As a policy instrument, monetary policy is of recent origin, particularly in relation to fiscal policy. It was not until the nineteenth century that the question of monetary policy came to be investigated systematically. It was taken up by theoretical economists and practical experts in connection with the problem of Napoleonic wars in Europe and their aftermath and later in connection with the periodically recurrent business cycles. In developing countries, because of their stage of development formal market as a place of exchange of goods were limited and the use of money, as a means of value and of exchange was confined to the formal market. Supply of money in these countries prior to market-based development was determined either arbitrarily or based on guesswork. In Europe, particularly in the UK, the original trickle of literature on monetary policy developed into a vast flood. It continued to grow throughout the twentieth century and from sixties of that century there were few subjects that had a more expensive literature.
Notwithstanding this, relatively little thought was given to the finding of a definition for the meaning of monetary policy. Most of the experts and practitioners assumed that the actual scope of the discussion on the subject implied its definition. Monetary policy was defined as the effort to reduce to a minimum the disadvantages and increase the advantages resulting from the operation of a monetary system. Even this definition only applied to an ideal monetary policy. In reality throughout monetary history there have been instances where result of monetary policy was an increase in the disadvantages rather than their advantages.
It is, of course, possible to interpret 'advantages' and 'disadvantages' in a sense that would come within the terms of the above definition to be able to finance a war with the aid of inflation may be claimed to be a political and military advantages. It, of course, does not augment the advantage (welfare) for the vast mass of people. The distinction between old type of monetary policy is on its increasing emphasis on social welfare function. Even autocratic regimes cannot ignore this for long unless they are too confident of controlling social turmoil. Beginning from the middle twentieth century fiscal policy and other non-monetary policies (industrial, trade, etc) were adopted with an eye on the monetary situation.
KEYNESIANISM VS MONETARISM: In America, the monetarist school led by the department of the economists of Chicago University led by Milton Friedman pioneered the crusade against the supremacy of expansionary Keynesian fiscal policy. With the Great Depression left behind the Chicago School's espousal of monetary policy in command of a free market economy took hold.
A tug of war continued between the heirs of Keynesian economics led by Paul Samuelson and the ultra conservative monetary school for the control of current economic policy making. As it has turned out in the American economy neither school has been an absolute winner. Every time the economy changes from full employment to recession with incipient unemployment there is a change of fortune of the two views regarding their interventions in the macro economy either through fiscal or monetary policy.
The latest development has been the primacy of monetary policy in rescuing banks in trouble banks and financial institutions after the financial crisis of 2008 when fiscal measures to salvage the vulnerable institutions proved inadequate. The Federal Reserve Board (Fed) introduced quantitative easing (QE) to purchase government bonds from banks and other institutions, lending them money at zero interest. As of now, monetary policy with an unconventional edge (QE) is ruling the roost in macro economic policy making. The Trump administration's sweeping tax cuts, along with the priority agenda of massive public expenditure on infrastructure, point to a period of deficit financing which will increase public debt. This is a rare instance where both aggressive monetary policy and active fiscal policy have been pressed into service. But this is going to spike inflation above the tolerable level of 5.0 per cent when increase in the monetary instrument of interest will become compelling. The Fed has already started increasing the basic policy rate incrementally. The Trump administration is obviously against this but the Fed, aware of its obligations, will have a mind of its own in this matter.
In Europe, particularly in the UK, central banks followed a similar policy in regard to easy money through QE coupled with low interest rate. Governments in the Eurozone part of European Union (EU), on the other hand, tried to tackle the financial crisis represented by ballooning public debt through tightening public expenditure based on austerity programme. Though belatedly, the European Central Bank (ECB), along with the International Monetary Fund (IMF) had to step in with loans to countries that had or were about to default on private and public debt. So in these countries also interventionist monetary policy had to be introduced.
