Introduction

The motivation for this conference has been the impression of growing incomprehension between central bankers and academic monetary economists in recent years.. In some respects at least, monetary theory and central bank operating doctrines seem farther apart today than at any time previously. Among central bankers, one meets a certain impatience with the "abstract" nature of much recent theory while, in academic circles, the complaint is that central bank operations do not seem to be conducted on any understandable theoretical basis.

The engagement between policy makers and university economists seemed stronger a couple of decades ago. But there is little purpose to exaggerating the matter. Obviously, any number of central bank economists are perfectly up-to-date with recent theoretical work, just as every country has its complement of professors who know their way inside central banks. Yet, almost all who were approached about participating in the conference agreed with its premise and some did so most emphatically.

There is much to discuss. In this paper, I want to confine myself to three themes. One is the great change in the context and content of macroeconomic policy debate in the last 25 years or so. The second is the modern emphasis in academia on intertemporal equilibrium (IGE) models. It tends, on the one hand, to slight a number of traditional monetary policy concerns but has, on the other, greatly clarified a number of fundamental issues. The third is the question of the real powers of the central bank, that is, the question of under what conditions monetary policy can affect real and not only monetary magnitudes.
 

Policy Doctrines: Changing Context, Changing Content

A quarter century ago, in the waning days of the so-called Keynesian consensus, macropolicy was still stabilization policy. It was believed that the private sector was unstable but that the discretionary policies of a benevolent, competent and consistent government could maintain high employment and reasonable price stability.

This pessimism about the private sector and optimism about government of that earlier time has turned into optimism about the market and pessimism about democratic government. This great, underlying shift in beliefs and attitudes has changed the context in which monetary policy is being debated -- and, therefore, also the content of the debate.

Today, policy theory has become the art of constraining governments, of fashioning institutions to prevent politicians from violating intertemporal budget constraints and more generally from engaging in short-sighted, time-inconsistent policies that, in the end, produce only inflation. The current vogue for independent central banks pursuing low inflation targets is largely motivated by this view that governments must be forcefully restrained from mismanaging the public finances. The arguments for independence meet little dissent from within the central banks.

At the same time, in modern theory, the stability of the private sector is supposed to take care of itself. Stabilization policy, in the old sense, is regarded as a misguided ambition. This doctrine would relieve the monetary authorities of any responsibility for unemployment and the cycle. Yet, it is not one they can very well embrace.

This great change in the prevailing political economy did not occur without real reasons. It is in large part a response to the great worsening of the fiscal position of so many national governments in the 1970's and 80's. Governments saddled with large debts and running chronic deficits cannot entertain Keynesian ambitions. Keynesian economics had its beginnings in a world of failed banks, bankrupt businesses and foreclosed farms -- and perfectly sound public finances. Governments of undoubted credit worthiness, with peacetime records of always spending well below its capacity to tax, were in a position where they could borrow and spend so as to ease the liquidity constraints of an overleveraged private sector and thus stimulate aggregate activity. It would be able to do so without adding to the money supply and without necessarily causing inflation. The "functional finance" of Abba Lerner, which envisaged government surpluses in booms repaying the deficits of recessions, also kept the maintenance of the solvency of the government firmly in view.

In the "rigid wages" brand of Keynesian economics, it was envisaged that real activity could be stimulated (or dampened) simply by inflating (of deflating) nominal aggregate demand. In Monetarist theory, the real effects of monetary policy also depended on the stickiness of nominal wages. In macrotheories of this variety, the issue of the creditworthiness of governments was lost from sight. It had to be rediscovered. The work on intertemporal monetary general equilibrium models by Sargent and Wallace at Minnesota brought it back into focus.

The importance of government solvency was, however, also being forcefully demonstrated in practice by the experience with high inflation in a number of (at the time, mostly Latin American) countries. What these experiences showed was that impecunious governments, lacking credit, cannot stimulate aggregate activity. Printing money will not only produce high inflation but actually depress real activity so that disinflation and stabilization generates a growth spurt (e.g., Heymann & Leijonhufvud 1995)..

The governments of Western Europe and North America have not been in this situation, of course. But while governments with high outstanding debts and additional large unfunded liabilities may not be utterly powerless in this sense, they are in the risk zone. If the markets come to conclude that the polity of a country is unlikely ever to deal effectively with chronic deficits, interest rates on its debt will increase and the acceptable maturities shorten. In this risk zone, additional deficit spending will raise the rate of inflation and cause exchange depreciation but have little or no effect on aggregate activity and employment. And a monetary policy that monetizes past deficits will do no better.

