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ABSTRACT This paper discusses the current ‘new consensus’ view on monetary policy
and the theoretical framework on which that practical view relies, namely, the ‘targets-
and-instrument approach’. We argue that in the modern world of financial innovation
and liability management central banks cannot choose between an interest rate-targeting
policy and a money-targeting policy. A money-targeting regime is not desirable, if not
unfeasible. In addition, in the context of Poole’s approach to the ‘instrument’ problem, the
implementation of a money-targeting regime would raise the expected value of the loss
function of the central bank and would thus shift the balance in favour of an interest-rate
targeting regime.
Central bankers and even some monetary economists talk knowledgeably of using
interest rates to control inflation, but I know of no evidence from even one economy
linking these variables in a useful way, let alone evidence as sharp as that displayed
in figure 1 [showing a simple correlation between inflation and money growth]. The
kind of monetary neutrality shown in this figure needs to be a central feature of any
monetary or macroeconomic theory that claims empirical seriousness (Robert E.
Lucas, Nobel Lecture, 1996).
Introduction
In a recent issue of the Journal of Economic Perspectives, De Long (2000, pp. 83–84)
has claimed that the influence of monetarism over current macroeconomics is
profound and widespread. In particular, he argues that the emergence of mone-
tary policy as one of the most critical government responsibilities is the result of
the triumph of classic monetarism as developed, for example, by Friedman &
ISSN 0269-2171 print; ISSN 1465-3486 online/04/010025-17 © 2004 Taylor & Francis Ltd.
DOI: 10.1080/0269217032000148627
26 G. Fontana & A. Palacio-Vera
dP dM dV dY
≡ + − (1a)
dt dt dt dt
The logarithmic growth rate of prices P—that is, the inflation rate—is equal to the
logarithmic rate of growth of some representative monetary aggregate M, plus the
logarithmic rate of change in the velocity of circulation of money V, minus the
logarithmic growth rate of real income Y. According to Laidler (2002), those central
bankers would also argue that in the long run changes in real income and the
velocity of circulation of money are exogenous and, therefore, outside their control
so that expression (1a) can be written in the following way:
dP dM
≡ (1b)
dt dt
For what matters, expression (1b) is perfectly compatible with standard monetarist
propositions. Causality is read from right to left, the independent and causal vari-
able being the monetary aggregate M and the dependent variable being the price
level P. Thus, any change in the money supply that monetary authorities succeed
in bringing about manifests itself in the long run in higher prices but not in higher
real output.2 But does it really matter that expression (1b) could be made consistent
with a monetarist approach to monetary policy?3 What do central bankers really
do in the day-to-day setting of monetary policy? Again, according to Laidler, the
same central bankers would surely agree that in the short run they use roughly a
set of three equations—namely, an expectations-augmented Phillips curve, an IS
curve, and a Fisher equation:
e
dP dP
− = g Y −Y
dt dt
(∗ ( (2)
Y − Y ∗ = h (r, X ) (3)
e
dP
r =i− (4)
dt
where (Y – Y*) measures the output gap (for the problematic nature of the compu-
tation of potential output, see Dalziel, 2002), (dP/dt)e is the expected value of the
inflation rate, X is a vector of variables that shift the IS curve, and r and i are the
real and nominal rates of interest, respectively.
However, as Laidler promptly recognises, there is an unresolved tension over
the way the ‘new consensus’ literature approaches the setting of monetary policy.
28 G. Fontana & A. Palacio-Vera
Expression (1b) seems to make money all important for inflation in the long run
while equations (2–4) treat it as irrelevant in the short run. From a monetarist
perspective, equation (3) is a Trojan horse in the citadel of the quantity theory of
money. What a true monetarist would like to see in its place is the following equa-
tion—namely, a positively sloped LM curve:
M
= m ( i, Y ) (5)
P
where (M/P) indicates the equilibrium real money balances of our economy and M
is assumed to be exogenously determined. Of course, there is a good, though often
neglected, reason for using an IS curve as in equation (3) rather than an LM curve.
