NCPA - National Center for Policy Analysis

The Fed, Right After All These Years

August 21, 2003

After seven decades of poor performance, says Milton Friedman, the Federal Reserve has improved markedly over the past 15 years. It has done much better at achieving price stability, he says, because it has abandoned Keynesian theory.

The economist John M. Keynes had taught that the quantity of money did not matter, that what mattered was spending and the turnover of money in the economy. The role of monetary policy was to keep interest rates low to promote investment and thereby full employment. Inflation, he claimed, was produced primarily by pressures on cost that could best be restrained by direct controls on prices and wages.

  • Central banks the world over performed badly prior to the 1980s because they accepted the theory.
  • Many central banks have improved their control of inflation at about the same time in the 1980s, including the central banks of New Zealand, the United Kingdom, Canada, Sweden, Australia and others.
  • Many of these central banks adopted a policy known as inflation targeting, under which they specified a narrow target range for inflation -- 1 percent to 3 percent, for example.
  • But inflation targeting and noninflation targeting central banks did about equally well in controlling inflation, so explicit inflation targeting is not the answer.

What happened was that the Keynesian vision was discredited by inflation, recession and stagflation in the 1970s.

Now central bankers accept the proposition that inflation is always and everywhere a monetary phenomenon: inflation is the expansion of the money supply. They accept that the crucial function of a central bank is to produce price stability, interpreted as a low and relatively steady recorded rate of inflation. Once the banks adopted price stability as their primary goal, they were able to improve their performance drastically.

This is being called the "New Keynesian Economics."

Source: Milton Friedman (Hoover Institution), "The Fed's Thermostat," Wall Street Journal, August 19. 2003.


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