2.MONETARY POLICYThe Central bank is considered to be “thebank of other banks” and it is responsible for controlling the monetary economyof a country. After central banks around the world gained their independencefrom the influence of the government in regard to the conduct of policy, theyhave continuously used monetary policy as a tool in contributing to theeconomic growth of a country. Monetary policy is a very important topic thathas been reviewed by the literature. Also, Monetary policy contributes to the stabilizationof the economy by using interest rate as an instrument to control inflation andcontrol money supply, this would be explained further in the paper. In this paper, we use the relevantliterature to examine what macroeconomics variable have been used to determinemonetary policy and examine how central banks can control inflation and also ifthey should focus only on inflation. Monetary policy is an important economic toolused by the central bank of a country to maintain economic growth andstability.
According to Poole and Wheelock (2008), “The Federal Reserve Act asamended in 1977 directs the Federal Reserve to pursue monetary policy toachieve the goals of maximum employment, stable prices and moderate long-terminterest rates”. This objective is applicable to most central banks in a country.Monetary policy plays a crucial role in the growth of a country’s economy bycontrolling the money supply in order to control inflation, reduce the level ofunemployment and boost consumer spending and borrowing. The breakdown of the Bretton Woods era gaverise to the modernization of monetary policy in the 1970s.
The Bretton Woodssystem was created so that exchange rate would remain stable while inflationrate was also stable. However, after the Bretton Woods system ended, theeconomy of several countries crashed. There was a rise in unemployment ratesand the inflation rate was unstable. These made policymakers reconsider monetarypolicy as a tool to be used by central banks and to accommodate its norms thatwere not considered during the Bretton Woods system. These norms include;monetary policy strategies such as inflation targeting, central bank independenceand the separation of monetary policy from regulatory activities such as banksupervision. Also, after the 2008 financial crisis, monetary policy was used toassist in stabilizing financial markets and restoring liquidity.
WHAT DETERMINES MONETARY POLICY?One of the objectives of central banks isto maintain low and stable inflation in the economy. This is carried out byusing policy interest rate to impact inflation through transmission mechanism.Interest rates play a major role in conducting monetary policy as it helps incontrolling inflation. However, when the inflation rate is too low orunemployment rate is too high, central banks respond to this by reducing theshort-term interest rates but they have to be cautious as interest rates cannotfall below zero (zero lower bound). If this happens, it would be difficult torevive the economy through further monetary easing, instead quantitative easingwould be used to increase the money supply in the economy (Bernanke, 2017).
Williamson(2017) explains that “quantitative easing consists of large-scale assetpurchases by central banks, usually of long-maturity government debt but alsoof private assets, such as corporate debt or asset-backed securities”. Before the 2008 financial crisis, the zero-lowerbound on short-term interest rates was regarded as irrelevant by mosteconomists. However, during the crisis in 2008, the Federal Reserve Systemresponded to this crisis by reducing its policy rate close to zero (Bernanke,2017).
2.2.CAN CENTRAL BANKS CONTROL INFLATION?One of the main objectives of centralbanks is to ensure low and stable inflation. However, economists have arguedabout the ability of the central bank to control inflation.
In a paper byClaeys and Wolff (2015), they discuss the control of inflation by examining ifglobalization is reducing the ability of central banks to control inflation. Theyexplain this using three forms, which includes; “globalization for goods andservices in the market, global integration of labor markets, increasedfinancial integration” (Claeys and Wolff 2015). Regarding the first point, the world is aglobal market and this means that goods and services are produced in differentparts of the world. This means that the prices of these goods are set ininternational markets and are imported to other countries. This situation couldreduce the ability of the central bank to control inflation.
Also, competitionin the global markets could affect inflation. An increase in market competitionusually leads to increase in productivity, as each producer would want toproduce more quality products than his competitor and this could apply downwardpressure on production costs and prices. (Claeys and Wolff, 2015).Secondly, the continuous increase in theglobal labor force has led to a continuous increase in productivity as moreworkers are available to produce exportable goods and services. This leads to adecrease in the bargaining power of workers in advanced countries in settingwages which has an effect on the domestic inflation rates. (Claeys and Wolff,2015).Thirdly, one of the major factors that weakensthe ability of the central bank to control interest rate is increasingfinancial integration.
The effect it has on the central bank in controllinginterest rates causes it to have an influence on output and inflation. (Claeysand Wolff, 2015).All three forms listed above make itdifficult for central banks to achieve their inflation targets. In a worldwhere there is continuous global economic development, central banks need totake these changes into consideration. However, through the control they haveover interest rates, central banks have powerful instruments to preventfinancial conditions that might have an effect on inflation.2.
3.MONETARY POLICY STRATEGYMonetary policy strategies have continuedto evolve since the 1970s dating back to the Bretton Woods era. According toHouben (2000), “monetary policy strategy is considered to consist of thespecification of the intended monetary reaction function to economicdevelopments as well as the communication of this reaction function and ofactual policy decisions to the outside world.” Several strategies have beenused in different eras to contribute to the economic growth of a country. Thethree main strategies include; money targeting, exchange rate targeting, inflationtargeting (Houben, 2000).For the purpose of this literature, wewill focus on inflation targeting as it is considered the best objective forthe central bank. This is because one of the goals of a central bank is tomaintain a low inflation rate and it is better for the central bank to have aninflation rate target than money target. This is so as central banks havelittle control over the growth of M2 (broad money) and M1(currency andcheckable deposits) which is why in most central banks, monetary policy hasshifted from focusing on M1 or M2 to focusing on inflation.