The deterioration of the public finances of many industrialized countries up through the 1980's is thus one reason -- one good reason -- why we hear less today about macroeconomic measures to combat unemployment. But it is not the only good reason.

The industrialized economies are far more highly integrated today than they were a few decades ago. Foreign trade looms much larger in relation to GDP while capital moves freely around the world, and moves more readily, perhaps, in response to lower taxes than lower wages. For small open economies, therefore, the room for independent macroeconomic policies is all but non-existent -- and every country is "smaller" in the relevant sense than it used to be.

Other developments have contributed to changing the context and thus the content of debate. The constraints on the macropolicies that are feasible have tightened at a time when the pressures for structural change are unrelenting. Manufacturing as a source of employment is going the way that agriculture has already gone in the century now almost past -- and it is probably receding even faster, although the pace is impossible to foresee. The same forces of technological change are eliminating many traditional white-collar jobs as well.

But, if the response to the European unemployment problems of the last ten to fifteen years has been little more than pleas for more labor market "micro flexibility", the tightening feasibility constraints on macropolicy are not the only reasons. It is also, of course. that macro and monetary theory has changed and changed drastically.
 

New Theory and Old

Traditionally, monetary policy theory has had two main preoccupations: nominal anchoring and the stability of credit. The first set of questions concerns how the nominal scale of relative prices is determined and how to assure that the anchor does not drag or let go, causing inflation. These questions were more or less neglected in the older central banking literature which took a metallic standard for granted. Concern with the golden anchor that might let go promted Wicksell’s "pure credit economy" model of 1898, but the theory of inconvertible fiat money became of dominant importance first with the great inflations of the 1920's. The monetary theory of the last 25 years or so has advanced our understanding in this area very considerably. The "monetarist arithmetic" and related capital theoretic developments have, in particular, clarified the fiscal conditions of monetary stability.

At the same time, modern monetary theory represents a break with the main tradition of central banking doctrines which was concerned with controlling the credit cycle so as to avoid financial crashes and bank panics and with managing the system's reserves so that the convertibility of the bank's money into the standard commodity could almost always be defended. Today's theory assumes that the real sector of the economy is in intertemporal general equilibrium (IGE). In so doing, it in effect assumes away the problems with which older central banking theories sought to cope. The following properties of the IGE model are germane:

Whatever it is Greenspan thinks he is doing, this isn't it.
 

A Brief Retrospective

Contrast this modern theoretical framework to some older, once influential theories:

A. Wicksell

In Wicksell's 'cumulative process', competition between banks with excess reserves depresses the market rate below the real intertemporal equilibrium ('natural') rate. The result is inflation fueled by expansion of inside money.

Wicksellian theory, therefore, differs from the modern theory on two critical points, namely (1) that the market real rate of interest may differ from the equilibrium rate, and (2) that inside money plays a crucial role in explaining the time-path of the price level.

B. Gold Standard Central Banking

The central banking doctrine which evolved in the gold standard world presumed that the gradually growing world stock of gold and the private sector's gradual learning to economize on gold reserves determined the trend of the price level. But general expansions of trade and bank credit may drive prices above this trend, just as credit contractions may drive them below it. The 'trade cycle' consisted of alternating periods of 'high' and 'low' prices (relative to the equilibrium level or trend). 'High prices' would stimulate output and employment but high prices in one country relative to the rest of the world would cause an 'external drain' of reserves which in severe cases could precipitate a banking crisis.

The primary function of the central bank in this setting was to moderate the trade cycle so that the exchange rate could always be defended and banking crises avoided. The instrument for so doing was Bank Rate. A secondary function was that of 'lender of last resort', especially in those instances when an external drain was amplified by an internal drain, threatening a general bank panic.

C. Mises & Hayek

The monetary cycle theory of the Austrians hypothesized that the lowering of the real rate of interest associated with a Wicksellian inflation must raise the level of investment, especially in durable capital, and thus distort the allocation of resources.

In this overinvestment theory, while monetary expansion is inflationary it is not neutral. Although Austria had suffered through an outside money hyperinflation after World War I, this Austrian cycle theory was set in a gold (exchange) standard context. It is inside money that expands in the cyclical upswing. The gold anchoring of the nominal scale should sooner or later force reversion to the longer term trend of the price level. Rational expectations within such a regime imply that expansions and contractions of the banking system's monetary (demand) liabilities are in large part expansions and contractions of the real volume of credit in the economy.

The mean reversion tendency also means that when the overinvestment boom collapses, much of the credit outstanding may prove unsound once prices fall below the level at which it was extended.

