Laurence Meyer: Does money matter?
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, on the occasion of the 2001 Homer Jones Memorial Lecture, Washington University,
St. Louis, Missouri, 28 March 2001.
* * *
It is always a pleasure to return to St. Louis and to Washington University and to see so many friends
and former colleagues. But it is a special pleasure to be here for this occasion, the Homer Jones
Lecture. Homer Jones was still active at the Federal Reserve Bank of St. Louis when I arrived at
Washington University in 1969, and his wife, Alice, was a faculty member in the economics
department. I had the pleasure of getting to know both. Homer was special in many ways. He was, of
course, a leader in building the research department of the Federal Reserve Bank of St. Louis and in
orienting it toward a monetarist perspective. But there was also the remarkable contrast of his strong
convictions and his gentle manner. It was a combination to both admire and emulate. I admit I may
have been more successful in emulating the strong convictions than the gentle manner. But that only
makes me admire Homer even more.
I can remember vividly my first visit to St. Louis and Washington University in early 1969. I was a
graduate student at MIT visiting the university in search of an appointment as an assistant professor of
economics. I was picked up at the airport and delivered to my hotel, in advance of my seminar at the
university the following day. When I walked into my hotel room, a small sign on a desk immediately
caught my attention. It read: "Money matters." My first reaction was awe at the reach of the St. Louis
Fed. They take this monetarism bit pretty seriously, I thought. It turned out in fact to be an ad for a
local commercial bank, not for the St. Louis Fed. But the story about this incident provided a humorous
opening to my seminar the next day. I was nervous, so getting the seminar off to a good start with an
amusing story helped. It gave me momentum. And look where I ended up.
So when I considered topics for the Homer Jones Lecture, I thought of monetarism and the role of
money. My mind quickly took me back to that incident and I took as my title, "Does Money Matter?"
What I had in mind was an assessment of monetarism's role in shaping current thinking about
macroeconomic modeling and the conduct of monetary policy.
I often start my papers working back from my conclusion. Monetarism is about money, but money
plays no explicit role in today's consensus macro model, and it plays virtually no role in the conduct of
monetary policy, at least in the United States. The conclusion appeared to be, therefore, that
monetarism has had no influence on either macroeconomics or monetary policy. That conclusion was
a problem: I did not want to write that paper for the Homer Jones Lecture.
I decided, therefore, to take a completely novel approach to this paper. I would postpone writing the
conclusion until I had written the paper. So I invite you to share my journey in search of a conclusion. I
will start by outlining the essential features of monetarism, set out my interpretation of today's
consensus macro model, and interpret the role of monetarism in shaping this consensus. Whatever
the lasting influence of monetarism, this journey will still find no explicit role for money in the
consensus model and little or no explicit role in the current practice of monetary policy, at least in the
United States. This leads me to explore whether current models and current practice undervalue the
role of money.
I. Money and monetarism
In my view, monetarism has several essential features. First and foremost, monetarism is the
reincarnation of classical macroeconomics, with its focus on the long-run properties of the economy as
opposed to short-run dynamics.
Classical macroeconomics emphasized several key long-run properties of the economy, including the
neutrality of money and the quantity theory of money. Neutrality holds if the equilibrium values of real
variables - including the level of output - are independent of the level of the money supply in the long
run. Superneutrality holds when real variables - including the rate of growth of output - are
independent of the rate of growth in the money supply in the long run. The quantity theory of money
holds that prices move proportionately to changes in the money supply so that inflation is linked to
money growth. Together, these propositions identify both what monetary policy can achieve and what
it cannot and therefore delineate the responsibilities of central banks. They mean that central banks
have no effect on the level or growth rate of output in the long run but do determine the rate of inflation
in the long run.1
Second, monetarism focuses less on the structure of the economy and short-run dynamics and more
on longer-run conclusions, such as the long-run relationship between money and output and money
and inflation. This focus reflects, in part, a skepticism about our ability to understand or to adequately
quantify the structural linkages and dynamics. For this reason, monetarists tend to prefer reduced-form
equations or VARs to structural equations or structural econometric models and focus more on
longrun results than short-run dynamics.
