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Home > Monetary policy

2 Trends in Central Banking

In the 1980s, many economists began to believe that making a nations central bank independent of the rest of executive government is the best way to ensure an optimal monetary policy, and those central banks which did not have independence began to gain it. This is to avoid overt manipulation of the tools of monetary policies to effect political goals, re-electing the current government for example. Independence typically means that the members of the committee which conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited independence. Independence has not stunted a thriving crop of conspiracy theories about the true motives of a given action of monetary policy.

In the 1990s central banks began adopting formal, public inflation targets. The goal of which is to make the outcomes, if not the process, of monetary policy more transparent. That is, a central bank may have an inflation target of 2% for a given year, if inflation turns out to be 5%, then the central bank will typically have to submit an explanation. The Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation target of 2.5%.

3 Types of Monetary Policy

In practice all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency is called open market operations.

Constant market transactions by the monetary authority modifies the liquidity of base money and this impacts on other market variables such as short term interest rates, the exchange rate and the domestic price of spot market commodities such as gold. Open market operations are undertaken with the objective of stabilising one of these market variables.

The distinction between the various types of monetary policy lies primarily with the market variable that open market operations are used to target. Targeting being the process of achieving relative stability in the target variable.

3.1 Inflation Targeting

Under this policy approach Inflation is defined as the rate of change in the CPI. It requires that a basket of consumer prices is monitored and from these prices a CPI ( Consumer Price Index) defined.

For example the target might be to keep increases in the CPI index between 2 and 3% per year. The specific Inflation rate objective is achieved through periodic adjustments to an interest rate target. The interest rate target generally refers to the interest rate at which banks lend to eachother over night for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.

The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.

Changes to the interest rate target are done in response to various market indicators in an attempt to forcast economic trends and in so doing keep the market on track towards achieving the defined inflation target.

This monetary policy approach was pioneered initially in New Zealand. It is currently used in Australia, New Zealand, Sweden and the United Kingdom.

3.2 Price Level Targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.

This type of policy is used by the European Central Bank.

3.3 Monetary Aggregates

In the 1980s several countries used an approached based on a constant growth in the money supply. Such schemes were refined to include different classes of money and credit (M0, M1 etc). Most such monetary policies were ultimately abandoned.

This approach is also sometimes called monetarism.

Whilst most monetary policy focuses on a price signal of one form or another this approach is focused on monetary quantities.

3.4 Fixed Exchange Rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. Base money is bought and sold by the central bank on a daily basis to achieve the target exchange rate. This policy somewhat abdicates responsiblitity for monetary policy to a foreign government.

This type of policy is used by China. The Chinese yuan is managed such that its exhange rate with the United States dollar is fixed.

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Topics: Monetary Policy Money Rate Bank Currency Central Target Market...

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