Monetary policy is an economic policy which aims to achieve macroeconomic goals such as low inflation, low unemployment, high economic growth and financial stability. The second major macroeconomic policy is fiscal policy conducted by governments. Monetary policy is usually conducted by independent central banks.
For example, the Federal Reserve is in charge of U.S. monetary policy. Monetary policy affects the economy via determining the money supply and interest rates. We say that monetary policy is expansionary (or loose, or dovish) when it expands the money supply and lowers interest rates. This is traditionally used to combat unemployment during recessions. On the other hand, monetary policy is contractionary (or restrictive, or hawkish) when it tightens the money supply and raises interest rates. This is used to control inflation.
Monetary authorities can use distinct target variables to achieve their goals. These different types of monetary policy are called monetary regimes. The gold standard was one of them, widely adopted across the world since the mid-19th century until 1971 when President Nixon closed the gold window. In such a system, central banks target the price of gold. However, they may also target the money supply growth, the exchange rate, the price level or the inflation rate. Nowadays, inflation targeting prevails, which means that central banks have an explicit target inflation rate.
Standard Monetary Policy
Traditionally, monetary authorities use three major tools to achieve their goals. The primary tool is open market operations which include buying or selling short-term government bonds to expand or contract the money supply. The second traditional instrument is a discount rate which is the interest rate charged by the central banks to depository institutions on short-term loans. The third standard tool are reserve requirements which determine the portion of deposits that banks must maintain either in their vaults or on deposit at a central bank. The rise in reserve requirements is contractionary, while the cut is expansionary. In response to the Great Recession, the major central banks cut their main interest rates almost to zero. Since the standard tools turned out to be ineffective at the zero bound, the central banks started to conduct unconventional monetary policy.
Monetary Policy and Gold
Monetary policy is an important driver of gold prices. Monetary policy affects the money supply growth which in turn determines the inflation rate (in the long run). And gold is, under certain conditions, an inflation hedge. The money supply growth and the central bank’s stance determine also the exchange rates. Therefore, the Fed actions significantly affect the U.S. dollar’s strength and thus the price of gold, which is negatively correlated with the greenback. Moreover, the central banks’ actions affect real interest rates, which are an important driver of gold prices. Last but not least, the level of risk premias affected to a significant extent by what central bankers say and do. Since gold is a safe-haven asset, it is moved by changes in risk aversion among investors.
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