The view of discretionary monetary policy that has emerged from this chapter and the preceding two chapters is that through open-market operations the central bank can stimulate the economy by increasing the money supply, alternatively viewed as pushing down the interest rate. In a longer-run context an eye must be kept on the rate of growth of the money supply to ensure that inflation is not allowed to escalate, but in a noninflationary environment, discretionary use of monetary policy is a useful alternative or supplement to fiscal policy.

Both fiscal and monetary policy shift the AD curve in the aggregate-supply/aggregate-demand diagram. Fiscal policy changes aggregate demand directly; monetary policy changes aggregate demand by changing the interest rate. Two marked differences between monetary and fiscal policy, however, should be noted.

1. Timing considerations. Monetary policy can be implemented much more quickly than fiscal policy, since it does not require congressional approval. Once implemented, however, it affects the economy more slowly than fiscal policy because it takes time for decision makers to react to lower interest rates. It has been estimated, for example, that only about one-third of the impact of an interest rate change on aggregate demand occurs within one year, and only about one-half within two years. Furthermore, these lags are variable as well as long, making it quite difficult for monetary authorities to deduce the correct timing for monetary policy. Therefore, any temporary, discretionary, diversion from the monetarist rule must be undertaken with great care.

2. Discrimination considerations. Monetary policy affects the economy very broadly, allowing the impersonal forces of supply and demand to distribute its impact efficiently across the economy. Fiscal policy has this effect when it takes the form of tax changes, but not when it takes the form of government spending changes; the discriminatory effects of government spending could be either an advantage in that the spending could be directed at a depressed region or a disadvantage in that it may be directed by political whims. Despite the impersonality of monetary policy, however, it is discriminatory. The components of aggregate demand that are more sensitive to interest-rate changes bear the costs of adjustment. The sector most strongly affected in this regard is the housing sector, which is notoriously sensitive to interest-rate changes. A fall in the mortgage rate from 10 percent to 8 percent, for example, decreases the monthly payment on a 30-year mortgage by more than 16 percent. This saving markedly increases the demand for residential construction. The export- and import-competing sectors are also strongly affected. Interest-rate changes cause foreigners to change their demand for our currency to invest in our financial assets, altering the exchange rate and affecting the profitability of business in the international sector.

Our discussion of monetary policy is not yet complete. The next chapter examines its role in an inflationary environment, providing further insight into the relationship between monetary policy and interest rates. Chapter 16 looks at how monetary policy is affected by international influences.