Monetary Policy 101 for the CFA Level 1 Exam

The real key to this section for the CFA Level 1 exam is being able to trace how a change in one variable (say demand for money or the purchase of money on the open market by the central bank) cascades through the system. In particular you should have a clear understanding of how interest rates affect investment demand, demand for money, and how those factors trickle into aggregate demand.

What is Monetary Policy?

Monetary Policy is policy enacted by the central bank. It affects the money supply and interest rates and through this impacts economic activity.

  • Expansionary monetary policy is when the central bank increases money supply (by reducing interest rates).
  • Restrictive monetary policy is contractive and involves decreasing the money supply (usually by increasing interest rates).

Having covered the basics in terms of money and how it flows through the economy let’s dive into what a central bank is, what it purposes are, and how it employs tools to affect its desired outcomes.

Understand Central Banks 

Primary purpose of a central bank

The primary purpose of a central bank is to control inflation and promote price stability.

Controlling inflation is the primary goal of monetary policy because high (and unexpected) inflation is especially devastating to an economy.

The specific costs of unexpected inflation include: 

  • If inflation higher than expected borrowers gain at the expense of lenders (the opposite is true if inflation is lower than expected)
  • Volatile inflation will cause lenders to require higher premiums/interest to lend slowing business investment and economic activity
  • Volatile inflation makes price forecasting less certain and can increase or decrease the magnitude of business cycles

Developed nations generally have an inflation target of 2-3%.

Note that L1 lists two additional types of costs caused by inflation—menu costs and shoe leather costs. 

Menu costs come from having to change the prices you display (literally re-printing your menu).

Shoe leather costs refers to the costs of making frequent trips to the bank in order to minimize holding too much cash. This occurs in an inflationary environment because high inflation will increase the cost of holding money and decrease the quantity of money held. 

But while inflation is the primary goal of a central bank that doesn’t mean it’s the only one.

Other Goals of Central Banks Include

Other mandates can include:

  • Create full employment
  • Create stability in foreign exchange rates
  • Promote stable positive economic growth
  • Hold long-term interest rates to a moderate level

Generally a central bank pursuing one of these goals will advertise its goals and strategy to the broader market. This takes 3 main forms:

  • Interest rate targeting involves increasing the money supply when specific interest rates go above or below certain target bands
  • Inflation targeting is the most widely used system today. Generally inflation is set at a target (2% is standard) with a ±1% band. This is to avoid deflation which is both disruptive to economic activity and hard to combat with standard fiscal/monetary tools.
  • Exchange rate targeting is more popular in developing countries and involves pegging a local currency to a foreign one, often the $. If the foreign exchange rate of the domestic currency falls the central bank would use its foreign reserves to purchase domestic currency (which will increase interest rates).

The Actual Jobs Performed by a Central Bank

Now that we know the goals of a central bank we need to understand what they do on a day-to-day basis (and then how they change those actions to influence the economy).

  • Supplier of currency – sole legal supplier. Used to be backed by gold, now fiat money as it not backed by any tangible value
  • Banker to governments/other central banks
  • Regulator and supervisor of the payments system – oversee risk taking by banks and establish reserve requirements
  • Lender of last resort – As they can print money they can supply banks w/ shortages and prevent runs on banks
  • Holder of Gold / Foreign Exchange reserves
  • Conductor of monetary policy

Qualities of a Good Central Bank

A central bank should meet these criteria in order to be viewed as credible:

  • Independence Banks need to be relatively free of political influence as contractionary policies can be politically unpopular. Operational independence is freedom to set the policy rate, target independence means the bank determines how it measures inflation
  • CredibilityAn effective central bank must be seen as credible in its ability to stop bank runs or in creating policies to hit inflation targets (think self-fulfilling prophecies)
  • TransparencyMaking the criteria for decisions available and periodically disclosing thinking makes central bank actions more predictable and easier to implement

