>

Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page


Lecture Fifteen

Macroeconomic Policy; Rules vs. Discretion
(Economics 100b; Spring 1996)

Professor of Economics J. Bradford DeLong
601 Evans, University of California at Berkeley
Berkeley, CA 94720
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net

February 26, 1996


Administration
Is the Macroeconomy Inherently Unstable?
The Money Supply
Limits of Stabilization Policy
Policies Made According to Discretion, or by Following a Rule?


Administration

Is the Macroeconomy Inherently "Unstable"?

If you begin to read chapter 12 of Mankiw's Macroeconomics textbook, you will read that:

Some economists... view the economy as inherently unstable.... experienc[ing] frequent shocks to aggregate demand and aggregate supply.... [M]acroeconomic policy should "lean against he wind," stimulating the economy when it is depressed and slowing the economy when it is overheated.

Other economists... view the economy as naturally stable. They blame bad economic policies for the large... fluctuations we have sometimes experienced. They argue that economic policy should not try to "fine tune" the economy. Instead, economic policymakers should recognize their limitations and be satisfied if they do no harm.


Mankiw is simply wrong. The difference between his "some economists" and "others"--by whom he means those who think like William McChesney Martin, who was Chairman of the Board of Governors of the Federal Reserve for nearly two decades; and those who think like Nobel-prize winner Milton Friedman--is not that one group thinks that the economy is naturally unstable and one thinks it is naturally stable, it is that the second group thinks that the economy is easily stabilized--and easily stabilized through the more or less mechanical operation of simple rules.

What do I mean? Well, consider Milton Friedman and his recommendation that the central bank simply control the money stock--M1, in its original formulations--and set interest rates and conduct whatever open market operations (sales of bonds for cash) were necessary to keep the money stock growing at some fixed, constant rate like 5% per year, year after year.

Wait a minute, you say. A fixed and stable rate of growth of the money stock--all that does is give a fixed and stable position to the LM curve. The IS curve still fluctuates, and so output fluctuates.

But not in Milton Friedman's cosmology. Or, perhaps I should say, not on Planet Friedman. On planet Friedman the velocity of money is nearly constant, and so the LM curve is very steep: fix the money stock or the growth of the money stock at a predictable rate, and you find that all shifts in the IS curve do is change the interest rate.

(Hence changes in the interest rate should not be of much interest to the central bank, and it should not make policy based on them.)

How does this work? Suppose that velocity is nearly constant--that people's desired holdings of wealth in the form of readily spendable purchasing power are a constant fraction of their income--and suppose that an outward shock to investment, consumption, or government purchases boosts incomes and thus boosts consumers' desired expenditure. To support this increase in expenditure, people begin liquidating other assets and building up their checking accounts and cash balances.

But banks are not allowed to increase deposits indefinitely. They have to show the Federal Reserve that they have "enough" cash-on-hand and balances-at-the-Federal-Reserve to support these deposits. Firms start selling off Treasury Bills to raise cash to deposit back at the Federal Reserve. Firms start bidding to borrow each other's deposits at the Fed "overnight" to show that they are meeting reserve requirements. Both of these reduce the prices of assets, and raise interest rates.

But the increase in interest rates doesn't do much to decrease consumer demand for checking account balances--remember, velocity was nearly constant. And so interest rates rise more. Equilibrium is attained only when higher interest rates have discouraged enough investment that incomes, expenditure, and desired money balances are back where they were before the initial shock.



There are only two problems with this vision: The first is that velocity is not constant--the LM curve does not appear to be steep in any relevant sense.



The Money Supply

The second is that keeping the money stock growing at a constant rate is very hard work. Let's start with the monetary base--the sum of currency and of reserve deposits of banks at the Federal Reserve. This the Federal Reserve can control: the only way to get a reserve deposit is to pay currency into the Federal Reserve or to sell a Treasury Bill to the Federal Reserve; the only way to get currency is to swap a deposit at the Federal Reserve for currency. None of these transactions happens without the Federal Reserve wanting them to happen.

