(Related to the Apply the Concept on page 916 ) 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?

Step by step solution

01

Understand key terms

First, define the main terms in the query: active monetary policy and monetary growth rule. Active monetary policy refers to a government's or central bank's actions to adjust the money supply to influence the economy. On the other hand, a monetary growth rule, as proposed by Friedman, argues for a constant, predictable increase in the money supply at a rate equivalent to the growth in real GDP.

02

Discuss advantages of active monetary policy

Active monetary policy allows more flexibility to respond to economic changes as they happen. It can adjust based on current economic conditions. While it is challenging due to uncertainties and imperfect information, it likely offers a better response to inflation, unemployment or economic growth than a fixed rule, due to its adaptability.

03

Discuss disadvantages of monetary growth rule

The main disadvantage of a monetary growth rule, according to its critics, is its lack of flexibility. A one-size-fits-all rule may not be appropriate for different stages of the business cycle or in response to different economic shocks (like recessions or booms). The rule does not consider other factors such as interest rates, unemployment, or inflation rates.

04

Draft the conclusion

Based on the above, it can be concluded that despite acknowledgements of challenges and uncertainties, the Federal Reserve engages in active monetary policy due to its flexibility and adaptability to dynamic economic conditions. This flexibility is likely seen as an advantage over the potential rigidity of a fixed monetary growth rule.

Unlock Step-by-Step Solutions & Ace Your Exams!

• Full Textbook Solutions

  Get detailed explanations and key concepts

• Unlimited Al creation

  Al flashcards, explanations, exams and more...

• Ads-free access

  To over 500 millions flashcards

• Money-back guarantee

  We refund you if you fail your exam.

Start your free trial

Over 30 million students worldwide already upgrade their learning with Vaia!

Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Active Monetary Policy

The concept of an active monetary policy involves deliberate actions taken by a central bank, such as the Federal Reserve, to control the money supply and interest rates with the aim of achieving macroeconomic goals. These goals typically include controlling inflation, managing unemployment rates, and fostering economic growth.

The Federal Reserve, for instance, may lower interest rates to encourage borrowing and stimulate spending during economic downturns, or it may raise them to curb inflation during economic boom periods. This policy approach is grounded in the belief that central banks can adjust their monetary policies in response to rapid changes in the economy, thereby minimizing adverse effects of economic fluctuations. Critics, however, point to the difficulties in getting timely economic data and the challenge of understanding the complex dynamics of the economy which may impede the effectiveness of such policies.

Monetary Growth Rule

The monetary growth rule is a concept championed by economist Milton Friedman, who argued for a fixed, predictable rate of increase in the money supply, tailored to the long-term growth rate of real GDP. Under this rule, monetary authorities would commit to a set formula, reducing the role of discretionary policy decision-making.

Supporters of this approach believe that a steady growth rate in the money supply can maintain price stability and reduce uncertainty in the economic environment. However, its main downfall is the lack of flexibility to respond to immediate economic crises, unforeseen events, and the dynamic nature of modern economies. In practice, this makes the monetary growth rule less attractive to policy-makers, who prefer the adaptability of active monetary policy despite its complexities.

Economic Indicators

Economic indicators are statistics that provide insights into the overall health of the economy. They include various types of data such as unemployment rates, GDP growth rates, inflation rates, and consumer confidence indices.

Policy-makers rely on these indicators to gauge economic performance and to craft monetary policies. However, the timing of these indicators is critical and often challenging, as there are innate lags in the publication of data. As a result, sometimes these indicators can provide a delayed view of the economy's state, which complicates the decision-making process for implementing active monetary policies. Central banks must anticipate these lags and use various models and projections to make informed, albeit imperfect, policy decisions.

Federal Reserve System

The Federal Reserve System is the central banking system of the United States, often simply referred to as 'the Fed'. It plays a fundamental role in the U.S. economy by conducting the nation's monetary policy, supervising and regulating banks, maintaining financial stability, and providing financial services to depository institutions, the U.S. government, and foreign official institutions.

The Fed’s decisions on active monetary policy are made in a challenging environment, taking into account a myriad of economic indicators amidst the reality of ever-changing economic landscapes. Despite the hurdles, the Federal Reserve system remains committed to active monetary policy to tailor its responses to economic conditions effectively and strive towards its mandate of maximum employment, stable prices, and moderate long-term interest rates.