Monetary Policy Meaning, Types, and Tools

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What Is Monetary Policy?

Monetary policy is a set of tools used by a nation's central bank to control the
overall money supply and promote economic growth and employ strategies
such as revising interest rates and changing bank reserve requirements.

In the United States, the Federal Reserve Bank implements monetary policy
through a dual mandate to achieve maximum employment while keeping
inflation in check.1

KEY TAKEAWAYS

 Monetary policy is a set of actions to control a nation's overall money

supply and achieve economic growth.
 Monetary policy strategies include revising interest rates and changing
bank reserve requirements.
 Monetary policy is commonly classified as either expansionary or
contractionary.
 The Federal Reserve commonly uses three strategies for monetary
policy including reserve requirements, the discount rate, and open
market operations.
Xiaojie Liu / Investopedia

Understanding Monetary Policy

Monetary policy is the control of the quantity of money available in
an economy and the channels by which new money is supplied.

Economic statistics such as gross domestic product (GDP), the rate of inflation,
and industry and sector-specific growth rates influence monetary policy
strategy.

A central bank may revise the interest rates it charges to loan money to the
nation's banks. As rates rise or fall, financial institutions adjust rates for their
customers such as businesses or home buyers.

Additionally, it may buy or sell government bonds, target foreign

exchange rates, and revise the amount of cash that the banks are required to
maintain as reserves.

Types of Monetary Policy

Monetary policies are seen as either expansionary or contractionary
depending on the level of growth or stagnation within the economy.

Contractionary

A contractionary policy increases interest rates and limits the outstanding

money supply to slow growth and decrease inflation, where the prices of
goods and services in an economy rise and reduce the purchasing power of
money.2

Expansionary

During times of slowdown or a recession, an expansionary policy grows

economic activity. By lowering interest rates, saving becomes less attractive,
and consumer spending and borrowing increase.1

Goals of Monetary Policy

Inflation
Contractionary monetary policy is used to temper inflation and reduce the
level of money circulating in the economy. Expansionary monetary policy
fosters inflationary pressure and increases the amount of money in
circulation.

Unemployment

An expansionary monetary policy decreases unemployment as a higher

money supply and attractive interest rates stimulate business activities and
expansion of the job market.

Exchange Rates

The exchange rates between domestic and foreign currencies can be

affected by monetary policy. With an increase in the money supply, the
domestic currency becomes cheaper than its foreign exchange.

Tools of Monetary Policy

Open Market Operations

In open market operations (OMO), the Federal Reserve Bank buys bonds from
investors or sells additional bonds to investors to change the number of
outstanding government securities and money available to the economy as a
whole.3

The objective of OMOs is to adjust the level of reserve balances to

manipulate the short-term interest rates and that affect other interest rates.3

Interest Rates

The central bank may change the interest rates or the required collateral that it
demands. In the U.S., this rate is known as the discount rate.4 Banks will loan
more or less freely depending on this interest rate.

The Federal Reserve commonly uses three strategies for monetary policy
including reserve requirements, the discount rate, and open market
operations.

Reserve Requirements
Authorities can manipulate the reserve requirements, the funds that banks must
retain as a proportion of the deposits made by their customers to ensure that
they can meet their liabilities.

Lowering this reserve requirement releases more capital for the banks to offer
loans or buy other assets. Increasing the requirement curtails bank lending
and slows growth.

Monetary Policy vs. Fiscal Policy

Monetary policy is enacted by a central bank to sustain a level economy and
keep unemployment low, protect the value of the currency, and maintain
economic growth. By manipulating interest rates or reserve requirements, or
through open market operations, a central bank affects borrowing, spending,
and savings rates.

Fiscal policy is an additional tool used by governments and not central banks.
While the Federal Reserve can influence the supply of money in the economy
and impact market sentiment, The U.S. Treasury Department can create new
money and implement new tax policies.5 It sends money, directly or
indirectly, into the economy to increase spending and spur growth.6

Both monetary and fiscal tools were coordinated efforts in a series of

government and Federal Reserve programs launched in response to the
COVID-19 pandemic.7

How Often Does Monetary Policy Change?

The Federal Open Market Committee of the Federal Reserve meets eight
times a year to determine changes to the nation's monetary policies.8 The
Federal Reserve may also act in an emergency as was evident during the
2007-2008 economic crisis and the COVID-19 pandemic.

How Has Monetary Policy Been Used to Curb Inflation In

the United States?
A contractionary policy can slow economic growth and even increase
unemployment but is often seen as necessary to level the economy and keep
prices in check. During double-digit inflation in the 1980s, the Federal
Reserve raised its benchmark interest rate to 20%.9 Though the effect of
high rates spurred a recession, inflation was reduced to a range of 3% to 4%
over the following years.

Why Is the Federal Reserve Called a Lender of Last

Resort?
The Fed also serves the role of lender of last resort, providing banks
with liquidity and regulatory scrutiny to prevent them from failing and creating
financial panic in the economy.

The Bottom Line

Monetary policy employs tools used by central bankers to keep a nation's
economy stable while limiting inflation and unemployment. Expansionary
monetary policy stimulates a receding economy and contractionary monetary
policy slows down an inflationary economy. A nation's monetary policy is
often coordinated with its fiscal policy.

Monetary Policy
An economic policy that manages the size and growth rate of money supply

What is Monetary Policy?

Monetary policy is an economic policy that manages the size and growth rate of the money
supply in an economy. It is a powerful tool to regulate macroeconomic variables such
as inflation and unemployment.

These policies are implemented through different tools, including the adjustment of the interest
rates, purchase or sale of government securities, and changing the amount of cash circulating in
the economy. The central bank or a similar regulatory organization is responsible for formulating
these policies.
Objectives of Monetary Policy

The primary objectives of monetary policies are the management of inflation or unemployment
and maintenance of currency exchange rates.

1. Inflation

Monetary policies can target inflation levels. A low level of inflation is considered to be healthy
for the economy. If inflation is high, a contractionary policy can address this issue.

2. Unemployment
Monetary policies can influence the level of unemployment in the economy. For example, an
expansionary monetary policy generally decreases unemployment because the higher money
supply stimulates business activities that lead to the expansion of the job market.

3. Currency exchange rates

Using its fiscal authority, a central bank can regulate the exchange rates between domestic and
foreign currencies. For example, the central bank may increase the money supply by issuing
more currency. In such a case, the domestic currency becomes cheaper relative to its foreign
counterparts.

