Comment on 'On the Fit of a Neoclassical Monetary Model in High Inflation: Israel 1972-1990.'(response to Article in This Issue, P. 725) (Dynamic Effects of Monetary Policy)

By Watson, Mark W. | Journal of Money, Credit & Banking, November 1997 | Go to article overview

Comment on 'On the Fit of a Neoclassical Monetary Model in High Inflation: Israel 1972-1990.'(response to Article in This Issue, P. 725) (Dynamic Effects of Monetary Policy)


Watson, Mark W., Journal of Money, Credit & Banking


One of the important successes in empirical macroeconomics is the relative stability of money demand during the extremes of hyperinflations. Beginning with the seminal work of Cagan, this stability has been found in many different countries over many sample periods. Bental and Eckstein study the Israel inflation of the 1970s and 80s and persuasively demonstrate this stability in an environment that includes inflation ranging from essentially 0 percent to over 200 percent per annum. Figure 7 in their paper is a beautiful summary of the empirical success of a simple model of money demand, and the paper is worth remembering if only for this remarkable picture.

The paper makes several other contributions, however. It proposes a simple representative agent-optimizing model that rationalizes the demand for money function. It demonstrates that the model does a reasonable job mimicking the trends in money demand, interest rates, seigniorage, and employment. It shows that the disinflation was carried out with little of the output losses suggested by a traditional Phillips curve, consistent with Sargent's study of interwar hyperinflations. Finally, Bental and Eckstein use their model to quantify the welfare gains associated with the disinflation.

My comments will focus on three aspects of the study: the fit of model, the Phillips curve trade-off, and the welfare calculation.

One of the paper's empirical findings is that the log-log money demand function: log([m.sub.t]/[c.sub.t]) = [Alpha] + [Beta] x log[(1 + [R.sub.t])/[R.sub.t] fits the Israeli data better than the semilogarithmic specification log([m.sub.t]/[c.sub.t]) = [Alpha] + [Beta] x [R.sub.t]. The paper's Figure 7 shows this result quite clearly. The standard error for the log-log specification is 15 percent, while the standard error for the semilog specification is 34 percent. This improvement in fit is much more difficult to see in economies with more moderate variations in inflation. For example, comparing the same two money demand specifications for U. S. annual MI data over the twentieth century yields standard errors of 15 percent for the log-log specification and 14 percent for the semilog specification. Thus, for the United States both models apparently fit the data equally well.

While Figure 7 shows that the basic model fits die data well, there are two sets of points that fit less well. The first are the poststabilization observations highlighted in the graph and discussed at length in the paper. The second set are the points directly above the poststabilization cluster. This second set of errors correspond to the rapid increase in nominal interest rates that occurred in 1979-80 (see Figure 6). It would be interesting to know more about the apparent unusually high money demand during this period.

The authors carefully discuss potential explanations associated with the shortfall of money demand post-1985. One detailed explanation is the subject of their section 6. The basic idea is that during the high-inflation period, the possibility of stabilization and associated decline in future inflation leads to higher money demand. After stabilization occurs, there is no longer the possibility for additional future sharp decreases in inflation and this leads to a lower money demand. …

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