Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 14 April 2013

Why a Dual Mandate is Essential

Monetary policy has two crucial roles. The first is to set the medium/long term inflation rate. Pretty well everyone understands this. The economy will not by itself settle down to an inflation rate of 2% or whatever - it needs monetary policy to set this rate and help achieve it.

The second is to ensure that aggregate demand matches aggregate supply. Now here there is sometimes confusion, even among the best economists. [1] The basic idea is that there is a ‘natural’ level of output determined by supply side factors, like how much people want to work, the degree of monopoly in the labour market, the state of technology etc. [2] There will be a real rate of interest associated with this level of output, which we can call the natural interest rate. On the other hand how much firms produce in the short run is largely determined by aggregate demand: firms tend to set prices, and do not ration demand. There is no reason why aggregate demand has to equal supply in the short run in a monetary economy. The difference between actual output and natural output is the output gap. If the output gap is not zero, problems will arise. For example with excess demand we get inflation, and with deficient demand we can have wasted resources and the misery of involuntary unemployment.

Aggregate demand depends on real interest rates. As monetary policy can influence real interest rates in the short run, then its job is to try and match aggregate supply and demand, by bringing the real interest rate as close as possible to the natural interest rate. [3]

These two roles for monetary policy map nicely into the two objectives macroeconomists typically ascribe to policy makers: minimising excess inflation and the output gap. With two goals there will also be conflicts, producing a trade-off between short run inflation stability and eliminating the output gap. Macroeconomics has extensively examined what to do when these conflicts arise.

A permanent non-zero output gap is not compatible with stable inflation in the long run. As a result, it is possible to reduce both roles to one single objective, the stabilisation of inflation, as long as that stabilisation is done ‘flexibly’. Hence the idea of a single, but flexible, inflation target. I now believe having only an inflation target, or making it 'primary', is an important mistake for two reasons. We can label each mistake as MPC and ECB for short.

The first (MPC) is due to persistent shocks to the relationship between the output gap and inflation (or equivalently to the Phillips curve). This sets up a potential conflict between the two goals. Although we know how to optimally deal with this conflict, the policy that results can appear inconsistent with inflation targeting, which puts a strain on an inflation targeting policy. The problem can be ‘solved’ by making inflation targeting even more ‘flexible’, but this in turn makes the policy less clear.

Of course macroeconomists have always acknowledged this possibility, but have thought that the impact of excess or deficient aggregate demand would always be strong enough for this not to matter in practice. However, as the recent IMF study I discuss here shows, either low inflation or credible inflation targets (or both) seem to have weakened the impact of the output gap on inflation, which makes the problem of persistent cost-push shocks more important. This has been the problem the MPC in the UK have been grappling with in recent years, and I believe the lack of a dual mandate has made their decisions less optimal. More generally, as Paul Krugman says here, thinking that stable low inflation must mean everything is OK could be very wrong.

The second (ECB) is that, in the wrong hands, the flexible inflation targeting regime can become a severely non-optimal policy that pays too little (or asymmetric) attention to the output gap, even in the absence of supply side shocks. In academic language, we could express this in terms of Rogoff’s conservative central banker (giving less weight to the output gap than the public does), but it also allows bad policy enacted by an incompetent central bank (that does not understand the importance of the output gap) or a malevolent central bank (that wants to achieve its own objectives that may not just involve hitting an inflation target).

There is a nice quote by Duisenberg from February 2003 contained in this paper by Jörg Bibow (page 35) that a comment from an earlier post pointed me to. In discussing what price stability meant, he said it “implies that, in practice, we are more inclined to act when inflation falls below 1% and we are also inclined to act when inflation threatens to exceed 2% in the medium term.” [4] Now Andrew Watt and others would argue that this is not a good reading of the ECB’s actual mandate, but it seems to me a good reading of what they actually do, and it is one that a single rather than a dual mandate helps them to get away with.

So what is the objection to a dual mandate? As it reflects how an academic thinks about monetary policy, it should not lead to suboptimal policy in the hands of an informed and benevolent policy maker. So the fear must be that it will misdirect an uninformed policy maker, and encourage non-benevolent behaviour. The exemplar here is the 1970s, but for reasons I discussed here, I do not think that period should be used as evidence against the dual mandate. I discuss here why I think the standard inflation bias story is also overrated in this respect.