Tools of Monetary Policy

Central banks use various tools to implement monetary policies. The widely utilized policy tools
include:

1. Interest rate adjustment

A central bank can influence interest rates by changing the discount rate. The discount rate (base
rate) is an interest rate charged by a central bank to banks for short-term loans. For example, if a
central bank increases the discount rate, the cost of borrowing for the banks increases.
Subsequently, the banks will increase the interest rate they charge their customers. Thus, the cost
of borrowing in the economy will increase, and the money supply will decrease.

2. Change reserve requirements

Central banks usually set up the minimum amount of reserves that must be held by a commercial
bank. By changing the required amount, the central bank can influence the money supply in the
economy. If monetary authorities increase the required reserve amount, commercial banks find
less money available to lend to their clients, and thus, money supply decreases.

Commercial banks can’t use the reserves to make loans or fund investments into new businesses.
Since it constitutes a lost opportunity for the commercial banks, central banks pay them interest
on the reserves. The interest is known as IOR or IORR (interest on reserves or interest on
required reserves).

3. Open market operations

The central bank can either purchase or sell securities issued by the government to affect the
money supply. For example, central banks can purchase government bonds. As a result, banks
will obtain more money to increase the lending and money supply in the economy.

Expansionary vs. Contractionary Monetary Policy

Depending on its objectives, monetary policies can be expansionary or contractionary.

 Expansionary Monetary Policy

This is a monetary policy that aims to increase the money supply in the economy by decreasing
interest rates, purchasing government securities by central banks, and lowering the reserve
requirements for banks. An expansionary policy lowers unemployment and stimulates business
activities and consumer spending. The overall goal of the expansionary monetary policy is to
fuel economic growth. However, it can also possibly lead to higher inflation.

Contractionary Monetary Policy

The goal of a contractionary monetary policy is to decrease the money supply in the economy. It
can be achieved by raising interest rates, selling government bonds, and increasing the reserve
requirements for banks. The contractionary policy is utilized when the government wants to
control inflation levels.

Monetary Policy: How

Central Banks Regulate
The Economy

Reviewed
Michael Adams
Lead Editor, Investing

Updated: Apr 12, 2023, 9:23am

Editorial Note: We earn a commission from partner links on Forbes Advisor. Commissions do not
affect our editors' opinions or evaluations.

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Monetary policy is the bedrock of any nation’s economic policy, and

everyone from part-time workers to huge financial institutions, both
foreign and domestic, are impacted as it shifts. Here’s how
managing the supply of money affects you and the rest of the
economy.
What Is Monetary Policy?

Central banks use monetary policy to manage the supply of money

in a country’s economy. With monetary policy, a central bank
increases or decreases the amount of currency and credit in
circulation, in a continuing effort to keep inflation, growth and
employment on track.
In the U.S., the Federal Reserve is responsible for monetary policy.
Congress has tasked the Fed with a “dual mandate” that it pursues
with monetary policy: maximize employment and maintain steady
prices. In general, that means the Fed aims to keep unemployment
low, but not zero, to foster productivity without inciting higher
inflation. There’s no official target range, but historically the Fed
has focused on keeping unemployment at about 3.5% to 4.5%.
As for inflation, the Fed normally targets average annual price
increases of about 2%. When unemployment is low and inflation is
around the 2% level, consumers and businesses are in a good
position to spend and invest money—as well as save adequate cash
reserves—which meets the Fed’s mandate for a highly functioning
economy.

“The power of the Fed is derived primarily from its authority over
these two prominent aspects of the economy,” says Robert Johnson,
professor of finance at Creighton University. “The Fed executes
these objectives through its power to control the money supply.” It
was given these responsibilities in 1977 through a Congressional
dual mandate, and it may enact its powers using a handful of tools.

Monetary Policy Tools

Federal funds rate. Commonly called the fed funds rate, or the
fed funds target rate, this is the target interest rate set by the
Federal Open Market Committee (FOMC) at its eight yearly
meetings. Commercial banks reference the fed funds rate when
they lend their excess reserves to each other overnight.
Open market operations. The Fed buys and sells government
securities, like Treasury bills and bonds, in the open market. By
buying back securities, the Fed effectively increases the supply of
money circulating—conversely, selling securities lowers the supply.
Historically, open market operations are the most commonly used
tool to conduct monetary policy.
Reserve requirements. The Fed keeps a close eye on reserve
requirements, or the amount of cash banks must have on hand at
any time to comply with banking regulations. Those reserves must
either be secured in bank vaults or via a deposit in a qualified
Federal Reserve Bank to ensure they have money available should
customers need it. By lowering the amount of cash banks are
required to keep on hand, the Fed can encourage banks to lend out
more money. And by raising that requirement, it can do the inverse.
The Discount rate. This is the interest rate charged by the Fed on
short-term loans to financial institutions. Generally, these loans are
meant to cover reserve requirements or liquidity issues banks can’t
meet through loans from other banks, which offer a lower federal
funds borrowing rate. Typically, when the U.S. economy is
humming on all cylinders, discount rates are relatively high
because the Fed doesn’t need to make borrowing money cheap to
incentivize activity. However, when the economy is in a slump, the
Fed often lowers interest rates to spur lending and credit to
individuals and businesses.
Quantitative easing (QE). With QE, a central bank like the
Federal Reserve uses its massive cash reserves to buy up large-
scale financial assets like government and corporate bonds as well
as stocks. This may sound similar to open markets, but quantitative
easing often takes place on a much larger scale in more dire
circumstances, involves buying more than just shorter-term
government bonds and generally occurs when interest rates are
already at or near 0%, meaning the Fed has already fully extended
one of its primary weapons. Central banks must be careful with QE,
however, because continued large-scale asset purchases can lead to
economic conditions monetary policy makers don’t want, like
higher inflation and asset bubbles.
Public service announcements. When implementing a nation’s
monetary policy, a central bank will announce to the financial
markets and the general public its general outlook on the economy
and any policy measures its taking. In and of themselves, these
PSAs may influence the market and economy in ways that the
central bank is hoping for.
Expansionary Monetary Policy vs Contractionary
Monetary Policy

Depending on the economic circumstance, monetary policy may be

categorized in one of two ways: expansionary monetary policy or
contractionary monetary policy.

Expansionary Monetary Policy

Also known as loose monetary policy, expansionary policy increases
the supply of money and credit to generate economic growth. A
central bank may deploy an expansionist monetary policy to reduce
unemployment and boost growth during hard economic times.
It usually does so by lowering its benchmark federal funds rate, or
the interest rate banks use when they lend each other money to
satisfy any reserve requirements. While in the U.S. the Federal
Reserve cannot require a certain federal funds rate, it can set
guidelines and influence the rate banks charge each other by
altering the supply of money. In turn, this may lower other interest
rates, like those banks use when they lend money to consumers,
which helps spur consumer spending through increased credit and
lending throughout the nation’s economy.

