Economics Update (July-September 1997)

Measuring Monetary Policy's Effects
Is Difficult in Practice

A lthough the textbook fundamentals of economics are rarely disputed, economists are sometimes quite divided on the more advanced aspects of the discipline, such as the quantitative, or measurable, impact of monetary policy. In an article in the Atlanta Fed's Second Quarter 1997 Economic Review, economist Tao Zha argues that measuring monetary policy's effect is difficult because the theoretical models from which economists make inferences about economic behavior do not encompass all of the relevant conditions present in the actual economy.

Zha explains that the central bank interacts with other players to influence the impact of monetary policy. The actions of consumers, producers and financial market participants affect the economy in complex ways, placing constraints on how influential monetary policy is and which economic factors influence it. The author stresses that sorting out the central bank's behavior from that of other participants is an important step in assessing the effects of monetary policy.

Because of the roles that these other groups play, central banks must carefully monitor a number of factors before determining which actions will ensure that their economic objectives are met. For this reason, Zha considers monetary policy to be actually the central bank's reaction to economic conditions. The variables the Fed monitors and influences include inflation, exchange rates and economic output. The author argues that evaluating these factors is best done by separately examining the supply and demand sides of the market for money.

Zha also contends that assumptions that allow models of the money market to be identified must make economic sense. For instance, if the market participants in one country were expected to behave the same as in another closely related country, but in reality they do not, then the inference of the effects of monetary policy in both countries may be misleading.

Monitoring the factors that affect policy is complicated since it is not always easy to separate behaviors of the supply side of the market from those of the demand side and independently analyze the impacts. This difficulty, according to Zha, is one that researchers must work to eliminate in order to better understand the measurable effects of monetary policy.

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