Monetary policy refers to the actions taken by central banks, such as the Federal Reserve in the United States, the Bank of England and the Bank of Australia, to affect the money supply and the overall performance of their respective nations' economies. Central banks use short-term interest rates, government securities and banking reserve requirements to affect the availability of money and credit in the economy. Like other forms of economic policy, monetary policy comes with a set of advantages and disadvantages.
Advantage: Low Inflation
The two goals of monetary policy are to promote maximum sustainable levels of economic output and foster a stable price system. Stable prices mean keeping inflation low, and the Federal Reserve Bank of San Francisco concedes that low inflation is all that monetary policy can achieve in the long run. Inflation reduces the purchasing power of money, harming economic growth. In contrast, stable prices enable households and businesses to make financial decisions without worrying about sudden, unexpected price increases.
Disadvantage: Conflicting Goals
The Federal Reserve and other central banks can use monetary policy to achieve low inflation in the long run and affect economic output and employment in the short run. The Federal Reserve Bank of San Francisco reports that these goals sometimes conflict. Reducing interest rates to expand the money supply and stem rising unemployment rates during a recession, for example, could spark future inflation if monetary policy remains expansionary for too long. The best monetary policy seeks to strike a balance between these short- and long-term goals.
Advantage: Political Independence
When central banks operate free of political pressures, they are free to make policy decisions based on economic conditions and the best available data on economic performance, rather than short-term political considerations imposed by elected officials or political parties. The U.S. Federal Reserve operates with a high level of political independence, even though it is accountable to Congress. Federal Reserve board members are presidential appointees but have staggered terms to make it more difficult for a president to load the board with favourite appointees. When central banks lack this independence, monetary policy becomes subject to political pressures. Harvard economist Greg Mankiw, for example, writes that central bankers that lack political independence may manipulate monetary policy in a manner favourable to the political party in power.
Disadvantage: Time Lag
In contrast to fiscal policy, which quickly stimulates additional money into the economy as governments increase spending for government programs and public projects, monetary policy actions take time to work their way through the economy, especially a large modern economy such as that of the U.S. and other world economic powers. The San Francisco Fed estimates that monetary policy actions to affect output and employment can take three months to two years for their effects to be felt. Actions may take even longer to affect inflation -- sometimes more than two years.