MONETARY POLICY UNCOVERED: THEORY AND PRACTICE

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1 ABSTRACT: This paper discusses the current new consensus view on monetary policy and the theoretical framework on which that practical view relies, namely, the targets-andinstrument approach. The papers shows that in the modern world of financial innovation and liability management central banks cannot really choose between an interest targeting policy and a monetary aggregate targeting policy. The relationship between reserves and monetary aggregates on one side, and between monetary aggregates and nominal income on the other side, is a very unstable one. A monetary aggregate policy is simply not feasible. The rate of change in monetary aggregates is in fact a function of the level of net deficit spending in the economy, which is, in turn, a function of the interest rate set by the central bank. In short, central banks have no choice but to have an interest targeting policy. 1

2 Central bankers and even some monetary economists talk knowledgeably of using interest rates to control inflation, but I know of no evidence from even one economy linking these variables in a useful way, let alone evidence as sharp as that displayed in figure 1 [showing a simple correlation between inflation and money growth]. The kind of monetary neutrality shown in this figure needs to be a central feature of any monetary or macroeconomic theory that claims empirical seriousness (Robert E. Lucas, Nobel Lecture, 1996) MONETARY POLICY UNCOVERED: THEORY AND PRACTICE 1. Introduction In a recent issue of the Journal of Economic Perspectives De Long has claimed that the influence of monetarism over current macroeconomics is profound and widespread (De Long, 2000, pp. 83 4). In particular, he argues that the emergence of monetary policy as one of the most critical government responsibilities is the result of the triumph of classic monetarism as developed, for instance, by Friedman and Schwartz (1963). A similar sort of evocation of monetarism is also at the core of a recent paper by Laidler on the transmission mechanism (Laidler, 2002). Some economists would find comfort in these assessments. They would see them as providing further evidence to the view that modern monetary policy is monetarist in nature despite some degree of play-acting, even deception, by current policy makers (e.g. Parguez, 1999). However, most Post Keynesians would disagree with these conclusions. For instance, Dalziel (2002, p. 1) has shown that the cornerstone of monetarism, the quantity theory of money, is no longer used by central banks. He argues that today monetary policy is aimed to maintain aggregate demand growth compatible with supply- 2

3 side capacity growth, a framework that he traces back to Chapter 21 of Keynes s (1936) General Theory. Does current monetary policy then mark the triumph of Friedman and monetarism, or is it rather the triumph of Keynes and Post Keynesianism? This paper invites a non-dualistic response to the questions, and in this way aims to uncover the tension between theory and practice of modern central banking. The main tenet of the new consensus is that (a) monetary policy is the major direct determinant of inflation and (b) low and stable inflation is critically important for economic growth (Bernanke et al., 1999). The theoretical framework supporting these propositions is the targets-andinstrument approach (Blinder, 1997) and is based on an often-tacit combination of elements that are derived from the work of Keynes, Friedman, and their followers. This paper aims to show the basic features of that framework and some of the controversial issues related to the new consensus in monetary policy. The structure of the paper is as follows. Section 2 reviews the current practices of central banking. Section 3 discusses the theoretical framework on which that practice relies, namely, the targets-and-instrument approach. Section 4 looks at the monetary aggregates targeting policy, one of the policies consistent with the targets-andinstrument approach, and offers a Post Keynesian critique of that policy. This is followed by a section suggesting further institutional arguments against the monetary aggregates targeting policy. Finally, Section 6 presents conclusions. 2. Central banking in practice: the new consensus view The first proposition of the new consensus on monetary policy is that monetary policy is the major direct determinant of inflation (Bernanke et al., 1999, p. 3). According 3

