Writing Central Bank and Monetary History - What is the issue? Michael D. Bordo Rutgers University and NBER Norges Bank and Graduate Institute of International and Development Studies. Geneva October 30-31, 2008

2 Monetary History and Business Cycles Key problem for mercantile and industrial economies is business cycle – goes back to the 18 th century Central banks have been assigned the task of stabilizing the real economy since the 1930s Before then real stability not viewed as important as price stability and financial stability. Belief that providing stable money and financial stability would create stable real environment. Under the gold standard business cycle and price cycles were correlated. CBs followed rules of the game

3 Monetary History and Business Cycles Growth of suffrage, labor unions made domestic real stability a political goal This led to a new task for CBs Countercyclical policy and belief in full employment comes from Keynesian economics in the 1930s. Classical view is wages would adjust and unemployed could emigrate to America.. Great Depression caused by poor monetary policy in US and elsewhere - followed bad theories - real bills doctrine led to procyclical policy

4 Monetary History and Business Cycles Keynesian era. CBs fine tune. Target low unemployment. Follow Phillips curve tradeoff, attach lower welfare costs to inflation than unemployment Friedman ( 1953) shows stabilization policy is destabilizing. Friedman and Schwartz ( 1963) show that monetary policy in US explains cyclical instability, Friedman ( 1969) shows that Phillips curve is vertical in long run. Lucas( 1973) Rational expectations show Phillips curve vertical in short run. Great inflation leads to change in thinking away from using countercyclical monetary policy

5 Monetary History and Business Cycles Business cycles often reflect real shocks, CBs can accommodate them but should not offset them, eg oil price shocks of the 1970 Politics very important. Employment Act of 1945 in US. Similar legislation in other countries makes full employment a goal of monetary policy. Creates Dual Mandate in the US Central banks follow Taylor rules but weights on output and inflation differs across countries Modern emphasis on inflation targeting( explicit and implicit)argues that real economy will be more stable in an environment of low inflation To organize a study of a central bank’s history, it may be of value to categorize policy regimes by weights in the Taylor Rule.

6 Session II(continued) Monetary History and the Monetary Policy Framework The central bank uses its tools of monetary policy to affect the supply of money and credit Three key goals of monetary policy: – Price stability – Stable real economy – Financial stability The history of central banks goes back to the 17 century Riksbank 1668, Bank of England 1694 Joint stock banks of issue established to aid in government finance

7 Session II(continued) Monetary History and the Monetary Policy Framework Also engaged in private banking business As bankers banks became LLR Later CBs established beginning of 19C, Bank de France 1800 to stabilize currency and aid government finance Early CBs were private and independent Third wave of CBs turn of 20C to adhere to gold standard and deal with financial stability, eg Federal Reserve, SNB

8 Session II(continued) Monetary History and the Monetary Policy Framework Classical CB policy, adhere to gold standard convertibility, follow rules of the game, follow Bagehot’s rule to maintain financial stability 20C CBs become concerned with the real economy, reflected changes in political economy and in economic thinking CB learning curve was steep in 20C, learning to steer between internal and external stability, price stability and real economy stability Eg) Federal Reserve adhered to real bills doctrine and gold standard. Great Depression consequence of real bills.

9 Session II(continued) Monetary History and the Monetary Policy Framework Fed and banks blamed for Great Depression. Leads to regulation of financial system and Fed loses independence and is subservient to the Treasury. Monetary policy becomes impotent in 30s and 40s. Similar story in European countries Fed regains independence within the government in Other countries wait until1980s (exception Germany, Switzerland) Bretton Woods – adjustable peg, gold dollar standard. Conflict between internal and external goals. By mid 60s in US internal goal of full employment wins, leads to inflation and end of gold constraint. Great Inflation follows. Same story in Europe except Germany, Switzerland and Austria

10 Session II(continued) Monetary History and the Monetary Policy Framework Great Inflation ends with tight money Volcker/ Thatcher Return to price stability as key goal in mid 80s, stable nominal anchor under fiat money Inflation targeting ( explicit/ implicit) in early 90s. Case for price level targeting. Pattern of financial instability begins after deregulation in 70s. Cycle of regulation/ financial innovation deregulation/ financial innovation. Financial instability tied up with inflation instability Pattern of asset booms and busts in environment of price stability. Debate over whether CB acts proactively or retroactively. Study of Central Bank history may distinguish between policy regime based on the three goals.