Chapter 6: Choice of the Strategy of Monetary Policy for Price Stability
INTRODUCTION During the early 1970s, worldwide inflation and the recession thereafter created a paradigm shift from activist monetary policy for economic stabilisation to one of sustained price stability (Clayton et al., 1977). By researching global economic shocks and other events throughout the 1980s and 1990s, economists began to comprehend the workings of economies better with respect to inflation, balance-of-payments crises and economic growth. With the rapid opening up most economies since the 1980s, the role of macroeconomic factors in economic growth and stability has gained greater significance (Dornbusch and Giovannini, 1990; Fischer, 1990; 1993). In particular, the danger of expansionary monetary policy has become much greater in small open economies. Experiences of different countries have therefore led policy-makers in most countries to acknowledge that monetary policy has a comparative advantage in achieving and maintaining price stability, compared with the Keynesian attempt at moderating business cycles (Friedman, 1968a). It follows the proposition that monetary policy cannot achieve real objectives such as raising economic growth or lowering unemployment except in the short run. The use of monetary policy to achieve real objectives also carries the danger of igniting inflation. As happened in many Latin American developing countries since the 1950s, activist monetary policy often leads to economic and political crises (Diz, 1970; Dornbusch, 1993; Dornbusch and Edwards, 1990). Consequently, the art of central banking has changed remarkably since the 1990s. Most developed countries have changed their strategies of monetary policy with respect to goals and instruments. To make it effective, the conduct...
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