Why Does Countercyclical Monetary Policy Matter?

BY SATYAJIT CHATTERJEE

countercyclical monetary policy. odern capitalistic economies use stabili- The source of this develop- zation policies to minimize fluctuations in ment is the same as that which M underlies most major developments in the unemployment and inflation rates. In macroeconomics in the last half- century, namely, the desire to ground the United States, the Federal Open Market Com- macroeconomics in sound theoretical foundations. As in the other sciences, mittee (FOMC) lowers the target interest rate for “sound theoretical foundations” means explaining macro-level phenomena in interbank loans as economic activity slows or when terms of micro-level phenomena; for example, using theories of household a financial crisis looms (as in the fall of 1998) and and business behavior to explain the behavior of, say, aggregate consumer raises it when inflation threatens to accelerate (as spending or aggregate business in late 1999 and early 2000). investment. The desire for micro- foundations also means that macro- level policies (such as countercyclical monetary policy) need to be justified in terms of micro-level effects — how Such countercyclical monetary policy ment and inflation rates. In contrast, such policies ultimately benefit is one example of a stabilization policy. macroeconomists have directed much households. Surprisingly, the link Other examples of U.S. stabilization less effort to understanding why between less macroeconomic volatility policies include the federal insurance countercyclical monetary policy is and improved household well-being of bank deposits (and the concomitant beneficial. This neglect reflects the has proven weaker than many supervision and regulation of banking) fact that, until recently, macro- macroeconomists might have sup- and income-maintenance programs, economists of very different persua- posed. such as unemployment insurance. sions agreed that policies aimed at Concerns about the benefits Macroeconomists have reducing the volatility of unemploy- of countercyclical monetary policy devoted much effort to understanding ment and inflation are desirable. Of (and of stabilization policies in how countercyclical monetary policy course, economists disagreed about general) are obviously of great impor- affects the volatility of the unemploy- what form those policies should take, tance to the Federal Reserve System. but no one questioned the premise My purpose in this article is to that a less volatile macroeconomic accomplish two tasks: to state clearly Satyajit Chatterjee environment was a desirable policy the mainstream view of the supposed is an economic goal. benefits of countercyclical monetary advisor in the That is no longer the case. policy and the challenge posed to it by Research Depart- During the last dozen years or so, an recent microfoundations-oriented ment of the influential minority of macroecono- research; and to consider how this Philadelphia Fed. mists has questioned the supposed challenge may alter our views about benefits of reducing volatility and, by the benefits of countercyclical mon- implication, the supposed benefits of etary policy. www.phil.frb.org Business Review Q2 2001 7 A PRIMER ON MAINSTREAM actual unemployment rate threatened able; it can only be inferred from long- MACROECONOMICS AND to exceed the natural rate and raise term trends in the economy. Thus, ITS POLICY IMPLICATIONS them whenever the opposite hap- policymakers will sometimes judge a Let’s begin with a brief pened. If this policy were successful, change in the unemployment rate to account of how mainstream macroeco- the actual unemployment rate would be a deviation from the natural rate nomics makes sense of countercyclical track the natural unemployment rate when, in fact, it reflects a change in monetary policy.1 In the mainstream closely. Since the natural unemploy- the natural rate itself, or vice versa. In view, the actual unemployment rate such situations, countercyclical can deviate from the natural, or long- monetary policy will make the inflation term, unemployment rate. This natural “How much would an rate more volatile, not less. For rate is determined by factors that instance, a persistent attempt to change slowly, such as demographics, average person in the reverse a decrease in the natural technology, laws and regulations, and U.S. pay to avoid all unemployment rate will lead to social mores. Because markets don’t deflation, and a persistent attempt to work perfectly, there can be extended cyclical volatility in reverse an increase in the natural periods when the actual unemploy- aggregate U.S. con- unemployment rate will lead to ment rate exceeds the natural rate. sumer spending?” inflation — both of which reduce During such times, mainstream public well-being. Thus, misper- macroeconomic theory predicts that Robert E. Lucas, Jr. ceptions concerning the natural rate the inflation rate will fall because may lead to policy errors. aggregate demand for goods and Third, mainstream macroeco- services will tend to fall short of ment rate changes only gradually over nomics recognizes that the effects of aggregate supply. At other times, the time, the result would be a less volatile monetary policy actions are felt with unemployment rate can fall below the actual unemployment rate. Without long and variable lags. Uncertainty natural rate, and during those times, persistent gaps between the actual and about the length of time it takes for theory predicts that the inflation rate natural unemployment rates, the policy to have an effect on the will rise because aggregate demand will inflation rate would also be less economy is another potential source of tend to exceed aggregate supply. Ac- volatile. Generally speaking, house- policy errors. cording to mainstream macroeconom- holds and businesses do not care for ics, business cycles are a manifestation volatility in the unemployment rate or STANDARD OF LIVING AS A of these deviations between the actual inflation rate, so such a policy would CRITERION FOR EVALUATING and natural unemployment rates. enhance public well-being. MACROECONOMIC POLICY This mainstream view of However, the mainstream The fact that countercyclical business cycles provides the rationale view acknowledges some important monetary policy has both benefits and for countercyclical monetary policy. limits on the scope of countercyclical costs suggests that it’s important to Suppose that the monetary authority monetary policy. First, countercyclical find out whether the benefits exceed uses monetary policy to eliminate the monetary policy cannot change the the costs to determine if such policies gap between the actual and the natural level of the natural unemployment rate are worth pursuing. University of unemployment rates. In practice, the directly. As noted earlier, the natural Chicago economist and Nobel laureate monetary authority would lower short- unemployment rate is determined by Robert E. Lucas, Jr. was the first to term interest rates whenever the factors such as technology, demograph- explore this issue in the context of the ics, laws and regulations, and social U.S. economy. Lucas observed that mores. Effective countercyclical cyclical volatility in the unemployment monetary policy may provide an and inflation rates per se is not 1 Some textbooks call this theory the New environment that is conducive to important to people. What really Keynesian or IS-LM approach to macroeconom- innovation (and therefore the advance matters is the resulting cyclical ics. But labels can be misleading; for instance, Bradford De Long calls the same theory a of technology), but it does not have a volatility in people’s standards of subspecies of monetarism. To avoid confusion I direct effect on the natural unemploy- living. Since consumer spending is one call it the “mainstream view” because it is the ment rate. of the most commonly used indexes of view that characterizes a broad swath of academic macroeconomics and virtually all of Second, the natural unem- living standards, Lucas posed the policy-oriented macroeconomics. ployment rate is not directly observ- question: “How much would an

8 Q2 2001 Business Review www.phil.frb.org average person in the U.S. pay to avoid burden falls disproportionately on household in two ways: the probability all cyclical volatility in aggregate U.S. people who become unemployed of job loss for employed members and consumer spending?” From the perspec- during recessions. Taking this fact into the probability of job gain for unem- tive of mainstream macroeconomics, an account is likely to raise estimates of ployed members. For instance, during a answer to this question provides an the maximum potential benefit of recession, when the unemployment estimate of the maximum potential countercyclical monetary policy. rate is relatively high, the probability of benefit from the Fed’s pursuit of However, such criticisms miss job loss for employed workers is also countercyclical monetary policy.2 a deeper point: Lucas’s insistence that relatively high, and the probability of As one would expect, the the benefits of countercyclical mon- job gain for unemployed individuals is answer depends on how much etary policy be judged from the effect relatively low. Thus, all individuals households dislike random fluctuations such policies have on the welfare of face a higher risk of lost earnings. in their standard of living (i.e., on their