In its broadest sense, monetary policy includes all actions of governments, central banks, and other public authorities that influence the quantity of money and bank credit. It therefore embraces policies relating to such things as choice of the nation’s monetary standard; determination of the value of the monetary unit in terms of a metal or foreign currencies; determination of the types and amounts of the government’s own monetary issues; establishment of a central banking system and determination of its powers and rules for its operation; and policies concerning the establishment and regulation of commercial banks and other related financial institutions. A few even extend the meaning of monetary policy to include official actions affecting not only the quantity of money but also its rate of expenditure, thus embracing government tax, expenditure, lending, and debt management policies.

It has become customary, however, to define monetary policy in a more restricted sense and to exclude from it choices relating to the broad legal and institutional framework of the monetary and banking system. This narrower concept will be employed here. Monetary policy in this sense refers to regulation of the supply of money and bank credit for the promotion of selected objectives.

Elements of monetary policy

Like all economic policies, monetary policy has three interrelated elements: selection of objectives, implementation, and at least an implicit theory of the relationships between actions and effects. All three elements present problems of choice and are continuing subjects of controversy.

Monetary policy can be directed toward achieving many different objectives. For example, the supply of money can be regulated to provide the government with cheap or even costless funds, to maintain interest rates at some selected level, to regulate the exchange rate on the nation’s currency, to protect the nation’s gold and other international reserves, to stabilize domestic price levels, to promote continuously high levels of employment, and so on. Such multiple objectives are unlikely to be fully compatible at all times. Rational policy making therefore requires identification of the various objectives, analysis of the extent to which they are or can be made compatible, and choices from among those that conflict with one another. A later section will stress changes in the objectives of monetary policy and some of the problems of reconciling them.

The role played by monetary policy in promoting selected economic objectives depends greatly on the nature of the economic system and on attitudes toward the use of other methods of regulation. This role is usually secondary in economies characterized by government operation of most economic enterprises and government control of resource allocation, distribution of output, and prices of in-puts and outputs. Even in these economies monetary policy is not trivial. An excessive supply of money can create excessive demand and inflationary pressures, which are evidenced in black markets, hoarding, and bare shelves. On the other hand, a deficient supply of money can impede the flow of production and trade. Yet the major function of monetary policy in such economies is that of passive accommodation, that is, to provide the amount of money needed to facilitate the operation of other government controls; it is not to serve as a prime regulator.

Monetary policy usually plays a more positive regulatory role in economic systems that rely heavily on market forces to organize and direct processes of production and distribution. In such economies, decisions of business firms relating to rates of output, amounts of labor employed, rates of capital formation, and so on, are strongly influenced by relationships between costs and actual and prospective demands for output. If aggregate demands are deficient, firms will not find it profitable to employ all available labor, to utilize fully existing capacity, or to purchase all the new capital goods that could be produced. On the other hand, excessive aggregate demands for output are inflationary. A major function of monetary policy, therefore, is to regulate the behavior of aggregate demand for output in order to elicit a more favorable performance by the economy. This function is shared with fiscal policy in many countries and in many different combinations or “mixes.” Although the deliberate use of fiscal policy for this purpose has increased considerably in recent decades, monetary policy continues to be a major instrument.

Primary responsibility for administering monetary policies is usually entrusted to central banks, although there are varying degrees of government control of central banks and their policies. Central banks regulate the money supply and influence the supply of credit in two principal separate but closely related capacities: as controllers of their own issues of money and as regulators of the amount of money created by commercial banks. Both are important, but their relative importance depends in part on the stage of financial development of the country and on the types of money employed. In countries where bank deposits have not yet come to be widely used, notes issued by the central bank often constitute a major part of the money supply. In such cases the central bank may regulate the money supply largely by controlling directly its own note issues. However, in countries that have reached a later stage of financial development, central bank notes constitute a smaller part of the money supply; deposits at commercial banks are the major component, and the actions of commercial banks directly account for a large part of the fluctuations of the money supply. In such countries, the central bank is primarily a regulator of the commercial banks, although control of its own money creation remains important and is a part of the process.

