Monetary Policy

Monetary policy became an issue of economic governance in developed capitalist economies in the 1980s. Until then, the conduct of interest rate, money supply, and exchange rate policies was considered to belong to “the art of central banking,” more of practical than scholarly interest. The watershed is symbolized by the so-called “Volcker shock,” with which the U.S. Federal Reserve (under Chairman Paul Volcker and during the administration of President Jimmy Cater) ended an accommodating stance that had led to rising inflation rates. Other central banks followed suit. Researchers closely scrutinized goals, instruments, and the desirable degree of activism in monetary policy.

Monetary policy has essentially two goals: price stability and low unemployment. In practice, these are difficult to operationalize and quantify. Price stability is compatible with some rise of the price level, an index of money prices, but not with a spiral of rising prices, driven by windfall profits or supply shocks, and rising wage demands. Low unemployment means, somewhat circularly, an employment level that is compatible with price and wage stability so that all unemployment is frictional or seasonal rather than cyclical. Central banks typically react to deviations of these goals from a desired value or long-term trend by raising or lowering the interest rate. This behavior has been found a robust empirical regularity by estimating the so-called Taylor Rule (named for John Taylor) that shows how strongly a central bank can respond to deviations from these two goals of monetary policy.

The instruments of monetary policy consist, in principle, of the short-term interest rate at which banks can get credit from the central bank (discount rate policy) and of money supply that the central bank can manipulate by selling and buying bonds in the money market (open market policy). These instruments are used to manipulate transmission variables such as the long-term interest rates, stock prices, exchange rates, or the volume of credit. These transmission variables are the economic indicators that ultimately account for the spending and saving [Page 573]decisions of economic agents and the competitiveness of firms. This transmission is fraught with uncertainty.

Monetarism has strongly advocated abstaining from manipulating the interest rate as an ambiguous indicator of how lax or strict credit market conditions are. It advocated instead using monetary aggregates such as M1, M2, or M3, which added to central bank (“high powered”) money other means of payment that households dispose of in the form of banking accounts of different maturities. Yet, virtually all central banks now use the short-term interest rate only whereas money growth rates are only one set of indicators among many. The use of monetary aggregates is reliable only if monetary demand is quite stable, but this is not the case, largely because of the internationalization and deregulation of financial markets.

Monetary policy is an issue of governance because it raises the question of how far a key economic policy should be delegated to an independent agent. The independence of central banks is a time-honored topic, mainly asking to what extent the monetary authority should be instrument-independent and goal-independent. Although virtually all independent central banks react to deviations from employment and inflation goals with changes in the short-term interest rate, there is now debate whether a central bank should pre-commit to quantified and announced goals and thus follow an explicit rule and to what extent it should use discretion.

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