It is related to the so-called ‘instrument’ problem, a major component of the
‘targets-and-instrument approach’ that is currently used by most central bankers
(Blinder, 1998). The debate around the ‘instrument’ problem began with Poole’s
seminal work (Poole, 1970). In Poole’s approach, the analysis was conducted in
the context of a stochastic IS-LM framework where the money supply was
assumed to be controllable by the monetary authorities. The crux of the matter
was to determine the conditions under which an interest rate r policy was
preferred to a monetary aggregate M policy. The main result of the debate was
that, in theory, the latter policy tends to represent an optimal choice of monetary
policy when ceteris paribus the variance of shocks to the commodity market is
larger than the variance of shocks to the monetary sector. However, in practice,
monetary targets were often missed and, in addition, at least in the US during the
mid-to-late 1980s, fluctuations in money growth ceased to anticipate fluctuations
in either output or prices. Central banks were thus led to interpret the empirical
evidence as suggesting that the theoretical conditions for an interest rate policy
had actually arisen. In a recent study using the VAR methodology, Friedman &
Kuttner (1996, pp. 115–116) provide support for this view and, in addition, they
show that in the US economy the variance of shocks to the monetary sector rose
substantially relative to the variance of shocks to the real sector in the mid-to-late
1980s. Thus, the controversy between advocates of r targets and advocates of M
targets was settled in practice. As argued by Blinder (1997, p. 7), ‘these [theoreti-
cal] conditions then arose in practice, and one central bank after another aban-
doned M targets in favour of r targets’.
This is all well known, and the controversy over the optimal choice of monetary
policy instruments is now history. However, there is a problem with this argument
and the often-quoted successful interaction between theory and practice of central
banking. Consistency with the ‘targets-and-instrument approach’ requires that,
were the relative size of the variance of shocks to the commodity market to be
larger than the variance of shocks to the monetary sector, it might again be appro-
priate to use monetary aggregates as intermediate targets. This possibility may
justify, among other things, keeping the base money-multiplier approach as the
essential tool for explaining the money supply process in standard textbooks.
Indeed, this seems to be the view of the president of the Federal Reserve Bank of
New York, who is not short of praise for using monetary aggregates as a targeting
framework for monetary policy (see also Volcker, 2002). According to him, it is
only the ‘momentary’ absence of a stable and predictable relationship between the
money target and nominal income that prevents the adoption of that policy frame-
work in modern times (McDonough, 1997, p. 4; also Taylor, 1995, p. 12, n. 1).
Monetary Policy Uncovered 29
However, critics like Moore (1988) and Wray (1990) as well as leading monetary
practitioners like Goodhart (2002) have talked openly about the myth of the money
multiplier. In particular, these authors have denounced the ex-post tautological
nature of the multiplier and thus its uselessness for forecasting purposes. The
money multiplier seems to ignore both modern liability management practices
implemented by banks and the effects of the loan demand by the non-bank private
sector. As shown in the next sections, these critics thus maintain that a money-
targeting strategy is neither feasible nor desirable.
Before moving to the problems of the current use of the ‘targets-and-instrument’
approach, it is worthwhile noting that there is much more than a numerical substi-
tution in having an IS curve rather than a positively sloped LM curve in the set of
equations (2)–(4). For the day-to-day setting of monetary policy, central bankers
seem to have lost any confidence in the ability of targeting monetary aggregates in
order to deliver price stability.4 It is the central bank’s key interest rate that is now
seen as the policy instrument for achieving the desired inflation rate through its
effects on aggregate demand (Bank of England, 1999). Recent work by Arestis &
Sawyer (2002) on current monetary policy in the United Kingdom confirms this
view. They argue that interest rate-targeting policy has little to do with monetary
aggregates. In the basic macroeconomic models of the Treasury and the Bank of
England, the supply of money is not even mentioned. More importantly, the
demand for money is either viewed as unstable or is treated as a residual. Simi-
larly, in the macroeconomic model of the US economy used by the Federal
Reserve, shifts in monetary policy are fully captured by innovations to the federal
funds rate, with no role for monetary aggregates (Federal Reserve Board, 1996).
