RBI and its Monetary

Policy

MANAGERIAL ECONOMICS-II

Prof. Vashali Sukla

NIRANJAN MAJITHIA DEGREE COLLEGE OF

COMMERCE
 Monetary policy
Monetary policy is the process by which the government, central bank, or monetary authority of
a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or
rate of interest, in order to attain a set of objectives oriented towards the growth and stability of
the economy. Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy is referred to as either being an expansionary policy, or a contractionary policy,

where an expansionary policy increases the total supply of money in the economy, and a
contractionary policy decreases the total money supply. Expansionary policy is traditionally used
to combat unemployment in a recession by lowering interest rates, while contractionary policy
involves raising interest rates in order to combat inflation. Monetary policy is contrasted with
fiscal policy, which refers to government borrowing, spending and taxation.

Contents
 1 Overview
o 1.1 Theory
 2 History of monetary policy
o 2.1 Trends in central banking
o 2.2 Developing countries
 3 Types of monetary policy
o 3.1 Inflation targeting
o 3.2 Price level targeting
o 3.3 Monetary aggregates
o 3.4 Fixed exchange rate
o 3.5 Gold standard
o 3.6 Policy of various nations
 4 Monetary policy tools
o 4.1 Monetary base
o 4.2 Reserve requirements
o 4.3 Discount window lending
o 4.4 Interest rates
o 4.5 Currency board
 5 References
Overview
Monetary policy rests on the relationship between the rates of interest in an economy, that is the
price at which money can be borrowed, and the total supply of money. Monetary policy uses a
variety of tools to control one or both of these, to influence outcomes like economic growth,
inflation, exchange rates with other currencies and unemployment. Where currency is under a
monopoly of issuance, or where there is a regulated system of issuing currency through banks
which are tied to a central bank, the monetary authority has the ability to alter the money supply
and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary
policy as such comes from the late 19th century, where it was used to maintain the gold standard.

A policy is referred to as contractionary if it reduces the size of the money supply or raises the
interest rate. An expansionary policy increases the size of the money supply, or decreases the
interest rate. Furthermore, monetary policies are described as follows: accommodative, if the
interest rate set by the central monetary authority is intended to create economic growth; neutral,
if it is intended neither to create growth nor combat inflation; or tight if intended to reduce
inflation.

There are several monetary policy tools available to achieve these ends: increasing interest rates
by fiat; reducing the monetary base; and increasing reserve requirements. All have the effect of
contracting the money supply; and, if reversed, expand the money supply. Since the 1970s,
monetary policy has generally been formed separately from fiscal policy. Even prior to the
1970s, the Britton Woods system still ensured that most nations would form the two policies
separately.

Within almost all modern nations, special institutions (such as the Bank of England, the
European Central Bank, Reserve Bank of India, the Federal Reserve System in the United States,
the Bank of Japan, the Bank of Canada or the Reserve Bank of Australia) exist which have the
task of executing the monetary policy and often independently of the executive. In general, these
institutions are called central banks and often have other responsibilities such as supervising the
smooth operation of the financial system.

The primary tool of monetary policy is open market operations. This entails managing the
quantity of money in circulation through the buying and selling of various credit instruments,
foreign currencies or commodities. All of these purchases or sales result in more or less base
currency entering or leaving market circulation.

Usually, the short term goal of open market operations is to achieve a specific short term interest
rate target. In other instances, monetary policy might instead entail the targeting of a specific
exchange rate relative to some foreign currency or else relative to gold. For example, in the case
of the USA the Federal Reserve targets the federal funds rate, the rate at which member banks
lend to one another overnight; however, the monetary policy of China is to target the exchange
rate between the Chinese renminbi and a basket of foreign currencies.
The other primary means of conducting monetary policy include:

(i) Discount window lending (lender of last resort);

(ii) Fractional deposit lending (changes in the reserve requirement);

(iii) Moral suasion (cajoling certain market players to achieve specified outcomes);

(iv) "Open mouth operations" (talking monetary policy with the market).

