Tuesday, June 14, 2011

"Hayek on Why the Fed Cannot Create Inflationary Stimulus"

From John Carney at NetNet:
One thing that bothers me about the debate over monetary policy is that it is so stubbornly resistant to influence from reality.

I’ve tried over and over again to explain that the traditional mechanisms for stimulating the economy through monetary policy have simply broken down. But let me try again. 

In the standard, schoolbook model, increases in the money supply stimulate the economy because they create illusory profits. The demand for goods unexpectedly rises, pushing prices up. Businesses expand to meet this excess demand, hiring new workers, opening shops, and so on. The “extra profits” are invested. Stimulus!
A slightly more sophisticated version says that when interest rates are lowered, this stimulates business investment on the expectation that lower interest rates signal higher savings—which indicate there will be more wealth available for future consumption. 

But that didn’t happen this time around. The Fed lowered interest rates down to zero. And then it engaged in quantitative easing twice in an effort to provide monetary policy economic stimulus beyond the so-called “zero bound.” 

And none of this worked.
(Or rather, it didn’t work to stimulate the economy. It might have worked to achieve other goals, such as stabilizing the financial system.) 

So why has monetary policy become ineffective? The answer is simple: because we all understand monetary policy too well. 

Monetary policy can only have a stimulating effect if the rise in prices or fall in interest rates is unexpected and misunderstood. 

When monetary inflation is understood and expected, it doesn’t stimulate the economy. Instead, what you get is some version of stagflation....MORE