For example, when the U.S. banking system collapsed leading to

the Great Recession of 2007-2008, the Federal Reserve cut interest
rates to near-zero to jumpstart the U.S. economy, thus “expanding”
economic growth. It recently did the same thing to pull the country
out of the 2020 Covid-19 recession.

Contractionary Monetary Policy

Also known as tight monetary policy, contractionary policy
decreases a nation’s money supply to curb rampant inflation and
keep the economy in balance. A central bank will likely hike
interest rates and try to slow the growth of money and prices.

At the outset of the 1980s, for instance, when the U.S. inflation rate
soared to almost 15%, the Fed aggressively raised interest rates to
nearly 20%. While that move led to a nationwide recession, it also
brought inflation back to about 3%, helping set the stage for a
robust U.S. economy for the remainder of the decade.

Monetary Policy vs Fiscal Policy

When it comes to regulating the economy, a country has two main
levers it can pull: monetary policy and fiscal policy.
While they might sound similar—both involve words that suggest
money or finance—they’re quite different and are enacted by
distinct sectors of the government. Monetary policy is controlled by
the Federal Reserve; fiscal policy, on the other hand, is driven by
the U.S. government’s executive and the legislative branches.

Practically speaking, this means “fiscal policy deals with taxation

and government spending,” says Dr. Guy Baker, CFP, Ph.D.,
founder of Wealth Teams Alliance, in Irvine, Calif. In contrast,
monetary policy involves effecting change by manipulating the
monetary supply.
Monetary policy
Monetary policy is the policy adopted by the monetary authority of a nation to affect
monetary and other financial conditions to accomplish broader objectives like
high employment and price stability (normally interpreted as a low and stable rate
of inflation).[1][2] Further purposes of a monetary policy may be to contribute to economic
stability or to maintain predictable exchange rates with other currencies. Today most
central banks in developed countries conduct their monetary policy within an inflation
targeting framework,[3] whereas the monetary policies of most developing countries'
central banks target some kind of a fixed exchange rate system. A third monetary policy
strategy, targeting the money supply, was widely followed during the 1980s, but has
diminished in popularity since that, though it is still the official strategy in a number
of emerging economies.
The tools of monetary policy vary from central bank to central bank, depending on the
country's stage of development, institutional structure, tradition and political system.
Interest rate targeting is generally the primary tool, being obtained either directly via
administratively changing the central bank's own interest rates or indirectly via open
market operations. Interest rates affect general economic activity and consequently
employment and inflation via a number of different channels, known collectively as
the monetary transmission mechanism, and are also an important determinant of the
exchange rate. Other policy tools include communication strategies like forward
guidance and in some countries the setting of reserve requirements. Monetary policy is
often referred to as being either expansionary (stimulating economic activity and
consequently employment and inflation) or contractionary (dampening economic
activity, hence decreasing employment and inflation).
Monetary policy affects the economy through financial channels like interest rates,
exchange rates and prices of financial assets. This is in contrast to fiscal policy, which
relies on changes in taxation and government spending as methods for a government to
manage business cycle phenomena such as recessions.[4] In developed countries,
monetary policy is generally formed separately from fiscal policy, modern central banks
in developed economies being independent of direct government control and directives.
[5]

How best to conduct monetary policy is an active and debated research area, drawing
on fields like monetary economics as well as other subfields within macroeconomics.
History[edit]

Banknotes with a face value of 5000 in different

currencies. (United States dollar, Central African CFA franc, Japanese yen, Italian lira,
and French franc)
Issuing coins and paper money[edit]
Monetary policy has evolved over the centuries, along with the development of a money
economy. Historians, economists, anthropologists and numismatics do not agree on the
origins of money. In the West the common point of view is that coins were first used
in ancient Lydia in the 8th century BCE, whereas some date the origins to ancient
China. The earliest predecessors to monetary policy seem to be those of debasement,
where the government would melt coins down and mix them with cheaper metals. The
practice was widespread in the late Roman Empire, but reached its perfection in
western Europe in the late Middle Ages.[6]
For many centuries there were only two forms of monetary policy: altering coinage or
the printing of paper money. Interest rates, while now thought of as part of monetary
authority, were not generally coordinated with the other forms of monetary policy during
this time. Monetary policy was considered as an executive decision, and was generally
implemented by the authority with seigniorage (the power to coin). With the advent of
larger trading networks came the ability to define the currency value in terms of gold or
silver, and the price of the local currency in terms of foreign currencies. This official
price could be enforced by law, even if it varied from the market price.

