Monetary Policy Essay ⋆ Political Science Essay Examples ⋆ EssayEmpire

Monetary policy is a set of actions taken by a government authority to influence the supply of money and credit in circulation. Research indicates that changes in the rate of growth of the money supply affect unemployment, output, inflation, and interest rates. There is also a substantial political dimension to monetary policy. In the past, political scientists studied the effects that political parties, executive and legislative branches, and elections have on policy outcomes. What has not been widely studied by political scientists, however, are two other important monetary policy research issues: (1) policy maker use of economic targets in both policy and outcomes, and (2) policy implementation.

In the academic literature (largely done in economics) policy target research questions center on whether to stress unemployment (output) or inflation stabilization. On the other hand, policy implementation research focuses on the economic trade-offs associated with the use of discretionary policy (e.g., responding to current circumstances) versus following a predictable course of action (termed a policy rule).

Policy Targets And Policy Implementation: Historical Developments

In the United States, legislation such as the Employment Act of 1946 and the Federal Reserve Act of 1977 mandated economic growth, employment, and inflation stability as objectives. During the same period, the most important legislation pertaining to policy implementation was the Accord of 1951. This “Accord” granted the Federal Reserve enhanced independence from political pressure. In their 1993 article, “Central Bank Independence and Macroeconomic Performance,” Alberto Alesina and Lawrence Summers find monetary authority independence leads to lower inflation. The Accord of 1951, however, is silent on mandating discretionary policy or a policy rule.

Evolution Of Policy Target Emphasis

Due to the research of economist A. W. Phillips, unemployment reduction became the early policy target priority. Phillips demonstrated an inverse relation between wages and unemployment: Higher unemployment was associated with lower wages, while higher wages were associated with lower unemployment. This relation was graphically demonstrated on what is now called the Phillips curve.

However, a critique soon emerged of the assumptions underlying the use of the Phillips curve and discretionary policy. Milton Friedman and Edmund Phelps reasoned the Phillips curve was based on false assumptions about how people formed their expectations and, therefore, was bound to give incorrect predictions about inflation and unemployment. Friedman and Phelps argued that a simulative policy reduced unemployment for a brief time if workers set their wage demands too low. This stimulative effect occurred if workers underestimated future inflation. Friedman and Phelps reasoned that workers could not be fooled for long; consequently, there could be no stable or predictable Phillips curve trade-off. The result would instead be a combination of higher and more volatile unemployment and inflation—a combination that came to be known as stagflation. During the late 1960s and for most of the 1970s, many industrialized countries ignored the Friedman and Phelps critique of the Phillips curve and, as a result, experienced stagflation.

The Role Of Public Expectations: Consequences For Policy Implementation

Friedman and Phelps’s critique and the subsequent validation of their predictions highlight the importance of accounting for the role of the public and their expectations. These insights had implications for policy discretion. Discretionary policy, because it responds to current circumstances and puts

less emphasis on past conditions and public expectations, was thought to create greater uncertainty and greater economic volatility. The reason is that policy changes and the use of policy maker discretion are sometimes at odds with anchoring and stabilizing public expectations. Discretionary policy is undermined by the threat of time consistency, since “a policy that may be the best thing to do in general may not be the best thing to do at a particular time.”

Recent Developments On Policy Targets And Policy Implementation: Inflation Targeting

Policy rules, whether they involve money growth or interest rates, account for public expectations and can minimize the time consistency problem. In addition, policy rules have now shifted to targeting inflation. A policy rule involving inflation targeting has the monetary authority adjusting money growth and nominal interest rates in response to deviations of inflation from a prespecified target (e.g., 2 percent). Since the 1990s, many industrialized countries have adopted inflation targeting. Inflation targeting is effective, because it helps coordinate and stabilize inflation expectations. When policy makers achieve and maintain inflation stability, the public can substitute what they think is an implicit or explicit inflation target for past inflation. In this environment, plans (i.e., contracts) now exhibit (price/inflation) stability. For these reasons inflation targeting—and emphasizing inflation stability—in various forms have resulted in a reduction in the average extent and volatility of inflation in advanced industrial countries.

There also appears to be a relation between achieving and maintaining inflation stability and output stability. One manifestation of this relation is the length of business cycle expansions. If we examine U.S. peacetime business expansions recorded since 1854, we find the average duration is approximately 30.5 months. However, when we examine the average duration of the two peacetime expansions between 1982 and 2002, a period of policy-induced inflation stability, the duration is 106 months. These policy successes—in contrast to the policy errors of the 1970s and the economic crisis ongoing as of early 2010—suggest political forces encouraging inflation stability have the most salutary economic consequences. A new literature indicates political forces influenced monetary policy to deviate from promoting inflation stability (e.g., keeping interest rates artificially low) and created the conditions for the housing bubble that started to burst in 2008.

Bibliography:

Alesina, Alberto, and Lawrence Summers. “Central Bank Independence and Macroeconomic Performance.” Journal of Money, Credit, and Banking 25 (May 1993): 151–162.
Bernanke, Ben.,Thomas Laubach, Frederic Mishkin, and Adam Posen. Inflation Targeting: Lessons from the International Experience. Princeton, N.J.: Princeton University Press, 2005.
Friedman, Milton. “The Role of Monetary Policy.” American Economic Review 58 (March 1968): 1–17.
Granato, Jim., and M. C. Sunny Wong. The Role of Policymakers in Business Cycle Fluctuations. New York: Cambridge University Press, 2006.
“Using Monetary Policy to Coordinate Price Information: Implications for Economic Stability and Development.” The Whitehead Journal of Diplomacy and International Relations 6, no. 2 (Summer/Fall 2005): 47–59.
Keech,William R. Economic Politics:The Costs of Democracy. New York: Cambridge University Press, 1995.
“Rules, Discretion, and Accountability in Macroeconomic Policymaking.” Governance 5 (March 1992): 259–278.
Kydland, Finn, and Edward C. Prescott. “Rules Rather than Discretion: The Inconsistency of Optimal Plans.” Journal of Political Economy 85, no. 3 (June 1977): 473–491.
Phelps, Edmund. “Money Wage Dynamics and Labor Market Equilibrium.” The Journal of Political Economy 76, no. 4 (July/August 1968): 687–711.
Phillips, A.W. “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861–1957.” Economica 25, no. 100 (November 1958): 283–299.
Sheffrin, Steven. The Making of Economic Policy: History, Theory, Politics. Cambridge, Mass.: Basil Blackwell, 1989.
Stein, Herbert. Presidential Economics: The Making of Economic Policy from Roosevelt to Reagan and Beyond. New York: Simon and Schuster, 1985.
Sowell, Thomas. The Housing Boom and Bust. New York: Basic Books, 2009.
Taylor, John B. Getting Off Track. Stanford, Calif.: Hoover Institution Press, 2009.

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