**A Half-Century of Changes in Monetary Policy**

John B. Taylor

Under Secretary of Treasury for International Affairs

Written Version of Remarks Delivered at the

Conference in Honor of Milton Friedman

University of Chicago

November 8, 2002

It is a real pleasure for me to participate in this conference in honor
of Milton Friedman. I have been asked to review changes in monetary
policy since the end of World War II, or during the half-century or more
since Milton Friedman first began writing on monetary economics.

Monetary policy changes during this period have been truly dramatic, not
only in the United States, but also throughout the world. As every
monetary economist knows, Milton Friedman's monetary research and policy
advice---on monetary policy rules, on flexible exchange rates, on money
growth, on the natural rate of unemployment, on the flaws in the
Phillips curve, and on the real interest rate---had an enormous
influence on these changes.

In the United States, the first big post-war change in monetary policy
came in 1951 when the famous Accord was reached between the Treasury and
the Federal Reserve. By freeing the Fed from the obligation to peg
interest rates, that Accord allowed the Fed to make its own decisions
about the instruments of monetary policy and to focus on key price
stability goals. At nearly the same time, William McChesney Martin---who
played an important role in negotiating the Accord---moved from the
Treasury to the Fed and began implementing these goals. Since then we
have seen many more changes in U.S. monetary policy, including a major
transformation in how the instruments of policy are adjusted.

Similarly, but later on, the end of the Bretton Woods fixed exchange
rate system freed central banks in the rest of the world to set their
own instruments of monetary policy. And the changes have continued since
then. Now the Bundesbank and other central banks of Europe are joined in
a single central bank for all of Euroland with a single money supply and
a single overnight interest rate. The international monetary system has
been transformed into a system with a wide variety of monetary policies:
(1) inflation targeting with a flexible exchange rate and a procedure
for setting the policy instrument---usually the short-term interest
rate, as in New Zealand, Chile, the United Kingdom, Sweden and Korea,
(2) monetary unions---in western and central Africa and the eastern
Caribbean as well as in western Europe, (3) dollarization---where the
term refers both to the official use of Euros, as in Montenegro, and to
the official use of dollars, as in El Salvador, (4) currency boards---as
in Bulgaria or Bosnia, and (5) managed pegs---as in Singapore. One of
the jobs of the International Affairs staff at the U.S. Treasury is to
monitor monetary policy changes in other countries. I can attest that
there have been a lot of changes to track.

For the most part these changes have resulted in better economic
performance. There is greater monetary transparency and accountability
in many countries, with explicit announcements of changes in policy
instruments and published inflation and monetary policy reports. But
unfortunately, not all has been good. In the midst of these positive
changes, money mischief---to use the title of Milton Friedman's 1994
book---has continued, from hyperinflations in the early years of
transition in the former Soviet bloc countries to multiple currencies in
Afghanistan.

**Three Broad Historical Developments**

Clearly it is impossible to cover all these changes in one talk. But
there are three broad historical developments during this period that
provide a convenient organizing framework for reviewing the key monetary
policy changes.

One development is the significant *rise and fall of inflation* during
the post-World War II period. In the United States we went from price
stability in the 1950s through the mid 1960s, to inflation from the late
1960s to the early 1980s, to disinflation in the early 1980s, to price
stability in much of the period since then. Thus, the monetary history
of this period consists of the Great Inflation flanked by two periods of
relative price stability.

Another development---closely related to the first---concerns the
procedures used at central banks for setting the instruments of monetary
policy. The main change here is that decisions about the instruments of
policy---frequently the overnight interest rate---are being approached
and analyzed in a *more rule-like or systematic* fashion both in
research and in practice. And when viewed in this more systemic fashion,
one can detect a change in the responsiveness of the instruments of
policy to inflation and to the real economy. In other words, the
estimated coefficients in monetary policy rules have changed
significantly.

A third development is the *diffusion of ideas and experience* about
monetary policy around the world. The Great Inflation is frequently
discussed as if it were solely an American inflation. But this same
general pattern can be found in many countries and regions of the world.
In recent years the diffusion of ideas and experience is found in the
increasing number of central banks emphasizing targets for inflation,
transparency, and independence in setting the instruments of policy.

Most changes in post-war monetary theory, history, and policy are best
understood in the context these three historical developments. I'll now
consider each in turn.

