Utopia, you are standing in it!

The competing visions of central banks over monetary policy have been defined by Franco Modiglani and Milton Friedman respectively. Modiglani considers the Keynesian vision of macroeconomic policy to be:

a market economy is subject to fluctuations which need to be corrected, can be corrected, and therefore should be corrected.

The Keynesian claim implies that central banks have sufficient knowledge of the structure of the economy to be able to choose the policy mix appropriate to a given set of circumstances. It is possible to target unemployment, interest rates and inflation in such a way that they can be maintained (and hence made predictable) by constant adjustment of policy instruments to new shocks.

The Keynesian approach assumes that the economy can slip into recessions for all sorts of reasons (Barro 1989). Business fluctuations result from shocks to aggregate demand. The principal source of these shocks are expectations induced shifts in investment demand. The role of the central bank is to make prompt, frequent policy responses to counteract this instability.

The task of government is to discover the particular monetary and fiscal polices which can eliminate shocks emanating from the private sector. A key finding of recent macroeconomic research is that anticipated monetary policy has very different effects to unanticipated monetary policy.

The Keynesian vision thus presuppose that government can foresee shocks which are invisible to the private sector but at the same time it is unable to reveal this advance information in a credible way and hence defusing the shock because it is no longer unanticipated. In addition, the counter cyclical monetary policies of governments must themselves be unforeseeable by private agents, but at the same time systematically related to the state of the economy (Lucas and Sargent 1979)

Of course, the Keynesian view of central banking is also premised on a goodwill theory of government. Governments pursue policies that are in the public interest. That is a public interest that is well-defined and is free of conflicts over income distribution, electoral success and power the could lead policy-makers to pursue goals other than full employment, stable prices and efficiency. Thus, if the latest forecast is a recession, additional stimulus is the usual prescription. However, since most Keynesian economists accept the permanent income and natural rate hypotheses, more stimulus implies less later at some unknown time.

Friedman’s vision of central banking is far more circumspect:

The central problem is not designing a highly sensitive [monetary] instrument that offsets instability introduced by other factors[in the economy], but preventing monetary arrangements becoming a primary source of instability (Milton Friedman 1959).

Friedman considers that a key element in the case for policy discretion is whether the sufficient information is available that can be used to reduce variability and assist the economy’s adjustment the unforeseen. A well intentioned policy-maker will destabilise if he is mislead by incomplete or incorrect information.

From the monetarist standpoint, price stability can be approximately attained under a well chosen and predictable monetary policy rule. Under this view, the unemployment and interest rates are unpredictable and can manipulated only at a prohibitive cost. The Keynesian and monetarist views are mutually incompatible and lead to very different policy recommendations (Lucas 1981).