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Economic Review

Economic Review
C O N T E N T S
Second Quarter 1997/Volume 82, Number 2

Economic Review articles are posted on the Web as they become available. Page numbers in the PDF file posted here may not reflect the page numbers of the printed version.

History and Theory of the NAIRU:
A Critical Review
Identifying Monetary Policy: A Primer
Marco A. Espinosa-Vega
and Steven Russell
4 Tao Zha 26

Economic commentators regularly urge the Fed to use the level of unemployment or the rate of change in wages as leading indicators of inflation and as guides to whether they should ease or tighten monetary policy. The logic behind this approach is based on modern (post-1970) Keynesian macroeconomics and, more specifically, on the Phillips curve and the nonaccelerating inflation rate of unemployment (NAIRU). This article attempts to provide some basic information about this NAIRU theory of the causes of inflation and the role of monetary policy. After describing the historical development of the NAIRU theory, the discussion raises some practical questions about the validity of the theory and its usefulness as the basis for policy advice. Perhaps the most important question involves the difficulty of distinguishing policy-induced changes in nominal wages that reflect future changes in the price level from changes in relative wages associated with real changes in the economy. The authors also describe recent developments in neoclassical theory that indicate that business cycle fluctuations in employment and output may be caused primarily by real forces—a situation that, if true, increases the danger that monetary policy based on the NAIRU may interfere with the proper functioning of the price system.

The question of the quantitative effect of monetary policy has been of considerable debate for decades. Economists' beliefs about it stem largely from theoretical models that imply the effects of changing monetary policy, and different experiments or theories lead to different conclusions. The actual economy, however, is not the result of any such controlled experiment. In the real world, inferences about the quantitative effect of monetary policy must rely on observations of actual economic activity in which many variables are changing simultaneously.

This article argues that to assess the actual effect of monetary policy requires understanding the interaction among all players in the economy—the central bank, financial market participants, producers, and consumers. The author first explains the conceptual importance of sorting out the central bank's behavior from that of the many other players. He then discusses difficulties involved in sorting out such a behavior in any given country. Finally, he illustrates this sorting-out process with a few examples in the economics literature.

International Settlements: A New Source of Systemic Risk?
Robert A. Eisenbeis 44

Recent market developments have heightened concerns about the potential for systemic risk in the payments system. At the same time that markets are becoming more integrated and global in scope, they are becoming more segmented in the sense that there is a growing separation evolving between the clearing and settlement of transactions that raises the prospect of a need to invoke the safety net and introduces a possible distortion into the international payments system. As a consequence, both public-sector and private markets have given great attention to attempting to identify and control risk exposures.

The author of this article observes that one of the more interesting developments in this evolution has been the push, for several reasons, toward real-time gross settlement systems with collateralization. Systems, instruments, and markets are evolving at a fast pace that is putting pressure on the political entities to bring their various rules and regulations into harmony, and such harmonizing requires extensive international coordination and cooperation. In addition, central banks realize that they still may be thrust into the role of the lender of last resort should the difficulties threaten to bring down settlement and clearing systems.