Central Banks & Monetary Policy

Anna Valiullina

Dec 2019 · 10 min read

 

 

In today’s article, we are interested in describing the current affairs of Central Banks and by doing so we will briefly remind you about different ways which are used to affect the economy.

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To start with, there are mainly 2 ways how one can affect the current state of the economy: using Fiscal and Monetary Policy. The first one is controlled by the government and is associated with changes in taxes and government spending. The second approach, Monetary Policy, works through changes in money supply and changes in the interest rate on government bonds. Here we all remember the agiotage around FED’s meetings. (FED – Federal Reserve, the central bank of the United States). This mechanism of affecting the interest rate is exactly what we would like to cover today.

To give you a piece of intuition, in order for the economy not to be artificial improved before the president’s elections and thus give a false picture to the voters, the apparatus of Fiscal and Monetary Policies are strictly divided (i.e. the head country’s central bank doesn’t report to a president of the government). But let’s look at where the situation is now and whether the Central Banks still has the same power to affect the state of the economy as they used to?

For the last decade, we saw the interest rate going down dramatically. In some countries, for example, Switzerland, the interest rate became even negative. Under such circumstances, some of the economists claim that Monetary Policy is not as effective as it used to be. 

 

Source: Bloomberg

 

In practice, negative interest rates were introduced as a tool to mitigate the consequences of financial crises when no other policy would work. To this end, let us remind you that in 2009 Sweden, Denmark and since 2014 European Central Bank have introduced negative interest rates. Thinking of the recent crises, we saw a situation of great uncertainty which normally leads to stagnation of the economy, reduced output and increased rate of unemployment. The decision of cutting interest rates was done in the attempt to boost the economy since in this setting the investors are penalized for not spending money.

 

As a small note, let us give you an intuition on how exactly the Central Banks proceeds on their way to reduce the interest rates of government bonds. Central Banks use the tactic called Quantitative Easing (QE), they purchase the government bonds on the open market increasing the money supply and lowering the supply of the bonds. Having this, the rate of return on bonds is decreasing.

Talking about the current situation, it is clear that there is a boundary below which the interest rate is not expected to fall. The closer we approach the boundary the harder and harder it gets for the Central Banks to affect the state of the economy. While most of the countries are not willing to increase government spending (or actively employ Fiscal Policy), the Central Banks do not have any other option than searching for more complex tools to affect the economy or try to negotiate with government’s officials. 

 

For more information on this theme we would suggest the following reading:

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Stay tuned for other articles from The Finance Association of EPFL! Don’t hesitate to send us any suggestions to tfa@epfl.ch or write to us in our Facebook and Instagram pages

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Written by Anna Valiullina

 

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