Criteria for monetary policy and central bank inflation control effectiveness

Central Banks

What criteria are, and have been, used to determine monetary policy. Examine the evidence for and against the view that central banks can control inflation. Should central bank's target zero inflation?

What criteria are, and have been, used to determine monetary policy. Examine the evidence for and against the view that central banks can control inflation. Should central bank's target zero inflation?

Central Banks and Inflation

The Ideal Indicator

An Open Mind

The Consumption Function

Historical and Future Analysis

of the Criteria for Determination

of Monetary Policy

Optimum Currency Area Theory

The Microeconomic Benefits

Reduced Costs of Foreign Exchange Dealings

Chapter Five

Findings and Conclusions

Signature/Approval Page

An Economics Dissertation

Central Banks, Monetary Policy and Zero Inflation

Department

Dr. *** *********, Major Professor

Dr. *** ******, Committee Member

Chapter One

Introduction

With fundamental banking problems throughout the world, as revealed by 1997-99 crises, and with the European Union a reality, we ask questions that are no longer just hypothetical. For example: How does one go about structuring and provisioning a new central bank on the basis of analysis, the comparisons of central banks, the facts, the experiments, and the phases of post-World War II developments? Without ignoring the policy matters we associate with the economic analysis, we shall in this thesis, discuss summary statements of interest-rate/fiscal-policy and money-stock regimes and reconsider some hypotheses and institutional concerns. The European Monetary Union (EMU) was an enormous achievement. An overview of it and the related central bank operations go along a twofold route: one, to a sketch of a model central bank for countries emerging with open market economies; and, two, to reflect on central banking and monetary control with respect to the turn-of-the-century Asian economies.

The main central banks introduced in the evolution of central banking are the pre-Blair Bank of England, the post-1930s Federal Reserve, and the pre-EMU Bundesbank. The first is the oldest of the three, as we have said. However, open market operations of a special sort came about at the Federal Reserve Bank of New York and were later written into the Federal Reserve Act. They arise because of key features, namely: the trading desk at the New York Fed may enter the New York market primarily to influence reserves without the requirement that a targeted interest rate is set; and, in the presence of shifts to liquidity, the operations do not require that borrowers take the initiative to expand the money and credit aggregates. The operation may be directed toward inflation-rate targeting and/or controlling money and credit aggregates, even if imprecisely, and irrespective of any interest rate, except as a surrogate for monetary policy (Posen, 2005. pp 254).

The special nature of these New York operations is highlighted by a situation where the short- or long-term bond rate may be quite low -- as in the United States during the 1937-38 recession and in Japan during the 1997-98 Asian crises. In these cases, firms and households do not on the average take the initiative to borrow and accelerate spending. As pointed out by Obstfeld & Rogoff (2006), by contrast, the special open market operations may expand the money stock directly at first and then indirectly by satisfying first the liquidity preference of banks and then that of households. Although these matters require emphasis and go back in the Federal Reserve's history, and although the European Union's European Central Bank (ECB) enters near the century's turn, the pre-EMU Bundesbank is the most recent of the prominent central banks of the twentieth century. Its legacy appears in the new century's European Monetary Union. Early in the move toward a central bank for the EMS member countries, British Labor Party politician Roy Jenkins, German Chancellor Helmut Schmidt, and French President Valery d'Esting were the main players. However, as an early Friedman monetarist, Britain's Margaret Thatcher reacted negatively to the EMS developments. She raised issues over sovereignty and the exchange-rate mechanism, which linked to central bank involvement with fiscal policy prior to Tony Blair's 1997 success with the British Labor Party (Faust, 2006 268-9).

As an early leader in the redirection of the 1970s policies bearing on inflation and efforts at controlling prices by price-control, direct means, Thatcher is a major political figure in the "big U-Turn" (Gerling, et al. 2003). I see this in connection with new ideas contained in the Friedman system of analysis and economic problems such as Thatcher confronted. Also, a focus on the pre-EMU Bundesbank's noninflationary demeanor, its orientation as a central bank, and the notion of ideas impacting policy, draw consideration to Germany, the pervasiveness of changes in the 1980s, and the ideas concerning economic analysis, policy implementation, traditions, and practices. These and other matters of importance to economic analysis accompany the separation-of-effects problem (Sibert, 2003 pp 662) and the symbolic equation. Juxtaposing alternatives found in economic analysis, for the most part, leads to conflicts with what we encounter in the European Community (EC) experience with economic integration. In extending the monetary analysis we ask further why so much attention was given to "one money" or a German/French-led currency block to begin with. The answer centers on transaction costs and exchange-rate uncertainties. Most notably, the substitution of a single currency with a zero inflation rate for multiple currencies with diverse inflation rates and disparate central banking arrangements offered the following prospects (Dixit & Luisa 1999). First, the substitution reduced the direct cost of exchanging one money for another in order to make across the-border purchases. Second, the one money with the attained zero inflation goal reduced the uncertainty associated with holding a given stock of money balances and undertaking long- and short-term contracts concerning the repayment of debt and future deliveries of goods and payments denominated in a currency of uncertain future value. Third, closely allied with reduced uncertainty were reduced costs of getting information about future prospects and legal statuses governing contracts in one vs. another unit of account.

