The Conduct of Monetary Policy

Abstract

Nowadays the Central Bank of a country is the monopoly supplier of legal tender currency. The commercial banks are committed to making their deposits convertible at par into such currency. So the banks need to keep reserves in the form of currency and deposits at the Central Bank. The Central Bank primarily conducts its policy by buying and selling financial securities, e.g. Treasury bills or foreign exchange, in exchange for its own liabilities, i.e. open market operations. Academic economists generally regard such operations as adjusting the quantitative volume of the banks' reserve base, and hence of the money stock, with rates (prices) in such markets simultaneously determined by the interplay of demand and supply. Central Bank practitioners, almost always, view themselves as unable to deny the banks the reserve base that the banking system requires, and see themselves as setting the level of interest rates, at which such reserve requirements are met, with the quantity of money then simultaneously determined by the portfolio preferences of private sector banks and non-banks. This difference in perceptions is discussed again in Section III. Whether the monetary policy operations of Central Banks should be viewed primarily in terms of quantity, or rate, setting actions, (though, of course, one is the dual of the other), these had allowed inflation, and inflationary expectations, to become entrenched by the end of the I970s. A selection of representative statistics for a number of the leading industrialised countries is given in Table i below. This table indicates a common pattern, among the countries, of interaction between interest rates, inflation and the growth of output. The first period, I969-78, is marked by high inflation, negative real interest rates, and slightly above average growth; the second period, I979-82, by very high nominal, and high real, interest rates, high (but falling) inflation, and very low output growth. The final period, i983-7, is marked by much lower inflation, lower nominal, but still high real, interest rates, and a recovery in output growth, in some cases to above average rates. In contrast, the relationship in these countries between the growth of their chosen key monetary aggregate and nominal incomes appears much weaker; also see Clinton and Chouraqui (I987), especially p. 7. Whether measured in terms of monetary growth, or in terms of' real' interest rates, i.e. after adjustment for prospective future inflation, policy during the