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How the World Achieved Consensus on Monetary Policy

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

2. How did the Federal Reserve policy produce an understanding of the


practical principles of Monetary Policy?
Paul Volcker became Chairman of the Federal Reserve Board in August 1979,
determined to take aggressive action against inflation by placing a greater
emphasis on controlling money to fight inflation. The Volcker Fed was willing
to let short-term interest rates rise (deemphasizing short term rates)
dramatically to bring inflation down. In the fall of 1979 the federal funds rate
rose by 3%. In January and February of 1980 the 30-year government bond
rate rose by 2% despite a weakening economy, reflecting the first of two
unprecedented “inflation scare” in the bond market. Causes contributed to
this included the 1979-80 oil price shock, the increase in the dollar price of
gold to $850/ounce in January, and the Soviet invasion of Afghanistan. Also,
the Fed did not want to tighten the money supply for fear of a recession. This
early 1980 inflation scare forced Fed to choose between fighting
unemployment and fighting inflation, which lost the effectiveness in the
“stop-go” policy. The Fed allowed the funds rate to rise by another 3% to
17% in March 1980. In the second quarter of 1980 Real GDP declined 10% as
a response to monetary tightening because of credit controls (recession
ended in June 1980 when the credit controls were lifted). Aggressive MP
easing that brought the federal funds rate down to 8% in July and Real GDP
growth bounced back in the 4th quarter of 1980. MP was a disaster in 1980.
The U.S. suffered a recession and destabilizing inflation scare leaving inflation
above 10% at the end of the year. Early 1981 the nominal funds rate was up
to 19% and a 9% real funds rate (average is 1-2%). The Fed wanted to
disinflate the economy without tightening interest rates further as
unemployment began to rise. In 1981, the bond market experienced a
second inflation scare. The 30-year government bond rate rose by 3% from
January to October 1981 reflecting another 3% increase in inflation
expectations. The U.S. entered a recession in 1981 and the Fed responded
differently than it did in 1980. The Fed pursued deliberate disinflation in
1981-82 by keeping a tight monetary policy even as the recession deepens.
By 1982 inflation fell to 5% by the first quarter. The Fed persisted with a 9%
real funds rate until interest rates on long-term bonds began to fall from its
peak at 14% in the summer of 1982 (shows credibility for its disinflation).
The Fed eased monetary policy and in November of 1982 the recession
ended with 10% UR, 4% inflation, and long-term interest rate on bonds at
10%.
Volcker disinflation taught the following lessons that are among the founding
practical principals of the new consensus Monetary policy: 1) MP alone
(without wage, price, or credit controls, and without fiscal policy) could
reduce inflation permanently at the cost to output and employment that,
while substantial, was far less than in common Keynesian scenarios. 2) A
“stand alone” central bank can acquire credibility for low inflation without
institutional mandate from a government. 3) A well-timed aggressive interest
rate tightening can reduce inflation expectations and resurgence of inflation
without creating a recession.
Greenspan was Chairman of the Fed from 1987-2006.
How the World Achieved Consensus on Monetary Policy
by Marvin Goodfriend

3. How did formal institutional support abroad for targeting low


inflation follow from an international acceptance of these ideas?
Inflation Targeting Regimes characteristics: 1) Central bank announces
explicit numerical inflation target. 2) Patience in reversing inflationary shock
to minimize adverse effects on employment. 3) Transparency of central bank
concerns and intentions about the economy and interest rate policy. 4)
Formal governance mechanisms designed to hold a central bank accountable
for inflation outcomes.
After the Volcker Fed demonstrated its power over inflation, other countries
began to adopt “inflation targets” to bring down inflation from previously
high levels.
Examples: New Zealand (1990, Canada (1991), Sweden and United Kingdom
(1992). After the collapse of the fixed exchange rate at the end of the
decade, many emerging market economies adopted inflation targeting (Korea
1998, Thailand 2000, and the Philippines 2002). The IMF used inflation
targeting after Brazil’s dollar peg collapsed in 1999.

4. How did a consensus theoretical model develop in academia?


Early work in the 1970’s encouraged the Volcker Fed to act against inflation
and academic economists built on earlier work in the light of evidence
generated by the Volcker disinflation as components of theoretical framework
for the MP analysis in the 1990s. The monetarist and rational expectations
economists of the 1970s were influential because it offered a way out of the
inflationary chaos of the 1970s through monetary policy alone (instead of the
nonmonetary options that failed to control inflation i.e. wage, price, and
credit controls). Volcker took monetarist advice (Friedman, Meltzer, and
Brunner) by targeting money growth tightly in October 1979 and in 1981 to
deliberately disinflate the economy.
The consensus model that emerged in the mid to late 1990s was from
advances in rational expectations econometrics, analysis of real business
cycles, modeling of interest rate policy, and modeling of dynamic relationship
between inflation and unemployment. Foundations included from the 1980’s
that prices were marked up over costs, there was a natural rate of
unemployment (output equals potential), inflation accelerates when output is
expected to exceed potential (inflation decelerates when output is expected
to fall short of potential).
Stanley Fischer, John Taylor, and Guillermo Calvo pioneered models of
dynamic forward-looking wage and price setting (Staggered sticky price
setting).

5. How the Consensus theory supports monetary policy practice


Reinforces 4 main advances: 1) priority for price stability. 2) Targeting of
core rather than headline inflation. 3) Importance of credibility for low
inflation. 4) Preemptive interest rate policy supported by transparent
objectives and procedures.

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