Question

Then work on Problems and Applications 3.12, at the end of Chapter 26, answering and discussing the questions in that exercise.

3.12

[Related to the Making the Connection on page 867] The following is from a Federal Reserve publication:

In practice, monetary policymakers do not have up-to-the-minute, reliable information about the state of the economy and prices. Information is limited because of lags in the publication of data. Also, policymakers have less-than-perfect understanding of the way the economy works, including the knowledge of when and to what extent policy actions will affect aggregate demand. The operation of the economy changes over time, and with it the response of the economy to policy measures. These limitations add to uncertainties in the policy process and make determining the appropriate setting of monetary policy . . . more difficult.

If the Fed itself admits that there are many obstacles in the way of effective monetary policy, why does it still engage in active monetary policy rather than use a monetary growth rule, as suggested by Milton Friedman and his followers?

Source: Board of Governors of the Federal Reserve System, The Federal Reserve System: Purposes and Functions, Washington, DC, 1994.

Answer 1

Fed engages in active monetary policy rather than use a monetary growth rule because of the uncertainties in the economy. There are various uncertainties in the economy which makes it difficult for the policymakers to use a monetary growth rule in which money supply is increased or reduced by a fixed amount leading to a proportionate shift in the aggregate demand curve of the economy. Active monetary policy can be changed instantaneously as per the economic conditions and thus active monetary policy is always better in an economy facing uncertain events as compared to the monetary growth rule suggested by Milton Friedman and his followers.