The future of monetary aggregates in monetary policy analysis

Abstract

This paper considers the role of monetary aggregates in modern macroeconomic models of the New Keynesian type. The focus is on possible developments of these models that are suggested by the monetarist literature, and that in addition seem justified empirically. Both the relation between money and inflation, and between money and aggregate demand, are considered. Regarding the first relation, it is argued that both the mean and the dynamics of inflation in present-day models are governed by money growth. This relationship arises from a conventional aggregate-demand channel; claims that an emphasis on the link between monetary aggregates and inflation requires a direct channel connecting money and inflation, are wide of the mark. The relevance of money for aggregate demand, in turn, lies not via real balance effects (or any other justification for money in the IS equation), but on money's ability to serve as a proxy for the various substitution effects of monetary policy that exist when many asset prices matter for aggregate demand. This role for monetary aggregates, which is supported by empirical evidence, enhances the value of money to monetary policy.

Inflation and monetary dynamics in the USA: a quantity-theory approach

“…For example, NewKeynesian models incorporated policy rules setting short-term interest rates with no explicit money terms, and the adoption of direct inflation targeting by policymakers in several countries contributed to shift attention away from monetary aggregates. However, the existence of a long-run link between inflation and money growth is still widely believed by theorists and policymakers, despite some recent challenging evidence (Nelson 2003 In this paper we studied the link between inflation and money growth in the US over the 1960-2003 period, adopting the quantity theory as a general framework relating inflation to the growth rates of nominal money aggregates and real output in the long run. The common persistence properties of the variables, modelled as fractionally integrated and cointegrated series, have been exploited to construct a measure of the long-run inflation trend closely linked to monetary dynamics, using principal components techniques in the frequency domain.…”

“…According to Svensson (2003), nominal money growth would be exogenous relatively to inflation under strict money growth targeting, while inflation would be exogenous relatively to nominal money growth under strict inflation targeting. However, as argued by Nelson (2003), even when money is not used as a policy instrument, monetary policy decisions have an impact on money growth dynamics. For instance, an open market operation which increases the policy rate aiming at a given level of inflation will slow money growth by reducing directly the monetary base.…”

“…A one-to-one proportionality between changes in the steady-state money growth rate and the rate of inflation in the long-run is commonly regarded as an explanation of inflation grounded in the quantity theory of money (Nelson, 2003). This conception is summarized in the famous statement by Milton Friedman that "inflation is always and everywhere a monetary phenomenon" (Friedman (1963), restated in Friedman (1992)).…”

“…This evidence has been interpreted as implying that, when inflation is relatively low, changes in the money growth rate are very noisy signals of inflationary pressures. Hence, monetary authorities like the European Central Bank should not regard money growth as a valuable information variable and should abandon the practice of setting "reference values" for the growth rate of some monetary aggregate (Begg et al, 2002;Svensson, 2002 Leeper and Roush (2003) and Nelson (2003) have recently provided fresh evidence for the US and the UK supporting the basic "quantity-theory" proposition that inflation and money growth are strongly correlated once allowance is made for lags in the monetary transmission. Moreover, the analysis by Gerlach and Svensson (2003) and Bagliano et al (2002 of the Euro-area experience since 1980 lends support to a P * model (Hallman et al, 1991) of the long-run relation between prices, monetary aggregates and output, while even a more direct reference to the quantity theory is made by Morana (2002Morana ( , 2005, where the long-run quantity theory relationship is estimated.…”

“…Our empirical investigation of the relation between inflation and monetary growth is cast in the theoretical framework provided by the quantity theory, according to which inflation is a monetary phenomenon, in the sense of a one-to-one relationship between the steady-state values of the inflation and monetary growth rates (Nelson (2003) provides an insightful discussion of the quantity theory proposition in the context of the recent monetary policy literature). This relationship can be derived directly from the equation of exchange by (log)first-differencing, obtaining…”