This chapter takes the cyclical mechanisms of the previous chapter and fleshes out the details of how they apply to a monetary economy and monetary policy. The real analysis of Chapter 2 can be translated directly into two basic monetary scenarios for business cycles. In the first scenario, increases in the rate of base money growth lower real interest rates, setting off a boom and a subsequent increase in economic cyclically. In the second scenario, an increase in monetary uncertainty or volatility induces an economic contraction without any prior boom. The courses of these scenarios already have been presented; this chapter expands upon these scenarios and relates them to the relevant issues in monetary theory and policy.
I will consider whether these two scenarios are consistent with the stylized facts about money and business cycles and then I will examine how the monetary models operate when banks ration credit and loan markets do not clear; in that case monetary policy has real effects through finance constraints rather than real interest rates. How the monetary scenarios vary across institutional regimes, including money supply rules, nominal interest rate smoothing, nominal GNP targeting, commodity monies, and New Monetary Economics systems is discussed as well as the transmission of monetary cycles from one currency area to another. The concluding section considers some foundational issues and examines how and why monetary policy affects real variables and real interest rates at all.
This chapter keeps all of the assumptions outlined in Chapter 2, while focusing on the real effects for monetary policy. As in Chapter 2, I do not assume that investors are fooled by the money supply, or that investors do not understand the effects of monetary inflation.