Essay/Term paper: Conflicts in monetary policy

Essay, term paper, research paper:  Management

Goals of monetary policy are to "promote maximum employment, inflation
(stabilizing prices), and economic growth." If economists believe it's possible
to achieve all the goals at once, the goals are inconsistent. There are
limitations to monetary policy.

The term "maximum employment" means that we should try to hold the
unemployment rate as low as possible without pushing it below what
economists call the natural rate or the full- employment rate. Pushing
unemployment below that level would cause inflation to rise and thereby ruin
the other objective--stable prices, economic growth, which is our objectives
in the long run.

Overall financial stability will lead to a better balance between consumption
and saving that will make resources available for investment purposes, reduce
changes in the economy created by the inflation in the past, and by the
reactions of savers, as well as fostering high and sustainable economic
growth; and contribute towards an investor friendly environment that will
attract foreign investors to the country.

Evidence has suggested that economies perform better, in terms of growth,
employment and living standards, in low inflation environments than they do
when inflation is persistently high. This evidence is a comparison across
countries over long periods. The association between economic performance,
measured by growth of output or growth of productivity, and inflation. This
indicates a negative relation; that is, the higher the inflation, the lower the
rate of real growth.


Evidence suggesting that low inflation promotes growth has motivated
recent decisions by a number of central banks and governments, most notably
New Zealand. Canada, the United Kingdom and Sweden also have moved in
recent years to establish monetary policy with official low inflation targets.
Decisions to adopt a policy objective of low inflation suggest that other
policy-makers are reading the evidence pertaining to inflation and growth as
we are.

Consistent attempts to expand the economy beyond its potential for
production will result in higher and higher inflation, while ultimately failing
to produce lower average unemployment. Therefore, most economists would
argue that there are no long-term gains from consistently pursuing
expansionary policies.

Monetary policy can determine the economy's average rate of inflation in
the long run. And that's important for the economy, because high inflation
can hinder economic growth. For example, when inflation is high, it also
tends to vary a lot, and that makes people uncertain about what inflation will
be in the future. That uncertainty can hinder economic growth in a couple of
ways--it adds an inflation risk premium to long-term interest rates and it
complicates the planning and contracting by business and labor that are so
essential to capital formation. High inflation also hinders economic growth in
other ways. For example, because the tax system isn't in agreement with
inflation, high inflation arbitrarily helps and hurts different sectors of the
economy. In addition, it makes people spend their time hedging against
inflation instead of pursuing more productive activities.

Because the government can determine the economy's average rate of
inflation, some commentators--and some members of Congress as well--have
emphasized the need to define the goals of monetary policy in terms of price
stability, which is achievable.

One kind of conflict involves deciding which goal should take
precedence at any point in time. For example, the government needs to be
careful to avoid letting short-run temporary successes in preventing
employment losses during recessions lead to longer-run failures in
maintaining low inflation. Another kind of conflict involves the potential for
pressure from the political arena. For example, in the day-to-day course of
governing the country and making economic policy, politicians may be
tempted to put the emphasis on short-run results rather than on the longer-run
health of the economy. The government is somewhat insulated from such
pressure, however, by its independence, which allows it to achieve a more
appropriate balance between short-run and long-run objectives.

When unemployment is high the policy that should take place is inflation
should increase slightly to drive up prices in order to cause increases in
output. When unemployment is below average and nearing full employment
the policy that should take place is to slightly lower the productivity of the
workers and therefore cause a decrease in the output. This would slow the
economy down and into the ideal condition of maximum employment.
When the production is at its maximum and unemployment at a minimum the
government must raise the inflation rate in order to make sure that the
situation stays where it is. It must be sure not to raise inflation too sharply or
else everyone will be afraid to spend their money.

The belief that a 4% unemployment rate and stable prices are inconsistent
is shaped by the widely accepted "natural rate hypothesis." It argues that
monetary policy has no effect on the economy's unemployment rate, which is
often called the natural rate of unemployment. The reason is that, in the long
run, unemployment depends on so-called "real" factors--such as technology
and people's preferences for saving, risk, and work effort; these factors are
beyond the reach of monetary policy. Most current estimates place the natural
rate of unemployment in the range of 5¾-6¾%.

Consistent attempts to expand the economy beyond its potential for
production will result in higher and higher inflation, while ultimately failing
to produce lower average unemployment. Therefore, most economists would
argue that there are no long-term gains from consistently pursuing
expansionary policies.