Monetary policy and economic theory: a recap
Keynesian monetary policy focuses on interest rates. As the title of Keynes's book The General Theory of Employment, Interest and Money implies, interest is the intermediary between the real sphere (employment) and the financial sphere (money). Keynesian theory stipulates that a lower interest rate will stimulate business investment and possibly consumption, and thus aggregate demand. To speed up the economy, the Fed can lower interest rates by increasing bank reserves; to slow it down, it can raise interest rates.
Concept Check 8: Suppose the Fed wants to maintain low interest rates, as an intermediate target of monetary policy? What is the monetarist argument against interest rates as an intermediate target? (Hint: What must the Fed do in order to maintain low interest rates? Look at Chapter 27. Answer at end of chapter.)
Answer: The only way to maintain low interest rates is to allow the money supply to grow. According to the monetarists the consequence is inflation, and that can only lead to increases in the nominal interest rate (which is the real interest rate plus the expected inflation rate). The attempt to get lower rates by pumping up M fails - in fact, does the opposite. Therefore, they say, it is virtually impossible to sustain an artificially low interest rate against the pressures of the market.
The monetarists argue that the Fed concentrate on monetary aggregates--M1 or preferably the broader measure M2. Their reasons are that 1) there is a stable relationship between the intermediate target M2 on one hand and output, inflation, unemployment, and other relevant economic variables on the other; and 2) the Fed is able to control M2. As you may recall from Chapter 27, monetarists stress the direct impact of real balances (the real value of the money holdings) on spending. They argue that raising the money supply raises people's real balances and result in increased spending. Want people to spend more? Give 'em more money.
Concept Check 9: In view of their belief in the power of money, why do monetarists advocate the rule of constant money growth rather than an active monetary policy? After all, by manipulating the money supply the Fed could stabilize the economy? Bring aggregate supply into your answer.
Answer: In monetarist theory the distinction between the short and long run effects is crucial. The Fed can manipulate M2 to stabilize the economy only in the short run. In the longer run workers will notice the price changes that are an inevitable consequence of changes in the money supply. They will adjust their expectations, alter their wage demands, and cause the aggregate supply curve to shift. The shifting continues until total output and unemployment have returned to their "natural" levels. Thus, in the long run the aggregate supply curve reacts, eliminating any real effect that the monetary policy had at first.
New classical economists tend to follow the monetarist argument, but some do not. Those who do agree that changes in the money supply can have a powerful influence on output, but only if changes are not anticipated by workers. As soon as workers catch on (which they do quickly if their expectations are rational), aggregate supply shifts in to eliminate the initial positive effect on output. The agents in the economy play the game smarter under new classical assumptions, catching on quicker to policies the Fed is attempting, and outsmarting the policies. Some new classicals have recently argued that money does not matter much and that the more important shocks to the economy are changes in productivity and other supply-side considerations.
To review the historical record of monetary policy, consider the graphs in Figures 36-8 and 9, depicting movements in interest rates and growth rates of the money supply. The highlighted bars indicate periods of recession.
Figure 33-8. Long and short term interest rates in the U.S., 1973 to 2005
Caption: Most remarkable in this graph is the upsurge in interest rates around 1980. That also happened to be the period in which the Fed followed a monetarist regime. The highlighted bars show recessions.
Figure 33-9. Growth rates of the U.S. money supply (M2), 1973 to 2005
Caption: After 1975 M2 grew at an accelerated rate. Around 1980, the period of the monetarist regime, the growth rates stabilized. After an acceleration in the early 1980s the growth rate came down. Yet, the interest rates came down as well (see Figure 33-8).
During the 1970s the Federal Reserve pursued an active Keynesian monetary policy. The policy shows in the gyrations of the interest rates, which were manipulated to affect investment. The intermediate target was the federal funds rate, which is the rate that banks charge each other for overnight loans. The main policy instrument during the decade was open market operations. The interest rate climbed before recessions and dropped after the recession had begun. Money growth fluctuated as well, but as a side effectof the interest policy than as the result of purposeful action.
In October 1979 the Federal Reserve switched targets. The Keynesian target of the federal funds rate was replaced with the monetarist target of the monetary aggregates. The intent was to manipulate bank reserves through open market transactions so that money growth would remain within a preset range, 3 to 6 % for M1 and 5 to 8 % for M2. The consequences are clearly visible. While the money growth was reasonably stable the interest rates fluctuated wildly--since smoothing them was no longer the target. Note in Figure 33-8 that short-term interest rates exceeded long term rates, a sign that the market for short term assets was unusually tight. Chapters 29 and 30 tell the story further: inflation came down but at the expense of two recessions in quick succession and a steep increase in the unemployment rate--just what the Phillips curve would have predicted.
By the beginning of 1982 inflation had returned to an acceptable level of 4 percent; the worst of the recession seemed over. But the Federal Reserve had also learned that keeping money growth in the stipulated range was difficult. A few times it had missed the targets. The financial community was annoyed by the uncertainty of interest rates. In the summer of 1982 Volcker and his colleagues decided to abandon a strict monetarist policy. Money growth accelerated for a few years (see Figure 33-9), causing Friedman to predict accelerating inflation. But inflation did not accelerate. Friedman missed the mark again when he predicted a recession to come in 1987, after a sharp decrease in the growth rate of the money supply. Like the earlier failures of Keynesian predictions, it did not help the credibility of the monetarist approach to monetary policy.
Concept Check 10: Use the distincion between nominal and real interest rates, as defined in chapter 22, to explain that interest rates fell in the second part of the eighties in spite of the declining growth rate of the money supply.
Answer: Nominal interest rates equal the real interest rates plus expected inflation. Nominal rates are the observed ones (they are recorded in Figure 33-8). Since inflation stayed low, you'd expect inflationary expectations to come down. As long as real interest rates did not go up too much, lower expected inflation drives down nominal rates.
In the 1990s, under the chairmanship of Alan Greenspan, the Fed returned to the old policy of the interest rate as its intermediate target. In 1991, with the economy going into a recession, the Fed lowered its discount rate three times, from 6.5 percent to 4 percent and got the federal funds rate down from 6.9 percent to 4.4 percent. But the decrease in short term interest rates did not immediately produce a similar decrease in the long term rates, as Figure 33-8 shows. Because long term rates are most relevant to home-buyers and business investors, it is doubtful that the interest rate policy of the Fed was effective in countering the recession. In 1994 inflationary expectations compelled the Fed to raise interest rates. In this case long term interest rates followed suit.
Concept Check 11: How can the Fed increase interest rates? (Answer at the end of chapter.)
Answer: The Fed can increase the federal funds rate by selling Treasury bills to banks. The move will tighten the market for bank reserves, causing the federal funds rate to go up. The Fed can only hope that the increase in the federal funds rate leads to an increase in long term interest rates; the relationship is not always very stable, as Figure 33-8 shows.
And so monetary policy has come into a phase of muddling through. The Fed uses a mixture of instruments and theories, without dogma and with a good deal of praying, to manage the monetary aggregates. The practice is unsatisfactory from a theoretical point of view. But in the absence of rock-solid theory the muddling does not look so bad. In view of our uncertainties about the economy--the new classicals have taught us to not believe we are so smart--prudence is in order. Herbert Stein's pessimistic caution looks smart.
In your advice to the President as to what to do about a faltering economy, you hope for lower interest rates, at least if you subscribe to the Keynesian perspective. If you have monetarist doubts about interest rate policies, you may just as well call for a passive policy that is intent to keep the growth in the money supply predictable to provide an optimally stable environment. Both sides have plausibilities, and problems.