What is “Optimal” Monetary Policy?

O'Driscoll, knowledge problem, monetary conference, central banks, Hayek, Milton Friedman
Cato Institute

O'Driscoll, knowledge problem, monetary conference, central banksOn Thursday, November 12th, Cato hosts its 33rd Annual Monetary Conference.  This year’s conference theme is “Rethinking Monetary Policy.”  I will be presenting a paper on “Monetary Policy: The Knowledge Problem.”

The knowledge problem in conducting monetary policy, or any other government policy, is that the required knowledge is simply not available to policymakers.  The knowledge is not available in any one place, nor can it be assembled in a form that would enable policymakers to formulate an “optimal” policy.

My paper focuses on Friedrich Hayek because he first formulated the knowledge problem.  He argued that knowledge is inherently dispersed and localized across the population of economic agents.  It is not possible to assemble the totality of knowledge existing in society in any one mind or place.  Moreover, what the totality of individuals knows far exceeds what any policymaker can know, no matter his expertise and wisdom.

In order to formulate an optimal policy, a monetary authority must predict how alternative policy actions will affect the plans of millions of people.  That information is unavailable.  Assuming it exists in an economic model doesn’t make it so.

It is the conceit of central bankers (or at least most) that they can acquire the knowledge needed to conduct optimal monetary policy.  In his Nobel Prize lecture, Hayek called that “The Pretence of Knowledge.”

In my paper, I also detail Milton Friedman’s contribution to the knowledge problem in monetary policy.  That contribution has been under-appreciated in the literature.

Some problems cannot be solved.  The knowledge problem is one such.  But it can be mitigated, and I conclude my paper by discussing how that might happen.  I suggest, as did Hayek and Friedman, that a monetary rule works best.

(If you would like to see O'Driscoll present his paper at the November 12th monetary conference, you can register here.  With several central bankers on the distinguished line up, including St. Louis Fed President James Bullard, Richmond Fed President Jeffrey Lacker, and Bank of Mexico Deputy Governor Manuel Sánchez, this year's conference is a particularly interesting place to discuss the knowledge problem in the context of central banking.  If you cannot attend, the conference papers will appear in a forthcoming edition of the Cato Journal. — Ed.)

  • Andrew_FL

    The normal solution to the knowledge problem is not to engage in central planning.

    It's amazing to me that people just take the idea of having a Central Bank for granted.