What is likely to happen to the economy when theres too much money or credit circulating?

i Virtually people think economic science is the study of money. But at that place is a paradox in the office of money in economic policy, which is this: the attention actually paid by fundamental banks to money has declined, whereas in fact, price stability is recognised as the central objective of cardinal banks.

2 It is no accident that during the "Keen Inflation" of the postal service-war period, money, equally a causal factor for inflation, was ignored by much of the economical establishment. In the belatedly 1970s, the counter-revolution in economics – the idea that in the long run money affected the toll level and non the level of output – returned money to the centre stage in economic policy. As Milton Friedman put it, "inflation is ever and everywhere a budgetary phenomenon". If inflation was a monetary phenomenon, then decision-making the supply of money was the road to low aggrandizement. Monetary aggregates became central to the conduct of monetary policy. Just the passage to depression inflation proved painful. Nor did the monetary aggregates respond kindly to the attempts by central banks to control them. Equally the governor of the Bank of Canada at the fourth dimension, Gerald Bouey, remarked, "nosotros didn't abandon the monetary aggregates, they abandoned us".

3 And then, as central banks became more and more focussed on achieving price stability, less and less attending was paid to movements in money. Indeed, the decline of involvement in money appeared to go hand in paw with success in maintaining low and stable inflation. How do nosotros explain the apparent contradiction that the acceptance of the idea that aggrandizement is a budgetary phenomenon has been accompanied by the lack of any reference to money in the conduct of monetary policy during its virtually successful period? That paradox is the subject of my talk.

4 Of course, some fundamental banks, especially the Bundesbank and the Swiss National Bank, always paid a good bargain of attention to budgetary aggregates. But when the European Central Banking concern acquired responsibility for monetary policy information technology adopted a reference value for money growth every bit only i of its two pillars of monetary policy, with an cess of the outlook for aggrandizement as the other. And the Swiss National Depository financial institution recently replaced its target for the budgetary aggregates with one for inflation. In the United states of america, the Federal Reserve, at its own request, has been relieved of the statutory requirement, imposed in 1978, to written report twice a year on its target ranges for the growth of money and credit. As Larry Meyer, a Governor of the Federal Reserve Lath explained earlier this year, "money plays no explicit office in today's consensus macro model, and it plays about no function in the carry of budgetary policy."

5 The decline in the importance of coin in policy formation can be witnessed past the reduction in the number of references to money in the speeches of central bank governors. So much so that over the past two years, Governor Eddie George, of the Banking concern of England, has made one reference to money in 29 speeches, Chairman Greenspan, of the Federal Reserve, one in 17, Governor Hayami, of the Bank of Japan, one in xi, and Wim Duisenberg, of the European Central bank, three in thirty.

Coin and inflation: the evidence

6 Allow me brainstorm by looking at some of the historical evidence. Chart ane, which extends the results of McCandless and Weber (1995), shows the correlation between the growth of the budgetary base and of aggrandizement over different fourth dimension horizons for a large sample of 116 countries. Countries with faster growth rates of money experience college inflation. It is clear from Nautical chart 1 that the correlation between coin growth and inflation is greater the longer is the time horizon over which both are measured. In the curt run, the correlation between budgetary growth and inflation is much less apparent. Agreement why this is and so is at the heart of monetary economics and however poses problems for economists trying to empathise the impact of coin on the economic system. I shall return to this later.

Nautical chart 1

Annual aggrandizement and growth of narrow money at different horizons across countries

Annual inflation and growth of narrow money at unlike horizons across countries

Notes: Narrow money is Reserve Coin, which includes currency in apportionment (data item xiv in each IFS land table).
Aggrandizement is the per centum increase in the consumer cost index (particular 64).
For presentation purposes, countries with average annual money growth or aggrandizement exceeding 100% have not been included in the charts.

Few empirical regularities in economics are so well documented every bit the co-move of money and inflation. Chart 2 shows that this human relationship is truthful for broad money too as the monetary base. The other side of the coin to this shut relationship betwixt coin and prices is the absence of a long-run relationship between money and output growth, shown in Nautical chart 3. Over the xxx year horizon 1968-1998, the correlation coefficient between the growth rates of both narrow and broad money, on the one paw, and inflation, on the other, was 0.99. Correspondingly, the correlation between the growth of narrow coin and real output growth was – 0.09 and between wide money growth and output growth was – 0.08.

