Monetary and Economic Studies Vol.1, No.2 / October 1983

Monetary Policy in an Uncertain World

James Tobin

Power attracts advice and criticism. These days central banks are the most powerful actors in the economic drama. Polls of American leaders rate Paul Volcker the second most powerful person in the United States. Outside military and diplomatic contexts, Chairman Volcker probably plays a more decisive role than the President himself. So if central bankers are receiving ever larger quantities of conflicting advice from citizens in general and economists in particular, that is testament to their recognized power. And if the counsels of the various critics cancel one another out, as may happen even at this conference and even in this session, then the central bankers can continue in good conscience to do what they would do anyway.
This conference is well-timed, for several reasons. First, the world economy is just beginning to recover from its worst depression since the 1930s; a strong and sustained recovery is still not assured. The monetary authorities of the leading economic powers, the United States, Japan, and the European Community, bear proximate responsibility for the depression, the byproduct of the severe counter-inflationary measures they felt compelled to take at the end of the 1970s. The immediate practical question is what role monetary policies should play in accommodating or promoting recovery.
Second, intellectual developments in macroeconomics converge with real-world events in raising just now some fundamental issues about the conduct of monetary policy. Monetarism, having won the hearts and minds of many economists and central bankers in the 1970s, may now be losing some adherents and influence-partly because of the depression, partly because regulatory, institutional, and technological changes have so clearly altered the meanings and velocities of monetary aggregates. Last summer and fall Chairman Volcker and his colleagues suspended their monetarist targets, to nearly universal relief. But no coherent philosophy of monetary control, no systematic strategy, has yet replaced them. What responsibility central banks should assume for recovery in this decade is a specific instance of a general issue, the weight that real macroeconomic performance should have in monetary policy decisions. A currently influential view is that monetary policies can and should aim solely at nominal, not real, outcomes.
Third, both recent experience and contemporary theory underscore the international dimensions of monetary policies. They will not be overlooked at a meeting here in Tokyo, with participants from several nations. Recent events in the United States played out with remarkable accuracy the textbook scenario for the effects of restrictive monetary policy in a world of floating exchange rates. High interest rates attracted funds to dollar assets and appreciated the home currency; deterioration of the U.S. trade balance was the major component of decline in final demand. Other countries have not welcomed the impacts on their interest rates, exchange rates, and prices. Rhetoric at Versailles and Williamsburg summits recognized the interdependence of our economies and financial markets and the need for coordination of macroeconomic and monetary strategies. But very little concrete progress is evident. In consonance or dissonance the major central banks together determine the international monetary environment and the general levels of interest rates throughout the world. None of the three "locomotives" can claim it is too small to influence the world economy. If in my discussion I fall into the old American habit of talking about one closed economy with one monetary authority, please interpret me as referring to the OECD as a whole and to the several leading central banks as a group.
My keynote remarks are divided into three Parts. Part I takes up the fundamental issue mentioned above, the place of real economic objectives in the making of monetary policy. I argue against the proposition that only nominal variables should concern the central bank. Part II discusses the hierarchy of ultimate objectives, intermediate targets, and instruments in relation to uncertainties monetary policy-makers face over various horizons. Part III discusses some current issues of policy connected with recovery from the world depression.

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 1983 Bank of Japan All Rights Reserved.

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