Monetary Policy is not about Interest Rates; the Liquidity Effect and the Fisher Effect

The purpose of this paper is to clarify the relation between money and interest rates. In section 1, the author examines the empirical validity of Keynes’s claims for his liquidity preference theory by looking at the relation between changes in interest rates and changes in the quantity of money. In section 2, the author considers Irving Fisher’s findings. Fisher, whose studies had mostly preceded Keynes, had shown that over any longer-term horizon the relation between money and interest rates was exactly the reverse of Keynes’ hypothesis of short-term liquidity preference. A reconciliation is proposed that treats Keynes’ theory as a short-term, liquidity effect, and Fisher’s results, which incorporate the effect of inflation or inflation expectations, as the longer-term determinant of interest rates. In section 3, the author applies the resulting combined theory of the relation between money and interest rates to five case studies in recent decades: two from Japan, and one each from the Eurozone, the U.K. and the U.S. The conclusion is that interest rates are a highly misleading guide to the stance of monetary policy; it is invariably better to rely on the growth rate of a broad definition of money when assessing the stance of monetary policy