Monetary policy is the alternative to fiscal policy for stabilization purposes. By default, it is currently the main instrument of American economic stabilization policy, because the flexibility of fiscal policy is severely limited by large deficits. The possible actions available to monetary authorities have to do with the levels of interest rates and the rate of growth of the money supply, which in turn may affect the level of economic activity and rates of inflation.

Good and successful monetary policy can bring an appropriate balance between economic growth and stable prices, but of course the meaning of “appropriate” is contestable. Poor or unsuccessful monetary policy runs two main risks. If the money supply grows much faster than real economic activity, the result will be inflation or even hyperinflation. The opposite risk is that there will not be enough financial liquidity to support the real economic activity that would take place if credit were more readily available. The United States has never experienced hyperinflation, but monetary policy has been at least partly responsible for the sustained increases in price levels since World War II. The second risk was experienced in the banking panics and recessions of the nineteenth and early twentieth centuries, and the Great Depression itself has been attributed to poor monetary policy.

Just as there are two main risks inherent in poor monetary policy, there are two basic alternative strategies for good policy.