So! What is monetary policy?
Monetary policy is the macroeconomic policy laid down by the central bank of a country. Monetary policy refers to the use of instruments under the control of the central bank to regulate the availability, cost and use of money and credit. It involves management of money supply and interest rate and is the demand side economic policy used by the government of a country to achieve macroeconomic objectives like inflation, consumption, and liquidity. Further goals of a monetary policy are usually to contribute to economic growth and stability, to lower unemployment, and to maintain predictable exchange rates with other currencies. Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values. Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.
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. 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 (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.
So what is the Gold Standard?
The gold standard is a monetary system where a country’s currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. Between 1696 and 1812, the development and formalization of the gold standard began as the introduction of paper money posed some problems. In 1797, due to too much credit being created with paper money, the Restriction Bill in England suspended the conversion of notes into gold. Also, constant supply imbalances between gold and silver created tremendous stress to England’s economy. A gold standard was needed to instill the necessary controls on money. By 1821, England became the first country to officially adopt a gold standard. The century’s dramatic increase in global trade and production brought large discoveries of gold, which helped the gold standard remain intact well into the next century. As all trade imbalances between nations were settled with gold, governments had strong incentive to stockpile gold for more difficult times. Those stockpiles still exist today. The international gold standard emerged in 1871 following the adoption of it by Germany. By 1900, the majority of the developed nations were linked to the gold standard.
The gold standard is not currently used by any government. Britain stopped using the gold standard in 1931 and the United States abandoned the system in 1971. The gold standard was completely replaced by fiat money. The term fiat money is used to describe currency that is used because of a government’s order, or fiat, that the currency must be accepted as a means of payment. So for the U.S., the dollar is fiat money and for India it is the rupee.
So how did the gold standard work?
This topic has been fabulously explained by philosophicaleconomics(dot)com. We begin with a simple barter economy in which individuals exchange goods and services directly, without using money. In a barter economy, certain commodities will come to be sought after not only because they satisfy the wants and needs of their owners, but also because they are durable and easy to exchange. Such commodities will provide their owners with a means through which to store wealth for consumption at a later date, by trading. On this measure, metals–specifically, precious metals–will score very high, and will be conferred with a trading value that substantially exceeds their direct and immediate usefulness in everyday life. Crucially, the trading value of precious metals will end up being grounded in a self-fulfilling belief and confidence in that value, learned culturally and through a process of behavioral reinforcement. Individuals will come to expect that others will accept precious metals in exchange for real goods and services in the future, therefore they will accept precious metals in exchange for real goods and services now, holding the practice in place and validating the prior belief and confidence in it. Every form of money gains its power in this way–through the self-fulfilling belief and confidence that it will be accepted as such.
Now, in economic systems where precious metals are the predominant form of money, two practical problems emerge: measurement and fraud. It is inconvenient for individuals to have to measure the precise amount of precious metal they are trading every time they trade. Furthermore, what is presented as a precious metal may not be fully so–impurities may have been inserted to create the illusion that more is there than actually is. The inevitable solution to these problems comes in the form of “Mints.” Mints are credible entities that use stamping and engraving to vouch for the weight and purity of units of precious metal. In a healthy, progressing economy, where learning, technological innovation and population growth drive continual increases in output capacity–increases in the amount of wanted “stuff” that the economy is able to produce each year–the supply of money also needs to increase. If it doesn’t increase, the result will either be deflation or economic stagnation. Both of these options are undesirable.
Fortunately, in a metal-based monetary system, there is a natural mechanism through which the money supply can expand: mining. Miners extract metals from the ground. They take the metals to mints to have them forged into coins. They then spend the coins into the economy, increasing the money supply. The problem, of course, is that there is no assurance that the output of the mining industry, which sets the growth of the money supply, will proceed on a course commensurate with growth in the output capacity of the real economy–its ability to to produce the real things that people want and need. If the mining industry produces more new money than can be absorbed by growth in the economy’s output capacity, the result will be inflation, an increase in the price of everything relative to money. This is precisely what happened in Europe in the years after the Spanish and Portuguese discovered and mined The New World. They brought its ample supply of precious metal back home to coin and spend–but the economy’s output capacity was no different than before, and could not meet the demands of the increased spending. In contrast, if the mining industry does not produce enough new money to keep up with growth in the economy’s output capacity, the result will be deflation–what Europe frequently saw in the periods before the discovery of The New World.