D. Fisherian Debt-deflation

In Irving Fisher's debt-deflation theory of great depressions, a deflationary shock to the system becomes endogenously self-amplifying. If, initially, the economy had the equilibrium volume of inside credit, a fall in the price level will make its real value larger than either debtors or creditors desire. The attempt by debtors to improve their cash-flow so as to avoid default will increase excess supplies in all goods markets. This, in turn, exacerbates the deflation and the real value of outstanding debts grows still larger. The feedback is deviation-amplifying, carrying the system further and further away from a Modigliani-Miller equilibrium.

E. Early Keynesian Theory

In the original version of Keynesian theory, unemployment was caused by saving out of full employment income exceeding investment. Similarly, investment exceeding saving would imply excess demand for goods and labor and thus cause inflation. The central hypothesis was thus that the real interest rate could fail to coordinate transactor plans so as to maintain the system in intertemporal equilibrium.

Monetary policy is useful in this theory in so far as it can be effective in nudging the real interest rate towards its 'natural' value (to use the Wicksellian term).

The distinction between inside and outside money was in general not clearly drawn in the Keynesian literature. In Keynes's Treatise cyclical variations in the money supply are clearly changes in inside money, but in the General Theory the money supply is treated on the whole as an exogenously fixed stock of outside money. Except in the work of James Tobin, this ambiguity runs through both the later Keynesian and the Monetarist literature.

F. Keynesian Economics

In later Keynesian theory the analysis of intertemporal saving-investment coordination disappears entirely. It focuses instead on the relationship between nominal aggregate demand and the ('sticky') money wage.

The Keynesian analysis of monetary policy was carried out in the IS-LM framework. An increase in the money stock would depress the interest rate and stimulate current investment and consumption spending. If money wages are sticky, real output and employment rise.

This analysis is conceptually consistent if the monetary regime is operated so as to resemble a gold standard (albeit an attenuated gold standard). In such an institutional context, the central bank's open market purchases should be seen as injections of inside (reserve) money enabling a more general expansion of inside credit; moreover, rational expectations are that the price level will show reversion to trend. Equilibrium wages and prices in such a regime will not vary in proportion to the money stock (whether measured as M1 or M2).

G. Monetarism

Monetarist theory postulates an exogenously controlled or controllable money stock (in which outside and inside components are aggregated). Nominal income is determined by the condition that the amount of M1 (or M2) demanded equal this supply.

From Friedman's "Restatement" of the Quantity Theory (1956) onward, credit has nothing to do with it. Early Monetarist theory had a quite explicit polemical thrust not only against theories emphasizing unmeasurable "liquidity" or "credit conditions" (Radcliffe Report) but also, for example, against Tobin's insistence that open market operations did not have the same wealth effects as helicopter drops of currency.

From Friedman's AEA Presidential Address (1968) onward, another element enters in, namely, the hypothesis that the real rate of interest is determined entirely by real factors over which the central bank has no control (and that observed variations in the market rate of interest should be interpreted as revealing changes in the Fisher expected inflation premium).

Even before the Rational Expectations development, therefore, Monetarist doctrine was conceptually "close" (on some admittedly undefined metric) to theories assuming intertemporal general equilibrium and generalized Modigliani-Miller.

H. Rational Expectations Monetarism

In Lucas' formal and more restrictive version of Friedmanian monetarism (Lucas (1972, 1975), changes in the stock of "money" may temporarily disequilibrate perceptions of the real rate of return and thus affect activity levels. This transitory effect evaporates as the true value of M becomes known.

A whole literature of game-theoretical exercises purporting to constitute a political economy theory of monetary policy has been built on this Lucasian foundation. In these models, central banks try to create "unanticipated" inflations as often and as much as seems worth the loss of credibility, etc. Whether any central banker will recognize this as "what goes on behind closed doors", I am not privileged to know.

I. Intertemporal General Equilibrium

Consistent centralized accounting (at equilibrium intertemporal prices) implies Ricardian equivalence and the ineffectiveness of open market operations. It also implies that the traditional Quantity Theory proposition that the equilibrium price level should vary in proportion to the contemporaneous stock of money is false (in this modelling context). Instead, the price level should vary in proportion to a present value measure of "outside" money.

This requirement holds independently of the size of the outside money stock, i.e., even if the outside money component is vanishingly small.

