Bernanke Lecture

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Lecture 2: The Federal Reserve after World War II
1. Early Challenges 2. The Great Moderation 3. Origins of the Recent Crisis

What Is the Mission of a Central Bank?
• Macroeconomic stability - All central banks use monetary policy to strive for low and stable inflation; most a so use monetary policy to try to promote stable growth in output and employment. • Financial stability - Central banks try to ensure that the nation's financial system functions properly; importantly, they try to prevent or mitigate financia panics or crises.

Fed-Treasury Accord of 1951
• During World War II and subsequently, the Fed was pressed by the Treasury to keep longer-term interest rates low to allow the government debt accrued during the war to be financed more cheaply. • Keeping interest rates low even as the economy was growing strongly risked economic overheating and inflation.

• In 1951, the Treasury agreed to end the arrangement and let the Fed set interest rates independently as needed to achieve economic stability. • The Fed has remained independent since 1951, conducting monetary policy to foster economic stability without responding to short-term political pressures.

The Fed in the 1950s and Early 1960s
• Between World War II and the recent financial crisis, macroeconomic stability was the predominant concern of central banks. • During most of the 1950s and Chairman, 1951-1970 early 1960s, the Federal [quote]"Inflation is a thief in Reserve followed a "lean the night and if we against the wind" monetary don't act promptly and policy that sought to keep decisively we will both inflation and economic always be behind." growth reasonably stable. [end of quote.]

The Great Inflation: Monetary Policy from the Mid-1960s to 1979 Inflation

• Starting in the mid1960s, monetary policy was too easy. • This stance led to a surge in inflation and inflation expectations. • Inflation peaked at about 13 percent.

[For the accessible version of this figure, please see the accompanying HTML.]

The Great Inflation: Why Was Monetary Policy Too Easy?
• Monetary policymakers were too optimistic about how "hot" the economy could run without generating inflation pressures. • When inflation began to rise, monetary policymakers responded too slowly.

• Exacerbating factors included
- oil and food price shocks - fiscal policies (such as spending for the Vietnam War) that stretched economic capacity - Nixon's wage-price controls that artificially held down inflation for a time

Central Banking in an Evolving Economy
• These experiences illustrate how central banks have to struggle with an evolving economy and imperfect knowledge. [imageof]Arthur Burns Chairman, 1970-1978

world the opportunities for making mistakes are legion."[end of quote].

The Volcker Disinflation
• To subdue double-digit inflation, Chairman Volcker announced, in October 1979, a dramatic break in the way that monetary policy would operate. • In practice, the new approach to monetary policy involved high interest rates (tight money) to slow the economy and fight inflation. [quote]

[imageof]Paul Volcker Chairman, 1979-1987
"To break the [inflation]

c y c l e , ... w e m u s t credible and



m o n e t a r yp o l i c y . " [ e n dofquote].

Inflation in the 1980s

• In the years after the new disciplined monetary policy began, inflation fell markedly. • When Chairman Volcker left his post in 1987, the inflation rate was around 3 to 4 percent.

[For the accessible version of this figure, please see the accompanying HTML.]

The 1981-1982 Recession
Unemployment Rate

• The high interest rates needed to bring down inflation were costly. • In the sharp recession during 1981 and 1982, unemployment peaked at nearly 11 percent.

[For the accessible version of this figure, please see the accompanying HTML.]

The Great Moderation
• During the Great...
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