http://www.cepii.fr/francgraph/publications/ecointern/rev88/rev88king.pdf
 
In this article, Mervyn King, Deputy Governor, examines the apparent contradiction that the acceptance of the idea inflation is a monetary phenomenon has been accompanied by the lack of references to money in the conduct of monetary policy during its most successful period. The disappearance of money from the models used by economists is, however, more apparent than real, with official interest rates playing the leading role as the instrument of policy, with money in the wings off-stage. Nevertheless, there are real dangers in relegating money to this behind-the-scenes role.

Most people think economics is the study of money. But there is a paradox in the role of money in economic policy. It is this: that as price stability has become recognised as the central objective of central banks, the attention actually paid by central banks to money has declined.

It is no accident that during the 'Great Inflation' of the post-war period money, as a causal factor for inflation, was ignored by much of the economic establishment. In the late 1970s, the counter-revolution in economics – the idea that in the long term money affected the price level and not the level of output – returned money to center stage in economic policy. As Milton Friedman put it, “inflation is always and everywhere a monetary phenomenon”: If inflation was a monetary phenomenon, then controlling the supply of money was the route to low inflation. Monetary aggregates became central to the conduct of monetary policy. But the passage to low inflation proved painful. Nor did the monetary aggregates respond kindly to the attempts by central banks to control them. As the governor of the Bank of Canada at the time, Gerald Bouey, remarked, “we didn't abandon the monetary aggregates, they abandoned us”.

(…) As Larry Meyer, a Governor of the Federal Reserve Board explained earlier this year, money plays no explicit role in today's consensus macro model, and it plays virtually no role in the conduct of monetary policy.

The decline and fall of money in policy formation is confirmed by a fall in the number of references to money in the speeches of central bank governors. So much so that over the past two years, Governor Eddie George has made one reference to money in 29 speeches, Chairman Greenspan one in 17. Governor Hayami one in 11, and Wim Duisenberg three in 30.

Money and inflation: the evidence

(…) The results of McCandless and Weber^[1] (1995), shows the correlation between the growth of the monetary base and inflation over different time horizons for a large sample of 116 countries. Countries with faster growth rates of money experience higher inflation. (…) Few empirical regularities in economies are so well documented as the co-movement of money and inflation. (…) This relationship is true for broad money as well as the monetary base. The other side of the coin to this close relationship between money and prices is the absence of a long-run relationship between money and output growth (…) Correlation, of course, is not causation. The essence of monetary theory is trying to understand the structural relationship between money growth, demand, output and price movements. Stable structural relationships can give rise to unstable short-run correlations between any of these variables. It is, therefore, somewhat surprising that some economists have argued that the instability of observed short-run correlations casts doubt on the long-run importance of money growth in the inflationary process. (…)There is no reason to expect a simple relationship between inflation and output and money growth in reduced-form estimates.

This last point was clearly grasped by Friedman and Schwartz in their classic 1963 study of money in the United States. They took great care to identify periods in which there was an exogenous shock to the money supply, such as moves on to and off the gold standard, and changes in reserve requirements imposed on banks. More recent studies, such as Estrella and Mishkin (1997), Hendry (2001), Gerlach and Svensson (2000) and Stock and Watson (1999) produce conflicting and unstable regression results for the influence of money growth on inflation.

To understand the true role of money, a clear theoretical model is required and that model must allow for the central role of expectations. The key role of expectations is best illustrated by considering extreme cases of high inflation, known as hyperinflations. In hyperinflations the effect of expectations on money and inflation is amplified relative to other influences, such as the business cycle. (…)

The link between money and prices in four hyperinflations

Two of these are drawn from the inter-war period, namely the hyperinflations in Austria and Hungary, and two are post-war hyperinflations, in Argentina and Israel. At their peak, these hyperinflations involved annual inflation rates of 9,244%, 4,300%, 20,266%, and 486% respectively. All four hyperinflations illustrate the importance of expectations. (…) Announcements of credible fiscal stabilisations changed inflation expectations and led extremely quickly to a rapid fall in inflation.

