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Monday, November 13, 2006

Money and Monetary Policy

Here's a bit more on the controversy over using money in monetary policy. For those who are interested, I've included a few pages from Michael Woodford's book on this topic at the end (he's mentioned in the article). It's a section in the first chapter called "General Criticisms of Interest-Rate Rules." It doesn't directly address the Trichet-Bernanke controversy, but it does give the major objections to the use of interest-rate targeting, and it does relate to the issue:

Central bankers need money in monetary policy, by Wolfgang Munchau, Commentary, Financial Times: If there is one area where Europeans are from Mars and Americans from Venus, it is monetary policy and the role of monetary aggregates. Last week, the world’s two most prominent central bankers publicly disagreed. Jean-Claude Trichet, European Central Bank president, argued in the Financial Times why monetary analysis would remain an essential part of the ECB’s tool kit. Ben Bernanke, US Federal Reserve chairman, said a central bank would be unwise to rely too heavily on money since financial innovation had been causing disturbances to monetary statistics.

It seems at first like an ancient Keynesian-versus-monetarist debate but this is not so. For a start, this is about the role of money, not monetarism, the theory that postulated that central banks should target the money supply to stabilise inflation over the medium term. Even the ECB does not go that far. ...

Mr Trichet and colleagues believe that a careful analysis of monetary conditions – the so-called second pillar of ECB strategy – carries important signals. ... [I]t uses monetary analysis as a cross-check.

Most – but not all – of the academic community is behind Mr Bernanke. At an ECB conference last week, Michael Woodford, a monetary economist from Columbia University, made a powerful case against money. He said there was no need for a separate monetary analysis. The so-called neo-Keynesian economic models, which included no reference to money, delivered all the information central bankers needed to judge future price pressures. This type of model is consistent with everything conservative central bankers believe: that inflation is ultimately a monetary phenomenon and that money is neutral in the long run... The implication is that a second pillar is redundant at best...

Those in favour of a separate monetary analysis assign an important role to the transmission channels of monetary policy, such as bank lending or the financial markets. Lawrence Christiano from Northwestern University and Roberto Motto and Massimo Rostagno, both from the ECB, have argued that the traditional neo-Keynesian models cannot conceivably explain the strength of the boom-bust cycles in stock markets. For that to happen, money is essential.

Suppose that people are unduly optimistic about a new technology. Companies hire staff and expand production. In a world with inflexible wages, companies create excess capacity but wages do not rise sufficiently fast. The result is that inflation falls. An inflation-targeting central bank would be forced to cut interest rates under these circumstances, which would lead to even more investment. In this model, monetary policy is directly responsible for creating a boom-bust cycle.

This debate is far from concluded. My own sense is that money will probably make some form of a comeback... [T]he way financial markets are evolving, it may be unwise for central bankers to throw away the key to monetary analysis altogether.

Here's Woodford [pdf file].

    Posted by on Monday, November 13, 2006 at 01:05 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (4)


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