The major options for a monetary regime are a classical gold standard, a gold exchange standard, discretionary monetary policy, a monetary-targeting rule, an exchange rate-targeting rule, a commodity price-targeting rule, an inflation-targeting rule, and a nominal gross domestic product (NGDP)-targeting rule. Except for a fiat currency with a discretionary monetary policy, the choice of a nominal anchor – a quantifiable objective – defines every monetary regime. The nominal anchor shapes the expectations of firms and households how monetary policy affects real gross domestic product, international flows, prices, wages and interest rates.
Classical gold standard
Money functions as medium of exchange, unit of account and store of value. Money originated in Greece during the 6th century BCE when city-states began to mint specie (i.e., gold and silver) coins. Until the 18th century, European kingdoms were on a silver standard. After the Master of the Mint Sir Isaac Newton overvalued the guinea in terms of silver, the United Kingdom adopted a de facto gold standard in 1717, while its major rival, France, remained on a silver standard.
Modern commercial banking arose in Italian city-states during the Renaissance. The Bank of England was established in 1694 as the first hybrid central-commercial bank. The First and Second Banks of the United States were modelled on the Bank of England. During the 19th century, the Bank of England evolved into a modern central bank.
The classical gold standard began with resumption of convertibility in the United Kingdom following the Napoleonic Wars in 1821, reached near universality with Germany’s switch from a silver standard to a gold standard in 1871, and ended with the suspension of convertibility at beginning of the World War I in 1914.
Under the classical gold standard, countries defined their currencies in terms of a weight of gold, known as the par value. In most participating countries, central banks issued bank notes, held gold reserves, and freely exchanged bank notes and gold at the par value with firms and households. Under free banking in Scotland until 1845 and in Canada throughout the classical gold standard period, competing chartered commercial banks rather a central bank issued bank notes, held gold reserves, and stood ready to exchange their bank notes and gold at the par value with firms and households.
The classical gold standard effectively fixed exchange rates among all participating countries.
Arbitrage and international gold flows quickly resolved any imbalance in the distribution of gold among participating countries and ensured a common price level in all participating countries.
Under the classical gold standard, the profitability of the gold mining and processing industry determined the gold supply and thus the monetary base. In turn, the frequency and size of new gold finds and advances in mining and processing technology determined the profitability of the gold mining and processing industry. Consequently, the classical gold standard did not produce price stability from year to year. Significant multiyear price inflations and deflations occurred because the gold production varied from year to year and was not proportional to the real GDP growth rate among participating countries.
The classical gold standard promoted free international trade and investment flows because the classical gold standard (1) created a common price level in all participating countries, and (2) prevented participating countries from manipulating the foreign exchange value of their currencies to gain a competitive advantage. Thus, the classical gold standard encouraged economically efficient production decisions by firms and households in participating countries.
The classical gold standard was largely self-enforcing through the free exchange of gold and currency in participating countries and free flow of gold among participating countries. The classical gold standard limited the ability of central banks to engage in discretionary monetary policy and cushion participating countries from adverse shocks. Consequently, participating countries relied primarily on internal devaluations (i.e., downward flexibility in domestic wages and prices) and fiscal policy (i.e., tax reductions, spending increases, and the ability to borrow) to address adverse shocks.
The key to sustaining the classical gold standard was the commitment of participating countries to do whatever was necessary to maintain convertibility. When gold reserves dwindle to a critical level, governments must be prepared to attract gold inflows by reducing domestic demand for imported goods and services through spending reductions, tax increases and tight credit conditions and increasing net financial inflows through higher interest rates. Once firms and households became convinced of this commitment, the gold reserves needed to operate the classical gold standard were quite small relative to the money supply.
Gold exchange standard
The gold exchange standard began at the Bretton Woods Conference in July 1944 and ended on 15 Aug. 1971 when US President Richard Nixon closed the ‘gold window’. Under the gold exchange standard, the US dollar was the global reserve currency with a par value of $35 per ounce of gold. Other participating countries, referred to as peripheral countries, defined their currencies in terms of the US dollar.
The gold exchange standard shared some characteristics with the classical gold standard. The gold exchange standard provided a system of fixed exchange rates that created a common price level among all participating countries. Yet, in other ways, the gold exchange standard was quite different.
Under the gold exchange standard, the Federal Reserve’s monetary policy determined the US monetary base – currency in circulation and commercial bank reserves at the Fed – through open market operations, buying or selling securities for the Fed’s portfolio. Through the money multiplier, the monetary base determined the money supply and price level in the United States.
