Monetary Policy

The economy generally moves in cycles, from high to low, then to high again. When the economy is optimal, then the economic output is also optimal, with unemployment at a stable, low rate. When the economy overheats, then inflation increases, because aggregate demand grows faster than aggregate supply. Eventually, the economy reverses, with aggregate demand decreasing, thus forcing businesses to lay people off. When an economy is in a recession, tax revenues declined at the same time that the government needs to spend more money to help the unemployed and to stimulate demand. There are 2 major types of tools that a government can use to stimulate the economy: monetary policy and fiscal policy.

Monetary policy is usually conducted by the country's monetary authority, which for most modern economies is the central bank, through the use of operations that influence interest rates or the quantity of money so that certain macroeconomic objectives, such as low-inflation and optimized economic output, can be achieved. However, as Milton Friedman pointed out, monetary policy can only affect the economy in the short run. In the long run, the economy will reach a new equilibrium based on the change in money supply, but, with all else being equal, the economic output will be the same as it was before the change of monetary policy, assuming that the economy was at equilibrium then.

Fiscal policy, on the other hand, consists of operations by the government to achieve macroeconomic goals through changes in taxation, public borrowing, and government expenditures.

Monetary Policy Regimes

There are different monetary tools available and different ways to influence economy. These tools are implemented according to a set of rules, which can be grouped according to the specific macroeconomic objective that they are trying to achieve.

Monetary policy rules are developed because it takes time to gather information about an economy and it takes time for a monetary policy to effect changes in that economy. Therefore, many believe it is better to follow monetary policy rules that have worked well in the past and that are well understood. If central bankers had discretion, they would attempt to fine-tune the economy based on their intuition, which could have negative effects in the economy, but would not be knowable till later.

A monetary policy regime is a set of monetary policy rules used to achieve a specific objective. Some regimes target specific macroeconomic rates, such as the exchange rate, inflation rate, and the growth of the money supply. Generally, these regimes attempt to keep the exchange rate, inflation rate, or the money supply growth rate within narrow constraints. A common objective on the money supply growth rate is equalize it with the nominal income growth. A more nebulous regime attempts to manage economic risks by using more tools targeting different aspects of the economy, to try to preempt monetary or economic instability.

Recognizing that inflation can be high while the economic output is less than optimal makes it difficult to stimulate the economy by only considering the inflation rate. To solve the problem for the Federal Reserve, the economist John Taylor came up with a rule that that relates the federal funds rate to both the inflation rate and the output gap, which became known as Taylor's rule:

Federal Funds Rate = 1 + (1.5 × Inflation Rate) + (0.5 × Output Gap)

Primary Monetary Policy Tool: Setting the Federal Funds Range

In the United States, the Federal Reserve enacts monetary policy primarily by setting a target interest rate, specifically, the federal funds rate. In Europe, the equivalent rate is the Euro Overnight Index Average (EONIA). The federal funds rate varies with supply and demand continuously, so the target rate cannot be set exactly. Instead, the Federal Reserve sets a range of about 0.25% that is easier to implement. For instance, as of March 12, 2018, the target range is 1.25% to 1.5%. By monitoring the effective federal funds rate (EFFR), which is the interest rate actually charged in the federal funds market, the Fed can take appropriate action to move the EFFR back toward the middle of the range, if the EFFR is near the lower or upper bound of the range.

The Federal Reserve sets reserve requirements for banks, the minimum of money in their vaults or in their accounts at the Federal Reserve. If they fall below this minimum, then they must get more capital from their owners, attract new deposits, or borrow money from other banks or from the Federal Reserve. On the other hand, banks do not want to keep much more than the minimum, because they incur an opportunity cost of not earning interest that could otherwise be earned by lending the money. Hence, banks often fall short of the minimum reserve requirements, requiring them to borrow in the interbank market, known as the federal funds market. The interest rate charged in this market is the federal funds rate, which the Fed keeps within its target range by buying or selling US Treasuries, thereby increasing or decreasing the money supply.

When the Federal Reserve wants to lower the federal funds rate, it buys US Treasuries from its dealers, which are major banks. These purchases increase the amount of money that these banks have on hand, thereby decreasing their need to borrow the money in the federal funds market. As with other things, a lower demand lowers prices, and the price of money is the interest rate charged for its borrowing. Because holding cash incurs an opportunity cost of not earning a return for the money, the dealers seek out other bonds to buy, which increases the demand for those bonds, thereby increasing their prices and decreasing their yields, since bond prices and yields are inversely proportional. The Federal Reserve pays for these purchases by simply incrementing the accounts of the dealers who are selling by the amount of their purchase. When the Federal Reserve wants to raise the federal funds rate, then it does the reverse: it sells US Treasuries to its primary dealers, thus lowering the amount of money that they have on hand, which increases their demand in the federal funds market, which increases the cost of credit, i.e. the interest rate. Banks may also sell other bonds to increase their reserves, thus increasing the supply of bonds, which decreases their costs, and increases their interest rates.

