A nation's monetary policy objectives and the framework for setting and achieving those objectives stems from the relationship between the central bank and the government. Central banks in different countries have a variety of objectives, such as maximum employment, stable prices, and moderate long-term interest rates. In the long run, these objectives are in harmony and reinforce each other, but in the short run, they might be in conflict.
The key objective is price stability. It is the source of maximum employment and moderate long-term interest rates.
The Costs of Inflation
Unanticipated inflation is an increase in the general level of prices that was not expected by most decision makers. It is a surprise to most individuals. For example, if someone anticipates an inflation rate of 3% but the actual inflation rate turns out to be 10%, it will catch that person off guard.
Unanticipated inflation redistributes income, creates uncertainty, and can have a potentially destabilizing impact on the economy.
Monetary Policy Tools
Central banks manipulate the money base that creates the change in the money supply. When following an expansionary monetary policy, they increase the growth rate of the money supply. Conversely, when following a restrictive monetary policy, they reduce the growth rate of the money supply.
Central banks have three major means of controlling the money stock.
Open Market Operations. Since it can be undertaken easily and quietly, this is the most common tool used by a central bank to alter the money supply. For example, to increase the money supply, the central bank buys government securities from commercial banks. This increases the money supply.
The Central Bank's Policy Rate. Sometimes banks find themselves in a position where they are not holding enough bank reserves relative to the value of the deposits they hold (i.e., they have extended too many loans!). As a result, they may need to acquire a short-term loan from the central bank to cover this shortage of required reserves. They may apply to the central bank for a loan; the interest charged on the loan is known as repo rate (in the U.S. it is called the discount rate).
An increase in the policy rate is restrictive on money supply - it tends to discourage banks from shaving their excess reserves to a low level.
In the U.S., borrowing from the Fed amounts to less than one-tenth of 1% of the available loanable funds of banks. A bank can go to the federal funds market to borrow to meet its reserve requirements. The market is where banks with excess reserves extend short-term loans to those banks seeking additional reserves. The interest rate in this market is called the federal funds rate. The federal funds rate and the discount rate tend to move together.
Reserve Requirements. The central bank sets the rules. Since banking institutions will want to hold interest-earning assets rather than excess reserves, an increase in the reserve requirements will reduce the supply of money, and vice versa. However, the central banks of developed countries have seldom used their regulatory power over reserve requirements to alter the supply of money, due to its disruptive impact on banking operations - small changes in reserve requirements can sometime lead to large changes in the money supply.
The Transmission Mechanism
When a central bank lowers its official interest rate:
When the Fed raises the federal funds rate, the ripple effects go in the opposite direction.