Third, monetarists are skeptical of the ability to use monetary policy for short-run stabilization, despite
the fact that they believe short-run variations in money growth do affect aggregate demand and hence
output. As a result, they favor rules, often passive rules, that focus on achieving a rate of money
growth consistent with price stability in the long run, with no adjustment to cushion short-run
fluctuations in aggregate demand.2 This preference reflects again the uncertainty about the structure
of the economy and about short-run dynamics and the long and variable lags in the response of
aggregate demand to changes in the money supply.
There is an over-riding theme across these features of monetarism: They focus on the role of money
and the conclusion that "money matters." Money matters - indeed it is just about all that matters - for
inflation in the long run. Given the widespread commitment to price stability, monetarists believe that
central banks should therefore give appropriate attention to money growth in the conduct of monetary
policy.
II. The consensus macro model: monetarism without money?
One way to judge the influence of monetarism is by the conformity of today's consensus macro model
with monetarism's central features, as set out above.
One of my favorite sayings about economists is, "Two economists, three opinions." That saying is
more true of macroeconomists than of microeconomists. For that reason defining a consensus macro
model has always been a challenge. But I believe there has been some convergence toward a
consensus in recent years. This consensus is typically expressed in terms of a simple three-equation
dynamic model:3
(1) Yg = a Yg + b - c +
t t-1 Et(Yg t+1) [Rt -Et(pt+1)] xt
(2) pt = d (Yg t) + w1 pt-1 + w2 Et(pt+1) + zt, w1 + w2 = 1
(3) = r* + + f Yg + g - pT),
Rt Et(pt+1) t-1 (pt-1
where Yg equals the output gap (the percentage point difference between actual and potential output),
R equals nominal interest rate, r* equals equilibrium real interest rate, p equals inflation, and pT equals
inflation target, x and z are stochastic shocks, and all the coefficients are positive.
The model includes an aggregate demand equation, a Phillips curve, and a monetary policy rule. The
aggregate demand equation, given by equation 1, is essentially a dynamic version of the old IS curve,
in which the level of output (in this case the output gap) depends on the real interest rate. This
specification allows for effects of both lagged output and expectations about future output. The Phillips
curve, given by equation 2, relates the inflation rate to the output gap (measuring the balance between
supply and demand in the output market) and to both past inflation and inflation expectations. The
effect of past inflation captures the role of sticky prices, while inflation expectations are assumed to be
1
Superneutrality is more controversial than neutrality. Indeed, the fundamental justification for a price stability objective is that
inflation undermines the efficiency of the economy and perhaps distorts saving and investment choices. What is essential is
that monetary policy cannot raise the level or growth rate of output by increasing the rate of money growth.
set, as in equation 1, according to rational expectations. The policy rule, equation 3, relates the
interest rate, viewed as the instrument of monetary policy, to the output gap and the difference
between inflation and the central bank's inflation target. That is, policy is adjusted in response to the
deviations of output and inflation from their respective objectives - full employment and price stability.4
There are at least three innovations in the consensus model compared with the IS-LM framework,
perhaps yesterday's consensus model. First, the IS-LM model had two equations and three unknowns
and therefore could be solved only by assuming that either the price level or the output level was fixed.
Today's consensus model allows for both sticky prices in the short run and full price flexibility in the
long run by introducing the Phillips curve. In effect, the Phillips curve pins down the degree to which
prices are sticky in the short run, allowing scope for both short-run movements in actual output relative
to potential and for stabilization policy while providing a mechanism that ensures a transition to the
long-run classical equilibrium.
Second, today's consensus model replaces the LM equation with a policy rule. The LM curve
expresses the equilibrium condition in the money market, the balance between the supply of and the
demand for money. Implicitly, the money supply is treated as the instrument of monetary policy. The
policy rule in today's consensus model specifies the way policymakers adjust the interest rate to
economic developments. This specification has the advantage of more accurately capturing the
prevailing operating procedure at central banks around the world, given that they, almost without
exception, implement monetary policy by setting a target for some key interest rate. It also reflects a
more modern view of "policy" as a systematic adjustment of the policy instrument or instruments to
ongoing economic developments rather than simply as an exogenous process, outside the model.
