What is Monetary Policy? Governments most commonly use two types of policy tools in macroeconomics.

The first is Fiscal Policy, and the second is Monetary Policy. Fiscal Policy can simply be understood as government spending. The goal is to control growth rates or prevent recessions (in other words, the goal is to achieve stability). By increasing spending, governments can stimulate the economy. On the other hand, if there is high inflation they can reduce spending. We have witnessed a lot of Fiscal Policy in the aftermath of the recent financial crisis. The governmnet taxes its citizens in order to generate the income that it spends. If governmnet spend more than they tax, they are forced to borrow money and go in to deficit. If governmnet spend less than they earn from taxation they reduce the deficit, or increase a surplus (depending on the initial position). Monetary Policy has similar goals to Fiscal Policy, however it is concerned with the supply of money. In other words, how much money is there in the economy? This can be done through a number of methods, such as literally creating new money (Quantitative Easing), buying/selling government bonds (open market operations) or by setting interest rates. The most common method is the setting of interest rates. If interest rates are low, the incentive to save your money is less (because you get less interest on savings) and the incentive to make debt is high (because you pay less interest on loans). In this way, people put more money into circulation and it acts as a form of stimulus similar to Fiscal Policy. Most countries use Monetary Policy and the setting of interest rates to target inflation. If inflation is too high, they increase interest rates. If inflation is low then interest rates can be lowered to stimulate spending and growth. Monetary Policy is usually set by the Central or Reserve Bank of a country. Normally, this bank is an independent body, and it sets Monetary Policy separately to the elected government. It is said that an independent body is good to avoid politically motivated policy decisions and better encourage stability. Companies and individuals often make long-term economic plans based on the credibility of the Monetary Policy decisions (do you save or spend?). This is determined by what you can predictably say the Central Bank will decide to do with interest rates). Therefore a stable, predictable and credible monetary policy is important. Monetary Policy and Exchange Rates The Bretton Woods system aimed to create an international economic order which would prevent the global economic problems that led to the Great Depression. For example, the

proposed International Trade Organisation (which became the GATT and later the WTO we have today) was aimed at preventing trade-wars where countries put tariffs up against each other. The International Monetary Fund was concerned with the value of currency. Before the IMF, countries would competitively devalue their currency. This means that they would set the price of their currency artificially low. This would make their products cheaper in foreign markets, and boost their exports. For example, if the Rand is really weak, then people in the USA can buy things from South Africa very cheaply. At R10 per Dollar, they can get R100 for $10 which gives them a lot of purchasing power. However at R5 per Dollar, they can only get R50 for the same $10, which means they can buy a lot less for the same amount. Therefore the weaker the Rand, the better for South African companies trying to export. What used to happen however, is that when one country devalued, other countries would devalue in retaliation. The result was a race to the bottom, where countries would competitively devalue their currencies with no positive results. More important than the actual value of your currency, however, is whether its value is stable. Individuals who export need to be able to predict how much profits they will make, and similarly people who rely on imports for their business need to accurately value their costs. Trade and Development therefore require exchange rate stability. The IMF instituted a system to control this. All countries had to peg or value their currency relative to the US Dollar (which itself was then backed by Gold), and the IMF would ensure that these valuations are accurate. This system remained successful initially, but it had a number of implications for the US (such as losing control over interest rates, and requiring them to run huge deficits to facilitate the global accumulation of Dollar Reserves). Importantly, by 1971 the US could no longer back its currency in gold, and was unwilling to remain the currency that others were pegged against. After the collapse of that system, the IMF promoted Floating Exchange rates. This meant that currencies were valued through the market forces of supply and demand. Associated with this was later the promotion of Capital Account Liberalisation. This simply means, that money would be allowed to move in and out of a countries without any restrictions (the global free-flow of currency). This helped to more accurately value a currency. A country can indirectly attract higher levels of foreign currency, by having higher interest rates. This means that foreign investors get higher returns. Similarly, if you have foreign inflows that are too high, you can cut interest rates (this is currently happening in South Africa). However, it seems that in reality, domestic interest rates are dictate by the flow of

money, and not the other way around. Many investors speculate and trade on currencies for quick profits (often through quick buying and selling to capture price differences between currencies this is called arbitrage). This rapid flow of money in and out of a country (facilitated through the capital count liberalisation) leads to what is termed as hot flows and this causes the value of a currency to fluctuate. The resulting instability of the currency is highly problematic for a developing economy. Ultimately, all nations want to achieve three things: control over their monetary policy, stable (and sometimes weak) exchange rates, and control over the flow of money in and out of the country. However, it is impossible to control all three of those things (this is called the Unholy/Impossible Trinity or Trilemma). In the modern IMF era, countries focus on just controlling interest rates, exposing them to the whim of international financial markets. It is also noteworthy that several developing nations have opted to control their currencies rather than interest rates. An example would be China, which has a devalued currency, which makes it more competitive in exporting goods to the USA (however, it can be argued that this is unfair to other developing countries who are trying to compete but have floating exchange rates).