Monetary policy

As monetary policy (including monetary policy ) collectively known all economic policy measures that a central bank is taking to achieve their goals. The most important instrument of monetary policy is the key interest rate for central bank money . For a restrictive monetary policy , the key interest rate is increased in order to make borrowing more expensive and to reduce the money supply, for example to dampen inflation . This indirectly slows economic growth. Lowering the key interest rate makes loans cheaper and is intended to increase the money supply through an expansive credit policy by the commercial banks in order, for example, to counteract deflation and to stimulate economic growth.

Monetary policy objectives

A distinction is made between the following objectives pursued by monetary policy:

Overarching economic policy goals: These are usually derived from the central bank statutes. At the European Central Bank (ECB) this is price level stability . The US central bank (the Federal Reserve System , “Fed” for short ) also has growth and employment targets. The ECB also has the secondary objective of supporting general economic policy. Sometimes central banks also pursue exchange rate targets .
Objectives of central bank policy: these are intermediate objectives that are pursued in the fulfillment of economic policy objectives. The intermediate goal is an indicator of whether the economic policy goal can be met. This can be, for example, the amount of money , the interest rate , the inflation rate , economic growth , the price index or a combination of several goals.

Economic policy goals of monetary policy

Theoretical foundations

The role of money in economic activity and thus also the importance of monetary policy is controversial between the economics schools.

The Classical economics assumes generally the neutrality of money. In other words, it sees money as an important transaction medium and assumes that it only serves as a “lubricant” - without any repercussions on the real economy. In other words: whether and how much is produced is decided independently of monetary policy, which, according to the classic view, only influences the price level.

The Keynesianism comes from the monetary policy of real economic consequences, with the monetary policy in a deep recession but the demand can not stimulate because the economy then in the liquidity trap is, in the interest rates on bonds can not fall further. For Keynes, the interest rate was an important determinant of investment activity, so Keynesianism regards monetary policy in terms of interest rate policy. Above all, Keynes was of the opinion that, contrary to the classic view, monetary policy cannot simply control prices via the money supply, but rather runs the risk of triggering a deflationary depression such as the global economic crisis with a restrictive monetary policy to lower wages and prices .

For monetarism, however, monetary policy plays a central role. Instead of short-term interventions , he advocates predictable, steady conditions for the economy. The central goal is price level stability . To ensure this, the advocates of monetarism recommend rule-based money supply growth.

Because of the negative effects of inflation on capital formation and growth, price level stability is the most important objective of monetary policy. Since inflation devalues financial assets and favors debtors, economic agents are unwilling to save when inflation is high . That is why there is no money capital available for investments during inflation; Too little physical capital is formed and that hinders growth. In addition, a high rate of inflation masks the signals that prices send out to market events: If a product becomes more expensive, it is unclear whether this only follows general inflation or because the demand for it is increasing, so that companies should turn to the production of this good .

Goals in practice

Based on the different theoretical positions, one can conclude that in countries where a more Keynesian policy is pursued, the central bank has primarily growth and employment goals. In countries with a monetarist orientation of economic policy, the focus is more on price level stability. The distinction is not easy. Historical experiences also play an important role in the derivation of goals. In Germany, after two hyperinflations, price stability was always an important goal, regardless of the general direction of economic policy.

In view of the economic and financial crisis, IMF chief economist Olivier Blanchard has proposed raising the central banks' inflation targets significantly from two to four percent. This move sparked an international discussion.

Intermediate objectives of monetary policy

In order to achieve their respective economic policy goals, the central banks influence the money supply and interest rates and thus the financing conditions in the economy . They are based on intermediate goals, which are ideally easy to observe in the short term and at the same time are sufficiently closely related to the economic policy goal. Common intermediate targets are the money supply , interest rates , the inflation rate itself, and sometimes the exchange rate .

A money supply control, as z. B. operated by the Deutsche Bundesbank from 1975 until the transfer of monetary policy competence to the ECB, is based on the assumption of monetarism that the demand for money in an economy is stable over the long term. Under this assumption, a simple rule for monetary growth can be derived from the quantity equation, which on the one hand offers sufficient scope for economic growth and on the other hand does not allow inflation to arise. For example, with an average rate of 3% and the central bank considers an inflation rate of 2% to be acceptable (or unavoidable), the money supply must be expanded at a rate of 5% in the long term. On the one hand, this does not prevent the economy from growing and, on the other hand, it does not result in unacceptably high inflation.