The apprehension is growing in some circles that smart cards may soon drive the demand for government produced currency to the vanishing point. At the same time the pressure is mounting to abolish reserve requirements (as in Canada, for example) so as not to keep banks at a competitive disadvantage. The combination of these two developments would mean that the denominator of the standard base money multiplier is tending to zero. That would spell the realization, one century postponed, of the conditions envisaged by Wicksell in his "pure credit economy" analysis (op.cit.). But modern theory denies that there is a problem, beyond the choice of a new unit of account.
 

The Natural Rate of Unemployment

It is today a widespread view that monetary policy should not be used to attempt to "steer" real variables , such as unemployment or the rate of growth. Among the theoretical premises of this policy passivity doctrine, the assumption that wage flexibility will suffice to make the system home in on the "natural rate of unemployment" (or NAIRU) occupies a central role.

The introduction by Milton Friedman (1968) of the natural rate concept spelled the beginning of the end for Keynesian aggregate demand management policies. The original argument was straightforward, stemming from the conviction that, as long as money was neutral, no significant social problem could be solved merely by printing the stuff. Thus, inflationary policies would affect labor market outcomes only in so far as they were not anticipated and their employment effects, if any, could only be transitory. This doctrine, often summarized in the proposition "the long run Phillips curve is vertical", has become all but universally accepted. Yet, the doctrine is not without problems.

Firstly, consider an outside money driven inflation. Outside money is neutral. Suppose, for simplicity superneutrality. If we now imagine that the history of the system were to have been one of x% outside money inflation higher than what actually took place, we should also imagine the scatter of Phillips data points to have been x% higher. In this type of conceptual experiment, every point in the scatter gives rise to a "vertical Phillips curve."

Secondly, the natural rate doctrine stipulates a unique vertical Phillips curve "in the long run". Friedman’s theory presupposes that all deviations in the scatter of the actual from the natural unemployment rate arose from accelerations and decelerations in inflation that were not fully anticipated. These should be inflations in which the ratio of inside to outside money was constant. Otherwise there is no presumption that an anticipated price level change should produce a neutral result. But in Friedman’s theory the inside-outside distinction is not made.

And we have really no reason to presuppose that all the price level changes in the historical Phillips scatter were due to purely "outside" nominal shocks.

Thirdly, the proposition that unemployment will converge on the natural rate as soon as wages have caught up with previous changes in the money supply is not generally true. Catching up, in this context, may involve not only learning to anticipate but also overcoming frictions, such as Taylor-type staggering of wage agreements.

The idea that the achievement of employment depends only on adjustments in the labor market was not one to which "sticky wages" Keynesians were apt to take exception. But it marks a relapse of macroeconomics into partial equilibrium thinking in that it treats the "rest state" of the labor market as independent of the state of all the other markets in the system.

To see what is wrong with the NAIRU doctrine, begin with the simplicities of early Keynesian theory. The "Keynesian Cross" used to be the vehicle for demonstrating that if at the full employment rate of output, X*, saving exceeded investment, real incrscore the point: S(X*) > I implies r > r*, that is, when full employment saving exceeds investment, the market rate of interest exceeds the natural rate. Intertemporal prices are wrong.

The natural rate doctrine, in other words, carries with it the implicit assumption that the system is always in intertemporal equilibrium. This is a strong assumption, to say the least. Keynes once pointed out that Ricardo had reached the conclusion that the rate of profit uniquely determined the (real) rate of interest because he assumed full employment. Presumably he would have criticized Friedman for having assumed Ricardo's conclusion in order to conclude Ricardo's assumption. Accepting either proposition on faith will make the other seem plausible. As we have seen in the previous section, virtually all those problems with which older theories of central banking sought to cope would simply disappear if intertemporal activities were to be perfectly coordinated at all times. That stabilization policy might be equally as ineffective as it is "inappropriate" in such a world does not come as a surprise.

Yet, the particular case of intertemporal lack of coordination that preoccuppied Keynes does not seem of much relevance currently. Few countries are plagued by either excessive household saving or lack of government spending at present. It is helpful, instead, to focus on the financial behavior implied by Keynes’s S > I analysis. In his case, the marginal efficiency of investment was declining but bear speculation on the exchanges prevented the real long-term rate of interest from declining at the same pace. The speculators would move their funds down towards the short and liquid end of the term structure. At the end of the chain of substitutions would emerge an excess demand for (outside) money. If there is no accomodating increase in the supply of outside money, income would then have to fall.