The terms “monetary policy” and “credit policy” are often used interchangeably or with only slightly different shades of meaning. This has come about primarily because in most modern systems the creation and destruction of money by central and commercial banks are so closely intertwined with their expansion and contraction of credit. They typically create and issue money (currency and deposits) by making loans or purchasing securities, usually debt obligations. Thus, one side of the transaction is the issue of money; the other is the provision of funds to borrowers or sellers of securities, which tends to lower interest rates. Central and commercial banks typically withdraw money (currency and deposits) by decreasing their outstanding loans or by selling securities, usually debt obligations. Thus there is both a decrease in the supply of money and a decrease in the funds available to borrowers and to purchasers of the securities sold by the banks, which tends to increase interest rates.

Those who speak of monetary policy tend to focus on the behavior of the stock of money, while those who speak of credit policy tend to focus on the quantity of loan funds available from the central and commercial banks. Such differences in focus need not lead to differences in either analysis or conclusions. Yet they sometimes do. Those who focus on the stock of money are more likely to stress “real balance effects” on both consumption and investment spending, while those who focus on credit are likely to put more stress on the direct effects on interest rates, the availability of funds, and investment. Monetary theory has made considerable progress in reconciling and integrating these approaches, but much remains to be done.

The third element in monetary policy is at least an implicit theory of the relationships between actions and effects. If its actions are to promote its objectives, the monetary authority needs some theory as to the nature, direction, magnitude, and timing of the responses. The relevant responses are numerous and on several levels. For example, they include the response of the supply of money and credit; the response of aggregate demand for output; and the responses of real output, employment, and prices. There are still disagreements among both economists and central bankers on many of these theoretical and empirical issues, and these disagreements underlie many continuing controversies over the proper nature and scope of monetary policy. Some of these will be treated in a later section.

Evolution of objectives

Monetary policy, in the modern sense of deliberate and continuous management of the money supply to promote selected social and economic objectives, is largely a product of the twentieth century, especially the decades since World War i. In the earlier period, when most countries were on either a gold or a bimetallic standard, the primary and overriding objective of monetary policy was to maintain redeemability of the nation’s money in the primary metal, both domestically and internationally. A decline of the nation’s metallic reserves to dangerously low levels, or any other threat to redeemability, became a signal for monetary and credit restriction, whatever might be its other economic effects. When redeemability seemed secure, monetary policy was used to promote other objectives—to deal with panics, crises, and other credit stringencies and even to expand money somewhat when business was depressed. But such intervention was sporadic rather than continuous and its purposes limited rather than ambitious. The international gold standard of the pre-1914 period was not purely automatic, but it was managed only marginally.

Many forces have contributed to the change and growth of monetary policy since World War i. One set of forces includes the breakdown of the international gold standard and other changes and crises in monetary systems—inflation during and following World War I and the long period of suspension of gold redeemability in most countries, the changed and insecure nature of the gold and gold exchange standards re-established in the 1920s, the renewed breakdown of gold standards during the great depression of the 1930s, and world-wide inflation during and following World War n. All these had profound effects on attitudes toward monetary policy. Both countries that had too little gold and those that had too much shifted to the view that the state of their gold reserves was no longer an adequate guide to policy and that new objectives and guides should be developed. Monetary actions became increasingly less sporadic and limited and more continuous and ambitious in scope.

The objectives of monetary policy have also been powerfully influenced by changes in attitudes concerning the responsibilities of central banks and governments for the performance of the economy. The 1920s witnessed growing demands that some central agency reduce instability of price levels and business activity. These demands were strengthened immeasurably by the economic catastrophe of the 1930s and by fears that World War n would be followed by another world-wide depression. Within a few years after that war the governments of almost all Western nations had formally assumed responsibility for promoting continuously high levels of employment and output. And within a few more years almost all of these governments had signified their intentions to promote economic growth. Monetary policy is required, in some cases by government and in others by the force of public opinion and pressure, to contribute to such objectives.

Although often phrased in different terms, it is now common for monetary authorities to state four major or basic objectives of monetary policy: (1) continuously high levels of employment and output, (2) the highest sustainable rate of economic growth, (3) relatively stable domestic price levels, and (4) maintenance of a stable exchange rate for the nation’s currency and protection of its international reserve position. In some countries monetary policy is also influenced by other considerations, such as a desire to maintain low interest rates to facilitate government finance or other favored types of economic activity.

