Purpose of Monetary Policy

Recently, there has been much debate about the direction of monetary policy. Should we make monetary policy ‘looser’ – expansionary monetary policy through quantitative easing / lower interest rates in order to boost growth and reduce unemployment. Or should we consider ‘tightening’ monetary policy – higher interest rates, no quantitative easing in order to reduce inflation

Most economists would agree monetary policy involves

  1. Maintaining a low and stable rate of inflation.
  2. Promoting sustainable economic growth and low unemployment.

These two economic goals may not sound too controversial. But, there is a big debate about which goal is more important, and whether we should ever sacrifice a strict inflation target to pursue higher economic growth.

To some economists, the overriding target of monetary policy should be low inflation. They argue that if the Central Bank targets low inflation, then that provides the optimal environment for long-term economic prosperity. If the Central Bank starts targeting economic growth and ignoring inflation, then there is a danger that the Central Bank will lose credibility. The economy will end up with higher inflation, without any long term boost to economic growth. Furthermore, if you allow inflation to increase, this increases long-term inflation expectations and, in the future, it will be more difficult and costly to keep inflation low.

This is essentially the view of the German Bundesbank, and by and large the European Central bank.

If you look at an economic boom, such as the late 1980s in the UK, in this case inflation was allowed to rise as the UK pursued a higher than usual rate of growth. However, it later proved unsustainable and we had a boom and bust.

If low inflation is seen as primary economic goal, then:

  • Quantitative easing is seen with great distaste as there is the possibility of future inflation.
  • There should be no flexibility over the inflation target. E.g. even temporary cost push inflation should be a matter of concern, over fears that the higher inflation could change expectations and lead to permanent inflation.
  • There is an unwillingness to use monetary policy to boost demand and hasten economic recovery.
  • The solution for high unemployment and negative growth tends to be:
  • Supply side policies to increase competitiveness
  • patience, allowing market forces to invest, encouraged by macro economic stability of a low inflation environment.

The Opposite View.

The opposite view suggests that targeting economic growth and lower unemployment is much more important – at least in a recession and liquidity trap.

In the case of the UK in the late 1980s, targeting inflation would have made sense because growth was very strong. But, in 2012, circumstances are very different, GDP is still below the 2008 peak. In 2012, the over-riding economic problem is not a relatively modest inflation rate, but prolonged recession and mass unemployment.

Inflation may be above the target due to temporary cost push factors. But, this is misleading to the underlying inflationary pressures in the economy. The great recession of 2008-12, shows that you can have a high headline inflation rate, but at the same time have a large output gap and deficiency of aggregate demand.

7-3 Rule. One rule of monetary policy is to pursue  monetary easing as long as unemployment is over 7% and inflation is still below 3%. Other economists may say, that it could even be a 7-4 rule. Though generally, economists seem reluctant to target unemployment.

Recently critics argue that quantitative easing (QE3) may lead to higher inflation, but in a liquidity trap and period of mass unemployment – that is precisely the goal. If inflationary expectations are too low, it encourages low spending, low investment and deflationary pressures. Higher inflation expectations, decrease real interest rates and encourage investment.

The second criticism of quantitative easing is that it creates the potential for future inflation. But, again, supporters of active monetary policy will say, deal with the current problem first. If inflation and demand take off – monetary policy can be reversed. But, it doesn’t make sense to avoid monetary policy on the grounds it may have to be reversed. It is like saying don’t raise interest rates to reduce inflation and a boom because it may cause an economic downturn, and the need to cut interest rates later.

The Limitation of Inflation Targeting

Another issue is that targeting inflation may lead to false confidence in the stability of the economy. Inflation was very  low in the UK during (93-2007) –  an asset and house price bubble. Inflation isn’t sufficient to ensure macroeconomic stability.

Why is This Important?

In future months, we may see a rise in cost push inflation – due to rising food prices and rising oil prices. Yet, Europe is still in a deep recession with unemployment reaching close to 10%. In southern Europe, unemployment is even higher.

If the ECB stick rigidly to a low inflation target, the consequence is likely to be lower growth and higher unemployment. This low growth will also make it much more difficult to deal with the EU debt crisis.

It will also be even worse for southern Europe, who are trying to improve competitiveness through internal devaluation.

A higher inflation target, would make it easier for southern Europe to deal with  debt and improve competitiveness without resorting to very costly deflation.

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2 Responses to Purpose of Monetary Policy

  1. Ralph Musgrave September 27, 2012 at 5:53 am #

    To claim, as the above article does, that controlling inflation and unemployment are the two main objectives of monetary policy is questionable in that those two objectives are also the objectives of fiscal policy. I.e. an economy can be boosted via fiscal or monetary means (and the normal result in both cases is higher employment plus more inflation).

    That raises the question (which perhaps should have been the basic question posed in the above article): “what can monetary policy do that fiscal policy cannot?”.

    My answer is “sweet nothing”. That is, I don’t see the case for separating monetary and fiscal policy. Put another way, if stimulus is needed, I suggest simply having the government / central bank machine create new money and spend it into the economy. The equals monetary and fiscal combined.

    And there are numerous people out there who agree with me. E.g. “monetary combined with fiscal” policy seems to be advocated by most adherents to Modern Monetary Theory. The combined system is also advocated in a submission to the Vickers commission by Positive Money, Prof. Richard Werner and the New Economics Foundation. See:

    http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf

    • Rob Slack October 2, 2012 at 9:12 pm #

      ” that controlling inflation and unemployment are the two main objectives of monetary policy

      is questionable in that

      those two objectives are also the objectives of fiscal policy.”

      Does the second part mean the first is questionable?

      Monetary policy can be adjusted more quickly than fiscal policy…though its effects may not be immediate.

      Expansionary spending involves spending..on what? We shouldn’t just build things in order to stimulate the economy** (though maybe now there are things on which we could productively spend, such as housing in the right places). Reduced taxes might be a better way to boost spending (it has a monetary effect, just as you suggest for increased spending) except right now people are likely to use some of the tax cuts to pay down debt, rather than spend it).

      **we might as well pay people to did holes and fill them in.

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