Tying a block of currencies to a single "hard" currency, via an exchange rate mechanism, was a step toward reducing uncertainties and information costs, but this action did not go quite all the way to reducing uncertainty through the acceptance of one monetary medium. Reduced uncertainty over transactions costs and future purchasing power are thought to encourage trade and the indirect exchange of goods through the acceptance of money. However, and more important, the market mechanism with a satisfactory money umbrella disburses power and enhances voluntary association in market, as discussed by Kydland, et al. (1977). The acceptance of the monetary arrangement itself goes back to the definition of money, the speculative shifts in the demand for money, business conditions generally, and the interplay of money as a liquid asset and the real goods markets where we find less liquid assets. Although the following parts of our thesis paper has a special focus (the central banks, the EMS), awareness about money, central banks, and Europe's new place in the global community should be raised by the existence of the European Union. The money and central banking lessons should not be lost on countries seeking to undertake transformations to market economies that call for viable monetary systems.

Central Banks and Inflation

In much of the period 1867-1975, for which Faust analyzed data (Faust, 2006), the world was on a gold or gold-exchange standard. In fact, for most of the nineteenth century and until the early 1930s, with World War I and its immediate aftermath aside, the neighborhood in and about London was on a gold or gold-exchange standard that gains its significance in relation to the gold-flows mechanism. Under the classical form of the gold standard three rules held: (1) there is free coinage of gold; (2) the price of gold is fixed by law in terms of a country's monetary unit (e.g., the dollar in the United States and the pound in the United Kingdom), and hence there are fixed relations between the units of account (e.g., $/£ const.) for the most part; and (3) paper currency, coins, and bank deposits are freely convertible into gold under a gold-exchange standard. It comes about where some currency, such as the British pound in its day, is accepted by other central banks as a key currency and hence as good as gold.

Quite briefly, under the gold standard, countries trade goods and services and compete for sales in domestic and foreign markets where attention is focused on prices. The matter is viewable as if the respective countries have averages for their prices (or price indexes). As one country's relative position is favored for trade purposes [say, -? (P U.S. / P UK ) for a favored U.S. position], that country exports more and enjoy an inflow of monetary reserves (the symbol G. In the bank reserve equation), as a rule. There is a balancing out of reserves as the countries compete in terms of trade in goods and services. The main point, however, is that the competition regulates price averages and disperses power that may otherwise reside in the hands of state planners, price controllers, and government bureaus. Under the arrangement, moreover, a country with efficient production and a favored competitive position (including as enhanced by new capital goods) is rewarded with rising income and reduced unemployment. No grand scheme of state or international planning and direct control is required. Exchange rates are for the most part fixed under the classical gold-flows mechanisms (say, $/£ const. within fixed limits), as stated, and adjustments to trade imbalances take place through price-level changes (e.g., PU.S. versus P. UK ) or product prices (and the special part of product prices called wages) (Bullard & Christopher 2004 101). Faced with unemployment, a country's position can be improved by enhancing productivity and having prices on its real goods and services and wages adjust downward relative to those of other countries.

Another way to achieve adjustments in trade positions (or more generally balance of international payments positions) is to have exchange rate changes rather than price changes. Whatever the case-exclusive of full floating that the world does not come to -- some elements of economic efficiency and wage and price discipline (via relative prices, as under the gold-flows mechanism) enter from an international point-of-view. This mechanism of monetary flows and price-level discipline, as it were, impacts on the domestic monetary mechanism (the G. term in the bank reserve equation). Complexities aside, in principle the idea is that of a stock of reserves being identical to factors such as international monetary reserves, and credit extended by the central bank (with discount windows and open market operations as the principal sources).

These reserves, in turn, support liabilities of banking institutions (mainly, since the National Banking Act in the United States, deposit liabilities). These liabilities are in the form of bookkeeping entries. They are a part of the money supply, and paper and other currency can be freely exchanged for the deposit liabilities. Here is the idea of a money supply (the currency and deposit liabilities) that can vary in its measures, depending on the assets included from the point-of-view of the economic "agent" (Briault, et al. 1997 301). Since reserves can be controlled, allowing for various factors, they have a link with the money supply, which in turn can be controlled, after allowances for shifts in the liquidity preference necessities for reserves, because of the banks themselves, and other factors such as changes in the ratio of the currency held by the public to deposit liabilities.

The bookkeeping entries on the liabilities side are a part of the money supply, as stated, and they may come about as bank credit expands in response to increases in bank reserves (mostly via open market operations, or historically gold inflows). The expansion of the money supply comes about via banks extending credit (loans), or purchasing securities. Both actions give rise to banks increasing deposit liabilities, as personal and business accounts are credited, coincidental with the depositing of checks or the crediting of accounts. The banking institutions that are in turn dependent on the central bank have balance sheets that can be thought of as an aggregate balance for all of the banking, money-creating institutions comprising the national economy. On the asset side are mainly the reserves (R o ) and bank loans and investments (called "bank credit") (McCallum, 1999 210), and on the liabilities side are mainly a component of the money supply. There are what can be called credit and money multipliers, to refer to the inverse of the fractional relations (i.e., the inverse of R. o to bank credit, and Ro to the deposit liabilities, respectively). These concepts are synonymous with the idea of a fractional reserve banking system.