Theory

Monetary policy is the process by which the government, central bank, or monetary authority of
a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or
rate of interest, in order to attain a set of objectives oriented towards the growth and stability of
the economy. Monetary theory provides insight into how to craft optimal monetary policy.

Monetary policy rests on the relationship between the rates of interest in an economy, that is the
price at which money can be borrowed, and the total supply of money. Monetary policy uses a
variety of tools to control one or both of these, to influence outcomes like economic growth,
inflation, exchange rates with other currencies and unemployment. Where currency is under a
monopoly of issuance, or where there is a regulated system of issuing currency through banks
which are tied to a central bank, the monetary authority has the ability to alter the money supply
and thus influence the interest rate (in order to achieve policy goals). The beginning of monetary
policy as such comes from the late 19th century, where it was used to maintain the gold standard.
A policy is referred to as contractionary if it reduces the size of the money supply or raises the
interest rate. An expansionary policy increases the size of the money supply, or decreases the
interest rate. Furthermore, monetary policies are described as follows: accommodative, if the
interest rate set by the central monetary authority is intended to create economic growth; neutral,
if it is intended neither to create growth nor combat inflation; or tight if intended to reduce
inflation.

It is important for policymakers to make credible announcements and degrade interest rates as
they are non-important and irrelevant in regarding to monetary policies. If private agents
(consumers and firms) believe that policymakers are committed to lowering inflation, they will
anticipate future prices to be lower than otherwise (how those expectations are formed is an
entirely different matter; compare for instance rational expectations with adaptive expectations).
If an employee expects prices to be high in the future, he or she will draw up a wage contract
with a high wage to match these prices. Hence, the expectation of lower wages is reflected in
wage-setting behavior between employees and employers (lower wages since prices are expected
to be lower) and since wages are in fact lower there is no demand pull inflation because
employees are receiving a smaller wage and there is no cost push inflation because employers
are paying out less in wages.

In order to achieve this low level of inflation, policymakers must have credible announcements;
that is, private agents must believe that these announcements will reflect actual future policy. If
an announcement about low-level inflation targets is made but not believed by private agents,
wage-setting will anticipate high-level inflation and so wages will be higher and inflation will
rise. A high wage will increase a consumer's demand (demand pull inflation) and a firm's costs
(cost push inflation), so inflation rises. Hence, if a policymaker's announcements regarding
monetary policy are not credible, policy will not have the desired effect.

If policymakers believe that private agents anticipate low inflation, they have an incentive to
adopt an expansionist monetary policy (where the marginal benefit of increasing economic
output outweighs the marginal cost of inflation); however, assuming private agents have rational
expectations, they know that policymakers have this incentive. Hence, private agents know that
if they anticipate low inflation, an expansionist policy will be adopted that causes a rise in
inflation. Consequently, (unless policymakers can make their announcement of low inflation
credible), private agents expect high inflation. This anticipation is fulfilled through adaptive
expectation (wage-setting behavior); so, there is higher inflation (without the benefit of increased
output). Hence, unless credible announcements can be made, expansionary monetary policy will
fail.

Announcements can be made credible in various ways. One is to establish an independent central
bank with low inflation targets (but no output targets). Hence, private agents know that inflation
will be low because it is set by an independent body. Central banks can be given incentives to
meet their targets (for example, larger budgets, a wage bonus for the head of the bank) in order to
increase their reputation and signal a strong commitment to a policy goal. Reputation is an
important element in monetary policy implementation. But the idea of reputation should not be
confused with commitment. While a central bank might have a favorable reputation due to good
performance in conducting monetary policy, the same central bank might not have chosen any
particular form of commitment (such as targeting a certain range for inflation). Reputation plays
a crucial role in determining how much markets would believe the announcement of a particular
commitment to a policy goal but both concepts should not be assimilated. Also, note that under
rational expectations, it is not necessary for the policymaker to have established its reputation
through past policy actions; as an example, the reputation of the head of the central bank might
be derived entirely from his or her ideology, professional background, public statements, etc. In
fact it has been argued (add citation to Kenneth Rogoff, 1985. "The Optimal Commitment to an
Intermediate Monetary Target" in 'Quarterly Journal of Economics' #100, pp. 1169-1189) that in
order to prevent some pathologies related to the time-inconsistency of monetary policy
implementation (in particular excessive inflation), the head of a central bank should have a larger
distaste for inflation than the rest of the economy on average. Hence the reputation of a particular
central bank is not necessary tied to past performance, but rather to particular institutional
arrangements that the markets can use to form inflation expectations.