Thus, what Laidler (2002) defines as an unresolved tension in the modern setting
of monetary policy is simply evidence of the large bridge that has, for long time
now, separated theory from practice. As Wray (1998, p. 98) explains, ‘the central
bank never has controlled, nor could it ever control, the quantity of money; neither
can it control the quantity of reserves in a discretionary manner’. For the current
setting of monetary policy, the monetarist interpretation of expression (1b) is then
simply a relic of what theorists suggested that central banks should do, and what
these same central banks could not do. Therefore, a more general or encompassing
interpretation of expression (1a) would be that, in the long run and in the absence
of significant changes in the velocity of circulation of money, the money supply
will move in line with nominal income. Similarly, the implied direction of causa-
tion, if any, in expression (1b) would then be from changes in nominal income to
changes in the stock of money.5
(1970), the literature regarding the choice of monetary policy instruments has laid
down the conditions under which a price variable, for instance an interest rate, was
to be preferred to a quantity variable like borrowed (BOR) or non-borrowed
(NBOR) bank reserves.
In Poole’s seminal contribution (Poole, 1970) a stochastic IS–LM framework is
formulated where the commodity and monetary sectors are subjected to exoge-
nous random shocks. The monetary policy strategy that minimises a loss function,
presented as the quadratic deviation of current Y from desired level of output Y’,
will be the preferable one:
( )
L = E Y − Y∗
2
(6)
control the level of interest rates in order to affect the rate of monetary expansion
indirectly’. An important implication of this argument is that control of the rate of
expansion of the money supply ultimately rests on the ability of central banks to
affect bank lending to the non-bank private sector. This is a proposition that has
long been advocated by Post Keynesians like Kaldor & Trevithick (1981), Moore
(1988), Niggle (1990, 1991), Arestis & Howells (1992), Dow (1993) and Chick (1995).
Within a Post Keynesian framework, the key question is how variations in interest
rates impinge on the decisions to deficit-spend by the non-bank private sector and
the willingness to lend by the banking system. In this respect, Arestis & Howells
(1992, p. 149) argue that ‘it is clear that the UK authorities now see interest rate
changes as having an impact upon aggregate demand through a number of diverse
channels. These include the cost of borrowing, income and wealth effects, and the
exchange rate’. In summary, the type of institutional arrangements characteristic
of modern economies with developed financial markets make it very unlikely that
both the theoretical and practical conditions necessary to run a money-targeting
regime will be fulfilled.
In an extension of Poole’s analysis by Modigliani et al. (1970), the money supply
process incorporates two types of disturbances. First, there are the standard shocks
affecting the aggregate demand function and the money demand function. Second,
and importantly, the model also includes shocks affecting the relationship
between high-powered money and the money supply. The difference with Poole’s
analysis is that targeting interest rates now damps the impact on income of mone-
tary disturbances that could consist of variations in the money multiplier as well
as shocks to the money demand function. On the other hand, targeting high-
powered money now damps to a lesser extent than in Poole’s model the impact on
income of shocks to the IS function. This is because aggregate demand shocks may
be accompanied, for instance, by variations in the money multiplier, thus leading
to changes of the same sign in the LM function. We will return to this point below.
Secondly, another feature of Poole’s approach is that the standard deviation of
shocks to the monetary sector σm and the covariances of shocks to the commodity
and monetary sectors are assumed to be exogenous and, therefore, independent of
the monetary policy regime implemented. But these parameters, and this is our
main contention, are likely to be a function of the monetary policy regime pursued
by a central bank. In particular, it will be argued below that the implementation of
a money-targeting regime will raise σm and vary the covariance terms in such a
way as to shift the balance in favour of an interest rate-targeting regime. As a
result, the choice of a money-targeting regime is likely to be self-defeating. Would
then its implementation raise σm and vary the value and sign of the covariance
terms as much as to make an interest rate-targeting regime preferable? The expe-
rience with money-targeting regimes is not helpful here because, in practice, no
central bank has ever succeeded in determining money growth with precision over
a reliable period of time (Bernanke et al., 1999, p. 304). This fact raises serious
doubts about the possibility of a central bank ever being able to implement
successfully a money-targeting regime.8 For instance, Friedman and Kuttner (1996,
pp. 80–93) present evidence showing that the Federal Reserve did for a while genu-
inely use money growth targets to conduct monetary policy in the sense that it
varied either the federal funds rate or NBOR in response to observed fluctuations
of either M1 or M2 that departed from the corresponding target. However, around
the mid-1980s, the Federal Reserve started to ignore monetary aggregates
although legislation calling for their use remained in force for much longer. As
32 G. Fontana & A. Palacio-Vera
If the CB [central bank] tried to run a system of monetary base control, it would fail.
