Policy Making
16. Monetary policy

Should you advise the President to rely on monetary policy instead? Figure 33-7 outlines the Tinbergen model of monetary policy.

Figure 33-7 Monetary Policy according to the Tinbergen model
  • Tastes
    • Ultimate Goals
      - High growth
      - Low unemployment
      - Low inflation
      - Domestic Stability
      - Stability in international relations
  • Constraints and Tools
    • Intermediate Targets
      - Interest rates (Keynesian prescription)
      - Money supply (monetarist prescription)
      - The exchange rate *
    • - Policy instruments
      - Open market transactions (buying and selling Treasury bills)
      - Discount rate (the rate charged by the Fed to the member banks)
      - Required reserve ratio (the ratio of certain liabilities that banks are required to keep in reserve.)
      - Foreign currency transactions (the buying and selling of foreign currencies.)

* Note that the value of the dollar on foreign currency markets can be an intermediate target in the pursuit of the goal of stability in foreign trade.

Active monetary policy is a recent practice. In the 1950s economists, mostly Keynesian then, did not expect much from it. According to Keynesian theory interest rates should be the intermediate target, but they were already very low at the time and were therefore not considered to have much effect on private investment.

Dissent came only from the University of Chicago, where first Henry Simons (formerly of the University of Iowa) and then Milton Friedman insisted on monetary policy as the only stabilization policy worth conducting. But they insisted on the money supply, and not the interest rates, as the appropriate intermediate target.

For many years Friedman's anti-Keynesian ideas were laughed at. During the early 1970s the laughing stopped, and not only because in 1976 Friedman won the Nobel prize. Frustrated with Keynesian fiscal policies or simply looking for something new, politicians turned to Friedman and his ideas. Throughout the world, monetary policy became the focus of economic policy. Governments in Chile, Israel, England, and Germany professed to follow Friedman's advice. On October 6, 1979 the United States followed suit. The Chairman of the Federal Reserve Bank, Paul Volcker, announced that the bank would stop controlling interest rates and focus on monetary aggregates instead. Friedman seemed vindicated. But only briefly. Policy makers became rapidly frustrated with the monetarist regime, especially when interest rates went through the roof. After a few years the Fed compromised by watching both interest rates and monetary aggregates.

Before jumping to the same conclusion as the policy makers, however, it's worth reviewing the arguments and the historical record.