Step 13: Monetary Policy

What a central bank actually controls

Think about a family deciding whether to buy a car on credit. At a 4% loan rate the payments look manageable; at 9% they wait another year. Multiply that across millions of households and firms. A committee of about a dozen people, meeting around eight times a year, sets the one number that shapes these choices: the policy rate.

Commercial banks create most money when they lend, so the central bank does not control the quantity of money. It controls the price of money, the short-term interest rate, because it is the only supplier of the reserves banks use to settle payments.

Conventional tools

1. The policy rate: the overnight rate at which banks lend reserves to each other.
2. Open market operations: buying or selling government bonds to change the amount of reserves. Once the main tool, now secondary.
3. Interest paid on reserves: no bank will lend reserves to another bank for less than the central bank pays risk-free, so this rate sets a floor for market rates. Since 2008 it has become the main tool in the US.
4. Reserve requirements: largely obsolete. The US set its requirement to zero in March 2020; the UK, Canada, Australia and New Zealand never had one.

Unconventional tools, used when the policy rate can go no lower:

• Quantitative easing (QE): large purchases of long-dated bonds to push down long-term interest rates.
• Forward guidance: publicly promising to keep rates low for a long time, which lowers long-term rates today.
• Negative interest rates: charging banks for holding reserves, used by the European Central Bank and the Bank of Japan. Rates cannot go far below zero, because banks would hold cash instead.

The transmission mechanism: four channels

A rate cut does not raise output directly. It travels through four channels, each with its own delay. Here is what happens when the central bank cuts its rate (expansionary policy):

All four push up \( AD = C + I + G + (X – M) \). In the short run, output and prices rise; in the long run, because LRAS is vertical, only prices are higher. Contractionary policy works in reverse. Its temporary output loss is measured by the sacrifice ratio: output given up per percentage point of inflation removed.

Remember the link between the two kinds of interest rate:

Inflation targeting and independence

Until the 1980s many central banks targeted money supply growth, but the link between base and broad money proved unstable. Goodhart’s law (1975): a statistical relationship tends to break down once you use it for control.

New Zealand adopted the first explicit inflation target in 1990, and the idea is now almost universal. It has three parts:

1. A public numerical target, usually 2%.
2. Operational independence: the central bank sets the rate without political direction (the government usually sets the target).
3. Accountability: the bank must explain publicly when it misses.

Why let unelected officials decide? Kydland and Prescott (1977) pointed to time inconsistency. A government before an election is tempted to promise low inflation, then create surprise inflation to boost output. Workers expect this, so they demand higher wages in advance, and the result is higher inflation with no extra output. An independent central bank removes the temptation, so its promise is believed. That belief, credibility, anchors inflation expectations.

Critics say this gives great power to an unelected body whose decisions affect rich and poor differently.

The Taylor rule

In 1993 John Taylor noticed that the US Federal Reserve’s behaviour could be described by a simple formula. It is now the standard benchmark.

Here \(i\) is the recommended nominal policy rate, \(r^*\) is the neutral real interest rate (the rate consistent with output at potential, often taken as 2%), \(\pi\) is current inflation and \(\pi^*\) is the inflation target, usually 2%.

Notice that inflation appears twice, so its total weight is \(1 + 0.5 = 1.5\). A 1 point rise in inflation raises the recommended nominal rate by 1.5 points, so the real rate rises by 0.5 points. This is the Taylor principle.

The limits of monetary policy

• Long and variable lags. The full effect on inflation arrives after roughly 12 to 24 months, and the lag varies. Central banks must act on forecasts using variables nobody can observe directly, such as potential output and the neutral rate. Milton Friedman argued that a simple rule would beat this kind of guesswork.
• The zero lower bound. Nominal rates cannot fall far below zero, because people can hold cash at a zero return. With 2% deflation and a zero nominal rate, the real rate is \(0 – (-2) = +2\%\): contractionary just when the economy needs a boost. This is why QE and forward guidance were invented, and a main reason the target is 2% rather than zero.
• The liquidity trap. People will hold any amount of money at a very low rate, so extra money does not lower rates: “pushing on a string”. This is the strongest case for fiscal policy instead.
• Other limits. It cannot fix cost-push inflation without a recession, it is blunt (one rate for every region), and it needs a healthy banking system.

The chapter compares two US tightenings. Under Paul Volcker, inflation fell from 13.5% in 1980 to 3.2% by 1983, but unemployment reached 10.8%. Under Jerome Powell in 2022 to 2023, inflation fell from 9.1% to about 3% with no recession. The difference was credibility: expectations stayed anchored, so workers did not build high inflation into wage demands.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

Check yourself

The short version

• The central bank sets the price of money (the policy rate), not the quantity. Its main tools are the policy rate, open market operations and interest on reserves; QE, forward guidance and negative rates are unconventional.
• Rate changes work through interest rates, asset prices, the exchange rate and expectations, with a lag of 12 to 24 months.
• Inflation targeting with an independent central bank solves the time-inconsistency problem and builds credibility.
• Taylor rule: \( i = r^* + \pi + 0.5(\pi – \pi^*) + 0.5(\text{gap}) \). The nominal rate must rise by more than inflation so the real rate rises.
• Limits: long and variable lags, the zero lower bound, the liquidity trap, supply shocks, bluntness and uneven effects on rich and poor.

This guide covers the core of Chapter 27 of Economics Made Simple. For the full chapter, with the Volcker and Powell case study and 15 exam-style questions with a complete answer key, see the book.