Abstract
This chapter deals with the macroeconomic effects of monetary policy. Specifically, a distinction is made between economic effects in the long-term—during which economic conditions, such as prices, can react flexibly and, thus, the neutrality property of money holds—and the short-term—during which monetary policy affects the business cycle and employment via the so-called ‘monetary-policy transmission mechanisms’.
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Notes
- 1.
Friedman, Milton, 1970: The Counter-Revolution in Monetary Theory, IEA Occasional Paper no. 33, p. 11.
- 2.
In practice, measuring general price trends is not trivial. To do so, a representative consumer basket must be defined. Then, based on this basket, a price index is calculated so that the development of purchasing power is comparable across countries and time. The corresponding calculation is usually done relative to a certain base year, in which the index is, by definition, normalised to 100 points, that is P 0 = 100. The percentage change in the index across time measures inflation. If the price index climbs in year t to, for example, P t = 103, inflation during that period was (103∕100 − 1)=0.03 or 3%. Using the price index, it is also possible to convert nominal values into real economic values. For example, the real values at time t and 0 can be compared by applying the factor 100∕103. In particular, when Y t reflects the nominal value of an economic variable such as income, then y t = Y t ∗ (100∕103) is its real value, which has been corrected by the change in the purchasing power of money.
- 3.
Figure 6.1 ignores several countries, which reformed their currency systems due to becoming independent, joining a common currency, or suffering from hyperinflation. For these countries, structural breaks and missing data prevent the calculation of long-term averages.
- 4.
The exact formula of the real interest rate is given by
$$\displaystyle \begin{aligned} \text{real interest rate} =(\text{nominal interest rate}-\text{inflation rate})/(1+\text{inflation rate}). \end{aligned}$$As long as inflation is relatively low, the denominator on the right-hand side is approximately equal to one and can be neglected. Hence, the value of the real interest rate is approximately given by
$$\displaystyle \begin{aligned} \text{real interest rate} \approx \text{nominal interest rate}-\text{inflation rate}. \end{aligned}$$For example, with a nominal interest rate of 5% and an inflation rate of 3%, the real interest rate is approximately 2%.
- 5.
For discussions on the determinants of the real interest rates see, for example, Fessenden, Helen, 2015: Real Interest Rate, Econ Focus, Federal Reserve Bank of Richmond. A more extensive review can be found in Obstfeld, Maurice, and Linda Tesar, 2015: Long-term Interest Rates: A Survey, Washington, President’s Council of Economic Advisors.
- 6.
Prominent Monetarists include Milton Friedman (1912–2006), Allan Meltzer (1928–2017), and Karl Brunner (1916–1989). In its heyday during the 1970s, some ideas postulated by Monetarism were implemented in the actual conduct of monetary policy. In particular, after the collapse of the Bretton Woods System, some central banks began to announce explicit growth targets for monetary aggregates. However, reflecting changes in payment habits and financial innovations in the 1980s, the unstable behaviour of monetary aggregates proved to be a caveat against this approach. Therefore, during the 1990s, most central banks switched to a so-called ‘inflation-targeting regime’, in which the development of the average price level serves directly as a monetary-policy goal (see Sect. 2.6). However, the intellectual heritage of Monetarism resonates to this day in discussions about the role of monetary aggregates as economic indicators, the drawbacks of discretionary monetary policy, and the importance of central-bank mandates. An insightful overview of the key propositions of Monetarism can be found in Friedman, Milton, 1970: The Counter-Revolution in Monetary Theory, Institute of Economic Affairs Occasional Paper, no. 33.
- 7.
This ‘rule of seventy’ is the result of the exponential nature of price-level growth, that is
$$\displaystyle \begin{aligned} P_{t}=P_{0}(1+\pi/100)^{t}. \end{aligned}$$Here, P 0 is the initial and P t the final price level, π is the inflation rate (in per cent), and t the period under consideration. A doubling of the average price level implies that P t = 2 × P 0. By means of natural logarithms, the doubling time t can be calculated by
$$\displaystyle \begin{aligned} t=\frac{\ln(2)}{\ln(1+\pi/100)}. \end{aligned}$$According to the Taylor-rule, we have approximately that \(\ln (1+\pi /100)\approx \pi /100\). Furthermore, we have that \(\ln (2)=0.693...\approx 0.7\). Hence, the rule of 70 arises, since
$$\displaystyle \begin{aligned} t\approx\frac{0.7}{\pi/100}=\frac{70}{\pi}. \end{aligned}$$ - 8.
See, for example, He, Liping, 2017, Hyperinflation: A World History, Routledge.
- 9.