In a metal-based monetary system, there is a natural feedback that helps keep the mining industry from producing too much or too little new money. If the industry produces too much new money, the ensuing inflation of prices and wages will make mining less profitable in real terms, and discourage further investments in mining. If the mining industry does not produce enough new money, the deflation of prices and wages will make mining more profitable in real terms, and encourage further investments in mining. To the extent that a metallic monetary system is closed to external flows, this feedback is the only feedback present to stabilize business cycles. Obviously, it can’t act quickly enough or with enough power to keep prices stable, which is why large cycles of inflation and deflation frequently occurred prior to the development and refinement of modern central banking. If it seems crazy to think that humanity could have survived under such a primitive and constricted monetary arrangement–an arrangement where a limited, unsupervised, unmanaged supply of a physical object forms the basis of all major commerce–remember that the economies of the past were not as specialized and dependent upon money and trade as they are today. Trading in money would have been something that the wealthy and royal class would ever have to worry about. The rest would meet the basic needs of life–food, water, shelter–by producing it themselves, or by working for those with means and receiving it directly in compensation, as a serf in a feudal kingdom might do.
The Price-Specie Flow Mechanism
What is unique about a metal-based monetary system is that money from any one country or geographic region can easily be used in any other, without a need for conversion. All that is necessary is that individuals trust that the money consists of the materials that it claims to consist of, as signified in its stamp or engravement. Then, it can be traded just as its underlying materials would be traded. After all, it is those materials–its being those materials is the basis for its being worth something. In early British America, Spanish silver dollars, obtained from trade with the West Indies, were a popular form of money, owing to the tight supply of British currency in the colonies. To use the Spanish dollars in commerce, there was no need to convert them into anything else; they were already 387 grains of pure silver, their content confirmed as such by the mark of the Spanish empire.
The prospect of simple, undistorted international flows under a metal-based monetary system gives way to an important feedback that enforces a balance of payments between different regions and nations and that acts to stabilize business cycles. This feedback is called the “price-specie flow mechanism”, introduced by the philosopher David Hume. For a relevant example of the price-specie flow mechanism in action, suppose that Europe is on a primitive gold standard, and that Germans make lots of stuff that Greeks end up purchasing, but Greeks don’t make any stuff that Germans end up purchasing. Money–in this case, gold–will flow from Greece to Germany. The Greeks will literally be spending down their money supply, removing liquidity and purchasing power from their own economy. The liquidity and purchasing power will be sent to Germany, where it will circulate as income and fuel a German economic boom. The ensuing deflation of prices and wages in Greece, and the ensuing inflation of prices and wages in Germany, will prevent Greeks from purchasing goods and services from Germany, and will make it more attractive for Germans to purchase goods and services from Greece (or to invest in Greece). Money–again, gold–will therefore be pulled back in the other direction, from Germany back to Greece, moving the system towards a balanced equilibrium.
It is only with fiat money, money that can be created by a government at will, that this mechanism can be circumvented. The Chinese monetary authority, for example, can issue new Renminbi and use them to purchase U.S. dollars, exerting artificial downward pressure on the Renminbi relative to the U.S. dollar, and preserving a large trade imbalance between the two nations. Metal, in contrast, cannot be created at will, and so there is no way to circumvent the mechanism under a strict metallic monetary system.
Paradigm Shift: The Development of Fractional-Reserve Free Banking
Up to now, all we have for money are precious metals–coins and bars of gold and silver. There are promises, there is borrowing, there is debt–but these are not redeemable on demand for any defined amount. Anyone who accepts them as payment must accept illiquidity or the risk of mark-to-market losses if the holder chooses to trade them.
