Inside Money, outside Money, and Short-Term Interest Rates
Chari, V. V., Christiano, Lawrence J., Eichenbaum, Martin, Coleman, John, Rotemberg, Julio J., Journal of Money, Credit & Banking
THIS PAPER presents a quantitative general equilibrium model with multiple monetary aggregates. Developing such a framework is important for answering various questions concerning the cyclical behavior of those aggregates. For example, what drives the observed positive correlation between broad monetary aggregates and output: exogenous movements in outside money, or endogenous movements in inside money? Why do different monetary aggregates covary differently with short-term interest rates? To make progress on these questions, we need a model that distinguishes between different monetary aggregates. This paper takes a modest step toward developing such a model.
The framework presented here incorporates a banking sector and distinguishes between M1, the monetary base, currency, and various measures of bank reserves: total, excess and nonborrowed. The key features of our model that distinguish it from standard real business cycle models are as follows. First, households have a technology that allows them to use currency and demand deposits to economize on time spent purchasing consumption goods. Second, there is a banking sector that produces loans and demand deposits using capital, labor, and reserves. Third, the monetary authority controls the monetary base while the private sector determines the composition of the base between currency and bank reserves.
We use a variant of our model to discuss the following phenomenon: broad monetary aggregates like MI and the base covary positively with current and future values of short-term interest rates, while the opposite is true for nonborrowed reserves. This "sign switch" is interesting because it lies at the core of recent debates about the effects of monetary policy actions on short-term interest rates. Analysts who focused on broader monetary aggregates tended to conclude that exogenous monetary injections drive short-term rates up. Analysts who focused on nonborrowed reserves tended to reach the opposite conclusion [see Christiano (1995) for a review]. The interesting question is: how can we account for both phenomena simultaneously? The answer embedded in our model is that movements in nonborrowed reserves are dominated by exogenous shocks to monetary policy, while movements in the base and MI are dominated by endogenous responses to nonpolicy shocks.
To articulate this argument, we need a model with the following features. First, it must allow for several types of shocks. We take the simplest possible approach, by allowing for two shocks: exogenous shocks to the growth rate of the monetary base and exogenous shocks to technology. Second, the model must allow for broad monetary aggregates to respond to nonpolicy shocks. This happens in our model because the banking sector expands after a technology shock to the goods--producing sector. Since these shocks also have the effect of raising equilibrium interest rates, the model can account for the observed positive correlation between MI and interest rates. Third, to account for the positive relation between the monetary base and interest rates we take a particular stand on Federal reserve monetary policy. We assume that innovations to the growth rate of the monetary base are composed of two components. One component is purely exogenous, while the other reacts to contemporaneous innovations in technology. We identify the former with innovations to the nonborrowed component of the monetary base. We identify the latter with innovations in borrowed reserves. These assumptions reflect our view that in the data innovations to nonborrowed reserves are dominated by exogenous shocks to policy while innovations to borrowed reserves primarily reflect the response of discount window borrowing to nonpolicy shocks. It is this reactive component of innovations to the base that allows the model to account for the observed positive correlation between the base and the interest rate.(1)
Fourth, our model must incorporate elements that imply that nonborrowed reserves covary negatively with the interest rate. …