In practice, all types of monetary policy involve modifying the amount of base currency (M0) in circulation. This process of changing the liquidity of base currency through the open sales and purchases of (government-issued) debt and credit instruments is called open market operations.
Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.
The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.
Monetary Policy:
Target Market Variable:
Long Term Objective:
Inflation Targeting
Interest rate on overnight debt
A given rate of change in the CPI
Price Level Targeting
Interest rate on overnight debt
A specific CPI number
Monetary Aggregates
The growth in money supply
A given rate of change in the CPI
Fixed Exchange Rate
The spot price of the currency
The spot price of the currency
Gold Standard
The spot price of gold
Low inflation as measured by the gold price
Mixed Policy
Usually interest rates
Usually unemployment + CPI change
The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonized consumer price index).
[edit] Inflation targeting
Main article: Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.
The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.
Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.[12]
The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Canada, Chile, the Eurozone, New Zealand, Norway, Iceland, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.
[edit] Price level targeting
Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.
Something similar to price level targeting was tried by Sweden in the 1930s, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operates monetary policy based on a price level target.
[edit] Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.
This approach is also sometimes called monetarism.
While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.
[edit] Fixed exchange rate
This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)
Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.
Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).
These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.
See also: List of fixed currencies
[edit] Gold standard
Main article: Gold standard
The gold standard is a system in which the price of the national currency as measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationals. (i.e. open market operations, cf. above). The selling of gold is very important for economic growth and stability.
The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".
Today this type of monetary policy is not used anywhere in the world,[citation needed] apart from Switzerland[citation needed] (one of the world's most stable economies),[citation needed] although a form of gold standard was used widely across the world prior to 1971. For details see the Bretton Woods system. Its major advantages were simplicity and transparency.
[edit] Policy of various nations
Australia - Inflation targeting
Brazil - Inflation targeting
Canada - Inflation targeting
Chile - Inflation targeting
China - Monetary Targeting and targets a currency basket
Eurozone - Inflation Targeting
Hong Kong - Currency board (fixed to US dollar)
India - Inflation Targeting
New Zealand - Inflation targeting
Singapore - Exchange rate targeting
South Africa - Inflation targeting
Turkey - Inflation targeting
United Kingdom[13] - Inflation Targeting, alongside secondary targets on 'output and employment'.
United States[14] - Mixed policy (and since the 1980s it is well fitted/described by the "Taylor rule" which shows that the Fed funds rate responds to shocks in inflation and output)
Further information: Monetary policy of the USA
Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.
The distinction between the various types of monetary policy lies primarily with the set of instruments and target variables that are used by the monetary authority to achieve their goals.
Monetary Policy:
Target Market Variable:
Long Term Objective:
Inflation Targeting
Interest rate on overnight debt
A given rate of change in the CPI
Price Level Targeting
Interest rate on overnight debt
A specific CPI number
Monetary Aggregates
The growth in money supply
A given rate of change in the CPI
Fixed Exchange Rate
The spot price of the currency
The spot price of the currency
Gold Standard
The spot price of gold
Low inflation as measured by the gold price
Mixed Policy
Usually interest rates
Usually unemployment + CPI change
The different types of policy are also called monetary regimes, in parallel to exchange rate regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a relatively fixed regime towards the currency of other countries on the gold standard and a floating regime towards those that are not. Targeting inflation, the price level or other monetary aggregates implies floating exchange rate unless the management of the relevant foreign currencies is tracking the exact same variables (such as a harmonized consumer price index).
[edit] Inflation targeting
Main article: Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the Central Bank interest rate target. The interest rate used is generally the interbank rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.
The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.
Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the Taylor rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The rule was proposed by John B. Taylor of Stanford University.[12]
The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It is currently used in Australia, Canada, Chile, the Eurozone, New Zealand, Norway, Iceland, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.
[edit] Price level targeting
Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in subsequent years such that over time the price level on aggregate does not move.
Something similar to price level targeting was tried by Sweden in the 1930s, and seems to have contributed to the relatively good performance of the Swedish economy during the Great Depression. As of 2004, no country operates monetary policy based on a price level target.
[edit] Monetary aggregates
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc). In the USA this approach to monetary policy was discontinued with the selection of Alan Greenspan as Fed Chairman.
This approach is also sometimes called monetarism.
While most monetary policy focuses on a price signal of one form or another, this approach is focused on monetary quantities.
[edit] Fixed exchange rate
This policy is based on maintaining a fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)
Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.
Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).
These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, credit channels and other economic factors.
See also: List of fixed currencies
[edit] Gold standard
Main article: Gold standard
The gold standard is a system in which the price of the national currency as measured in units of gold bars and is kept constant by the daily buying and selling of base currency to other countries and nationals. (i.e. open market operations, cf. above). The selling of gold is very important for economic growth and stability.
The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And the gold price might be regarded as a special type of "Commodity Price Index".
Today this type of monetary policy is not used anywhere in the world,[citation needed] apart from Switzerland[citation needed] (one of the world's most stable economies),[citation needed] although a form of gold standard was used widely across the world prior to 1971. For details see the Bretton Woods system. Its major advantages were simplicity and transparency.
[edit] Policy of various nations
Australia - Inflation targeting
Brazil - Inflation targeting
Canada - Inflation targeting
Chile - Inflation targeting
China - Monetary Targeting and targets a currency basket
Eurozone - Inflation Targeting
Hong Kong - Currency board (fixed to US dollar)
India - Inflation Targeting
New Zealand - Inflation targeting
Singapore - Exchange rate targeting
South Africa - Inflation targeting
Turkey - Inflation targeting
United Kingdom[13] - Inflation Targeting, alongside secondary targets on 'output and employment'.
United States[14] - Mixed policy (and since the 1980s it is well fitted/described by the "Taylor rule" which shows that the Fed funds rate responds to shocks in inflation and output)
Further information: Monetary policy of the USA
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