[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Interventionists
New Keynesian economists generally accept that policies can have no long-run effect
on GDP or the natural rate of unemployment because wages, prices, and expectations
eventually adjust, but they think markets respond slowly, so periods of cyclical unemployment
can persist. Discretionary macroeconomic policy can be effective, and
governments should design built-in stabilizers that can help make the economy
less volatile.
Should the Federal Reserve
Target Inflation?
Compared to our global financial system today, the financial structure of the country
was vastly different in 1913, when the Federal Reserve was established. Its role
has therefore evolved over time. The original intention of Congress, as laid out in
the 1913 Federal Reserve Act, was that the Fed should prevent financial panics and
bank runs. Only in the post–World War II era, after the experience of the Great
Depression, have governments recognized that they bear a responsibility for preventing
economic fluctuations. Accordingly, today the Fed’s goal in conducting monetary
policy is to promote low inflation, general economic stability, and sustainable
economic growth.
An important lesson from the full-employment model examined in Part Six is
that monetary policy is the chief determinant of inflation. Central banks, through
their policies that affect reserve supply and the money supply, can control the average
rate of inflation. This does not mean that inflation can be closely controlled
month to month, or even year to year, but over longer time periods a central bank
can exercise considerable control over the average level of inflation that the economy
experiences. For this reason, in recent years most central banks have accepted that
one of their primary responsibilities is to maintain low average inflation.
Monetary policy can also have important effects on two other macroeconomic
goals—low (and stable) unemployment and economic growth. However, according
to the full-employment model, neither the economy’s potential GDP nor the unemployment
rate at full employment depends on the money supply. They rest instead
on household decisions about how much labor to supply in the marketplace, firms’
decisions about how many workers to hire, and the economy’s capital stock and
technology—factors that do not vary with the absolute level of prices or the number
of pieces of paper (green or any other color) that make up the money supply. Put in
terms of our short-run model of Part Six, the level of potential GDP does not depend
on the position of the central bank’s policy rule.
This implication of the full-employment model is important. If full employment
corresponds to an unemployment rate of, say, 5 percent, then the Fed cannot push
the unemployment rate down to 4 percent and keep it there. It can do so temporarily,
but as wages and prices adjust to restore labor market equilibrium, unemployment
will return to 5 percent. The mechanisms that ensure this return to full
employment are discussed in detail in Chapter 33. If monetary policy cannot suc-
848 ∂ CHAPTER 38 CONTROVERSIES IN MACROECONOMIC POLICY