Monetary Policy in the Short Run and the Long Run

Monetary policy has different effects in the short run and the long run. Expansionary monetary policies designed to reduce short-term interest rates and spur full employment and economic growth eventually lead to higher interest rates as they induce inflation. This means that monetary policy must be carefully applied. If the Fed introduces a monetary stimulus, they must also plan to remove the stimulus in order to prevent future inflation. The problem for policymakers is in timing the policy. Early removal of monetary stimulus might result in a protracted recession, but maintaining low interest rates for too long will almost certainly lead to higher inflation.

Central bank independence is key to controlling inflation. In countries with independent central banks, the temptation of government to pay its debts by printing currency is severely limited. If Congress ran the Fed, then the temptation to print up currency instead of raising taxes might prove too big a temptation, and inflation would ensue.

Too much reliance on monetary policy to reduce inflation can also lead to problems. Over the business cycle, if government uses expansionary fiscal policy to offset recessions and then relies on the Fed to contain periods of inflation, interest rates will ratchet up and long-term economic growth will be stymied. At some point government must reign in its spending and/or raise taxes to keep long-term interest rates from rising too high. Some observers think that the Fed's goals of price stability and full employment are mutually exclusive and impossible to simultaneously achieve. Those within the Fed who have a similar view tend to be labeled as inflation hawks for their insistence that price stability be the overarching goal of the Fed.

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