Is there any evidence that the US with its dual mandate has done better compared to inflation targeters? There has been some discussion of that recently (e.g. here and here), although the data analysis is not very sophisticated. [5] Until we see good evidence that having a dual mandate worsens outcomes, then I believe the presumption must be that the dual mandate is better because it reflects the two goals of monetary policy.

My argument here concerns higher level objectives. It is not about how best to achieve those objectives, which is where I would locate questions about the wisdom of nominal GDP targets. It does not address the relative weight that the two objectives should have, or the extent that the objectives should be vague or concrete. My own view is that the benefits of a publicly announced inflation target are overwhelming - indeed so much so that I recently forgot how new this ‘innovation’ was for the Fed. How best to express the goal of matching aggregate demand with supply is more difficult, because of the uncertainties involved in measuring the output gap. However output gap uncertainty is not so great that we should ignore the concept, and so this uncertainty cannot justify a single inflation mandate. There are lots of things in life that are difficult to define, but which are still worth striving for.

[1] See, for example, Brad DeLong here. The reasons for this confusion are interesting, but I have speculated on this elsewhere and do not want to get distracted. Of course none of this implies that the natural level of output and its associated interest rate need be in any sense optimal or efficient, but that should be a different and separable question.

[2] There is nothing mysterious about the natural level of output. It is the output which pretty much every macroeconomist not investigating problems of aggregate demand analyse. It could be called the level of output that comes out of an RBC model, for example. It is often described as the level of output that would occur if prices were completely flexible, and here I do have a quibble, because at a zero lower bound and with inflation targets I cannot see how increasing the flexibility of prices will ensure that output reaches the natural level.

If monetary policy cannot do this, then fiscal policy can help reduce the output gap. We could describe this as fiscal policy raising the natural interest rate, but an equivalent and more intuitive description is that fiscal policy just raises aggregate demand.

There are plenty of caveats to this econ 101 account, such as the possibility that actual output might have an influence on longer term aggregate supply.
[4] If the implied asymmetric differentiation between actual and possible future here was a slip, I’m tempted to suggest it was a Freudian one.

For example, MPC decisions since the recession have tended to define flexibility as ‘seeing through’ actual inflation and focusing on expected inflation two years out. Inflation targets then become a constraint when the impact of cost-push shocks persist for two years or more.


  1. I'm afraid I laughed when you said output gap uncertainty was "not so great"! The OBR Budget report this year had independent estimates of the 2012 output gap ranging from -6% to -0.8%. That's "not so great"?

    1. Not so great that it does not tell you anything. It tells me that if forecast inflation is at or near target, monetary policy should be trying to stimulate the economy. But with only an inflation mandate, nothing happens.

  2. I really enjoyed this post.

  3. “Aggregate demand depends on real interest rates.” If an interest rate cut induces more borrowing, then demand will rise. But suppose everyone is deleveraging beceause they’ve had their fingers burned in a recent credit crunch. In that case doesn’t the interest rate cut lose some or all it’s traction?

    The base rate was 5% up to mid 2008 and then declined to 0.5% in early 2009. And the effect on M4 borrowing? Having expanded at about 12%pa up to early 2009, it then collapsed and was CONTRACTING by about 5%pa by mid 2012.

    That’s not so much “loss of traction” as “inadvertently going into reverse gear”.

  4. Maybe I should be more verbose... I think that many central banks have been far too focused on inflation, including the US. In retrospect, I have wondered whether the US Fed has not only been too strident in its anti-inflation bias both in the current depression and also the early 2000s.

  5. derrida derider16 April 2013 at 08:21

    Nice stuff. But it misses, IMO, a really important point - even if you believe in a single mandate the number in your mandate really matters. Yes, high rates of inflation tend to high volatility, but the difference in volatility between a 2% and 4% target is pretty small, at least in terms of welfare losses.

