What You Don't Know Can Hurt You: Knowledge Problems in Monetary Policy

Abstract

While the primary causes of the 2007-8 financial crisis are disputed, many economists hold that the monetary policy missteps played a role in causing or prolonging the financial crisis. In light of the perceived failure of monetary orthodoxy, monetary models are being theoretically refined and empirically recalibrated. Absent from these technical debates is a recognition of the immense knowledge burdens inherent in monetary policy. We argue that Fed authorities simply do not, and in all likelihood cannot, have the knowledge required to achieve their own monetary objectives, given their inability to approximately measure or predict changes in the demand for money. Finally, we evaluate the ability of NGDP targeting and free banking to overcome this knowledge problem.

Keywords: Central banking, free banking, Hayek, knowledge problem, monetary policy, NGDP targeting

JEL Classification: E42, E52, E58, E61, P16