Many nations, including the United States, follow an active monetary policy in which a committee of central bankers reviews current economic conditions, assesses the economy’s future course and responds with what committee members consider the appropriate policy actions. Describing active monetary policy requires that you distinguish active from passive policy, as well as understand the tools of monetary policy that central banks have at their disposal.
An active monetary policy can be contrasted with a passive monetary policy. Under an active monetary policy, a central bank, such as the Federal Reserve Board (the “Fed”) in the United States, uses its discretion to set monetary policy in response to changing economic conditions. Active policy means the central bank can act, or choose not to act, based on its assessment of the nation’s economy. Passive monetary policy, by contrast, involves a set of rules that dictate monetary policy actions. A rule requiring a 1 percent cut in short-term interest rates for every 1 percent drop in aggregate economic output, as measured by the inflation-adjusted gross domestic product, is an example of passive monetary policy based on predetermined rules rather than the discretionary actions of policy makers.
The Center for Economic Policy Research (CEPR) writes that a 1993 paper by economist John Taylor became the basis of a body of research that advocated an active monetary policy in which central bankers changed short-term interest rates in response to fluctuations in inflation and output. According to CEPR, this interest rate feedback became known as the “Taylor rules.”
Active monetary policy requires that the central bank’s policy-making body meet regularly to review the most recent economic data and decide policy actions. In the U.S., that group is the Federal Reserve’s Federal Open Market Committee. According to the Federal Reserve Bank of San Francisco, the Federal Open Market Committee meets eight times a year in Washington, D.C., to determine monetary policy. The committee’s policy tools include trading government securities, or open market operations; changing reserve requirements for banks; and changing the Federal Funds Rate, a short-term interest rate that banks charge one another for overnight loans.
Central banks enact monetary policy to ensure the most sustainable levels of economic output and employment, as well as to maintain a stable price system by containing inflationary pressures. Active monetary policy grants policy makers the flexibility and discretion to act when inflation exceeds expected levels or if the course of economic activity expands or contracts at greater levels than anticipated. Active policy allows the central bank to moderate economic fluctuations that could create instability.
While beneficial, active monetary policy has risks and drawbacks. Economists such as Milton Friedman contended that active policy relied too heavily on the judgment of central bankers and that excessive adjustment through monetary policy could exacerbate economic problems. In addition, active policy is vulnerable to the claim that central bankers manipulate economic conditions in response to political pressure to achieve outcomes that support the reelection of a sitting government. In the U.S., the president appoints Federal Reserve Board members, but the Fed operates largely independent of Congress and the president, insulating it from most political pressures.