Objectives of Monetary Policy

Table of Contents

I. Policies that Influence Economic Development and Welfare
1. Fiscal Policy
2. Monetary Policy

II. Monetary Policy
1. Objectives
a The “magic triangle”
b Full employment
c Equity
d Growth
e Balance of exchange rates
f Price stability
2. Tools

III. Limitation of Monetary Policy

IV. Bibliography

V. Appendix:
Welfare and welfare change

I. Policies that Influence Economic Development and Welfare

1. Fiscal Policy

Two fields of policy have a strong impact on a national economy and its development. The first of the two policies that are designed to supplement each other, falls into governments responsibility, more exactly it is formulated by the minister of finance. This one is fiscal policy. The second one, monetary policy, is designed by the national bank. For making clear the difference between both I would like to explain both policies as an introduction to the topic of this paper.

- Fiscal Policy

“The government’s choice of tax and spending programs, which influences the amount and maturity of government debt as well as the level, composition, and distribution of national output and income. Many summary indicators of fiscal policy exist. Some, such as the budget surplus or deficit, are narrowly budgetary. Others attempt to reflect aspects of how fiscal policy affects the economy. For example, a decrease in the standarized-budget surplus (or increase in the standarized-budget deficit) measures the short-term stimulus of demand that results from higher spending or lower taxes. The fiscal gap measures whether current fiscal policy implies a budget that is close enough to balance to be sustainable over the long term. The fiscal gap represents the amount by which taxes would have to be raised, or spending cut, to keep the ratio of debt to GDP from rising forever. Other important measures of fiscal policy include the ratios of total taxes and total spending to GDP.”^[1] In the way of deciding about the amount of expenditures and premises for spending, fiscal policy is an important tool for government for setting macroeconomic conditions.^[2]

2. Monetary Policy

Beside government’s fiscal policy macroeconomic conditions and development also is influenced by the monetary policy of the national bank

- Monetary Policy

“The process of managing the supply of money and credit to contribute to economic performance. The national bank (original: Bank of Canada) manages the national (original: Canadian) monetary policy mainly through its influence on short-term interest rates, though it is ultimately answerable to the federal government for its actions. The Bank influences short-term interest rates by adjusting its own bank rate. A rise in the bank rate is an act of “tightening” the supply of money and credit, at once restraining elements in the economy which contribute to inflation and elements which contribute to economic performance. The reserve is also true. The bank rate and the money supply influences interest rates and the exchange rate of the national currency (original: Canadian dollar) and determine the monetary conditions in which the (…) economy operates.”^[3]

This definition shows the strong relation between monetary policy and economic development. The objectives of monetary policy and the tools that provide possibilities to achieve these goals are topic of this essay.

II. Monetary Policy

1. Objectives

a The “magic triangle”

Regardless the more detailed introduction of the objectives of monetary policy in the passages below I would like to mention the “magic triangle” that contains the three most important goals. It is usual to describe the certain objectives in measurable dimensions. In general these aims are broadly accepted targets of economic and monetary policy. In general, the aims are described in the way of identification of individual aims that express a special part of the whole purpose. A well known model is that of the “magic triangle” that’s aims should be achieved by monetary policy:^[4]

illustration not visible in this excerpt

Figure 1: The magic target triangle of monetary policy, own illustration

b Full employment

In general, in a free market economy a price for any kind of goods or services is determined through the play of market forces: supply and demand. Everyone who is satisfied with such an equilibrium price can sell or buy the things wanted. On the other hand, if anyone expects the price changing he can speculate and hold the trade back. Especially sellers would hold their goods if they expect to get more money for them and being able to realise higher future profits. But this is a bit different if authorities try to influence the market by compulsion. If the government decrees and enforces minimum prices higher than the potential equilibrium price on the free market, a part of the supply offered for sale at the official minimum price will remain unsold. Therefore, if a government wants to push the price of any good above the potential market price in consideration of general economic targets, not simply a price is fixed. Rather it tries to reduce the quantity of supply, for instance by purchasing and withholding a part of the supply available. These basic market functions also apply for workforce. At the wage rates determined in a free labour market, everybody who wants will get a job and everybody who wants to employ staff can hire them. In the unhampered labour market, wage rates tend to an equilibrium that in this case means full employment. But as labour market is not a free market, the national bank has the objective to support full employment under the conditions of a regulated labour market.^[5]

In the case of the European Central Bank (ECB) beside the prior aim of price stability the ECB should support the general economic policy within the community that are defined in article 2 of the Treaty that establishes the European Community: “The Community shall have as its task, by establishing a common market and an economic and monetary union and by implementing common policies or activities (…), to promote throughout the Community a harmonious, balanced and sustainable development of economic activities, a high level of employment and of social protection, equality between men and women, sustainable and non-inflationary growth, a high degree of competitiveness and convergence of economic performance, a high level of protection and improvement of the quality of the environment, the raising of the standard of living and quality of life, and economic and social cohesion and solidarity among Member States.”^[6] As the ECB has to support these targets the ECB should take care about employment as one of the given aims.

c Equity

Another target for monetary policy is to support social equity.^[7] For the ECB equity is an objective that should be achieved beside efficiency and stability. It is the proper role of public authorities to impress upon the public the need for this balancing act, although certain communities have different preferences. In Europe, historically, equity belongs to the aims to which much attention was spent by the national banks. This is reflected in the extensive welfare system and social protection from which Europeans could benefit, as well as in the traditional preference for pay-as-you-go pension arrangements in several countries. However, as the political framework changes due to fiscal problems in the European countries the in general laudable goal of equity will be achieved only if these arrangements are reformed so that they could fulfil their challenge effectively in the face of the changes in population and society. It is a duty of the ECB to support policies that aim to better equity. Also the national bank could assist these changes that help to stabilize the national economy.^[8]

The aim of better social equity also is stipulated in most party platforms and therefore a central political target: “A juster disposition of incomes establishes social compensation and also increases demand and therefore more jobs.”^[9] As research shows, also competition is linked with welfare: “One can see that more competition is bad under any degree of nominal rigidity. The latter is bad for welfare up to a point where more rigidity is indeed good. A plausible rationale for this result is that the ability of the central bank to control the economy under almost fixed prices allows the monetary authority to reach higher levels of stability despite the output dispersion distortion that the rigidity brings about.”^[10] This objective is valid for most parts of the world, what the following citation shows: “The most important task of the government in Latin America consists in improving equity. The increasing disparities between the different segments of the population have a great impact on political interaction in more pluralistic societies.”^[11] An interesting feature of the figure included in the appendix (see figure no. 3) is that it indicates the implication of assuming that the degree of nominal rigidity is a function of the degree of competition, that could not directly be influenced by the central bank, but is a field for national economic policy.

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^[1] www.teachmefinance.com/Financial_Terms/fiscal_policy.html

^[2] Compare www.answers.com/topic/fiscal-policy

^[3] www.fin.gc.ca/gloss/gloss-m_e.html

^[4] Compare Zimmermann/Henke (2001), page 302

^[5] Compare www.mises.org/efandi/ch16.asp

^[6] http://ec.europa.eu/employment_social/equ_opp/treaty_en.html

^[7] Compare Hockley (1979), page 413

^[8] Compare www.ecb.int/press/key/date/2003/html/sp030307.en.html

^[9] Party platform of German Social Democratic Party, in: Zimmermann/Henke (2001), page 225

^[10] Lombardo (2002), page 28

^[11] http://Tiss.zdv.uni-tuebingen.de/webroot/sp/spsba01_W98_1/chile4.htm