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Monetary policy: why money matters, and interest rates don’t

  • Daniel L. Thornton

Since the late 1980s the Fed has implemented monetary policy by adjusting its target for the overnight federal funds rate. Money’s role in monetary policy has been tertiary, at best. Indeed, several influential economists have suggested that money is irrelevant for monetary policy. They suggest that central banks can control inflation by (i) controlling a very short-term nominal interest rate and (ii) influencing financial market participants’ expectation of the future policy rate in order to exert greater control over longer-term rates. I offer an alternative perspective: namely, that money is essential for the central bank’s control over the price level and that the monetary authority’s control over interest rates is exaggerated.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2012-020.

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Date of creation: 2012
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Handle: RePEc:fip:fedlwp:2012-020
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  1. Reynard, Samuel, 2007. "Maintaining low inflation: Money, interest rates, and policy stance," Journal of Monetary Economics, Elsevier, vol. 54(5), pages 1441-1471, July.
  2. Lucio Sarno & Daniel L. Thornton & Giorgio Valente, 2005. "The empirical failure of the expectations hypothesis of the term structure of bond yields," Working Papers 2003-021, Federal Reserve Bank of St. Louis.
  3. Michael D. Bauer & Glenn D. Rudebusch, 2014. "The Signaling Channel for Federal Reserve Bond Purchases," International Journal of Central Banking, International Journal of Central Banking, vol. 10(3), pages 233-289, September.
  4. Mervyn King, 1999. "Challenges for monetary policy : new and old," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 11-57.
  5. Thornton, Daniel L., 2004. "The Fed and short-term rates: Is it open market operations, open mouth operations or interest rate smoothing?," Journal of Banking & Finance, Elsevier, vol. 28(3), pages 475-498, March.
  6. Daniel L. Thornton, 1998. "The Federal Reserve's operating procedure, nonborrowed reserves, borrowed reserves and the liquidity effect," Working Papers 1998-009, Federal Reserve Bank of St. Louis.
  7. Bennett T. McCallum, 1982. "Price Level Determinacy with an Interest Rate Policy Rule and Rational Expectations," NBER Working Papers 0559, National Bureau of Economic Research, Inc.
  8. Daniel L. Thornton, 2007. "The daily and policy-relevant liquidity effects," Working Papers 2007-001, Federal Reserve Bank of St. Louis.
  9. Massimo Guidolin & Daniel L. Thornton, 2010. "Predictions of short-term rates and the expectations hypothesis," Working Papers 2010-013, Federal Reserve Bank of St. Louis.
  10. Thomas J. Sargent, 1982. "The Ends of Four Big Inflations," NBER Chapters, in: Inflation: Causes and Effects, pages 41-98 National Bureau of Economic Research, Inc.
  11. Friedman, Benjamin M, 2000. "Decoupling at the Margin: The Threat to Monetary Policy from the Electronic Revolution in Banking," International Finance, Wiley Blackwell, vol. 3(2), pages 261-72, July.
  12. Nelson Edward, 2005. "The Great Inflation of the Seventies: What Really Happened?," The B.E. Journal of Macroeconomics, De Gruyter, vol. 5(1), pages 1-50, July.
  13. John Y. Campbell & Robert J. Shiller, 1989. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," NBER Working Papers 3153, National Bureau of Economic Research, Inc.
  14. Jeremy M. Piger & Robert H. Rasche, 2008. "Inflation: Do Expectations Trump the Gap?," International Journal of Central Banking, International Journal of Central Banking, vol. 4(4), pages 85-116, December.
  15. Michael Woodford, 2008. "How Important Is Money in the Conduct of Monetary Policy?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(8), pages 1561-1598, December.
  16. Thornton, Daniel L., 2005. "Tests of the expectations hypothesis: Resolving the anomalies when the short-term rate is the federal funds rate," Journal of Banking & Finance, Elsevier, vol. 29(10), pages 2541-2556, October.
  17. Carpenter, Seth & Demiralp, Selva, 2006. "The Liquidity Effect in the Federal Funds Market: Evidence from Daily Open Market Operations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(4), pages 901-920, June.
