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  • What Do We Know aboutMonetary Policy that

    Friedman Did Not Know?

    Charles Wyplosz

    WORKING PAPER NO.63

  • WORKINGPAPERNO.63

    WhatDoWeKnowaboutMonetaryPolicythat

    FriedmanDidNotKnow?

    CharlesWyplosz

  • 2009TheInternationalBankforReconstructionandDevelopment/TheWorldBankOnbehalfoftheCommissiononGrowthandDevelopment1818HStreetNWWashington,DC20433Telephone:2024731000Internet: www.worldbank.org www.growthcommission.orgEmail: info@worldbank.org contactinfo@growthcommission.orgAllrightsreserved1234512111009TheCommissiononGrowthandDevelopmentissponsoredbythefollowingorganizations:AustralianAgencyforInternationalDevelopment(AusAID)DutchMinistryofForeignAffairsSwedishInternationalDevelopmentCooperationAgency(SIDA)U.K.DepartmentofInternationalDevelopment(DFID)TheWilliamandFloraHewlettFoundationTheWorldBankGroupThefindings,interpretations,andconclusionsexpressedhereindonotnecessarilyreflecttheviewsofthesponsoringorganizationsorthegovernmentstheyrepresent.Thesponsoringorganizationsdonotguaranteetheaccuracyofthedataincludedinthiswork.Theboundaries,colors,denominations,andotherinformationshownonanymapinthisworkdonotimplyanyjudgmentonthepartofthesponsoringorganizationsconcerningthelegalstatusofanyterritoryortheendorsementoracceptanceofsuchboundaries.Allqueriesonrightsandlicenses,includingsubsidiaryrights,shouldbeaddressedtotheOfficeofthePublisher,TheWorldBank,1818HStreetNW,Washington,DC20433,USA;fax:2025222422;email:pubrights@worldbank.org.Coverdesign:NaylorDesign

  • What Do We Know about Monetary Policy that Friedman Did Not Know? iii

    AbouttheSeries

    The Commission on Growth and Development led by Nobel Laureate MikeSpencewasestablishedinApril2006asaresponsetotwoinsights.First,povertycannotbereduced in isolationfromeconomicgrowthanobservationthathasbeen overlooked in the thinking and strategies of many practitioners. Second,thereisgrowingawarenessthatknowledgeabouteconomicgrowthismuchlessdefinitivethancommonlythought.Consequently,theCommissionsmandateistotake stockof the stateof theoretical andempiricalknowledgeoneconomicgrowthwithaviewtodrawingimplicationsforpolicyfor thecurrentandnextgenerationofpolicymakers.

    To help explore the state of knowledge, the Commission invited leadingacademics and policy makers from developing and industrialized countries toexplore and discuss economic issues it thought relevant for growth anddevelopment, including controversial ideas. Thematic papers assessedknowledgeandhighlightedongoingdebatesinareassuchasmonetaryandfiscalpolicies, climate change, and equity and growth. Additionally, 25 country casestudieswerecommissionedtoexplorethedynamicsofgrowthandchangeinthecontextofspecificcountries.

    WorkingpapersinthisserieswerepresentedandreviewedatCommissionworkshops, which were held in 200708 in Washington, D.C., New York City,and New Haven, Connecticut. Each paper benefited from comments byworkshop participants, including academics, policy makers, developmentpractitioners, representatives of bilateral and multilateral institutions, andCommissionmembers.

    The working papers, and all thematic papers and case studies written ascontributions to the work of the Commission, were made possible by supportfromtheAustralianAgencyforInternationalDevelopment(AusAID),theDutchMinistryofForeignAffairs,theSwedishInternationalDevelopmentCooperationAgency(SIDA), theU.K.Departmentof InternationalDevelopment (DFID), theWilliamandFloraHewlettFoundation,andtheWorldBankGroup.

    TheworkingpaperserieswasproducedunderthegeneralguidanceofMikeSpenceandDannyLeipziger,ChairandViceChairoftheCommission,andtheCommissions Secretariat, which is based in the Poverty Reduction andEconomic Management Network of the World Bank. Papers in this seriesrepresenttheindependentviewoftheauthors.

  • iv Charles Wyplosz

    Acknowledgments

    IamindebtedtoRobertoN.ZaghaandLuisServenforcommentsonanearlierversionofthispaper.

  • What Do We Know about Monetary Policy that Friedman Did Not Know? v

    Abstract

    This paper offers a personal review of the current state of knowledge onmonetary policy. In a nutshell, I argue that a number of old resultswhatFriedman knewhave survived, but that modern monetary policy departs insome important ways from older principles. The older wisdom that monetarypolicydetermines inflation in the longrunbutcanhavesystematicshorterruneffects has survived a major challenge. Most of the new ideas stem from therecognitionofthecrucialroleofexpectations.Intodaysworld,thisobservationliesbehindthespectaculartrendtowardevergreatercentralbanktransparency.Then it is more than likely that ideas will change in the wake of the globalfinancialcrisis.Earlydebateschallengetheoldwisdomthatcentralbanksoughttobemainlyconcernedwithprice stability. Inparticular, financial stabilityhasalwaysbeenpartofacentralbanksmission,butithasoccupiedlimitedspaceintheoreticalandempiricalstudies.