With an interest rate policy, the central bank tries to influence the interest rates on the capital market , which are decisive for the financing conditions of companies and consumers. The capital market rates are the result of supply and demand and can therefore only be influenced indirectly by the central bank by influencing the supply on the capital market through its monetary policy instruments. However, especially with open capital markets and international capital mobility, there are situations in which the central bank can only insufficiently influence capital market rates.

A third possibility is direct inflation targeting: central banks set an inflation target and observe the current price increase and factors that determine future price increases (e.g. economic growth). If they see a threat to their inflation target, make their monetary policy more restrictive, i. that is, they take measures to restrict the circulation of money.

For small countries with a large external sector in particular, it can make sense to subordinate monetary policy to an exchange rate target. This subordination to a currency board is complete , in which the central bank is only allowed to put as much money into circulation as it has foreign currency reserves.

The European Central Bank pursues a mixed strategy ( two-pillar strategy ). On the one hand, it pursues an inflation target, but on the other hand it also pays attention to the money supply, which indicates its long-term inflation risk.

Expansive monetary policy

Expansive monetary policy is a monetary policy measure of the expansion of the money supply or the money supply of a central bank . This is an attempt to achieve economic policy goals. A tightening of the money supply is known as a restrictive monetary policy .

The central bank has a number of monetary policy instruments at its disposal to achieve its monetary policy objectives. It conducts open market operations , offers standing facilities and requires credit institutions to deposit minimum reserves with it. Expansionary monetary policy is also reflected in the fact that the central bank buys certain securities and bills of exchange from commercial banks, for example . As part of the open market policy , the central bank is also able to acquire securities on the securities market. An expansionary monetary policy pursues the lowering of the reserve ratios by the central bank and thus enables the creation of excess reserves.

Effects

“Monetary policy is an effective instrument for short-term stabilization of business cycles.” Compared to restrictive monetary policy, expansionary monetary policy is used in recessions in order to stimulate the economy. In the short term it has a real and rapid effect on production or the interest rate , but in the medium term it is ineffective and in the end all that remains is a price increase.

Effects in the short term

Expansive monetary policy in the AS-AD model and IS-LM model

In the short term , an expansionary monetary policy causes the interest rate to fall and production and price levels to rise. The production situation of an economy improves in the short term.

With the help of the IS-LM model and AS-AD model , the expansive monetary policy shows how it affects the economic situation. It is first assumed that all markets are in equilibrium. This is point A of the intersection of the IS and LM curves in the figure: Expansive monetary policy in the AS-AD model and IS-LM model before the change in the nominal money supply . I.e. production is at its natural level Y _n and the interest rate is equal to i . This also corresponds to the equilibrium point A in the AS-AD model. An expansion of the nominal money supply causes the LM curve to shift to the right. In the AS-AD model, the aggregated demand also shifts to the right, from AD to AD '. Note the AD curve from the equation: The increase in the nominal money supply M causes the real money supply M / P to increase. This results in a new equilibrium at point A 'in both models. The end effect would be the interest rate cut on the money market and thereby corresponding stimulation of investment and production on the goods market. ${\ displaystyle Y = Y (M / P, G, T)}$

Effects in the medium term

At the new equilibrium A ', production is now above its natural level. As long as production is above its natural level, the price level rises over time. This is due to the fact that the additional production causes the unemployment rate to fall and thus wages and prices rise. As a result, however, the real money supply M / P continues to decline. The LM curve shifts further back up along the IS curve until it has reached its original position again. The interest rate rises steadily again, investment demand and production decrease accordingly. With the steady expansion of the price expectations, the aggregated supply curve shifts over time upwards along the aggregated demand AD 'until it reaches point A' '. This then means that the natural level of production corresponds to the actually expected price level, with which the adjustment process ends. In the medium term, the aggregated supply curve is given by AS ''. The economy is at point A '': Production is again equal to Y _n , but the price level is higher at point P ''. In the medium term, the increase in the nominal money supply is fully reflected in a proportional increase in the price level; H. the change in the nominal money supply does not affect production or the interest rate in the medium term, only the price level; this is also known as the neutrality of money over the medium term.