Conflicts of objectives

Some of the most basic problems of monetary policy relate to the compatibility of such multiple objectives. Can all these be achieved simultaneously and to an acceptable degree even if a nation has precise control of the behavior of aggregate demand for output? Of course, the answer depends in part on the ambitiousness of the goals; perfection in all respects is hardly to be expected.

The answer also depends to an important extent on the responses of output, employment, money wage rates, and prices to changes in aggregate demand. The most favorable case is that in which the supply of output is completely elastic at existing price levels up to the point of “full employment” and capacity output. In such cases, increases of demand would elicit only increases in output until the economy reached its maximum capacity to produce. Price inflation would appear only when demand became excessive relative to productive capacity.

Problems of reconciling objectives relating to output, employment, and price level stability arise, however, when the supply of output does not respond in such a favorable manner to increases of demand—when prices rise before the economy has neared its capacity to produce. Even in the face of considerable amounts of unemployment, average money wage rates may rise faster than average output per man-hour, thereby tending to raise costs of production. And for this, or other reasons, business firms may raise the prices of their products even though considerable amounts of excess capacity persist. Under such conditions it may be impossible to achieve all objectives, to acceptable degrees, solely by controlling aggregate demand. Levels of demand sufficient to elicit “full employment” and capacity output may bring inflation, while levels of demand low enough to assure stability of price levels may leave large amounts of unemployment and unused capacity.

Because of such difficulties, many economists and other observers have come to believe that objectives relating to output, employment, and price levels can be reconciled satisfactorily only if regulation of aggregate demand through monetary and fiscal policies is supplemented by measures designed to elicit more favorable responses by the economy. These measures are of several types, which can only be listed here: (1) reform of wage-making processes in order to avoid inflationary increases of money wage rates, (2) decrease of monopoly power in industry, and (3) increase of regional and occupational mobility of labor.

The above discussion related to possible conflicts among a nation’s multiple domestic objectives. One, or more, of these domestic objectives may also conflict with the nation’s international objectives of maintaining a stable exchange rate for its currency and of protecting its international reserve position. Fortunately, domestic and international objectives do not always conflict. For example, a nation may have a deficit in its balance of payments primarily because of excessive domestic demands and rising prices. In such cases, restrictive monetary policies may be appropriate for both domestic and international reasons. On the other hand, a nation may have a surplus in its balance of payments primarily because of unemployment and depressed output and incomes at home, which depress its demands for imports. In this case an expansionary monetary policy will promote both its domestic and international objectives.

Cases do arise, however, in which domestic objectives and the objectives of maintaining stable exchange rates and a balance in international payments come into conflict. For example, a nation may have a large and persistent surplus in its balance of payments while demands for its output are so large as to bring actual or threatened inflation. An expansionary monetary policy, aimed at reducing the surplus in its balance of payments, would increase inflationary pressures at home; while a restrictive policy, aimed at inhibiting domestic inflation, would continue, and perhaps even increase, the surplus in its balance of payments. A nation faced with this situation may be compelled to sacrifice its domestic objective of preventing inflation or to increase the exchange rate on its currency in order to decrease the value of its exports relative to its imports.

Considered by most countries to be even more serious is the situation in which there is a large and persistent deficit in the balance of payments combined with actual or threatened excess unemployment at home. Employing expansionary monetary and fiscal policies to increase domestic demand and eradicate excess unemployment would tend to widen the deficit in the nation’s balance of payments and to drain away its international reserves. But employing restrictive policies to eradicate the deficit in its balance of payments would increase unemployment at home. The nation may be forced to sacrifice its domestic objectives relating to employment, output, and growth or to lower the exchange rate on its currency.

Because of such conflicts, many economists have become critical of arrangements under which ex-change rates remain fixed over long periods of time. They see little merit in stable exchange rates as such and would alter them whenever they conflict with important economic objectives. However, their prescriptions vary widely. For example, some favor stability of exchange rates most of the time with adjustments only in case of “fundamental disequilibrium.” Others favor continuously flexible exchange rates, with or without official intervention to influence their behavior. The entire field of ex-change rate policy remains highly controversial. [See International monetary economics. article On exchange rates .]