  • What Do We Know about Monetary Policy that Friedman Did Not Know? vii

    Contents

    AbouttheSeries.............................................................................................................iiiAcknowledgments.........................................................................................................ivAbstract.............................................................................................................................vIsInflationaMonetaryPhenomenon?..........................................................................1ChannelsofMonetaryPolicy.........................................................................................3TheInflationTarget.........................................................................................................5TheLinkbetweenFiscalandMonetaryPolicy............................................................7TheRoleofExpectations.................................................................................................9CentralBankTransparency..........................................................................................12ShouldCentralBanksReacttoAssetPrices?.............................................................14Conclusion:WhatWillWeLearnfromtheCrisis?...................................................16References.......................................................................................................................19

  • What Do We Know about Monetary Policy that Friedman Did Not Know? 1

    WhatDoWeKnowaboutMonetaryPolicythatFriedmanDidNotKnow?CharlesWyplosz1

    In many respects, modern monetary policy remains largely framed by MiltonFriedmans writings. This concerns the fundamental view that price stability isthecentralbankskeyresponsibilityandthattheoutputorunemploymentgapsare, at best, temporary objectives. Many details of the channels of monetarypolicydescribedbyFriedmanandSchwartzalsoremaincentraltocentralbankoperations.Ontheotherhand, todayscentralbanksdealwith issuesthathavesurfacedover the last threedecades,manyofwhicharenotyet fully resolved.Thecrisisofthe2000shasledtounprecedentedactionsbycentralbanksaroundthe world which previously would have seemed impossible or outrightnonsensical.

    IsInflationaMonetaryPhenomenon?

    Thelongrunneutralityofmoneylogicallyimpliesthatlongrunpricestabilityisthe exclusive responsibility of central banks. Friedmans celebrated conclusionwas that centralbanksshould target themoneystockandchoosegrowth ratesthat deliver low inflation. The early adoption by the Bundesbank of moneygrowthtargetingprovedtobeasuccessinthe1980s.Manyothercentralbanksfollowed suite, including the U.S. Federal Reserve in theearly 1980s under thechairmanshipofPaulVolcker.VolckersstatementthattheFedwouldonlyfocuson money supply growth and let the markets set the interest rate was soonfollowedbydeclininginflation.

    Money growth targeting was soon seen as consistent with most schools ofthought.Friedmanitemonetaristsnaturallyelevatedthestrategytothestatusofunassailablefundamentalprinciple.Keynesiansbroughtthelongrunneutrality1CharlesWyploszisProfessorofInternationalEconomicsattheGraduateInstituteofInternationalStudiesinGeneva,whereheisDirectoroftheInternationalCentreofMoneyandBankingStudies.Previously,heservedasAssociateDeanforResearchandDevelopmentatINSEADandDirectorofthePhDprograminEconomicsattheEcoledesHautesEtudesenScienceSocialesinParis.Hewasalso Director of the International Macroeconomics Program of CEPR, the leading Europeannetwork of economists. His main research areas include transparency of monetary policy,Europeanmonetaryintegration,fiscalpolicydiscipline,economictransition,andcurrentregionalintegrationinvariouspartsoftheworld.

  • 2 Charles Wyplosz

    ofmoneywithintheirframeworkbyextendingtheirtraditionalemphasisontheshort run.Strikingly,however, theBundesbank found itselfunable tomaintainits strategy in the 1990s. The reason was important changes in bankingtechnology as computers slashed the costs of undertaking and recordingincreasingly complex operations. As a result, the demand for money changedandbecameunstable(Baltensperger,1999).Theepisodemadeitclearthatmoneytargetingis impliedbytheneutralityprincipleonly ifmoneydemandisstable.Indeed, longrun neutrality implies that any change in the supply over andbeyond demand eventually dissipates into a reduction of moneys purchasingpowerthatbringsinlinewiththepurchasingpowerthatpeoplewanttohold.Ifdemandisstable,thelinkbetweenmoneygrowthandinflationisonetoone.Ifdemand is unstable, the link still exists, but it is variable and cannot thereforeserveasaguidetopolicy.

    The current crisis provides a spectacular example. Badly hurt commercialbankshaveincreasedtheirowndemandformoney,preferringtoholdcashthatbringsnointerestthanassetsthatcanloosevalue.Centralbankshaverespondedbyincreasingthemoneysupplybyunprecedentedamounts.Itisfartooearlytodrawdefinitiveconclusionsbut,atthetimeofwriting,inflationhasnotrisenquite the opposite. It may still rise if central banks do not withdraw the cashwhen the situation eventually normalizes and commercial banks return tonormalpractice.Whatisclear,however, isthatthemassiveincreasesinmoneysupplyhavepreventedadisastroussystemicbankingcollapse.Thismovewouldhave been impossible had moneysupply been driven by the quantitative rulesassociatedwithmoneytargeting.

