MONETARY POLICY

measures employed by governments to influence economic activity, specifically by manipulating the supply of money and credit and rates of interest. Monetary measures are frequently used in tandem with fiscal policy (q.v.) to achieve certain goals. The usual goals of both monetary and fiscal policy are to achieve or maintain full employment, to achieve or maintain a high rate of economic growth, and to stabilize prices and wages. Until after World War II, monetary policy was thought by most experts to be of little use in influencing the economy. Postwar inflationary trends, however, forced governments to adopt monetary measures as a principal means of achieving economic stability. Monetary policy is the domain of a nation's central bank. In the United States, monetary policy is the responsibility of the Federal Reserve Board (commonly called the Fed), while in Great Britain it is the Bank of England's responsibility. Although there are some differences between the operations of the Fed and those of the Bank of England, the fundamentals are almost identical. The Fed uses three main instruments in regulating the money supply: open-market operations, the discount rate, and reserve requirements. The first is by far the most important. By buying or selling government securities, the Fed (or a central bank) affects the money supply and interest rates. If, for example, the Fed buys government securities, it pays with a check drawn on itself, which has the effect of creating money in the form of additional deposits by the sellers of the securities in commercial banks; by adding to the cash reserves of the commercial banks, those banks are enabled to increase their lending. The additional demand for government bonds bids up their price and thus reduces their yield (i.e., interest rates). The rationale of this operation is to ease the availability of credit and reduce interest rates so as to encourage the business sector to invest more and consumers to increase their spending. The selling of government securities by the Fed achieves the opposite effect of contracting money supply and increasing interest rates. The second tool is the discount rate, which is the interest rate at which the Fed (or a central bank) lends to commercial banks. A rise in the discount rate discourages the banks from lending, because of the high rates involved in funding. In most countries the discount rate is used as a signal, and a change in it is followed by a similar change in the interest rates the commercial banks themselves charge to their customers. The third tool is reserve requirements. Commercial banks by law hold a specific percentage of their deposits and required reserves with the Fed (or a central bank), either in the form of reserve accounts or as cash. This reserve requirement acts as a brake on the lending operations of the commercial banks. By increasing or decreasing this reserve-ratio requirement, the Fed can influence the amount of money available for lending, and hence the money supply. The Bank of England and most other central banks have in their armouries a number of other tools, such as treasury directive regulation of installment purchasing and special deposits. Historically, under the gold standard, monetary policy was primarily directed to the protection of the central banks' gold reserves. When a nation's balance of payments was in deficit, an outflow of gold resulted. In order to stem this drain the central bank raised the bank rate and undertook open-market operations to bring about a reduction in the total quantity of money in the country. This led to a fall in prices, income, and employment and reduced the demand for imports, thus correcting the trade imbalance. The reverse process was used to correct a balance of payments surplus. The stability of the domestic economy was essentially hostage to external market conditions. Domestic considerations assumed a greater importance in the 1930s in response to the massive unemployment problem, but the chief role in combating it was given to fiscal policy. The inflationary conditions of the post-World War II period led to a revival of interest in monetary policy. Many economists were skeptical of monetary policy's ability to control inflation; they argued that to work, monetary policy must exert a prolonged restraining influence on the rate of consumption and investment expenditures in the private sector and that the cure might prove more damaging than the disease. The consensus in favour of fiscal policy gave way to greater reliance on monetary policy in the second half of the 1970s as inflation in the Western world rose to a level three times the 195070 average. The writings of monetarists such as Harry G. Johnson, Milton Friedman, and Friedrich Hayek concentrated on the link between the growth in money supply and accelerating inflation and argued that tight control of money-supply growth was a far more effective way of squeezing inflation out of the system than were demand-management policies. Monetary policy has grown in favour as a means of controlling cyclical fluctuations in the economy.