Central banks create the monetary standard. Standard Federal Reserve System (Fed) rhetoric is that the Federal Open Market Committee (FOMC) pursues the dual mandate legislated by Congress. Over some appropriately long time horizon, the FOMC assures the public that it conducts policy in a way that achieves “maximum employment” and “price stability.” But how? In a market economy, there is no central planning. There are no wartime price controls that dictate how firms set prices. There is no wartime rationing to control the spending of households. The financial system is free to allocate credit. What then is the monetary standard?
As a central bank, the Fed has the unique responsibility to give money a well-defined value, that is, to determine the behavior of the price level. A perennial empirical regularity is the joint occurrence of monetary (price level) instability and real instability (cyclical fluctuations in output and employment). What accounts for fluctuations in the value of money over long periods of time, and what accounts for the joint interaction of the value of money with the cyclical fluctuations in the real economy?
An answer not only to the question “What is the monetary standard” but also to the question “What is the optimal monetary standard” requires a model. The model will explain how the behavior of the Fed in setting its instrument interacts with the price system to influence the behavior of households and firms. That model should bring coherence to the monetary history of the United States. It should do so by organizing a summary of the evolution of the monetary standard and by informing when the standard has stabilized the economy and when it has destabilized the economy.
Knut Wicksell said a hundred years ago in his Lectures on Political Economy:
With regard to money, everything is determined by human beings themselves, i.e. the statesmen, and (so far as they are consulted) the economists; the choice of a measure of value, of a monetary system, of currency and credit legislation—all are in the hands of society.
Wicksell followed up by noting:
The establishment of a greater, and if possible absolute, stability in the value of money has thus become one of the most important practical objectives of political economy. But, unfortunately, little progress towards the solution of this problem has, so far, been made.
The Federal Reserve System operates under a “dual mandate” from Congress to provide for stability in prices and in employment. Because the mandate is so general, it provides no guidance as to the actual monetary standard that policy makers (Wicksell’s “statesmen”) have “determined.” Without explicit articulation by Fed policy makers and without thorough debate and examination by academic economists, the monetary standard will always be fragile and subject to political pressures. The accident of personality of who becomes a policy maker can cause the monetary standard to become destabilizing.
Wicksell also wrote: “Monetary history reveals the fact that that folly has frequently been paramount; for it describes many fateful mistakes. On the other hand, it would be too much to say that mankind has learned nothing from these mistakes.” How does one know what the Fed has learned? Learning requires admission that policy makers can make “fateful mistakes.” What model captures those mistakes and the lessons learned?
Economists have long asked the Fed for a model and for a characterization of the consistency in its behavior (a rule). James Tobin wrote:
There is really no substitute for making policy backwards, from the desired feasible paths of the objective variables that really matter to the mixture of policy instruments that can bring them about. . . . The procedure requires a model—there is no getting away from that. Models are highly imperfect, but they are indispensable. The model used for policy-making need not be any of the well-known forecasting models. It should represent the policymakers’ beliefs about the way the world works, and it should be explicit. Any policymaker or advisor who thinks he is not using a model is kidding both himself and us. He would be well advised to make explicit both his objectives for the economy and the model that expresses his view of the links of the economic variables of ultimate social concern to his policy instruments.
The most famous proponent of an explicit rule was Milton Friedman, who wrote:
Every now and then a reporter asks my opinion about “current monetary policy.” My standard reply has become that I would be glad to answer if he would first tell me what “current monetary policy” is. I know, or can find out, what monetary actions have been: open-market purchases and sales and discount rates at Federal Reserve Banks. I know also the federal funds rate and rates of growth of various monetary aggregates that have accompanied these actions. What I do not know is the policy that produced these actions. . . . The closest I can come to an official specification of current monetary policy is that it is to take those actions that the monetary authorities, in light of all evidence available, judge will best promote price stability and full employment—i.e., to do the right thing at the right time. But that surely is not a “policy.” It is simply an expression of good intentions and an injunction to “trust us.”
A characterization of the monetary standard requires a structural model of the economy and a rule that summarizes the behavior of the Fed, that is, a summary of how the Fed responds to incoming information on the economy given its objectives. In modern monetary models, households and firms (“agents”) base their behavior on how the Fed’s rule determines the monetary standard (“the stochastic environment agents believe themselves to be operating in”): Robert Lucas wrote,
Our ability as economists to predict the responses of agents rests, in situations where expectations about the future matter, on our understanding of the stochastic environment agents believe themselves to be operating in. In practice, this limits the class of policies the consequences of which we can hope to assess in advance to policies generated by fixed, well understood, relatively permanent rules (or functions relating policy actions taken to the state of the economy). . . . Analysis of policy which utilizes economics in a scientific way necessarily involves choice among alternative stable, predictable policy rules, infrequently changed and then only after extensive professional and general discussion, minimizing (though, of course, never entirely eliminating) the role of discretionary economic management.
Lucas also noted, “I have been impressed with how non-controversial it [the above argument for rules] seems to be at a general level and with how widely ignored it continues to be at what some view as a ‘practical’ level.”
An answer to the pleas of these economists for articulation by the Fed of the consistency in its behavior (the rule it follows) and of the structure of the economy that constrains its behavior requires a model that elucidates the nature of the monetary standard. Discovering the nature of the monetary standard, how it has evolved over time, and what constitutes the optimal monetary standard is an exercise in “identification.” The reason is that the Fed functions as part of the macroeconomy in which all variables are correlated. “Identification” of the monetary standard requires a model that allows separation of how the Fed influences the behavior of the economy and how the behavior of the economy influences the Fed. That is, it requires separation of causation from correlation.
The strategy pursued here is to use historical narrative based on contemporaneous documentary evidence and the state of knowledge among policy makers and economists to understand how the Fed has responded to the state of the economy. How has monetary policy in the sense of the consistency in its response to the behavior of the economy (its rule or reaction function) evolved over time? This evolution comprises the semicontrolled experiments that provide evidence on the optimal monetary standard. A conclusion is that absent monetary disorder produced by money creation that causes the price level to evolve unpredictably the price system works well to maintain macroeconomic stability.
The hypothesis tested here is that the monetary standard provides for macroeconomic stability if the Fed follows a rule that provides for a stable nominal anchor (price stability) and that allows the price system an unfettered ability to determine real variables like output and employment. Failure to follow the rule creates the correlation in the data between monetary and real disorder. This rule emerges from the Goodfriend and King basic version of the New Keynesian model in which a policy of price stability is optimal. With price stability, the central bank turns over to the price system (the real business cycle core of the economy) the unfettered determination of real variables like output and employment.
Reprinted with permission from The Federal Reserve: A New History by Robert L. Hetzel, published by the University of Chicago Press. © 2022 by the University of Chicago Press. All rights reserved.