Peripheral countries pursued fiscal and monetary policies to maintain fixed exchange rates with the US dollar. Since the US dollar was the global reserve asset under the gold exchange standard, central banks in peripheral countries used US dollars as both official foreign exchange reserves and part of the domestic monetary base. As peripheral countries grew, their central banks needed to accumulate US dollars in proportion with their real GDP growth to maintain fixed exchange rates.
While the United States and other peripheral countries pursed the progressive liberalisation of international trade flows through General Agreement on Tariffs and Trade (GATT) negotiations, the United States and peripheral countries imposed strict controls on international financial flows to maintain fixed exchange rates. If a peripheral country suffered a ‘balance of payments’ crisis that put its exchange rate with US dollar under stress, the International Monetary Fund (IMF) provided temporary financial assistance while such country tightened its domestic fiscal and monetary policy to resolve the crisis. If a peripheral country was unsuccessful, it devalued its currency against the US dollar.
Robert Triffin identified a fundamental problem with the gold exchange standard, which became known as the Triffin dilemma. The United States as the anchor country supplying the global reserve currency had to run sustained current account deficits so that peripheral countries could accumulate US dollars needed to maintain fixed exchange rates. At the same time, however, the large accumulation of US dollars and US dollar-denominated financial assets in the peripheral countries would eventually undermined confidence in the value of the US dollar and the willingness of the United States to keep the ‘gold window’ open.
Unlike the classical gold standard, the gold exchange standard was not self-enforcing. Only foreign central banks could exchange US dollars for gold. The Federal Reserve’s pursuit of an overly accommodative monetary policy to support President Lyndon Johnson’s ‘butter and guns’ policies as the Vietnam War escalated exported rising US inflation to peripheral countries. Nevertheless, NATO member states, Japan and South Korea were reluctant to demand gold, fearing a disruption in their political and security relations with the United States.
By 1971, the Bretton Woods system began to implode. Switzerland and France demanded and received gold valued at $50 million and $191 million, respectively, from the US government. On 9 Aug. 1971, the United Kingdom demanded $3 billion in gold. President Richard Nixon balked. On 15 Aug. 1971, Nixon announced his New Economic Plan that, among other things, closed the ‘gold window’, effectively ending the gold exchange standard.
Discretionary monetary policy
After several failed attempts to restore the gold exchange standard, the era of fiat money and floating exchange rates began in 1974. Central banks did not have any rule to guide monetary policy. Thus, monetary policy became entirely discretionary.
Central banks had little experience with managing a fiat currency. Their charters assumed that they would operate under either a classical gold standard or a gold exchange standard.
The Federal Reserve Act directed the Fed to “supply an elastic currency” to resolve the form-seasonality problem. The learning curve for central banks proved quite steep. Price inflation became a global problem.
Without an anchor, inflationary expectations grew. As Milton Friedman warned in 1968, firms and households change their behaviour when they expect price inflation. Viewing any change in relative prices, a normal part of functioning markets, as a harbinger of higher price inflation, firms increase their prices in anticipation of higher costs, and households seek higher wages in anticipation of higher prices. Inflationary expectations grow, leading to a price-wage spiral.
The eventual costs of bring price inflation under control in terms of lost real GDP and employment increase as inflationary expectations rise.
Robert Lucas extended the assumption in microeconomic that economic actors are rational to macroeconomics in 1972. In what came be known as rational expectations, Lucas proved that people learn the models used by fiscal and monetary policymakers and adapt their behaviour to models. Therefore, the adoption of a monetary policy rule and its adherence by a central bank can reduce the economic cost of bring inflation under control compared with discretionary monetary policy.
The Federal Reserve and other central banks needed a new objective for monetary policy and a monetary rule to constrain inflationary expectations and help to achieve the objective.
Amending the Federal Reserve Act in 1977, Congress established the ‘dual mandate’ of maximum employment and price stability as the objective for the Fed’s monetary policy: The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
The remainder of this essay describes alternative monetary rules that have been proposed and tried in the United States and other countries.
Karl Brunner, Milton Friedman, Allan Meltzer, Anna Schwartz, and Clark Warburton developed monetarism after World War II. Focussing on the exchange equation, Mt * Vt = Pt * Rt, in which Mt = money supply at time t, Vt = velocity of money at time t, Pt = price level at time t, and Rt = real GDP at time t, monetarists held that an unanticipated increase in the growth of the money supply above the growth rate of real GDP would temporarily boost demand in very short term, but over a variable lag, the price level would increase proportionally to the increase in the growth rate of the monetary supply less the growth rate of real GDP. If firms and households began to anticipate inflation, the temporary, very short-term boost to aggregate demand and the lag until the price level rose diminished.
