Policy, Monetary
Policy, Monetary
CONTROLLING MONEY, CREDIT, AND INTEREST RATES
THE FUTURE OF MONEY AND MONETARY POLICY
Monetary policy is the management of money, credit, and interest rates by a country’s central bank. Unfortunately, this short definition is clearly inadequate. What is money? What is credit? What is an interest rate? What is a central bank and how does it control them? And, most importantly, why should anyone care? The purpose of this entry is to answer these questions (for more detail, see the relevant chapters of Stephen G. Cecchetti [2006]).
A FEW BASICS
Money is an asset that is generally accepted as payment for goods and services or repayment of debt; money acts as a unit of account, and serves as a store of value. That is, people use money to pay for things (it is a means of payment); quote prices in dollars, euros, yen, or the units of our currency (it is a unit of account); and use money to move purchasing power over time (it is a store of value). Credit is the borrowing and lending of resources. Some people have more resources than they currently need (they are savers) while others have profitable opportunities that they cannot fund (they are investors). Credit flows from the savers to the investors. And an interest rate is the cost of borrowing and the reward for lending. Since lenders could have done something else with their resources, they require compensation—interest is rent paid by borrowers.
THE CENTRAL BANK
The U.S. Federal Reserve System, the Bank of Japan, and the Bank of England are all central banks. Nearly every country in the world has a central bank. It is easiest to understand a central bank by looking at what it does (for a history of money and central banks, see Glyn Davies [2002]). A modern central bank both provides an array of services to commercial banks (it is the bankers’ bank) and manages the government’s finances (it is the government’s bank). While not universally true, we will assume that only banks and governments have accounts at central banks. As the bank for bankers, the central bank holds deposit accounts and operates a system for interbank payments that enables commercial banks (the ones the public uses) to transfer balances in these accounts to one another. The central bank is also in a unique position to provide loans to commercial banks during times of crisis—more on this shortly.
Like any individual or business, the government needs a bank to make and receive payments. So, the central bank keeps an account for the government. When the government wants to make or receive a payment, it needs a bank just like the rest of us. The central bank does that job. In addition, the government gives the central bank the right to print money—that is the paper currency that people use in everyday life.
At its most basic level, printing money is a very profitable business. A $100 bill costs only a few cents to print, but it can be exchanged for $100 worth of goods and services. It is logical then that national governments create a monopoly on printing money and use the revenue it generates to benefit the general public. Also, government officials know that losing control of the money printing presses means losing control of inflation.
CONTROLLING MONEY, CREDIT, AND INTEREST RATES
The fact that the central bank has the license to issue money makes it unique. If individuals want to make a purchase, they need to have the resources to do it. So, for example, someone using a debit card to purchase groceries will have to have sufficient balances in a commercial bank account to cover it. If the grocery purchaser does not have sufficient resources of his own, he will need the financial assistance of someone who is willing to make him a loan. The central bank is different. If the central bank wants to buy something—say a government-issued bond—it can just create the liabilities to do it. Essentially it can issue the money. Importantly, the central bank can expand the size of its balance sheet at will. No one else can do this.
The central bank uses its ability to expand (and contract) its assets and liabilities to implement monetary policy. Figure 1 is a simple version of the central bank’s balance sheet, stripped of a number of incidental items (like buildings and gold). When looking at any balance sheet, the most important thing to remember is that assets equal liabilities, so any change in one side must be matched by a change in the other. When a central bank purchases a government security, increasing its assets, this is normally matched by an increase in commercial bank reserve liabilities. Banks hold these reserves both because they are required by law and in order to make interbank payments.
At its technical, day-to-day level, monetary policy is all about buying and selling securities to control the quantity of reserves in the commercial banking system. Modern central banks, like the Federal Reserve or the European Central Bank, use their monopoly over the supply of commercial bank reserves to control an interest rate of their choosing. In some, like the Reserve Bank of Australia, it is the deposit rate the central bank pays commercial banks on the balances in their reserve account. In the United States, it is the federal funds rate —the rate banks charge each other for overnight loans of reserves. The Federal Reserve decides on its target for the federal funds, and then buys and sells securities to set the supply of reserves to hit this target. Twenty-first century monetary policy is not about controlling the quantity of money or its growth rate; it is about interest rates. (For a technical discussion of the use and the abandonment of money
as a target, see Laurence Meyer [2001a]. For a detailed discussion of the monetary policy of the European Central Bank, see Otmar Issing et al. [2001]).
