The Federal Reserve The Gold Standard: A Critique the meaning of sound money ECO 285 – Macroeconomics – Dr. D. Foster

Is Policy the Right Choice? Time lags make effective policy uncertain. Discretionary policy promotes uncertainty. Rules and credible adherence can eliminate bias. Independence is a likely key requirement.

Time Lags in Monetary (& Fiscal) Policy Policy time lags Recognition lag Response lag Transmission lag Real GDP Business cycle time

Monetary Policy may be counterproductive Real GDP time Ideally, policy would dampen the business cycle… But, dampening the business cycle may lower ave. growth! Or, if policy kicks in at the wrong time, it could worsen recessions and exacerbate inflationary periods.

Discretion versus Rules (Milton Friedman) Discretionary policy is the source of instability. A policy rule can eliminate that instability. Set target for Bank Reserves, Monetary Base, Money Supply to grow in LR sustainable fashion. This is a commitment to a fixed strategy no matter what happens to other economic variables. To be successful, the commitment must be credible. The public believes the Fed will act this way.

Has the Fed maintained stable prices?

Has the Fed maintained the value of the $? 4%

Why is Fed pursuing 2% inflation????? “The Board of Governors … shall maintain long run growth of the monetary and credit aggregates … so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” “The … (FOMC) judges that inflation at the rate of 2 percent … is most consistent over the longer run with the Federal Reserve's mandate for price stability and maximum employment. .” “Does the Fed really want to increase annual inflation to 2%, such that the price level of the country will increase by more than 700% over the next century? Is that what Congress had in mind when it tasked the Fed with achieving ‘stable prices’?”

Central Bank Independence, Average Inflation, and Inflation Variability in Major Developed Nations SOURCE: Alberto Alesina and Lawrence Summers, “Central Bank Independence and Macroeconomic Performance,” Journal of Money, Credit, and Banking (May 1993): 151–162.

Making Monetary Policy Rules Credible Place constitutional limits on monetary policy. Achieve credibility by establishing a reputation. Maintain central bank independence. Establish central banker contracts. Appoint a “conservative” central banker.

Making Monetary Policy Rules Credible Place constitutional limits on monetary policy. Achieve credibility by establishing a reputation. Maintain central bank independence. Establish central banker contracts. Appoint a “conservative” central banker.

Advantages to the Gold Standard It promotes trade by eliminating uncertainty. It keeps governments from creating money. It insures that a nation’s currency will maintain its value over time.

How the Gold Standard works A gold standard implies that we have “fixed” exchange rates between currencies. $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $50 mill. $4.86 = £1 £10.29 mill. American firms export goods to England … tractors. Value = $50 m. British firms export goods to U.S. … fish & chips. Value = £10.29 m. At exchange rate of $4.86 = £1, the £ earned by U.S. firms will just trade for the $ earned by the British firms. Suppose that British exports fall by 23% and that there is only £8 mill available in foreign exchange market (to buy $).

How the Gold Standard works $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $50 mill. $4.86 = £1 £8 mill. Now, American exporters can’t exchange all of their £10.29 mill. for $. They can only exchange £8 mill. at the going exchange rate. . . . receiving $38,880,000. But, they aren’t going to lose here… They would cash the rest out in gold: £2.29 mill. = 538,823 oz. They would redeem in U.S. for dollars: 538,823 oz. = $11,120,000 Total value received = $50,000,000

How the Gold Standard works $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $50 mill. $4.86 = £1 £8 mill. 538,823 ounces The flow of gold from England to U.S. won’t persist over time.  gold =  MS  MS =  P deflation  gold =  MS  MS =  P inflation U.S. exports fall and British exports rise until trade flows balance.

Confounding the Gold Standard In England, the outflow of gold will lead to price deflation and probably a recession (or a depression). So, the Bank of England raises interest rates. This attracts foreign investment (capital inflows) which ends outflow of gold. In the U.S., expanding the money supply means inflation and falling exports. The Fed can buy this gold by selling Treasury securities, so not allowing the money supply to increase. But, this will also raise U.S. interest rates which works against British policy and encourages more gold inflows!

The Gold Standard - Stress & Collapse WWI - Combatant countries go off gold standard to spending. After, move back to gold standard. Gold stocks insufficient for existing price levels. Worldwide deflation (i.e., depression) is required. Only U.S. and U.K. go back to gold standard. U.K. depression through 1924-25. Great Depression adds in more stress. 1933 – FDR abolishes gold std. 1971 – Nixon abolishes international gold payments. We now live in an era of “flexible” exchange rates and there is no restraint on monetary policy.

The Federal Reserve The Gold Standard: A Critique the meaning of sound money ECO 285 – Macroeconomics – Dr. D. Foster