This is the final essay that I wrote for my Economics and Public Policy Synthesis. It can be considered useful for someone looking for an introduction to central banking, monetary economics, or some of the recent plans and Fed policies.
Introduction
Introduction
Monetary economics is one of the most popular fields in economics. This is likely due to its prominent position as the creators of domestic economic prosperity. Central bankers, of course, do nothing of the sort. They do not harvest any wheat, forge any iron, or create any future endeavors. Monetary policy does not do anything which creates or provides real working capital. Central bankers simply manage the aggregates of fiduciary media and attempt to influence credit conditions. Naturally, as the medium is generally the denominator to most exchanges, its condition is a sensitive matter to the general health of any economy.
This essay seeks to explain the legal genesis for the monetary framework in the United States. It will show how those laws have been changed and how those changes have driven policy decisions. It will show major economic arguments for and against active monetary policy, and a survey of some major modern monetary economic policies as advised by leading voices in the field. Martin Feldstein proposes monitoring growth by using monetary aggregates. John B. Taylor offers his own rule and current Federal Reserve Board Chairman Benjamin S. Bernanke pursues a policy of inflation targeting. All of these can be considered viable ways of conducting monetary policy, and comparing them will give us an idea of the range of ideas amongst serious monetary economists.
There are a growing number of voices concerned with whether a central bank can or should endeavor to use monetary growth to stimulate economic growth. Many of these criticisms are valid, but it should be understood that this essay and the theories that it relays are within the sphere of Keynesian or Monetarist economics. There will be a rebuttal to Keynes in the academic section of this essay, but that will be the limits of the criticism. This is not done to undermine critics, but rather to focus on current monetary policies. Ultimately this essay will conclude with policy recommendations which will be based on the available information.
The Legal Framework of Monetary Policy and Mechanisms
Monetary policy is not new. It could be said that any institution or individual issuing anything that is used as money is practicing monetary policy by their very action. Gold functions as one of the oldest token for capital in trade as a store of value. Governments would endeavor to find and mine more of it, mostly without success. Those that did find success found only inflated prices as the actual value of gold declined with increased supply. (Barnes, 237) Governments attempting to create versions of nominal value policies are not new either. The most recent and common way is to go off the gold standard and create paper money policies, even if only temporarily. (Barnes, 704)
The United States Constitution confers upon Congress the ability “to coin money, regulate the value thereof.” (U.S. Const. Art. I, § 8) It is the third central bank of the United States (U.S.) and the first not to be given a timed charter. The constitutionality of central banking has been debated back to the signers of the Constitution. The Supreme Court ruled in McCulloch v. Maryland that Congress did have the authority to create a central bank under the necessary and proper clause. (Hammond, 263) In 1913, Congress passed The Federal Reserve Act which created the Federal Reserve System (Fed). (Meltzer, 75)
The Federal Reserve Act laid out a range of Reserve Banks that were to be established. (Federal Reserve Act §1) It compelled any bank organized under the National Bank Act to “to subscribe to the capital stock of such Federal reserve bank in a sum equal to six per centum of the paid-up capital stock and surplus of such bank, one-sixth of the subscription to be payable on call of the organization committee or of the Federal Reserve Board, one-sixth within three months and one-sixth within six months thereafter, and the remainder of the subscription, or any part thereof, shall be subject to call when deemed necessary by the Federal Reserve Board, said payments to be in gold or gold certificates.” (Federal Reserve Act, 2) This outlines that Reserve Banks will be owned by their member banks with restricted property rights.
The Federal Reserve Act also lays out the means by which Reserve Bank Presidents, Governors, Directors, and other positions are to be chosen and their organizational function. (Federal Reserve Act §4) The methods by which stock will be created in the private Reserve Banks and how profits may be divided up is also explained. (Federal Reserve Act §7) The Fed Board of Governors is created and given authority over the Reserve Banks. (Federal Reserve Act §10) In practice, the early Fed Banks had large degrees of autonomy. (Meltzer, 75)
The Act creates Federal Reserve Notes, or as they are commonly called today, Dollars. “Federal reserve notes, to be issued at the discretion, of the Federal Reserve Board for the purpose of making advances to Federal Reserve banks through the Federal reserve agents as hereinafter set forth and for no other purpose, are hereby authorized. The said notes shall be obligations of the United States and shall be receivable by all national and member banks and Federal reserve banks and for all taxes, customs, and other public dues.” (Federal Reserve Act, 17) This made the Federal Reserve Note legal tender. The Act also enables the Fed Board to determine the rate of interest that Fed Banks charge member banks on loans and other terms of those loans.
