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Advantage: Low Inflation


The two goals of monetary policy are to promote maximum
sustainable levels of economic output and foster a stable price system. Stable
prices mean keeping inflation low, and the Federal Reserve Bank of San
Francisco concedes that low inflation is all that monetary, harming economic
growth. In contrast, stable prices enable households and policy can achieve in
the long run. Inflation reduces the purchasing power of money businesses to
make financial decisions without worrying about sudden, unexpected price
increases.
Advantage: Political Independence

When central banks operate free of political pressures, they are free to
make policy decisions based on economic conditions and the best available data
on economic performance, rather than short-term political considerations
imposed by elected officials or political parties. The U.S. Federal Reserve
operates with a high level of political independence, even though it is
accountable to Congress. Federal Reserve board members are presidential
appointees but have staggered terms to make it more difficult for a president to
load the board with favorite appointees. When central banks lack this
independence, monetary policy becomes subject to political pressures. Harvard
economist Greg Mankiw, for example, writes that central bankers that lack
political independence may manipulate monetary policy in a manner favorable
to the political party in power.
Disadvantage: Time Lag

In contrast to fiscal policy, which quickly stimulates additional money


into the economy as governments increase spending for government programs
and public projects, monetary policy actions take time to work their way
through the economy, especially a large modern economy such as that of the
U.S. and other world economic powers. The San Francisco Fed estimates that
monetary policy actions to affect output and employment can take three months
to two years for their effects to be felt. Actions may take even longer to affect
inflation -- sometimes more than two years.
Disadvantage: Conflicting Goals

The Federal Reserve and other central banks can use monetary policy
to achieve low inflation in the long run and affect economic output and

employment in the short run. The Federal Reserve Bank of San Francisco
reports that these goals sometimes conflict. Reducing interest rates to expand
the money supply and stem rising unemployment rates during a recession, for
example, could spark future inflation if monetary policy remains expansionary
for too long. The best monetary policy seeks to strike a balance between these
short- and long-term goals.
o

Advantages. Despite its imperfections, monetary policy has several


advantages over the two alternative types of stabilizersfiscal policy
and direct controls (price controls and rationing).
o First, it is highly impersonal. Monetary policy
interferes very little with the freedom of the
market,
although
market
imperfections
sometimes intensify the effects of policy upon
particular sectors of the economy. A tight
monetary policy cuts down the rate at which
total spending can rise, but it does not dictate
which particular expenditures must be slowed or
reduced. The expenditures cut are the ones to
which spenders attach the lowest priorities.
Similarly, a policy of ease stimulates total
outlays, but the market dictates their form. In
contrast, such policy devices as price and wage controls interfere
directly with the choices of business firms and households.
o Second, monetary policy is flexible. The Federal Open Market
Committee usually meets about every six weeks, reaches a
decision, and acts on that decision immediately.
o Finally, and perhaps most important, Congress has carefully
insulated the Federal Reserve from day-to-day political pressures
so it may act in the best interests of the country. Congress wisely
spread the policymaking machinery throughout the System to
avoid undue concentration of power. It made the System
responsible to Congress rather than to the Executive Branch. It

provided for 14-year terms for Board members, made them


ineligible for reappointment after they have served a full term, and
staggered their terms of office. The System has, of course, only
such powers as Congress has given it, and can lose those powers if
it does not exercise good stewardship. The powers are broad,
however, and Congress so far has chosen to permit the Federal
Reserve System to base its policy actions almost entirely upon
economic considerations.

Limitations. Formulating monetary policy is a difficult task, and there


are definite limitations to what policy can do. Real economic stability
requires not only wise monetary policy but sound fiscal actionsthe
manner in which the government taxes, spends, and manages its
debtand sufficient competition throughout the economy so individual
prices are free to move down as well as up. Obviously, trouble can
develop in all three areas, so it is difficult to achieve perfect stability.
But even if fiscal policy were always perfectly prudent and competition
sufficient to prevent monopolistic price increases, there would be
limitations on what monetary policy could do. Under the best conditions,
there are "slippages" in the financial mechanism. For example, depository
institutions may not always promptly contract or expand earning assets in
response to System nudging, thus negating some of the action. In
addition, even if they do respond promptly, shifts in the public's demand
for money may partly offset changes in the money supply. Both kinds of
slippage complicate the task of the money authorities, although their
long-term importance can be overrated. More fundamentally, although
monetary policy can help stabilize short-term economic activity, it cannot
affect real variables, such as employment and output, over the longer run.