Problem cases

However, there are also special cases in which the expansionary monetary policy remains ineffective:

Investment trap

expansionary monetary policy in case of investment trap

The IS curve is vertical, the elasticity of the investments is zero. An expansionary monetary policy shifts the LM curve to the right. The amount of investment does not change even if the interest rate falls. The expansionary monetary policy does not affect investments. This can result from negative future or return expectations of the investment.

Liquidity trap

ineffective expansionary monetary policy in the event of a liquidity trap

An expansionary monetary policy leads to a right shift in the LM curve, but the interest rate level remains as before, since this has already reached a lower point and additional money is only kept in liquidity instead of being invested. The investment is not stimulated. This means that expansionary monetary policy is also ineffective in this case.

Money trap

In this constellation, an expansionary monetary policy can have the opposite effect. If the central bank increases the money supply too much beyond the set target, an increase in interest rates will follow the increase in prices. This leads to an increase in the nominal interest . Now the expansionary monetary policy is even having a restrictive effect. And the central bank can basically no longer send an easing signal.

Quantitative easing

If the central bank's key interest rate has already been lowered to zero percent, the central bank can try to continue to pursue an expansive monetary policy through quantitative easing - such as the Japanese Central Bank from 2001 or the European Central Bank in the euro area from 2015.

Contractive monetary policy

The contractionary monetary policy encompasses all measures that the money supply , ie the amount of in circulation money is reduced. A central bank can use open market operations to reduce the monetary base . This is typically done by selling securities for cash. By collecting this cash, it withdraws money from the economy and thus shortens the monetary basis. Contractive monetary policy can be carried out with the central bank requiring commercial banks to hold higher reserve requirements . Banks hold only a fraction of their assets for instant cash withdrawals. The rest is invested in cashless things, such as loans or mortgages . Contractive monetary policy is an effective instrument, especially in times of economic overheating. It leads to increases in interest rates, a fall in production and investment, and curbs the risk of increased inflation .

Explanation on the AS-AD model

The AS-AD model combines total supply (aggregated supply) and total demand (aggregated demand). It thus brings together the labor, goods and money markets and describes the interactions between production and price levels.

AS curve: ${\ displaystyle \! \ P = P ^ {\ mathrm {e}} (1+ \ mu) F (1-Y / L, z)}$

It describes the overall offer based on the labor market with the following meanings:

P = actual price level
P ^e = expected price level
µ = structural variable of the goods market (degree of completeness of competition on the market: → perfect competition, as a rule ; the larger µ, the higher the degree of monopoly) ${\ displaystyle \ mu = 0}$ ${\ displaystyle 0 <\ mu <1}$
Y = income
L = number of economically active persons
z = structural variable of the labor market (includes all characteristics that make up the structure of a labor market, e.g .: working conditions, protection)

AD curve: ${\ displaystyle \! \ Y = Y (M / P, G, T)}$

It forms the union of the IS and LM curves (see below), where:

Y = production level
M = nominal money supply
P = price level
G = government expenditure
T = taxes

Effects of Contractual Monetary Policy on the AS-AD Model

The processes that trigger a reduction in the amount of money will now be explained:

For a better understanding of the explanations, it should be said that over time, production tends to adapt to the natural production level Y _n ( production capacity with normal employment). At this point the actual price level corresponds to the expected price level.

The reduction in the money supply only affects the demand curve , since the total supply is independent of the monetary base . Assuming production during normal employment, the nominal money reduction also leads to a real money reduction, as the price level remains constant for the time being. The money supply falls, the total demand falls (shift of the AD curve to the left). This reduces production and the price level drops to P ' . As a result of the decline in production, production is now below its normal level. This results in a reduction in employment. Furthermore, the actual price level is now below the expected. These facts lead to changed price expectations. Wages are being revised downwards. Because of this, the overall offer will eventually change. The curve is shifting down as prices fall. Actual and expected prices adjust until the natural level of production is reached again (A '').

