Conventional and Unconventional Monetary Policy (1)

Keynote lecture at the International Center for Monetary and Banking Studies (ICMB),
Geneva, 28 April 2009

The escalating financial crisis since last autumn of 2008 has pushed the theme of conventional and unconventional monetary policy to centre stage. 

Central banks throughout the world have been responding to the crisis by taking both 

• conventional and 
• unconventional policy measures. 

It is important to have a 

• good understanding of the unconventional policies and 
• how they differ from the conventional ones.

To understand, focus on four groups of questions:

1.  First, why and when should central banks resort to such measures? 

There is no tried-and-tested timetable or sign-posted pathway for moving from conventional to unconventional measures. For instance, an issue to consider is whether unconventional measures should or can be implemented 

• only after the nominal short-term interest rate has reached its lower bound and while downside risks to price stability prevail, or 
• be adopted while interest rates are still positive.

2.  Second, what are the main characteristics of unconventional measures?

3.  Third, how are unconventional measures implemented if and when they are needed? 

To answer this question, we have to distinguish between different types of unconventional measures, 

• from quantitative easing 
• to credit easing. 

Each measure has different effects and counter-effects, depending on the structure of the financial system or other factors.

3.  Fourth, how and when do central banks need to unwind the extra monetary stimulus? 

By definition, unconventional measures are not what is generally done, so they are not supposed to become the standard mode of monetary policy. When deciding on them, monetary policy-makers have to think ahead and ask themselves: 

• “We can get in, but how do we get out?” 
• They need to consider carefully the timing of their withdrawal of such monetary measures – for there are risks in doing it too early, and there are risks in leaving too late.

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The Economic Climate (11): Fed and Money Supply

The agency in charge of climate control is the Federal Reserve System, also known as the Fed. 

It has a special way of heating things up and cooling things down - not by blowing on them, but by adding and subtracting money.  Given its huge importance, it's amazing how few people know what the Fed is all about.

In a survey from several years ago, some people said the Federal Reserve was a national park, while others thougth it was a brand of whiskey.

In fact, it's the central banking system that controls the money supply. (Monetary policy)



Whenever the economy is cooling off too much, the Fed does 2 things. 

(1)  It lowers the interest rates that banks must pay when they borrow money from the government. 

• This causes the banks to lower the interest rates they charge to their customers, so people can afford to take out more loans and buy more cars and more houses. 
• The economy begins to heat up.

(2)  The Fed also pumps money directly into the banks, so they have more to lend. 

• This pumping of money also causes interest rates to go down. 

And in certain situations, the government can spend more money and stimulate the economy the same way you do every time you spend money at a store. (Fiscal policy)



If the economy is too hot, the Fed can take the opposite approach:  raising interest rates and draining money from the banks. 

This causes the supply of money to shrink , and interest rates go higher. 

• When this happens, bank loans become too expensive for many consumers, who stop buying cars and houses. 
• The economy starts to cool off. 
• Business lose business, workers lose jobs, and store owners get lonely and slash prices to attract customers.

Then at some point, when the economy is thoroughly chilled, the Fed steps in and heats it up again.  The process goes on endlessly, and Wall Street is always worried about it.