4 to a prominent monetary economist, this means that most central bankers around the world would undoubtedly subscribe to the following equation (Laidler, 2002, p. 3): dp dt = dm dt + dv dt dy dt (1.A) The logarithmic growth rate of prices - that is, the inflation rate - is equal to the logarithmic rate of growth of some representative monetary aggregate, plus the logarithmic rate of change in the velocity of circulation of money, minus the logarithmic growth rate of real income. According to Laidler (2002), central bankers would also accept that in the long run changes in the money supply do not affect real income, 1 and changes in the velocity of circulation of money are outside their control. Therefore, for a central bank equation (1.A) can be written in the following way: dp = dt dm dt (1.B) Equation (1.B) is thus the basic long run equation driving what Laidler (2002) considers to be the new consensus approach to monetary policy. For what matters, this equation is perfectly compatible with the standard monetarist propositions. Changes in the money supply have a substantial effect on aggregate demand. More importantly, any change in the money supply that monetary authorities succeed in bringing about manifests itself in the long run in higher prices but not in higher real output. But does it really matter that equation (1.B) could be made consistent with a monetarist approach to monetary policy? 2 What do central bankers really do in the day-to-day setting of monetary policy? Again, according to Laidler (2002), the same central bankers would 4

5 surely agree that in the short run they use roughly a set of three equations - namely, an expectations-augmented Phillips curve, an IS curve, and a Fisher equation: dp dt Y Y * = h e dp dt ( r, X ) dp r = i dt = g e * ( Y Y ) (2) (3) (4) where (Y Y*) measures the output gap (for the problematic nature of the value of this variable, see Dalziel, 2002), (dp/dt) is the expected value of the inflation rate, (r) and (i) are the real and nominal rates of interest respectively, and (X) is a vector of variables that shift the IS curve. However, as Laidler promptly recognises, there is an unresolved tension over the way the new consensus literature approaches the setting of monetary policy. Equation (1.A) makes money all important for inflation in the long run while equations (2 4) treat it as irrelevant in the short run (Laidler, 2002, p. 5). From a monetarist perspective, equation (3) is a Trojan horse in the citadel of the quantity theory of money. What a true monetarist would like to see in its place is the following equation - namely, a positively sloped LM curve: M = P m( i,y) (5) where (M/P) indicates the equilibrium real money balances of our economy. Of course, there is a good, though often neglected, reason for explaining the use of an IS curve rather than an LM curve. It is related to the so-called instrument problem (IP hereafter), a major component of the targets-and-instrument approach that is currently used by most central bankers (Blinder, 1997). The long and intense debate around the IP began with Poole s 5

6 seminal work (Poole, 1970). The crux of the matter was to determine the conditions under which an interest rate (r) policy was preferred to a monetary aggregate (M) policy. The main result of the debate was that, in theory, the latter policy tends to represent an optimal choice of monetary policy when the variance of shocks to the commodity market is larger than the variance of shocks to the monetary sector. The controversy between advocates of (r) targets and advocates of (M) targets was then finally settled in practice. As argued by Blinder (1997, p. 7), these [theoretical] conditions then arose in practice, and one central bank after another abandoned M targets in favour of r targets. 3 This is all well known, and the controversy over the optimal choice of monetary policy instruments is now history. However, there is a problem with this argument and the often-quoted successful interaction between theory and practice of central banking. Consistency with the targets-and-instrument approach requires that, were the practical conditions ever to be reversed, it would again be appropriate to use monetary aggregates as intermediate targets. This possibility may justify, among other things, keeping the base money-multiplier approach as the essential tool for explaining the money supply process in standard textbooks. Indeed, this seems to be the view of the president of the Federal Reserve Bank of New York, who is not short of praise for using monetary aggregates as a targeting framework for monetary policy. According to him, it is only the lack in modern times of a stable and predictable relationship between the money target and nominal income that prevents the adoption of that policy framework (McDonough, 1997, p. 4; also Taylor, 1995, p. 12, n. 1). More to the point, Paul Volcker explains that the shortcomings of the monetarist experiment at the Fed in the late 70 s were due to particular historical circumstances: People dependent upon bank lending did not follow 6

