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The Use of Monetary Aggregate to Target Nominal GDP

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  • Martin Feldstein
  • James H. Stock

Abstract

This paper studies the possibility of using the broad monetary aggregate M2 to target the quarterly rate of growth of nominal GDP. Our findings indicate that the Federal Reserve could probably guide M2 in a way that reduces not only the long-term average rate of inflation but also the variance of the annual rate of growth of nominal GDP. An optimal M2 rule, derived from a simple VAR, reduces the mean ten-year standard deviation of annual GDP growth by over 20 percent. Although there is uncertainty about this value because of both parameter uncertainty and stochastic shocks to the economy, we estimate that the probability that the annual variance would be reduced over a ten year period exceeds 85 percent. A much simpler policy based on a single equation linking M2 and GDP is shown to be almost as successful in reducing this annual GDP variance. Additional statistical tests indicate that M2 is a useful predictor of nominal GDP. Moreover, a battery of recently developed tests for parameter stability fails to reject the hypothesis that the M2 - GDP link is stable, but the MI - GDP and monetary base - GDP relations are found to be highly unstable. This evidence contradicts those who have argued that the M2 - GDP relation is so unstable in the short run that it cannot be used to reduce the variance of nominal GDP growth.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4304.

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Date of creation: Mar 1993
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Publication status: published as Monetary Policy, N. Gregory Mankiw, ed., pp.7-70, (Chicago: University of Chicago Press: 1994).
Handle: RePEc:nbr:nberwo:4304

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  1. Sims, Christopher A, 1972. "Money, Income, and Causality," American Economic Review, American Economic Association, vol. 62(4), pages 540-52, September.
  2. Arturo Estrella & Gikas A. Hardouvelis, 1989. "The term structure as a predictor of real economic activity," Research Paper 8907, Federal Reserve Bank of New York.
  3. Ploberger, Werner & Krämer;, Walter, 1990. "The Local Power of the CUSUM and CUSUM of Squares Tests," Econometric Theory, Cambridge University Press, vol. 6(03), pages 335-347, September.
  4. Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, vol. 48(1), pages 1-48, January.
  5. Hendry, David F. & Ericsson, Neil R., 1991. "Modeling the demand for narrow money in the United Kingdom and the United States," European Economic Review, Elsevier, vol. 35(4), pages 833-881, May.
  6. Hoffman, Dennis L & Rasche, Robert H, 1991. "Long-Run Income and Interest Elasticities of Money Demand in the United States," The Review of Economics and Statistics, MIT Press, vol. 73(4), pages 665-74, November.
  7. Stock, James H. & Watson, Mark W., 1989. "Interpreting the evidence on money-income causality," Journal of Econometrics, Elsevier, vol. 40(1), pages 161-181, January.
  8. Hafer, R W & Jansen, Dennis W, 1991. "The Demand for Money in the United States: Evidence from Cointegration Tests," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(2), pages 155-68, May.
  9. Robert King & Mark W. Watson, 1992. "Testing Long Run Neutrality," NBER Working Papers 4156, National Bureau of Economic Research, Inc.
  10. R.A. Pecchenino & Robert H. Rasche, 1990. "P* Type Models: Evaluation and Forecasts," NBER Working Papers 3406, National Bureau of Economic Research, Inc.
  11. James H. Stock & Mark W. Watson, 1990. "Business Cycle Properties of Selected U.S. Economic Time Series, 1959-1988," NBER Working Papers 3376, National Bureau of Economic Research, Inc.
  12. Banerjee, Anindya & Lumsdaine, Robin L & Stock, James H, 1992. "Recursive and Sequential Tests of the Unit-Root and Trend-Break Hypotheses: Theory and International Evidence," Journal of Business & Economic Statistics, American Statistical Association, vol. 10(3), pages 271-87, July.
  13. Saikkonen, Pentti, 1991. "Asymptotically Efficient Estimation of Cointegration Regressions," Econometric Theory, Cambridge University Press, vol. 7(01), pages 1-21, March.
  14. Christiano, Lawrence J, 1992. "Searching for a Break in GNP," Journal of Business & Economic Statistics, American Statistical Association, vol. 10(3), pages 237-50, July.
  15. Ljungqvist, Lars & Park, Myungsoo & Stock, James H. & Watson, Mark W., 1988. "The convergence of multivariate unit root distributions to their asymptotic limits : The case of money-income causality," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 489-502.
  16. Christopher A. Sims, 1982. "Policy Analysis with Econometric Models," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 13(1), pages 107-164.
  17. McNees, Stephen K, 1986. "Forecasting Accuracy of Alternative Techniques: A Comparison of U.S. Macroeconomic Forecasts," Journal of Business & Economic Statistics, American Statistical Association, vol. 4(1), pages 5-15, January.
  18. Ploberger, Werner & Kramer, Walter, 1992. "The CUSUM Test with OLS Residuals," Econometrica, Econometric Society, vol. 60(2), pages 271-85, March.
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