Monetary Policy in Theory and Practice LARS HORNGREN In Sweden, as in many other countries, monetary policy is aimed at controlling the gene- ral development of prices. The relationships between monetary policy, its instruments and price formation are discussed in this article together with the significance of these relationships’ characteristics for monetary policy’s implementation. In January 1993 the Governing Board of the Riksbank stated that the monetary po- licy target is to »limit the annual increase in the consumer price index in 1995 and onwards to 2 per cent, with a degree of tole- rance of +/- 1 per cent. It is primarily in the private sector, however, that prices for goods and services are actually set. In or- der to influence the overall development of prices ~ the aggregate result of millions of individual decisions ~ the Riksbank has to operate indirectly. In order to understand how monetary policy works, itis therefore necessary to de- tail the instruments a central bank is able touse, as well as how these instruments im- pinge on price developments. In this article I shall discuss the relationships between central bank instruments and price devel- opment in principle. In conclusion I shall consider the significance of these relations- hips for the implementation of monetary policy. ‘The Governing Board’s motivation for the decision quoted above was that »Price stability is a prerequisite for sustained eco- nomic growth as well as full employment and it prevents an arbitrary redistribution of income and wealth«, In the present con- Lars Horngren, Senior Adviser, Sveriges Riksbank. text I shall not go into the reasons why price stability is an important economic policy objective.! Effects of monetary policy — general principles The defining characteristic of a central bank is that it issues »money« (in the form of bank notes and coins) and does so in practice with an exclusive right. Bank no- tes are not the only means of making pay- ments; the alternatives include giro tran- sactions, checks and credit cards. But the central bank has the exclusive right to create assets that can be used for final pay- ‘ment. A payment is final when no further transactions are required to give the payee access to the due amount. Notes have this property. The final settlement of a giro payment occurs when the amount is credi- ted to the payee’s bank account. The trans- fer is arranged on the banks’ accounts with the central bank, which means that the central bank is involved also in such cases. 1. The choice ofa monetary policy objective is discus sed by Svensson (1994), where further references will be found, 2.Central bank clearing systems are described in ‘more detail by Barr (1994) —5-QUARTERLY REVIEW 1995:3 An analysis of monetary policy and its effects therefore has to start from the role of the central bank as the creator of means of payment. Monetary policy is basically a matter of the central bank’s management of its monopoly. What, then, has monetary policy to do with inflation? The connection will be clea- rer if we reformulate inflation as the dep ciation of money. A general price rise is eq valent to a fall in the value of money mea- sured in terms of goods and services. Changes in the price level are therefore in- extricably linked to the value of the central bank’s monopoly product. In simple terms, inflation is what happens when the supply of money has grown faster than de- mand. If people have a surplus amount of money (in the sense of means of payment), they will spend it on additional goods and services. The increased demand causes prices to rise. The money that is spent re~ mains in circulation — it simply changes hands from buyers to sellers ~ but the hig- her prices mean that an increasing amount of money is needed to complete the tran- sactions of households, firms and others. The process of inflation continues until pri ces have risen to the point at which de- mand matches the amount of money sup- plied by the central bank. Seen from this angle, inflation is inextri- cably linked to the action of the central bank. However, that does not mean that the central bank lies behind every change in the price level. A general impact on pri- ces may come, for instance, from autono- mous wage and price increases or from fi- nancial developments that are initiated in- dependently of monetary policy. But it is 3. fuller account would also include demand for f- nancial assets, imported goods, etc., but my purpose here is simply toillustrate the most fundamental mec- anisms. the monetary policy reaction to these changes that determines whether or not they become permanent. Higher prices lead to an increased demand for money and if the central bank meets this demand by increasing the money supply — com- monly referred to as an accommodating mo- netary policy ~ the upward shift in the price level will become permanent. If the central bank refrains from increasing the money supply, on the other hand, the re- verse of the process described above will lead to a downward adjustment of prices until they return to their initial level. In this highly stylized account, mone- tary policy works in simple ways. The si: tuation in reality is less straightforward be- cause the economy and the inflation pro- cess are both more complex than assumed above. It is often