fischer (eds) NBER Macroeconomics Annual 1992. MIT Press, 1992: 183-228. NBER Working Paper no.4082 May 1992. Survey of monetary policy strategies and operating procedures. Derives a number of 'positive' and 'normative' conclusions.
- John Taylor's, Monetary policy rule homepage. Website of the 'inventor' of the Taylor rule. Links to research on monetary policy rules.