This is the fractional reserve system with reference to a simplified and consolidated balance sheet for the non-central bank part of the U.S. banking system. Under such a system, reserves (R o ) are some fraction of deposit liabilities (say, one-fifth of check transferable deposits) and a slightly smaller fraction of bank credit (say, one-fourth B. c ). The deposit liabilities are identifiable in the United States as a main component of the money supply since the National Banking Act of 1863, and they are readily substitutable for currency considered as paper notes and coins (Obstfeld & Kenneth 2006). Confronted with an increase in reserves, under the properly functioning fractional reserve system, banks have every inducement to expand bank credit in that it is the major source of income to the banks. The increase in reserves may come about in the United States because of deposits of currency (or gold coins at an earlier date) and/or because of the deposits of checks drawn on the Federal Reserve and used in the purchase of commercial paper and/or government securities by the Federal Reserve.

As bank credit is extended via an increase in loans (or purchases of securities), the recipient of the credit rarely wants the credits to his or her deposit account to hold. A deposit is soon transferred and the bank loan remains on the books. Questions remain about how fast the deposit liabilities get moved around and turned over (the matter of the income-velocity ratio Y/M). These are discussed on various occasions. Further, the process of reserve, bank credit, and deposit creation may go fast, slow, or in reverse. The process of expansion may start in a financial center (say, New York, to continue with open market operations of a special sort) and spread throughout the banking system. There are two reinforcing mechanisms -- those within the banking system and those within the larger financial system. Within the banking system, the reserves may get passed around through trading among banks in reserves (called in the United States trading in federal funds) and through other means, including the sale of securities, mortgages, or loans to other banks. In the larger financial system, a deposit balance for a New York securities dealer (the dealer who sold securities to the New York Fed), may get passed to the hinterland as the dealer replaces the inventory by the purchase of more securities from a firm in the hinterland. Financial markets adjust quite rapidly, even internationally (Walsh, 2005 159). The point, nevertheless, is that important control is exerted through the fraction of reserves supplied by the central bank. This control may be for good, or for evil. It exists, whatever the latter complexities. The general thrust of operations under the historical gold-type mechanism leads to a conclusion: namely, efforts via effective international competition to export goods (as symbolized by -? PU.S. / P UK ) and to obtain gold (or monetary reserves) under fractional reserve banking arrangements raise nominal and/or real income within the time frame of the inflow, and possibly with some lag afterward.

Starting the sequence of events with a more favorable stance with respect to U.S. via-a-vis U.K. prices (-?P U.S. / P UK ) would result in a more favorable balance of trade in the United States. The United States could face greater monetary growth without adverse balance-of-payments consequences. The money growth or inflow of monetary reserves (?R U.S. ) could support the expansion of bank credit and the money stock (?M) and also contribute to the prospect of increased spending and increased income received (?

). There would always be the threatening prospect of relatively higher U.S. prices (?P U.S. / P UK ) (Lohmann, 2004 284). Quite clearly, causation is from money to income (? ). And indeed this process may continue in a money and markets oriented economy. However -- and perhaps not surprisingly for one who reads the lines in the financial press and between them -- all of this balance-of-payments balancing out is not what we encounter in the global economy we come to in the 1990s and upon entry to the twenty-first century. In this new, emerging open-economy world, traditions and practices (including saving to income ratios) vary as we emphasize.

Indeed, there may be a permanent (or quasi-permanent) balance of sorts, exclusive of above and below the line balance in the U.S. balance of international payments. In it Japan appears as a major capital-funds exporting economy in the world and, reversing a century of economic thought, the largest, most developed economy in the world attracts inflows of capital funds (Kydland & Edward, 2004 481). Again reversing the tradition in economic theory, these inflows of capital funds to the United States may come about even with prevailing low interest rates via-a-vis selected Asian economies, Russia, Brazil, and emerging market economies on the average.

Chapter Two

Literature Review

We have drawn distinctions between an essentially i-regime and an M-regime/inflation-rate targeting approach at the national level with roots in Keynes's work and Friedman's respectively. In this interest-rate orientation, as set on a course by Keynes, however, "the interest rate" is the long-term rate (iL), although short-rate control arrangements enter into the Keynes/Keynesian investment and liquidity preference blocks. As pointed out in the i-regime context, these control arrangements are such that direct control by the central bank over the short rate is expected to impact change in the same direction to the long-term rate (iL.). There are no New York-revenge and Bundesbank effects (Lucas, 2003 330), no psychological time enters to confront possible interest-rate effects, and no bond traders enter to process information and thereby set a long-bond rate. In the presence of these foregoing conflicts, a matter of expediency on the part of operating officials appears with respect to the envisioned arrangements because of central bank traditions and practices. They are such that attention drifted to control over the short rates because the central banks were thought to control such rates and because institutional complexities made the attainment of money aggregates difficult. I came to do two things against such a background -- to question why the institutions were not changed to accommodate control of money aggregates, and to see a combination of the pre-EMU Bundesbank and the post U-Turn Federal Reserve as a preferred model for a central bank in a markets oriented world.

