Monetary policy approach

 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, 

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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