Nice summary of time inconsistency by Kydland and Wynne



Champ and Freeman on monetary stability


Alan Blinder and Fed Speak

When President Clinton appointed Alan Blinder to be deputy chair of the Fed, his big hope was to find out what Alan Greenspan really thought rather than the public facade of gobbledygook. The term Fedspeak (also known as Greenspeak) is what Alan Blinder called "a turgid dialect of English" used by Federal Reserve Board chairmen in making wordy, vague, and ambiguous statements. Greenspan described it this way:

To Blinder’s astonishment, Alan Greenspan spoke just the same as he did at monetary policy meetings of the Fed as he did in public! Blinder never disagreed fundamentally with Greenspan about monetary policy.

Real and Pseudo-Financial Crises, the Chinese share market crash and Anna Schwartz

If we could take time out from the breathless journalism about the Chinese stock market, which some people may have heard of before this week, it’s crash should be seen through the lens that Anna Schwartz developed in 1987 of a pseudo financial crisis and a financial crisis.

Her paper is written at the same time as the 1987 stock market crash. On financial crises, Anna Schwartz said:


As for those pseudo financial crises, she said:


Schwartz’s principal concern with regard to pseudo financial crisis was:

proposals to deal with pseudo-financial crises is the perpetuation of policies that promote inflation and waste of economic resources

As we are talking about the Chinese stock market, Anna Schwartz also wrote about the concepts of real systemic international risk and and pseudo international systemic risk.

Once again, and as with pseudo financial crises and real financial crises, what distinguishes real systemic international risk and pseudo international systemic risk is a threat to the payment system. The threat of bank runs, which can easily be eliminated through lender of last resort facilities:


As always it is about the security of the payments system – of avoiding bank runs, not private losses:


The lesson for the day is that when people start panicking about the economy or the stock market or international markets, don’t go to a macroeconomist for advice, go to a monetary historian. They have seen it all before.

Milton Friedman on the monetarist triumph


Paul Samuelson on inflation targeting

Paul Samuelson on inflation targeting


What influence did Milton Friedman have on 1980s and 1990s Australian monetary policy?

The Hayek and Friedman Monday conferences on the ABC in 1976 and 1975 are still ruling the Australian policy roost, if some of the Left over Left in Australia are to be believed. Milton Friedman is said to have mesmerised several countries with a flying visit with his Svengali powers of persuasion.

When working at the next desk to a monetary policy section in the Australian Prime Minister’s Department in the late 1980s, I heard not a word of Friedman’s Svengali influence:

• The market determined interest rates, not the Reserve Bank was the mantra for several years. Joan Robinson would have been proud that her 1975 Monday conference was still holding the reins.

• Monetary policy was targeting the current account. Read Edwards’ biography of Keating and his extracts from very Keynesian Treasury briefings to Keating signed by David Morgan that reminded me of Keynesian macro101.

When as a commentator on a Treasury seminar paper in 1986, Peter Boxhall – fresh from the US and 1970s Chicago educated – suggested using monetary policy to reduce the inflation rate quickly to zero, David Morgan and Chris Higgins almost fell off their chairs. They had never heard of such radical ideas.

In their breathless protestations, neither were sufficiently in-tune with their Keynesian educations to remember the role of sticky wages or even the need for the monetary growth reductions to be gradual and, more importantly, credible as per Milton Freidman and as per Tom Sargent’s end of 4 big and two moderate inflations papers in the early 1980s.

I was far too junior to point to this gap in their analytical memories about the role of sticky wages, and I was having far too much fun watching the intellectual cream of Treasury senior management in full flight. (I read Friedman & Sargent much later).

Milton Friedman on the ideal monetary policy


The Reserve Bank Governor (2013) versus the Labour Party on whether its monetary policy upgrade will increase the inflation rate and destabilise the exchange rate

Attempts to keep the dollar from going “too high” would have ruinous domestic consequences as the Governor of the Reserve Bank explained last year:

If New Zealand decided to cap the NZ dollar, depending on where the cap is enforced, similar levels of intervention might be required as global foreign exchange turnover in NZ dollars relative to GDP is similar to that in Swiss francs.

The OCR would need to drop to zero first in order to eliminate the interest arbitrage motivation for NZ dollar inflows. Any attempt to retain non-zero interest rates by “sterilising” such massive intervention would be very difficult.

In effect therefore a Swiss type operation to cap the value of the NZ dollar through large scale FX intervention would also amount to quantitative easing. As I mentioned, this would be highly inflationary in the NZ context.

Graeme Wheeler, Governor of the Reserve Bank of New Zealand

20 February 2013

Manufacturing decline not just a dollar story A speech delivered to the New Zealand Manufacturers and Exporters Association in Auckland

Sterilised interventions in the foreign exchange market are a fool’s errand

If exchange rate manipulation had any chance of working, the U.S. Fed, the Bank of England, the European Central Bank and the Bank of Japan would be all over it already. Their mutual efforts to depreciate their own currencies would cancel out.

Most central banks gave up on exchange rate interventions in the mid-1990s because attempts to manipulate exchange rates without loosening monetary policy rarely worked.  Brute experience taught them that they were on fool’s errand.

These exchange rate interventions, known as sterilised interventions, become an independent source of exchange rate instability and invite counter-speculation by currency traders and hedge funds. Every hint that a central bank might intervene in the exchange rate invites currency speculation. As Milton Friedman said:

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…

By trying to move the value of the dollar, the Reserve Bank of New Zealand will add its own element of currency instability and invite counter speculation by currency traders and hedge funds. This is a dangerous game for a small Reserve Bank to play.

