Modern Monetary Policy

In early economics, the government supply the currency by minting precious metal
with their stamp. No matter what the credit worthiness of the government, the worth
of the currency depended on the value of its underlying precious metal. A coin was
worth its gold or silver content, as it always be melted down to this. A country’s worth
and economic clout was largely to its holding of gold and silver in the national
treasury. Monarch, despots and even democrats tried to skirt this inviolate law by
filling down their coinage or mixing with other substances to make more coins out of
the same amount of gold and silver. There were inevitably found out by the traders,
money lenders and others who depended on the worth of that currency (Walsh,
2001).
Monetary policy is one of the tools that a national government uses to influence its
economy. Using its monetary authority to control the supply and availability of
money, a government attempt to influence the overall level of economic activity in
line with its political objectives (Clarida 1999). According to Peter (1999), monetary
policy has no specific definition in economic fields. It define the actions design to
manipulate the money supply including bank credit, in order to achieved the
specified economic objectives by duly authorized public authority, most commonly a
central bank.
Modern macroeconomics is divided into two camps which is the neo or new-classical
and the new Keynesianisme theory. New Keynesian are different from the old. The
new Kenynesian looking so much like old classical and it can be conclude that the
term “Keynesian” has out-lived its usefulness. The economist did not agree with the
main goal of the monetary policy which is to attain the best performance possible. It
is because they think that the economic are always influenced by the politician.
While, according to the Federal Reserve Banks, the aims of this monetary policy are
the attainment of maximum sustainable economic growth. Beside, another aim is to
improve living standard and low unemployment and also low or no inflation.
(Belongia,1996)
There are some assumptions in the basic principles of the new monetary policy by
Keynes. The new policy are not about an exegesis of Keynes (1963). New
Keynesianism (NUKE) does not put in doubt that the insights of classical theory are
helpful for economic analysis. NUKE does not believe that capitalism is threatened
by oversaving and that must be hindered by deficit spending programs. Monetary
policy is more powerful in fighting recession than fiscal policy, the policy undertaken
should not be discretionary but ruled based. Lastly, the monetary policy need to
consider that the inflation has it costs. NUKE do not believe that a monopolized
money economy is necessary. As Woodford (2001), it is quite possible that the
information revolution strengthens and privatization of money supply. But, even in
such system, central bank would play a central role due historical network
externalities. Therefore, a privatization of money supply does not change the NUKE
basic concept of optimal monetary policy (Gordon, 1990).
In light of the empirical failure of new classical economics to give a plausible
explanation for the occurring changes in output, employment and unemployment, it
is hardly astonishing that the basic principles are virtually identical with the core
principles of modern macroeconomics. Firstly, in industrial countries real output

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oscillates along an increasing growth path. In the long run, this growth path is
determined by the supply-side. Second, in the long run there is no trade-off between
inflation and unemployment rate. The “natural” equilibrium unemployment rate is
determined exclusively by real factors, remains unaffected by monetary policy.
Hence, in the long run central banks should have an inflation target only. Third,
short-run fluctuations are generated by changes in aggregate demand. In the short
run, there is a trade-off between inflation and unemployment, as is described
empirically by the Phillips curve. This trade-off is only possible, because in the short
run wages and prices are not flexible enough to clear markets continously. For
practical monetary policy this implies that it should strive to stabilize the growth of
aggregate demand in order to minimize fluctuations of real output and inflation.
Fourth, expectations of households and firms react to policy measures. Hence,
monetary policy has to consider these expectations and act accordingly: building up
credibility and transparency is the name of the game. Fifth, the evaluation of
monetary policy should not be based on isolated one-time changes in policy
instruments but on a series of changes which are connected by a policy rule.
The tools of the monetary policy are open market operations, discounts loans and
changes in reserve requirements. Open market operations can be defined as the
buying or selling of bonds by the Federal Reserve (Fed) in the open market.
Expansionary when Fed buys bonds (injects reserves) while Contractionary is when
Fed sells bonds (drains reserves). Sometimes, its done for temporary periods.
Repurchase Agreement - Fed purchases US government securities will an
agreement that the seller will buy them back (repurchase them) at a specified price
on a specified date, usually within two weeks. A repo is therefore like a temporary
open market purchase, temporarily increasing the monetary base. Matched Sale-
Purchase Transaction (reverse repo) - The Fed sells US government securities with
an agreement that the buyer will sell them back at a specified price on a specified
date, again usually within two weeks. A reverse repo is therefore like a temporary
open market sale, temporarily decreasing the monetary base. Hence, in conducting
monetary policy, open market operations have a number of advantages which is
They are under the direct and complete control of the Fed. They can be
large or small and can be easily reversed. They are also can be
implemented quickly (Gordon, 1990).

