Monetary Policy: Factors of Influence, Role of a Central Bank


The purpose of this study is to have a look into the factors which affect monetary policy. The study also involves bringing to light the role of a central bank in stabilizing an economy and economic indicators like unemployment, poverty, interest rates, and inflation.

Role of the Phillips Curve

Phillips curve shows the inverse relationship between unemployment and inflation. (Phillips Curve), where Nairu stands for a non-accelerating inflation rate of unemployment. The PC, which is the long red line, changes in the long run because of the change in expectations, and thus only a single rate of unemployment was consistent with the inflation rate. If the unemployment rate stays behind the red line inflationary expectations will rise, which will take the short-term PC upwards as indicated by B.

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Role of the Phillips Curve.

Economists attribute this inverse correlation to the errors that people make while forecasting price levels. These forecasting errors of the public were manipulated by the economists to generate better performance of the economy. As discussed by Hall Robert below:

The benefits of inflation derive from the use of expansionary policy to trick economic agents into behaving in socially preferable ways even though their behavior is not in their own interest… The gap between actual and expected inflation measures the extent of the trickery… The optimal policy is not nearly as expansionary [inflationary] when expectations adjust rapidly, and most of the effect of an inflationary policy is dissipated in costly anticipated inflation. (Qtd in Rational Expectations)

Having understood the Phillips curve and the inverse relationship between inflation and unemployment, we will now try to find a balance between unemployment and inflation. How much is inflation inversely related to unemployment? To what extent is the trade-off existent? We will also look at the possible causes behind the inverse relationship between unemployment and inflation.

As discussed above, the Phillips curve is the historical inverse relationship between unemployment and inflation. Higher the unemployment, lesser the inflation and lower the unemployment, higher the wages paid to the labor of the economy, which results in a better flow of currency within the economy, which eventually leads to inflation. American economist Irving Fisher pointed to the same kind of Phillips curve inverse relationship long back in the 1920s, whereas, Phillips’ original curve described and showcased the behavior of money wages and for this reason, some economists believe that the Phillips curve should be called the “Fisher curve.” (Phillips Curve)

In the years after his 1958 paper, many economists in advanced industrial countries believed that Phillips’ results showed a permanent and stable relationship between inflation and unemployment. One of the critical implications of this concept for government policy was that governments could control unemployment and inflation within a policy. They could tolerate a pretty reasonable rate of inflation on the higher side, as this would definitely lead to lower unemployment because there would be a trade-off between inflation and unemployment.

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For example, monetary policy (deficit spending) could be used to stimulate the economy, raising the gross domestic product, and lowering the unemployment rate. So the governments always had this choice to manipulate this pay-off and make things favorable in the economy. Consequently, this would lead to a higher inflation rate, the cost paid to have a lower unemployment rate. (Phillips Curve)

One would notice that there are several other reasons behind the fact that the unemployment rate can actually go down without much change in the interest rate scenario. The unemployment rate basically depends on many other factors like, there can be a slowdown in the rate of growth of labor supply, which can be directly responsible for the unemployment rate to come down if there is not a pick-up in demand for labor.

The unemployment rate in the UK had actually climbed up because of the fact that the labor supply in 2005-06 picked up because of inward immigration, which the country witnessed. The anomaly got corrected in late 2006 when the labor supply saw a decline. Though the present scenario is not very favorable because the workforce still remains plenty, but given the fact that its rate of growth has fallen down, we have witnessed unemployment rates stabilizing pretty fast, however, it remains to be seen, as to how long the scenario does not change, as there is plenty of inward immigration prevalent in the economy.

Benefits and Costs of a Nominal Anchor

There can be a lot of nominal anchors which can either be price-based or quantity-based. A few examples of price-based targets can be encompassing the Exchange Rate, Price of gold, Prices of specific commodities, or the Inflation Rate. Quantity-based anchors on the other hand can be Monetary Aggregates and Nominal Income. All the anchors have their own advantages and disadvantages. Exchange rate targeting is a monetary policy under which the value of the domestic currency is fixed to that of a low inflation country like the US. This kind of pegging is desirable when a country either seeks more integration with its neighbors or does not have its own monetary policy framework.