**The Rise and Fall of Inflation**

Figure 1 documents the rise and fall of inflation in the United States.
Inflation began to rise in the late 1960s and fluctuated in a generally
rising pattern until the start of the disinflation in the late 1970s. By
the mid 1980s inflation had been reduced substantially and a period of
relative price stability began. That period of price stability has
continued ever since with relatively small fluctuations.

Figures 2 through 4 show that a similar pattern of inflation occurred in
the United Kingdom, Australia, and Canada, although the inflation ended
somewhat earlier in the United States. Of course, not every single
country in the world experienced precisely the same timing. Japan, for
example, dealt with the inflation problem much earlier than the United
States, and with the current deflation it has gone too far in reducing
inflation. Nevertheless, there is a general global pattern, and Figure 5
endeavors to summarize the global pattern. It shows the median inflation
rate over 5-year intervals in the major regions of the world. In each
case we see a rise and fall of inflation. Not shown in Figure 5 is the
experience of the transition economies that emerged from the Soviet
bloc. These countries also experienced a rise and fall in inflation, but
it was larger---reaching hyperinflation levels---and shorter---starting
and ending in the 1990s.

## What caused the Great Inflation? I will take as a given that inflation is a monetary phenomenon. Milton Friedman and Anna Schwartz provided convincing evidence of this long ago in their monetary history. In Figure 6, scatterplots of countries' money growth rate and inflation rate show that inflation is still a monetary phenomenon. There is a remarkably close association over time between inflation and money growth. The question is why central banks increased money growth during the period of high inflation. Monetary economists have offered a number of explanations.

### Exogenous Oil Price Shocks and Monetary Accommodation 

### 

### Long before the Great Inflation was over and long before it acquired its current name, people began focussing on "oil price shocks" as the cause of the rise in inflation. Alan Blinder, for example, stressed the importance of oil shocks in raising the rate of inflation. According to this explanation the shock-induced increase in inflation forced policymakers to accommodate the shock by raising money growth; the accommodation would prevent a decline in real money balances and avoid an increase in unemployment. If the shock were not accommodated, then unemployment would increase. 

The passage of time and later experiences with oil shocks under
different monetary regimes have raised questions about this view.
Writing from the vantage point of 1997, Brad DeLong noted that the
inflation was already underway in the late 1960s in the United States,
well before 1972 when the oil price shocks began. Moreover, the
experiences with later oil shocks in the United States and other
countries were much different from the first shocks; these experiences
suggest that a less accommodative monetary policy could prevent price
shocks from getting imbedded in inflation without significant
unemployment effects. Oil price shocks in the late 1970s had very small
effects in Japan when a much less accommodative monetary policy was in
place.

***Historical Bias: Lessons from the Great Depression***

In rejecting the price shock view, Brad DeLong provided another
explanation for the Great Inflation. According to this explanation, the
memory of very high unemployment in the Great Depression caused
policymakers to err on the side of higher inflation. They were fearful
of a return to high unemployment. He argues that policymakers and the
public were willing to let inflation rise because, having recently
experienced the high unemployment of the 1930s, they worried that
maintaining price stability would lead to greater unemployment.

However, if the experience of the Great Depression caused the rise in
inflation in the late 1960s and 1970s, then why did monetary policy
leave the price level so nearly stable during the William McChesney
Martin years of the 1950s and 1960s---a period much closer in time to
the Great Depression? Shouldn't we have seen the inflation rate rise
much earlier if the Great Depression had created such a bias in monetary
policy?

***Time-Inconsistency Bias: Expectations Traps***

The time-inconsistency problem of Finn Kydland and Edward Prescott has
also been frequently cited as a possible reason for the rise and fall of
inflation. One version of the time-inconsistency explanation is due to
Michael Parkin using the model of Robert Barro and David Gordon. In the
basic time-inconsistency model of inflation and unemployment there are
economic benefits from actual inflation being higher than expected
inflation and there are economic costs from inflation itself. The model
predicts that policymakers---who are unable to fully commit to
policies---will eventually find themselves in a sub-optimal equilibrium.
The unemployment rate is always equal to the natural unemployment rate
in this equilibrium, no matter what the inflation rate is. The
equilibrium is sub-optimal because, if policymakers could commit, it
would be possible for them to achieve a lower inflation rate with the
same rate of unemployment. Thus, time-inconsistency causes an
inflationary bias in monetary policy.

