Monetary policy is a term that is used to describe the actions taken by the government of a nation through the central bank, to control the cost as well as the availability of money to aid in achieving nation’s economic targets. (Federal Reserve systems, 2008). Monetary policy is a tool mostly used by the government to ensure a stable currency in an economy, maintaining of a condition of full employment and ensure welfare of citizens. Questions about inflation targeting are usually midterm goals. In the long term the central bank uses the monetary policy to ensure an economic growth in the long run. It’s usually centered on setting interest rates for loans, which are overnight decisions of the central banks.
This interest rate usually affects other interest rates all over the economy. It’s not a regular practice for a government to use monetary policy along to ensure achievement of its economic goals. Besides the monetary policy there is the fiscal policy, which affects taxes of a country. Both are used together simultaneously by the government to reach its economic targets. The decision process usually involves the board of the central bank and it mostly meets on a monthly basis where they prepare as minutes a detailed account of their meeting. To implement the policy, the central bank boards of directors’ decisions are usually made public through media via electronic news and also it’s published in websites for various central banks. Any change therefore, to the entire economy, takes place the day after such the media release. (Reserve Bank of Australia, 2008)
There are two major types of monetary policy for instance the expansionary policy is a term used to describe low interest rates conditions set by the central bank, which causes an increase in total money supply in the economy I.e. with low interest rates of borrowing commercial banks and other depository institutions can easily borrow from the central bank. With these borrowings they can lend to the public, who would want to invest such money, and thus increasing money supply in the economy. Expansionary policy is usually used by the government to bring down high levels of unemployment. Contractionary policy on the other hand is generally used to describe a situation where we have high interest rate set to be charged by the central bank to commercial banks and other financial institutions wishing to borrow funds from them, so as to decrease the amount of money supply in the economy. Money supply in the economy declines since commercial banks are not willing to pay these high rates of interests to borrow from the central bank. Hence in the process funds in the disposal to the public and other investors in the economy are at low levels. Thus, in effect money supply in the entire economy declines. Contractionary policy is usually used by the government to bring inflation levels down.
There are three major tools used by the central bank to implement the monetary policy; discount rates, open market operations and reserve requirements. Open market operations are the major tool used by the government to stabilize the economy, by determining levels of money in circulation around the economy. Also there are various systems in the central bank that are responsible for the implementation and formulation of the monetary policy using these three tools for example; in the United States of America, the Federal Reserve System is set to see to the implementation and formulating of reserve requirements and discount rates, while the responsibility of open market operations in centered on the Federal Open Market Committee. These systems differ with various nations, though.
How money is created. The central bank, through is board of governors sets the funds interests, “these are the interest rates which commercial banks and other depository institutions borrow balances from the central bank” triggering various effects. Some of the effects may be the amount of money supply and credit. One major tool used to increase/decrease money supply is the open market operations therefore; through this tool the government can create money. This is further explained as follows: the central bank usually sells or buys government securities to influence money supply, and therefore it buys these securities, sometimes issuing new notes to the buying bank and thus effecting the increase of money in the economy. It is important to note that the central bank can also buy other government assets previously sold to commercial banks and other institutions to effect open market operations of creating money such as gold and foreign currencies. (Federal Reserve Systems, 2008)
There’s also a way of creating money by the commercial banks. This can simply, be referred to as fractional reserve way of lending by the commercial banks. This process is carried out as follows; the commercial bank can, from its reserve of notes and coins, use this money to finance investments which are highly profitable but illiquid, and in the process creating liquidity to the investors in such undertakings. The commercial banks aim is to have a stake in profits arising from such investments. They (commercial banks) can also use the money multiplier method of money creation for example; commercial bank may be required to maintain 10 percent of their deposits as legal reserve requirements by the central bank and thus can lend the rest to other banks or individuals, those other banks can also lend these amounts to other banks and willing individuals. This is so long as they maintain the 10% requirements by the central bank as demand deposits (amount of money available to the public/clients for withdrawals). Through this process of money is created by commercial banks. Money multiplier is therefore also another method through which commercial banks can also create money. (Reserve bank of Australia, 2008)
Which combination of monetary policy can help you to best achieve a balance between economic growth, low inflation and reasonable rate of unemployment? Inflation, this can be defined as a rise in general price levels of commodities in a given economy. The major factor defining high inflation is a rise in CPI (Consumer Price Index) (Reserve bank of Australia, 2008). With inflation there is a decrease in real value of money. Inflation can have negative effects in the economy, though it’s not totally discouraged for example, a reasonable amount of inflation is encouraged to increase earnings of exporters by the government. Dwelling on negative effects we have for instance, the public reducing levels of investments and savings rates due to uncertainties on future levels of inflation and the rising costs of basic commodities.
