The Choice of Monetary Policy and Its Relevance for Economic Performance: Empirical Evidence from a Global Perspective

Article excerpt

Introduction

One would think that in our modern society in which central banks are taken for granted as institutions operating the monetary policy of a country (and capable of generating miracles during financial crises) economists have reached a consensus on several issues. What is certain is that today central banking means that a governmental authority (somewhat independent of the political influences of the government, but sometimes part of the government and Ministry of Finance) is in charge of discretionary monetary management, creating and controlling (or at least trying to control) the money supply in a certain country/region, holding monopoly over such activity, managing the country's international reserves, and regulating the banking system. This implies a couple of functions such as lender of last resort for the banking system, the bankers' bank and the imposition of certain requirements on the system. After many severe financial crises, central banks have assumed not only the purpose of achieving price stability, but also that of achieving financial stability. Yet, other fundamental enquiries deserve our attention. For example, what is money and how does it influence the overall economy? What impact on the economy does monetary policy have and how should central banks exercise it? Does money have a role in the conduct of monetary policy? Surprisingly, there is considerable disagreement over the answers to the questions above, from both academic and professional point of views.

The 20th century debate focuses on the neutrality of money: does increasing the money stock impact real variables such as real interest rates, employment or output? Nowadays, most economists (including monetarists and Keynesians, but not real-business cycle proponents who assume neutrality) agree that there is a short-term effect of monetary changes over output, but that in the long run, money is neutral (Brunner and Meltzer, 1993). Still, Austrian economist Mises (1912) demonstrated that money will have an impact on relative prices and incomes in the end, changing even the structure of production in the economy. The so-called modern literature begins with Tobin's 1965 article "Money and economic growth", published in Econometrica. In a fiat money system, Tobin's portfolio shift would mean that if non-interest-bearing money is considered to be an asset, then people can be induced to "shift" their savings in more productive forms--i.e. real capital. The result of his "descriptive" model is that faster money growth (and, thus, faster inflation) will increase the capital stock and output per person (Orphanides and Solow, 1990), though not the rate of real growth, as noted by the two authors. The debate is not over yet: many empirical studies have tried tackling the neutrality issue with inconclusive results, assessing whether monetary policy influences macroeconomic performance.

The 19th century debate introduced the idea of one monetary authority "producing" money, thus institutionalizing the concept of central bank, while Walter Bagehot (1826-1877) described the 'lender of last resort' role that the Bank of England should have--i.e. helping banks in distress, lending them liquidity in order to avoid disaster in the whole banking system--institutionalizing the prototype of the modern central bank. The free-banking option was left out of the equation for good. Thus, today, monetary policy represents the sum of actions and activities undertaken by a central bank--using instruments such as interest rates, reserves, base money creation etc.--with the purpose of achieving its objectives (for example, maintaining price stability). The statutory objectives are usually set through different Acts governing the central bank (Treaty on the Functioning of the European Union, Article 127 (1) in the case of the European Central Bank (ECB), the Federal Reserve Act established by the Congress in the USA etc.). Sometimes these objectives are vaguely mentioned, or cover a wide range of issues, which leaves to the central bankers to decide on the priorities of the moment (Eijffinger and de Haan, 1996). …