(Blanchard andJohnson, 2013). 2.3.1.INFLATION TARGETINGOver the years, central banks around theworld have adopted inflation targeting as a guide in carrying out monetarypolicy. Abel et al. (2008) explain that “Inflation targeting implies that thecentral bank announces the inflation rate that it will try to achieve over thesubsequent one to four years”. Inflation targeting was pioneered in 1990 by NewZealand and afterward was adopted by several countries around the world (Mishkin,2001).
Before the introduction of inflation targeting, New Zealand used moneytargeting as its monetary policy strategy. But why the shift towards inflationtargeting??Money targeting was introduced in 1975 bythe central bank of Germany and was later adopted by other countries. Moneytargeting involved the central bank announcing the rate of growth of money thatit will try to achieve over the next year. However, this form of monetarypolicy strategy was later abandoned.
The Fed explained that money targeting wasabandoned due to rapid changes in the United States financial system. Thesechanges involved unstable velocity in the demand for money which made moneytargeting an ineffective monetary policy strategy and this made other countriesabandon money targeting. (Abel et al., 2008).
According to Mishkin (2001), inflationtargeting contains five main elements that are important in helping the centralbank of a country make economic plans that include the central bank informingthe public about its forecast on the future inflation rate. These elementsinclude;a) “Thepublic announcement of medium-term numerical targets for inflation.b) Aninstitutional commitment to price stability as the primary goal of monetarypolicy to which other goals are subordinated.c) An information inclusive strategy in whichmany variables, and not just monetary aggregates or the exchange rate, are usedfor deciding the setting of policy instruments.d) Increased transparency of the monetary policystrategy through communication with the public and the markets about the plans,objectives, and decisions of the monetary authorities.
e) Increased accountability of the central bankfor attaining its inflation objectives”.(Mishkin, 2001). 2.3.2SHOULD CENTRAL BANKS TARGET ZERO INFLATION? Several economists have argued about theinflation rate goal, stating that having an inflation rate that is too low couldincrease the rate of unemployment and could lead to inefficiency in the economyof a country. However, Mishkin (2001) says that “setting the long-run inflationtarget at zero would make deflations more likely and deflations can lead tofinancial instability and sharp contractions”.
This statement explains thattargeting zero inflation is far worse than having an inflation rate that is toolow. Also, Billi and Kahn (2008) agree that inflation rate should not fallbelow zero because the costs of deflation are too high. However, targeting zero inflation has itspros and cons. According to Mankiw (2016), an advantage of targeting zeroinflation is that zero provides a more focal point for policy makers than anyother number. He explains with an example saying that “for instance, if the Fedwere to announce that it would keep inflation at 3 percent, would the fedreally stick to the percent target?”. He went further to say “If eventsinadvertently pushed inflation up to 4 or 5 percent, why wouldn’t it just raisethe target? There is, after all nothing special about the number 3”. Heconcluded by saying that “by contrast, zero is the only number for theinflation rate at which the fed can claim that it has achieved price stabilityand further eliminated the costs of inflation”. His explanation is about thepercentage of the inflation target being more feasible.
However, this cannotjustify the damage it will cause on the economy of a country which is why thereare disadvantages. Billi and Kahn(2008) agree that inflation should be kept abovezero. They explain that if inflation is targeted at zero, it would affect thenominal interest rates because nominal interest rates cannot fall below zero.They said that, “when inflation is low and expected to remain low, investorsare willing to accept a low inflation premium when purchasing nominal debtinstruments and as a result, nominal interest rates will tend to be low”.
Theyfurther explained that “because central banks counteract slowing economicactivity by lowering short term interest rates, a very low inflationenvironment limits the extent to which policymakers can respond to an economicslowdown”. They concluded by saying, “Once short-term rates fall to zero,conventional monetary policy tools no longer work to stimulate economicactivity”. This explains that setting an inflation target of zero is going tobe terrible for the economy because there will not be solutions to the damagesdone to the economy for a very long time.
Also, as inflation rate is linked tomoney supply, an increase in the money supply reduces the value of money, whichleads to an increase in the price level. In Summary, monetary policy is animportant tool for central banks and it has been in the front burner of theeconomic world because of the role it plays in the economy of a country. Asstated earlier, it contributes to the growth of an economy by using interestrate to control inflation rate. However, central bank controlling inflationrate does not necessarily mean they can control inflation. As the worldcontinues to evolve, several factors such as globalization may affect theability of the central bank to control inflation. This is because there iscompetition in global markets and every producer wants to be the best.
So, thismakes it difficult for the central bank to control inflation because the pricesof goods and services are different around the world. In addition, the centralbank of different countries use inflation targeting in order to prevent futuredamages to the economy. Using inflation targeting prevents future cases ofdeflation which could leave the economy helpless. Therefore, I believeinflation targeting is the best monetary policy strategy for the central bankas they have more control over the inflation rate.