Third, the model explicitly incorporates forward-looking elements in economic behavior and accounts
for the importance of expectations. In the eclectic form presented here, the model allows for both
forward-looking elements and lagged adjustment due, for example, to adjustment costs.
The consensus model is widely used in teaching macroeconomics and in policy analysis, specifically
in evaluating the properties of alternative policy rules. Larger-scale macro models used for policy
analysis and forecasting typically have richer structures, including a more richly defined set of
monetary policy channels. This set generally includes a range of interest rates and asset prices and
the exchange rate, but almost never a direct or independent role for money. This is true of the FRB-US
model used by the staff at the Board of Governors for policy analysis and forecasting. That model has
a structure very much consistent with this simple consensus model in that its aggregate demand and
inflation equations, for example, have the same mix of lagged adjustment and forward-looking
expectations and its interest rate determination is anchored by a policy rule.
So what is the influence of monetarism on today's consensus model? On the one hand, the model has
no apparent role for money. On the surface, therefore, today's consensus model appears to be a clear
and definitive rejection of the "money matters" focus of monetarism. On the other hand, the classical
properties I outlined hold in this model (at least if we redefine them in terms of "monetary policy" rather
than the "money supply"). Monetary policy does not affect the level or growth rate of potential output,
and inflation is determined by monetary policy in that it converges to a target set by the central bank in
the policy rule.
My conclusion, therefore, is that we can still clearly see the influence of monetarism in the consensus
model. Monetarism focused attention on the role of the central bank in determining inflation by
emphasizing the relation between money and inflation. The consensus model may bypass money, but
it has retained the key conclusion that central banks ultimately determine the inflation rate.
The relation between money, output, and inflation is obviously beneath the surface of this model. We
could bring it to the surface by simply appending yesterday's LM curve to today's consensus model.
This provides a fourth equation and a fourth variable, the money supply. The LM curve, however, is
not part of the simultaneous structure of the expanded model. The first three equations determine
output, interest rate, and inflation without calling upon the LM curve. All the LM curve does is
determine the level of the nominal money supply consistent with solutions for output, prices, and the
interest rate. In effect, the LM curve identifies the amount of money that the central bank will find that it
has to supply when it follows the policy rule, given the shocks to the economy. So the money supply
has become a less interesting, minor endogenous variable in the story.
This approach is not, however, inconsistent with a stable empirical relation between money growth
and other economic variables, specifically between money growth and inflation. In fact, if the money
demand equation (underlying the LM curve) is stable, there will be a stable relationship between
money and inflation in the long run.
The expanded model also makes clear that there is nothing inconsistent with a stable long-run
relationship between money and inflation, as emphasized by monetarists, and the
expectationsaugmented Phillips curve, a mainstay in Keynesian-type structural models as well as a part of today's
consensus macro model. The monetarist proposition is about an outcome, a result. This conclusion
about the long-run relationship between money and prices is implicit in the consensus model, provided
the money demand equation is stable. The consensus structural model is also about structure or
process. It explains how monetary stimulus raises inflation.
The consensus model remains consistent with a relationship between money growth and inflation, but
it appears to downgrade the role of money. But does it shortchange the role of money? In a search for
answers, I will focus on monetary policy in Japan and on the differing role of money in the conduct of
monetary policy by the European Central Bank and the Federal Reserve.
III. The monetization debate: Does the consensus model shortchange the role of money?
In Japan, the policy interest rate was taken to zero and remains close to zero. Zero is the logical lower
bound for the nominal rate because, if the interest rate were negative, everyone would prefer to hold
cash and there would be no demand for bonds. But even with a short-term policy rate nearly at zero,
the Japanese economy remains weak, and a case can be made for additional monetary stimulus.
However, according to the consensus model, once the policy rate is taken to zero, the central bank
has exhausted its ability to stimulate the economy.
Monetarists, among others, reject this conclusion. They argue that Japan should embark on a strategy
of monetization, or quantitative easing, and judge the stimulus of its policies in terms of the rate of
growth in the money supply, not by the level of its policy rate. The Bank of Japan has recently taken a
step in the direction of such a monetization strategy.