Much of this legislation has been amended, struck, or super ceded by more recent statutes. This initial act of Congress authorized discretion in terms of monetary policy, albeit less discretion than there is today. They were authorized to issue notes with a degree of discretion, but still had to be mindful of gold reserves. Thus, the early Federal Reserve can be considered to have always been working with real values. The Federal Reserve Act sets reserve requirements and that has since become discretionary as well.
Early Fed policies were constrained by the notes convertibility to gold, but that was eroded in a series of government actions. The first shock came during the bank panic of 1933. President Franklin Roosevelt issued a bank holiday and ordered excess deposits of gold (save for industrial or coin collecting purposes) to be collected by the Fed Banks. (Roosevelt, 111) Roosevelt then devalued the dollar in terms of gold. (Meltzer, 456) The Federal Open Market Committee (F.O.M.C.) was started by the Banking Act of 1933 to work directly within the markets and limited Reserve Banks to only perform activities in the market as directed by the committee. (12 U.S.C. §263)
Nixon would eventually take the United States off the gold standard completely in 1971. During his address titled “The Challenge of Peace,” Nixon said “we must protect the dollar from the attacks of international money speculators.” (Nixon, 886) That protection of the dollar came in the form of turning it into a fiat currency. This made it completely dependent upon the monetary policy of the Federal Reserve System. The Federal Reserve Reform Act of 1977 redefined the Fed’s guidelines for monetary policies which are largely still in place today. “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” (12 U.S.C. §225a)
A Public Choice Approach to the Federal Reserve System
An interesting way to analyze Central Banks and Central Bankers is from the public choice perspective. Basic public choice theory states that all individuals are actors with goals. There are three groupings in the model: politicians, who seek votes; voters who are rent seeking; and bureaucrats, who seek budget maximization. In the United States, the Fed System is a public and private endeavor, so the line might not even be clear even after an application of the logic. The Fed policymakers are not elected by the public and thus are not politicians. It could be argued that, at least, the Board Members are bureaucrats. Are they a good example of this? Are they attempting to budget maximize? It can be difficult to understand this because they do not receive their funding from the U.S. Congress, but rather from Reserve Banks. The Reserve Banks are quasi-private-public institutions in that they are private, but heavily regulated by the Board which is public. Could the Fed Board then be considered as politicians for their banks which would then be voters within the public choice lingo? This is not perfect because despite the fact that they receive their funding from Reserve Banks, they are not elected by them. They are chosen by the President of the U.S. (and confirmed by the Senate).
Let us, then, focus on the rest of the F.O.M.C., which votes on most monetary policy. This committee is made up of the seven Federal Reserve Board members, but also the President of the Federal Reserve Bank of New York and a rotating membership of the other 11 Reserve Bank Presidents for a total of 12 members. These Reserve Bank Presidents are selected by their Reserve Bank Board of Directors whose membership is comprised of three classes of directors, two of which are elected by member banks; one to represent the banks and the other to represent the public. The third class is appointed by the Board of Governors. ("Board of Directors")
It can be said that the Fed Board members have a confused position within the public choice framework and it is unclear what their true position and behavior will be predicted. This is due to the split nature of their origin and their budget, both of which contribute to behavior in the public choice model. The Presidents are part pure politicians and part bureaucrat/politicians. One third of their voting body is directed to represent member banks, another third to represent the public (as voted on by member banks so it can be said that they will represent the public, but not to be unrepresentative of the member bank voters to which they owe their origin). These thirds can be seen as political in nature or even as a regulated cartel of sorts because the voters are not of the public but private members. The final third, appointed by the Fed Board, can be seen as a feedback mechanism for the true control of the bank, and in this capacity they can be seen as lower level bureaucrats. This, again, makes for an impossibly skewed vision within the public choice model. It will take further study to truly determine the nature of the Federal Reserve System within a public choice frame work, and possibly an amendment to the model.
