Thursday, July 16, 2009

Monetary Policy Goals

In the Federal Reserve Act, passed in 1913, the attainment of "an elastic currency" was given as one goals of this new central bank. The national Banking system, then effect, had as one of its major defects an inelastic currency, i.e., a currency that would not expand and contract with the needs of trade. In subsequent years, however, particularly after the economic debacle of the early 1930‘s and the emphasis placed on full employment and economic growth in the post-world war II period, broader and more sophisticated economic goals were assumed by the federal reserve system.
Four Major Goals
There appear to be four major policy goals of this central bank in the 1970‘s:(1) to preserve the value of the dollar over time ,i.e., minimize inflation of the price level,(2) to maintain full employment ,i.e., to keep unemployment from rising very much above 4to5 percent, (3)to achieve a significant rate of economic growth ,i.e., to help maintain a real growth rate of output of 5 to 6 per cent year, and (4)to help achieve equilibrium in the American balance of payments. It should not be thought that the Federal Reserve System has imagined that it could a chive even one of these goals solely by the manipulation of the monetary policy weapons at its disposal. It is fully understood in the Federal Reserve System that the achievement of any, or all, of these public policy goals requires a coordinated effort by many governmental agencies.
FISCAL POLICY VERSUS MONETARY POLICY In the case of a budget deficit, the powerful demand effects of fiscal policy could overwhelm the resulting effects of the monetary policy. Then, inflation of price level could continue, even though interest rates were still rising, e.g., in 1973-1974. On the other hand, assuming that the Federal Reserve is successful in its deflationary efforts, some undesirable side effect may occur. Although the desired goal of credit restraint by the monetary authorities is to slow down or eliminate inflation, a slowdown in output and employment may also result.
THE PHILLIPS CURVE the trade-off between unemployment and the price level can be summarized in a Phillips curve, named after the English economist who first performed the critical empirical research. Studies not only in England but in unites state as well, have shown that money wages, and indeed the price level, tend to rise more rapidly when unemployment is reduced, and vice versa. Hence, part of the cost of restraining inflation may be to rising unemployment.
Price stability and full employment are thus seen to be incompatible, conflicting goals. Nevertheless, some economists and some policy makers in the 1970‘s came to believe that a permanently lower unemployment rate could be achieved by paying the price of some constant rate of inflation, and that wage price guideposts and\or manpower policies could shift the Phillips curve toward the origin and thus reduce the amount of inflation related to any given unemployment rate. Other economists; especially Milton Friedman, argued that inflationary expectations would render any such trade-off policy ineffective.
Friedman believed tat there was a "natural rate of unemployment," which was the equilibrium rate for the economy. Temporarily, workers might have an expected rate of inflation below the actual rate of inflation and thereby permit their real wages to be reduced, so that employers would hire more workers and thus reduce the unemployment rate. Believing, however, that workers would not suffer a "money illusion" in the long run, the ultimate effect of public policies to reduce the unemployment rate would be a return to the "natural rate of unemployment," but at a higher rate of inflation than formerly.
Most economists came to agree that there were families of short-run Phillips curves, and that these curves could shift to alter the inflation-unemployment relationship. Nevertheless, the dominant view still seemed to be that there was such a trade-off in the long run, though the price of full employment might be a high (or even unacceptable) rate of price inflation, while the price of price level stability might be a high (or even unacceptable) rate of unemployment.
ADVERSE EFFECT OF INFLATION ON BALANCE OF PAYMENTS inflation at home is also unlikely to be compatible with a satisfactory equilibrium in country‘s balance payments which is the accounting statement that records all the flows of goods, services, and capital between one country and the rest of the world. An increase in export prices more repaid than that of one‘s major foreign competitors would likely lead to a diminution of growth in exports and a rise in imports. An inflationary growth of income in a country thus has both price and income effects on the country‘s balance of payment. A rise in prices of most goods also result in arise in prices of goods exported, which will tend to adversely affect exports. Also, the rise in income will tend to increase imports. If the country already has equilibrium in its balance of payments, a deficit in the balance of payments will now result.
GOAL OF ECONOMIC GROWTH An emphasis on economic growth as a major concern of the monetary authorities in the united states did not develop until the late 1950‘s and early 1960‘s. by that time, the soviet Union was seen as an importance economic, as well as ideological, competitor of the U.S. Hence, the United States came to look at its rate of economic growth as compared with that of the Soviet Union. By the early 1960‘S, the Federal Reserve, along with other parts of the federal government, was determined to assist in the attainment of higher rate of economic growth.
HIGHER PRICE ECONOMIC GROWTH Until The Mid-1960‘s, It Seemed That a higher rate of economic growth And a lower unemployment rate might be compatible with stable prices, or at least a slowly rising price level. After the Vietnam escalation began in 1965, government military expenditures began to rise sharply, and welfare spending was also increased. The subsequent added rise in private investment expenditures and consumer expenditures also increased the fuel feeding the inflationary fires that were earlier ignited. After several years of strong economic growth, the unemployment rate was finally reduced below 5 per cent in late 1973. Unfortunately, as the unemployment rate fell, the rate of inflation accelerated.
In 1973, consumer prices rose more than 6 per cent. In 1974 and 1975 they rose in many months at double-digit rates. Prices, which rose by 12 per cent or more 1974, increased on the average by 9.3 per cent in 1975. It took the severe recession of 1973-1975, which produced higher unemployment rates, not only then but also in 1976 and 1977, to reduce the inflation rate to more acceptable levels. In 1976 prices rose at an annual rate at the retail level in excess of 5 per cent and in 1977 about 6.5 percent.
By the 1970‘s, therefore, a higher rate of economic growth, with the low rates of unemployment accompanying it, was also seen as somewhat incompatible with price level stability. The trade-off problem for the monetary policy makers had become clearly established, both for the United States and Great Britain.

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