The Conduct of Monetary Policy, Essay Example

What are the relevant targets for monetary policy? Consider inflation targeting, price level targeting, monetary targeting and nominal GDP targeting.

The three most relevant monetary policy targets include interest rates, monetary aggregates, and exchange rates (Fender, 2012). “These targets are usually intermediate targets that can be quickly achieved and easily measured, but then move the economy toward the ultimate macroeconomic goals of full employment, stability, and economic growth” (Monetary Policy Targets, 2015). Overall, it is important to consider that many different variables have an impact on the type of monetary policy implemented and these targets may also differ for monetary policies that are developed in different territories. Furthermore, the various targets for monetary policy interact in complex ways, which contribute to a need for a thorough understanding for their interactions.

In the past several decades, the key trends that have been apparent in monetary policy are as follows: there has been a greater amount of independence for central banks, there is a lesser discretion towards rules-based monetary policy, there is a focus on inflation targeting, and there is use of short-term nominal interest rates the main instrument of monetary policy.

Specifically, inflation targeting was introduced as a component of the UK Post-War Monetary Policy in 1992. Inflation targeting occurs when a central bank has a large explicit target inflation rate. This is done to enhance the long-term growth of the economy and enhance GDP. By having tight control over the money supply, the government hopes to stabilise currency and control inflation, which is the primary role of establishing a monetary policy (Muth, 1961). However, under certain economic climates it is important to consider that this stabilisation may only be seen in the short-term.

The interest rate could also be thought of as the price of money. Many monetary policies, such as the Eurozone regime, aim for price stability. Typically, this stability is measured using the Consumer Price Index (CPI). Interest rates could be adjusted in order to ensure that the price level is adequately targeted. It is important to consider that a major disadvantage of using price level targeting as an aspect of monetary policy can reasonably contribute to variation in terms of employment and inflation in the short-term.

Monetary targeting has been shown to be a useful strategy to control inflation in Sweden and Germany, however, other countries have not been able to accomplish a similar level of success. According to the literature, “Inflation targeting therefore is more likely to lead to better economic performance for countries that choose to have an independent domestic monetary policy” (Mishkin, 2000). Therefore, this is an important understanding for countries to consider when they are developing their monetary policy. Furthermore, a combination of monetary targeting and inflation targeting has allowed governments to focus exclusively on domestic policies.

Last, nominal GDP targeting has been used in part in an attempt to stabilise the economy. By targeting nominal GDP, “Such a rule would specify how the Federal Reserve should adjust policy to affect a short-term interest rate in response to deviations of nominal

GDP from target” (Clark., 1994). While this is how this economic situation is described in terms of the United States’ economy, it is important to consider that this rule could be applied to the economies of other nations as well. Targeting nominal GDP would likely work to stabilise the economy in situations in which monetary aggregates serve as reliable guides. Since this has not been the case for most economies in recent years, it may be reasonable to forgo this process for economy stabilisation.

Overall, it is important to consider that the relevant targets for monetary policy depend upon the individual country and the economic institutions that they currently have in place. Each characteristic comes into play depending upon the particular needs and economic standing of a nation. It is therefore important for governments to analyse targeting, price level targeting, monetary targeting and nominal GDP targeting in the context of their own situation.

How does monetary policy feed through into the real economy? What role does the banking sector have in this process?

In practice monetary policy feeds through into the real economy by causing changes in the behaviour of the money stock have. Therefore, changes to the monetary policy could be implemented into establish a greater control over the behaviour of money. Overall, monetary policy has a reasonable effect on output, employment and inflation. It is apparent to many that a decrease in the unemployment rate is a substantial indicator of an improved economy. Furthermore, the output and inflation are also measurement tools that can be used to gain an understanding of the economic situation. Since monetary policy changes have the ability to control these variables, it is important to consider that a combination of these factors are realistic indicators of whether or not certain monetary policy is effective. Governments can adjust these policies according to this output in order to refine economic practices (Boivin et al., 2010).

