Academic journal article Review of Social Economy

On the Effectiveness of Monetary Policy and of Fiscal Policy

Academic journal article Review of Social Economy

On the Effectiveness of Monetary Policy and of Fiscal Policy

Article excerpt

Abstract There has been a major shift within macroeconomic policy over the past two decades or so in terms of the relative importance given to monetary policy and to fiscal policy in both policy and theoretical terms. The former has gained considerably in importance, with the latter being rarely mentioned. Furthermore, the nature of monetary policy has shifted away from any attempt to control some monetary aggregate (prevalent in the first half of the 1980s), and instead monetary policy has focused on the setting of interest rates as the key policy instrument. There has also been a general shift towards the adoption of inflation targets and the use of monetary policy to target inflation. This paper considers the significance of this shift in the nature of monetary policy. This enables us to question the effectiveness of monetary policy, and to explore the role of fiscal policy. We examine these questions from the point of view of the "****new consensus" in monetary economics and suggest that it is rather limited in its analysis. When the analysis is broadened out to embrace empirical issues and evidence the clear conclusion emerges that monetary policy is relatively impotent. The role of fiscal policy is also considered, and we argue that fiscal policy (under specified conditions) remains a powerful tool for macroeconomic policy. This is particularly an apt conclusion under current economic conditions.

Keywords: "new consensus", macroeconomics, monetary policy, fiscal policy

INTRODUCTION

There has been a major shift within macroeconomic policy over the past two decades or so in terms of the relative importance given in both policy and theoretical terms to monetary policy and to fiscal policy with the former gaining considerably in importance, and the latter being rarely mentioned. Furthermore, the nature of monetary policy has shifted away from any attempt to control some monetary aggregate (which was prevalent in the first half of the 1980s), and instead monetary policy has focused on the setting of interest rates as the key policy instrument. (1) There has also been a general shift towards the adoption of inflation targets and the use of monetary policy to target inflation. In this paper we begin by considering the significance of this shift in the form of monetary policy. This consideration leads us to firstly question the effectiveness of monetary policy, and then to explore the role of fiscal policy.

The difficulties, which Central Banks had in the control of monetary aggregates, can be largely ascribed to the endogenous nature of money and to the unstable nature of the demand for money. The concept of endogenous (bank) money has become an important one for macroeconomic analysis, especially within Keynesian economics. Endogenous credit bank money provides a more realistic approach to money in comparison with the exogenous, controlable money approach (in the sense that we know that most money in an industrialized economy is bank money). Further, the concept of endogenous money fits well with the current approach to monetary policy based on the setting (or targeting) of a key interest rate by the Central Bank, with the stock of money becoming almost irrelevant. (2) In the case of endogenous money, the causal relationship between the stock of money and prices is reversed as compared with the exogenous money case. Endogenous money plays an important role in the causal relationships between investment and savings: simply the expansion of investment expenditure requires the availability of loans, which leads to a corresponding expansion of bank deposits, and the investment expenditure generates a corresponding level of savings.

A simple representation of the endogenous money approach treats the Central Bank rate of interest as given with the Central Bank providing bank reserves that are required (at a price which it sets). Loans are provided by banks at a rate of interest, which is a mark-up over the Central Bank rate, and the banks meet the demand for loans so far as their liquidity preference allows. …

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