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Monetary policy of central banks

Central banks set monetary policy. The primary objective of monetary policy is either to influence the price of money (the interest rate) or the quantity of money. In essence, the two approaches are equivalent; for any quantity of money, there is an implied interest rate, and vice versa. The relationship between the price and quantity of money is given by the demand for money.

The central bank influences interest rates by expanding or contracting base money, which consists of currency in circulation and banks' reserves on deposit at the central bank. The primary ways that the central bank can affect base money is by open market purchases or sales of 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. 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 base money analogous to open market purchases and sales of government debt; if the central bank buys foreign exchange, base money increases, and vice versa. 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 decrease base money 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.

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 base money rapidly. In general, central banks in developing countries have had a poor record in managing monetary policy.

Finally, 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[?]). The Austrian school of economics[?], which includes Friedrich von Hayek and Ludwig von Mises, among others, contends that central banks actually cause business cycles by setting interest rates lower than they would be set in a free market. Recent experience in Japan and the United States lends credibility to the Austrian argument, but most economists fall into either the Keynesian or neoclassical camps on this issue.

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