Monetary policy

Monetary policy has become the preferred policy instrument to be used in the pursuit of economic stability. It is customarily operated for that purpose by open market operations and by varying the central bank discount rate in response to indications concerning the degree of capacity utilisation in the economy. It has also been used as a temporary expedient to counter the threat of deflation by central bank purchases of government bonds and private sector securities - a practice termed quantitative easing or "credit easing" (and popularly known as "printing money"). The practice, advocated by proponents of monetarism, of the day-to-day targeting of monetary policy on the money supply in order to counter inflationary tendencies has generally fallen into disuse. Some authorities are, however, considering the use of monetary instruments to prevent the potentially destabilising buildup of asset-price bubbles.

Regulatory policy

Policy Objectives

The remits of the major central banks differ only in respect of the relative weights to be given to their objectives. The remit of the United States Federal Reserve Board is "to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates" . The remit given to the European Central Bank, on the other hand, assigns overriding importance to price stability by requiring it "without prejudice to the objective of price stability" to "support the general economic policies in the Community" including a "high level of employment" and "sustainable and non-inflationary growth". . The British Government's 1997 remit to the Bank of England also gives priority to the control of inflation by requiring it to "deliver price stability" ..."and without prejudice to that objective to support the Government's policies including its objectives for growth and employment"

The transmission mechanism

It operates by use of the central bank's power to control interest rates .). The effect an increase in interest rates is todiscourage borrowing and encourage savings and, because borrowers tend to spend more than savers, that discourages consumer spending. Also, mortgage lenders usually respond by raising their interest charges, leaving householders with less to spend.

The Taylor rule

Regulatory action depends mainly upon empirical data concerning the relation between the inflation rate and the output gap such as is embodied in the Taylor Rule.

Since it takes about a year for interest rate changes to affect output and about two years to affect inflation, policy action depends upon judgements of forthcoming inflation. The authorities make use of economic forecasting models to assist those judgements, but they usually take account also of a range of factors including inflationary expectations (as indicated by the differences between the prices of fixed-interest and index-linked bonds) and the state of the housing market.