Monetary Policy

According to Mitra (2007, p. 4), monetary policy implementation is an economic activity of the Central Bank that is delegated to it by the government. Seidman (2003, p. 4) further states that this policy is meant to control the inflation rate, create employment and favorable balance of payments, as well as to spur economic growth. Therefore its ultimate goal is to maximize economic welfare of the citizens.

According to Schmidt, Shelley and Bardes (2012, p. 310), for the central bank to achieve this economic goal, it has to focus on the creation and consistent implementation of the monetary policies. To make of its monetary decisions, the bank normally has two independent approaches that can be adopted. These are the rule policy and the discretionary policy approaches. In the rule approach, economic policies are laid down for a specific period and followed throughout that period irrespective of the changes in economic circumstances. While the discretionary approach focuses on adopting the monetary policies when tackling a particular economic problem. To aid the policy making process, Sasse (2011 p. 4) states that such monetary policy instruments as the open market operations, changing of discount rates and control of reserve requirements for the commercial banks are used by the central bank.

However, Melvin and Boyes (2012 p. 325) state that despite the economic control tools, the central bank faces the problem of Time Inconsistency. According to Falaschetti  (2009 p. 52), this is an economic problem that arises when the monetary policy makers make a decision in advance to handle the economic issues but then come up with another different decision at the time of implementation. Falaschetti notes that changes in decisions are majorly due to the changes in economic circumstances and needs.

According to Snowdon and Vane (2003, p. 699), one of the factors that lead to the time inconsistency is the unanticipated changes in the economy. For instance, any increase in the rate of inflation calls for decisions in order to tackle the problem. An example is a case where the government had earlier on promised the public that it would charge very low interest rates on loans for investments but later realizes that many investors borrowed money, as a result of that leading to huge money supply in the economy. In this case, the remedy can be to reduce the money supply by increasing the interest rates on loans which had initially been kept low.

According to Taylor (2007, p. 700), the other possible cause of time inconsistency is the behavior of households and bond price fluctuations. This is because the central bank does not have control over some economic aspects, such as the price of bonds and the amount of money that the households choose to keep in banks as deposits. In the long run this leads to unanticipated economic fluctuations which have to be responded to as they occur. Thomas (2006, p. 565) further emphasizes that this unpredictable behavior in effect prompts the central bank to alter the earlier made economic decisions. Additionally,  Rajan and Reinert (2008, p.1093) states that the tendency by the central bank to increase the rate of employment in the long run for the improved welfare of the citizens may also lead to time inconsistency. This is because with time the inflation rate will increase prompting changes on the policy decisions.

Taylor (2007, p. 700) further states that the need for economic development may make the government to encourage research and development by the private firms through the central bank. For that to happen, the government may have to promise monopoly over the newly invented products of the firms. As a result, private firms will be encouraged to invest and invent new products. However, after the invention and introduction of such commodities into the market, the government may want to make them affordable to the general public. It then has to come up with price controls over such commodities; a step which automatically breaks the monopoly promise to the investors.

Due to the time inconsistency phenomenon, Taylor (2006, p. 354) states that the investors and the general public may lose trust and credibility on the central bank as the government’s monetary policy maker. This is because of the ever-changing economic policies. According to Gordon (2004, p. 207), time inconsistency also destabilizes the economy’s transition since there are no certain rules and guidelines which can be followed in order to reach the targeted economic goals.

Bernhard, Broz and Roberts (2003, p. 4) state that in order to control the problem of the time inconsistency, the government should let the central bank to operate independently so as to stay more focused in its economic responsibilities. This, according to Neck et al (2008, p. 51), will improve the credibility of the monetary policy decisions since it will be done by the professionals without the influence of others.

Another mitigating factor is abandonment of the discretionary monetary policy which should then be replaced with the rules-based monetary policy. This is to allow the policymakers to formulate and announce in advance how they will deal with the rising economic situations and hence avoiding changes in their decisions. Apart from the central bank which should stick to the rules-based policy making, Neck et al (2008, p. 52) further recommend that a different institution should be created by the government so as to deal with the abrupt economic changes without having to alter the already made monetary policy strategies. Finally, Neck et al (2008, p. 51) state that the electorate should also be committed to punishing the politicians who break the monetary policy commitments because of their influence on the public.


In conclusion, it is worth noting that the monetary policy makers can never perfectly predict the economic trends. This makes it difficult to be very certain about efficiency of the formulated monetary policies. There is therefore the need for more research on the best way to handle this issue.

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