7 a nice conceptual textbook approach. They were caught up in ongoing operations so they kept borrowing (Volcker, 2002, p. 3). But Post Keynesians like Moore (1988) and Wray (1998) as well as leading monetary practitioners like Goodhart (2002) have openly talked about the myth of the money multiplier. As is shown in the next sections, these authors maintain that a money supply-based monetary policy strategy is neither feasible nor desirable. Before moving to the problems of the current use of the targets-and-instrument approach, it is worthwhile to note that there is much more than a numerical substitution in having an IS curve rather than a positively sloped LM curve in the set of equations (2 4). For the day-to-day setting of monetary policy, central bankers seem to have lost any confidence in the ability of a monetary aggregate strategy to deliver price stability. 4 It is now the central bank key interest rate that is seen as the instrument to hit the desired inflation rate through its effects on aggregate demand (Bank of England, 1999b). Recent work by Arestis and Sawyer (2002) on current monetary policy in the United Kingdom confirms this view. They argue that interest rate targeting policy has little to do with monetary aggregates. In the basic macroeconomic models of the Treasury and the Bank of England, the supply of money is not even mentioned. More importantly, the demand for money is either viewed as unstable or is treated as a residual (Arestis and Sawyer, 2002, p. 12). Similarly, in the macroeconomic model of the US economy used by the Federal Reserve, shifts in monetary policy are fully captured by changes in the federal funds rate, with no role at all for monetary aggregates (Federal Reserve Board, 1996). Thus, what Laidler (2002) defines as an unresolved tension in the modern setting of monetary policy is simply evidence of the large bridge that has for a long time now 7

8 separated theory from practice. If, from a practical point of view, equation (1.A) really mattered, then it would necessarily follow that central banks would seek to use open market operations to determine the quantity of bank reserves and, via the multiplier, the quantity of money, whose long run impact would be on prices only. But is that policy choice really open to a central bank? As Wray (1998, p. 98) explains, [t]he central bank never has controlled, nor could it ever control, the quantity of money; neither can it control the quantity of reserves in a discretionary manner (see also Goodhart, 2002). For the current setting of monetary policy, equation (1.A) is then simply a relic of what theorists suggested that central banks should do, and what these same central banks could not do. A more general or encompassing interpretation of equation (1.A) would be that, in the long run and in the absence of persistent changes in the velocity of circulation of money, the money supply would move in line with nominal income. Similarly, the implied direction of causation, if any, in equation (1.B) would then be from changes in nominal income to changes in the stock of money. 5 As explained in a recent report by the Bank of England (1999a, p. 13), sustained increases in prices cannot occur without an accompanying increase in the money stock. That does not mean that money causes inflation. When the short-term nominal interest rate is viewed as the policy instrument, both money and inflation are jointly caused by other variables (see also Arestis and Sawyer, 2002, p. 7). 8

9 3. Conventional theories of central banking: the instrument problem framework The instrument problem (IP) of monetary policy arises because of the need to specify how central banks implement open market operations. In particular, the IP consists in the choice of a variable that will be set directly by central bankers via purchasing and selling securities. A central bank may buy or sell a certain amount of securities, thereby providing or withdrawing the equivalent amount of bank reserves. Alternatively, a central bank may purchase or sell whatever amount of securities other market participants want to exchange at a specified price. In this case, central banks would let the market determine the quantity of bank reserves to be held at that price. Literature regarding the choice of monetary policy instruments, beginning with Poole (1970), laid down the conditions under which a price variable, for instance an interest rate, was to be preferred to a quantity variable like borrowed (BOR) or non-borrowed bank reserves (NBOR). In Poole s seminal contribution (Poole, 1970) a stochastic IS LM framework is formulated where the commodity and monetary sectors are subjected to exogenous random shocks. The monetary policy strategy that minimises a loss function, presented as the quadratic deviation of current (Y) from desired level of output (Y*), will be the preferable one: If L = E * [( Y Y )] 2 (6) σ v is the standard deviation of disturbances to the money demand function, the standard deviation of disturbances to the commodity sector, and b 1 the income elasticity of the demand for money, a sufficient condition for a money-targeting regime to σ u 9

10 σ v be preferable to an interest rate-targeting regime is < 1 σ u (Poole, 1970, p. 206). In the context of the IS-LM framework used by Poole, targeting money supply damps the impact on income of disturbances to aggregate demand (to the IS function), whereas targeting the interest rate damps the impact of disturbances to money demand (to the LM function). σ v and In general, the choice of the monetary policy instrument depends on the values of σ u, the structural parameters of the model determining slopes of the IS and LM functions, and the covariance of disturbances to the commodity and monetary sectors. Given the values of the three behavioural parameters of the model and the covariance of shocks, a larger variance of disturbances to the commodity sector makes the money stock more likely to be the preferable instrument, and vice versa. As a result, as Friedman (1990, p. 1191) notes, the policy choice is inherently empirical. For example, in recent years more complicated models have brought in other factors, yet the logic and essential results of Poole s approach have remained unchallenged (Friedman, 1990, pp ). Notwithstanding his merits (Palley, 1996a, p. 593), Poole s approach suffers from several problems, not least that it ignores the interdependence between the commodity market (IS function) and the money market (LM function). 6 However, the focus of this paper is on only two issues. Firstly, Poole s analysis implicitly assumes that central banks have full control of the money supply. However, most of the money used by the public, either as a means of payment or as a liquid store of value, represents the liabilities of private depository institutions. Central banks have some influence over the lending activity of these institutions, but they cannot fix the stock of money in a country. The money supply is not 10

