According to some economic commentators, the key for economic stability is that the central bank should state clearly the likely course of the monetary policy ahead. In this way of thinking, expected monetary policy is a factor of stability while unexpected policy sets shocks and instability. The transparency framework is based on the ideas of the Chicago School economists Milton Friedman and Robert Lucas.
In his writings, Friedman held that there is a variable lag between changes in money supply and its effect on real output and prices. According to Friedman, in the short run changes in money supply are likely to be followed by changes in real output. However, in the long-run, changes in the money supply will have an effect on prices.
Friedman held that, if the central bank were to follow a constant money growth rule, this would cause money to become neutral with respect to economic activity also in the short-run. The only effect that money would have is on the prices of goods and services.
According to such thinking, various disruptions in economic activity are caused by unexpected monetary policies. These policies generate volatility in the money supply growth rate. This, in turn, causes fluctuations in economic growth. Hence, according to Friedman, by making the money supply growth rate stable, the Fed could eliminate disruptive economic fluctuations.
Similarly, in his Nobel lecture, Robert Lucas suggested that if monetary growth is expected, then people will adjust to it rather quickly and there will not be any effect on the economy. According to Lucas, expected money supply growth will result in a corresponding increase in the prices of goods, which will offset the increase in the monetary spending. However, if the growth rate of money is not expected, then—according to Lucas—it will stimulate production. Following this logic, only unexpected monetary growth can cause economic growth. Such economic growth, however, is likely to be unstable.
Both Friedman and Lucas believe that it is desirable to make money neutral in order to avoid instability and, therefore, unsustainable economic growth.
Money, Expectations, and Economic Growth
Even if everyone were to accurately anticipate the money supply growth rate, there are always going to be the first recipients of the new money and the late recipients. The early recipients can purchase goods at unchanged prices while the later recipients of money would likely have to pay much higher prices. This sets in motion the transfer of wealth from the late or non-recipients to the early recipients of money and this, in turn, is likely to change the relative prices of goods and services. As a result, money cannot be neutral.
Even if money is injected into the economy in such a way that everybody receives it instantaneously, changes in the demand for money will vary—after all, every individual is different from other individuals—there will always be somebody who will spend the newly-received money before somebody else. This will result in the redirection of wealth to the first spender from the last spender. This will result in the depletion of the pool of resources through the exchange of nothing for something, which, in turn, will undermine economic growth.
Note also, that to stabilize individuals’ expectations, the Fed will be compelled to tamper with the growth rate of money supply. This however will set in motion disruptions in terms of boom-bust cycles.
We can conclude that both expected and unexpected money supply growth will weaken the pool of resources, private saving, and stable economic growth.
Additionally, Friedman’s constant money growth rule cannot make money neutral since the constant money growth rule is still about increases in the money supply despite it being at a constant rate. This means that, in Friedman’s framework, we will also have an exchange of nothing for something and, therefore, boom-bust cycles and economic instability. The Fed’s transparent monetary policy cannot prevent economic bust.
In the words of Ludwig von Mises,
The boom brought about by the banks’ policy of extending credit must necessarily end sooner or later. Unless they are willing to let their policy completely destroy the monetary and credit system, the banks themselves must cut it short before the catastrophe occurs. The longer the period of credit expansion and the longer the banks delay in changing their policy, the worse will be the consequences of the malinvestments and of the inordinate speculation characterizing the boom; and as a result, the longer will be the period of depression and the more uncertain the date of recovery and return to normal economic activity.
The view that it is possible to stabilize the economy by means of transparent policies is questionable. Thus, Friedman’s constant money growth rule cannot make money neutral since the constant money growth rule is still about increases in the money supply despite it being at a constant rate. There will also be an exchange of nothing for something and, therefore, boom-bust cycles and economic instability.
A better way to stop the menace of boom-bust cycles and economic instabilities is for the central bank to stop the tampering with financial markets. Note that, as a rule, however, central banks respond to the bust by again loosening their stance thereby starting the new boom-bust cycle phase.
Conclusions
A policy of transparency employed by the Fed cannot prevent the boom-bust cycles, which are set in motion by the Fed’s tampering with financial markets. Neither Friedman’s constant money growth rule, nor Lucas’s perfect anticipation of the money growth rate, can eliminate boom-bust cycles, and thus these measures are counterproductive and actually set the platform for economic stability. Money is not neutral. Furthermore, what would bring economic stability is for central banks to cease inflationary monetary policy. What is required for economic growth is voluntary production, private saving, and capital investment. The ever-expanding government and central bank intervention remains a major obstacle to all these things.
