Monetary Policy as an Output Stabilizer
Monetary policy as an output stabilizer
Monetary and fiscal policy are therefore interdependent, and it is difficult to analyse the stabilizing role of monetary policy in isolation. One way of avoiding this complex interdependence is to think of monetary policy as 'independent' in the short to medium run, but constrained by or constraining the fiscal deficit in the long run. This procedure also has the merit that monetary stabilization policy - to which we turn next - can be thought about separately from fiscal policy or long-run monetary growth.
I take as axiomatic the role of monetary policy in controlling inflation via the systematic long-run control of money supply growth. The role of monetary policy in stabilizing output fluctuations demands more careful examination. Before the advent of the rational expectations hypothesis, no one doubted that in principle monetary policy could and should stabilize output, given slowly moving price expectations. The debate resolved around three assumptions: that the central bank has up-to-date information at least as good as that available to the private sector, that the central bank has a good model of the economy with which to forecast the effects of policy, and that it is efficient in implementing required policy. Those opposed to an 'activist' monetary policy argued that all three assumptions were invalid and concluded that activist policy would be at least as likely to increase as to dampen fluctuations.
Rational expectations has widened the scope of this debate. Individuals in the private sector incorporate knowledge of the central bank's reactions into their expectations, if these are indeed formed rationally. Under certain conditions this can neutralize the effects of monetary policy on output. In general, rational expectations complicate the economy's responses to stabilization policy, and this raises questions about the desirability of activist policy.
An economic theory must upset strongly held policy
Monetary and fiscal policy are therefore interdependent, and it is difficult to analyse the stabilizing role of monetary policy in isolation. One way of avoiding this complex interdependence is to think of monetary policy as 'independent' in the short to medium run, but constrained by or constraining the fiscal deficit in the long run. This procedure also has the merit that monetary stabilization policy - to which we turn next - can be thought about separately from fiscal policy or long-run monetary growth.
I take as axiomatic the role of monetary policy in controlling inflation via the systematic long-run control of money supply growth. The role of monetary policy in stabilizing output fluctuations demands more careful examination. Before the advent of the rational expectations hypothesis, no one doubted that in principle monetary policy could and should stabilize output, given slowly moving price expectations. The debate resolved around three assumptions: that the central bank has up-to-date information at least as good as that available to the private sector, that the central bank has a good model of the economy with which to forecast the effects of policy, and that it is efficient in implementing required policy. Those opposed to an 'activist' monetary policy argued that all three assumptions were invalid and concluded that activist policy would be at least as likely to increase as to dampen fluctuations.
Rational expectations has widened the scope of this debate. Individuals in the private sector incorporate knowledge of the central bank's reactions into their expectations, if these are indeed formed rationally. Under certain conditions this can neutralize the effects of monetary policy on output. In general, rational expectations complicate the economy's responses to stabilization policy, and this raises questions about the desirability of activist policy.
An economic theory must upset strongly held policy