Does Money Still Matter for Monetary Policy?

A nice crisp review by Renee Haltom of Richmond Fed on monetarism.

Economists agree that infl ation is a monetary phenomenon, but since 1982,  monetary policymakers have demoted measures of the money supply from  prime targets to key indicators to incidental byproducts. With excess bank  reserves at all-time highs, however, measures of money may have a renewed  purpose as red flags for inflation.

She starts nicely saying what c-banks really do:

There are two ways for a central bank to conduct monetary policy: targeting the quantity of money or targeting the price of money. Specifically, the Federal Reserve can set a target for the quantity of reserves within the banking system, leaving the price banks pay to borrow those reserves (the fed funds rate) up to market forces, or the Fed can target the fed funds rate and supply whatever quantity of reserves the market demands at that rate.

The Fed uses one of these operational targets to influence intermediate targets that the Fed cannot control directly, such as the money supply or the availability of credit, which are thought to influence the Fed’s ultimate objectives of maximum sustainable employment and low, stable inflation. Today the Fed’s operational target is the fed funds rate, and there is considerable evidence that the central bank pays little attention to money in conducting monetary policy. The Fed does not have an intermediate target for money supply, and most economic models that explain the behavior of inflation, output, and interest rates do not structure private decisions as depending on the money supply. In addition, most modern central banks, including the Fed, face legislative mandates to focus on real economic variables, such as employment and output.

There is a very interesting description on Volcker era when monetarism picked up. Fed shifted from interest rates to reserves targeting during Volcker.

In 1979, the Fed switched from focusing on the price  of money to focusing on the quantity of money in an effort to curb the very high inflation that had emerged in the mid- to late-1970s. Specifically, the Fed dropped the fed funds rate as its operational target and began targeting a measure of money, the proportion of bank reserves that are not borrowed from the Fed, which were adjusted to achieve broader target growth rates of M1. There are several possible interpretations of how the Fed thought the policy change would help solve the inflation problem. A leading view, supported by FOMC transcripts and other documents from the time, suggests that Fed Chairman Paul Volcker thought the bold change would establish credibility with the public that the Fed was serious about achieving low inflation. Volcker had been a student of expectations, and believed strongly that “inflationary psychology” was keeping infl ation high.

” A second interpretation holds that the Fed knew interest rates would have to rise signifi cantly, but it was not clear by how much. Hetzel (1984) said that a resolution to this problem was to let the market adjust rates as high as necessary to maintain the four quarter target range for M1.

A third interpretation suggests that a reserves target allowed the Fed to escape political culpability for the adverse economic effects of tighter policy. The shift to a money target was immediately followed by relatively dramatic volatility in the fed funds rate. (See Figure 1.) The real economy suffered from tighter monetary policy, and legislation was introduced by both political parties that would have limited the experiment. Before Congress could act, however, the Fed abandoned its money target in 1982 and resumed using the fed funds rate as its operational target for monetary policy. The short-run relationship between money and nominal expenditure had broken down because financial innovation—the result of deregulation and high interest rates—had changed how people held money. By that time, however, the Fed had earned credibility for being willing to let the fed funds rate rise to prevent an increase in inflationary expectations.

I was unaware of this. The third explanation or angle is awesome. The politicians understand interest rates and who would know what bank reserves mean. May be RBI should start targeting reserves as well to keep FinMin guys away..:-)

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