Despite the frequent discussion of credibility as it relates to monetary policy, the exact meaning
of credibility is rarely defined. Such lack of clarity can serve to lead policy away from what is
believed to be the most beneficial. For example, capability to serve the public interest is one
definition of credibility often associated with central banks. The reliability with which a central
bank keeps its promises is also a common definition. While everyone most likely agrees a central
bank should not lie to the public, wide disagreement exists on how a central bank can best serve
the public interest. Therefore, lack of definition can lead people to believe they are supporting
one particular policy of credibility when they are really supporting another.[3]
History of monetary policy
Monetary policy is primarily associated with interest rate and credit. For many centuries there
were only two forms of monetary policy: (i) Decisions about coinage; (ii) Decisions to print
paper money to create credit. Interest rates, while now thought of as part of monetary authority,
were not generally coordinated with the other forms of monetary policy during this time.
Monetary policy was seen as an executive decision, and was generally in the hands of the
authority with seigniorage, or the power to coin. With the advent of larger trading networks came
the ability to set the price between gold and silver, and the price of the local currency to foreign
currencies. This official price could be enforced by law, even if it varied from the market price.

With the creation of the Bank of England in 1694, which acquired the responsibility to print
notes and back them with gold, the idea of monetary policy as independent of executive action
began to be established.[4] The goal of monetary policy was to maintain the value of the coinage,
print notes which would trade at par to specie, and prevent coins from leaving circulation. The
establishment of central banks by industrializing nations was associated then with the desire to
maintain the nation's peg to the gold standard, and to trade in a narrow band with other gold-
backed currencies. To accomplish this end, central banks as part of the gold standard began
setting the interest rates that they charged, both their own borrowers, and other banks who
required liquidity. The maintenance of a gold standard required almost monthly adjustments of
interest rates.

During the 1870-1920 period the industrialized nations set up central banking systems, with one
of the last being the Federal Reserve in 1913.[5] By this point the role of the central bank as the
"lender of last resort" was understood. It was also increasingly understood that interest rates had
an effect on the entire economy, in no small part because of the marginal revolution in
economics, which focused on how many more, or how many fewer, people would make a
decision based on a change in the economic trade-offs. It also became clear that there was a
business cycle, and economic theory began understanding the relationship of interest rates to that
cycle. (Nevertheless, steering a whole economy by influencing the interest rate has often been
described as trying to steer an oil tanker with a canoe paddle.) Research by Cass Business School
has also suggested that perhaps it is the central bank policies of expansionary and contractionary
policies that are causing the economic cycle; evidence can be found by looking at the lack of
cycles in economies before central banking policies existed.

Monetarist macroeconomists have sometimes advocated simply increasing the monetary supply
at a low, constant rate, as the best way of maintaining low inflation and stable output growth.[6]
However, when U.S. Federal Reserve Chairman Paul Volcker tried this policy, starting in
October 1979, it was found to be impractical, because of the highly unstable relationship
between monetary aggregates and other macroeconomic variables.[7] Even Milton Friedman
acknowledged that money supply targeting was less successful than he had hoped, in an
interview with the Financial Times on June 7, 2003.[8][9][10] Therefore, monetary decisions today
take into account a wider range of factors, such as:

 short term interest rates;

 long term interest rates;
  velocity of money through the economy;
 exchange rates;
 credit quality;
 bonds and equities (corporate ownership and debt);
 government versus private sector spending/savings;
 international capital flows of money on large scales;
 Financial derivatives such as options, swaps, futures contracts, etc.

