Monetary Policy and Stabilization Rules

Monetary Policy and Stabilization Rules

I. Monetary policy

The quantity of money in the economy is called the money supply. In an economy that uses fiat money (money that has no intrinsic value), as in most countries today, the government controls the supply of money: legal restrictions give the government a monopoly of the printing of money. The control over the money supply is called monetary policy [1, p.81].
In the UK and many other countries, including the United States, monetary policy is delegated to a partially independent institution called the central bank.
The UK central bank is the Bank of England. In the US, the central bank is called the Federal Reserve and for the Eurozone the central bank is called the European Central Bank located in Frankfurt.

II. Stabilization policy rules

Stabilization policy consists of government actions to try to keep output close to potential output [2, p.234]. In particular, stabilization policy is aimed at reducing the severity of short-run economic fluctuations.

Many monetary (and fiscal) policies can be persuaded to stabilize the business cycle to stabilize the real GDP growth and the inflation rate. Nevertheless, all these policies fall into three broad categories [Reference: 3, Chap. 32]

1. Fixed-rule policies.
2. Feedback-rule policies.
3. Discretionary policies.

1. Fixed-rule policies.
A fixed rule policy specifies an action to be pursued independently of the state of the economy. An everyday example of a fixed rule is a “one-way road” sign. If all traffic is travelling in the direction inverse to yours, you cannot enter the road regardless of the state of road ahead – even if no other vehicle is using the road. One, proposed by Milton Friedman, is to keep the quantity of money growing at a constant rate of zero per year.

2. Feedback-rule Policies
A feedback-rule policy specifies how policy actions respond to changes in the state of the economy. A “give way” sign is an every day example of such a policy.
A feedback...

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