Expansionary or contractionary monetary policy action
Monetary policy action is said to be contractionary when the monetary policy rate is above the neutral interest rate and is said to be expansionary when it is below the neutral interest rate. Neutral interest rate is the rate of growth of money supply that neither increases nor decreases the economic growth.
As already learnt in the previous post, monetary policy action is contractionary when the money supply in the economy is decreased and it is expansionary when the money supply is increased. The ultimate aim of a monetary policy action is to control inflation and thereby maintain price stability and achieve positive economic growth.
Therefore monetary policy action is often adjusted to reflect the source of inflation. If inflation is high due to increased demand, following a contractionary policy is appropriate. However if inflation is high due to reduction is supply, a contractionary policy action will make the situation worse. Similarly, when inflation is below target due to lack of demand, expansionary policy is needed to spur economic growth.
Inflation, interest rates and exchange rate targeting by central banks
Inflation targeting is currently the most widely used monetary policy tool by central banks. Inflation target is generally set at 2%, with a ±1% band around it. 0% inflation is not generally targeted as the ±1% band would allow the inflation to be negative i.e. deflation which is not desirable for the well being of any economy.
Interest rate targeting
In order to maintain interest rates at desired levels, the supply of money in the economy is increased thus putting downward pressure on interest rates, when the rise above the target levels. Similarly when interest rates fall below the desired levels, the supply of money is decreased pushing interest rates back upwards.
Exchange rate targeting
Inflation is sometimes controlled indirectly through targeting the exchange rate between the domestic currency and a foreign currency most often the U.S Dollar. If the domestic currency falls against the U.S Dollar and below the targeted exchange rate, the central bank will move to purchase the domestic currency by selling its forex reserves. This will reduce the supply of the domestic currency and push up interest rates. Conversely, if the domestic currency appreciates beyond the targeted exchange rate, the central bank will move to sell the domestic currency in the foreign exchange market, thus increasing the supply of the domestic currency and decreasing interest rates.
Read all about currency exchange rates below;
Limitations of monetary policy action
Monetary policy action does not always produce desired results.
For example, decreasing money supply may hike the short term rates however they may not increase the long term interest rates. This is because if people believe that the monetary policy action will be successful in reducing the inflation their expectation of future inflation will be low. This will cause the long term interest rates to fall rather than increase. Conversely, increase in money supply will cause short term rates to fall, however it will also increase the expectation of higher inflation in future, which will cause the long term rates to increase rather than decrease.
Again in case an economy is experiencing deflation, the increase in money supply to spur economic growth will not cause the interest rates to come down. This is because in a deflationary situation people tend to horde money rather than invest it or give it to banks. Therefore, since people are not investing even at higher interest rates, banks are not in a position to transmit the monetary policy by reducing the rates.
In another example, as was seen after the 2008 financial collapse, the central bank in the United States and the ECB infused money in the system by carrying out quantitative easing. They purchased government securities and mortgage securities in large quantities from banks. However though the banks now had sufficient reserves they were unwilling to lend due to uncertain future prospects of the economy. Therefore after an economic collapse expansionary monetary policy action may not always stimulate the economy.
That’s all on monetary policy folks…. Thanks for reading….I hope it was useful to you…. If you liked what you read do share it or pin it 🙂 ….also feel free to share your views on the post with me….if u think something more needs to be included let me know via comments…
p.s. if you want the post in your inbox use the SUBSCRIBE buttons on the page…bye for now…
For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
This post contains affiliate links. Please see the disclosure policy for more information.