Monetary policy and aggregate demand

The preceding sections dealt with some of the problems that would be encountered in promoting multiple economic objectives simultaneously, even if the monetary authority possessed precise control over the behavior of aggregate demand for output. But it is unsafe to assume without analysis that the monetary authority, or even the monetary authority together with the fiscal authorities, can control aggregate demand precisely. The monetary authority has no direct control over aggregate demand for output or over any of its major components, such as demands for consumption, for investment or capital formation, for government use, or for export. Its powers are largely confined to regulation of the supply of money and credit. Even at this level its controls may lack precision. Presumably the central bank can accurately control its own creation and destruction of money; but its control of the creation and destruction of money and credit by the commercial banking system, exercised largely through its control over the reserve position of the banks, may be less accurate. And even if the monetary authority has precise control of the money supply, aggregate demand for output may not respond in a uniform or precisely predictable manner; the income velocity, or rate of expenditure, of money may fluctuate. Thus there are many links in the chain of causation from central bank action to the reaction of aggregate demand and many possibilities of slippage.

The effectiveness of monetary policy as a regulator of aggregate demand does not depend on the existence of some fixed relationship between the supply of money and aggregate demand. It requires only that changes in the money supply influence aggregate demand in the desired direction and in a predictable way and that the monetary authority have power to change the money supply to the extent required to offset adverse variations in the income velocity of money. However, the possibility of control of aggregate demand does suffer to the extent that changes in money supply fail to affect aggregate demand, that the power of the monetary authority to change the money supply is limited, and that the relationship between the money supply and aggregate demand is unpredictable.

Few economists doubt the ability of monetary policy, in the absence of strong cyclical forces, to regulate effectively the secular behavior of both the money supply and aggregate demand for output. Secular changes in the velocity of money are usually gradual and can be allowed for in determining the appropriate rate of change of the money supply. There is much less agreement, however, concerning the effectiveness of monetary policy alone for offsetting cyclical forces and stabilizing aggregate demand over the various phases of the business cycle.

Monetary policy meets its most severe test in dealing with the strong forces that cause recessions or depressions. Consider the extreme case in which an economy has slipped into a severe depression with widespread unemployment and unused capacity. Under such conditions businessmen are likely to view the future pessimistically and to see few opportunities for investment in capital facilities that promise favorable rates of return. Their demand functions for output to be used for capital formation may be so low that only extremely low interest—rates, perhaps rates approaching zero, would induce them to invest enough to lift the economy back toward full-employment levels.

But monetary policy may be incapable of depressing interest rates, and especially long-term rates, to such low levels. The monetary authority may encounter difficulties in increasing the money supply under such conditions because the banks prefer to hold excess reserves rather than lend and take risks. Interest rates, and especially long-term rates, may fall only sluggishly, even in the face of large increases in the money supply. One reason for this is the fear of default by borrowers under depression conditions. John Maynard Keynes suggested another reason—his famous “liquidity trap.” He argued that there was some long-term rate of interest, not far below that previously prevailing, that the public considered “normal,” in the sense that it would again prevail. No one would hold securities at lower yields because of fear of capital losses when interest rates returned to their normal levels. Below this normal rate the public would increase its holdings of money balances indefinitely rather than lend at a lower rate.

Thus monetary policy may be incapable of lowering interest rates enough to offset the decline of investment demand functions, and recovery may be delayed until something increases the expected profitability of private investment or until the government adopts expansionary fiscal policies.

In how many cases would a well-conceived and well-executed monetary policy prove incapable of dealing with depressive forces? On this there is still lack of agreement among economists. Some have argued that experience during the great depression proved the ineffectiveness of monetary policy. This experience is hardly relevant to the present question, however, because the monetary policies of that period were hardly exemplary. To protect gold standards or for other reasons, many countries actually followed deflationary monetary policies for a considerable period. Expansionary policies were in many cases initiated only after a long delay, during which excess capacity had be-come widespread, expectations had deteriorated, and the entire financial system had come under serious strain. It may well be that in this and other recessions an ambitious expansionary monetary policy introduced promptly after the downturn would have proved effective in arresting the decline of aggregate demand. However, many economists—including some who are optimists about the effectiveness of monetary policy—believe that monetary policy alone may not be potent enough to offset strong depressive forces and that expansionary fiscal policies should also be employed under such conditions.

