Some commenters argue that the Fed can’t control the monetary base. And they say that open market operations won’t affect the price level, as the Fed is simply swapping one asset for another asset of equal value. This is not true, as currency is not generally a close substitute for other assets. So when you increase the stock of currency via OMOs, the value of currency will usually fall. Between December 1947 and December 1964 the Fed increased the currency stock from $28.9 billion to $39.7 billion, and prices rose modestly. Then they started printed money like crazy, and prices soared between December 1964 and December 1981. By the end of 1981 the currency stock had hit $144.4 billion:
Some old style Keynesians will point to fiscal stimulus, but deficits weren’t particularly large during the Great Inflation (and indeed were very small in real terms.) Deficits actually got much bigger after the Great Inflation ended. The currency printing policy was instituted to bring down unemployment. It succeeded, but only up through 1969.
Some will ague that the currency stock is endogenous; the Fed controls the monetary base. Technically that’s true, but until 1914 the entire base was currency, and indeed when the IOR is zero it really doesn’t matter whether bank reserves are held as deposits at the Fed or vault cash. In any case, reserves are only a small share of the base. The Great Inflation was basically caused by printing lots of currency. That’s what central banks do. Fama was right.
Fiscal theories of the price level can’t explain the Great Inflation, nor can they explain the Volcker disinflation.
However the quantity theory of money also has trouble explaining the Volcker disinflation. The growth rate of the currency stock did slow after 1981, but only very slightly. Meanwhile the inflation rate fell sharply. Why doesn’t the QTM explain the Volcker disinflation? Because when inflation slows the demand for base money rises. Recall that inflation/interest rates are the opportunity cost of holding currency. So you actually need to model both the supply of currency (under Fed control) and the demand for currency (related to the opportunity cost of holding currency.) When you do both, you have a pretty good model of the price level.
Here’s another problem with the Fiscal Theory of the Price Level. When the Fed decided to target inflation at around 2%, they pretty much succeeded. Raise your hand if you think Congress should be congratulated for bringing inflation down sharply in 1981-82 with the massive Reagan deficits, and then after 1990 holding inflation near 2% for decades. Congress adeptly nudges deficits up and down to keep that darn inflation rate pegged right around 2%. I don’t see any hands in the air.
Printing money is what the Fed does. (Speaking loosely—another agency actually runs the printing presses.) That policy affects all sorts of other variables, such as the fed funds rate. The Fed’s Great Inflation policy caused the fed funds rate to soar into double digits by 1981, so don’t assume that printing money causes lower interest rates, at least over any extended period of time.
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