There are two paths to the conclusion that such a strategy will allow monetary policy to provide
additional stimulus, even once the policy rate is driven to zero. First, some monetarists argue that
money directly affects aggregate demand. That is, the IS curve in the consensus model is mispecified
because it allows only for an interest-rate channel of influence and not for a direct effect of money on
spending. Plug in the money supply as an additional determinant of aggregate demand and, presto,
monetization works! Second, even if money does not directly affect aggregate demand, the
transmission mechanism is certainly more complicated than the simple IS curve specification
suggests. Money could play a role in structural equations for aggregate demand, or in VARs, as a
proxy for channels that may be difficult to quantify or were simply left out.
Personally, I do not believe that there is a direct effect of money on aggregate demand. But I may be
biased. My view is based in part on my own research. I tested and rejected the hypothesis of such a
direct effect in my dissertation. In my dissertation I also tested the proxy role hypothesis and rejected
it, too. But, the proxy role for money deserves further attention.5
When leading monetarists, such as Milton Friedman, have discussed the transmission mechanism,
they have described monetary policy as operating through a broad range of interest rates and asset
prices.6 As I noted earlier, large-scale structural models also incorporate a much more detailed
treatment of monetary policy channels of monetary policy - including not only a range of after-tax real
5
Large-scale models allow for the well-known real balance effect. Increases in real money balances that raise the real value
of net worth operate through the wealth effect in such models. However, open market operations involve an exchange of
money for bonds and therefore do not directly alter household wealth. McCallum (2000) and Svensson (2001) discuss
conditions under which money could directly affect aggregate demand. Svensson summarizes the conditions as follows: "[A]
direct money effect would arise if real balances entered the representative agent's utility function and this utility function was
not additively separable in consumption and real balances but had a positive cross derivative." Svensson and McCallum
agree that, for reasonable parameter values, this effect is likely to be so small that it can be disregarded.
6
Friedman and Meiselman (1963).
interest rates but also equity prices and the real exchange rate - compared with the single policy rate
in the consensus model. The consensus model adequately summarizes this transmission mechanism
with a single policy rate under two assumptions: First, monetary policy operates by changing some
short-term interest rate; second, all other interest rates and asset prices are linked, directly or
indirectly, to the policy rate through stable and predictable arbitrage relationships.
Monetary policy might still have life left in it, even after the policy rate has been driven to zero, if
monetary policy operations could somehow affect the spreads between the policy rate and other
interest rates - longer-term rates and private rates - and its relationship to other asset prices, such as
equity prices or exchange rates.
In simple theoretical models, such an effect is possible as long as short-term government bonds are
not perfect substitutes for longer-term bonds, private bonds, equities, and foreign financial assets. In
this case, open market operations in long-term government bonds could in principle lower the
longterm government bond rate relative to the policy rate, with spillover effects on longer-term private
rates. Monetary policy in short-term private assets, such as commercial paper could not only lower
private rates relative to government rates but also allow the central bank to work around an ailing
banking system. Finally, open market operations involving foreign financial assets - effectively
unsterilized intervention in the foreign exchange markets - could, in principle, affect exchange rates.
However, there is really no substantive difference between sterilized and unsterilized operations when
the short-term interest rate is already zero.
One way in which open market operations in other assets might affect other rates or other asset prices
would be if there were relative asset-supply effects determining longer-term private rates and
exchange rates. For example, if the relative supplies of short- and longer-term government bonds
affected their relative yields, open market purchases of long-term bonds could lower long-term rates
relative to the already near-zero short-term rate. Whether or not the relative supply effects are
significant is then an empirical question. The traditional answer has been that such effects, though
possible, are negligible and, effectively, not a useful part of monetary policy. And even if monetization
could push long-term rates to zero, there is no guarantee that will provide enough stimulus, given the
prevailing deflation. The real bond rate could still be too high.
This proxy role for money could, in principle, cover other channels besides long-term government and
private interest rates and asset prices - such as liquidity and credit effects - that might be activated by
increases in the money supply. In this case, even additional conventional operations - open market
operations in Treasury bills - might stimulate aggregate demand, even if they could not further lower
the short-term nominal interest rate. However, that affect does not seem very plausible. For example,
would the increased liquidity of holding money versus short-term bills stimulate aggregate demand? If
economic agents wanted the additional liquidity they could have acquired it with no holding cost by
selling zero-interest-rate bills and acquiring cash. Why, when the central bank initiates this change,
would it affect spending, if no interest rates or asset prices were affected?
