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Tuesday, June 07, 2011

FRBSF: Economics Instruction and the Brave New World of Monetary Policy

John Williams explains why "the Fed has moved away from targeting the monetary aggregates in conducting monetary policy" (this is the first part of a much longer explanation of recent changes in monetary policy):

Economics Instruction and the Brave New World of Monetary Policy, by John Williams, Economic Letter, FRBSF: ...The first major difference between monetary policy today and policy of a generation or so ago is that our decisions have had less and less to do with monetary aggregates, such as M1. This reflects the fact that payments technology has changed so dramatically over the past 50 years. In the 1950s, when June Cleaver went to buy groceries, she probably paid with cash or perhaps a check. If her purse was empty, she had to get to the bank before it closed at three o’clock, wait in line for the next available teller, and then withdraw enough cash to last until her next bank visit. These simple facts of life determined the monetary theories of that day. They even shaped the definition of M1, which has a nostalgic 1950s simplicity about it.
For example, M1, the most liquid measure of money, is defined as cash and coin, traveler’s checks, demand deposits, and similar bank balances. These include the measures of money that June Cleaver used for her transactions every day. In terms of understanding how much cash June wanted to hold, the Baumol-Tobin theory of money demand might apply. In that theory, households calculate how many times to go to the bank to withdraw cash and how much cash to take out based on two things: the inconvenience cost of each trip to the bank and the household’s typical monthly shopping needs.
Let’s now fast-forward 50 years. Instead of driving to the bank and waiting in line, many of us do most of our banking online or at ATMs. And purchases today can be made using a dizzying array of payment options, including credit cards, debit cards, gift cards, and PayPal, to name just a few. Debit cards and PayPal have many similarities to traditional checking accounts and can be fitted into traditional monetary theories. But credit cards present a much greater challenge. Credit card balances are nowhere to be found in the monetary aggregates, even though they make up a large fraction of total U.S. transactions. If you or I drained our bank accounts, we could still shop until we dropped by running up our credit card balances.
How do 1950s theories of cash and checks apply in a world in which you and I can instantly take out a loan of several thousand dollars with the swipe of a card at the cash register? When Milton Friedman first advocated slow and stable growth of the money supply, he didn’t write a word about credit cards, checkable brokerage accounts, or checkable home equity loan accounts. In the 1950s, these innovations hadn’t been invented or existed only in the most rudimentary form.
Let’s take a closer look at the classic quantity theory of money: MV = PY. It becomes very tenuous when traditional measures of M make up a smaller and smaller fraction of the value of transactions. For example, the velocity of M1 was around three or four in the 1950s. Now it is about eight—and that’s down from a peak of about 10½ a few years ago. Today’s economy uses cash and checking accounts much more efficiently (see Goldfeld 1976).
There have been a number of attempts to find a broader measure of “money” that has a stable relationship with nominal spending—that is, a constant velocity. These include M2 and variants of M2 that incorporate the latest financial innovations (see Small and Porter 1989 and Duca 1995). But, despite repeated efforts, like the mythical city of El Dorado, this ideal measure of money has proven elusive. It is precisely because of the volatility of velocity (V) that the Fed has moved away from targeting the monetary aggregates in conducting monetary policy. Instead, for the past few decades, the Fed has targeted short-term interest rates, in particular the federal funds rate and the interest rate on bank reserves. By targeting these rates directly, the Fed bypasses the uncertain and unpredictable link between money and the economy. Other major central banks target short-term interest rates as well. ...

    Posted by on Tuesday, June 7, 2011 at 01:17 AM in Economics, Monetary Policy, Universities | Permalink  Comments (6)


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