Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

What Is the Monetary Standard, or, How Did the Volcker-Greenspan FOMCs Tame Inflation?

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

What Is the Monetary Standard, or, How Did the Volcker-Greenspan FOMCs Tame Inflation?

Article excerpt

(ProQuest: ... denotes formula omitted.)

What is the monetary standard? Another way to ask this question is to ask how central banks control the price level. In this article, I contrast two views. What I term the "quantity-theory" view implies that to control inflation (with the interest rate as its policy instrument) the central bank needs a policy (reaction function) that relinquishes control of real variables to the price system and that controls trend inflation through the way it shapes the expectational environment in which price setters operate. With credibility, a central bank can allow drift in the price level arising from inflation shocks because these shocks do not propagate. What I term the "nonmonetary" view implies that to control inflation the central bank needs a reaction function whose central element is the manipulation of the difference between the unemployment rate and a full employment benchmark for unemployment subject to the constraint imposed by the Phillips curve. The Phillips curve gives the cost in terms of excess unemployment of preventing inflation shocks from propagating into inflation.

Section 1 exposits the quantity-theory view while Section 2 makes it relevant to actual central bank procedures. Section 3 presents the nonmonetary view. Section 4 treats the contrast between the pre-and post-Volcker periods as an "experiment" in policy procedures useful for choosing between these two views.

1. THE QUANTITY-THEORY VIEW OF INFLATION

The nominal-real distinction is at the heart of the quantity theory. It arises from the "rationality postulate." Namely, only real variables (physical quantities and relative prices) as opposed to nominal variables (dollar magnitudes) affect individuals' well-being. Because individuals care only about real variables, the implication follows that central banks must care about (control) a nominal variable to control the price level. Central banks possess a monopoly on the creation of the monetary base (a nominal variable). However, because they use the interest rate as their policy variable, money (the monetary base) is determined by market forces. What nominal variable do they control that allows them to influence the behavior of price setters, who care about only real variables (relative prices)? The following explanation proceeds from the insights incorporated in the Cambridge equation of exchange, to theWicksellian discussion of money supply determination, to the rational expectations discussion of nominal determinacy with central bank interest rate targeting, and finally to discussion of how central banks influence the behavior of price setters.

Equation (1) shows the Cambridge equation of exchange:

... (1)

with m^sub t^ the nominal money stock; pt the price level; k(r^sub t^) the fraction of its income the public desires to hold in the form of money, which depends on the nominal interest rate, r^sub t^; and y^sub t^ real income (Pigou 1917). Equation (1) receives content from the assumption that the central bank can cause nominal money, m^sub t^, to change independently of the public's demand for real money (purchasing power), k(r^sub t^) y^sub t^. In these circumstances, the price level will adjust. As a heuristic illustration of how nominal money can change without a prior change in real money demand, Milton Friedman ([1969]1969) made famous the example of a drop of helicopter money.1

This formulation is not generally applicable to historical experience because central banks have only rarely attempted to control money directly through targets for monetary aggregates.2 Nevertheless, what is captured by the quantity-theory appellation is that changes in the price level function as an equilibrating variable in a way that depends on how the central bank controls money creation. In the case in which it pegs its exchange rate to another currency, the price level varies to cause the real terms of trade to vary to equilibrate the balance of international trade. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.