Are we the great British Public responsible for the recent hikes in interest rates?

Question

I mean If we didn't have a culture of spending and loaning money the economy would be stable would it not. Or are these interest rate hikes meant to make the economy more stable?

Please explain to this uneducated one in the economy of this country.... UK. Thank you.

I've taken the hint bluescap....phew I asked for a reply not a thesis

Answer 1

It is a complicated question and I don´t have a complete answer.

Money is actually all borrowed - for every pound in your pocket came from a bank that lent the money to someone who used it to buy something (such as a house) and that money ended up in your pocket.

With low interest rates it is easy to borrow money (as the repayments are low) so people tend to borrow lots. This causes an economic boom with lots of people spending the borrowed money, and lots of people working hard to provide goods and services to them.
Conversely when interest rates are high there are not so many loans so there is less money swilling about.
Governments and central banks use interest rates to control these patterns, and for political reasons (such as wanting to get re-elected) they often make them go up and down, causing economic cycles.

The great british public is not responsible for the recent interest rate hikes - the Bank of England is, and this is as a result of the policies of the chancellor Gordon Brown.

Answer 2

Interest rates were until some 10 years ago set by the chancelor of the Exchequer,but since then they have been set by the Bank of England and announced by the Govener of the bank,They are reviewed every month from the statistics collected by its review body and published monthly.
They are set by the bank to controll inflation,Inflation is caused by many factors,high street spending,house prices,foriegn exchange rates,taxation,balance of payments,personal savings,industrial investment and economic growth to name but a few,the bank will increase the interest rates on loans accordigly in line with national trends in general spending,ie,if we spend more the economy can increase to quickly and a run on prices will occure,more money out and less in.
To counter this the bank make borrowing more expensive and the result is to curb our spending on luxury goods and services,it will put more money back into investments and savings.
So to put it simply,,,,if we spend more than the economy can handle the interest rates go up,and vice versa.So yes we are responsible as a country for the interest rate hikes,you can bet there will be at least 1 more this year and possibly 2

Answer 3

In a global economy the interest rates depend more on flows of capital, trade and business activity than household behavior in the country. Domestic savings levels still matter but in most countries much of domestic savings/borrowing is done by business and government. Household behavior varies least overtime varying less than 1/3 as much as business investment.
The business cycle (economic Instability) is a phenomenon exhibited by capitalist economies and capital markets. However capital markets are also what allows investment to flow to the most productive sectors and produce economic growth. No one has figured out how to get the benefits without some instability, but monetary policy (interest rate and money supply manipulation by central bank) seem to damp down the fluctuations. Read more at http://www.finpipe.com/monpol.htm

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Answer 5

To put it simply, when we're borrowing a lot, interest rates go up. When we're saving a lot, interest rates go down.

You could argue we're responsible for interest rates going up but personally, I like to place the blame with the credit card and loan companies that allow people on an average wage to get themselves into tens of thousands of pounds worth of debt and the mortgage companies that offer first time buyers mortgages that are 5 times their annual salary.

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Answer 7

Interest
From Wikipedia, the free encyclopedia
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This article or section needs copy editing for grammar, style, cohesion, tone and/or spelling.
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This article has been tagged since February 2007.
For other senses of this word, see interest (disambiguation).
Interest is the fee paid on borrowed money. The lender receives a compensation for foregoing other uses of their funds, including (for example) deferring their own consumption. The original amount lent is called the "principal," and the percentage of the principal which is paid/payable over a period of time is the "interest rate."

Contents [hide]
1 Types of interest
1.1 Simple interest
1.2 Compound interest
1.2.1 Fixed and floating rates
1.3 Real interest
1.4 Cumulative interest or return
1.5 Other conventions and uses
2 Market interest rates
3 Interest rates in macroeconomics
3.1 Output and unemployment
3.2 Open Market Operations in the United States
3.3 Interest Rates and Credit Risk
3.4 Money and inflation
4 History
5 See also
6 References
7 External links



[edit] Types of interest

[edit] Simple interest
Simple interest: simple interest does not take compounding into account, and is determined by multiplying the principal by the interest rate (per period) by the number of time periods.

To calculate: Add up all the interest paid/payable in a period. Divide that by the principal at the beginning of the period. E.g. on $100 (principal):

credit card debt where $1/day is charged. 1/100 = 1%/day.
corporate bond where $3 is due after six months, and another $3 is due at year end. (3+3)/100 = 6%/year.
certificate of deposit (GIC) where $6 is paid at year end. 6/100 = 6%/year.
There are three problems with simple interest.

