Monetary Policy: An Institutionalist Approach

While this chapter will not present a detailed history of monetary policy, it is useful to first take a quick look at the evolution of thinking about the nature of monetary policy. We will first examine the famous Currency School-Banking School debates of the early 19th century, then turn to the insightful analysis of Walter Bagehot. We next turn to the creation of the Federal Reserve System (Fed) and early 20th century thinking about the role of the central bank. The discovery of the “deposit multiplier” in the 1920s as well as the developing understanding of open market operations had a very large influence on the post-WWII theory of central bank control of the money supply. While postwar “Keynesian” economists were skeptical of the potency of monetary policy, the Monetarist approach gradually gained adherents and came completely to dominate thinking about monetary policy by the last quarter of the 20th century. However, Monetarism experienced a quite remarkable turnaround of fortunes at the end of the century. As we begin the 21st century, orthodox thinking about monetary policy is in nearly complete disarray. However, there are themes that run through the 20th century and even the 19th century that offer some guidance in reformulating and creating a truly institutionalist approach to monetary policy.