Central bank actions to manage money supply, interest rates, and credit conditions.
Monetary policy encompasses the actions of a central bank, currency board, or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates, inflation, and overall economic activity.
The main goals of monetary policy include price stability (controlling inflation), supporting economic growth, reducing unemployment, and stabilizing currency exchange rates.
Central banks typically use various tools to implement monetary policy, including open market operations (buying and selling government securities), setting policy interest rates, adjusting reserve requirements for banks, and forward guidance (communicating future policy intentions).
In recent years, unconventional monetary policies such as quantitative easing and negative interest rates have also been employed, especially when traditional policy rates approach the zero lower bound.
The transmission mechanism of monetary policy operates through various channels, including the interest rate channel, the credit channel, the exchange rate channel, and the expectations channel. The effectiveness of monetary policy can be influenced by factors such as the liquidity trap, the structure of the financial system, and the credibility of the central bank.
Grounded in monetarist theory and the work of economists like Milton Friedman, monetary policy focuses on controlling inflation and supporting economic stability. It also incorporates insights from New Keynesian economics and the rational expectations hypothesis.
If the central bank communicates its policies and intentions clearly, then it can better manage market expectations and enhance policy effectiveness. For example, the Federal Reserve's adoption of explicit forward guidance in 2011, stating that it expected to keep interest rates low 'at least through mid-2013,' helped to lower long-term interest rates and support economic recovery.
If the central bank operates independently from political pressures, then it can make more objective decisions focused on long-term economic stability. Research by Alesina and Summers (1993) found that countries with more independent central banks tend to have lower and more stable inflation without sacrificing economic growth.
If the central bank adopts a flexible inflation targeting approach, then it can balance price stability with other economic objectives more effectively. The Bank of Canada's flexible inflation-targeting regime, which allows for temporary deviations from the 2% target to support employment and output stability, has been credited with helping maintain low and stable inflation while supporting economic growth since its adoption in 1991.
If monetary policy is complemented by macroprudential policies, then it can better address financial stability concerns while pursuing its primary objectives. For instance, the Bank of England's use of loan-to-value and debt-to-income limits for mortgage lending alongside its interest rate policy has helped manage housing market risks without compromising broader monetary policy goals.
If central banks carefully design and implement unconventional policies like quantitative easing, then they can provide additional stimulus when interest rates are near zero. The European Central Bank's Targeted Longer-Term Refinancing Operations (TLTROs), introduced in 2014, provided low-cost funding to banks conditional on their lending to the real economy, which helped support credit growth and economic recovery in the Eurozone.