Academic Origins of Modern Monetary Policy
Central Banks have existed since the seventeenth century, but have not always had a monopoly on regulating the value of currency. The first and second central banks of the United States had the U.S. government as their exclusive client, and as such their notes were accepted by the government for taxation. While these gave the first two central banks significant competitive advantages, the fact that they were still on the gold standard meant that their internal fractional reserve system had to be responsible to their customer’s demand for convertibility. In this sense, early central banks did not engage in monetary policy as is observed today because they still worked in real values and only governments, when they would vote to suspend the gold standard or to devalue their currencies, would practice monetary policy as would be observed today. Though not for the aims that is stated today.
The leading advocate for modern macroeconomic policy was John Maynard Keynes. In his landmark book, The General Theory of Employment, Interest and Money, Keynes seeks to define a relationship between employment and aggregate demand. This work stands in contrast to most of classical economics. He writes that classical economists have not been able to allow for the “involuntarily unemployed.” (Keynes, 6) He then goes through the four ways to increase employment as suggested by A. C. Pigou: improved organization, lower wages, increased marginal productivity of given labor, and lastly, “an increase in the price of non-wage-goods compared with the price of wage-goods, associated with a shift in the expenditure of non-wage-earners from wage-goods to non-wage-goods.” (Keynes, 7)
The final way is an argument for an inflation of prices to help with the issue of wage price stickiness during periods of contraction or weak demand. The basic premise of the General Theory is that classical theorists have failed in their description of the market because they have failed to allow for differing behaviors relating to nominal price changes. If a general nominal price increase can occur, then real wage prices can fall without a corresponding fall in supply. He writes that although workers will not accept a reduction in nominal wages without a corresponding reduction in supply, but they will accept a reduction in real wages. (Keynes, 9)
He writes, “Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labour willing to work for it at that wage would be greater than the existing volume of employment.” (Keynes 14) The amount of workers that are employed, merely as a function of inflation, are defined as Keynes’ would-be involuntarily unemployed. This encourages the pursuit of an optimal level of inflation. It also lays the burden of this class of individuals, the would-be unemployed, as logically dependent upon the actions of a central banker.
Classical economists have long postulated that a decrease in demand must have a corresponding decrease in price if the supply is to remain constant. This is foundational to the linear supply - demand understanding of economics. Keynes writes that this is incorrect and that there can be a market failure of “effective demand.” (Keynes 23) Keynes writes that demand is a function of employment in his equation of aggregate demand: D = f (N) where D is demand and it is equal to a function of N, the number of employed individuals. It relates to his aggregate supply function Z = ϕ (N) where Z is the aggregate supply price and it is equal to the amount of labor which entrepreneurs decide to employ. The point at which these equations meet is the effective demand. (Keynes, 25) He restates the effective demand in another way as D1 + D2 = D where D1 is the relationship between the community’s income and what it can be expected to consume and D2 is the amount expected to be invested. Ultimately he states that the aggregate supply function of employment is equal to this effective demand. D = ϕ (N). (Keynes, 29) He also writes about the marginal efficiency of capital, but his theory sounds strikingly similar to the familiar marginal costs equal marginal revenues. “The relation between the prospective yield of one more unit of that type of capital and the cost of producing that unit, furnishes us with the marginal efficiency of capital.” (Keynes 135)
He also restates Say’s Law in an interesting way, “supply creates its own demand.” (Keynes, 18) Keynes transposes the phrase as f (N) = ϕ (N) for all points on the demand curve. Starting from this, he means that a central banker can increase the supply of money to create demand. Large tracts of modern economics falls from this reasoning that the government, whether through stimulus or central banking, can and should stimulate the economy to mitigate negative effects of the so-called business cycle.
