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Measuring Monetary Policy

The late 1950s and early 1960s saw the rise of monetarism, which was a revival of a tradition of monetary theory stretching from Henry Thornton to Irving Fisher. The monetarists believed that monetary policy was far more important than fiscal policy in changing total spending. They also emphasized the use of monetary aggregates, such as M1 or M2, as the best way to measure monetary policy. The most prominent of the monetarists was Milton Friedman, whose most influential work was A Monetary History of the United States, 1867-1960, which he co-authored with Anna Schwartz.1

Friedman and Schwartz argued that existing views about the cause of the Great Depression were wrong. The Great Depression was not the result of a defect in capitalism or of stock market speculation. Rather, the Federal Reserve had allowed the Depression to happen by allowing money stock to decline by 25%. This view of Friedman and Schwartz was revolutionary and unsettling to many people. Big events seem more meaningful if they have important causes. To say that the ineptness of a few unknown people had caused a decade of tremendous suffering seemed to trivialize that experience. Others had vested interests in existing explanations. The new explanation suggested that the generation of intellectuals that had reject capitalism to embrace socialism and Marxism had based their intellectual lives on a mistake. The many programs of the New Deal were justified with the belief that government needed to protect people from the vagaries of the market, but if the Depression had been caused by the mistakes of government officials, what happened to the justification for all those programs?

The idea that monetary policy caused the Great Depression was hotly contested, but it has triumphed among economists. Even the Federal Reserve, which no longer feels threatened by this interpretation as it still did in the 1960s, now largely accepts it, and it has influenced monetary policy. The Fed will not allow a financial crash or a bank run to reduce money stock as it did in the 1930s. It now reacts vigorously to such threats, pouring reserves into the banking system if necessary. Examples are evident in the Fed's response to the run on Continental Illinois in 1984, the stock market crash in October of 1987, the liquidity problems of Long Term Capital Management in September of 1998, and the threat of cash withdrawals from the banking system as the result of fears of the so-called millennium bug in January 2000. The Fed's response to the financial panic in September of 2008 was an unprecedented expansion of bank reserves, a response designed to make sure that mistakes of the 1930s were not repeated.

Although monetarists were successful in arguing the importance of monetary policy, they were not successful in convincing others that monetary policy is best measured by the quantity of money in circulation. They have argued that a 10% growth rate in money indicates an "easier" policy than does a 2% growth. This is an obvious way to measure monetary policy in the quantity-theory framework because money enters directly into the equation that determines total spending: money multiplied by velocity equals total spending.

In the Keynesian framework, however, money enters the equation that determines total spending only indirectly. The line of causation runs through the financial markets: a change in money changes interest rates, which changes investment, which is part of GDP. From this perspective it is not obvious that one should use money stock as a measure of monetary policy—interest rates are an alternative possibility. Using interest rates puts one closer to the determination of GDP than does money stock. In this interpretation, higher interest rates signal a "tighter" monetary policy and lower interest rates signal an "easier" monetary policy.

The question of what is the best way to measure monetary policy has spurred considerable debate in economics. Let us begin by reviewing the arguments for using interest rates. We will explain the argument by examining what must be going on in the financial market.

The financial market can be seen in terms of a supply of and a demand for loanable funds. The exact shapes of these curves are unknown. One can argue that the supply curve is very steep because interest rates do not greatly affect savings, or one can argue that it is very flat because any one country is but a small part of the international financial market. Neither is it clear how responsive demanders are to interest rates. Nonetheless, financial markets can be represented in terms of supply and demand curves such as those in the graph below.

Supply and Demand of Loanable Funds

Suppose that the amount of money increases. In a modern credit economy the additional money flows through the financial markets and will influence the curves in the graph above. In particular, banks will create an increase of money either through the lending of money to customers or by purchasing existing debt from people who want to sell it. In either case, the banks are supplying funds to the financial markets. In terms of the graph above, the increase of money will shift the supply curve to the right and lower interest rates. A decrease in money will shift the supply curve to the left and increase interest rates.

The advantage of using interest rates to measure monetary policy, according to its proponents, is that it makes clear the transmission process by which an increase in money affects total spending. On one hand, if one accepts that financial markets transmit the preponderance of the effects of a change in money to spending, then interest rates should indicate the impact of a change in money stock. Further, any changes in demand for money that offset or accentuate the impact of a change in money will also show up in the interest rates. Thus, if people suddenly decide to hoard money at the same time the central bank increases it, there will be little effect on interest rates or the economy, and watching interest rates will give a more accurate picture of what the effect of the increase in money will be than will watching money stock. On the other hand, if there are important channels of transmission other than the financial markets, interest rates may give misleading results. But those who prefer money to interest rates as an indicator have not come up with a convincing explanation of what the other avenues of transmission are.

Those who prefer interest rates to a measure of money stock also point out that several measures of money (or several monetary aggregates, to use economists' jargon) are available, and those who want to use a measure of money cannot agree among themselves which is best. Further, in a period of rapid financial change, such as in the late 1970s and early 1980s, rules and regulations involving checking accounts change and behavior should change as well. As a result, there is even more than normal confusion about how to measure money, and one should not expect any measure of money to be a good indicator of the effects that monetary policy will have on the economy.

Finally, those who argue that interest rates are the better way of measuring money often point to a problem in using money, the problem of reverse causation. There was an impressive correlation between changes in money and changes in total spending, but it is unclear how much of this correlation was due to changes that move from spending to money. One can view the amount of money determined by the interaction of supply and demand. The interest rate is the price of money, and there is a positively-sloped demand curve and a negatively-sloped supply curve. If income falls, people will demand less money at any rate of interest, or the demand curve shifts left. The money market will find its equilibrium at a lower rate of interest and a lower amount of money. Thus, a change in income may cause changes in money rather than vice versa. Although this argument is flawed with a commodity money, it can have merit if the central bank establishes certain sorts of policy rules.

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1Friedman, Milton and Schwartz, Anna Jacobson. A Monetary History of the United States, 1867-1960. Princeton, NJ: Princeton University Press, 1963.

Copyright Robert Schenk