This site uses cookies

This site and its partners use technology such as cookies to personalise content and ads and analyse traffic. By using this site you agree to its privacy policy. You can change your mind and revisit your choices at anytime in future.

Last Modified: Thu, May 17 2018. 05 24 AM IST

Monetary policy comes full circle in 2018

We are back to asking the same question that Milton Friedman asked in 1968: can central banks impact the real economy?

Milton Friedman. Photo: Reuters
Amol Agrawal

The year 2018 is significant for two developments in monetary economics.

First, this year marks the 50th anniversary of Milton Friedman’s landmark lecture titled “The role of monetary policy”. Before the lecture, the Phillips curve, which showed that there was a trade-off between inflation and unemployment, dominated policy thinking. Thus, policy could be tinkered to achieve the desired objectives—lower unemployment and higher inflation, or vice versa.

Friedman instead argued that monetary policy can only impact nominal variables, such as prices, and not real variables such as the gross domestic product and employment. The so-called trade-off was only for the short run, and any tinkering would result in higher inflation over the long run. Thus, he argued, the central banks should focus on inflation—something that turned the accepted wisdom on its head. That the lecture continues to be celebrated shows the remarkable longevity of his ideas. In the history of economic thought, Friedman’s arguments were not new. It was both the timing of the lecture—when both inflation and unemployment were rising—and Friedman’s oratory skills which contributed to making his lecture iconic.

The second significant development is the Reserve Bank of New Zealand (RBNZ) changing its highly successful inflation targeting (IT) framework. The RBNZ adopted IT in 1989 and it shaped the discourse of monetary policy for the next 30 years.

The two developments are obviously connected. Friedman’s prescription for central banks was to target money supply as only changes in money impact inflation. However, this led to problems as one was unsure about the measure of money supply to target. Barring Germany’s Bundesbank, no other central bank could really use monetary targeting effectively. This famously led Bank of Canada’s governor Gerald Buoey to remark: “We didn’t abandon monetary aggregates, they abandoned us.”

The search for an alternate framework led RBNZ to adopt IT, where one managed inflation using interest rates and not money supply. The word flew quickly and major central banks of Canada, England and Sweden adopted IT by the early 1990s. Success begets success and one saw several developing countries also implementing the IT framework. So much so, that most policy advisory in its reform agenda included having an IT framework as one of the musts for any reforming economy. Gill Hammond of Bank of England noted that 27 countries had adopted IT by 2011. A couple more have been added, including India in 2016. There are some others like the European Central Bank and Swiss National Bank which have adopted a numeric inflation target but do not consider themselves as IT central banks.

The period of 1989-2008 was also a period of Great Moderation as economic activity boomed and inflation remained subdued. Apart from factors like globalization and supply chains, economists also credited IT as one of the key reasons behind this performance. A whole cottage industry developed researching all aspects of IT, from the choice of numerical target and monetary policy committees, to high transparency in communications.

Some others dissented by noting that inflation was generally benign due to low oil and commodity prices and IT barely played a role. They cited how the US Federal Reserve (Fed) also achieved a similar economic performance despite not being an inflation-targeting central bank. They warned that focusing on price stability was making central banks ignorant about other risks, particularly financial stability.

The warnings came true with the financial crisis of 2008. The US was at the forefront of the crisis and historically the Fed had twin goals of low inflation and maximum employment (there is a third goal of moderate long-term interest rates which we are not discussing here). It pushed its policy rate to near-zero levels to prevent inflation from falling and unemployment from rising, despite sharp criticism. As economic normalcy returned, the Fed was credited for the turnaround. This approach was followed by other central banks as well, with mixed records.

These events lead to the perennial question: Should the central banks continue to follow a single-goal model like the RBNZ or move to a twin-goal model like the Federal Reserve (with financial stability added)?

It is interesting that the RBNZ itself has changed its highly successful model and has adopted Fed’s strategy. The Labour Party in New Zealand had announced in its poll campaign that it would broaden the scope of RBNZ Act on being voted to power. On being voted, it ushered these changes rather quickly, showing the political pressures to address rising unemployment woes.

It is worth quoting Grant Robertson, the finance minister, on this change: “The Reserve Bank Act is nearly 30 years old. While the single focus on price stability has generally served New Zealand well, there have been significant changes to the New Zealand economy and to monetary policy practices since it was enacted. The importance of monetary policy as a tool to support the real, productive, economy has been evolving and will be recognized in New Zealand law by adding employment outcomes alongside price stability as a dual mandate for the Reserve Bank, as seen in countries like the US, Australia and Norway.”

The reactions on this historic change have been surprisingly muted. One reason could be that some of the central banks had already included real activity and this is nothing new. The scholarship had already differentiated between the two forms of IT, strict and flexible, with the former focusing on price stability (Mervyn King named them “inflation nutters”), and the latter focusing on both prices and real economy (as adopted by the RBI recently).

At the end, one is left wondering how Friedman would have responded on the anniversary of his lecture. After all, we are back to asking the same question he asked in 1968: Can central banks impact the real economy? True to his witty style, he is likely to remark, “Monetary economics like life keeps going in circles”!

Amol Agrawal teaches at Ahmedabad University and blogs at Comments are welcome at

Topics: monetary policyMilton Freedmancentral banksUS Federal ReserveReserve Bank of India

First Published: Thu, May 17 2018. 05 24 AM IST

Latest News »