Reproduction of a Song dynasty note, possibly a Jiaozi,

redeemable for 770 mò.
Paper money originated from promissory notes termed "jiaozi" in 7th century China.
Jiaozi did not replace metallic currency, and were used alongside the copper coins. The
succeeding Yuan Dynasty was the first government to use paper currency as the
predominant circulating medium. In the later course of the dynasty, facing massive
shortages of specie to fund war and maintain their rule, they began printing paper
money without restrictions, resulting in hyperinflation.
Central banks and the gold standard[edit]
With the creation of the Bank of England in 1694,[7] which was granted the authority to
print notes backed by gold, the idea of monetary policy as independent of executive
action[how?] began to be established.[8] The purpose of monetary policy was to maintain the
value of the coinage, print notes which would trade at par to specie, and prevent coins
from leaving circulation. During the period 1870–1920, the industrialized nations
established central banking systems, with one of the last being the Federal Reserve in
1913.[9] By this time the role of the central bank as the "lender of last resort" was
established. It was also increasingly understood that interest rates had an effect on the
entire economy, in no small part because of appreciation for the marginal revolution in
economics, which demonstrated that people would change their decisions based on
changes in their opportunity costs.
The establishment of national banks by industrializing nations was associated then with
the desire to maintain the currency's relationship to the gold standard, and to trade in a
narrow currency band with other gold-backed currencies. To accomplish this end,
central banks as part of the gold standard began setting the interest rates that they
charged both their own borrowers and other banks which required money for liquidity.
The maintenance of a gold standard required almost monthly adjustments of interest
rates.
The gold standard is a system by which the price of the national currency is fixed vis-a-
vis the value of gold, and is kept constant by the government's promise to buy or sell
gold at a fixed price in terms of the base currency. The gold standard might be regarded
as a special case of "fixed exchange rate" policy, or as a special type of commodity
price level targeting. However, the policies required to maintain the gold standard might
be harmful to employment and general economic activity and probably exacerbated the
Great Depression in the 1930s in many countries, leading eventually to the demise of
the gold standards and efforts to create a more adequate monetary framework
internationally after World War II.[10] Nowadays the gold standard is no longer used by
any country.[11]
Fixed exchange rates prevailing[edit]
In 1944, the Bretton Woods system was established, which created the International
Monetary Fund and introduced a fixed exchange rate system linking the currencies of
most industrialized nations to the US dollar, which as the only currency in the system
would be directly convertible to gold.[12] During the following decades the system secured
stable exchange rates internationally, but the system broke down during the 1970s
when the dollar increasingly came to be viewed as overvalued. In 1971, the dollar's
convertibility into gold was suspended. Attempts to revive the fixed exchange rates
failed, and by 1973 the major currencies began to float against each other. [13] In Europe,
various attempts were made to establish a regional fixed exchange rate system via
the European Monetary System, leading eventually to the Economic and Monetary
Union of the European Union and the introduction of the currency euro.
Money supply targets[edit]
Monetarist economists long contended that the money-supply growth could affect the
macroeconomy. These included Milton Friedman who early in his career advocated
that government budget deficits during recessions be financed in equal amount
by money creation to help to stimulate aggregate demand for production.[14] Later he
advocated simply increasing the monetary supply at a low, constant rate, as the best
way of maintaining low inflation and stable production growth.[15] During the 1970s
inflation rose in many countries caused by the 1970s energy crisis, and several central
banks turned to a money supply target in an attempt to reduce inflation. However, when
U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in October 1979,
it was found to be impractical, because of the unstable relationship between monetary
aggregates and other macroeconomic variables, and similar results prevailed in other
countries.[10][16] Even Milton Friedman later acknowledged that direct money supplying
was less successful than he had hoped.[17]
Inflation targeting[edit]
In 1990, New Zealand as the first country ever adopted an official inflation target as the
basis of its monetary policy. The idea is that the central bank tries to adjust interest
rates in order to steer the country's inflation rate towards the official target instead of
following indirect objectives like exchange rate stability or money supply growth, the
purpose of which is normally also ultimately to obtain low and stable inflation. The
strategy was generally considered to work well, and central banks in most developed
countries have over the years adapted a similar strategy.[18]
The Global Financial Crisis of 2008 sparked controversy over the use and flexibility of
the inflation targeting employed. Many economists argued that the actual inflation
targets decided upon were set too low by many monetary regimes. During the crisis,
many inflation-anchoring countries reached the lower bound of zero rates, resulting in
