Learning Module 4
Monetary Policy
Key Outcomes Summary & Practice Problems
What you must be able to do
Curriculum Year: 2026
Describe the roles and objectives of central banks.
Describe tools used to implement monetary policy, the monetary transmission mechanism, and explain the relationships between monetary policy and economic growth, inflation, interest, and exchange rates.
Describe qualities of effective central banks; contrast their use of inflation, interest rate, and exchange rate targeting; and describe the limitations of monetary policy.
Explain the interaction of monetary and fiscal policy.
1 · Roles and Objectives of Central Banks
Roles of Central Banks — Monopoly supplier of the currency, banker to the government and bankers' bank, lender of last resort, regulator and supervisor of the payments system, conductor of monetary policy, and supervisor of the banking system.
Fiat Money — Money that is not convertible into any other commodity. It derives its value through government decree and because people accept it for payment.
Primary Objective — Price stability (controlling inflation). Most central banks have an overarching objective of maintaining stable purchasing power of the currency.
Secondary Objectives — Full employment, economic growth, stability of the financial system, maintaining confidence in the currency.
Key Central Bank Examples: Federal Reserve (US) — maximum employment, stable prices, moderate long-term interest rates; European Central Bank — price stability as primary objective; Bank of England — CPI inflation target of 2%.
2 · Monetary Policy Tools
Purchase and sale of government bonds from/to commercial banks. Buying bonds → increases reserves → expansionary. Selling bonds → decreases reserves → contractionary.
The rate at which the central bank lends to commercial banks. Also called the official policy rate, repo rate (UK/ECB), discount rate (US), or federal funds rate target (US).
The proportion of deposits banks must hold as reserves. Raising requirements → contractionary; lowering → expansionary. Less commonly used in developed economies today.
Federal Funds Rate — The interbank lending rate on overnight borrowings of reserves in the US. The FOMC sets a target level and uses open market operations to achieve it.
Repo Rate — The rate on repurchase agreements (collateralized loans). Used by the Bank of England and ECB as their policy rate.
3 · Monetary Transmission Mechanism
Changes in policy rate → changes in commercial bank rates → affects borrowing costs for households and businesses.
Interest rate changes affect the discount rate for future cash flows, impacting bond prices, equity valuations, and property values.
Rate changes signal central bank intentions, influencing consumer and business expectations about future economic conditions.
Interest rate differentials affect currency values, which impact import prices and export competitiveness.
4 · Inflation Targeting
Features of Inflation Targeting — An independent and credible central bank; commitment to transparency; a decision-making framework considering a wide range of indicators; a clear, symmetric, forward-looking inflation target (typically 2%, with a range of ±1%).
Central Bank Independence — Operationally independent (can set interest rates) and/or target independent (can set the target itself). Most central banks are operationally independent.
Credibility — If economic agents believe the central bank will hit its target, expectations become self-fulfilling. Credibility reduces the cost of disinflation.
Transparency — Central banks explain their decisions through inflation reports, press conferences, and forward guidance.
Exceptions — The Federal Reserve (dual mandate: price stability + maximum employment) and the Bank of Japan (fighting deflation) do not have formal inflation targets.
Why 2%? Central banks target 2% because it is high enough to avoid the risk of deflation (zero lower bound problem) but low enough to ensure price stability.
5 · Exchange Rate Targeting
Fixed Exchange Rate — The central bank pegs the currency to another currency (e.g., USD) or a basket. Monetary policy is subordinated to maintaining the peg.
Dollarization — The country adopts the US dollar (or another currency) as its legal tender. Gives up independent monetary policy entirely.
Currency Board — A monetary regime based on a legislative commitment to exchange domestic currency for a specified foreign currency at a fixed rate, with 100% foreign currency reserves backing the monetary base.
Crawling Peg — The exchange rate is adjusted frequently (weekly or daily) to keep pace with inflation (passive crawl) or pre-announced (active crawl).
Managed Float — The exchange rate is allowed to float but with occasional central bank intervention ("dirty floating").
5 · Exchange Rate Targeting
Contractionary Policy — Raising interest rates to reduce money supply and control inflation. Used when economy is overheating.
Expansionary Policy — Lowering interest rates to increase money supply and stimulate economic activity. Used in recessions.
Neutral Rate — The interest rate that neither spurs nor slows the economy. Neutral rate = Trend growth + Inflation target.
Liquidity Trap — A condition where the demand for money becomes infinitely elastic (horizontal demand curve), so further injections of money do not lower interest rates or affect real activity.
Quantitative Easing (QE) — Large-scale asset purchases (government bonds, mortgage-backed securities) to inject money into the economy when policy rates are near zero. Unconventional monetary policy.
Limitations — Central banks cannot control the amount of money households and corporations deposit, nor the willingness of banks to create credit. Deflation poses a particular challenge (zero lower bound).
Neutral rate = Trend growth + Inflation target
Policy rate above neutral → contractionary
Policy rate below neutral → expansionary
7 · Interaction of Monetary and Fiscal Policy
Easy Fiscal / Tight Monetary — Higher output, higher interest rates, government sector expands.
Tight Fiscal / Easy Monetary — Private sector stimulated, public sector shrinks, interest rates lower.
Easy / Easy — Highly expansionary, lower interest rates, growing both sectors.
Tight / Tight — Contractionary, higher interest rates, reduced demand from both sectors.
Monetary Accommodation — When monetary policy supports fiscal expansion by keeping interest rates low, multipliers are larger.
Ricardian Equivalence — If tax cuts have no impact on private spending (individuals anticipate future taxes), fiscal policy is less effective, favoring monetary tools.