Money and monetary policy

What does this debate about the transmission mechanism of monetary policy mean for the conduct of monetary policy today ? The role of money in determining the price level, and its embodiment in the quantity theory of money, evolved over several hundred years. The broad shape of this theory was accepted by most economists. It is certainly evident in the writings of both John Maynard Keynes and Irving Fisher. As the theory of monetary economics developed, so too did the practice of monetary policy. In Britain, the beginning of the theory and practice of monetary policy as we know it today started with the Bank Charter Act of 1844. (…)

Thinking of monetary policy in terms of interest rates has become the norm in central banks today. Frequent and volatile shifts in the demand for money led central banks to change their focus from monetary aggregates towards the control of short-term interest rates. Few major central banks now place the monetary aggregates at the centre of their targeting regime. Instabilities in the demand for money are not new. In the early years of the Bank of England, there were unexpected shifts in the demand for money and credit resulting from uncertain arrival times in the port of London of ships laden with commodities from all over the world. The uncertainty derived from changes in the direction and speed of the wind carrying ships up the Thames to the port of London. Hence the Court Room of the Bank of England contained a weather vane which provided an accurate guide to these shifts in money demand – the weather vane is there to this day, and it still works. If only monetary policy could be as scientific today ! Financial liberalisation and changes in the technology of payments and settlements have led to large volatilities in money demand. No one has yet worked out how to translate such shifts into a simple reading on the financial equivalent of a weather vane. So central banks have paid decreasing attention to the monetary aggregates as an intermediate indicator of their policy stance.

(…) Rules, such as the Taylor rule, provide a useful benchmark against which to judge whether interest rates are too high or too low. But the analysis provided by the Bank of England is not restricted to interest rates. It is crucial to look at developments in quantities in the monetary area and credit conditions, as well as prices. Using historical relationships estimated from the data, developments in money and credit, and their sectoral patterns, can be used as indicator variables for near-term activity and inflation. (…)

Conclusions

I return to the paradox with which I began. Most people believe that economics is about money. Yet most economists hold conversations in which the word 'money' appears hardly at all. Surprisingly, that appears true even of central bankers. The resolution of this apparent puzzle, is, I believe, the following. There has been no change in the underlying theory of inflation. Evidence of the differences in inflation across countries, and changes in inflation over time, reveal the intimate link between money and prices. Economists and central bankers understand this link, but conduct their conversations in terms of interest rates and not the quantity of money. In large part, this is because unpredictable shifts in the demand for money mean that central banks choose to set interest rates and allow the public to determine the quantity of money which is supplied elastically at the given interest rate.

The disappearance of money from the models used by economists is, as I have argued, more apparent than real. Official short-term interest rates play the leading role as the instrument of policy, with money in the wings off-stage. But the models retain the classical property, that, in the long run, monetary policy, and hence money, affect prices rather than real activity. Nevertheless, there are real dangers in relegating money to this behind-the-scenes role. Three dangers seem to me particularly relevant to present circumstances. First, there is a danger of neglecting parts of the monetary transmission mecanism that operate through the impact of quantities on risk and term premia of various kinds. The current debate about the appropriate monetary policy in Japan illustrates this point. Second, by denying an explicit role for money there is the danger of misleading people into thinking that there is a permanent trade-off between inflation, on the one hand, and output and employment, on the other. Third, by discussing monetary policy in terms of real rather than monetary variables, there is the danger of giving the impression that monetary policy can be used to fine tune short-run movements in output and employment and to offset each and every shock to the economy. These dangers all derive from the habit of discussing monetary policy in terms of a conceptual model in which money plays only a hidden role.

Habits of speech not only reflect habits of thinking, they influence them too. So the way in which central banks talk about money is important. There is no inconsistency between the consensus models we use to analyse policy in terms of interest rates and the proposition that monetary growth is the driving force behind higher inflation. But it would be unfortunate if the change in the way we talk led to the erroneous belief that we could turn Milton Friedman on his head, and think that 'Inflation is always and everywhere a real phenomenon'.

My own belief is that the absence of money in the standard models which economists use will cause problems in future, and that there will be profitable developments from future research into the way in which money affects risk premia and economic behaviour more generally. Money, I conjecture, will regain an important place in the conversation of economists. As Hilaire Belloc wrote, “I'm tired of Love. I'm still more tired of Rhyme. But Money gives me pleasure all the time”.

[1] McCandless G.T. Jr et Weber W.E. (1995), Some Monetary Facts, Federal Reserve Bank of Minneapolis Quaterly Review, 19(3), Summer 2-11