Monetary Policy

Monetary policy has several important aims including eliminating unemployment, stabilizing prices, economic growth and equilibrium in the balance of payments. Monetary policy is planned to fulfill all these goals at once. Everyone agrees with these ambitions, but the path to achieve them is the subject of heated contention.

Eliminating unemployment altogether may not be possible, so economists aim for what is known as "full employment." This concept includes the idea that there will be a small percentage of unemployed people in a given populace. However, the ideal rate of unemployment is also a controversial matter. Some experts believe that 3 percent or 4 percent is an ideal unemployment rate while others feel that 5 percent is the absolute minimum around which the unemployment rate should hover.

At some level, the argument about the perfect unemployment rate has to do with an economist's politics. Conservatives will advocate for a higher rate of unemployment than will liberals. Another way by which people measure the desired rate of unemployment is predicated upon the unemployment rates of recent past history. In 1934, for example, economists might have deemed a 5 percent unemployment rate to be full employment. In any event, monetary policy sets forth a target for full employment and aims to achieve this end.

Price stability, by nature, is also not straightforward as a monetary policy goal. Just as full employment allows for some unemployment, so too price stability includes the idea that there can be fluctuations in prices. These should, of course, be minor price changes, but what is the definition of a minor price change? Some economists would say that price stability has been achieved when prices change only 0.25 percent each year. Others feel that a price change of 1 percent is minor while perhaps a third group of economists will push the envelope and state that a 2 percent price change still represents a state of price stability.

One complication in determining the perfect rate at which prices can change and still remain compliant with price stability is that there is an upward bias to the Consumer Price Index (CPI). Recent research has led to some enhancements on that score. However, one such CPI bias involves an inherent inability to account for quality improvements. This is easier to understand when viewed through the lens of a concrete example: adjustments to the basket of goods and services.

The price of the typical basket of goods and services is altered each decade to reflect current economic realities. However, these adjustments also make it possible for the CPI to conceal the gradual decline of a population into a state of poverty. For example, lowered wages may force a situation in which people must use public transportation to get to work instead of using their cars. The economists who decide on the basket of goods and services can substitute bus fare costs for the costs of operating private cars. This example is just one way to express that the CPI is a biased ruler that may not give an accurate accounting of price changes for the sake of determining price stability.

Even the very promising-sounding phrase economic growth is fraught with difficulties. Monetary policy must determine the rate of economic growth that can be sustained. At times, Federal Reserve officials have posited that the growth rate can be increased for brief periods by implementing inflationary policies, but that the growth rate in such a scenario cannot be sustained. These officials feel that monetary policy must be aimed toward achieving sustainable growth. However, it is difficult to pinpoint the parameters that define the concept of sustainable growth. It is difficult, therefore, to form monetary policy around the indefinable goal of sustainable growth.

The final lynchpin of monetary policy is also imprecise: the balance of payments equilibrium or having the means to pay for goods and services and the ability to balance the national budget. Is the concept of balance of payments equilibrium consonant with a small deficit in the national balance of payment?

In many countries, the United States dollar is the reserve currency of choice. As the demand grows for international reserves, a certain amount of deficit in the balance of payments for the United States might be expected. This type of deficit might still be considered conformable with balance of payments equilibrium. Determining the size of such an "allowable" equilibrium deficit, and whether it can even be allowed to exist, is also a matter of judgment and subject to dispute.

While these four ideals: full employments, price stability, economic growth and balance of payments equilibrium have formed the traditional foundations of monetary policy, other goals have been factored into the development of monetary policy at various points in time. During World War I, for instance, monetary policy was geared toward enabling sales of government securities. From World War II through 1951, the major aim of monetary policy was to maintain stable prices for government securities. Preserving the system of private enterprise has also remained an important monetary policy goal for the United States.

Monetary Policy: Selected full-text books and articles

Monetary Policy in the Euro Area: Strategy and Decision Making at the European Central Bank By Otmar Issing; Vitor Gaspar; Ignazio Angeloni; Oreste Tristani Cambridge University Press, 2001
What Monetary Policy Can and Cannot Do: It Can Do a Lot, but It Is Important to Know Its Limits By Santomero, Anthony M Business Economics, Vol. 37, No. 1, January 2002
Peer-reviewed publications on Questia are publications containing articles which were subject to evaluation for accuracy and substance by professional peers of the article's author(s).
Monetary Policy Decision-Making and Accountability Structures: Some Cross-Country Comparisons By Aldridge, Tim; Wood, Amy The Reserve Bank of New Zealand Bulletin, Vol. 77, No. 1, March 2014
Inflation and Monetary Policy in the Twentieth Century By Christiano, Lawrence J.; Fitzgerald, Terry J Economic Perspectives, Vol. 27, No. 1, Spring 2003
The Depoliticization of Monetary Policy: A Contemporary Test of Persistent Myths By Tempelman, Jerry H Business Economics, Vol. 43, No. 2, April 2008
Peer-reviewed publications on Questia are publications containing articles which were subject to evaluation for accuracy and substance by professional peers of the article's author(s).
U.S. Monetary Policy in an Integrating World: 1960 to 2000 By Cooper, Richard N.; Little, Jane Sneddon New England Economic Review, May-June 2001
The Art of Monetary Policy By David C. Colander; Dewey Daane M. E. Sharpe, 1994
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