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CFA® Level I · Economics · free lesson
Monetary Policy
Central bank decisions move every asset class, from money-market yields to equity valuations and exchange rates. This module explains what central banks are for, the tools they use and how money is created, how a change in the policy rate travels through the economy, how to judge whether policy is tight or loose, which targeting regimes central banks adopt, where monetary policy reaches its limits and how it interacts with fiscal policy.
What you will learn
1. Describe the roles and objectives of central banks, explain why they aim for low and stable inflation, and identify the qualities of independence, credibility and transparency that make monetary policy effective.
- Roles: currency issuer, banker to government and banks, lender of last resort, supervisor, reserve manager, monetary policy.
- Main objective: price stability, often about 2% inflation; some banks have employment or financial stability mandates.
- Unexpected inflation redistributes wealth and raises risk premiums; a small positive target protects against deflation.
- Effective central banks are independent, credible and transparent.
- Credibility anchors inflation expectations, so smaller rate changes achieve the target.
2. Describe the tools central banks use to implement monetary policy, explain how fractional reserve banking creates money, and calculate the money multiplier.
- Fractional reserve banking: banks lend most deposits, creating new deposits in the next bank.
- Money multiplier = 1 / required reserve ratio (a maximum; actual expansion is smaller).
- Three tools: policy rate, reserve requirements, open market operations.
- Buying securities adds reserves and lowers short-term rates; selling drains reserves.
- Quantity theory: MV = PY; with stable V and Y, money growth drives inflation in the long run.
3. Explain the monetary transmission mechanism and how a change in the policy rate affects market interest rates, asset prices, expectations, the exchange rate, output and inflation.
- Channels: market interest rates, asset prices, expectations, and the exchange rate.
- A rate rise lowers domestic demand and net exports, slowing growth and inflation.
- Higher domestic rates tend to appreciate the currency, reducing import prices.
- Effects arrive with long and variable lags, so policy responds to inflation forecasts.
- Channel strength depends on mortgage structure and openness to trade.
4. Contrast inflation, interest rate and exchange rate targeting, and determine whether monetary policy is expansionary or contractionary by comparing the policy rate with the neutral rate.
- Inflation targeting: explicit target, forecast-based decisions, independence and transparency.
- Exchange rate targeting imports the anchor's policy but gives up independent monetary policy.
- Defending a weak pegged currency means selling reserves, which tightens domestic liquidity.
- Neutral rate = real trend growth + inflation target; above neutral = contractionary, below = expansionary.
- Fisher: (1 + nominal) = (1 + real)(1 + expected inflation).
5. Describe the limitations of monetary policy, including the zero lower bound and the use of unconventional tools, and explain how monetary and fiscal policy interact.
- Easing may fail if banks will not lend or borrowers will not borrow (pushing on a string).
- At the zero lower bound, deflation keeps real rates too high; a liquidity trap makes extra money ineffective.
- Unconventional tools: quantitative easing, negative rates, forward guidance, yield curve control.
- Easy fiscal plus tight monetary policy raises interest rates and the public sector's share of output.
- Tight fiscal plus easy monetary policy lowers rates and expands the private sector's share.
Module at a glance
- Central banks aim mainly at price stability; independence, credibility and transparency make policy effective.
- Money multiplier = 1 / reserve ratio; buying securities adds reserves and lowers short-term rates.
- Quantity theory: MV = PY; sustained money growth beyond real growth means inflation.
- Transmission: market rates, asset prices, expectations and the exchange rate, with long and variable lags.
- Neutral rate = real trend growth + inflation target; above it policy is contractionary.
- Exchange rate targeting imports the anchor's policy and gives up monetary independence.
- At the zero lower bound, central banks use QE, negative rates, forward guidance and yield curve control.
- Easy fiscal with tight monetary policy raises rates and the public sector's share of output.
This free module has 5 lessons, 13 practice questions with full explanations.