inflation rates decreasing to almost zero or even deflation.[19]
As of 2023, the central banks of all G7 member countries can be said to follow an
inflation target, including the European Central Bank and the Federal Reserve, who
have adopted the main elements of inflation targeting without officially calling
themselves inflation targeters.[18] In emerging countries fixed exchange rate regimes are
still the most common monetary policy.[20]

The Bank of Finland, in Helsinki, established in 1812.

The headquarters of the Bank for International Settlements, in Basel (Switzerland).

 

The Reserve Bank of India (established in 1935) Headquarters in Mumbai.

The Central Bank of Brazil (established in 1964) in Brasília.

The Bank of Spain (established in 1782) in Madrid.

Monetary policy instruments[edit]

The instruments available to central banks for conducting monetary policy vary from
country to country, depending on the country's stage of development, institutional
structure and political system.[1] The main monetary policy instruments available to
central banks are interest rate policy, i.e. setting (administered) interest rates
directly, open market operations, forward guidance and other communication activities,
bank reserve requirements, and re-lending and re-discount (including using the term
repurchase market. While capital adequacy is important, it is defined and regulated by
the Bank for International Settlements, and central banks in practice generally do not
apply stricter rules.
Expansionary policy occurs when a monetary authority uses its instruments to stimulate
the economy. An expansionary policy decreases short-term interest rates, affecting
broader financial conditions to encourage spending on goods and services, in turn
leading to increased employment. By affecting the exchange rate, it may also
stimulate net export.[21] Contractionary policy works in the opposite direction: Increasing
interest rates will depress borrowing and spending by consumers and businesses,
dampening inflationary pressure in the economy together with employment.[21]
Key interest rates[edit]

2016 meeting of the Federal Open

Market Committee at the Eccles Building, Washington, D.C.
For most central banks in advanced economies, their main monetary policy instrument
is a short-term interest rate.[22] For monetary policy frameworks operating under an
exchange rate anchor, adjusting interest rates are, together with direct intervention in
the foreign exchange market (i.e. open market operations), important tools to maintain
the desired exchange rate.[23] For central banks targeting inflation directly, adjusting
interest rates are crucial for the monetary transmission mechanism which ultimately
affects inflation. Changes in the central banks' policy rates normally affect the interest
rates that banks and other lenders charge on loans to firms and households, which will
in turn impact private investment and consumption. Interest rate changes also
affect asset prices like stock prices and house prices, which again influence
households' consumption decisions through a wealth effect. Additionally, international
interest rate differentials affect exchange rates and consequently
US exports and imports. Consumption, investment and net exports are all important
components of aggegate demand. Stimulating or suppressing the overall demand for
goods and services in the economy will tend to increase respectively diminish inflation.[24]
The concrete implementation mechanism used to adjust short-term interest rates differs
from central bank to central bank.[25] The "policy rate" itself, i.e. the main interest rate
which the central bank uses to communicate its policy, may be either an administered
rate (i.e. set directly by the central bank) or a market interest rate which the central bank
influences only indirectly.[22] By setting administered rates that commercial banks and
possibly other financial institutions will receive for their deposits in the central bank,
respectively pay for loans from the central bank, the central monetary authority can
create a band (or "corridor") within which market interbank short-term interest rates will
typically move. Depending on the specific details, the resulting specific market interest
rate may either be created by open market operations by the central bank (a so-called
"corridor system") or in practice equal the administered rate (a "floor system", practised
by the Federal Reserve[26] among others).[22][27]
As an example of how this functions, the Bank of Canada sets a target overnight rate,
and a band of plus or minus 0.25%. Qualified banks borrow from each other within this
band, but never above or below, because the central bank will always lend to them at
the top of the band, and take deposits at the bottom of the band; in principle, the
capacity to borrow and lend at the extremes of the band are unlimited.[28]

Yield curve becomes inverted

when short-term rates exceed long-term rates.
The target rates are generally short-term rates. The actual rate that borrowers and
lenders receive on the market will depend on (perceived) credit risk, maturity and other
factors. For example, a central bank might set a target rate for overnight lending of
4.5%, but rates for (equivalent risk) five-year bonds might be 5%, 4.75%, or, in cases
of inverted yield curves, even below the short-term rate.
Many central banks have one primary "headline" rate that is quoted as the "central bank
rate". In practice, they will have other tools and rates that are used, but only one that is
rigorously targeted and enforced. A typical central bank consequently has several
interest rates or monetary policy tools it can use to influence markets.

