There are a number of ways in which policy actions get transmitted to the real economy Ireland, Through the exchange rate channel, exports are reduced as they become more expensive, and imports rise as they become cheaper.
However, it typically takes time to legislate tax and spending changes, and once such changes have become law, they are politically difficult to reverse. This belief stems from academic research, some 30 years ago, that emphasized the problem of time inconsistency.
It usually rises when the central bank tightens by soaking up reserves. Monetary policy has an important additional effect on inflation through expectations—the self-fulfilling component of inflation.
A rise in interest rates also tends to reduce the net worth of businesses and individuals—the so-called balance sheet channel—making it tougher for them to qualify for loans at any interest rate, thus reducing spending and price pressures.
That expands the money supply. The exception is in countries with a fixed exchange rate, where monetary policy is completely tied to the exchange rate objective.
But this is not the end of the story. When rates can go no lower After the onset of the global financial crisis incentral banks worldwide cut policy rates sharply—in some cases to zero—exhausting the potential for cuts.
Add to that concerns that consumers may not respond in the intended way to fiscal stimulus for example, they may save rather than spend a tax cutand it is easy to understand why monetary policy is generally viewed as the first line of defense in stabilizing the economy during a downturn.
This is usually done through open-market operations, in which short-term government debt is exchanged with the private sector. Central banks responded by targeting those problem markets directly.
If policymakers hike interest rates and communicate that further hikes are coming, this may convince the public that policymakers are serious about keeping inflation under control. A rate hike also makes banks less profitable in general and thus less willing to lend—the bank lending channel.
When a central bank speaks publicly about monetary policy, it usually focuses on the interest rates it would like to see, rather than on any specific amount of money although the desired interest rates may need to be achieved through changes in the money supply. Long-term contracts will then build in more modest wage and price increases over time, which in turn will keep actual inflation low.
Twin objectives The monetary policymaker, then, must balance price and output objectives. The one people traditionally focus on is the interest rate channel. Fiscal policy —taxing and spending—is another, and governments have used it extensively during the recent global crisis.
Banks get additional reserves the deposits they maintain at the central bank and the money supply grows.James Poterba, president James Poterba is President of the National Bureau of Economic Research. He is also the Mitsui Professor of Economics at M.I.T.
Monetary policy has lived under many guises. But however it may appear, it generally boils down to adjusting the supply of money in the economy to achieve some combination of inflation and output stabilization.
Most economists would agree that in the long run, output—usually measured by gross domestic product (GDP)—is fixed, so any changes in the money supply only cause prices to change.Download