Much, perhaps most, of the time it would still be accommodating the day-to-day
demand of the banking system for reserves at a penal interest rate of its own choice,
whenever its Mo [monetary base] target was below the system’s demand for reserves.
Otherwise when its target was above the system’s demand, overnight rates would fall
to near zero.
Similarly, talking of the experience of the United States, Moore (1988, p. 122) has
argued that, by keeping an unsatisfied demand of NBOR, the Fed controls the
amount of discount-window borrowing and, indirectly, it sets the federal funds
rate. As the demand for BOR rises, the marginal effective total cost (discount rate
plus frown costs) of obtaining reserves rises above the discount rate. As a result,
the federal funds rate rises pari passu above the discount rate. Increases in NBOR
relative to total reserves (TR), with TR = BOR + NBOR, operate in the opposite
direction, reducing BOR and, therefore, short-term interest rates. Regarding the
newly created institution of the European Central Bank (ECB), its deposit and
lending facilities set a lower and upper bound to overnight rates in the euro-zone.
To the extent that, in principle, there is no explicit limit—other than the assets used
Monetary Policy Uncovered 33
by banks as collateral—to the amount individual banks can borrow (lend) through
the lending (deposit) facilities, the ECB cannot closely control the amount of total
aggregate reserves. Thus, more generally, it is fair to claim that central banks only
set the supply price of reserves. As a result, the reserve supply function is horizon-
tal in the market period, at an interest rate exogenously administered by central
banks.
Secondly, the money-multiplier is not stable (condition (a2)). The explanation
for the instability and, hence, for the uncertainty attached to any forecast of money
multipliers, were a money-targeting regime ever be implemented, relies on the
idea that the money supply in modern monetary production economies is credit-
driven and demand-determined. Credit-money is created when loans are granted
by the banking system to the non-bank private sector, and is extinguished when
loans are repaid, so that the level and the rate of expansion of the money supply
are ultimately a decision of the private sector of the economy. The rate of monetary
expansion is thus determined by the level of planned aggregate deficit-spending
net of loans repayment. Thus, for instance, if a central bank increases NBOR
through open market operations, banks may voluntarily opt not to increase lend-
ing if they do not identify any profitable outlet, and, instead, increase their level of
excess reserves (ER). According to several authors, this was the behaviour of US
banks in the aftermath of the Great Depression. Similarly, non-bank private sector
units—that is, firms and households—can easily dispose of any unwanted money
balances through loans repayment (the reflux mechanism). In these cases, an
increase in NBOR will be offset by a rise in the aggregate reserve-deposit ratio and,
therefore, a decrease in the money multiplier. Thus, any attempt by central banks
to impose a high rate (relative to the rate desired by the private sector) of monetary
expansion through, for instance, an increase in NBOR will be ineffective. This rate
is ultimately determined by lending and/or net deficit-spending decisions of the
private sector.
Likewise, attempts by central banks to restrain the level of bank reserves below
either the level of required reserves (RR), where TR = BOR + NBOR = RR + ER, or
TR will encourage banks to look for reserves elsewhere. For instance, banks may
borrow from the discount window or on the inter-bank market. In any case, inter-
bank market interest rates will tend to rise and banks will only be able to obtain
additional reserves at a higher cost. As a result, banks will be encouraged to imple-
ment portfolio adjustments on the liability side of their balance sheets by searching
for alternative sources of funds with lower reserve requirements. These adjust-
ments are commonly known as liability management practices (Earley & Evans,
1982; Evans, 1984; Goodhart, 1984, Ch. 3; Podolski, 1986; De Cecco, 1987).
