Allan H. Meltzer

A Theory of Ambiguity, Credibility, and Inflation under Discretion and Asymmetric Information

This paper develops a positive theory of credibility, ambiguity, and inflation under discretion and asymmetric information. The monetary policymaker maximizes his own (politically motivated) objective function that is positively related to economic stimulation through monetary surprises and negatively related to monetary growth. The relative importance he assigns to each target shifts stochastically through time. His current preference trade-off is known to him but not to the public. When choosing the (state contingent) path of money growth for the present and the future, the policymaker compares the benefits from current stimulation with the costs associated with higher future inflation expectations. Current monetary growth conveys information to the public about future money growth because there is persistence in the policymakers objectives. Although expectations are rational, information is imperfect because monetary control procedures are imprecise. As a result the public cannot correctly distinguish persistent changes of emphasis on different policy objectives from transitory monetary control errors. The public becomes aware of changes gradually by observing past monetary growth. Credibility is defined in terms of the speed with which the public recognizes changes in the objectives of the policymaker. Credibility is lower the noisier monetary control and the more stable the objectives of the policymaker. Looser monetary control and a higher degree of time preference on the part of the policymaker induce him to produce higher and more variable monetary growth. When the policymaker is free to determine the accuracy of monetary control he does not always choose the most effective control available in spite of the fact that monetary surprises always have an expected value of zero. The reason is that ambiguous control procedures enable the policymaker to generate positive surprises when he cares more than on average about economic stimulation. He leaves the inevitable negative surprises for periods in which he cares more about inflation prevention. This result provides an explanation for the Feds preference for ambiguity, recently documented by Goodfriend (1986). The policymaker is more likely to pick more ambiguous control procedures the more uncertain his objectives and the higher his time preference. The paper also provides a theoretical underpinning for the well documented crosscountry positive correlation between the level and the variability of inflation.

A History Of The Federal Reserve

Allan H. Meltzers critically acclaimed history of the Federal Reserve is the most ambitious, most intensive, and most revealing investigation of the subject ever conducted. Its first volume, published to widespread critical acclaim, spanned the period from the institutions founding in 1913 to the restoration of its independence in 1951. Book 1 of the two-part second volume chronicles the evolution and development of the Federal Reserve from the Federal Reserve Accord in 1951 to the first phase of the Great Inflation in the 1960s, revealing the inner workings of the Fed during a period of rapid and extensive change. Book 2 chronicles the evolution and development of the Federal Reserve from the Nixon administration to the mid-1980s, when the Great Inflation ended.

The Demand for Money: The Evidence from the Time Series

T *IHE arguments or variables that enter the demand function for money, and the definition of the quantity of money appropriate for the demand function, have received substantial attention in both the recent and more distant past. For present purposes, it is useful to distinguish three separate disputes about these variables. First, there is the question of the constraint that is imposed on money balances-whether the appropriate constraint is a measure of wealth, income, or some combination of the two. A second dispute has centered on the importance of interest rates and price changes as arguments in the demand function. Third, the question of the definition of money balances has often been raised. Is a more stable demand function obtained if money is defined inclusive or exclusive of time and/or savings deposits, and perhaps other assets that have value fixed in money terms? In his recent survey of monetary theory, Harry Johnson has suggested that the above issues-the definition of money to be used in the money demand function, the variables on which the demand for money depends, and the stability of 1 This article is a part of the research on monetary theory and monetary policy conducted under the joint responsibility of Karl Brunner, of the University of California, Los Angeles, and myself. I wish to acknowledge many helpful discussions with Brunner. The suggestions made by Philip Cagan, Michael Hamburger, and Richard Nelson and the excellent assistance of George Haines and Peter Frost have contributed to the paper. I would like also to express appreciation for the research support made available by the Graduate School of Industrial Administration, Carnegie Institute of Technology. the demand function-are the chief substantive issues outstanding in monetary theory.2 This paper deals with each of them and attempts to evaluate empirically the results obtained from some alternative money demand functions and some alternative definitions of money. These results are used to appraise some propositions that have been advanced in monetary theory. With respect to one of these issues, the constraint on money balances the wellknown work of Hicks, and the more recent studies of Friedman and Tobin suggest that monetary theorists are now agreed that the demand function for money is to be treated as a problem in balance sheet equilibrium or asset choice.3 However, there are important differences among those who view monetary theory as a part of capital theory. Two of these differences are noted here. One concerns the importance of money for macroeconomic theory; the other is the question of the definition of wealth.