The time periods used for measurement can be different, making comparisons wrong. You cannot say the 1%/day credit card interest is 'equal' to a 365%/year GIC.
The time value of money means that $3 paid every six months hurts more than $6 paid only at year end. So you cannot 'equate' the 6% bond to the 6% GIC.
When interest is due, but not paid, it must be clear what happens. Does it remain 'interest payable', like the bond's $3 payment after six months? Or does it get added to the original principal, like the 1%/day on the credit card? Each time it is added to the principal it 'compounds'. The interest from that time forward is calculated on that (now larger) principal. The more frequent the compounding, the faster the principal grows, and the greater the interest amount is.

[edit] Compound interest
Compound interest: In order to solve these three problems, there is a convention in economics that interest rates will be disclosed as if the term is one year and the compounding is yearly, otherwise known as the effective interest rate. The discussion at compound interest shows how to convert to and from the different measures of interest. Interest rates in lending are often quoted as nominal interest rates (compounding interest uncorrected for the frequency of compounding. Loans often include various non-interest charges and fees (such as points on a mortgage loan in the United States; many jurisdictions require lenders to provide information on the 'true' cost of finance, often expressed as an annual percentage rate, which expresses the total cost of a loan as an interest rate after including the additional fees and expenses (the details, however, vary). In economics, continuous compounding is often used due to specific mathematical properties.


[edit] Fixed and floating rates
Loans may not always have a single interest rate over the life of the loan (although they generally still use compound interest). Loans for which the interest rate does not change are referred to as fixed rate loans. Loans may also have a changeable rate over the life of the loan based on some reference rate (such as LIBOR), usually plus (or minus) a fixed margin. These are known as floating rate, variable rate or adjustable rate loans. Combinations of fixed-rate and floating-rate loans are possible and frequently used. Less frequently, loans may have different interest rates applied over the life of the loan, where the changes to the interest rate are not tied to an underlying interest rate (for example, a loan may have a rate of 5% in the first year, 6% in the second, and 7% in the third).

The formula to calculate CI is = [P(1+R/100)^n] - P where P = Amount deposited

R = Rate of Interest
n = number of years
^ = Raised to the power of i.e., n

[edit] Real interest
Real interest: This is approximated as (nominal interest rate) - (inflation). It attempts to measure the value of the interest in units of stable purchasing power. See the discussion at real interest rate.


[edit] Cumulative interest or return
Cumulative interest/return: This calculation is (FV/PV)-1. It ignores the 'per year' convention and assumes compounding at every payment date. It is usually used to compare two long term opportunities. Since the difference in rates gets magnified by time, so the speaker's point is more clearly made.


[edit] Other conventions and uses
Other exceptions:

US and Canadian T-Bills (short term Government debt) have a different convention. Their interest is calculated as (100-P)/P where 'P' is the price paid. Instead of normalizing it to a year, the interest is prorated by the number of days 't': (365/t)*100. (See also: Day count convention). The total calculation is ((100-P)/P)*((365/t)*100)
Corporate Bonds are most frequently payable twice yearly. The amount of interest paid is the simple interest disclosed divided by two (multiplied by the face value of debt).
Rule of 78: Some consumer loans calculate interest by the "Rule of 78" or "Sum of digits" method. Seventy-eight is the sum of the numbers 1 through 12, inclusive. The practice enabled quick calculations of interest in the pre-computer days. In a loan with interest calculated per the Rule of 78, the total interest over the life of the loan is calculated as either simple or compound interest and amounts to the same as either of the above methods. Payments remain constant over the life of the loan; however, payments are allocated to interest in progressively smaller amounts. In a one-year loan, in the first month, 12/78 of all interest owed over the life of the loan is due; in the second month, 11/78; progressing to the twelfth month where only 1/78 of all interest is due. The practical effect of the Rule of 78 is to make early pay-offs of term loans more expensive. Approximately 3/4 of all interest due on a one year loan is collected by the sixth month, and pay-off of the principal then will cause the effective interest rate to be much higher than than the APY used to calculate the payments. [1]

The United States outlawed the use of "Rule of 78" interest in loans over five years in term. Certain other jurisdictions have outlawed application of the Rule of 78 in certain types of loans, particularly consumer loans. [2]

Rule of 72: The "Rule of 72" is a "quick and dirty" method for finding out how fast money doubles for a given interest rate. For example, if you have an interest rate of 6%, it will take 72/6 or 12 years for your money to double, compounding at 6%. This is an approximation that starts to break down above 10%.