Monetarists emphasised the importance of long-term price stability to maximise long-term real GDP growth. Monetarists advocated a monetary-targeting rule, in which central banks would seek to grow the money supply in proportion to long-term real GDP growth. In particular, Milton Friedman advocated that Federal Reserve should adopt a monetary targeting-rule under which the Federal Open Market Committee (FOMC) would increase the monetary base by a constant percentage each year. If velocity were stable, this monetary-targeting rule would produce long-term price stability.
As Keynesian economists were unable to explain the ‘stagflation’ of the 1970s, monetarism gained adherents. Although the Fed never adopted a monetary-targeting rule, monetarism influenced Chair Paul Volcker both directly through monetarists on the FOMC and indirectly through other FOMC members that incorporated monetarism into their decision-making.
Consequently, the Federal Reserve focused on the growth of the monetary aggregates to bring inflation under control during 1979 to 1983.
During the 1980, financial deregulation blurred the sharp distinction between checking accounts and other accounts at commercial banks. Moreover, many accounts at other financial institutions became checkable. Consequently, the definition of the money supply became unclear, and the statistical relationship between money supply growth and price inflation grew weaker. In deregulated financial markets, the velocity of money became much less stable than monetarists had assumed. Thus, most economists came to view a monetary-targeting rule as impractical.
Exchange rate-targeting rule
After the gold exchange standard collapsed, least developed, developing and newly industrialising countries confronted a choice. They could (1) eliminate their currencies altogether and use the US dollar or the currency of another major developed country, (2) tie the foreign exchange value of their currencies to the US dollar or the currency of another major developed country, or (3) let central banks use open market operations to achieve domestic economic policy objectives and allow the foreign exchange value of their currencies to float.
Some least developed, developing and newly industrialising countries chose to unify their currencies with an anchor country’s currency, usually the US dollar, through: (1) dollarisation, or (2) currency boards. Dollarisation occurs when a peripheral country officially adopts an anchor country’s currency, usually the US dollar, as its own. A currency board is a monetary authority sponsored by a peripheral country that pledges to maintain a fixed exchange rate between a peripheral country’s currency and an anchor country’s currency, usually the US dollar. A currency board maintains reserves in the anchor currency in excess of 100% of the value of the peripheral country’s currency at the fixed exchange rate.
Unlike a central bank, a currency board is passive and cannot exercise discretionary monetary policy, lend to the peripheral country’s government, or serve as a lender-of-last-resort to banks or other financial institutions in the peripheral country.
Currency unification means that peripheral country effectively imports the monetary policy of the anchor country, whether or not such policy is economically appropriate for the peripheral country. Thus, currency unification works best when one or more of the following conditions are met: (1) the peripheral country has small, open economy, (2) prices and wages in the peripheral country are flexible, (3) a large percentage of the peripheral country’s international trade and investment flows are with the anchor country or denominated in the anchor country’s currency, and (4) the peripheral country’s business cycle is highly correlated with the anchor country’s business cycle.
The governments in many least developed, developing and newly industrialising countries lack credibility, and their financial markets are not deep enough to conduct open market operations effectively. Consequently, some peripheral countries have tried to peg their currency to the US dollar or the currency of another major developed country. Under a pegging rule, the central bank in the peripheral country simultaneously pursues an independent monetary policy to achieve domestic economic policy objectives while maintaining a targeted exchange rate by buying or selling the anchor currency.
When a peripheral country has suffered from economic mismanagement, pegging may be useful as short- or medium-term monetary tool for a peripheral country to stabilise the value of its currency. Eventually, the monetary policy that is appropriate for promoting stable prices and long-term real GDP growth in the peripheral country is inconsistent with maintaining a pegged exchange rate. At some point, the business cycles in the anchor country and the peripheral country diverge. Monetary policy changes made by the central bank in the anchor country to response to its business cycle put stress on the peg. For a while, the central bank in the peripheral country can use its foreign exchange reserves to maintain an overvalued peg, or the central bank in the peripheral can accumulate foreign exchange reserves to maintain an undervalued peg, while trying to sterilising the expansionary effects of additional reserves on the domestic economy. Neither can last forever. Overvalued pegged regimes usually end in a rapid drop in the foreign exchange value of the peripheral country’s currency, a financial crisis and a severe recession.
