Module: 2
Project on Monetary policy - Growth, Inflation and The Conduct of Monetary Policy
[Source: RBI Report of Currency & Finance 2001-2002]

Monetary Policy and Growth

For monetary policy to be effective in supporting the revival, it must exert a systematic influence on economic activity, i.e., output, employment, real interest rates and real exchange rates. Thus, the question of what monetary policy can or cannot do in the context of the deceleration is inextricably linked to the debate on the issue of neutrality of money, i.e., whether or not monetary policy has any lasting influence on the real economy. The debate itself has dominated economic thinking in the 20th century - does money matter (non-neutral) or not (neutral). The swings in the paradigm across the spectrum of the debate have been a powerful force in shaping the stance and conduct of monetary policy.

The classical view of a dichotomy between the real and nominal worlds, and thereby, of monetary policy being neutral, was co-terminus with the view of the economy as self-correcting, inherently prone to revert to equilibrium and full employment. Accordingly, money had no influence on real variables in the long run; changes in money supply caused a proportionate change in the price level via the quantity theory. The Great Depression of 1929 and the growing dominance of Keynesianism in its aftermath swung the debate in favour of non-neutrality. Policy makers were confronted with the clear danger of the economy slipping further and further away into depression. Consequently, interventions had to be made in the form of monetary and fiscal policies to prevent and correct macroeconomic failures.

Until the 1950s, monetary policy was subordinated to fiscal policy. Expansionary fiscal policy supplemented by the discretionary financing of fiscal deficits by monetary policy, while keeping interest rates low in order to stimulate investment was the preferred combination. In the 1960s, influential work on the US economy showed that peaks and troughs of money supply changes systematically preceded the peaks and troughs of economic activity, leading up to the premise that monetary policy has powerful effects on real variables in the short run (Friedman and Schwartz, 1963). Accordingly, the debate produced a transient synthesis during the 1960s and the 1970s within the dominance of the Keynesian paradigm. Money began to matter and central banks began to employ monetary policy to reduce fluctuations in real variables. Several developed countries including the USA, Canada and Britain pursued expansionary monetary policies and experienced healthy increases in output and reduction in unemployment rates (Handa, 2000).

Although the period 1940-71 was characterised by fixed exchange rates under the Bretton Woods par value system, most countries sought to have some discretion in the conduct of monetary policy. Many countries, both developed and developing, established exchange controls and revenue was extracted through financial repression and seigniorage. The fiscal domination of monetary policy set up an inconsistency with the exchange rate objective, and when the USA suspended the convertibility of the US dollar in 1971-73, the end of an era was in sight. Monetary policy had lost its nominal anchor. The massive oil price hike of 1973 stepped up global inflation and worsened the situation. Inflation in the industrial countries rose from low levels in the 1950s and the 1960s to double digit levels. At the same time, unemployment rates remained persistently high; the phenomenon of 'stagflation' was incompatible with the standard Keynesian analysis and the latter's abandonment in the design of policy frameworks seemed imminent.

The stagflation of the 1970s fuelled scepticism about the beneficial effects of expansionary monetary policy. The counterrevolution was led by Milton Friedman, the keeper of the 'living tradition' of the classical faith (Colander, 1986). Persistent inflation was found to be largely or solely the result of excessive monetary growth. Augmenting the Phillips curve with expectations showed that the trade-off between unemployment (growth) and inflation could possibly exist in the short run; in the long run, however, there was no trade-off. Furthermore, it was argued that long and variable lags in the operation of monetary policy can destabilise the impact of counter-cyclical monetary policy and accordingly the desired short-run impact was virtually unpredictable. Indeed, short-run discretionary monetary policy was rendered dangerous by forecast errors - expansionary monetary policy to fight a downturn can take effect when the economy is booming. All this led to the advocacy for resisting the temptation to exploit the possible short-run trade-off and to set up a rigid rule fixing the growth rate of money stock to the trend growth rate of output. Backed by the predictive model of the Federal Reserve Bank of St. Louis (1968), money began to matter in influencing output and employment, although its potentially destabilising effects were emphasised and long-run neutrality regained prominence in shaping the contours of monetary policy.