A small but vocal group of people advocate for a return to the gold standard (the elimination of
the dollar's fiat currency status and even of the Federal Reserve Bank). Their argument is
basically that monetary policy is fraught with risk and these risks will result in drastic harm to
the populace should monetary policy fail. Others see another problem with our current monetary
policy. The problem for them is not that our money has nothing physical to define its value, but
that fractional reserve lending of that money as a debt to the recipient, rather than a credit, causes
all but a small proportion of society (including all governments) to be perpetually in debt.

In fact, many economists disagree with returning to a gold standard. They argue that doing so
would drastically limit the money supply, and throw away 100 years of advancement in
monetary policy. The sometimes complex financial transactions that make big business
(especially international business) easier and safer would be much more difficult if not
impossible. Moreover, shifting risk to different people/companies that specialize in monitoring
and using risk can turn any financial risk into a known dollar amount and therefore make
business predictable and more profitable for everyone involved.

Trends in central banking

The central bank influences interest rates by expanding or contracting the monetary base, which
consists of currency in circulation and banks' reserves on deposit at the central bank. The
primary way that the central bank can affect the monetary base is by open market operations or
sales and purchases of second hand government debt, or by changing the reserve requirements. If
the central bank wishes to lower interest rates, it purchases government debt, thereby increasing
the amount of cash in circulation or crediting banks' reserve accounts. Alternatively, it can lower
the interest rate on discounts or overdrafts (loans to banks secured by suitable collateral,
specified by the central bank). If the interest rate on such transactions is sufficiently low,
commercial banks can borrow from the central bank to meet reserve requirements and use the
additional liquidity to expand their balance sheets, increasing the credit available to the
economy. Lowering reserve requirements has a similar effect, freeing up funds for banks to
increase loans or buy other profitable assets.

A central bank can only operate a truly independent monetary policy when the exchange rate is
floating.[11] If the exchange rate is pegged or managed in any way, the central bank will have to
purchase or sell foreign exchange. These transactions in foreign exchange will have an effect on
the monetary base analogous to open market purchases and sales of government debt; if the
central bank buys foreign exchange, the monetary base expands, and vice versa. But even in the
case of a pure floating exchange rate, central banks and monetary authorities can at best "lean
against the wind" in a world where capital is mobile.
Accordingly, the management of the exchange rate will influence domestic monetary conditions.
In order to maintain its monetary policy target, the central bank will have to sterilize or offset its
foreign exchange operations. For example, if a central bank buys foreign exchange (to counteract
appreciation of the exchange rate), base money will increase. Therefore, to sterilize that increase,
the central bank must also sell government debt to contract the monetary base by an equal
amount. It follows that turbulent activity in foreign exchange markets can cause a central bank to
lose control of domestic monetary policy when it is also managing the exchange rate.

In the 1980s, many economists began to believe that making a nation's central bank independent
of the rest of executive government is the best way to ensure an optimal monetary policy, and
those central banks which did not have independence began to gain it. This is to avoid overt
manipulation of the tools of monetary policies to effect political goals, such as re-electing the
current government. Independence typically means that the members of the committee which
conducts monetary policy have long, fixed terms. Obviously, this is a somewhat limited
independence.

In the 1990s, central banks began adopting formal, public inflation targets with the goal of
making the outcomes, if not the process, of monetary policy more transparent. In other words, a
central bank may have an inflation target of 2% for a given year, and if inflation turns out to be
5%, then the central bank will typically have to submit an explanation.

The Bank of England exemplifies both these trends. It became independent of government
through the Bank of England Act 1998 and adopted an inflation target of 2.5% RPI (now 2% of
CPI).

The debate rages on about whether monetary policy can smooth business cycles or not. A central
conjecture of Keynesian economics is that the central bank can stimulate aggregate demand in
the short run, because a significant number of prices in the economy are fixed in the short run
and firms will produce as many goods and services as are demanded (in the long run, however,
money is neutral, as in the neoclassical model). There is also the Austrian school of economics,
which includes Friedrich von Hayek and Ludwig von Mises's arguments, but most economists
fall into either the Keynesian or neoclassical camps on this issue.