It is important to note that some central banks decide to use their ability to control the size of their balance sheet to target something other than interest rates. The natural alternative is the exchange value of their currency—that is, the value of the number of dollars it takes to purchase the currency issued by another central bank. But, by the beginning of the twenty-first century, this had become increasingly rare. A central bank cannot control the total quantity of money and credit in the economy directly, and no modern central bank tries.
Finally, in addition to the size of their balance sheet, central banks have two additional tools. During times of financial stress, the central bank stands ready to provide loans to banks that are illiquid (so they cannot make payments) but still solvent (so their net worth is positive). Policymakers set interest rates on these loans. When the lending is done properly, this eliminates financial systemwide panics. In addition, central banks in many countries are given the power to set requirements governing how banks hold their assets. So, for example, they may require a certain level of reserve deposits, or prohibit the holding of common stock.
MONETARY POLICY OBJECTIVES
The central bank is part of the government. Whenever an agency of the government involves itself in the economy, people need to ask why. What makes individuals incapable of doing what they have entrusted to the government? In the case of national defense and pollution regulation, the reasons are obvious. Most people will not voluntarily contribute their resources to the army, nor will a country’s citizens spontaneously clean up their own air.
The rationale for the existence of a central bank is equally clear. While economic and financial systems may be fairly stable most of the time, when left on their own they are prone to episodes of extreme volatility. In the absence of a central bank, economic systems tend to be extremely unstable. The historical record is filled with examples of failure, such as the Great Depression of the 1930s, when the American banking system collapsed and economic activity plummeted.
Central bankers adjust interest rates to reduce the volatility of the economic and financial systems by pursuing a number of objectives. The three most important are: (1) low and stable inflation; (2) high and stable real growth, together with high employment; and (3) stable financial markets. Let’s look at each of these in turn.
The rationale for keeping the economy inflation-free is straightforward. Standards, everyone agrees, should be standard. A pound should always weigh a pound, a measuring cup should always hold a cup, a yardstick should always measure a yard, and one dollar should always have the same purchasing power. Maintaining price stability enhances money’s usefulness both as a unit of account and as a store of value.
Prices are central to everything that happens in a market-based economy. They provide the information individuals and firms need to ensure that resources are allocated to their best uses. When a seller can raise the price of a product, that is supposed to signal that demand has increased, so producing more is worthwhile. Inflation degrades the information content of prices, reducing the efficient operation of the economy.
Turning to growth, central bankers work to dampen the fluctuations of the business cycle. Booms are good; recessions are not. In recessions, people lose their jobs and businesses fail. Without a steady income, people struggle to make their auto, credit card, and mortgage payments. Consumers pull back, hurting businesses that rely on them to buy products. Reduced sales lead to more layoffs, and so on. The longer the downturn goes on, the worse it gets.
Finally, there is financial stability. The financial system is like plumbing: when it works, it is taken for granted, but when it does not work, watch out. If people lose faith in banks and financial markets, they will rush to low-risk alternatives, and the flow of resources from savers to borrowers will stop. Getting a car loan or a home mortgage becomes impossible, as does selling a bond to maintain or expand a business. When the financial system collapses, economic activity also collapses.
THE POLICY FRAMEWORK
Central banks use their ability to control their balance sheet to manipulate short-term interest rates in order to keep inflation low and stable, the growth high and stable, and the financial system stable. But what makes monetary policymakers successful? Today, there is a clear consensus that to succeed a central bank must be: (1) independent of political pressure; (2) accountable to the public; (3) transparent in its policy actions; and (4) clear in its communications with financial markets and the public.
Independence is the most important of these elements. Successful monetary policy requires a long time horizon. The impact of today’s decisions will not be felt for a while—not for several years, in most instances. Democratically elected politicians are not a patient bunch; their time horizon extends only to the next election. Politicians are encouraged to do everything they can for their constituents before the next election—including manipulating interest rates to bring short-term prosperity at the expense of long-term stability. The temptation to forsake long-term goals for short-term gains is simply impossible to resist. Given the ability to choose, politicians will keep interest rates too low, raising output and employment quickly (before the election), but resulting in inflation later (after the election).
Knowing these tendencies, governments have moved responsibility for monetary policy into a separate, largely apolitical, institution. To insulate policymakers from the daily pressures faced by politicians, governments must give central bankers control over their budgets, authority to make irreversible decisions, and long-term appointments.
