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Monetary Policy

Monetary Policy

Monetary policy is conducted by the government’s monetary authority in the form of a central bank, such as the Federal Reserve in the United States, or the Bank of England in the United Kingdom. These institutions are criticized for trying to manipulate the economy by maintaining low, stable inflation, maximum employment, and having moderate long term interest rates.

The Federal Reserve exists due to an act of Congress, but is run like a private company. Its purpose is supposedly to serve the public, while following government direction and targets. Transparency is meant to be encouraged, alongside explaining all policies clearly, so as to better influence the public’s financial decisions.

Central banks are tasked with encouraging or restraining the growth of demand for goods and services through interest rate changes, in response to changes in inflation compared to target rates. This will also affect foreign exchange rates. Another tool for manipulating the amount of money in the economy is the buying and selling of corporate and government bonds.  

Criticism of inefficient monetary policy

Many economists criticize the central bank system, though the majority do not advocate its abolishment. 

Milton Friedman believed that the Federal Reserve was responsible for aggravating the Great Depression. In his book, The Great Contraction, 1929-1933, co-authored by Anna Schwartz, he claimed that the restrictive monetary policy pursued by the Federal Reserve had turned a fairly severe recession into a catastrophe. Friedman favored the constant increase of money supply by a fixed factor each year. This became known as Friedman’s K-Percent Rule, and he advocated the abolishment of the Federal Reserve, in favor of a computer system, which would buy and sell securities in response to changes in the money supply. 

Although Murray Rothbard also favored abolition of the Federal Reserve due to its inefficiencies, he reached this conclusion with a slightly different argument. Rothbard agreed with Friedman that the actions of the Federal Reserve tended to aggravate inflation, stating that: ‘…ever since the Fed was visited upon us in 1914, our inflations have been more intense, and our depressions far deeper than ever before.’ 

He concluded that the Reserve had caused the Great Depression by its loose monetary policy in the preceding years, and favored a return to the gold standard.

In more recent times, former congressman Ron Paul and his son, Rand Paul, have attacked the role of the Federal Reserve, accusing it of devaluing the dollar and being responsible for the ‘booms, bubbles and bust’ cycles in the economy, preferring to allow interest rates to find a natural market led level. 

Alternative solutions for improving economic stability

Friedman’s K-Percent Rule was a popular theory in the 1970s, influencing thoughts and ideas, but it was not used in practice, as it allows no role for the discretion of policy makers. Friedman considered this to be counterproductive and detrimental to controlling inflation. Such strict adherence to the rule is a source of criticism among other economists who are unfavorable towards rule-based systems.

The Gold Standard, favored by Rothbard among others, involves governments not being able to increase the value of paper money in circulation, unless they hold the equivalent amount of gold in reserve. 

This effectively checks government overspending, and thus inflation. Gold has a high liquidity, similar to cash. Currently, no government uses the Gold Standard. 

As of 1931, it was no longer used in Britain, and the U.S. abandoned it in 1933, with final replacement in 1971. Economic pressure after World War I caused the breakdown of the system. Additionally, heavy expenditure post-war made it increasingly difficult for countries to guarantee their gold reserves. 

Little interest exists in the Gold Standard, unless inflation is high. It was a very effective method of controlling inflation, which rose only 0.1% in the U.S. between 1880 and 1914. Costs of producing the amount of gold necessary for reserves is extremely high, but the stability of the Gold Standard still attracts debate.

Most countries passed through a transition period from the commodity currency of the Gold Standard, towards the current fiat currency system. Fiat currency has no intrinsic value, but has a value based on trust in the governments which  issued it. 

In recent years, the meteoric rise of alternative currencies has offered new potential. Cryptocurrencies, such as Bitcoin and Ethereum, have become well established and more popular means of payment. Even the central banks are having to consider the question of whether or not cryptocurrency could eventually replace traditional currencies altogether. 

Currency is a matter of trust. The increased development in blockchain technology and cryptocurrencies highlights a declining trust in governments, with a shift away from their issued currency. It is rare for the public to trust anything other than a centralized body, and blockchain is quite the opposite.   

Why monetary policy matters to SFL

At Students For Liberty, we believe that responsible monetary policy is of vital importance in promoting stable economic growth. This is also crucial in avoiding the recurrence of past catastrophes such as financial crises and hyperinflation. The possibilities to be gained from alternatives to mainstream monetary policy should not be discounted, and central banks must be transparent and accountable for their actions.  We also believe in the merits of a free and competitive market for currencies, including cryptocurrencies and any other means of exchange used for payment.

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