What is monetary policy for?
price stability
monetary policy, prices and output
price stability 
The broad aim of monetary policy is to achieve stable prices.
Price stability means that changes in the general level of prices
across the economy are relatively small and gradual - in other
words, prices do not rise by much from month to month and from
year to year. In practice, price stability equates to low and
stable inflation.
the broad aim of monetary policy is to achieve price stability
A quote from Alan Greenspan, a former Chairman of the US Federal
Reserve - the central bank of the United States - is one of
the most apt.
"For all practical purposes, price stability means that
expected changes in the average price level are small enough
and gradual enough that they do not materially enter business
and household decisions."
The goal of price stability has become widely accepted as the
appropriate objective of monetary policy, and is now one of
the primary considerations of central banks around the world.
This consensus reflects an understanding of how the economy
works and a practical experience of the ineffectiveness in effectiveness
of using monetary policy to achieve other economic objectives.
monetary policy, prices and output
The effects of monetary policy - interest rates - are ultimately
seen in prices. A change in interest rates feeds through the
economy, influencing demand, costs and then prices. This process
is explained in 'Inflation' under the heading 'How
do interest rates affect inflation?'. Boosting demand, by
lowering interest rates, may cause output to rise at a faster
rate for a time. But monetary policy does not have a lasting
impact on output.
Suppose the Bank of England printed double the amount of money
in the economy and left it on street corners for people to help
themselves. People would go out and spend more. But the economy
cannot simply produce twice as much. Firms would try to increase
output to meet the extra demand and imports might rise. But
the extra demand for resources would force costs and prices
higher. In the same way, changing interest rates will result
in changes in demand in the economy. But, overall, it cannot
affect what the economy is able to produce, other than in the
short term as output responds to fluctuations in demand.
Some of the mistakes in economic policy in the past resulted
from a belief that it was possible to raise output and employment
permanently by accepting a degree of inflation - there was an
assumed trade - off between inflation and unemployment. But
efforts to exploit this it, by trying to boost demand through
higher government spending or lower interest rates, led to increasing
rates of inflation - they revealed that, in the long run, there
was no such trade-off.
there is no general, lasting trade-off between output and
inflation
There is, however, a recognised trade-off between output and
inflation in the short term, ie a few years. This is very important
to the workings and conduct of monetary policy. In the short
term, if demand and output are growing too quickly, increasing
interest rates can reduce output growth back to a level which
does not result in inflationary pressure.
the effects of monetary policy are ultimately seen in prices
Conversely, reducing interest rates can increase output growth.
But, in the longer run, there is no lasting trade-off between
output and inflation. Changes in interest rates affect prices
only.
The role of monetary policy is restricted to influencing
the level of demand in the economy in order to control inflation.
Changes in monetary policy do affect output and employment in
the short term. But these influences do not last.
©2000-2009 Bank of England.
