|
|
Enron Mail |
<
< < Dr. Levine: < I found this article quite useful in understanding the evolution of < the U.S. monetary policy. Do you think this is appropriate for the < entire class? < Thanks, < < -Jay Iyer < < http://www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-04.html < < < Economic Research < < < < < < < FRBSF Economic Letter < < < < < < < Number 99-04; January 29, 1999 < < < < < < ---------- < < <../index.htm<Economic Letter Index < < The Goals of U.S. Monetary Policy < * The evolution of the Fed's legislative mandate < * The debate about the Fed's current mandate < * References < < ---------- < The Federal Reserve has seen its legislative mandate for monetary policy < change several times since its founding in 1913, when macroeconomic policy as < such was not clearly understood. The most recent revisions were in 1977 and < 1978, and they require the Fed to promote both price stability and full < employment. The past changes in the mandate appear to reflect both economic < events in the U.S. and advances in understanding how the economy functions. < In the twenty years since the Fed's mandate was last changed, there have been < further important economic developments as well as refinements in economic < thought, and these raise the issue of whether to modify the goals for U.S. < monetary policy once again. Indeed, a number of other countries--notably < those that adopted the Euro as a common curency at the start of this < year--have accepted price stability as the new primary goal for their < monetary policies. < < In this Letter, we spell out the evolution of the legislation governing U.S. < monetary policy goals and summarize the debate about whether they could be < improved. < < The evolution of the Fed's legislative mandate < < The Federal Reserve Act of 1913 did not incorporate any macroeconomic goals < for monetary policy, but instead required the Fed to "provide an elastic < currency." This meant that the Fed should help the economy avoid the < financial panics and bank runs that plagued the 19th century by serving as a < "lender of last resort," which involved making loans directly to depository < institutions through the discount windows of the Reserve Banks. During this < early period, most of the actions of monetary policy that affected the macro < economy were determined by the U.S. government's adherence to the gold < standard. < < The trauma of the Great Depression, coupled with the insights of Keynes < (1936), led to an acknowledgment of the obligation of the federal government < to prevent recessions. The Employment Act of 1946 was the first legislative < statement of these macroeconomic policy goals. Although it did not < specifically mention the Federal Reserve, it required the federal government < in general to foster "conditions under which there will be afforded useful < employment opportunities ... for those able, willing, and seeking to work, < and to promote maximum employment, production, and purchasing power." < < The Great Inflation of the 1970s was the next major U.S. economic < dislocation. This problem was addressed in a 1977 amendment to the Federal < Reserve Act, which provided the first explicit recognition of price stability < as a national policy goal. The amended Act states that the Fed "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." The goals of "stable prices" and < "moderate long-term interest rates" are related because nominal interest < rates are boosted by a premium over real rates equal to expected future < inflation. Thus, "stable prices" will typically produce long-term interest < rates that are "moderate." < < The objective of "maximum" employment remained intact from the 1946 < Employment Act; however, the interpretation of this term may have changed < during the intervening 30 years. Immediately after World War II, when < conscription and price controls had produced a high-pressure economy with < very low unemployment in the U.S., some perhaps believed that the goal of < "maximum" employment could be taken in its mathematical sense to mean the < highest possible level of employment. However, by the second half of the < 1970s, it was well understood that some "frictional" unemployment, which < involves the search for new jobs and the transition between occupations, is a < necessary accompaniment to the proper functioning of the economy in the long < run. < < This understanding went hand in hand in the latter half of the 1970s with a < general acceptance of the Natural Rate Hypothesis, which implies that if < policy were to try to keep employment above its long-run trend permanently < or, equivalently, the unemployment rate below its natural rate, then < inflation would be pushed higher and higher. Policy can temporarily reduce the < unemployment rate below its natural rate or, equivalently, boost employment < above its long-run trend. However, persistently attempting to maintain < "maximum" employment that is above its long-run level would not be consistent < with the goal of stable prices. < < Thus, in order for maximum employment and stable prices to be mutually < consistent goals, maximum employment should be interpreted as meaning maximum < sustainable employment, referred to also as "full employment." Moreover, < although the Fed has little if any influence on the long-run level of < employment, it can attempt to smooth out short-run fluctuations. Accordingly, < promoting full employment can be interpreted as a countercyclical monetary < policy in which the Fed aims to smooth out the amplitude of the business < cycle. < < This interpretation of the Fed's mandate was later confirmed in the < Humphrey-Hawkins legislation. As its official title--the Full Employment and < Balanced Growth Act of 1978--clearly implies, this legislation mandates the < federal government generally to "...promote full employment and production, < increased real income, balanced growth, a balanced Federal budget, adequate < productivity growth, proper attention to national priorities, achievement of < an improved trade balance . . . and reasonable price stability..." (italics < added). < < Besides clarifying the general goal of full employment, the Humphrey-Hawkins < Act also specified numerical definitions or targets. The Act specified two < initial goals: an unemployment rate of 4% for full employment and a CPI < inflation rate of 3% for price stability. These were only "interim" goals to < be achieved by 1983 and followed by a further reduction in inflation to 0% by < 1988; however, the disinflation policies during this period were not to < impede the achievement of the full-employment goal. Thereafter, the timetable < to achieve or maintain price stability and full employment was to be defined < by each year's Economic Report of the President. < < The debate about the Fed's current mandate < < The Fed then has two main legislated goals for monetary policy: promoting < full employment and promoting stable prices. With this mandate, the Fed has < helped foster the exceptional