The backdrop of such a policy, however, is that the pegging country loses the use of monetary policy against any domestic shocks which might be different from that of the anchor country. Exchange rate pegs also leave countries open to domestic currency attacks and any major depreciation of the domestic currency can lead to a severe financial crisis because it might increase the country’s liabilities in domestic currency. (Monetary Policy Strategy, Mishkin S Frederic)

Central Bank’s concern on Financial Market Stability

The Central bank comes out with the monetary policy in order to ensure certain key objectives like delivering price stability with a low inflation level coupled with an objective to support the Government’s economic objectives of growth and employment. Price stability is taken care of, by the Government’s usual inflation target of 2%. There is a need to contemplate the crucial and critical role played by price stability in achieving the aforesaid economic stability, and in providing just the right conditions for a sustainable and longer living growth in output and employment. The official rate, which is set by the Central bank, influences many aspects of an economy such as market rates, asset prices including the house prices, expectations, and exchange rate.

This gives rise to demand, which is the sum total of domestic plus external demand, which in turn gives rise to inflationary pressure resulting in inflation, another important point shown, which deserves a mention is a relationship between the exchange rate and import prices, or the price paid for imports. As explained above, the stronger the exchange rate the lesser the price paid for imports, and the weaker the currency the higher the price paid for imports. (How Monetary Policy Works)

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Any decision is taken after considering the condition of the whole economy and all sections of the society at large and there are several other methods to tackle the prices of properties, but it will always be better to increase the rates at a slower but steady pace, rather than giving a monetary shock. Rising Inflation, if not tackled properly and at the right time may create a cycle, wherein inflation keeps rising due to no change in interest rates.

Transmission Mechanism of Monetary Policy

The Bank of England has a monetary policy and it uses the same to regulate the mechanism of the economy. Like when it decides to change the interest rate, the government is trying to check the overall expenditure of the economy. A change in interest rates is mostly used to contain inflation, which is the result of lavish expenditure by the country.

The bank sets a fixed interest rate at which it lends money to financial institutions and depending on this interest rate, individual banks and other financial institutions set up their own interest rates, which apply to the whole economy. This step is of indispensable importance to the economy, as this is very widely used to contain inflation. The only purpose behind such a step is just to contain undue inflationary levels prevailing in an economy.

The point to be noted here is that this interest rate set by the Bank of England is so effective and powerful that it chips in greatly to regulate the whole economy. It affects the stock and bond prices and also influences the asset prices throughout the country. This interest rate also regulated the savings in an economy, which eventually results in capital formation and reinvestment. It is noted that when interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets, and similarly high interest rates boost up the savings.

Lower interest rates make asset and real estate prices go up, as people start ignoring conventional saving instruments and make use of the high growth ventures like shares and houses, which pushes up their prices. Interest rate change also affects exchange rates, as an increase in the interest rate in UK will yield better returns to the investors compared to their overseas ventures. The diagram given below explains better

The transmission mechanism of monetary policy

The above diagram explains the concept of system regulation. It shows that the official rate, which is set by the Bank of England, influences many parts of an economy such as market rates, asset prices including the house prices, expectations, and exchange rate. This gives rise to demand, which is the sum total of domestic plus external demand, which in turn gives rise to inflationary pressure resulting in inflation, another important point shown, which deserves a mention is the relationship between the exchange rate and import prices, or the price paid for imports. As explained above, the stronger the exchange rate the lesser the price paid for imports and the weaker the currency the higher the price paid for imports. (How Monetary Policy Works)

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Activist Monetary Policy

The purpose of a Monetary Policy as explained earlier should be to promote maximum sustainable output at highest employment levels with a low inflation. Activist Monetary Policy is a policy under which the Central Bank focuses on the output fluctuations while setting their policy. This kind of policy is likely to produce worse outcomes for inflation as well as output fluctuations. This strategy can also false communication with regard to the Central Bank’s strategy besides leading to an inappropriate Monetary Policy.

The Central bank should focus on the long run price stability which is achievable only through maintaining a low and stable inflation, which needless to say, results in maximum economic output. Price stability is clearly the most important thing while setting up a policy and price stability is more a long run phenomenon as opposed to setting up the output fluctuations right, which is a short term concept. The more a Central bank cares about the output fluctuations the more time it will take to bring about price stability in the economy. Output fluctuation is no doubt looked into seriously as it is a very important indicator, but designing a policy keeping just the output fluctuations in mind can be disastrous.

Works Cited

“How Monetary Policy Works” bankofengland. 2008. Bank of England. Web.

Mishkin S Frederic, “Monetary Policy Strategy” Google Book Search. 2008. Web.

“Output and supply” bankofengland. 2008. Bank of England. Web.

“Phillips Curve”. 2008. Tutor 2 u. Web.

Sargent J. Thomas, “Rational Expectations” The Library Of Economics And Liberty. 2008. Web.

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