Does Money Still Forecast Economic Activity?

By Becketti, Sean; Morris, Charles | Economic Review - Federal Reserve Bank of Kansas City, Fourth Quarter 1992 | Go to article overview

Does Money Still Forecast Economic Activity?


Becketti, Sean, Morris, Charles, Economic Review - Federal Reserve Bank of Kansas City


Until recently, most economists agreed that movements in the quantity of money help to forecast changes in national output. This generally accepted usefulness of money as an economic indicator is one reason the Federal Reserve has continued to monitor the monetary aggregates despite significant changes in the economy and financial markets. Indeed, weakness in the monetary aggregates was the first reason given by the Federal Reserve for the four most recent cuts in the discount rate.

New research, however, challenges this consensus view (Friedman and Kuttner). The results of this research suggest that money lost the ability to forecast economic activity after the 1970s. If this finding is correct, money no longer provides policymakers with information about future economic activity.

This article investigates the claim that money lost the ability to predict economic activity after the 1970s. The results from this study suggest that, except during the early 1980s, money has remained a useful indicator of future economic activity. Of course, this does not mean that money is the best or only indicator of future economic activity.(1)

The first section of this article explains why money should be a useful indicator of future economic activity and discusses some of the reasons the money-output relationship may have changed. The second section examines previous research on the ability of money to forecast economic activity. The third section presents new evidence showing money's undiminished ability to forecast economic activity.

WHY SHOULD MONEY FORECAST ECONOMIC ACTIVITY?

Money is useful for forecasting economic activity only if there is a systematic and stable relationship between money and economic activity. Virtually all modem theories of the macroeconomy claim that money is systematically related to future economic activity. But changes in financial markets in the 1980s may have altered money supply and money demand relationships and thereby obscured money's ability to forecast economic activity.

WHY MONEY IS RELATED TO ECONOMIC ACTIVITY

Most macroeconomic theories agree that money is related to economic activity. In these theories, the relationship between money and Economic activity depends on whether changes in the money stock are due to shifts in money supply or money demand. For example, increases in money supply spur economic activity, while increases in money demand tend to dampen economic activity. And, these shifts in money supply and demand affect output indirectly, through their effects on interest rates.(2)

MONEY SUPPLY. Shifts in money supply are positively associated with output through their effect on interest rates. Money supply increases, for example, drive down interest rates to persuade investors to hold the additional money balances. The decline in interest rates, in turn, boosts interest-sensitive components of spending, such as investment. Thus, increases in money supply reduce interest rates and increase output.

For money supply shifts, the change in interest rates--and therefore the change in output--depends on the interest elasticity of money demand, Specifically, the more elastic is money demand, the smaller is the change in interest rates and, therefore, in output.(3) Suppose the supply of money increases. If money demand is very sensitive to changes in interest rates--money demand is very elastic--interest rates need not fall far for money demand to equal money supply. As a result, the increase in output is small. On the other hand, if money demand is inelastic, interest rates must fall a lot for money demand to equal money supply, and the increase in output is greater. Thus, the size of the interest rate effect of a shift in money supply is inversely related to the interest elasticity of money demand.

MONEY DEMAND. Shifts in money demand are negatively associated with output through their effect on interest rates. Suppose money demand increases. …

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