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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.

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Copyright Robert Schenk