individual households. As he put it: Conversely, during an economic degree of risk aversion), and Lucas “[A]n economic system is a collection expansion, the probability of job loss experimented with a variety of of people and serious evaluation of for employed workers is relatively low, estimates, some more plausible than economic policy involves tracing the and the probability of job gain for others. What he found was that a consequences of policies back to the unemployed workers is relatively high. person would be willing to pay rather welfare of the individuals they affect.” Thus, all individuals face a lower risk small amounts to avoid all fluctuations This quote succinctly expresses one of of lost earnings. If countercyclical in the aggregate standard of living. the core principles of microfounda- monetary policy successfully keeps the One estimate, based on a plausible tions-oriented research: volatility in unemployment rate equal to the amount of risk aversion, implies that a person would pay no more than $23 per year for such a benefit! Such a “An economic system is a collection of people paltry sum makes it hard to build a case for countercyclical monetary and serious evaluation of economic policy policy. involves tracing the consequences of policies Of course, Lucas’s finding back to the welfare of the individuals they that cyclical volatility is not very painful was (and remains) controver- affect.” sial. For one thing, economists were Robert E. Lucas, Jr. quick to note that the degree of risk aversion can be judged in a variety of ways, and some of these alternative the unemployment and inflation rates natural rate over time, the probability ways suggest that the gains from should concern policymakers only if it of job loss for employed individuals and eliminating all cyclical volatility in results in unacceptable volatility in the the probability of job gain for unem- consumer spending are several standard of living. As I explain in the ployed individuals would be less hundred-fold larger than Lucas remainder of this article, evaluating variable. So an effective counter- estimated. Also, as Lucas himself policies based on the standard of living cyclical monetary policy reduces the noted, his calculations assumed that all has surprising implications for the volatility of household earnings by households share the burden of benefits of countercyclical monetary reducing fluctuations in the risk of business cycles equally. In reality, the policy. unemployment. How does a reduction in the SELF-INSURANCE AS A volatility of earnings affect fluctuations SUBSTITUTE FOR in a household’s standard of living? 2 The answer provides only an estimate of the COUNTERCYCLICAL Suppose that a household always maximum potential benefit for two reasons. MONETARY POLICY spends the full amount of its monthly First, it ignores the costs of policy errors. Second, it ignores the fact that some portion of Let’s examine how reducing earnings and does not borrow or save. the volatility in consumer spending should be the volatility of the unemployment In this case, fluctuations in consumer excluded from the benefit calculation because it rate affects the volatility of consumer spending will exactly match fluctua- stems from fluctuations in the natural unemployment rate and cannot be eliminated spending. Fluctuations in the unem- tions in household earnings, and a by countercyclical monetary policy. ployment rate affect members of a policy-induced reduction in the www.phil.frb.org Business Review Q2 2001 9 volatility of household earnings will have induce households to reduce the savings probability of job loss, the gain in well- a direct and equal effect on the built up to protect against such volatility. being would be around $69 per person volatility of consumer spending. These two effects have opposing per year.6 Although larger than Lucas’s But what if households save consequences for the volatility of estimate, the gain was still quite or borrow? Then, consumer spending consumer spending. The first effect small.7 As Imrohoroglu noted in her may not fluctuate as much as earnings. lowers the volatility of consumer article, her findings reflected the fact If a member of the household becomes spending while the second raises it.4 that individuals in her artificial temporarily unemployed, the house- What will the combined economy self-insured themselves pretty hold may draw on a pool of savings effect be? Theory predicts that the first well against temporary spells of (built up over the years for such an effect will dominate and the volatility unemployment. As a result, although eventuality) to protect its standard of of consumer spending will decline. effective countercyclical policy did living. So, consumer