Monetary policy

Monetary policy refers to the actions taken by a nation's monetary authority to influence financial conditions. These actions aim to achieve broad economic goals. Common objectives include maintaining high employment levels and ensuring price stability. Price stability is usually understood as keeping the rate of inflation low and predictable. Some policies also aim to foster economic stability or maintain steady exchange rates against other currencies.

Central banks use various instruments to manage the economy. The most common tool is interest-rate targeting. A central bank can change rates directly through administrative decisions. They can also act indirectly through open market operations. Open market operations involve buying or selling assets to influence the money supply.

Other tools include setting reserve requirements for banks. Some authorities also use forward guidance, which is a communication strategy to signal future policy. These tools work through the monetary transmission mechanism to affect spending and employment.

Monetary policy is often categorized as either expansionary or contractionary. An expansionary policy involves lowering interest rates to stimulate economic activity. This approach aims to encourage spending on goods and services, which can increase employment. Conversely, a contractionary policy seeks to dampen economic activity. This is often done to decrease inflation when prices are rising too quickly. These policies affect the economy through various financial channels, such as exchange rates and the prices of financial assets.

Historically, monetary policy has evolved alongside the development of money itself. In the West, coins may have originated in ancient Lydia during the 8th century BCE. Some historians suggest origins in ancient China. Early forms of policy included debasement. This was the practice of melting coins and mixing them with cheaper metals. This was common in the late Roman Empire and western Europe during the late Middle Ages.

Paper money emerged from promissory notes called jiaozi in 7th-century China. These notes were used alongside copper coins. The Yuan dynasty later became the first government to use paper currency as the main circulating medium. However, the dynasty printed money without restrictions to fund wars. This led to hyperinflation. Later, the Bank of England was created in 1694. It was granted the power to print notes backed by gold. This helped establish monetary policy as something separate from direct executive action.

Between 1870 and 1920, industrialized nations established formal central banking systems. The Federal Reserve was created in the United States in 1913. During this era, many nations followed the gold standard. Under this system, a national currency's price was fixed relative to gold. Central banks adjusted interest rates almost monthly to maintain this link. While the gold standard provided a framework for trade, it could harm employment. Many believe these rigid policies exacerbated the Great Depression in the 1930s.

In 1944, the Bretton Woods system introduced a different fixed exchange rate system. This linked most industrialized currencies to the US dollar. The dollar was the only currency directly convertible to gold. This system provided stability for decades until it broke down in the 1970s. In 1971, the US suspended the dollar's convertibility into gold. By 1973, major currencies began to float against one another. This led to new regional attempts at stability, such as the European Monetary System.

Modern policy often relies on inflation targeting. New Zealand was the first country to adopt this official strategy in 1990. Instead of targeting the money supply, central banks adjust interest rates to hit a specific inflation goal. As of 2024, 45 countries and the Eurozone use inflation targeting. The average inflation target is 3.5 percent, though individual targets range from 2 to 35 percent.

Central banks have maintained inflation within their target ranges about 44 percent of the time in any given year. This strategy differs from fiscal policy, which uses taxation and government spending to manage the economy.