    But on the other hand the output volatility of a higher target rate is less - partly because of Bob Solow's point about the MICROeconomic effect of downward nominal wage inflexibility (ie about ease of relative rather than aggregate wage adjustment) and partly because of Blanchard's "keep well clear of a liquidity trap so your monetary policy always keeps traction". And of course output volatility has very large welfare effects. I can understand the attraction of inflation targeting, but I can't understand the attraction of a very low target.

    1. I am not an economist, so I'm probably missing something important that took place over the last twenty or so years. My memory (which is not the most reliable tool in the box) is that since I was a kid, that is since World War II, we had regular inflation, except for the 1970s, of about 3.5-5% a year. Even in the early 2000s I seem to recall a Social Security COLA of over 3%, and nobody was terribly concerned about hyperinflation. The less than 2% we've seen over the last five years is a frightening anomaly in my world. So when did 2% become the norm, and does anybody besides me think that is 'way too low a target? It sounds more to me like a target set by the Bank of Japan, except their behavior over the last twenty years suggested their real target ow 0% and they jumped on the brakes any time it threatened to go over that, so they've had this mild deflation for so long.

  6. 1. Fully agree about a publicly anounced inflation target.
    I would probably favour something like 2% (or close) and over a period of 10 year. Which would give the CB some room to play with. Limits possibility of abuse (things seem always biased in the for the decisionmaker most beneficial (including political orientation) direction).
    It would for a big part stabilise things, as a plus now must be compensated by a minus and visa versa. Although markets seem to have a very short horizon at the moment. Anyway add a sort of (informal or formal if you like formula) as direction and things can be priced in (and make prices less volatile). Stable (not volatile) prices in general beneficial, for consumer confidence and for investing in real stuff be it houses or factories.

    2. I am not yet convinced whether or not a dual mandate is the best solution:
    a. In more general terms it looks clearly less of a problem at least in a seperate country than in a dysfunctional monetary union like the EZ. Where you bump directly into a lot of political problems.

    b. By serving 2 masters you often end up in a mess (think it was Tinbergen who said something very similar). There is clearly a problem here. Which one is given priority when things colide? At the end of the day the choice which one first and by how much is a political one.
    How to deal with other imbalances, like current account, or bubbles.
    Who determines the figures things are based upon?
    I am a bit reluctant here. Would rather see some rules that guarantee things be publicly announced at least in a rough form.
    Combined with an independent agency who provides the data (bit like inflation in that respect).
    Maybe with inflation the primus inter parus or even only the primus.
    Also the collision with especially bubbles and other imbalances is an issue. Like we see governments act way too slowly on that.

    The split of of monetary policy is imho partly artificial. In the EZ one could argue that debt, or current account deficits or competitiveness are at least as big a problem. or some of the bubbles we have seen. They likely are.
    Which means that the optimum total (monetary, fiscal and economic in general) policy might have to focus on these inbalances iso outputgaps. Like we see now in the US the stockmarket is bubbling creating a considerable future problem. Gains/profits now will basically not be made in the future and that will lateron be priced in. Or the RRE market a huge part of the present crisis also caused for a large part by too friendly CB policies.

    Or cut the mandate with standard tasks like inflation. And other tsks that could be done when requested/demanded by government or another institution or in cooperation with. More an operational point.

    The problem with CBs as I see it that they often try too hard and the situation like now with the stockexchanges going through the roof while the real economy, consumers and investors is completely depressed. Not only governments should be protected for trying too hard and not only politicians have alterior motives.
    Some checks and balances might not be a bad idea here as well. Usually gives more stable systems.

    An optimum solution will never be reached as we donot know how the following crisis will look and what caused them. Should be a system that works in a general sense.

  7. Regarding the "natural rate" of output being determined by supply-side factors: what about Hysteresis, which Larry Ball has shown to be a real and big problem?

    1. I very much agree, which was what I had in mind with the last sentence of footnote [3]. Hysteresis seems to clearly strengthen the case for a dual mandate.

  8. I am only an undergraduate and hence I do not know much "advanced economics", but I came to realise that measures of the output gap are not entirely reliable.
    So my question is, well, the same way sometimes undergraduate macro models do better than complex, microfounded ones, at least as far as I have read and heard, why not look and combine easier to read and measure indicators, not only unemployment as I have seen, but mainly stock building agains consumption and average wages (specially for low-paid jobs)?


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