spending will not But theory also suggests that this reduce the volatility of consumer fall as much as earnings. When the decline will be minor. In other words, spending, the resulting gain in well- member regains employment, house- private stocks of savings are a partial being was minor.8 hold spending will not rise as much as substitute for the beneficial effects of What about volatility in the earnings because a portion of the countercyclical policies: an improved inflation rate? From a household’s earnings will be used to replenish the countercyclical policy partly substitutes point of view, inflation volatility could savings drawn down during unemploy- for actions that a household takes to be important because it affects the ment. Building up and maintaining a deal with the ill effects of earnings volatility of the real return on financial stock of savings to protect oneself from volatility.5 assets, the assets that households use temporary spells of unemployment or The significance of self- to self-insure against temporary loss of unanticipated expenses is called self- insurance for assessing the benefits of earnings. If the expected real return on insurance.3 countercyclical policy was first these assets is poor, it will blunt the A surprising implication of recognized in an article published in self-insurance is that it weakens the 1989 by Ayse Imrohoroglu. Imro- ability of countercyclical monetary horoglu simulated an economy in policy to improve public well-being which individuals could borrow and 6 Even if countercyclical monetary policy because, from a household’s point of save to protect their living standards in manages to keep the unemployment rate view, self-insurance is a partial substi- the face of temporary spells of unem- constant, an individual’s earnings may still tute for countercyclical monetary ployment. Her simulations showed fluctuate over time because of the possibility that an individual may lose his or her job. Thus, policy. To see this, suppose the that even if countercyclical policies even when monetary policy is perfect, monetary authority introduces a new made the unemployment rate constant households have to self-insure against temporary spells of unemployment. countercyclical policy that lowers the and ensured that each individual faced volatility of household earnings. Faced a constant (rather than fluctuating) 7 In her article, Imrohoroglu presented results with lower volatility of earnings, a from several different simulations. The result reported here is for the simulation where household will have an incentive to individuals borrow at an annual real interest lower its stock of savings. Recall that rate of 8 percent and save at a real interest rate of 0 percent. Like Lucas’s, Imrohoroglu’s these savings were accumulated, in 4 It will raise the volatility of spending because, calculations provide an estimate of the part, to protect living standards from all else remaining the same, a lower stock of maximum potential benefit from countercyclical shortfalls in earnings; however, lower savings means that a household is less able to monetary policy. She ignores the potential costs protect living standards in case of a loss in of countercyclical monetary policy, and she earnings volatility means that such earnings. assumes that a fully effective countercyclical situations arise less often. policy corresponds to no fluctuations in the 5 That being said, it’s important to recognize unemployment rate. Thus, improved counter- that some households may not be in a position cyclical policy will have two effects: it to self-insure. For instance, a poor household 8 Improved countercyclical policy permits will reduce the volatility of a living hand-to-mouth is not going to be able to households to lower savings. The additional self-insure and will benefit substantially from a one-time increase in consumer spending household’s earnings, and it will less volatile macroeconomic environment. But permitted by the decline in savings is another such households do not constitute the majority. benefit of improved countercyclical policy. But a Furthermore, there are social programs in place one-time increase in consumer spending cannot that attempt to deal directly with the many permanently improve well-being. For permanent 3 causes and consequences of poverty. Given improvements, one must look at how improved Building up savings includes the case of paying these programs, the appropriate goal of countercyclical policy affects the volatility of off debt to keep open the option of borrowing monetary policy is to concentrate on improving consumer spending. But that effect, as already more in the future. the well-being of the typical household. noted, is minor.