Chart 2

Annual inflation and growth of broad coin at different horizons across countries

Annual aggrandizement and growth of wide money at different horizons beyond countries

Notes: Broad coin includes demand deposits and time deposits (data items 34 and 35 in each IFS state table).
Inflation is the percent increase in the consumer price index (detail 64).
For presentation purposes, countries with average almanac money growth or inflation exceeding 100% have not been included in the charts.

Nautical chart 3

Annual growth of broad money and output at dissimilar horizons across countries

Annual growth of broad coin and output at unlike horizons across countries

Notes: Real output is nominal Gross domestic product (data detail 99b in each IFS country table) deflated past the consumer price index (item 64). A GDP deflator was only available for a pocket-sized sample of countries, and was therefore not used. The horizontal line represents the average annual real output growth across countries for each time horizon.
For presentation purposes, countries with average almanac money growth or inflation exceeding 100% accept not been include in the charts.
In that location were 8 countries that had negative average real output growth over the 1978-98 period. These countries have not been included in the charts.

Correlation, of course, is not causation. The essence of budgetary theory is trying to understand the structural human relationship between money growth, money demand, output and price movements. Stable structural relationships can give rise to unstable curt run correlations between any of these variables. It is, therefore, somewhat surprising that some economists take argued that the instability of observed brusk run correlations casts doubt on the long run importance of money growth in the inflationary process. Chart 4 shows the behaviour of the price level in the UK and its relationship with the ratio of money to real income over the flow from 1885 to 1998. Short-run movements in the velocity of money are apparent, likewise as the long-run link between money and inflation.

Chart 4

Prices and coin relative to real incomes in the UK (1885-1998)

Prices and coin relative to existent incomes in the Uk (1885-1998)

vii The view that money does not matter has been encouraged by those who bespeak to regressions of aggrandizement and output on monetary growth, and discover that the influence of money is either insignificant or unstable. But these results tell us petty about the significance of money in the manual mechanism of monetary policy. They are based on what economists call reduced-form equations, the coefficients of which will be complex functions of the true structural parameters of the economy, as well as expectations of future policy responses by the budgetary authorities. There is no reason to await a simple relationship betwixt inflation and output and coin growth in reduced form estimates.

8 This last bespeak was conspicuously grasped by Friedman and Schwartz in their classic 1963 study of money in the United states. They took dandy care to place periods in which there was an exogenous daze to the money supply, such as moves on to and off the gold standard, and changes in reserve requirements imposed on banks. More recent studies, such as Estrella and Mishkin (1997), Hendry (2001), Gerlach and Svensson (2000) and Stock and Watson (1999) produce alien and unstable regression results for the influence of money growth on inflation.

9 To sympathize the true office of money, a articulate theoretical model is required and that model must allow for the key role of expectations. The cardinal role of expectations is best illustrated by considering extreme cases of high inflation, known as hyperinflations. In hyperinflations the upshot of expectations on money and aggrandizement is amplified relative to other influences, such equally the business cycle.

ten Nautical chart v shows the link between coin and prices in 4 hyperinflations. Two of these are fatigued from the inter-war catamenia, namely the hyperinflations in Austria and Hungary, and 2 are postal service-war hyperinflations, in Argentina and Israel. At their peak, these hyperinflations involved almanac aggrandizement rates of nine,244%, 4,300%, 20,266%, and 486% respectively. All four hyperinflations illustrate the importance of expectations. In the case of the ii inter-state of war hyperinflations, large government deficits were monetised, leading to rapid money growth and inflation. The public tried to economise on money holdings, and then real money demand fell. Announcements of credible fiscal stabilisations changed inflation expectations and led extremely speedily to a rapid fall in aggrandizement. Lower inflation encouraged real money demand to rise again, and so nominal money growth continued to ascension for some fourth dimension after inflation had fallen. Inflation was, therefore, stabilised ahead of the slowdown in coin growth, although the causation ran from the credible announcement of monetary contraction to lower inflation. The vertical lines in the charts point the announcement dates of stabilisation packages. In Argentine republic, inflation expectations were stabilised by the convertibility program of 1991 which established a currency lath to dorsum the local currency in terms of the U.s.a. dollar. Aggrandizement expectations fell and, as in the earlier cases, the fall in inflation preceded the slowdown in coin growth. The example of Israel is somewhat different in that the absence of any delay between the annunciation and the implementation of the stabilisation program in 1985 meant that the gap between the fall in inflation and the contraction of budgetary growth was shorter than in the other cases shown in Chart 5. Although hyperinflations are extreme examples, they practise illustrate the fact that, even when monetary wrinkle is evidently the crusade of a autumn in inflation, the rapid response of expectations means that inflation may fall before signs of a slowing of monetary growth itself.