The first half of the 1970s was thus characterised by a considerable amount of uncertainty regarding the conduct of monetary policy. 'Policy ineffectiveness' raised questions regarding the ability of policy makers to 'fine tune' the economy. The operational design of monetary policy was marked by an increasing recourse to credit rationing. The introduction of floating exchange rates, however, did not provide the independence for monetary policy to pursue domestic objectives. External viability remained as a dominant concern of monetary policy right through the 1980s. 5.10 In the second half of the 1970s and up to the mid-1980s, monetary targeting became the raison d'etre of the conduct of monetary policy. Empirical investigation turned out systematic evidence of stability in the money demand function (or the LM curve) which strengthened the case for using monetary aggregates as the intermediate target since changes in money supply could be traced to predictable changes in prices, interest rates and income. Money supply rules were also seen as a means of securing freedom for monetary policy from fiscal domination by eschewing discretionary actions. Germany, Switzerland and the USA were amongst the first to adopt monetary targets in the operating framework of monetary policy in 1975, followed by Canada in 1976, and France and Australia in 1977 (Argy et al, 1989). Beginning in 1978 and well into the 1980s, many developing countries also adopted various formulations of the money rule.

During this period, the institutional setting for monetary policy, however, underwent radical changes. Globalisation and financial sector reforms and the explosion of financial innovations had a fundamental impact on the stability of the money demand function, both in the parametric and in the predictive senses. As a consequence, there was a breakdown in the observed relationship between monetary aggregates, the inflation rate and the real activity. In part, this reflected the operation of Goodhart's law: any observed statistical regularity will tend to collapse once pressure is placed on it for control purpose. Incorporating rational expectations and market clearing into macro-economic analysis produced theoretical conclusions which questioned Keynesian and 'synthesis' propositions (Muth, 1961; Phelps, 1967; Lucas, 1972). Under these conditions, discretionary policies, both fiscal and monetary, are ineffective in influencing real variables as people anticipate policy changes and respond in a manner which renders policy changes sterile. This triggered a 'new classical' renewal of the classical money neutrality hypothesis although new Keynesians produced non-neutral effects of monetary policy even with rational agents on account of the existence of rigidities in the system (Box V.1). The impact of this shift in the paradigm in the debate on money neutrality brought about a fundamental revision in the conduct of monetary policy in the 1980s. In the 1980s, several countries either modified the operating framework of monetary policy to a monetary-cum-output targeting approach or abandoned monetary targeting altogether. Germany and Switzerland persevered with monetary targeting, although in a significantly modified form of the monetary rule. In view of these developments, the European Central Bank (ECB) follows two pillar-framework of monetary policy, with reference values of money supply being only one of the pillars.

In the period since the latter half of the 1980s, central banks all over the world are experimenting with a variety of operating instruments and analytics with a broad preference for indirect instruments and a market orientation of monetary policy. In recent years, particularly in the 1990s, there has been an upsurge of interest in the operational framework for monetary policy. Beginning in 1989, a number of countries have put in place institutional settings for directly achieving the primary target of monetary policy - inflation.

Essentially inflation targeting relies on the use of simple and explicit rules for monetary policy. While inflation targeting has been characterised alternatively as 'constrained discretion' and 'the interest rate analog of a money growth rule', it has opened up a number of dilemmas for practitioners of monetary policy, i.e., the lack of complete integration into economic theory, the neutrality hypothesis and the relationship between growth and inflation, what to target - a precise number or a range, the trade-off between the exchange rate and inflation and the transmission channels from the instrument to the target.

The debate on the neutrality of money remains unsettled. The central opposing views have modified their positions and moved closer. Monetarists, for instance, have toned down their argument regarding the Phillips curve being vertical in the long run. Keynesians concede that if a long run trade-off exists, it is limited and the scope for long run policy activism is small. In the interregnum, monetary policy and its operational framework transit through a twilight zone.