The First Practical Guide to Inflation Targeting

When Sweden left the gold standard on September 27, 1931, the Swedish government declared that the aim of monetary policy should be to stabilize the domestic purchasing power of the Swedish currency, the krona. With this step, price level targeting officially became for the first time the goal for a central bank. Soon after, the Riksbank (Bank of Sweden) sent a questionnaire to three prominent economics professors, Gustav Cassel, David Davidson and Eli Heckscher, asking for advice about the new monetary situation. In a few weeks, the Riksbank received their replies. This paper presents the three reports, for decades kept as classified documents in the archives of the Riksbank. The reports give an excellent view of the monetary thinking in the early 1930s of the first generation of modern Swedish economists, prior to the outbreak of the world depression of the 1930s and the emergence of the Stockholm School in macroeconomics. The reports are strikingly modern. They deal with the central issues in the present discussion on inflation targeting, such as the choice of price index to target, the proper instrument to use, the importance of creating public credibility for the new monetary rule, potential legal changes to anchor the new standard, and the appropriate central bank response to changes in the exchange rate. In short, the three economists prepared the first practical guide to inflation targeting at the zero rate. The paper also considers the impact of the reports on the policy of the Riksbank. Most strikingly, the Riksbank started to construct and collect a weekly consumer price index to use as a guide for implementing the new policy of price stabilization. This task was carried out by Dag Hammarskjöld under the guidance of Erik Lindahl.