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Should monetary policy be conducted by a nation’s Congress or legislature comprised of elected representatives? Or should it be conducted by a politically appointed central bank that is more independent of voters? Here are some of the arguments made by each side.
The Case for Greater Democratic Control of Monetary Policy
Elected representatives conduct fiscal policy by passing tax and spending bills. They could handle monetary policy in the same way. Sure, they will sometimes make mistakes, but in a democracy, it is better to have mistakes made by elected officials accountable to voters than by political appointees. After all, the people appointed to the top governing positions at the Federal Reserve—and to most central banks around the world—are typically bankers and economists. They are not representatives of borrowers like small businesses or farmers nor are they representatives of labor unions. Central banks might not be so quick to raise interest rates if they had to pay more attention to firms and people in the real economy.
The Case for an Independent Central Bank
Because the central bank has some insulation from day-to-day politics, its members can take a nonpartisan look at specific economic situations and make tough, immediate decisions when necessary. The idea of giving a legislature the ability to create money and hand out loans is likely to end up badly, sooner or later. It is simply too tempting for lawmakers to expand the money supply to fund their projects. The long term result will be rampant inflation. Also, a central bank, acting according to the laws passed by elected officials, can respond far more quickly than a legislature. For example, the U.S. budget takes months to debate, pass, and be signed into law, but monetary policy decisions can be made much more rapidly. Day-to-day democratic control of monetary policy is impractical and seems likely to lead to an overly expansionary monetary policy and higher inflation.
The problem of excess reserves does not affect contractionary policy. Central bankers have an old saying that monetary policy can be like pulling and pushing on a string: when the central bank pulls on the string and uses contractionary monetary policy, it can definitely raise interest rates and reduce aggregate demand. However, when the central bank tries to push on the string of expansionary monetary policy, the string may sometimes just fold up limp and have little effect, because banks decide not to loan out their excess reserves. This analogy should not be taken too literally—expansionary monetary policy usually does have real effects, after that inconveniently long and variable lag. There are also times, like Japan’s economy in the late 1990s and early 2000s, when expansionary monetary policy has been insufficient to lift a recession-prone economy.
Velocity is a term that economists use to describe how quickly money circulates through the economy. The velocity of money in a year is defined as:
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