Saturday, 25 August 2012

Your Humble Guide to Public Finance IV. - Advanced monetary policy

In our final post of our series on public finance, we will first discuss the methods and the effects of controlling money supply, and the types and targets of monetary policy.

Money supply control

So what are the goals of monetary policy besides controlling inflation? What can the growth of the money supply influence besides the average price level?
There are four principal aspects monetary policy can influence through it's control of the money supply – growth, inflation, currency strength and unemployment. But in order to assess these questions, we must first mention how does the central bank create money.
They do not print all the money and do not mint all the coins – in fact, most of the money created by the central bank is created indirectly, through commercial banks. Regular banks get their money from the central bank – they borrow from the central bank at the base interest rate, and they repay it later, by giving out the loan to the populace in the form of additional loans, with higher interest rates. This act of the central banks creates money in itself. Hence, one of the most important tools for controlling money supply by the central banks is the rising and lowering of base interest rate.

Raising base interest rates

If the central bank raises the interest rates at which it lends money to the commercial banks, loans will become more expensive, meaning a slower growth of money supply in the economy. This causes several changes in economic performance, like:

Slowing growth – If money(loans) is more expensive, people will use less of it. Fewer loans mean less opportunity for investment and consumption, which in turn will cause a decrease of economic output.
Decreasing inflationRemember the equation? If money supply growth (and somewhat velocity) decreases, that will in turn mean lowered price levels.
Stronger currency – More expensive money means, well, that money is more expensive. That means that in foreign markets, people will have to pay more in order to buy a particular currency, which is however, bad for the exporters, whose products will be less competitive in international markets.
Increasing unemployment – If growth decreases, the demand for labour also decreases. This means that increasing interest rates cause an increase in unemployment as well.

Decreasing base interest rates

When interest rates are lowered, it is the other way round – money is cheaper, meaning a quicker growth of money supply. This causes the following:

Increasing growth – Less expensive money means more room for investment, and hence increased economic output. However, this is only effective in short terms – during longer periods, increased inflation 'eats away' the increase of growth.
Increasing inflation – This time it's the other way round – as mentioned above, increased money supply means increasing levels of inflation.
Weaker currency – If money is cheap, people will pay fewer in foreign currencies in order to buy local currency. This is good news for exporters, though – their products will be more competitive.
Decreasing unemployment – in connection with the short term economic growth, lower interest rates can cause an increase in employment statistics as well.

However, these effects are only the ideal and intended effects – macroeconomists can't agree on the exact strength and viability of these

The categorisation of monetary policy

So having read all this – congratulations! - you must wonder how can all of this be put into effect; what do central bankers do in practice when trying to control their respective countries' monetary policy. The answer is two-fold.
Firstly, monetary policy can be categorised simply according to the velocity of money supply growth – and secondly, according to the economic indicators decision makers try to approximate their numbers to – which is in turn the single most controversial element of monetary decisionmaking.

Velocity of money supply growth

Regarding velocity, there are two types of monetary policy; expansionary and contractionary.

Expansionary monetary policy aims to increase growth of the supply of money quicker than usual – usually during recessions, with the hope that a fastened inflow of money into the economy will urge businesses to once again begin expansion, and hence lower unemployment and raise GDP growth. This method however, also causes higher inflation – the amount and relevance of which during recessions is a matter of fierce debate.

Contractionary monetary policy aims to do the opposite – lowering inflation, and simultaneously helping the government (and private) sector pay back it's debts. However, this also comes at the cost of slower economic growth, increased unemployment – their amount and relevance once again debated.

Monetary policy targeting

The other issue to discuss about practical monetary policy is the role of targeting. Now why do central bankers need targets?
They need them to be able to scientifically assess and measure the success of monetary policy – for example, countries which are inflation-targeting aim to conduct monetary policy with the primary aim of keeping inflation growth at a fix level (in Hungary, this is 3%). Most of the countries are inflation-targeters, but several other ideas exist. These include price level targeting, which means that monetary decision makers set up a plan for a few years in advance regarding future price levels, correcting for imbalances meanwhile – as opposed to inflation-targeters, who only look at present data. There is also the strategy of monetary aggregates, which targets a constant and reliable rate of money supply growth, and NGDP targeting, a new (or renewed) concept of targeting nominal (non-inflation corrected) GDP growth instead of inflation growth, hoping to balance the extremities in economic cycles.

Special cases

Finally, we must mention the historical gold standard, and the various uses of fixed exchange rates as well – but the uses of the latter are so unique and diverse that they deserve later, individual posts.

Congratulations! You have finished reading Your Humble Guide to Public Finance. We hope that now you understand better the concepts of fiscal and monetary policy.


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