A History of the Federal Reserve, Volume 2 Read Online Free
Author: Allan H. Meltzer
based on judgments of current and possibly longer-term consequences of events and policy actions.
Early in the discussion of rules and discretion Friedman (1951) recognized the importance of information and uncertainty in choosing between a rule and discretionary actions. A well-intentioned policymaker may destabilize if he is misled by incomplete or incorrect information. Later work by Kydland and Prescott (1977) and a large literature that followed analyzed time inconsistency and the credibility of policy actions and announcements. Kydland and Prescott showed that the dynamic path that the economy follows depends on the choice of policy rules. A discretionary policy that made an optimal choice today was time inconsistent if it did not follow a rule restricting future actions. An individual or firm planning its future actions experienced increased uncertainty when faced by discretionary policy.
7 Meltzer (1998) has a more complete discussion of the result of the controversy. Modigliani (1977) is a useful statement from a Keynesian perspective of the consensus reached at the end of the 1970s.
A major change in economic theory came with recognition of uncertainty and the role of information. This heightened attention to the role of expectations. Lucas (1972) developed earlier work on rational expectations. 8 Rational expectations raised a question about the meaning of discretion. In practice, many central banks responded by providing more and better information about current and future actions. Rational expectations implies that central banks depend on market responses and markets depend on central bank actions. Setting and achieving a target for inflation two or three years ahead is a recognized way of reducing uncertainty about future actions. Federal Reserve officials have not adopted a formal inflation target, but, for a time, they encouraged a belief that they try to hold inflation in the 1 to 2 percent range, and in 2007 they began to forecast inflation, output, and unemployment for three years ahead. In early 2008, however, they gave most weight to forecasts of possible recession and less weight to inflation.
These actions constitute a major change from the secrecy traditionally practiced by central banks. It recognized the developments in monetary theory about the role of information, the importance of anticipations, and the success achieved by foreign central banks that announced inflation targets. But United States governments have not adopted fixed rules and are unlikely to do so in the foreseeable future.
Central bankers continue to meet regularly to decide current actions. Prominent central bankers have explained why they do not commit to a fixed rule. The former chairman of the Federal Reserve, Alan Greenspan (2003), explained that a fixed rule could not take account of the many contingencies to which monetary officials might wish to respond. The contingencies are infinite and most are unforeseeable. Many of the contingencies arise from actual or potential financial failures. The monetary rules developed in the literature do not incorporate these contingencies. In the past, following Bagehot (1873 [1962]) the central bank or the government announced in advance that it would suspend the gold standard rule at such times and provide the increased reserves demanded. This became part of the monetary rule.
8. Brunner and Meltzer (1993) point out that rational expectations models usually assign considerable weight to information but zero weight to the cost of acquiring information.
Greenspan’s successor, Ben Bernanke (2004), recognized that the central bank can do a great deal to reduce uncertainty about its future actions, but “specifying a complete policy rule is infeasible” (ibid., 8). He accepted Greenspan’s reason for infeasibility. Mervyn King (2004), governor of the Bank of England, called for “constrained discretion.” “Suitably designed, monetary institutions can help to reduce the
Early in the discussion of rules and discretion Friedman (1951) recognized the importance of information and uncertainty in choosing between a rule and discretionary actions. A well-intentioned policymaker may destabilize if he is misled by incomplete or incorrect information. Later work by Kydland and Prescott (1977) and a large literature that followed analyzed time inconsistency and the credibility of policy actions and announcements. Kydland and Prescott showed that the dynamic path that the economy follows depends on the choice of policy rules. A discretionary policy that made an optimal choice today was time inconsistent if it did not follow a rule restricting future actions. An individual or firm planning its future actions experienced increased uncertainty when faced by discretionary policy.
7 Meltzer (1998) has a more complete discussion of the result of the controversy. Modigliani (1977) is a useful statement from a Keynesian perspective of the consensus reached at the end of the 1970s.
A major change in economic theory came with recognition of uncertainty and the role of information. This heightened attention to the role of expectations. Lucas (1972) developed earlier work on rational expectations. 8 Rational expectations raised a question about the meaning of discretion. In practice, many central banks responded by providing more and better information about current and future actions. Rational expectations implies that central banks depend on market responses and markets depend on central bank actions. Setting and achieving a target for inflation two or three years ahead is a recognized way of reducing uncertainty about future actions. Federal Reserve officials have not adopted a formal inflation target, but, for a time, they encouraged a belief that they try to hold inflation in the 1 to 2 percent range, and in 2007 they began to forecast inflation, output, and unemployment for three years ahead. In early 2008, however, they gave most weight to forecasts of possible recession and less weight to inflation.
These actions constitute a major change from the secrecy traditionally practiced by central banks. It recognized the developments in monetary theory about the role of information, the importance of anticipations, and the success achieved by foreign central banks that announced inflation targets. But United States governments have not adopted fixed rules and are unlikely to do so in the foreseeable future.
Central bankers continue to meet regularly to decide current actions. Prominent central bankers have explained why they do not commit to a fixed rule. The former chairman of the Federal Reserve, Alan Greenspan (2003), explained that a fixed rule could not take account of the many contingencies to which monetary officials might wish to respond. The contingencies are infinite and most are unforeseeable. Many of the contingencies arise from actual or potential financial failures. The monetary rules developed in the literature do not incorporate these contingencies. In the past, following Bagehot (1873 [1962]) the central bank or the government announced in advance that it would suspend the gold standard rule at such times and provide the increased reserves demanded. This became part of the monetary rule.
8. Brunner and Meltzer (1993) point out that rational expectations models usually assign considerable weight to information but zero weight to the cost of acquiring information.
Greenspan’s successor, Ben Bernanke (2004), recognized that the central bank can do a great deal to reduce uncertainty about its future actions, but “specifying a complete policy rule is infeasible” (ibid., 8). He accepted Greenspan’s reason for infeasibility. Mervyn King (2004), governor of the Bank of England, called for “constrained discretion.” “Suitably designed, monetary institutions can help to reduce the
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