Should the Federal Reserve spur growth?

Although production recovered much faster than many expected in the wake of the COVID-19 downturn, real GDP declined in the first two quarters of 2022. Naturally, this left many wondering what could be done to boost economic growth.

Nick Temeraus recently wrote in the Wall Street Journal: “After the 2008 financial crisis, the United States relied heavily on the Federal Reserve to stimulate growth, leading to frequent mockery that monetary policy had become ‘the only game in town.'” In contrast, he thinks of many Supply-side reforms that would increase immigration, boost labor force participation, and make America less dependent on foreign energy.

If these supply-side reforms improve our ability to produce valuable goods and services with available physical and human capital, they must be implemented—not because production growth is slow and inflation is currently high, but because such reforms Always worth doing. They make us more productive.

On the other hand, the Fed’s argument for stimulating growth is not straightforward.

Overall, I think we should dispense with the idea that the Fed’s job is to stimulate growth. This framework obscures the fact that growth could be very high, as it has likely been for most of the past year. It also exaggerates the impact of monetary policy on growth. Rather than trying to stimulate growth, the Federal Reserve should do its best to ensure that the economy is not over- or under-productive.

The main engine of economic growth

Production ultimately depends on available physical and human capital (or factors of production) and total factor productivity – that is, our ability to use physical and human capital to produce valuable goods and services. Total worker productivity increases as we discover new and better ways of doing things. These increases in total factor productivity enable us to produce more output with fewer inputs. Total factor productivity growth is the primary driver of long-run economic growth.

Monetary policy can enhance aggregate factor productivity to some extent, by reducing the risk and cost of inflation. Individuals change prices and re-contract frequently in countries where inflation tends to be high or is difficult to predict. These activities use real resources that can be used to produce other goods and services – and they can be used to produce other goods and services if monetary policy is better. By lowering the resource costs associated with inflation, sound money promotes long-term economic growth.

Although sound money is pro-growth, the effect of better monetary policy on long-run economic growth in rich countries may be minimal. How often do we change rates or re-contract as a result of less than ideal monetary policy? What is the potential cost savings?

Real GDP reached nearly $20 trillion last year. If better monetary policy cut costs by $20 billion, it would boost GDP by about one tenth of one percent. If you cut costs by $100 billion, you’d add one-half of one percent. I doubt the potential gains are that big. To be clear, the necessary monetary reforms must be made and the gains enjoyed. But we must also be realistic about the potential size of those gains. Monetary reform will not add one to two percentage points to real GDP growth, as Some people claim.

Booms and busts

Although monetary policy may have a small effect on economic growth in the long run, it can have very large effects over short periods of time. When monetary policy is loose, people are deceived by overproduction. When monetary policy is tight, they are tricked into underproduction. Of course, you can’t fool all of the people all of the time. They are the ultimate wisdom. You can cheat on them sometimes, but you don’t have to.

A sound monetary policy adjusts to changes in the demand for holding money, so that nominal spending grows at a steady and predictable rate. This informational content enhances prices, which will rise and fall to reflect real changes in relative scarcity, thus supporting companies engaged in long-term planning and workers considering long-term contracts. Instead of deceiving people into over- or under-production, sound monetary policy helps them produce what they want given their preferences and available technology.

to stimulate growth

I understand why some say the Fed should stimulate growth. When the economy is low in production, the Federal Reserve must increase nominal spending so that production rises to a level consistent with the economy’s sustainable potential. However, the phrase is misleading. By highlighting the increase in production, it obscures the suboptimal starting point which is necessary for such a policy to be desirable.

The stimulus-growth framework also perpetuates the misconception that economic growth is always good and more economic growth is always better. It is possible to produce a lot, as people do when they think the dollars made in return will be worth more than they actually will be.

Whether the Fed should stimulate growth depends on how production compares to the economy’s sustainable potential. It’s better to be clear about that. Instead of thinking about whether the Fed should stimulate growth, we should realize that its primary task is to prevent overproduction and underproduction.

William J. Luther

William J. Luther

William J. Luther is director of the Sound Money project at AIER and associate professor of economics at Florida Atlantic University. His research mainly focuses on coin acceptance questions. He has published articles in leading scholarly journals, including the Journal of Economic Behavior and Regulation, Economic Investigation, the Journal of Institutional Economics, Public Choice, and the Quarterly Review of Economics and Finance. His famous writing has appeared in The Economist, Forbes, and US News & World Report. His work has been featured in major media outlets, including NPR, The Wall Street Journal, The Guardian, TIME Magazine, National Review, Fox Nation, and VICE News.

Luther received his master’s and doctoral degrees. He holds a BA in Economics from George Mason University, and a BA in Economics from Capital University. He was a participant in the AIER Summer Fellowship Program in 2010 and 2011.

Selected Publications

“Cash, Crime, and Cryptocurrency.” Co-authored with Joshua R. Hendrickson. Quarterly Review of Economics and Finance (Coming, express, appears).

“Central Bank Independence and the Federal Reserve’s New Operating System”. The article was co-authored by Jerry L. Jordan. Quarterly review of economics and finance (May 2022).

“Federal Reserve Response to the COVID-19 Downturn: A Preliminary Assessment.” The article was co-authored by Nicholas Kashansky, Brian Katsinger, Thomas L. Hogan, and Alexander W. Salter. Southern Economic Journal (March 2021).

“Is Bitcoin Money? And what does that mean”. Co-authored by Peter K. Hazlitt. Quarterly review of economics and finance (August 2020).

Is Bitcoin a decentralized payment mechanism? The article was co-authored by Sean Stein-Smith. Journal of Institutional Economics (March 2020).

“Self-Matching and Money with Random Consumption Preferences.” Co-writer: Thomas L. Hogan. BE Journal of Theoretical Economics (June 2019).

“Adaptation and Central Banking.” Co-writer: Alexander W. Salter. general option (January 2019).

“Starting off: The State of Bitcoin.” Journal of Institutional Economics (2019).

Bitcoin ban. Co-authored with Joshua R. Hendrickson. Journal of Economic Behavior and Organization (2017).

“Bitcoin and the Rescue”. Co-writer: Alexander W. Salter. Quarterly review of economics and finance (2017).

“The Political Economy of Bitcoin.” Co-authored with Joshua R. Hendrickson and Thomas L. Hogan. Economic inquiry (2016).

“Cryptocurrencies, Network Effects, and Switching Costs”. Contemporary Economic Policy (2016).

Positively value paper money after the disappearance of sovereignty: the case of Somalia. Co-author: Lawrence H. White. behavioral economics review (2016).

“The Monetary Mechanism of Stateless Somalia.” general option (2015).

William J Luther books

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