difficult, for instance, to tell how demand for money is developing and this leads to uncertainty about how the money supply should be managed with a view to promoting price stability. More- over, instead of affecting prices directly, monetary policy works via the demand for and production of goods and services. This means that the adjustment process invol- ves changes in quantities as well as in pri- ces. The interrelationships in this respect are often difficult to predict and interpret. The ways in which monetary policy acts must therefore be analyzed more closely. The transmission mechanism A more detailed study can start by conside- ring the ways in which central bank measu- res affect the economy and the price level ~ a process known as the transmission mecha- nism. The following general account of the transmission mechanism rests on two im- portant premises. One is the assumption that monetary policy is conducted by the central bankQUARTERLY REVIEW 1995:3 with the aid of interest rate targeting. This is currently the case in all the industrialized countries, including Sweden. It is the cen- tral bank's role as the producer of means of payment that enables it to target interest rates, This monopoly allows the central bank to control the overnight rate on inter- bank loans for balances with the central bank* Interest rate targeting modifies the de- scription of monetary policy effects compa- red with the earlier assumption that the central bank uses its monopoly to deter- mine the money supply directly. But the basic mechanisms are the same. An inte- rest rate cut has the same effects in prin- ciple as an increased supply of money, just as a higher interest rate corresponds to a decreased supply.> ‘The other premise is that monetary po- licy effects are primarily transmitted via aggregate demand. If the growth of demand exceeds the expansion of production capa- city, inflationary pressure will grow and vice versa. Matters are complicated by the fact that the process is also affected by expectations of future policy. To the extent that price in- creases are duc to expectations that infla- tion will be allowed to accelerate in the fu- ture, inflation can be held in check by con- ducting monetary policy so that expecta- tions change. In many cases, however, this also calls for a period of restrictive policies 4. In the Swedish system of interest rate management the Riksbank uses its repo rate to indicate the ap- proximate level of the overnight rate, The system is. described by Homgren (1994). 5, Note that when the central bank operates by mana- ging interest rates, the money stock is determined by demand. The central bank can influence the money stock by adjusting interest rates so that money de~ ‘mand changes; but at any given level of interest rates the central bank must provide the amount of money which the non-bank public demands. because the central bank may need to re- sort to tangible measures — in the form of interest rate increases ~ to demonstrate that the inflation expectations are unfoun- ded. Via its effect on demand, monetary po- licy influences production and employ- ment. By stabilizing demand, monetary policy is thus able to stabilize production. But monetary policy cannot be expected to have any lasting (positive) effects on pro- duction and growth ~ it cannot contribute toa permanently higher growth rate. This view leads to the conclusion that price sta- bility is only feasible long-term objective for monetary policy.® ‘The transmission mechanism accor- dingly has to do with how changes in the short-term interest rate affect demand and how this shows up in prices. A useful app- roach to these effects is to consider them as three components: the interest rate chan- nel, the exchange rate channel and the cre~ dit channel. For the sake of simplicity, the following account refers throughout to an increase in the instrumental rate, that is, a tightening of the monetary stance. The interest rate channel ‘The interest rate channel describes the most direct effects of an altered instrumen- tal rate, When the central bank raises the instrumental rate, the short market inte- 6. Note that monetary policy can harm economic ‘growth and other policy targets if it contributes to in- stability and high inflation. The damage includes hig- her unemployment in periods when the rate of infla- tion is being brought down. Fears of this leading to permanently higher unemployment underscore the importance of safeguarding price stability. The short- and medium-term trade-ofls between price stability and stable employment are discussed by Svensson (1994),QUARTERLY REVIEW 1995:3 rest rates move up more or less proportio- nally. An agent with funds to invest for, say, a week can now obtain a higher yield by lending on a daily basis in the overnight market. To attract funds for a week, bor- rowers must therefore offer a higher rate. The higher cost of short-term borrowing generates increased demand for longer loans. But as short-term investments have become more attractive, the supply of longer credits diminishes. As a result, longer interest rates also tend to rise. The longer the expected duration of the higher short-term interest rate, the more pro- nounced will be the upward tendency in the longer rates. Higher interest rates make saving —post- poning consumption ~ more attractive. A similar effect comes via lower asset values. ‘The prices of both financial and real assets (shares, long bonds, real estate, etc.) fall because the present value of their future re- turn is lower when interest rates rise. Hou- seholds with a shrinking stock of wealth be- come less prone to consume. The higher in- terest rates also add to the cost of financing real capital formation. Consequently, hig- her interest rates curb demand from house- holds as well as firms. Other things equal, the inflationary pressure eases.’ The exchange rate channel This channel exists because monetary po- licy also affects the exchange rate. With all 7.t should be added that while the central bank is able to influence nominal interest rates, many econo- ‘mic decisions are governed by real interest rates, in principle the nominal rate less the expected rate ofin- flation during the period to maturity. However, as in- flation expectations are rigid in the short run, changes in the nominal rate on short-term assets are matched by shifts in short real rates. On the other hand, the central bank is notin a position to control longer real else equal, an increase in the instrumental rate normally leads to a stronger exchange rate. This is because in the short run, hig- her interest rates make domestic assets more attractive relative to investments in other currencies. The resultant capital in- flow involves increased demand for the do- mestic currency, which strengthens the ex- change rate. Monetary policy is also important for the exchange rate in the long term. The ex- change rate is, by definition, the price of the domestic currency expressed in the cur- rency of another country, which means that it is influenced by country differences in the rate of inflation. A tighter monetary policy implies a lower rate of inflation and this in time can be expected to lead to a stronger exchange rate. ‘An appreciation of the domestic cur- rency has two main effects. One is that the prices of foreign goods falls relative to those of domestic products, which stimulates im- ports and curbs exports. The resultant weakening of demand for domestic pro- ducts eases inflationary pressure. In addition, the price level is directly af= fected by the exchange rate in that shifts in the latter alter the domestic currency pri- ces of traded goods. In this way an appre- ciation tends to lower the rate of inflation by making imports and goods competing with imports cheaper. That reinforces the anti-inflationary effect of decreased de- mand pressure. However, the direct effect of an exchange rate adjustment on the price level occurs once and for all and by itselfhas no impact on the underlying price trend. It should be stressed that current mone- tary policy is by no means the only factor that acts on the exchange rate, particularly in the short run, Other factors include the budget situation. Excessively large budget deficits undermine confidence in long-term ~8-QUARTERLY REVIEW 1995:3 price stability. Fears of future inflation weaken the current exchange rate and this may fuel inflation via the mechanisms out- lined above. In order to preempt self-fulfl- ling expectations, such uncertainty must then be countered by the central bank via increased interest rates. The credit channel ‘The third channel, finally, concerns ways in which monetary policy affects the level of demand via banks and other credit insti- tutions. The argument here is that some borrowers (small and medium-sized firms in particular) are not in a position to bor- row in the securities market and are depen- dent on bank loans. This has to do with the cost of obtaining information about the sol- vency of potential borrowers. When a firm borrows from a bank, the credit assessment is made by a single agent. In securities markets, where a great many agents fi- nance the credits, the cost of valuations and surveillance is very much higher un- less the borrower is already large and well known, for instance because its shares are listed on the stock exchange. When market interest rates rise, banks will choose to curtail their lending and buy. bonds instead. Bank borrowers then have less access to credit. In this situation bank lending rates are likely to rise but it is not certain that loans will be provided for firms that are prepared to pay the higher rates. This is because there is reason to fear that borrowers who are prepared to pay high rates for loans will be less prone to service and repay them. A similar effect from in- creased interest rates and their downward impact on demand is that firms adjust to a lower expected profitability and become less prepared and able to carry debt. Firms that are not allowed or prepared to borrow have to cut back their operations, postpone investments and so on, leading to weaker demand. A point worth noting is that banks may also counter monetary policy effects by rai sing their lending rates to established cus- tomers by less than the increase in market rates. This is because a bank tends to have long-term relationships with many of its customers and can therefore count on re- couping the interest income when business is booming and customers are prepared to pay a slightly higher rate in order to main- tain the established link with the bank. While this does counter the restrictive ef fect