Monetary Policy and the Role of the Central Bank

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Most countries with a mature economic system have some form of a central bank serving as the principle authority for the country’s financial matters. While specific tasks and functions may vary, the primary duties for the majority of central banks can be summarized as follows:[1]

  • Implement a monetary policy that provides stable growth and employment
  • Promote the stability of the country’s financial system
  • Manage the production and distribution of the nation’s currency


For this article, the term “central bank” is used to represent any institution performing these duties. To learn more about specific responsibilities for individual central banks, please refer to the series of articles for the following countries / regions:

Fiscal and Monetary Policy

The terms fiscal policy and monetary policy are often used interchangeably, but these terms have different implications and you should be clear on the distinction. Fiscal policy is the economic direction a government wishes to pursue with respect to taxation, spending and borrowing. Only government bodies have the ability to raise revenues through taxation, but in return, citizens expect government to spend the tax revenue it collects on the provision of services to the citizens it serves.[2]


Monetary policy on the other hand, is the set of actions a government takes – usually through some form of a central bank – that influences the economy. A government has several options at its disposal and most concentrate on establishing short-term interest rates intended to expand or contract the economy, depending on the latest inflation concerns. By influencing the demand for currency through interest rates, the central bank attempts to maintain a favorable environment for economic growth as well as the preservation of value for the currency.[3]

Central Bank Autonomy

For a majority of the world’s economies, the central bank is simply another administrative branch functioning under the government’s direct authority and control. However, many experts argue that it is not an ideal arrangement to have the implementation of monetary policy (i.e. the role of a central bank authority) under the direct control of those responsible for authorizing the nation’s fiscal policy (i.e. the role of the government). The concern of course is that politicians – in a bid to secure re-election or divert negative press coverage – may make decisions that are not in the best long-term interests of the country.


The fact of the matter is that it is sometimes necessary to make unpopular decisions for the overall good of the economy. For this reason, a non-elected body, independently responsible for implementation but fully accountable to an elected assembly, is considered by many economists to be the most effective approach for managing the fiscal policy goals.


In a speech at the Bank of Albania Open Forum, Malcolm Knight, the General Manager of the Bank for International Settlements discussed the importance of autonomy for central banks. In this speech, delivered in December of 2005, he noted “…if central banks are to achieve the objectives that have been set for them, they need to have sufficient autonomy to do so. Without it, there is a risk that short-term political or fiscal considerations will dominate. Therefore, central bank policy decisions need to be shielded from undue political pressure or sectarian interests.”[4]


While most western countries have relatively independent central banks, the process is not completely devoid of politics. In most cases, the government of the day appoints the individuals to serve and there is generally a system of checks and balances to ensure some level of accountability.


In the case of the United States for instance, Governors for the central bank – officially the Federal Reserve Bank, or simply the “Fed” – are appointed to fourteen year terms. In addition, the President appoints a Governor to a four-year term to serve as the Chairman, but this appointment must be confirmed by the Senate.


These appointments often result in various charges of cronyism and political interference; however, once appointed and confirmed, Federal Reserve Governors cannot be removed for their policy views. The length of terms – and the fact that Governors cannot be removed if the Fed’s policy conflicts with the current administration – contribute to the insulation of the Governors from day-to-day political pressures.[5]

How Central Banks Implement Monetary Policy

Short-Term Interest Rates

Central banks typically supply operating capital to the country’s commercial banks to ensure sufficient liquidity to cover expected transactions. The interest rate charged to the commercial banks impacts the longer-term interest rates for corporate and consumer loans.


The central bank uses the relationship between short and long-term rates to manage the economy - if the central bank feels that a boost is needed to stimulate the economy, it can lower short-term interest rates to provide cheaper capital. If a tightening of the economy is needed to slow inflation, an increase in interest rates serves to reduce spending.

Supply and Demand of Currency

Central banks can also adjust the currency supply by buying or selling directly on the global currency market in what is known as open market operations. If the central bank wishes to increase the value of the country’s currency, the bank can buy and hold currency thereby reducing the amount available on the forex market. Once supply drops below the demand, the exchange rate generally increases against other currencies. Conversely, if the central bank wants to lower the exchange rate of the currency, it can sell its reserves into the market thus increasing the available supply.


Common ways for central banks to increase the supply of its currency on the FX markets include:

  • Direct purchase of foreign currency – the central bank buys foreign currency and holds it in reserve to be sold at a time when it wants to decrease the supply of its own currency. Foreign currency is a common security for central banks to hold as it can easily be converted back to native currency.
  • Reverse Operations or “Repos” – Repos are contracts for the temporary lending of money and are traded on the Repo market. Repos are an agreement between the buyer and seller with a fixed maturity (usually one week or one month).
  • Foreign exchange swaps (forex swaps) – a forex swap is a contract to buy or sell a specific amount of currency, at an agreed upon rate and date, and to simultaneously resell or buy the same amount of currency for a later date, also at an agreed upon rate.
  • Cash Reserves

Some central banks require commercial banks to keep cash reserves either on hand or deposited with the central bank. By adjusting these minimum cash reserves that commercial banks are obligated to maintain, central banks can influence the money supply required for day-to-day operations.


References

  1. ↑ The Federal Reserve System; Purpose and Functions - published by the Board of Governors of the Federal Reserve System
  2. ↑ Economic Concepts - Government of Canada website
  3. ↑ Bank of England website
  4. ↑ Malcolm Knight, General Manager, Bank of International Settlements, addressing the Bank of Albania Open Forum, December 1 2005.
  5. ↑ Federal Reserve Bank of New York website
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