One thing to keep in mind …

I have noticed a lot of talk about how we need to change the monetary policy paradigm (like here, here, here, here, and here).  Comments here, and here, have been especially vocal.  There has been a lot of talk of monetary policy being “20 years old” so we should “fix it”.

However, what is monetary policy.  At heart it is policy regarding money.  As we discussed, in the long-run this doesn’t matter – as all prices adjust.  In the short-run, we have a trade-off between output and inflation because some prices in the economy are inflexible (read wages).

Monetary policy at heart isn’t about “unemployment” or “output” or “the exchange rate” (which is a relative price).  Monetary policy is about money, it is about the supply of money, it is about the price level and inflation.  The “interest rate” is merely an instrument central banks use to control the money supply and keep “inflation stable”.  By keeping inflation stable we increase certainty and we help make sure that money remains a good indicator of the relative value of REAL goods and services.

The idea that we should mess around with this to tinker with other things misses the point – if our exchange rate is funny, unemployment is high, or output is below potential we have to ask “what issues in REAL economy are causing this”.  Monetary policy in itself is irrelevant – monetary policy IS about money, it IS about inflation, it IS about expectations regarding these nominal variables, it IS NOT about real economic variables.

I am not saying that monetary policy hasn’t moved real variables – but in a world where monetary policy IS solely focused on inflation and consistent expectations is a world where monetary policies impact on the real economy is at its best.

Saying we need to change the monetary policy is equivalent to saying “we don’t know what the real issues are in the economy, and we are going to use the money supply as a political instrument to hide this lack of knowledge”.

When the Reserve Bank Act was made they recognised these facts.  They realised that the focus of monetary policy was money (funnily enough) and they kept it there.  Other policies (fiscal and prudential) can be used to deal with other issues in the economy, but monetary policy IS the policy of growth in the money supply – that is all.  It seems that this knowledge has been lost along the way – lets not let this gap in our memories lead us to dumping the Reserve Bank Act and forgetting the real issues that exist in the NZ economy.

  • Hear hear, I can’t believe some of the rubbish I’m reading.

  • Please keep these posts coming; they’re urgently needed.

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  • I have linked to these posts, as you explain it far better than I can.
    Keep it coming, we need some sense to these debates.

    Some of the ill informed comment around is frightening!

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  • Raf

    Matt,

    I wasn’t aware the RB was trying to control the money supply. I thought their remit was to keep an artificially constructed number (CPI) within certain parameters.

    Control of the money supply would be a very good idea mind you.

  • Hi all,

    Go to http://www.rogerdoulgas.org.nz to see his latest alternative tax plan – the great man who floated the dollar, it seems, still has a better understanding of REAL economic indicators than most in the House. Shame he is a backbencher in times like these.

  • A woman after my own heart.