Question

What is Monetary Policy? Why is it designed to be out of the reach of political control? What are the benefits and drawbacks to this? What is the Dual Mandate? How do the two components of the Dual Mandate tend to be contradictory to each other (tend to move in opposite directions)? In what ways does this make politically isolating members of the Board of Governors a greater benefit, and greater drawback? Explain.

Answer 1

Monetary policy :

The monetary policy is relevant to the money or monetary system which is undertaken by the central government of the country.It is a process undertaken by the central bank, currency board or the government to control the availability of money and its supply as well as the interest rates on loans and the amount of bank reserves. Its goals include addressing the problem of unemployment, maintain balance in exchange rates and stabilize the economy.

In the United States, the Federal Reserve System which was established on December 23, 1913 is the agency which executes monetary policy which can either be expansionary or contractionary. The former increases the supply of money by lowering interest rates on loans to urge businesses to expand to reduce the number of the unemployed during recession. Conversely, the latter aims to slow the supply and even limit it to slow down inflation and prevent the devaluation of assets. In a contractionary monetary policy, interest rates are higher.

The Federal Reserve also decides how much interest rates it will impose on banks when money is borrowed from it. Conversely, banks will determine how high the interest rates will they be asking from borrowers. If the Federal Reserve set low rates for banks, consumers and commercial interest rates will also benefit from lower interest rates from banks.

• Types of Monetary Policy

Inflation Targeting – This approach is used to ensure that inflation does not go over the desired limit and will be adjusted depending on current interest rates.

Price Level Targeting – This strategy targets the Consumer Price Index instead of inflation.

Monetary Aggregates – This approach is practiced by countries in relation to money supply and affects credit and classes of money.

Fixed Exchange Rate – This is the set price, usually against other currencies to ensure the U.S. dollar value is maintained within the desired perimeter.

Gold Standard – This approach aims to keep the value of money the same as the value of gold.

Economists and policy makers are divided on the effect of monetary policy on the economy and the American people. Although setting a policy can work in stabilizing the economy, there are also limitations to what it can do. This is why it is important to have pertinent information about the two sides of this approach.

• Advantages of Monetary Policy:

1. Expansionary monetary policy makes it possible for more investments come in and consumers spend more.

With the banks lowering the interest rates on mortgages and loans, more business owners will be encouraged to expand their businesses since they are more available funds to borrow with interest rates that they can afford. On the other hand, prices of commodities will be lowered and the buying public will have more reason to buy more consumer goods. In the end, companies will profit while their customers are able to afford what they need like basic commodities, property and services.

2. Lowered interest rates also lower mortgage payment rates.

Another advantage of monetary policy in relation to lowered rates is that it also affects the payments home owners need to meet for the mortgage of their homes. Reduced mortgage fees will leave home owners more money to spend. Also, they will be able to settle their monthly payments regularly. This is a win-win situation for merchandisers, creditors and property investors as well.

3. It allows the Central Bank to apply quantitative easing.

The Federal Reserve can make use of this policy to print or create more money which enables it to purchase government bonds from banks. The end result is increased cash reserves in banks and also monetary base. This also leads to reduced interest rates and more money for the bank to lend its borrowers.

4. It promotes predictability and transparency.

Supporters say that policymakers are obliged to make announcements that are believable to business owners and the consumers when it comes to the type of monetary policy to be expected in the coming months for it to be a success,

• Disadvantages of Monetary Policy

1. Despite expansionary monetary policy, there is still no guaranteed economy recovery.

Some economists who criticize the Federal Reserve on the policy say that in times of recession, not all consumers will have confidence to spend and take advantage of low interest rates. If this is the case, then it is a disadvantage.

2. Cutting interest rates is not a guarantee.

Others also claim that even if the banks are given lower interest rates by the Central Bank when they borrow money, some banks might have the funds. If this happens, there will be insufficient funds people can borrow from them.