Discount rate can be defined as the rate of the interest charged to banks that borrow
from the Federal Reserve. When a bank receives a discount loan from the
Fed, it is said to have received a loan at the “discount window.”The Fed
can affect the volume of discount loans by setting the discount rate. A
higher discount rate makes discount borrowing less attractive to banks
and will therefore reduce the volume of discount loans. A lower discount
rate makes discount borrowing more attractive to banks and will therefore
increase the volume of discount loans. Advantage of discount loans are
they allow the Fed to act as a lender of last resort during a financial panic.
Disadvantages of using discount loans as a tool for monetary policy during
normal times are the volume of discount loans can be influenced by the
Fed, but not completely controlled. The Fed cannot be sure how many
banks will request discount loans at any given interest rate. Beside that,
changes in the discount rate must be proposed by the Federal Reserve

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Banks before being approved by the Board of Governors. Hence, they are
neither quickly made nor easily reversed.

While reserve ratio is designed to change the amount of require reserves. It affects
M2 by changing the multiplier. Disadvantages to using changes in reserve
requirements as a tool for monetary policy are large changes in reserves must be
approved by Congress. Hence, large changes cannot be made quickly and easily.
Also, if a bank holds only a small amount of excess reserves and the required
reserve ratio is increased, the bank will have to quickly acquire reserves by
borrowing, selling securities, or reducing its loans. Each of these three options is
costly and disruptive. Beside that, changes in reserve requirements can cause
problems for banks by making liquidity management more difficult.

The NUKE theory of optimal monetary policy has the imply on the constitution of
central banks and practical monetary policy (Fisher, 1994) which is the central bank
should be given the authority to change the interest rate and other variables relevant
for monetary policy so that it can achieve its policy goals. The central banks should
have a clearly defined mandate including price stability and they also should publicly
announce and explicit symmetrical positive inflation goal for a specified period of
three years. The announcement should describe exactly the circumstances, which
give allowances for deviation from the inflation target due changes in the terms of
trade, the interest rates, and indirect taxes.

Besides that, the central bank should target a consumer price index which does not
take into account interest related cost. The reason for this is that an increase of the
interest rate would have a contrary effect of raising the inflation rate. The central
bank should pursue the concept of flexible inflation forecast targeting. This implies
that the central bank should stabilize output and inflation. In order to make sure that
the central bank does not act in an excessively discretionary way and to ensure that
inflation forecasts are not biased, its is imperative to maintain the greatest possible
transparency with respect to the numeric inflation goal and the weight of the output
stabilization goal in the lost function of the central bank. For transparency in
monetary policy translates into a commitment of the central bank to do everything,
absolutely everything, to minimize it loss function. The require transparency is given
credence by the publication of inflation reports. Lastly, responsibilities for exchange
rate policy and interest rate policy should nit be divided as long as the exchange
rates, the exchange rate and the interest rate are interdependent.

As a conclusion, the collapsing of money supply and credit availability great

contributed to the savagery of this depression. This realization that money supply
affected economic activity led to active government attempt to influence money
supply through monetary policy. Difference from the new Classical, NUKE exists
more in terms of modelling the supply side and less in modelling in demand side and
the effects of monetary policy. Until the new label is found, however, we can safely
say that Keynesian economics is alive and well (Mankiw, 2001).

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References :
Belongia, M.T (1996) “Measurement Matters : recent result for monetary economic
re-examined” , Journal of Political Economy, Vol. 104 No 5, October.

Clarida, Richard et al. 1999. “The Science of Monetary Policy: A New Keynesian
Perspective.” Journal of Economic Literature 37 : 1161-707

Gordon, Robert J. 1990. “What is New Keynesian Economics?” Journal of Economic

Literature 28 : 1117-171

Mankiw, Gregory N. “The Reincarnation ok Keneysian Economics.” Europen

Economic Review 36: 559-65

Peter R. Senn (1999) “Mpnetary Policy and The Definition of Money”, Journal of
Economic Studies, Vol.26, No.4/5, pp 338-382.

Walsh, Carl E. 2001. “The Science and Art of Monetary Policy.” Federal Reserve
Bank of San Francisco Economic Letter (May 4): 2001-13

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