As stated by Paul Krugman in 1999 on the concept of the impossible trinity: free capital movement, a fixed exchange rate, and an effective monetary policy –

The point is that you can’t have it all: A country must pick two out of three.

It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain – or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today or for that matter most of Europe).

Exchange rate manipulation by the Reserve Bank cannot alter the competiveness of exporters. The looser monetary policy will inevitably lead to higher CPI inflation that will erode any temporary advantage to exporters from the initial depreciation of the NZ dollar.

What did the Swiss do to keep their exchange rate down in the GFC?

Labour’s Monetary Policy Upgrade referred to the efforts of the Swiss National Bank to cap a massive appreciation of the Swiss Franc after 2009 and the Euroland sovereign debt crisis:

The Swiss have actively protected their currency from appreciating to the detriment of their tradeable sector (p.16)

The Swiss National Bank stemmed the rise of Swiss franc by loosening their monetary policy as they say so themselves:

The Swiss National Bank has successfully maintained its exchange-rate floor against the euro, often through heavy nonsterilized purchases of foreign exchange (Swiss National Bank Annual Report, 2012, p. 34).

These non-sterilised exchange rate interventions were a loosening of Swiss monetary policy. The Swiss National Bank happens to be one of a number of central banks that conduct their monetary policies by buying and selling in the foreign exchange markets.

Labour’s aim of a positive external balance through a tightening of monetary policy is a repeat of the fool-hardy policies of the Hawke-Keating government in the late 1980s.

1988 witnessed a major monetary policy tightening in Australia. The tightening was motivated by a current account deficit rather than double-digit inflation:

  • The inflation rate fell to below 3% in 1991.
  • The current account did not change much as a result of the deep recession and 10%+ unemployment rate designed to bring it under control.

The current account deficit as a major policy problem was then quietly forgotten in Australia.

Three conflicting monetary policy objectives

The New Zealand Labour Party wants the Reserve Bank to do three impossible things before breakfast:

  1. Loosen monetary policy to bring the dollar down such as in Switzerland after 2009;
  2. Tighten monetary policy to reduce the current account deficit such as in Australia after 1988; and
  3. Loosen and tighten monetary policy as required to stay within the inflation target.

The best contribution of monetary policy to the competitive positions of exporters is low inflation.


Inflation targeting removes monetary policy as in independent source of exchange rate instability. Attempts to manipulate the exchange rate undermines the inflation target that has been such a great success since 1989, and reduces the commitment of public policy to a stable, predictable business climate. Bordo and Humpage add:

…sterilised foreign-exchange intervention can sometimes affect exchange-rate movements, but sterilised intervention does not provide central banks with a mechanism for systematically altering exchange rates independent of their monetary policies.

Attempts to stabilise or undervalue exchange rates necessarily weaken a country’s control of its monetary policy and ultimately leave the real exchange rate unaffected.

What really matters?

Labour’s monetary policy upgrade is a distraction from the only game in town for the future prosperity of New Zealanders:

Productivity isn’t everything, but in the long run it is almost everything. A country’s ability to improve its standard of living over time depends almost entirely on its ability to raise its output per worker.

Paul Krugman

The Age of Diminishing Expectations (1994)


2014 Homer Jones Memorial Lecture – Robert E. Lucas Jr.

The first part of his lecture discusses how the Fed can influence inflation and financial stability.

Central banks can control inflation. Can central banks maintain economic stability’s financial stability? This is still an open question as to whether central banks can do that. The quantity theory of money makes certain sharp predictions about monetary neutrality which are well borne out by the cross country evidence.

In the second part of this lecture, Lucas discusses how central banks around the world have used inflation targeting to keep inflation under control.

What is the Fed to do with the stable relationship between money and prices? Inflation targeting is superior to a fixed growth monetary supply growth rule. This always pushes policy in the direction of the inflation rate you want. Central banks around the world have succeeded in keeping inflation low by explicitly or implicitly targeting the inflation rate.

In the last part of his lecture, Lucas discusses financial crises. he agrees with Gary Gordon’s analysis that 2008 financial crisis was a run on Repo. A run on liquid assets accepted as money because they can be so quickly changed into money. The effective money supply shrank drastically when there was a run on these liquid assets.

Lucas favoured the Diamond and Dybvig of bank runs as panics. The logic of that model applies to the Repo markets now was well as to the banking system. How to extend Glass–Steagall Act type regulation of bank portfolios to the Repo market is a question for future research.

Inflation targeting is working well but the lender of last resort function is yet to be fully understood.

Note: The Diamond-Dybvig view is that bank runs are inherent to the liquidity transformation carried out by banks. A bank transforms illiquid assets into liquid liabilities, subject to withdrawal.

Because of this maturity mismatch, if depositors suspect that others will run on the bank, it is optimal for each depositor to run to the bank to withdraw his or her deposit before the assets are exhausted. The bank run is not driven by some decline in the fundamentals of the bank. Depositors are spooked for some reason, panic, and attempt to withdraw their funds before others get in first. In this case, the provision of deposit insurance and lender of last resort facilities reassures depositors and stems the bank run

In the Kareken and Wallace model of bank runs, deposit insurance is problematic because of the incentives it gives to deposit taking institutions that are insured to take much greater risks. When there is deposit insurance, depositors don’t care about the greater risk in the portfolios of their banks. The greater risk taking leads to higher returns at no extra cost because if these risky investments do fail, the deposit insurance covers their losses

It is therefore necessary to regulate the portfolio of insured banks to ensure that they do not do this. That is the great dilemma for banking regulation because quasi-banks and other liquidity transformation intermediaries such as a Repo market spring up just outside the regulatory net.


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