Framework for Monetary Policy 1
https://substack.com/home/post/p-141899825
Josh Hendrickson at the “Economic Forces” Substack has an argument [https://substack.com/home/post/p-141899825] that in the long run the price of gold would be constant. There also an unstated implication that a “gold standard” in which the currency unit is legally defined as a fixed physical quantity of gold would be desirable. Scot Sumner has a good argument [https://www.econlib.org/is-the-value-of-gold-stable/] for why the price of gold would not necessarily be constant, but even if it were and the price level did not change in the long run, why would that be considered an advantage?
I would like to jump off from this question to a means of pulling together several ideas into a framework for thinking about inflation, recessions and monetary policies in the non-gold standard, multi-sector economies we live in.
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A fixed price of gold would imply that inflation averaged zero. Nothing in Hendrickson’s set of assumptions leading to the conclusion of zero inflation under a gold standard precludes shocks to the different sectors of the economy. Sectoral shocks require:
a) reallocation of resources from one sector to another, indeed, from one product or service line to another, require
b) changes in relative prices to
c) accomplish those re-allocations and allowing markets to clear (no recession).
But if some prices, or wages (which are the price of a specific kind of labor) are inflexible downward, the only way that relative prices change is by some other prices rising. Some prices rising and other remaining unchanged implies an increase in the price level, non-zero inflation. Note, the increase in the price level/non-zero inflation is a feature of any kind of shock: positive or negative, demand or supply. It is NOT the case that some shocks would require increases in the price level and others a fall. A fixed price of gold, a “gold standard” CANNOT be optimal in a multi-sectoral economy subject to sectoral shocks with some downwardly inflexible prices.
In contrast, a fiat currency system with a central bank to manage the means of payment CAN allow/engineer changes in the price level, can produce inflation rates greater than zero and so CAN facilitate the relative price movements that achieve sectoral reallocation of resources without recession. Whether it WILL or not depends on the skill of the central bank in manipulating its policy instruments to engineer inflation.
As a multi-sector economy with some downwardly inflexible prices is constantly experiencing shocks of some average size and frequency (a sort of Brownian movement of changes at the individual product and service level of supply and demand), and the degree of downward inflexibility of prices does not change, it would be optimal for a central bank to allow/engineer an average rate of inflation that facilitates the needed relative price movements. Moreover, as there are also some prices that are inflexible upward, the central bank would aim for the minimum rate of inflation that facilitates relative price movements maximizes real income.
These considerations lie behind the practice of many central banks of having an Average Inflation Target. The larger and more frequent the shocks and the less flexible the prices, the higher the income maximizing inflation target will be. That different central banks have all chosen inflation targets near 2% [1] suggests that the target has not been chosen in every case to maximize income of that country. Bob’s your uncle.
The same considerations, however, imply that an extraordinary large shock to a sector or sectors would require larger reallocations of resources, greater changes in relative prices and, temporarily, higher than target inflation. This would justify most countries that have an Average Inflation Target allowing a range. The US Fed has explicitly committed to a Flexible Average Inflation Target to allow over-target inflation in response to an extraordinary shock. When the extraordinarily large relative price changes have been accomplished, the central bank will return inflation to its target level.
It is worth noting that the inflation target in this concept is always a forward-looking one. It has supposedly been chosen as the rate that maximizes income for the expected average size and frequency of shocks. It is not a backward-looking rule that seeks to make the inflation rate average out over some arbitrary period.
Perhaps at this point it is also worth distinguishing the sectoral shocks of average size and frequency that requires a central bank to target inflation at a non-zero level or an extraordinary sectoral shock that requires temporarily over-target inflation, from a “pure” change in aggregate demand, say additional spending on a wide variety of goods and services or a revenue decreasing tax change that likewise would affect demand for a wide variety of goods and services. In this case there is no presumption of the need to facilitate changes in relative prices and so no need for over target inflation. The Central Bank would just take account of the change in fiscal policy and adjust its policy instruments, usually short-term interest rates, so as to maintain inflation on target. If the change in fiscal policy, however, were large enough or affected sectoral supply and demand enough to require extraordinary changes in relative prices, this would be the kind of extraordinary shock that DID call for temporarily higher inflation.
This is not to say that a change in fiscal policy might not make it more difficult for the central bank to know what policy instrument settings WILL keep inflation on target, neither too high that has some real and larger political costs to the government in power or too low so that markets fail to clear -- recession. Or the central bank might decide in light of the risk of producing too little inflation and causing recession, to depart from its policy of targeting inflation in order to “accommodate” a higher fiscal deficit, allowing higher inflation for a time instead of a higher short -term interest rate. Both a mistake and a central bank decision to accommodate [2] would to an outsider appear that fiscal policy had caused the increase in inflation. But in the Aristotelian “efficient cause” sense, it is still the central bank that caused the inflation.
Enough for now. In a follow up I will apply this framework to some events and controversies in the US.
I have put forward some of these ideas in other posts:
https://thomaslhutcheson.substack.com/p/why-no-recession
https://thomaslhutcheson.substack.com/p/the-lessons-of-pandemic-inflation
https://thomaslhutcheson.substack.com/p/fighting-over-fait
[Standard bleg: Although my style is know-it-all-ism, I do sometime entertain the thought that, here and there, I might be mistaken on some minor detail. I would welcome comments on these views.]
[1] The US Federal Reserve has a target of 2% for the Price of Consumer Expenditures which is equivalent to about 2.3% of the better-known Consumer Price index. The Bank of England has a 2% target for its Consumer price index. The European Central Bank targets a Euro-wide Harmonized Consumer Price Index at 2% “over the medium term.” The Royal Bank of Australia has a target band of 2%-3%; New Zealand, 1%-3%; Sweden, 2%; Canada, 1% - 3%; etc.
[2] Before the epoch of interest rate targeting, it was more or less expected that central banks would accommodate fiscal policy, so it WAS the case that fiscal policy more directly caused inflation, though central banks were left with the task of reining in inflation, often at the expense of recession. Some people still reason as if that were the case.