2. using interest rate as an instrument to

2.
MONETARY POLICY

The Central bank is considered to be “the
bank of other banks” and it is responsible for controlling the monetary economy
of a country. After central banks around the world gained their independence
from the influence of the government in regard to the conduct of policy, they
have continuously used monetary policy as a tool in contributing to the
economic growth of a country. Monetary policy is a very important topic that
has been reviewed by the literature. Also, Monetary policy contributes to the stabilization
of the economy by using interest rate as an instrument to control inflation and
control money supply, this would be explained further in the paper.

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In this paper, we use the relevant
literature to examine what macroeconomics variable have been used to determine
monetary policy and examine how central banks can control inflation and also if
they should focus only on inflation.

Monetary policy is an important economic tool
used by the central bank of a country to maintain economic growth and
stability. According to Poole and Wheelock (2008), “The Federal Reserve Act as
amended in 1977 directs the Federal Reserve to pursue monetary policy to
achieve the goals of maximum employment, stable prices and moderate long-term
interest rates”. This objective is applicable to most central banks in a country.
Monetary policy plays a crucial role in the growth of a country’s economy by
controlling the money supply in order to control inflation, reduce the level of
unemployment and boost consumer spending and borrowing.

The breakdown of the Bretton Woods era gave
rise to the modernization of monetary policy in the 1970s.The Bretton Woods
system was created so that exchange rate would remain stable while inflation
rate was also stable. However, after the Bretton Woods system ended, the
economy of several countries crashed. There was a rise in unemployment rates
and the inflation rate was unstable. These made policymakers reconsider monetary
policy as a tool to be used by central banks and to accommodate its norms that
were not considered during the Bretton Woods system. These norms include;
monetary policy strategies such as inflation targeting, central bank independence
and the separation of monetary policy from regulatory activities such as bank
supervision. Also, after the 2008 financial crisis, monetary policy was used to
assist in stabilizing financial markets and restoring liquidity. (Oxenford,
2016).

2.1.
WHAT DETERMINES MONETARY POLICY?

One of the objectives of central banks is
to maintain low and stable inflation in the economy. This is carried out by
using policy interest rate to impact inflation through transmission mechanism.
Interest rates play a major role in conducting monetary policy as it helps in
controlling inflation. However, when the inflation rate is too low or
unemployment rate is too high, central banks respond to this by reducing the
short-term interest rates but they have to be cautious as interest rates cannot
fall below zero (zero lower bound). If this happens, it would be difficult to
revive the economy through further monetary easing, instead quantitative easing
would be used to increase the money supply in the economy (Bernanke, 2017). Williamson
(2017) explains that “quantitative easing consists of large-scale asset
purchases by central banks, usually of long-maturity government debt but also
of private assets, such as corporate debt or asset-backed securities”.

Before the 2008 financial crisis, the zero-lower
bound on short-term interest rates was regarded as irrelevant by most
economists. However, during the crisis in 2008, the Federal Reserve System
responded to this crisis by reducing its policy rate close to zero (Bernanke,
2017).

 

2.2.
CAN CENTRAL BANKS CONTROL INFLATION?

One of the main objectives of central
banks is to ensure low and stable inflation. However, economists have argued
about the ability of the central bank to control inflation. In a paper by
Claeys and Wolff (2015), they discuss the control of inflation by examining if
globalization is reducing the ability of central banks to control inflation. They
explain this using three forms, which includes; “globalization for goods and
services in the market, global integration of labor markets, increased
financial integration” (Claeys and Wolff 2015).

Regarding the first point, the world is a
global market and this means that goods and services are produced in different
parts of the world. This means that the prices of these goods are set in
international markets and are imported to other countries. This situation could
reduce the ability of the central bank to control inflation. Also, competition
in the global markets could affect inflation. An increase in market competition
usually leads to increase in productivity, as each producer would want to
produce more quality products than his competitor and this could apply downward
pressure on production costs and prices. (Claeys and Wolff, 2015).

Secondly, the continuous increase in the
global labor force has led to a continuous increase in productivity as more
workers are available to produce exportable goods and services. This leads to a
decrease in the bargaining power of workers in advanced countries in setting
wages which has an effect on the domestic inflation rates. (Claeys and Wolff,
2015).

Thirdly, one of the major factors that weakens
the ability of the central bank to control interest rate is increasing
financial integration. The effect it has on the central bank in controlling
interest rates causes it to have an influence on output and inflation. (Claeys
and Wolff, 2015).

All three forms listed above make it
difficult for central banks to achieve their inflation targets. In a world
where there is continuous global economic development, central banks need to
take these changes into consideration. However, through the control they have
over interest rates, central banks have powerful instruments to prevent
financial conditions that might have an effect on inflation.

2.3.
MONETARY POLICY STRATEGY

Monetary policy strategies have continued
to evolve since the 1970s dating back to the Bretton Woods era. According to
Houben (2000), “monetary policy strategy is considered to consist of the
specification of the intended monetary reaction function to economic
developments as well as the communication of this reaction function and of
actual policy decisions to the outside world.” Several strategies have been
used in different eras to contribute to the economic growth of a country. The
three main strategies include; money targeting, exchange rate targeting, inflation
targeting (Houben, 2000).