[edit] Market interest rates
There are markets for investments which include the money market, bond market, as well as retail financial institutions like banks, which set interest rates. Each specific debt takes into account the following factors in determining its interest rate:

Opportunity cost: This encompasses any other use to which the money could be put, including lending to others, investing elsewhere, holding cash (for safety, for example), and simply spending the funds.

Inflation: Since the lender is deferring his consumption, he will at a bare minimum, want to recover enough to pay the increased cost of goods due to inflation. Because future inflation is unknown, there are three tactics.

Charge X% interest 'plus inflation'. Many governments issue 'real-return' or 'inflation indexed' bonds. The principal amount and the interest payments are continually increased by the rate of inflations. See the discussion at real interest rate.
Decide on the 'expected' inflation rate. This still leaves both parties exposed to the risk of 'unexpected' inflation.
Allow the interest rate to be periodically changed. While a 'fixed interest rate' remains the same throughout the life of the debt, 'variable' or 'floating' rates can be reset. There are derivative products that allow for hedging and swaps between the two.
Default: There is always the risk the borrower will become bankrupt, abscond or otherwise default on the loan. The risk premium attempts to measure the integrity of the borrower, the risk of his enterprise succeeding and the security of any collateral pledged. For example, loans to developing countries have higher risk premiums than those to the US government due to the difference in creditworthiness. An operating line of credit to a business will have a higher rate than a mortgage.

Creditworthiness of businesses is measured by bond rating services and individual's credit scores by credit bureaus. The risks of an individual debt may have a large standard deviation of possibilities. The lender may want to cover his maximum risk. But lenders with portfolios of debt can lower the risk premium to cover just the most probable outcome.

Deferred consumption: Charging interest equal only to inflation will leave the lender with the same purchasing power, but he would prefer his own consumption NOW rather than later. There will be an interest premium of the delay. See the discussion at time value of money. He may not want to consume, but instead would invest in another product. The possible return he could realize in competing investments will determine what interest he charges.

Length of time: Time has two effects.

Shorter terms have less risk of default and inflation because the near future is easier to predict than events 20 year off.
Longer terms allow for investments in larger projects with higher eventual returns. Contrast this to the lender's preference for readily available cash for contingencies. This is why banks pay higher interest on non-redeemable GICs than on chequing account balances.
Long-term interest rates fell in much of the developed world in the second half of 2006.
Other: Borrowers and lenders may face individual tax rates, transaction costs and foreign exchange rate risks. In a liquid market they cannot exert their personal preferences. It is the sum total of the participants who determine rates. The market for financial instruments has moved from the local, to the national, and is now international.


[edit] Interest rates in macroeconomics

[edit] Output and unemployment
Interest rates are the main determinant of investment on a macroeconomic scale. Broadly speaking, if interest rates increase, then investment decreases due to the higher cost of borrowing (all else being equal).

Interest rates are generally determined by the market, but government intervention - usually by a central bank- may strongly influence short-term interest rates, and is used as the main tool of monetary policy. The central bank offers to buy or sell money at the desired rate and, due to their control of certain tools (such as, in many countries, the ability to print money) they are able to influence overall market interest rates.

Investment can change rapidly to changes in interest rates, affecting national income, and, through Okun's Law, changes in output affect unemployment.


[edit] Open Market Operations in the United States

The effective federal funds rate charted over fifty yearsThe Federal Reserve (often referred to as 'The Fed') implements monetary policy largely by targeting the federal funds rate. This is the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed.

Open market operations are one tool within monetary policy implemented by the Federal Reserve to steer short-term interest rates. Using the power to buy and sell treasury securities, the Open Market Desk at the Federal Reserve Bank of New York can supply the market with dollars by purchasing T-notes, hence increasing the nation's money supply. By increasing the money supply or Aggregate Supply of Funding (ASF), interest rates will fall due to the excess of dollars banks will end up with in their reserves. Excess reserves may be lent in the Fed funds market to other banks, thus driving down rates.


[edit] Interest Rates and Credit Risk
It is increasingly recognized that the business cycle, interest rates and credit risk are tightly interrelated. The Jarrow Turnbull Model was the first model of credit risk which explicitly had random interest rates at its core. Lando (2004), Darrell Duffie and Singleton (2003), and van Deventer and Imai (2003) discuss interest rates when the issuer of the interest-bearing instrument can default.


[edit] Money and inflation
Loans, bonds, and shares have some of the characteristics of money and are included in the broad money supply.

By setting i*n, the government institution can affect the markets to alter the total of loans, bonds and shares issued. Generally speaking, a higher real interest rate reduces the broad money supply.

Through the quantity theory of money, increases in the money supply lead to inflation. This means that interest rates can affect inflation in the future.