It is generally conceded that well-conceived monetary policies can be more effective in restricting increases in aggregate demand during the prosperity phases of business cycles. However, such prosperity periods are usually characterized by increases in aggregate demand relative to the money supply. This increase in the income velocity of money, or “economizing of money balances relative to expenditures,” reflects several forces that usually accompany prosperity—greater optimism on the part of both households and business firms concerning their future receipts of income, which decreases the amounts of money held against contingencies; more profitable opportunities for investing idle balances held by business firms; and rising interest rates. Theorists have tended to stress, perhaps to overstress, the role played by rising interest rates. The rise of investment demand during prosperity tends to raise interest rates, and the rise of rates is accentuated by a restrictive monetary policy. In turn, the availability of higher yields on other assets induces both business firms and households to economize their holdings of money balances that yield no interest.

Such increases of velocity—induced in part, but only in part, by restrictive monetary policy—do constitute a slippage in the operation of monetary policy. This does not mean that monetary policy is rendered ineffective; it means only that larger restrictive actions are required to achieve any specified amount of restriction of aggregate demand. Of course, the monetary authority may be unable or unwilling to restrict money to the required extent. For example, it may be inhibited by inadequacy of the control instruments currently at its disposal, fear that further restriction would precipitate a recession, dislike of high interest rates, or charges that credit restriction discriminates against both new and small business firms. However, these are not limitations on the capability of monetary policy to restrict aggregate demand. They are only considerations affecting the willingness of the monetary authority to use its powers of restriction.

Lags in monetary policy

The effectiveness of monetary policy as a countercyclical instrument depends heavily on the quickness of policy action and the quickness of response of the economy. Ideally, policy actions would be taken as soon as adverse developments appeared, or even in anticipation of such developments; and there would be an immediate and full response of aggregate demand and of such policy objectives as employment and output. Under such ideal conditions a high degree of stability might be maintained continuously. In practice, of course, such ideal performance is not realized. Economists have long recognized three lags in monetary policy: (1) the recognition lag—the interval between the time when a need for action develops and the time the need is recognized; (2) the administrative lag—the interval between recognition and the actual policy action; and (3) the operational lag—the interval between policy action and the time that the policy objectives, such as output and employment, respond fully.

Both the length and significance of these lags depend heavily on the reliability of economic forecasting. If developments could be reliably forecast well in advance, the first two lags could be eliminated and actions could be taken soon enough to allow for the operational lag. But when economic forecasting is unreliable the monetary authority is likely to wait until a development appears before taking action to deal with it. In such cases the length of the operational lag becomes highly important for countercyclical policy. Those who favor flexible countercyclical monetary policies implicitly assume that the operational lag is rather short, that all or most of the effects of a monetary action will be achieved within a few months or a year. [See Prediction and forecasting, economic.]

This view has been challenged by some economists, notably by Milton Friedman. These economists contend that the responses to a given monetary action are distributed over time and that the full effects are realized only after a lag of considerably more than a year. Because of this, monetary actions taken to counter cyclical fluctuations may actually produce, or at least accentuate, these fluctuations. For example, expansionary policy actions taken to counter recession may have little effect for several months and then achieve their full expansionary effects on aggregate demand only when the economy is in its next boom phase. And actions taken to restrict aggregate demand during a boom may in fact precipitate and accentuate an ensuing depression.

For this and other reasons, members of this school oppose flexible countercyclical monetary policies. They believe that a greater degree of stability will be achieved by a monetary policy aimed at a steady growth of the money supply, regardless of cyclical conditions. This growth should be at an annual rate approximating the growth rate of real gross national product.