Because banks make money by charging a higher interest rate for their loans than what they pay on their debts or other sources of capital, the federal funds rate determines the interest rates on most other loans. Because of its simplicity and effectiveness, setting a target interest rate range is a primary monetary tool used by most central banks.

Lowering the interest rate stimulates the economy, especially if it is at less than its potential output. With lower interest rates, consumers are willing to buy more and businesses are willing to invest more, which increases consumption and investment, thereby increasing GDP. With higher interest rates, the opposite happens: people buy less and businesses cut back on investments and other purchases, thereby slowing the economy.

Theoretical Foundations

There are several theoretical principles that underpin monetary policy. A primary principle is the Quantity Theory of Money: monetary policy can influence the prices of goods and services, but not the quantity; thus, changing the money supply cannot change economic activity in the long run.

Although the quantity theory of money shows that economic activity cannot be increased over the long term by increasing the money supply, it can increase economic activity over the short run. A.W. Phillips noticed in 1958 that there was an inverse relationship between the inflation rate and the unemployment rate. Hence, the curve showing this relationship is called the Phillips curve. The short-term relationship showed that the central banks could lower the unemployment rate by temporarily increasing the quantity of money, which also increased inflation.

Unemployment arises naturally from causes other than from lack of jobs, such as when people, such as new graduates, recent immigrants, or women returning to the job market, or those suddenly laid off or fired, look for jobs — so-called frictional unemployment — or when there is a mismatch between the skills offered by the labor force and the skills demanded by employers — structural unemployment. Because transitory and structural unemployment exist regardless of the number of jobs in the marketplace, there will always be what is called a natural rate of unemployment, or as some economists refer to as the nonaccelerating inflation rate of unemployment (NAIRU). If the central bank tries to lower the unemployment rate below its natural rate, then monetary policy will have the opposite effect of what is trying to be achieved: both unemployment and inflation will increase. Only cyclical unemployment, which is the unemployment that results when there are fewer jobs than there are people looking for work, can be influenced effectively through monetary policy.

If the economy were already at the natural rate of unemployment, then any attempt by the central bank to increase economic activity by increasing the money supply would only increase inflation while decreasing unemployment for only a short time. Eventually, the unemployment rate would revert to the natural rate of unemployment, but inflation would be higher.

Graph of both the short-run and long-run Phillips curves, showing the relationship between the inflation rate and unemployment rate.
Graph of both the short-run and long-run Phillips curves, which shows the relationship between the inflation rate and unemployment rate.

Over time, NAIRU itself can shift because of changes in the economy and especially because of changes in technology. For instance, with the rise of the Internet, it became easier and faster to find a new job. However, since about 2010, the employment rate did not fall commensurately with increase in job vacancies because many workers did not have the necessary skills or knowledge to fill those vacancies. Hence, the long run Phillips curve can shift to a different rate of unemployment over time.

Economic output is related to the unemployment rate. Since labor is a major factor in the production of goods and services, less than full employment reduces economic output. On the other hand, if the economy is overheating, then output will be slightly higher than the regular output at full employment, since people work overtime to meet the higher aggregate demand. The gross domestic product (GDP) associated with full employment is the normal economic output. If actual output differs from this normal output, then there is an output gap:

Output Gap = Actual GDP − Potential GDP

Author Okun noted this relationship in 1962, that economic output varied inversely with unemployment, a relationship called Okun's law. Thus, the output gap is something that central banks consider when deciding a monetary policy.

Historically, central banks relied on the historical relationship between unemployment, economic activity, interest rates, etc. However, it became clear that those relationships could also be affected by what people would expect from changes in the monetary policy. They would anticipate the consequences of monetary policy changes, then alter their behavior accordingly, thereby reducing the effectiveness of the policy change. Therefore, any economic model that would try to forecast how the economy would change in response to a monetary policy change must also incorporate possible changes in people's behavior based on their expectation of future inflation. That changes in people's behavior based on their expectations changes the results of the monetary policy change forms the basis of the rational expectations hypothesis. Thus, the central bank must have a credible policy of controlling inflation; otherwise, if higher inflation is expected, then people will demand higher wages and businesses will raise prices, thus increasing inflation.

Based on the rational expectations hypothesis, the Lucas critique proposes that economic policy based only on historical aggregate information will be ineffective. To rectify this, economic models should consider economic agents, i.e. consumers, at the microeconomic level to better anticipate what changes in monetary policy may do. Economic agents may counteract changes in monetary policy, thereby reducing their effectiveness — what has become known as the policy ineffectiveness proposition. This proposition has been used to explain the stagflation in the late 1970s and 1980s, when the Federal Reserve attempted to mollify the effects of high oil prices at that time and to lower the unemployment rate by using an expansionary monetary policy. Instead, inflation increased while unemployment remained high.