[edit] History
The collection of interest was restricted by Jewish, Christian, Islam and other religions under laws of usury. This is still the case with Islam, which mandates no-interest Islamic finance.[3]

Irving Fisher is largely responsible for shaping the modern concept of interest with his 1930 work, The Theory of Interest.


[edit] See also
Look up interest in Wiktionary, the free dictionary.Rate of return on investment
Credit rating agency
Credit card interest
Fisher equation
Mortgage loan
Risk-free interest rate
Yield curve
Time Value of Money
Usury
Monetary policy
Cash accumulation equation


Monetary policy
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Monetary policy is the process by which the government, central bank, or monetary authority manages the money supply to achieve specific goals—such as constraining inflation or deflation, maintaining an exchange rate, achieving full employment or economic growth. (Usually the goal of monetary policy is to accommodate economic growth in an environment of stable prices.) Monetary policy can involve changing certain interest rates, either directly or indirectly through open market operations, setting reserve requirements, acting as a last-resort lender (i.e. discount window lending), or trading in foreign exchange markets. [1]

Monetary policy is generally 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 has the goal of raising interest rates to combat inflation (or cool an otherwise overheated economy). Monetary policy should be contrasted with fiscal policy, which refers to government borrowing, spending and taxation.

Contents [hide]
1 Overview
2 History of monetary policy
3 Trends in central banking
4 Developing countries
5 Types of monetary policy
5.1 Inflation targeting
5.2 Price level targeting
5.3 Monetary aggregates
5.4 Fixed exchange rate
5.5 Managed Float
5.6 Gold standard
5.7 Mixed policy
6 Monetary policy tools
6.1 Monetary base
6.2 Reserve requirements
6.3 Discount window lending
6.4 Interest rates
7 Currency board
8 Monetary policy theory
9 Monetary policy used by various nations
10 References
11 See also



[edit] 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. Further monetary policies are described as accommodative if the interest rate set by the central monetary authority is intended to spur economic growth, neutral if it is intended to neither spur 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. And even prior to the 1970s, the Bretton 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 or the Federal Reserve System in the United States) exist which have the task of executing the monetary policy 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, however, 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.


[edit] History of monetary policy
Monetary policy is associated with currency and credit. For many centuries there were only two forms of monetary policy: decisions about coinage, and the decision 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. Monetary policy was seen as an executive decision, and was generally in the hands of the authority with seniorage, 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. [2] 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 back 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. [3] By this point the understanding 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.)

The advancement of monetary policy as an engineering discipline has been quite rapid in the last 150 years, and it has increased especially rapidly in the last 50 years. Monetary policy has grown from simply increasing the monetary supply enough to keep up with both population growth and economic activity. It must now take into account such diverse factors 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.

Most 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; they can turn any financial risk into a known dollar amount and therefore make business predictable and more profitable for everyone involved.


[edit] 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 (basically 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. [4] 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. Independence has not stunted a thriving crop of conspiracy theories about the true motives of a given action of monetary policy.

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. That is, 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%.

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 Misesan's arguments, but most economists fall into either the Keynesian or neoclassical camps on this issue.


[edit] Developing countries
Developing countries may have problems operating monetary policy effectively. 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, central banks in developing countries have had a poor record in managing monetary policy.

However, recent attempts at liberalising and reforming the financial markets particularly the recapitalisation of banks and other financial institutions in Nigeria and elsewhere are gradually providing the leeway required to implement monetary policy frameworks by the relevant central banks.


[edit] 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 is called open market operations.

Constant market transactions by the monetary authority modify the liquidity of currency and this impacts other market variables such as short term interest rates, the exchange rate and the domestic price of spot market commodities such as gold. Open market operations are undertaken with the objective of stabilizing one of these market variables.

The distinction between the various types of monetary policy lies primarily with the market variable that open market operations are used to target. Targeting being the process of achieving relative stability in the target variable.




Monetary Policy: Target Market Variable: Long Term Objective:
Inflation Targeting Interest rate on overnight debt A given rate of change in the CPI
Price Level Targeting Interest rate on overnight debt A specific CPI number
Monetary Aggregates The growth in money supply A given rate of change in the CPI
Fixed Exchange Rate The spot price of the currency The spot price of the currency
Gold Standard The spot price of gold Low inflation as measured by the 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 harmonised consumer price index).


[edit] Inflation targeting
Under this policy approach the target is to keep inflation, under a particular definition such as Consumer Price Index, at a particular level.

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 over night 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 done 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.