In contrast to this questioning, however, a variant of the i-regime orientation gets attention. It appears in a Federal Reserve publication by Vickers, (1998) and in lesser measure in comments by Alan Greenspan, and it appeared in the failure of the Federal Reserve to come within the target range for dollars M2 in 1992. So we turn to the Weiner analysis, assess it from a Friedman system perspective, note comments by Hoskin (1991) and turn to the discussion of "the interest rate" as a surrogate for monetary policy.

The Ideal Indicator

The ideal indicator would consist of the change in money growth (± ) and the income velocity of money (Y/M), along the lines already introduced. Along these, the change in growth provides the direction of policy and the velocity ratio indicates the amount of work the change performs. Taking the product of money growth and velocity, and multiplying by 100 to get growth in percentage terms, monetary accommodation and discipline appear as:

(Y/M) x 100 > 0 (accommodation) -?

(Y/M) x 100 < 0 (discipline)

The idea of accommodation is that the monetary authority accommodates other things, such as government financing of deficits and wage increases that appear as higher priced goods and services and that on the average exceed the growth in productivity. Discipline, of course, is just the reverse of accommodation. In that case, authority is moving to deny government any special accommodation and to reduce inflation inducing price changes, and so on. Monetary neutrality with respect to prices, wages, and production and the real goods economy is attained when the indicator approximates a zero value for a sustained period. However, these are data and policy/control impediments to attaining such refinements in the imperfect world, even for the United States. As to the relevant data series, there are small, detailed impacts on them that get magnified as errors when the series are refined to obtain measures for acceleration and deceleration (Svensson, 2003). As for the velocity ratio, the income component is available only on a quarterly basis and usually with some error of estimation, all when central bankers want the most immediately available information. Also, accounting difficulties as regards the currency (coins-and-notes) component of the money supply arise for the United States when we inquire about changes in the ownership of the currency, whether by parties in the United States or abroad. At different times, a part of U.S. currency may appear as circulating currency in Mexico, Poland, Russia, Cuba, Argentina, and elsewhere. So, taking the United States as an example, we turn to a surrogate for monetary policy -- whether it is inflationary or deflationary. (McCallum, 1999 209).

An Open Mind

Weiner pleads for an open mind about the matters at hand. He says "there is no inherent reason why a central bank need target the money stock." Even though I believe that history and a host of facts enter, as opposed to "no inherent reason," we proceed with Weiner's exposition. He says:

It could be the case that another intermediate target, say, a medium-term interest rate, is deemed to be more closely related to the ultimate goal variables. If so, monetary control can be de-emphasized or even abandoned, in which case reserve requirements again become irrelevant as a vehicle for directly controlling the money stock. (Prescott & Robert, 2000).

In the argument advanced by Weiner, the distinction is made between an "interest rate operating procedure" and the "reserve operating procedure." Weiner embraces these distinctions as Friedman intended when he said, "Direct control of the monetary base is an alternative to fiscal policy and interest rates as a means of controlling monetary growth." Although not touching on fiscal policy at all, Weiner says (Bullard & Christopher, 2004 pp 95) along the lines of H. CB (Walsh, 2005) "institutional structure within a country . . . may still have an important role to play" (meaning in the public choice between the interest rate and reserve requirements operating procedures). Weiner's case for a short-rate orientation proceeds with time series for "effective" reserve ratios and the money multipliers that go with them in fractional reserve banking systems (Svensson, 2003). U.S., Canadian, and German series appear. They show downward trends for the effective reserve ratios from the early 1970s to 1992 and upward trends in the corresponding money multipliers. In any event, Weiner goes back to what I see as earlier stages of the Keynesian orientation (Faust, 2006) to come up with ordinary supply and demand functions for the money stock, with the view of also dealing with the unlikely prospects of actually identifying the respective functions. For the monetary approach I associate with Friedman, this problem of the identification of supply and demand relations is dealt with by viewing money demand in terms of velocity, by treating households as determining the real money stock (Kreps & Robert, 2002) and by having the central bank determine the nominal money stock (Gerling, et al. 2003). The behavior of the households and velocity, on the one hand, and that of the central bank, on the other, is thought to be different, hence identification. 3

Weiner offers a money/interest-rate (M-i) plane with M. On the horizontal axis and with I (short-term) on the vertical axis. A downward-sloping demand curve and an upward-sloping supply curve are imposed on the plane. They intersect at the "effective money supply" line (Ms, effective). The intersection is a solution (equilibrium, or balance) point [point A (M*, i*)]. Growth conditions such as I stress throughout are possible in that the static money supply and demand curves (Ms and Md) may move about and outward as growth occurs. The idea, under the conditions of change, is that point A moves along the path for the effective money supply (Ms effective ). A money supply line with lower reserve requirements appears (Ms, Irr ). It intersects at point A, and rotates downward as reserve requirements are lowered. The downward rotation also reflects the potentially greater impact of short-term interest rate changes on the quality of money (the M-axis), but that variable is insignificant to the analysis. It just comes about and appears as the effective money supply. It comes about apart from being targeted directly.

