Monetary Policy: Limitations, Advantages

Limitations. Formulating monetary policy is a difficult task, and there are definite limitations to what policy can do. Real economic stability requires not only wise monetary policy, but also sound fiscal policy (the government’s use of taxing and spending to stabilize the economy) and sufficient competition in the economy. It can be difficult to coordinate the three areas to achieve perfect economic stability.

But even if fiscal policy was always perfectly prudent and the economy was sufficiently competitive, there would be limitations on what monetary policy could do. Under the best conditions, there are “slippages” in the financial mechanism. For example, depository institutions may not always promptly react in response to policy changes. In addition, even if they do respond promptly, shifts in the public’s demand for money may partly offset changes in the money supply. Both kinds of slippage complicate the task of the money authorities. More fundamentally, although monetary policy can help stabilize short-term economic activity, it cannot affect real variables, such as employment and output in the long run.

Advantages. Despite its imperfections, monetary policy has several advantages over alternative types of policies.

Monetary policy interferes very little with the freedom of the market, although market imperfections sometimes intensify the effects of policy upon particular sectors of the economy. A tight monetary policy cuts down the rate at which total spending can rise, but it does not dictate which particular expenditures must be slowed or reduced. The expenditures cut are the ones to which spenders attach the lowest priorities. Similarly, a policy of ease stimulates total outlays, but lets the market dictate which expenditures are increased.

Monetary policy is flexible. The Federal Open Market Committee meets about every six weeks, reaches a decision, and acts on that decision immediately.

Perhaps most important, Congress has carefully insulated the Federal Reserve from day-to-day political pressures so it may act in the best interests of the country. Congress wisely spread the policymaking machinery throughout the System to avoid undue concentration of power. It made the System responsible to Congress rather than to the Executive Branch. It provided for 14-year terms for Board members, made them ineligible for reappointment after they have served a full term, and staggered their terms of office. The System has, of course, only such powers as Congress has given it, and can lose those powers if it does not exercise good stewardship. The powers are broad, however, and Congress so far has chosen to permit the Federal Reserve System to base its policy actions almost entirely upon economic considerations.