Monetary Policy Lessons of Recent Inflation and Disinflation

Abstract

I will consider the monetary policy lessons of the recent inflation and disinflation. The next section of this paper is devoted to the decline of M1 velocity after 1981 and the demise of the “standard” money demand function. Some authors conclude that this evidence leaves us so uncertain about the nature of money demand that policymakers cannot rely at all on any presumed money demand regularities. In contrast, my working hypothesis is that the money demand continues to be a stable function of relatively few variables, but that the interest elasticity of money demand is substantially higher than previously thought. Events have not been kind to Keynesian monetary policy positions either. Keynesians tend to concentrate on interest rates -- especially real interest rates -- as the best guide to the effects of monetary policy on the economy. The real rate is discussed in the third section of the paper. The fourth section is devoted to an analysis of the importance of market expectations about monetary policy, with a particular focus on how market expectations were influenced by the Federal Reserve's introduction of new monetary control procedures in October 1979. The fifth section of the paper contains an evaluation of the contribution of monetary policy to the disinflation of the 1980s. In the sixth and final section, I conclude with some comments on the implications of the previous sections for the debate on monetary rules.

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• Brown University US

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