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A Few Notes on Monetary Policy

What is Monetary Policy?

Monetary policy is used to manage the money supply (how much there is of it) and interest rates (the price of borrowing the money). Central banks determine monetary policies.  For example, the European Central Bank (ECB) determines monetary policy for countries that use the Euro as their official currency, including France. When a central bank wants to increase the amount of money in an economy, it usually reduces interest rates, or in other words, makes borrowing cheaper. This encourages consumers and businesses to borrow more often to spend their money on investments for future growth.  When a central bank wants to decrease the amount of money, they usually raise interest rates. Interest rates are increased to make borrowing more expensive for people and businesses, encouraging them to spend less money.

There are three main types of monetary policy:

·       Expansionary monetary policy

·       Contractionary monetary policy

·       Neutral monetary policy

Expansionary monetary policy is: when the money supply increases by the central bank to stimulate economic activity. This can be done by buying government bonds from banks or lowering interest rates. The intention is to encourage people and businesses to borrow and spend more, thus increasing inflation.

Contractionary monetary policy is when the central bank decreases the money supply to cool down the economy and reduce inflation. This can be accomplished by selling government bonds from banks or by raising interest rates. The goal of contractionary monetary policy is to encourage people and businesses to save more, thus contracting economic activity.

A neutral monetary policy is when the central bank keeps the money supply stable, with little or no effect on inflation. This policy is used to keep inflation low and stable and to avoid unnecessary fluctuations in interest rates and economic activity.

Tools.

The most common tool used to influence economic activity is by changing interest rates with open market operations. The Central Bank can also change the required reserve ratio, the number of money banks must hold in reserve. It can also change the maturity structure of government debt it buys or sells. Finally, the Central Bank can interfere in the foreign market exchange to buy or sell its currency. 

Purpose.

The process by which a government or central bank regulates the amount of money in circulation is called Monetary policy. This can be achieved through several different mechanisms, such as adjusting the rate of interest and setting the number of money banks are required to hold in reserve. The main goal of monetary policy is to control inflation and promote economic growth. When prices start rising, central banks begin to increase interest rates. This makes it more expensive for individuals and companies to borrow money and slows the rate of inflation. If prices start falling, central banks lower interest rates so that borrowing is less expensive and lending occurs with greater frequency. The main goal of monetary policy in modern economies is to keep prices relatively stable. 

Fiscal vs Monetary

In economics, monetary policy is a set of actions taken by a central bank to regulate the supply of money and credit over time paired with the interest rate they charge financial institutions to borrow or lend. By changing quantities of money in circulation through open market operations, buying back government bonds, or increasing reserve requirements, a central bank can increase or decrease short-term interest rates and the money supply.

In contrast, fiscal policy is the use of government spending and taxation to influence economic growth and stability. It is usually enacted by the government to smooth out business cycles, spur economic activity in a downturn, or reduce budget deficits.

There is often a lot of overlap between monetary and fiscal policy, which is why they are both sometimes referred to as “contractionary policy.” For instance, raising interest rates or reducing the money supply will generally lead to lower spending and increased savings by individuals and businesses, slowing down the economy. Lowering taxes may also encourage more consumer spending by putting more cash in people’s wallets. 

Economic theories

Monetary policy is the practice of controlling the amount of money available in a nation.

For example you are targeting an inflation rate or interest rate to maintain price stability and confidence in the currency.

-Milton Friedman’s monetarism is a monetary theory based on his principles. The idea is that management of the money supply should be the main tool for regulating economic activity.

-Austrian economics is a school of economic thought that emphasizes the spontaneous order of the market and criticizes central planning. The Austrian School of Economics was founded by Carl Menger in 1871. Ludwig von Mises was one of its most famous members. The school was developed in response to the classical economics of Adam Smith and David Ricardo. The Austrian School follows an approach termed methodological individualism, a version of which was codified by Ludwig von Mises. It is sometimes called “praxeology” or the “subjective theory of value.”

-Theory of Liquidity preference – The theory states that people will want to hold more money as it becomes more valuable. This is because people can use the money to buy goods and services, and as the economy grows, the prices of these goods and services will increase. The demand for money will also increase as people want to protect their savings from inflation.

-Theory of rational expectations – The theory suggests that people make economic decisions based on what they think the future will be like. This means that if the government tries to change the economy by using expansionary or contractionary monetary policy, people will quickly adjust their expectations, and the policy will have no effect.

-The Quantity Theory of Money – The theory states that the amount of money in circulation must be directly proportional to a country’s level of economic activity, specifically the number of goods and services being bought and sold.

-Neoclassical theories – The theory states that central banks should focus on price stability when making monetary decisions, as inflation reduces the value of money over time. If people expect prices to rise in the future, they will delay buying things today, which will lead to a decline in economic activity.

-New Keynesian theories – The theory suggests that central banks should also focus on keeping the level of employment stable when making monetary decisions. If people are unemployed, they have less money to spend, which will lead to a decrease in demand and lower levels of economic activity.

-Financial repression  – is a term used to describe measures used by governments to channel funds to themselves, reducing market risk premium, i.e., the risk-adjusted return on government bonds is reduced relative to its benefits in terms of an increase in liquidity and money supply. It often involves low nominal interest rates imposed by the government on certain types of financial assets (such as government bonds), coupled with measures to restrict the flow of credit or capital out of the country.

Real Economy

Monetary policy is the process by which a government or central bank uses its ability to create money to influence prices and employment in order to achieve specific economic goals. It can also be used as a tool for stabilizing an economy.

The reversal of the global economic recession that began in 2008 was brought on by a number of factors, including fiscal stimulus packages implemented by many industrialized countries. Although governments around the world responded quickly to the crisis with these temporary programs, their effects on employment lasted less than two years. Additionally, tax rebates—fiscal stimulus that reduces disposable income—often had a little stimulative effect on the economy because citizens saved or paid off debts rather than spending the money.

Monetary policy, in contrast, has a more sustained impact on the economy. Central banks can use different tools to achieve their economic goals, such as changing the interest rate or the amount of money in circulation. When central banks cut the interest rate, for instance, it becomes cheaper for people and businesses to borrow money, so they borrow more. People are likely to spend their additional income, creating economic growth.

While money supply is not the only way to achieve monetary policy goals, it is one of the most useful tools at central banks’ disposal. By adjusting how much money goes into circulation, central banks can raise or lower prices—which can help stabilize economic growth. This is particularly important when prices are rising quickly because central banks can slow spending by making money more expensive to borrow.

References:

https://www.investopedia.com/terms/m/monetarypolicy.asp

https://www.federalreserve.gov/faqs/money_12855.htm

https://www.britannica.com/topic/monetary-policy

https://www.thebalance.com/what-is-monetary-policy-objectives-types-and-tools-3305867

https://www.thebalance.com/monetarism-and-how-it-works-3305866

https://www.investopedia.com/articles/economics/09/austrian-school-of-economics.asp

https://thebusinessprofessor.com/en_US/economic-analysis-monetary-policy/liquidity-preference-theory-definition

https://www.investopedia.com/insights/what-is-the-quantity-theory-of-money/

https://www.levyinstitute.org/publications/can-monetary-policy-affect-the-real-economy

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