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Monetary Policy and Economic Objectives

When the price level rises, fewer goods and services can be consumed using the same amount of
currency. This is known as inflation – a loss of real purchasing power. The effects of inflation are
significant in the ways of a decrease in the real value of money, the creation of uncertainty about
the future inflation, and thus, discouraging firms and individuals to invest and save. Besides, high
inflation may lead to the shortage of goods if there is a high expectation of future inflation so that
households are likely to buy more currently which will lead to the rises of prices. Monetarists
believe that the most significant factor influencing inflation is the management of money supply
by easing or tightening of credit.1 Thus, central banks play very important role in controlling the
size of the money supply in order to achieve the macroeconomic goals including low and stable
inflation, low unemployment, and sustained economic growth and so on.

European Central Bank (ECB)’s Monetary Policy Strategy

To maintain price stability is the primary objective of the Eurosystem. This is laid down in the
Treaty establishing the European Community. It states that “without prejudice to the objective of
price stability”, the Eurosystem will also “support the general economic policies in the
Community with a view to contributing to the achievement of the objectives of the Community”.
These include a “high level of employment” and “sustainable and non-inflationary growth”.2 This
Treaty builds a clear hierarchy of objectives for the Eurosystem and it assigns prior importance to
price stability. It also implies that the Eurosystem should take into account the wider economic
goals. If it is given that monetary policy can influence real activity in the short term, the ECB
should avoid generating fluctuations in output and employment.

In the long term, real income or the employment rate are determined by the real factors such as
technology, population growth or the economic agents’ preferences. The central bank cannot just
expand the money supply or keep the short-run interest rates at a level since it can only affect the
general price level. Maintaining price stability is the only way that central bank can contribute to
the potential economic growth.

Federal Reserve Bank (Fed)’s Monetary Policy Strategy

The long-term goal of the Fed’s monetary policy is to ensure that money and credit grow
sufficiently in order to achieve high employment, sustainable growth and stable prices. 3 What the
Fed can do, is to create an environment which is conductive to favourable economic growth by
pursuing price stability. So, like most central banks, the Fed cares about both inflation and
measures of the short-run performance of the economy.4

1
http://en.wikipedia.org/wiki/Inflation
2
http://www.ecb.europa.eu/mopo/intro/objective/html/index.en.html
3
http://www.newyorkfed.org/education/fed/monpol.html
4
http://www.frbsf.org/publications/federalreserve/monetary/goals.html
A stable level of price encourages saving and prevents the erosion of assets by unanticipated
inflation, thus increase the aggregate demand of the economy, leading to sustained output and
employment growth.

However, sometimes these goals are in conflict. For example, if there is a recession and the Fed
needs to prevent the employment losses. But this short-run success might turn into a long-run
problem if monetary policy remains expansionary too long, causing inflationary pressures. So it is
very important for the Fed to find the balance between its short-run goal of stabilization and its
long-run goal of maintaining low inflation.5

Hierarchical Mandate VS Dual Mandate

In the long run, these two types of mandates are not very different. However, in the short run, a
hierarchical mandate puts too much emphasis on inflation control, leading to large fluctuations in
output and employment. But it gets around the time inconsistency problem 6 by limiting the
policies of the central bank. A dual mandate allows the central bank to balance the employment in
the short run while still setting a long run target of price stability. At the same time, the time
inconsistency problem may occur. Obviously, the goal of price stability should be seen as primary
goal only in the short run.

How Fed operates so that achieving lower unemployment? The Fed can affect inflation and
unemployment through its manipulation of the federal fund rate. By setting a target value for the
funds rate and adjusting the amount of funds in the banking system, causing the funds rate move
towards the target value. When the funds rate rises, the long-term interest rate also increases and
the dollar appreciates. The increase in the long-term rate cuts the spending on interest-sensitive
goods such as houses and autos; the appreciation of dollar reduces exports. Both spending and
exports decline causing aggregate demand decreases, output, employment, and the price level drop
as well. Thus, when the Fed seeks lower inflation, it raises the funds rate target, and when it seeks
lower unemployment, it decreases the rate target.7

Criticism—Keynesian view

Keynesian economic theory describes that changes in money supply do not directly affect prices,
and the visible inflation is caused by the pressures in the economy expressing themselves in
prices. Keynesian economists typically emphasize the role of aggregate demand in the economy

5
http://www.frbsf.org/publications/federalreserve/monetary/goals.html
6
A good plan for the long run is time-inconsistent if it cannot be consistently followed over time (because reneging
has short run gains), and will be abandoned soon. Monetary policy maker pursuing long run price stability are
always tempted (or pressured) to pursue a discretionary monetary policy that is more expansionary than expected,
because such an unexpected expansionary policy would boost economic output in the short run. However, when
expectations about inflation are raised, wages and prices will lead to higher inflation, but will not result in higher
output. A nominal anchor can help prevent the time-inconsistency problem in monetary policy by providing an
expected constraint on discretionary policy.
http://www.sfu.ca/~hxiang/210/Slides/Monetary%20policy.pdf
7
Willem Thorbecke (2000)
rather than the money supply in determining inflation. This means, for Keynesians, the money
supply is only one of the causes of inflation.

The “triangle model” which is called by Robert J. Gordon illustrates three major types of inflation:
increases in aggregate demand due to increased government and private spending cause Demand-
pull inflation; because of natural disasters or increase prices of inputs, aggregate supply drops
leading to Cost-push inflation; firms charge higher prices on their customers in order to cover the
increased labour wages, leads to a “vicious circle” and thus, Built-in inflation.

Some Keynesian economists also disagree that central banks fully control the money supply, they
arguing that central banks should have little control, since the money supply adapts to the demand
for bank credit which is issued by commercial banks. This is known as the theory of endogenous
money.8

Conclusion

A hierarchical mandate reinforces the public’s belief in the central bank’s commitment to price
stability, while a dual mandate leads a central bank to pursue short-run expansionary policies
without worrying about the long-run consequences. Either type of mandate is acceptable as long
as it operates to make price stability as the primary goal in the long run, but not in the short run.

References:
Inflation-Wikipedia, the free encyclopedia: http://en.wikipedia.org/wiki/Inflation
The European Central Bank: History, Role and Functions, Hanspeter K. Scheller (2006), Second
Revised Edition
ECB’s official website: http://www.ecb.europa.eu/mopo/intro/role/html/index.en.html
http://www.ecb.europa.eu/mopo/intro/objective/html/index.en.html
http://www.ecb.europa.eu/mopo/intro/benefits/html/index.en.html
Monetary Policy: Goal, Institutions, Strategies, and Instruments Peter Bofinger (2001) Oxford
University Press
http://www.frbsf.org/publications/federalreserve/monetary/goals.html
http://www.newyorkfed.org/education/fed/monpol.html
Article: Inflation Goals: Guidance from the Labor Market? Erica L.Groshen and Mark E.
Schweitzer (1997)
Article: A Dual Mandate for the Federal Reserve, Willem Thorbecke (2000)
http://www.sfu.ca/~hxiang/210/Slides/Monetary%20policy.pdf
http://www.docstoc.com/docs/13238923/Central-Bank-Policy

8
http://en.wikipedia.org/wiki/Inflation