One of the first to give a serious review of Keynes’ General Theory was Economist J. R. Hicks. Hicks invented what has since become called the IS/LM model (originally IS/LL) as an explanation of the relationship between outputs (horizontal axis) and interest rates (vertical axis). The IS curve describes a schedule of investment and savings equilibriums. The LM curve describes a schedule of liquidity preference and money supply equilibriums. When these two curves form equilibrium between outputs and interest rates it is called the General Equilibrium. (Hicks, 148-153)
Economist Robert Mundell used the IS/LM model to show a fall in the real rate of interest under conditions of inflation. Figure one shows the traditional IS/LM model with reference points for R and T. It is supposed that individuals would only offer T loans for R returns as not to receive negative profits under expectations of Keynesian inflation. In this working of the model, the supply of investments is diminished by expectations of inflation. (Mundell, 281)
Figure 1
Keynes’ General Theory attracted large amounts of praise and considerable amounts of criticism. Hicks referred to it as Keynes’ “special theory” and that it was merely the economics of the depression. (Hicks, 152, 155) The leading critic was Friedrich Hayek who wrote a competing book shortly after, The Pure Theory of Capital. In it he states that Keynes would add capital to stimulate absolute demand in a contracting economy, but that only relative demand would change. Overall, he argues that Keynes analyses changes in demand in nominal terms but that analysis in real terms is superior. (Hayek, 70)
The statement that supply creates its own demand is actually a bit different than Say’s Law and has become a famous turn of phrase in its own regard. Say’s Law means that we do not actually pay for goods and services with money, but rather with other goods and services. The money is only for transaction purposes and is actually somewhat superfluous, save for arbitrage. “Supply” is usually taken to mean actual product. Keynes’ supposition that if a central banker increases the amount of money, it will stimulate demand is to supplant money for product within Say’s logic. If Say’s original intent was to remove money from the reader’s concept of transactions, then it is a perversion to try and reintroduce it “supply.”
Milton Friedman was also one of the most important monetary economists in history. He viewed an active monetary policy as negative and preferred rules to govern central banks. (Friedman, 13) In his landmark essay, “The Role of Monetary Policy,” Friedman states that there are two items that monetary policy cannot do and two that it can. The first that it cannot do is the pegging of interest rates. When people are induced to hold a larger quantity of money by bidding down interest rates, they initially increase the quantity of money, but the increased spending and incomes eventually begin to bid up interest rates as demand for loans increases and the inflation of prices is also a reduction in the real quantity of money. Friedman, 6) The second thing that it cannot do is target an unemployment rate. There can be considered a natural level of employment within a structure of real wage rates and any attempt to create excess demand moves those natural wage rates higher. (Friedman, 6) Then he references the well-known Phillips Curve, in which A. W. Phillips offers additional insights of inflation, and unemployment are likely to have an inverse relationship. (Phillips, 283)
Friedman writes that monetary policy can do something. It can ensure that money does not get in the way of economic growth and provide a stable background for the economy. (Friedman, 12) He quotes John Stuart Mill to explain the idea more fully, “There cannot, in short, be intrinsically a more insignificant thing, in the economy of society, than money; except in the character of a contrivance for sparing time and labour. It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order.” (Mill, 488) Friedman instructs that policy makers should only guide themselves by magnitudes that they can control. “Attempting to control directly the price level is therefore likely to make monetary policy itself a source of economic disturbance because of false starts and stops.” (Friedman, 15)
Modern Monetary Policies
Martin Feldstein and Nominal GDP Targeting through Monetary Aggregates
Most modern monetary policies are used to target one thing or another. Martin Feldstein targets nominal GDP by using the M2 aggregate. In an essay written in the 1990’s with James Stock, he observes that the relationship between the M2 and nominal GDP is sufficiently strong. (Mankiw [Ed.], 7)
Feldstein and Stock, like most would-be potential bankers, are concerned with price stability and reducing the gap between actual and potential GDP. (Mankiw [Ed.], 9) They are also concerned with ending the judgmental eclecticism by interjecting rules into their decisions, but they are not explicit. (Mankiw [Ed.], 11) They prefer basing judgment on econometric models rather than professional forecasters. (Mankiw [Ed.], 13) This is, in part due to their agreement with Milton Friedman that the Fed has a significant bias towards inflation. (Mankiw [Ed.], 14) One of their rules, which allows for feedback on the growth of M2 in response to nominal GDP, is as follows:
“Where µx is the target growth rate of nominal GDP, µm is the mean money-growth rate, and 0 < λ < 1. Thus money growth adjusts by a fraction λ when realized GDP growth in the previous quarter deviates from its target value by the amount µx – xt-1.” (Mankiw [Ed.], 46)
That is,
Where:
Both John B. Taylor and Bennett McCallum reviewed Feldstein and Stock’s essay. Both were reasonably impressed by the link between nominal GDP and M2, but each had concerns. Taylor was mostly interested in critiquing assumptions of the models, such as the lack of allowance for international capital mobility or exchange-rate policy. He was also critical of their focus on nominal GDP growth rather than inflation and real GDP. (Mankiw [Ed.], 63) McCallum praised a technical innovation, and noted that it was similar to his own work. He noticed differences such as GDP target misses being treated as bygone mistakes rather than mistakes needing corrective action. (Mankiw [Ed.], 67) Secondly, he argues that M2 is not a controllable instrument because it is not on the Fed’s balance sheet.
