NS3040 Fall Term 2018 Monetary Policy Consensus View Ed Dolan, As we Move into Budget Chaos, Just How Bad is Fiscal Policy Really? EconoMonitor, October 2, 2013

Basics of Monetary Policy I A principal objective of any central bank must be to maintain the purchasing power of the currency. Rapidly rising prices (inflation) reduce purchasing power (especially among poor people who have fewer opportunities to diversity to other assets) while disrupting economic activity. Similarly, if prices are falling, the real burden of debt increases and activity slows as purchases are delayed in anticipation of lower prices. Inflation is a monetary phenomenon because rising/falling prices can only ultimately be sustained if accompanied by monetary expansion/contraction. Thus, it is appropriate that control of inflation is a primary concern of monetary policy.

Basics of Monetary Policy II Essentially, monetary policy involves influencing the demand and supply of money, through controlling either the quantity of money in circulation or its price (the interest rate). However, beyond this general principle there has been widespread disagreement over the relationship between money and other economic variables. The transmission mechanism of monetary policy remains only partially understood, Reflecting both the underlying complexity and its varying across economies as well as evolving (sometimes rapidly) over time.

New Consensus I The ‘New Consensus' In recent years, the prevailing consensus among economists regarding monetary policy is based on a number of key propositions regarding both theory and practice. Often referred to as the ‘New Consensus', This refers to previous disputes over the proper role of monetary policy, such as that between the ‘Keynesians' and the ‘Monetarists' that divided economists from the 1960s to the 1990s.

New Consensus II Key Elements of the New Consensus Theoretical 1. The long-term neutrality of money: the long run impact of a monetary expansion or contraction is solely on prices rather than output and employment, which are determined by other factors notably availability of productive capacity, enhanced by improvement to technology and/or productivity). For this reason, there is no long-term trade-off between inflation and output/employment. The implication of this is that the underlying purpose of monetary policy is as a means to control inflation, rather than a means of permanently boosting economic activity.

New Consensus III 2. The existence of short-term price rigidities these constrain the pace that prices adjust (through contractual obligations, for example), thus giving monetary policy some leverage over economic activity in the short term. This means that monetary policy can be used for purposes of economic stabilization. 3.The importance of expectations of future inflation: if people expect prices to rise quickly, there will be pressure for them to do so (through wage demands, for example), reducing the effectiveness of monetary policy in controlling inflation. Moreover, such expectations can be influenced by the policy framework. A policy that is both credible and well communicated will be more effective.

New Consensus IV Practical 1. Fiscal policy is of limited use as a tool for countercyclical economic policy Using fiscal policy (i.e., the balance between government expenditure and revenue) takes time to implement and can be difficult to reverse, especially if this requires tax increases and spending cuts; While anticipation of future tax increases may dampen the impact of a fiscal stimulus. In addition, fiscal activism may result in problems of excessive budget deficits, with debt accumulating to unsustainable levels.

New Consensus V 2. The need for central bank independence: In contrast to fiscal policy, monetary policy changes can be adjusted quickly through changes to interest rates (although there may be substantial lags before the impact is felt through all stages of the transmission mechanism). However, for this to be most effective it is best undertaken a step removed from the political process through a central bank that has instrument independence in terms of policy making In return for this freedom, centrals banks should demonstrate transparency and accountability in their operations.

New Consensus VI 3. The emphasis of policy should be on final rather than intermediate objectives: Many previous controversies had been fueled by an emphasis on perfecting the choice of intermediate target narrow or broad monetary aggregate, exchange rate anchor, etc.). This had limited the general understanding of the ultimate purpose of the policy while at the same time undermining policy credibility when, as frequently occurred, the relationship between the intermediate and final target (that is, inflation) had became unstable.