Monetary Policy

This paper has offered an explanation of what monetary policy is, and why it matters. As a quick summary, the paper's key points are:

1. Why inflation? By maintaining low and relatively stable inflation, central banks make their best contribution to the economic health of a nation. This objective is grounded in the propositions that (1) high inflation is damaging to the economy, and (2) monetary policy is unable to have a systematic and lasting effect on macroeconomic variables other than the rate of inflation.

2. Low inflation is desirable. The biggest cost of inflation is the uncertainty that it generates and the inefficiencies it creates by distorting the information conveyed by relative prices. Cross-country evidence suggests that countries with higher rates of inflation also tend to have more volatile rates of inflation. Canada's rate of inflation has been lower and less volatile in the years following the 1991 adoption of inflation targeting than in the preceding decade.

3. Stable output growth is desirable. Genuine benefits come from having a more stable growth rate of real output and also from having a more stable output gap. Canada's output growth and output gap have been more stable in the years following 1991 than in the preceding decade.

4. Good policy or good luck? It is impossible to determine precisely that the greater stability in inflation and output growth has been the result of better monetary policy rather than just a less volatile economic environment. There is some evidence, however, that the economic environment actually became more volatile following 1991, suggesting that some of the improved macroeconomic performance does indeed reflect better monetary policy.

5. Monetary policy is forward-looking. The transmission mechanism of monetary policy is the complex chain of cause and effect that connects policy actions by the Bank of Canada to aggregate demand, output, and inflation. Monetary policy works with long and variable lags, and monetary policy must therefore be forward-looking, anticipating events that are likely to happen in the world and domestic economies.

6. Two types of uncertainty. Two types of uncertainty complicate the conduct of monetary policy: uncertainty about the precise workings of the transmission mechanism, and uncertainty about economic events in both the global and Canadian economies. Both types of uncertainty require that the Bank of Canada invest considerable resources in research, current analysis, and projection in order to make the best-informed policy decisions.

This paper, while providing a broad outline of what the Bank of Canada does, and why, has barely scratched the surface of Canadian monetary policy. Economies are complicated structures, and we continuously strive to learn more about them. Similarly, monetary policy works through a complex process. As we continue our theoretical research and our analysis of data, our knowledge of this complexity will grow, but so too will our questions about it. Given the importance of monetary policy to our well-being, this continued effort is well worth the investment.