The central bank is the monetary authority in an economy, it has a monopoly on the issuance of currency, it also has economic objectives and its main objectives are price stability and, in some cases, the maximization of employment and the stability of interest rates.
Monetary policy directly affects the economy: It has a monopoly on bank money. It is the only issuer of banknotes and the only provider of bank reserves, that is, it has a monopoly on the monetary base, which is the set of liabilities held by individuals and financial institutions.
Monetary base = cash + reserves
In the short term, a variation in the interest rate by the monetary authority in the money market imply the implementation of a series of mechanisms and actions of the agents that has as a result an evolution in the economic variables, such as the growth of the economy or prices. This complex process is called the transmission of monetary policy.
In the long term, once the adjustments have been made in the economy, that is, a change in the amount of money in circulation in the economy, keeping the other variables constant, will have as effect a variation in the prices of an economy but it will not cause permanent variations in real variables, such as unemployment, although, for example, in the short term a decrease in the interest rate may bring with it a rise in prices. This is known as the long-term neutrality of money.
In the long term, both disposable income and the level of employment in an economy are mainly determined by real factors (which are located on the supply side), such as population growth or technology. The central bank cannot affect economic growth by modifying the money supply; in fact, periods with high inflation (or stagflation) go hand in hand with periods with high economic growth, which means an increase in the amount of money in circulation.
Although other factors, such as variations in technological changes or the prices of raw materials, can affect this price evolution in an economy over a short-term horizon, in the long term these effects can be offset by an adjustment of the money supply.
In this regard, we can say that central banks can control longer-term trends in prices or inflation. The close relationship that exists, on the one hand, between the growth of money and, on the other hand, between the long-term neutrality that exists in a monetary policy has been confirmed over the years together with the costs of the rise or fall of prices. Therefore, price stability contributes to increase economic well-being and growth potential of an economy.
In this task, the central bank is constantly submitted to high uncertainty both due to the economic changes that affect the economy and the power of the relationships among the different macroeconomic variables.
The monetary policy decision is based on a detailed analysis of the risks that may exist for price stability. It is organized from two scenarios: Economic analysis and monetary analysis. This joint analysis of the two views is intended to ensure that relevant information is not lost when assessing these risks, paying adequate attention to the different views and contrasting the information in order to assess risks.
