Monetray Policy

INTRODUCTION

In this project I will present the general issues of monetary policy. Monetary policy is one of the two ways (the other being fiscal policy) that a national Government use to influence the economy of a country. Using its monetary authority to control the money supply, a government attempts to influence the pace and direction of overall economic activity, with its political objectives. Through the monetary policy the government wants to reach the "macroeconomic stability" - low unemployment, low inflation, economic growth, and a balance of external payments. Monetary policy is usually administered by a Government appointed "Central Bank", the Bank of Canada and the Federal Reserve Bank in the United States.

The types of the monetary policy are presented in the following table:

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.”1

1.http://en.wikipedia.org/wiki/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 is called open market operations. I will briefly present this types of monetary policy.

Inflation Targeting

“Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, at a particular level. 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 over night for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.”1

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.”2

Monetary Aggregates

“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.”3

Monetarism is a set of views concerning the determination of national income and monetary economics. It focuses on the supply and demand for money as the primary means by which economic activity is regulated. Monetary theory focuses on money supply and on inflation as an effect of the supply of money being larger than the demand for money.

Fixed Exchange Rate

“A fixed exchange rate, sometimes (less commonly) called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold. As the reference value rises and falls, so does the currency pegged to it. A currency that uses a fixed exchange rate is known as a fixed currency. The opposite of a fixed exchange rate is a floating exchange rate.” 4