of a higher instrumental rate, it does not disrupt the credit channel be: her borrowers lack such close bank. Perhaps the clearest instance of this is people who are planning to start a firm. All this means that a tighter monetary stance (a higher instrumental rate) re- strains demand via all three channels and inflationary pressure is thereby subdued. It also shows that monetary policy has its primary effects on the economy in gene- ral — consumption, production, employ- ment, etc. When demand approaches the capacity ceiling, monetary policy should act so that demand is subdued and vice versa. In general it can therefore be said that if monetary policy succeeds in stabili- zing the price level, it also contributes to the stabilization of demand and employ- ment. Under these conditions demand will follow the development of production ca~ pacity. The situation will then be one of price stability, not in the sense that the rate of inflation ceases to fluctuate but that re- current overheating followed by setbacks can be avoided. Designing monetary policy As noted already, the ultimate objective of monetary policy is price stability (low in- -g-QUARTERLY REVIEW 1995:3 flation). The central bank’s instrument for achieving this objective is the short interest rate. Thus it is up to the central bank to set the instrumental rate so that the price level - via the transmission mechanism — remains stable. This task is easy to formu- late but a number of factors complicate its execution in practice. The transmission mechanism was desc- ribed above in purely qualitative terms. The reason for this was not just to outline the process in general and reasonably un- derstandable terms. An equally important reason is our limited knowledge of the transmission mechanism. The magnitude of effects and their distribution over time are therefore difficult to specify. Even dis- regarding any monetary policy measures, moreover, economic developments are by no means easy to predict. These circum- stances clearly condition the practical de- sign of monetary policy. ‘The transmission mechanism is com- plex, as indicated above, and involves a number of indirect relationships between the instrumental rate and price develop- ments. The strength of the various mecha- nisms depends on personal and business decisions about saving, consumption, in- vestment, prices, wages etc. These deci- sions are influenced in turn by changeable expectations about the future, not least about future economic policy. All this means that the effects of a given measure are liable to vary in ways that are difficult, to foresee. The complex links between the instru- ment and the ultimate objective also mean that the effect of a measure takes time to materialize. A common estimate, which also reflects the uncertainty about this lag, is that the effects arise after one to two years. A characteristic of monetary policy is thus that neither the magnitude nor the timing of its impact can be predicted precisely? Because of the time it takes for the effects to materialize, a central bank has to base its action on predictive assessments of the di rection in which inflation and the economy in general are moving. Monetary policy is not capable of influencing the current rate of inflation and should focus instead on in- flation one to two years ahead. This is where monetary policy needs the support of indicators, a comprehensive term for va~ riables used by a central bank to assess eco- nomic tendencies. Any economic (or other) variable that improves the assessment can, serve in principle as an indicator. The most relevant, however, are obviously variables that can be expected, on theoretical and empirical grounds, to influence or mirror current and future inflationary pressures. ‘The discussion in earlier sections singles out the exchange rate, the money supply, the volume of credit, asset prices and bond rates as natural indicators. In the next stage of the transmission mechanism there are the variables that mirror the demand situation and production capacity, for in- stance producer prices, capacity utilization and unemployment. It is also important to consider private agents’ assessments and expectations because these may be to some extent self-fulfilling. The assessment of inflation is accor- dingly based on a comprehensive picture of how economic activity and capacity are 8. Economists commonly refer here to Milton Fried- ‘man's description of monetary policy as being subject to »long and variable lags. 9, Formally, the problem in monetary policy decisions ‘consists in the central bank acting so that its inflation forecast for one to two years ahead, taking its own ‘measures into account, is in line withthe inflation tar- get -10-QUARTERLY REVIEW 1995:3 developing."” The continuous flow of new information makes it necessary to update the economic assessments and, not least, to assess the economic response to earlier mo- netary policy measures. This perspective raises doubts about the practical feasibility of basing monetary po- licy on an intermediate target. With such a strategy, the central bank concentrates on the control of a variable that is not its ulti, mate objective. Considering the unavoi- dable link between money and inflation, a natural candidate for the role of interme- diate target is (some measure of) the mo- ney supply.'