Monetary Policy & Price Stability

Monetary policy can be defined broadly as any policy relating to the supply of money. Since the main agency concerned with the supply of money is the nation's central bank, the Federal Reserve, monetary policy can also be defined in terms of the directives, policies, statements, and actions of the Federal Reserve, particularly those from its Board of Governors that have an effect on aggregate demand or national spending. The nation's financial press and markets pay particular attention to the pronouncements of the chairman of the Board of Governors, the nation's central banker. The reason for this attention is that monetary policy can have important effects on aggregate demand and through it on real Gross Domestic Product (GDP),unemployment, real foreign exchange rates, real interest rates, the composition of output, etc. It is paradoxical, however, that these important effects, to the extent that they occur, are essentially only short-run in nature. Over the longer run, the major effect of monetary policy is on the rate of inflation. Thus, while a more rapid rate of money growth may for a time stimulate the economy leading to a more rapid rate of real GDP growth and a lower unemployment rate, over the longer run these changes are undone and the economy is left with a higher rate of inflation. In some societies where high rates of inflation are endemic, more rapid rates of money growth fail to exercise any stimulating effect and are almost immediately translated into higher rates of inflation. Traditionally, two means have been used to measure the posture of monetary policy. Since monetary policy involves the Federal Reserve's contribution to aggregate demand or money spending, it would be logical to examine the growth rate of the money supply. A growing money supply is important for the subsequent growth in money spending or aggregate demand. Giving empirical content to the abstract concept of "the supply of money" has not been easy. For the United States, three different collections of assets have been defined as "money" and labelled M1, M2,and M3. Unfortunately, over the period 1990-2004 these aggregates have not been consistently linked to money spending and, consequently, they are not the major focus of monetary policy. Rather, the Federal Reserve executes monetary policy by setting a target for an overnight interest rate called the federal funds rate. Low or falling rates are usually taken as a sign of monetary ease; high or rising rates usually indicate monetary tightness. Changes in the federal funds rates affect primarily short-term interest rates, and through these changes, money spending. The book then looks more closely at five economies that have adopted a price stability goal: New Zealand (which was the first country to adopt targeting), Canada, the United Kingdom, Sweden, and the Euro area. One key finding from these case-studies is that, in practice, central banks tend to operate with greater latitude and more discretion than some targeting proponents may have envisioned. For example, central banks still tend to respond to a decline in economic activity by lowering interest rates, even though strict attention to the target might not justify it. This is possible because exceptions to the targets are granted for a variety of shocks and the definition of inflation being targeted often excludes price changes due to factors such as food, energy, and excise taxes. The book concludes with a brief analysis of the record of inflation targeting in the developing world. It finds that the improvement in economic performance following the adoption of inflation targeting is greater in the developing world. Since developing world countries often experience economic and political instability.