Understanding Monetary Policy Tools and Their Impact | CFA Level I Economics

In this lesson, we’ll delve deeper into the monetary policy tools used by central banks to achieve price stability, understand expansionary and contractionary policies, and examine the monetary transmission mechanism.

Three Main Monetary Policy Tools

Central banks use monetary policy tools to maintain price stability. The three main tools are:

1. Reserve requirement
2. Policy rate
3. Open market operations

Reserve Requirement

Reserve requirement is the percentage of deposits banks must keep as reserves. This tool is directly tied to the fractional banking system. By adjusting the reserve requirement, central banks can influence the availability of funds for lending and ultimately, interest rates.

When a central bank wants to stimulate the economy, it can decrease the reserve requirement, which increases available funds for lending and lowers interest rates. Conversely, increasing the reserve requirement reduces lending and raises interest rates.

Although reserve requirements are not used as a tool in most developed economies, they are actively used in many developing countries to control lending and regulate market interest rates. Reserve requirements can be more effective in these countries due to their high demand for capital.

Policy Rate

The policy rate is the official or benchmark interest rate set by the central bank to influence market interest rates and real economic activity. This is the rate at which the central bank lends money to commercial banks, often through repurchase agreements. Examples include the two-week repo rate used by the Bank of England and the refinancing rate used by the European Central Bank.

Central banks can control prices through the policy rate by setting it above or below the neutral interest rate, which is the growth rate of the money supply that neither increases nor decreases the economic growth rate. Expansionary policies involve setting a lower policy rate, while contractionary policies involve setting a higher policy rate.

A lower policy rate reduces banks’ cost of funds, leading to a decrease in overall interest rates. On the other hand, a higher policy rate increases the cost of funds, decreasing lending and increasing interest rates.

Open Market Operations

Open market operations involve the buying and selling of government bonds by the central bank. Buying bonds increases the money supply and lowers interest rates (expansionary policy), while selling bonds reduces the money supply and raises interest rates (contractionary policy).

In the US, the Federal Reserve uses open market operations to achieve the fed funds rate, the rate banks charge each other on overnight loans of reserves. Open market operations are the most commonly used monetary tool for this purpose.

Expansionary vs Contractionary Policies

Expansionary policies, such as lowering reserve requirements, policy rates, or open market bond purchases, aim to increase money supply, aggregate demand, and raise prices when inflation is too low. Contractionary policies, such as increasing reserve requirements, policy rates, or open market bond sales, aim to decrease money supply, aggregate demand, and moderate price increases when inflation is too high.

Before implementing monetary policies, central banks must consider the source of inflation, as contractionary policies may harm the economy if cost-push inflation is present. If inflation is caused by higher food or energy prices, contractionary policies may result in higher unemployment, which could be detrimental to the economy.

Monetary Transmission Mechanism

The monetary transmission mechanism refers to the ways in which a change in monetary policy, specifically the central bank’s policy rate, affects the price level and inflation. There are four channels through which a change in the policy rate is transmitted to prices:

1. Market interest rates
2. Asset values
3. Consumer and business confidence
4. Currency exchange rates

Let’s examine the transmission mechanism when the central bank increases the policy rate to lower inflation.

First, raising the policy rate increases the costs for commercial banks to borrow from the central bank and each other, leading to higher short-term lending rates. This decrease in aggregate demand causes consumers to reduce credit purchases and businesses to cut back on investment in new projects.

Second, bond prices, equity prices, and asset prices in general will decrease as the discount rates applied to future expected cash flows are increased. This wealth effect may lead to an increase in the savings rate and a decrease in consumption.

Third, an increase in the policy rate can negatively affect consumer and business confidence, lowering expectations for future economic growth. As a result, expenditures and investments may decrease, leading to lower domestic demand.

Lastly, the increase in domestic interest rates may attract foreign investment in debt securities, leading to an appreciation of the domestic currency. This can reduce the external demand for the country’s export goods by increasing their foreign currency prices.

All of these effects act to decrease aggregate demand and put downward pressure on the price level, ultimately lowering inflation. In addition, the stronger currency makes imports of foreign goods cheaper, further contributing to lower inflation.

Limitations of Monetary Policy

While monetary policy can be an effective tool for managing inflation and economic growth, it does have limitations:

1. Monetary policy can’t address structural issues within the economy.
2. There’s often a lag between the implementation of policy changes and their effects on the economy, making it difficult for central banks to respond quickly to economic fluctuations.
3. Central banks may face challenges in coordinating monetary policy with fiscal policy, as the latter is often determined by political factors.
4. Monetary policy can sometimes have unintended consequences, such as exacerbating asset price bubbles or causing currency instability.

Despite these limitations, monetary policy remains an essential tool for central banks in their pursuit of price stability and sustainable economic growth.

And that wraps up this lesson on monetary policy! In the next lesson, we’ll discuss the limitations of monetary policy and explore other factors that central banks must consider when implementing policy changes.