Monetary Policy

Christopher Ragan ^*
Department of Economics
McGill University

Abstract

This paper provides a non-technical introduction to monetary policy—what it is, how it works, and why it matters. It discusses inflation volatility and why this is damaging to the economy, as well as why increased stability of output growth is desirable. In both cases, changes in Canadian economic performance over the past few decades are examined. The paper also provides a detailed discussion of the transmission mechanism for monetary policy and of the types of uncertainty that central banks must face in their conduct of monetary policy. Finally, the paper describes the types of information that central banks need in order to conduct monetary policy prudently.

Introduction

Central banks and the conduct of monetary policy have often been viewed as impenetrable mysteries, understood only by the limited few who somewhere along the way gained access to an exclusive club. The mystique is only magnified by the attention members of the financial press devote to parsing and interpreting often-cryptic remarks from senior central bankers.

This paper aims to provide answers to several key questions about monetary policy without requiring the reader to have any particular expertise in economics. First, what is monetary policy? Second, why have many central banks focused on controlling inflation rather than on other macroeconomic variables? Third, how do the actions of the central bank influence the level of economic activity and the rate of inflation? And, finally, how can monetary policy deliver genuine and significant benefits to society? Although the paper's main messages apply to central banks and monetary policy in many countries, the emphasis here is on Canadian monetary policy and the operation of the Bank of Canada.

This topic should interest non-economists for two related reasons. First, monetary policy is important to the operation of the economy. On any given day, it would be difficult not to see a news item discussing inflation, real output growth, changes in the exchange rate, or what the central bank is likely to do at its next interest rate announcement. Even well-informed citizens will find it difficult to think clearly about many economic issues and debates without having at least an approximate understanding of what central banks do, and why they do it.

The second reason relates to the broader benefits of such understanding. Central banks exist in most countries as government-owned institutions operating with considerable independence from the governing political structures. It is crucial, therefore, that the central bank be accountable to the people through their elected officials. Monetary policy may be sufficiently complex and technical that its implementation is left to experts who specialize in nothing else, but in a well-functioning and democratic market economy, the people must ultimately be left to judge the performance of those experts. Such judgment requires a basic understanding of the main issues.

This paper is organized as follows. Section 1 begins by explaining what monetary policy is—and also what it is not. This discussion provides a broad-brush description of monetary policy, including some explanation of why most central banks focus on low and stable inflation as their primary objective. Section 2 examines Canada's inflation performance over the past 40 years and explains why low inflation is desirable. An important benefit of low inflation is that it generates less uncertainty, interferes less with the operation of the price system, and thus imposes fewer costs on society. Section 3 examines Canada's aggregate output growth over the past few decades and shows that output growth has become more stable over time. It also explains why this stability is beneficial to the Canadian economy.

Some details about how monetary policy actually works are presented in Section 4, which describes how the Bank of Canada operates a system of inflation targeting. This discussion involves a little investment on the part of the reader in understanding the transmission mechanismThe complex chain of cause and effect that connects the central bank's policy instrument (typically the setting of a short-term interest rate) with asset prices, aggregate demand, total output, the output gap, and, eventually, inflation. of monetary policy. With this framework in place, the informational requirements for monetary policy to be conducted in a prudent manner are then outlined. Essentially, successful monetary policy requires central banks to invest in the creation, monitoring, and projection of economic information—all devoted to achieving a better understanding of developments and relationships in the domestic and world economies.