The money stock comes about when the specific short-term market rate (i*) is set by the central bank. While overlooking the phenomenon called "the chasing of interest rates," Waller says (2003) the central bank focuses on achieving this special market interest rate (i*) rather than providing reserves and relying on the link between reserves and the money supply. The implication is that the market interest rate known as the "federal funds rate" may be used to target a real rate of interest (and hence a zero inflation rate goal). Waller says "a crucial implication is that the level of reserve requirements is now irrelevant, i.e., requirements no longer play a direct role in monetary control." In taking up a changing role for reserve requirements, he says ( 2003, 412): "Reserve requirements are no longer seen as a vehicle to directly control the money stock but rather as a vehicle to facilitate control over short-term interest rates." Going further, he says "depending on a country's institutional framework, there may be scope for reducing or even eliminating reserve requirements."

Of course, changes in reserve requirements per se are no unusual thing, nor need they be seen as a means of controlling reserves (or "base money" defined as reserves plus currency and coins in circulation). In the context of the bank reserve equation, the Federal Reserve may readily intervene with open market operations to counter the reserve requirement change and continue to control the growth of reserves (or "base money") irrespective of the legally required level for reserves. From a money aggregates control perspective according to Faust (2006), nothing really changes but possibly the "effective" money and bank-credit multipliers.

Chapter Three

Research Methodology

There are crucial factual and analytical difficulties with the view of setting monetary policy in terms of a short-term interest rate such as the federal funds rate in the United States. First, it is misleading to say, as Obstfeld, (2001), that the Bundesbank has made a choice to target the money stock via "an interest rate operating procedure" or to target some variable other than the money supply with the view to attaining German economic goals for income and inflation rates. Citing the Bundesbank's own text (1989), and drawing on Kydland & Edward (2004) and other print media, the view of the Bundesbank's management of liquidity to set a money-stock variable within a target range is more accurate than the Weiner position. Moreover, even Weiner vacillates on the matter, saying "German [pre-EMU] monetary policy" is "geared somewhat more toward traditional monetary control considerations." In addition, in Weiner's reference to McCallum, (1999) McCallum also says Dudler characterizes the pre-EMU Bundesbank as not following a "pure 'interest rate' strategy" and as stressing that short-run procedures are not based on a rigorous 'money multiplier' approach" (McCallum, 1999 207).

Quite clearly, where central banks commit themselves to offsetting the effects of destabilizing episodes and liquidity shifts such as appear initially in money and financial markets, there is unlikely to be any pure reserve and money-multiplier approach. Shifts toward liquidity such as coincide with the 1937-38 recession in the United States (or even 1990-91) need to be met by monetary policy when possible if it is to be stabilizing, but there are problems in most historical context. For example, inadvertent or otherwise Greenspan likely used the 1990-91 recession to bring interest rates more toward a noninflationary level. Indeed, in the context of deficit reduction and a lowering of the prospects for renewed or continued inflation (via monetary accommodation), stabilization was not possible in the 1990-93 period in the United States (Barro & David 2003 590). And in more general terms, the difficulty with the U.S., pre-money-aggregates policy was that it has too often been destabilizing in connection with the interest-rate orientation, as referred to by the phrase "chasing interest rates."

Second, the rationale for the upward sloping money supply curve is as follows: "The money supply curve slopes upward because increases in the market interest rate encourage borrowing [on the part of the non-central bank] and discourage excess reserves, boosting the money supply." Even though this may be the rationale, I see it as being based on observations which are that banks and households draw down on liquidity as booms progress and market interest rates rise. At such times, banks borrow reserves more aggressively to support the growth of loan and investment portfolios. So it is not the interest rates that encourage borrowing but rather the boom state. Inflationary expectations may enter, where not held in check by deficit reduction or other measures, so a rise in interest rates is possible [i = i (real) + ?e ]. Third, the money demand curve slopes downward on the Keynesian rationale. Stated on a priori grounds by Weiner, it is that when interest rates are lower "the break cost of holding money also declines, reducing the incentive for households and businesses to economize on money holdings." Now, this too is at odds with the evidence on the behavior of interest rate and liquidity shifts by households and firms, namely: (1) shifts into liquidity on the part of banks coincide with low interest rates (as discussed by Briault, et al. 1997 302); (2) the velocity of money also declines in tandem with low interest rates; and (3) there is no evidence that the central banks raise and lower long-term interest rates exclusive of their control over inflation. Indeed, considering the interest-rate and inflation-rate, I see that interest rates trend upward with monetary accommodation and rising inflation and downward with monetary deceleration and declining inflation rates. Further, I see that the Federal Republic of Germany had the lowest interest rates of the three countries shown, as well as the lowest inflation rates.