Chart 5

Money and prices during 4 hyperinflations

Money and prices during iv hyperinflations

Note: Vertical lines indicate the date at which a stabilisation plan involving financial and budgetary reforms was announced.
lhs: left-mitt calibration; rhs: right-hand scale.

11 To brand progress, a more than complete business relationship is required of the role of money in the manual mechanism, and it is to this that I now plow.

Understanding the part of money

12 There is an old joke to the event that economists spend their fourth dimension trying to work out how something that works in practice can work in theory. The role of money in the economy offers an excellent example. In modelling the monetary transmission mechanism, economists take tended to rely on two types of "rigidities" which introduce fourth dimension lags into the procedure by which changes in money atomic number 82 to changes in prices. These are lags in the adjustment of prices and wages to changes in demand – then called "nominal rigidities" – and lags in the adjustment of expectations to changes in the monetary policy regime – so chosen "expectational rigidities". These rigidities mean that money affects real variables in the brusque run and prices in the long run.

xiii But we take no skillful theories to explain either type of rigidity, nor a clear thought of when the curt run turns into the long run. Hence Milton Friedman'southward dictum that there are "long and variable" fourth dimension lags between changes in monetary policy and their affect on aggrandizement. To sympathise these theoretical shortcomings, information technology is helpful to consider an abbreviated history of the models used by economists to analyse the bear on of money. The standard or consensus model comprises four basic equations (come across TABLE i). Get-go, in that location is an equation for aggregate need which relates full demand to either money or interest rates and to expected inflation. The aggregate demand office is sometimes known every bit the "IS" bend. Second, there is an equation describing the supply side of the economic system in which full output is related to differences betwixt expected and actual inflation; this is the "Phillips-Lucas supply curve". 3rd, at that place is an equation for the demand for money relating wide money holdings to total expenditures and the interest rate; the "LM" bend. 4th, at that place is an equation describing budgetary policy in which the supply of wide coin is determined past the actions of the primal banking concern in controlling base money (bank reserves plus notes and coin in circulation) which in plow influences broad money provided past the cyberbanking system through the "coin multiplier". This equation represents the monetary policy reaction part of the central bank. The model determines the values of output, inflation, the involvement rate, and money growth. Most models used to analyse monetary policy are based on a variant of this iv-equation system, with increasing weight given over time, to the function of expectations in the Phillips curve.

Tabular array 1

Standard monetary model

Standard budgetary model

14 In this framework, the standard theoretical view of the transmission mechanism of monetary policy works every bit follows. An unexpected increase in the money supply reduces the nominal interest rate in order to persuade households to hold larger coin balances. If aggrandizement expectations are dull to adapt to the increase in the money supply – because of expectational rigidities – so the autumn in the nominal involvement rate also implies a fall in the real interest rate. This raises expenditures on items such equally investment and consumer durables which are sensitive to interest rates. If prices and wages are slow to adjust to higher demand – considering of nominal rigidities – and so in the brusk run firms are induced to supply more output. Equally the pressure on capacity in the economy rises, employees demand higher wages to reflect increased demand and both wages and prices rising. In the long run, output is adamant solely by real factors, and the increment in money supply is reflected in a rise in the toll level.

15 More recently, the equation for money supply has been replaced by an explicit feedback rule for interest rates. The money need equation plays no explicit part in determining output, aggrandizement and interest rates. Money, information technology would appear, has been eased out of the picture. In these new models, a loosening of monetary policy – characterised past an unexpected reduction in the nominal interest charge per unit – raises demand, output and, ultimately, inflation. In the long run the aggrandizement charge per unit is determined by monetary policy, in the sense that the monetary policy reaction office determining involvement rates contains an explicit aggrandizement target. The higher money growth, the higher the inflation charge per unit, just, if the model were an authentic description of the economy, the interest charge per unit would be a sufficient statistic of monetary policy. Models of this type in which involvement rates are the policy instrument are widely used both in theoretical analysis and in the pattern of empirical policy rules, such equally the well known Taylor rule. Given this prominent part for involvement rates rather than money in the theoretical analysis of policy, it is, perchance, not surprising that econometric forecasting models in most major key banks include interest rates, just not the quantity of money.

