A principal objective of any central bank must be to maintain the purchasing power of the currency. Rapidly rising prices (inflation) reduce purchasing power (especially among poor people who have fewer opportunities to diversity to other assets) while disrupting economic activity. Similarly, if prices are falling, the real burden of debt increases and activity slows as purchases are delayed in anticipation of lower prices. Inflation is a monetary phenomenon because rising/falling prices can only ultimately be sustained if accompanied by monetary expansion/contraction. Thus, it is appropriate that control of inflation is a primary concern of monetary policy.

Essentially, monetary policy involves influencing the demand and supply of money, through controlling either the quantity of money in circulation or its price (the interest rate). However, beyond this general principle there has been widespread disagreement over the relationship between money and other economic variables. The transmission mechanism of monetary policy remains only partially understood, reflecting both the underlying complexity and its nature varying across economies as well as its evolution (sometimes rapidly) over time.

The ‘New Consensus'

In recent years, the prevailing consensus among economists regarding monetary policy is based on a number of key propositions regarding both theory and practice. Often referred to as the ‘New Consensus', this refers to previous disputes over the proper role of monetary policy, such as that between the ‘Keynesians' and the ‘Monetarists' that divided economists from the 1960s to the 1990s.

Key Elements of the New Consensus

The long-term neutrality of money: the long run impact of a monetary expansion or contraction is solely on prices rather than output and employment, which are determined by other factors (notably availability of productive capacity, enhanced by improvement to technology and/or productivity). For this reason, there is no long-term trade-off between inflation and output/employment. The implication of this is that the underlying purpose of monetary policy is as a means to control inflation, rather than a means of permanently boosting economic activity.
The existence of short-term price rigidities: these constrain the pace that prices adjust (through contractual obligations, for example), thus giving monetary policy some leverage over economic activity in the short term. This means that monetary policy can be used for purposes of economic stabilisation.
The importance of expectations of future inflation: if people expect prices to rise quickly, there will be pressure for them to do so (through wage demands, for example), reducing the effectiveness of monetary policy in controlling inflation. Moreover, such expectations can be influenced by the policy framework. A policy that is both credible and well communicated will be more effective.
Fiscal policy is of limited use as a tool for countercyclical economic policy: using fiscal policy (i.e., the balance between government expenditure and revenue) takes time to implement and can be difficult to reverse, especially if this requires tax increases and spending cuts; while anticipation of future tax increases may dampen the impact of a fiscal stimulus. In addition, fiscal activism may result in problems of excessive budget deficits, with debt accumulating to unsustainable levels.
The need for central bank independence: in contrast to fiscal policy, monetary policy changes can be adjusted quickly through changes to interest rates (although there may be substantial lags before the impact is felt through all stages of the transmission mechanism). However, for this to be most effective it is best undertaken a step removed from the political process through a central bank that has instrument independence in terms of policy making (i.e., while the objective of monetary policy may be set externally, the central bank has the freedom to determine how this should be pursued). In return for this freedom, central banks should demonstrate transparency and accountability in their operations.
The emphasis of policy should be on final rather than intermediate objectives: many previous controversies had been fuelled by an emphasis on perfecting the choice of intermediate target (e.g., narrow or broad monetary aggregate, exchange rate anchor, etc.). This had limited the general understanding of the ultimate purpose of the policy while at the same time undermining policy credibility when, as frequently occurred, the relationship between the intermediate and final target (that is, inflation) had become unstable.
For further reading see, for example, Bean, C (2007), 'Is there any New Consensus in Monetary Economics?'. The Bank of Botswana Annual Report 2008 also provides useful information on the evolution of monetary policy.

Based on this consensus, since the early 1990s there has been a clear trend for national authorities to adopt a framework for monetary policy based on the following key elements:

  • policy is explicitly based on the final objective of price stability, often in terms of a numerical target for a specified measure of consumer prices
  • policy is implemented independently from government by the central bank
  • central banks place greater emphasis on transparency, effective communication and policy credibility.

Inflation Targeting

Within this general trend, some central banks have formally adopted a framework of inflation targeting (IT). This entails a binding to conduct monetary policy with the aim of achieving a numerically specified target level (or range) of inflation within a specified time period, and where the central bank is held accountable for meeting the inflation target. Typically, the target is defined by the government as a means of ensuring democratic accountability for the policy, while the central bank is guaranteed independence to pursue this mandate without interference. The means of accountability (such as publishing the minutes of meetings where policy decisions are taken), as well as the consequences for failing to meet the target are also clearly established. In practice, IT also places great emphasis on aligning the policy stance with the medium-term forecast of inflation, with the forecast effectively assuming the role of intermediate target in the IT framework.

However, despite the dominance of the IT stereotype, there remains considerable variety across monetary policy frameworks. This reflects the need for each country to adopt a framework that is appropriate for national circumstances, and there are many differences even among IT countries: in some countries, the central bank is itself responsible for setting the target, for example. Several of the world's major central banks have not formally adopted IT, notably in the United States (the Federal Reserve), Japan (Bank of Japan) and the euro zone (the European Central Bank (ECB), which has a very clear numerical inflation objective, but puts less emphasis on the role of the inflation forecast, while continuing to use monetary targets). It is also important to consider both the economic and institutional preconditions that need to be in place before IT can be adopted successfully.

Institutional Preconditions Economic Preconditions
Instrument independence Appropriate price index
Effective monetary policy instrument Width and horizon of inflation target
Accountability Adequate knowledge of the transmission mechanism of monetary policy
Transparency/disclosure Availability of inflation forecast
Well developed financial sector Adequate measurement and well-timed economic information
Floating exchange rate regime  
Public support  
Harmony with fiscal policy  
Sole target  

Source: Bank of Botswana Annual Report 2008 (Table 2.4, p108) based on Bernanke, B. S., Laubach, T., Mishkin, F. S.,  and Posen, A. S.  (1999), 'Inflation Targeting: Lessons from the International Experience', Princeton University Press.

Lessons for Monetary Policy From the Global Economic Crisis

In the wake of the global economic and financial crises that first emerged in 2007 and subsequently deteriorated, resulting in both a severe contraction of the global economy and the near collapse of the international banking system, the IT policy pursued by many of the world's major central banks has come under critical scrutiny. In particular, there are concerns that, by focussing solely on inflation, central banks:

  • had paid too little attention to warning signs of broader economic distress and financial instability: for example, rapidly rising asset prices (that do not generally feature in measures of consumer price inflation) and global imbalances between savings and investments;
  • were ill-equipped to pursue sufficiently activist policies of monetary policy easing. Thus, while many banks embarked on policy easing of unprecedented size and scope (including both interest rate cuts and actions directly aimed at monetary expansion), more prompt action in this respect could have helped moderate the impact of the global recession.

As a result of such criticisms, there have been widespread calls for the framework to be radically revised, or even dropped completely. Certainly, central banks need to review the adequacy of one of their policy frameworks: the operational mandates of central banks may need a broader perspective than the sole objective of price stability, including taking into account issues relating to financial stability. Some of the key elements of the New Consensus are also being re-evaluated: notably, many governments introduced substantial fiscal stimulus packages to combat the recession. However, this seems more likely to result in IT being supplemented by additional objectives and policy tools rather than being dropped.