Monetary policy

(This policy bulletin is extracted from FMF monograph Money, central banking and monetary policy in the global financial arena, published by the FMF in 2001.)

In the not too distant future, I hope young people studying economics in our colleges and universities will find it humorous at best when the professor describes a recent past period of history when it was thought that a positive rate of inflation was in some ways desirable. There actually was a line of thinking that concluded that a gradually rising price level and gradually falling purchasing power of money was a good thing. In most countries of the world today, most people would consider it a silly idea for their politicians to suggest that a higher rate of inflation would be desirable.

This is not to deny that there are powerful and politically expedient or “necessary evil” arguments about inflation. For some time it seemed that central banks and the activity we call monetary policy operated under the cloud of a fiscal-dominance hypothesis. The idea was simply that any place that found it difficult to constrain government outlays in a range around the amount of tax receipts would also lack the political will to resist the temptation to debase the currency as a form of unlegislated tax. In that sense, monetary policy became a form of fiscal action – an alternative way of financing government expenditures. It was a highly regressive and dishonest form of taxation, as well as a form of taxation that undermined the efficient utilisation of resources. Nevertheless, it was politically popular in many places. The ultimate failure of any policy that was tolerant of inflation, however, has undermined its political appeal.

In search of stability…

An important question for central banks that issue fiat currencies is: How can we expect to achieve monetary stability in the current environment? Recently, questions have been raised about the implications for the formulation and implementation of monetary policy of rapid technological innovation and increased productivity. Efforts to deal with these issues have been confounded by breakdowns in both of the two most popular frameworks for implementing monetary policy.

Let me elaborate on the output-demand and money-supply management concepts I mentioned previously. For a long period of time, people thought about monetary policy within either of these two competing paradigms. One of them had to do with supply and demand for something we call money. The other had to do with supply and demand for output or labour. Both of them enjoyed a period when their statistical reliability appeared quite high, and they seemed to perform pretty well and served as guides to policy decisions. In the United States, and in other countries around world, the supply-and-demand-for-money paradigm worked quite well for much of the post-World War II period. The basic idea behind it was that statisticians could somehow estimate the demand for money balances. If non-inflationary money demand was predictable – stable in a functional way – and if it were possible to control the money supply, then (theoretically, at least) you can keep the two of them in balance and avoid inflation.

The competing paradigm was supply-and-demand for output or employment – the so-called Phillips Curve. There the idea was that supply and demand entered with the reverse relationship. The effort was to estimate the non-inflationary supply of output (or labour) and control the demand for it. So, both paradigms had an element of supply, and they both had an element of demand. Both had something you forecast and something you controlled to try to maintain a balance, and both provided guidance that for some time tended to work pretty well.

Neither paradigm plays a very useful role in thinking about monetary policy today. Money-supply management seemed to come apart in the 1990s, particularly in the US, where the non-inflationary target for the money supply became impossible to estimate. Likewise, the non-accelerating-inflation rate of unemployment that had provided a fixed target for demand management broke down. To our satisfaction, we have witnessed both lower unemployment and lower inflation than had seemed possible.

Instead of these defective paradigms, I find it more productive to think about monetary policy from the vantage point of interest rates in a stable monetary environment.

Economists argue that a household’s consumption spending tends to reflect its expectation about longer-term ability to consume. This phenomenon has been called the life-cycle hypothesis, standard or standardised income, or, as in Milton Friedman’sTheory of the Consumption Function, permanent income.

The basic idea is familiar to everyone. We observe that as transitory changes in measured income or cash flow fluctuate around some longer-term average, household consumption behaviour does not (in the short-run) fully reflect these transitory changes. Rather, it is observed that household consumption behaviour tends to smooth out such fluctuations over time. Sudden sharp increases in measured cash-flow income are not fully reflected in the corresponding increases in current consumption – nor are sudden rapid declines in measured cash-flow income reflected in corresponding declines in consumption spending.

…in periods of increasing change

The way this theoretical framework and its related empirical observations have been used traditionally is to assume that permanent income is relatively stable over time, while transitory changes in measured income are more variable.

However, it can also be the case that in periods of significant technological innovations and rising productivity there is a generalised perception that permanent income is rising relative to measured or cash-flow income. People come to form this expectation in a variety of ways. It may be simply that fewer or shorter periods of unemployment and growing pay-cheques lead them to expect not only that their real standard of living has risen, but that it will continue to rise in the future – possibly at a faster rate than previously expected. People come to expect that they will be able to consume more in the present, as well as in the future, than they previously thought. For example, observing that their savings plans or defined-contribution retirement programs now promise a higher future stream of income than previously thought, households feel justified in consuming more of their current income.

It may also be that a sustained period of low inflation and increased credibility of the central bank’s commitment to maintain a non-inflationary environment causes the inflation premium in nominal interest rates to be purged from the financial markets. This affords households (and businesses) the opportunity to refinance debt obligations at lower nominal interest rates and thus reduce debt-service burdens. As a consequence, the discretionary component of disposable income is higher than before, creating the opportunity for greater consumption spending out of a given cash flow.

As a result of any (or some combination) of the various forces at work in the “new economy” environment, households perceive that their long-term ability to consume is higher. They believe they can not only consume more in the future but also, through access to credit markets or through reduced contemporaneous savings, afford greater consumption in the present. In economists’ language, they have moved to a higher indifference curve. The trade-off between present and future consumption is manifested in higher real interest rates.

At the same time, in the business or entrepreneurial sector, an enhanced pace of technological innovation and rising productivity mean that the marginal efficiency of capital is higher. Again in economists’ jargon, the production possibility boundary has shifted outward. This also translates into higher real interest rates because the new opportunities will be associated with a higher rate of return on new business investment.

Notice that these higher real interest rates are not a matter of policy choice, or of anyone’s discretion. Rather they are a manifestation of the economic forces that result in heightened competitive uses for available productive resources. Real interest rates rise in financial markets to compete with higher returns to capital investment. Recognition of increased wealth in ownership of more productive capital makes consumers join businesses in increasing demands for current resources. Higher real interest rates are a necessary part of the mechanism for resolving these competing claims. They also attract foreign investment, which bids up the real exchange rate and supplies foreign exchange to raise imports to meet household and business demands for current resources.

This Monograph can be downloaded here.

AUTHOR  Jerry L Jordan. This Policy Bulletin may be republished without prior consent but with acknowledgement to the author. As always the views expressed in this Monograph are those of the author's and are not necessarily shared by the members, directors or staff of the Foundation.

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