Monetary policy is the monitoring and control of money supply by a central bank, such as

the Federal Reserve Board in the United States of America, and the Bangko Sentral ng Pilipinas in
the Philippines. This is used by the government to be able to control inflation, and stabilize currency.
Monetary Policy is considered to be one of the two ways that the government can influence the
economy – the other one being Fiscal Policy (which makes use of government spending, and taxes).
[1]
 Monetary Policy is generally the process by which the central bank, or government controls the
supply and availability of money, the cost of money, and the rate of interest.

Over the past few decades, policy makers throughout the world have become increasingly aware of the
social and economic costs of inflation and more concerned with maintaining a stable price level as a goal
of economic policy.

The role of a nominal anchor: a nominal variable such as the inflation rate or the money supply, which
ties down the price level to achieve price stability…

Nominal anchors[edit]
A nominal anchor for monetary policy is a single variable or device which the central bank uses to
pin down expectations of private agents about the nominal price level or its path or about what the
central bank might do with respect to achieving that path. Monetary regimes combine long-run
nominal anchoring with flexibility in the short run. Nominal variables used as anchors primarily
include exchange rate targets, money supply targets, and inflation targets with interest rate policy. [18]
Inflation targeting[edit]

Under this policy approach the target is to keep inflation, under a particular definition such as
the Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the central bank interest rate target.
The interest rate used is generally the overnight rate at which banks lend to each other overnight for
cash flow purposes. Depending on the country this particular interest rate might be called the cash
rate or something similar.
Central banks can choose to maintain a fixed interest rate at all times, or just temporarily. The
duration of this policy varies, because of the simplicity associated with changing the nominal
interest rate.
The interest rate target is maintained for a specific duration using open market operations.
Typically the duration that the interest rate target is kept constant will vary between months and
years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy
committee.[18]

Hierarchical Versus Dual Mandates:

hierarchical mandates put the goal of price stability first, and then say that as long as it is achieved
other goals can be pursued
dual mandates are aimed to achieve two coequal objectives: price stability and maximum employment
(output stability
Price Stability as the Primary, Long-Run Goal of Monetary Policy- Either type of mandate is acceptable as
long as it operates to market price stability the primary goal in the long run, but not the short run

The Goals of Monetary Policy

Price Stability

High Employment

Economic Growth

Financial Market Stability

Interest Rate Stability

Exchange Rate Stability

3 Price Stability Implies keeping inflation both low and stable

Increasingly viewed as the most important goal of monetary policy

The costs of inflation:

Menu costs

Shoeleather costs

Increased uncertainty

Arbitrary redistributions of wealth

Increasing evidence that high inflation actually slows economic growth.

Need to use a nominal anchor (monetary aggregate or the inflation rate?)

4 High Employment

High unemployment creates both personal and societal costs

With unemployment, there are idle resources that could be put to work.

What employment rate should the Fed target?

Frictional Unemployment

Structural Unemployment

Natural Rate of Unemployment

Tricky policy target, as the natural rate can change over time.
Better short run target than a long run one.

5 Economic Growth

Promoting economic growth should lead to lower unemployment and lower inflation in the long run

Supply Side Economics:

Give firms a greater incentive to invest and people a greater incentive to save.

Increased investment rates will expand the capital stock in the future.

Greater production will lead to both lower unemployment and lower prices as returns trickle down
throughout the economy

Effective in theory, but may generate significant short-run pain.

6 Stability Financial Market Stability Interest Rate Stability

Bank panics and financial crises can create great strain on the economy

The Fed can help avert these crises by acting as a lender of last resort and providing technical assistance
to financial markets.

Interest Rate Stability

Volatile interest rates increase uncertainty and reduce both savings and investment.

Rapidly rising interest rates may create hostility toward the Central Bank, leading to a loss of
independence.

Exchange Rate Stability

International trade and investment is damaged by wildly fluctuating exchange rates.

Central bank intervention in foreign exchange markets can temper these movements, increasing
stability.

