AMonetary Policy Paradox - Inflation and Monetary Policy - Money Growth and the Funds Rate: The Long and Short of It

Sep 21, 2026

Uploaded by Aurora

Central banks face a paradox when communicating monetary policy: reducing inflation today typically requires raising short-term interest rates, yet durable price stability depends on lower long-term rates. The transition hinges on private expectations and how the public interprets near-term decisions. Using the late-1970s shift in U.S. policy and the subsequent inflation and recession outcomes as context, the text argues that credibility and publicly accountable, multi-year price-level objectives are crucial. It then explains how interest rates work through money growth and why apparent short-run anti-inflation actions can align with long-run disinflation.

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AMonetary Policy Paradox

Inflation and Monetary Policy

Money Growth and the Funds Rate: The Long and Short of It

by Charles T.Carlstrom One of h mos ifcuitasks facedby any central bank is explaining to thepublic the role that interest rates play inthe conduct of monetary policy.Thecommon understanding is that the Fed-eral Reserve fights inflation by acting toraise short-term interest rates.But aspointed out by economist Irving Fishermany years ago,reduced inflation isassociated with lower,not higher,ratesof interest. The key distinction between these twoviews,of course,lies in the short-runversus the long-run level of interestrates.However,the transit to the longrun depends crucially on private expec-tations,which in turn depend on how thepublic perceives particular decisions inthe shortrun. This issue is of great practical impor-tance.By the end of the 1970s,inflationwas hovering around 13 percent.Withthe announcement on October 6,1979,of the switch from interest-rate targetingto nonborrowed reserves targeting,U.S.monetary policy adopted a strong anti-inflationary stance.The new approachwas successful in that inflation was cutto around 4 percent by the end of 1983.During this same period,however,theeconomy suffered twin recessions.Many,if not most,economists attributethe losses in jobs and output to slowlyadjusting inflation expectations. A debate is now under way aboutwhether another monetary policy revolu-tion is needed.The argument this timefocuses on whether the Federal Reserve # AMonetary Policy Paradox should pursue price stability.Like thelast battle,the new one could also provecostly unless the Fed can credibly signalits commitment to price stability andthen follow that policy relentlessly. This Economic Commentary exploresthe paradoxical link between interestrates and inflation in the short versus thelong run.It may be more difficult for acentral bank to achieve credibility—andhence a less costly transition to a stableprice environment—without first mak-ing the monetary authorities accountablefor publicly stated multiyear objectivesfor the price level. ## ■ Inflation and Monetary Policy Years ago,Milton Friedman issued hisnow-famous maxim that inflation isalways and everywhere a monetary phe-nomenon.This statement is as truetoday as it wasthree decades ago.Ofcourse,every blip in the Consumer PriceIndex is not caused by Federal Reservepolicy.Supply shocks,such as the oilshock in the mid-1970s,can lead to shortperiods in which the price level risesrapidly.But continuous increases in theprice level can occur only if the centralbank accommodates such shocks withfaster money growth. This sounds simple enough.One can seewhy Friedman once called for the Fed toset the growth rate of money at 3 percentper year(the long-run growth rate ofout-put),declare the battle over,and gohome.Alas,life is not that simple.It isdoubtful that a constant money growthrule would be sufficient to achieve a August 15,1995 Central banks wishing to pursue pricestability must deal with the paradoxthat reducing inflation today requiresraising short-term interest rates,eventhough price stability can ultimatelybe sustained only with lower,nothigher,rates of interest.Without along-term objective,such as a multi-year path for the price level,it may beextraordinarily difficult for a centralbank to signal its resolve to stabilizeprices. long-run price-level target,and even when particular money growth ranges aredesired,such targets are typically soughtvia changes in short-term interest rates. Interest-rate operating procedures areuniformly used by the world's centralbanks for a variety of reasons,but manyeconomists believe it is desirable tosmooth short-term interest-rate fluctua-tions arising from the temporary liquid-ity needs of the financial sector.Sincepeople are unable to adjust their portfo-lios quickly in response to variousshocks to the economy,the central bankshould jump in and supply the neededliquidity by adding enough reserves tosmooth interest rates. In the United States,the interest rate usedto conduct monetary policy is t

FAQs

What paradox does the commentary describe about interest rates and inflation?

Reducing inflation today may require higher short-term interest rates, even though long-run price stability ultimately aligns with lower rates.

Why are private expectations important for the effectiveness of monetary policy?

The move to long-run outcomes depends crucially on how private expectations form, which in turn reflects how the public interprets short-run policy decisions.

How does money growth relate to interest rates in the long run?

The text argues that money growth influences the price level, and it highlights the link between inflation and nominal interest rates, implying that interest-rate-driven actions can plant future inflation risks unless expectations and objectives are credible.

Sep 21, 2026

Uploaded by Aurora