Monetary policy

Learning outcomes

After studying this text the learner should / should be able to:

1. Appreciate the relationship between money and inflation.

2. Elucidate the origin of monetary policy.

3. Discuss the present status of monetary policy.

4. Expound on the monetary policy transmission mechanism.


After abandonment of the gold standard, countries' stocks of money were no longer constrained by a shortage of gold. Now it was up to governments to take on the responsibility for maintaining the value of the currency. The temptations were too large and many governments after WWI and WWII could not resist the temptation of creating money by borrowing from their non-independent central bank and the banks.

There are many examples of inflation after 1931, and a new term came into being: hyperinflation. The highest hyperinflation rate before the new century was recorded in Hungary in 1946. Amazingly, given the norm of sound monetary management examples after 1946, this record was breathtakingly exceeded in 2008 in Zimbabwe, which recorded an inflation rate of over seven sextillion percent per annum.

The source of inflation is excessive demand for loans leading to new money creation. As we know, since 1931, there is no natural brake on loan / money creation. Therefore, there has to be a policy on money creation: monetary policy, which is the primary function of the central bank (CB). And the primary operational tool of the CB is interest rates. Look at it this way: if the public regards bank deposits as the means of payments, and banks are able to create their own liabilities by making loans, there is theoretically an unlimited supply of funding. This is a recipe for close-to-zero interest rates (= limited or no price allocation function), and therefore high demand for loans, and therefore hyperinflation.

We know that hyperinflation creates major distortions and destroys economic growth. Therefore, an institution is required to set interest rates so that an allocation function is in place. This institution is the CB, and its responsibility is profound.

We have all been conditioned to believe that we live in a society / system that is well-ordered by a free market system. The most significant price, interest rates, is not a market-determined price, and central bankers are fallible, as evidenced in the continued existence of the cycles of boom and bust. The question arises: if central banks supervise banks, who supervises the central banks? It is supposed to be government, but governments are not always responsible either. These interesting issues are discussed in this section under the headings:

• Money and inflation.

• A policy on money: then.

• A policy on money: now.

• The path of monetary policy: from interest to inflation.

Money and inflation

Morgan136 stated in 1965: "So long as [inconvertible notes and deposits] retain public confidence, they have great advantages of convenience, but they are liable to abuse and, on many occasions in their... history, they have broken down. The government which adopts an inconvertible currency, therefore, takes on a heavy responsibility for maintaining its value..."

Box 1: Devaluation of money

Devaluation of money

It is interesting indeed to note that periods of high inflation in England occurred when the gold standard was suspended in 1797-1819 and 1914-1925. Newlyn informs us that the 1797-1819 period of inconvertibility (which coincided with the French wars) ".. .produced one of the first major loans inflations and it was followed by one of the most famous inquiries of the many inquiries that have taken place... their report blamed the inflation upon the excessive issues of bank notes by the Bank of England and the consequential excessive issues by the country banks."

We know that Britain also experienced high inflation during the 1914-1925 inconvertibility period, exacerbated by WWI. "Hyperinflation" became a new word in this period, but not in Britain; it reared its ugly head in Germany, also exacerbated by WWI. Germany at that time did not have a convertible currency. We also know that in the period after 1931, when the gold standard was finally done away with, many countries experienced hyperinflation, the highest being that of Hungary in 1946, as referred to earlier.

We also know that the inflation record of Hungary was finally broken in 2008 / 2009 by Zimbabwe. A reminder: there are no official numbers for the country, but John Robertson, a Zimbabwean economist, estimated the inflation rate to have been about 7 000 000 000 000 000 000 000 (7 sextillion) percent per annum. In 2009 the Zimbabwean dollar lost all its functions and qualities (medium of exchange, store of value and unit of account) when the USD and the ZAR (South African Rand) were officially designated legal tender.

Milton Friedman and Anna Schwartz famously wrote in the nineteen-seventies that "inflation is always and everywhere a monetary phenomenon."138 Today it is not even debated whether excessive monetary expansion causes inflation. It does! But how it comes about and what the consequences are, are the interesting parts of the equation.

On "how it comes about" we can only present you with a written offering at this stage of the discussion. In order to understand it fully, we need to conjure up the balance sheet analysis again. In short, the CB and the government are to blame. In most countries today the CB is immune to the monetary antics of government. If, for example, government borrowed excessively from the "institutions" and the banks (which could only happen at high rates of interest), the CB will most likely increase interest rates by a large margin to curb the demand for loans (which we know if satisfied creates money). In other words the independent CB will "lean against the wind".

