Monetary Policy The question of whether or not growth of the money supply should be governed by rulles or by monetary authorities

exercising discretionary powers has been debated probably since it was first discovered that money does not manage itself. Use of a commodity standard such as the gold standard to determine the m.oney supply automatically was finally discontinued in the 1960s and probably will never by resumed. n alternative procedure would be to ma!e a govermnent"controlled money behave as though it were a commodity"based money# that is# to grow at a steady rate. That idea has been advocated for years by $lar! %arburton# &ilton 'riedman# and others as the most effective way to achieve a reasonable degree of stability in economic activity and the price level. (iscretionary use of money"supply changes to offset changes in inflation rates# and thus to combat business cycles# was advocated by )rving 'isher and other monetary economists before the *reat (epression. fter the rise of income"expenditure theories in the 19+0s# changes in growth rates of the money supply were not believed to have more than minor# slow effects on economic activity. ,owever# policyma!ers after %orld %ar )) attempted to supplement fiscal policies with changes in money supply growth rates as contracyclical instruments and in pursuit of full employment. These policies proved to have an inflationary bias. -y 19.0# recognition of the disturbing and often perverts effects of discretionary changes in growth rates of the money supply on economic activity# inf1ation rates# interest rates# and exchange rates was leading more economists and even some policyma!ers to advocate reducing the variability of money"supply growth rates. lthough no monetary authority in the world has# specifically renounced its discretionary powers over rates of monetary expansion# some have begun to behave# almost as though they had# by announcing target rnoney growth rates in advance. The new theories of rational expectations# which were developed in the 19/0s# have provided an impressive rationale for the use of a steady0money growth rule rather than discretionary changes in money growth rates. 1conomists of this school argue that wor!ers and managers of business firms learn to anticipate changes in fiscal and rnonetary policies# if they believe# for example# that a restrictive monetary policy intended to combat inflation will be followed by an expansionary policy# they will not reduce rates of increase in wages and prices. This explains the persistence of high inf1ation rates during recessions that developed after the mid"1960s. Control of the Money Supply %ith recognition of the importance of money"supply changes has come increasing interest in how money supply is created and how it should be controlled# )t is now generally recogni2ed that the money supply is 3ointly determined by decisions by the government or central ban!# commercial ban!s# and the public. The government and central ban! control the supply of monetary base# or high"powered money# which consists of paper currency and coin issued by the government and liabilities of the central ban! to commercial ban!s. The money supply held by the public is some multiple of the monetary base so that an increase in the monetary base provided by the govemment and the central ban! will cause the money supply to increase by more than the increase in the base. )n early 19.0# in the United 4tates# for example# a 51 increase in monetary base would result in an increase of about 56.70 in narrowly defined money supply# &"1 8demand deposits and currency9. The multiplier determining the si2e of the money supply per unit of monetary base is not constant. (ecisions of the ban!s regarding the quantity of reserves they want to hold in the form of currency or in deposits at the central ban!# in relation to their deposits# and decisions of the public regarding the shares of their money holdings they want to !eep in currency and in ban! deposits change the multiplier and# thus# change the quantity of money supply associated with any given quantity of monetary base. lthough such a change in the multiplier can produce unanticipated changes in the money supply over short periods# a substantial body of research indicates that these changes can be predicted well enough to be

offset by changes in the monetary base so that the monetary authorities should be able to !eep growth of the money supply within a tolerable range of error around a desired growth path# if they decide to try. ln actual practice# until the early 19/0s# growth of the money supply in most countries was essentially an incidental result of central ban! actions in pursuit of other ob3ectives# such as to stabili2e interest rates or foreign exchange rates# or to facilitatate the financing of government budget deficits. -y 19.0# however# the central ban!s and governments of many countries# including the United 4tates# the United :ingdom# %est *ermany# )taly# ;apan# 4pain# and 4wit2erland# were attempting achieve more precise control over their money supplies through reducing emphasis on operations designed to stabili2e interest rates or exchange rates and increasing emphasis on direct control of the monetary base or other monetary aggregates. <n <ctober 6# 19/9# for example# the 'ederal =eserve 4ystern of the United 4tates announced that it had changed open"mar!et operating procedures to place more emphasis on controlling ban! reserves directly in order to provide more assurance or attaining basic money"supply ob3ectives. Commercial banks Unli!e other private institutions# commercial ban!s create money through extending loans and ma!ing investments. To do so# ban!s need reserves which are provided primarily by the central ban!# the ban!er>s ban!er. The essence of monetary policy is to control the release of reserves in a manner which stimulates ban! lending and investing in support of consumer and business spending in order to foster economic growth without contributing to inflationary pressures. &onetary policy has the capacity to exert an enormous impact on the level of employment# the volume of output# and the rate of inflation and serves as a ma3or policy tool for influencing economic activity. -asically# two conditions are required for ban!s to create money. <ne is the widespread acceptance of what might be called ban! money. t one time# ban! money consisted largely# if not exclusively# of paper currency. ,owever# in time# ban!s were restricted in issuing their own currency and were able to maintain their money"creation role through the introduction and then the widespread adoption of the use of chec!s 8demand deposits9 as a means of payment. The other necessary condition is the ability of ban!s to function either by operating experience or regulatory requirement with reserve balances being maintained at only a fraction of their deposit liabilities? that is# under a fractional reserve system. 8)f ban!s held reserves equal to 100 percent of their deposit liabilities# ban!s could not create money# and they would serve solely as intermediaries between depositors and borrowers.9 *reenwald 1ncyclopedia of 1conomics @p 6A+"6A7 y 66."669