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Wednesday, January 16, 2008

Elaborate on Monetary Policy

Monetary policy is the process by which the government, central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.[1] Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy is generally referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy has the goal of raising interest rates to combat inflation (or cool an otherwise overheated economy). Monetary policy should be contrasted with fiscal policy, which refers to government borrowing, spending and taxation.

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 through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations.

Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.

The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy:

Target Market Variable:

Long Term Objective:

Inflation Targeting

Interest rate on overnight debt

A given rate of change in the CPI

Price Level Targeting

Interest rate on overnight debt

A specific CPI number

Monetary Aggregates

The growth in money supply

A given rate of change in the CPI

Fixed Exchange Rate

The spot price of the currency

The spot price of the currency

Gold Standard

The spot price of gold

Low inflation as measured by the gold price

Mixed Policy

Usually interest rates

Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonised consumer price index).

Inflation targeting:

Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight 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 forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target.

This monetary policy approach was pioneered in New Zealand. It is currently used in the Eurozone, Australia, Canada, New Zealand, Norway, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

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.

Something akin to price level targeting was tried in the 1930s by Sweden, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operates monetary policy based on a price level target.

Monetary aggregates:

In the 1980s several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.

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.

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.

Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.

Under dollarisation, foreign currency (usually the US dollar, hence the term "dollarisation") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to reign in inflation and import credible monetary policy).

These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align withe monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.

Managed Float:

Officially, the Indian Rupee (INR) exchange rate is supposed to be 'market determined'. In reality, the Reserve Bank of India (RBI) trades actively on the INR/USD with the purpose of controlling the volatility of the Rupee - US Dollar exchange rate - within a narrow bandwidth. ( i.e pegs it to the US Dollar )

Other rates - like the INR/Pound or the INR/JPY - have volatilities which reflect the volatilities of the US/Pound and the US/JPY respectively.

The pegged exchange rate is accompanied by an elaborate system of capital controls.

- On the current account, there are no currency conversion restrictions hindering buying or selling foreign exchange (though trade barriers do exist).

- On the capital account, "foreign institutional investors" have convertibility to bring money in and out of the country and buy securities (subject to an elaborate maze of quantitative restrictions).

- Local firms are able to take capital out of the country in order to expand globally.

- Local households have quantitative restrictions( which are being relaxed in recent times) in their ability to do global diversification . ( example while local firms can buy real estate - individuals may not). However they are able to purchase items ( mainly consumer items - say a laptop) and services reasonably freely ( there are quantitative restrictions ). Most of these transactions happen through credit cards through the internet.

Owing to an enormous expansion of the current account and the capital account, India is increasingly moving into de facto convertibility. However - it still cannot be considered a fully convertible currency.

The INR is not a highly traded currency - beyond India. It is traded by way of Forwards through inter bank transactions. ( again the US Dollar exchange rate determines the INR / other Crosses exchange rate )

As any currency traded in the international market - the INR does trade at a market determined premium / discount for the forward months.

Gold standard:

The gold standard is a system in which the price of the national currency as measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationnals. (i.e. open market operations, cf. above). The selling of gold is very important for economic growth and stability.

The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".

Today this type of monetary policy is not used anywhere in the world, although a form of gold standard was used widely across the world prior to 1971. For details see the Bretton Woods system. Its major advantages were simplicity and transparency.

Mixed policy:

In practice a mixed policy approach is most like "inflation targeting". However some consideration is also given to other goals such as economic growth, unemployment and asset bubbles.

This type of policy was used by the Federal Reserve in 1998.

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