Milton Friedman, the Demand for Money, and the ECB's Monetary Policy Strategy

By Hall, Stephen G.; Swamy, P. A. V. B. et al. | Federal Reserve Bank of St. Louis Review, May-June 2012 | Go to article overview

Milton Friedman, the Demand for Money, and the ECB's Monetary Policy Strategy


Hall, Stephen G., Swamy, P. A. V. B., Tavlas, George S., Federal Reserve Bank of St. Louis Review


The European Central Bank (ECB) assigns greater weight to the role of money in its monetary policy strategy than most, if not all, other major central banks. Nevertheless, reflecting the view that the demand for money became unstable in the early 2000s, some commentators have reported that the ECB has "downgraded" the role of money demand functions in its strategy. This paper explains the ECB's monetary policy strategy and shows the considerable influence of Milton Friedman's contributions on the formulation of that strategy. The paper also provides new evidence on the stability of euro area money demand. Following a conjecture made by Friedman (1956), the authors assign a role to uncertainty in the money demand function. They find that although uncertainty is nonstationary and subject to wide swings, it is nonetheless mean reverting and has substantial effects on the demand for money. (JEL C20, E41)

Federal Reserve Bank of St. Louis Review, May/June 2012, 94(3), pp. 153-85.

INTRODUCTION

The primary objective of the European Central Bank's (ECB's) monetary policy strategy is to maintain price stability in the medium term. (1) In pursuing that objective, the ECB assigns more weight to the longer-term relationship between money growth and infation than most, if not all, other major central banks. This emphasis reflects, in part, the ECB's views that (i) "inflation is ultimately a monetary phenomenon" and (ii) "price stability enhances the potential for economic growth" (ECB, 2011, pp. 55-56). Effectively, the emphasis reflects the notion that longer-term growth is determined by real factors--including an economy's resources, the growth of its population, and the technical skills of its labor force--and that the most monetary policy can do to help the economy reach its growth potential is deliver a stable price level (ECB, 2011, p. 56).

In several important respects, the ECB's monetary policy strategy reflects the substantial influence of Milton Friedman's research during the 1950s and 1960s. (2) One such respect concerns the stability of the demand for money, which helps underpin the idea that there exists a reliable, longer-term relationship between the growth in the money supply and inflation. Friedman (1959) found that demand for money in the United States was stable, a finding corroborated for the euro area in early work by the ECB staff (Calza, Gerdesmeier, and Levy, 2001). However, beginning around 2003, most euro area money demand functions began exhibiting instability, leading some commentators to infer that the role of money had been "downgraded" in the ECB's monetary policy strategy (see Section 2).

In this paper, we explain the key linkages between Friedman's work, including the relevance of a stable money demand function, and the strategy adopted by the ECB. We also provide new evidence on the stability of euro area money demand based on a framework that captures the effect of uncertainty on the demand for money, an idea first proposed by Friedman (1956).

The remainder of this paper is structured as follows. To set the stage, Section I provides an overview of Friedman's earlier research findings, which, as we show, underpinned his famous policy proposal for a constant money supply growth rate, first published in 1958. Section 2 describes the monetary policy strategy of the ECB, including the role of the demand for money in that strategy; this section also describes the influence of Friedman's work on the ECB's monetary policy strategy. We show that, although the finding in the mid-2000s by ECB economists that the demand for money in the euro area was no longer stable subsequently led to what the press reported as a "downgrading" of the role of money in the ECB's strategy, the role of monetary analysis in the ECB's strategy remains pivotal in assessing the outlook for future price developments. Section 3 turns to our analysis of euro area money demand and provides the basic theoretical framework we use to estimate money demand. …

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