In this article, we will attempt to give the reader the basics of how monetary policy is conducted and explain the variables that influence the monetary policy adopted. This topic is one of the topics that a trader needs to understand thoroughly, since many economic agents pay a lot of attention to the actions taken by the central bank. Recently, understanding monetary policy has become even more important because interest rates have been in the spotlight due to high inflationary expectations. Central banks can be defined as monopolists providing fiat money, which can be defined as money that has no intrinsic value and is the state bank and lender of last resort to banks. In times of difficulty, when banks experience a large outflow of funds due to customer withdrawal. These actions can lead to crises as banks use short-term deposits to finance long-term positions.
A central bank is ideally placed to ensure that institutions do not pose a threat to the economy as a whole. These are just some of the functions of a central bank, but there are many tasks for which they are responsible that will not be covered in this article. Their mandate differs from country to country, but the most common mandate among them is to maintain stability in the financial system. In order to understand how they became monopoly providers of money, we need to know the history of money. It will be interesting to see how innovations in the monetary sector play a role in the future, cryptocurrencies are currently getting a lot of attention, but many countries have not adopted them as an alternative to fiat money, at least not yet. In ancient civilizations, money did not exist, and people exchanged goods that they did not need or that were in abundance for goods that they needed.
Sometimes the quantity of goods exchanged was indivisible, that is, in some cases the products exchanged were not equal in value. When a person wants to save his goods for future use, and the goods are perishable, it makes it impossible for people to store their wealth. Gold and silver began to be recognized as a store of value, and people turned in their physical gold to jewelers and were given receipts as proof of ownership. The accumulation of a large amount of Gold caused the jewelers to start lending some of the Gold and profit from the interest paid by the borrower. Lending was the result of the belief that not all customers would come to collect their gold at the same time, and this was the birth of modern banking. Nowadays, money is a medium of exchange and can eliminate all the problems of the barter economy.
Money allowed people to buy and sell goods that had a money price. It is very beneficial for a country's currency to have physical characteristics, which makes it difficult to counterfeit, which will certainly contribute to the effectiveness of monetary policy. For example, if the committee decides to cut the money supply to bring down inflation and many counterfeits are produced, this could have an adverse effect on the economy because it would be the opposite of the committee's move. Different central banks use different methods to determine the amount of money in circulation in an economy. Since they are faced with the task of maintaining a price level that contributes to the sustainable growth of the economy, they must control the money circulating in the economy, increasing or decreasing it.
When more money is in circulation, it loses value and inflationary pressure increases. This can simply be explained by the quantity theory of exchange, which states that spending in an economy is proportional to the money supply, meaning that one variable directly affects another, provided that other variables, such as output, remain constant. In recent years, some countries have tried to use this theory when inflation is falling or when facing a recession, reducing/increasing the money supply, thereby reducing pressure. For example, in the 1970s, the UK experienced the highest inflation in history. The president did not trust the tools at his disposal at the time and suggested manipulation of the money supply, although it was not effective due to limited control over the foreign sector.
Today, the instruments of the money supply are more perfect and significantly improved, but their principles are not much different from those used in the past. Monetary policy aims to keep inflation under control, which brings us to a discussion of the sources that can cause inflationary shocks. If consumers consume more than usual and there is an excessive increase in investment, this is called a demand shock and is caused by the inability of the firm to meet demand. When supply is limited by higher prices for energy commodities such as oil, this will mean that the cost of production will be more costly and firms will pass their costs on to consumers by raising the price of goods, which will increase inflation. Reducing or expanding the money supply in the economy is one of the committee's most frequently used tools through open market operations.
They do this by buying and selling government debt to commercial banks. When central banks buy securities, commercial banks will have additional capital and will use that money to lend it to businesses and people, which will bring more money into the economy. On the contrary, when they sell bonds to commercial banks, the banks will experience a decline in their capital, which will cause banks to refrain from lending in large amounts. Interest rates are one of the tools that the central bank will use to bring down inflation. When rates rise, it becomes expensive for banks to borrow money in the interbank market, mortgages will have higher interest rates, and the cost of financing for corporations will be higher. The opposite will happen if the interest rate falls. Short-term rates will be used to influence long-term rates. When short-term rates are expected to rise, long-term rates will also rise to make up the difference in returns.
The yield curve shows the ratio of rates with different maturities but with the same default risk. Central banks can either be independent or be controlled by the government, although most of them are accountable to the government and make their own decisions. When this is controlled by the government, there may be times when politicians may try to push for the implementation of policies that serve their needs and not the nation. The absence of government oversight gives the bank the freedom to act without fear of stepping on someone's toes. The bank must have credibility in order for its actions to be effective. If economic agents do not consider the central bank to be trustworthy, they will not consider the materials submitted by the bank. On the contrary, when economic agents find it credible, they will believe the remarks made by the committee.
They should also be transparent, informing the public about their plans and what indicators will be considered as the basis for future policy. Money patterns can be hawk or dove as they are called in their street terms. Policies have limitations, especially in emerging markets. In emerging economies, there are no bond markets to facilitate effective policy implementation. A rapidly changing economy makes it difficult to determine a neutral interest rate. A neutral rate is defined as a rate that is neither expansion nor contraction.