Why Money Growth Determines Inflation in the Long Run: Answering the Woodford Critique
Nelson, Edward, Journal of Money, Credit & Banking
SEVERAL ECONOMISTS FAMILIAR with New Keynesian models have argued that these models imply that money growth determines inflation in the long run. For example, Ireland (2004, p. 979) concluded an analysis of an estimated New Keynesian model by observing that "the monetary authority must choose the steady-state rate of inflation, which is ultimately determined by the rate of nominal money growth." Woodford (2008), however, argued that economists who believe that money growth determines inflation in the long run in New Keynesian models do so because of their own "misunderstanding" of how these models work. In this paper, I provide a rebuttal to this argument and make the case that in New Keynesian models, money growth indeed determines inflation in the long run. I do not want this discussion to overshadow substantial areas of agreement with Woodford (2008), so I state those areas of agreement first and explore their implications for work on monetary policy. The areas of agreement are covered in Section 1, and the long-run money growth/inflation relationship is the subject of Section 2. Section 3 considers the possible objections, and Section 4 provides brief concluding remarks.
1. AREAS OF AGREEMENT
Three major areas of agreement with Woodford are on (i) emphasizing the contribution of monetarism to present-day monetary analysis, (ii) the false leads provided by some advocates of monetary aggregates, and (iii) distinguishing money and credit. What follows is not a simple catalog of agreement. Instead, my intention is to bring out some points not covered by Woodford: connections of monetarism to New Keynesian economics beyond those he listed; common elements in Woodford's (2008) views on money and credit and those in the monetarist literature, and how the criticism of New Keynesian models made by Alvarez, Lucas, and Weber (2001), though motivated by appealing to the quantity theory of money, actually finds no support in the work of Milton Friedman.
1.1 Contributions of Monetarism
While the topic of Woodford's paper is "How Important Is Money in the Conduct of Monetary Policy?," his Section 1 deals with "The Historical Significance of Monetarism." It is very appropriate that a discussion of money's present status should begin with a discussion of monetarism. It is as natural and essential to consider monetarism in a discussion of today's role for money as it is to consider the Great Inflation in a discussion of the Great Moderation. Many of the policymaking principles put into practice in major countries today are inherited from ideas articulated by monetarists during earlier periods. Moreover, the durability of monetarist ideas is also manifested in research that improves upon and extends New Keynesian models. The study by Christiano, Motto, and Rostagno (2003) is a leading example of the productive interaction of the monetarist literature and state-of-the-art modeling. Their work proposes several modifications to a New Keynesian baseline model, with the added model elements inspired by the desire to test hypotheses advanced in the monetarist literature. The result is a much more rigorous foundation for the frictions mentioned in monetarist work than achieved in the existing New Keynesian, or any preceding, literature. Another example of a productive synthesis of the monetarist literature and modern macroeconomic modeling is that in Dotsey and King (2005, pp. 214, 227), who connect the properties of their state-dependent pricing model to the list of empirical propositions about the effects of monetary policy given in Friedman (1987).
Clarifying the enduring contribution of monetarism is especially important because many prior discussions provide quite a misleading picture. I find the contributions of Alan Blinder and Willem Buiter to be particularly interesting in illustrating the problems of correctly disentangling the legacy of monetarism. These authors hold special positions in that they both contributed prominent papers on the Keynesian side during the years of Keynesian-monetarist debate (see Blinder and Solow 1973, Tobin and Buiter 1976). …