The Federal Reserve
A Critique
The Gold Standard:
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.
The Gold Standard
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.
$50 mill.
1 oz. = £4.25
$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.
$50 mill.
1 oz. = £4.25
$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.
$50 mill.
1 oz. = £4.25
$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
inflation
 gold =  MS
 MS =  P
deflation
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
A Critique
The Gold Standard:
the meaning of sound money
ECO 285 – Macroeconomics – Dr. D. Foster