Academic journal article Federal Reserve Bank of St. Louis Review

Can the Central Bank Achieve Price Stability?

Academic journal article Federal Reserve Bank of St. Louis Review

Can the Central Bank Achieve Price Stability?

Article excerpt

principal diagonal of matrix A. (ii) The effects of inflation and anticipated inflation upon the change in unemployment and the change in inflation are equal and opposite. (iii) All variables are measured as deviations from their steady-state values. Then the SM dynamic system is:

(A.1) D[Pi] = -.197 [Pi]     - .1 u         + .197[Pi]*
(A.2) Du = -.1[Pi]           - .347u        + .1[Pi]*
(A.3) D[Pi]* =                              - . 138[Pi]*

Surrogate system (estimates from Table 2, rounded) THE FOMC'S STATED POLICY objectives are to "foster price stability and promote sustainable growth in output." Can these objectives be achieved with the tools available? We know that there is a long-run relationship between the ratio M/y = Money/real GDP and the P = GDP deflator of the form

(a) P = V(M2/y),

where V is the velocity function, shown in Figure 1. The Federal Reserve would like to select ranges for monetary growth over the coming year consistent with price stability.(1) This is the policy of monetary targeting. The rationale for the policy of monetary targeting is the existence of a stable and reliable relationship between the rate of growth of monetary aggregate Mi [denoted [[Mu].sub.i](t)] and the rate of inflation (denoted [Pi]) either during year t or possibly t + 1 of the form

(b) [Pi](t) = c + c[prime][[Mu].sub.i] (t) or

(c) [Pi](t) = c + c[prime][[Mu].sub.i](t - 1).

Equation (a) is a long-run relation between the price level and the stock of money per unit of real GDP, and equations (b) and (c) are shorter-run relations between the rate of growth of prices and the rate of growth of money. They are quite different.

It has been amply demonstrated by monetarists that neither the growth of M1 nor of M2 produces a stable and reliable relationship of the form (b) or (c).(2) The targeting of M1 was abandoned when the velocity function changed drastically after 1980, and M2 targeting was then used. There was subsequent disappointment with targeting M2. Figure 2a-d shows why monetary targeting equations (b) and (c), either for M1 or M2, are not reliable. The source of the problem is the instability and unreliability of the velocity function (V1 for M1, and V2 for M2 in Figure 3a). This led Alan Greenspan (1993) to question the usefulness of M2 targeting [equation (b) or (c)]:(3)

"...the relationship between money [M2] and the economy may be undergoing a significant transformation....This is not to argue that money growth can be ignored in formulating monetary policy....Selecting ranges for monetary growth over the coming year consistent with desired economic performance, however, is especially difficult when the relationship [velocity] between money and income has become uncertain. Recent experience suggests that...measuring money against such ranges may lead to erroneous conclusions regarding the stance of monetary policy."

Greenspan's disappointment with the use of monetary targeting (M2) has led him to revive the concept of interest rate targeting.

The ultimate question is how the central bank should try to produce price stability and sustainable growth. Our paper addresses several important questions:

1. Is there an economically significant, structurally stable, policy-rule-invariant relationship between the rate of growth of a monetary aggregate and the rate of growth of the price level? If so, that monetary aggregate is referred to as an indicator. What monetary aggregates, if any, qualify as indicators?

2. Which monetary aggregate is an intermediate target? An intermediate target is defined as a variable Z which is an indicator and is also controllable over a range of policy regimes.

3. Under what conditions can Federal Reserve policy be used to speed the recovery and what will be the consequences for the rate of inflation?

4. Does the controllable Treasury bill rate qualify as an indicator or intermediate target? …

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