How Important Is Money in the Conduct of Monetary Policy?
Woodford, Michael, Journal of Money, Credit & Banking
IT MIGHT BE THOUGHT obvious that a policy aimed at controlling inflation should concern itself with ensuring a modest rate of growth of the money supply. After all, every beginning student of economics is familiar with Milton Friedman's dictum that "inflation is always and everywhere a monetary phenomenon" (e.g., Friedman 1992), and with the quantity theory of money as a standard account of what determines the inflation rate. Yet nowadays monetary aggregates play little role in monetary policy deliberations at most central banks. King (2002, p. 162) quotes then--Fed Governor Larry Meyer as stating that "money plays no explicit role in today's consensus macro model, and it plays virtually no role in the conduct of monetary policy."
Not all agree that this de-emphasis of money growth as a criterion for judging the soundness of policy has been a good thing. Notably, the European Central Bank (ECB) continues to assign a prominent role to money in its monetary policy strategy. In what the ECB calls its "two-pillar strategy," one pillar is "economic analysis," which "assesses the short-to-medium-term determinants of price developments." According to the ECB, this analysis "takes account of the fact that price developments over those horizons are influenced largely by the interplay of supply and demand in the goods, services and factor markets." But in addition, a second pillar, "monetary analysis," assesses the medium- to long-term outlook for inflation, "exploiting the long-run link between money and prices." The two alternative frameworks for assessing risks to price stability are intended to provide "cross-checks" for one another (ECB 2004, p. 55).
But what exactly is the nature of the additional information that can be obtained by tracking trends in the growth of monetary aggregates, and why should it be of such crucial importance for the control of inflation as to constitute a separate "pillar" (not infrequently characterized as the "first pillar") of the ECB's policy strategy? And does "monetary analysis" genuinely represent a distinct and complementary perspective on the determinants of inflation, that cannot be subsumed into an "economic analysis" of the inflationary pressures resulting from the balance of supply and demand in product and factor markets, and that can be used to guide policy decisions?
I here review several of the most important arguments that have been made for paying attention to money, considering both the purported omissions made by "economic analysis" alone and the asserted advantages of the information revealed by monetary trends. Of course, it is impossible to review the voluminous literature on this topic in its entirety, so I shall have to stick to a few of the most prominent themes in recent discussions.
First, I consider whether ignoring money means returning to the conceptual framework that allowed the high inflation of the 1970s. The architects of the ECB's monetary policy strategy were undoubtedly concerned not to repeat past mistakes that have often been attributed to a failure to appreciate the role of money in inflation determination. Have those central banks that assign little importance to money, like the current Federal Reserve, forgotten the lessons of the crucial debates of a quarter century ago? Second, I consider the theoretical status of models of inflation determination with no role for money. Are such models incomplete, and hence unable to explain inflation without adding the additional information provided by a specification of the money supply? Or, even if complete, are they inconsistent with elementary economic principles, such as the neutrality of money? Third, I consider the implications for monetary policy strategy of the empirical evidence for a long-run relationship between money growth and inflation. And finally, I consider reasons why a monetary policy strategy based solely on short-run inflation forecasts derived from a Phillips curve may not be a reliable way of controlling inflation, and ask whether "monetary analysis" is an appropriate way to increase the robustness of the conclusions reached regarding the conduct of policy. …