Long- and short-term interest rates in a risky world

Abstract The paper develops and tests a general equilibrium model in which variability, or risk, affects the choice of portfolios. Our measures of variability include only the variability of unanticipated growth in monetary and non-monetary aggregates, and our tests use data ending with the change in Federal Reserve procedures in October 1979. We find that increased variability of unanticipated money growth raises demands for debt and money, and reduces the demand for real capital. Interest rates on both short- and long-term debt rise by a risk premium. We estimate the size of the risk premium before and after the October 1979 change, and we show that the change in Federal Reserve procedures moved the economy to a less efficient point.

The Effect of Aggregate Economic Variables on Congressional Elections

This paper uses rational voting behavior as an organizing device to develop a framework within which to consider the effect of economic aggregates on voters. Unlike most previous studies, ours permits the voter to vote for candidates of either party or to abstain. A principal finding is that the effect of the main economic aggregates on the participation rate is much clearer than the effects on either party. Our results deny that an incumbent administration can affect the control of Congress by stimulating the economy. Voters appear to make judgments about inflation, unemployment and economic growth. We investigated on the basis of long-term, not short-term performance.

Stagflation, persistent unemployment and the permanence of economic shocks

Abstract When changes occur, people do not know how long they will persist. Using a simple stochastic structure that incorporates temporary and permanent changes in an augmented IS-LM model, we show that rising prices and rising unemployment — stagflation is likely to follow a large permanent reduction in productivity. All markets clear and all expectations are rational. People learn gradually the permanent values which the economy will reach following a permanent shock and gradually adjust anticipations. In our model, optimally perceived permanent values take the form of a Koyck lag of past observations.

The Transmission Process

I must confess some vested interests in this topic. I first discussed it in a paper with Karl Brunner, more than thirty-five years ago (Brunner and Meltzer, 1963). I have returned to the topic many times, most recently in a published symposium (Meltzer, 1995). I will refrain from reviewing these earlier studies, although I will refer in passing to some of the main ideas. I will concentrate on two topics. They do not exhaust the subject, but they raise issues that I believe are central.

Money and economic activity, inventories and business cycles☆

Abstract Incomplete information is a necessary condition for any real effects produced by monetary impulses. An alternative to the local-global inference problem is explored in this paper. Agents are confronted with permanent and transitory shocks. Even with full knowledge about the stochastic structure their best perception at any particular time will usually be erroneous. Prices for each period are set at the beginning of the period on the basis of market conditions. The realization of the shock process thus creates a short-run ‘disequilibrium’ absorbed by inventory adjustments. This adjustment translates perceived transitory monetary shocks into serially correlated output movements. The analysis proceeds within the context of rational expectations It offers a generalization of equilibrium analysis in two respects. Prices are always in equilibrium relative to perceived conditions, but they do not reflect all ongoing shocks. Quantity adjustments reflect the perceived transitory shocks. The framework used involves moreover a stock-flow interaction operated by inventory adjustments. The stock-flow interaction imposes at any time a future expected adjustment path (for price-level and quantities) to the systems unique stock equilibrium. A major implication of the analysis resolves a puzzle experienced in a recent paper by Robert Hall. It reconciles intertemporal substitution with lagged effects of monetary impulses. It also reconciles small and inconclusive cyclic movements in real wages with the occurrence of production function and large variations in unemployment. Lastly, the nature of the inference problem determined by the pattern of incomplete information produces serially correlated movements conditioned on large permanent shocks.

What’s Wrong With The IMF? What Would Be Better?

The International Monetary fund (IMF) and the World Bank were created in 1944 reflecting the experience of the 1920s and 1930s. The fund’s tasks were to adjust current account imbalances and manage the exchange rate system. The bank’s main tasks were to lend for the reconstruction of Europe and eliminate the alleged bias against lending to developing countries.

Major Issues in the Regulation of Financial Institutions

IL financial institutions in the United States are regulated to greater or lesser extent and are encumbered with restrictions that range from regulation of entry to restrictions on the purchase of particular assets and of the rate of interest paid on particular liabilities (Gies, Mayer, and Ettin, 1963). The owners of financial institutions are, in part, compensated by special treatment under the tax laws (Keith, 1963), so that the net effect of governmental laws and decisions on the volume of assets invested in financial institutions as well as the relative effect on the various specialized institutions is difficult to calculate. The effect on resource allocation of these restrictions and tax shelters is unknown also. The major issue about regulation is whether regulation achieves a desirable social purpose when both the costs and benefits of the restrictions are considered. Broad issues of this kind cannot be resolved abstractly. They require analysis of the effect of each of the restrictions and of the combined effect, since some may partially or totally offset the effect of others and some may impose no constraint. Unfortunately, there is no verified theory which permits a searching examination of the effect of regulation, so we must use a less satisfactory meth-