The banking sector is impacted by monetary policy change because “Easier monetary policy increases loan supply, but also contributes to higher leverage of banks and broker-dealers and greater risk taking (more credit to riskier firms)” (Adrian & Liang, 2014). Essentially, the banking sector acts as the middle man between the government and the average citizens because they have a degree of control over money as well. Strong monetary policy decreases the power that these bankers have and minimized their individual risk, while the implementation of a less stringent policy contributes to the opposite effect (Meltzer, 1995). In some instances, this risk is beneficial to developing a strong economy. Therefore, it is important for the governments to adequately analyse effects that monetary policy will have on banks so they could more accurately determine how these implementations will impact individuals down the line. Furthermore, the extent to which members of the banking sector could engage in unethical behaviours also has a direct impact on the economy. Since they are often in control of large sums of money, the disappearance of these funds could be considered to be highly detrimental to economic stabilisation. Therefore, it is the government’s role to identify the possibilities of these decision and to put associated laws in place in order to control these behaviours. There are a lot of complex interactions that dictate the ability for monetary policy to feed through into the real economy. To gain a full understanding of this process, it is also important to gain an understanding of business practices that are occurring within the nation and externally with foreign nations. It is reasonable for governments to build models that reflect the summation of all of these factors in order to understand this transfer process. While banks play a major role, large corporations and other businesses also play a part in this complex understanding as well.

Should central banks consider asset prices (e.g. house prices, equity prices) when setting policy rates? Do central banks do this in practice?

It is important for central banks to consider asset prices when setting policy rates. An example provided in the lecture stated that “higher mortgage rates reduce the demand for housing and reduce house prices”. This is an important consideration when constructing monetary policy because this could negatively impact the economic earnings of individuals tied directly to this industry (Mishkin, 1995). On the other hand, it could also make housing more affordable for those with greater incomes which would prevent individuals with lower income from being able to buy to a greater extent. As a result, it is necessary for banks to understand the full extent to which their policies will impact the people. Even if their concern is primarily monetary, it is important for them to consider that such housing policies will contribute to a loss of money from being fed back into the housing system, which could contribute to a greater degree of housing instability. Since housing instability is generally associated with overall economic instability, it is necessary for central banks to consider the implications of such practices.

Despite the many economic implications of asset prices, it does not appear that central banks make these considerations in practice. Primary concern is with regards to inflation, and banks hope that a control over inflation will eventually contribute to a stabilised economy (Taylor, 1995). While this has been the case historically, the amount of time required for an economy to normalize after the implementation of detrimental policies has been relatively variable. Thus, taking these and other complex aspects of these choices into consideration could reasonably contribute to stronger and more effective economic policy. However, it is also important to recognize that target assets is challenging in practice. Most experts argue that to do so correctly, it is necessary to recognize a bubble and how to fix a target (Brittan, 2009). In spite of this, there is no certain way to do this. Rather than conducting numerical analyses, it is important for economists to rely on their judgement for these situation. Even though at best, only quantitative data could be collected to achieve such an understanding, it is important for central banks to implement these understandings in their policies.

Overall, it is important to consider that if central banks due play a role in setting house prices and other assets, they will be in a greater place of power. It may be strategic for them to remain minimally involved in this process so they could assert a degree of regulatory control without becoming directly involved in these interactions. In practice central banks do tend to pass more indirect policies that impact these assets, although it is important to consider that they would be able to maintain more control depending upon the type of government that facilitates them in addition to a national need for them to do so.

Should monetary policy be used to stabilise share prices / house prices? Do central banks attempt to do this in practice?

