The Ideal Monetary Policy

Decade after decade, the Federal Reserve, under its dual statutory mandates to minimize both inflation and unemployment, has favored the attack on unemployment over that of inflation. Depending on the monetary policy of the time, this has led to the inflation of asset bubbles, to price inflation, or to stagflation.   In the 1960s and the 1970s Keynesians believed in an inverse relationship between the inflation and unemployment rates called the Phillips curve. Doing a least squares fit to 1960s data yields the Phillips curve shown below.

During the 1970s Milton Friedman and the monetarist school of economics associated with him severely criticized the curve as being correct only in the short term. In an inflationary environment they claimed that once people came to expect a particular level of inflation, they would demand and employers would give an extra increase in their wages to counteract inflation. This “wage inflation” would then generate additional price inflation. In addition, the employers would eventually not be able to pass on their labor costs and would be forced to layoff workers. The monetarists were proven correct when the Federal Reserve easy money policy in the 1970s led to the combination of economic stagnation with high inflation, the dreaded stagflation. Keynesians and the Phillips curve had both said this outcome was impossible.

Taking the monetarist criticism to heart along with other insights from neoclassical economists such as Robert Lucas and Milton Friedman, the Keynesians adopted some of these neoclassical ideas into their new neoclassical synthesis (See here and here and here). One of the consequences of this new synthesis was that the Keynesians adopted monetary policy as a new tool in their arsenal for government demand stimulation (see here and here). This new Keynesian tool has been extensively used by the Federal Reserve under the chairmanships of Alan Greenspan, Ben Bernanke, and Janet Yellen, contributing to asset bubble formations in both the stock and real estate markets. Central bank culpability in asset bubble formation has also been seen in Japan.

Is there any better way to frame monetary policy that will not lead to the periodic booms and busts of asset bubbles? What do we expect from the functions of money, and how in light of those expectations do we regulate the rate of money creation? Because of the central role that money plays in any economy, one would think that absolutely the first concern would be to defend the ability of money to play its three major roles. These are: 1) to be a unit of exchange, 2) to be a store of value, and 3) to be a unit of account. The first two of these monetary functions are self-explanatory, but the third probably needs a sentence or two of explanation for non-economists. To be a unit of account means that money should operate in a way that the price of a good ranks it in value relative to all other goods. One good with a higher price would have a higher value than any other good with lower prices. You might protest that ranking a new car with an apple in price is like, well, mixing cars with apples; the units are incommensurable. What makes your protest incorrect is we are not quantitatively comparing a unit of one car with a unit of one apple. Instead we are comparing the value of one car relative to the value of one apple as determined by the marketplace, where the units of value are dollars. It is this third function of money that allows Adam Smith’s invisible hand to balance the demand of a good with its supply.

Any economic force that disrupts the balance between the supply of goods with its demand will change the relative values of goods in the economy. Some disruptions will be natural, for which people can do nothing but adapt. For example, in a drought food may be in short supply. In that case, one can only allow the law of marginal utility to adjust the supply and demand curves until they are again balanced. Other disruptions, however, are created by man and are entirely avoidable. Examples of this are government taxation and regulation that change the relative costs of producing goods. Anyone who values a healthy economy should want to minimize the economic interference of the President and Congress to only what is absolutely necessary to allow society to function. The disruption that we are most focused on in this post is that produced by the fourth branch of government, the Federal Reserve System.

The way the Fed can disrupt supply and demand balance is to change the value of money over time. If the Fed creates either deflation or inflation by under-supplying or over-supplying new money, it impairs all three of the functions of money. Indeed, we have seen in the hyperinflations of the last century, many people ceased using money for exchange and bartered instead. In deflations, the tendency to hoard cash was one of the sources of inspiration for John Maynard Keynes’ ideas. Therefore, the changing value of money can be injurious to the role of money as a unit of exchange. Clearly, either inflation or deflation also impairs money’s role as a store of value. Deflation diminishes the value of a debt held by a lender, while inflation reduces the value of any dollars held by anyone. Inflation can be considered to be a tax on everyone’s hard-earned dollars. Finally, changing monetary values disrupt the economic messages passed to both suppliers and consumers required to find balance for supply and demand. If the prices for one good are expressed in terms of dollars from a different time than those for another, the prices are actually expressed in incommensurate units. Such  confusion in economic communications will disrupt the balance between supply and demand.

Considering all this, one would think that the best monetary policy for the Federal Reserve would be to adopt a policy that, as much as possible, keeps the value of a dollar constant. As I wrote in The Federal Reserve and Monetarism,

Given all these considerations, one would think that the optimal course of the Federal Reserve would be to choose  a rate of growth or contraction of the money supply to exactly cancel the effects of any changes in the velocity of money and the growth (or contraction) of the economy. If the Fed could achieve that, there would be neither inflation nor deflation, and stable money value would allow money to fulfill all three of its functions.

This is a goal that is much easier to say than to execute! Also, the political opposition by Keynesians to remove discretion from the Fed in the creation of money would be considerable. Their view is that maximum discretion should be granted the Federal Reserve so that the FOMC could use their technocratic expertise to choose the optimal way to increase or decrease the money supply. They believe the U.S. economy is entirely too complex for money supply to be governed by a simple “monetary rule”.  In addition, a number of monetary rules have been proposed to govern the rate of money creation, and it is not at all clear what the best one would be. We will discuss monetary rules in our next post on the Federal Reserve.

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