Monetary Policy:

What it is, how it works

and why it matters
Christiane Baumeister
Bank of Canada
Honors Program, Ghent University
March 18, 2015
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Bitcoin: The money of the future?

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 What is Bitcoin?
• Bitcoin is a digital currency for which no government,
bank or central bank, or corporation takes responsibility.

• Bitcoin is issued by a software without interference by

the government. It is essentially “nationless”.

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 What makes money special?
• Money is anything that serves as:

Unit of account – to provide a common measurement
of the relative value of goods and
services

Means of payment – to be widely accepted in
exchange for goods and services
(liquidity service of money)

Store of value – to hold value over long periods of
time

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 Why do we need a central bank?
• Combining the last two functions is challenging:

If issuance of money is too tight, there is not enough money
moving around to meet the payment needs of the economy.
This can lead to recession and deflation.

If too much money is issued, the result will be inflation,
which erodes the value of money.
• The quantity of money that society needs changes
constantly because of fluctuations in economic and
financial activity.
Central bank controls the supply of money.

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 The origins of money and central banks
• Prior to the 17th century, most money was commodity
money (gold and silver) BUT paper claims (promises to
pay) were issued to facilitate transactions.
Problem: bank runs and liquidity crises
• Precursor of modern central bank: Bank of England

Founded in 1694 as a private institution

Acted as “bank of banks”:
→ Banks had to keep deposit at BoE.
→ BoE would bail out banks in trouble thereby contributing
significantly to the stability of the financial system.

1844: gained monopoly to issue new banknotes

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What are the main goals of monetary policy?
• Macroeconomic stability

The primary objective of all central banks is to strive
for low and stable inflation.

Most central banks also try to promote stable growth
in output and to foster full employment.

• Financial stability

Central banks try to ensure that the financial system
functions properly.

Importantly, they try to prevent or mitigate financial
crises.

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How does a central bank try to achieve those
goals?
• Monetary policy

Central banks decide about the amount of money in
circulation in the economy.

This is tantamount to setting the level of the short-
term interest rate to influence spending, production,
employment and inflation.
• Provision of liquidity

Central banks provide short-term loans to financial
institutions or markets to calm financial panics,
serving as the “lender of last resort”.
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 The conduct of monetary policy
Central bank’s balance sheet
ASSETS LIABILITIES
Government securities Currency in circulation
Discount loans Reserves
Monetary Base
• Currency in circulation: amount of currency in the hand of the
public
• Reserves: deposits that commercial banks hold at the central
bank
• Government securities: central bank’s holdings of securities
issued by the Treasury
• Discount loans: loans that the central bank makes to banks
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 The conduct of monetary policy
• The central bank controls the monetary base through:

Purchases or sales of government securities in the
open market (open market operations)

Extensions of discount loans to banks

Example: Open market purchase of $100 of bonds from a bank

paid for with a $100 check (which it can deposit at the
central bank or cash in)

Banking System Central Bank

Assets Liabilities Assets Liabilities
Bonds ̶ $100 Securities +$100 Reserves +$100
Reserves +$100

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 What about the interest rate?
• Policy instrument: central bank announces a target for
the overnight interest rate
• However, the interest rate is determined by demand and
supply in the market for reserves (interbank money market).
By adjusting the supply of reserves via open market
operations, the central bank acts to obtain the target:

A purchase of securities leads to an increase in money supply
which decreases the interest rate (monetary easing).

A sale of securities leads to a decrease in money supply and
hence, to a rise in the interest rate (monetary tightening).
To know which action is called for, the central bank
has to carefully monitor the market for reserves.
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 What about the interest rate?
• The central bank also determines the interest rate on the
discount loans that it provides to commercial banks.
• This discount rate is usually higher than the overnight
interest rate.
So, what’s the point?

Source of liquidity for sound banks but especially
for banks in financial trouble

Important to prevent financial panics: effective tool to
provide reserves to the banking system during a crisis
to avert “fire sales” of assets and restore confidence
Useful instrument to perform role of lender of last resort
Issue: moral hazard problem (“too-big-to-fail”)
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 Objectives of monetary policy
• Primary (long-run) goal: low and stable inflation
• Related (often subordinate) goals:

Promote high employment consistent with a stable price
level

Steady economic growth

Interest-rate stability

Stability of financial markets
⋮
2 reasons for focusing mainly on inflation:
a. High inflation is damaging to the economy and costly for
firms and households.
b. Monetary policy cannot have a sustained effect on other
macroeconomic variables.
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 Why does inflation matter?
• Market prices are a signal of the relative scarcity of
individual products: if the price of a product rises, this
means that this product is in scarce supply or high
demand.
Producers have an incentive to increase supply.
Consumers have an incentive to economize on the use.
• In the presence of inflation, the information conveyed
by prices is harder to interpret: Is a single good getting
scarcer or are all prices rising?
• Effects: a. High inflation creates uncertainty.
b. Inflation hampers economic growth.
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 How to set the target interest rate?
• Central bank responds to changes in current and future
economic conditions.
• Taylor rule:
Interest rate target = inflation rate + equilibrium real
interest rate + 0.5(inflation gap) + 0.5(output gap)