Fourth, mentioning numerous analysts, Vickers says the Bundesbank seeks "to closely influence longer term money market rates" ( 1998 432-4). However, in opposition to this I quote the Bundesbank's ( 1989, 82, 83, 84) position before monetary union:

[T]he Bundesbank decided after much deliberation to make its intentions in stabilization policy clear to the public in advance by announcing an annual monetary growth target. The Bundesbank still regards this as a most valuable intermediate target.

Longer-term rates in the capital market in particular are likely to change spontaneously with fluctuations in the price climate, without any action by the central bank, i.e., to contain "inflation premiums" which are very hard to measure. The "ambivalent" nature of interest rate movements makes market rates an unsuitable intermediate goal for a monetary policy directed towards price stability. The close empirical connection which exists over the longer term between the movement of the money stock and the movement of prices also suggests that the most suitable intermediate target to show the effects of the Bundesbank's stabilization policy is to be found in the range of aggregates relating to the volume of money. Fifth, drawing on what Waller regards as "most analysts," he distinguishes between sources of shocks (I say, episodic impacts) on the data series. On the one hand, he says:

An economy subject to frequent shocks in money demand emanating from portfolio shifts, for example, is best served by an interest rate intermediate target. Such an approach insulates the real economy from unwanted fluctuations, and while the money stock may increase or decrease unexpectedly, such movements have no effect on the inflation rate.

On the other hand, he says:

An economy subject to frequent shocks in money demand emanating from unexpected changes in consumer or business spending . . . is best served by a money stock intermediate target. By allowing interest rates to adjust, a money stock target prevents large fluctuations in real growth and at the same time keeps inflation close to its desired level. (Lucas, 2003 326)

But the analytical difficulty here is that most significant episodes are indistinguishable in their impacts on financial markets and household spending in the real goods sector. To be sure, adjustments to impacts appear first in the markets for the most liquid assets and may even be reversed in the minor instances before the effects appear in the real-goods sector. Yet all of this does not separate the money and financial markets from the real goods and service markets where we observe the spread of events to production growth, employment, and inflation rates. A major effect of Lohmann's extensions of analysis to transitory and trend time frame and to the four-asset model (1992 273-274) was the link between the monetary and real goods sectors. To repeat an earlier position: If there are changes in the underlying conditions (say, a change toward the prospect of a decline in prices), then there would be an increase in the demand for money in connection with its store of value function of money demand (1992 279).

But that is not the main immediate point. Rather a positive (negative) shift in the community's demand to hold money gives rise to a decline (rise) in velocity and output in product market terms. If output adjusts faster than prices, as when recession occurs, we end at an unemployment level of output (qu) (Rogoff, 1985). On the other hand, if and when supply conditions (and wages as a special price) adjust to the demand-shift condition, we end at point C. And full employment output (qf). So Waller is straining to separate effects that should not be separated and likely cannot be separated by known statistical means over time frames that matter for the economy. The ultimate goals for the central bank and the state, or the G-7 and monetary union countries, appear in respect to the real goods sector. The monetary role is that of a vehicle for arriving there.

The Consumption Function

Milton Friedman framed his consumption function in terms of the permanent income path noted in Figure 1.1 (part b):

C = k (. . .)Y p

Figure 1.1 a.

It was a remarkable achievement in that its statements reconciled two known sets of observations; namely, results obtained from consumption and income data for households at a given time, which provided evidence in support of Keynes's function, and results from Simon Kuznets's national income studies (Lohmann, 2004 274), which more or less appeared after Keynes's statement of his function ( 1936, 96). The Kuznets studies pointed to more of a constancy of the saving-to-income ratio for the United States (S/Y, and thus also C/Y), over long periods.

Figure 1.1 b

Via such routes, I extend the list of the great ratios to include

C = k[i (real), Wnh/W, u]Y p and thus another variable factor of proportionality [i.e., k (. . .)]. The factor k (. . .) can vary with two measures of interest to central bank enthusiasts and a collection of other forces (u) that can also rotate the consumption function/ratio line of Figure 1.1 (part d) upward or downward. The first measure of interest, of course, is the real rate of interest [i (real)]. The other is a measure of liquidity consisting of the ratio of nonhuman wealth (cash, bonds, stocks, plant and equipment, and so on) to total wealth.

Figure 1.1 c

The greater the liquid part of wealth, the higher the Wnh-to-W ratio and the more likely the consumption function line of Figure 1.1 (part d) will rotate in response to a shock bearing on the ratio (Drazen, 2000). In addition to the global turmoil effects of August and September 1998, we may point to Thatcher's privatization of government-owned companies in the second half of the 1980s, along lines discussed later.

Figure 1.1 d

Viewed overall, very dynamic analysis surrounds the function in such a way as to facilitate a reorientation of Keynes's economics, albeit in a setting where saving is more global as on page 54. By way of this, algebraic operations can lead to a restatement of the simpler Keynes/Keynesian function (C = a + bY), where I show it in 1.2 on the Keynes-Keynesian/income-expenditure plane and impose Friedman's function as well. It is such that the intercept parameter (a) is made to depend on permanent income from the last period [a = f (Y P, t-l, . . .)]. Parameter a (and hence total spending) -- shown on the vertical axis -- is set in motion by past values for the growth path for income. To begin with, the total spending line (C + I) intersects the 45-degree (dY/dY) line at point A and Keynes's consumption function at point B (both at income value Y 0 ) (Barro & David, 1983).

