With Ben Bernanke being nominated as the next Fed chief who would be replacing Alan Greenspan, there is wide speculation in the financial markets over the stance of monetary policy that would be followed by the Federal Reserve in the coming months.

This speculation is arising from the fact that Bernanke is a strict advocate of "inflation targeting" and, therefore, favours a strict "rule-based" monetary policy in contrast to Greenspan who favours a "discretion-based" or "flexible" monetary policy.

The importance of being Ben Bernanke

The advocates of "inflation targeting" believe that the sole target of monetary policy should be to set up an explicit and quantitative inflation target for a year or longer period and try to achieve the target following a strict "rule-based" monetary policy.

New Zealand's Central Bank was the first to adopt an inflation targeting policy in 1990 followed by Bank of Canada in 1991 and Bank of England in 1992. Since then no less than 20 foreign central banks are currently pursuing inflation targeting monetary policies with the US Federal Reserve being a rare exception who under the leadership of Greenspan has preferred to follow a flexible or discretionary monetary policy.

What kind of monetary policy is best suited for the long-term health of the economy? Given the pitfalls witnessed by the use of short-term discretionary policies in the annals of history, it is much better to have a monetary policy, which is transparent and based on long-term rules. This would render greater credibility to the central bank in its attempt to maintain price stability and growth.

The discretionary monetary policies fail due to the "time consistency problem" in government decision-making -- that is, economic policy-makers who cannot commit to a rule in advance often will conduct a policy that confers sub-optimal results, despite their avowed intention of achieving the best possible outcome.

A rule-based monetary policy such as inflation targeting rests on the basic premise that money is neutral. What it basically means is that increases (decreases) in the quantity of money will bring about simultaneous and proportional increases (decreases) in all prices. Money's effect on the economy would, therefore, be nominal and not real. Or in other words, money supply changes would be neutral in their effects on the economy.

But is money really neutral in its effects? In a real world, the answer is a resounding no. Apart from reasons like sticky wages and imperfect information, the main argument for non-neutrality of money is that monetary changes in an economy follow a temporal sequence rather than a one-time effect on the economy. Let us take an example. Say, money supply increases in an economy.

This will lead to additional cash balances available in the economy but the distribution of this money supply will take a temporal sequence. The first group of people who are the beneficiaries of the additional money supply will be net gainers because now they have additional money to buy more goods and services at the same price.

The additional demand generated by the first group of people will bid up the prices of not all goods but only those particular goods and services that the first round beneficiaries wished to purchase because it takes time for production to catch up with additional demand.

However, the receivers of the additional money supply (sellers of the additional goods to the first round of people) from the first round of people are now the gainers (though their gain is lesser than the first round of people due to the sequential increase in prices) who would have additional cash balances to spend their money for other goods and services.

This creates further demand for those particular goods and services whose demand has been increased by the second group of people and drive up prices higher. This process continues until the prices of all goods and services have increased. It is important here to note that though the expansion in money supply has ultimately resulted in inflation, the price increases have been impacted in a temporal sequence and at varied degrees.

Moreover, the group of people to receive the additional money supply first are the net gainers of the monetary expansion and the people who are at the fag end of the monetary expansion cycle are the net losers.

Therefore, the monetary effects on the economy are always non-neutral in nature and affect the real variables in the economy, even if we relax the assumption of sticky prices and wages and perfect information among economic agents in the market.

For money to be neutral, each economic agent in the market has to correctly guess as to when and at what extent the demand and the price for his specific resources will be affected due to the monetary change in the system. This is clearly impossible.

Inflation as measured by some price indexes is, therefore, just a statistical average of individual price changes with some prices above and some below the average. It is therefore impossible to correctly guess the changes in relative prices of goods and incomes given the temporal sequence in which a monetary change affects the economic variables in the country.

In the absence of neutrality of money, a monetary policy aimed at price stabilisation may itself prove to be counter productive and distortionary in nature. Therefore, if Bernanke resorts to inflation targeting policies in a misguided attempt to maintain a "stable" price level, he might actually end up aggravating the mess that the American economy is reeling under, created none other than by his predecessor Greenspan.

The author is an economist at SBI [Get Quote] Capital Markets Ltd. Views expressed are personal.