This sub-optimal equilibrium has the property that the higher is the
natural rate of unemployment, the higher is the equilibrium inflation
rate. This property yields a possible explanation for the Great
Inflation in the United States because the natural rate of unemployment
rose in the 1970s. As the post-World War II baby boom generation entered
the workforce, the fraction of young people, who typically have higher
unemployment rates, rose. This caused the natural rate of unemployment
to rise. Then, as the baby boom generation grew older in the 1980s, the
natural rate of unemployment declined. Thus, with a rising and then
falling natural rate of unemployment, the time-inconsistency model
implies that the inflation rate should have risen and then fallen as
well.

I have questioned whether policymakers---who are assumed in this story
to be well aware of the time-inconsistency problem---could have dealt
with it long ago. Wouldn't they have seen the sub-optimality of the
equilibrium and dealt with it? In any case, even if Parkin's explanation
applies here, it cannot explain the rise and fall of inflation in Europe
and other parts of the world---see Figure 5---where the natural rate of
unemployment did not follow the same pattern.

V.V. Chari, Lawrence Christiano, and Martin Eichenbaum developed another
version of the time-inconsistency model that can be offered as an
explanation of the Great Inflation. As described by Christiano and
Christopher Gust the model is based on rational expectations with sticky
prices rather than the imperfect information used by Kydland and
Prescott. In this model a rise in people's expectations of inflation
forces a choice on the central bank: either accommodate the increase in
inflationary expectations by an increase in money growth, or do not
accommodate the increase and let unemployment rise. Their version of the
time-inconsistency problem is similar to the price shock explanation in
the sense that the central bank is "forced" into increasing money growth
in order to avoid a decline in real money balances and an increase in
unemployment. To complete this explanation, Christiano and Gust note
that expectations of inflation did rise in the late 1960s along with the
increase in actual inflation. For this model to explain the *end* of the
Great Inflation, however, more is needed---perhaps a sudden recognition
by policymakers that this time-inconsistency problem exists.

***Poor Data: Overestimating Potential GDP***

Athanasios Orphanides argues that an overestimate of potential GDP and a
corresponding underestimate of the full-employment unemployment rate
were factors that led monetary policymakers to provide too much monetary
stimulus and cause the Great Inflation. His analysis is based on
estimates of the actual data that existed in the 1970s. He feeds this
data into standard monetary policy rules and finds that the setting of
the interest rate is similar to the actual interest rates,
which---certainly based on what we know today---were way too low and
would be expected to lead to inflation, as they did.

Orphanides' work is a very useful reminder of the dangers that
uncertainty about potential GDP can create for monetary policy
procedures that use potential GDP. However, his estimates of real-time
potential GDP have their own problems. In my view they exaggerate the
size of the policy error that could be attributed to an overestimate of
potential GDP. Most important is that the potential GDP series used by
Orphanides was recognized at the time by monetary policy and business
cycle experts to be flawed. In fact, plans were in place at the Council
of Economic Advisers to publish a more realistic series for potential
GDP. In any case, I doubt that an expert historian of the business cycle
such as Federal Reserve Chairman Arthur Burns would have been confused
by this estimate of potential GDP.

### Ideas: The Development of Models of Inflation 

The development of new economic ideas and the adoption of these ideas by
policymakers and their staffs can obviously have an impact on economic
policy. But not all new economic ideas are correct. In my view the
idea---developed in the 1960s---that there was a long-run tradeoff
between inflation and unemployment contributed greatly to the Great
Inflation. Moreover, the discovery of flaws in those models by Milton
Friedman and the development of new models by Friedman, Edmund Phelps,
Robert Lucas, and others in the 1970s and 1980s helped create the
rationale for the disinflation and for the more recent period of price
stability.

A.W. Phillips' paper was published in 1958, and by the mid 1960s the
idea of a long-run Phillips curve tradeoff between inflation and
unemployment regularly appeared in the *Economic Report of the
President.* It appeared in textbooks and was widely discussed by the
media. Of course, the monetary policy implication of the Phillips curve
tradeoff was that unemployment could be permanently reduced if the
central bank increased money growth and created a higher rate of
inflation. The idea clearly had an impact on fiscal and monetary policy.
Recent historical work by Christina Romer and David Romer finds evidence
of this in the records of policymakers at the time. As the idea of a
long-run Phillips curve gained acceptance, it led politicians to be less
concerned about using monetary policy to overstimulate the economy.

