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Conventional vs unconventional monetary policy

Unconventional monetary policy

Conventional monetary policy is a central bank tool that changes the cost to borrow money (official cash rate/interest rate) to increase or reduce demand. Central banks lower interest rates when demand is weak such as during the GFC in 2007 and COVID-19 in 2020 and raise interest rates when demand is high to combat inflation.

Unconventional Monetary Policy uses other tools to affect supply and demand. These can include:

  • Forward guidance – Communicates the plan for interest rates and other monetary policy changes to the market and public to sway supply and demand.
  • Asset purchases – The central bank buys private assets to stimulate the economy and increase demand. Asset purchases can include buying government bonds through quantitative easing. The central bank will force demand by buying bonds until they reach a target price, lowering interest rates on bonds.
  • Term funding facilities – Basically lending private banks money at interest rates lower than they can get anywhere else. In theory, banks respond by lowering interest rates for customers.
  • Adjustments to market operations – This includes softening trade regulation and collateral requirements as well as increasing liquidity to banks to create confidence for financial institutions so that they increase lending.
  • Negative interest rates – Several countries lowered interest rates below zero after the GFC. This meant that banks could theoretically charge clients interest for holding money in a savings account although in practice this did not eventuate.

In 2020, to combat COVID-19 restraints, the Reserve Bank of Australia (RBA) purchased government bonds issued by the Australian Government specifically for this purpose. In other words, the government created bonds and then bought the bonds from themselves, essentially printing money.

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