The Everyday Economist

There has been a lot of talk about monetary policy given the ongoing collapse of the housing market and the candidacy of Rep. Ron Paul. Thus I thought that I would outline my views on monetary theory and policy:

1.) The quantity theory of money summarizes the long-run relationship between money and inflation.

2.) Economic growth (in line with the quantity theory) is deflationary.

3.) Short-term fluctuations in the economy are largely caused by monetary disturbances.

4.) Too much emphasis is placed on the overall price level in the short-run. We should be more focused on relative prices.

5.) I do not trust discretionary monetary policy. The Fed should operate by using a monetary policy rule, a money growth rate target, or an inflation target.

6.) The focus of monetary theory should be on credit markets because it is directly through these markets that monetary policy is conducted.

I suspect that I may get some disagreement on 2, 4, and perhaps 5. It is my opinion that number 6 and number 4 represent the future of monetary theory.

The 75th Anniversary Lionel Robbins Conference took place this week in London. While I have only had a chance to give it a quick skim, Charles Goodhart has written an intriguing paper on monetary policy entitled, “The Continuing Muddles of Monetary Theory.” Here is the abstract:

Lionel Robbins was much concerned about the methodology of economic science. When he discussed the desirable relationship between theory and ‘reality’, two of the three examples that he presented where the theoretical analysis was not sufficiently based on a knowledge of historical fact were taken from monetary economics. Indeed, monetary theory has remained prone to such shortcomings ever since. Amongst the worst are:

(1) IS/LM: the monetary authorities set the monetary base, and the interest rate isdetermined in the market;

(2) The monetary base multiplier of bank deposits, and the role of reserve ratios;

(3) The current three equation neo-classical consensus, which not only assumesperfect creditworthiness for all agents, but also an essentially non-monetarysystem, e.g. no need for banks;
(4) The standard theory of the evolution of money.Monetary economics can only get better, but it has a long way yet to go.

Here is a link to the paper.HT: New Economist