The economic situation in Europe after the Second World War was characterised by low demand and low investment whereas post-2018 situation in America is one of growing public debt and low investment. Keynesian fiscal policy has not been proved to be a panacea in all cases. Hence, the triumphant entry and operation of monetary policy has been seen on both sides of the Atlantic.
In developing countries like Bangladesh, fiscal policy is still being used as the main instrument for economic development, and it still enjoys priority. It is significant that monetary policy in countries like Bangladesh is announced after the fiscal policy, implying that it has a complimentary role to the former.
The past history and the current practice in developed and developing countries do not distract from the objectives of monetary policy, even though these may not be always pursued with urgency because of sudden emergencies and compulsions. These are: to maintain price stability, ensure proper functioning of financial institutions including banks and capital market and, last but not least, to promote economic growth. The various instruments used in monetary policy are policy rate of the central bank, open market operation and determination of exchange rate. Through the first two instruments monetary policy seeks to change monetary supply (M2) and through it the volume of credit made available by banks.
THE ROLE OF CENTRAL BANKS: Monetary policy is within the jurisdiction of central banks and the banks are supposed to be independent. In practice, the independence differs from country to country. Where the political authorities do not control the central bank directly in their day-to-day operation, indirect control is exercised by choosing the head and members of the bank on the basis of their political inclinations.
In America, it is assumed that the Fed Chairman and governors will keep in mind the ideology of the political authorities who selected them and decide on policies accordingly.
In the UK, the Bank of England is slightly more independent but this is diluted by the committee that decides on day-to-day operation and is composed of both independent and government nominees.
In EU, the ECB is relatively more independent, there being no single country overseeing it. It can take decisions on the basis of ground reality, e.g., growing public debt and risk of default by both private sector and national governments.
In Japan, the central bank is pursuing a dominant monetary policy consistent with three arrows of the economic policy of the Prime Minister Abe (Abenomics), the core objective being to kick in inflation with easy money. Towards this end the Japanese central bank even opted for negative interest rate.
FISCAL AND MONETARY POLICIES CANNOT WORK AT CROSS PURPOSES: It would be a mistake to compare fiscal and monetary policy in terms of their superiority over each other. A more pragmatic basis for comparison would be to consider their relevance to particular contexts. There is no doubt that both are useful tools of policy making covering the whole economy. Together they determine the shape and health of the macro economy in respect of its main parameters. They have in common the main macro economic indicators that call for nuanced application of both fiscal and monetary policy. Thus, a slower growth rate in both developed and developing countries will call for greater investments in both public and private sectors. Here both the fiscal and monetary policies have their roles to play.
When coordinated in application and fine-tuned in design they can deliver the optimum outcome. For fiscal policy, it will mean greater public expenditure on growth-enhancing activities and projects. Greater availability of credit to the private sector will call for adequate supply of credit at moderate rate of interest. The operation of both of these policies at the same time will, however, give rise to inflation. As a rule of thumb 5.0 per cent of inflation is tolerable for the consumers but any rise above this has to be treated to be cautioned because it may undermine the growth-enhancing aspects of fiscal and monetary policies. For instance, savings is discouraged in the midst of rising inflation resulting in slower rate of investment. Inflation also makes exports costlier with consequent impact on balance of payment which, in turn, may call for depreciation of currency.
Fiscal policy may be a one-off exercise undertaken in a year but in view of changes it brings about, together with an expansionary monetary policy, the latter needs to be regularly fine-tuned to address the prevailing situation in the macro economy. That is why monetary policy, unlike fiscal policy, is declared twice a year in Bangladesh and in other countries it is revised as and when necessary.
Much has been said about independence of central bank in formulating monetary policy. It is an important issue, no doubt, but often is overstated. A government would not like to have a monetary policy that runs counter to a fiscal policy, nor would it like common goals like price stability to be ignored. Price stability to control inflation is consistent with the welfare maximising model which underlies all public policy. Sharing these goals in common, it is axiomatic that the fiscal and monetary policies cannot work at cross purposes.