onetary policy has lived under many guises. But however it may appear, it generally boils down to adjusting the supply of money in the econ...
onetary policy has lived under many guises. But however it may appear, it generally boils down to adjusting the supply of money in the economy to achieve some combination of inflation and output stabilization. Most economists would agree that in the long run output is fixed, so any changes in the money supply only cause prices to change. But in the short run, because prices and wages usually do not adjust immediately, changes in the money supply can affect the actual production of goods and services. This is why monetary policy—generally conducted by central banks such as the U.S. Federal Reserve (Fed) or the European Central Bank (ECB)—is a meaningful policy tool for achieving both inflation and growth objectives. In a recession, for example, consumers stop spending as much as they used to; business production declines,
leading firms to lay off workers and stop investing in new capacity; and foreign appetite for the country’s exports may also fall. In short, there is a decline in aggregate demand to which government can respond with a policy that leans against the direction in which the economy is headed. Monetary policy is often that countercyclical tool of choice. Such a countercyclical policy would lead to the desired expansion of output (and employment). But, because it entails an increase in the money supply, it would also result in an increase in prices. As an economy gets closer to producing at full capacity, increasing demand will put pressure on input costs, including wages. Workers then use their increased income to buy more goods and services, further bidding up prices and wages and pushing generalized inflation upward— an outcome policymakers usually want to avoid. Twin objectives The monetary policymaker, then, must balance price and output objectives. Indeed,
even central banks, like the ECB, that only target inflation would generally admit that they also pay attention to stabilizing output and keeping the economy near full employment. And at the Fed, which has an explicit dual mandate from the U.S. Congress, the employment goal is formally recognized and placed on an equal footing with the inflation goal. Monetary policy is not the only tool for managing aggregate demand for goods and services. Fiscal policy—taxing and spending—is another, and governments have used it extensively during the current crisis. However, it typically takes time to legislate tax and spending changes, and once such changes have become law, they are politically difficult to reverse. Add to that concerns that consumers may not respond in the intended way to fiscal stimulus (for example, they may save rather than spend a tax cut), and it is easy to understand why monetary policy is generally viewed as the first line of defense in stabilizing the economy during a downturn. (The exception is in countries with a fixed exchange rate, where monetary policy is completely tied to the exchange rate objective.) Independent policy Although it is one of the government’s most important economic tools, most economists think monetary policy is best conducted by a central bank (or some similar agency) that is independent of the elected government. This belief stems from academic research, some 30 years ago, that emphasized the problem of time inconsistency.
Monetary policymakers who were less independent of the government would find it in their interest to promise low inflation to keep down inflation expectations among consumers and businesses. But later, in response to subsequent developments, they might find it hard to resist expanding the money supply, delivering an inflation surprise. That surprise would at first boost output, by making labor relatively cheap (wages change slowly), and would also reduce the real, or inflation-adjusted, value of government debt. But people would soon recognize this inflation bias and ratchet up their expectations of price increases, making it difficult for policymakers ever to achieve low inflation. To overcome the problem of time inconsistency, some economists suggested that policymakers should commit to a rule that removed full discretion in adjusting monetary policy. In practice, though, committing credibly to a (possibly complicated) rule proved difficult. An alternative solution, which would still shield the process from politics and strengthen the public’s confidence in the authorities’ commitment to low inflation, was to delegate monetary policy to an independent central bank that was insulated from much of the political process—as was the case already in a number of economies. The evidence suggests that central bank independence is indeed associated with lower and more stable inflation.
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