Flexible Exchange Rates, Fed Behavior, and Demand Constrained Growth in the USA

This paper examines Chairman Greenspan's recent claim that central bankers around the world have been operating "as if" monetary policy were constrained by gold that backs up reserves. I argue, instead, that central banks in flexible exchange rate regimes operate with an overnight interest rate target, which eliminates the possibility of discretionary control over bank reserves. In other words, central banks cannot behave as if reserves are constrained by gold. I contend that fiscal policy, on the other hand, has been operating as if it faced financing constraints—so growth has been demand-constrained by austere fiscal policy. However, the perceived constraints on fiscal policy are not appropriate to a sovereign government operating with a floating currency. I conclude by arguing that adoption of a floating rate system from the mid-1970s (what Greenspan disparagingly calls a fiat money standard) has made it possible to operate fiscal policy without these constraints—that is, to take advantage of the possibilities offered to the issuer of a floating currency. This includes maintenance of full employment at home while enjoying the benefits of a trade deficit.