11 an exogenously set policy variable. Rather, it is the result of the portfolio decisions of the bank and non-bank private sector (Wray, 1998). This is what Post Keynesians mean when they say that the money supply is endogenously determined as a residual of the economic process (Palley, 2002). Allegedly, in an extension of Poole s analysis by Modigliani et al. (1970), the money supply process incorporates two types of disturbances. First, there are the standard shocks affecting the aggregate demand function and the money demand function. Second, and importantly, the model also includes shocks affecting the relationship between NBOR and the money supply. The difference with Poole s previous analysis is that targeting interest rates now damps the impact on income of monetary disturbances that could, in principle, consist of variations in either BOR or the money multiplier, as well as shocks to the money demand function (and therefore, to the velocity of circulation of money). On the other hand, targeting NBOR now damps, to a lesser extent than in Poole s framework, because aggregate demand shocks may be accompanied by variations in BOR and/or the money multiplier, thus leading to changes of the same sign in the LM function, the impact on income of shocks to the IS function. The second analytical shortcoming of Poole s approach is that the standard deviation of disturbances to the monetary sector, no matter whether they affect the portfolio decisions of the bank or the non-bank private sector, is assumed to be independent of the monetary policy regime implemented. But the standard deviation of disturbances to the monetary sector (i.e. σ ) is likely to be a function of the monetary m policy regime pursued by a central bank. In particular, it will be argued below that implementation of a money-targeting regime will tend to raise σ m. Therefore, the 11

12 problem is not choosing between two alternative monetary policy regimes according to empirical criteria, for instance the variance and covariance of disturbances to the commodity and monetary sectors and several behavioural parameters. Rather, the problem is that σ m itself is a function of the monetary policy regime actually implemented. As a result, the choice is likely to be self-defeating. Would then the implementation of a money-targeting policy regime raise σ m as much as to make an interest rate-targeting regime preferable?. The experience with money-targeting regimes is not helpful here because, as argued among others by Bernanke et al. (1999, p. 304), in practice, no central bank has ever adopted a rigid rule for determining money growth. Even those countries traditionally associated with money-targeting regimes, like Germany and Switzerland, have willingly deviated from their announced monetary targets in order to meet other short-term objectives, such as stabilisation of output or exchange rate. In addition, the announced monetary targets were adjusted from year to year to reflect economic conditions and competing objectives of the monetary authorities. Despite these problems, the shortcomings of money targeting have apparently tended to go unconsidered in the literature on controlling monetary aggregates. In this literature, the problem was to hit a target for a monetary aggregate, where the target was usually taken as given (see, for instance, Rasche et al., 1987). As such, the problem encompassed both control of bank reserves (and the monetary base) and forecast of money multipliers. Therefore, little or no attention at all was paid to control problems posed, for instance, by disturbances to the income velocity of money. 12

13 4. Monetary aggregates targeting: A Post Keynesian perspective According to Post Keynesians, money-targeting regimes are undesirable, if not infeasible. For a money-targeting regime to be viable, at least two conditions must be met: (a) central banks have full control of the money supply and (b) there is a stable relationship between the money supply and nominal income. In turn, if condition (a) is to hold, two additional conditions must be fulfilled, namely, (a1) central banks control the monetary base (or the level of bank reserves) and (a2) there is a stable relationship between the monetary base and the money supply (i.e. the base money-multiplier is stable). The discussion below intends to show that, in practice, most (if not all) of these conditions do not hold in economies with modern financial systems Do central banks have full control of the money supply? The first type of problem for a money targeting policy is related to the effectivess of quantity controls of bank reserves. Central banks may not have indeed full control of bank reserves (condition (a1)). For instance, Kaldor (1985, p. 10) argues that central banks cannot close the discount window, since the maintenance of the solvency of the banking system is their most important function. Similarly, Moore (1988) and Goodhart (1994) have highlighted several institutional features of the US and UK monetary policy frameworks respectively, which make attempts at controlling the monetary base ineffective, at least in the short run. For example, Goodhart (1994, p. 1425) argues that If the CB [central bank] tried to run a system of monetary base control, it would fail. Much, perhaps most, of the time it would still be accommodating the day-today demand of the banking system for reserves at a penal interest rate of its own choice, whenever its M o [monetary base] target was below the system s demand 13