For the purpose of this literature, we
will focus on inflation targeting as it is considered the best objective for
the central bank. This is because one of the goals of a central bank is to
maintain a low inflation rate and it is better for the central bank to have an
inflation rate target than money target. This is so as central banks have
little control over the growth of M2 (broad money) and M1(currency and
checkable deposits) which is why in most central banks, monetary policy has
shifted from focusing on M1 or M2 to focusing on inflation. (Blanchard and
Johnson, 2013).

2.3.1.
INFLATION TARGETING

Over the years, central banks around the
world have adopted inflation targeting as a guide in carrying out monetary
policy. Abel et al. (2008) explain that “Inflation targeting implies that the
central bank announces the inflation rate that it will try to achieve over the
subsequent one to four years”. Inflation targeting was pioneered in 1990 by New
Zealand and afterward was adopted by several countries around the world (Mishkin,
2001). Before the introduction of inflation targeting, New Zealand used money
targeting as its monetary policy strategy.

But why the shift towards inflation
targeting??

Money targeting was introduced in 1975 by
the central bank of Germany and was later adopted by other countries. Money
targeting involved the central bank announcing the rate of growth of money that
it will try to achieve over the next year. However, this form of monetary
policy strategy was later abandoned. The Fed explained that money targeting was
abandoned due to rapid changes in the United States financial system. These
changes involved unstable velocity in the demand for money which made money
targeting an ineffective monetary policy strategy and this made other countries
abandon money targeting. (Abel et al., 2008).

According to Mishkin (2001), inflation
targeting contains five main elements that are important in helping the central
bank of a country make economic plans that include the central bank informing
the public about its forecast on the future inflation rate. These elements
include;

a)      “The
public announcement of medium-term numerical targets for inflation.

b)        An
institutional commitment to price stability as the primary goal of monetary
policy to which other goals are subordinated.

c)       An information inclusive strategy in which
many variables, and not just monetary aggregates or the exchange rate, are used
for deciding the setting of policy instruments.

d)       Increased transparency of the monetary policy
strategy through communication with the public and the markets about the plans,
objectives, and decisions of the monetary authorities.

e)       Increased accountability of the central bank
for attaining its inflation objectives”.

(Mishkin, 2001).

2.3.2
SHOULD CENTRAL BANKS TARGET ZERO INFLATION? 

Several economists have argued about the
inflation rate goal, stating that having an inflation rate that is too low could
increase the rate of unemployment and could lead to inefficiency in the economy
of a country. However, Mishkin (2001) says that “setting the long-run inflation
target at zero would make deflations more likely and deflations can lead to
financial instability and sharp contractions”. This statement explains that
targeting zero inflation is far worse than having an inflation rate that is too
low. Also, Billi and Kahn (2008) agree that inflation rate should not fall
below zero because the costs of deflation are too high.

However, targeting zero inflation has its
pros and cons. According to Mankiw (2016), an advantage of targeting zero
inflation is that zero provides a more focal point for policy makers than any
other number. He explains with an example saying that “for instance, if the Fed
were to announce that it would keep inflation at 3 percent, would the fed
really stick to the percent target?”. He went further to say “If events
inadvertently pushed inflation up to 4 or 5 percent, why wouldn’t it just raise
the target? There is, after all nothing special about the number 3”. He
concluded by saying that “by contrast, zero is the only number for the
inflation rate at which the fed can claim that it has achieved price stability
and further eliminated the costs of inflation”. His explanation is about the
percentage of the inflation target being more feasible. However, this cannot
justify the damage it will cause on the economy of a country which is why there
are disadvantages.

Billi and Kahn
(2008) agree that inflation should be kept above
zero. They explain that if inflation is targeted at zero, it would affect the
nominal interest rates because nominal interest rates cannot fall below zero.
They said that, “when inflation is low and expected to remain low, investors
are willing to accept a low inflation premium when purchasing nominal debt
instruments and as a result, nominal interest rates will tend to be low”. They
further explained that “because central banks counteract slowing economic
activity by lowering short term interest rates, a very low inflation
environment limits the extent to which policymakers can respond to an economic
slowdown”. They concluded by saying, “Once short-term rates fall to zero,
conventional monetary policy tools no longer work to stimulate economic
activity”. This explains that setting an inflation target of zero is going to
be terrible for the economy because there will not be solutions to the damages
done to the economy for a very long time. Also, as inflation rate is linked to
money supply, an increase in the money supply reduces the value of money, which
leads to an increase in the price level.

In Summary, monetary policy is an
important tool for central banks and it has been in the front burner of the
economic world because of the role it plays in the economy of a country. As
stated earlier, it contributes to the growth of an economy by using interest
rate to control inflation rate. However, central bank controlling inflation
rate does not necessarily mean they can control inflation. As the world
continues to evolve, several factors such as globalization may affect the
ability of the central bank to control inflation. This is because there is
competition in global markets and every producer wants to be the best. So, this
makes it difficult for the central bank to control inflation because the prices
of goods and services are different around the world. In addition, the central
bank of different countries use inflation targeting in order to prevent future
damages to the economy. Using inflation targeting prevents future cases of
deflation which could leave the economy helpless. Therefore, I believe
inflation targeting is the best monetary policy strategy for the central bank
as they have more control over the inflation rate.