Monetary Policy

Monetary policy is the control that a country's central bank or government exercises over the money supply and credit or, alternatively, over a short-term interest [Page 1398]rate. Along with fiscal policy, it is the most important policy for achieving macroeconomic stability. Stability is usually taken to mean low and stable inflation, real interest rates compatible with reasonable levels of saving and investment, sufficient financing of economic activity, and a stable and competitive exchange rate.

Implementing monetary policy is the job of the central bank (such as the Federal Reserve in the United States, the European Central Bank in the euro zone, the Bank of England, and the Bank of Japan): a public financial institution that specializes in controlling the money supply, credit, and interest rates. Ultimate responsibility for deciding monetary policy objectives and strategy used to belong to government, although nowadays there is a broad consensus that it is better assigned to a central bank that is independent of the executive (the central banks mentioned above, and many others, are independent).

The goals of monetary policy may vary widely, but there is a broad consensus that its main objective should be to achieve and maintain a low, stable, and predictable rate of inflation for a sufficiently extended period. In many cases, there is a second objective: to maintain the real gross domestic product growth at a rate close to its potential rate or employment at a level close to full employment. The European Central Bank, for example, pursues only the first of those two goals, whereas the U.S. Federal Reserve System pursues both at once. The debate about which of the two strategies is preferable remains open, and the solution is likely to depend on each country's economic, social, historical, and institutional circumstances. In either case, monetary policy is a means for government to intervene in the economic system to enable its smooth functioning.

Important ethical issues for monetary policy relate to the short-term trade-off between employment and inflation. A decision to reduce inflation can result in higher unemployment. Many argue that this shifts burdens unfairly to the poor. In contrast, a loose monetary policy designed to stimulate employment may adversely affect those on fixed incomes, such as retirees. Thus, monetary policy has implications for social justice and welfare. Consequentialist ethical approaches are useful to understand and balance these implications. Distributive justice is a consequentialist approach that focuses attention on the fairness with which the impacts of monetary policy are distributed throughout the society. Utilitarian approaches focus on the amount of net benefit that monetary policy creates.