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The New Monetary Policy

Implications and Relevance

Edited by Phillip Arestis, Michelle Baddeley and John S.L. McCombie

Beginning with an assessment of new thinking in macroeconomics and monetary theory, this book suggests that many countries have adopted the New Consensus Monetary Policy since the early 1990s in an attempt to reduce inflation to low levels. It goes on to illustrate that the explicit control of the money supply, which was fashionable in the 1970s and 1980s in the UK, US, Europe and elsewhere, was abandoned in favour of monetary rules that focus on interest rate manipulation by the central bank. The objective of these rules is to achieve specific, or a range of, inflation targets.
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Chapter 14: International aspects of current monetary policy

L. Randall Wray


L. Randall Wray 1. INTRODUCTION This chapter will examine monetary policy appropriate for an open economy operating with a floating exchange rate. It will be shown that most of the conventional wisdom regarding each of the following issues is flawed: interest rate determination; ability of the central bank to ‘pump liquidity’ into an economy to fight deflation; central bank ‘monetization’ of budget deficits; central bank ‘sterilization’; the relation between the ‘twin deficits’ and their impacts on exchange rates. Briefly, the central bank sets the overnight interest rate target and then supplies or drains reserves to ensure banks have the quantity desired and/or required. The central bank can always ‘pump’ excess reserves into the system, but this will simply result in a zero-bid condition in the overnight market, causing overnight rates to fall to zero (or to the support rate if the central bank pays interest on reserves). The treasury spends by crediting bank accounts and taxes by debiting them – deficits simply mean that bank accounts have been net-credited; hence reserves have increased. If this has created a position of excess reserves, the central bank or treasury must sell bonds or the overnight rate will fall. Hence there is no operational meaning to be attached to the notion of central bank ‘monetization’ of deficits. Central bank operations are always defensive, and if international payments cause actual reserves to deviate from desired/required reserve positions, the central bank has no choice but to ‘sterilize’ (accommodate) by supplying...

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