Chapter 26: Monetary Policy Implications
The purpose of a central bank is to stabilize the economy by managing the money supply, but its primary function is psychological rather than financial. It must give people the confidence to take action with an expectation of having certain results, because in the end it is this confidence that motivates human action, and human action that creates financial crises. So to maintain stability in the market, the central bank must make a credible commitment to stability and convince people that it can and will stop prices from rising to prevent them from panicking or functionally withdrawing from engaging in commercial exchanges (production, consumption, and trade).
Ultimately, it is behavior that matters: if people do not rush to the bank to withdraw their savings but remain confident that the central bank will resolve a temporary crisis, than the bank panic and stock market crash of the early 20th century, precipitating the Great Depression, may not have occurred. There would still have been losses when borrowers failed to repay their loans, but a more moderate solution could have mitigated the damage.
It's also noted that speculators keep a close eye on the central bank, attempting to predict its actions to gain an advantage. They do so at their own risk, but if an accurate and reliable prediction model became available to all speculators, this could undermine the ability of the central bank to mitigate inflation: if people know in advance that the inflation rate will increase, they will begin behaving as if it already has, or take other steps to mitigate their actions to prevent losses and maximize gains as a result of the change. So the expectations of speculators and others in the market need to be considered when the central bank takes action.
New Keynesians
Generally speaking, the position of classical and neoclassical economic theory is that there is very little that government can do to the economy without doing damage, hence it should be given as little power as possible to influence the economy. Meanwhile, Keynes and his followers maintain that government can and ought to control the economy for the benefit of all - and this camp (not to mention the politicians who gain power from the acceptance of their theories) could not sit still when the neoclassical economists reiterated their position.
In retaliation, these camps developed the "new Keynesian" model, which indicates that economic agents are reluctant to react to changes in the economic environment (even when it is clearly in their interest to do so) and government must step in to force their hand to help the market maintain stability. The reluctance of agents to accept change cannot be disputed (workers are never happy at the prospect of having a decrease in wages when the currency gains strength, homeowners will not gladly refinance their mortgage to a higher rate, etc.), but whether government intervention is necessary of beneficial to the overall health of an economy remains in dispute.
To the new Keynsean school, debasement is the very way in which individuals can be encouraged to take actions that are against their better interests, as they are unable to influence the value of money. Workers are paid the same or higher wages, but because of inflation these wages are worth less. Homeowners may not refinance their mortgages, but they may find they have to repay them with more expensive dollars because inflation and interest rates have been manipulated. And most importantly, central banks should be as opaque and unpredictable as possible to prevent speculators from forming accurate predictions about changes in the money supply.
Inflation Busting
By some theories, a completely stable markets are not good for economic growth and that some amount of inflation is necessary and desirable. If money maintains its value, there is no reason to invest it in productive facilities to preserve its value. And if there is a need to tighten the money supply, it can never be loaned at less than 0% (paying people to take loans), but a central bank can cause there to be less-than-usual inflation (disinflation) to cause prices to decrease more slowly than the increase in wages, thereby increasing the buying power of the workers (in theory).
But it is counter-argued that the wealth and welfare of a nation is reflected in the benefits delivered to its people by the consumption of goods. To have more dollars and fewer goods is not an improvement, though the numbers would suggest so. And in general, it creates a greater sense of confidence for there to be economic stability. When wages and prices change very little, there is less reason for strife and negotiations can be made based on reasonable predictions. For example, a worker need not argue for a larger pay increase to account for the diminishing value of money, but only based on the evidence of the value of his contribution to production. In this sense, it is stability and transparency that contribute to the health of the economy.
The author supports these arguments with a few charts and equations, and concludes with advice for central banks: that they must strive to remain independent of government and manage the money supply with a goal of providing stability if they are to foster a healthy, growing market economy.