As early as 1966 Milton Friedman was pointing out the theoretical flaws
in the Phillips curve argument. He showed using basic economic theory
that there could be no long-run tradeoff; excessive monetary expansion,
which temporarily brought unemployment below the natural rate, would
lead to accelerating inflation as people began to expect higher
inflation. He put his natural rate theory before the whole American
Economic Association in his presidential address in 1967. His model was
very controversial at the time, but as the Great Inflation picked up
steam and the inflation-unemployment facts started rolling in, the model
was proven to be right on the mark. Soon his natural rate idea was being
incorporated into econometric models used at the Fed and elsewhere.

Thomas Sargent's recent work on learning describes how the estimated
econometric models of the Philips curve equations changed as the Great
Inflation started and continued. With price stability in the 1950s and
early 1960s, expectations of inflation were low and the expectations
term in the Philips curve was small (certainly less than one). But as
inflation picked up so did the coefficient on the expectations term,
leading to confirmation of the Friedman model. One implication of
Sargent's work is that now that the Great Inflation is over, the
expectations term will decline again (which it has) and could again lead
economists to think that there is a long-run tradeoff. That is why it is
so important not to blindly run regressions, but rather to ground
empirical work on good economic theory as Milton Friedman did.

At least in the early years of the Great Inflation, the Friedman model
did not appear to have had a practical influence in leading to less
inflationary monetary policies. The Great Inflation started and it
continued. But the model did change the nature of the monetary policy
debate in a profound way. Rather than arguing that higher inflation
would lead to lower unemployment (the facts were not supporting such an
argument), people started arguing that there would be great costs of
*reducing* inflation. Such an argument was supported by the Friedman
model when *combined* with slowly adaptive expectations---the so called
"expectations augmented" Philips curve. If the Fed tried to reduce
inflation, people argued, expectations of inflation would come down very
slowly, and the gap between expected and actual inflation would raise
unemployment. Thus the model was used to justify a policy of avoiding
disinflation; such a reduction would be too costly. For example, George
Perry calculated that it would require a reduction of 10 percent of GDP
to reduce inflation by 1 percentage point. To the extent that such
estimates were incorporated into policymakers' thinking, they delayed
the disinflation and kept the Great Inflation going.

The 1974 White House *Economists Conference on Inflation* is indicative
of mainstream economic thinking at the time. Many distinguished
economists attended the event. Virtually all of them stressed the high
costs of disinflation. Walter Heller said "in bringing inflation to its
knees, we will put the economy flat on its back." Paul Samuelson said we
do not need a Winston Churchill-like "blood, sweat, and tears" program
to reduce inflation. Among all these distinguished economists, only
Milton Friedman argued unequivocally for inflation reduction. He said
the "strength \[of the U.S. economy\] is currently being eroded by the
disease of inflation. If that disease is not checked it will take a
heavy toll including, in my opinion, the very likely destruction of our
personal, political and economic freedoms....I heartily applaud, also,
the expressed determination of the Federal Reserve to slow monetary
growth...despite the cries of anguish about this table and elsewhere
about tight money, the slowing has so far lasted two or three months so
we cannot yet be sure the Fed has really departed from the ever more
inflationary path it has been following for the past decade".

So once again Milton Friedman was the exception. The more common view
among economists throughout the 1970s was that it was not worth the
costs to reduce inflation. This common view was based on the
expectations-augmented Phillips curve, not on the original Phillips
curve.

What started to shift economists' thinking about disinflation, in my
view, was the "rational expectations" revolution, and, in particular,
the replacement of adaptive expectations with rational expectations in
the "expectations-augmented" Phillips curve. Robert Lucas's 1972 paper
laid out the basic theory. Thomas Sargent and Neil Wallace drew out the
policy implications: the costs of disinflation were essentially zero for
a credible policy of disinflation. Of course, these striking findings
required the extreme assumption that prices and wages were perfectly
flexible, but they certainly got people to think about alternative
views.