This attempt to build up liquidity, we recognize from a number of other situations that are also associated with intertemporal disequilibrium and with unemployment. When capital inflows to Mexico or Argentina reverse, for example, interest rates in the domestic market move up relative to the prospective return to capital and, as the supply of short-term capital drains abroad, a liquidity crunch develops that is associated with a sharp rise in unemployment. When big bubbles in real estate collapse in Japan or Sweden, leaving banks and other lenders in a morass of non-performing loans, all-around attempts to restore liquidity to balance sheets plunge the economies in recession. The rise in unemployment, which in some of these cases has been abrupt, large and persistent, should not be interpreted as a shift of NAIRU (brought on by increasing "inflexibility" in the respective labor markets). Like the present South East Asian crises, these are the kind of credit-fueled booms and bust that traditionally were the responsibility of central banks to prevent or moderate -- or, else, to clean up afterwards.

This section can be summarized in a few ages-old truisms: If real interest rates are above the IGE level, real aggregate demand will be below its equilibrium level and unemployment will be above NAIRU even at (general) equilibrium wages. And with real interest rates too low, aggregate demand will be high and put upward pressure on the price level even if the fiscal-monetary authorities are not adding to the outside money supply.

For monetary policy is to be at all effective in regulating real aggregate demand, it must have some leverage over real interest rates (and perhaps other credit or financial market conditions). The question then becomes: Under what conditions will the central bank have "real" powers? When is monetary policy not equivalent to some sort of trivial currency reform which multiplies nominal values by some constant?

A second question also arises. Clearly, monetary policy aimed at real interest rates and credit conditions, with the ultimate targets being real aggregate demand and employment, must be adaptive, governed by assessments of current conditions. Can central banks be given the discretion to pursue such policies without creating the kind of "Random Walk Monetary Standard" that we suffered from some twenty years ago?
 

Monetary Regimes

The distinction between inside and outside money used to be a simple bookkeeping matter. Money issued directly or indirectly against someone's debt, such that it would be extinguished on the repayment of that debt, was inside money. Money not created against debt -- but injected into the system by deficit spending -- or, according to time-honored classroom examples, by "helicopter drops" or as gifts by the "toothfairy" -- was outside money. Additions to outside money create a pure real balance effect: the price level must rise to bring perceived and realizable wealth into line and thus reequilibrate the system. The credit transactions that result in inside money being created are off-setting moves by borrower and lender along their respective intertemporal budget constraints. If they take place at equilibrium real interest rates, the excess demand for present goods and thus the price level should be unaffected.

Intertemporal general equilibrium theory has made the inside-outside distinction, on the one hand, conceptually clearer and, on the other, operationally all but impossible. Gurley and Shaw (1960), who introduced the distinction, brought it to bear simply on the private sector’s consolidated balance sheet in the current period. Thus, for example, borrowed reserves were inside money but the rest of the monetary base was regarded unambiguously as outside. The "fiscalist" IGE approach to monetary theory makes clear that, in principle, the entire future course of government deficits and surpluses is relevant to the determination of whether an open market operation, for example, should have the real balance effect of an outside money injection or at best a liquidity effect. Money that is issued to finance a government deficit today but will be retired through a corresponding surplus tomorrow does not give rise to a real balance effect since it does not alter the calculation of the private sector’s net worth evaluated at current nominal prices

An econometrician could handle the Gurley-Shaw concepts. But what does he do with the conceptually correct intertemporal ones? To make them operational, one would have to predict the entire future time-path of taxes and expenditure. If fiscal policy evolves adaptively as a sequence of short-horizon political compromises, this is not an enviable task.

Consider then the problem of some ordinary transactor. For concreteness, let us suppose a seller for whom it would be rational to vary the price he sets in proportion to changes in outside money. If he fails to raise prices when outside money is increased, he will incur losses. But the consequences of mistaking changes in inside money for changes in outside money would be just as bad. Keying on Friedman’s M2, for instance, would not have been a strategy with much survival value for most of this century.

So agents face a signal extraction problem, namely, how to distinguish outside from inside money changes. Under certain regimes, they can do so with a high degree of confidence. If you have lived under conditions of high inflation for years, for instance, it is rational to act on the understanding that the money printed to cover today’s deficit is not going to be offset by future surpluses. But under other circumstances, the signal extraction can be exceedingly difficult. It may be, for instance, that the very slow adjustment of nominal interest rates to the U.S. inflation of the 1970's and the equally lengthy period that it took for them to come back down to "normal" in the 1980's, reflect in part the time it takes the market first to learn and then again to unlearn changes in the fiscal-monetary regime.

It is instructive to examine alternative monetary regimes from the perspective of this particulr signal extraction problem. How difficult or easy is it, under a given regime, to determine whether credit obtained today will have to be paid back in money of roughly the same purchasing power or in "debased coin"? Is the banking system’s nominal lending "real" or based on growth in outside money?

