Page 526 - Introduction to Business

500 PART 5 Finance

by market forces. Unfortunately, due to increases in the demand for money at that
time, interest rates shot up to over 15 percent by 1980. Oddly, while attempting to
bring down inflation rates and related interest rates, Fed monetary policy pushed
interest rates even higher! This unexpected result triggered a recession due to the
unprecedented high level of interest rates. The lesson learned was that fighting
inflation cannot be carried out as in Exhibit 14.6 without keeping an eye on eco-
nomic productivity and employment.
Today, central banks around the world employ a balanced approach to mone-
tary policy that seeks to foster both economic productivity (or interest rate target-
ing) and price stability (or money supply targeting). The relative emphases on these
policy goals can shift according to economic conditions. For example, since infla-
tion was at historically low levels in the 1990s and early 2000s, most central banks
targeted interest rates more aggressively than money supply in monetary policy
decisions. In Japan, inflation has been so low for over a decade that it has become
negative; in other words, prices are falling. Stock prices, real estate prices, wages of
employees, costs of goods and services, and so on, have experienced dramatic
declines in some cases. These falling prices are causing Japanese monetary policy
makers to worry that the economy will slip into a depression unless it can be
revived. With no reason to worry about inflation, the Japanese central bank is fol-
lowing a monetary policy of keeping interest rates down—close to zero—and
increasing the money supply to stimulate the economy. In the early 2000s, a slow-
ing economy in the United States and Europe raised concerns that a similar episode
of negative inflation could be coming. Consequently, like Japan, central banks in
the United States and Europe have been cutting interest rates to levels not seen in
over 50 years. Will Japan’s economy recover? Will Western industrialized countries
avoid Japan’s recent experience? With long and variable lags between monetary pol-
icy actions and economic results, we will have to keep an eye on the financial press
in the years ahead to find out.
Exhibit 14.7 illustrates how economic goals can affect monetary policy choices.
Assume that the Fed has decided that the target range of M1 money supply growth
needed to maintain a healthy growth rate of GNP is 3 to 5 percent per year. How-
ever, in the previous month M1 grew at a rapid rate that placed it above the target
range at point Z. At its next meeting, the Board of Gover-
EXHIBIT 14.7 nors could consider three alternative monetary strategies
Monetary Policy Strategy: Inflation Versus Interest for getting back within its M1 target range. Point A implies
Rate Targeting a rapid decrease in money supply to immediately get back
within the M1 target range. This aggressive monetary strat-
Monetary Goal egy is consistent with policy that seeks to control inflation
3–5 percent as a priority. At the other extreme, if inflation were not a
Z growth rate
C
of M1 money major concern, point C could be used. This less aggressive
supply
Money supply A toward its M1 target range, thereby enabling it to focus
B
monetary strategy would allow the Fed to gradually work
more attention on target interest rates and related GDP
and employment goals than point A. The intermediate
approach at point B would balance inflation goals and
GDP or employment goals. This example demonstrates
that central bank monetary policy must take into consid-
eration current and expected economic conditions when
Time (months)
making monetary policy and strategy decisions.
A = Aggressive control of money supply to fight inflation
B = Moderate approach balancing inflation targets and
interest rate targets Fiscal Policy Versus Monetary Policy. Rather
C = Less control of money supply to target interest rates than use monetary policy, the government can implement

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