14 for reserves. Otherwise when its target was above the system s demand, overnight rates would fall to near zero. Similarly, for the United States, Moore (1988, p. 122) argues that, by keeping an unsatisfied demand of NBOR, the Fed controls the amount of discount-window borrowing. As the demand for BOR rises, the marginal effective total cost (discount rate plus frown costs) of obtaining reserves rises above the discount rate. As a result, the federal funds rate rises pari passu above the discount rate. Increases in NBOR relative to total reserves (TR = BOR + NBOR) operate in the opposite direction, reducing BOR and, therefore, short-term interest rates. Thus, central banks set the supply price but not the total supply of reserves. The reserve supply function may be viewed as horizontal in the market period, at an interest rate exogenously administered by central banks (Moore, 1988, p. 405). Secondly, the base money-multiplier is not stable (condition a2). The explanation for the instability and, hence, for the fundamental uncertainty attached to any forecast of money multipliers relies on the idea that the money supply in modern monetary production economies is credit-driven and demand-determined. Credit-money is created when loans are granted by the banking system to the non-bank private sector, and is extinguished when loans are repaid, so that the level and the rate of expansion of the money supply are ultimately a decision of the private sector of the economy. The rate of monetary expansion is determined by the level of aggregate net deficit-spending (Moore, 1988, Ch. 12). If a central bank increases NBOR through open market operations, banks may voluntarily opt not to increase lending if they do not identify any profitable outlet, and, instead, increase their level of excess reserves (ER). Similarly, non-bank private sector units - that is, firms and households - can easily dispose of any unwanted money 14

15 balances through loan repayment (the reflux mechanism). In these cases, an increase in NBOR will be offset by a decrease in the money multiplier. Thus, any attempt by central banks to impose a rate of monetary expansion upon the private sector through, for instance, an increase in NBOR will be ineffective. This rate is indeed determined by lending and/or deficit-spending decisions of the private sector. Similarly, attempts by central banks to restrain the level of bank reserves below either the level of required reserves (RR) (where TR = BOR + NBOR = RR + ER) or total reserves would encourage banks to look for reserves in wholesale markets. For instance, banks may borrow from the discount window or on the inter-bank market. In any case, inter-bank market interest rates will tend to rise and banks will only be able to obtain additional reserves at a higher cost. As a result, banks will now be encouraged to implement portfolio adjustments by searching for alternative sources of funds with lower reserve requirements. These adjustments are commonly known as liability management practices (Earley and Evans, 1982; Evans, 1984; Goodhart, 1984, Ch. 3; Podolski, 1986; De Cecco, 1987). As these funds are obtained, banks transform their balance sheets, allowing them to increase their loan/reserve and deposit/reserve ratios (Pollin, 1991; Palley, 1996a, 1996b, 1998; Moore, 1998). As recognised, among others, by Moore (1998) and Palley (1998), banks, as profit maximisers, continually seek to raise their deposit/reserve ratio by discovering new financial products, thus making money multipliers and money velocity exhibit an upward trend. In addition, as interest rates rise (fall), banks feel more (less) pressure to search for alternative sources of funds with lower reserve requirements such that, other things being the same, the rate of financial innovation will tend to speed 15