This whole question, which is obviously crucial for countercyclical monetary policy, remains unresolved and controversial. Friedman’s theoretical and statistical arguments have been strongly challenged but not wholly refuted. Much more research is needed on both the magnitude and timing of responses to monetary policy actions. The same applies to the various types of fiscal policy actions.

Monetary and fiscal policies

Nations face complex problems in determining the relative roles to be played by monetary policies and by the various types of government expenditure and tax policies in promoting the economic objectives described earlier. Only a few of the considerations determining these relative roles can be mentioned here. One is, of course, the whole set of cultural, institutional, and political conditions determining the actual availability of these policy instruments. For example, in some countries it is in fact acceptable to use government tax and expenditure policies in a timely and flexible manner. Other governments are not yet in this position. Still others may find it possible to reduce taxes or increase expenditures to support aggregate demand but not to restrict it by fiscal measures. There can also be comparable differences in the actual availability of monetary policy instruments.

Also relevant are judgments concerning the relative effectiveness of monetary and fiscal policies in achieving some desired behavior of aggregate demand. For example, an expansionary fiscal policy may be judged to be necessary to promote quick recovery from depression conditions but to be no more effective than monetary policy in restricting increases of demand.

The optimum mix of monetary and fiscal policies also depends in part on the nature of economic objectives and on their relative priorities. Suppose that it is possible to achieve some selected level of aggregate demand with various combinations of monetary and fiscal policies—with, say, some restrictive fiscal policy and some expansionary monetary policy or with some expansionary fiscal policy and some restrictive monetary policy. This level of aggregate demand can reflect various combinations of consumption and capital formation. If the objective is only to achieve some selected level of total output and employment, without regard to the distribution of output between consumption and capital formation, many different combinations of monetary and fiscal policies may be equally acceptable. But this may cease to be true if promotion of economic growth through a higher rate of capital formation is also an objective. For this purpose a restrictive fiscal policy and an easy monetary policy may be most appropriate. Large taxes relative to government expenditures for current purposes can be used to force the nation to consume a smaller part, and to save a larger part, of its total income; and an easy monetary policy, instituted to lower interest rates, can encourage the use of savings for capital formation.

A somewhat different case is that in which a nation wishes to raise aggregate demand for its output while it faces an undesired deficit in its balance of payments. Both expansionary fiscal policies and expansionary monetary policies tend to increase the deficit in the balance of payments to the extent that they succeed in raising aggregate demand, which in turn increases imports. But an expansionary monetary policy, which lowers interest rates, will also tend to increase capital outflows or at least to reduce capital inflows. In such a situation, an optimum policy mix may require more expansionary fiscal policies to raise domestic demand, together with a less expansionary monetary policy to support interest rates and attract capital inflows or at least to retard capital outflows.

These are but a few of the many considerations that determine the relative roles of monetary and fiscal policies. These relative roles have changed markedly in recent decades and are likely to continue to change with changes in the nature and relative priorities of economic objectives, with changes in attitudes toward the flexible use of fiscal policies for stabilization purposes, and with changes in our knowledge concerning the magnitudes and timing of responses to various types of both monetary and fiscal actions.

Lester V. Chandler

[See also Fiscal policyand Money .]

BIBLIOGRAPHY

Commission on Money and Credit 1961 Money and Credit: Their Influence on Jobs, Prices and Growth. Englewood Cliffs, N.J. Prentice-Hall.

Culbertson, J. M. 1960 Friedman on the Lag in Effect of Monetary Policy. Journal of Political Economy 68: 617–621.

Culbertson, J. M. 1961 The Lag in Effect of Monetary Policy: Reply. Journal of Political Economy 69:467–477.

Friedman, Milton 1961 The Lag in Effect of Monetary Policy. Journal of Political Economy 69:447–466.

Great Britain, Committee on the Working of the Monetary System 1959 Report. Papers by Command, Cmnd. 827. London: H. M. Stationery Office. → Known as the Radcliffe Report.

Scammell, W. M. (1957) 1962 International Monetary Policy. 2d ed. London: Macmillan; New York: St. Martins.

Yeager, Leland B. (editor) 1962 In Search of a Monetary Constitution. Cambridge, Mass. Harvard Univ. Press.