16 Despite appearances, however, these new models give no less weight to coin than the older versions. Irrespective of whether the central bank uses base of operations money or interest rates equally the policy instrument, the quantity theory of coin still applies. In the new models, monetary quantities play no independent function in the manual mechanism over and higher up that summarised in interest rates. Notwithstanding, as in the old models, monetary policy impacted on the economy through its furnishings on interest rates. The primal question is non whether the central bank uses the budgetary base or interest rates as its policy instrument. It is whether the equations which are embedded in both the old and new models of monetary policy exclude important channels through which monetary policy works.

17 Before attempting to answer this question, the consensus model can be used to illustrate a key point fabricated earlier, namely that in that location is no reason to expect a stable relationship between money and inflation in the short run. Using a linearised model of the type described in Tabular array ane, the exact details of which are given in the technical appendix, fake data can be generated for long time periods corresponding to realisations of the various shocks to the economy. In particular, a quarterly model was constructed using calibrated parameters and processes for the stochastic shocks in each equation. Several variants of the model were then created, keeping the main model parameters constant, but altering the variance and persistence of the stochastic shocks. Past simulating the shock processes 10,000 times for each variant, several datasets spanning 2,500 years were created. Reduced form regressions were then run on the variants of the model to estimate the dependence of aggrandizement on lagged values of output, money growth and inflation itself. Annotation that, by construction, money has a stable causal effect on inflation. The regression results obtained from unlike sample periods produce a wide variation of estimated coefficients on money in determining inflation (see Tabular array 2). In fact, these coefficients can be either positive, negative or insignificantly different from nada, depending on the constellation of shocks hitting the economic system. Moreover, the reduced class relationships change with the length of the horizon (see Table three). Money appears to incorporate little information about very curt-term inflationary pressures, merely it becomes much more meaning in the long run. In dissimilarity, the impact of output growth on inflation falls as the horizon lengthens. The conclusion is straightforward. Unproblematic reduced form econometrics are no substitute for a articulate theoretical structural model of how monetary policy works [a indicate also made by Nelson (2001)]. Thinking needs to be liberated from the "tyranny of regressions".

Table 2

What tin can we learn from this model about simple econometrics?

What tin we learn from this model near simple econometrics?

Consider two reduced-form regressions, specified as:

Table 3

What can we learn about coin from elementary econometrics?

What tin we acquire about money from unproblematic econometrics?

The correlations betwixt the simulated information depend on their frequency, as they do in the historical data.

18 Both old and new models of the budgetary transmission machinery take important limitations. Crucially, in that location is merely a single financial asset. But in the traditional monetarist account (Friedman and Schwartz, 1963) money is an imperfect substitute for a wide range of financial and real assets, including bonds, disinterestedness, physical uppercase and durable appurtenances. A monetary policy change induces a re-balancing of portfolios in general, affecting nominal need both direct (through wealth and substitution effects on real assets), and indirectly (through adjustments in a wide range of financial yields relevant to expenditure decisions). Hence both old and new models may ignore an important part of the transmission mechanism of monetary policy.

19 The practical relevance of this consideration is extremely topical. The conventional model suggests that monetary policy is ineffective if interest rates have reached their natural flooring of zilch and a further reduction of existent interest rates is required to stimulate demand. Nippon appears to be in exactly that situation at nowadays. Chart 6 shows the recent experience of monetary policy in Japan. Aggrandizement has been very low; indeed, it has been negative in recent years. The Bank of Nippon has lowered interest rates to the indicate where they take now hit their lower bound of zero. Interest rates have been extremely low for five years, and have been most exactly zero since Feb 1999. The question of whether monetary policy is impotent when interest rates are aught has remained open since the possibility of a "liquidity trap" was suggested by Keynes in the General Theory and revived recently past Paul Krugman.