16 up (slow down) (Palacio-Vera, 2001). As a result of this process, money multipliers (as well as the income velocity of monetary aggregates) will also exhibit a pro-cyclical pattern. In this way, financial innovation loosens the connection between reserves and lending (Earley and Evans, 1982; Evans, 1984, p. 444). Since central banks cannot know in advance either the rate or the pattern of financial innovation, they will not be able to accurately predict the rate of growth of base money necessary to obtain a given growth rate of the monetary aggregate selected as intermediate target. Finally, another problem central bankers will face in case of adopting a moneytargeting regime is the existence of a high interest-elasticity of the demand for money coupled with a low or negligible short-run interest-elasticity of aggregate demand. This combination entails that, even if a central bank manages to hit its money growth targets (although the arguments put forward above suggest that this is an unlikely scenario) it may fail to keep nominal income growth (and inflation) on the desired path. As quoted in Taylor (1998, p. 14; 1999, p. 326), in commenting on a money growth strategy, Alan Greenspan reasoned: Because the velocity of such an aggregate [M1] varies substantially in response to small changes in interest rates, target ranges for M1 growth in [the FOMC s] judgement no longer were reliable guides for outcomes in nominal spending and inflation. He adds that in response to an unanticipated movement in spending and hence the quantity of money demanded, a small variation in interest rates would be sufficient to bring money back to path but not to correct the deviation in spending (Greenspan, 1997, pp. 4 5) Is the velocity of circulation of money stable? The idea of a stable relationship between the money supply and nominal income (condition b) has not enjoyed much empirical support in recent times. 7 As argued by 16

17 Blinder (1997, p. 7; 1998, pp. 26 9), beginning in the 1970s, the instabilities showing up in money demand functions in the United States, in the United Kingdom, and in many other countries, led academics and policy makers alike to conclude that a moneytargeting regime was not a viable option. For instance, in a recent study, Estrella and Mishkin (1997) conclude that the empirical relationships involving monetary aggregates, nominal income, and inflation are not sufficiently strong and stable in the United States and Germany to support a straightforward role for monetary aggregates in the conduct of monetary policy. Similar results are presented by Friedman and Kuttner (1992, 1996). A common explanation for the abandonment of money-targeting regimes is the notion that the relationship between the money supply and nominal income has proven to be unstable (Friedman, 1984, 1988; Goodhart, 1986, 1989; Friedman and Kuttner, 1992, 1996; Bernanke et al., 1999, p. 305). In more formal terms, the unstable nature of the relationship between monetary aggregates and nominal income shows up in the empirical observation that the various monetary aggregates are not co-integrated with nominal income - that is, velocity is non-stationary (Goodhart, 1989, p. 316). Under such circumstances, any attempt to run a money-targeting regime is bound to lead to severe short-run volatility in interest rates and, perhaps, even in money growth, as the monetarist experiment in the United States revealed (see, for instance, Friedman, 1984; 1988, p. 55). In turn, the break-up of this relationship is attributed to a combination of deregulation of financial markets, improvements in transactions technology, and, especially, financial innovation (Hester, 1981; Minsky, 1982, Ch. 7; Goodhart, 1984, Ch. 3, 1986, 1989; Podolski, 1986; De Cecco, 1987; Arestis and Howells, 1992; Clarida et al., 1999, p. 1685). It is now commonplace to conclude that changes in financial markets 17

18 in the last three decades have made the growth rate of the money supply much less controllable and predictable. For instance, Podolski (1986, p. 162) argues that it is now easier for financial institutions to match demand and supply of funds by operating in the wholesale markets. As a result, the capacity of the financial system to circumvent central bank policy has increased. Post Keynesians have also emphasised the role of liability management practices in enhancing the ability of banks to accommodate loan demand in a scenario where the central bank attempts to restrain banks reserves (Minsky, 1982; Evans, 1984; Rousseas, 1986; Wray, 1990; Pollin, 1991; Palley, 1996). Liability management practices allow banks to capture non-deposit funds in wholesale markets by paying market interest rates. In turn, as argued in the previous discussion on the money multiplier, the way these nondeposit funds alter the structure of the liability side of the balance sheets of banks is difficult to predict. As Podolski (1986, p. 164) explains, the demand for an aggregate is likely to shift depending on whether new funds are likely to be attracted to it or whether there would be a net escape of funds in a given set of circumstances. Thus, the impact of liability management and associated innovations is likely to be uncertain and unpredictable. In short, financial innovation and liability management practices have made both the relationship between reserves (or base money) and deposits (or the money supply) and the relationship between money and nominal GDP an unstable one. 5. Money-targeting, liability management, and the instrument problem A closely related explanation for the break-up of the money income relationship is Goodhart s Law. According to it, any observed statistical regularity tend to collapse 18