    Structural changes in banking technology and increasing internationalfinancial integration constantly modify the use and definition of monetaryaggregates. They do not challenge the neutrality principle but they makemonetary targeting impossible, in fact misleading. The response has been thewidespreadadoptionoftheinterestrateasthepolicyinstrument.Inaway,thisis a return to preVolcker and preFriedman views, which explains continuinghostility to the new approach. In fact, it is simply a consequence of moneydemandinstabilityandtheconsequentlypoorperformanceofmoneygrowthasapredictoroffutureinflation.

    Importantly,theusesoftheinterestrateasaninstrumentdoesnotchallengetheneutralityprincipleanditdoesnoteitherabsolvecentralbanksfromthetaskofdeliveringpricestabilityinthelongrun.Theonlydifferenceisthatcausalitybetweenmoneyandpricesisreversed.Thecentralbanksuseoftheinterestrateasaninstrumentmeansthattheymustbereadytoprovidetheamountofmoneythat is demanded at the chosen rate. Instead of setting the money supply andletting the interest rate be determined by the market to bring demand in linewithsupply,centralbanksnowsettheinterestrateandletthemoneysupplybedemanddetermined. Inthe longrun,moneyadjusts totheprice levelachievedby thecentralbankand theneutralityprinciple is respected (Gerlach,2003). In

  • What Do We Know about Monetary Policy that Friedman Did Not Know? 3

    brief, money is now endogenous, meaning that its stock is a consequence ofmonetarypolicyandothereconomicdevelopments.

    What,then,guidescentralbanksinchoosingtheinterestrate?Mostcentralbanks, explicitly or implicitly, follow the inflationtargeting strategy, which isfurther discussed below. They know that changing the interest rate will affectinflationwithalagofonetotwoorthreeyears.Theydecidewhatinflationratetheywouldliketoseeatthathorizon;thisisthetarget.Thentheyformaforecastofwhereinflationwillbeandtheymovetheinterestrateupifinflationforecastsexceed the target, and down in the opposite case. This is trial and error morethanacleanruleof theFriedmantypeand,as thesurgeof inflation in200708illustrates, itdoesnotworkall the time.Worse, the current crisis is sometimesblamed on a long period of toolow interest rates as central banks focused oninflation and overlooked an excessively fast increase in bank credit and themoney supply. These observations are important but they stop short of arehabilitation of the money growth rule, especially since the crisis providesadditionalevidenceonmoneydemandinstability.Theyindicate,though,thatanarrowfocusoninflation,akeylegacyofFriedman,isnowchallenged.Centralbanks have long defended this focus and resist being given a wider mandate,preciselybecausetheyfullyendorsetheviewthattheycandetermineinflationinthelongrunwhiletheirimpactongrowthorassetpricesisnilinthelongrunthis iswhymoneyissaidtobeneutralandhighlyuncertain intheshortrun.Butcriseshappenintheshortrunandcentralbankswillhavetoaddressthesequestions.

    ChannelsofMonetaryPolicy

    Ifmoney isnotexogenousanymore, thenhowdoesmonetarypolicyaffect theeconomy? At least in developed countries, the longheld wealth effect is nolonger a serious contender, if it ever was. This is a key element of Friedmansview.Heconsideredthatmoneymattersintheshortrunbecauseanincreaseinthe money supply makes people feel richer and induces them to spend more.Overtime,heargued,withtoomuchmoneychasingtoofewgoods,pricesrise,which reduces the purchasing power of money and brings it back to its initiallevel.Inotherwords,moremoneycreatesatemporaryillusionofhigherwealth,whichbooststhelevelofactivity,butthiseffectdoesnotlastandneutralitytakesholdasaresultofhigherinflation.

    The interest rate channel Severalotherchannelsarebelievedtoplayarole,butthereissurprisinglylittleevidence on their respective importance. A first channel is the interest rate,which makes borrowing cheaper and should therefore encourage spending onloanfinancedgoodslikehousing,durables,orproductiveequipment.However,

  • 4 Charles Wyplosz

    theoretically, the effect of the interest rate on consumption spending isambiguous.True,lowerinterestratesmakeborrowingcheaperbutitalsomeansthat one needs to save more to reach the same amount of wealththis is astandard tradeoffbetween incomeandpriceeffects. Inaddition, centralbankscontrol very shortterm interest ratesusually the overnight ratewhileconsumers and firms borrow over periods of months and years. Thus, for theinterestratechanneltobeeffective,monetarypolicymustbeabletoaffectlongterm rates, which is far from trivial. Indeed, shortterm interest rates affectlongerterm rates through expectations of future shortterm rates. How centralbankscanorienttheseexpectationsisacrucialissuedealtwithfurtherbelow,but the evidence so far is that the link is tenuous at best. Finally, rationalborrowers are not meant to respond to nominal but to real interest rates. Thismeansthatthechannelalso...