Monetary Policy

Brief Historical Overview

Whereas money is an old invention, monetary policy is very recent. Although it is hard to date back exactly, money was introduced as a medium of exchange and a unit of account approximately 3,000 years ago. Yet, monarchs did not establish a prerogative on the coinage of money or the issuing of coins until the 16th century; paper notes began to be used as a substitute for coins in the 18th century. It was, however, with the establishment of the first central banks in Sweden and—more importantly—in England as monetary authorities in the second half of the 17th century that the notion of monetary policy emerged, particularly to regulate the inflow and outflow of gold. By the late 19th century, a system of modern monetary policy was well established in industrializing nations, culminating in the period of the classical gold standard from 1880 to 1914, in which central banks fulfilled the key role of maintaining gold convertibility. Having shifted toward a fiat money regime, that is, money generating its value from a mandate by the government making it the accepted method of payment within a given territory, monetary policies’ main aims are the establishment of the domestic price level, output stability (growth), and the external value of the currency (exchange rate).

The Economics of Monetary Policy

Monetary policy aims to exercise some control over the equilibrium in the money market—in other words, the money supply in an economy and the resulting short-term interest rate. Because central banks can issue a theoretically unlimited amount of fiat money, they can purchase or sell securities (most often short-term bonds) to control the money supply and thereby reach a “target rate” for short-term interest rates. Given the [Page 1183]central banks’ capacity to control the money supply, it plays a predominant role in setting the level of prices in an economy but also affects the degree of investment activity: A high short-term interest rate is likely to slow down investment and consumption activities, thus lowering economic output, whereas a low rate will have the opposite effect and increase investment, consumption, and output. Because the political leadership in an economy is usually interested in higher output, monetary policy under direct political control is likely to result in an oversupply of money and lower interest rates. Most economic theorists agree that, although such overly “expansionary” monetary policy might well result in output increases in the short term, it will ultimately trigger significant price increases and, thus, inflation in the medium to long term (“political business cycle”). To prevent the abuse of monetary policy for political purposes, many central banks today enjoy independence from political influence and are given the clear mandate to stabilize prices.

...