Better Monetary Policy Lies Behind Unprecedented Economic Stability

More efficient monetary policy has been the driving force behind the improved macroeconomic performance of the world economy since the early 1990s. That is the onclusion of new research by Professors Stephen Cecchetti, Alfonso Flores-Lagunes and Stefan Krause, published in the April 2006 Economic Journal.

The 1990s were a remarkable decade. Information technology (IT) came of age, bringing the benefits of computerisation into our lives through everything from cars to dishwashers. Because of the internet, incredible libraries are now available in our homes and offices. What may be even more extraordinary is that the 1990s brought unprecedented economic stability. Compared with the 1980s, growth was higher, inflation was lower and both were more stable nearly everywhere. Inflation volatility fell across the world, while output variability declined in more than half of the 23 industrialised countries for which data are available.

There are three possible explanations for this phenomenal worldwide economic

  • The first is luck – the 1990s simply happened to be an exceptionally calm period.
  • The second is that economies have become more flexible in responding to the everpresent unexpected changes in the economic environment.
  • And the third is that monetary policy-makers figured out how to do their job more effectively.

Which one of these explanations is most likely?

With the major economic crises in Latin America and Asia, the Russian debt default, the collapse of Long-Term Capital Management, and the volatility of raw material prices, it is difficult to argue that the stability of the 1990s was simply good fortune.

Instead, something must be cushioning the impact of external shocks. While advances in IT surely allow manufacturers to respond more flexibly to changes in demand for their products, these changes have been too gradual to explain the relatively sudden decline in volatility we have seen.

This study examines the third possibility – that the stability of the 1990s is the consequence of improved monetary policy. Today, economists have a much better understanding of how to implement monetary policy than they did as recently as 20 years ago. To succeed in keeping inflation low and stable while at the same time keeping real growth high and stable, central bankers must focus on raising interest rates when inflation goes up and lowering them when inflation goes down.

These researchers develop a method for measuring the contribution of improved monetary policy to observed changes in macroeconomic performance, and apply it to 24 countries.

The estimates suggest that improved policy-makers have played a stabilising role in 21 of the 24 countries. Seventeen countries experienced smaller shocks, but overall this had a modest impact on economic performance.

Overall, the researchers conclude that improved central bank policy accounts for roughly half of the reduction in the volatility of growth and inflation. More efficient monetary policy has been the driving force behind improved macroeconomic performance.

''Has Monetary Policy Become More Efficient? A Cross-country Analysis'' by Stephen Cecchetti, Alfonso Flores-Lagunes and Stefan Krause is published in the April 2006 issue of the Economic Journal