Nautical chart 6

Interest rates, money and inflation in Japan (1989-2001)

Interest rates, money and inflation in Japan (1989-2001)

Notes: Broad coin is M2 and CDs.

20 Broadly speaking in that location are two answers to this question. The first is that monetary policy is indeed impotent when interest rates are cypher. At this point, households and firms have an infinitely elastic demand for money balances, and and so any increase in money supply is absorbed passively in college balances. An increase in coin supply has no implications for spending or output. In such circumstances, the only manner to touch the economy is past an expansionary fiscal policy. The second answer is that, at some indicate, households and firms go satiated with money balances at the current level of income, and any attempt to increase the coin supply leads them to accommodate portfolios in order to limit their holding of coin balances. These changes in household portfolios atomic number 82 to changes in relative yields on different fiscal and existent assets, and hence on asset prices and, in turn, real spending. Despite involvement rates remaining at naught, monetary policy, in this globe, can influence nominal spending and incomes.

21 Which view is the more attractive theoretically and empirically? It is clear that, in part, the answer depends on the response of the need for money equally interest rates tend to goose egg. If the demand for money tended to infinity, as the interest rate tended to naught, then an expansion in the money supply would have no real effect on demand and output because any additional coin created would simply be absorbed passively in money holdings. But if the demand for money is satiated at a finite level as interest rates tend to zero, then the creation of money beyond that point would exist translated into a demand for other avails and college incomes. Since observations on involvement rates close to naught are rare in practice, there is piffling prove to support either of these two hypotheses.

22 A recent study by economists in the Bank of England (Bakhshi, Martin and Yates, 2002) finds some evidence of a satiation point in the demand for narrow coin in the United kingdom of great britain and northern ireland, although Bental and Eckstein (1997) and Lucas (2000) find show for an asymptote. The empirical show is not, therefore, decisive. There are very considerable uncertainties surrounding these estimates. But they are at least consistent with the possibility that monetary policy may have authorization even at zero involvement rates.

23 What, therefore, has economic theory to say most how changes in money might affect nominal need, over and above any influence via interest rates? This is a question that is relevant to all economies, not only those, such every bit Japan, facing zero involvement rates. I view, associated with Pigou (1943) and Patinkin (1965) is that, in the presence of sticky prices ("nominal rigidities"), a monetary expansion will lead to a rise in the real value of the money stock which volition, in plow, raise household net wealth and atomic number 82 to higher expenditures. In that location are ii objections to this view. The start is that the only part of the coin supply which constitutes net wealth for the economy as a whole is "outside" money, namely the monetary base of operations. And this accounts for only a very small fraction of financial wealth – a footling over one% in the UK. So the quantitative impact of the real residual upshot is inevitably small-scale.

24 The 2nd is that fifty-fifty this effect is subject to households failing to have into account the impact on future generations of the use of budgetary financing. Nevertheless, models by which money changes real balances accept become more than fashionable recently. Building on the work of Sidrauski (1967), a number of economists have examined the impact of college money holdings on the size of transaction costs. An unexpected budgetary expansion lowers transactions costs, according to this view, and increases the attraction of consumption. Effects of varying size take been claimed by authors such as Ireland (2001a, 2001b), Koenig (1990), McCallum (2001) and Woodford (2002). Such transmission mechanisms, withal, do not announced to be empirically pregnant nor do they stand for to the primary channels of policy as seen by earlier generations of economists.

25 The main deviation between the models described to a higher place and before writings on money is the absenteeism in those models of fiscal yields other than the short-term interest rate. In principle, many more asset yields could enter the demand for money. In his own writings, Keynes placed emphasis on the yield on long term government bonds. In this view, expansionary budgetary policy can take the form of open up marketplace operations in which the central bank purchases a wide variety of assets, not just short-term government securities. Yields on a wide diversity of financial assets respond, and in plow so does need. One of these financial prices is the exchange charge per unit. That is why some economists see the salvation for Nihon in terms of the exchange rate. They recommend strategies such as expanding the monetary base in order to produce a fall in the market exchange rate which would atomic number 82 to an upturn driven by net merchandise. Alternatively, economists such as Svensson (2001) accept recommended pegging the yen at a much lower exchange rate against the dollar. This, information technology is argued, would pb to expectations of higher inflation which, given zero nominal interest rates, would produce a negative real interest rate that would generate an expansionary bear on on the economic system.