Benjamin S. Bernanke and Inflation Targeting
Benjamin S. Bernanke is the current Chair of the Federal Reserve Board. (Bernanke, Monetary Policy, 1) He is the most prominent academic author of the present system of inflation targeting. He has long argued that the Federal Funds Rate has a large influence on short-run fluctuations rather than non-policy influences. He makes three arguments for the system. First, inflation targeting seeks to affect the long run inflation rate, because he is hesitant about their abilities to affect short term inflation rates. Second, even moderate inflation is harmful to economic efficiency. Third, price stability should be the long-term goal of the Fed. (Bernanke, et all [1999], 10)
He also writes of the benefits of low inflation, “Strictly speaking, inflation is a general rise in all prices, wages, and incomes. As such, it should have little or no effect on real purchasing power or the economic incentives of individuals, since a general rise in prices leaves relative prices unaffected.” (Bernanke, et all [1999], 17) He argues further, “’Price stability’ never in practice means literally zero inflation, however, but usually something closer to a 2 percent annual rate of price change.” (Bernanke, et all [1997], 99) However, he is cautious about central bankers causing high levels of inflation as well, “it appears that the benefits of expansionary policies (such as lower unemployment) are largely transitory, whereas the costs of expansionary policies (primarily inefficiencies associated with higher inflation) tend to be permanent, absent any countervailing policies.” (Bernanke, et all [1999], 14)
He is interested in announcing inflation targets which would then communicate expectations to consumers with a goal of optimizing GDP by affecting long term inflation rates. Further, he argues that by making inflation the target, it reduces the role of intermediate targets such as M2 growth or exchange rates. (Bernanke, et all [1997], 101) He cites Switzerland and Germany as countries that have pursued low inflation and have had higher unemployment and output than possible. (Bernanke, et all [1997], 105)
As for the actual target, he cites Alan Greenspan who defined price stability as one so low that nobody has to take it into account for their everyday purchases. He also relays that CPI’s may be biased upwards because of substitution issues. (Bernanke, et all [1999], 28) He finally argues that the inflation target should be 1-3%. (Bernanke, et all [1999], 30)
John B. Taylor and the Taylor Rule
John B. Taylor is one of the leading experts in monetary economics. In 1992, he released the rule which would bear his name. The Taylor Rule is a simple one that is sensitive to both inflation and real GDP. It was a good explanation of Fed policies in the late 1980’s in the beginning of the Greenspan era Fed, which was generally accepted as a period of good central bank management. Many central banks from around the world began monitoring this rule to inform their decisions. (Orphanides, 8)
Taylor would have been very happy with the outcome of other countries using his rule. In the essay that spawned the rule, Discretion Versus Policy Rules in Practice, he noted that credibility was an important ingredient to any monetary policy. It may be more useful for a central bank to use rules rather than discretion, if their credibility was low. (Taylor 196) In nations with very low central bank credibility, gold, fixed exchange rates, and other methods are commonly used. Taylor suggests that firm rules may have similarly positive effects on credibility when money users were able to observe their stabilizing effects.
