🪅Global Monetary Economics Unit 3 – Central Banking and Monetary Policy

Key Concepts and Definitions

• Central bank an institution responsible for overseeing the monetary system and policy of a country or region (Federal Reserve, European Central Bank)
• Monetary policy actions taken by a central bank to influence the money supply and interest rates to achieve macroeconomic objectives (price stability, economic growth)
  • Expansionary monetary policy increases money supply and lowers interest rates to stimulate economic activity
  • Contractionary monetary policy decreases money supply and raises interest rates to combat inflation
• Inflation rate at which the general price level of goods and services is rising, reducing the purchasing power of money
• Deflation sustained decrease in the general price level of goods and services
• Money supply total amount of money in circulation within an economy (currency, demand deposits, other liquid assets)
• Interest rates cost of borrowing money or the return on lending money, expressed as a percentage
• Reserve requirements minimum amount of customer deposits that commercial banks must hold in reserve, set by the central bank

Historical Context of Central Banking

• Origins of central banking trace back to 17th century Europe with the establishment of the Swedish Riksbank (1668) and the Bank of England (1694)
• Early central banks primarily focused on financing government expenditures and managing public debt
• Gold standard a monetary system in which a currency's value is directly linked to gold, prevalent in the late 19th and early 20th centuries
• Bretton Woods system post-World War II international monetary system that established fixed exchange rates and the U.S. dollar as the global reserve currency (1944-1971)
• Collapse of Bretton Woods in 1971 led to the adoption of floating exchange rates and increased autonomy for central banks
• Global financial crises such as the Great Depression (1929-1939) and the Global Financial Crisis (2007-2009) have shaped the evolution of central banking and monetary policy
• Rise of independent central banks in the late 20th century aimed to insulate monetary policy from political pressures and enhance credibility

Structure and Functions of Central Banks

• Governance structure varies across countries but typically involves a board of governors or monetary policy committee responsible for decision-making
• Independence from government important for maintaining credibility and avoiding political interference in monetary policy
• Primary functions include:
  • Conducting monetary policy to achieve price stability and support economic growth
  • Serving as the lender of last resort to provide liquidity to the financial system during crises
  • Regulating and supervising commercial banks to ensure financial stability
  • Managing the country's foreign exchange reserves and exchange rate policy
• Research and data analysis central banks employ economists and analysts to monitor economic conditions and inform policy decisions
• Communication and transparency central banks use various channels (press conferences, reports, speeches) to convey their policy stance and manage expectations
• Accountability central banks are often required to report to the government or parliament and justify their actions

Monetary Policy Tools and Strategies

• Open market operations central bank buys or sells government securities to influence the money supply and short-term interest rates
  • Buying securities injects money into the economy and lowers interest rates
  • Selling securities absorbs money from the economy and raises interest rates
• Reserve requirements central bank sets the minimum amount of customer deposits that commercial banks must hold in reserve, influencing their lending capacity
• Discount rate interest rate at which commercial banks can borrow from the central bank, serving as a benchmark for other interest rates
• Forward guidance central bank communicates its future policy intentions to shape market expectations and enhance the effectiveness of monetary policy
• Quantitative easing unconventional monetary policy tool used when interest rates are near zero, involves large-scale asset purchases to lower long-term interest rates and stimulate the economy
• Inflation targeting a monetary policy strategy in which the central bank sets an explicit target for the inflation rate and adjusts policy to achieve that target over the medium term
• Price level targeting an alternative strategy that aims to keep the price level (rather than the inflation rate) stable over time
• Nominal GDP targeting a strategy that focuses on achieving a target level or growth rate of nominal GDP (real GDP growth plus inflation)

Transmission Mechanisms of Monetary Policy

• Interest rate channel changes in policy rates affect borrowing costs and saving incentives, influencing consumption and investment decisions
• Credit channel changes in interest rates and bank lending standards affect the availability and cost of credit, impacting spending and investment
• Exchange rate channel changes in interest rates affect the value of the domestic currency relative to foreign currencies, influencing net exports and domestic prices
• Asset price channel changes in interest rates affect the prices of financial assets (stocks, bonds) and real estate, influencing wealth and spending
• Expectations channel central bank's communication and credibility shape expectations about future inflation and economic conditions, influencing current spending and investment decisions
• Time lags monetary policy actions take time to work through the transmission channels and affect the real economy, typically several quarters or longer
• Asymmetric effects monetary policy may have different impacts during expansions and recessions or on different sectors of the economy

Challenges and Limitations of Monetary Policy

• Zero lower bound when nominal interest rates are near zero, conventional monetary policy tools become less effective, requiring unconventional measures (quantitative easing, negative interest rates)
• Liquidity trap a situation in which monetary policy is ineffective because interest rates are low and savings rates are high, making monetary expansion ineffective in stimulating the economy
• Structural changes long-term shifts in the economy (demographics, technology, globalization) can alter the effectiveness of monetary policy and require adaptations
• Financial stability concerns monetary policy actions aimed at stimulating the economy may contribute to asset price bubbles or excessive risk-taking, potentially undermining financial stability
• Fiscal dominance a situation in which fiscal policy constrains the ability of monetary policy to achieve its objectives, often due to high government debt levels
• Uncertainty about key economic relationships (natural rate of interest, potential output, inflation dynamics) complicates the conduct of monetary policy
• Political pressures central banks may face political pressure to pursue short-term objectives at the expense of long-term stability, underscoring the importance of independence

Global Implications and International Coordination

• Spillover effects monetary policy actions in major economies (U.S., Eurozone, Japan) can have significant spillover effects on other countries through financial markets, trade, and capital flows
• Policy divergence differences in economic conditions and policy stances across countries can lead to tensions and challenges for international coordination
• Currency wars competitive devaluations or accusations of manipulating exchange rates for trade advantages can strain international relations
• Global financial cycles cross-border transmission of financial conditions (credit growth, asset prices) can influence domestic economic conditions and complicate monetary policy
• International policy coordination efforts to align monetary policies and address common challenges through forums like the G7, G20, and Bank for International Settlements (BIS)
• Role of international financial institutions (International Monetary Fund, World Bank) in promoting global monetary stability and providing support to countries in crisis
• Importance of effective communication and transparency to manage expectations and reduce uncertainty in an interconnected global economy

Current Debates and Future Trends

• Reviewing monetary policy frameworks central banks are reassessing their strategies and tools in light of changing economic conditions and lessons from past crises
• Adopting alternative policy targets some central banks are considering moving away from inflation targeting and towards price level targeting or nominal GDP targeting
• Incorporating financial stability considerations into monetary policy frameworks to better address the linkages between monetary policy and financial stability
• Adapting to digital currencies and fintech innovations central banks are exploring the potential issuance of digital currencies (CBDCs) and the implications of fintech for monetary policy transmission
• Addressing climate change risks central banks are increasingly recognizing the potential impact of climate change on financial stability and the role of monetary policy in supporting a transition to a low-carbon economy
• Enhancing central bank communication and transparency to build public trust and manage expectations in an era of heightened uncertainty and scrutiny
• Fostering international cooperation and policy coordination to address global challenges and spillovers in an interconnected world economy
• Preparing for future crises and building resilience by strengthening policy frameworks, financial regulation, and crisis management tools based on lessons from past experiences