Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Monetary Policy Comes of Age: A 20th Century Odyssey

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Monetary Policy Comes of Age: A 20th Century Odyssey

Article excerpt

In the early 1960s the Federal Reserve (Fed) was little known outside of the financial services industry and university economics departments. Twenty years later Fed Chairman Paul Volcker was one of the most recognized names in American public life. Now hardly a week goes by when the Fed is not featured prominently in the business news. The Fed was thrust into the limelight in the intervening years when the public came to associate it with inflation-fighting policy actions that raised interest rates and weakened economic activity. Even though inflation has been held in check since the mid1980s, the public remains acutely aware of Fed policy today.

Monetary economists and central bankers alike now understand that effective monetary policy must be built on a consistent commitment to low inflation. That is why in recent years the Fed has made low inflation a particularly high priority. The large fraction of the public having first-hand experience with high inflation naturally supports the view that inflation must be contained. As the collective memory of inflation fades, however, public support for low inflation will become increasingly difficult to sustain. A permanent national commitment to price stability requires that citizens personally unfamiliar with the trauma of high inflation understand the rationale for price stability and the tactical policy actions needed to maintain it.

This article reviews the history of U.S. monetary policy in the 20th century with the aim of providing that understanding. It identifies mistakes that led to high and volatile inflation, lessons learned from the experience, and principles applied in the pursuit of low inflation today. U.S. monetary policy came of age in the 20th century in the sense that the country left the strict rules of the gold standard for the freedom of an inconvertible paper standard, which the Fed only slowly and painfully learned to manage. What follows is the story of that 20th century odyssey.

Section 1 discusses monetary policy under the gold standard and the circumstances that led to the founding of the Fed. Section 2 outlines the main conceptual obstacles that had to be overcome in order to manage monetary policy under a paper standard. The causes and disruptive consequences of inflationary policy at mid-century are discussed in Section 3.

Certain key theoretical and practical developments paved the way for the Fed to take responsibility for controlling inflation in the early 1980s. Section 4 covers these developments. Progress in the theory of the demand for and the supply of money as well as empirical evidence supporting the theory played key roles here. The failure of nonmonetary approaches to controlling inflation was also important. The recognition that a credible Fed commitment to price stability could minimize the unemployment cost of achieving low inflation also played a role.

Section 5 recommends that the Fed be given a legislative mandate for low inflation. The case is based on lessons learned in the inflationary 1960s, '70s, and early '80s, and on the principles that have been applied successfully to maintain low inflation since then. The closing section summarizes the monetary policy lessons learned on the 20th century odyssey.

1. MONETARY POLICY UNDER THE GOLD STANDARD

When the Federal Reserve was established in 1913, inflation was not the problem it was to become in the latter part of the century. The nation was on a gold standard and the purchasing power of money in 1913 was about what it had been 30 years before, or for that matter, 100 years before. The gold standard sharply restricted inflation by requiring that money created by the U.S. Treasury be backed by gold.1

The classical gold standard yielded price stability only to the extent that the Treasury's stock of monetary gold happened to expand at a rate sufficient to satisfy the economy's demand for money at stable prices. For instance, slow growth in the gold supply caused the price level to decline at over 1 percent per year from 1879 to 1897, and gold discoveries and new mining techniques caused inflation to average over 2 percent per year between 1897 and 1914. …

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