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  • What We Still Don't Know about Monetary and Fiscal Policy
  • Benjamin M. Friedman

Two thousand and seven may seem an odd moment to question what we know about monetary policy. The past quarter-century has been about as good a run, at least in aggregate dimensions, as one is likely to get—and certainly far superior to what the early Brookings Panel participants, in the 1970s, ever thought likely. The United States has experienced only two business recessions during the last twenty-five years, neither lasting longer than eight months and neither involving a decline in total production as great as 1½ percent.1 Annual price inflation has converged onto a 1½ to 2 percent norm, with the average increase apart from food and energy (the U.S. central bank's preferred measure) falling exactly in the middle of this range over the past ten years and not a single year as much as ¼ percentage point either above or below. Neither the severe one-day stock market crash in October 1987, nor the collapse of a good portion of the nation's thrift deposit industry in the late 1980s, nor the protracted stock market decline of 2000-03, nor the quadrupling of world oil prices since 2002 had much, if any, visible impact on either aggregate nonfinancial economic activity or economy-wide inflation. Euroland and most of the world's other advanced economies have enjoyed similarly favorable rides, and even the one outstanding exception—Japan—proves the rule, in that monetary policy there was so plainly wrong-headed. Among academic [End Page 49] economists it has become commonplace to hail the tremendous advances in knowledge about the subject, and even to refer to monetary policy, as practiced today, as a science.2

Fiscal policy today likewise seems on a surer footing of knowledge than in earlier eras. Despite the expense of simultaneously fighting two wars, and despite a tax cut that had put the U.S. government's budget on a path toward deficit even before either war began, the ratio of the government's outstanding interest-bearing debt to national income has fluctuated narrowly within the range of 0.33 to 0.37 since the beginning of the decade. (The government's unfunded liabilities, mostly for Social Security and Medicare, are another matter, but lack of knowledge is not the problem.) The experience of 2001, recalling that of 1981, has even led to some talk of tax cuts in particular as potentially efficacious in spurring recovery from recessions. For the most part, however, fiscal policy has mostly disappeared from discussion at both the popular and the academic levels.

Well-earned complacency notwithstanding, some modest reflection suggests that despite the recent gains in knowledge, several questions of some seriousness, about both monetary and fiscal policy, remain to be answered. Some are primarily conceptual, while others spring more directly from operational concerns. But in both of these policy areas, experience suggests that often what starts out as a largely conceptual inquiry leads, in time, to implications with practical import.

A Conceptual Question: How Does the Central Bank Make Monetary Policy in the First Place?

Most economics textbooks introduce the role of monetary policy by deriving one or more sources of demand for the central bank's liabilities: banks need reserves to satisfy reserve requirements and to settle interbank transactions, the nonbank public needs currency to conduct everyday business, and so on. The next step is to posit, reasonably enough, that the central bank is a monopoly supplier of its own liabilities and therefore can, unless directed otherwise by higher authorities, set that supply at whatever level it chooses. Because both the banks' and the nonbank public's demand for the central bank's liabilities is likely to be interest sensitive, [End Page 50] the equilibrium of demand and supply in this market establishes the price at which these liabilities are exchanged for other assets: conceptually, some kind of interest rate. Given the role of interest rates and asset returns more generally in affecting aggregate demand, the economic consequences of monetary policy actions—that is, of changes in the supply of central bank liabilities—follow with however much elaboration seems appropriate...


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