Nations around the world use monetary policy to ensure sustainable economic growth, as well as low levels of inflation and unemployment for their citizens and businesses. Central banks affect monetary policy through their control of the national money supply and availability of credit. A variety of factors, both political and economic, help determine a nation's monetary policy.
Monetary Policy Framework
A monetary policy framework includes the institutions, mandates and targets that shape monetary policy. Central banks, such as the Federal Reserve in the U.S., the Bank of Japan and the Bank of Canada, are the institutions that oversee monetary policy for their countries. Mandates consist of laws and directives creating the central bank and defining its mission. Typically, the mandates are broad in nature. The Federal Reserve’s mandate from Congress, for example, includes maintaining a stable price system. Targets include measurable targets for inflation and money supply growth. For example, a central bank may set an inflation target of no more than 2 percent increase a year.
Central Bank Independence
Central bank independence from other elements of the government helps ensure monetary policy that is based on economic, rather than political, considerations. The Federal Reserve, for example, has a high degree of independence from the president and Congress. Fed governors are presidential appointees but serve seven-year terms, limiting the ability of a president to load the board with political allies. The Fed also is independent of fiscal control by Congress. A central bank that lacks independence could be vulnerable, for example, to pressure to manipulate the money supply in a way that favors a sitting government at election time.
Current conditions in the economy affect monetary policy decisions by the central bank. The Federal Reserve Bank of San Francisco reports that Fed policy makers review the most recent data on important metrics such as unemployment, gross domestic product and productivity, but cautions that even the most up-to-date information reflects only the recent past.
Monetary policy conditions reflect not only a response to the most recent indicators of the economy’s performance, but also a judgment by the central bank on where the economy is going. The San Francisco Fed reports that Federal Reserve policy makers try to identify the most relevant economic developments, incorporating them into a model that helps them estimate future conditions. This means that assessments of current conditions, as well as projections about the economy’s future, help determine policy actions. If the central bank believes the economy is at risk of overheating, which could spark inflation, it may respond with contractionary actions that tighten credit and reduce the money supply. If economic growth appears sluggish, the central bank may lower interest rates and increase the money supply to ensure a steady supply of credit to the financial system, encouraging more lending and investment activity.