Figure 1.2 The Dynamic Consumption Function

Growth could have proceeded from there, such that the initial points A and B. were sent to the right by the growth of income as in Figure 1.1 (parts a and b). Now, an increase in saving (demonstrated later in Figure 1.4) -- and hence the saving-to-income ratio and the real rate of interest -- means faster economic growth (an upward rotation of the income path in Figure 1.1 (parts a and b). The increase in the ratio (say, via the real rate) rotates the Friedman function [C = k (. . .) Y p] downward. The downward rotation goes with faster growth as in Figure 1.3 and, overall, consumption at income one (Y 1) is greater than consumption shown there at income with subscript zero (Y 0).

As with liquidity preference and overshooting, the main features of the Keynes/Keynesian analysis are reversed. In the earlier figure, accelerated money growth meant higher interest rates [via I = I (real) + ?e] rather than lower rates. Now, greater saving out of income (? S/Y) means higher income rather than lower income and a higher real rate of interest in Figure 1.4 [and also continuing in the Friedman system context of open market operations, where we point out that monetary policy is well equipped to resist deflation such as occurred in the 1930s (Kreps & Robert, 2002 260). Contrary to such operations, however, the real rate is not exactly at the direct control of central banks, even less so than the nominal rate (i L).

Chapter Four

Findings and Discussions

The classical, gold-standard arrangement was rather impersonal in its operation. It worked according to certain rules, and dispersed the power that might otherwise reside in a government-managed economic system. As Keynes indicated, its function was surrounded by mystery, respect, and certain amounts of awe and reverence. However, as Keynes reviewed the matters of the 1920s, he saw that the managed financial system had crept in. To be sure, some phases of it that bear on the present analyses, its conclusions, and extensions of national policies to an open-economy setting have been reviewed here. At the domestic level, there are the i-orientation and its fiscal policy accoutrements, which I associated with In M = a 0, + a 1, ln I + a 2, ln Y (Symbolic of Keynesian and Bank of England views of controlling money balances, the last equation can be rewritten ln M = a 0 + a 1, ln I + a 2 ln Y (2) ), monetary accommodation, the causation issue, Lord Kaldor, and all (Buiter & Anne, 2001 183). Moreover, these topics were extended to others: namely, to notions about controlling prices directly enter via theories of imperfect and oligopolistic market structures, where inflation may arise (Cukierman & Allan 2007-1099); to the uses of force that arise that may extend to making the world fit the models (Cukierman & Allan 2007-1123); and to income redistribution via income policies and the uses of the tax and transfer powers of the state.

Figure 1.3

Juxtaposed to this, on the domestic level, was the M-orientation, which limited the government's function in fiscal, price-control, and market matters. It does several things: it suggests different utility and consumption functions (Barro & David 2003 589); introduces the prospects of freedom and voluntary association in markets as an economic goal (Barro & David 2003 591); and pictures monetary neutrality (?0) as the attainment of the zero inflation goal. "The optimal inflation rate has a large variance around its trend (about 20%) because it is desirable for the government to use its fixed nominal debt, in conjunction with variable inflation, to generate changes in the real burden of its debt over the business cycle" (Hoskins, 1991 2).

Figure 1.4

Now, in the open economy context, the conflicts, issues, and choices take on international extensions. What appears domestically as the "freedom issue" becomes the sovereignty issue. The interest-rate orientation and its fiscal policy accouterment still exist, and notions about a super national central bank and different exchange rate mechanisms enter the picture. Quite basically of course, countries' prices (as in a price index) are extended internationally by means of exchange rates. They are stated in terms of the unit of account for one currency in relation to another (e.g., the dollar price of the pound, $/£, the Deutsche mark, $/DM, the yen, $/¥), and so on (Briault et al. 1997 309). Exchange rates appear at times as fixed and at other times as variable, along the lines set forth in dealing with control arrangements and their ideological extensions. To the extent that domestic central banks bear crucial responsibility for price levels, and to the extent that currencies are freely traded in the foreign exchange markets, speculation in currencies reduces mainly to speculation over the prospects for monetary policy in the respective national states. So anticipations about the future enter with respect to central bank policies, domestic price levels, and exchange rates. As illustrated, these last two sets of prices bear on a country's prospects for importing and exporting goods and services as well as capital.

The existing paradigm of the theory of monetary policy has the central bank's credibility at its centre. The central result, in a world of rational expectations and no information asymmetries, is that discretionary monetary policy has an inflationary bias. That bias can only be eliminated, with a consequent gain in social welfare, if the central bank is pre-committed by strictly tying monetary expansion to a rule. The inflationary bias of discretionary policy exists because central bank announcements are not credible. Here lack of credibility is identical with dynamic inconsistency. If the central bank announces a zero inflation policy, the public, with perfect information including information about the bank's objective function, rationally expects the bank to adopt a different, surprise, policy to expand employment once inflation expectations have been formed, and therefore determines its actions on those fully informed expectations. Dynamic inconsistency means that the bank's announced policy is not credible (Rogoff, 1985; Posen, 2005; Barro & David 1983; Cukierman & Allan 2007).

