The economic decisions of households and firms are not directly affected by the amount of
money in circulation, according to new research by Javier Andrés, David López-Salido
and Javier Vallés, published in the April 2006 Economic Journal. This implies that central
banks that pursue ‘monetary policy without money’ – focusing on setting interest rates to
achieve their inflation objectives – are on the right path.
Recent research in macroeconomics has simultaneously reaffirmed the effect of monetary
policy actions on the short-run evolution of output and inflation, and downplayed the
importance of monetary aggregates in the way monetary policy is conducted. According to
this widespread (though by no means unanimous) view, central banks ought to set the
interest rate at the level consistent with its inflation objective, with a complete disregard for
the amount of money in circulation.
This view has led some people to talk about ‘monetary policy without money’. It is in stark
contrast with the more conventional approach, according to which it is not only the real
interest rate but mainly the amount of money in circulation, which affect people’s spending
decisions.
The so-called ‘two-pillars’ strategy followed by the European Central Bank (ECB) and other
monetary authorities lies somewhere in between these two attitudes in relation to the role of
money in monetary policy. The ECB conducts its policy for the euro area paying some
attention to deviations of M3 growth from a reference value when setting interest rates, thus
deaf to those who argue that a simpler ‘one-pillar’ inflation targeting strategy would be
preferable.
This study’s findings support the academic view that plays down the role of monetary
aggregates. Once the effect of the real interest rate is appropriately controlled for, the
incidence of real balances on the evolution of variables, such as inflation and output, is very
limited. In other words, the decisions taken by households and firms are not directly
affected by the amount of money in circulation.
This evidence is obtained by confronting data on output, inflation, interest rates and money
in the euro area with what academics call a ‘structural model’, one in which policy
experiments take account of the rationality of market participants and the ‘intertemporal’
nature of their decisions.
Taken at face value, these results imply that, for given inflation expectations, movements of
the interest rate aimed at correcting misalignments in monetary aggregates should not be
pursued. These corrections add nothing to the effectiveness of monetary policy and make it
less comprehensible.
These results confirm that it is the real interest rate and not the quantity of money that really
steers households’ and firms’ decisions about how much to spend, save and invest and
hence what affects inflation and output in the short run. According to this, an inflation
targeting strategy that links the two components of the real interest rate seems the most
appropriate one.
But these results do not imply that central banks should stop paying attention to the
evolution of monetary aggregates. There might be other channels not explored in this study
(mainly those operating through the relative return of different assets) that may restore
some role for monetary aggregates in central banking, at least, as privileged indicators of
people’s expectations about future events.
ENDS
Notes for editors: ‘Money in an Estimated Business Cycle Model of the Euro Area’ by
Javier Andrés, David López-Salido and Javier Vallés is published in the April 2006 issue of
the Economic Journal.
Javier Andrés is at Universidad de Valencia. David López-Salido is at the Federal Reserve
Board. Javier Vallés is at Oficina de Presidencia del Gobierno.
For further information: contact Javier Andrés +34-96-382-8246 (email:
Javier.Andres@uv.es); David López-Salido via email: David.J.Lopez-Salido@frb.gov;
Javier Vallés via email: jvalles@presidencia.gob.es; or Romesh Vaitilingam on 0117-983-
9770 or 07768-661095 (email: romesh@compuserve.com).