The rationale for independent monetary policy

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1. Introduction

Recently there has been a great deal of media discussion concerning the independence of the Federal Reserve in its role as the designer and implementer of monetary policy. In this outpouring of words there has, however, been little if any explicit discussion of the rationale for central bank independence. This absence is extremely unfortunate, for it makes little sense to discuss the desirability of central bank independence, and the design of alternative arrangements for providing and insuring – or modifying – such independence, in the absence of an understanding of what it is supposed to accomplish and how it is expected to do so. In the present paper, I will argue that a crucial aspect of monetary policy is a systematic discrepancy in the times that elapse after policy actions before the observance of real and monetary effects. This discrepancy lends an inflationary bias toward policy efforts that is more pronounced, the more impatient is the policymaker. Finally, I compare current monetary practices with those specified by the U.S. Constitution, and indicate how the intentions promoted by the Constitution could be fulfilled under today’s fiat money monetary institutions.

2. Response-Time Discrepancy

There is, no doubt, more than one line of argument for central bank (CB) independence. Nevertheless, I will focus on one particular rationale, presuming that other members of the SOMC will be discussing others1. The simplest way to describe the one that I have in mind is as follows: When the CB eases policy – i.e., making monetary conditions more stimulative and aggregate demand stronger – the socially desirable effects arrive more promptly than do the undesirable effects. That is, there will normally be effects that can be thought of as expansions (relative to what would have prevailed in the absence of the policy change) of output and employment that will begin to occur within two or three months. Then after one or two years there will also occur upward pressures on the inflation rate. If instead the policy action is one that tightens policy, rather than loosening it, there will be relatively prompt reductions of output and employment, followed in a year or so by reductions in the inflation rate. Now, it is the case that most economists, congressmen, commentators, and citizens consider expansions in the level of employment and output to be desirable and consider increases in the inflation rate to be undesirable. Accordingly, if monetary policy is required to be politically acceptable, there is a tendency for policy to be more expansionary and inflationary the more impatient is the policymaker – the shorter is his effective time horizon.

What is it in the workings of the economy that creates this difference between the speeds with which output-employment and inflation responses occur? There is, unfortunately, some disagreement among monetary and macro economists about the exact nature of the “transmission mechanism” from policy actions to outcomes; indeed, I have argued in the past that this issue represents the weakest link in our models of the economy2. There is, however, essentially no disagreement as to the existence of the asymmetry. Builders of “Classical,” “Keynesian,” “New Classical,” “New Keynesian,” “Real Business Cycle,” “Austrian,” and “Minskyian” models all share this agreement, as do the proponents of both highly structured dynamic-stochastic-general-equilibrium (DSGE) methods and also non-structural vector-autoregression (VAR) approaches.

By far the most widely-held position among mainstream economists, however, is that the lagging aspect of inflation-rate effects, relative to output effects, stems from some form of “stickiness” of nominal prices and/or wages – some sluggishness in the price adjustment mechanism. This type of behavior is at the heart of New-Keynesian (NK) approaches, reflecting J.M. Keynes’s emphasis on models with precisely that feature (i.e., models in which prices do not adjust at all “in the short run” with all adjustment taking place in quantities). But it is also central to the “monetarist” analysis of Milton Friedman (and, e.g., Anna Schwartz, Karl Brunner, and Allan Meltzer) and to its current-day counterpart in the “New Neoclassical Synthesis” as described by Goodfriend and King (1997).

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