Some people argue about whether the macroeconomy is inherently stable or unstable. I don't think that's a very useful question. Because.....it depends. And one of the things it depends on is monetary policy. And that is a useful discussion to have, because we can actually do something about monetary policy.
Don't adopt a monetary policy that would make an equilibrium unstable. Because if you miss that equilibrium by even the tiniest amount (which you almost certainly will) the economy will move further and further away from equilibrium.
I thank Steve Keen for (inadvertently) reminding me to do something that George Selgin had wanted economists like me to do. It's not often any of us get the chance to write a post that will make both Steve and George happy at the same time. (Well, Steve should be happy, because I'm talking about unstable equilibria, but you never can tell.)
There's nothing new here. Just the old stuff, but perhaps told in a slightly different way.
1. Don't use monetary policy to target unemployment.
Targeting a real variable like unemployment sounds like a really good idea. Because it's real variables like the unemployment rate, and real income, that really matter to people. Much more than nominal variables like the price level, or inflation rate. So why not tell the central bank to target unemployment?
Like most economists, I think that if you loosen monetary policy then inflation goes up and unemployment goes down. At least, temporarily. There's some sort of short run trade-off. But I'm less sure about the long run. If you permanently loosen monetary policy, so that inflation is permanently higher, will unemployment go down, go up, or stay the same?
It is easy to build a theoretical model in which there is no long run trade-off. The Long Run Phillips Curve is vertical. Now any macroeconomist with any ingenuity could tweak that model to make the Long Run Phillips Curve slope in either direction. But I wouldn't trust those tweaks in either direction. The data don't help much either. When I look at the data, I think I see that countries with high average inflation tend to have high average unemployment rates. Which means the Long Run Phillips Curve slopes the "wrong" way. But I don't totally trust my lying eyes. Because it might just be that screwed up countries tend to get everything wrong, and it's not that their loose monetary policy is causing high inflation and high unemployment. It might just be something else that is screwed up in those countries, that is causing both the high unemployment and the loose monetary policy.
But if you want monetary policy to target unemployment, you had better be very confident that the Long Run Phillips Curve slopes the "right" way. Because if it slopes the wrong way, you have got an unstable equilibrium. If you miss the equilibrium by just the tiniest bit, and set a slightly too low target for the unemployment rate, you loosen monetary policy to bring unemployment down, inflation will rise, the unemployment rate will eventually rise too, so you loosen monetary policy further, and so on, getting further and further way from the equilibrium (assuming it even exists).
Even if the Long Run Phillips Curve does slope the right way, and a stable equilibrium exists, it might be very different from what regular folk might think of as stable. A Russian doll is stable, but it sways back and forth a lot in a gusty wind. If the Long Run Phillips Curve slopes the "right" way, but is very steep, small shifts in the Phillips Curve will cause very big fluctuations in inflation if you target unemployment.
Most economists say the Long Run Phillips Curve is vertical, and so monetary policy can't target unemployment in the long run. They don't really mean that. They mean they don't really know which way it slopes, and vertical is probably a good approximation. And they don't want monetary policy to target unemployment, because the risk of the equilibrium being unstable, even if it exists, is far too high for comfort. And even if it is technically stable, it will move around a lot, so it won't look "stable" in the ordinary sense of the word.
As older readers will remember, targeting unemployment has been tried before. And it took a couple of decades to recover from the experiment and get both inflation and unemployment back down again.
Lets not go there again. It's a really bad idea.
2. Don't use monetary policy to target a nominal interest rate.
But that's what the Bank of Canada does, isn't it? Well, yes and no. Mostly no. What the Bank of Canada does is target 2% inflation. It only targets a nominal interest rate for a very short time period, of about 6 weeks. Every 6 weeks it adjusts the interest rate target, as needed, to try to keep inflation at the 2% target.
There (probably) exists a time-path for the nominal rate of interest that is compatible with an equilibrium in which inflation stays at (roughly) 2%. But:
We don't know what it is. It won't be a constant. And, most importantly, it will (almost certainly) be an unstable equilibrium. If we miss that equilibrium, by even the smallest amount, the economy will move further and further away from the equilibrium.
Suppose the central bank sets the rate of interest too low. Demand will be too high, and inflation will start to rise, and keep on rising.
It gets worse. As inflation rises, expected inflation rises too, the real interest rate falls for any given nominal rate, and so demand increases still further.
None of this is news to New Keynesian macroeconomists. They know you will get an unstable equilibrium if the central bank holds the nominal interest rate constant. So they insist that the central bank must adjust the nominal interest rate quickly enough and by a large enough amount to try to turn an unstable equilibrium into a stable equilibrium. And if people are confident that they can and will do this, expected inflation will stay anchored at the 2% target, which helps prevent one of the destabilising forces.
Whether that feedback rule for the nominal interest rate will always operate quickly enough and strongly enough and be credible enough to convert an unstable equilibrium into a stable equilibrium.....is another question. The answer looks a lot different at the Zero Lower Bound than it did before. Maybe it's time to stop using even very short term interest rate targets?