Monetary Policy and Macroeconomic Variables

The central banks play the major role in the implementation of the monetary policy in the country, and they have three tools to try to change aggregate demand and thus to influence the level of economic activity. They can buy or sell government bonds through open-market operations; they can change the discount rate, or they can change reserve requirements. They can also use these tools in combination. In the next section of this chapter, where we discuss the notion of a liquidity trap, we will also introduce more extraordinary measures that the central banks have at their disposal.

Monetary policy is an economic policy implemented by the central bank of the country if it is independant. The purpose of monetary policy is to affect aggregate demand in the economy by changing the supply of money or cost of money. Money supply is currency in circulation outsides banks plus the sight deposits of commercial banks against which the private sector can write cheques. In other words, this is the money used as a means of payment. The cost of money is the cost of lending and borrowing both by households and firms which is determined by the interest rates. The central bank’s monopoly of the supply of cash allows it to control interest rates in the economy.

Thus central banks are responsible for implementing monetary policy, i.e. controlling – or attempting to control – firstly, the money supply and consequently inflation or, secondly, the cost of money (interest rates). The change in money supply or in interest rates has an effect on the level of spending in the economy.

In the past, monetary policy was mainly focused on the control of the money supply. But there were difficulties in that because the supply of money is to a large extent determined by demand for money. If people start borrowing more money, the resulting shortage of money in the banks will lead to an increase in interest rates. The banks will have an incentive to create extra credit to meet the demand for money at higher interest rate: money supply will expand. If banks find themselves short of liquidity, they can always borrow from the central bank.

The demand for money is a demand for real money, i.e. nominal money deflated by the price level to undertake a given quantity of transactions. Hence, when the price level doubles, other things equal, the demand for nominal money balances doubles as well, leaving the demand for real money balances unaltered. People want money because of its purchasing power in terms of the goods it will buy.

Today, monetary policy is primarily focused on the control of interest rates. Interest rates connect the present and the future, affecting spending decisions of both households and firms. Changing interest rates can be very effective. Since the early 1990s, most governments have used interest rate changes as the major means of keeping aggregate demand and inflation under control.

In some countries, the central bank is independent from the government. In the others, it is controlled by the government. In a country with an independent central bank, the government cannot manipulate the money supply (e.g. before the elections), but it can, of course, plan its taxation and spending policies with the date of the next election in mind. Many politicians in left-of-centre parties, for example, social democratic parties believe that governments should have the possibility to increase the money supply during recessions, in order to reduce unemployment. This is the idea of Keynesians who argue that the central bank should be controlled by the elected government, rather than by bankers, who are generally unsympathetic to Keynesian ideas and more concerned with preserving price stability than reducing the level of unemployment. However, there is evidence that in the countries with independent central banks both inflation rate and the budget deficit are lower, for example, in the European euro-zone countries that lost the ability to manipulate their money supply or interest rates after the introduction of the euro in 2002.