Developing countries

Developing countries may have problems establishing an effective operating monetary policy.
The primary difficulty is that few developing countries have deep markets in government debt.
The matter is further complicated by the difficulties in forecasting money demand and fiscal
pressure to levy the inflation tax by expanding the monetary base rapidly. In general, the central
banks in many developing countries have poor records in managing monetary policy. This is
often because the monetary authority in a developing country is not independent of government,
so good monetary policies takes a backseat to the political desires of the government or are used
to pursue other non-monetary goals. For this and other reasons, developing countries that want to
establish credible monetary policy may institute a currency board or adopt dollarization. Such
forms of monetary institutions thus essentially tie the hands of the government from interference
and, it is hoped, that such policies will import the monetary policy of the anchor nation.
Recent attempts at liberalizing and reforming the financial markets (particularly the
recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually
providing the latitude required in order to implement monetary policy frameworks by the
relevant central banks.
Types of monetary policy
In practice, all types of monetary policy involve modifying the amount of base currency (M0) in
circulation. This process of changing the liquidity of base currency through the open sales and
purchases of (government-issued) debt and credit instruments is called open market operations.

Constant market transactions by the monetary authority modify the supply of currency and this
impacts other market variables such as short term interest rates and the exchange rate.

The distinction between the various types of monetary policy lies primarily with the set of
instruments and target variables that are used by the monetary authority to achieve their goals.

Monetary Policy: Target Market Variable: Long Term Objective:

Interest rate on overnight
Inflation Targeting A given rate of change in the CPI
debt
Interest rate on overnight
Price Level Targeting A specific CPI number
debt
The growth in money
Monetary Aggregates A given rate of change in the CPI
supply
The spot price of the
Fixed Exchange Rate The spot price of the currency
currency
Low inflation as measured by the gold
Gold Standard The spot price of gold
price
Mixed Policy Usually interest rates Usually unemployment + CPI change

The different types of policy are also called monetary regimes, in parallel to exchange rate
regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a
relatively fixed regime towards the currency of other countries on the gold standard and a
floating regime towards those that are not. Targeting inflation, the price level or other monetary
aggregates implies floating exchange rate unless the management of the relevant foreign
currencies is tracking the exact same variables (such as a harmonized consumer price index).

Inflation targeting

Under this policy approach the target is to keep inflation, under a particular definition such as
Consumer Price Index, within a desired range.

The inflation target is achieved through periodic adjustments to the Central Bank interest rate
target. The interest rate used is generally the interbank rate at which banks lend to each other
overnight for cash flow purposes. Depending on the country this particular interest rate might be
called the cash rate or something similar.
The interest rate target is maintained for a specific duration using open market operations.
Typically the duration that the interest rate target is kept constant will vary between months and
years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy
committee.

Changes to the interest rate target are made in response to various market indicators in an attempt
to forecast economic trends and in so doing keep the market on track towards achieving the
defined inflation target. For example, one simple method of inflation targeting called the Taylor
rule adjusts the interest rate in response to changes in the inflation rate and the output gap. The
rule was proposed by John B. Taylor of Stanford University.

The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It
is currently used in Australia, Canada, Chile, Colombia, the Eurozone, New Zealand, Norway,
Iceland, Philippines, Poland, Sweden, South Africa, Turkey, and the United Kingdom.

Price level targeting

Price level targeting is similar to inflation targeting except that CPI growth in one year is offset
in subsequent years such that over time the price level on aggregate does not move.

Something similar to price level targeting was tried by Sweden in the 1930s, and seems to have
contributed to the relatively good performance of the Swedish economy during the Great
Depression. As of 2004, no country operates monetary policy based on a price level target.

Monetary aggregates

In the 1980s, several countries used an approach based on a constant growth in the money
supply. This approach was refined to include different classes of money and credit (M0, M1 etc).
In the USA this approach to monetary policy was discontinued with the selection of Alan
Greenspan as Fed Chairman.

This approach is also sometimes called monetarism.

