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December 5, 2007

Michael Woodford: How Important is Money in the Conduct of Monetary Policy?

Michael Woodford, who knows more than a little bit about this topic, discusses the use of monetary aggregates as a basis for setting monetary policy.

His bottom line is that monetary aggregates should not be used as targets of monetary policy, or even play a prominent role in policy discussions, but they do have their uses. Many macroeconomic variables are unobservable and, to the extent that monetary aggregates are correlated with these unobservables, monetary aggregates can be used to extract information about them and thus help to determine the potential evolution of the macroeconomy. Thus, Woodford believes that monetary aggregates may contain useful information about the economy, but there is currently no good reason to assign target values to monetary aggregates in the conduct of policy.

This is the abstract, introduction, and conclusion - the paper itself is a bit technical:

How Important is Money in the Conduct of Monetary Policy?, by Michael Woodford, NBER WP 13325, August 2007 [open link]: Abstract: 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. 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 provides a compelling reason to assign a prominent role to monetary aggregates in the conduct of monetary policy.


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. King (2002, p. 162) quotes 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."

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 for paying attention to money, considering both the purported omissions made by "economic analysis" alone and the asserted advantages of the information revealed by monetary trends. Of course, it is impossible to review the voluminous literature on this topic in its entirety, so I shall have to stick to a few of the most prominent themes in recent discussions.

First, I consider whether ignoring money means returning to the conceptual framework that allowed the high inflation of the 1970s. The architects of the ECB's monetary policy strategy were undoubtedly concerned not to repeat past mistakes that have often been attributed to a failure to appreciate the role of money in inflation determination. Have those central banks that assign little importance to money, like the current Federal Reserve, forgotten the lessons of the crucial debates of a quarter century ago? Second, I consider the theoretical status of models of inflation determination with no role for money. Are such models incomplete, and hence unable to explain inflation without adding the additional information provided by a specification of the money supply? Or, even if complete, are they inconsistent with elementary economic principles, such as the neutrality of money? Third, I consider the implications for monetary policy strategy of the empirical evidence for a long-run relationship between money growth and inflation. And finally, 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, and ask whether "monetary analysis" is an appropriate way to increase the robustness of the conclusions reached regarding the conduct of policy.

1 The Historical Significance of Monetarism

One of the more obvious reasons for the ECB's continuing emphasis on the prominent role of money in its deliberations is a concern not to ignore the lessons of the monetarist controversies of the 1960s and 1970s. Monetarists faced substantial opposition to their theses at the time, but they largely won the argument with their Keynesian critics, especially in the minds of central bankers. Moreover, those central banks, such as the Bundesbank, that took on board monetarist teachings to the greatest extent had the best performance with regard to inflation control in the 1970s and 1980s. Hence it may be feared that abandoning an emphasis on monetary aggregates in the conduct of monetary policy would mean returning to the intellectual framework of 1960s-vintage Keynesianism, with the consequent risk of allowing a return of the runaway inflation experienced in many countries in the 1970s.[1]

But is this fear well-founded? Monetarism did surely represent an important advance over prior conventional wisdom, and it would indeed be a grave mistake to forget the lessons learned from the monetarist controversy. Yet I would argue that the most important of these lessons, and the ones that are of greatest continuing relevance to the conduct of policy today, are not dependent on the thesis of the importance of monetary aggregates.[2]

First, monetarism established that monetary policy can do something about inflation, and that the central bank can reasonably be held accountable for controlling inflation. This was not always accepted -- in the 1950s and 1960s, many Keynesian models treated the general price level as given, independent of policy, or only affected by policy under relatively extreme circumstances (when capacity constraints were reached), but not in the most common situation. Even in the 1970s, when inflation could no longer be considered a minor detail in macroeconomic modeling, it was often argued to be due to the market power of monopolists or labor unions rather than to monetary policy.

Monetarists contested these skeptical theses about the possibility of controlling inflation through monetary policy, and the quantity theory of money provided them with an important argument. Given that central banks obviously could affect -- and even to a certain extent control -- the quantity of money, the quantity-theoretic view of inflation made it clear that central banks could affect inflation, and indeed could contain it, at least over the medium-to-long run, if they had the will to do so.

But it is not true that monitoring monetary aggregates is the only way that a central bank can control inflation. Present-day central banks that pay little attention to money do not, as a consequence, deny their responsibility for inflation control. To the contrary, many have public inflation targets, and accept that keeping inflation near that target is their primary responsibility. And while the Fed has no explicit target of this kind, Federal Reserve officials speak often and forcefully about their determination to ensure price stability, and the record of the past decade makes such statements highly credible. Nor do the models used for policy analysis within such banks, even when these do not involve money at all, imply that monetary policy cannot affect inflation, as is discussed further in the next section.

