Monetary and Economic Studies Vol.5, No.2 / September 1987

On Monetary Stability and Monetary Reform

Allan H. Meltzer

The organizers have asked an important question, in my view, one of the most important questions - or more accurately set of questions - that can be asked of economists. How do we achieve greater stability? How big are the instabilities now, and how many of them are caused, or magnified, by current policy arrangements? Do fluctuating exchange rates augment or buffer shocks arising elsewhere, or are fluctuating exchange rates an independent source of disturbance? Can monetary reforms, domestic or international, increase stability without fiscal reforms, greater stability of trade policy and perhaps, either changes in political systems or fewer opportunities for politicians to influence economic events.
Alas, like most big questions, these questions (and others that might be asked) are much easier to pose than to answer. It is not difficult to develop optimal policies for a world in which all prices are flexible, information is costless, policymakers relentlessly pursue the public interest - and only the public interest - and we all agree on the arguments and parameters of a social objective function. The abstract world of economic theory is useful. We rely on it to guide our thinking and to increase knowledge and understanding. Unfortunately, economic analysis has not offered, and probably cannot now offer, more than conditonal answers to many of the questions. Some of the answers depend on empirical estimates, while others depend on more comprehensive models than we have yet developed or on a combination of the two - more comprehensive models and more data analysis.
To answer questions such as these, we need to specify a criterion or objective. I propose to use measures of variability - unanticipated variability - to compare altemative policy arrangements. I take as the proper objective of economic policy reduction of risk and uncertainty to the minimum level inherent in nature and trading arrangements. Risk and uncertainty are assumed to increase with unanticipated variability.
Critics of fluctuating exchange rates implicitly use variability as a criterion when they decry the variability of exchange rates. Unfortunately, the critics typically err in their use of the criterion by emphasizing the variability of real or nominal exchange rates. Variability of either nominal or real exchange rates is not evidence that an economy experiences excessive risk or bears an excess burden. The benefits of relative price changes are known to often exceed the costs. Despite greater variability of real exchange rates, or even as a result of such variability, fluctuating exchange rates may permit a country to reach an optimum.
To measure variability, I use the variance of unanticipated changes in output and the general price level. These measures are relevant for decisions to hold domestic or foreign assets or to hold money or real capital, so they affect the rate of interest, the intertemporal allocation of resources and the size of the capital stock. Excessive variability of output and prices contributes to the variability of returns, thereby raising the required rate of return on private investment above the minimum rate of return that society could reach.
Since past efforts to determine analytically whether fixed or flexible exchange rates are Pareto superior have been inconclusive, I have taken an empirical approach. In the following section, I restate some of the main arguments for fixed and fluctuating exchange rates and discuss the importance of variability. Both exchange rate systems can be operated under an inflexible rule, a flexible rule or with different degrees of discretion. Variability and uncertainty are affected by the choice between a rule and discretionary action. On this issue also, I present some evidence. The evidence suggests that discretionary action is likely to increase variability and uncertainty.
The empirical findings suggest that uncertainty can be reduced by developing rules for monetary policy. I propose a rule to increase domestic price stability while reducing exchange rate variability. A conclusion summarizes principal findings.

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 © 1987 Bank of Japan All Rights Reserved.

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