While most monetary policy focuses on a price signal of one form or another, this approach is
focused on monetary quantities.

Fixed exchange rate

This policy is based on maintaining a fixed exchange rate with a foreign currency. There are
varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed
exchange rate is with the anchor nation.

Under a system of fiat fixed rates, the local government or monetary authority declares a fixed
exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is
enforced by non-convertibility measures (e.g. capital controls, import/export licenses, etc.). In
this case there is a black market exchange rate where the currency trades at its market/unofficial
rate.

Under a system of fixed-convertibility, currency is bought and sold by the central bank or
monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a
fixed level or a fixed band within which the exchange rate may fluctuate until the monetary
authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In
this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed
exchange rate with bands where the bands are set to zero.)

Under a system of fixed exchange rates maintained by a currency board every unit of local
currency must be backed by a unit of foreign currency (correcting for the exchange rate). This
ensures that the local monetary base does not inflate without being backed by hard currency and
eliminates any worries about a run on the local currency by those wishing to convert the local
currency to the hard (anchor) currency.

Under dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is
used freely as the medium of exchange either exclusively or in parallel with local currency. This
outcome can come about because the local population has lost all faith in the local currency, or it
may also be a policy of the government (usually to rein in inflation and import credible monetary
policy).

These policies often abdicate monetary policy to the foreign monetary authority or government
as monetary policy in the pegging nation must align with monetary policy in the anchor nation to
maintain the exchange rate. The degree to which local monetary policy becomes dependent on
the anchor nation depends on factors such as capital mobility, openness, credit channels and
other economic factors.

Gold standard

The gold standard is a system in which the price of the national currency as measured in units of
gold bars and is kept constant by the daily buying and selling of base currency to other countries
and nationals. (i.e. open market operations, cf. above). The selling of gold is very important for
economic growth and stability.

The gold standard might be regarded as a special case of the "Fixed Exchange Rate" policy. And
the gold price might be regarded as a special type of "Commodity Price Index".

Today this type of monetary policy is not used anywhere in the world, apart from Switzerland
(one of the world's most stable economies), although a form of gold standard was used widely
across the world prior to 1971. For details see the Bretton Woods system. Its major advantages
were simplicity and transparency.
Policy of various nations

 Australia - Inflation targeting

 Brazil - Inflation targeting
 Canada - Inflation targeting
 Chile - Inflation targeting
 China - Monetary Targeting and targets a currency basket
 Eurozone - Inflation Targeting
 Hong Kong - Currency board (fixed to US dollar)
 India - Inflation Targeting
 New Zealand - Inflation targeting
 Singapore - Exchange rate targeting
 South Africa - Inflation targeting
 Turkey - Inflation targeting
 United Kingdom[13] - Inflation Targeting, alongside secondary targets on 'output and
employment'.
 United States[14] - Mixed policy (and since the 1980s it is well fitted/described by the
"Taylor rule" which shows that the Fed funds rate responds to shocks in inflation and
output)
Monetary policy tools
Monetary base

Monetary policy can be implemented by changing the size of the monetary base. This directly
changes the total amount of money circulating in the economy. A central bank can use open
market operations to change the monetary base. The central bank would buy/sell bonds in
exchange for hard currency. When the central bank disburses/collects this hard currency
payment, it alters the amount of currency in the economy, thus altering the monetary base.

Reserve requirements

The monetary authority exerts regulatory control over banks. Monetary policy can be
implemented by changing the proportion of total assets that banks must hold in reserve with the
central bank. Banks only maintain a small portion of their assets as cash available for immediate
withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the
proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability
of loanable funds. This acts as a change in the money supply. Central banks typically do not
change the reserve requirements often because it creates very volatile changes in the money
supply due to the lending multiplier.

Discount window lending

Many central banks or finance ministries have the authority to lend funds to financial institutions
within their country. By calling in existing loans or extending new loans, the monetary authority
can directly change the size of the money supply.

