6. Monetary Policy Should be Concerned with Output as Well as PriceFluctuations.Price stability is a means to an end, a healthy economy, and should notbe treated as an end in itself.Thus, central bankers should not be obsessed with inflationcontrol,andbecomewhatMervynKing(1997)hascharacterizedas"inflationnutters"Clearly the public cares about output as well as inflation fluctuations, and so theobjectives for a central bank in the context of a long-run strategy should thus not onlyinclude minimizing inflation fluctuations, but should also include minimizing outputfluctuations.Objective functions with these characteristics have now become standard inthe monetary economics literature which focuses on the conduct of monetary policy(e.g., see the papers in Taylor, 1999)7.TheMostSerious EconomicDownturns areAssociated withFinancialInstability.A reading of U.S. monetary history (Friedman and Schwartz, 1963,Bernanke, 1983,and Mishkin,1991)indicates that the most serious economic contractionsin U.S.history,including the Great Depression,have all been associated with financialinstability. Indeed this literature suggests that financial instability is a key reason forthe depth of these economic contractions.The recent financial crises and depressions inMexico and East Asia also support this view (Mishkin,1996,1999a and Corsetti, Pesenti,and Roubini,1998).Preventingfinancial instability is therefore crucial to promotingahealthy economy and reducing output fluctuations, an important objective for centralbanks, as wehaveseenabove.II.ImplicationsfortheRoleofaCentralBankArmed with these seven guiding principles, we can now go on to look whatinstitutional features a central bank should have in conducting its operations.We derivethe following implications/criteria for the role of a central bank: 1) Price stabilityshould be the overriding, long-run goal of monetary policy; 2) An explicit nominalanchor should be adopted; 3) A central bank should be goal dependent; 4) A central bankshouldbeinstrument independent; 5)Acentralbankshouldbeaccountable; 6)Acentral5
5 6. Monetary Policy Should be Concerned with Output as Well as Price Fluctuations. Price stability is a means to an end, a healthy economy, and should not be treated as an end in itself. Thus, central bankers should not be obsessed with inflation control, and become what Mervyn King (1997) has characterized as "inflation nutters". Clearly the public cares about output as well as inflation fluctuations, and so the objectives for a central bank in the context of a long-run strategy should thus not only include minimizing inflation fluctuations, but should also include minimizing output fluctuations. Objective functions with these characteristics have now become standard in the monetary economics literature which focuses on the conduct of monetary policy (e.g., see the papers in Taylor, 1999) 7. The Most Serious Economic Downturns are Associated with Financial Instability. A reading of U.S. monetary history (Friedman and Schwartz, 1963, Bernanke, 1983, and Mishkin, 1991) indicates that the most serious economic contractions in U.S. history, including the Great Depression, have all been associated with financial instability. Indeed this literature suggests that financial instability is a key reason for the depth of these economic contractions. The recent financial crises and depressions in Mexico and East Asia also support this view (Mishkin, 1996, 1999a and Corsetti, Pesenti, and Roubini, 1998). Preventing financial instability is therefore crucial to promoting a healthy economy and reducing output fluctuations, an important objective for central banks, as we have seen above. III. Implications for the Role of a Central Bank Armed with these seven guiding principles, we can now go on to look what institutional features a central bank should have in conducting its operations. We derive the following implications/criteria for the role of a central bank: 1) Price stability should be the overriding, long-run goal of monetary policy; 2) An explicit nominal anchor should be adopted; 3) A central bank should be goal dependent; 4) A central bank should be instrument independent; 5) A central bank should be accountable; 6) A central