At about the same time, models with staggered wage and price setting and
rational expectations that preserved the long-run neutrality that
Friedman required were also being developed. In these new sticky wage
and price setting models the costs of disinflation also appeared to be
much lower than previously thought. Using estimated econometric models
that combined staggered price setting (rather than perfectly flexible
prices) with rational expectations, I calculated in the late 1970s the
disinflation costs: they were not zero but they were much smaller than
those found using conventional models.

***Changes in Leadership***

So far the explanations I have mentioned focus on economic models, on
shocks, on biases, and on data errors. Another explanation of the Great
Inflation and its demise can be found in changes in economic and
political leadership. Here, once again, Milton Friedman's insights are
valuable. He argues that the Great Inflation occurred because of the
political and economic officials who were in charge at the time that it
started. And the Great Inflation ended because of the people who were in
charge at the time that it ended. In fact, he places more importance on
changes in leadership than on changes in knowledge. He notes the lack of
economic leadership in the late 1960s and early 1970s and the
re-emergence of leadership during the disinflation period in the early
1980s.

I can do no better than to quote Milton Friedman on the topic of
leadership using excerpts from an interview I recently conducted.

> *Taylor*: Why did inflation start to rise in the late 1960s and 1970s
> in the United States?
>
> *Friedman*: Yes, the Great Inflation, the explanation for that is
> fundamentally political, not economic\....I believe that Arthur Burns
> deserves a lot of blame, and he deserves the blame because he knew
> better. He testified before Congress that, if the money supply grew by
> more than 6 or 7 percent per year, we'd have inflation, and during his
> regime it grew by more than that. He believed in the quantity theory
> of money but he wasn't a strict monetarist at any time\....
>
> *Taylor*: Do you think Burns was part of the culture of the times in
> that he put less emphasis on inflation, or that he was willing to risk
> some inflation to keep unemployment low, based on the Philips curve?
>
> *Friedman*: Not at all. You read all of Arthur's writings up to that
> point and one of his strongest points was the avoidance of inflation.
> He was not part of that Keynesian group at all\....
>
> *Taylor*: Another thing that people say now is that Burns was as
> confused as other people were about potential GDP, and that he thought
> the economy was either below capacity or that it was capable of
> growing more rapidly than it was. Do you think that was much of a
> factor?
>
> *Friedman*: I don't think that was a major factor. I think it may have
> been a factor.
>
> *Taylor*: What about the end of the Great Inflation?\...
>
> *Friedman*: Well, there's no doubt what ended it. What ended it was
> Ronald Reagan. If you recall the details, the election was in 1980. In
> October of 1979, Paul Volcker came back from a meeting in Belgrade, in
> which the U.S. had been criticized, and he announced that the Fed
> would shift from using interest rates as its operating instrument to
> using bank reserves or base money\....Reagan was elected and Reagan
> was determined to stop the inflation and willing to take risks. In
> 1981, we go into a severe recession. Reagan's public opinion ratings
> went down, way down. I believe that no other president in the post-war
> period would have accepted that without bringing pressure on the Fed
> to reverse course. That's the one key step: Reagan did not. The
> recession went on in 1981 and 1982. In 1982 Volcker turned around and
> started to raise the money supply and at that point the recession came
> to an end.

**The Evolution of Monetary Policy Rules**

A second important strand in post-World War II monetary history is the
change in the way the instruments of policy are set. To describe this
change I need to first focus on what the instrument of monetary policy
is. The choice is between the interest rate and the monetary base.
(There is also the related question, which I am not addressing here,
about whether there should be an intermediate target for a broader
monetary aggregate or simply an inflation target.) There has been an
increased focus on the interest rate in recent years. To some extent
this has been a matter of increased transparency; in the past many
central banks had been implicitly setting interest rate targets. In 1994
the Federal Open Market Committee (FOMC) began issuing public statements
about its federal funds rate decisions. The FOMC now directs the Trading
Desk in New York to buy and sell securities so that conditions in the
federal funds market are consistent with an average funds rate near its
stated target. Similar developments occurred at other central banks with
the overnight interest rate typically being determined by stated
borrowing and lending rates as in New Zealand, Canada, and the European
Central Bank.

