Is There an Active Role for Monetary Policy in the Endogenous Money Approach?

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The "New Consensus" View on Monetary Policy

In the last two decades or so monetary policy has gained the most prominent role in the economic policy debate. More importantly, academics and policy makers have abandoned the targeting of monetary aggregates, generally considered nor to be co-integrated with nominal income, and are now engaged in unison in aggregate demand fine tuning through interest rate management. This is what Laurence Meyer, a member of the Board of Governors of the Federal Reserve System, has defined as the "new consensus view on macroeconomics (2001). The aggregate demand fine tuning is understood to work through changes in the output gap.

The story goes as follows. Changes in real factors such as population, investment in physical and human capital, and technology determine the growth of potential real GDP. Changes in consumption, investment, government expenditure, and net exports determine the growth of aggregate demand. Then, when aggregate demand is greater than potential real GDP, inflation pressures are generated. The reverse holds when aggregate demand grows too slowly. By changing the short-term nominal interest rate, central banks can then bring the growth of aggregate demand in line with the growth of potential output. In the "new consensus" view, inflation is thus a proxy for the state of economic balance. It is an outcome "summary statistic" describing the gap between current and potential output. To put it bluntly, changes in the rate of inflation, and the resulting changes in the interest rate set exogenously by the central bank, are the primary mechanism of reconciliation between the demand-determined actual level of output and the supply-determined level of potential output. In addition, price stability, in the form of a low and stable rate of inflation, emerges in the "new consensus" view as the primary objective of monetary policy. Price stability means better allocation of resources and improved planning for the private sector and hence real economic gains for the economy.

Proponents of the "new consensus" view have also been quick to point out the practical advantages of inflation targeting (hereafter IT). IT has been defined as "a framework for monetary policy characterised by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit acknowledgement that low, stable inflation is monetary policy's primary long-run goal" (Bernanke et al. 1999, 4). One result is of particular interest here: macroeconomic performance depends on the type of monetary policy rule implemented (Taylor 1999). Bernanke et al. have explained that the implementation of IT regimes provides central banks with a nominal anchor and, as a result, it helps to control inflation expectations, improves planning in the private sector, and, to the extent that transparency in the policy-making process is enhanced, increases the accountability of central banks (1999, 20).

The dominance in the policy arena of the "new consensus" view has left endogenous money theorists with a difficult task at hand. On one side, the recent implementation of IT frameworks by central banks around the world has discredited the old enemy of monetarism. Pace J. B. De Long (2000), the quantity theory of money is no longer relevant for modern monetary policy. P. Dalziel has indeed suggested that the macroeconomic model introduced in chapter 21 of Keynes' General Theory (1936, 298) is the historical source behind the "new consensus" view (Dalziel 2002). On the other side, the advocacy of IT regimes is usually based on the principle of the long-run neutrality of money and monetary policy. For instance, M. Eichenbaum has argued that one of the "fundamental empirical truths" of the last three decades is that "monetary policy does not affect the long-run growth rate of output. This fact is the bedrock of all serious discussions about monetary policy" (1997, 237). …