The central bank can use inflation targeting monetary policy type to achieve lower levels of inflation. To achieve this, the central bank can increase interest rates paid by borrowers to use money from them eg commercial banks. Here therefore, discount rates are used as a tool of monetary policy to implement this. High rates of interests, means that contractionary monetary policies are used. These high interest rates in effect reduce the amount of money supply to the public. Since money supply has a parallel effect on prices levels, this contractionary policy therefore has an effect of lowering inflation levels. (Reserve bank of Australia, 2008)
Unemployment is witnessed where persons are available for work but they are without jobs. The extent of unemployment is measured through unemployment rates. We have various schools of economists which believe in various ways of reducing unemployment. For example, monetarists believe that if inflation levels are controlled (eg. Reduced levels of inflation), this stimulates growth of an economy since there is more investment and saving is also encouraged. With this growth lower levels of unemployment are witnessed gradually or in the mid term. Judging from this point of view, the central bank can use contractionary monetary policy to reduce unemployment.
Traditionally, an expansionary policy has been used to achieve high levels of employment. This is due to the fact that with reduced interest rates there’s high amount of money supply in the economy and thus raising savings and investments. With high savings and investments have high levels of economic growth which creates jobs, are attained. The latter type of monetary policy however contradicts the fact that the government wants to lower the levels of inflation and therefore, it has to stick to the former. Another way of reducing unemployment by the central bank is by use of reserve requirements. With the set interest rates under contractionary monetary policy, the central bank can reduce the levels of reserve requirements to the commercial banks and thus increase the level of money supply available for investments and savings to the entire public. The commercial banks can increase the levels of money supply through fractional reserve method as aforementioned, with these lesser amounts of legal reserve requirements. Thus, this can also reduce unemployment.
Economic growth can be defined as a steady growth in the productive capacity of an economy which leads to a growth in national income. (Federal, 2008). The government can have various monetary policies to ensure economic growth since they don’t want to contradict the contractionary monetary policy, which has been explained earlier to be used to achieve low levels of unemployment and inflation; here the central bank can use open market operations. The central bank can buy government securities which it had previously sold to the various buying banks, in turn issuing notes and coins to these banks. With an increase of money supply in the economy, they have triggered investments, which create an expansion of output in the economy. These increase employment levels causing a bigger economy. (Reserve bank of Australia, 2008).
So, in summary to ensure low levels of inflation, reasonable unemployment and economic growth and at the same time ensuring that a balance among the three is struck. The government can take a contractionary policy to ensure lower levels of inflation and without interfering with the same use reserve requirements as a tool to ensure reasonable unemployment and lastly use open market operations to spark economic growth. Conclusively therefore the government can use the three combinations to ensure a balance of the three economic targets. These three types of monetary policies can also be used in moderation to reduce the force of contradiction while trying to achieve the economic targets. E.g. accommodative interest rates to ensure low levels of unemployment, neutral interest rates to ensure inflation targets set for the economy are reached.
Federal Reserve System, (2008) Federal Open Market Committee. Retrieved on 18th October 2008 at, http://www.federalreserve.gov/pubs/bulletin/1997/
Reserve Bank of Australia, (2008). About Monetary Policy. Retrieved on 19th October 2008 from, http://www.rba.gov.au/MonetaryPolicy/about_monetary_policy.html