We mentioned earlier that monetary policy refers to measures taken by the government or central bank to affect economic activity, especially measures to control the money supply and regulate interest rates. Used to achieve specific or maintain policy goals—for example, to suppress inflation, achieve full employment, or economic growth.
There is no separation between central bank and monetary policy. When we talk about central bank or monetary policy, we will inevitably talk about the other of the two.
Although some missions and objectives are shared by different central banks, due to economic differences, central banks also have unique policy objectives.
The ultimate goal of monetary policy is to maintain price stability and promote economic growth.
To achieve these goals, the central bank will use monetary policy to control the following aspects:
⊙ Interest rate
⊙ Money supply
⊙ Deposit reserve
⊙ Discount window financing
Monetary policy categories
Monetary policy can be divided into different categories. If the central bank reduces the money supply, or adopts interest rate increase measures, it is called a tightening monetary policy.
The purpose of tightening monetary policy is to curb the excessive growth of the economy. Increasing interest rates will lead to higher borrowing costs, which will reduce consumption and investment.
On the other hand, if the money supply is increased or interest rate cuts are taken, it is called expansionary monetary policy.
The purpose of the rate cut is to promote consumption and investment.
The purpose of expansionary monetary policy is to promote economic growth by cutting interest rates or expanding the money supply, while contractionary monetary policy is to suppress inflation or restrain excessive economic growth.
Finally, the purpose of neutral monetary policy is to neither promote economic growth nor suppress inflation.
One thing we need to keep in mind is that the central bank usually sets an inflation target of 2%.
Some central banks may not clearly state their inflation targets, but their monetary policy operations are committed to maintaining inflation within a reasonable range.
They know that moderate inflation is good for the economy, but excessive inflation will affect people’s confidence, affect people’s employment, and ultimately affect their wallets.
By setting inflation targets, market participants can better understand how the central bank will respond to the current economic situation.
Let us illustrate.
Back in January 2010, the annual rate of inflation in the United Kingdom at that time increased by 3.5%, compared with an increase of 2.9% in the previous month. Since the inflation target set by the Bank of England is 2%, the 3.5% inflation rate is far beyond the Bank of England’s target.
In order to appease the uneasy people, Bank of England Governor Jin En immediately stated that temporary factors led to a relatively large increase in inflation levels. The current inflation rate will decline in the short term, and the Bank of England will not take special action.
His statement was later proved to be correct is not the focus of our discussion here. We just need to explain to you that when investors understand the central bank’s policy intentions, they are usually in a better position.
In short, traders like stability.
The central bank also likes stability.
Economies like stability. Understanding the existence of inflation targets will help traders understand why central banks may adopt different monetary policies.