Renewing the Search for a Monetary Constitution: Reforming Government's Role in the Monetary System by Lawrence White

Author:Lawrence White [White, Lawrence]
Language: eng
Format: epub
Publisher: Cato Institute
Published: 0101-01-01T00:00:00+00:00

The Natural Interest Rate and Monetary Policy Rules

Although the Austrian business-cycle theories aimed to model real business cycles, they can be used as a framework for classifying and identifying monetary policy mistakes. Based on the Austrian concept of the natural interest rate—which balances saving and investment—two types of monetary policy mistakes can be defined.

First, during an economic upswing, the central bank keeps the interest rate below the natural interest rate (for too long) (monetary policy mistake of type 1). This triggers an overinvestment boom as described above, which inevitably leads into crisis and recession. Second, during recessions the central bank keeps the central-bank rate above the natural interest rate (for too long), thereby aggravating the downturn (monetary policy mistake of type 2).

The policy implication arising from the monetary overinvestment theories is that central banks should keep central-bank rates close to the natural interest rate both in boom and recession to smooth business cycles (Hayek [1929] 1976). Although the natural interest rate remains a theoretical concept and therefore unknown to policymakers, it should be the task of central banks to gain sufficient information to keep the central-bank rate close to the natural interest rate. In this spirit, Taylor (1993) provided an inflation-targeting rule. It aims to isolate independent central banks from producing Philips-curve type short-term employment effects (Kydland and Prescott 1977). White (2010) characterizes such a constitutional constraint on monetary policymakers as “rule of law” rather than “rule by authorities.”

However, since the 1990s, inflation targeting regimes as frameworks to contain inflationary pressure and economic stability failed for two reasons. First, given the fall of the iron curtain and the integration of a large set of low-wage countries (in particular, China) into the world economy, money supply in large industrial countries could grow without any visible impact on domestic consumer price inflation (Hoffmann and Schnabl 2011b).

Second, the gradual growth of international financial markets allowed money-supply growth to be absorbed by capital markets rather than goods markets. Easing monetary conditions showed up in rising asset prices rather than goods prices. With national monetary expansion in the large industrialized countries being absorbed by foreign goods and domestic and foreign financial markets, monetary expansion could assume a Keynesian discretionary stimulus function without violating consumer-inflation-based monetary policy rules.

During a period that was dubbed the Great Moderation (Bernanke 2004), central banks could keep interest rates low for long periods during booms because the impact of monetary expansion on consumer price inflation was postponed via a loop way through emerging market economies and financial markets. Easing monetary conditions fueled bubbles in emerging and financial markets, which only made inflation rise with a significant lag when the wealth effects of rising asset prices made economic agents indulge in consumption.

In the large countries issuing the large international currencies, these loop ways are particularly extended, as they take their ways through fast-growing emerging-market economies (Hoffmann and Schnabl 2011b). For instance, monetary expansion in the United States stimulated capital outflows to China, where the resulting growth impulses helped absorb the additional money

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