26 The major question, notwithstanding, is how an expansion of the money supply operates through indirect effects on the yields of other avails which are excluded from conventional models of the transmission machinery. If future interest rates are incorporated into optimal consumption behaviour, then the but channel by which budgetary policy can operate, other than via interest rates, is through changes in run a risk premia.

27 How might we try to integrate monetary theory and portfolio theory? Niggling assist will come from traditional finance theory. The reason being that most finance theory is mainly based on the supposition that equilibrium yields on assets, including risk premia, are independent of the quantities of the supplies of unlike assets. Hence the search for a amend model of the monetary manual mechanism is, in office, a search for evidence of supply effects on financial asset yields. That is why the view that money matters, over and higher up interest rates, is intimately bound upward with a question of whether the supplies of different avails bear on yields, and hence whether the limerick of government debt affects both money and real economical behaviour. In the Uk, Tim Congdon has emphasised the importance of "funding policy" in the decision of the wide money supply, a subject field which has been analysed in detail past Goodhart (1999). The wide weight of opinion, to engagement, is that supply effects are hard to notice. Many years agone, for instance, the U.s.a. tried to change the slope of the yield bend on its regime debt by "Operation Twist" in which the limerick of government debt was contradistinct in an attempt to change relative yields. This experiment was widely regarded as a failure. Intriguingly, however, there is renewed interest amongst finance theorists in the impact of supply effects on yields. More than and more puzzles in the theory of finance appear to be related to the existence of supply effects.

28 There seems to exist a gap between mod finance theory and the traditional monetarist view in which a budgetary expansion causes a re-balancing of portfolios putting direct upward pressure on a range of nugget prices, which in turn stimulates higher nominal demand. To span this gap requires a more careful assay of exactly what is special nigh coin. Much of the traditional monetarist account relies on the imperfect substitutability between various marketable assets, including coin. But in that location is oft a weak theoretical rationale for the mechanisms discussed. Thus, while it is clear that financial markets take a much richer construction than is conventionally assumed past the models described earlier, the monetarist argument that this is sufficient to imply a significant role for coin remains unproven. What are the promising avenues for future research? The solution, I conjecture, will exist based on two observations:

• Transaction costs are of import in determining asset prices – many of the puzzles in the behaviour of nugget prices, such as the equity risk premium, can be partly resolved by taking the effects of transaction costs seriously;
• Money reduces transaction costs.

Rather than rely on a barter economic system, goods (or labour) can be exchanged for coin, and money for appurtenances. But there is no reason to suppose that the same argument cannot be used in asset markets.

29 If the quantity of money tin can affect the size of transaction costs in financial markets, then it will have an effect on expenditures and inflation, over and above any change via the transmission from changes in risk-gratuitous interest rates. Over the by decade, economists have made strides in setting out a more than coherent theoretical story of the way in which money reduces trading frictions in markets for goods and services. Traditional models of exchange economies brand strong demands on the institutional arrangements that underlie transactions. Coin can help reduce these transactions costs. And it is possible that money might have a like office in alleviating frictions in fiscal markets, thus expanding the telescopic of the transmission machinery of monetary policy. It is hitting that nearly a quarter of the money stock in the U.k. is held by non-depository financial institution financial firms. The frictions which money helps to overcome in financial markets are related to its role in providing liquidity services. Money enables individuals, both households and firms, to avoid borrowing should they hit a cash-menses constraint. Since the probability of experiencing such a constraint falls as the stock of money rises, changes in coin could bear upon relative nugget returns. Introducing fiscal frictions into models of asset prices, and recognising the role of money in reducing those frictions, provides, in my view, a potentially more pregnant role for money in the transmission mechanism than has been examined hitherto in a rigorous manner. The theoretical support for, and empirical relevance of, such an approach is withal unclear. So at that place is a substantial agenda for futurity research.

30 The link between money and the provision of fiscal services more generally is articulate in the historical development of "inside coin", such as checking accounts and credit cards, which now constitute the bulk of broad money. Credit services can displace the use of "outside money" in transactions, but only where their toll is sufficiently depression, and that may depend upon the private characteristics of the agents undertaking the transactions. As a result, the parameters of the money demand function are dominated by the engineering of transaction services, and can be unstable over time (every bit for example, in the model of Aiyagari, Braun and Eckstein, 1998). This instability derives not from the irrelevance of coin, only from changes to technology.

