The first aim of monetary policy must be to prevent government from
embarking upon inflation and from creating conditions which encourage
credit expansion on the part of banks (Ludwig von Mises, Human Action, 1998
The Keynesian dream is gone even if its ghost continues to plague politics for decades- F. A. Hayek (Nobel Prize-Winner in Economics)
When money gets out of order, it throws a monkey wrench into the operations of all the other machines... (M.Friedman)
Monetary theory is like a Japanese garden. It has esthetic unity born of variety; an apparent simplicity that conceals a sophisticated reality; a surface view that dissolves in ever deeper perspectives. Both can be fully appreciated only if examined from many different angels, only if studied leisurely both in depth. Both have elements that can be enjoyed independently of the whole, yet attain their full realization only as part of the whole-Milton Friedman(the Optimum Quantity of Money)
Monetary and fiscal policies are distinct only in financially developed countries, where the government does not have to cover budget deficits by printing money but can sell obligations to pay money in the future, like treasury bills, notes, and bonds.
FISCAL POLICY:
Fiscal policy is the use of government spending and taxation to try to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy.
MONETARY POLICY:
MILTON FRIEDMAN ON THE ROLE OF MONETARY POLICY:
Friedman's economic research on the role of monetary policy remains a classic in the developmant of a monetary-policy framework. In this he discusses what monetary policy cannot do, what it can do, and so how montary policy should be conducted.
According to friedman, regarding what monetary policy cannot do:
It cannot control real variables such as unemployment and output or GDP. It can only control nominal variables, such as the exchange rates, the price level, or monetary aggregates.
First, It can avoid being major source of disturbance; it should avoid major mistakes. Second, monetary policy can provide a stable background for the economy by achieving price stability. Third, monetary policy can contribute to offsetting major disturbances in the economic system arising from other sources. That is the most we can asked from monetary policy at our present state of knowledge.
"There is two limitations of monetary policy: from the infinite world of negations, (1) the monetary policy cannot peg interest rate for more than very limited periods; (2) it cannot peg the rate of unemployment for more than very limited periods".
"Paradoxically, the monetary authority (the Central Bank) could assure low nominal rate of interest- but to do so it would have to start out in what seems like the opposite directions, by engaging in a deflationary monetary policy. Similarly, it could assure high nominal interest rates by engaging in an inflationary policy and accepting a temporary movements in interest rates in the opposite directions".
"These considerations not only explain why monetary policy cannot peg interest rates; they also explains why interest rates are such a misleading indicator of whether monetary policy is tight or easy. For that, it is far better to look at the rate of change of the quantity of money".
Body of the empirical evidence shows that "the monetary authority controls nominal quantities- directly, the quantity of its own liabilities.
In principle, it can use this control to peg a nominal quantity- an exchange rate, the price level, the nominal level of national income, the quantity of money by one or another definition- or to peg the rate of change in a nominal quantities- the rate of inflation or deflation, the rate of growth of the quantity of money. It cannot use its control over nominal quantities to peg a real quantities- the real rate of interest, the rate of unemployment, the level of real national income, the real quantity of money, the rate of growth of real income, or the rate of growth of the real quantity of money. Monetary policy cannot peg these real magnitudes at predetermined levels; but, monetary policy can and does have important effects on these real magnitudes. The one is in no way inconsistent with the other".
"There is (may be) a temporary trade-off between inflation an unemployment; there is no permanent trade-off. The temporary trade-off comes not from inflation per se, but from unanticipated inflation, which means, from a rising rate of inflation".
What monetary policy can do ?
(1) "The first thing monetary policy can do is it prevents money itself from being a major source of economic disturbance. There is a positive and important task for the monetary authority- improvement of the monetary machine that will reduce the chance that it will get out of order, and to use its own powers so as to keep the monetary machine in good working order and conditions".
(2) "The second thing monetary policy can do is it provides a stable background for the economy- to keep the monetary machine in good working order and conditions".
(3) "Finally, monetary policy contributes to offsetting major disturbances in the economic system arising from other sources".
- "If there is an independent secular stagnation, monetary policy helps to hold it in check by a slower rate of monetary growth than would otherwise be desirable".
- "If an explosive government budget threatens unprecedented deficit, monetary policy holds any inflationary dangers in check by a slower rate of monetary growth than would otherwise be desirable".
- "If the end of a substantial war offers the country an opportunity to shift resources from wartime to peacetime production, monetary policy eases the transition by a higher rate of monetary growth than would otherwise be desirable-through it is not very encouraging that it can do so without going too far and creating a high level of inflation".
"The path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a clear and present danger to the economic system. This is because: (1) we do not know enough to be able to recognize minor disturbances or be able to predict either what their effects will be with any precision or what monetary policy is required to offset their effect; (2) We also do not know enough to be able to achieve stated objectives by changes in the mix of monetary and fiscal policy".
How should monetary policy be conducted to make contribution to our goals ?
"The first requirement of the monetary policy is that the monetary authority (the Central Bank) should guide itself by magnitudes that it can control, not by ones that it cannot control. Of the various alternative magnitude that it can control, the most appealing guides for policy are (1) the price level that defined by some index, (2) monetary total or a still boarder total and (3) exchange rates.
In today's world, for many countries, exchange rates are an undesirable guide; It is far better to let the market through floating exchange rates to adjust the world conditions".
"Clearly, in the three guides listed, the price level is the most important in its own right. However, the link between the policy action of the Central Bank and the price level is more indirect than the link between the policy actions of the Central Bank and any of the several monetary totals. Moreover, monetary action takes a longer time to affect the price level than to affect the monetary totals, and both the time lag and the magnitude of effect vary with circumstances. As a result, we cannot predict at all accurately just what effect a particular monetary action will have on the price level and what it will have that effect. Attempting to control directly the price level is therefore likely to make monetary policy itself a source of economic disturbance because of false stops and starts".
"The second requirement of the monetary policy is that the monetary authority should avoid sharp swings in policy and moving policy in the wrong directions; too late and too much moving in direction has been the general practice of the monetary authority !
"The failure of monetary authority to allow for delay between their actions and the subsequent effects on the economy has been general practice. They tend to determine their actions by today's conditions but their actions will affect the economy nine to twelve or fifteen months later".
Money, Prices and the Real Economy
"The purely monetary connection between ruler and subject demonstrated the absence of any other relationship. The continuous depreciation of currency by rulers was an appropriate technique within such a relationship; for these methods, which give all the benefits to one side and the entire loss to the other. This has been traced to the fiscal policy of rulers who use the royal prerogative of coinage as a means of taxation without concern for the consequences of devaluation- Georg Simmel, from Philosophy of Money.
Nobel Laureate Friedrich von Hayek suggests that inflation can be stopped by introducing competition in currency. The notion that it is a proper function of government to issue the national currency is false. Citizens should be free to use and refuse any currencies they wish: politicians and central banks would then have to limit their quantities.
Friedrich von Hayek argues that the government monopoly of money must be abolished to stop recurring bouts of inflation and deflation. Abolition is also the cure for the more deep-seated disease of the recurring waves of depression and unemployment attributed to 'capitalism'.
There are at least three requirements for an economy to maintain stable prices. Policy markers and opinion formers must understand that inflation brings no medium or long-term economic benefit; the causes of inflation - monetary growth -must be also be understood; and there needs to be a stable and credible institutional structure that will deliver a sound monetary policy.
WHAT HAVE ECONOMISTS LEARNED ABOUT MONETARY POLICY OVER THE PAST 50 YEARS ?
THE LIMITS OF MONETARY POLICY
The Case Against Currency Boards
The Case Against Currency Monopoly