Thinking About Monetary Policy

Nick Rowe and Bill Woolsey bring up some interesting points in their recent posts. These points are often neglected, but are of the utmost importance for monetary policy. Below, I will explore what is meant by a monetary policy tool, target, and goal and why it is important to understand the distinct characteristics of each.

Often times, we are told that monetary policy is tight (or loose) by observing the interest rate. In a recent post, I made the case that the real interest rate isn’t a good predictor of the output gap. In a standard New Keynesian framework, if the real rate doesn’t predict the output gap, it will not help to predict inflation either. Thus, the real interest rate does not appear to be a good indicator of policy. In that same post I argued that the growth of the Divisia monetary aggregates do help to predict the output gap. So does this mean that these aggregates are a good indicator of the stance of policy? Potentially, but not necessarily.

To motivate the discussion, consider a simple monetary equilibrium framework captured by the equation of exchange:

mBV = Py

where m is the money multiplier, B is the monetary base, V is the velocity of the monetary aggregate, P is the price level and y is real output. The monetary base, B, is the tool of monetary policy because it is under more or less direct control by the Federal Reserve. The Fed’s job is to adjust to base in order to achieve a particular policy goal.

Other important factors in the equation of exchange are the money multiplier, m, and the velocity of circulation, V. These are important because V will reflect changes in the demand for the monetary aggregate whereas m will reflect changes in the demand for the components of the monetary base.

Now suppose that the Federal Reserve’s goal is to maintain monetary equilibrium. In other words, the Fed wants to ensure that the supply of money is equal to the corresponding demand for money. In the language of the equation of exchange, this would require that mBV is constant. Or, in other words, that changes in m and V are offset by changes in B.

This goal would certainly make sense because an excess supply of money ultimately leads to higher inflation whereas an excess demand for money results in — initially — a reduction in output. Unfortunately, this is a difficult task because it is difficult to observe shifts in m and V in real time. Nonetheless, there is an alternative way to ensure that monetary equilibrium is maintained. For example, in the equation of exchange, a constant mBV implies a constant Py. Thus, if the central bank wants to maintain monetary equilibrium, they can establish the path of nominal income as their policy goal.

Thus far, the framework we have employed has outlined two aspects of monetary policy. First, the monetary policy tool (or instrument) is the monetary base. This is considered a policy instrument because it is directly controlled by the Fed. Second, the goal of monetary policy is to target a desired path for nominal income. This goal is considered desirable because it maintains monetary equilibrium. Even with the instrument and goal in place, the analysis is not complete. The central bank needs an intermediate target.

The intermediate target of monetary policy can be anything that has a strong statistical relationship with the goal variable. In addition, it must be available at higher frequencies than the goal variable. This intermediate target can be a measure of the money supply, the federal funds rate, or even the forecast of the goal variable. (It is important to note that the federal funds rate is NOT the instrument of monetary policy despite the frequent usage of this term.)

Returning to the equation of exchange, a natural choice for an intermediate variable (so long as there exists a strong statistical relationship) is a monetary aggregate. Re-writing the equation of exchange, we have the more familiar form:

MV = Py

where M is the monetary aggregate used as the intermediate target.

The behavior of monetary policy is characterized as follows. The central bank chooses the monetary base with the intent of guiding the path of nominal expenditures. However, the control of the monetary base in and of itself is not always enough to ensure that the policy goal is met. This is because changes in the demand for the monetary base will result in changes in the money multiplier and, as a result, a different relationship between the monetary base and nominal expenditure. In order to ensure that the monetary base is being adjusted enough to maintain the desired path of nominal expenditures, the central bank uses the monetary aggregate as the intermediate target. In other words, the central bank chooses B so as to ensure that:

mB = M*

where M* is the desired level of the monetary aggregate. What’s more, this desired level of the monetary aggregate is chosen such that it maintains the desired level of nominal expenditure.

The most important question that I want to address is in regards to the “best” measure of the stance of monetary policy. In our example, the monetary base serves to demonstrate the actual adjustments made by the monetary authority. However, it does not necessarily demonstrate the stance of monetary policy (i.e. if policy is loose or tight). For example, if there is a change in the demand for the components of the monetary base, the money multiplier will change and, depending on the direction of the change, the monetary base might suggest that monetary policy has been expansionary or contractionary even when M and Py remain correspondingly constant.

The same problem exists for M. The central bank adjusts the monetary base to target the intermediate variable, M. The target of M is meant to generate the desired path for Py. Like the monetary base, however, movements in M will not be sufficient to produce the desired path of nominal expenditure if the demand for M — reflected in V — changes. Relying on M to discover the stance of monetary policy is potentially misleading as well in that higher than expected changes in M might merely reflect declines in V.

So what is the best way to determine the stance of monetary policy?

The answer is quite simple. If the goal is to achieve a certain level of nominal expenditure, (Py)*, then the stance of monetary policy is best determined by deviation of the goal variable from its target:

Py – (Py)*

If this value is positive, it suggests that policy has been overly expansionary. If this value is negative, it suggests that policy has been overly contractionary. This point seems to be missed by many within the United States, but is widely accepted elsewhere. For example, the Bank of England has an explicit inflation target. If their target is 2% and inflation comes in at 3%, there would be little doubt that the policy was over-expansionary regardless of the level of the nominal interest rate or the behavior of monetary aggregates. The problem in the United States seems to center around the fact that the Fed has no explicit goal for monetary policy. Rather the Fed is to promote full employment and low inflation. As a result, we tend to rely on the behavior of the intermediate targets like the federal funds rate and monetary aggregates to gauge the stance of policy when, in fact, these variables can potentially be misleading.