The paradigm shift that formally connected borrowing and debt with securities redeemable on demand for a defined amount occurred with the development of free banking. Historically, savers sought to keep their supplies of gold and silver–in both coin and bar form–in safe deposits maintained by goldsmiths. The goldsmiths would charge a fee for the deposit, and would issue a document–a banknote–redeemable for a certain amount of gold and silver on the holder’s request. Given that the goldsmiths generally had reputations as honest dealers, the banknotes would trade in the market as if they were the very gold and silver that they could be redeemed for.
Eventually, the goldsmiths realized that not everyone came to redeem their gold and silver deposits at the same time. The gold and silver deposits coming in (i.e., the banknotes being created) would generally balance out with the gold and silver deposits leaving (i.e., the banknotes being redeemed). This balancing out of incoming and outgoing deposit flows allowed the goldsmiths to issue more banknotes than they were storing in actual gold and silver. They could print and loan out banknotes in excess of the gold and silver deposits that they actually had on hand, and receive interest in compensation. Thus was born the phenomenon of fractional-reserve banking. Initially, the banking was “free” banking, meaning that there was no government involvement other than to enforce contracts. The banknotes of each bank were accepted as payment based on the reputation and credibility of the bank. Each bank could issue whatever quantity of banknotes, over and above its actual holdings of gold and silver, that it felt comfortable issuing. But if the demand for redemption in gold and silver exceeded the supply on hand, that was the problem of the banks and the depositors–not the problem of the government or the taxpayer. In lieu of banknotes, bank customers also accepted simple deposits, against which they could write cheques. The difference between a cheque and a banknote is that a banknote represents a promise to pay to the holder, on demand. A cheque represents an order to a bank to pay a specific person, whether or not she is currently holding the cheque. So, for example, if I have a deposit account with Pittsfield bank in Massachussets, and I write a cheque to someone, that person has to deposit the cheque in order to use it as currency. He can’t trade it with others directly as money, because it was written to him from me. He has to take the cheque to his bank–say, Windham bank–to cash it (or deposit it). In that case, coins (gold and silver) will be transferred from Pittsfield to Windham. In contrast, if I give the person a banknote from Pittsfield as payment, he can use it directly in the market–provided, of course, that Pittsfield has a sound reputation as a bank.
The issuance of banknotes, and their widespread acceptance as a working substitute for the actual metallic money that they were redeemable for, created a mechanism through which the money supply–the supply of legal tender that had to be accepted to pay debts public and private–could expand in accordance with the economy’s needs. Granted, prior to the advent of fractional-reserve banking, it was possible to trade debt securities and debt contracts in lieu of actual gold and silver–but these securities and contracts were not redeemable on demand. The recipient had to accept a loss of liquidity and optionality in order to take them as payment. A banknote, in contrast, is redeemable on demand, by anyone who holds it, therefore it is operationally equivalent to the legal money–the coined precious metal–that backs it.
A true gold standard is a gold standard built on fractional-reserve free banking. The government defines the value of the currency in terms of precious metals, and then leaves banks in the private sector to do as they please–to issue whatever quantity of banknotes they want to issue, and to pay the price in bankruptcy if they behave in ways that create redemption demand in excess of what they can actually redeem. There is no government intervention, no regulatory imposition, no reserve requirement, no capital ratio–just the supervision of market participants themselves, who have to do their homework.
The gold standard became a domestic standard regulating the quantity and growth rate of a country’s money supply. Because new production of gold would add only a small fraction to the accumulated stock, and because the authorities guaranteed free convertibility of gold into nongold money, the gold standard ensured that the money supply, and hence the price level, would not vary much. But periodic surges in the world’s gold stock, such as the gold discoveries in Australia and California around 1850, caused price levels to be very unstable in the short run. The gold standard was also an international standard determining the value of a country’s currency in terms of other countries’ currencies. Because adherents to the standard maintained a fixed price for gold, rates of exchange between currencies tied to gold were necessarily fixed. For example, the United States fixed the price of gold at $20.67 per ounce, and Britain fixed the price at £3 17s. 10½ per ounce. Therefore, the exchange rate between dollars and pounds—the “par exchange rate”—necessarily equaled $4.867 per pound.
