Academic journal article Review - Federal Reserve Bank of St. Louis

Empirical Evidence on the Recent Behavior and Usefulness Of

Academic journal article Review - Federal Reserve Bank of St. Louis

Empirical Evidence on the Recent Behavior and Usefulness Of

Article excerpt

The Federal Reserve Bank of St. Louis has been, for the last three decades or so, at the center of an approach to macroeconomic policy which became universally known as "Monetarism." Indeed, the very term entered the public domain through an article in the Federal Reserve Bank of St. Louis' Review by Karl Brunner in 1968. The central tenet of monetarism was that there is a stable demand function for something called "money." Policy advice came down to recommending that the monetary authorities should deliver a steady rate of the growth of money within some target range.

The 1970s were a good time for monetarists. Velocity in the United States appeared to be on a stable trend, and the adoption of floating exchange rates generated a need for independent measures of monetary stance in most of the industrial countries. Monetary targeting was widely adopted and monetarism became a worldwide credo. Since the end of the 1970s, however, life has been much harder for monetarists. The stability of empirical monetary relationships became much more difficult to maintain, and government after government has given up even the notional attempt to target monetary aggregates. The allegedly monetarist government of Margaret Thatcher abandoned monetary targets in the United Kingdom in 1985. The Chairman of the Federal Reserve Board has recently announced that the Fed has ceased to monitor M2 and, instead, will be using the real interest rate as an indicator of monetary stance. Only the Bundesbank appears to be retaining any faith in the significance of monetary aggregates, though they have been widely criticized for so doing. (Norbert Walter, the chief economist of Deutsche Bank, has, for example, been quoted as saying that "...M3, the broad money supply indicator targeted by the central bank, was obviously distorted and devalued as an indicator." Financial Times, August 10, 1993, p. 2).

The standard explanation for why previously stable monetary relationships have broken down is financial innovation. In particular, liberalization and competition in banking have generated shifts in demand between components of money which have undermined earlier empirical regularities. Interest payments on transaction deposits have made it more difficult to distinguish money held for transaction from money held for savings.

Robert Rasche (1993) in his paper to the St. Louis Fed conference 12 months ago identified the beginning of the 1980s as a time of a critical regime change. This structural change, he claimed, had destroyed the validity of the traditional St. Louis reduced-form methodology as a means for explaining and forecasting the course of GNP. Policy makers around the world have clearly also been convinced that monetary aggregates provide little useful information to guide macro policy.

Presumably, nobody would argue that no guide to monetary policy was necessary. How. ever, the advocates of a simplistic policy based upon any traditional measure of money as the sole guide are disappearing rapidly.

At the theoretical level, the significance of exogenous monetary shocks as a cause of business cycles has been under threat from the so-called Real Business Cycle school. For them, monetary disturbances are not the trigger to cycles but, rather, are an endogenous response to shocks emanating in the real economy. While this approach does not necessarily eliminate the validity of countercyclical monetary policy, it certainly reduces the significance of the traditional monetarist line that monetary shocks are the primary trigger to the cycle. Several recent empirical studies have apparently produced evidence to support the contention that money does not have any explanatory power -- at least for real economic activity. (De Long and Summers, 1988; Friedman and Kuttner, 1992, 1993.)

The consensus view emerging from all of this appears to be that trying to target and control money is no longer a very sensible thing for policy makers to do. …

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