! In order to function as an in- termediate target, the money supply needs to be controllable with central bank instru- ments and also have such close and stable links with the ultimate objective that hol- ding the intermediate target variable at the desired level suffices to attain the ultimate objective. The main advantages of an in- termediate target are that it simplifies the management of monetary policy and ma- kes the action of the central bank easier to interpret in that it focuses on a single, ob- servable variable. ‘The doubts about this strategy, however, have been confirmed in practice. The rela- tionship between the money supply and in- flation has proved to be insufficiently stable. The far-reaching changes in the fi- nancial system are probably an important 10. The way in which indicators are used to build up aan assessment of inflation is presented extensively in the Riksbank’s Inflation Reports, of which the most recent was published in June 1995. For a discussion of how interest and exchange rates can be combined. to form a kind of indicator index, see Hansson & Lindberg (1994) 1. The discussion here is restricted to monetary po- licy with a flexible exchange rate, In the ease of fixed. exchange rate, this functions as an intermediate tar- fet; but the conditirest Rates,« Quarterly Review 199323, Sveriges Riksbank, 32—42, reason for this. The pattern of payments and saving behaviour have been modified by the introduction of new financial instru- ments and institutions. As a result, de- mand for money, defined in a particular way, is not sufficiently predictable for the central bank to be able to determine the growth rate that is compatible with price stability. As a result, countries with a flexible ex- change rate throughout the world now base the implementation of monetary po- licy on some form of indicators. This ap- plies even in countries, of which Germany is one, where the money supply is a formal target. The more versatile approach with indicators is a logical solution in that mo- netary policy has to be based on predictive assessments. A central bank has no cause to rest its policy on a single variable, any more than those who make regular infla- tion assessments rely solely on the money, supply. Unlike a strategy with an intermediate target, a policy based on indicators does not use quantified yardsticks and may there- fore be perceived as intransparent and difficult to interpret. The effort to make monetary policy clearer and more transpa- rent is an important reason why, in recent years, more countries, including Sweden, have adopted quantified inflation targets. ‘An advantage of this strategy is that the central bank — in the same way as with an intermediate target operates with a target that is clear and numerical.'? This gives people a yardstick for the central bank's adherence to the target. This yardstick and. the possibility of exacting responsibility enhances confidence that the announced policy will be followed. The target, more- 12, Experiences in countries with inflation targets are reviewed in Leiderman & Svensson (1995). -ll-QUARTERLY REVIEW 1995:3 over, is expressed in terms of the ultimate policy objective. Tt would be naive to suppose that a cen- tral bank can earn credibility simply by specifying a quantified target. The crucial point is the central bank’s ability to imple- ment a policy that is and is generally per- ceived to be in line with the target. But the design of monetary policy can help in this respect by guiding decisions and expecta- tions about them in the desired direction. Conclusion An important message in this article is that inflation and economic development are governed by complex processes. Simple, mechanical rules are therefore out of place in the conduct of monetary policy. Neither can we expect to achieve fine tuning. It would therefore be unrealistic to expect too much of monetary policy (or other stabili- zation policy, for that matter) when it co- mes to managing cconomic activity. This complexity also means that d sions have to be based on trade-offs and as- sessments. In this article I have tried to il- lustrate the relevant factors. When the cen- tral bank obtains new information it has to ask: How does this affect our assessment of inflation in the coming years? A single indi- cator seldom motivates a reassessment of the stance but congruent signs from a num- ber of indicators that the outlook for infla- tion is changing do provide a foundation for adjusting the instrumental rate. Those engaged in predicting the action of the cen- tral bank have cause to adopt the same approach. Bibliography Barr, D. (1994), »The Riksbank, the RIX system and systemic risk,« Quarterly Re- view 1994:3, Sveriges Riksbank. Hansson, B. & Lindberg, H. (1994), »Mo- netary conditions index — a monetary policy indicator,« Quarterly Review 1994:3, Sveriges Riksbank, Hérgren, L. (1994), »The Riksbank’s new interest rate management system,« Quarterly Review 1994:2, Sveriges Riks- bank. Leiderman, L. & Svensson, L.E.O. (eds.), Inflation Targets, Centre for Economic Policy Research, London. Svensson, L.E.O. (1994), Penningpolitiska Alternativ for Sverige (Monetary policy al- ternatives for Sweden), Annex 14 to the 1995 Medium Term Survey of the Swe- dish Economy, Fritzes Forlag, Stock- holm. ~12-