A k-percent rule for monetary policy in West Germany.

Geldmengensteuerung; Deutschland;

Central banks: no reason to ignore money

The need for a stable monetary policy arises from several facts about business cycles. For example, practically all recessions in industrial countries were preceded by restrictive measures of central, banks. The main cause for the instability, however, was the expansionary policy that led to a boom and too high inflation. There is no question that high inflation in the long run is caused by high money growth; the empirical evidence in favor of the quantity theory of money is overwhelming. Inflation reduces economic growth considerably if it exceeds a certain level. At rates below 10 percent, the negative effects appear to be small. But recent studies show that there is a tremendous welfare gain even if inflation is reduced from a low rate of two percent to zero. This follows from the existence of distorting taxes and from a high demand for non-interest bearing cash at low rates of interest. The conclusion is that zero inflation can be achieved and that it produces a sizable free lunch for a society. While there is a consensus that monetary policy should follow a rule because discretionary policies have a bias towards higher inflation, it is not clear what the best strategy should be. It is often stated that monetary targeting cannot be used in the case of an unstable money demand function. This is not necessarily true because this instability can often be taken account of. Actually, rules exist according to which money growth adjusts to changes in the trend rate of the velocity of money. An instability of the money demand function does not invalidate the policy of monetary targeting or the main predictions of the quantity theory of money. The instability of money demand has led many central banks to pursue inflation targeting instead. But this policy, too, is fundamentally affected if the demand for money is not stable: The strategy requires a forecast for inflation which critically hinges on the conditions on the money market. In the case of an instability, it is difficult or even impossible to predict inflation accurately. This means that inflation targeting may not be better than monetary targeting. According to the Taylor rule, which is often propagated, the central bank reacts to the output gap as well as to the difference between actual inflation and the inflation target. If the central bank wants to set the short-term interest rate accordingly, an estimate for the real equilibrium interest rate is needed. Given the large variations in the trend of real short-term interest rates in the past, it is quite possible that a central bank uses a "wrong" estimate when following the rule. A small underestimation may already produce considerably higher inflation. Such an error is equivalent to the error concerning the estimate of trend velocity in the strategy of monetary targeting, so both strategies may lead to deviations from the target inflation rate. In other words: The Taylor rule is not necessarily superior. The future European Central Bank will choose between monetary targeting and inflation targeting. The start of the European Monetary Union may lead to an instability of the demand for money because of the regime shift. Therefore, the strategy of monetary targeting may lose some of its appeal. However, it does not follow that it is better to pursue a policy of inflation targeting. Any strategy will have difficulties when the fundamental link between money, prices, income and interest rates is disturbed. The rules for monetary policy have desirable features: inflation is to be kept under control, and fluctuations of output are to be reduced. But obviously, there is no single rule which is always and everywhere better than the alternatives. To conclude: It is not justified to disregard monetary targeting — a tendency which seems to prevail among central bankers and economists alike. After all, the quantity theory of money holds well enough to stress the importance of monetary aggregates as an anchor for the price level. --

Before EMU starts: economic policy stimulates recovery in Europe

The decision on EMU strongly affects the course of monetary and fiscal policies in 1997 and especially in 1998. We assume that the monetary union will start in January 1, 1999 with a sizable number of participating countries. Once the decision on the members is made in the spring of 1998, any differences between short-term interest rates in the participating countries can be eliminated. Currently, money market rates in Italy, in Spain and in Portugal are substantially higher than, for example, in Germany. These high rates will be reduced quickly. Monetary policy will thus become more expansionary not only in these countries but also in Western Europe as a whole. It is not likely that the central banks in countries with relatively low interest rates will tighten their policy because such moves would be resisted in the light of the severe unemployment in Europe. While fiscal policy is concerned with reducing budget deficits this year in order to qualify for EMU, the course will change in 1998. Governments can afford to loosen this policy stance because the actual deficits in 1998 are not decisive for the entry into the monetary union. Also, the stability pact will become effective only from 1999 onwards, so there will not be any sanctions even if budget deficits are excessive in 1998. Therefore, further substantial cuts in expenditures or increases in revenues are not likely. In a few countries, even tax cuts were announced for 1998, for example, in France and in Germany. In summary, fiscal policy will have an expansionary effect on economic activity in 1998. The upswing in Western Europe will continue in 1997 and in 1998. Export conditions are favorable since the world economy will expand at a healthy pace. The increase in internal demand will accelerate because of the impulses from economic policy. In practically all countries, capacity utilization will reach or even surpass its normal level in the course of next year. As central banks will be expansionary in the fourth consecutive year, the phase of disinflation in Europe is coming to an end. Inflation will go up somewhat in 1998 and more so in the following year. Because of the deteriorating outlook for inflation, European currencies will further devalue against the US dollar and long-term interest rates will increase considerably. All these developments are a burden for the start of EMU. The future European Central Bank will have to follow a restrictive course if it wants to demonstrate its commitment to price level stability. . The Dublin resolution for a "stability pact" is intended to limit budget deficits after EMU will have started. However, the agreement is not sufficient to reach this target for several reasons: First, the governments themselves will decide on sanctions; this raises the possibility that political factors play a major role and that opportunistic behavior will dominate. Second, the sanction mechanism has no bite because too much time goes by until sanctions are implemented. Furthermore, in order to avoid the payment of a fine it is sufficient to reduce the budget deficit to a level of 3 percent of GDP once in five years. A strict sanction mechanism is probably objected by several governments because they fear that it would prevent the automatic stabilizers from working appropriately, so that, e.g., fiscal policy would have to be restrictive in a recession. However, this fear is not warranted because the cyclical budget deficits in all EU countries have not been veiy large during the last fifteen years. In order to avoid excessive deficits in the future, it would be necessary to reduce the structural deficits considerably, in some cases even to zero. This is an ambitious target, but it is precisely what was decided upon in Dublin. So far, however, this is merely a promise because in practically no major country efforts are made to balance the budget by 1999 — a fact which reduces the credibility of the Dublin resolution even more. --