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Monetary policy can be defined broadly as any policy relating to
the supply of money. Since the main agency concerned with the
supply of money is the nation's central bank, the Federal Reserve,
monetary policy can also be defined in terms of the directives,
policies, statements, and actions of the Federal Reserve,
particularly those from its Board of Governors that have an effect
on aggregate demand or national spending. The nation's financial
press and markets pay particular attention to the pronouncements of
the chairman of the Board of Governors, the nation's central
banker. The reason for this attention is that monetary policy can
have important effects on aggregate demand and through it on real
Gross Domestic Product (GDP),unemployment, real foreign exchange
rates, real interest rates, the composition of output, etc. It is
paradoxical, however, that these important effects, to the extent
that they occur, are essentially only short-run in nature. Over the
longer run, the major effect of monetary policy is on the rate of
inflation. Thus, while a more rapid rate of money growth may for a
time stimulate the economy leading to a more rapid rate of real GDP
growth and a lower unemployment rate, over the longer run these
changes are undone and the economy is left with a higher rate of
inflation. In some societies where high rates of inflation are
endemic, more rapid rates of money growth fail to exercise any
stimulating effect and are almost immediately translated into
higher rates of inflation. Traditionally, two means have been used
to measure the posture of monetary policy. Since monetary policy
involves the Federal Reserve's contribution to aggregate demand or
money spending, it would be logical to examine the growth rate of
the money supply. A growing money supply is important for the
subsequent growth in money spending or aggregate demand. Giving
empirical content to the abstract concept of "the supply of money"
has not been easy. For the United States, three different
collections of assets have been defined as "money" and labelled M1,
M2,and M3. Unfortunately, over the period 1990-2004 these
aggregates have not been consistently linked to money spending and,
consequently, they are not the major focus of monetary policy.
Rather, the Federal Reserve executes monetary policy by setting a
target for an overnight interest rate called the federal funds
rate. Low or falling rates are usually taken as a sign of monetary
ease; high or rising rates usually indicate monetary tightness.
Changes in the federal funds rates affect primarily short-term
interest rates, and through these changes, money spending. The book
then looks more closely at five economies that have adopted a price
stability goal: New Zealand (which was the first country to adopt
targeting), Canada, the United Kingdom, Sweden, and the Euro area.
One key finding from these case-studies is that, in practice,
central banks tend to operate with greater latitude and more
discretion than some targeting proponents may have envisioned. For
example, central banks still tend to respond to a decline in
economic activity by lowering interest rates, even though strict
attention to the target might not justify it. This is possible
because exceptions to the targets are granted for a variety of
shocks and the definition of inflation being targeted often
excludes price changes due to factors such as food, energy, and
excise taxes. The book concludes with a brief analysis of the
record of inflation targeting in the developing world. It finds
that the improvement in economic performance following the adoption
of inflation targeting is greater in the developing world. Since
developing world countries often experience economic and political
instability.
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