Goals of a Monetary Policy Finance. Monetary Term Paper

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Goals of a Monetary Policy

Finance.

Monetary policy is a complex framework of money demand and money supply. It cannot be framed easily as the formulating of the monetary policy for the state is a massive responsibility for the central bank of that state because the composers of the monetary policy are very well aware of the fact that there little mistake can cost the state and its economic development a lot. (Labonte, 2006)

Monetary policy can be defined as a set of policies that are related to the supply of money. As the sole agency which is responsible for the money supply in a state is the central bank of that state, therefore, monetary policy can also be defined as the rules, policies or statements of the central bank of a state, especially of its board of directors, that have an impact on the aggregate demand and national spending. (Labonte, 2006)

Specific attention is being paid to the announcements, of the Chairman of the central bank and the board of directors, that relate to the monetary policy by the financial press and markets. This is because the monetary policy has a direct impact on the aggregate demand and through aggregate demand; it can influence the Gross Domestic Product (GDP) of a state.the monetary policy of a state can have an influential impact on other variables such as real foreign exchange rates, unemployment, interest rates, and output etcetera. (Labonte, 2006)

Though all the above mentioned variables are the important ones, but the impact of monetary policy on these variables usually occurs in the short run. The monetary policy, however, has a long-term impact on the rate of inflation. An increase in the money supply can lead towards a decrease in interest rates which will lead towards an increase in investment. This increase in investment will lead towards an increase in Gross Domestic Product (GDP) and this will consequently increase employment and economic stability but all this will happen in the short run. (Labonte, 2006)

In the long run, however, an increase in the money supply would lead towards a rapid increase in the rate of inflation. So the positive effects of the rapid growth of money are evident only in the short run and in the long run the economy is left to handle with extreme rates of inflation. In the economies where high rates of inflation are common, the rapid growth of money does not stimulate any positive effect instead it causes the rates of inflation to go higher. (Labonte, 2006)

2. Goals of a Monetary Policy

According to the Federal Reserve Act, 'the Board of Governors and the Federal Open Market Committee should seek to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.' It can be said that stable prices in the long run can trigger sustainable economic growth and employment and they can also lead towards moderate interest rates. (The Federal Reserve System: Purposes and Functions, 2005)

When the prices of goods, services and labor are stable then this indicates that the prices are not distorted by the changes in the rates of inflation. Such stable prices provide a clear way for the allocation of resources and thus the resource allocation can be made more efficient. This in return can lead towards a higher standard of living. (The Federal Reserve System: Purposes and Functions, 2005)

In addition to that, stable prices also lead towards an increase in the rate of savings and generation of capital. This because the risk of loss in the value of assets, due to inflation, is decreased and the households are encouraged to save more, and businesses and investors are also encouraged to invest in different projects. (The Federal Reserve System: Purposes and Functions, 2005)

In addition to that, employees of the Federal Reserve and other central banks also include economic growth, stability of financial markets and the stability of foreign exchange markets in the key goals of a monetary policy. (Conduct of Monetary Policy: Goals and Targets, 2003)

2.1. Price Stability

Price stability is the primary and the most widely accepted goal of the monetary policy. The most important reason for maintaining price stability is that inflation can cause a country to suffer a lot both in economic and social terms. This can be proved by the fact that price stability has a negative relation with the economic growth in the long run. Throughout the world, the central banks usually make long-term price stability their primary goal. (Gaspar & Abreu, 1999)

Both inflation and deflation are economic phenomena that can have negative effects on the economy.

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Inflation can be defined as a continuous increase in the prices of goods and services over a long period of time, which can cause the value of the money to decline and can have an unpleasant effect on the purchasing power of the money as well. (Gerdesmeier, 2007)

Deflation on the other hand is a constant decline in the prices of goods and services over a long period of time. When there is no inflation or deflation in a country then it can be said that the prices are stable. If the prices remain same over a period of time then this is known as the condition of stability. For example, if $100 can buy the same basket of goods as it could have bought one or two years back then the prices are said to be stable. (Gerdesmeier, 2007)

Price stability decreases the risk of inflation and deflation and by doing so it brings about more opportunities for the people of a country. It helps the citizens to achieve higher living standards and it also provides the employees with higher employment opportunities. (Gerdesmeier, 2007)

Price stability also helps the citizens to better understand the prices of goods in terms of other goods, also known as relative prices. As due to price stability the relative prices are not distorted by the unwanted fluctuations in price. It helps the economy to allocate its resources efficiently and hence puts an end to the uneven allocation of resources. Long-term stability of the prices of goods and services has a tremendous impact on the economy and it also welfares the citizens a lot. (Gerdesmeier, 2007)

Price stability also reduces the rate of inflation risk premium and as a result it contributes towards the stabilization of the economy. If the prices are stable, then the creditors know that there would not be any unwanted fluctuations in the prices and hence they do not ask for the inflation risk premium. (Gerdesmeier, 2007)

The inflation risk premium can be defined as the compensation that the creditors get for bearing the risk of inflation. Low inflation risk premium leads towards the low nominal rate of interest. This low nominal interest rate encourages the investors to invest more in the economy and hence they improve the growth rate of the economy. (Gerdesmeier, 2007)

Price stability can also lead towards a decrease in unnecessary hedging activities as the organizations and the individuals do not need to protect themselves from the unpredictable fluctuations in the prices. They, therefore, divert their funds from protective functions, such as hedging, into some productive functions. (Gerdesmeier, 2007)

In the times of inflation, people resist holding the money in hand as the value of money keeps on decreasing. Inflation has an inverse relation with the value of money. In other words, it can be said that the higher the inflation rates the lower would be the value of money. If the inflation is fully expected then people do not keep money in their hand but this resistance in keeping money in hand causes them to make back to back visits to their bank whenever they are in need of the cash. In addition to that, the decrease in the value of money and resistance to hold money in hand because of the high rates of inflation has high transaction costs as well but price stability stabilizes the value of money and it also puts an end to high transaction costs. (Gerdesmeier, 2007)

By looking at the above arguments, it can be concluded that by maintaining price stability central banks can achieve its broader goals, such as high living standards, increased employment rate and enhanced economic stability etcetera, as well. As it has been suggested by a number of studies, that the economies that have lower rates of inflation tend to grow more, economically, than those with higher rates of inflation. (Gerdesmeier, 2007)

2.2. Employment

Monetary policy is a wide term and it has a broad meaning. Generation of employment and maximization of output is also one of the main objectives of the monetary policy. The number of jobs that a monetary policy generates (employment) and the rate of increase in output because of a monetary policy depends on the price stability, technology, people's priorty to save money and trends of working and risk taking over the period of time. (Cambazo-lu & Karaalp, 2012)

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