|
Case for Monetary Aggregegates
Those who prefer to use the money aggregates to measure
monetary policy point to episodes in which they believe
interest rates clearly gave the wrong story about monetary
policy. In the late 1960s and early 1970s the growth rate of
money increased (with some fluctuations) which indicated
that monetary policy was getting easier and easier. Interest
rates, on the other hand, also rose in this period, which
indicated that monetary policy was getting tighter and
tighter. Those who prefer money as an indicator argue that
the analysis explained in the last section ignores the
effect of inflation, and once inflation enters, changes in
money and changes in interest rates need not be inversely
related.
Suppose there is a rapid increase in money stock.
Initially the increase in money supplies funds to the
market, reduces interest rates, and spurs spending. Suppose
the increased spending is large enough to increase the rate
of inflation. As prices rise and people begin to expect
inflation, the demand curve in the market for loanable funds
shifts to the right, and interest rates rise. Once people
begin to expect higher inflation, they change their behavior
regarding borrowing. A higher expected rate of inflation
will shift the demand curve for funds to the right. Further,
if people learn to expect inflation from rapid increases in
money, the time lag between an increase in money and a shift
of the demand curve will be short. Hence, it is very
possible that an increase in money can cause an increase in
interest rates, not a decrease. Thus higher interest rates
do not necessarily mean tighter monetary policy.
One can eliminate the inflation problem by looking at
real rates of interest rather than nominal rates. Since the
real rate is the nominal rate less the expected rate of
inflation, all one has to know is the expected rate of
inflation. Unfortunately, knowing this poses problems that
have not yet been solved. And even if one knows the real
rate of interest, problems remain with interest rates as an
indicator of monetary policy.
Interest rates are sensitive to business fluctuations. In
a boom, when profits are rising and businesses decide they
need to expand their productive capacity, they are willing
to borrow more at each rate of interest, or in terms of the
supply and demand for loanable funds, the demand curve for
loanable funds moves to the right. Savings may also
increase, but the shift they cause in the supply curve of
loanable funds need not match the shift in the demand curve.
Historically, interest rates have risen during periods of
boom and fallen during periods of recession. There is a
"reverse causation" problem for interest rates. Changes in
interest rates may not indicate "tighter" or "easier"
monetary policy. Instead they may indicate that business
conditions have changed.
Those who argue that monetary aggregates are the best way
to measure monetary policy cannot dismiss the problem of
reverse causation. There are cases in which the amount of
money clearly seems to have been influenced by changes in
economic activity, and, indeed, cases seemed so obvious to
"monetarists" before Keynes that they built business-cycle
theories on the basis of two-way causation between money and
income. However, most people who prefer monetary aggregates
believe that most of the correlation between fluctuations in
money and income cannot be explained by the effects of
income on money. In effect they argue that those who present
the reverse-causation position lack a plausible
transmission mechanism. Thus many of the fluctuations
in money can be explained in terms of changes in income, but
sometimes the explanation must appeal to gold flows,
sometimes to bank borrowing or other bank behavior,
sometimes to currency-deposit substitution of the public,
and other times to reactions of the central bank. The way
reverse causation works has continuously changed over the
past century as financial institutions and the financial
environment have changed. Those who favor monetary
aggregates argue that it is implausible that a close
correlation between money and income, lasting over a century
and apparent in many countries, can be due to such an
ever-changing variety of transmission processes.
There is another way to present the arguments involved in
this dispute. Consider the market for oranges. One could
measure the "tightness" of the orange market either by the
number of oranges exchanged or by the price of oranges. An
increase in the supply of oranges (movement of the supply
curve right) would decrease price and increase quantity,
both indicating "easier" conditions. But an increase in
demand (movement of the demand curve right) would increase
quantity, indicating "easier" conditions, and increase
price, indicating "tighter" conditions. Price better
indicates the "ease" or "tightness" of the orange market
because it responds correctly to both changes in demand and
in supply. Could not one make the same argument for money,
showing that the price of money, the interest rate, is a
better indicator of ease or tightness of monetary policy
than is the quantity of money?
Those who prefer monetary aggregates generally answer
this question by denying that the interest rate is the price
of money. The price or value of an orange is what one can
get in exchange for it. The price or value of money is what
one can get in exchange for it. One gets goods and services
for money. If one gets fewer goods this year than last year
for money, the price of money has fallen. The proper way to
measure the value of money, according to this argument, is
to look at the inverse of the price level.
The argument that the price of money is the inverse of
the price level should lead economists to use it as the
proper indicator of whether monetary policy is easy or
tight. Some economists do rely on measures of this kind; the
value of foreign exchange when exchange rates float has been
used as an indicator of whether monetary policy is easy or
tight, and the justification for tying money to gold is that
this linkage keeps the price level constant (or almost
constant). There is a lag, however, between a change in the
supply of money and a change in the price level. Many
economists believe that if they want to know what is
happening to monetary policy now, looking at changes in the
amount of money will tell them more than any other
indicator.
Copyright
Robert Schenk
|