Thomas M. Humphrey

English

Research Papers in Economics

48 Region Focus • Winter 2004
OPINION
S
ir Isaac Newton’s remark about seeing farther because he
stood on the shoulders of giants also applies to central
bankers. The latter stand on the shoulders of Knut Wicksell,
a Swedish economist who in 1898 advanced the policy-analysis
prototype that central bankers have been using ever since. It was
Wicksell who first showed that inflation and deflation result when
the central bank sets its interest rate at the wrong level—and that
it can stabilize prices through judicious adjustment of the rate. 
Some have alleged that Federal Reserve Chairman Alan
Greenspan is a Wicksellian because he implicitly targets the
economy’s natural rate of interest. This reasoning is suspect.
Greenspan has never indicated that he targets the natural
rate. And Wicksell himself denied that the unseen natural
rate could be targeted. Instead, he thought central bankers
should target the price level because it
is observable and because its deviations
from target indicated corresponding
deviations of market interest rates from
the unseen natural rate.
Are there other, valid grounds to
believe that the Federal Reserve is
Wicksellian? To answer that, let’s reverse
the question and ask if Wicksell would
see his beliefs embodied in recent
Federal Reserve policy. The evidence is
mixed at best.
On the yes side is Wicksell’s under-
standing of rational expectations, a
concept he employed after World War I to claim that a pre-
announced and fully anticipated deflation would not affect
real activity. All central bankers are Wicksellians now in
believing that credibility and rational expectations in a flex-
ible-price economy are capable of rendering systematic mon-
etary policy neutral in its real effects. Equally, they believe
that unpredictable, random policy would have painful real
effects. It would drive the economy away from the growth
path depicted in real business cycle (RBC) models. 
Against these similarities are at least three differences.
First, Wicksell defined price stability as absolute constancy
of the price level. The Fed, by contrast, typically defines it as
a rate of inflation so low as to leave business decisionmaking
unaffected. Wicksell would complain that this definition triv-
ializes the idea of price stability. Believing that price-level con-
stancy is as important as that of all standard weights and
measures, he advocated a government board to determine an
unvarying standard price level for the central bank.
Second, in advocating stabilization of the price level rather
than merely keeping inflation low, Wicksell offered tradeoffs
different from those offered by inflation-targeting central
bankers. Wicksell’s price-level targeting yields zero-price drift
at the cost of greater price and interest-rate volatility. By con-
trast, implicit inflation targeting yields less price and inter-
est-rate volatility at the cost of more price drift.
Third, Wicksell rejected the New Economy notion that
rapid technological progress and productivity growth ease
the central bank’s job by holding inflation in check. Wick-
sell always claimed that such forces, prevalent in his time as
they are in ours, influenced relative prices but not the general
price level. The latter, in his view, was determined by mon-
etary policy, thus rendering the eradication of inflation and
deflation the responsibility of the central bank. The upshot
of these differences is that Fed policymakers are Wicksel-
lian only in the broad sense that all modern monetary econ-
omists are: They concur with some but
not all of Wicksell’s views.
The question remains: Would Wick-
sell, whose analytical frameworks dictated
his policy stance, have been a good chair-
man of the Federal Open Market Com-
mittee? Here the key point is that
Wicksell’s analysis of the relation
between money and prices—his famous
cumulative process model—was com-
pletely divorced from his analysis of busi-
ness cycles in which fluctuations are seen
as driven by real shocks such as techno-
logical progress and wars. In one sense,
the mutual exclusivity of real and monetary models is right
and correct: When agents have rational expectations and the
central bank has credibility, then monetary policy, being
entirely neutral, is disconnected from the real sector, which
follows the dictates of real business cycle models. If you
believe RBCs are optimal—that is, they offer the best
dynamic paths along which the economy can grow—then
Wicksell’s analysis, and the divorce between his money and
real models, makes perfect sense. Armed with these models
and the policy stances emanating from them, he would have
made a good chairman.
On the other hand, if you use sticky-price models, as many
central bankers do, to show that money temporarily affects
real activity, then Wicksell is wrong. With sticky prices,
money and monetary policy affect real as well as nominal
variables, making Wicksell obsolete as a policy advisor.
Indeed, the message of sticky-price models is that central
banks that use their credibility to anchor price expectations
also have the flexibility to mitigate slumps in real activity.
The Federal Reserve in the Greenspan era has appreciated
this. Wicksell arguably did not. RF
BY THOMAS M. HUMPHREY
Is Greenspan a Wicksellian?
“Wicksell rejected the
New Economy notion
that rapid technological
progress and productivity
growth hold 
inflation in check.”

Opinion : is Greenspan a Wicksellian?

http://www.richmondfed.org/publications/research/region_focus/2004/winter/pdf/opinion.pdf

Opinion : is Greenspan a Wicksellian?

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