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  • Print publication year: 2011
  • Online publication date: June 2012

16 - Monetary Policy

from Part VIII - Macroeconomic Policy


The chairman of the Board of Governors of the Federal Reserve System Ben Bernanke is frequently called the “second most powerful man in the United States.” His immediate predecessors, Alan Greenspan and Paul Volcker, were similarly regarded in their days. How is it that an unelected public servant should be widely regarded as having an influence over the state of the nation second only to the president of the United States? Our goal in this chapter, indirectly, is to answer that question. The short answer is straightforward: the chairman of the Federal Reserve stands at the center of monetary policymaking in the United States. But that just raises other questions: Why is monetary policy so important? How does monetary policy work? To answer those questions is the main business at hand.

Monetary and Fiscal Policy

Monetary policy is one of the two main types of macroeconomic policy. In Chapter 13 (section 13.2) we defined the other type, fiscal policy, as comprising those government actions that aim to influence macroeconomic performance through the manipulation of government revenue (taxes) and government spending (both on goods and services and on transfer payments). Monetary policy comprises those government actions that aim to influence macroeconomic performance through the financial system. Although we touched on monetary policy in the discussion of the financial system in Chapter 7 (section 7.6.1), a complete picture needs much more detail. The main discussion of fiscal policy is in Chapter 17. Nonetheless, because monetary and fiscal policies are not independent, we shall consider their relationship in this section.

The Government Budget Constraint

Like all agents in a free-market economy, the government must pay for the goods and services it receives. When tax revenues fall short of expenditure (i.e., it runs a deficit), the government must raise the money some other way. Most often, it does so by selling government bonds, which adds to the stock of government debt held by the private sector (BG ). There is another possibility: instead of borrowing, the government can “print money.” Sometimes, it is literally true that governments finance their spending by printing more currency. More often, this phrase refers to the central bank (in the United States, the Federal Reserve) purchasing some of the government bonds. They pay for these bonds with central-bank reserves – that is, by credits to the accounts of commercial banks with the central bank. As we saw in Chapter 6 (section 6.3.2), the monetary base (MB) equals currency plus central-bank reserves.

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Suggested Readings
Blinder, Alan S. Central Banking in Theory and Practice Cambridge, MA MIT Press 1998
Blinder, Alan S. The Federal Reserve: Purposes and Functions Washington, DC Board of Governors of the Federal Reserve System 1994
Friedman, Milton Schwartz, Anna A Monetary History of the United States, 1867–1960 Princeton Princeton University Press 1963
Goodhart, Charles. A. E. The Evolution of Central Banks Cambridge, MA MIT Press 1988
Hetzel, Robert L. The Taylor Rule: Is It a Useful Guide to Understanding Monetary Policy Economic Quarterly 86 2000 1
Meltzer, Alan A History of the Federal Reserve, volume 1: 1913–1951 Chicago University of Chicago Press 2003
Meulendyke, Ann-Marie U.S. Monetary Policy and Financial Markets New York Federal Reserve Bank of New York 1998