3. It will not be useful during global recession.

Proponents of expansionary monetary policy say that even if banks will lower interest rates and more consumers will spend money, during a global crisis, the export industry might suffer. They say that if this is the current situation, the losses of exporters are more than what businesses can earn from sales.

4. Contractionary monetary policy can discourage businesses from expansion.

Opponents claim that if the Federal Reserve will impose this policy, interest rates will increase and businesses will not be interested to expand their operations. This can lead to less production of manufacturers and higher prices. Consumers might not be able to afford goods and services. Worse, it might take a long time for these businesses to recover and eventually force them to close shop. If this continues, workers might lose their jobs.

Nudimentary Typology of Political Factors :

The first distinction that I wish to draw is between factors that directly involve the legally constituted process of governing and other factors, that, while important for governing, are more accurately conceived as characteristics of the nongovernmental organization of society. This is, of course, the familiar distinction between "state" and "society." The second distinction is between slowly and rapidly changing political factors. This, also familiar, is the distinction between structural and variable factors. Where the line is drawn between state and society is, as we shall see, extremely important, and appears to have significant consequences for monetary policy. Politics involves the use of authority to resolve distributional issues, and it is clear that decisions about the range of societal affairs subjected to authoritative

(as opposed to market) decisions are fundamental political decisions. We should not fail to recognize that monetary policy is both constrained by those decisions and may be part of a continuing process of remaking or refining those decision.

II, Political Structure and the Impact of Type I Politics

the impact of type I politics on monetary policy as being mediated through the political structure. By this mean that the statutory position of the central bank together with other structural features of politics determines the degree to which central banks are exposed to the pressures of type I politics. Students of the Federal Reserve have argued that independence from conventional budget processes and appointments for long terms in office help to guarantee Federal Reserve independence from the President and the Congress. In fact, major central banks differ very little in terms of these kinds of structural differences--certainly not enough to account for any pronounced difference in macroeconomic performance (Woolley, 1984a). Arguably more important is the degree to which legislation clearly defines certain policy priorities for the central bank. Clear statutory guidance appears to reduce the scope for short-term political influence (Parkin and Bade, 1978). The Bundesbank, for example, is explicitly charged with making inflation its first priority, unlike the other two banks. Also imporant are differences in the degree to which central banks control all of the instruments relevant to monetary policy, such as financial institution regulation, administered interest rates, mechanisms for credit allocation. In this respect, the Bank of France shares authority with other institutions more than does the Bank of England which, in turn, shares authority more than does the Bundesbank. To reduce this kind of interdependence is, by definition, to enhance autonomy. Functional independence is not equal to an ability to resist pressures from other actors, but it does reduce the number of occasions requiring negotiation and possible compromise.

Dual Mandate :

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

The term “dual mandate” refers to employment and price stability, as those are potentially contradictory. The idea is that the Fed has to use some judgement to decide which of those two (employment or price stability) to prioritize over the other.

I am not saying that they are in fact contradictory at all times, but that was thought to be the case at the time the terminology came into use.

Breaking Down the Federal Reserve's Dual Mandate:

The current mandate of the Federal Reserve first made its way into the Federal Reserve Act in November 1977. The 1970s were plagued with high inflation and unemployment, a severe adverse macroeconomic condition known as stagflation, which motivated Congress to reform the original Act of 1913. With the intention of clarifying the Fed’s Board of Governors and the Federal Open Market Committee’s (FOMC) roles, Congress’ Reform Act explicitly identifies “the goals of maximum employment, stable prices, and moderate long-term interest rates.” It is these goals that have come to be known as the Fed’s “dual mandate."

The first thing to notice is that the so-called dual mandate actually appears to be a triple mandate of achieving the following three goals: 1) maximum employment; 2) stable prices; and 3) moderate long-term interest rates. We shall begin by looking at the first one, maximum employment, before we turn to the other two, which can effectively be treated as a single mandate.