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The monetary instrument matters

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Author Info
William T. Gavin
Benjamin D. Keen
Michael R. Pakko

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Abstract

This paper revisits the debate over the money supply versus the interest rate as the instrument of monetary policy. Using a dynamic stochastic general equilibrium framework, the authors examine the effects of alternative monetary policy rules on inflation persistence, the information content of monetary data, and real variables. They show that inflation persistence and the variability of inflation relative to money growth depend on whether the central bank follows a money growth rule or an interest rate rule. With a money growth rule, inflation is not persistent and the price level is much more volatile than the money supply. Those counterfactual implications are eliminated by the use of interest rate rules whether prices are sticky or not. A central bank's use of interest rate rules, however, obscures the information content of monetary aggregates and also leads to subtle problems for econometricians trying to estimate money demand functions or to identify shocks to the trend and cycle components of the money stock.

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Article provided by Federal Reserve Bank of St. Louis in its journal Review.

Volume (Year): (2005)
Issue (Month): Sep ()
Pages: 633-658
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Handle: RePEc:fip:fedlrv:y:2005:i:sep:p:633-658:n:v.87no.5

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Keywords: Monetary policy ; Money supply ; Interest rates;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Robert Dittmar & William Gavin & Finn Kydland, 2002. "Inflation Persistence and Flexible Prices," Computing in Economics and Finance 2002 190, Society for Computational Economics.
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  2. Cooley, Thomas F & LeRoy, Stephen F, 1981. "Identification and Estimation of Money Demand," American Economic Review, American Economic Association, vol. 71(5), pages 825-44, December. [Downloadable!] (restricted)
  3. Bennett T. McCallum, 2001. "Monetary Policy Analysis in Models Without Money," NBER Working Papers 8174, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Michael Dotsey, 1999. "The importance of systematic monetary policy for economic activity," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 41-60. [Downloadable!]
  5. Soyoung Kim, 2003. "Monetary Policy Rules and Business Cycles," Scandinavian Journal of Economics, Blackwell Publishing, vol. 105(2), pages 221-245, 06. [Downloadable!] (restricted)
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  6. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  7. King, Robert G & Watson, Mark W, 1998. "The Solution of Singular Linear Difference Systems under Rational Expectations," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 1015-26, November.
  8. Cooley, Thomas F & Hansen, Gary D, 1989. "The Inflation Tax in a Real Business Cycle Model," American Economic Review, American Economic Association, vol. 79(4), pages 733-48, September. [Downloadable!] (restricted)
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  9. Robert G. King & Alexander L. Wolman, 1996. "Inflation Targeting in a St. Louis Model of the 21st Century," NBER Working Papers 5507, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. Cho, Jang-Ok & Cooley, Thomas F, 1995. "The Business Cycle with Nominal Contracts," Economic Theory, Springer, vol. 6(1), pages 13-33, June.
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  11. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April. [Downloadable!] (restricted)
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  13. Lawrence J. Christiano & Martin Eichenbaum, 1992. "Liquidity effects and the monetary transmission mechanism," Staff Report 150, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  14. Ireland, Peter N., 2003. "Endogenous money or sticky prices?," Journal of Monetary Economics, Elsevier, vol. 50(8), pages 1623-1648, November. [Downloadable!] (restricted)
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  15. Jordi Gali, 1999. "Technology, Employment, and the Business Cycle: Do Technology Shocks Explain Aggregate Fluctuations?," American Economic Review, American Economic Association, vol. 89(1), pages 249-271, March. [Downloadable!] (restricted)
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  16. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December. [Downloadable!] (restricted)
  17. Ireland, Peter N, 1996. "The Role of Countercyclical Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 104(4), pages 704-23, August. [Downloadable!] (restricted)
  18. King, Robert G & Watson, Mark W, 2002. "System Reduction and Solution Algorithms for Singular Linear Difference Systems under Rational Expectations," Computational Economics, Springer, vol. 20(1-2), pages 57-86, October. [Downloadable!]
  19. Kimball, Miles S, 1995. "The Quantitative Analytics of the Basic Neomonetarist Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1241-77, November. [Downloadable!] (restricted)
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  20. Sharon Kozicki & P.A. Tinsley, 2003. "Permanent and transitory policy shocks in an empirical macro model with asymmetric information," Research Working Paper RWP 03-09, Federal Reserve Bank of Kansas City. [Downloadable!]
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  21. Mankiw, N Gregory & Miron, Jeffrey A & Weil, David N, 1987. "The Adjustment of Expectations to a Change in Regime: A Study of the Founding of the Federal Reserve," American Economic Review, American Economic Association, vol. 77(3), pages 358-74, June. [Downloadable!] (restricted)
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  22. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February. [Downloadable!] (restricted)
  23. Robert B. Barsky & Jeffrey A. Miron, 1989. "The Seasonal Cycle and the Business Cycle," NBER Working Papers 2688, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  24. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April. [Downloadable!] (restricted)
  25. Keen, Benjamin D., 2004. "In search of the liquidity effect in a modern monetary model," Journal of Monetary Economics, Elsevier, vol. 51(7), pages 1467-1494, October. [Downloadable!] (restricted)
  26. Peter N. Ireland, 2005. "Changes in the Federal Reserve's inflation target: causes and consequences," Working Papers 05-13, Federal Reserve Bank of Boston. [Downloadable!]
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  27. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc. [Downloadable!]
  28. McCallum, Bennett T & Nelson, Edward, 1999. "An Optimizing IS-LM Specification for Monetary Policy and Business Cycle Analysis," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(3), pages 296-316, August.
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Peng-fei Wang & Yi Wen, 2006. "Inflation dynamics: a cross-country investigation," Working Papers 2005-076, Federal Reserve Bank of St. Louis. [Downloadable!]
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  2. Andreas Schabert, 2005. "Money Supply and the Implementation of Interest Rate Targets," Tinbergen Institute Discussion Papers 05-059/2, Tinbergen Institute. [Downloadable!]
    Other versions:
  3. William T. Gavin & Benjamin D. Keen & Michael R. Pakko, 2007. "Inflation risk and optimal monetary policy," Working Papers 2006-035, Federal Reserve Bank of St. Louis. [Downloadable!]
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  4. Peter N. Ireland, 2005. "Changes in the Federal Reserve’s Inflation Target: Causes and Consequences," Boston College Working Papers in Economics 607, Boston College Department of Economics. [Downloadable!]
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  5. Andreas Schabert, 2006. "Central Bank Instruments, Fiscal Policy Regimes, and the Requirements for Equilibrium Determinacy," Tinbergen Institute Discussion Papers 06-025/2, Tinbergen Institute. [Downloadable!]
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  6. Piti Disyatat, 2008. "Monetary policy implementation: Misconceptions and their consequences," BIS Working Papers 269, Bank for International Settlements. [Downloadable!]
  7. William T. Gavin, 2005. "Recent developments in monetary macroeconomics and U.S. dollar policy," Working Papers 2005-062, Federal Reserve Bank of St. Louis. [Downloadable!]
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  8. Andreas Schabert, 2005. "Discretionary Policy, Multiple Equilibria, and Monetary Instruments," Tinbergen Institute Discussion Papers 05-098/2, Tinbergen Institute. [Downloadable!]
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