The leads and lags on monetary policy are long and variable
25 Jul 2014 Leave a comment
in business cycles, inflation targeting, macroeconomics, Milton Friedman, monetarism, monetary economics Tags: leads and lags on monetary policy, Milton Friedman, monetary policy
Many Keynesians, Friedman notes, advocate “leaning against the wind.” By this they mean, in some sense, that the monetary (and fiscal) authorities should try to balance out the private sector’s excesses rather than passively hope that it adjusts on its own.
There are large uncertainties about the size and timing of responses to changes in monetary policy. There is a close and regular relationship between the quantity of money and nominal income and prices over the years. However, the same relation is much looser from month to month, quarter to quarter and even year to year.
Monetary policy changes take time to affect the economy and this time delay is itself highly variable. The lags on monetary policy are three in all:
- The lag between the need for action and the recognition of this need (the recognition lag)
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The lag between recognition and the taking of action (the legislation lag)
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the lag between action and its effects (the implementation lag)
These delays mean that is it difficult to ascertain whether the effects of monetary policy changes in the recent past have finished taking effect. Secondly, it is difficult to ascertain when proposed changes in monetary policy will take effect. Thirdly, feedbacks must be assessed. The magnitude of the monetary adjustment necessary to deal with the problem at hand is thus never obvious. It is common for a central bank to act incrementally. The central bank makes small adjustments to monetary conditions over time as more information is available on the state of the economy and forecasts are updated.
The existence of lags may mean that by the time policy has its full effect, the problem with which it was meant to deal may have disappeared.
Milton Friedman (1959) tested the Fed’s success at leaning “against the wind” by checking whether the rate of money growth has truly been lower during expansions and higher during contractions. He admits that this method of grading he Fed’s performance is open to criticism, but he decided to go ahead and see what turns up. Friedman found that Fed has – for the periods surveyed – been unsuccessful.
By this criterion, for eight peacetime reference cycles from March 1919 to April 1958. Actual policy was in the ‘right’ direction in 155 months, in the ‘wrong’ direction in 226 months; so actual policy was ‘better’ than the [constant 4% rate of money growth] rule in 41% of the months.
Nor is the objection that the inter-war period biased his study is good since Friedman found that:
For the period after World War II alone, the results were only slightly more favourable to actual policy according to this criterion: policy was in the ‘right’ direction in 71 months, in the ‘wrong’ direct in 79 months, so actual policy was better than the rule in 47% of the months.
One of the best ways to parry a metaphor is with another metaphor. Keynesians have a host of metaphors in their rhetorical arsenal; one frequently voiced is that a wise government should “lean against the wind” when choosing policy. Friedman counters:
We seldom know which way the economic wind is blowing until several months after the event, yet to be effective, we need to know which way the wind is going to be blowing when the measures we take now will be effective, itself a variable date that may be a half year or a year or two from now. Leaning today against next year’s wind is hardly an easy task in the present state of meteorology.
Friedman’s remarks, as even his strong critics admit, are mighty and strike at the heart of any activist stabilisation policy. By meeting Keynesians on their own theoretical turf and scrutinising their practice, Friedman manages to produce objections that both Keynesians and non-Keynesians must take seriously. A key part of any response to Friedman rests on the ability of forecasters to do their jobs with tolerable accuracy.
Keynesian policies do not necessarily follow even if the Keynesian theory of the business cycle were conclusively proved. It must also be demonstrated that the government has the ability and willingness of the government to act as the theory prescribes. Friedman’s critique does not depend on the quantity theory of money.
Robert Lucas explained his support for U.S. monetary policy in 2008 as follows
10 Jul 2014 Leave a comment
in global financial crisis (GFC), great recession, macroeconomics, Robert E. Lucas Tags: fiscal policy, GFC, monetary policy, Robert Lucas
- There are many ways to stimulate spending, but monetary policy was the most helpful counter-recession action because it was fast and flexible.
- There is no other way that so much cash could have been put into the system as fast, and if necessary it can be taken out just as quickly. The cash comes in the form of loans.
- There is no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These were important virtues.
The end of the great inflation in Australia in 1990 was a policy accident
02 May 2014 Leave a comment
in macroeconomics, Milton Friedman, politics - Australia Tags: current account deficits, inflation, monetary policy
No one under 40 has an adult memory of inflation in Australia. They have forgotten what high inflation was like.
Those older than 40 have forgotten how inflation was tamed.
Edward Nelson’s paper ‘Monetary policy neglect and the Great Inflation in Canada, Australia, and New Zealand‘ is good on this. His paper trawls through the press reports of the 1970s onwards to document exactly what the views of the day were of the causes of inflation:
- Policy-makers at least from 1971 viewed inflation as resulting from factors beyond their control, not as a consequence of their monetary policy decisions;
- Policy-makers embraced non-monetary approaches against inflation in a manner that defied political classification; and
- Highly interventionist strategies of compulsory wage and price controls was adopted by the traditionally more anti-interventionist of the major political parties;
The Governments and Reserve Bank of the 1970s and 1980s attributed the double-digit inflation of that time to a range of causes other than loose monetary policy.
1988 witnessed a major monetary policy tightening in Australia.
The tightening itself was motivated by balance-of-payments rather than inflation considerations. It was that old bogey, the current account deficit. The current account is the most pernicious statistic published.
The fall in inflation to 3% in 1991 transformed the views of policymakers and observers about the role of monetary policy in inflation control.
As late as 1990, the Governor of the Reserve Bank rejected central-bank inflation targeting as infeasible in Australia, and cited the need to use other tools such as wages policy.
When inflation fell below 3% in early 1991—clearly a response to the period of monetary restraint – I can assure you that none of the briefings to ministers at that time forecasted inflation to fall so rapidly.
Policy attitudes changed all through brute experience; no neo-liberal conspiracies here. Milton Friedman was still a swear word back then and the idea that inflation was a monetary phenomenon was still career limiting.
Gruen and Stevens (2000) record that in the 1990s, “the main insight of two centuries of monetary economics… that monetary policy ultimately determined inflation” convinced the authorities that non-monetary approaches to inflation control should be abandoned in favour of central-bank inflation targeting.
The current account did not change much as a result of the deep recession designed to bring it under control. The current account deficit as a major policy problem was quietly forgotten.
Utopia, you are standing in it! 
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