So you have to differentiate between short and medium term. In the short term, demand will decline due to the reduction in money. Production and price levels are falling. In the medium term, production will return to its natural level due to the further price adjustment (reaction of the supply). The price level alone is lower.

Explanation on the IS-LM model

The IS-LM model shows the relationship between the goods and money markets. The goods market is described by the IS function and the money or financial market by the LM function. The aim of this model is to explain the interactions between income (or production) and interest.

Impact within a closed economy

In a closed economy there are no economic ties to other countries, that is, there are no cross-border trade relations .

IS curve: ${\ displaystyle \! \ Y = C + I (Y, i) + G}$

It represents the equilibrium in the goods market. The following applies:

Y = production
C = consumption (income - taxes)
I = investments, depending on income and interest rate
G = government expenditure

LM curve: ${\ displaystyle \! \ M / P = YL (i)}$

It describes the balance in the money market, whereby the following applies:

M = nominal money supply
P = price level
Y = income
L (i) = liquidity demand, depending on the interest rate

Effects of Contractual Monetary Policy on the IS-LM Model

The processes involved in reducing the amount of money will now be explained using the model:

Since the money supply has no influence on the IS curve , monetary policy measures only affect the LM curve in the form of a shift. The reduction in the nominal money supply also leads to a reduction in the real money supply due to the fact that the price level remains constant. The money supply is therefore falling, which, if demand remains the same, leads to an increase in interest rates. For any income, the interest that leads to a money market equilibrium is now higher. The LM curve thus shifts upwards. A new equilibrium A 'occurs, in which less income is now available, which leads to a reduction in consumption. This consequence and the increase in interest rates just explained result in a decline in investment and production.

This model is based on a constant price level, which means that the nominal money supply reduction is equal to the real money supply reduction. If you take into account the versions of the AS-AD model, you can see that the price level will adjust in the medium term. The decrease in the nominal money supply consequently leads to a decrease in the price level after a while. Thus the real money supply rises again. The effects of the monetary reduction will be partially reversed. The LM 'curve shifts again in the direction of the LM curve (this effect is not shown in the figure for reasons of clarity). The initial impact on the interest rate subsides.

Effects within an open economy

An open economy is characterized by lively trade relations with foreign countries in the form of exports and imports

IS curve: ${\ displaystyle \! \ Y = C + I (Y, i) + G + NX (Y, Y ^ {*}, E)}$

It represents the goods market equilibrium . The following applies:

Y = production
C = consumption (income - taxes)
I = investments, depending on income and interest rate
G = government expenditure
NX = net exports (value of exports - value of imports), depending on domestic and foreign production and the exchange rate

LM curve: ${\ displaystyle \! \ M / P = YL (i)}$

It describes the balance in the money market, whereby the following applies:

M = nominal money supply
P = price level
Y = income
L (i) = liquidity demand, depending on the interest rate

The effect of contractive monetary policy can be described as follows:

In principle, the processes are similar to those in a closed economy. The decrease in the money supply (domestically) only affects the LM curve, which leads to a decrease in the money supply and an increase in interest rates. This increase in interest rates results directly in a decrease in production. In contrast to the closed economy, the exchange rate also plays a decisive role. An increase in the domestic interest rate also causes an increase in the exchange rate in accordance with the interest parity relationship . Since a rise in interest rates increases the attractiveness of the securities, many (foreign) investors want to invest in them, which means that they have to exchange their foreign currency for domestic currency. The domestic currency thus experiences an appreciation , which results in the relative price increase of domestic versus foreign goods. The demand for domestic goods is falling, production is falling. As a result, the rise in interest rates has a negative impact on production both directly and indirectly (via the exchange rate). This decrease causes the demand for money to decrease, which leads to a decrease in interest rates and thus partially cancels out the effects just described. The LM curve again tends towards its starting position LM (see illustration of the IS-LM model in a closed economy).

