June 23, 2023 | 4-minute read (745 words)
Monetary policy is the foundation of any country’s economic policy which influences the interest and inflation rates thus impacting net exports, employment, business expansion, debt costs and the relative cost of consumption versus saving, all of which have a direct or indirect effect on the aggregate demand in the market.
Monetary policy is used by central banks to moderate economic volatility and attain price stability that aids low and stable inflation.
What is a central bank?
The term “central bank” refers to a country’s chief monetary authority. The central bank of a country is tasked with a variety of responsibilities but the primary one is the issuance of money that circulates in the economy, and is used by individuals, enterprises and households to generate transactions, which is ultimately tracked down to know where the money is being spent.
Furthermore, central banks ensure an economy’s financial stability by setting the money supply, monitoring banks, lending to banks and supporting consumer protection. Also, when the government needs funds and there are no other options or access to finances, the central bank acts as the lender of last resort.
Central banks also monitor and keep track of economic data, based on which economists derive key insights. For example, the U.S. Federal Reserve prepares an inflation report with a ‘dot plot,’ which is an economic projection chart that shows each Fed official’s forecast for the central bank’s main short-term interest rate.
Why is monetary policy important?
Monetary policy is used by central banks to regulate the supply of money and credit in the economy in an ongoing effort to control inflation, economic growth and employment. In the U.S., the Federal Reserve is in charge of monetary policy.
When it comes to regulating the supply of money in the economy, it’s done through purchasing or selling securities in the open market. These operations affect the short-term interest rates thus making an impact on the long-term interest rates.
The fluctuation in the interest rate determines the ease and tightening of monetary policy – lower interest rates translate to a higher supply of money whereas higher interest rates translate to a lower supply of money.
How was monetary policy used in recent times?
During the COVID-19 pandemic, central banks globally took steps to ease monetary policy, provide liquidity in the market and keep credit flowing. Many central banks in emerging markets used asset purchase programs and foreign exchange interventions to reduce the strain on currency and bond markets. Recently, central banks across economies have tightened monetary policy by raising interest rates in response to soaring inflation.
How is monetary policy linked to the exchange rate?
A country’s monetary policy exerts an important influence over its exchange rate regime. The monetary policy changes that impact the country’s interest rates change the value of its currency.
Higher interest rates as a result of tightening monetary policy tend to attract foreign investment, increasing the demand for and value of a country’s currency. Lower interest rates, on the other hand, weaken a country’s currency value.
But the dynamics are significantly different in a fixed exchange rate regimen. In such economies, the central bank is not free to follow an independent monetary policy, instead, it must adjust the monetary policy to keep the interest rate fixed in order to maintain the exchange rate.
What is the role of the IMF in central banking and monetary policy?
The IMF oversees the international monetary system and monitors global economic developments to identify potential risks and advise on needed policy adjustments to facilitate sound economic growth.
It also undertakes a regular health check of the economic and financial policies to provide policy recommendations and technical assistance to central banks to build capacity and operate more effectively.
It participates in dialogue with country central banks on a regular basis to provide bilateral policy advice, known as Article IV consultation. As part of this consultation process, the IMF team meets with central bank officials to discuss important macrocritical issues — fiscal, financial, foreign exchange, monetary, and structural — to help them identify risks and vulnerabilities and formulate appropriate policy responses.
Additionally, the IMF’s Central Bank Transparency Code (CBT) helps central banks to examine their existing transparency practices and facilitate informed discussion with their stakeholders, contributing to policy effectiveness.
Last but not least, the IMF works with the central banks to help them modernize their monetary, macroprudential and exchange rate policies as well as frameworks.