What monetary policy can do.

• Author: Lacker, Jeffrey M.

Thank you for the opportunity to participate in this discussion on monetary policy and what it can and can't do. In thinking about this topic, it occurred to me that one side of the question--what it can't do--generates a very long list. So for today's discussion, I intend to focus on the positive and discuss the one thing that I think we should be pretty certain monetary policy can indeed do, and that is to determine the long-run path of the price level. Recent experience has caused some to question whether monetary policy's ability to achieve even this modest goal has diminished or been lost in the years since the Great Recession. I will argue that a central bank's ability to influence inflation and how it does so is essentially unchanged. I also believe that monetary policy's ability to affect inflation is essentially independent of its effects on real economic activity, which I view as limited and temporary. My view of what monetary policy can do is based on the (perhaps old-fashioned) idea that money creation is at the heart of price level determination.

A Basic Framework

I take as my starting point that monetary policy is uniquely capable of affecting the price level over the longer term. Indeed, in the benchmark classical (or neoclassical) economic model without some form of friction--in which money is neutral--the price level is all that monetary policy will affect. The price level, after all, is simply the rate of exchange between money and goods. So the quantity of money must be related to how much of the latter each unit can buy. How to match the quantity of money in a theoretical model to a particular empirical measure of money is not always straightforward. But the ability of monetary policy to affect the price level, or the rate of inflation, over time is a natural starting point and one that is embedded in the Federal Open Market Committee's statement concerning its long-term goals (Board of Governors 2012/2015).

In contrast, monetary policy's ability to affect real economic activity--when monetary policy is being reasonably well-executed--can be quite limited and is almost always short lived (Friedman 1968). Real activity is driven predominantly by factors beyond the control of monetary policy--productivity and population growth, for example. In the standard models used in policy analysis, monetary policy's real effects generally derive from frictions that impede the rapid adjustment of the overall level of the price. Such frictions are, almost always, short-run phenomena that generate transitory deviations in real activity, and their empirical significance is a matter of ongoing research and debate. It is true that egregious monetary policy errors can seriously damage the economy--for instance, by adding extraneous volatility and reducing the informativeness of relative price signals. But in typical circumstances, monetary policy that successfully stabilizes inflation and inflation expectations will have only modest, temporary effects on real activity.

The mechanism through which monetary policy has its ultimate effect on the price level is through the process of money creation--that is, the process by which central bank actions affect the distinct forms of money, such as bank deposits, that people use in transactions for goods and services. It is more common these days to think of monetary policy as setting an interest rate target, rather than a money supply, in part because money demand seems to fluctuate significantly (Goodfriend 1991). Nonetheless, prior to 2008, the Fed achieved its target...