The development of monetary policy - Part 1

Monetary Policy (Introduction)

Fiscal policy takes up most of the policy debate, however, with talks of a coming recession in Australia, that may be about to change. Monetary policy defines the instruments by which central banks can influence the money supply in the economy. The money supply has huge influence on inflation, which is the rate by which goods are increasing in price, as a percent. They key instrument by which the central banks can control monetary supply is through the cash rate, which is the percentage borrowing cost the central bank charges when loaning money to commercial banks. The cash rate is more commonly known as the interest rate, as commercial banks generally pass the rate onto consumers, hence resulting in an identical interest rate.[1]

The Keynesian Revolution

It has been commonly understood that the economy is characterised by fluctuations in output, a business cycle, in which the value of the currency would go up and down depending on the productivity of the economy. Prior to the Great Depression of 1929, it was commonly understood that the business cycle would self-regulate to an equilibrium. However, the prolonged deflation and unemployment of the Depression caused many to call for a more active role for the central bank. British economist, John Maynard Keynes pioneered a vision for a more influential central bank. Keynes believed that the government could regulate the business cycle by spending in the bust periods and saving in the boom periods.[2] Keynes saw the central bank as another instrument in which this could be achieved. In bust periods, low interest rates would make it easier for people to get loans from banks, thus putting more money into the economy. In 1958, economist William Phillips, theorised that there was an inverse relation between unemployment and inflation. The ‘Phillips curve’, inferred that the central bank could monitor unemployment, as they could alter inflation and expect an inverted response in unemployment.[3] The Phillips curve gave impetus to Keynesian ideas as they assumed the central bank could take a more active role in moderating the business cycle, without much risk.[2] Other economists of the Keynesian school of thought argued that governments should pick a point on the curve at which inflation was tolerable and aim to keep unemployment at the according level.[4]

‘Stagflation’ 70s Style

The Keynesian ideal of government moderation of the business cycle had been deemed a success, until the ‘stagflation’ crisis, suffered across many Western countries, including the US and here, in Australia.[5] During the 1970s, Western countries suffered from the perfect storm of both high inflation and low economic growth, known as ‘stagflation’. ‘Stagflation’ was inexplicable by the Phillips curve, which decreed that high inflation was a sign of low unemployment and hence a stimulated economy. So, what happened? The stagflation crisis is commonly associated with the 1973 oil embargo. In 1973, as a response to the US support of Israel in the Yom Kippar War, major oil producing nations in the Middle East combined in opposition to the US by cutting their oil exports. This caused a supply shock, resulting in an increase in price and a slow of the economy.

However, scholars agree that the problem lay deeper than this, with the policies of Richard Nixon, motivated by Keynesian ideas, partly to blame. Nixon introduced price controls, with the intention of stimulating the economy by making oil more accessible to the consumer. However, by artificially increasing demand, the American supply of oil was exhausted.[6] Moreover, scholars argue that the seeds of the ‘stagflation’ crisis were sown before then, by the low interest rate policies of President Nixon designed to stimulate the economy as a result of the US shortage of oil. Instead this led to an increase in prices as the increase in demand was not matched by an equal increase in supply.

To explore this further, Conor Yung discusses critiques of the Phillips curve in Part 2 of his analysis.

[1] Investopedia. (2019). Monetary Policy Retrieved from https://www.investopedia.com/terms/m/monetarypolicy.asp

[2] Dobrescu, M., Paicu, C., & Iacob, S. (2011). The Natural Rate of Unemployment and its Implications for Economic Policy. Theoretical & Applied Economics, 18(2).

[3] Phillips, A. (1958). The Relationship Between Unemployment and the Rate of Change of Money Wage rates in the UK 1862-1957. Economica, 25, 283-299.

[4] Samuelson, P. A., & Solow, R. M. (1960). Analytical aspects of anti-inflation policy. The American Economic Review, 50(2), 177-194.

[5] Investopedia. (2018). Stagflation, 1970s style. Retrieved from https://www.investopedia.com/articles/economics/08/1970-stagflation.asp

[6] Barsky, R., & Kilian, L. (2000). A Monetary Explanation of the Great Stagflation of the 1970s.