April 26, 2022

Learning from the Pandemic Monetary Policy Experiment

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Abstract

In response to the pandemic, which unfurled starting in March 2020 and raised unemployment dramatically, the FOMC adopted a highly expansionary monetary policy.  The policy restored the activist policy of aggregate demand management that had characterized the 1970s.  It did so in two respects.  First, the FOMC rejected the prior Volcker-Greenspan policy of raising the funds rate preemptively to preserve price stability.  Second, through quantitative easing, it created an enormous amount of money by monetizing government debt.  In the 1970s, activist policy was destabilizing.  Reflecting the “long and variable lags” phenomenon highlighted by Milton Friedman, a temporary reduction in unemployment from monetary stimulus gave way in time to a sustained increase in inflation.  In response, the succeeding Volcker-Greenspan FOMCs rejected an activist monetary policy in favor of a neutral policy.  That policy concentrated on achieving low trend inflation and abandoned any attempt to lower unemployment by exploiting the inflation-unemployment trade-offs promised by the Phillips curve.  The success or failure of the FOMC’s activist monetary policy offers yet another opportunity to learn about what kinds of monetary policies stabilize or destabilize the economy.

JEL codes: E, E4, E5, E42, E51, E52, E58

Keywords: monetary policy, Federal Reserve System; Jerome Powell, Arthur Burns, Paul Volcker, Alan Greenspan, William McChesney Martin, monetarism, Phillips curve, NAIRU, flexible average inflation targeting, stop-go, Milton Friedman, money, inflation, M2, Federal Open Market Committee, rules versus discretion