Inflation, Unemployment and Monetary Policy

Citation

Gbosi, A.N. (2001), "Inflation, Unemployment and Monetary Policy", International Journal of Manpower, Vol. 22 No. 4, pp. 393-405. https://doi.org/10.1108/ijm.2001.22.4.393.4

The book comprised two papers presented at the First Alvin Hansen symposium on Public Policy, Harvard University. The book which was edited and introduced by Benjamin Friedman revealed that a great division exists amongst economists and other policy makers in the use of monetary policy in achieving price level stability and other measures of real economic activities.

In his view, Benjamin Friedman argued that the two‐way interaction between monetary policy and macroeconomic outcomes, if not properly understood and adequately adjusted, would continually render monetary policy ineffective. In his conclusion of the introductory speech, he observed that certain interactions and imperfections explain the dynamics between monetary policy and macroeconomic outcomes. These interactions continually account for the evolution of ideas regarding the best monetary policy that should be used effectively to predict real world economies with accurate precision, regardless of distortions of assets’ price movements, oil price shocks and countless other events all happening simultaneously. The papers therefore focus on the trade‐off between monetary policy and macroeconomic stability.

Robert Solow was inspired by the works of Alvin Hansen, who favoured fiscal policy measures. However, like Hansen, he advocated a macroeconomic policy, which automatically combined both fiscal and monetary policy measures. He claimed that monetary policy is favoured by people because of the correlation between votes and public services. Solow believed that monetary policy is a trial and error approach to finding a fair balance between the fluctuation of inflation rates and the benefits of high output and employment. He faulted the accelerationist model on the grounds of the assumption of a degree of supply‐demand balance in the economy as a whole and the inability of the model to clearly establish a constant “neutral rate” of unemployment. He qualifies the accelerationist model as an elastic measuring rod, which thrives on adjustable, unobservable parameters to keep a theory afloat in rough seas.

In faulting the accelerationist model further, he established a model that used unemployment rate as the neutral rate, only if the rate persisted long enough. His findings were supported by Douglas Staiger, James Stock and Mark Watson (1997). He further disagreed with Robert Eisner and described Eisner’s findings as insubstantial. Specifically, he contended that this model was capable of producing a better or worse situation once the disclarity resolved itself. In the same manner, he pointed out that a prudent policy maker would be unwise to act as though he or she knew, with any level of accuracy, where the neutral rate actually is in today’s economy. This, according to him, explains why people can afford to explore, experiment, and move forward in a time of monetary policy and quick reverse actions, since the cost to an economy as a result of making an error is not usually zero.

Solow underlined the importance of time lag in the transmission mechanisms. He, however, cautioned against the frequent changing and promoting of monetary policy as some of the intended effects may only be achieved once certain circumstances have been changed and may even cause reverse results. He supported neither a delayed nor an immediate monetary policy as this could result in the Central Bank feeding inflation and contributing to the economy’s weaknesses. He went on to observe that lags could be long and responses sluggish and approximately symmetric. Furthermore, as long as there is uncertainty regarding the current neutral rate of unemployment, monetary policy can only afford to be an exploratory and one‐sided approach to macroeconomic issues. He concluded by noting that macroeconomic policy is no easy task and the only way to find out whether it is successful or not is through continuous experimentation.

In his paper, John B. Taylor believes that monetary policy does affect economic activity in the short‐run. He argued, however, that there is no long‐run trade‐off between the rate of inflation and the rate of unemployment in an economy. He firmly supported the accelerationist model or the natural rate, and used data of unemployment and inflation in the USA over four decades to support his claims. He believes that the Central Banks of countries have crucial roles to play in designing monetary policy decisions. This, he claimed, is as a result of economies being subjected to shocks and he observed that, once a shock occurred, the Central Bank may respond in one of two ways – either to embark on or initiate an expansionary monetary policy or a restrictive one.

In a similar fashion, he argued that the Central Bank should take into account the real effects of its policy actions on economic activity. He specifically proved that apart from the intentional effort to lower or raise inflation from any given point, monetary policy should aim directly at whatever the Central Bank perceives to be the full real activity employment rate. In the summation of his paper, Taylor argued that monetary policy should follow a set rule, and concluded that the economics of monetary policy is far from a closed field in which all important questions have already been answered.

Professors Solow and Taylor established themselves as economists of international repute, as they spent their time adequately and critically addressing the important issue of alternative views on monetary policy and macroeconomic outcomes. In their respective papers, the two authors agreed in principle that monetary policy does affect real economic activity in the short‐run. While Solow did not believe in the accelerationist model or the natural rate and did not hesitate to do away with it because he lacked strong evidence, Taylor, on the other hand, is an advocate of the accelerationist model. Solow’s position in the argument seems clearer and more straightforward as he demonstrated that the accelerationist model was extremely limited to the USA’s experience since 1970 and could not be supported by US experience before 1970 and the experience of other European countries.

Professor Solow explicitly advocated that the Central Bank should take into account the real effects of its policy actions. Taylor, however, claimed that apart from the intentional effort by the Central Bank to lower or raise inflation rates from any given point, monetary policy should be designed to achieve full employment as is perceived by the Central Bank.

I however, to some extent, disagree with the authors, but I do agree with Alan Greenspan, who had previously argued that the right approach is to halt the use of the full employment rate. It is further argued that a lighter monetary policy will unmistakably push the economy into the inflationary range.

Both Taylor and Solow are of the opinion that the Central Bank should take the effects on real activity into account in its policy‐making decisions. I greatly share their views, but some people may disagree. A contrary view may arise from the activity of the Federal Reserve as it may assume to have no authority in making monetary policy decisions, except that the state of the real economy would have a bearing on the behaviour of prices and a financial crisis both at home and abroad. The authors projected their views very well. Their position provides great solutions to an interesting aspect of macroeconomic problems (inflation and unemployment). The text is good supplementary material in undergraduate and graduate courses dealing with Macroeconomics, Monetary or Labour Economics.