Central banks: no reason to ignore money

The need for a stable monetary policy arises from several facts about business cycles. For example, practically all recessions in industrial countries were preceded by restrictive measures of central, banks. The main cause for the instability, however, was the expansionary policy that led to a boom and too high inflation. There is no question that high inflation in the long run is caused by high money growth; the empirical evidence in favor of the quantity theory of money is overwhelming. Inflation reduces economic growth considerably if it exceeds a certain level. At rates below 10 percent, the negative effects appear to be small. But recent studies show that there is a tremendous welfare gain even if inflation is reduced from a low rate of two percent to zero. This follows from the existence of distorting taxes and from a high demand for non-interest bearing cash at low rates of interest. The conclusion is that zero inflation can be achieved and that it produces a sizable free lunch for a society. While there is a consensus that monetary policy should follow a rule because discretionary policies have a bias towards higher inflation, it is not clear what the best strategy should be. It is often stated that monetary targeting cannot be used in the case of an unstable money demand function. This is not necessarily true because this instability can often be taken account of. Actually, rules exist according to which money growth adjusts to changes in the trend rate of the velocity of money. An instability of the money demand function does not invalidate the policy of monetary targeting or the main predictions of the quantity theory of money. The instability of money demand has led many central banks to pursue inflation targeting instead. But this policy, too, is fundamentally affected if the demand for money is not stable: The strategy requires a forecast for inflation which critically hinges on the conditions on the money market. In the case of an instability, it is difficult or even impossible to predict inflation accurately. This means that inflation targeting may not be better than monetary targeting. According to the Taylor rule, which is often propagated, the central bank reacts to the output gap as well as to the difference between actual inflation and the inflation target. If the central bank wants to set the short-term interest rate accordingly, an estimate for the real equilibrium interest rate is needed. Given the large variations in the trend of real short-term interest rates in the past, it is quite possible that a central bank uses a "wrong" estimate when following the rule. A small underestimation may already produce considerably higher inflation. Such an error is equivalent to the error concerning the estimate of trend velocity in the strategy of monetary targeting, so both strategies may lead to deviations from the target inflation rate. In other words: The Taylor rule is not necessarily superior. The future European Central Bank will choose between monetary targeting and inflation targeting. The start of the European Monetary Union may lead to an instability of the demand for money because of the regime shift. Therefore, the strategy of monetary targeting may lose some of its appeal. However, it does not follow that it is better to pursue a policy of inflation targeting. Any strategy will have difficulties when the fundamental link between money, prices, income and interest rates is disturbed. The rules for monetary policy have desirable features: inflation is to be kept under control, and fluctuations of output are to be reduced. But obviously, there is no single rule which is always and everywhere better than the alternatives. To conclude: It is not justified to disregard monetary targeting — a tendency which seems to prevail among central bankers and economists alike. After all, the quantity theory of money holds well enough to stress the importance of monetary aggregates as an anchor for the price level. --

A k-percent rule for monetary policy in West Germany.

Geldmengensteuerung; Deutschland;

End of the upswing in Euroland: No reason to cut interest rates

Economic expansion in Euroland has decelerated considerably after mid-2000 as a consequence of the weakening of growth in the world economy, the tightening of monetary policy by the European Central Bank as well as the burden imposed by higher oil prices. While the upswing in the euro area has come to an end, there is no reason to dramatize the current situation. It has to be kept in mind that economy-wide capacity utilization has already risen to its normal level, and it is not likely that real GDP will fall below potential output. The government budget of euro-area countries showed a surplus in 2000 for the first time since the 1960s. This year and next year the euro-area budget will change into a deficit also because taxes had been cut in a number of countries. It has to be criticized that consolidation efforts have ceased; in particular Germany, France, and Italy are still far away from a balanced budget. There is a risk that these countries will not meet their targets; the stability and growth programs are somewhat unrealistic because governments expect that higher trend growth than in the past will solve the problem. Many observers have urged the ECB to follow the example of the Fed and cut interest rates in order to prevent a sharp drop in economic activity. But in our view the ECB neither should nor will alter its course. First of all the current stance of monetary policy is not restrictive; according to the Taylor rule, short-term interest rates are even too low. Moreover, the growth of M3 will not fall below the reference value. Finally, the projections presented by the ECB last December do not justify a cut in interest rates. In the medium run, the expansion of the money stock is the most important factor for inflation, while in the short run inflation is also influenced by other factors. These considerations underlie the P-star model in which the development of inflation depends on the liquidity overhang, defined as price gap, as well as on cost factors. This model can explain the past movements of inflation quite well. As regards the inflation forecast it is important to note that the price gap has closed due to a rise in the price level and the slower increase in M3 in the past months. Consequently, we expect that the increase in consumer prices will gradually slow in 2001 and 2002. Recently, the Irish government has been criticized by the Council of European finance ministers for its fiscal policy. This came as a surprise in view of the excellent situation of public finances in Ireland. The critique aimed at the loosening of fiscal policy which would aggravate the bottlenecks in the economy. But it is also questionable whether a fiscal contraction in Ireland would be the appropriate response. All in all, the only way to cool down the economy seems to be an acceleration of wage growth and inflation and the implied real appreciation of the Irish pound. --