7 The Time Inconsistency of Monetary Policy

Monetary policy is often crafted to produce a long-run outcome (like price stability)

However, the actions needed to achieve this long run goal may not be the best choices in the short run.

Such policies are time-inconsistent

We do not consistently follow the plan over time. Such a plan will almost always be abandoned.

Suppose the Fed wanted to pursue the long run goal of price stability
In the short run, they will be tempted to inflate the economy to boost economic output.

Doing so jeopardizes the goal of long run price stability as people revise their expectations about the
Fed’s policy stance

Expected inflation rises, which causes wages and prices to rise in the long run!

8 Should Price Stability be the Primary Goal?

In the long run, price stability and the other goals of monetary policy are not mutually exclusive.

The natural rate of unemployment is unaffected by inflation

Economic growth is only affected by real variables in the long run

Price stability will promote interest rate and exchange rate stability in the long run.

However, short-run price stability will frequently conflict with these other goals of monetary policy.

Faced with rapidly rising prices, the Fed would have to cut the money supply and raise interest rates

Doing so increases short-run unemployment and creates volatility in financial markets though!

9 Hierarchical vs. Dual Mandates

Price stability is an important goal for monetary policy, but should it take precedence over all others?

In a hierarchical mandate, price stability is the first goal and any other policy objective may only be
targeted so long as it doesn’t interfere with price stability.

The ECB has a hierarchical mandate – it can pursue high levels of employment and economic growth as
long as it doesn’t endanger price stability.

In a dual mandate, the central bank can simultaneously pursue both price stability and other goals
(usually low unemployment). These goals may conflict in the short run.

The Fed operates under such a system, with the stated goals of maximum employment, stable prices,
and moderate long-term interest rates.

There is no stated order of preference amongst these goals.

10 Hierarchical vs. Dual Mandates

A hierarchical mandate reinforces the public’s belief in the central bank’s commitment to price stability.

It gets around the time inconsistency problem by limiting the policies that the central bank can do.

However, it can lead to the central bank targeting short-run price stability, leading to large fluctuations
in output and employment.
A dual mandate gives central banks the freedom to stabilize employment in the short run while still
setting a long run policy target of price stability.

However, the dual mandate is subject to the time inconsistency problem.

If people believe that the central bank is always going to promote employment over price stability in the
short run, they will revise their inflation expectations upward.

11 Monetary Targeting

To achieve price stability, you need to have some benchmark that tells you how stable prices are.

Two such targets are widely used: monetary aggregates and the inflation rate.

In monetary targeting, the central bank announces that it will target an annual growth rate in a
particular monetary aggregate (like M1 or M2).

Once the rate is set, the Central Bank is responsible for hitting this target

This policy is transparent, flexible and accountable.

It sends a strong signal of the Central Bank’s policy objective and inflation expectations should adjust.

However, it does require that the target (M1 for example) and the goal variable (inflation) have a strong
relationship.

12 Inflation Targeting

The biggest weakness of monetary targeting is that there may not be a strong relationship between the
monetary target and inflation.

So why not directly target inflation?

With inflation target, the central bank makes a public announcement of the inflation target.

This is an attempt to revise inflation expectations

Then the central bank makes an institutional commitment to price stability (and the inflation target) as a
long-run goal.

Policy decisions (to hit the inflation target) are made using as much information as is available

The process by which the central bank reached a policy is made transparent through open
communication with the public

If the central bank fails to hit its objective, it is held accountable.

13 Inflation Targeting
Inflation targeting has been successfully used to achieve long-run price stability in Canada, New Zealand,
and the UK.

However, the process by which long-run stability was achieve involved significant short-term pain.

Advantages

Does not rely on one variable to achieve the target

Transparent and policymakers are accountable for their actions.

Better insulated from time-inconsistency problem.

Disadvantages

Delayed signaling  inflation rates are known ex-post, oftentimes with long lags. Need to know current
rate to know the stance of the central bank’s target.

Too inflexible, potentially leading to disruptive output fluctuations

During the transition period, there is low economic growth  how long until we reach the long run?