Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

A Quantity Theory Framework for Monetary Policy

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

A Quantity Theory Framework for Monetary Policy

Article excerpt

One of the oldest and most useful ideas in economics is the quantity theory of money. The quantity theory explains the determination of variables measured in dollars such as the price level. Modern expositions of the quantity theory assume that the monetary authority controls directly a reserve aggregate like the monetary base (currency plus bank deposits with the monetary authority). In actual practice, however, monetary authorities use an interest rate rather than a reserve aggregate as their policy variable. This fact poses a challenge to the quantity theorist. How does he reconcile his theory with actual policy procedures? There are no modern expositions of the quantity theory that assume interest rate targeting by the monetary authority.

This article provides such an exposition. The exposition brings out the standard quantity theory distinction between the determination of the real and nominal quantity of money and explains changes in the price level as equating the nominal demand with the nominal supply of money.

Modern expositions of the quantity theory assume reserve control in part because reserve control constitutes a major item on the reform agenda of quantity theorists. Control of reserves and, at one remove, a monetary aggregate constitutes control of a nominal variable and, therefore, draws attention to the responsibility of the monetary authority to control the price level, also a nominal variable. Quantity theorists dislike the interest rate as a policy variable. Interest rate control suggests that the monetary authority is controlling the price of resources made available to investors. The analysis here retains these concerns. In particular, the article explains how rate targeting encourages the public to confuse the monetary authority's control over nominal variables with control over real variables. These concerns motivate a proposal for a change in monetary policy procedures designed to help the Fed achieve its goal of price stability.


AN EXAMPLE OF MONEY CREATION Suppose the monetary authority sets a target for the interest rate and follows a "lean-against-the-wind" policy of raising its rate target when economic activity strengthens and lowering it when economic activity weakens. Because information on the economy becomes available with a lag, the monetary authority would then supply reserves when economic activity strengthens and withdraw them when economic activity weakens. Furthermore, it would not necessarily offset these changes in reserves later. As a result, random disturbances would be permanently incorporated into future levels of reserves and money. By following a "let bygones-be-bygones" policy of base drift in reserves, the monetary authority causes the price level to wander randomly.(1)

Suppose also that introduction of a new technology raises the rate of return on capital and, therefore, investment demand. When the market rate, reflecting this higher return, begins to rise above its targeted level, the monetary authority buys securities. As a result, the monetary base and the money stock increase.(2)

The individuals who sold securities to the monetary authority did so because they were offered a good price, not because they wanted to reduce their holdings of assets. After selling securities, they allocate their additional money among different assets to replace the securities sold. Temporarily, the increased demand for financial assets depresses the interest rate. Consequently, real expenditure rises until the price level increases sufficiently to return real money balances to their original level. Real money balances return to their original level through a rise in the price level, not through a fall in the nominal quantity of money.


An understanding of the consequences of the monetary authority's reserve injection begins with the distinction between real and nominal variables. …

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