bank should stress transparency and communication; 7) A central bank should also havethegoal offinancial stability.Price Stability Should be the Overriding, Long-Run Goal of MonetaryPolicyTogether, thefirst three principles for monetary policy outlined above suggestthat the overriding, long-run goal of monetary policy should be price stability. A goalof price stability immediatelyfollows from the benefits of low and stable inflationwhich promote higher economic output.Furthermore, an institutional commitment toprice stability is one way to make time-inconsistency of monetary policy less likely.Aninstitutional commitment to the price stability goal provides a counter to time-inconsistency because it makes it clear that the central bank must focus on the long-runand thus resist the temptation to pursue short-run expansionary policies that areinconsistentwiththelong-run,price stabilitygoal.The third principle that fiscal policy should be aligned with monetary policyprovides another reason why price stability should be the overriding, long-run goal ofmonetary policy.As McCallum (1990) has pointed out,"unpleasant monetaristarithmetic"onlyarises ifthefiscal authorities arethe first mover.In otherwords if thefiscal authorities are the dominant player and so can movefirst, thus setting fiscal policyexogenouslyknowing thatthe monetary authorities will beforced to accommodatetheir policies to maintain the long-run government budget constraint, then fiscal policywill determine the inflation rate. Indeed, this is the essence of the fiscal theory of theprice level.On the other hand, as McCallum (1990) points out, if the monetaryauthorities are the dominant player and move first, then it will be fiscal policy that willaccommodate in order to satisfy the long-run government budget constraint, andmonetarypolicy will determinethe inflation rate.An institutional commitment to pricestability as the overriding, long-run goal, is just one way to ensure that monetary policymoves first and dominates,forcingfiscal policyto align with monetarypolicy.The sixth guiding principle that output fluctuations should also be a concern ofmonetary policy suggests that a fanatic pursuit of pursuit of price stability could beproblematic because policymakers should see not only price fluctuations but also outputfluctuations as undesirable. This is why the price stability goal should be seen asoverriding in the long-run, but not in the short-run. As Lars Svensson (1999) has put it,6
6 bank should stress transparency and communication; 7) A central bank should also have the goal of financial stability. Price Stability Should be the Overriding, Long-Run Goal of Monetary Policy Together, the first three principles for monetary policy outlined above suggest that the overriding, long-run goal of monetary policy should be price stability. A goal of price stability immediately follows from the benefits of low and stable inflation which promote higher economic output. Furthermore, an institutional commitment to price stability is one way to make time-inconsistency of monetary policy less likely. An institutional commitment to the price stability goal provides a counter to timeinconsistency because it makes it clear that the central bank must focus on the long-run and thus resist the temptation to pursue short-run expansionary policies that are inconsistent with the long-run, price stability goal. The third principle that fiscal policy should be aligned with monetary policy provides another reason why price stability should be the overriding, long-run goal of monetary policy. As McCallum (1990) has pointed out, "unpleasant monetarist arithmetic" only arises if the fiscal authorities are the first mover. In other words if the fiscal authorities are the dominant player and so can move first, thus setting fiscal policy exogenously knowing that the monetary authorities will be forced to accommodate their policies to maintain the long-run government budget constraint, then fiscal policy will determine the inflation rate. Indeed, this is the essence of the fiscal theory of the price level. On the other hand, as McCallum (1990) points out, if the monetary authorities are the dominant player and move first, then it will be fiscal policy that will accommodate in order to satisfy the long-run government budget constraint, and monetary policy will determine the inflation rate. An institutional commitment to price stability as the overriding, long-run goal, is just one way to ensure that monetary policy moves first and dominates, forcing fiscal policy to align with monetary policy. The sixth guiding principle that output fluctuations should also be a concern of monetary policy suggests that a fanatic pursuit of pursuit of price stability could be problematic because policymakers should see not only price fluctuations but also output fluctuations as undesirable. This is why the price stability goal should be seen as overriding in the long-run, but not in the short-run. As Lars Svensson (1999) has put it