 Marginal lending rate – a fixed rate for institutions to borrow money from the central
bank. (In the USA this is called the discount rate).
 Main refinancing rate – the publicly visible interest rate the central bank announces.
It is also known as minimum bid rate and serves as a bidding floor for refinancing
loans. (In the USA this is called the federal funds rate).
 Deposit rate, generally consisting of interest on reserves – the rates parties receive
for deposits at the central bank.
Open market operations[edit]
 Mechanics of open market operations: Demand-Supply
model for reserves market
Through open market operations, a central bank may influence the level of interest
rates, the exchange rate and/or the money supply in an economy. Open market
operations can influence interest rates by expanding or contracting the monetary base,
which consists of currency in circulation and banks' reserves on deposit at the central
bank. Each time a central bank buys securities (such as a government bond or treasury
bill), it in effect creates money. The central bank exchanges money for the security,
increasing the monetary base while lowering the supply of the specific security.
Conversely, selling of securities by the central bank reduces the monetary base.

1979 $10,000 United States Treasury bond

Open market operations usually take the form of:

 Buying or selling securities ("direct operations").

 Temporary lending of money for collateral securities ("Reverse Operations" or
"repurchase operations", otherwise known as the "repo" market). These operations
are carried out on a regular basis, where fixed maturity loans (of one week and one
month for the ECB) are auctioned off.
 Foreign exchange operations such as foreign exchange swaps.
Forward guidance[edit]
Main article: Forward guidance
Forward guidance is a communication practice whereby the central bank announces its
forecasts and future intentions to influence market expectations of future levels
of interest rates.[29] As expectations formation are an important ingredient in actual
inflation changes, credible communication is important for modern central banks.[30]
Reserve requirements[edit]
 A run on a Bank of East Asia branch in Hong Kong,
caused by "malicious rumours" in 2008.
Historically, bank reserves have formed only a small fraction of deposits, a system
called fractional-reserve banking. Banks would hold only a small percentage of their
assets in the form of cash reserves as insurance against bank runs. Over time this
process has been regulated and insured by central banks. Such legal reserve
requirements were introduced in the 19th century as an attempt to reduce the risk of
banks overextending themselves and suffering from bank runs, as this could lead to
knock-on effects on other overextended banks.

Gold certificates were used as paper currency in

the United States from 1882 to 1933. These certificates were freely convertible into gold
coins.
A number of central banks have since abolished their reserve requirements over the last
few decades, beginning with the Reserve Bank of New Zealand in 1985 and continuing
with the Federal Reserve in 2020. For the respective banking systems, bank capital
requirements provide a check on the growth of the money supply.
The People's Bank of China retains (and uses) more powers over reserves because
the yuan that it manages is a non-convertible currency.[citation needed]
Loan activity by banks plays a fundamental role in determining the money supply. The
central-bank money after aggregate settlement – "final money" – can take only one of
two forms:

 physical cash, which is rarely used in wholesale financial markets,

 central-bank money which is rarely used by the people
The currency component of the money supply is far smaller than the deposit
component. Currency, bank reserves and institutional loan agreements together make
up the monetary base, called M1, M2 and M3. The Federal Reserve Bank stopped
publishing M3 and counting it as part of the money supply in 2006.[31]
Credit guidance[edit]
Main article: Window guidance
Central banks can directly or indirectly influence the allocation of bank lending in certain
sectors of the economy by applying quotas, limits or differentiated interest rates. [32][33] This
allows the central bank to control both the quantity of lending and its allocation towards
certain strategic sectors of the economy, for example to support the national industrial
policy, or to environmental investment such as housing renovation.[34][35][36]

The Bank of Japan, in Tokyo, established in 1882.

The Bank of Japan used to apply such policy ("window guidance") between 1962 and
1991.[37][38] The Banque de France also widely used credit guidance during the post-war
period of 1948 until 1973 .[39]
The European Central Bank's ongoing TLTROs operations can also be described as
form of credit guidance insofar as the level of interest rate ultimately paid by banks is
differentiated according to the volume of lending made by commercial banks at the end
of the maintenance period. If commercial banks achieve a certain lending performance
threshold, they get a discount interest rate, that is lower than the standard key interest
rate. For this reason, some economists have described the TLTROs as a "dual interest
rates" policy.[40][41]
China is also applying a form of dual rate policy.[42][43]
Exchange requirements[edit]
To influence the money supply, some central banks may require that some or all foreign
exchange receipts (generally from exports) be exchanged for the local currency. The
rate that is used to purchase local currency may be market-based or arbitrarily set by
the bank. This tool is generally used in countries with non-convertible currencies or
partially convertible currencies. The recipient of the local currency may be allowed to
freely dispose of the funds, required to hold the funds with the central bank for some
period of time, or allowed to use the funds subject to certain restrictions. In other cases,
the ability to hold or use the foreign exchange may be otherwise limited.
In this method, money supply is increased by the central bank when it purchases the
foreign currency by issuing (selling) the local currency. The central bank may
subsequently reduce the money supply by various means, including selling bonds or
foreign exchange interventions.
Collateral policy[edit]
In some countries, central banks may have other tools that work indirectly to limit
lending practices and otherwise restrict or regulate capital markets. For example, a
central bank may regulate margin lending, whereby individuals or companies may
borrow against pledged securities. The margin requirement establishes a minimum ratio
of the value of the securities to the amount borrowed.
Central banks often have requirements for the quality of assets that may be held by
financial institutions; these requirements may act as a limit on the amount of risk and
leverage created by the financial system. These requirements may be direct, such as
requiring certain assets to bear certain minimum credit ratings, or indirect, by the central
bank lending to counter-parties only when security of a certain quality is pledged
as collateral.
Unconventional monetary policy at the zero bound[edit]
Other forms of monetary policy, particularly used when interest rates are at or near 0%
and there are concerns about deflation or deflation is occurring, are referred to
as unconventional monetary policy. These include credit easing, quantitative
easing, forward guidance, and signalling.[44] In credit easing, a central bank purchases
private sector assets to improve liquidity and improve access to credit. Signaling can be
used to lower market expectations for lower interest rates in the future. For example,
during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for
an "extended period", and the Bank of Canada made a "conditional commitment" to
keep rates at the lower bound of 25 basis points (0.25%) until the end of the second
quarter of 2010.
Helicopter money[edit]
Main article: Helicopter money
Further similar monetary policy proposals include the idea of helicopter money whereby
central banks would create money without assets as counterpart in their balance sheet.
The money created could be distributed directly to the population as a citizen's dividend.
Virtues of such money shocks include the decrease of household risk aversion and the
increase in demand, boosting both inflation and the output gap. This option has been
increasingly discussed since March 2016 after the ECB's president Mario Draghi said
he found the concept "very interesting".[45] The idea was also promoted by prominent
former central bankers Stanley Fischer and Philipp Hildebrand in a paper published
by BlackRock,[46] and in France by economists Philippe Martin and Xavier Ragot from the
French Council for Economic Analysis, a think tank attached to the Prime minister's
office.[47]
Some have envisaged the use of what Milton Friedman once called "helicopter money"
whereby the central bank would make direct transfers to citizens[48] in order to lift inflation
up to the central bank's intended target. Such policy option could be particularly
effective at the zero lower bound.[49]
Nominal anchors[edit]
Central banks typically use a nominal anchor to pin down expectations of private agents
about the nominal price level or its path or about what the central bank might do with
respect to achieving that path. A nominal anchor is a variable that is thought to bear a
stable relationship to the price level or the rate of inflation over some period of time. The
adoption of a nominal anchor is intended to stabilize inflation expectations, which may,
in turn, help stabilize actual inflation. Nominal variables historically used as anchors
include the gold standard, exchange rate targets, money supply targets, and since the
1990s direct official inflation targets.[10][19] In addition, economic researchers have
proposed variants or alternatives like price level targeting (some times described as an
inflation target with a memory[50]) or nominal income targeting.
 Monetary Target Market
Long Term Objective Popularity
Policy Variable

