Formulating Economic Policies4 min read

How is monetary policy determined?

To understand how a policy is formulated, you have to first understand the motivation of the Central Bank. Depending on the country we are referring to, the central bank either is independent of or controlled by the government. Regardless, in general it is safe to assume that the Central Bank wants to achieve its mandate. For the Federal Reserve in the US, it is maximum employment (5.2% to 5.5%), stable prices (2% inflation), and moderate long-term interest rates; for the Bank of England, it is similar, it has the dual mandate of maintaining financial stability and meeting the government’s inflation target, which is at 2%; for the Monetary Authority of Singapore, it aims to promote sustained non-inflationary economic growth, a sound and progressive financial centre using the exchange rate as a main policy instrument. The key economic principle here is that agents respond to incentives, and agents are rational. The Central Bank’s staff is incentivised to achieve the bank’s objectives and will find ways to do so actively.

Positive Economics

The next step after understanding the aim is to be aware of the policy tools that are at the banks’ disposal. For the UK and the US, the main policy instrument is the central bank interest rate; for Singapore, the main instrument is the exchange rate, or the S$NEER.

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Image source: www.mas.gov.sg

Macroeconomics then provides the framework and models for the banks to understand how changes in these variables will influence the rest of the economy. The aim of positive macroeconomics is to explain the causal links between these tools and the economy’s performance. Some questions one could ask are: How does raising the Central Bank’s interest rates affect unemployment and output? What are the short term and long-term effects of lowering the exchange rate? To answer these questions, central bankers build models to describe the economy. The models in H2 Economics are not good enough because they tend to be too simplistic to capture the complexities in an actual economy. Central Banks also have to contend with uncertainty and randomness and they need to ensure the policies have a positive impact in both short term and long term. Once these issues are addressed, central bankers are almost done. Their mandates are confined to economic variables and thus they do not have to contend with issues of welfare and distribution. But this also creates the possibility that a policy that achieves the aims of the central bank may not actually be good for the citizens.

What about government policies in general?

Government policies in general tend to be more complicated because the (direct or indirect) aim of the government is to maximise the welfare and raise the standard of living of its citizens. These go beyond economic variables. Politicians have to think about how these variables translate into actual outcomes for citizens. Therefore, there is an additional step involved: thinking about trade-offs.

Here we enter the realm of normative economics. Now we know that lowering interest rates can increase national income in the short run and lower unemployment through its impact on investment and consumption; we also know that lower interest rates will hurt savers and may spur a housing bubble and over-investment in certain sectors. Here we have to weigh the pros and the cons of the policy. What sort of benchmark should we use to evaluate the policy? Here comes the intersection of ethics, politics and economics. In H2 Economics, the implicit assumption in any macroeconomics analysis is that everyone has roughly the same level of wealth and that utilitarianism is used as an ethical principle. Unfortunately, this part is often glossed over in H2 Macroeconomics. You are taught very well on how to spell out the various effects of policies but when it comes to evaluating them, you are reduced to relying on vague phrases like, “Lowering unemployment and increasing national income are good” or “The policy may be good in the short term but bad in the long term.” There is often a failure to contextualise the evaluation, address underlying assumptions and offer an explicit side-by-side comparison of trade-offs.

To summarise, policy in macroeconomics can be understood from three big ideas:

  1. Economic agents, such as governments and central banks, have objectives and they respond to incentives.
  1. To achieve these aims, they first have to understand how the economy works. This is called positive macroeconomics. Central Banks’ jobs mostly end here because they only concern themselves with economic variables.
  2. Governments on the other hand have to consider how these economic variables reflect actual citizens’ welfare. Asking questions such as: Is it necessary right to increase output and lower unemployment if it means greater stress and longer working hours? Does lowering interest rates actually benefit society?

Till next time, dream economics.

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