performance of the U.S. economy during the past < decade. Still, some have argued that the Fed's mandate could be improved, < especially in looking ahead to future attempts to maintain or < institutionalize recent low inflation. Much discussion has centered on two < topics: the transparency of the goals and their dual nature. < < The transparency of goals refers to the extent to which the objectives of < monetary policy are clearly defined and can be easily and obviously < understood by the public. The goal of full employment will never be very < transparent because it is not directly observed but only estimated by < economists with limited precision. For example, the 1997 Economic Report of < the President (which has authority in this matter from the Humphrey-Hawkins < Act) gives a range of 5 to 6% for the unemployment rate consistent with full < employment, with a midpoint of 5.5%. Research suggests that there is a very < wide range of uncertainty around any estimate of the natural rate, with one < prominent study finding a 95% probability that it falls in the wide range of < 4 to 7-1/2 % (see Walsh 1998). < < Price stability as a goal is also subject to some ambiguity. Recent economic < analysis has uncovered systematic biases, say, on the order of 1 percentage < point, in the CPI's measurement of inflation (see Motley 1997). In this case, < actual price stability would be consistent with measured inflation of 1%. In < addition, at any point in time, different price indexes register different < rates of inflation. Over the past year, for example, the CPI has risen about < 1-1/2%, while the GDP price index has risen about 1%. Still, a transparent < price stability goal could be specified as a precise numerical growth rate < (or range) for a particular index (which could take into account any biases). < However, economists have also suggested other ways to enhance the < transparency of policy. For example, publishing medium-term inflation < forecasts might help to clarify the direction of policy (Rudebusch and Walsh < 1998). Because the central bank has some control over inflation in the medium < term, its forecasts would contain an indication of where it wanted inflation < to go. < < A second recent proposed modification to the Fed's goals involves focusing to < a larger extent on price stability and de-emphasizing business cycle < stabilization. Some economists have argued that having dual goals will lead < to an inflation bias despite the Fed's best attempts to control inflation. < This argument stresses that the temptation to engineer gains in output in the < short run will overcome the central bank's desire to control inflation in the < long run. As a result of elevated inflation expectations of the public, < inflation will end up being higher than the central bank intended, despite < its best efforts. This "time-inconsistency" argument, as economists call it, < coupled with the pain incurred in the 1970s as inflation skyrocketed and in < the early 1980s as inflation was reduced to moderate levels, persuaded many < that the primary goal of the central bank should be to stabilize prices. < < This view is embodied in the charter for the central bank in the new European < Monetary Union: "The primary objective of the European System of Central < Banks is to maintain price stability. Without prejudice to the objective of < price stability, the ESCB shall support the general economic policies in the < Community." Among these latter policies are "a high level of employment" and < "a balanced development of economic activities." < < Economists remain divided on the importance of the time inconsistency problem < and on the need to put primary emphasis on price stability at the expense of < output stabilization. Some stress the fact that the central bank is the only < entity that can guarantee price stability, and that this goal is not likely < to be attained for long unless price stability is designated as the primary < goal. Others find the arguments for time inconsistency implausible because < policymakers, who are aware of the arguments about an inflationary bias and < see the implications for inflation, can conduct policy without an < inflationary bias (McCallum 1995). Still others argue that the abdication of < other goals is irresponsible (Fuhrer 1997). Also, a good deal of empirical < research using simulations of models of the U.S. economy suggests that a < focus on dual goals can reduce the variance of real GDP (i.e., smooth the < business cycle) while achieving an inflation goal as well (Rudebusch and < Svensson 1998). < < While these issues are not yet resolved, the experience of the past two < decades provides some support to those who think dual goals that lack < transparency can function successfully. It is true that some countries around < the world have reduced inflation over this period while putting primary < emphasis on explicit inflation targeting. But at the same time, with its < current legislative mandate, the Fed also has had success in reducing < inflation, while maintaining the flexibility of responding to business cycle < conditions. < < John P. Judd < Vice President and Associate < Director of Research < < Glenn D. Rudebusch < Research Officer < References < < Fuhrer, Jeffrey C. 1997. "Central Bank Independence and Inflation Targeting: < Monetary Policy Paradigms for the Next Millennium?" New England Economic < Review January/February, pp.20-36. < Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and < Money. Harcourt, Brace, and Company: New York. < < McCallum, Bennett. 1995. "Two Fallacies Concerning Central Bank < Independence." American Economic Review Papers and Proceedings, vol. 85, no. 2 < (May), pp. 207-211. < < Motley, Brian. 1997. "Bias in the CPI: Roughly Wrong or Precisely Wrong." < <../el97-16.htm<FRBSF Economic Letter<../el97-16.htm< 97-16 (May 23). < < Rudebusch, Glenn D., and Lars E.O. Svensson. 1998. < <http://www.iies.su.se/data/home/leosven/papers/rs.pdf<;"Policy Rules for < Inflation Targeting." NBER Working Paper 6512. < < Rudebusch Glenn D., and Carl E. Walsh. 1998. "U.S. Inflation Targeting: Pro < and Con." <../wklyltr98/el98-18.htm<FRBSF Economic < Letter<../wklyltr98/el98-18.htm< 98-18 (May 29). < < Walsh, Carl E. 1998. "The Natural Rate, NAIRU, and Monetary Policy." < <../wklyltr98/el98-28.htm<FRBSF Economic Letter < <../wklyltr98/el98-28.htm<98-28 (September 18). < < ---------- < Opinions expressed in this newsletter do not necessarily reflect the views of < the management of the Federal Reserve Bank of San Francisco or of the Board < of Governors of the Federal Reserve System. Editorial comments may be < addressed to the editor or to the author. Mail comments to: << << Research Department << Federal Reserve Bank of San Francisco << P.O. Box 7702 << San Francisco, CA 94120 < < David I. Levine Associate professor Haas School of Business ph: 510/642-1697 University of California fax: 510/643-1420 Berkeley CA 94720-1900 email: levine@haas.berkeley.edu http://web.haas.berkeley.edu/www/levine/
|