Academic journal article Federal Reserve Bank of St. Louis Review

The Monetary Instrument Matters

Academic journal article Federal Reserve Bank of St. Louis Review

The Monetary Instrument Matters

Article excerpt

This paper revisits the debate over the money supply versus the interest rate as the instrument of monetary policy. Using a dynamic stochastic general equilibrium framework, the authors examine the effects of alternative monetary policy rules on inflation persistence, the information content of monetary data, and real variables. They show that inflation persistence and the variability of inflation relative to money growth depend on whether the central bank follows a money growth rule or an interest rate rule. With a money growth rule, inflation is not persistent and the price level is much more volatile than the money supply. Those counterfactual implications are eliminated by the use of interest rate rules whether prices are sticky or not. A central bank's use of interest rate rules, however, obscures the information content of monetary aggregates and also leads to subtle problems for econometricians trying to estimate money demand functions or to identify shocks to the trend and cycle components of the money stock.

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Central banks around the world have long settled on the use of interest rates as instruments to implement monetary policy; but, until recently, there was no sound theory supporting this choice. The intuition for why interest rate rules dominate is straightforward in a world with sticky prices and interest-elastic money demand (see boxed insert). When the demand for real money balances is interest elastic, any shock that affects the path for expected inflation or the real interest rate causes money demand to shift. When the central bank follows a money growth rule, this shift causes the price level to jump. If price adjustment is costly, this jumping can create real distortions. When the central bank follows an interest rate rule, on the other hand, the money stock is endogenous and absorbs the adjustment. The central bank can accommodate this jump in the money stock almost instantaneously and with little cost.

This article explains the theory behind this intuition by comparing and contrasting the properties of four monetary general equilibrium models. The four models differ along two dimensions: the monetary authority's policy rule and the nature of price adjustments. We examine two monetary policy rules--an exogenous money growth rule and an interest rate rule based on Taylor (1993)--and two price adjustment mechanisms--flexible prices found in a typical real business cycle (RBC) model and sticky prices found in a typical New Keynesian model. The closest work to this article is Kim (2003), which looks at how the cyclical nature of the real economy depends on the specification of the policy rule and the form of the nominal frictions. The author concludes that getting the policy rule right is at least as important as getting the nominal frictions right. Our paper emphasizes the behavior of money and prices, but also reports results for real variables that are consistent with Kim's findings.

Early dynamic stochastic general equilibrium models that featured money as the policy instrument also included flexible prices--and hence implied small effects of monetary shocks on real variables and unrealistically high price-level variability with low inflation persistence; examples include Cooley and Hansen (1989, 1995), Lucas (1990), Fuerst (1992), and Christiano and Eichenbaum (1992). (1) Later, models with sticky prices came to dominate the literature; Cho and Cooley (1995), Kimball (1995), King and Wolman (1996), and Yun (1996) are representative of this approach. (2)

Kimball (1995), for example, examined a sticky-price model that assumed a constant velocity of money and an exogenous money supply rule. This article demonstrates that two distinct elements omitted from Kimball's model are crucial for understanding price dynamics. The first is an interest-sensitive money demand function, and the second is a monetary policy reaction function based on an interest rate rule. …

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