Now, with the focus increasingly on the overnight interest rate as the
instrument, there has been a shift in how monetary economists analyze
central bank decisions. Rather than evaluate each decision as an
isolated one-time adjustment, the evaluation is about the overall
dynamic strategy for setting the instrument. In other words, policy
analysis places greater emphasis on the coefficients of monetary policy
rules. This change in emphasis is quite profound. It grew out of early
work on monetary policy rules by Milton Friedman; the recent resurgence
was motivated in part by endeavors to incorporate anticipatory behavior
in markets into policy evaluation. Following Lucas, such forward-looking
behavior has frequently been modeled by assuming rational expectations.
In a rational expectations environment one cannot even evaluate monetary
policy without thinking of a policy rule that lays out future
contingencies. These were some of the motivations for the policy rule
research that I was engaged in during the 1970s and 1980s and which
resulted in the normative proposal in my 1993 "Rules versus Discretion
in Practice" paper.

This change in thinking about monetary policy is observed both inside
and outside of central banks. When economists evaluate monetary policy,
they simulate models with policy rules inserted in them rather than
simply simulating one-time changes in the instruments. When financial
market analysts try to determine what a central bank should or should
not do, they usually consider a monetary policy rule. And central banks
frequently use policy rules as an input to their actual decisions.

An unexpected benefit of the monetary policy rule approach is that it
has revealed changes in the decisionmaking processes at central banks.
One important change is in how the federal funds rate has responded to
events in the economy. The response can be measured by the coefficient
in the policy rule. John Judd and Glenn Rudebusch discovered such a
change for Federal Reserve policy by empirically estimating a policy
rule for the federal funds rate. They found that the response of the
federal funds rate to the inflation rate has increased over time. During
the late 1960s and 1970s the coefficient was less than one; during the
period since the mid 1980s the coefficient has been greater than one.

The difference in the estimates in the two time periods is illustrated
in Figure 7; note how the slope of the interest rate response line has
increased, holding the response to other variables constant. A more
dramatic illustration of the change is shown in Figures 8 though 11
where the interest rate is shown at two different points in time. In the
United States when the inflation rate approached four percent in 1968,
the federal funds rate was about five percent. When the inflation rate
approached four percent in 1989, the federal funds rate was about ten
percent, clearly a much larger response. The same phenomenon is seen for
the United Kingdom, Canada and Australia in Figures 9-11.

Whether the coefficient is greater than one or not is important. With
the coefficient greater than one, the response of the nominal interest
rate is of a large enough magnitude that the *real* interest rises when
inflation rises. This interest rate response reduces inflationary
pressures and brings inflation back down. With the coefficient less than
one, an increase in inflation is not countered by an increase in the
real interest rate; in this case monetary policy is very accommodative
and this leads to less price stability. It is not enough simply to raise
the overnight interest rate when inflation rises. It is necessary to
increase the interest rate by the right amount. Economic theory and
model simulations both show that if a central bank is to use an interest
rate instrument, it needs to respond appropriately if it is to achieve
price stability. It is thus no coincidence that the low (less than one)
coefficient describes the years of price instability during the Great
Inflation, while the higher (greater than one) coefficient describes the
years of price stability that followed. Monetary history confirms what
theory and econometrics predict.

I have always stressed that monetary policy rules are only a guide or
approximation to central bank decisions. Real world monetary policy
decisionmaking requires judgement and leadership, but policy rules can
be helpful. Now let me consider how the Fed came to change the interest
rate responses in the direction suggested by Judd and Rudebusch. The
evolution of an estimated monetary policy rule is, in my view, best
understood as a gradual process of central banks learning how to conduct
monetary policy. This learning occurs through research by the central
bank, through the criticism by monetary economists outside the central
bank, through observation of central bank behavior in other countries,
and through direct practical policy experience of central bankers
themselves. Discussions of how policy should respond are probably as old
as central banks. For example, there were discussions of the idea of
"leaning against the wind" early in the Fed's history. The 1923 annual
report stated "it is the business of the \[Federal\] Reserve system to
work against extremes either of deflation or inflation and not merely to
adapt itself passively to the ups and downs of business" (quoted in
Friedman and Schwartz). But there was no agreement about how much
leaning against the wind there should be. Leaning against the wind would
result in a policy rule, but the parameters of the policy rule could be
far from optimal.

