William T. Gavin

English

Research Papers in Economics

June 2004 MonetaryTrends
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
How Money Matters
O
ver the past 15 years the quantity of money has
largely disappeared from policy discussions and
the economic models used to provide monetary
policy advice. Most central banks that were targeting
money growth have stopped doing so. We no longer ask
which measure of money is the “correct” indicator for
monetary policy. Instead, we directly examine measures
of inflation and output for guidance about setting the
stance of monetary policy.
Yet, money still matters. It plays three fundamental
roles in the economy: a medium of exchange, a store of
value, and the unit of account. Traditionally, monetary
policy was viewed as operating through the medium of
exchange or the store of value, or both. We focused on
M1 when we thought the medium of exchange role was
dominant, because the funds in M1 are primarily used to
make transactions. We focused on M2 when we thought
that the wealth effect was important or that close substitutes
for M1 would be informative. 
Since 1982, however, measures of the quantity of
money have provided little useful information about the
near-term outlook for spending or inflation. Money
growth has remained highly variable even as infla-
tion has become less variable. As the chart shows,
the variability of inflation, calculated as the stan-
dard deviation of quarterly percent changes in the
CPI, declined by half between 1970-82 and 1983-
2003. But the variability of the money stock, meas-
ured using either M1 or M2, actually went up a bit.
This disconnect between the variability of
inflation and money growth is partly due to the
success of policy in reducing inflation and causing
expectations of future inflation to become more
stable. In this environment, the Federal Reserve
has been able to keep its federal funds target
rate fixed for months at a time. When the funds
rate is fixed, the short-run money supply is per-
fectly elastic with respect to the interest rate and
all changes in money demand are perfectly
accommodated. 
The role of money as our unit of account, the dollar,
is at center stage in monetary policy today. Our models
and our discussions focus not on the quantity of money
but on the purchasing power of the dollar. More uncertainty
about the value of a dollar, both now and in the future,
causes consumers, investors, and business managers to
make mistakes that reduce economic efficiency and living
standards. That is, changes in expected inflation and errors
that result when actual inflation deviates from previous
expectations cause economic inefficiencies. Of course,
many aspects of our economy are not fully indexed for
inflation. A higher inflation rate, for example, results in a
higher effective tax rate on capital gains. Higher inflation
also causes more uncertainty about inflation. 
In fact, an important channel by which the Federal
Reserve stabilizes the value of a dollar is through expecta-
tions of future inflation, the main channel through which
monetary policy affects the real economy. We do not have
to pay attention to the quantity of money today because
policymakers are paying attention to its price, by focusing
on inflation and inflation expectations.
—William T. Gavin
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0
1
2
3
4
5
6
7
1970-1982 1983-2003
M1
M2 CPI
M1
M2
CPI
Standard Deviation of Money Growth and Inflation
Percent
NOTE: The standard deviations are calculated from quarterly data
and reported at annual rates.

How money matters

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How money matters

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Research Papers in Economics