In “Framework for Monetary Policy 1 I started being more systematic about a subtle but important distinction about how we should be thinking about central bank macroeconomic management.[1] Instead of viewing the central bank as managing aggregate supply and demand we should view it as facilitating adjustments in relative prices among goods and differentiated labor in response to shocks that affect sectors differently.
The "facilitation" is critical because sectoral shock changes equilibrium relative prices of some goods and services and their relative prices need to go down to permit markets to clear. If the prices of the things whose relative price needs to go down are nominally sticky downward then the average of nominal prices has to go up, something that only the central bank can make happen. This has implications for the average target rate of inflation that a central bank following a Flexible Average Inflation Target (FAIT) sets to facilitate "Brownian movement shocks" as well as how "flexible" it should be in engineering over target inflation the face of extraordinary shocks requiring extraordinary movements in relative prices.
At the time of Framework for Monetary Policy 1 I intended to follow up with the application of those concepts to recent issues and events. But in response to comments, I see that, I need to better distinguish the more commonly used aggregate supply/demand view from the facilitation view.
It is implicit in the management of aggregate supply/demand view that the economy produces only one good with one input -- undifferentiated labor -- and therefore, has only one relative price -- the real wage. Any inflation is bad or at least useless for increasing real incomes. Unemployment results from inadequate aggregate demand which reduces the nominal price of the one good and, if wages are not equally flexible downward (as they are reasonably assumed not to be), this raises the real wage and reduces the amount of labor demanded.
Inadequate aggregate demand might result from a desire of consumers to increase holdings of “safe” assets (a financial crisis), a collapse in investors’ “animal spirits” (a lower expectation of future growth) a spontaneous decrease in government spending (“austerity”) a decline in net exports, or contractionary monetary policy. And since one person’s spending is another person’s income, any decrease in spending caused by any of the causes above further reduces spending so the total change is a multiple of the original cause. [The reader will notice the description of the standard income identity, Y=C+I+G+ (X-M).]
Whatever the cause, the response of the central bank should be the same, expansionary monetary policy. [Since the amount of money that market participants will hold depends on interest rates, the policy instrument can be thought of as either changes in interest rates or changes in money supply.] Expansionary policy would have the effect of providing more safe assets, reducing investors cost of capital, devaluing the currency to increase net exports or, if the government were operating according to a NPV principle, increasing government spending.
As an aside, we could note that since there is only one good, a change in demand of any component is as effective as any other in changing income. This suggests that discretionary fiscal policy could substitute for monetary policy in restoring aggregate demand. And, if one further believed that monetary policy were ineffective (“pushing on a string”) or constrained (zero lower bound), fiscal policy would HAVE to substitute.
There is little contrast between the policy response in the relative price adjustment view and the aggregate supply/demand in a scenario in which there is even a large economy-wide shock that affects demand or supply for different goods and services approximately uniformly. Under either view expansionary monetary policy should restore aggregate demand. For a uniform shock, however, it would be sufficient for monetary policy to merely maintain or restore the target level of inflation to prevent market clearing failures in the labor market = unemployment.
When a large shock affects demand or supply non-uniformly, however, there can be many relative prices out of equilibrium and merely to maintain or restore the target level of inflation, which has been chosen to maximize real income in the face of Brownian movement shocks, may not be sufficient to prevent market clearing failures, and temporarily above-target inflation will be needed.
[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] Some of the earlier posts are:
https://thomaslhutcheson.substack.com/p/arrrrr
thomaslhutcheson.substack.com/p/supply-…
Of course hindsight is 20/20, but we should have learned that 2021 was the time for a bit revenue raising tax reform. [If you're skittish about the Fed not being expansive enough, post pone effectiveness a year.] And that way when the Fed delayed starting to reduce inflation in 2021, Biden could have blamed the Fed. [He could and should have anyway, but having reduced the deficit and since many people mistakenly THINK deficits cause inflation, he would have been on the high ground.]
Close. Fiscal policy does not affect inflation (or unemployment) if the Fed is targeting inflation as it now supposedly is. What fiscal policy affects is interest rates. Interest rates are the “give” in the way the Fed deals with changing fiscal policy. And higher interest rates are a drag on long term growth. THAT, rather than because their causing inflation, is why we need tax reform to close the deficit. [The difference with the Obama era is that back then the Fed was not really targeting inflation. It apparently sort of had an inflation ceiling but it did not act to prevent inflation from falling below 2%. The 2009 relief package really DID provide “stimulus.”]
I think the Fed ought to have already started inching down the Effective Federal Funds Rate; if 5.25% is good for continuing to slow inflation, 5.00% would be almost as good. More to the point, however is that the Fed needs to be more flexible, willing to move rate down and, if necessary, back up as circumstances change. My concerns is that it allows itself to be constrained by its own previous announcements and could still get caught flat footed and cause a recession. I think this happened in reverse, in 2021 when it delayed raising the EFFR (until March 2022)
See [https://thomaslhutcheson.substack.com/p/framework-for-monetary-policy-1]
And [https://thomaslhutcheson.substack.com/p/framework-for-monetary-policy-2?r=8ylpe&utm_campaign=post&utm_medium=web]