Elements of monetary policy

Like all economic policies, monetary policy has three interrelated elements: selection of objectives, implementation, and at least an implicit theory of the relationships between actions and effects. All three elements present problems of choice and are continuing subjects of controversy.

Monetary policy can be directed toward achieving many different objectives. For example, the supply of money can be regulated to provide the government with cheap or even costless funds, to maintain interest rates at some selected level, to regulate the exchange rate on the nation’s currency, to protect the nation’s gold and other international reserves, to stabilize domestic price levels, to promote continuously high levels of employment, and so on. Such multiple objectives are unlikely to be fully compatible at all times. Rational policy making therefore requires identification of the various objectives, analysis of the extent to which they are or can be made compatible, and choices from among those that conflict with one another. A later section will stress changes in the objectives of monetary policy and some of the problems of reconciling them.

The role played by monetary policy in promoting selected economic objectives depends greatly on the nature of the economic system and on attitudes toward the use of other methods of regulation. This role is usually secondary in economies characterized by government operation of most economic enterprises and government control of resource allocation, distribution of output, and prices of in-puts and outputs. Even in these economies monetary policy is not trivial. An excessive supply of money can create excessive demand and inflationary pressures, which are evidenced in black markets, hoarding, and bare shelves. On the other hand, a deficient supply of money can impede the flow of production and trade. Yet the major function of monetary policy in such economies is that of passive accommodation, that is, to provide the amount of money needed to facilitate the operation of other government controls; it is not to serve as a prime regulator.

Monetary policy usually plays a more positive regulatory role in economic systems that rely heavily on market forces to organize and direct processes of production and distribution. In such economies, decisions of business firms relating to rates of output, amounts of labor employed, rates of capital formation, and so on, are strongly influenced by relationships between costs and actual and prospective demands for output. If aggregate demands are deficient, firms will not find it profitable to employ all available labor, to utilize fully existing capacity, or to purchase all the new capital goods that could be produced. On the other hand, excessive aggregate demands for output are inflationary. A major function of monetary policy, therefore, is to regulate the behavior of aggregate demand for output in order to elicit a more favorable performance by the economy. This function is shared with fiscal policy in many countries and in many different combinations or “mixes.” Although the deliberate use of fiscal policy for this purpose has increased considerably in recent decades, monetary policy continues to be a major instrument.

Primary responsibility for administering monetary policies is usually entrusted to central banks, although there are varying degrees of government control of central banks and their policies. Central banks regulate the money supply and influence the supply of credit in two principal separate but closely related capacities: as controllers of their own issues of money and as regulators of the amount of money created by commercial banks. Both are important, but their relative importance depends in part on the stage of financial development of the country and on the types of money employed. In countries where bank deposits have not yet come to be widely used, notes issued by the central bank often constitute a major part of the money supply. In such cases the central bank may regulate the money supply largely by controlling directly its own note issues. However, in countries that have reached a later stage of financial development, central bank notes constitute a smaller part of the money supply; deposits at commercial banks are the major component, and the actions of commercial banks directly account for a large part of the fluctuations of the money supply. In such countries, the central bank is primarily a regulator of the commercial banks, although control of its own money creation remains important and is a part of the process.

The terms “monetary policy” and “credit policy” are often used interchangeably or with only slightly different shades of meaning. This has come about primarily because in most modern systems the creation and destruction of money by central and commercial banks are so closely intertwined with their expansion and contraction of credit. They typically create and issue money (currency and deposits) by making loans or purchasing securities, usually debt obligations. Thus, one side of the transaction is the issue of money; the other is the provision of funds to borrowers or sellers of securities, which tends to lower interest rates. Central and commercial banks typically withdraw money (currency and deposits) by decreasing their outstanding loans or by selling securities, usually debt obligations. Thus there is both a decrease in the supply of money and a decrease in the funds available to borrowers and to purchasers of the securities sold by the banks, which tends to increase interest rates.

Those who speak of monetary policy tend to focus on the behavior of the stock of money, while those who speak of credit policy tend to focus on the quantity of loan funds available from the central and commercial banks. Such differences in focus need not lead to differences in either analysis or conclusions. Yet they sometimes do. Those who focus on the stock of money are more likely to stress “real balance effects” on both consumption and investment spending, while those who focus on credit are likely to put more stress on the direct effects on interest rates, the availability of funds, and investment. Monetary theory has made considerable progress in reconciling and integrating these approaches, but much remains to be done.

The third element in monetary policy is at least an implicit theory of the relationships between actions and effects. If its actions are to promote its objectives, the monetary authority needs some theory as to the nature, direction, magnitude, and timing of the responses. The relevant responses are numerous and on several levels. For example, they include the response of the supply of money and credit; the response of aggregate demand for output; and the responses of real output, employment, and prices. There are still disagreements among both economists and central bankers on many of these theoretical and empirical issues, and these disagreements underlie many continuing controversies over the proper nature and scope of monetary policy. Some of these will be treated in a later section.

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