Overview of the effect of the instruments

An increase (/ decrease) in the minimum reserve rate typically triggers the following reactions:

The commercial banks can generate fewer (more) deposits (credit when lending), lend lower (larger) credit volumes to private individuals, companies, and public budgets - money creation decreases (increases).
The circulation of money decreases (increases) as a result.
A lower (higher) circulation of money dampens (increases) inflation (with the same quantity of goods), since demand decreases (increases).
Since less (more) credit money can be drawn, the interest rate rises (falls) (theoretically, without taking the key rate into account); Interest is the price for money, so it is an indicator of scarcity.
Higher (lower) interest rates dampen economic growth (stimulate the economy).
With higher (lower) interest rates, more (less) savings and less (more) consumption and investments.
Higher (lower) interest rates lead to capital imports (exports) and thus to an appreciation (depreciation) of one's own currency.
Revaluations (devaluations) also dampen (increase) inflation and economic growth.

An increase (/ decrease) in the refinancing rate results in the following:

It is becoming more expensive (cheaper) for the banks to obtain central bank money from the central bank
They pass on the increased (decreased) interest rates to their customers.
Less (more) loans are given.
The volume of money as well as its circulation decrease (increase) as a result.
A lower (higher) currency in circulation dampens (increases) inflation (with the same quantity of goods and constant employment).
Higher (lower) interest rates lead to capital imports (exports) and thus to an appreciation (depreciation) of one's own currency.
Revaluations (devaluations) also dampen (increase) inflation and economic growth.

An increase (/ decrease) in interest rates on securities does the following:

It becomes more lucrative (less lucrative) for banks to “buy” securities (assets) ( creating money when purchasing assets ).

Therefore they buy more (less) securities and give less (more) loans. NOTE Buying a government bond is already CREDIT !!!

The acquisition (sale) of assets increases (decreases) the equity ratio of credit institutions.

Higher (lower) interest rates on securities are typically based on higher (lower) risks, for which higher-weighted (lower- weighted ) equity is required (accepted) ( Basel II , Basel III ) and thus increase the higher (lower) attractiveness of higher (lower) interest rates . on.

literature

Ralph Anderegg: Fundamentals of monetary theory and monetary policy. Oldenbourg Wissenschaftsverlag, 2007. ISBN 978-3-486-58148-5
Peter Bofinger, Julian Reischle, Andrea Schächter: Monetary Policy: Aims, Institutions, Strategies and Instruments. Vahlen, Munich 1996, ISBN 3-8006-2017-0
Walter Heering: European Monetary Policy. Fischer Taschenbuch Verlag. ISBN 3-596-15366-2
Egon Görgens, Karlheinz Ruckriegel, Franz Seitz: European monetary policy. Publishing house Lucius & Lucius. ISBN 3-8252-8285-6
Otmar Issing: Introduction to Monetary Theory. 8th edition. Verlag Vahlen, Munich 1991, ISBN 3-8006-1556-8

Individual evidence

↑ Dietmar Neuerer: Financial politicians attack the Bundesbank's monetary policy. Handelsblatt , February 26, 2010.

↑ See: Gustav Dieckheuer: Macroeconomics. 2nd, improved edition, Springer textbook, Berlin / Heidelberg 1995, pages 115-120

^ Peter Schmid, Julian Reischle: Money & Monetary Policy. ( Memento of the original from February 25, 2012 in the Internet Archive ) Info: The archive link was inserted automatically and has not yet been checked. Please check the original and archive link according to the instructions and then remove this notice. Th. Mann GmbH & Co. KG, Nordring (2002 /) 2003, page 58. @1@ 2

↑ Blanchard, Illing: Macroeconomics. 3rd, updated edition, Person Studium, Munich 2003, page 217.

↑ ^a ^b Blanchard, Illing: Macroeconomics. 3rd, updated edition, Person Studium, Munich 2003, pages 217–220.

↑ ^a ^b ^c Manfred O. E. Hennies: Considerations on the efficiency of monetary policy measures of the euro system in depressive economic phases . (PDF; 43 kB) Kiel University of Applied Sciences 2005

^ Schmid et al .: Economic Policy for Political Scientists . Schöningh UTB, Paderborn 2006, ISBN 3-8252-2804-5 , p. 44 f .