central banks should pursue what he calls "flexible inflation targeting", in which thespeed at which a central bank tries to get to price stability reflects their concerns aboutoutput fluctuations.Themore heavily a central bank cares aboutoutput fluctuations,themore time it should take to return to price stability when it is not already there.However, because a "flexible inflation targeter"always sets a long-term price stabilitygoal for inflation, the fact that a central bank cares about output fluctuations is entirelyconsistent with price stability as the long-run, overriding goal.AnExplicit Nominal Anchor Should beAdoptedAlthough an institutional commitment to price stability helps solve time-inconsistency and fiscal alignment problems, it does not go far enough because pricestability is not a clearly defined concept. Typical definitions of price stability have manyelements in common with the commonly used legal definition of pornography in theUnited States --you know it when you see it.Constraints on fiscal policy anddiscretionary monetary policy to avoid inflation might thus end up being quite weakbecause not everyone will agree on what price stability means in practice, providingboth monetary policymakers and politicians a loophole to avoid making toughdecisions tokeep inflation under control. A solution to this problem which supports thefirst three guiding principles is to adopt an explicit nominal anchor that ties downexactly whatthe commitmenttoprice stabilitymeans.There are several forms that an explicit nominal anchor can take.One is acommitment to a fixed exchange rate. For example, in 1991, Argentina established acurrency board that required the central bank to exchange U.S. dollars for new pesos at afixed exchange rate of one to one.A second nominal anchor is for the central bank tohave a money-growth target, as was the case in Germany. A third nominal anchor is forthere to be an explicit numerical inflation goal as in inflation targeting countries such asNew Zealand, Canada and the United Kingdom, Australia and Brazil, among others.Allthese forms of explicit nominal anchors can help reduce the time-inconsistency problem,as the success of countries using them in lowering and controlling inflationdemonstrates (Mishkin, 1999b) These nominal anchors also help restrain fiscal policyand are also seen as an important benefit of inflation targeting in countries such as NewZealand and Canada (Mishkin and Posen, 1997, and Bernanke, Laubach, Mishkin andPosen, 1999).7
7 central banks should pursue what he calls "flexible inflation targeting", in which the speed at which a central bank tries to get to price stability reflects their concerns about output fluctuations. The more heavily a central bank cares about output fluctuations, the more time it should take to return to price stability when it is not already there. However, because a "flexible inflation targeter" always sets a long-term price stability goal for inflation, the fact that a central bank cares about output fluctuations is entirely consistent with price stability as the long-run, overriding goal. An Explicit Nominal Anchor Should be Adopted Although an institutional commitment to price stability helps solve timeinconsistency and fiscal alignment problems, it does not go far enough because price stability is not a clearly defined concept. Typical definitions of price stability have many elements in common with the commonly used legal definition of pornography in the United States - you know it when you see it. Constraints on fiscal policy and discretionary monetary policy to avoid inflation might thus end up being quite weak because not everyone will agree on what price stability means in practice, providing both monetary policymakers and politicians a loophole to avoid making tough decisions to keep inflation under control. A solution to this problem which supports the first three guiding principles is to adopt an explicit nominal anchor that ties down exactly what the commitment to price stability means. There are several forms that an explicit nominal anchor can take. One is a commitment to a fixed exchange rate. For example, in 1991, Argentina established a currency board that required the central bank to exchange U.S. dollars for new pesos at a fixed exchange rate of one to one. A second nominal anchor is for the central bank to have a money-growth target, as was the case in Germany. A third nominal anchor is for there to be an explicit numerical inflation goal as in inflation targeting countries such as New Zealand, Canada and the United Kingdom, Australia and Brazil, among others. All these forms of explicit nominal anchors can help reduce the time-inconsistency problem, as the success of countries using them in lowering and controlling inflation demonstrates (Mishkin, 1999b) These nominal anchors also help restrain fiscal policy and are also seen as an important benefit of inflation targeting in countries such as New Zealand and Canada (Mishkin and Posen, 1997, and Bernanke, Laubach, Mishkin and Posen, 1999)