Inflation Interest rate on Usual regime in developed countries

Low and stable inflation
Targeting overnight debt today

Fixed Exchange The spot price of Usually low and stable Abandoned in most developed economies,
Rate the currency inflation common in emerging economies

Money supply The growth in Influential in the 1980s, today official

Low and stable inflation
targeting money supply regime in some developing countries

Low inflation as
The spot price of Used historically, but completely
Gold Standard measured by the gold
gold abandoned today
price

Price Level Interest rate on A hypothetical regime, recommended by

Low and stable inflation
Targeting overnight debt some academic economists

Nominal income Stable nominal GDP A hypothetical regime, recommended by

Nominal GDP
target growth some academic economists

Usually interest
Mixed Policy Various A prominent example is the US
rates

Empirically, some researchers suggest that central banks' policies can be described by
a simple method called the Taylor rule, according to which central banks adjust their
policy interest rate in response to changes in the inflation rate and the output gap. The
rule was proposed by John B. Taylor of Stanford University.[51]
Inflation targeting[edit]
Main article: Inflation targeting
Under this policy approach, the official target is to keep inflation, under a particular
definition such as the Consumer Price Index, within a desired range. Thus, while other
monetary regimes usually also have as their ultimate goal to control inflation, they go
about it in an indirect way, whereas the inflation targeting employs a more direct
approach.
The inflation target is achieved through periodic adjustments to the central bank interest
rate target. In addition, clear communication to the public about the central bank's
actions and future expectations are an essential part of the strategy, in itself influencing
inflation expectations which are considered crucial for actual inflation developments.[52]
Typically the duration that the interest rate target is kept constant will vary between
months and years. This interest rate target is usually reviewed on a monthly or quarterly
basis by a policy committee.[19] Changes to the interest rate target are made in response
to various market indicators in an attempt to forecast economic trends and in so doing
keep the market on track towards achieving the defined inflation target.
The inflation targeting approach to monetary policy approach was pioneered in New
Zealand. Since 1990, an increasing number of countries have switched to inflation
targeting as its monetary policy framework. It is used in, among other
countries, Australia, Brazil, Canada, Chile, Colombia, the Czech
Republic, Hungary, Japan, New
Zealand, Norway, Iceland, India, Philippines, Poland, Sweden, South Africa, Turkey,
and the United Kingdom.[53] In 2022, the International Monetary Fund registered that 45
economies used inflation targeting as their monetary policy framework.[20] In addition,
the Federal Reserve and the European Central Bank are generally considered to follow
a strategy very close to inflation targeting, even though they do not officially label
themselves as inflation targeters.[18] Inflation targeting thus has become the world’s
dominant monetary policy framework.[54] However, critics contend that there are
unintended consequences to this approach such as fueling the increase in housing
prices and contributing to wealth inequalities by supporting higher equity values.[55]
Fixed exchange rate targeting[edit]
This policy is based on maintaining a fixed exchange rate with a foreign currency. There
are varying degrees of fixed exchange rates, which can be ranked in relation to how
rigid the fixed exchange rate is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares
a fixed exchange rate but does not actively buy or sell currency to maintain the rate.
Instead, the rate is enforced by non-convertibility measures (e.g. capital controls,
import/export licenses, etc.). In this case there is a black market exchange rate where
the currency trades at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank
or monetary authority on a daily basis to achieve the target exchange rate. This target
rate may be a fixed level or a fixed band within which the exchange rate may fluctuate
until the monetary authority intervenes to buy or sell as necessary to maintain the
exchange rate within the band. (In this case, the fixed exchange rate with a fixed level
can be seen as a special case of the fixed exchange rate with bands where the bands
are set to zero.)
Under a system of fixed exchange rates maintained by a currency board every unit of
local currency must be backed by a unit of foreign currency (correcting for the exchange
rate). This ensures that the local monetary base does not inflate without being backed
by hard currency and eliminates any worries about a run on the local currency by those
wishing to convert the local currency to the hard (anchor) currency.
Under dollarization, foreign currency (usually the US dollar, hence the term
"dollarization") is used freely as the medium of exchange either exclusively or in parallel
with local currency. This outcome can come about because the local population has lost
all faith in the local currency, or it may also be a policy of the government (usually to
rein in inflation and import credible monetary policy).
Theoretically, using relative purchasing power parity (PPP), the rate of depreciation of
the home country's currency must equal the inflation differential:
rate of depreciation = home inflation rate – foreign inflation rate,
which implies that
home inflation rate = foreign inflation rate + rate of depreciation.
The anchor variable is the rate of depreciation. Therefore, the rate of inflation at
home must equal the rate of inflation in the foreign country plus the rate of
depreciation of the exchange rate of the home country currency, relative to the
other.
With a strict fixed exchange rate or a peg, the rate of depreciation of the
exchange rate is set equal to zero. In the case of a crawling peg, the rate of
depreciation is set equal to a constant. With a limited flexible band, the rate of
depreciation is allowed to fluctuate within a given range.
By fixing the rate of depreciation, PPP theory concludes that the home country's
inflation rate must depend on the foreign country's.
Countries may decide to use a fixed exchange rate monetary regime in order to
take advantage of price stability and control inflation. In practice, more than half
of nations’ monetary regimes use fixed exchange rate anchoring.[19] The great
majority of these are emerging economies, Denmark being the
only OECD member in 2022 maintaining an exchange rate anchor according to
the IMF.[20]
These policies often abdicate monetary policy to the foreign monetary authority
or government as monetary policy in the pegging nation must align with
monetary policy in the anchor nation to maintain the exchange rate. The degree
to which local monetary policy becomes dependent on the anchor nation
depends on factors such as capital mobility, openness, credit channels and other
economic factors.
Money supply targeting[edit]
In the 1980s, several countries used an approach based on a constant growth in
the money supply. This approach was refined to include different classes of
money and credit (M0, M1 etc.) The approach was influenced by the theoretical
school of thought called monetarism.[56] In the US this approach to monetary
policy was discontinued with the selection of Alan Greenspan as Fed Chairman.
Central banks might choose to set a money supply growth target as a nominal
anchor to keep prices stable in the long term. The quantity theory is a long run
model, which links price levels to money supply and demand. Using this
equation, we can rearrange to see the following:
π = μ − g,
where π is the inflation rate, μ is the money supply growth rate and g is the
real output growth rate. This equation suggests that controlling the money
supply's growth rate can ultimately lead to price stability in the long run. To
use this nominal anchor, a central bank would need to set μ equal to a
constant and commit to maintaining this target. While monetary policy
typically focuses on a price signal of one form or another, this approach is
focused on monetary quantities.
However, targeting the money supply growth rate was not a success in
practice because the relationship between inflation, economic activity, and
measures of money growth turned out to be unstable.[10] Consequently, the
importance of the money supply as a guide for the conduct of monetary
policy has diminished over time,[57] and after the 1980s central banks have
shifted away from policies that focus on money supply targeting. Today, it is
widely considered a weak policy, because it is not stably related to the
growth of real output. As a result, a higher output growth rate will result in a
too low level of inflation. A low output growth rate will result in inflation that
would be higher than the desired level.[19]
In 2022, the International Monetary Fund registered that 25 economies, all of
them emerging economies, used some monetary aggregate target as their
monetary policy framework.[20]
Nominal income/NGDP targeting[edit]
Main article: Nominal income target
Related to money targeting, nominal income targeting (also called Nominal
GDP or NGDP targeting), originally proposed by James Meade (1978)
and James Tobin (1980), was advocated by Scott Sumner and reinforced by
the market monetarist school of thought.[58]
So far, no central banks have implemented this monetary policy. However,
various academic studies indicate that such a monetary policy targeting
would better match central bank losses[59] and welfare optimizing monetary
policy[60] compared to more standard monetary policy targeting.
Price level targeting[edit]
Price level targeting is a monetary policy that is similar to inflation targeting
except that CPI growth in one year over or under the long term price level
target is offset in subsequent years such that a targeted price-level trend is
reached over time, e.g. five years, giving more certainty about future price
increases to consumers. Under inflation targeting what happened in the
immediate past years is not taken into account or adjusted for in the current
and future years.
Nominal anchors and exchange rate regimes[edit]
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 following a gold standard and a floating regime
towards those that are not. Targeting inflation, the price level or other
monetary aggregates implies floating the exchange rate.

Type of Nominal Anchor Compatible Exchange Rate Regimes

Currency Union/Countries without own currency,

Exchange Rate Target
Pegs/Bands/Crawls, Managed Floating

Money Supply Target Managed Floating, Freely Floating

Inflation Target (+ Interest

Managed Floating, Freely Floating
Rate Policy)