This monetary policy approach was pioneered in New Zealand. It is currently used in the Eurozone, Australia, Canada, New Zealand, Norway, Poland, Sweden, South Africa, Turkey, and the United Kingdom.


[edit] 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 like price level targeting was tried in the 1930s by Sweden, 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.


[edit] 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.

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


[edit] Fixed exchange rate
This policy is based on maintaining a fixed exchange rate with a foreign currency. Currency is bought and sold by the central bank on a daily basis to achieve the target exchange rate. This policy somewhat abdicates responsibility for monetary policy to a foreign government.

This type of policy was used by China. The Chinese yuan was managed such that its exchange rate with the United States dollar was fixed.

See also: List of fixed currencies





[edit] Managed Float
Officially, the Indian Rupee (INR) exchange rate is supposed to be 'market determined'. In reality, the Reserve Bank of India (RBI) trades actively on the INR/USD with the purpose of controlling the volatility of the Rupee - US Dollar exchange rate - within a narrow bandwidth. ( i.e pegs it to the US Dollar )

Other rates - like the INR/Pound or the INR/JPY - have volatilities which reflect the volatilities of the US/Pound and the US/JPY respectively.

The pegged exchange rate is accompanied by an elaborate system of capital controls.

- On the current account, there are no currency conversion restrictions hindering buying or selling foreign exchange (though trade barriers do exist).

- On the capital account, "foreign institutional investors" have convertibility to bring money in and out of the country and buy securities (subject to an elaborate maze of quantitative restrictions).

- Local firms are able to take capital out of the country in order to expand globally.

- Local households have quantitative restrictions( which are being relaxed in recent times) in their ability to do global diversification . ( example while local firms can buy real estate - individuals may not). However they are able to purchase items ( mainly consumer items - say a laptop) and services reasonably freely ( there are quantitative restrictions ). Most of these transactions happen through credit cards through the internet.

Owing to an enormous expansion of the current account and the capital account, India is increasingly moving into de facto convertibility. However - it still cannot be considered a fully convertible currency.

The INR is not a highly traded currency - beyond India. It is traded by way of Forwards through inter bank transactions. ( again the US Dollar exchange rate determines the INR / other Crosses exchange rate )

As any currency traded in the international market - the INR does trade at a market determined premium / discount for the forward months.


[edit] Gold standard
The gold standard is a system in which the price of the national currency as measured in units of gold is kept constant by the daily buying and selling of base currency. (i.e. open market operations, cf. above).

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, 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.


[edit] Mixed policy
In practice a mixed policy approach is most like "inflation targeting". However some consideration is also given to other goals such as economic growth, unemployment and asset bubbles.

This type of policy was used by the Federal Reserve in 1998.


[edit] Monetary policy tools

[edit] 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.


[edit] 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.


[edit] 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.


[edit] 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.

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 lending. Both of these effects reduce the size of the money supply.


[edit] Currency board
Main article: currency board
A currency board is a monetary authority which is required to maintain an exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target.

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 emphasised the fact that currency boards are not irrevocable, and hence may be abandoned in the face of speculation by foreign exchange traders.

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.

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.


[edit] Monetary policy theory
It is important for policymakers to make credible announcements regarding their 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 behaviour 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.

However, 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.

However, 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. Therefore, (unless policymakers can make their announcement of low inflation credible), private agents expect high inflation. This anticipation is fulfilled through adaptive expectation (wage-setting behaviour) and 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 would markets 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 her or his 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.


[edit] Monetary policy used by various nations
Australia - Inflation Targeting
Canada - Inflation Targeting
China - Targets a currency basket
Eurozone - Inflation Targeting
Hong Kong - Fixed Exchange Rate (US dollar)
New Zealand - Inflation Targeting
United Kingdom[5] - Inflation Targeting, although with some focus on wide issues
United States [6] - Mixed policy

[edit] References
^ "Monetary Policy", Federal Reserve Board, January 3, 2006.
^ "Bank of England founded 1694", BBC, March 31, 2006.
^ "Federal Reserve Act", Federal Reserve Board, May 14, 2003.
^ "Exchange Rates", The Library of Economics and Liberty, March 31, 2006.
^ "Monetary Policy Framework", Bank Of England, 2006.
^ "U.S. Monetary Policy: An Introduction", Federal Bank of San Francisco, 2004.

[edit] See also
Contractionary monetary policy
Currency devaluation
Digital gold currency
Macroeconomic policy instruments
Expansionary monetary policy
Monetary base
Monetary policy of the Eurozone
Monetary policy of the USA
Monetary policy of Sweden
Money
Quantity theory of money
International reserve system
Private currency
Inconsistent trinity
Hafsa Begum
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