To understand the difficulties of conducting monetary policy, consider the following imaginary experiment. First, place a brick on one side of a table and then sit on the opposite side with your face at table level. Next, try to pull the brick across the table using a rubber band looped around it. For a long time nothing happens, but then ...
This experiment, which you shouldn't try at home, illustrates two key problems with the application of monetary policy in a market economy. It suggests that the economy can be slow to respond to changes in policy, which means that policy-makers must allow for lags of varying periods before their decisions have any effect. But, above all, it shows that the effects can be extremely serious if the policies are wrong. Moreover, there are many other problems associated with monetary policy that might make us wonder why governments should attach such importance to it.
The consistent and effective management of a modern market economy by the government presupposes three things:
* A set of objectives.
* A set of economic policy instruments.
* An economic theory explaining how economies work.
A set of objectives is necessary--a government's economic policy would be aimless otherwise. Over the years a consensus has developed that full employment, price stability, economic growth and external stability are all reasonable and desirable aims of economic management. The relative importance placed on each factor may change over time. In the UK, for example, the objective of price stability (ie, the avoidance of excessive inflation) has become a high priority. Because inflation is largely--entirely, according to monetarist economists--a monetary phenomenon, monetary policy is likely to be an important part of a government's economic management toolkit.
The second requirement is a set of economic instruments by which a government can influence the behaviour of the economy. These might be policy instruments designed to exert a direct effect on particular parts of the economy--for example, taxes intended to alter the price of particular goods--or policies designed to affect the economy as a whole. The two main instruments here are fiscal policy and monetary policy. Both are used to change the behaviour and performance of the economy by influencing the level of aggregate monetary demand (AMD).
How does using fiscal or monetary policy to influence the level of AMD in an economy help a government to achieve its objectives of full employment, price stability and so on? This is the role of economic theory, because it provides explanations for inflation, unemployment etc. Without a theory, governments wouldn't know how to use fiscal and monetary policy to influence the economy. At the very least, a government would have a problem of assignment. If it had two main objectives--eg, price stability and full employment--and it had two policy instruments--eg, fiscal policy and monetary policy--which instrument should it assign to which objective? Of course, if the theory is wrong, a government can end up making mistakes in the conduct of economic policy. But, if there were no theory at all, the development of an economic policy would be a complete guessing game at best.
Economic theory indicates that the use of monetary policy is appropriate for controlling inflation. Monetary policy is designed to change the level of AMD in the economy by influencing the monetary environment. This raises two questions: why is it important to influence the level of AMD in the economy, and how can monetary policy do this?
The level of AMD is important because most economic theorists see this as the main determinant of the rate of inflation. They believe that inflation is in effect a demand phenomenon: excessive AMD in the economy will exert upward pressure on prices. Consider both the total demand for goods and services in the economy (aggregate demand) and the ability and willingness to supply goods and services (aggregate supply). …