Monetary Economics: Issues and Applications
This article discusses some of the issues and applications in monetary economics.
1.Disconnect between money supply and inflation:
The quantity theory of money proposes the following identity:
Money Supply * Velocity = Price * Quantity of Goods and Services (MV = PQ)
By rearranging the equation we can state that P = M*(V/Q) which implies that holding velocity constant and assuming that quantity changes only gradually, price level is a factor of money supply. In fact monetarists argue that in the long run a) money supply is the only factor that influences nominal GDP and b) all real variables such as output, employment and unemployment are independent of money supply.
In the chart below we examine the relationship between change in money supply M1 and change in Consumer Price Index for the US economy from 1960 to present.
As we can observe, the regression between Change in Money Supply M1 and Change in CPI is a loose fit and the correlation between these variables is not of any statistical significance. Therefore it is safe to conclude that money supply is not the only variable that impacts nominal GDP in the short run and long run. Other variables such as fiscal policy, consumer spending, investment expenditure also impact the nominal GDP.
The bottom line is that money supply is one of the important factors influencing price levels. Weimar's Germany after the first world war and Zimbabwe more recently are examples of situations where high quantities of money supply led to very high inflation. But during normal times the relationship between money supply and inflation is not a one-to-one relation as shown in the chart above.
M1 as per Federal Reserve's definition is stated below. In simple terms, M1 is monetary base + demand deposits + Other liquid deposits.
1. M1 consists of (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) demand deposits at commercial banks (excluding those amounts held by depository institutions, the U.S. government, and foreign banks and official institutions) less cash items in the process of collection and Federal Reserve float; and (3) other liquid deposits, consisting of other checkable deposits (or OCDs, which comprise negotiable order of withdrawal, or NOW, and automatic transfer service, or ATS, accounts at depository institutions, share draft accounts at credit unions, and demand deposits at thrift institutions) and savings deposits (including money market deposit accounts). Seasonally adjusted M1 is constructed by summing currency, demand deposits, and other liquid deposits, each seasonally adjusted separately.
2. Monetarist Experiment and Velocity of Money:
Strict monetarists argue that the role of a central bank is overstated and the growth of supply of money in an economy can be fixed in line with the growth rate and currency needs of the economy. The fundamental tenet underlying this belief is based on the equation above in which velocity of money is assumed to be constant. This quantitative approach to monetary policy was used as by Paul Volcker, Chairman of Federal Reserve in the 1970s to curb inflation by cutting down the money supply. This led to a decline in inflation from 13% in 1979 to 4% by 1982 and interest rates rose sharply in response. Ironically, the quantitative approach to monetary policy lost its significance after the so called 'monetarist experiment' of Paul Volcker due to the introduction of money market accounts and financial innovation. Velocity of money, which was hitherto, assumed to be constant became more volatile in response to interest rates and ceased to be an independent monetary policy instrument.
So the Federal Reserve targets the federal funds rate to conduct its monetary policy by using open market operations, discount window etc., and the importance of money aggregates as tools of policy has diminished over the decades.
3.Asset Price Bubbles:
The flip side of promoting growth and employment for a central bank is the chance of inflating a bubble in some asset class in some pocket of the economy. The complexity of the financial system today is such that accommodative monetary policy for very long periods may result in asset price bubbles. For example, many economists cite the low interest rate environment as one of the reasons for the build up of the 2007-2009 credit crisis.
In the chart above showing the federal funds rate,the shaded regions show recessions.
It is not an easy task for the central banks around the world to predict an asset-price build up given the interconnected-ness and complexity of the modern day financial system.They cannot micro-manage the investment or credit decisions of all the market participants in free market economies. The net result is that we need to brace ourselves for financial asset price corrections once in a while and regulators can only be reactive more often than not.
4.Liquidity Trap:
Theoretically, an accomodative monetary policy must induce growth by lowering the cost of capital. But as you can see in the chart below, the example of US economy, for several years now the Federal Reserve has kept the interest rates low by providing ample liquidity, yet the real GDP growth has not really responded.
Increase in fiscal expenditures has only led to increase in nominal GDP, increase in prices on the back of increased consumption spending.
In fact if you take a look at the interest rates across different countries as shown in the chart below, there are as many countries struggling with the lack of demand to push the real GDP growth as those that are struggling to maintain price stability.
Low interest rate environment for long periods of time may lead to asset price bubbles and bursts in the domestic and emerging market economies through international capital flows.
A more prudent way would be to find people with higher propensity to consume and others with higher propensity to invest.
5. Supply bottle necks vs Price Stability:
Price instability can wreak havoc in any economy, so maintaining stable price levels is at the center of the monetary economics. Maintaining price stability requires sacrificing growth at least in the short run. Particularly in emerging economies there are supply side bottle necks like lack of infrastructure which require significant time for resolution. Even in developed countries infrastructure needs maintenance and upgradation.So central banks have no option but to curtail demand by raising interest rates to maintain price stability.
6.Independence of Central banks:
Availability of cheap credit is one of the ways to assuage people's (read voting population!) needs. So central banks are under constant pressure from the elected officials to maintain a dovish stance.
7. Expectations Theory:
People's expectations play a central role in setting the direction and magnitude of the economic variables like inflation, consumer spending etc. Central banks do take people's expectations in to consideration by conducting economic surveys. For example here is a note from New York Fed's website: The November Survey of Consumer Expectations shows another increase in short-term inflation expectations, but a decline in medium-term inflation expectations. However, consumers conveyed increased uncertainty about future inflation. Year-ahead spending growth expectations rose to a new series high. Home price growth expectations declined slightly, while remaining elevated.
Conclusion
Monetary economics did find its place in the mainstream macro economics. Keynesians do acknowledge the role played by money supply and interest rates in impacting aggregate demand of an economy. Both fiscal policy and monetary policy need to complement each other with a view on consumer expectations.
References:
1) https://www.federalreserve.gov/releases/h6/current/default.htm
2) Economics by Samuelson
3) BLS and BEA
4)https://www.thebalance.com/national-debt-by-year-compared-to-gdp-and-major-events-3306287
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