SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 47)

The Goals of Monetary Policy

by

Charles Lamson

Macroeconomic policy consists of (1) monetary policy, which involves the Fed's use of its policy instruments to affect the cost and availability of funds in the economy, and (2) fiscal policy, which involves alterations in government spending or taxes proposed and enacted by Congress and the president. The changes in fiscal and monetary policies that lead to changes in aggregate demand interact, in turn, with aggregate supply to produce changes in prices, real output and employment.

In conducting monetary policy, the Fed works through the financial system. The Fed's primary tools for influencing the financial system include control of the monetary base, the required reserve ratio, and the discount rate. Monetary policy, in turn, influences the borrowing, lending, spending, and saving behavior of the household, business, government, and rest-of-the-world sectors. As depicted in Exhibit 1, the specific goals of monetary policy are to design and implement policies that will achieve sustainable economic growth, full employment, stable prices, and a satisfactory external balance. Now, let us take a closer look at the rationales underlying these goals.

Downloadable papers that describe the general purpose and goals of monetary policy can be found at www.federalreserve.gov/pf/pf.htm.

1. The Goals of Monetary Policy

Click to enlarge.

Economic Growth

The size of the "economic pie" divided up among a nation's citizens is determined by the quantity of goods and services produced. That is, the size is determined by real output, or specifically, real GDP. Simply put, if the size of a nation's economic pie and thus its potential standard of living are to rise over time, the productive capacity of the economy must expand: the natural level of real output (long-run aggregate supply) must increase.

Most economists agree that the growth of aggregate supply over time is determined primarily by the growth of capital, the labor force, and productivity. Thus, growth of the key inputs in the production process and technological improvements are the key to long-run growth of output. So far so good, but what determines the growth of capital, labor, and productivity?

The growth of the capital stock depends directly on the amount of investment spending undertaken by firms. By definition, the change in the capital stock is equal to net investment spending. The productivity of capital is thought to depend on the amount of resources devoted to research and development and on the resulting technological advances that lead to new and more productive plants and machines. Labor force growth flows from the growth of the population and from increases in the proportion of the population that participates in the labor force. The productivity of labor is thought to depend on the educational attainment and health of workers, the quantity and quality of the capital stock with which they work, and, perhaps, the competitive environment faced by firms and their employees.

In general, a thriving nation's productive capacity grows over time. Research shows that macroeconomic policy, through its effects on the determinants of economic growth, influences the pace of growth in a number of ways. While ignoring many of the detailed relationships and linkages, it is worth noting here that the government's tax policy affects both the willingness of firms to invest and engage in research and development and the willingness of households to work and save. Similarly, the level of interest rates resulting from the interaction of the monetary and fiscal policies pursued has a decisive influence on spending and saving decisions. Over time, such decisions affect an economy's growth potential and therefore affect aggregate supply.

On the other hand, an unstable environment characterized by a series of inflationnary booms and deflationary recessions is likely to inhibit long-run growth. In such a situation, aggregate demand almost always grows faster or slower than aggregate supply, thereby generating either inflationary pressures or an economic slowdown. Hence, the shorter-run stabilization objectives are not really separate and distinct from the long run goals but rather support and complement the nation's pursuit of economic growth over the long run. Short-run fluctuations around the long-term trend influence the trend itself.

Recap

The goals of monetary policy are sustainable economic growth, full employment, stable prices, and a satisfactory external balance. Sustainable economic growth is determined by the growth and productivity of the labor force and capital stock. Policies that achieve full employment and a noninflationary environment help to achieve maximum sustainable growth.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003,  MAUREEN BURTON & RAY LOMBRA, PGS. 601-602*

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