Monetary policy encompasses a variety of measures that are used to influence currency conditions. Traditional instruments include open market operations, reserve requirements, and discount rates. The Federal Reserve System was established in 1913, allowing the United States Federal Reserve to enforce it. In the 20th century, monetarism began to gain prominence, advocating maintaining control over the money supply so as to control inflation. After the 2008 economic crisis, unusual policies emerged, such as quantitative easing and forward guidance, used by the European Central Bank and the Bank of Japan. Forward guidance is helpful in communicating future policy intentions to influence market expectations. Negative interest rates, such as those seen in Europe and Japan, are another unusual tool to stimulate spending. Overall, monetary policy development strives to address economic challenges while achieving stability and growth.
1. Conventional Monetary Policy
Traditional monetary policy, which dates from the early 20th century to the present day, primarily uses central bank tools, particularly interest rate adjustments, to direct economic variables such as inflation, unemployment, and economic growth. . Central banks, such as the Federal Reserve, typically change short-term interest rates to achieve their policy objectives. As an example, during the Great Depression of the 1930s, the Federal Reserve used traditional monetary measures to mitigate the economic downturn. Another important example is the Volcker disinflationary policies, implemented in the early 1980s, where the Federal Reserve, under Chairman Paul Volcker, rapidly raised interest rates to prevent inflation. These historic events demonstrate the enduring importance of conventional monetary policy as a key tool in shaping economic direction.
2. Unconventional Monetary Policy
Unconventional monetary policy refers to unconventional measures adopted by central banks at times of high inflation or interest rates when conservative tools are not effective. It became important during and after the global economic crisis of 2007–2008. Central banks such as the Federal Reserve, the European Central Bank, and the Bank of Japan initiated massive money purchasing programs, known as quantitative easing (QE). Along with QE, unusual policies include forward guidance and credit easing. These measures were undertaken to inject liquidity into financial markets, stimulate credit production, and promote economic reconstruction. While accommodative monetary policies were initially implemented as emergency measures, they have since become important tools in the arsenal of central banks to manage economic downturns and promote growth.
3. Expansionary Monetary Policy
Expansionary monetary policy, often implemented during a downturn in the economy, aims to increase growth by increasing the money supply, lowering interest rates, and increasing borrowing and spending. Central banks orient such policies to strengthen community demand and reduce unemployment. This strategy, most often used during recessions, stimulates economic activity by making it cheaper to borrow, thereby encouraging investment and consumption. However, if prolonged, expansionary monetary policy may lead to increased inflationary pressure due to increased money supply. Therefore, central banks have to balance the benefits of economic stimulus against the risks of inflation. Historically, during the global financial crisis of 2008–2009 and subsequent recessions, central banks around the world used such policies to stimulate economic growth and stabilize financial markets.
4. Contractionary Monetary Policy
Contractionary monetary policy, often adopted by central banks, is designed to stoke economic expansion and suppress inflation. By reducing the supply of cash and setting interest rates high, this policy restricts borrowing and spending. Its main objective is to prevent economic stagnation and maintain price stability. Although likely to cause small spikes in unemployment in the initial phase, accommodative cash policy proves important for long-term inflation control. Historically, central banks have used this tool during periods of high economic growth and rising inflation. Major events include the actions of the Federal Reserve in the United States in the late 1970s and early 1980s to combat stagflation. Similarly, as a result of the 2008 global financial crisis, central banks around the world implemented contractionary measures to suppress inflation.
5. Inflation Targeting
Monetary policy framework adopted by various countries in which central banks set a fixed inflation target and adjust policy instruments accordingly. This approach was first introduced in the year 1990s, and became especially popular in Canada, the United States, and New Zealand. Central banks communicate these goals to the public, thereby increasing transparency and accountability. To achieve these goals, interest rates or other policy instruments are modified when they deviate from the target. By constraining inflation expectations and encouraging economic stability, inflation has proven effective in managing price levels and promoting sustainable growth. Its application has evolved over time, reflecting changes in economic conditions and global activities. Overall, inflation remains a main pillar of modern monetary policy, which is always adjusted to meet the challenges of the changing economic landscape.
6. Nominal GDP Targeting
Nominal GDP targeting was proposed as a monetary policy strategy distinct from traditional inflation targeting, and its proponents supported its adoption because of its holistic economic assessment. Originating in the late twentieth century, its core element lies in central banks setting nominal GDP growth targets, rather than focusing solely on inflation metrics. This approach necessitates adjustments in policy instruments to keep nominal GDP growth stable around a predetermined level, incorporating considerations of aggregate nominal GDP growth and real economic activity. Promoters say this approach, which closely incorporates inflation and real growth, provides a more complete measure of economic performance. As an alternative framework, nominal GDP targeting was proposed, particularly after the 2008 global financial crisis, as economists were searching for stronger methods for economic recovery. Its proponents say that by targeting nominal GDP, central banks can better address high inflationary pressures and fluctuations in economic output, potentially leading to more stable and sustainable growth nationally.
7. Exchange Rate Targeting
Exchange rate targeting, a monetary policy strategy, involves central banks setting specific exchange rate targets and intervening in foreign exchange markets to achieve them. Typically done through interest rate adjustments, foreign exchange market intervention, and capital controls, it attempts to maintain the intended exchange rate level. For example, a central bank may peg its currency to a foreign currency or a foreign currency wallet. Exchange rate targeting serves to meet various policy objectives, such as promoting export competitiveness or ensuring currency stability. This strategy has been used by various countries throughout history, with prominent examples being the gold standard period of the late 19th and early 20th centuries and the Bretton Woods system established in 1944. Today, exchange rate targeting is used as a tool by Central Banks worldwide to pursue currency management and economic goals.