10 Q2 2001 Business Review www.phil.frb.org incentive to self-insure. In a sequel to employment is often mitigated by state should probably be greater” (Touche her first article, Ayse Imrohoroglu and unemployment insurance programs and Ross, 1989, p.10). Perhaps because of this Edward Prescott used simulation by the progressive nature of the federal commonsense aspect, surveys of techniques to investigate the impact of tax code (tax liabilities fall faster than household finances show that saving inflation volatility on public well-being. earned income). From a household’s for emergencies is the most important Assuming that fluctuations in the perspective, self-insurance is also a reason cited for saving. These surveys expected inflation rate led to opposite substitute for social insurance programs also find that a household’s stock of fluctuations in the expected real return and so raises troubling questions about financial wealth is very volatile, even on assets, they found that inflation the net benefits of these programs as over short periods. Furthermore, volatility had virtually no adverse well. However, Ayse Imrohoroglu and studies show that households that face effect on well-being.9 As they noted in Gary Hansen have shown that even if greater uncertainty about earnings their article, what mattered most to households self-insure, unemployment tend to accumulate more financial people in their model was the average insurance programs are generally quite wealth. expected real return on financial beneficial, at least as long as the All these findings are assets, not the volatility of the ex- programs don’t adversely affect people’s consistent with households’ using pected real return. desire to seek work. financial wealth as a buffer against In short, both theory and random shocks to income and ex- simulation results suggest that self- penses. In addition, self-insurance insurance acts as a partial substitute accounts for several puzzling patterns for effective countercyclical policies. In short, both theory in consumer spending. It would take us Households can protect their standard and simulation results too far afield to discuss all of these of living from temporarily low earnings suggest that self- here, but one is worth mentioning. by drawing on a pool of savings built Researchers have known for some time up for such eventualities. If they do insurance acts as a that a typical household does not begin not have savings, they can borrow, partial substitute for to save for retirement until fairly late then repay the debt when earnings go in life. This late start in providing for back to normal. In such a situation, effective counter- retirement has puzzled economists improvements in countercyclical cyclical policies. because it seems inconsistent with policy partly substitute for private forward-looking behavior. However, actions that people take to contain simulations have now shown that self- volatility in their standard of living. insurance may dominate other motives Consequently, the net effect on public Before we take the policy for saving until an individual reaches well-being is not as large as one might implications of self-insurance seriously his or her late 40s. It’s only in late otherwise suppose. we must ask if, theory and simulations middle age that retirement-related Of course, the decline in aside, households really do self-insure. considerations surface as the main household income due to loss of Fortunately, a body of evidence now determinant of savings behavior. Thus, speaks to that question.10 First, self- self-insurance may go a long way insurance accords with common sense. toward accounting for the puzzling For instance, one financial planning delay in providing for retirement.11 From a theoretical point of 9 The real return on financial assets depends on guide recommends that households the difference between the yield (or interest accumulate a stock of savings to deal view, self-insurance is a basic outcome rate) on these assets and the inflation rate. with uncertainty: “It is generally held of forward-looking behavior, and the According to mainstream macroeconomics, the real return on financial assets is countercyclical. that your liquid assets should roughly idea played a key role in Milton The yield on financial assets does not rise as equal four to six months’ employment much as the inflation rate when the unemploy- ment rate falls below the natural rate, and it income. If you are in an unstable does not fall as much as the inflation rate when employment situation…the amount the unemployment rate rises above the natural rate. The article by Imrohoroglu and Prescott examined the extreme case in which the 11 This result emerges because self-insurance interest rate on financial assets stayed constant, requires that households save in safe financial so that any change in the expected inflation rate assets, the return on which is usually low. The led to an equal and opposite change in the 10 This discussion draws heavily on Christopher low return discourages saving for retirement expected real return. Carroll’s 1997 article on the subject. until late middle age. www.phil.frb.org Business Review Q2 2001 11 Friedman’s Nobel Prize-winning work side-effect of self-insurance: