8 - Monetary policy

Summary

A central reason for interest in monetary theory is that monetary policy remains one of the most effective means by which the government can control the level of the economy's activity, at least at certain times. It is by now well recognized that the mechanisms for self–adjustment of the economy are at best imperfect; that the economy, on its own, may have extended periods of underemployment or inflation. Traditional monetary theory has government controlling the money supply, which affects interest rates, which in turn affect the level of investment. Under the new paradigm:

1. (1) What affects the level of economic activity is the terms at which credit is made available to the private sector, and the quantity of credit, not the quantity of money itself.

2. (2) The relationship between the terms at which credit is available (e.g. the loan rate) and the T–bill (or deposit) rate may change markedly over time.

3. (3) Similarly, the supply of credit may not change in tandem with the money supply; and changes in the relationship between money and credit may be particularly marked in periods of crisis.

4. […]