Equilibrium real interest rate is the rate that is

consistent with full employment in the long run: ~ 2%

Inflation gap: deviation of current inflation from a
central bank’s inflation target

Output gap: gap between actual output and potential
output (acts as indicator of future inflation)
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 What happens in practice?
3 pillars of the policy decision-making process:
• Current analysis: To study economic developments at
home and abroad, central banks collect and analyze
data on hundreds of variables and conduct surveys.
• Economic projections: To act in a forward-looking
manner, central banks need to forecast the future path
of key macroeconomic variables.
• Research: To interpret data and to generate accurate
forecasts, theoretical and empirical research on
economic relationships is important.

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 Monetary policy: how does it affect us?
• Examine how monetary policy actions affect the
economy as a whole.
Monetary transmission mechanism
• Effectiveness of policy actions is enhanced by:

Good communication with the public

Credibility of the central bank

Independence from the government

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The Transmission of Monetary Policy
Transmission channels
Commercial
Investment
interest rates
Net exports

Asset prices
Policy Demand for
Interest goods and
Rate Credit services
Consumption
Expectations
Housing Durables
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 Traditional interest rate channel

M ݅௡ ݅௥ I Y

• A monetary expansion leads to a decrease in the interest

rate (both nominal and real).
• Lending money becomes cheaper and hence firms will
make more investments and consumers will buy more
houses and durables (e.g. cars).
• Demand will rise and hence, real output (Y) will rise.

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 Other asset price channels
• In addition to bond prices, two other asset prices play a role
as channels for monetary policy:
1) Exchange rates
M ݅௡ ݅௥ EX NX Y

The increase in money supply leads to a fall in interest
rates.

The dollar depreciates since domestic deposits become
less attractive.

Domestic goods become cheaper which leads to a rise in
net exports (NX) and hence aggregate output (Y)

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2) Stock prices
M ܲௌ ‫ݍ‬ I Y

The increase in money supply makes people buy stocks
in the stock market.

The higher demand for stocks leads to higher stock
prices.

For a firm a higher price for the equity (stock) it has
issued implies a higher value of the firm (denoted by ‫)ݍ‬.

This stimulates new investment and leads to higher
output.

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 Credit channels
• Two transmission channels arise from asymmetric
information in financial markets:
1) Bank lending channel
M bank deposits bank loans I Y

Banks play a special role in the financial system.

Many borrowers are dependent on bank loans to
finance investments so that an expansionary monetary
policy that increases bank deposits and bank loans will
lead to a rise in spending.

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2) Balance sheet channel
M ܲௌ adverse selection & moral hazard
lending I Y

Adverse selection: bank and firm have different information
about the quality of the firm which might lead to losses

Moral hazard: people are more willing to take on risks if
it is not their own money that is at stake

Expansionary monetary policy leads to an increase in
stock prices which implies that the worth of firms rises.

When firms are worth more, then the problems of
adverse selection and moral hazard decrease and firms
can obtain more lending.

This leads to more investment and output.
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 From normal to turbulent times
Financial crisis:
• Severe disruptions in financial markets

Policy response:
• Liquidity measures to avoid financial meltdown:

Maturity of discount loans was extended and discount rate
reduced.

Special liquidity and credit facilities were instituted to
stabilize key financial institutions and markets.

Traditional lender of last resort in action

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 From normal to turbulent times
Financial crisis:
• Spending and output contracted sharply in response to
reduced credit flows, skyrocketing borrowing costs and
plummeting asset values
Deep decline in economic activity
Chairman Bernanke (2009):
“Extraordinary times call for extraordinary measures”
• Short-term policy rates reduced to zero lower bound
• Large-scale asset purchases (“quantitative easing”): size
and composition of central bank’s balance sheet
• Forward policy guidance
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 The Fed’s balance sheet: ASSETS
Billions of dollars

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 The Fed’s balance sheet: LIABILITIES
Billions of dollars

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 What are the transmission channels of
unconventional monetary policies?
• Still revolve around interest rates:
1) LSAPs: decrease long-term interest rates directly by
purchasing longer-term securities
Channels:

Signaling channel: signal intention to add monetary
stimulus
ߨ௘ ݅௥ I Y

Portfolio channel: Reduced availability of
securities lead investors to purchase other assets
ܲ௔௦௦௘௧௦ ‫ݍ‬ I Y
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2) Forward guidance: “managing expectations” about
future path of short-term rates

Conditional commitment:
Fed declared to maintain the federal funds rate at its
prevailing level conditional on explicit quantitative
thresholds for unemployment rate (>6.5%) and inflation
projections (<2.5%).

Issues:

Credibility: incentive to renege on commitment

Communication: misunderstandings if too complex

Loss of policy flexibility

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