unbridled and does, happen on a larger scale. on the theory of consumer spending.12 self-insurance can be a source of Indeed, it’s what happened to many It’s remarkable that although macro- macroeconomic instability. A simple U.S. communities during the Great economists have been aware of self- example illustrates how this can Depression. insurance since the 1950s, its signifi- happen. This example highlights the cance for countercyclical monetary Imagine a small community point that actions that are beneficial policy remained unappreciated until served by a single bank. The bank from an individual’s point of view can the late 1980s. In all likelihood, the accepts deposits from local households be self-defeating when taken simulta- reason for this lies in the fact that for a and uses those deposits to make loans neously by many. The effect of a single long time, the criteria for evaluating to local businesses. Imagine also that household’s increasing its savings to countercyclical policies made no direct there is no federal insurance of bank self-insure against a heightened reference to living standards. When deposits or unemployment insurance. possibility of job loss is quite different Lucas insisted that macroeconomists A bank deposit is one financial asset from the effects of all households doing use living standards as a criterion for that households use to self-insure the same. A simultaneous increase in policy evaluation, the significance of themselves; another is cash. Under the desire to self-insure may be self- self-insurance quickly became appar- normal circumstances, a bank deposit defeating because it can make the ent. is the preferred financial asset for self- event against which insurance is insurance, since it accrues interest and sought more probable. John Maynard SO WHY DOES COUNTER- cash does not. Keynes observed long ago that an CYCLICAL MONETARY Now imagine that some economy in which saving and invest- POLICY MATTER? shock adversely affects many busi- ment decisions are carried out by Self-insurance raises doubts nesses in this community. Some different sets of people is susceptible to about the goals of countercyclical businesses close; some people become the paradox of thrift: if all individuals monetary policy as conceived by unemployed; and those that still have attempt to save more cash (so that the mainstream macroeconomics. Since jobs face a higher probability of job additional savings do not lead to a households can self-insure against the loss. The logic of self-insurance says corresponding increase in business adverse effects of earnings and that the employed will increase their investment), aggregate demand will inflation volatility, and the evidence savings to offset the heightened fall and so will income and savings.13 suggests that they do, policy-induced probability of job loss. As households Once we recognize that a reductions in earnings and inflation reduce their spending, businesses in simultaneous increase in the desire to volatility are predicted to yield only a the community will experience a self-insure could destabilize the minor improvement in public well- further fall in sales. The decline in economy, the current U.S. policy being. One could conclude from these sales will send more firms out of arrangement begins to make more findings that improving countercyclical business, causing more unemployment sense: self-insurance is only part of the monetary policy is not worth the cost; and making households even more solution to reducing earnings volatility. monetary authorities should de- eager to self-insure. Some of the burden of providing emphasize reducing volatility and If business failures continue, insurance against loss of earnings is concentrate on other monetary policy households will begin to think that the borne by the government through the goals, such as maintaining a low rate of next business to fail will be the bank, other two prominent stabilization inflation. However, such a conclusion and they’ll rush to convert their policies mentioned in the introduc- overlooks a potentially devastating savings into cash. The bank may well tion: federal insurance of bank deposits be sound, but the large-scale with- and state-run unemployment insur- drawals of deposits will cause it to fail. ance programs. Deposit insurance The bank failure will deprive local eliminates the need for households to 12 The idea also attracted the attention of businesses of a source of credit and, economic theorists, most notably Truman thus, force even more businesses to Bewley of Yale University. In a series of articles close. This cycle of falling demand, published in the 1970s, Bewley provided a wide- ranging discussion of the implications of self- rising unemployment, more hoarding, 13 The possibility that individually rational insurance. More recently, macroeconomists and further decline in demand is an actions can have bad social consequences is a have picked up where the theorists left off. recurring theme in economics. For a wide- Influential articles by macroeconomists include economic crisis. The sequence of events ranging and very readable discussion of this those by Mark Hugget and S. Rao Aiyagari. in this hypothetical community can, theme, see Thomas Schelling’s book.

