Sunday 25th March, 2007


Monetary policy explained

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The Bank of England was established in 1694. It issued bank notes or bills equivalent to the supply of gold. The objective was to be able to exchange the notes for gold at any time the customer required. From this arose the concept of the gold standard. But that went out the door finally by 1931.

Today, monetary policy is fairly complex and is used conjointly with fiscal policy to trigger economic objectives by governments. Last week, we dealt with fiscal policy. Today, we expand on that with monetary policy.

There are several types of monetary policy: the gold standard is still one of them, but more at the forefront are inflation targeting, price level targeting, fixing of exchange rates, managed float, monetary aggregates and a combination of all or some of the above. They are also known as monetary regimes.

The mechanisms in use to implement such policies include such things as interest rates, reserve requirements, momentary base and discount window lending.

Inflation targeting

We have all heard the term “open market operations.” In its simplest form, this refers to the ability of governments to alter or modify the amount of currency in circulation, also referred to as the liquidity factor. It seeks to stabilise or control the other economic variables such as interest rates and exchange rates.

Inflation targeting uses the Central Bank’s adjustment to the interest rates at which banks lend each other overnight in order to maintain cash flows. Such rates are then managed for a special period by pulling money out of the system or letting it flow in. The long-term expectation is that the Consumer Price Index will remain at a certain value.

Price level targeting also uses overnight debt interest rates, but is aimed at a specific CPI number. This is now an unpopular strategy.

Monetary aggregates are also unpopular, but were not disbanded by the FED in the US for the last several years. This policy was used to maintain money supply at specific levels.

The gold standard is no longer in use, but it refers to a kind of set pricing based on the value of gold; almost a fixed exchange rate.

Among the mechanisms used in monetary policy, we focus today on reserve requirements. This is really about demands made by the Central Bank on the ordinary banks.

From time to time, central banks shift the amount of reserves required from the bankers. The objective is to alter the money supply. The reserves take the form of assets pledged to the Central Bank, as well as the amount of cash being held in the bank. The banks only hold on to as much cash as is required to serve customers.

Central Bank dictates that a certain amount of cash must form the ceiling at any point in time. If the amount of cash that a bank can hold is reduced, the amount of money it can lend to its customers is also reduced. This makeover reduces the amount of money in supply for customers to borrow.

The challenge for us as individual consumers is how to insulate ourselves from the effect of monetary and fiscal policy.

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