Money and monetary policy

31 What does this argue well-nigh the transmission mechanism of monetary policy mean for the behave of budgetary policy today? The role of money in determining the toll level, and its embodiment in the quantity theory of money, evolved over several hundred years. The wide shape of this theory was accepted by most economists. It is certainly evident in the writings of both John Maynard Keynes and Irving Fisher. As the theory of monetary economics developed, and then also did the do of budgetary policy. In Britain, the beginning of the theory and practise of monetary policy as we know it today started with the Depository financial institution Charter Act of 1844. Keynes wrote that prior to the 1844 Human activity, "the principles and methods of currency management were but ill understood by those responsible for its management, namely, the Governors and Court of the Bank of England." (Treatise on Money, p.14-15). He went on to conclude, "The efficiency of depository financial institution-rate for the direction of a managed coin was a great discovery and besides a nearly novel one – a few years before the Banking concern of England had not had the slightest understanding of any connexion between bank-charge per unit policy and the maintenance of the standard" (op.cit. p. 15). I promise that the Bank of England today has at to the lowest degree some understanding of the relationship between interest rates and aggrandizement!

32 Thinking of monetary policy in terms of involvement rates has become the norm in central banks today. Frequent and volatile shifts in the need for money led central banks to alter their focus from monetary aggregates towards the control of short-term involvement rates. Few, major central banks now place monetary aggregates at the centre of their targeting government. Instabilities in the demand for money are not new. In the early on years of the Banking company of England, there were unexpected shifts in the demand for money and credit resulting from uncertain arrival times in the port of London of ships laden with commodities from all over the world. The uncertainty derived from changes in the direction and speed of the wind conveying ships upwardly the Thames to the port of London. Hence the Courtroom Room of the Bank of England contained a atmospheric condition vane which provided an accurate guide to these shifts in coin need – the conditions vane is there to this day, and it still works. If simply monetary policy could be as scientific today! Financial liberalisation and changes in the engineering of payments and settlements have led to large volatilities in money need. No one has withal worked out how to translate such shifts into a simple reading on the fiscal equivalent of a conditions vane. And then central banks have paid decreasing attention to monetary aggregates every bit an intermediate indicator of their policy stance.

33 Although there is no mechanical link from monetary aggregates to inflation, the underlying relationships, in quantitative form, still hold. Hence it is of import for a cardinal banking company to empathise changes in money. One of the features of the Bank of England's analysis of monetary developments is the attempt to sympathize the entire range of monetary quantities and prices facing agents in the economy. Each month the Monetary Analysis and Strategy Division of the Depository financial institution of England produces a Quarterly Budgetary Assessment in order to provide the Monetary Policy Commission with as much information as possible about monetary developments. Part of this includes an analysis of equilibrium interest rates and the opinion of monetary policy. Rules, such every bit the Taylor rule, provide a useful benchmark against which to judge whether interest rates are too high or also low. But the assay provided past the Bank of England is not restricted to interest rates. Information technology is crucial to await at developments in quantities in the monetary area and credit conditions, also as prices. Using historical relationships estimated from the information, developments in money and credit, and their sectoral patterns, can be used as indicator variables for about-term activeness and inflation. The short-term outlook for consumption, for example, can be related to movements in Divisia Money, whereas the outlook for investment is related to the financial position of the corporate sector.

Conclusions

34 I return to the paradox with which I began. Most people believe that economics is about money. However nigh economists hold conversations in which the word "money" appears hardly at all. Surprisingly, that appears true even of central bankers. The resolution of this credible puzzle, is, I believe, that in that location has been no modify in the underlying theory of inflation. Evidence of the differences in aggrandizement across countries, and changes in inflation over time, reveal the intimate link between money and prices. Economists and key bankers understand this link, but conduct their conversations in terms of interest rates and not the quantity of money. In large role, this is because unpredictable shifts in the demand for money mean that cardinal banks choose to set up interest rates and allow the public to decide the quantity of money which is supplied elastically at the given interest charge per unit.