Over the last hundred years, our monetary system has evolved from one relying on commodity convertibility to one depending on state control of the quantity of fiat base money. It is with the quantity control system that the problem of ensuring a predictable nominal scale has become so acute that, time and again, rigid rules of one kind or another are proposed that would deprive the monetary authorities of the discretionary ability to pursue stabilization policy.

Convertible systems have problems of their own. The classical gold standard was not all that predictable: the value of gold was subject to new discoveries, to new techniques of extraction, to the decisions by countries to abandon silver or bimettalism for gold, to the pyramiding of bank reserves and other technical progress in the payment mechanism. Its most important defect was probably its endogenous tendency to evolve into steadily more attenuated and politicized forms -- ending in our present system. In any case, there is no reason to wish to have the "barbarous relic" back -- and no point in trying.

But fixed rate convertible systems had one crucial property that would be worth imitating, namely, their built-in mean reversion to the trend of the price level. Monetary policy under convertibility is Bank rate policy. If the central bank in such a regime tries to hard to keep constant the growth-rate of some inside money aggregate, it will make the banking system "inelastic" and thus interfere with the occasional acceleration of growth that is the appropriate system response to new Schumpeterian opportunities. Alternatively, it may go too far in stabilizing interest rates in order to accomodate the "needs of trade", in which case its policy will amplify the fluctuations in activity levels and prices due to the real business cycle. But, since it cannot create outside money, its reserve position will prevent it from erring too far on the upside. More importantly, if it does err, it is forced to restore its depleted reserves before it can do so again. It is this need to manage reserves that will cause the mean-reversion of nominal proces to the trend set by the supply and demand for whatever serves as the outside money of the system.

In such a system, agents know that the rate of inflation is not going to develop as a random walk and, consequently, they will not extrapolate current changes in the price level. Price level expectations will tend to be inelastic, to use the old Hicksian term. Current money supply figures will have little or no information content for price setters. Under such regimes, monetary policy stimuli reduce market interest rates, rather than raise them, and movements of the interest rate are seen as mainly real rate movements, although they may have a partial Fisher premium component as well.

For a central bank to have some, even if limited, leverage over real magnitudes, it is crucial that the general expectation of this mean reversion tendency be the rational expectation. And to that purpose, it is preferable that it reflect, as far as possible, a "built-in" institutional property of the regime, rather than the personal reputation of (say) a Volker or a Greenspan.
 

Transmission Mechanisms

The prevailing views among economists about monetary policy transmission have changed repeatedly over time. This is appropriate for how monetary transmission works and how "effective" it may be is certainly historically contingent.

In the 1940's and 1950's, transmission was widely believed to be "ineffective". There were two versions of this ineffectiveness doctrine. I tend to think of one as American and the other as European, although I am not certain that such a systematic pattern in the views of economists on the two sides of the Atlantic can be documented. But one distills the experience of the American Great Depression whereas the other reflects a dawning realization of the constraints that fixed exchange rates impose on the monetary policy of non-key currency countries.

Clearly, "money" in Friedman’s reformulated model as well as in Lucas’ model is outside money or, rather, it is assumed that the M-aggregate is always proportional to the stock of outside money. In the context of the monetary history of the United States, these models are helpful in understanding the inflationary decade of the 1970's. This was a period of outside-money inflation -- as opposed to credit driven inflation -- with government deficits partly financed by the inflation tax. This was also the period when the markets would respond to easier monetary policies by raising interest rates, thus exhibiting the Fisher-effect predicted by these models.

Today, it is the prospect of tighter monetary policy that put the markets in fear of capital losses. We are back in a world where the relationship between money and interest rates is the "old" inverse one and where monetary transmission works in the non-neutral manner best explained by Brunner and Meltzer. This is a world in which central banks has some power to influence output and employment. The problem is finding an institutional arrangement such that this power can, at least occasionally, be used in a manner that will do more good than harm.
 

A Rule with Some Discretion

Suppose then, at least for the sake of argument, that it is possible for a central bank to have some influence on the real rate of interest and on the liquidity position of the private sector (also in real terms). Such powers would give it some limited ability to affect output and employment in the short run and, therefore, potentially to moderate the cycle. The question would remain whether it should be allowed to exercise these powers. The arguments against it are familiar. Countercyclical monetary policy would have to be adaptive and discretionary. Given "long and variable lags", it is likely to be ill-timed on occasion. And concern over reputation and credibility is not a reliable check to the tendency for successive discretionary actions to end up as an inflationary Random Walk Monetary Standard in the long run.