As these funds are obtained, banks transform their balance sheets, allowing
them to increase their loan/reserve and deposit/reserve ratios (Pollin, 1991;
Palley, 1996a, 1996b, 1998; Moore, 1998). As profit maximisers, banks continually
seek to raise their deposit/reserve ratio by discovering new financial products and
procedures, thus making money multipliers and money velocity—especially for
narrow definitions of money—exhibit an upward trend.9 However, with rising
interest rates and increasing returns on non-reserve assets, banks will have an
additional incentive to minimise average holdings of excess reserves (Davidson,
1990b, pp. 387–388). Furthermore, as interest rates rise (fall), banks feel more (less)
pressure to search for alternative sources of funds with lower reserve requirements
such that, other things being the same, the rate of financial innovation will tend to
speed up (slow down) (Palacio-Vera, 2001). As a result of these two processes,
34 G. Fontana & A. Palacio-Vera
money multipliers (as well as the velocity of circulation of narrow money) will also
exhibit a pro-cyclical pattern. In this way, financial innovation loosens the connec-
tion between reserves and bank lending (Earley & Evans, 1982; Evans, 1984,
p. 444). Since central banks cannot know in advance either the rate or the pattern
of financial innovation, they will not be able to predict accurately the rate of
growth of reserves necessary to obtain a given growth rate of the monetary aggre-
gate selected as an intermediate target variable (Pierce, 1984). For instance, in the
context of a stochastic IS-LM model, financial innovations will shift both the slope
and the position of the LM curve in an uncertain and unpredictable way. Notwith-
standing, it may well be the case that under a sufficiently elastic supply of reserves,
money multipliers remain stable. This is the case when the central bank fully satis-
fies the demand for reserves of banks at a constant short-term interest rate. Thus,
the issue of the stability of money multipliers is independent of the direction of
causality between reserves and deposits.
adopted in the early 1980s allowed the authorities freedom to raise interest rates to
levels that could subdue inflation. However, several authors have argued that high
real interest rates stimulate financial innovation. In turn, a higher rate of financial
innovation reflects a higher σ m. For instance, Hester (1981, p. 183) argues that ‘the
one clear lesson from recent history is that financial institutions innovate when-
ever customer relationships are jeopardised by slow monetary growth’.12 Like-
wise, Minsky (1982, pp. 171–172) argues that high interest rates are likely to
stimulate institutional changes that lead to an increasing lending ability of the
banking system. Porter et al. (1979, p. 217) c also show that high market interest
rates in 1973–74, 1978 and early 1979 increased the incentive for managers to
implement new cash-management techniques. In turn, the implementation of
these techniques led to a reduction in their average holdings of bank deposits
beyond what could be expected from higher interest rates according to any stan-
dard model of the demand for money by firms.
All the arguments provided above can be formally presented by resort to an
extension of Poole’s original model developed by Modigliani et al. (1970) and
intended to allow for some degree of endogeneity of the money supply. The model
is made up of the following three equations:
y = −␣1r + u (7)
m = 1 y −  2 r + (8)
m = ␦1h + ␦ 2 r + q (9)
( )
E y2
r
= u2 (10)
where σ2u is the variance of shocks to the demand for money, σ2q is the variance of
shocks to the relation linking h to the money supply, and σ2uv, σ2uq, and σ2vq are the
corresponding co-variance terms.