35 The disappearance of coin from the models used by economists is, every bit I take argued, more than apparent than real. Official brusque-term interest rates play the leading role equally the instrument of policy, with money behind the scenes. But the models retain the classical property, that, in the long run, monetary policy, and hence coin, impact prices rather than real action. Still, there are real dangers in relegating money to this behind the scenes role. And many economists having abandoned coin themselves are now advising the European Central Bank to give up the beginning colonnade of its monetary strategy. Is it sensible to give up a special role for money in the discussion of monetary policy? Although I prefer the clarity of a single pillar – an inflation target – to dual pillars, there are dangers in ignoring the special role of money. Three dangers seem to me particularly relevant to present circumstances. First, there is a danger of neglecting parts of the monetary transmission mechanism that operate through the impact of quantities on take a chance and term premia of various kinds. The electric current debate virtually the appropriate monetary policy in Nippon illustrates this point. Second, by denying an explicit role for money there is the danger of misleading people into thinking that in that location is a permanent trade-off betwixt inflation, on the one hand, and output and employment, on the other. 3rd, by discussing budgetary policy in terms of real rather than monetary variables, there is the danger of giving the impression that budgetary policy can be used to fine tune curt run movements in output and employment, and to offset each and every shock to the economy. These dangers all derive from the habit of discussing monetary policy in terms of a conceptual model in which money plays just a hidden function.

36 Habits of speech not only reflect habits of thinking, they influence them besides. So the way in which central banks talk almost money is of import. There is no inconsistency between the consensus models we use to analyse policy in terms of interest rates and the proposition that monetary growth is the driving forcefulness behind higher aggrandizement. But it would be unfortunate if the change in the way we talk led to the erroneous belief that we could turn Milton Friedman on his caput, and think that "Inflation is always and everywhere a real phenomenon".

37 My ain conventionalities is that the absenteeism of money in the standard models which economists apply will cause problems in hereafter, and that there volition be profitable developments from future research into the way in which money affects risk premia and economical behaviour more than more often than not. Coin, I conjecture, will regain an important place in the conversation of economists. Equally Hilaire Belloc wrote,

38 "I'm tired of Dear: I'm all the same more tired of Rhyme. But Coin gives me pleasure all the time" [iii].

39 M. Thou.

Technical appendix

The generation of the simulation results

forty The model used here is a linearised version of that shown in Tabular array 1, similar to that given in McCallum (2001), where the involvement rate reaction role below replaces the money supply equation.

Model

41

42 where y is the natural log of output, i is the nominal involvement charge per unit, ? is the inflation rate, y ^– the natural log of potential output, grand the natural log of money, ?* the inflation target. The parameter values are based on Nelson (2000), Neiss and Nelson (2001), and Neiss and Pappa (2002).

Calibration of the stochastic shocks

43 Each of the shocks is independently normally distributed with mean zero, and standard deviations and autocorrelations shown below for the benchmark example.

These values are consistent with Nelson (2000), Neiss and Nelson (2001), Neiss and Pappa (2002). In case i, the baseline parameters shown above are chosen. In example 2, we use the benchmark parameters, but increase the autocorrelation of demand shocks to 0.5. Case three is the benchmark, with the standard deviation of mark up shocks raised to 0.01. Case 4 is the benchmark, with an increase in the standard deviation of mark upward shocks to 0.01, the auto-correlation of marking up shocks to 0.8 and the standard deviation of policy shocks to 0.04.

The experiment

44 Simulated data were created by taking 10,000 random draws from a standard normal distribution for each shock, and scaling and transforming equally appropriate for each of the shocks to create autocorrelated series where required. Using the realisations for the shocks, we can solve for the model variables using the solution algorithm of Male monarch and Watson (1995). This gives a time series of 10,000 simulated observations for each model variable. Correlation coefficients and ordinary least squares regression coefficients were then calculated using standard statistical techniques on the simulated data.

Notes

• [1]

  Lecture to the Kickoff Economic Policy Forum held at the Banque de France, Paris, on xiii March 2002. An earlier version of this paper was presented at the Maxwell Fry Global Finance Lecture, University of Birmingham, Wednesday 24 October, 2001.

• [two]
• [3]

  I would particularly like to thank Andrew Hauser, James Proudman and Jan Vlieghe for their expert help in preparing this paper. I have as well benefited from useful comments from Peter Andrews, Kosuke Aoki, Zvi Eckstein and John Ability. Richard Geare, Alex Golledge and Amit Sohal provided aid with the data.

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