what+is+monetary+policy[1]
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What is Monetary Policy?
Governments most commonly use two types of policy tools in macroeconomics. The first is
Fiscal Policy, and the second is Monetary Policy.
Fiscal Policy can simply be understood as government spending. The goal is to control
growth rates or prevent recessions (in other words, the goal is to achieve ‘stability’). By
increasing spending, governments can stimulate the economy. On the other hand, if there is
high inflation they can reduce spending. We have witnessed a lot of Fiscal Policy in the
aftermath of the recent financial crisis. The governmnet taxes its citizens in order to generate
the income that it spends. If governmnet spend more than they tax, they are forced to borrow
money and go in to deficit. If governmnet spend less than they “earn” from taxation they
reduce the deficit, or increase a surplus (depending on the initial position).
Monetary Policy has similar goals to Fiscal Policy, however it is concerned with the supply of
money. In other words, how much money is there in the economy? This can be done through
a number of methods, such as literally creating new money (Quantitative Easing),
buying/selling government bonds (open market operations) or by setting interest rates. The
most common method is the setting of interest rates. If interest rates are low, the incentive to
save your money is less (because you get less interest on savings) and the incentive to make
debt is high (because you pay less interest on loans). In this way, people put more money
into circulation and it acts as a form of stimulus similar to Fiscal Policy.
Most countries use Monetary Policy and the setting of interest rates to target inflation. If
inflation is too high, they increase interest rates. If inflation is low then interest rates can be
lowered to stimulate spending and growth.
Monetary Policy is usually set by the Central or Reserve Bank of a country. Normally, this
bank is an independent body, and it sets Monetary Policy separately to the elected
government. It is said that an independent body is good to avoid politically motivated policy
decisions and better encourage stability. Companies and individuals often make long-term
economic plans based on the credibility of the Monetary Policy decisions (do you save or
spend?). This is determined by what you can predictably say the Central Bank will decide to
do with interest rates). Therefore a stable, predictable and credible monetary policy is
important.
Monetary Policy and Exchange Rates
The Bretton Woods system aimed to create an international economic order which would
prevent the global economic problems that led to the Great Depression. For example, the
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proposed International Trade Organisation (which became the GATT and later the WTO we
have today) was aimed at preventing trade-wars where countries put tariffs up against each
other.
The International Monetary Fund was concerned with the value of currency. Before the IMF,countries would competitively devalue their currency. This means that they would set the
price of their currency artificially low. This would make their products cheaper in foreign
markets, and boost their exports. For example, if the Rand is really weak, then people in the
USA can buy things from South Africa very cheaply. At R10 per Dollar, they can get R100 for
$10 which gives them a lot of purchasing power. However at R5 per Dollar, they can only get
R50 for the same $10, which means they can buy a lot less for the same amount. Therefore
the weaker the Rand, the better for South African companies trying to export. What used to
happen however, is that when one country devalued, other countries would devalue in‘retaliation’. The result was a race to the bottom, where countries would competitively
devalue their currencies with no positive results.
More important than the actual value of your currency, however, is whether its value is
stable. Individuals who export need to be able to predict how much profits they will make,
and similarly people who rely on imports for their business need to accurately value their
costs. Trade and Development therefore require exchange rate stability.
The IMF instituted a system to control this. All countries had to “peg” or value their currency
relative to the US Dollar (which itself was then backed by Gold), and the IMF would ensure
that these valuations are accurate. This system remained successful initially, but it had a
number of implications for the US (such as losing control over interest rates, and requiring
them to run huge deficits to facilitate the global accumulation of Dollar Reserves).
Importantly, by 1971 the US could no longer back its currency in gold, and was unwilling to
remain the currency that others were pegged against.
After the collapse of that system, the IMF promoted Floating Exchange rates. This meant
that currencies were valued through the market forces of supply and demand. Associated
with this was later the promotion of Capital Account Liberalisation. This simply means, that
money would be allowed to move in and out of a countries without any restrictions (the
global free-flow of currency). This helped to more accurately value a currency.
A country can indirectly attract higher levels of foreign currency, by having higher interest
rates. This means that foreign investors get higher returns. Similarly, if you have foreign
inflows that are too high, you can cut interest rates (this is currently happening in South
Africa). However, it seems that in reality, domestic interest rates are dictate by the flow of
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money, and not the other way around. Many investors speculate and trade on currencies for
quick profits (often through quick buying and selling to capture price differences between
currencies – this is called arbitrage). This rapid flow of money in and out of a country
(facilitated through the capital count liberalisation) leads to what is termed as “hot flows”
and this causes the value of a currency to fluctuate. The resulting instability of the currency is
highly problematic for a developing economy.
Ultimately, all nations want to achieve three things: control over their monetary policy,
stable (and sometimes weak) exchange rates, and control over the flow of money in and out
of the country. However, it is impossible to control all three of those things (this is called the
Unholy/Impossible Trinity or Trilemma). In the modern IMF era, countries focus on just
controlling interest rates, exposing them to the whim of international financial markets.
It is also noteworthy that several developing nations have opted to control their currencies
rather than interest rates. An example would be China, which has a devalued currency, which
makes it more competitive in exporting goods to the USA (however, it can be argued that this
is unfair to other developing countries who are trying to compete but have floating exchange
rates).