The Taylor Rule is as follows:
r = p + .5 y + .5 (p – 2) + 2
Where:
r is the Federal Funds Rate
p is the rate of inflation over the previous four quarters
y is the percent deviation of real GDP from a target.
That is,
y = 100 (Y – Y*) / Y*
Where:
Y is real GDP
Y* is trend real GDP
Figure Two
According to economist and Cyprus Central Bank governor, Athanasios Orphanedes, this rule proved to be a very stabilizing one for countries that followed it. It has come to replace the LM curve within Hicks’ IS/LM equilibrium and only runs into problems when approaching the 0 bound. (Orphanedes, 9) Another issue with the Taylor Rule is the issue of predicting or preempting major economic movements because the Taylor Rule lags in practice. (Orphanedes, 12)
There is also some debate about the coefficients in the Taylor Rule. Ben Bernanke says, “some empirical and simulation evidence suggests that the responsiveness of policy to the output gap, given by parameter b (the .5 coefficient to y) in the Taylor rule equation, should be higher the value of 0.5 originally chosen by Taylor. Higher values of b lead the Taylor rule to recommend somewhat lower policy rates during recessions and their aftermaths.” (Bernanke, Monetary Policy, 8)
Conclusions: Rules or Discretion?
There is some debate about whether monetary policies should be created from the discretion of policy makers or rules. Surely all policy stems from rules, but current Federal Reserve Policy follow rules that allow for the discretion of policy makers. This does not end the debate, because it was not one of semantics. The debate should be refined to be for firm rules or soft rules. A firm rule would be an action that is created as result of the logic of the rule, and without additional input from policy makers. A soft rule would be a set of aims which guide policy makers in a real way but do not constrain their ability to act as they see fit.
Milton Friedman argued for rules and cites the monetary authority’s propensity to overreact, delays between actions and effects in the economy as reasoning for hard rules. (Friedman, 16) Most other monetary economists advise against firm rules. Even self-described ‘New Monetarists’ acknowledge that frameworks are better than rules. Stephen Williamson and Randall Wright write, “No single model should be an all-purpose vehicle for dealing with every question in monetary economics.” (Williamson and Wright, 3) John Taylor writes of the growing consensus, “Even some of those who have advocated the use of rules in the past seem to have concluded that discretion is the only answer.” (Taylor, 197)
So if discretion is necessary in the face of unexpected shocks, why can’t a firm rule allow for discretion at some form of majority? This potential firm rule ensures that rules (such as the Taylor Rule) are followed under almost all situations, but allow for consensus (or super majority) overrides, and abrupt changes. Despite the fact that Fed players were not able to be clearly defined within the Public Choice definitions, it can be observed in Figure Two that policy makers cut targeted interest rates too often and too quickly. Then they are not quick enough to raise them. The long term effects of this inflation are, naturally, a substantial loss of value. Unsophisticated investors, or anyone using a savings account, are penalized every year by inflation targeting. Are sticky wage and search issues worth this constant inflation?
Central Bankers from the Fed to Sweden are even dropping interest rates below zero using methods such as quantitative easing or actually lowering lending rates below zero. (Svensson) The breaking of this zero bound may be exciting to Keynesian central bankers (Bernanke Reinhart and Sack, 7), but it breaks through a limit to inflationary pressures. All of this is done as a way of preventing deflation in the face of falling output but one wonders about the long term effects of inflation for policies made in response to potentially shorter term falls in asset prices. (Bernanke and Gertler, 253) John B. Taylor warns that “The Fed is now operating a completely unprecedented policy regime.” (Ciorciari and Taylor [Ed.], 85)
Because the Constitution gives Congress the right to regulate the value of the dollar, it can redefine the rules of the Central Bank as it sees fit. Rules have been shown in studies to be a better guard of value and output than discretion. Therefore, they should be used. Because price fluctuations and shocks are a semi-regular part of life, Central Bankers need discretion to smooth out liquidity crises. Having a firm rule that allows for a combination of these goals is a worthy aim.
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