Second, monetarism emphasized the importance of a verifiable commitment by the central bank to a non-inflationary policy. Monetarists were the first to emphasize the importance of containing inflation expectations, and to stress the role that commitment to a policy rule could play in creating the kind of expectations needed for macroeconomic stability. Research over the past several decades has only added further support for these views.[3]

The prescription of a money growth target provided a simple example of a kind of commitment on the part of a central bank that should guarantee low inflation, at least over the long run, and moreover of a type that would be relatively straightforward for the public to monitor.[4] But, once again, this is not the only kind of commitment that would serve, and a central bank can fully accept the importance of commitment, and of making its commitments clear to the public, without having a money growth target. Indeed, inflation targeting central banks do clearly bind themselves to a specific, quantitative commitment regarding what their policy will aim at, and they have given great attention to the issue of how to show the public that their policy decisions are justified by their official target, notably through the publication of Inflation Reports like those of the Bank of England or the Swedish Riksbank.

Thus in neither case does preservation of the important insights obtained from the monetarist controversy depend on continuing to emphasize monetary aggregates in policy deliberations. And the fact that inflation targeting central banks dispense with monetary targets and analyze their policy options using models with no role for money does not imply any return to the policy framework that led to (or at any rate allowed) the inflation of the 1970s.[5] Indeed, not even Milton Friedman continued, in his later years, to view monetary targets as a prerequisite for controlling inflation.[6]  ...


5 Conclusion

I have examined a number of leading arguments for assigning an important role to tracking the growth of monetary aggregates when making decisions about monetary policy. I find that none of them provides a convincing argument for adopting a money growth target, or even for assigning money the "prominent role" that the ECB does, at least in its official rhetoric. Of course, this is hardly a proof that no such reason will ever be discovered. But when one examines the reasons that have been primarily responsible for the appeal of the idea of money growth as a simple diagnostic for monetary policy, one finds that they will not support the weight that they are asked to bear. Thus while one must admit that it is always possible that monetary targeting might yet be discovered to have unexpected virtues, there is little ground for presuming that such virtues must exist, simply because of the familiarity of the hypothesis.

Nor do the arguments offered here imply that central banks should make a particular point of not seeking to extract any information from monetary aggregates. An inflation-targeting central bank should make use of all of the sources of information available to it, in judging the interest-rate policy that should be consistent with a projected evolution of the economy consistent with its target criterion (Svensson and Woodford, 2005). While I see no reason for either the policy instrument or the target criterion to involve a measure of the money supply, the model used to calculate the economy's projected evolution under alternative policy paths may involve a large number of state variables; and given that many of the state variables in such a model are not directly observed, or not with perfect precision, a large number of other variables may provide relevant information in judging the economy's state and hence the appropriate instrument setting. There is no reason why a variety of monetary statistics should not be among the large number of indicators that are used by a central bank in preparing its projections. But this appropriate use of the information contained in monetary statistics would not make money a target in its own right, and neither would it make monetary analysis a distinct basis for forming a judgment about the stance of monetary policy, independent of the considerations involved in an explicit economic model of wage and price-setting.


[1] For example, Lucas (2006) admits that "central banks that do not make explicit use of money supply data have recent histories of inflation control that are quite as good as the record of the ECB," but then warns: "I am concerned that this encouraging but brief period of success will foster the opinion, already widely held, that the monetary pillar is superfluous, and lead monetary policy analysis back to the muddled eclecticism that brought us the 1970s inflation" (p. 137).

[2] I do not pretend, of course, in the brief discussion that follows, to provide an exhaustive account of the desirable elements in monetarist thought. Many other ideas originated or championed by monetarists, such as the importance of the distinction between real and nominal interest rates and the concept of the natural rate of output, have had a profound effect on contemporary monetary economics and policy analysis | but these are even more obviously independent of any thesis about the importance of monetary aggregates.

[3]For example, both the importance of expectations in the monetary transmission mechanism and the advantages of suitably designed policy rules are central themes of Woodford (2003).

[4]Neumann (2006), in a review of monetary targeting by the Bundesbank, stresses the desire to influence public expectations of inflation as a central motivation for the strategy and a key element in its success.

[5]In section 4 I consider some specific errors in policy analysis that may have contributed to the "Great Inflation" of the 1970s, and discuss whether the avoidance of such errors requires a central bank to monitor the supply of money.

[6] Simon London (2003) reports an interview in which Friedman stated that "the use of quantity of money as a target has not been a success," and that "I'm not sure I would as of today push it as hard as I once did." In a more recent interview, Robert Kuttner (2006) quotes Friedman as having said,"I believe [that] economists in general have ... overestimate[d] how hard it is to maintain a stable price level. We've all worked on getting rules, my money rule and others, [on the ground that] it's such a hard job to keep prices stable. Then along comes the 1980s, and central banks all over the world target price stability; and lo and behold, all of them basically succeed.... So it must be that that [it] is easier to do than we thought it was.... Once [central banks] really understood that avoiding inflation, keeping prices stable, was their real objective, their first order objective, and put that above everything else, they all turned out to be able to do it."

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