50 years on and the role of monetary policy is still debated

The latest attempt comes from Neel Kashkari (the new “NK” at the Minnesota Fed, the previous one being Narayana Kocherlakota).

In 1967, Friedman´s “centerfold” for the role of monetary policy was:

“Provide a stable background for the economy”

NK´s “top of the list” role:

“Creating and maintaining a stable monetary environment”

In perfect agreement.

To Friedman, that meant:

keep the machine well oiled, to continue Mill’s analogy. Accomplishing the first task [avoid monetary disorder] will contribute to this objective, but there is more to it than that.

Our economic system will work best when producers and consumers, employers and employees, can proceed with full confidence that the average level of prices will behave in a known way in the future-preferably that it will be highly stable.

Under any conceivable institutional arrangements, and certainly under those that now prevail in the United States, there is only a limited amount of flexibility in prices and wages. We need to conserve this flexibility to achieve changes in relative prices and wages that are required to adjust to dynamic changes in tastes and technology. We should not dissipate it simply to achieve changes in the absolute level of prices that serve no economic function.

To NK, that meant:

Ensuring that inflation remains low and stable allows households and businesses to plan ahead and keeps borrowing costs low.

Thus, by doing its inflation-stabilization job well over the long run, a central bank helps create the environment that allows an economy to flourish. We saw the damage caused to Main Street in the 1970s when the Fed failed to control inflation. It took bold action by the Volcker Fed to regain control and put the economy back on a stable course.

“Feels the same”, but it´s different. Maybe the preliminary conclusion of George Selgin´s “A Monetary Policy Primer, Part 3: The Price Level” helps enlighten:

If, as I’ve claimed, changes in the general level of prices are an economy’s way of coping, however imperfectly, with monetary shortages and surpluses, then surely an economy in which the price level remains constant, or roughly so, must be one in which such surpluses and shortages aren’t occurring.  Right?

No, actually.  Despite everything I’ve said here, monetary order, instead of going hand-in-hand with a stable level of prices or rate of inflation, is sometimes best achieved by tolerating price level or inflation rate changes.  A paradox?  Not really.  But as this post is already too long, I must put off explaining why until next time.

Anyway, market monetarists eschew associating “stable monetary background/environment” with “stable average level of prices or inflation” preferring to associate it with the more encompassing “nominal stability”, by which we mean stable NGDP growth (along a defined level path).

The charts below, I believe, provide compelling evidence for requiring the central bank to provide nominal stability. As the Great Moderation shows, a period of nominal stability goes hand in hand with stable (and close to potential) real growth, low and stable inflation and “low” rate of unemployment.

Role of MP_1

Role of MP_2

Role of MP_3

Role of MP_4

The inflation panel is clear. Having low and stable inflation, as is true now as it was in 1994-05, does not equate with nominal stability!

2 thoughts on “50 years on and the role of monetary policy is still debated

  1. Excellent blocking.

    The guy on the US West Coast who’s experienced high rates of unemployment and exploding house prices in the last 10 years must wonder why the concurrent relative general price stability was so important.

  2. “We need to conserve this flexibility to achieve changes in relative prices and wages that are required to adjust to dynamic changes in tastes and technology.” We hear so little about this from consensus economists.

    In it was ok back in Friedman’s day to plan for relative losers and relative winners, so all would be absolute winners. Like with free trade, too. Nowadays we cannot plan for relative losers, all must be relative winners, and so we get lots of absolute losers.

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