Extensions to the model, permitting asymmetric information, uncertainty in the minds of the public, and sophisticated strategies in the central bank / public game lead to related results, but rather than credibility being simply present or absent, it is a function of reputation, influenced by central bank actions and a variety of institutional arrangements (Barro and Gordon 1983). The world has been experiencing a wave of institutional reforms in central banking. They include moves towards central bank independence, the appointment of central bank governors with 'conservative' reputations (in terms of the weight given to unemployment and price stability in their objective function), and contractual or constitutional rules regulating relations between government and the central bank. The theoretical rationale for each is located in such models of credibility-increasing institutional arrangements. Therefore the underlying concept of credibility deserves scrutiny, starting with the question 'who has to have confidence in the credibility of monetary policy?'.

The agents around which the model revolves are workers and employers and their critical actions occur in negotiating wages in the labor market. Specifically, they negotiate the nominal wages that will obtain over a period in an attempt to attain an optimum real wage over that period; thus, their negotiations reflect expected inflation over the period and, hence, the credibility of central bank policy announcements. Central bank credibility, therefore, is credibility in the eyes of labor market actors. If the bank lacks credibility, nominal wage settlements will rise faster than otherwise and, given technology and the degree of monopoly, that rate of wage inflation will be reflected in a higher rate of price inflation.

The models' focus on credibility in the labor market can also be seen in their assumption about the central bank's objective function, or loss function. Its two variables are inflation and unemployment, the determination of which is located in the labor market. With given inflation expectations in the labor market, a short-run Phillips curve would exist, apparently offering a trade-off between inflation and unemployment (Dixit & Luisa, 1999). If the central bank announces a policy ('zero inflation') it would not be credible to workers and employers because they know that dynamic inconsistency exists. That is, if the expectation of zero inflation were held, after announcing its zero-inflation policy the bank would then seek to maximize its objective function (minimize loss) by reneging on its announcement. It would try to reduce unemployment below its 'natural rate', and raise inflation, moving along that short-run Phillips curve to the point where it is tangential to an indifference curve of the objective function. Knowing that the bank has that incentive for dynamic inconsistency, nominal wage negotiators in fact generate a higher inflation rate. Thus, the driving force for the inflationary bias of discretionary monetary policy is lack of central bank credibility in the eyes of labor market actors.

Historical and Future Analysis of the Criteria for Determination of Monetary Policy

The Mechanics and Institutions of a Common Currency

The process of establishing a North American Monetary Union involves the following steps. On January 1, 20 xx, the public in Canada, Mexico, and the United States will surrender their current banknotes and coins in return for new ones, which might be called ameros (Svensson, 2003). At the same time, all prices in the three countries are converted to ameros. The North American Central Bank will be created and will determine monetary policy for the continent. The three member states are represented on the executive board and staff in proportions that reflect their economic importance. One crucial issue is the rate at which the national currencies are exchanged for ameros (Drazen, 2000). To minimize the cost of conversion, one U.S. dollar will be equal to one amero. The exchange of the Canadian and Mexican currencies for ameros will take place at a rate that leaves unchanged the international competitiveness of these countries. To minimize opposition to the monetary union by nationalists, one side of notes and coins circulating in each country will show appropriate national symbols, the other will exhibit abstract designs and writing that identifies them as amero notes or coins. To keep the circulation of national currencies dominant in each country, commercial banks will return foreign amero notes to their home country in exchange for their own country's notes. The currency circulating in each country can be produced locally so that each country can continue to earn the seigniorage profits from that activity and the mints remain in place (Svensson, 2003). The introduction of the amero at the appropriate rates of exchange leaves unchanged the real income and wealth of individuals in all three countries. Incomes, prices of goods, services, and assets all change in the same proportion. The process of creating a common currency involves only what in practice are accounting changes. The public in all countries is likely to get quickly used to the new unit of account. So what are the benefits from monetary union? The following analysis discusses a number of different sources of welfare gains, the assessment of which is facilitated by a brief review of OCA theory.

Optimum Currency Area Theory

After 1945 the international monetary system relied on a system of fixed exchange rates. This system was introduced to prevent the competitive devaluations that had aggravated the depression of the 1930s. However, during the 1960s this fixed exchange rate system came under criticism based in Keynesian economic theory (Gerling, et al. 2003). This theory suggested that countries could lower unemployment permanently by expansionary monetary and fiscal policies at the expense of only relatively small and constant inflation. The fixed exchange rate system was seen as the main obstacle to the pursuit of such policies, and the move to flexible exchange rates gained great momentum. During this period academics and politicians also gave much attention to Milton Friedman (1953) arguing the merit of freely floating exchange rates. His arguments were powerful and influential because he equated the exchange rate to the price of foreign exchange. He then developed the universally accepted idea that price flexibility assures the efficient allocation of resources and thus leads to the maximization of income. The confluence of Keynesian and Friedman's criticism of fixed rates ultimately resulted in the abandonment of fixed exchange rates (McCallum, 1999).