Monetary policy theory must be rebuilt

Since the early 1980s, the prevailing monetary policy theory has been that of Robert Barro and David Gordon (1) and central bank credibility. The central bank must have an abnormally high aversion to inflation in order to not be tempted into using unexpected inflation to stimulate activity in an inefficient manner. But the disappearance of the links between inflation and unemployment and between monetary policy and inflation makes this theory no longer fit for purpose . The right theory has become that of Thomas Sargent and Neil Wallace (2) , now known as fiscal dominance: when the public debt ratio becomes too high, the central bank is forced to use monetary policy to restore the government’s fiscal solvency by monetising the public debt. We still need to consider the long-term consequences of fiscal dominance. For Sargent and Wallace, it was the return of inflation. In contemporary economies, it is first asset price inflation , b ut there is a limit to this, as wealth cannot forever increase relative to incomes. It is then a monetary crisis, as economic agents refuse to hold even more money. (1) Robert Barro, David Gordon, “A Positive Theory of Monetary Policy in a Natural-Rate Model”, Journal of Political Economy, vol. 91, no. 4, 1983. (2) Thomas Sargent and Neil Wallace, “Some Unpleasant Monetarist Arithmetic”, Federal Reserve Bank of Minneapolis Quarterly Review, Autumn 1981.