 | Monetary policy: Encyclopedia II - Monetary policy - Types of monetary policy
Monetary policy - Types of monetary policy
In practice all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency is called open market operations.
Constant market transactions by the monetary authority modify the liquidity of currency and this impacts other market variables such as short term interest rates, the exchange rate and the domestic price of spot market commodities such as gold. Open market operations are undertaken with the objective of stabilizing one of these market variables.
The distinction between the various types of monetary policy lies primarily with the market variable that open market operations are used to target. Targeting being the process of achieving relative stability in the target variable.
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 on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonised consumer price index).
Monetary policy - Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, at a particular level.
The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other over night for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.
The interest rate target is maintained for a specific duration using open market operations. 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.
Changes to the interest rate target are done 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.
This monetary policy approach was pioneered in New Zealand. It is currently used in the Eurozone, Australia, New Zealand, Sweden, South Africa and the United Kingdom.
Monetary policy - Price level targeting
Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.
Something like price level targeting was tried in the 1930s by Sweden, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operates monetary policy based on a price level target.
Monetary policy - Monetary aggregates
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). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.
This approach is also sometimes called monetarism.
Whilst most monetary policy focuses on a price signal of one form or another this approach is focused on monetary quantities.
Monetary policy - Fixed exchange rate
This policy is based on maintaining a fixed exchange rate with a foreign currency. Currency is bought and sold by the central bank on a daily basis to achieve the target exchange rate. This policy somewhat abdicates responsibility for monetary policy to a foreign government.
This type of policy was used by China. The Chinese yuan was managed such that its exchange rate with the United States dollar was fixed.
Monetary policy - Gold standard
The gold standard is a system in which the price of the national currency as measured in units of gold is kept constant by the daily buying and selling of base currency. This process is called open market operations.
The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".
Today this type of monetary policy is not used anywhere in the world, although a form of gold standard was used widely across the world prior to 1971. For details see the Bretton Woods system. Its major advantages were simplicity and transparency.
Monetary policy - Mixed policy
A mixed policy approach is usually in practice most like "inflation targeting". However consideration is also given to other goals such as economic growth, unemployment and asset bubbles.
This type of policy is used by the Federal Reserve.
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