In second half of 1990s, the Federal Reserve tightened monetary policy as the US economy boomed, causing the foreign exchange value of the US dollar to appreciate. Indonesia, South Korea, and Thailand, which had pegged the rupiah, the won, and baht to the US dollar, saw the foreign exchange value of their currencies appreciate. This (1) made exports from these countries more expensive as competition from China intensified, (2) encouraged firms and households in these countries to borrow in US dollars, (3) triggered credit-fuelled asset price bubbles in these countries, and (4) made new foreign investment in these less attractive. For a while, these countries ran down their foreign exchange reserves to preserve their pegs.
When Thailand ran out on 2 July 1997, Thailand was forced to let the foreign exchange value of the baht to fall. This triggered the Asian financial crisis that spread to Indonesia and South Korea.
Central banks moved toward inflation targeting during the 1980s. New Zealand formally adopted an inflation-targeting rule in 1990. The Fed began de facto inflation targeting under Chairman Alan Greenspan and adopted a formal inflation target in 2012. The European Central Bank and most other central banks in developed countries now have inflation-targeting rules.
Under inflation targeting, a central bank sets a target for the inflation rate in terms of a broad price index and uses open market operations to stabilise the inflation rate at its target in the medium term. Inflation targeting provides firms and households with clarity about a central bank’s objectives, transparency about a central bank’s operations and accountability about whether a central bank is achieving its objectives. This helps to anchor inflationary expectations among firms and households.
Inflation targeting proved highly successful in stabilising inflation rates at very low rate. The period between 1983 and 2000 became known as the Great Moderation for its long and strong expansions with modest inflation.
Inflation targeting suffers from one weakness. Inflation targeting provides central bankers with unambiguous guidance on how to adjust monetary policy in response to a demand shock since output and price move in the same direction. However, inflation targeting cannot provide unambiguous guidance on how to adjust monetary policy in response to a supply shock since prices and output move in different directions.
Between 1989 and 1992, a series of remarkable events created a very large, positive supply shock to labour markets in the global trading economy. With the opening of the People’s Republic of China, the abandonment of autarky in India and the collapse of the Soviet Bloc, the world trading system added 1.5 billion potential workers. That was a 90% increase in the potential labour supply, about one-half of which was attributable to China.
Since 1992, China’s development strategy has been to take advantage of its abundant supply of unskilled and semi-skilled labour supply by encouraging manufacturing, at first in labour-intensive industries, such as apparel, sporting goods and toys, and later in other more capital-intensive industries. Low wages gave China a competitive edge. To compete, manufacturers in other countries cut costs, often by replacing labour with capital and outsourcing labour-intensive operations, to stay competitive. This is the ‘China price’ effect.
The rapid expansion of Chinese manufacturing and China’s increasing share of global trade in manufactured goods, particularly after China acceded to the World Trade Organization (WTO) on 11 Dec. 2001, reduced the prices for manufactured goods and depressed price inflation as measured by goods and services price indices both in the United States and around the world.
Expanding trade with China lowered prices for US manufactured goods by 7.6% between 2000 and 2006. The BIS Annual Report found, “Larger trade flows, and above all the greater contestability of both product and factor input markets, have made domestic inflation developments more dependent on international market conditions … the share of the variation in advanced economies’ inflation explained by Chinese export price inflation doubled to over 30% in the period 1999–2013.”
Implicit inflation targeting led the Federal Reserve to pursue an overly accommodative monetary stance after the 2001 recession. Not all disinflation or deflations of goods and services prices are bad. The Federal Reserve should only act to counter disinflations or deflations from demand-side shocks. Disinflations or even mild deflations from positive supply shocks should flow through to households, boosting real wages through lower prices. From 2002 to 2005, the Federal Reserve should have tightened more rapidly and allowed price inflation to remain below the Federal Reserve’s target of 2.0% in Personal Consumption Expenditure (PCE) Index for several years. Instead, by trying to achieve the inflation target through highly accommodative monetary policy, the Federal Reserve left the world awash with liquidity and inflated an unsustainable, credit-driven housing bubble in the United States.
Because of the US dollar’s status as the global reserve currency, the Federal Reserve’s monetary policy has a large influence on the monetary policy pursued by other central banks. This linkage helped to inflate asset bubbles in a number of other countries as well.