There have been criticisms of the rational expectations hypothesis because people are often times irrational, so basing models on irrational people can be problematic. However, behavioral economists believe that much irrationality is predictable, especially since people tend to follow others in their economic activity, such as buying stocks in the stock market or creating other asset bubbles. Nonetheless, the rational expectations hypothesis still offers better predictions than that offered by the simple historical relationship between the relevant macroeconomic factors.

Unconventional Monetary Policies

After the 2007 - 2009 Great Recession, central banks found it difficult to stimulate the economy using conventional methods. Therefore, other methods were used to try to stimulate the economy:

Central banks also extended liquidity to financial institutions and other key credit markets to stimulate lending as a means to increase economic activity. Another method by which central banks can increase lending is by offering banks cheaper financing if they lend a prescribed minimum to households and small and medium-sized enterprises (SMEs), such as the UK Funding for Lending, which the Bank of England set up in 2012.

During the Great Recession, the 1st monetary policy change was to reduce interest rates. Because the economy did not respond, central banks lowered the interest rate to 0 or nearly 0. Some central banks even charged other banks interest for keeping their funds at the bank so that they would be more likely to lend the money. However, people were out of work and already deeply in debt. Therefore, they could not borrow even at greatly reduced rates, so banks did not lend to them. Furthermore, people could not buy the goods and services offered by the economy, so businesses could not take advantage of the cheap credit because they had no way of paying it back.

The next tool that the United States Federal Reserve used to stimulate the economy was quantitative easing. Buying long-term securities lowers long-term borrowing costs, since interest rates on debt securities, especially government securities, are used as benchmarks for other lending rates. The security purchases lower the yield curve, especially for longer-term interest rates. There are 2 types of securities that central banks can buy: government securities and private sector securities. The purchase of longer-term government securities is called quantitative easing; the purchase of private sector securities is called credit easing. For instance, during the Great Recession, banks held a significant investment in mortgage-backed securities (MBS) that were falling in value because of pervasive defaults by subprime borrowers. Therefore, the Fed purchased these MBSs to prop up their prices and to keep the banks holding the securities solvent. In 2015, the European Central Bank (ECB) attempted to pull Europe out of the recession that has lingered on into 2015 by buying government bonds of distressed countries, such as Spain and Greece, to stimulate their economies by lowering their interest rates. Nevertheless, quantitative easing was little more effective than reducing interest rates, because unemployment and consumer debt were still high. Instead, buying securities increases their price, which increases the amount of money that bondholders get for their bonds. Since most bondholders are wealthy, the money went to the wealthy, who usually have no immediate need for the money. Instead, they anticipate inflation, so they buy assets that will increase in price along with the increase in the money supply, thereby creating asset bubbles.

The Best Monetary Policy is a Fiscal Policy: Tax the Poor Less

During recessions, the best means of achieving monetary policy objectives, in my opinion, is to use a fiscal policy: lower taxes on the poor. This immediately increases demand for all types of products and services, while avoiding the asset bubbles created by the rich when they receive higher prices for their bonds when the money supply is increased. Moreover, the poor suffer the most in recessions. Although the wealthy also suffer, they quickly earn their money back by investing in the stock market and in other markets that tend to grow as economy climbs out of the recession. On the other hand, poor people just suffer. With little or no money and mountains of debt, they cut back on their purchases, sinking the economy even more.

Not only are the poor out of work and deep in debt during recessions, they are also burdened with high taxes. For instance, in the United States, employment taxes take out about 15% of each worker's pay. Although the employer pays half of the employment tax, lower income workers bear most of the tax burden, in that the employers simply pay the workers less because of their share of the tax. Additionally, both states and their municipalities also put most of their tax burden on work, further increasing the tax burden. The United States attempted to lighten this burden by reducing the employment tax from 15.3% to 13.3% for 2 years. It helped. However, reducing taxes to 0 for poor people so that they can afford even to live would have been more effective. With their much higher marginal propensity to consume, they would immediately spend the extra money on the goods and services offered by businesses, thereby increasing business revenue, increasing employment, then increasing tax revenue.

Of course, lowering taxes on the poor means that others, notably the wealthy, would be forced to pay more taxes, but since the wealthy have significant influence with governments, they generally pay much lower taxes, because much or most of their income comes from investments or inheritance, which are taxed at much lower rates than employment, if they are taxed at all. By taxing work less, not only would labor be cheaper for employers, but it would also motivate people to work since they would be getting a higher price for their labor. As any economist knows, lower prices for employers would increase their demand for labor, while higher prices for suppliers of labor would increase their supply, i.e., people would be more willing to work. Furthermore, there is a large deadweight loss of taxation in taxing labor. On the other hand, there is no deadweight loss at all in taxing inheritance, since, as economists like to say, the supply of death is completely inelastic while the demand for gifts and bequests is completely elastic, since the beneficiaries do nothing to receive it.