With unlimited discretion, we want a rule to provide nominal stability; given a framework of nominal stability, we want discretion. Combining the two is the trick. It is possible to devise monetary regimes that combine stability and relatively good predictability of nominal values over the long run with the limited exercise of discretionary policy in the short run. The gold standard was such a regime and, for the non-key currency countries, so was Bretton Woods -- as long as the key currency country behaved itself. True, the discretion that Bretton Woods allowed resulted in much derided "stop-and-go" policies. But a look back at the growth and unemployment figures of the stop-and-go era from today's vantage-point does not make it appear particularly dreadful.

As an example, of a regime with the desired characteristics that would not depend solely on the reputation for conservatism of central bankers, let me revive an old proposal for a "one-sided growth path rule." The proposal is intended to apply to a key currency, such as the Ecu.

In this regime, you legislate a ceiling for the monetary base that the central bank could have in existence at any one time. This ceiling on the base should be made to rise (like a Friedman rule) at x percent per year, x being computed (approximately) as the difference between some long-run average for the growth rate of real output and the trend in the velocity of base money. The intercept of the rule, i.e., initial legal maximum when the legislation goes into effect, should be set some 10-20 percent above the actual base at that date.

The monetary base, as discussed above, is not the theoretically true "nominal scalar" of an economy. But the measure of outside nominal assets that determines the nominal scale in an IGE model is not operational in practice. The base ceiling might, however, be supplemented by a ceiling also on the central bank's holdings of government securities. Such a supplemental restriction should prevent the inconsistency between the operational rule and the theoretically perfect rule from causing practical problems of consequence.

This rule leaves some room for discretion. It also leaves open the choice of short-term policies and operating procedures. As long as the central bank finds itself well below the ceiling, it can expansd or contract, and it can execute either policy by targeting a money aggregate, an interest rate, or an inflation rate. But while the authorities would retain short-term discretion as long as they keep below the ceiling, the risk that monetary policy might evolve as a long sequence of predominantly inflationary moves would have been eliminated.

A central bank operating under a base ceiling law would have to treat the difference between the maximum legal and the actual base as if it were its foreign exchange reserves and the bank were operating in a fixerd exchange rate system. It could pursue an expansionary policy (or step in as lender of last resort) only as long as it had excess reserves. If, in trying to help the economy out of one recession, it were to go as far as to hit the ceiling, it would have to plan on a prolonged period of expanding at less than the permissible Friedmanian rate in order to accumlate the ammunition to help it out of another.

In this regime, the price level should exhibit the reversion to trend property which, in my view, is the crucial fulcrum that provides the central bank some leverage over real, as opposed to merely nominal, magnitudes. The longer-term nominal expectations of the public should come to approximate the expectations that are rational under a gold standard -- with the added benefit that agents do not have to worry about the vagaries of world gold production and the like.

One obvious problem with this proposal is that the current pace of financial innovation is such that the future demand for base money is hardly predictable very many years into the future. I would approach this problem by making price-level stabilization over the longer term the basic and overriding responsibility of the central bank. This provision should be seen as stating the basic intent of the monetary constitution and would serve as the escape clause under which changes in the growth rate rule could be made. If, for instance, the intially chosen low and constant inflation rule.
 

 References
 
Robert J. Barro and David B. Gordon (1983a) "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, 91:4, 589-610.

------------------ and -------------------- (1983b) "Rules, Discretion and Reputation in a Model of Monetary Policy," Journal of Monetary Economics, 12:2, 101-21.

Ben S. Bernanke and Frederic S. Mishkin (1997) "Inflation Targeting: A New Framework for Monetary Policy?" National Bureau of Economic Research, Working Paper 5893, January.

Fischer Black (1970) "Banking and Interest Rates in a World without Money," Journal of Bank Research, Autumn, 9-20.

Karl Brunner (1970) "The 'Monetarist Revolution' in Monetary Theory," Weltwirtschaftliches Archiv, 105, 1-30.

--------------- (1971) "A Survey of Selected Issues in Monetary Theory," Schweizerische Zeitschrift für Volkswirthschaft und Statistik, 186: 1-129.

Eugene Fama (1980) "Banking in a Theory of Finance," Journal of Monetary Economics, 6:1, 39-57,

Milton Friedman (1956) "The Quantity Theory of Money: A Restatement," in idem, ed., Studies in the Quantity Theory of Money, Chicago: Univ. Of Chicago Press.

(1968) "The Role of Monetary Policy," American Economic Review, 58:1, March.