Bernanke and Gertler have emphasized a credit channel as part of the transmission mechanism.7 But
this channel - though amplifying the effect of monetary policy - seems itself to require a change in
interest rates. For example, a decline in interest rates would, according to Bernanke and Gertler,
reduce existing committed cash flows of borrowers and therefore make the borrower more
creditworthy. This, in turn, could result in lenders offering additional credit. However, if interest rates do
not decline this channel is not activated.8
Finally, the proxy role for money could include the effect of monetization on expectations. This channel
depends on the ability of policymakers to alter expectations about the course and effects of future
policy. That is, the policy effect does not derive from a higher money supply today but from a
perceived commitment to a higher money stock in the future.
Expectation effects could alter current long-term real interest rates in two ways. First, convincing the
public that monetary policy will remain stimulative longer will lower expected future nominal short-term
interest rates and therefore longer-term nominal interest rates.9 Second, convincing the public that
monetary policy will achieve a higher inflation rate in the future, at least on average, could lower
7
Bernanke and Gertler (1995).
expected current longer-term real interest rates, reinforcing the effect on expected long-term interest
rates of a perceived commitment to a given path for the nominal policy rate.
These effects can be illustrated in terms of a simple model with two-period (non-overlapping) price
contracts. The current and expected future one-period nominal interest rates determine the current
nominal interest rate on the two-period bond. Assume that the current one-period interest rate (the
policy rate) has been driven to zero but the public expects a positive rate on the one-period bond next
period. If policymakers can convince the public that policymakers will drive the one-period rate to zero
in period two, the interest rate on the two-period bond will fall in the first period, stimulating aggregate
demand.
The first channel thus operates by lowering the expected future nominal policy rate, thereby lowering
current longer-term nominal interest rates. Essentially, it tries to lower nominal rates further along the
term structure, once the short-term policy rate has been driven to zero. It depends on the credibility of
the policy authorities to pre-commit to a more stimulative policy in the future - for example, to maintain
the zero rate policy for a longer period than is now anticipated.
The second way in which expectations can affect current real long-term interest rates involves the
effect of policy on inflation expectations. In order for this effect to work, policymakers must first
convince the public that policymakers will maintain a given path for the short-term nominal policy rate;
thus the second effect builds upon and reinforces the first effect. The second effect, by convincing the
public that inflation will be higher in the future, converts the perceived commitment to a given path for
the short-term nominal policy rate to a decline in future expected short-term real interest rates and
hence in current expected longer-term real interest rates.
Note that it is sufficient for policymakers to convince the public that inflation will be higher than
otherwise only for a while, not indefinitely. This is important, given that a promise to maintain inflation
higher indefinitely might be neither necessary nor credible. One way to activate the
inflationexpectations effect to stimulate aggregate demand in the short run, without compromising the
longerrun inflation objective, would be to implement a target price level. The central bank would promise, for
example, to target prices at a predetermined constant level, and would indicate in advance the period
over which it would attempt to return to the price-level target. If deflation follows, a price-level target
implies that the central bank will target rising prices - or inflation - for a while in order to return the
price level to its target level. The longer deflation lasts, the higher or longer lasting the expected future
inflation. Once higher inflation restored the initial price level, the objective would again be price stability
and, hence, zero inflation. A similar motivation underlies calls for the Bank of Japan to adopt an
inflation-targeting strategy.10 That is, by announcing an explicit inflation target, the Bank of Japan
might raise expectations of future inflation and therefore lower real long-term interest rates today.
On the one hand, simply undertaking monetization operations without effectively communicating the
intention with respect to future policy might not be effective. On the other hand, simply announcing an
inflation target without carrying out operations today that might support the objective also might not be
effective. However, doing both - carrying out monetization operations in support of an inflation target -
could possibly activate the expectations effect.
