David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 20 Monetary and fiscal policy
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Monetary policy
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Economists distinguish between rules and discretion. A smoker decides from minute to minute whether
to have a cigarette. Once we understand his preferences, the price of cigarettes, his income, and the attitude
of his friends, we can model his behaviour and predict pretty accurately how he will behave since this is
consistently related to the environment that he faces, even though he has discretion or freedom to decide
how much to smoke.
A rule is a commitment
describing how behaviour
changes when circumstances
change.
Discretion means free
choice without restrictions
imposed by prior
commitments.
A rule is a commitment on how to behave, for example to smoke no more than ten
cigarettes a day. This rule is credible only if we understand what prevents the
smoker having the eleventh cigarette when he desperately wants one. Being
abandoned by his friends if he smokes more than ten might be a commitment
mechanism to enforce the rule. A rule constrains his discretion, limits his freedom,
and precludes the choice he would otherwise have made.
What do we mean by a given monetary policy? This has two aspects. First, to what
variable does it refer - the interest rate or the money supply? For the reasons given
in the previous two chapters, we prefer to focus on the interest rate.
Second, does a given policy mean the choice of a particular interest rate? Changing the interest rate would
then be a change in policy. This is simple, but we can do better. We can usually model why that interest rate
was chosen: the relationship between the chosen interest rate and other economic variables. A particular
monetary policy is then a particular relationship rather than a particular interest
A particular monetary policy
is a relationship between the
state of the economy and the
interest rate chosen by the
central bank.
rate. This relationship may reflect discretionary choices of the central bank or a
commitment to a particular rule. Either way, a change in monetary policy is then
a change in the relationship between the chosen interest rate and the economic
circumstances faced by the central bank.
Thus interest rates change either because economic circumstances change (within
a given monetary policy) or because the central bank switches to a different
preferred relationship between interest rates and the state of the economy (a change in monetary policy).
In the heyday of monetarism, central banks used to adjust interest rates to stop the money supply deviating
from a given target path of monetary growth. Most central banks have abandoned this policy, preferring
to target the inflation rate itself.
Following a monetary
target, the central banks
adjust interest rates to
maintain the quantity of money
demanded in line with the
given target for money supply.
Inflation targeting makes no sense in a model in which we still assume prices are
fixed. We introduce inflation targeting in Chapter 21. In this chapter, we assume
instead that the central bank pursues a monetary target. This is a good way to
introduce many key ideas, and is useful in understanding how monetary policy
was set in the 1980s before inflation targeting became popular.
We now combine our analysis of the goods market and money market to examine
interest rates and output simultaneously. Chapters 16 and 17 analysed shortrun
equilibrium output using a diagram with the 45° line and a straight-line aggregate demand line. The
height of the aggregate demand line reflected autonomous demand from consumption, investment and
government spending; the slope of the line reflected the marginal propensity to spend out of national
income.
This diagram is not suitable in our extended model. As output changes, interest rates alter, affecting
consumption and investment demand. And changes in monetary policy, by changing interest rates at any
output level, can shift the aggregate demand schedule. To keep track of all these effects, it is easier to
develop a new diagram.
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