There are two considerations to make. First, the adoption of liability manage-
ment practices by banks or the adoption of cash-management techniques by firms
cannot be fully captured by increases in σq and σv, respectively. In particular, the
behaviour of banks and firms will lead, along the lines of the discussion above, to
structural change in equations (8) and (9). However, it may be argued that, for
policy purposes the consequences of structural change are akin to a rise in σ q and
σ v, i.e. the forecasting ability of the central bank is hindered. Secondly, the discus-
sion above has not made a distinction between v and q. We do so below. Now, a
rise in aggregate demand by the private sector (u>0) stimulates the demand for
loans and this, in turn, leads to a rise in the demand for reserves. Under a money-
targeting regime, and in a static context, the central bank would keep h unchanged
at its target value. As a result, interest rates in the money markets would rise. As
interest rates increase, banks have incentives to restructure the liability side of their
balance sheets in order to maintain or enhance their lending capacity. In other
words, banks encourage their customers to move from high-reserves liabilities into
low-reserves liabilities. In turn, the transformation of the liability side of the
balance sheets of banks would cause a fall in RR. Thus, for a broad measure of
money, q>0 in equation (9) so that σuq should generally be positive in equation (11).
For a narrow measure of money, however, the restructuring of the liability side of
the balance sheets of banks does not have such a clear-cut effect upon the corre-
sponding money multiplier. As the public shifts away from high-reserves depos-
its, the narrow measure of money contracts but, as banks reduce RR and
subsequently increase their lending, new deposits are created such that the narrow
measure of money expands. The net effect is uncertain.
Regarding the sign of σuv, the expansion in lending brought about by the fall in
RR will lead to an expansion in the supply of both narrow and broad money. Since
there has been a previous shift away from high-reserves into low-reserves bank
liabilities, the demand for narrow money relative to its supply has, in principle,
fallen so that v<0, but the demand for broad money relative to its supply would
have changed in an uncertain way. As a result, for the broad money case the values
of σuv and σqv in equation (11) are uncertain. In the narrow money case, it is quite
likely that v<0 so that σuv should be negative under normal circumstances.
However, the value of σqv is uncertain. Therefore, under a money-targeting regime
σ 2q and σ2v will tend to go up, thereby raising the value of the minimum expected
loss in equation (11). In addition, and in the broad money case, the changes
occurred in the covariance terms may raise that value even further since σuq>0
while the signs of σqv and σuv are uncertain. Similarly, in the narrow money case, it
is likely that σuv<0, whereas the signs of σuq and σqv are uncertain. In short, the
implementation of a money-targeting regime tends to increase the value of the
minimum expected loss in equation (11) relative to the value of (10) thereby shift-
ing the balance in favour of an interest rate-targeting regime.
38 G. Fontana & A. Palacio-Vera
Conclusions
This paper has shown that there is a not fully resolved tension in the modern
setting of monetary policy. In the long run, money is made all-important for infla-
tion, but in the short run it is treated as irrelevant. However, this tension is quickly
resolved when a distinction is made between what some academics have
suggested that central banks should do and what these same central banks felt
right to do. In the first part of the paper we have analysed the theoretical founda-
tions for the current practice of central banking, namely, the ‘targets-and-instru-
ment approach’ whose core element is Poole’s approach to the instrument problem
(Poole, 1970). This approach provides a criterion for choosing between a money-
targeting regime and an interest rate-targeting regime.
We have then argued that the endogenous money hypothesis, i.e. the proposi-
tion that the level and rate of expansion of the money stock is ultimately deter-
mined by the demand for loans of the private sector (the demand for money of the
latter being also relevant notwithstanding), precludes the implementation of a
money-targeting regime. In addition, we have discussed several arguments
whereby the implementation of a money-targeting regime will tend to raise the
relative variance of shocks to the monetary sector and vary the covariances
between shocks to the commodity and monetary sectors in such a way as to shift
the balance in favour of an interest rate-targeting regime. The main result of our
analysis is thus that the implementation of a money-targeting regime is undesir-
able—on the basis of Poole’s approach—if not unfeasible.
Acknowledgements
The authors are grateful to the editor of this journal and an anonymous referee for
stimulating comments. We are also grateful for comments and suggestions from
Philip Arestis, David Laidler, Tom Palley, Randall Wray and participants at the
First ADEK International Conference, held at the University of Bourgogne, Dijon,
France, in November 2002. A previous version of the paper was written when
Giuseppe Fontana was visiting research scholar at both C-FEPS and Economics
Department, University of Missouri Kansas City, Kansas City, USA. He would like
to express appreciation to members of those institutions for providing a stimulating
and pleasant working environment and to David Foster for proofreading the text.
