Motivation

You can run but most business people cannot hide from the constant barrage of information published about money, interest rates, inflation, and policy. Like other aspects of macroeconomics, monetary policy is typified by difference of opinion. This difference of opinion filters through to most of us through uncertainty about when and by how much the central bank should or will act. In every country we have a pretty active group of central-bank watchers – whether we call them ECB watchers or Fed watchers or Bank of Japan watchers – the game is always the same – to try to predict when the central bank is going to announce its next policy change….so we can predict changes in interest rates, AD, real GDP, inflation, and the rest.  

One thing to stress from the outset – this topic is all about AD. No matter how many concepts, theories, differences of opinion, or histories we discuss, this entire subject is all about how and to what extent a central bank can impact AD so as to influence output and inflation in the short-run and the long-run. We will see below that while there is plenty of controversy and uncertainty about the impacts of monetary policy, there is much agreement that monetary policy consists of one basic tool and the direct goal of that tool is to have a desired impact on AD.

Difference of Opinion

We will discuss several different opinions about monetary policy but central to the debate is that conservative economists tend to believe that monetary policy can influence nominal but not real AD and output. In other words, central banks can get us to want to buy more goods and services but they cannot affect a country’s long run capacity to produce (potential real GDP). If central banks can influence demand but not supply then we predict they will mostly impact the inflation rate.

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The famous monetarist Milton Friedman described inflation as the result of too many dollars chasing too few goods.

Liberal macroeconomists disagree that money only causes inflation and therefore they are more optimistic that central banks can influence output as well as inflation in the long-run. These more liberal economists are sometimes referred to as “policy activists.” There is some middle-ground here when it comes to the short-run, however. Most conservative and liberal macroeconomists will admit that monetary policy can impact real AD and GDP in the short-run. So when the U.S. Fed aggressively lowered interest rates in 2001 and 2002, most economists were willing to admit that at least for the coming year or two – this policy ought to have the effect of increasing output in the U.S. They felt confident that output, not inflation, would be most affected in the near term.

The more interesting questions and debate centered around what would happen after the economy recovered from the 2001 recession.

Conservative voices Liberal economists The rest of us
Worried that the Fed might stimulate AD too much and for too long. In that case, inflation would become a real worry Worried that the Fed might not stimulate AD enough and the recession would drag on for too long. Caught in the middle, making the best decisions we could make while not knowing exactly how fast and how far the Fed would go with interest rates.

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