Monetary Policy

Monetary policy encompasses the measures implemented by a country's central bank to affect the accessibility and cost of money and credit, with the aim of fostering a robust economy. It can be generally categorized into two types: expansionary and contractionary.

This policy involves managing the money supply and interest rates to achieve macroeconomic goals such as controlling inflation, consumption, growth, and liquidity. These objectives are pursued through actions like adjusting interest rates, buying or selling government bonds, regulating foreign exchange rates, and altering the reserve requirements for banks.

Tools of monetary policy include open market operations, direct lending to banks, bank reserve requirements, unconventional emergency lending programs, and managing market expectations, which depend on the central bank's credibility. Monetary authorities are usually assigned policy mandates to ensure a stable increase in gross domestic product (GDP), maintain low unemployment rates, and keep foreign exchange and inflation rates within a predictable range.

Monetary policy can be utilized alongside or as an alternative to fiscal policy, which involves taxes, government borrowing, and spending to manage the economy. In the United States, the Federal Reserve is responsible for establishing monetary policy, aiming to ensure that the money supply grows at a pace that neither leads to excessive inflation nor hinders economic growth.

The ideal inflation rate is around 2% annually, which helps maintain price stability, while the Fed also strives to keep unemployment below 5%. Its main tools for influencing the money supply include forward guidance, the discount rate, reserve requirements, open market operations, and large-scale asset purchases (LSAPs).

Currently, most monetary policy is executed through open market operations, which involve buying and selling government bonds in the secondary market. These operations allow central banks to effectively set short-term interest rates, which have long been viewed as the primary instrument of modern monetary policy.

Following the Great Financial Crisis, the Federal Reserve also aimed to influence longer-term interest rates by purchasing various long-term instruments, such as mortgage-backed securities, through a policy known as quantitative easing (QE).

Central bankers typically pursue multiple objectives when conducting monetary policy:

• They aim to sustain economic growth at the highest sustainable level.
• They seek to minimize unemployment.
• They strive to keep inflation low.
• They wish to maintain reasonable interest rates to encourage investment.
• They aim for stable exchange rates.
• They promote the stability of the financial system and work to minimize systemic risks.

While central bankers ideally want to achieve all these goals simultaneously, there is a general consensus that a primary objective should be to stabilize the price level. One approach to achieving this is inflation targeting, which involves raising interest rates (by slowing money growth) when inflation exceeds a target level—such as 2 percent—and lowering interest rates (by accelerating money growth) when inflation threatens to fall below that target.

In recent years, central banks have been reevaluating their role in promoting financial stability. The question arises: should financial stability be an explicit goal of central banks, on par with other objectives like price stability and sustainable economic growth?

Financial stability is defined as a condition in which the financial system can endure shocks without succumbing to cumulative processes that hinder the allocation of savings to investment opportunities and the processing of payments within the economy. Financial instability is characterized by three fundamental criteria:

• Significant divergence of certain financial asset prices from their fundamentals;
• Distortion in market functioning and credit availability, both domestically and potentially internationally;
• Resulting in aggregate spending deviating significantly, either above or below, the economy's production capacity.

The Federal Reserve has established the Division of Financial Stability, which identifies and analyzes potential threats to financial stability, monitors financial markets, institutions, and structures, and assesses and recommends policy alternatives to address these threats.