Monetary policy

Monetary policy has become the preferred policy instrument to be used in the pursuit of economic stability. It is customarily operated for that purpose by varying a central bank's discount rate in response to indications concerning the degree of capacity utilisation in the economy. It has also been used as a temporary expedient to counter the threat of deflation by central bank purchases of government bonds and private sector securities - a practice termed quantitative easing or "credit easing" (and popularly known as "printing money"). The practice, advocated by proponents of monetarism, of the day-to-day targeting of monetary policy on the money supply in order to counter inflationary tendencies has generally fallen into disuse. Some authorities are, however, considering the use of monetary instruments to prevent the potentially destabilising buildup of asset-price bubbles.

Routine regulatory policy

Under normal circumstances, monetary policy is nowadays targeted directly upon the inflation rate and aims to maintain it within predetermined limits. It operates by use of the central bank's power to control interest rates .). Briefly, an increase in interest rates discourages borrowing and encourages savings. Because borrowers spend more than savers it discourages consumer spending, and higher mortgage payments reinforce its effect by leaving householders with less to spend. Since it takes about a year for interest rate changes to affect output and two years to affect inflation, policy action depends upon judgements of forthcoming inflation. The authorities make use of economic forecasting models to assist those judgements, but they usually take account also of a range of factors including inflationary expectations (as indicated by the differences between the prices of fixed-interest and index-linked bonds) and the state of the housing market. Regulatory action depends mainly upon empirical data concerning the relation between the inflation rate and the output gap such as is embodied in the Taylor Rule.