How Important is Money in the Conduct of Monetary Policy ? ∗

I consider some of the leading arguments for assigning an important role to tracking the growth of monetary aggregates when making decisions about monetary policy. First, I consider whether ignoring money means returning to the conceptual framework that allowed the high inflation of the 1970s. Second, I consider whether models of inflation determination with no role for money are incomplete, or inconsistent with elementary economic principles. Third, I consider the implications for monetary policy strategy of the empirical evidence for a long-run relationship between money growth and inflation. (Here I give particular attention to the implications of “two-pillar Phillips curves” of the kind proposed by Gerlach (2003). ) And fourth, I consider reasons why a monetary policy strategy based solely on short-run inflation forecasts derived from a Phillips curve may not be a reliable way of controlling inflation. I argue that none of these considerations provide a compelling reason to assign a prominent role to monetary aggregates in the conduct of monetary policy. ∗Prepared for the Fourth ECB Central Banking Conference, “The Role of Money: Money and Monetary Policy in the Twenty-First Century,” November 9-10, 2006. An earlier version was presented as the 2006 W.A. Mackintosh Lecture, Queen’s University, Canada. I would like to thank Jordi Gali, Otmar Issing, Klaus Masuch, Rick Mishkin, Ed Nelson, Lucrezia Reichlin, Gregor Smith, and Lars Svensson for helpful discussions, while absolving them of any responsibility for the opinions expressed, and the (U.S.) National Science Foundation for research support through a grant to the National Bureau of Economic Research. It might be thought obvious that a policy aimed at controlling inflation should concern itself with ensuring a modest rate of growth of the money supply. After all, every beginning student of economics is familiar with Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” (e.g., Friedman, 1992), and with the quantity theory of money as a standard account of what determines the inflation rate. Yet nowadays monetary aggregates play little role in monetary policy deliberations at most central banks. In discussing this a few years ago, Mervyn King of the Bank of England noted that then-Bank of England Governor Eddie George had mentioned money only one time out of 29 speeches given over the previous two years, and that then-Fed Chairman Alan Greenspan had only mentioned money once in 17 speeches given over the same period. Moreover, he quoted then-Fed Governor Larry Meyer as stating that “money plays no explicit role in today’s consensus macro model, and it plays virtually no role in the conduct of monetary policy” (King, 2002, p. 162). Not all agree that this de-emphasis of money growth as a criterion for judging the soundness of policy has been a good thing. Notably, the European Central Bank continues to assign a prominent role to money in its monetary policy strategy. In what the ECB calls its “two-pillar strategy,” one pillar is “economic analysis,” which “assesses the short-to-medium-term determinants of price developments. ” According to the ECB, this analysis “takes account of the fact that price developments over those horizons are influenced largely by the interplay of supply and demand in the goods, services and factor markets. ” But in addition, a second pillar, “monetary analysis”, assesses the medium-to-long-term outlook for inflation, “exploiting the long-run link between money and prices. ” The two alternative frameworks for assessing risks to price stability are intended to provide “cross-checks” for one another (ECB, 2004, p. 55). But what exactly is the nature of the additional information that can be obtained by tracking trends in the growth of monetary aggregates, and why should it be of such crucial importance for the control of inflation as to constitute a separate “pillar” (not infrequently characterized as the “first pillar”) of the ECB’s policy strategy? And does “monetary analysis” genuinely represent a distinct and complementary perspective on the determinants of inflation, that cannot be subsumed into an “economic analysis” of the inflationary pressures resulting from the balance of supply and demand in product and factor markets, and that can be used to guide policy decisions? I here review several of the most important arguments that have been made