The relative supply effect is likely to be so small that it is not relevant to the conduct of monetary policy
in normal periods. This channel, therefore, is perhaps only of interest when the nominal interest rate
has been driven to zero, when further policy stimulus is desired, and when the size of policy
operations could be much larger than in normal times. However, the expectations channel - the effect
of expectations about future monetary policy on long-term real interest rates and hence on aggregate
demand today - is, I believe, an important part of the transmission mechanism both in normal periods
and in the more extreme circumstances.
Despite uncertainties about the effectiveness of monetization operations, we may have to think more
seriously about them when the policy rate has been taken to zero and there is still a case for further
monetary stimulus. The problem is that, if there is a possibility of providing stimulus through
monetization, we are not likely to find it by experimenting with such operations at the margin,
especially if the stimulus arises through relative supply effects. To have any promise of significant
results, such unconventional policy operations more likely would need to be implemented on a bold
scale. Moving in this direction is understandably difficult when there is uncertainty about the
effectiveness of the approach.
10
See, for example, Krugman (1998).
A fuller consideration of this topic would require us to assess the costs of such operations and the
ways these costs balance against the cost of not pursuing this direction in a period of persistent
deflation.11 If the costs are low, there is little damage if the operations are ineffective. But I will not try
here to reach a conclusion on the overall merits of monetization. My objective was to use the current
debate about monetary policy in Japan to highlight channels of monetary policy and a possible role for
monetary policy at the zero bound which are left out of the consensus model.
Let me now sum up conclusions about the absence of any role for money in the consensus model.
First, the consensus model incorporates a caricature of the consensus view of the determination of
output and inflation, including the transmission mechanism. In effect, it treats "the" interest rate as an
index of overall financial conditions, assuming that long-term interest rates, equity prices, and the
exchange rate all move in a stable and predictable way with changes in the policy rate. To be sure,
this is a considerable simplification, and some of the shortcomings become apparent when the policy
rate is driven to the zero nominal bound.
Second, though the consensus model has its shortcomings, the absence of money is not one of them
- except perhaps for the zero nominal bound case. As just noted, the consensus model significantly
oversimplifies the transmission mechanism. It also oversimplifies the supply side of the economy -
failing, in particular, to model the complex dynamics of the economy's response to an unexpected
acceleration in structural productivity growth.
Third, in situations where the policy rate has been driven to the zero nominal bound - as is the case in
Japan today - what the consensus model is missing - the proxy role for money - becomes the only
remaining leverage for monetary policy. Interestingly, larger macro models do not do much better
either, as they typically do not allow for relative asset-supply effects and often do not provide
opportunity for the inflation-expectations effects that might be so important. In this case, money growth
could be a valuable indicator of the degree of current and intended future stimulus to be provided by
monetary policy.
Fourth, understanding the ways in which monetary policy might still provide additional stimulus - once
the nominal policy rate had been driven to zero - may also provide us with a richer understanding of
how monetary policy works in normal times. In particular, the monetization debate highlights the role
that expectations play - in both normal and more extreme circumstances - in the effect of monetary
policy on aggregate demand. Indeed, it has become increasingly clear that monetary policy works not
only through decisions about the policy rate taken at each meeting but also by the expectations that
policymakers encourage - intentionally or otherwise - about expected future policy. The language in
the statement issued at the end of FOMC meetings and the statement about the balance of risks as
well as comments from FOMC members between meetings can affect those expectations. Those
expectations, in turn, have immediate effects on longer-term interest rates, on asset prices, and on
real exchange rates - channels of monetary policy that are not directly incorporated in the consensus
model.
IV. Money and monetary policy at the ECB and the Federal Reserve
The consensus model implies that monetary policy is conducted by setting a target for a policy interest
rate, without any consideration given to the prevailing rate of money growth. Does such an operating
strategy undervalue the usefulness of money in the conduct of monetary policy?
This question takes on added interest because of two recent and seemingly contradictory
developments. The ECB, a new central bank, has a two-pillar strategy, one pillar being a reference
value for money growth. The Federal Reserve, in sharp contrast, asked to be and was relieved of the
requirement to report semiannually on its target ranges for the growth of monetary and credit
aggregates. In this section, I discuss the evolution of mo