Monetary Policy and Central Banking

Central banks are crucial in monetary policy, ensuring price stability (low and stable inflation) and assisting in the control of economic swings. The policy frameworks under which central banks operate have changed dramatically during the last few decades.

Since the late 1980s, inflation targeting has been the main framework for monetary policy. The central banks of Canada, the eurozone, the United Kingdom, New Zealand, and other nations have set an explicit inflation target. Many low-income nations are also transitioning from monetary aggregate (a measure of the total amount of money in circulation) to inflation targeting. Recently, major central banks have begun revising their monetary policy frameworks, citing growing concerns about dwindling policy room in the environment of lower equilibrium interest rates and falling inflation expectations.

Central banks adjust the supply of money, usually through open market operations, to implement monetary policy. For example, a central bank could reduce its money supply by selling government bonds and receiving payments from commercial banks under a “sale and buyback” agreement. The purpose of such open market actions is to influence short-term interest rates, which in turn affect longer-term rates and overall economic activity. Many countries, particularly low-income countries, may not have as effective monetary transmission mechanisms as developed economies. Countries should build a framework to enable the central bank to target short-term interest rates before transitioning from monetary to inflation targeting.

Following the global financial crisis, central banks in industrialised economies loosened monetary policy by lowering interest rates until short-term rates approached zero, limiting the ability to lower policy rates even further (i.e., limited conventional monetary options). With the risk of deflation increasing, central banks used unorthodox monetary policies, such as buying long-term bonds (particularly in the United States, the United Kingdom, the eurozone, and Japan) in case of lowering the long-term rates and loosening monetary conditions. Short-term rates were even lowered below zero by several central banks.

Foreign exchange regimes and policies

The choice of a monetary framework and an exchange rate regime are inextricably intertwined. In comparison to a country with a more flexible exchange rate, a country with a fixed exchange rate will have little flexibility for autonomous monetary policy. Although some governments do not regulate the exchange rate, they do attempt to manage its level, which may necessitate a trade-off with the goal of price stability. An effective inflation targeting framework benefits from a completely flexible exchange rate regime.

Effective support of IMF on the central bank frameworks

Through multilateral surveillance, policy papers and research, bilateral engagement with its member nations, and data gathering for policy analysis and research, the IMF encourages effective central bank frameworks.

Global results can be improved through multilateral surveillance, policy analysis, and research:

• The IMF has provided policy advice on how to minimise negative consequences of unconventional monetary policy implementation and withdrawal, as well as set rules for low-income countries’ changing monetary policy regimes.

• The Fund has also looked at how monetary and macroprudential policies interact, and issued guidelines for establishing well-functioning macroprudential frameworks.

The IMF collaborates with its members to produce and maintain datasets to aid policy development and research:

• The IMF has been keeping track of countries’ monetary policy arrangements (AREAER), as well as central banks’ legislative frameworks (CBLD) and monetary operations and tools, for quite some time (MOID).

• The International Monetary Fund (IMF) has just released a new annual review of macroprudential policies and institutions. By giving specifics on the design of macroprudential policies and allowing comparisons between countries and across time, this study will aid IMF counsel and policymakers around the world.

• The IMF also created an extensive historical database of macroprudential measures (iMaPP), which incorporates the most recent survey data and allows for quantitative evaluation of macroprudential instruments. IMF economists are now using this database to measure policy effects, and it is also available to scholars all over the world.

Conclusion

The control of the amount of money available in an economy, as well as the channels through which additional money is transferred, is referred to as monetary policy. Central banks are crucial in monetary policy, ensuring price stability (low and stable inflation) and assisting in the control of economic swings. Recently, major central banks have begun revising their monetary policy frameworks, citing growing concerns about dwindling policy room in the environment of lower equilibrium interest rates and falling inflation expectations. 

Countries should build a framework to enable the central bank to target short-term interest rates before transitioning from monetary to inflation targeting. 

Following the global financial crisis, central banks in industrialised economies loosened monetary policy by lowering interest rates until short-term rates approached zero, limiting the ability to lower policy rates even further. 

The choice of a monetary framework and an exchange rate regime are inextricably intertwined. In comparison to a country with a more flexible exchange rate, a country with a fixed exchange rate will have little flexibility for autonomous monetary policy.

The IMF has provided policy advice on how to minimise negative consequences of unconventional monetary policy implementation and withdrawal, as well as set rules for low-income countries’ changing monetary policy regimes.