Overall, a stabilisation of share prices and house prices would indicate a stabilised economy. Thus it would be reasonable for central banks to control this in theory. Higher share prices and higher house prices occur because of the possible existence of the wealth effect. However, it is important to consider that in increase in house prices will also contribute to the building of more homes. In doing so, the economy will be able to grow and the supply and demand of homes would alter the prices once again. Therefore, while it would be reasonable under theoretical conditions for monetary policy to be used to stabilise share prices and house prices, this is not a necessarily realistic approach. While it would stabilise the economy, it could also prevent growth which is potentially more detrimental if the needs of people are not being met as a result.

In a sense, central banks attempt to control share prices and house prices in practice but the degree to which this is done varies depending upon the particular political and economic situations that a country is facing. In particular, the Irish Central Bank has faced this question. In response to their new monetary policy, they were asked about new regulations pertaining to residential mortgage lending. In response, the government indicated that this policy was put in place in order to “increase the resilience of the banking and household sectors to the property market and to reduce the risk of bank credit and house price spirals from developing in the future” (Central Bank of Ireland, n.d.). They also responded that the Central Bank will not control housing prices directly. This is an important understanding because it reflects the truth in many economic situations. While central banks can pass policies that will make the acquisition of homes either easier or more fair depending upon the economic situation, it cannot directly control this prices. This could potentially be damaging to the economy. Instead, it must do so indirectly to ensure that prices do not fluctuate in an unreasonable manner.

Thus, central banks do attempt to regulate share prices and house prices in practice, but they do so in a manner that is not direct. This ensures that they will be able to influence the economy in a manner that does not impart a direct force on business practices. Since many people are directly impacted by the housing marking, this is a more advantageous move overall. Monetary policy should only be used to control these prices in situations that are deemed to be an emergency. However, since policies have been put in place to make the prices of these assets relatively stable following the disaster of the Great Depression in many different countries, it does not appear that it is necessary for central banks to become involved in such an intervention. Therefore, it is important to consider that even though such an intervention could be possible, it will likely not be significantly reasonable in the current economic climate. Even with the depression that is currently occurring in Greece or Puerto Rico, it would not make sense for the banks to intervene on this significant level. However, it is an option in extreme situations.

References

Adrian T, Liang N. (2014). Monetary Policy, Financial Conditions, and Financial Stability. Retrieved from http://www.newyorkfed.org/research/staff_reports/sr690.pdf

Boivin, Kiley, and Mishkin, (2010). How Has the Monetary Transmission Mechanism Evolved Over Time? Handbook of Monetary Economics, 3.

Brittan S. (2009). Should, or Can, Central Banks Target Asset Prices? Retrieved from http://www.international-economy.com/TIE_F09_AssetPriceSymp.pdf

Fender J. (2012). Monetary Policy. Wiley. Central Bank of Ireland. (n.d.). FAQ – New regulations on residential mortgage lending. Retrieved from https://www.centralbank.ie/press-area/press-releases/Documents/FAQ%20%E2%80%93%20New%20regulations%20on%20residential%20mortgage%20lending.pdf

Clark TE. (1994). Nominal GDP Targeting Rules: Can They Stabilize the Economy? Retrieved from https://www.kansascityfed.org/publicat/econrev/pdf/3q94clrk.pdf

Meltzer. (1995). Monetary, Credit and (Other) Transmission Processes: A Monetarist Perspective. Journal of Economic Perspectives, 9(4): 49-72.

Mishkin. (1995). Symposium on the Monetary Transmission Mechanism. Journal of Economic Perspectives, 9(4): 3-10.

Monetary Policy Targets. (n.d.). AmosWEB Encyclonomic WEB*pedia. Retrieved from http://www.AmosWEB.com

Mishkin FS. (2000). From Monetary Targeting to Inflation Targeting: Lessons from the Industrialized Countries. Retrieved from https://www0.gsb.columbia.edu/faculty/fmishkin/PDFpapers/00BOMEX.pdf

Muth JF. (1961). Rational Expectations and the Theory of Price Movements. Econometrica, 29: 315–335.

Taylor. (1995). The Monetary Transmission Mechanism: An Empirical Framework. Journal of Economic Perspectives, 9(4): 11-26.