  18. Charles Goodhart, 2000. "Can Central Banking Survive the IT Revolution?," FMG Special Papers sp125, Financial Markets Group.
  19. Daniel L. Thornton, 2012. "How did we get to inflation targeting and where do we need to go to now? a perspective from the U.S. experience," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 65-81.
  20. Bennett T. McCallum & Marvin S. Goodfriend, 1987. "Money: Theoretical Analysis of the Demand for Money," NBER Working Papers 2157, National Bureau of Economic Research, Inc.
  21. Daniel L. Thornton, 2008. "The unusual behavior of the federal funds and 10-year Treasury rates: a conundrum or Goodhart’s Law?," Working Papers 2007-039, Federal Reserve Bank of St. Louis.
  22. Daniel L. Thornton, 2007. "Open market operations and the federal funds rate," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 549-570.
  23. Michael Woodford, 2000. "Monetary Policy in a World Without Money," NBER Working Papers 7853, National Bureau of Economic Research, Inc.
  24. Michael Woodford, 2001. "Monetary Policy in the Information Economy," NBER Working Papers 8674, National Bureau of Economic Research, Inc.
  25. John H. Cochrane & Monika Piazzesi, 2002. "Bond Risk Premia," NBER Working Papers 9178, National Bureau of Economic Research, Inc.
  26. Richard G. Anderson & Robert H. Rasche, 2000. "Retail sweep programs and bank reserves, 1994--1999," Working Papers 2000-023, Federal Reserve Bank of St. Louis.
  27. David Laidler, 2003. "Monetary Policy without Money: Hamlet without the Ghost," UWO Department of Economics Working Papers 20037, University of Western Ontario, Department of Economics.
  28. Rolnick, Arthur J & Weber, Warren E, 1983. "New Evidence on the Free Banking Era," American Economic Review, American Economic Association, vol. 73(5), pages 1080-91, December.
  29. William Poole & Robert H & Rasche & Daniel L. Thornton, 2002. "Market anticipations of monetary policy actions," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 65-94.
  30. Geert Bekaert & Robert J. Hodrick & David Marshall, 1996. "On biases in tests of the expectations hypothesis of the term structure of interest rates," Working Paper Series, Issues in Financial Regulation WP-96-3, Federal Reserve Bank of Chicago.
  31. Hamilton, James D, 1997. "Measuring the Liquidity Effect," American Economic Review, American Economic Association, vol. 87(1), pages 80-97, March.
  32. Daniel L. Thornton, 2005. "A new federal funds rate target series: September 27, 1982, - December 31, 1993," Working Papers 2005-032, Federal Reserve Bank of St. Louis.
  33. Roy Cromb & Emilio Fernandez-Corugedo, 2004. "Long-term interest rates, wealth and consumption," Bank of England working papers 243, Bank of England.
  34. Daniel L. Thornton, 2001. "Identifying the liquidity effect at the daily frequency," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 59-82.
  35. Della Corte, Pasquale & Sarno, Lucio & Thornton, Daniel L., 2008. "The expectation hypothesis of the term structure of very short-term rates: Statistical tests and economic value," Journal of Financial Economics, Elsevier, vol. 89(1), pages 158-174, July.
  36. Daniel L. Thornton, 2000. "Money in a theory of exchange," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 35-60.
  37. Bennett T. McCallum, 2001. "Monetary policy analysis in models without money," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 145-164.
  38. Benjamin M. Friedman, 2000. "Decoupling at the Margin: The Threat to Monetary Policy from the Electronic Revolution in Banking," NBER Working Papers 7955, National Bureau of Economic Research, Inc.
  39. Hamilton, James D, 1996. "The Daily Market for Federal Funds," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 26-56, February.
  40. Daniel L. Thornton, 2005. "When did the FOMC begin targeting the federal funds rate? what the verbatim transcripts tell us," Working Papers 2004-015, Federal Reserve Bank of St. Louis.
  41. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
  42. Nelson, Edward, 2007. "Comment on: Samuel Reynard, "Maintaining low inflation: Money, interest rates, and policy stance"," Journal of Monetary Economics, Elsevier, vol. 54(5), pages 1472-1479, July.
  43. Forni, Mario & Lippi, Marco, 1997. "Aggregation and the Microfoundations of Dynamic Macroeconomics," OUP Catalogue, Oxford University Press, number 9780198288008, March.
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