|
...1970s, ever thought likely. United States has experienced only two business recessions during the last twenty-five years, neither lasting longer than eight months and neither involving a decline in total production as great as 1 1/2 percent. (1) Annual price inflation has converged onto a 1 1/2 to 2 percent norm, with the average increase apart from food and energy (the U.S. central bank's preferred measure) falling exactly in the middle of this range over the past ten years and not a single year as much as 1/4 percentage point either above or below. Neither the severe one-day stock market crash in October 1987, nor the collapse of a good portion of the nation's thrift deposit industry in the late 1980s, nor the protracted stock market decline of 2000-03, nor the quadrupling of world oil prices since 2002 had much, if any, visible impact on either aggregate nonfinancial economic activity or economy-wide inflation. Euroland and most of the world's other advanced economies have enjoyed similarly favorable rides, and even the one outstanding exception--Japan--proves the rule, in that monetary policy there was so plainly wrong-headed. Among academic economists it has become commonplace to hail the tremendous advances in knowledge about the subject, and even to refer to monetary policy, as practiced today, as a science. (2)
Fiscal policy today likewise seems on a surer footing of knowledge than in earlier eras. Despite the expense of simultaneously fighting two wars, and despite a tax cut that had put the U.S. government's budget on a path toward deficit even before either war began, the ratio of the government's outstanding interest-bearing debt to national income has fluctuated narrowly within the range of 0.33 to 0.37 since the beginning of the decade. (The government's unfunded liabilities, mostly for Social Security and Medicare, are another matter, but lack of knowledge is not the problem.) The experience of 2001, recalling that of 1981, has even led to some talk of tax cuts in particular as potentially efficacious in spurring recovery from recessions. For the most part, however, fiscal policy has mostly disappeared from discussion at both the popular and the academic levels.
Well-earned complacency notwithstanding, some modest reflection suggests that despite the recent gains in knowledge, several questions of some seriousness, about both monetary and fiscal policy, remain to be answered. Some are primarily conceptual, while others spring more directly from operational concerns. But in both of these policy areas, experience suggests that often what starts out as a largely conceptual inquiry leads, in time, to implications with practical import.
A Conceptual Question: How Does the Central Bank Make Monetary Policy in the First Place?
Most economics textbooks introduce the role of monetary policy by deriving one or more sources of demand for the central bank's liabilities: banks need reserves to satisfy reserve requirements and to settle interbank transactions, the nonbank public needs currency to conduct everyday business, and so on. The next step is to posit, reasonably enough, that the central bank is a monopoly supplier of its own liabilities and therefore can, unless directed otherwise by higher authorities, set that supply at whatever level it chooses. Because both the banks' and the nonbank public's demand for the central bank's liabilities is likely to be interest sensitive, the equilibrium of demand and supply in this market establishes the price at which these liabilities are exchanged for other assets: conceptually, some kind of interest rate. Given the role of interest rates and asset returns more generally in affecting aggregate demand, the economic consequences of monetary policy actions--that is, of changes in the supply of central bank liabilities--follow with however much elaboration seems appropriate.
This idealized story bears essentially no resemblance to how most central banks today go about either formulating or conducting monetary policy. True, there was a time when many central banks, including the Federal Reserve System, carried out monetary policy either by setting the quantity or the rate of growth of the monetary base or by targeting the growth of some related measure of deposit money. But most central banks, including the Federal Reserve, gave up that practice some time ago. Instead most central banks today make monetary policy by setting some designated short-term interest rate (in the United States, the federal funds rate). (3)
According to standard representations, whether the central bank sets the quantity of its liabilities or the price at which those liabilities exchange for other assets is irrelevant except for stochastic considerations. (In the United States the federal funds rate is the price for borrowing central bank reserves overnight.) The central bank can set the quantity and let the market determine the equilibrium price, or it can set the price and let the market determine the equilibrium quantity. Either way, what the central bank is doing amounts to picking a point on the demand curve that it faces. Whether the supply curve it imposes is vertical or horizontal, or perhaps upward sloping, is of no consequence (again except for stochastic implications). What matters is only the point at which that supply curve intersects the demand curve.
The most glaring lacuna separating this idealized representation from reality is the implication that, unless the demand curve for central bank liabilities is nearly vertical, changing the interest rate requires nontrivial changes in the quantity of outstanding central bank liabilities--in other words, open market operations. In fact, today most central banks need to undertake little if any market intervention to change the designated policy interest rate. A mere announcement is normally sufficient. (4) Indeed, the Federal Reserve Bank of New York reports that in recent years even the announcement is often unnecessary. When a change in the Federal Open Market Committee's target for the federal funds rate is widely anticipated, market participants typically move the actual rate to the expected new target rate even before the committee has met to change the target. (5) Increasingly, the operating arm of the central bank is not the trading desk but the press office.
Any of several different hypotheses might explain this phenomenon, but most raise more questions than they answer, and in any case none bears much connection to the way in which standard economic models introduce the role of the central bank. To begin, perhaps the demand for central bank liabilities actually is (approximately) vertical. One immediate difficulty, however, is that a large body of both theory and empirical research has consistently indicated significant negative interest elasticity in banks' demand for reserves and even, albeit to a lesser extent, in the public's demand for currency. Further, a nearly vertical demand for central bank liabilities would imply that even very small changes in reserve quantities, not matched by shifts in the demand curve, would lead to huge interest rate fluctuations--a plainly counterfactual proposition. Although most central banks today do a pretty good job of anticipating the day-to-day demand curve shifts that occur for a variety of technical reasons (shifts from one kind of deposit to another, changes in the government's cash balance, fluctuations in the float, gold flows, and so forth), no one pretends that this activity has achieved perfection. An explanation that implies large interest rate fluctuations any time the trading desk's daily technical estimate is off by a billion dollars or two is hardly satisfactory.
A more familiar explanation is that because everyone understands that the central bank can carry out open market operations on even a vast scale, it is not necessary to do so: the mere threat is sufficient. (6) Although this idea may seem plausible at first thought, it, too, is highly problematic. There is a difference between saying that private sector agents (in this case banks and other investors) are price takers in some market and saying that they take whatever price they are given without adjusting their portfolios accordingly. This explanation is also inconsistent with the fact that, from time to time, shifts in the demand for central bank liabilities do require sizable open market operations merely to maintain the existing policy interest rate (as was the case, most recently, in the summer of 2007).
Alternatively, once one leaves currency aside (and no central bank attempts to make monetary policy by rationing the supply of its currency), in many countries the remainder of the central bank's liabilities bulk sufficiently small that,...
NOTE: All illustrations and photos
have been removed from this article.
More articles from Brookings Papers on Economic Activity
Monetary policy models., September 22, 2007
Living with global imbalances., September 22, 2007
Low interest rates and high asset prices: an interpretation in terms o..., September 22, 2007
Long-run changes in the wage structure: narrowing, widening, polarizin..., September 22, 2007
Selected issues in the rise of income inequality., September 22, 2007
Looking for additional articles?
Search our database of over 3 million articles.
Looking for more in-depth information on this industry?
Search our complete database of Industry & Market reports by text, subject, publication
name or publication date.
About Goliath
Whether you're looking for sales prospects, competitive information, company
analysis or best practices in managing your organization,
Goliath can help you meet your business needs.
Our extensive business information databases empower business
professionals with both the breadth and depth of credible,
authoritative information they need to support their business
goals. Whether it be strategic planning, sales prospecting,
company research or defining management best practices -
Goliath is your leading source for accurate information.
|
