Wednesday, November 17, 2010

Somebody Help Me Understand the Dual Mandate

For as long as I have known anything about it, I've entertained an untutored sense that  the "dual mandate" must be a bad idea.  That is: the  Federal Reserve is suppose to guarantee financial stability.  No wait, the Fed (since 1977) is also supposed to promote full employment.

But these two are naturally at war with each other.  In some cases (I am told), the best way to juice up employment is to promote a bit of inflation--in short, to destabilize.  It may the right thing to do, but these two are essentially political changes that shouldn't be made by a bunch of technocrats.

So I paid attention when I saw that Sen. Bob Corker and Rep. Mike Pence are calling for an end to the dual mandate--want to trim the Fed down to the job of stability only.

In the context, it is natural to suppose that this new impulse towards breaking the dual mandate must be some sort of vile Republican plot and it may well be.  But what kind of a vile plot?  Or more precisely, just exactly how does it play out on the ground?  Does the dual mandate make  inflation (deflation) more (less) likely?  And who cares?

Examples: I lived through a kind of "inflation golden age"--the 60s and 70s--when folks like me bought our houses at $20-$30k and watched the value inflate while we paid off our mortgages in little teeny deflated dollars.  Yet I understand that a brisk dose of inflation may help jump-start a sluggish economy because it effectively reduces sticky wages.

So, should we think of the inflation lobby as a bunch of carefree debtors who want to inflate away their obligations?  Or a bunch of grasping capitalists who want to impoverish the honest working man (if there be such any more)?

Another way of approaching the point.  Consider the Tea Partiers, who put the new lot into power.  Let's grant that they have an almost uncanny knack for embracing candidates fatal to their own best interests (end unemployment insurance, deregulate the banks again, and god forbid you should have health care). Exactly what is their interest in this little whirlpool?   I'm almost ready to take it as an article of faith that if Corker and Pence are for it, then it will end up doing harm to the TPs in the end.  But exactly how?

I'm not an economist and I don't even play one on TV.  Anybody?  Anybody?

3 comments:

Nuveen said...

The illustrative anecdote I keep seeing is that the ECB hiked rates in early 2008, while the Fed slashed them. The ECB has only a price stability mandate, and raised rates in the face of inflation, while at that point, our other economic woes were more important. But I'm guessing that the effects of either policy got lost in the noise of late 2008, so we're still left guessing.

Nuveen said...
This comment has been removed by the author.
Mark Thoma said...

See:

Real Wage Rigidities and the New Keynesian Model at

http://www.bos.frb.org/economic/wp/wp2005/wp0514.pdf

Abstract:
Most central banks perceive a trade‐off between stabilizing inflation and stabilizing the gap between output and desired output. However, the standard new Keynesian framework implies no such trade‐off. In that framework, stabilizing inflation is equivalent to stabilizing the welfare‐relevant output gap. In this paper, we argue that this property of the new Keynesian framework, which we call the divine coincidence, is due to a special feature of the model: the absence of nontrivial real imperfections.

We focus on one such real imperfection, namely, real wage rigidities. When the baseline new Keynesian model is extended to allow for real wage rigidities, the divine coincidence disappears, and central banks indeed face a trade‐off between stabilizing inflation and stabilizing the welfare‐relevant output gap. We show that not only does the extended model have more realistic normative implications, but it also has appealing positive properties. In particular, it provides a natural interpretation for the dynamic inflation‐unemployment relation found in the data.