Measures needed for responsible monetary policy

Summary 

  • Discussion of monetary policy tends to ignore entirely the behaviour of individuals and focuses instead on aggregate, or macro-economic, variables such as inflation, growth and employment.

  • An expansion of the quantity of money that leads to inflation will reduce the real value of cash balances that people hold.

  • Inflation may also induce people to hold lower cash balances because of the greater risk of holding cash and the potential erosion of the purchasing power of cash. From the micro-economic point of view, therefore, expansion of the money supply and the creation of inflation are damaging.

  • When the money supply is expanded, not all individuals are affected in the same way at the same time. The process by which the money supply is expanded and inflation is created distorts economic activity.

  • In particular, by reducing interest rates, expansion of the money supply encourages investment that is not viable in the long term.

  • In so far as monetary policy can expand the economy, it can only do so in the short run and by fooling wage-earners into thinking that real wages are higher than they really are.

  • It may be argued that it is necessary to expand the money supply and create inflation because nominal wages are sticky in the short run. However, trying to reduce real wages by creating inflation creates distortions in the economy, will not be successful in the long run and takes attention away from the underlying causes of unemployment and slow growth.

  • If the causes of slow growth are high levels of taxes and regulation, it is dangerous to use monetary policy to try to resolve these problems.

  • The fashionable idea of ‘market monetarism’ would be better described as ‘market Keynesianism’. Rather than trying to offset reductions in growth by tolerating higher inflation, monetary policy should be used to try to keep the growth in the money stock constant, thus allowing the economy to adjust to changes in real conditions.

  • Devaluations and depreciations do not ‘create jobs’ in the long run. They simply distort the economy. Any benefit from a devaluation or depreciation would be offset by higher internal inflation.

  • Low growth in Japan over the last two decades has been caused by real factors. There is no obvious relationship between low growth in Japan and the periods of tight monetary policy. Indeed, if anything, higher growth rates seem to follow periods of tight monetary policy.

  • In order to ensure more responsible monetary policies three things are necessary:


— As an interim measure, central banks should limit the growth of the money supply using a pre-defined rule. There should be sanctions if the rule is broken. Sanctions could include fines on monetary authorities which do not respect the rules; removing the governor of a central bank who does not reach the prescribed targets; or reducing the governor’s salary in proportion to the rate of inflation or money creation.

— Currency competition should be encouraged, including by the abolition of legal tender laws.

— New institutional arrangements which involve the private sector providing monetary services, most likely tied to a metallic standard, should be allowed to develop and replace central bank provision of money.

2014, Briefing Paper 14.07

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