Notes
1. Indeed, as a referee has pointed out, current central banking practice can be characterized as hyper
fine-tuning policy, with central banks potentially changing short-term nominal interest rates
monthly (or even more frequently) in pursuit of a medium-term inflation target.
2. This equation is a long-run relation as seen by monetarists. As a referee has noted, this equation
does not say anything about real aggregate demand. Presumably, the equation only says that, in
the long run, aggregate demand passively adjusts to aggregate supply, the latter being exogenously
given. As a result, a higher rate of growth of money supply can only, as far as monetarists are
concerned, lead to a higher rate of inflation in the long run.
3. Of course, in posing this question, this paper breaks away from Lucas’s policy recommendation as
expressed in his Nobel Lecture and quoted at the beginning of this paper (Lucas, 1996).
4. For instance, the ECB (European Central Bank, 2001, p. 47) remarks that although ‘most empirical
studies for the euro area support the view that there is a stable (long-run) money demand relation-
ship linking M3 to the price level and other macroeconomic variables… the reference value [for M3]
is not a monetary target. The ECB does not attempt to keep M3 growth at the reference value at any
particular point in time by manipulating interest rates’.
Monetary Policy Uncovered 39
5. In an empirical study for the period 1950–85, Hoover (1991) shows that, for the US economy, the
balance of evidence supports the view that money does not cause prices, and that prices do cause
money.
6. For an earlier example of this critique, see Davidson (1990a), and further developments by Rochon
(1999, pp. 132–139) and Palley (2002, pp. 166–176). In the context of Poole’s framework, this inter-
dependency could, in principle, be accounted for by the covariance of shocks to the commodities
and monetary sectors as we show above. However, Poole assumes this covariance to be random
and exogenous.
7. In this respect, Goodfriend (1991, p. 8) comments: ‘except for the period from 1934 to the end of the
1940s when short-term interest rates were near zero or pegged, the Fed has always employed either
a direct or an indirect Federal funds rate policy instrument’.
8. Indeed, as argued in Goodhart (1984), both the low short-run interest elasticity and instability of
loan demand make it extremely difficult for a central bank to fine-tune aggregate demand growth
so as to hit annual money growth targets.
9. However, this upward trend is not a universal prediction. As shown in Pollin and Schaberg (1998),
the spectacular increase in non-GDP transactions (financial and real state market trading) in the US
economy since the early 1980s explains, at least partially, the so-called ‘velocity puzzle’, i.e. the fact
that M1 velocity stopped rising in the early 1980s and has been falling since then.
10. According to Howells & Hussein (1999) the lack of co-integration of money and nominal income is
also due to the growth of the money stock being influenced by non-GDP transactions. The latter
have grown more rapidly than income in recent years.
11. As a referee has noted, not only may σm tend to rise, but whatever monetary aggregate is used for
policy control purposes, it will lose its previous meaning and, in effect, there should now be some
other monetary aggregate which is being targeted.
12. Hester (1981) identifies two waves of financial innovation in the US economy, respectively 1966–9
and 1973–5, which, according to him, were induced by restrictive monetary policies and high inter-
est rates.
13. If the central bank instrument is assumed to be high-powered money, we then have that, in prac-
tice, the central bank varies the level of high-powered money to achieve a certain rate of interest
which, in turn, determines the level of aggregate demand and, ultimately, (through equation (8)
and together with the level of real income) the amount of money demanded by the public. Indeed,
if we substitute equation (8) into (9) for the money supply, the resulting expression provides the
level of high-powered money required (for a given level of real income) to set a certain interest rate,
the money supply thus being a residual with no casual significance. Therefore, in this first case, the
central bank would only use equations (8) and (9) for computation purposes. In the case where the
interest rate is explicitly assumed to be the instrument, the central bank does not pay any attention
to equations (8) and (9) and simply injects or withdraws high-powered money in order to set the
interest rate which, in turn, affects the level of real aggregate demand.
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