Money Rules

Money is a relevant macroeconomic indicator in United States’ monetary policy. Photo: Pepi Stojanovski
Money is a relevant macroeconomic indicator in United States’ monetary policy. Photo: Pepi Stojanovski

By Irfan A. Qureshi

A rules-based approach to monetary policy needs to be part of any discussion involving central bank policy.

The interest rate policy of a central bank is often explained through simple monetary policy rules. These rules are heavily scrutinized to determine the most effective and fair way to achieve targets for inflation, output and employment. How should central bank’s design monetary policy to best achieve these goals?

In a recent paper, I tackle this issue by assessing whether tracking money aggregates that measure the supply of money improve the conduct of monetary policy. To test this claim, I include broad money aggregate as an additional policy objective in the simple policy rule (often referred to as Taylor’s rule after Stanford economist John B. Taylor), which prescribes that central banks set the interest rate in response to deviations in inflation from its target and to changes in the output gap. Including money in the Taylor-type framework better tracks the historical monetary policy actions of the Federal Reserve. On the prescriptive front, the money-based rule could be included by central banks in their monitoring and decision-making toolbox. For instance, a central bank meant to control inflation may also concern itself with tracking money.

To justify the policy implications of this framework, I examine the role of loose monetary policy in fueling the credit bubble that developed in the U.S. during the early 2000s. The monetary expansion during this period worked through both speculative and leveraging channels, especially in the lending practices of the housing sector. In short, the oversupply of credit made it possible for marginal borrowers to obtain loans with lower collateral values. Had the Fed set interest rate policy consistent with the money-based framework, they would have crowded out these borrowers through a tighter supply of credit. These findings build the case for central banks to track an appropriately measured money aggregate to deal with possible financial sector misalignments, and to detect and respond to bubbles in credit and asset markets.

The implementation strategy using the money-based rule can be viewed in reference to the European Central Bank’s “two pillar” strategy. For instance, a central bank may use a standard Taylor-type rule to come up with an initial recommendation for setting the policy rate as a function of inflation and the output gap, but then adjust the policy rate, as well, in response to observations of money growth that are perceived as either too high or too low to be fully consistent with the long-run policy objectives. This type of money cross-checking argument may improve inflation control and generate substantial stabilization benefits in the event of persistent policy misperceptions regarding potential output or the output gap, which are common issues facing central banks when setting policy.

  Monetary policy rules should not be taken as a one-stop solution to meet macroeconomic policy objectives.

What are the implications of these results for monetary policy in developing countries? Although both standard Taylor-type rules and money-augmented rules may be reliable, they may be potentially misleading when applied directly to describe and evaluate monetary policy in developing countries. This is because simple rules ignore other important factors such as the exchange rate, which are crucial for those countries that rely heavily on trade. More precise answers to the numerical value of the inflation target, the natural rate of interest and measuring the potential output also need to be considered. Another important constraint facing developing countries is the availability and accuracy of real-time macroeconomic data for decision making. Finally, even though money aggregates seem to have fallen out of favor with most central banks due to their seemingly unreliable relationship with real activity, more sophisticated measures of money, such as Divisa monetary aggregates may be developed for monetary policy assessment.

At the same time, monetary policy rules should not be taken as a one-stop solution to meet the macroeconomic policy objectives, and they are more effective in three situations. One, under prudent fiscal policy, which aims at controlling large and persistent deficits. Second, under financial markets that reduce incentives to incur unhedged foreign currency liabilities that destabilize the exchange rate. Third, under more independent central banks that are transparent about their policy rationale, and effectively communicate their current and future course of action to the public.

While no central bank would be likely to follow a simple formula for setting its policy instrument, rule-like behavior is systematic and disciplined, allowing policymakers to focus on the long-run consequences of current decisions, rather than paying too much attention to short-run remedies. Rules also allow policymakers to demonstrate that their interest rate decisions are driven by economic analysis alone and not influenced by political pressure. This injects credibility to monetary policy actions and is an important pre-requisite for successful monetary policy implementation.

What constitutes a monetary policy rule remains an open question. However, a rules-based approach to monetary policy is valuable and needs to be part of any discussion involving central bank policy.

The blog is based on the paper titled The Role of Money in Federal Reserve Policy in Macroeconomic Dynamics.