Wednesday, July 8, 2009

How do you use monetary policy effectively?

1-to use monetary policy effectively, you must know the potential level of income. Otherwise you won't know whether to use expansionary or concretionary monetary policy. Let's consider an example: mid 1991 the economy seemed to be coming out of a recession. The fed had to figure out whether to use expansionary monetary policy to speed up and guarantee the recovery, or use concretionary monetary policy and make sure inflation didn't start up again. Initially the fed tried to fight inflation, only to discover that the economy wasn't coming out of the recession. In early 1992, the fed switched from contractionary to expansionary monetary policy. It continued that policy through 1994, when fears of inflation caused it to start tightening the money supply slightly. In early 2000 the fed was again trying to decide whether to follow expansionary or contractionary policy. It decided to contract the money supply but quickly changed its stance when the economy slowed in stood ready to return to a more contractionary monetary policy stance at the first sign of inflationary pressure. As these examples show, monetary policy in an art. the need for expansionary or contractionary policy can change quickly.
2- To use monetary policy effectively, you must know whether the monetary policy you are using is expansionary or contractionaery. You might think that's rather easy, but it isn't. In our consideration of monetary policy tools, you now that the fed doesn't directly control the money supply. It indirectly controls it, generally through open market operations by changing the monetary base (the vault cash and reserve banks have at the fed). Then the money multiplier determines the amounts of M1, M2, and other monetary measures in the economy.
That money multiplier is influenced by the amount of cash that people hold as well as the lending process at the bank. Neither of those is the stable number that we used in calculating the money multipliers. They change from day to day and week to week, so even if you control the monetary base, you can never be sure exactly what will happen to M1and M2 in the short run. Moreover, the effects on M1 and M2 can differ; one measure is telling you that you are expanding the money supply and other measure is telling you you are contracting it.
Because money aggregates as a measure of monetary policy have become unreliable, the fed officially stopped targeting those 2000. Instead, if focuses on interest rates. Interest rates, however, have problems of their own. If interest rates rise, is it because of excepted inflation (which is adding an inflation premium to the nominal interest rates) or is it the real interest rate that is going up? There is frequent debate over which it is. Combined, these measurement problems make the fed often wonder not only about what policy it should follow but also what policy it is following.

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