Monetary policy is one of the tools that a national
Government uses to influence its economy. Using its monetary authority to
control the supply and availability of money, a government attempts to
influence the overall level of economic activity in line with its political
objectives. Usually this goal is "macroeconomic stability" - low
unemployment, low inflation, economic growth, and a balance of external
payments. A Government appointed “Central Bank” usually administers monetary
policy.
Central banks have not always existed. In early
economies, governments would supply currency by minting precious metals with
their stamp. No matter what the creditworthiness of the government, the worth
of the currency depended on the value of its underlying precious metal. A coin
was worth its gold or silver content, as it could always be melted down to
this. A country's worth and economic clout was largely to its holdings of gold
and silver in the national treasury. Monarchs, despots and even democrats tried
to skirt this inviolate law by filing down their coinage or mixing in other
substances to make more coins out of the same amount of gold or silver. They
were inevitably found out by the traders, moneylenders and others who depended
on the worth of that currency. This is the reason that movies show pirates and
thieves biting Spanish doubloons to ascertain the value of their booty and
loot.
The advent of paper money during the industrial revolution meant that
it wasn't too difficult for a country to alter its amount of money in
circulation. Instead of gold, all that was needed to produce more banknotes was
paper, ink and a printing press. Because of the skepticism of all concerned,
paper money was backed by a "promise to pay" upon demand. A holder of
a "pound sterling" note of the United Kingdom could actually demand
his pound of silver! When gold became the de facto backing of the world's
currency a "gold standard" was developed where nations kept
sufficient gold to back their "promises to pay" in their national
treasuries. The problem with this standard was that a nation's economic health
depended on its holdings of gold. When the treasury was bare, the currency was
worthless.
In the 1800s, even commercial banks in Canada and the United States
issued their own banknotes, backed by their promises to pay in gold. Since they
could lend more than they had to hold in reserves to meet their depositors’
demands, they actually could create money. This inevitably led to
"runs" on banks when they could not meet their depositors’ demands
and were bankrupt. The same happened to smaller countries. Even the United
States Treasury had to be rescued by JP Morgan several times during this
period. In the late 1800s and early 1900s, countries legislated their exclusive
monopoly to issue currency and banknotes. This was in response to
"financial panics" and bank insolvencies. This meant that all
currency was issued and controlled by the national governments, although they
still maintained gold reserves to support their currencies. Commercial banks
still could create money by lending more than their depositors had placed with
the bank, but they no longer had the right to issue banknotes.
Modern Monetary Policy
Modern central banking dates back to the aftermath of great depression of
the 1930s. Governments, led by the economic thinking of the great John Maynard
Keynes, realized that collapsing money supply and credit availability greatly
contributed to the savagery of this depression. This realization that money
supply affected economic activity led to active government attempts to
influence money supply through "monetary policy". At this time,
nations created central banks to establish "monetary authority". This
meant that rather than accepting whatever happened to money supply, they would
actively try to influence the amount of money available. This would influence
credit creation and the overall level of economic activity.
Modern monetary policy does not involve gold to a great extent. In
1968, the United States rescinded its promise to pay in gold and effectively
removed itself from the "gold standard". Since then, it has been the
job of the Federal Reserve to control the amount of money and credit in the
U.S. economy. I doing this, it wants to maintain the purchasing power of the U.S.
dollar and its comparative worth to other currencies. This might sound easy,
but it is a complex task in an information age where huge amounts of money
travels in electronic signals in microseconds around the world.
The Effectiveness of Monetary Policy
Economists debate the relevant measures of money supply.
"Narrow" money supply or M1 is currency in circulation and the
currency in easily accessed chequing and savings accounts. "Broader"
money supply measures such as M2 and M3 include term deposits and even money
market mutual funds. Economists debate the finer points of the implementation
and effectiveness of monetary policy but one thing is obvious. At the extremes,
monetary policy is a potent force. In countries such as the Russian Republic,
Poland or Brazil where the printing presses run full tilt to pay for government
operations, money supply is expanding rapidly and the currency becomes rapidly
worthless compared to goods and services it can buy. A very high level of
inflation or “hyperinflation” is the result. With 30-40% monthly inflation
rates, citizens buy hard goods as soon as they receive payment in the currency
and those on fixed income have their investments rendered worthless.
At the other extreme, restrictive monetary policy has shown its
effectiveness with considerable force. Germany, which experienced
hyperinflation during the Weimar Republic and never forgot, has maintained a
very stable monetary regime and resulting low levels of inflation. When
Chairman Paul Volcker of the U.S. Federal Reserve applied the monetary brakes
during the high inflation 1980s, the result was an economic downturn and a
large drop in inflation. The Bank of Canada, headed by John Crow, targeted 0-3%
inflation in the early 1990s and curtailed economic activity to such an extent
that Canada actually experienced negative inflation rates in several months for
the first time since the 1930s.
Without much debate, the effectiveness of monetary policy, its timing
and its eventual impacts on the economy are not obvious. That central banks
attempt influence the economy through monetary is a given. In any event,
insights into monetary policy are very important to the investor. The
availability of money and credit are key considerations in the pricing of an
investment.,
Operations of a Modern Central Bank
The Central Bank attempts to achieve economic stability by varying the
quantity of money in circulation, the cost and availability of credit, and the
composition of a country's national debt. The Central Bank has three instruments
available to it in order to implement monetary policy:
- Open market operations
- Reserve requirements
- The 'Discount Window'
Open market operations are just that, the buying or selling of
Government bonds by the Central Bank in the open market. If the Central Bank
were to buy bonds, the effect would be to expand the money supply and hence
lower interest rates, the opposite is true if bonds are sold. This is the most
widely used instrument in the day to day control of the money supply due to its
ease of use, and the relatively smooth interaction it has with the economy as a
whole.
Reserve requirements are a percentage of commercial banks', and other
depository institutions', demand deposit liabilities (i.e. chequing accounts)
that must be kept on deposit at the Central Bank as a requirement of Banking
Regulations. Though seldom used, this percentage may be changed by the Central
Bank at any time, thereby affecting the money supply and credit conditions. If
the reserve requirement percentage is increased, this would reduce the money
supply by requiring a larger percentage of the banks, and depository
institutions, demand deposits to be held by the Central Bank, thus taking them
out of supply. As a result, an increase in reserve requirements would increase interest
rates, as less currency is available to borrowers. This type of action is only
performed occasionally as it affects money supply in a major way. Altering
reserve requirements is not merely a short-term corrective measure, but a
long-term shift in the money supply.
Lastly, the Discount Window is where the commercial banks, and other
depository institutions, are able to borrow reserves from the Central Bank at a
discount rate. This rate is usually set below short-term market rates
(T-bills). This enables the institutions to vary credit conditions (i.e., the
amount of money they have to loan out), there by affecting the money supply. It
is of note that the Discount Window is the only instrument which the Central
Banks do not have total control over.
By affecting the money supply, it is theorized, that monetary policy
can establish ranges for inflation, unemployment, interest rates, and economic
growth. A stable financial environment is created in which savings and
investment can occur, allowing for the growth of the economy as a whole.
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