Credibility[edit]
The short-term effects of monetary policy can be influenced by the degree to
which announcements of new policy are deemed credible.[61] In particular,
when an anti-inflation policy is announced by a central bank, in the absence
of credibility in the eyes of the public inflationary expectations will not drop,
and the short-run effect of the announcement and a subsequent sustained
anti-inflation policy is likely to be a combination of somewhat lower inflation
and higher unemployment (see Phillips curve § NAIRU and rational
expectations). But if the policy announcement is deemed credible,
inflationary expectations will drop commensurately with the announced policy
intent, and inflation is likely to come down more quickly and without so much
of a cost in terms of unemployment.
Thus there can be an advantage to having the central bank be independent
of the political authority, to shield it from the prospect of political pressure to
reverse the direction of the policy. But even with a seemingly independent
central bank, a central bank whose hands are not tied to the anti-inflation
policy might be deemed as not fully credible; in this case there is an
advantage to be had by the central bank being in some way bound to follow
through on its policy pronouncements, lending it credibility.
There is very strong consensus among economists that an independent
central bank can run a more credible monetary policy, making market
expectations more responsive to signals from the central bank.[62]
Contexts[edit]
In international economics[edit]
Optimal monetary policy in international economics is concerned with the
question of how monetary policy should be conducted in interdependent
open economies. The classical view holds that international macroeconomic
interdependence is only relevant if it affects domestic output gaps and
inflation, and monetary policy prescriptions can abstract from openness
without harm.[63] This view rests on two implicit assumptions: a high
responsiveness of import prices to the exchange rate, i.e. producer currency
pricing (PCP), and frictionless international financial markets supporting the
efficiency of flexible price allocation.[64][65] The violation or distortion of these
assumptions found in empirical research is the subject of a substantial part of
the international optimal monetary policy literature. The policy trade-offs
specific to this international perspective are threefold:[66]
First, research suggests only a weak reflection of exchange rate movements
in import prices, lending credibility to the opposed theory of local currency
pricing (LCP).[67] The consequence is a departure from the classical view in
the form of a trade-off between output gaps and misalignments in
international relative prices, shifting monetary policy to CPI inflation control
and real exchange rate stabilization.
Second, another specificity of international optimal monetary policy is the
issue of strategic interactions and competitive devaluations, which is due to
cross-border spillovers in quantities and prices.[68] Therein, the national
authorities of different countries face incentives to manipulate the terms of
trade to increase national welfare in the absence of international policy
coordination. Even though the gains of international policy coordination might
be small, such gains may become very relevant if balanced against
incentives for international noncooperation.[64]
Third, open economies face policy trade-offs if asset market distortions
prevent global efficient allocation. Even though the real exchange rate
absorbs shocks in current and expected fundamentals, its adjustment does
not necessarily result in a desirable allocation and may even exacerbate the
misallocation of consumption and employment at both the domestic and
global level. This is because, relative to the case of complete markets, both
the Phillips curve and the loss function include a welfare-relevant measure of
cross-country imbalances. Consequently, this results in domestic goals,
e.g. output gaps or inflation, being traded-off against the stabilization of
external variables such as the terms of trade or the demand gap. Hence, the
optimal monetary policy in this case consists of redressing demand
imbalances and/or correcting international relative prices at the cost of some
inflation.[69][self-published source?]
Corsetti, Dedola and Leduc (2011)[66] summarize the status quo of research
on international monetary policy prescriptions: "Optimal monetary policy thus
should target a combination of inward-looking variables such as output gap
and inflation, with currency misalignment and cross-country demand
misallocation, by leaning against the wind of misaligned exchange rates and
international imbalances." This is main factor in country money status.
In developing countries[edit]
Developing countries may have problems establishing an effective operating
monetary policy. The primary difficulty is that few developing countries have
deep markets in government debt. The matter is further complicated by the
difficulties in forecasting money demand and fiscal pressure to levy the
inflation tax by expanding the base rapidly. In general, the central banks in
many developing countries have poor records in managing monetary policy.
This is often because the monetary authorities in developing countries are
mostly not independent of the government, so good monetary policy takes a
backseat to the political desires of the government or is used to pursue other
non-monetary goals. For this and other reasons, developing countries that
want to establish credible monetary policy may institute a currency board or
adopt dollarization. This can avoid interference from the government and
may lead to the adoption of monetary policy as carried out in the anchor
nation. Recent attempts at liberalizing and reform of financial markets
(particularly the recapitalization of banks and other financial institutions in
Nigeria and elsewhere) are gradually providing the latitude required to
implement monetary policy frameworks by the relevant central banks.
Trends[edit]
Transparency[edit]
Beginning with New Zealand in 1990, central banks began adopting formal,
public inflation targets with the goal of making the outcomes, if not the
process, of monetary policy more transparent. In other words, a central bank
may have an inflation target of 2% for a given year, and if inflation turns out
to be 5%, then the central bank will typically have to submit an explanation.
The Bank of England exemplifies both these trends. It became independent
of government through the Bank of England Act 1998 and adopted an
inflation target of 2.5% RPI, revised to 2% of CPI in 2003.[70] The success of
inflation targeting in the United Kingdom has been attributed to the Bank of
England's focus on transparency.[71] The Bank of England has been a leader
in producing innovative ways of communicating information to the public,
especially through its Inflation Report, which have been emulated by many
other central banks.[72]
The European Central Bank adopted, in 1998, a definition of price
stability within the Eurozone as inflation of under 2% HICP. In 2003, this was
revised to inflation below, but close to, 2% over the medium term. Since then,
the target of 2% has become common for other major central banks,
including the Federal Reserve (since January 2012) and Bank of
Japan (since January 2013).[73]
Effect on business cycles[edit]
There continues to be some debate about whether monetary policy can (or
should) smooth business cycles. A central conjecture of Keynesian
economics is that the central bank can stimulate aggregate demand in the
short run, because a significant number of prices in the economy are fixed in
the short run and firms will produce as many goods and services as are
demanded (in the long run, however, money is neutral, as in the neoclassical
model). However, some economists from the new classical school contend
that central banks cannot affect business cycles.[74]
Behavioral monetary policy[edit]
Conventional macroeconomic models assume that all agents in an economy
are fully rational. A rational agent has clear preferences, models uncertainty
via expected values of variables or functions of variables, and always
chooses to perform the action with the optimal expected outcome for itself
among all feasible actions – they maximize their utility. Monetary policy
analysis and decisions hence traditionally rely on this New
Classical approach.[75][76][77]
However, as studied by the field of behavioral economics that takes into
account the concept of bounded rationality, people often deviate from the
way that these neoclassical theories assume.[78] Humans are generally not
able to react in a completely rational manner to the world around them[77] –
they do not make decisions in the rational way commonly envisioned in
standard macroeconomic models. People have time limitations, cognitive
biases, care about issues like fairness and equity and follow rules of thumb
(heuristics).[78]
This has implications for the conduct of monetary policy. Monetary policy is
the final outcome of a complex interaction between monetary institutions,
central banker preferences and policy rules, and hence human decision-
making plays an important role.[76] It is more and more recognized that the
standard rational approach does not provide an optimal foundation for
monetary policy actions. These models fail to address important human
anomalies and behavioral drivers that explain monetary policy decisions.[79][76][77]
An example of a behavioral bias that characterizes the behavior of central
bankers is loss aversion: for every monetary policy choice, losses loom
larger than gains, and both are evaluated with respect to the status quo.
[76]
One result of loss aversion is that when gains and losses are symmetric or
nearly so, risk aversion may set in. Loss aversion can be found in multiple
contexts in monetary policy. The "hard fought" battle against the Great
Inflation, for instance, might cause a bias against policies that risk greater
inflation.[79] Another common finding in behavioral studies is that individuals
regularly offer estimates of their own ability, competence, or judgments that
far exceed an objective assessment: they are overconfident. Central bank
policymakers may fall victim to overconfidence in managing the
macroeconomy in terms of timing, magnitude, and even the qualitative
impact of interventions. Overconfidence can result in actions of the central
bank that are either "too little" or "too much". When policymakers believe
their actions will have larger effects than objective analysis would indicate,
this results in too little intervention. Overconfidence can, for instance, cause
problems when relying on interest rates to gauge the stance of monetary
policy: low rates might mean that policy is easy, but they could also signal a
weak economy.[79]
These are examples of how behavioral phenomena may have a substantial
influence on monetary policy. Monetary policy analyses should thus account
for the fact that policymakers (or central bankers) are individuals and prone
to biases and temptations that can sensibly influence their ultimate choices in
the setting of macroeconomic and/or interest rate targets.[76]