What are the monetary conditions?
The term 'monetary conditions" is very often used in connection with the evaluation of the monetary policy settings. The monetary conditions represent the combined effect of interest rates (the interest rate component of the monetary conditions) and the exchange rate (the exchange rate component) on the economy. These are the key variables through which monetary policy can affect economic activity and, through it, inflation. In a period of easy monetary conditions monetary policy has been set in such a way as to support economic growth. If, conversely, monetary policy suppresses growth, we speak of a period of tight monetary conditions. Finally, in the case of neutral monetary policy settings, the monetary conditions are also termed neutral. The components of the monetary conditions do not necessarily affect the economy in the same direction. The interest rate component may, for example, be evaluated as relaxed and the exchange rate component as tight, or vice versa.
The interest rate component plays the primary role in determining the monetary conditions. The exchange rate component - together with numerous other effects - adjusts to interest rates: low interest rates in a given period tend to lead to disinterest in the koruna and a weaker exchange rate, whereas high interest rates have the opposite effect.
The interest rate component of the monetary conditions is made up not of short-term interest rates, which are subject to direct control by the CNB, but of long-term rates. Most firms, households and other economic agents work with long-term interest rates (one-year or longer) when making decisions about their level of consumption and investment. High interest rates generally increase the attractiveness of deferring consumption and investment (including the aforementioned greater interest in the koruna) and of depositing any free funds in the interim on a koruna account to increase their value. This leads to weaker domestic demand, slower economic growth and a fall in inflation. By contrast, if interest rates are low it is generally better to realise one's consumption and investment plans now (including converting koruna into foreign currency), be it using one's own money or borrowed funds. The result is upward pressure on economic growth and inflation.
The exchange rate component of the monetary conditions is represented by the so-called real exchange rate, i.e. the relative price of domestic and foreign goods and services, where the foreign price level is converted into the domestic currency via the nominal exchange rate. Appreciation of the real exchange rate, i.e. an increase thereof, naturally leads to a shift in interest from domestic to foreign supply. The result is a decrease in domestic economic growth and downward pressure on prices of domestic goods. Depreciation of the exchange rate has the opposite effects.
Both main channels (interest rate and exchange rate) through which monetary policy affects economic activity are thus derived from changes in long-term interest rates.
It may seem at first glance that in their decisions on whether to consume and invest now or in the future, economic agents take into account observed nominal interest rates, i.e. the rates themselves. In reality, however, they usually simultaneously consider - at least in rough outline - expected price developments, since the future real value of deposited or borrowed money can be appreciably decreased or increased by inflation in the economy. The comparative advantage of consuming or investing now as opposed to deferring such activity to the future is therefore expressed by real interest rates, i.e. interest rates adjusted for expected changes in the price level.