Magazine article Business Review (Federal Reserve Bank of Philadelphia)

Why Does Countercyclical Monetary Policy Matter?

Magazine article Business Review (Federal Reserve Bank of Philadelphia)

Why Does Countercyclical Monetary Policy Matter?

Article excerpt

Modern capitalistic economies use stabilization policies to minimize fluctuations in the employment and inflation raters. In the United States, the Federal Open Market Committee (FOMC) lowers the target interest rate for interbank loans as economic activity slows or when a financial crisis looms (as in the fall of 1998) and raises it when inflation threatens to accelerate (as in late 1999 and early 2000).

Such countercyclical monetary policy is one example of a stabilization policy. Other examples of U.S. stabilization policies include the federal insurance of bank deposits (and the concomitant supervision and regulation of banking) and income-maintenance programs, such as unemployment insurance.

Macroeconomists have devoted much effort to understanding how countercyclical monetary policy affects the volatility of the unemployment and inflation rates. In contrast, macroeconomists have directed much less effort to understanding why countercyclical monetary policy is beneficial. This neglect reflects the fact that, until recently, macroeconomists of very different persuasions agreed that policies aimed at reducing the volatility of unemployment and inflation are desirable. Of course, economists disagreed about what form those policies should take, but no one questioned the premise that a less volatile macroeconomic environment was a desirable policy goal.

That is no longer the case. During the last dozen years or so, an influential minority of macroeconomists has questioned the supposed benefits of reducing volatility and, by implication, the supposed benefits of countercyclical monetary policy.

The source of this development is the same as that which underlies most major developments in macroeconomics in the last half-century, namely, the desire to ground macroeconomics in sound theoretical foundations. As in the other sciences, "sound theoretical foundations" means explaining macro-level phenomena in terms of micro-level phenomena; for example, using theories of household and business behavior to explain the behavior of, say, aggregate consumer spending or aggregate business investment.

The desire for micro-foundations also means that macro-level policies (such as countercyclical monetary policy) need to be justified in terms of micro-level effects -- how such policies ultimately benefit households. Surprisingly, the link between less macroeconomic volatility and improved household well-being has proven weaker than many macroeconomists might have supposed.

Concerns about the benefits of countercyclical monetary policy (and of stabilization policies in general) are obviously of great importance to the Federal Reserve System. My purpose in this article is to accomplish two tasks: to state clearly the mainstream view of the supposed benefits of countercyclical monetary policy and the challenge posed to it by recent microfoundations-oriented research; and to consider how this challenge may alter our views about the benefits of countercyclical monetary policy.


Let's begin with a brief account of how mainstream macroeconomics makes sense of countercyclical monetary policy.(1) In the mainstream view, the actual unemployment rate can deviate from the natural, or long-term, unemployment rate. This natural rate is determined by factors that change slowly, such as demographics, technology, laws and regulations, and social mores. Because markets don't work perfectly, there can be extended periods when the actual unemployment rate exceeds the natural rate. During such times, mainstream macroeconomic theory predicts that the inflation rate will fall because aggregate demand for goods and services will tend to fall short of aggregate supply. At other times, the unemployment rate can fall below the natural rate, and during those times, theory predicts that the inflation rate will rise because aggregate demand will tend to exceed aggregate supply. …

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