My Thoughts on Monetary Policy
By Arnold Kling
1. If you believe that aggregate demand matters, then monetary policy is too tight.
2. We won’t know whether or not to believe that aggregate demand matters until we see higher inflation. If we see 3 percent inflation or more for six months and no improvement in unemployment, then those of us who are skeptical of aggregate demand can say “told ya so.” But as long as inflation is as low as it is, it remains an open question.
3. I don’t understand why the Fed is still paying interest on reserves.
4. Some prominent Republican politicians oppose monetary expansion. I think they are wrong, but I assume that their motives are sincere.
5. Some prominent policy professionals, with names like Volcker, Rajan, and Taylor, also oppose monetary expansion. Again, I think they are wrong, but I assume that their motives are sincere.
6. As Scott Sumner has suggested, there may be a lot of folk economics out there which says that monetary expansion causes inflation but fiscal expansion does not. This is contrary to the theory of AS and AD.
7. I can think of at least three reasons why the Fed is not pursuing expansion with more determination. First, current policy is much closer to optimal for banks than it is for the country as a whole. This suggests a Fed controlled by banks. Second, the Fed may be intimidated by those who oppose faster expansion. Third, the Fed is just very slow to change direction. One story for the 1970s is that the Fed kept under-estimating the shifts in the Phillips Curve and the increases in the natural rate of unemployment. It kept following inflationary policies because it was slow to adapt to reality. Similarly, it appears now that the Fed is slow to adapt to downward shifts in aggregate demand. It is adjusting gradually while conditions are deteriorating rapidly. In the 1970s, the Fed took too long to tighten, and now it is taking too long to loosen.