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What Should Central Banks Peg? Arguments for the Interest Rate

By Renato Lembe Agurto

In 2002, on the occasion of the ninetieth birthday of Milton Friedman, the just appointed FED governor Ben Bernanke famously declared that Friedman’s diagnosis of the Great Depression was right. Six years later, he was given the opportunity to put into practice Friedman’s recommendation: between August 2008 and December 2008, the monetary base was increased from US$ 876 billion to US$ 1.6 trillion due to central bank’s massive purchasing of treasury bills. At last, liquidity was more than preserved.

One the other hand, Friedman’s suggestion to peg the money supply, rather than the interest rate, was overwhelmingly abandoned by economists – including Bernanke, among others now labeled as New Keynesian - in the early nineties. Indeed, they had a good excuse: monetary pegging had already been abandoned by central bankers themselves for a long time, with Paul Volcker being a solitary exception.

As it was demonstrated by Bernanke & Blinder (1990) and Taylor (1993), the Federal Reserve has historically targeted interest rate as a reaction to changes in inflation and income, adjusting the money supply to achieve this intended peg. However, the instability and uncertainty that would have resulted from such a policy according to the predictions of Friedman, Sargent & Wallace has not been empirically observed.

In order to address this supposed contradiction between theory and practice, New Keynesian economists put forward two alternative statements: first, money supply is not a relevant target for monetary policy; second, pegging interest rates does not necessarily causes prices to become unstable or indeterminate.

Let us, then, address the first issue. Have you ever asked yourself why you hold money, either in your pocket or in a deposit account? Generally, the answer is straightforward: in order to buy other things, especially in cases of urgent and unplanned need. In fact, most people would agree that in case they were paid more, they would buy more as well, proportionally. That is the axiom at the basis of the quantity theory of money: more money means more consumption (or investment, in the case of businesses), which implies, eventually, more income. However, what if people had incentives, other than some unexpected necessity, to hold money apparently idle? In this case, more money does not necessarily imply more spending, once it has not been exchanged for other goods.

Furthermore, most people actually rely on credit for their consumption, rather than on available cash. This is especially the case of entrepreneurs who struggle to maximize, under constrains of risk and profitability, the use of their working capital by negotiating term payments for labor and inputs. Again, the quantity of money does not seem to be associated with the amount of spending, for the latter can be done with or without it, under some broad limitations, just by performing credit transactions.

Indeed, as financial innovations take place – in the form of interest-bearing liquid accounts and broader access to stock or bond markets, just to name two examples – the relationship between the money supply and the real economy becomes increasingly unstable. Eventually, the former is not a trustworthy predictor of the latter anymore, nor an effective monetary instrument to rely on. That is precisely the case of most modern economies around the globe (Bernanke & Blinder, 1990; Friedman & Kutter, 1996; Mishkin, 2000).

Once the unsuitableness of targeting the money stock has been demonstrated, it also becomes necessary to counter the classic argument used against interest rate pegging. One of the first successful attempts in doing so came from Bennett McCallum (1980), who stressed that the indeterminacy problem would only occur if the authorities committed to preserve a specific interest rate regardless of its effect on the real economy. On the opposite case of authorities adjusting the interest rate in reaction to price level shifts, the latter would no longer be indeterminate.

Following the example brought in the previous article, bankers and businessmen’s price expectations would not be arbitrary in relation to monetary policy, because these private agents would anticipate the authorities’ move against price instability. In fact, it would not be very rational – in any sense - to expect central bankers to observe inertly inflationary or deflationary spirals.

As stressed by Woodford (2003), implementing a reactive interest rate rule would definitely solve not only the indeterminacy problem but also the instability problem emphasized by Friedman. However, there was one very important condition: if the authorities wanted to determine the inflation rate to be, for instance, 2% a year, they should move interest rate more than proportionally to deviations from this goal. For example: if the expected inflation rate is 3% - meaning a positive deviation of 1% – they should increase interest rate by more than 1% at least, otherwise indeterminacy problem would emerge.

Basically, that is the common monetary framework that guides modern central bankers today: a proper interest rate is settled so to favor the occurrence of an intended variation of prices.

One could paraphrase the famous statement attributed to Nixon: we are all [New] Keynesians now! That may have been the end of the monetary policy history… had there not been the subprime crisis in 2008. Since the crash, developed countries’ interest rates have stagnated near zero, meaning that the Central Bank cannot react more than proportionally to deflation, with the old problem of indeterminacy re-emerging. Inflation, however, has been paradoxically stable since then.

Is this the definite victory of the New Keynesian pegging, unexpected by the New Keynesian economists themselves? Or is it the death of macroeconomics as an objective inquiry? That is a theme for the next article.


Bernanke, B. & Blinder, A. (1990). The Federal Funds Rate and The Channels of Monetary Transmission. National Bureau of Economic Research Working Papers, 3487, 1-42.

Friedman, B. & Kutter, K. (1996). A Price Target for U.S. Monetary Policy? Lessons from the Experience with Money Growth Targets. Bookings Papers on Economic Activity, 27(1), 77-146.

McCallum, B. (1980). Price Leve Determinacy with an Interest Rate Policy Rule and Rational Expectations. National Bureau of Economic Research Working Papers, 559, 1-19.

Mishkin, F. (2000). From Monetary Targeting to Inflation Targeting: Lessons from The Industrialized Countries. Policy Research Working Papers, 2684, 1-35.

Taylor, J. (1993). Discretion versus Policy Rules in Practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195–214

Woodford, M. (2003). Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton, USA: Princeton University Press.

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