There is a major problem with central bank independence: It is inconsistent with representative democracy. Politicians answer to the voters; by design, independent central bankers do not. How can people have faith in the financial system if there are no checks on what the central bankers are doing? The economy will not operate efficiently unless policymakers are trusted to do the right thing.
The solution to this problem is twofold. First, politicians establish the goals for the independent central bankers, and second, monetary policymakers publicly report their progress in achieving those goals. Explicit goals foster accountability and disclosure requirements create transparency. While central bankers are powerful, elected representatives tell them what to do and then monitor their progress.
The institutional means for assuring accountability and transparency differ from one country to the next. In some countries, such as the United Kingdom and Chile, the government establishes an explicit numerical target for inflation. In others, such as the United States, the central bank is asked to deliver price stability as one of a number of objectives (for a discussion of the structure of central bank objectives, see Laurence Meyer [2001b]).
THE FUTURE OF MONEY AND MONETARY POLICY
In the early 1980s, nearly two out of three of the countries in the world were experiencing inflation in excess of 10 percent per year. In the early twenty-first century, this is one in six. Two decades ago nearly one country in three was contracting. By 2005, five in six countries were growing at a rate in excess of 2 percent per year. But not only has inflation been lower and output higher, both inflation and output appear to be more stable. And careful empirical analysis shows that monetary policy is a likely source of this low, stable inflation and high, stable growth (see Cecchetti, Flores-Lagunes and Krause [2006]).
Central bankers’ success can be traced to their ability to control interest rates. And their ability to manipulate interest rates relies on their control of the size of their balance sheet. This, in turn, requires that banks and individuals actually demand central bank liabilities. That is, people have to want to hold the currency issued by central banks, and commercial banks have to demand reserves. Won’t the day come when no one wants this stuff anymore? And when that happens, won’t monetary policy disappear?
The answer is almost surely no. While it is true that the creation of a secure and anonymous substitute for paper currency will ultimately cause dollar bills and euro notes to disappear, reserves are different. The central bank operates an interbank payments system based on reserves. It does this to ensure that, even during periods of crisis, banks can continue to make payments. And to ensure that commercial banks use their payments system, the central bank offers cheap access to this system—that is, it subsidizes the cost of the system’s operation. So long as banks want reserves, there will be monetary policy (for a discussion of the challenges facing monetary policy makers, see Gordon Sellon and Chairmaine Buskas [1999] and Laurence Meyer [2001c]).
SEE ALSO Business Cycles, Real; Inflation; Policy, Fiscal; Treasury View, The; Unemployment
BIBLIOGRAPHY
Cecchetti, Stephen G. 2006. Money, Banking, and Financial Markets. New York: McGraw Hill–Irwin.
Cecchetti, Stephen G., Alfonso Flores-Lagunes, and Stefan Krause. 2006. Has Monetary Policy Become More Efficient? A Cross-Country Analysis. Economic Journal 116 (4): 408–433.
Davies, Glyn. 2002. The History of Money from Ancient Times to the Present Day. 3rd ed. Cardiff, U.K.: University of Wales Press.
Issing, Otmar, Ignazio Angeloni, Vitor Gaspar, and Oreste Tristani. 2001. Monetary Policy in the Euro Area: Strategy and Decision-Making at the European Central Bank. Cambridge, U.K.: Cambridge University Press.
Meyer, Laurence H. 2001a. Does Money Matter? The 2001 Homer Jones Memorial Lecture, Washington University, Saint Louis, Missouri, March 28. http://www.federalreserve.gov/boarddocs/speeches/2001/20010328/default.htm.
Meyer, Laurence H. 2001b. Inflation Targets and Inflation Targeting. Remarks at the University of California at San Diego Economics Roundtable, San Diego, California, July 17. http://www.federalreserve.gov/boarddocs/speeches/2001/20010328/default.htm./boarddocs/speeches/2001/20010717/default.htm.
Meyer, Laurence H. 2001c. The Future of Money and of Monetary Policy. Remarks at the Distinguished Lecture Program, Swarthmore College, Swarthmore, Pennsylvania, December 5. http://www.federalreserve.gov/boarddocs/speeches/2001/20011205/default.htm.
Sellon, Gordon H., Jr., and Chairmaine R. Buskas, eds. 1999. New Challenges for Monetary Policy: A Symposium Sponsored by the Federal Reserve Bank of Kansas City. Kansas City, MO: Federal Reserve Bank of Kansas City.
Stephen G. Cecchetti