Between August 1929 and March of 1933--during the slide into the biggest Depression America has ever seen--the Federal Reserve expanded the monetary base--the sum of currency and reserve deposits--by nearly twenty percent, from $7.1 to $8.4 billion, by buying on net some $1.3 billion of government bonds from banks and other private firms. This means that monetary policy was quite expansionary during the slide into the Great Depression, right?

Milton Friedman would--and did--say no: the problem was that in 1929, banks wanted to hold $1 in reserves for every $7 in deposits; by 1933 banks wanted to hold $1 in reserves for every $5 in deposits; in 1929 consumers were happy to hold 1/6 of their spendable wealth in currency, and 5/6 in checking accounts; by 1933 consumers were terrified that their banks would fail and wanted to hold 40% of their spendable wealth in currency and 60% in checking accounts.

Thus the money supply fell from $26.5 billion in August 1929 to $19.0 billion in March 1933 because $1 of reserves generated $3.70 of "money" in the first period and only $2.30 of "money" in the second.

Milton Friedman's after-the-fact recommendation--a very good recommendation, and one that had it been followed would have averted much of the Great Depression--is that the Federal Reserve should have done much more: bought much more than $1.3 billion of bonds, expanded the monetary base by much more than 20%, done whatever it took to keep the stock of money--the amount of wealth households and businesses held in the form of readily spendable purchasing power--from falling.

So that even if we did live on Planet Friedman, and even if we could think that keeping the money stock growing at a smooth pace is 90% of the task of stabilizing the economy, I would still object to describing the Federal Reserve's policy of keeping the money stock growing smoothly as "passive" and reflecting the "natural stability" of the economy. Yes, the economy is stable--but only because the central bank has moved heaven and earth to do whatever it takes to the monetary base.

So when Mankiw draws a distinction between "active" and "passive" policies--and puts Milton Friedman's we-make-the-money-stock-grow-at-5%-per-year in the second group--I think he is just plain confused. On page 328, Mankiw writes of how the Great "Depression would have been avoided had the Federal Reserve been pursuing a passive monetary policy of increasing the money supply at a steady rate."

Friedman's "passive" Federal Reserve is putting an immense amount of effort into forecasting the evolution and behavior of the banking system so that they know just what actions to shift the monetary base are required to produce the smoothly-growing path for the money stock. It's not a call for a "passive" policy; what it is is a call to put all of your energy into estimating and keeping the LM curve on the rails--because it is the one that really matters.

Why, then, does Greg Mankiw frame the macroeconomic policy debate in this way? He is, after all, better paid than I am, and has a much better reputation as a hard worker and all around smart guy in the economics profession than I do. Why shouldn't I--or you--think that he is right and I am wrong? Why is he wrong?

I think Mankiw is confused for three reasons:


Limits of Stabilization Policy

Let me give an example of why, when you don't know what you are doing, you might not want to do anything. Suppose unemployment rate currently forecast to be 8% next year; pretty sure that the natural rate is 6%; thinking about a government speeding program; don't know the multiplier--your forecasters shrug their shoulders, and say that maybe it is one, and maybe it is three, they give 50/50 odds each way.


And suppose that you want to minimize the expected absolute deviation from the natural rate: 8% unemployment is bad, but 4% unemployment (and rapidly rising inflation) is as bad in a different way. 10% unemployment is twice as bad as 8%, etc.

Now let's look at our three proposed policies, and how much "bad" is left:

But this leaves you with (6%, 7 1/3%) 50-50 chances. You've deliberately undershot: done less than may well prove necessary to reach "full employment"

Why? Because if your policies have uncertain or variable effects, they are one of the sources of risk and distress that you are trying to stamp out.

And this is why, at least I think this is why, Mankiw has gotten confused: he has taken Friedman's powerful--and correct--critique of the "limits of stabilization policy" to imply that Friedman's own policy recommendation involve a passive role. I think Friedman has gotten tangled up to some degree in the same confusion: limits of knowledge mean policy should be cautious, yet what is a cautious policy?


Policies Made According to Discretion, or by Following a Rule?




>

Econ 100b

Created 4/30/1996
Go to
Brad De Long's Home Page


Professor of Economics J. Bradford DeLong, 601 Evans
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
http://www.j-bradford-delong.net/