Magazine article Economic Trends

Monetary Policy

Magazine article Economic Trends

Monetary Policy

Article excerpt

In simple textbook models of the aggregate economy, monetary policy is either expansionary, contractionary, or neutral with respect to the real economy and the price level, depending on the pace at which the money supply expands relative to demand. Making use of this framework, however, requires that supply and demand for money have a stable relationship with economic activity and prices. Unfortunately, experience demonstrates that these relationships lack the stability needed to transform the textbook model into a dependable, real-time policy tool.

In the early 1990s, for example, the M2 measure of money became less reliable as a guidepost for policy. Its relationship to economic activity as summarized by its velocity--the ratio of GDP to M2--changed unexpectedly M2 velocity increased dramatically relative to its opportunity cost. Thus, the increase in M2 growth during that period was not associated with an increase in inflation, as history would have suggested.

Another measure of money, M2 minus small time deposits, was unaffected by the events of the early 1990s. Although its growth has been strong in recent years, its velocity has fallen dramatically with declines in its opportunity cost. If interest rates rise, as the federal funds futures suggest, we would expect to see sharp declines in the growth of M2 minus small time deposits, along with increases in its velocity and thus prices. Its failure to slow down would be cause for concern.

At its March 19 meeting, the Federal Open Market Committee left the intended federal funds rate unchanged at 1. …

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