Stability in Financial and Labor Markets: Is There a Tradeoff?

Abstract

Does the FED have to choose between stability in financial markets and stability in labor markets? Some recent econometric simulations would seem to suggest that it does.' The very existence of such a tradeoff implies that policy making is more than a technical exercise. It is a political process; one constituency is hurt by instability in financial markets, while a largely different constituency is hurt by instability in labor markets. There is probably no reason to believe that the FED consciously favors one constituency over the other;' however, there is some reason to think that interest rate stability ranks high among its priorities. The real bills doctrine, which was a part of the original act establishing the Federal Reserve System, called for a policy that would set interest rates a view of accommodating commerce and business without encouraging wasteful or speculative ventures.3 More recently, there has been much discussion of the use of interest rates as intermediate targets of monetary policy, and indeed we have witnessed a variety of policy regimes which might be characterized by the degree of flexibility in the rate of interest. Most existing macroeconometric policy models are not well suited to investigate these matters. Typically, they do not explain what is wrong with instability in financial and labor markets. They do not explain who is being hurt or how, and they do not incorporate private sector reactions to a change in stability.4 Consequently, these models do not imply operational measures of stability in the two markets, and they are not likely to give accurate descriptions of policy tradeoffs. Indeed, there may not even be a tradeoff if stability is appropriately defined and if private sector responses to changes in stability are adequately taken into account.