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
February 26, 1996
Is the Macroeconomy Inherently Unstable?
The Money Supply
Limits of Stabilization Policy
Policies Made According to Discretion, or by Following a
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
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
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
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
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
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:
- Friedman; debater; nature-talk an edge for an economist;
natural rate of unemployment; natural monopoly; system of natural
liberty; being on the laissez-faire side is an edge; downgrading
of difficulties of monetary control...
- Friedman elsewhere a strong laissez-faire
economist--hence belief that his monetary economics (where he made
his reputation) must in some sense be "free market" as well...
- Active vs. passive and money stock growth rule got tied up
with another, very powerful argument about the limits of
stabilization policy in an uncertain environment.
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
- If the multiplier is one: need to boost federal spending next
year by $240 billion, and that will get you to 6% unemployment.
- But if the multiplier is three and you boost spending by $240
billion, your unemployment rate is 2% and inflation is through the
- If the multiplier is three: need to boost federal spending
next year by $80 billion, and that will get you 6% unemployment.
- But if the multiplier is one and you boost spending by only
$80 billion, you still have 7 1/3% unemployment--1 1/3% more than
you would like
- Split the difference? If the multiplier were 2, you'd boost
spending by $120 billion
- with real multiplier of 3, unemployment at 5%
- with real multiplier of 1, unemployment at 7%
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
- Stimulus of $240 billion: 2% of "bad"
- Stimulus of $120 billion: 1% of "bad"
- Stimulus of $80 billion: 2/3% of "bad"
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.
- Note that this argument--that if you do not know precisely the
effects of your policies, do less--applies as strongly to policies
that shift the monetary base to control the money stock as to
- Which is why if you read Friedman's writings in depth, you
pretty soon discover calls for something called "100% reserve
banking"--because that makes control of the money stock from the
monetary base much easier.
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
Policies Made According to Discretion, or by Following a