Monetary policy

Many (including myself) think that the Fed would be quite content with inflation of 2%.  This would imply that the current rate of monetary growth (10.5 %) is too high to be sustained.  [This rate of monetary growth would imply a much higher rate of inflation than we have currently.  But monetary policy works with a lag.]  But the Fed is currently focused on trying to revive economic growth. Once that goal is accomplished, it will act to slow the rate of monetary growth (and also raise interest rates) to insure the containment of inflation.  All of these calculations assume, however, that the potential growth rate of the economy is 3.5%, as assumed in the above equation. As you are probably aware, there is a lot of controversy about what the correct estimate of U.S. potential economic growth is. Until a few years ago, most economists (and central bankers) thought that the long-run potential growth of U.S. real GDP was somewhere around 2.5%.  Now, due to the recent surge (from 1997 to 2000) in productivity growth resulting from the application of information technology, many have upgraded their potential growth estimate. If, in fact, the potential growth rate were 4.0% (near the annual rate at which the economy grew between 1997 and 2000), then the equation of exchange would imply that the Fed can expand the money supply at a 6% clip while still maintaining inflation of 2%.  Several Fed Governors have stated that they believe potential real GDP growth may now be near 3.5%, implying that monetary growth of near 5.5% would be appropriate to keep inflation near 2%.  (All of this assumes, of course, that the velocity of money is constant, an assumption which a number of economists question.)

The Federal Reserve does not explicitly set monetary growth targets, but over most of the past decade the Fed has kept M2 growth at an average of around 5-6% per year.  The European Central Bank sets an explicit target for M3 growth of 4.5% per year.  Recently, M3 in the euro zone has been expanding higher, indicating that monetary policy is pretty easy.  This flies in the face of public criticism that the ECB has kept interest rates too high. 

Some central banks, such as those in Canada, Britain, Sweden, Australia, and New Zealand, operate monetary policy by setting strict inflation targets.  The thinking is that it is very difficult to hit monetary growth targets and, even then, to know how changes in the money supply will impact the economy.  So central banks should continually adjust monetary growth to hit a desired inflation rate. There is some good logic to this trial-and-error approach, given the imprecision of monetary policy in practice.

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