12 Q2 2001 Business Review www.phil.frb.org self-insure in the form of cash, and away from the natural rate, market suggests that if counter-cyclical policy unemployment insurance permits forces eventually bring the unemploy- eliminates even a very small likelihood households to face a higher probability ment rate back to the natural rate. of a Great Depression-like event, the of job loss with greater equanimity. The cycle of rising unemployment, resulting gain in living standards can Both programs attenuate the poten- more hoarding, and more unemploy- be quite significant. We estimate that a tially destabilizing effects of house- ment that I highlighted earlier is person would pay as much as $1,380 holds’ response to heightened eco- assumed to be impossible.14 But there per year to eliminate a once-in-83- nomic insecurity. is no theoretical presumption that years chance of living through a The benefit of countercyclical market economies are necessarily self- Depression-like event.16 Thus, if monetary policy can also be under- regulating. It’s possible to construct countercyclical monetary policy does stood in these terms. By attempting to macroeconomic models in which the nothing other than prevent economic reduce the volatility of the unemployment forces of self-regulation are weak crises, that benefit alone may provide rate, countercyclical monetary policy enough that adverse shocks precipitate an adequate justification for pursuing makes it less likely that households will economic crises.15 Whether the forces it. face a large simultaneous increase in the probability of job loss. In other words, countercyclical monetary policy helps By attempting to reduce the volatility of the to nip the problem of macroeconomic instability in the bud. One might think unemployment rate, countercyclical monetary that with two other stabilization policy makes it less likely that households will policies in place, it’s unnecessary for face a large simultaneous increase in the monetary policy to attempt to reduce fluctuations in the unemployment probability of job loss. rate. However, the two insurance programs provide partial, not com- plete, protection. The federal guaran- of self-regulation can be relied on to SUMMARY tee of bank deposits protects each avoid crises in actual economies is a Macroeconomists typically individual account up to $100,000, so controversial issue. view reducing the cyclical volatility of large accounts are not fully protected. If the true benefit of counter- the unemployment and inflation rates Most state unemployment insurance cyclical monetary policy lies in as the proper goal of countercyclical monetary policy. Generally speaking, programs replace somewhere between preventing economic crises, how much macroeconomists and policymakers one-half to two-thirds of a worker’s of an effect does it have on living have not been very explicit about why most recent weekly pay, but only for a standards? The answer depends on such reductions enhance well-being. maximum of 28 weeks. Because both how likely it is that economic crises This article discussed some research deposit and unemployment insurance will occur in the absence of counter- that bears on this question. In particu- are not complete, the possibility cyclical monetary policy. Although lar, it laid out the implications of the remains that a large enough increase in there is no accepted estimate of that view that the benefits of the unemployment rate may lead to likelihood, some of my research countercyclical monetary policy ultimately derive from the effect such enough of an increase in the desire to a policy has on people’s standard of self-insure so as to destabilize the living. economy. The standard-of-living That stabilization policies criterion has unexpected implications 14 The textbook New Keynesian or IS-LM exist to protect against instability model does not allow for the possibility of for assessing the benefits of counter- should not come as a surprise. What is economic crises. While a decline in aggregate cyclical monetary policy. If the goal of somewhat odd is that mainstream demand may cause a temporary rise in countercyclical monetary policy is to unemployment, the model predicts that market reduce volatility in the standard of macroeconomics does not really accept forces (in the absence of any further shocks to living, such a policy is unlikely to be the point that stabilization policies are aggregate demand) will eventually bring the unemployment rate back to the natural rate. necessary to prevent instability. The mainstream view is that market 15 MIT professor Peter Diamond demonstrated economies are self-regulating: if a this possibility in a series of influential articles in the early 1980s. His views are summarized in his 16 See my working paper with Dean Corbae for shock moves the unemployment rate 1982 book. details. www.phil.frb.org Business Review Q2 2001 13 very beneficial. The problem is that if as one might otherwise suppose. the likelihood of a sudden upward jump monetary authorities succeed in On the other hand, self- in the unemployment rate. Such a jump reducing the volatility of the unem- insurance may be a mixed blessing. could trigger a destabilizing rise in the ployment and inflation rates, this Sudden increases in the desire to self- desire to self-insure and cause an success will partly substitute for private insure can be a source of macroeco- economic crisis. If countercyclical actions taken to safeguard living nomic instability. Taking this possibility monetary policy eliminates even a standards (self-insurance). Thus, into account suggests that an impor- small likelihood of economic crisis, the because of self-insurance, the overall tant benefit of countercyclical mon- gain in the average person’s living reduction in the volatility of the etary policy (along with deposit and standard may be large enough to justify standard of living will not be as great unemployment insurance) is to reduce the potential costs of such a policy.

REFERENCES

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