Monetary policy is one of the tools that a national Government uses to
influence its economy. Using its monetary authority to control the supply and
availablity of money, a government attempts to influence the overall level of
economic activity in line with its political objectives. Usually this goal is "macroeconomic
stability" - low unemployment, low inflation, economic growth, and a
balance of external payments. Monetary policy is usually administered by a
Government appointed "Central Bank", the Bank of Canada and the
Federal Reserve Bank in the United States.
Central banks have not always existed. In early economies, governments
would supply currency by minting precious metals with their stamp. No matter
what the creditworthiness of the government, the worth of the currency depended
on the value of its underlying precious metal. A coin was worth its gold or
silver content, as it could always be melted down to this. A country's worth and
economic clout was largely to its holdings of gold and silver in the national
treasury. Monarchs, despots and even democrats tried to skirt this inviolate law
by filing down their coinage or mixing in other substances to make more coins
out of the same amount of gold or silver. They were inevitably found out by the
traders, money lenders and others who depended on the worth of that currency.
This the reason that movies show pirates and thieves biting Spanish dubloons to
ascertain the value of their booty and loot.
The advent of paper money during the industrial revolution meant that it
wasn't too difficult for a country to alter its amount of money in circulation.
Instead of gold, all that was needed to produce more banknotes was paper, ink
and a printing press. Because of the skepticism of all concerned, paper money
was backed by a "promise to pay" upon demand. A holder of a "pound
sterling" note of the United Kingdom could actually demand his pound of
silver! When gold became the de facto backing of the world's currency a "gold
standard" was developed where nations kept sufficient gold to back their "promises
to pay" in their national treasuries. The problem with this standard was
that a nation's economic health depended on its holdings of gold. When the
treasury was bare, the currency was worthless.
In the 1800s, even commercial banks in Canada and the United States issued
their own banknotes, backed by their promises to pay in gold. Since they could
lend more than they had to hold in reserves to meet their depositers demands,
they actually could create money. This inevitably led to "runs" on
banks when they could not meet their depositers demands and were bankrupt. The
same happened to smaller countries. Even the United States Treasury had to be
rescued by JP Morgan several times during this period. In the late 1800s and
early 1900s, countries legislated their exclusive monopoly to issue currency and
banknotes. This was in response to "financial panics" and bank
insolvencies. This meant that all currency was issued and controlled by the
national governments, although they still maintained gold reserves to support
their currencies. Commercial banks still could create money by lending more than
their depositors had placed with the bank, but they no longer had the right to
issue banknotes.
Modern Monetary Policy
Modern central banking dates back to the aftermath of great depression of
the 1930s. Governments, led by the economic thinking of the great John Maynard
Keynes, realized that collapsing money supply and credit availability greatly
contributed to the savagery of this depression. This realization that money
supply affected economic activity led to active government attempts to influence
money supply through "monetary policy". At this time, nations created
central banks to establish "monetary authority". This meant that
rather than accepting whatever happened to money supply, they would actively try
to influence the amount of money available. This would influence credit
creation and the overall level of economic activity.
Modern monetary policy does not involve gold to a great extent. In 1968,
the United States rescinded its promise to pay in gold and effectively removed
itself from the "gold standard". Since then, it has been the job of
the Federal Reserve to control the amount of money and credit in the U.S.
economy. I doing this, it wants to maintain the purchasing power of the U.S.
dollar and its comparative worth to other currencies. This might sound easy,
but it is a complex task in an information age where huge amounts of money
travels in electronic signals in microseconds around the world.
The Effectiveness of Monetary Policy
Economists debate the relevant measures of money supply. "Narrow"
money supply or M1 is currency in circulation and the currency in easily
accessed chequing and savings accounts. "Broader" money supply
measures such as M2 and M3 include term deposits and even money market mutual
funds. Economists debate the finer points of the implementation and
effectiveness of monetary policy but one thing is obvious. At the extremes,
monetary policy is a potent force. In countries such as the Russian Republic,
Poland or Brazil where the printing presses run full tilt to pay for government
operations, money supply is expanding rapidly and the currency becomes rapidly
worthless compared to goods and services it can buy. Very high levels of
inflation or "hyperinflation" is the result. With 30-40% monthly
inflation rates, citizens buy hard goods as soon as they receive payment in the
currency and those on fixed income have their investments rendered worthless.
At the other extreme, restrictive monetary policy has shown its
effectiveness with considerable force. Germany, which experienced
hyperinflation during the Weimar Republic and never forgot, has maintained a
very stable monetary regime and resulting low levels of inflation. When
Chairman Paul Volcker of the U.S. Federal Reserve applied the monetary brakes
during the high inflation 1980s, the result was an economic downturn and a large
drop in inflation. The Bank of Canada, headed by John Crow, targeted 0-3%
inflation in the early 1990s and curtailed economic activity to such an extent
that Canada actually experienced negative inflation rates in several months for
the first time since the 1930s.
Without much debate, the effectiveness of monetary policy, its timing and
its eventual impacts on the economy are not obvious. That central banks attempt
influence the economy through monetary is a given. In any event, insights into
monetary policy are very important to the investor. The availability of money
and credit are key considerations in the pricing of an investment.
Operations of a Modern Central Bank
The Central Bank attempts to achieve economic stability by varying the
quantity of money in circulation, the cost and availability of credit, and the
composition of a country's national debt. The Central Bank has three instruments
available to it in order to implement monetary policy:
- Open market operations
- Reserve requirements
- The 'Discount Window'
Open market operations are just that, the buying or selling of
Government bonds by the Central Bank in the open market. If the Central Bank
were to buy bonds, the effect would be to expand the money supply and hence
lower interest rates, the opposite is true if bonds are sold. This is the most
widely used instrument in the day to day control of the money supply due to its
ease of use, and the relatively smooth interaction it has with the economy as a
whole.
Reserve requirements are a percentage of commercial banks', and
other depository institutions', demand deposit liabilities (i.e. chequing
accounts) that must be kept on deposit at the Central Bank as a requirement of
Banking Regulations. Though seldom used, this percentage may be changed by the
Central Bank at any time, thereby affecting the money supply and credit
conditions. If the reserve requirement percentage is increased, this would
reduce the money supply by requiring a larger percentage of the banks, and
depository institutions, demand deposits to be held by the Central Bank, thus
taking them out of supply. As a result, an increase in reserve requirements
would increase interest rates, as less currency is available to borrowers. This
type of action is only performed occasionally as it affects money supply in a
major way. Altering reserve requirements is not merely a short-term corrective
measure, but a long-term shift in the money supply.
Lastly, the Discount Window is where the commercial banks, and other
depository institutions, are able to borrow reserves from the Central Bank at a
discount rate. This rate is usually set below short term market rates (T-bills).
This enables the institutions to vary credit conditions (i.e., the amount of
money they have to loan out), there by affecting the money supply. It is of note
that the Discount Window is the only instrument which the Central Banks do not
have total control over.
By affecting the money supply, it is theorized, that monetary policy can
establish ranges for inflation, unemployment, interest rates ,and economic
growth. A stable financial environment is created in which savings and
investment can occur, allowing for the growth of the economy as a whole. |