Consider the period after the 1951 Accord when the Fed had to decide
what to do with the interest rate. One recommendation was to lean
against the wind, raising the interest rate when the economy grew more
rapidly or inflation started to pick up. Leaning against the wind seemed
to have the directions of interest rate adjustments right, but it had
nothing to say about the size of the adjustments. What is the wind? How
do you measure it? What do you lean with and by how much? There were
many important, but unanswered, questions. Leaning against the wind---as
articulated by William McChesney Martin---became a guideline for
decisions. But the idea was still very vague. As stated by Friedman and
Schwartz, "There was essentially no discussion of how to determine which
way the relevant wind was blowing....Neither was there any discussion of
when to start leaning against the wind....There was more comment, but
hardly any of it specific, about how hard to lean against the wind."

I have found other commentary that indicates that monetary policymakers
still had much to learn about how to react. James Meigs at the St. Louis
Fed described the situation in the 1950s, "...The Manager \[of the open
market account\] generally tried to keep free or net borrowed
reserves...at a level, he thought would satisfy FOMC members' desires
for a little more, or a little less, or about the same degree of
restraint." But the degree of restraint was not quantitatively defined
and the impact of changes in the degree of restraint was uncertain. "We
were as uncertain about how monetary policy worked as were our
colleagues at the other Reserve Banks and the Board." A similar
accounting comes ten years later in the mid 1960s from then new board
member Sherman Maisel. According to Maisel, "After being on the Board
for eight months and attending twelve open market meetings, I began to
realize how far I was from understanding the theory the Fed used to make
monetary policy....Nowhere did I find an account of how monetary policy
was made or how it operated....Money market conditions cannot measure
the degree to which markets should be tightened or for how long
restraint should be retained." And when referring to a decision to raise
the short-term interest rate in 1965, he states, "It became increasingly
clear that an inflationary boom was getting underway and that monetary
policy should have been working to curb it." He argued that the actions
taken to raise interest rates were insufficient to curb the inflation.
He was correct. Interest rates did not go high enough. This is perhaps
not surprising in the absence of a quantitative measure of how high
interest rates should go.

The importance of having a quantitative guide for policy became even
more important when the Bretton Woods system fell apart in the early
1970s. Until then the long-run constraints on monetary policy were
similar to those of the international gold standard. If the Fed did not
lean hard enough against the wind, the higher inflation rate would start
to put pressure on the exchange rate and the Fed would have to raise
interest rates to defend the dollar. Without the dollar to defend, this
constraint on monetary policy was lost. After Bretton Woods ended there
was an even greater need for the Fed to develop a monetary policy rule
that was sufficient to contain inflation without the external
constraint.

The research program undertaken by monetarists---Milton Friedman, Homer
Jones, Allan Meltzer---helped change this situation. By measuring money
and by examining the demand for money, they helped policymakers see how
a policy rule---in this case a rule for the money supply---might work.
The research was also essential in helping policymakers distinguish
between real interest rates and nominal interest rates. A lack of
understanding of the real interest rate was one reason why the interest
rate reaction was too small. Of course, there were other factors that
led to the change in monetary policy, including the change in the macro
framework that I discussed earlier. But the increased emphasis on money
growth in the 1970s played a very useful role in clarifying the serious
problems of interest rate setting without any quantitative guidelines.
In my view, by the 1980s this learning process resulted in a recognition
that changes in interest rates had to be larger and quicker if inflation
was to be tamed and kept low once it was tamed.

***Changes in the Business Cycle***

How did this change in monetary policy affect the economy? We know that
the inflation rate came down and there has been greater price stability.
What about the real economy? Just as the natural rate theory predicted,
the lower inflation rate has not increased the unemployment rate. Indeed
the natural rate of unemployment declined in the United States in the
1990s.

What is perhaps most surprising, however, is that the volatility of the
business cycle has been much lower during the period of price stability.
This improvement in output stability is shown in Figures 12 through 15
for the United States and the other countries whose inflation rates are
shown in Figures 2 through 4. Thomas Dalsgaard and others have shown
that this improvement exists for most OECD countries.

For the United States, the 1980s and the 1990s expansions were the
second and first longest in peacetime history. The recession of 1990-91
was short and mild as was the 2001 recession. In a Homer Jones lecture
in 1998 I referred to the period of these long expansions as the Long
Boom. I have argued that the change in monetary policy was responsible
for this macroeconomic improvement. Others have suggested other
explanations---better inventory management, a more services-oriented
economy---but the reduction in the "boom-bust" cycle due to greater
price stability provides the simplest and most complete explanation in
my view. The changes in inventory management and in services are
long-term trends and do not coincide with the changes in Figures 12
through 15.

