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IT CAN DO A LOT, BUT IT IS IMPORTANT TO KNOW ITS LIMITS.
There is general agreement that price stability is necessary for macroeconomic success and that only monetary policy can achieve price stability. The Fed has been successful in this respect over the past twenty-two years. However, there is disagreement on whether monetary policy can do more. Future potential is limited by both the quality of data and the state of economic science. However, past success has created the irony that-while there is recognition that monetary policy is a blunt instrument-there are calls for the Fed to use it with surgical precision. A realistic appraisal of the potential for monetary policy suggests that persistent, incremental action-rather than aggressive attempts at fine-tuning-is the right direction for achieving an environment for maximum sustainable economic growth.
In this paper, I will present my thoughts on what monetary policy can and cannot do. I will first try to stake out the common ground-the ideas on which we can readily agree. Then, I'll talk about the more contentious issues-the areas in which there is legitimate room for disagreement-and offer some of my own perspective on these issues as well. I'll conclude with some thoughts about the implications of all this for the conduct of monetary policy.
I think most Fed policymakers-indeed, most professional economists today-would agree that: (1) the goal of monetary policy is to help create an economic environment that fosters maximum sustainable growth, and (2) the most important contribution the Fed can make to that environment is to provide price stability.
Behind this philosophy of appropriate monetary policy goals lie some important economic principles on which, again, I think there is broad agreement. The first economic principle is that price stability is crucial to a well-functioning market economy. Prices are signals to market participants. A stable overall price level allows people to clearly recognize shifts in relative prices and adjust their decisions about spending, saving, working, and investing in welfare-enhancing ways. Inflation, by contrast, jumbles and distorts price signals and generates bad economic decisions.
The second economic principle is that price stability is a contribution to financial stability and attendant economic growth that only monetary policy can make. We know that relative prices will fluctuate...