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The Role of Sound Monetary Policy in an Abundance Agenda
Want a vibrant economy? Greater stability can pave the way for more American economic confidence and greater prosperity
By Patrick Horan
A slowdown in economic growth is putting the American Dream out of reach for an increasing number of Americans. To counter that slowdown, it’s clear that we need an “abundance agenda” to boost American prosperity. Given the Federal Reserve’s importance in the American and global financial systems, it’s imperative that we ask: What is the role of monetary policy in an abundance agenda?
The answer is twofold. On one hand, a sound monetary policy is essential to macroeconomic stability, which is a prerequisite for prosperity. On the other hand, monetary policy, by itself, cannot do much to affect long-run growth. Thinking that monetary policy can be used to create abundance can ultimately lead to disaster.
A Crash Course in Monetary Theory
Most economists argue that the money supply is roughly neutral in the long run. This means that money only affects nominal variables such as nominal GDP (i.e., total dollars of spending) and inflation and that it does not affect real variables such as real GDP (i.e., total output) or unemployment. In the long run, real variables are determined by labor, capital and new ideas.
To understand monetary neutrality, consider a thought experiment. Suppose one day everybody wakes up and their income and wealth has risen tenfold. However, sellers of goods and services know everybody has 10 times as much money, so everything they sell is also now 10 times more expensive. Is anything really different from the way it was the day before? Besides an added zero at the end of everything, no. In this scenario, people are 10 times wealthier in nominal terms, not real terms. However, real growth is what matters for improving living standards: Monetary policy alone cannot produce abundance.
So to fully embrace an abundance agenda for America, we must focus on how to boost real growth. We cannot rely on monetary policy to make us more prosperous in the long run. Instead, we need to become more productive, so we can produce more of the things we want (houses, cars, education, medicines, etc.) with fewer inputs.
This thought experiment is useful for understanding how things work in the long run when prices can adjust to “shocks,” like unexpected changes in the money supply. In the short run, however, many prices are “sticky” for a variety of reasons (e.g., sellers may not want to raise prices to avoid losing customers). Price stickiness is why money can affect real variables in the short run. Imagine the Fed wants to pursue a more expansionary policy, and it purchases bonds with newly created money. The new holders of this money deposit it in bank accounts. Banks now have more money to lend out. Soon enough, this money finds its way to people and firms who can now purchase more in real terms because prices have not fully adjusted.
To see concrete examples of monetary non-neutrality in the short run and neutrality in the long run, let’s consider two cases in U.S. history: the Great Depression and the Great Inflation. The economists Milton Friedman and Anna Schwartz famously argued that the Fed’s poor monetary policy in the late 1920s and early 1930s is what caused the Depression. During this time, the Fed pursued an excessively tight monetary policy and allowed a series of banking failures. This led to a collapse in the supply of money and credit in the economy, which then led to a massive increase in unemployment and steep contraction in output.
Later, in the late 1960s and 1970s, the Fed erred in the opposite direction. By that time, the Fed was guided by a belief that there is a permanent tradeoff between unemployment and inflation (a crude version of what economists call the “Phillips curve”). If policymakers want lower unemployment, they can achieve that if they’re willing to tolerate higher inflation. However, this doctrine proved to be false. As firms came to expect inflation, they would simply raise prices to avoid losses in real terms. The economy saw both high inflation and high unemployment as the Fed kept resorting to high money growth to reduce unemployment.
This distinction between short-run non-neutrality and long-run neutrality comes with an important caveat. While we cannot rely on good monetary policy to produce abundance, bad monetary policy can leave us worse off even in the long run. Consider the case of the Great Depression when unemployment was frequently well over 10% (at times even higher than 25%!). Excessively contractionary monetary policy kept many people out of work for years—far longer than otherwise would have been the case. Such people missed out on years of earning an income and accumulating savings as their skills and their ability to be productive atrophied.
At the other extreme, very high inflation erodes the real value of savings. With less savings, there is less investment as banks make fewer loans that can go toward the creation of productive assets such as machines and other technologies. Hyperinflation, such as what occurred in modern-day Venezuela, are cases where extraordinarily high inflation wreaks havoc on the real economy.
What Should Monetary Policy Do?
If money matters for stability and real growth in the short run but is more limited in the long run, how should the Fed carry out its monetary policy to truly back an abundance agenda? The best monetary policy is one where the Fed targets a nominal variable and does so in a transparent, predictable manner. This would allow members of the public to have a better sense of what monetary policy will look like in the future so they can make more-informed decisions with their finances.
To some degree, the Fed and other central banks already do this, but their performances could still be improved. Most central banks practice inflation-targeting, where they try to keep inflation near an explicit target (typically, 2%). However, supply shocks caused by unpredictable global factors, such as the COVID pandemic or the Russia-Ukraine war, create major challenges for this approach. In theory, a central bank should only tighten monetary policy in response to inflation coming from demand shocks, factors that affect the total demand for goods and services in the economy. It should “see through” inflation from supply shocks, which reduce real growth, because tightening would only add to economic pain.
However, it’s very difficult to distinguish between supply shocks and demand shocks in real time. Right now, the Fed is between a rock and a hard place because it’s facing inflation from both supply and demand. Tightening too much will produce a recession, while tightening too little will mean persistent inflation.
Some economists argue that central banks such as the Fed should target the level of nominal GDP instead of inflation. Under nominal GDP level targeting, the Fed would only work to keep total spending on a stable path. If spending fell below or rose above the path, the Fed would pledge to bring it back to the path. One major advantage of this approach is that the Fed would not have to worry about whether changes to the price level are coming from supply shocks or demand shocks. It would only worry about keeping nominal GDP on its target path.
A second advantage is it allows the Fed to indirectly mitigate both unemployment and inflation. Unemployment is closely connected with falling real GDP growth. Since nominal GDP growth is equal to inflation plus real GDP growth, keeping nominal GDP growth on a stable path effectively anchors both prices and unemployment.
A third advantage, as my colleague David Beckworth and I show in a recent paper, the Fed can effectively carry out nominal GDP level targeting through “Taylor rules,” formulas for how to set a central bank’s main interest rate instrument. Such rules make monetary policy much more predictable and reduce the likelihood of the Fed making a serious error.
By keeping nominal GDP on a stable path, the Fed can minimize the pain from both unemployment and inflation. This would lead to greater macroeconomic stability in the short run. With low unemployment, more people would be able to work and sustain a living. With lower and more predictable inflation, the public could be more confident about the future of the economy and make better decisions for how to invest and spend their money. A sound monetary policy serves as a cornerstone for a vibrant, abundant economy.