Saturday, December 8, 2012

DeLong Smackdown Watch(?): Central Banking Edition

. Saturday, December 8, 2012

Brad DeLong takes Marco Rubio to task for not understanding how central banking works:
Rubio, you see, wants the Federal Reserve to stabilize three things: 
1. The path of the price level, 
2. The value of the dollar, and 
3.The level of interest rates.  
But you cannot do this. cannot stabilize the path of the price level and the exchange rate and nominal interest rates. Were we to confirm The One Who Is to chair the Fed, she could not do it.

If you stabilize the exchange rate--i.e., set up a gold standard and join it--interest rates and the price level will do their thing.  
If you stabilize the nominal interest rate, you will find yourself in either an inflationary or deflationary spiral.  
And if you stabilize the path of the price level, you will have to do some serious leaning against the wind with interest rates, and that will set the currency bouncing around.
This is true of the proverbial "small open economy" that macroeconomists generally model, and is therefore true for most actually-existing counties. But it is not necessarily true of the United States. Why? Because of the fact that in a world with n countries there are n-1 exchange rates. Whichever country controls the base currency has quite a bit more policy flexibility than all the others.

The United States is still that country, despite not having a formal exchange rate peg since the end of Bretton Woods. Other countries still conduct monetary policy with a view towards impacting exchange rates vis-a-vis the US dollar. So long as those countries are stabilizing (nominal) exchange rates, the US central bank can conduct monetary policy with an eye towards stabilizing the path of the price level and interest rates. Absent shocks on the real side, these are the same thing.

This is not what Rubio is saying... DeLong is right about that. What Rubio actually wants -- "The Federal Reserve Board should publish and follow a clear monetary rule – to provide greater stability about prices and what the value of a dollar will be over time" -- is a new way to criticize the Fed. But on its face this is not so crazy. It is what Scott Sumner wants: a stated 5% nominal GDP growth target. Others want some form of a Taylor Rule. The Fed itself actually has stated a goal of 2% long-run inflation. To the extent that the effectiveness of monetary policy depends on expectations, wanting a clearly-articulated policy is perfectly sensible.


DeLong Smackdown Watch(?): Central Banking Edition
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