19 once pressure is placed upon it for control purposes (Goodhart, 1984, p. 96). In the context of the discussion on the IP presented above, Goodhart s Law and the ability of banks to avert central bank-imposed reserve constraints by adopting liability management practices means that, were a central bank to ever adopt a money-targeting regime, would tend to rise. One reason is that, as the monetarist experiment in the United States showed, the implementation of a money-targeting regime substantially increases volatility in short-term interest rates (Friedman, 1988, p. 55). This volatility raises the degree of uncertainty about the expected future marginal cost of funds to banks, thereby encouraging them to hedge against it. As quoted by Goodfriend (1991, p. 14), according to Cukierman (1991), since loan rates are determined prior to the determination of the cost of funds to banks, unanticipated credit or money demand shocks after banks have entered into loan commitments create a negative correlation between competitive deposit rates and bank profits. As a result, smoothing of short-term interest rates by central banks protects banks against the risk of widespread insolvency. In the absence of interest rate smoothing as will be the case under a money-targeting regime resort to liability management practices allows banks to reduce this uncertainty but, as shown above, this in turn is likely to increase instability in the relation between reserves and the money supply on the one hand, and between money and nominal income on the other hand. According to Goodhart (1995, p. 259), the likely outcome of short-term volatility in interest rates would be the development of a mechanism for shifting financing flows between banks and non-bank intermediaries. In turn, such developments would facilitate stabilisation of money growth rates at the price of inducing greater variability in the relationship between money and nominal income. σ m 19

20 Another reason why σ m will tend to rise is that, if the income-velocity of money and loan demand are not sufficiently interest-elastic, implementation of a moneytargeting regime will not only cause short-run volatility in interest rates but may also lead to higher real interest rates than otherwise. This will occur if, for instance, the central bank attempts to impose on the private sector a rate of monetary growth that is lower than the rate desired by the latter. Several authors have argued that high real interest rates stimulate financial innovation, thereby raising σ m. For instance, Hester (1981, p. 183) argues that the one clear lesson from recent history is that financial institutions innovate whenever customer relationships are jeopardised by slow monetary growth. 8 Likewise, Minsky (1982, pp ) argues that high interest rates are likely to stimulate institutional changes that lead to an increasing lending ability of the banking system. The increased ability of banks to avert central bank-imposed reserve constraints has led to the view that, under the current institutional framework, central banks can only affect money supply growth indirectly - that is, through variations in short-term nominal interest rates (Niggle, 1990, p. 445; Arestis and Howells, 1992, p. 147). 9 For instance, Goodhart (1995, p. 252) suggests that, with a few possible exceptions, no central bank has ever run a true system of monetary base control and that instead, central banks sought to control the level of interest rates in order to affect the rate of monetary expansion indirectly. Interestingly, Mishkin (1998, pp ) argues that, in reality, the Fed monetarist experiment in the period was a smokescreen that was used by Paul Volcker to divert attention away from interest rates. In this way, the setting of targets for the growth rates of monetary aggregates allowed the Fed to set interest rates high enough to bring inflation down. Similarly, Goodhart (1989, p. 296; 2002, pp ) 20

21 argues that the policies adopted in the early 1980s did allow the authorities freedom to raise interest rates to levels that did subdue inflation. Finally, when reviewing the experience of the Bundesbank, von Hagen (1999) argues that the adoption of a moneytargeting regime was a signal that the previous monetary regime had been overcome. Similarly, it was a means of defining the role of monetary policy vis-à-vis other players in the macroeconomic policy game and of structuring the internal policy debate. Thus these results lead to the view that control of the rate of expansion of the money supply ultimately rests on the ability of central banks to affect bank lending to the non-bank private sector. This is a proposition that has long been advocated by Post Keynesians like Kaldor and Trevithick (1981), Chick (1986), Moore (1988), Niggle (1991), Arestis and Howells (1992), Dow (1993), and Goodhart (1995). Within a Post Keynesian framework, the key question is how variations in interest rates impinge on the decisions to deficit-spend by the non-bank private sector and the willingness to lend by the banking system. In this respect, Arestis and Howells (1992, p. 149) argue that it is clear that the U.K. authorities now see interest rate changes as having an impact upon aggregate demand through a number of diverse channels. These include the cost of borrowing, income and wealth effects, and the exchange rate. In summary, the type of institutional arrangements characteristic of modern economies with developed financial markets make it very unlikely that conditions necessary to run successfully a moneytargeting regime will be fulfilled. 21