Tools for Implementing Monetary Policy

When the central bank seeks to impact interest rates it has three primary tools as its disposal. The bank can manipulate the:

  • Reserve Requirement – The percentage of each deposit banks are required to retain. The lower the reserve requirement the higher the money multiplier and the higher the money supply. Raising the reserve requirement thus decreases MS
  • Policy rate – The policy rate is the rate at which banks can borrow from the Fed (usually overnight). The lower the rate the more expansive monetary policy as the lower cost of funds incents banks to lend more
  • Open Market Operations – This is buying or selling bonds on the open market. Buying bonds introduces new money and is expansionary. Selling bonds takes money out of the system and is contractionary.

Contractionary vs. Expansionary Monetary Policy

Monetary policy affects interest rates, prices, and inflation through four different transmission mechanisms.

Take a contractionary monetary policy. This will:

  • Increase the short-term lending rate for banks, which will reduce aggregate demand (less purchases on credit from both consumption and investment)
  • As interest rates rise, the PV of assets decreases (as the discount rate goes up). This may trigger a “wealth effect” where consumers decrease spending as they feel less wealthy
  • As interest rates rise and expectations of future growth decrease, expenditures may go down
  • An increase in interest rates may attract foreign investment chasing higher yields. This increase in demand will cause the currency to appreciate and reduce net exports, lowering aggregate demand

Conversely, an expansionary monetary policy could cause:

  • Businesses to invest more due to lower borrowing costs
  • Net exports to rise due to a decrease in the exchange rate

In all cases, you should be able to trace through the immediate and secondary effects of monetary policy in terms of its effect on aggregate demand, and thus on prices and output.

Determining Whether Monetary Policy Expansionary or Contractionary?

A Level 1 multiple choice question might ask you to figure out whether a given set of policies is expansionary or contractionary. If you’re asked this, you compare the policy rate against a neutral interest rate.[1]

  • If the policy rate is ABOVE the neutral rate, monetary policy is contractionary
  • If the policy rate is BELOW the neutral rate, monetary policy is expansionary

Unpacking monetary policy’s transmission mechanism

Monetary policy works, or is “transmitted,” via their effect on short term interest rates, asset values, currency exchange rates, or market expectations. Let’s run through an example with a contractionary policy:

  • Increase in policy rate increases short term interest rates, which decreases aggregate demand (I↓).
  • As discount rate ↑, future cash flows less valuable, so asset prices ↓
  • As expectations for future growth decrease both households and businesses may decrease their purchases

As interest rates rise ↑ that attracts foreign investment, causing more demand for the currency. A higher currency makes exports less competitive and imports cheaper, meaning net exports will fall.

Limits to Monetary Policy

Monetary policy may not always function as intended. It has limits. Many of these limits arise because the effectiveness of the policy partially depends on people’s expectations. For example, if raising short term interest rates decreases people’s expectations about future inflation, then long-term interest rates might actually RISE in opposition to the policy.[2]

Other reasons include:

  • Long term interest rates may not move in the same direction as short-term interest rates
  • Stimulus will just result in greater cash holdings (liquidity trap)
  • Banks may not lend more irrespective of central bank action and greater reserves
  • Short-term interest rates can’t go below zero (which is why deflation is more concerning to a central bank)
  • Developing countries may have their own issues with rapid changing conditions and lack of credibility

 How the CFA Level 1 Exam Tests Monetary Policy

In terms of directly testable material expect to see questions on all of these: (1) how a combination of monetary and fiscal policy might affect interest rates, AD, and GDP, (2) how the fiscal multiplier works, (3) the relative pros & cons of fiscal vs. monetary policy, (4) determining whether monetary policy is expansionary or contractionary using the neutral interest rate, (5) the Fischer effect, and (6) the quantity theory of money



[1] The real trend rate = the long-term sustainable growth rate

[2] This occurs because nominal interest rates have an inflation component built in. See our early discussion of what an interest rate consists of.