Instruments and Working of Monetary Policy | UGC NET Economics – Notes

Introduction

• Without doubt, money and monetary policy have evolved considerably. A monetary policy requires an arrangement of institutional practice to ensure that the right amount of money is made available to facilitate trade in an economy. It is no simple task to set the correct relative prices between various types of monies and goods and decide on how to get the right amount of money into circulation.

• Indeed, it can be argued that fiscal policy and monetary policy should run in tandem, so that in managing the latter attention is paid to the former and information is exchanged in the pursuit of the objectives jointly. It is worthwhile to recall that the nature and scope of the regulation of financial intermediation is closely linked to the monetary policy regime.

• In principle, there is a trade-off between designing instruments to stabilise the financial system and prevent excessively volatile financial outcomes, ensuring that financial sector retains appropriate incentives to create investment opportunities and allocate funds accordingly.

• The ultimate decisions in policymaking may be based on judgements and that could, unfortunately remain faulty, even in the presence of right information and foresight.

Targets of Monetary Policy

• The formal mandate of the central bank differs significantly across countries. De facto, though, central banks across the world appear to be increasingly pursuing a single nominal target. By and large, this single nominal target is an inflation target. It is desirable for monetary policy to target something it can actually hope to deliver, on an average and over time. The question relating to the choice of appropriate target for conducting monetary policy goes into the basic question of the interrelationship between money, output and prices.

• In general, most central banks have a broad mandate that includes not only price (or exchange rate) stability, but also the safeguarding of financial stability, as well as the promotion of economic growth, and, sometimes, financial development. The growth objective has also come to the forefront. To fulfil these multiple objectives within the constraints imposed by a particular policy regime, central banks use all available tools, including cooperation in some instances with fiscal authorities and other policymakers. Importantly, interest rates and foreign exchange intervention may not be sufficient to resolve the policy dilemmas resulting from the impact of external factors on the domestic financial system.

• There is a two-way street of monetary policy operating through financial markets and financial markets feeding back into monetary policy. The problem of central bank is compounded by the fact that their instruments do not directly affect the goals. The instruments affect variables such as money supply and interest rates, which then affect goal variables with a lag. In addition, these lags may be uncertain.

• Due to these problems, in the conduct of monetary policy, a distinction is made among:

  • i) Goals (or objectives)

  • ii) Targets (or intermediate targets)

  • iii) Indicators (or operational targets)

  • iv) Instruments (or tools)

• Target and indicator variables lie between goal and instrument variables. Target variables such as money supply and interest rates have direct and predictable impact on goal variables and can be quickly and more easily observed. Target variables are not directly affected by central bank instruments. The instruments affect target variables, through another set of variables called indicators. These indicators such as monetary base and short run interest rates are more responsive to instruments.

The conduct of monetary policy can be represented schematically as follows:

Instruments → Indicators → Targets → Goals

Kinds of variables:

• Despite listing six goals, it does not mean that different countries and regimes give same weight to all these goals. Different goals may get different emphasis in different countries and over times. All the goals may not be compatible with each other. For instance, goal of price stability may conflict with the goals of high employment and stability of interest rate at least in the short run.

• Three criteria determine how the target variables are chosen. These are:

  • (i) Measurability

  • (ii) Controllability

  • (iii) Predictable effects on goals

• Quick and accurate measurement of target variables is necessary because the target will be useful only if it signals rapidly when policy is off-track. For a target variable to be useful, a central bank must be able to exercise effective control over it. If the central bank cannot exercise effective control over it, knowing that it is off-track is of little help. Finally, and most importantly, target variables must have a predictable impact on goal variables. If target variables do not have predictable impact on goal variables, the central bank cannot achieve its goal by using target variables.

• Monetary aggregates and short and long run interest rates satisfy all three criteria. The same three criteria are used to choose indicators. They must be measurable, the central bank should have effective control over them, and they must have predictable effect on target variables.

• The general conclusion is that if the main source of disturbance in the economy is shocks to goods market (IS curve), then targeting money supply (or using money supply tool) is optimal. On the other hand, if the main source of disturbance is shocks to demand for money or financial market (LM curve), then targeting interest rate is optimal.