Interest rates

The contraction of the monetary supply can be achieved indirectly by increasing the nominal
interest rates. Monetary authorities in different nations have differing levels of control of
economy-wide interest rates. In the United States, the Federal Reserve can set the discount rate,
as well as achieve the desired Federal funds rate by open market operations. This rate has
significant effect on other market interest rates, but there is no perfect relationship. In the United
States open market operations are a relatively small part of the total volume in the bond market.
One cannot set independent targets for both the monetary base and the interest rate because they
are both modified by a single tool — open market operations; one must choose which one to
control.

In other nations, the monetary authority may be able to mandate specific interest rates on loans,
savings accounts or other financial assets. By raising the interest rate(s) under its control, a
monetary authority can contract the money supply, because higher interest rates encourage
savings and discourage borrowing. Both of these effects reduce the size of the money supply.
Currency board

A currency board is a monetary arrangement which pegs the monetary base of a country to that
of an anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local
currency in circulation is backed by foreign currency from the anchor nation at a fixed rate.
Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in
reserves with the currency board. This limits the possibility for the local monetary authority to
inflate or pursue other objectives. The principal rationales behind a currency board are three-
fold:

1. To import monetary credibility of the anchor nation;

2. To maintain a fixed exchange rate with the anchor nation;
3. To establish credibility with the exchange rate (the currency board arrangement is the
hardest form of fixed exchange rates outside of dollarization).

In theory, it is possible that a country may peg the local currency to more than one foreign
currency; although, in practice this has never happened (and it would be a more complicated to
run than a simple single-currency currency board). A gold standard is a special case of a
currency board where the value of the national currency is linked to the value of gold instead of a
foreign currency.

The currency board in question will no longer issue fiat money but instead will only issue a set
number of units of local currency for each unit of foreign currency it has in its vault. The surplus
on the balance of payments of that country is reflected by higher deposits local banks hold at the
central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks.
The growth of the domestic money supply can now be coupled to the additional deposits of the
banks at the central bank that equals additional hard foreign exchange reserves in the hands of
the central bank. The virtue of this system is that questions of currency stability no longer apply.
The drawbacks are that the country no longer has the ability to set monetary policy according to
other domestic considerations, and that the fixed exchange rate will, to a large extent, also fix a
country's terms of trade, irrespective of economic differences between it and its trading partners.

Hong Kong operates a currency board, as does Bulgaria. Estonia established a currency board
pegged to the Deutschmark in 1992 after gaining independence, and this policy is seen as a
mainstay of that country's subsequent economic success (see Economy of Estonia for a detailed
description of the Estonian currency board). Argentina abandoned its currency board in January
2002 after a severe recession. This emphasized the fact that currency boards are not irrevocable,
and hence may be abandoned in the face of speculation by foreign exchange traders. Following
the signing of the Dayton Peace Agreement in 1995, Bosnia and Herzegovina established a
currency board pegged to the Deutschmark (since 2002 replaced by the Euro).

Currency boards have advantages for small, open economies which would find independent
monetary policy difficult to sustain. They can also form a credible commitment to low inflation.
References
1. "Monetary Policy". Federal Reserve Board. January 3, 2006.
http://www.federalreserve.gov/policy.htm.
2. B.M. Friedman "Monetary Policy," International Encyclopedia of the Social &
Behavioral Sciences, 2001, pp. 9976-9984. Abstract.
3. Forder, James. ""Credibility" in Context: Do Central Bankers and Economists Interpret
the Term Differently?" (December 2004).
4. "Bank of England founded 1694". BBC. March 31, 2006.
http://www.bbc.co.uk/history/timelines/britain/stu_eng_bank.shtml.
5. "Federal Reserve Act". Federal Reserve Board. May 14, 2003.
http://www.federalreserve.gov/generalinfo/fract/.
6. Milton Friedman (1960), A Program for Monetary Stability. Fordham University Press.
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8. Edward Nelson (2007), 'Milton Friedman and U.S. Monetary History: 1961-2006',
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9. Blog: Favorite Friedman quotes
10. Wikiquote
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http://www.frbsf.org/publications/federalreserve/monetary/.