Why Monetary Policy Is Important

by: Scott Sumner

I’ve been asked to comment on a recent Andy Harless post that denied the existence of monetary policy:

So there you have it: there is no such thing as monetary policy. There is “central bank directed stabilization policy,” and, for convenience, you can refer to that as monetary policy if you want. If so, recognize that you are using the term loosely, and let’s not get into arguments about whether some particular Fed action is “really” monetary policy. None of it is really monetary policy.

I agree that when one takes a close look at monetary policy, things are never quite what they seem. And that it’s hard to draw a bright line that separates monetary policy from other policies. But I still think one can identify two basic types of monetary policy:

1. Policies that affect the supply (or quantity) of the medium of account.

In the US, the Fed creates two assets that serve as the medium of account; currency and bank deposits at the Fed. This aggregate is referred to as the monetary base. Open market operations are the primary method by which the supply of base money is altered, although discount loans are also used. Thus, the base is increased when the central bank buys an asset, or when the central bank lends base money to others.

2. Policies that affect the demand for the medium of account.

The central bank can affect the demand for base money in numerous ways:

  • Reserve requirement changes.
  • Changes in the interest rate on reserves (and perhaps currency when we fully shift to electronic money.)
  • Changes in the nominal policy target. Thus, a higher price level target, a higher NGDP target, or a higher foreign exchange rate peg would tend to reduce the real demand for base money, by creating higher inflation expectations. Indeed any action that increases the future expected supply of base money will tend to reduce the current real demand for base money.

To summarize, an expansionary monetary policy is any action or statement by the Fed that increases the supply of base money, or reduces the real demand for base money.

I see base money as being special because it is a medium of account. Thus, the price level can be modeled in terms of changes in the value of “money.” T-bills are different. An increase in the supply of T-bills might increase the price level, or it might reduce the nominal price of T-bills. Money is special; by convention its nominal price is equal to one. Fiscal policy has little impact on the price level. When Reagan generated huge deficits via tax cuts and a military buildup, and Volcker fought back with tight money, we all know who won. And the Fed also came out ahead when LBJ tried a tight fiscal policy in 1968-69, but monetary policy stayed easy. That’s why monetary policy is important, and worthy of special attention.