A History of the Federal Reserve, Volume 2 Read Online Free Page B
Author: Allan H. Meltzer
some central banks ignore some transitory changes in the price level. The Federal Reserve targets the so-called core deflator for private consumption expenditures. This excludes changes in the prices of food and energy on grounds that these prices are volatile and that many of the changes are transitory. The public experiences the effects of food and energy prices and considers these changes as inflationary. In 2007 the Federal Reserve accepted responsibility for controlling these prices over the longer term.
The use of a core price index is an inexact way of separating transitory from persistent price level changes to get a better measure of sustained inflation. A superior alternative would use statistical estimation of the relative variance of the permanent and transitory components to estimate whether a given change is likely to persist. Muth (1960) suggested a procedure.
Persistent price changes—infl ations—occur if sustained money growth rises in excess of sustained output growth. The inflation rate changes, therefore, if money growth rises relative to output growth or if normal output growth changes relative to money growth. The latter change occurred in the mid-1990s in the United States. It produced a fall in the sustained rate of inflation.
Implementing a monetarist policy to control inflation requires commitment to the low or zero inflation rule. Implementation of the policy requires judgment about the permanent rates of change of money and output. Many central banks now use an inflation target that they try to meet over two or more years.
The Role of Relative Prices
The simple Keynesian model of the 1940 and 1950s had a single interest rate representing the bond market or, in practice, the Treasury bill or federal funds rate. In the IS-LM model of that period, money was a substitute for bonds; money growth had little direct impact on output or employment. The real balance effect was small. Usually the price level remained fixed. Later a Phillips curve avoided fixed prices by making the rate of price change depend on some measure of the output gap. 9
Friedman’s (1956) essay on the demand for money broadened the interpretation of interest rates to include relative prices of assets and output. His analysis changed the explanations of the transmission of monetary impulses to include a wide range of substitutions between money and other objects. In place of the Keynesian transmission from money to Treasury bills found in textbooks and many versions of the Federal Reserve’s econometric models, monetarists claimed that changes in the quantity of money altered current and expected future prices on a wide variety of domestic assets and the exchange rate.
In classical monetary theory, monetary policy changed the quantity of real balances relative to the stocks of other assets and current consumption. Substitution occurred in many directions. An excess supply of real balances induces changes in asset prices and spending; a deficient supply does the opposite. A change in the price of existing capital relative to the price of current investment induces or discourages new production. Changes in real balances relative to current consumption expenditure encourage or discourage spending.
There is no possibility of a liquidity trap—a condition in which monetary changes are impotent. If the nominal rate on short-term bills falls to zero, this margin closes but other margins remain (Brunner and Meltzer, 1968). A central bank can always increase the quantity of real balances by buying long-term debt, foreign exchange, real assets, or claims to real assets until money holders find that they hold more real balances than desired. To reduce money holdings people spend on consumption or nonmoney assets, changing relative prices to restore portfolio balance.
In Federal Reserve history, deflation occurred several times. In some periods, such as 1938, the nominal short-term interest reached zero or slightly below. Each of
The use of a core price index is an inexact way of separating transitory from persistent price level changes to get a better measure of sustained inflation. A superior alternative would use statistical estimation of the relative variance of the permanent and transitory components to estimate whether a given change is likely to persist. Muth (1960) suggested a procedure.
Persistent price changes—infl ations—occur if sustained money growth rises in excess of sustained output growth. The inflation rate changes, therefore, if money growth rises relative to output growth or if normal output growth changes relative to money growth. The latter change occurred in the mid-1990s in the United States. It produced a fall in the sustained rate of inflation.
Implementing a monetarist policy to control inflation requires commitment to the low or zero inflation rule. Implementation of the policy requires judgment about the permanent rates of change of money and output. Many central banks now use an inflation target that they try to meet over two or more years.
The Role of Relative Prices
The simple Keynesian model of the 1940 and 1950s had a single interest rate representing the bond market or, in practice, the Treasury bill or federal funds rate. In the IS-LM model of that period, money was a substitute for bonds; money growth had little direct impact on output or employment. The real balance effect was small. Usually the price level remained fixed. Later a Phillips curve avoided fixed prices by making the rate of price change depend on some measure of the output gap. 9
Friedman’s (1956) essay on the demand for money broadened the interpretation of interest rates to include relative prices of assets and output. His analysis changed the explanations of the transmission of monetary impulses to include a wide range of substitutions between money and other objects. In place of the Keynesian transmission from money to Treasury bills found in textbooks and many versions of the Federal Reserve’s econometric models, monetarists claimed that changes in the quantity of money altered current and expected future prices on a wide variety of domestic assets and the exchange rate.
In classical monetary theory, monetary policy changed the quantity of real balances relative to the stocks of other assets and current consumption. Substitution occurred in many directions. An excess supply of real balances induces changes in asset prices and spending; a deficient supply does the opposite. A change in the price of existing capital relative to the price of current investment induces or discourages new production. Changes in real balances relative to current consumption expenditure encourage or discourage spending.
There is no possibility of a liquidity trap—a condition in which monetary changes are impotent. If the nominal rate on short-term bills falls to zero, this margin closes but other margins remain (Brunner and Meltzer, 1968). A central bank can always increase the quantity of real balances by buying long-term debt, foreign exchange, real assets, or claims to real assets until money holders find that they hold more real balances than desired. To reduce money holdings people spend on consumption or nonmoney assets, changing relative prices to restore portfolio balance.
In Federal Reserve history, deflation occurred several times. In some periods, such as 1938, the nominal short-term interest reached zero or slightly below. Each of
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