Why does monetary policy exist?

[costargh]

I was discussing with a friend today why monetary policy exists. Better worded, why does the government (or if you like, through the RBA) regulate the cost of credit?

Wouldn't the free market do a more effective job?

[marbs]

Seperate from the government takes away political bias, will intend to make pre-emptive moves for the Aus economy, that will help price stability, aid full employment, and help the economic welfare and prosperity of the Australian people. The RBA, is in charge of the money supply. How would the free market be able to manage the supply of money (fairly)?

[Collin Li]

I wish I could give you a real answer to this. Obviously you've come here not for a VCE Economics answer (where it talks about the goal of "price stability," rather than the overall well-being of Australians).

I think you are right that the free market can manage interest rates properly through the principles of supply and demand. Through other markets, price stability will be controlled by supply and demand as well. To manipulate the money supply (distorting the money markets) to try to tweak price stability is the norm however. Central banking is just commonly accepted. Here is an exchange I had with a famous professor over email:

To Professor. Caplan,

Hello, I recently read your article on why you are not an Austrian economist, and I found your writing style very appealing and understandable. You helped to point out a lot of technical failures with the Austrian school that I did not know about. However, there is still one question that bothers me that I hope you can answer:

I know that Austrians are opposed to central banks, but I am not sure about the neoclassical position. Can you clarify their position for me? If neoclassical economists are in favour of central banks (for example, I think Milton Friedman argued that there should be a constant growth of the monetary base), why is this justified? Doesn't it still devalue the currency?

Thanks very much, (and thank you for helping me understand why the Austrian Business Cycle theory is flawed!)
Collin

Most neoclassicals believe in central banking, but many don't.  The criticisms of central banking in e.g. Selgin's *Theory of Free Banking* are perfectly intelligible to mainstream economists; it's a debate about substance, not methodology.

What would most neoclassicals say about central banking?  Well, they'd agree that it increases inflation relative to a gold standard; they just think the gold standard has other, more serious problems.  See my monetary econ notes:

http://www.gmu.edu/departments/economics/bcaplan/e918/econ918.htm, especially Week 11.

[costargh]

ohh thanks. And yeh you are correct in assuming I wasn't looking for a vce answer lol. ill tell them whatever they want to hear just i reckon the principles of demand-supply could do a better job. (although Im not too sure how considering my limited knowledge)

[Collin Li]

Read more about the debate on the causes of inflation here

http://en.wikipedia.org/wiki/Inflation#Causes

There is broad agreement among economists that in the long run, inflation is essentially a monetary phenomenon.

[Eriny]

I'm not saying that things like inflation and so on won't exist without monetary policy, but it does have a tendency to soften the extremes of recession and boom. The market doesn't seem to be able to do this by itself.

[Collin Li]

I'm not saying that things like inflation and so on won't exist without monetary policy, but it does have a tendency to soften the extremes of recession and boom. The market doesn't seem to be able to do this by itself.

It depends whether you believe booms and busts are actually a bad thing. Then you have to ask, does the prescription make things better, or does it worsen things? Sure, it may smooth output, but why should we smooth it anyway?

The business cycle may very well be due to real shocks in the economy, and the modern economy is simply reacting to these shocks. See the Real Business Cycle Theory for one such theory. The Keynesian theory is also acceptable, and it states that the booms and busts are rational responses to shocks, but they are still "inefficient" (market failures) due to price-stickiness (which is rational, due to menu costs and information inefficiency - efficient by "bounded rationality").

I don't have an answer as to whether monetary policy (the prescription) makes things better. If there is information inefficiency, I don't see how monetary policy will fix this. It just follows a rule of smoothing output, and this seems irrelevant to an economy that just wants to be able to react to real shocks.

[Eriny]

Well, I think that overall growth is higher when the economy is more resistant to major shocks and isn't rife with extremes. I would value small fluctuations over big ones.