In Zimbabwe the CB never was and still is not independent. The early phase of the inflationary period began with excessive borrowing from the banks by the issuing of treasury bills. This creates deposit money. Because inflation is rising, workers demand higher wages. In Zimbabwe government is the largest employer (civil service, defense force, police, etc.). More securities are issued to the banks which now demand higher rates, and so the process continues until a point of no return is reached: the dreaded debt trap. Government borrows more from the banks to pay interest on debt and the debt burden increases so that more is borrowed to pay the higher interest burden and so on and so on....

The government reaches a stage when it realizes that a major reason for the sharply rising inflation is the interest burden. It then, via the CB, influences interest rates down. The banks, adversely affected by the high inflation rate, and now lower interest rates (lower than inflation), refuse to buy any further treasury bills. Then the principal hyperinflation cause kicks in: government forces the CB to buy its debt. Not only does this create money, it also creates liquidity in the banking system and interest rates fall further in relation to inflation. From this point on hyperinflation surges and can no longer be stopped.

On the ground the population loses confidence in the currency. They become reluctant to accept it as a means of payment, preferring to use the little foreign currency that may be available. If they cannot refuse the local money, they spend it as rapidly as possible, because its purchasing power falls quickly. The rush to spend increases prices further. As prices rise rapidly, the producers of goods, such as farmers, hold their produce back from the market. The shortage of goods is exacerbated and prices rise still further.

This process is cumulative and ".. .the situation soon gets completely out of hand; money ceases to perform its function as a means of payment and the public falls back on foreign currencies or commodities, or even reverts to barter. This process, of course, involves great disorganization of economic life, and the only remedy is to scrap the dislocated currency and replace it."

The shortage of goods is exacerbated by producers of goods, again like the farmers, transporting their goods over borders at night and selling them for the neighbors' stable currency. In the Zimbabwean case goods were smuggled over borders into South Africa, Mozambique and Botswana. Another factor that played a role at some stages is that government declared that the prices of certain commodities (like maize) were fixed. As input costs (such as fuel and fertilizer) were not fixed the farmers stopped producing because severe losses stared them in the face. Thus, the supply of these goods dried up and prices increased further.

The consequences of hyperinflation are profound. Production fell sharply, in other words economic output declined. In terms of the identity MV = PT, M increased exponentially, V probably increased as people spent as rapidly as possible, P increased exponentially, while T (real GDP) fell sharply. Although economic numbers dried up in mid-2008, it is reliably reported that unemployment rose to over 90%. With increased poverty, cholera broke out and many thousands died. The demise of many HIV/Aids sufferers was accelerated. People jumped borders nightly to offer their labour in neighboring countries, not for money but for food. Those that could not find work had themselves apprehended by the across-border immigration authorities - because of the meal that was available. Many of the hunger-refugees were apprehended daily.

As we saw earlier, in early 2009 the Zimbabwean dollar lost all the qualities that made it money. Foreign currencies were adopted as the means of exchange.

In most countries the stock of money in circulation increases virtually each month and the task of the CB is to ensure that the increase remains in the moderate range. The objective (in most cases formalized in an inflation target set by government for the CB) is to ensure that inflation remains in an acceptable range or does not exceed a particular number. Many countries have adopted a target of a maximum inflation rate of 2% per annum. It is evident that this level is an acceptable "price" to pay for the benefits of money creation.

What are the benefits of money creation? The major benefit is that money is available for projects (= investments) and for consumption. This is "regulated" by the private sector banks in the first instance and the CB in the second. The first level involves the screening of the projects of corporations, and the creditworthiness of individuals. The second level involves responsible monetary policy: a policy on money.

As you know, in 2008 neither level of responsibility was effectively executed. The underlying problem, which was not well recognized, was excessive money creation for the previous four to five years. It was a failure of monetary policy (inter alia). However, as indicated in the foregoing, the world experienced worse situations in the past. And we have the satisfaction of knowing that the central banks had the right tools to quickly reverse the 2008/09 recession. These tools have to do with money and the price of money, interest rates, and, judging by the shortness of the recession, they are effective.

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