-------------------- and Anna J. Schwartz (1963) "Money and Business Cycles." Review of Economics and Statistics, 45, Supplement, February.

R.L. Greenfield and Leland B. Yeager (1983) "A laissez faire Approach to Monetary Stability," Journal of Money, Credit and Banking, 15:3, 302-15.

John Gurley and Edward S. Shaw, Money in a Theory of Finance, Washington, DC: Brookings Institution.

Daniel Heymann and Axel Leijonhufvud (1995) High Inflation, Oxford: Oxford University Press.

Axel Leijonhufvud (1981) "The Wicksell Connection," in idem, Information and Coordination: Essays in Macroeconomic Theory, New York: Oxford University Press.

--------------------- (1984) "Inflation and Economic Performance," in Barry N. Siegel, ed., Money in Crisis, Cambridge, Mass.: Ballinger.

--------------------- (1985) "Constitutional Constraints on the Monetary Powers of Government," in James A. Dorn and Anna J. Schwartz, The Search for Stable Money: Essays on Monetary Reform, Chicago: Univ. Of Chicago Press.

--------------------- (1986) "Rules with Some Discretion: Comment on Barro," in C.D. Campbell and W.R. Dougan, eds., Alternative Monetary Regimes, Baltimore: Johns Hopkins.

---------------------- (1987) "The Wicksellian Heritage," Economic Notes, forthcoming.

---------------------- (1990) "Monetary Policy and the Business Cycle under 'Loose' Convertibility," Greek Economic Review, 12, Supplement: The Monetary Economics of John Hicks.

Robert E. Lucas, Jr. (1972) "Expectations and the Neutrality of Money," Journal of Economic Theory, 4, 103-24.

----------------------- (1976) "An Equilibrium Model of the Business Cycle," Journal of Political Economy, 83: 1113-44.

Brian Snowdon, Howard Vane and Peter Wynarczyk (1994) A Modern Guide to Macroeconomics: An Introduction to Competing Schools of Thought, Aldershot: Edward Elgar.

Thomas J. Sargent (1987) Dynamic Macroeconomic Theory, Cambridge, Mass.: Harvard University Press.

--------------------- and Neil Wallace (1981) "Some Unpleasant Monetarist Arithmetic," Federal Reserve Bank of Minneapolis Quarterly Review, 5:3.

Knut Wicksell (1898) Geldzins und Güterpreise: Eine Studie über die den Tauschwert des Geldes Bestimmenden Ursachen, Jena: Gustav Fisher Verlag.

Michael Woodford (1995) "Price Level Determinacy without Control of a Monetary Aggregate," National Bureau of Economic Research, Working Paper 5204, August.

---------------------- (1996) "Control of the Public Debt: A Requirement for Price Stability?" National Bureau of Economic Research, Working Paper 5684, July.

Symposium: The Monetary Transmission Mechanism
Frederic S. Mishkin (1995) "Symposium on the Monetary Transmission Mechanism," Journal of Economic Perspectives, 9:4, Fall

John B. Taylor (1995) "The Monetary Transmission Mechanism: An Empirical Framework," Journal of Economic Perspectives, 9:4, Fall

Ben S. Bernanke and Mark Gertler (1995) "Inside the Black Box: The Credit Channel of Monetary Policy Transmission," Journal of Economic Perspectives, 9:4, Fall

Allan H. Meltzer (1995) "Monetary, Credit (and Other) Transmission Processes: A Monetarist Perspective," Journal of Economic Perspectives, 9:4, Fall

Maurice Obstfeld and Kenneth Rogoff (1995) "The Mirage of Fixed Exchange Rates," Journal of Economic Perspectives, 9:4, Fall

Symposium: The Natural Rate of Unemployment
 
Joseph Stiglitz (1997) "Reflections on the Natural Rate Hypothesis," Journal of Economic Perspectives, 11:1, Winter.

Robert J. Gordon (1997) "The Time-Varying NAIRU and its Implications for Economic Policy," Journal of Economic Perspectives, 11:1, Winter.

Douglas Staiger, James H. Stock and Mark W. Watson (1997) "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, 11:1, Winter.

Olivier Blanchard and Lawrence F. Katz (1997) "What We Know and Do Not Know About the Natural Rate of Unemployment," Journal of Economic Perspectives, 11:1, Winter.

Richard Rogerson (1997) "Theory Ahead of Language in the Economics of Unemployment," Journal of Economic Perspectives, 11:1, Winter.

James K. Galbraith (1997) "Time to Ditch the NAIRU," Journal of Economic Perspectives, 11:1, Winter