22 6. Conclusion This paper has shown that there is a not fully resolved tension in the modern setting of monetary policy. In the long run money is made all-important for inflation, but in the short run it is treated as irrelevant. However, this tension is quickly resolved when a distinction is made between what some academics have suggested that central banks should do and what these same central banks felt right to do. In theory, targeting a monetary aggregate damps the impact on income of disturbances to aggregate demand, whereas targeting the interest rate damps the impact of disturbances to money demand. Thus, a monetary aggregate policy tends to be preferred to an interest rate policy when the variance of shocks to the commodity market is larger than the variance of shocks to the monetary sector. This is the so-called instrument problem view (Poole, 1970), a major component of the current new consensus in monetary policy. In practice, however, central banks consider the interest rate as their only instrument to hit the desired inflation rate through its effects on aggregate demand (Bank of England, 1999b). In today s world of financial innovation and liability management practices, central banks know that both the relationship between reserves (or base money) and deposits (or the money supply) and the relationship between money and nominal income (or GDP) are very unstable ones. A monetary aggregate policy is simply not feasible. This is what Post Keynesians have been claiming for a long time (see, for instance Moore, 1988). Money is a residual of the economic process. The rate of change in monetary aggregates is, in fact, a function of the level of net deficit-spending in the 22

23 economy, which is, in turn, a function of the interest rate set by the central bank. In short, monetary aggregates are credit-driven and demand-determined. 23

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28 Taylor, J.B. (1998) Applying academic research on monetary policy rules: an exercise in translational economics, The Manchester School, 66 (supplement), pp Taylor, J.B. (1999) A historical analysis of monetary policy rules, pp , in: J.B. Taylor (Ed.) Monetary Policy Rules (Chicago, University of Chicago Press). Volcker, P.A. (2002) Monetary policy transmission: past and future challenges, FRBNY Economic Policy Review, May, pp von Hagen, J. (1999) Money growth targeting by the Bundesbank, Journal of Monetary Economics, 43 (3), pp Wray, L.R. (1990) Money and Credit in Capitalist Economies: The Endogenous Money Approach (Aldershot, Edward Elgar). Wray, L.R. (1998) Understanding Modern Money: The Key to Full Employment and Price Stability (Cheltenham, Edward Elgar). 1 This is clearly stated by the European Central Bank (hereafter ECB) when it argues that the neutrality of money is a general principle underlying standard economic thinking (European Central Bank, 2001, p. 41). 2 Of course, in posing this question, this paper breaks away from Lucas s policy recommendation as expressed in his Nobel Lecture and quoted at the beginning of this paper (Lucas, 1996). 3 Friedman and Kuttner (1996) show that the variance of shocks to the monetary sector rose substantially relative to the variance of shocks to the real sector in the late eighties. According to them, this may explain the complete abandonment of money targets by the Fed. 4 For instance, the ECB remarks that although most empirical studies for the euro area support the view that there is a stable (long-run) money demand relationship linking M3 to the price level and other macroeconomic variables... the reference value [for M3] is not a monetary target. The ECB does not attempt to keep M3 growth at the reference value at any particular point in time by manipulating interest rates (European Central Bank, 2001, p. 47). 5 In an empirical study for the period , Hoover (1991) points out that, for the US economy, the balance of evidence supports the view that money does not cause prices, and that prices do cause money. 28

29 6 For an earlier example of this critique, see Davidson (1965), and further developments by Rochon (1999, pp ) and Palley (2002, pp ). 7 But, see note 4 above. 8 Hester (1981) identifies two waves of financial innovation in the US economy, respectively and , which, according to him, were induced by restrictive monetary policies and high interest rates. 9 In this respect, Goodfriend (1991, p. 8) comments: except for the period from 1934 to the end of the 1940s when short-term interest rates were near zero or pegged, the Fed has always employed either a direct or an indirect Federal funds rate policy instrument. 29