One criticism of adopting an explicit nominal anchor such as an inflation target isthat it will necessarily result in too little emphasis on reducing output fluctuations,which is inconsistent with the guiding principal that monetary policy should beconcerned with output as well as pricefluctuations.However, this view is mistaken.Inflation targeting, as it has actually been practiced (Mishkin and Posen, 1997, andBernanke,Laubach,Mishkin and Posen,1999),has been quiteflexible andhasnotled tolarger output fluctuations. Indeed, adoption of an inflation target can actually make iteasier for central banks to deal with negative shocks to the aggregate economy. Becausea decline in aggregate demand also leads to lower-than-expected inflation, a centralbank is able to respond with a monetary easing,without causing the public to questionit anti-inflationary resolve.Furthermore, inflation targeting can make it less likely thatdeflation, a fall in the price level, would occur. There are particularly valid reasons forfearing deflation in today's world, includingthe possibility that it might promotefinancial instability and precipitate a severe economic contraction.Indeed, deflation hasbeen associated with deep recessions or even depressions, as in the 1930s, and the recentdeflation in Japan has been one factor that has weakened the financial system and theeconomy. Targeting inflation rates of above zero, as all inflation targeters have done,makes periods of deflation less likely.The evidence on inflation expectations fromsurveys and interest rate levels suggest that maintaining a target for inflation abovezero (but not too far above) for an extended period does not lead to instability ininflation expectations or to a decline in the central bank's credibility.CentralBanksShouldbeGoalDependentAlthough there is a strong rationale for the price stability goal and an explicitnominal anchor, who should make the institutional commitment? Should the centralbank independently announce its commitment to the price stability goal or would it bebetter to have this commitment be mandated by the government?Here the distinction between goal independence and instrument independencemade by Debelle and Fischer (1994) and Fischer (1994) is quite useful.Goalindependence is the ability of the central bank to set its own goals for monetary policy,while instrument independence is the ability of the central bank to independently set theinstruments of monetary policy to achieve the goals. The fifth guiding principle, sobasic to democracy, that the public must be able to exercise control over government8
8 One criticism of adopting an explicit nominal anchor such as an inflation target is that it will necessarily result in too little emphasis on reducing output fluctuations, which is inconsistent with the guiding principal that monetary policy should be concerned with output as well as price fluctuations. However, this view is mistaken. Inflation targeting, as it has actually been practiced (Mishkin and Posen, 1997, and Bernanke, Laubach, Mishkin and Posen, 1999), has been quite flexible and has not led to larger output fluctuations. Indeed, adoption of an inflation target can actually make it easier for central banks to deal with negative shocks to the aggregate economy. Because a decline in aggregate demand also leads to lower-than-expected inflation, a central bank is able to respond with a monetary easing, without causing the public to question it anti-inflationary resolve. Furthermore, inflation targeting can make it less likely that deflation, a fall in the price level, would occur. There are particularly valid reasons for fearing deflation in today's world, including the possibility that it might promote financial instability and precipitate a severe economic contraction. Indeed, deflation has been associated with deep recessions or even depressions, as in the 1930s, and the recent deflation in Japan has been one factor that has weakened the financial system and the economy. Targeting inflation rates of above zero, as all inflation targeters have done, makes periods of deflation less likely. The evidence on inflation expectations from surveys and interest rate levels suggest that maintaining a target for inflation above zero (but not too far above) for an extended period does not lead to instability in inflation expectations or to a decline in the central bank's credibility. Central Banks Should be Goal Dependent Although there is a strong rationale for the price stability goal and an explicit nominal anchor, who should make the institutional commitment? Should the central bank independently announce its commitment to the price stability goal or would it be better to have this commitment be mandated by the government? Here the distinction between goal independence and instrument independence made by Debelle and Fischer (1994) and Fischer (1994) is quite useful. Goal independence is the ability of the central bank to set its own goals for monetary policy, while instrument independence is the ability of the central bank to independently set the instruments of monetary policy to achieve the goals. The fifth guiding principle, so basic to democracy, that the public must be able to exercise control over government