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by Marvin Goodfriend
1. Describe the ‘muddle state of affairs’ in the late 1970’s in both
theory and practice.
The late 1970’s was a confusion time for monetary policy. Theoreticians
were not sure how to conduct MP while central bankers who practice it were
not sure what to do. In practice, Central banks pursued “stop-go” MP in
response to balance public concerns between inflation and unemployment.
Central banks would stimulate employment during the “go” phase until rising
inflation came, then they would switch to “stop” MP with aggressive interest
rates to bring down inflation, while employment rates moved higher with a
lag. This pursuit of low unemployment and fighting inflation when it became
a predominant public concern increased the volatility of both inflation and
output. Another contribution to the disarray of the time is the 1960’s long-
run Philips Curve trade-off between inflation and unemployment. Arthur
Burns (head of the Fed from 1970-1978) was a proponent of the Phillips
Curve along with Okun. Central bankers allowed inflation to drift upward in
hopes of achieving lower unemployment levels. Other contributions such as
the productivity growth slowdown in the 1970s and oil price shocks that
occurred in 1973-74 and 1979-80 worsened the inflation problem. The
collapse of political institutions also contributed. Under the Bretton Woods
System, countries agreed to a fixed exchange rate but the “stop-go” policy
was not compatible with the maintenance of gold convertibility.
Milton Friedman, Karl Brunner and Allan Meltzer are monetarist economists
who show three ways (highly controversial at the time) that central banks
have the MP tools to act decisively against inflation. 1) International evidence
showed that even if short-term inflation can be affected by many factors,
long-term sustained inflation is always associated with excessive money
growth. 2) Developed the theory of money demand and supporting
econometric evidence to show that control of money is both necessary and
sufficient to control the trend rate of inflation. 3) They argued that a central
bank could exercise sufficient control over money to control inflation through
its monopoly on currency and bank reserves, even if fluctuations in demand
for money were hard to predict.
How the World Achieved Consensus on Monetary Policy
by Marvin Goodfriend