To understand the role of the government in monetary affairs along these lines see Friedman, Milton, 1959: A Program for Monetary Stability, Fordham University Press, pp. 4–9.
- 10.
In this regard, Keynes is in sharp disagreement with the Monetarists, who blamed the Great Depression on inadequate monetary policy, which arguably led to a collapse of the banking system and, in turn, the money supply. See, for example, Friedman, Milton, 1970: The Counter-Revolution in Monetary Theory, Institute of Economic Affairs Occasional Paper, no. 33.
- 11.
See Niehans, Jürg, 1990: A history of economic theory - Classical contributions 1720–1980, The Johns Hopkins University Press, pp. 54, 59, 103, 349. See also De Vroey, Michel, 2011: The Marshallian Roots of Keynes’ Theory. In: Arnon, Arie, Jimmy Weinblatt, Warren Young (eds.), Perspectives on Keynesian Economics, Springer, pp. 57–75.
- 12.
See e.g. Friedman, Milton, 1970, The Counter-Revolution in Monetary Theory, Institute of Economic Affairs Occasional Paper, no. 33, pp. 10–11.
- 13.
The total expenditure across the whole economy is also called the ‘aggregate demand’. Indeed, according the expenditure approach to national accounting, the Gross Domestic Product (GDP) can be calculated as
$$\displaystyle \begin{aligned} \text{GDP} \equiv \text{consumption}+\text{investment}+\text{government consumption} +\underbrace{\text{net exports.}}_{=\text{export}-\text{import} } \end{aligned}$$ - 14.
In other words, inflation expectations matter for the interest-rate channel, because together with the nominal interest rate, they determine the value of the ex-ante real interest rate (see Sect. 6.2). For example, lower inflation expectations matched with a constant nominal interest rate increase the expected real interest rate.
- 15.
The path that led to the IS/LM-model nicely illustrates many of the points made thus far. In 1933, Cecil Arthur Pigou (1877–1959), who was a fellow economist of Keynes at Cambridge University, published his ‘Theory of Unemployment’, which was lambasted in the ‘General Theory’, despite expressing quite similar views, such as that lower wages can, in principle, boost employment. However, this so-called ‘Pigou effect’ does not arise when wages are contractually fixed. Although their designers allegedly had personal animosities, it was indeed quickly shown that the Keynesian and Pigouvian explanations for unemployment could easily be reconciled. In particular, a year after the publication of the ‘General Theory’, a conference of the Econometric Society started the business of analysing what Keynes really meant. Although it tried to uncover the deviations from established economic thought, John Hicks’ paper entitled ‘Mr. Keynes and the ‘Classics’; A Suggested Interpretation’, which became famous for its IS/LM-model, essentially ended up finding considerable overlaps. For a historical overview of the IS/LM model, see De Vroey, Michel, and Kevin D. Hoover (eds.), 2005: The IS-LM Model: Its Rise, Fall, and Strange Persistence, Duke University Press.
- 16.
The exact mechanism through which depreciation maps into inflation can be illustrated by the purchasing-power-parity theory. This theory is a generalisation of the so-called ‘law of one price’, according to which the local prices of freely tradable goods should be identical after the foreign price has been converted into domestic currency. Otherwise, arbitrage opportunities, that is, the exploitation of international price differences to make easy profits, would arise. The absolute version of the purchasing-power-parity theory expresses the same idea in terms of aggregate prices. In other words, exchange rates offset, in the long-term (when prices are flexible), international price-level differences, that is
$$\displaystyle \begin{aligned} \text{exchange rate} =\text{foreign price level}/\text{domestic price level} \end{aligned}$$The relative version of purchasing power parity, given by
$$\displaystyle \begin{aligned} \text{change in exchange rate} = \text{foreign inflation rate} - \text{domestic inflation rate}, \end{aligned}$$re-expresses this relationship in terms of changes across time. Hence, exchange-rate changes reflect differences in inflation with a relatively high level of domestic inflation tending to depreciate the currency (here, a reduction of the exchange rate). This result is perhaps intuitive. When rampant inflation affects a currency, its external purchasing power can only be preserved by an increase in the cost of foreign currency in terms of domestic currency units. In other words, depreciation is an international reflection of the internal loss of purchasing power.
- 17.
In economics, the relationship between exchange rates and import prices is called the ‘exchange-rate pass through’, which is typically incomplete. Exchange-rate changes are often only partly reflected in import prices because they are rigid in the short-term, and competition between domestic and foreign companies is imperfect.
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Herger, N. (2019). The Initial and Final Effects of Monetary Policy on Inflation, Output, and (Un)employment. In: Understanding Central Banks. Springer, Cham. https://doi.org/10.1007/978-3-030-05162-4_6
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