Because exchange rates were fixed, the gold standard caused price levels around the world to move together. This comovement occurred mainly through the automatic balance-of-payments adjustment process – the price-specie-flow mechanism. The fixed exchange rate also caused both monetary and nonmonetary (real) shocks to be transmitted via flows of gold and capital between countries. Therefore, a shock in one country affected the domestic money supply, expenditure, price level, and real income in another country. The California gold discovery in 1848 is an example of a monetary shock. The newly produced gold increased the U.S. money supply, which then raised domestic expenditures, nominal income, and, ultimately, the price level. The rise in the domestic price level made U.S. exports more expensive, causing a deficit in the U.S. balance of payments. For America’s trading partners, the same forces necessarily produced a balance-of-trade surplus. The U.S. trade deficit was financed by a gold (specie) outflow to its trading partners, reducing the monetary gold stock in the United States. In the trading partners, the money supply increased, raising domestic expenditures, nominal incomes, and, ultimately, the price level. Depending on the relative share of the U.S. monetary gold stock in the world total, world prices and income rose. Although the initial effect of the gold discovery was to increase real output (because wages and prices did not immediately increase), eventually the full effect was on the price level alone.
For the gold standard to work fully, central banks, where they existed, were supposed to play by the “rules of the game.” In other words, they were supposed to raise their discount rates—the interest rate at which the central bank lends money to member banks—to speed a gold inflow, and to lower their discount rates to facilitate a gold outflow. Thus, if a country was running a balance-of-payments deficit, the rules of the game required it to allow a gold outflow until the ratio of its price level to that of its principal trading partners was restored to the par exchange rate. The exemplar of central bank behavior was the Bank of England, which played by the rules over much of the period between 1870 and 1914. Whenever Great Britain faced a balance-of-payments deficit and the Bank of England saw its gold reserves declining, it raised its “bank rate” (discount rate). By causing other interest rates in the United Kingdom to rise as well, the rise in the bank rate was supposed to cause the holdings of inventories and other investment expenditures to decrease. These reductions would then cause a reduction in overall domestic spending and a fall in the price level. At the same time, the rise in the bank rate would stem any short-term capital outflow and attract short-term funds from abroad.
Most other countries on the gold standard—notably France and Belgium—did not follow the rules of the game. They never allowed interest rates to rise enough to decrease the domestic price level. Also, many countries frequently broke the rules by “sterilization”—shielding the domestic money supply from external disequilibrium by buying or selling domestic securities. If, for example, France’s central bank wished to prevent an inflow of gold from increasing the nation’s money supply, it would sell securities for gold, thus reducing the amount of gold circulating. Yet the central bankers’ breaches of the rules must be put into perspective. Although exchange rates in principal countries frequently deviated from par, governments rarely debased their currencies or otherwise manipulated the gold standard to support domestic economic activity. Suspension of convertibility in England (1797-1821, 1914-1925) and the United States (1862-1879) did occur in wartime emergencies. But, as promised, convertibility at the original parity was resumed after the emergency passed. These resumptions fortified the credibility of the gold standard rule.
But because economies under the gold standard were so vulnerable to real and monetary shocks, prices were highly unstable in the short run. Moreover, because the gold standard gives government very little discretion to use monetary policy, economies on the gold standard are less able to avoid or offset either monetary or real shocks. Not coincidentally, since the government could not have discretion over monetary policy, unemployment was higher during the gold standard years. Finally, any consideration of the pros and cons of the gold standard must include a large negative: the resource cost of producing gold. Milton Friedman estimated the cost of maintaining a full gold coin standard for the United States in 1960 to be more than 2.5 percent of GNP. In 2005, this cost would have been about $300 billion. Although the last vestiges of the gold standard disappeared in 1971, its appeal is still strong. Those who oppose giving discretionary powers to the central bank are attracted by the simplicity of its basic rule. Others view it as an effective anchor for the world price level. Still others look back longingly to the fixity of exchange rates. Despite its appeal, however, many of the conditions that made the gold standard so successful vanished in 1914. In particular, the importance that governments attach to full employment means that they are unlikely to make maintaining the gold standard link and its corollary, long-run price stability, the primary goal of economic policy.
So that’s all for now folks….
IASBakra 
Pingback: Regulators of Banks and various Financial Institutions in India | IASBakra