Inflation targeting had the opposite effect in 2007 and 2008. The PCE Index is lagging economic static. As financial market conditions began to deteriorate in August 2007, the Federal Reserve continued to focus on the PCE Index, which reflected inflationary pressures from months earlier, instead of focussing on the deflationary pressures that were building. In retrospect, the Federal Reserve was slower than it should have been in providing liquidity to financial institutions and markets under stress. The Federal Reserve sterilised the additional liquidity that it provided through emergency lending facilities by selling Treasury instead of allowing the Fed’s balance sheet to expand. This decision had the unintended consequence of squeezing solvent banks and increasing stress in financial markets during the spring and summer of 2008. Only after the failure of Lehman Brothers on 15 Sept. 2008, did the Federal Reserve allow its balance sheet to expand in response to the crisis.
Following the global financial crisis, a new school of economic thought – market monetarism – gained prominence. While market monetarism and monetarism are very similar, there are a few significant differences. Market monetarists, such as David Beckworth, Lars Christensen, Joshua Hendrickson, Robert Hetzel, Nick Rowe, Scott Sumner and Bill Woolsey, stress the importance of rational expectations in monetary policy formulation. Rejecting Friedman’s long and variable lags, market monetarists hold that financial markets react almost instantly to monetary policy actions. Market monetarists find that the velocity of money is too unstable to use a monetary-targeting rule as Friedman advocated. Instead, market monetarists advocate that central banks target the growth rate of nominal GDP.
Market monetarists advocate setting a target growth rate for NGDP of around 5% to 6% (the sum of the long-term growth of potential real GDP and a long-term inflation rate of about 2%). When real GDP growth slows, NGDP targeting would loosen monetary policy modestly to allow a small increase in the inflation rate until real GDP growth picks up. When real GDP growth increases, NGDP targeting would tighten monetary policy modestly to force a small reduction in the inflation rate until real GDP slows in line with its long-term potential.
Essentially, market monetarists argue that NGDP target would produce a smoother growth path for real GDP (fewer booms and busts), while the inflation rate would be allowed to fluctuate within a narrow band.
In theory, a NGDP-targeting rule arguably addresses the problem that an inflation-targeting rule has in addressing supply shocks. However, no central bank has implemented a NGDP-targeting rule to see how it performs in practice.
Should financial stability be incorporating into monetary policy decision-making?
Modern economies have financial cycles as well business cycles. Financial cycles typically last for decades covering two or more business cycles. Financial cycles can produce credit-driven asset bubbles and are often followed by financial crises. Moreover, credit-driven asset bubbles and subsequent financial crises have severe adverse effects on the real output growth and employment over the long term.
Examining 21 developed economies from 1969 to 2015, Claudio Borio found that real labour productivity growth fell by 0.25 percentage points per year below its long-term growth trend in the five years before the peak of a credit boom. If a financial crisis followed, real labour productivity growth fell by 0.5 percentage points below its long-term growth trend in the five years after the peak of the credit boom. About two-thirds of the reduction below trend growth in the five years before the peak and four-fifths of the reduction below trend growth in the five years after the peak is attributable to the misallocation of labour. During the credit boom, lower productivity growth sectors that are focus of the asset bubble attract workers.
This effect of this labour misallocation is bigger after a financial crisis as a large number of workers in sectors that were the focus of the asset bubble do not have the right education, skills, licenses, or other credentials to move easily to other sectors.
Borio’s findings are largely consistent with actual US labour productivity data. A decade-long slowdown in real productivity growth means that real GDP growth, employment growth and real compensation growth will also fall significantly below trend for a decade or more, long after the financial crisis is over and the subsequent recession has ended. Thus, the costs of ignoring financial instability are unacceptably high.
In the years after the financial crisis of 2008, central banks have focused on macro-prudential supervision and regulation to monitor the financial cycle and address financial instability.
However, the success of this approach is untested. First, macro-prudential supervision and regulation expands the regulatory scope of central banks to financial institutions and markets that been unregulated or regulated by other government agencies. This is inherently controversial and a source for interagency conflicts. Second, central banks do not have a good record in identifying incipient sources of financial stability before they become menacing.
Central banks will need to develop new tools to monitor and judge financial stability. Third, if central banks correctly identify sources of increasing risk to financial stability, central banks will have issue unpopular regulations to contain these risks well before most firms and household recognise the problem.
If macro-prudential supervision and regulation is inadequate to address the financial cycle and contain financial instability, central banks could incorporate financial stability into monetary policy decision-making. To date, however, economists have not developed new monetary regimes that expressly incorporate financial stability.
The author of this article, who goes by the name ‘Hamilton’ is a senior US economist who frequently writes under a nom de plume.