From: levine@haas.berkeley.edu
To: e201b-1@haas.berkeley.edu, e201b-2@haas.berkeley.edu
Date: 1999-11-29 20:02:00+00:00
Subject: Fwd: FRBSF: Economic Letter (01/29/1999)

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

David I. Levine                 Associate professor
Haas School of Business    ph: 510/642-1697
University of California    fax: 510/643-1420
Berkeley CA  94720-1900                            email:
levine@haas.berkeley.edu
http://web.haas.berkeley.edu/www/levine/