Monetary policy—the government's decisions about how much money to supply to the economy—is one of the two principal tools available for affecting macroeconomic behavior.
(The other, fiscal policy, is discussed in Chapter 15.) Monetary policy decisions have widespread implications for the economy. The macroeconomic models that we have presented predict that changes in the money supply will affect nominal variables such as the price level and the nominal exchange rate.
In addition, theories that allow for nonneutrality (including the extended classical theory with misperceptions and the Keynesian theory) imply that, in the short run, monetary policy also affects real variables such as real GDP, the real interest rate, and the unemployment rate. Because monetary policy has such pervasive economic effects, the central bank's announcements and actions are closely monitored by the media, financial market participants, and the general public.In this chapter we look more closely at monetary policy, concentrating first on the basic question of how the nation's money supply is determined. We demonstrate that, although a nation's central bank (the Federal Reserve System in the United States) can exert strong influence over the level of the money supply, the money supply also is affected by the banking system's behavior and the public's decisions. We then explain why the Federal Reserve and many other central banks now target interest rates rather than the money supply.
In the second part of the chapter, we explore the question: How should the central bank conduct monetary policy? Not surprisingly, because of classical and Keynesian differences over the effects of monetary policy and the desirability of trying to smooth the business cycle (Chapters 10 and 11), the question is controversial. Keynesians usually argue that monetary authorities should have considerable latitude to try to offset cyclical fluctuations. Opposing the Keynesian view, both classical economists and a group of economists called monetarists believe that monetary policy shouldn't be left to the discretion of the central bank but instead should be governed by simple rules.
Although establishing rules for monetary policy might seem to tie policymakers' hands unnecessarily, monetarists and classicals argue that the use of rules would lead to a more stable and less inflationary economy in the long run. After examining the arguments for and against the use of rules, we discuss the effectiveness of rules-based monetary policies in the United States and other countries. We also discuss how the debate about rules is related to questions of how monetary policymaking institutions should be designed. For example, should the central bank be largely independent from the rest of the government, or should it be more directly controlled by the executive and legislative branches?Learning Objectives
14.1 Explain how the nation’s money supply is determined.
14.2 Describe the policy tools used by the Federal Reserve to control the money supply.
14.3 Explain the Fed’s setting of monetary policy targets.
14.4 Discuss the difficulties of making monetary policy.
14.5 Discusswhether monetary policy should be conducted by rules or discretion.
14.1