**The Diffusion of Monetary Policy Ideas**

Much of my discussion about the rise and fall of inflation and about
changes in monetary policy has focussed on the United States. But, as I
indicated, the same broad developments have occurred in many other
countries around the world. Inflation rose and fell in other countries
and price stability is now much more common, as I showed in Figures 2
through 5. There is also more transparency about interest rate
decisions.

What is the reason for this correlation? Could some of the same factors
driving the policy changes have been at work in other countries? In my
view the answer is yes. Clearly the ideas about the Phillips curve
inflation-unemployment tradeoff were discussed widely in many countries.
The ideas appeared at the OECD as much as the CEA. The natural rate
hypothesis and the rational expectations calculations that the costs of
disinflation were not so large, especially in comparison with the cost
of inflation itself, may have caught on more slowly in other countries;
but eventually they did catch on and would have the same impact on
policy as in the United States.

The inflation targeting movement also helped spread the ideas about the
cost/benefit calculations of achieving and maintaining price stability.
Inflation targeting has been helpful in the disinflation process in the
1990s, especially for countries that started with very high inflation
rates such as Brazil. New Zealand adopted inflation targeting as part of
a public management reform movement where each government agency was
made accountable for achieving measurable results. In New Zealand the
measurable result for the central bank was an explicit numerical target
for inflation. The experience in New Zealand and extensive writings by
Lars Svensson and others helped spread the idea of inflation targeting
to Sweden and other countries.

The use of monetary policy rules for analyzing monetary policy has also
spread to other countries. The experience of other countries and the
extensive research by Bennett McCallum and others on policy rules have
been a significant factor in the diffusion process. There are many ways
for policymakers in different countries to share experiences about what
is helpful and what is not. The activities of the Bank for International
Settlements and the International Monetary Fund provide opportunities
for many such exchanges. The web pages provided by central banks and
monetary economists outside of central banks also help in the diffusion
process.

There is another favorable development in the last few years. More
countries have chosen to abandon pegged exchange rates and, instead,
have chosen either to use a monetary policy based on flexible exchange
rate or to permanently connect monetary policy to other countries
through monetary union, dollarization, or a currency board. By our count
at the U.S. Treasury, 47 countries operate a monetary policy with a
flexible exchange rate and 50 countries are either dollarized, in
monetary unions, or using currency boards. The number with fixed or
heavily managed exchange rates is falling and is now at 75. Fortunately,
there are only 7 countries with multiple exchange rates.

In sum, there are now 97 countries that have dollarized, joined a
currency union, created a currency board, or floated their exchange
rate. There is a common feature in all 97 countries. They are
endeavoring to benefit from the progress made in the practice of
monetary policy. They are either tying to a central bank with good price
stability goals and instrument setting procedures, or they are trying to
pursue an independent monetary policy using those goals and procedures
themselves.

## Conclusion

Before I finish this historical review I need to remind everyone about
the many practical monetary problems that are still left in the world.
For example:

Among the industrial nations, a serious monetary problem is the
deflation in Japan. It has continued for seven years and appears to have
become persistent. The Bank of Japan ran a good monetary policy based on
price stability for much of the 1970s and 1980s. It was a policy based
on keeping the growth rate of money steady. But declines in money growth
in the 1990s led to deflation, which now needs to be addressed by
increasing money growth and reforming the banking sector.

Among the emerging market countries, the currency mismatch
problem---where banks, governments, and non-financial firms have
liabilities in dollars and assets or income streams in local
currencies---is a potential cause of instability. Without an adequate
supply of dollar reserves central banks cannot provide lender of last
resort facility for dollar deposits at banks.

And among the poor developing economies many still have yet to introduce
transparent monetary policies aimed at price stability.

Nevertheless, as I have tried to emphasize in this review, great
progress has been made in monetary economics and policy. I hope it is
clear from all the references to Milton Friedman that he has made an
enormous contribution to this progress. He is an inspiration for us all,
but especially for those who work in the areas of monetary economics and
policy.

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