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GIUSEPPE FONTANA AND ALFONSO PALACIO-VERA
Monetary policy rules:
what are we learning?
Abstract: The paper shows that the “monetary policy rules and inflation targeting” literature and the “endogenous money” literature share a reaction function approach to central banking policy. Monetary aggregates are the outcome
of the price-maker and quantity-taker behavior of central banks in the reserve
market, and of banks in the loans market. However, the paper argues that any
process of convergence between those two approaches has to confront the following four critical areas: (a) the meaning of endogenous money, (b) the theory
of inflation, (c) the theory of interest rates, and (d) the long-run role of money.
Key words: demand–pull and cost–push inflation, endogenous money, inflation
targeting, interest rates, long-run nonneutrality of money, monetary policy rule.
During the 1990s, there has been a convergence around the world in
both goals and methods used to conduct monetary policy. As for goals,
during the 1970s and 1980s, many countries experienced very high levels of inflation. This has led practitioners to the view that even moderate
levels of inflation damage economic growth and that low and stable
inflation has to be a primary objective of monetary policy (Cecchetti,
2000, p. 44). At the same time a broad consensus between leading monetary theorists has emerged. The overriding requirement for monetary
policy is to provide a “nominal anchor” to control inflation and inflationary expectations (Allsopp and Vines, 2000). Within this framework,
monetary policy is then better used for the stabilization of output compared to its long-run level. As for methods, there has been overwhelming evidence indicating that in most countries, money demand functions
The authors are Lecturers in Economics at the University of Leeds, United Kingdom,
and Universidad Complutense de Madrid, Spain, respectively. They are grateful to
Geoff Harcourt and Malcolm Sawyer for comments on an earlier draft. They also
thank participants at the Post Keynesian Study Group winter seminar (University of
Leeds, United Kingdom, November 2, 2001) for comments and discussion. Of course,
any remaining errors are the authors’.
Journal of Post Keynesian Economics / Summer 2002, Vol. 24, No. 4 547
© 2002 M.E. Sharpe, Inc.
0160–3477 / 2002 $9.50 + 0.00.
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are unstable and that, as a result of it, there is no secure link between
money and nominal income (Howells and Bain, 1998, p. 124). This has
led to the flourishing of an enormous literature supporting the gradual
abandonment of money targeting by most central banks and the subsequent adoption of monetary policy strategies where the main instrument
is a short-term interest rate and no monetary aggregate plays the role of
intermediate target.
As a result of those policy changes, some commentators have been
quick to suggest that the increasing focus on the instrumental role of
prices rather than quantities for controlling inflation has narrowed the
gap between practitioners and academics. For instance, Goodhart has
argued that “the yawning chasm between what theorists suggested that
central banks should do, and what those same central banks felt it right
to do has largely now closed” (Goodhart, 2001, p. 21; also, Laidler,
2001, pp. 25–26). However, what has been less promptly recognized is
that the convergence in both goals and methods of monetary policy has
opened up the possibility for a constructive dialogue between different
traditions of monetary thought. An unexpected and mostly unexplored
rapprochement between the monetary policy rule and inflation targeting
(IT) approach of Bernanke, Svensson, Taylor, and Woodford on one side,
and the endogenous money approach of Kaldor, Minsky, and Moore on
the other side has been slowly taking place. According to those groups
of authors, an interest rate policy reaction function approach goes hand
in hand with an endogenous money perspective of the money supply
process. Monetary aggregates are the outcome of the price-maker and
quantity-taker behavior of central banks in the reserve market and of
banks in the loans market. Thus, it seems that time is now ripe for reviewing the main features of those two approaches and for attempting a
preliminary investigation of the future prospect for a converging view
of the theory and practice of monetary policy.
Monetary policy rules and inflation targeting: a review
The focus on price stability as the primary objective of monetary policy
and the emergence of short-term interest rates as its main instrument
has led to an explosion of research on monetary policy rules. By far, the
simple monetary policy rule that has drawn the most interest is Taylor’s,
which, in turn, fits surprisingly well with the behavior of several central
banks (see Clarida and Gertler, 1996; Clarida et al., 1998; Taylor, 1993).
In Taylor’s rule, the short-term nominal interest rate is set the following
way (Taylor, 1993, p. 202):
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Ê y - y* ˆ
r = r n + p -1 + ap p - pd + ay Á * ˜ ,
Ë y ¯
(
)
where r is the short-term nominal interest rate (the federal funds rate in
Taylor’s version); aπ and ay are the policy reaction coefficients (set at
0.5 each in the initial version); rn is the “equilibrium” rate, which is
assumed to be close to the steady-state growth rate; π and πd are current
and target rates of inflation, respectively; π–1 is the rate of inflation over
the previous four quarters (a proxy for expected inflation); and y and y*
are current and trend level output, respectively.
Most of the literature has focused on the analysis of the stabilization
properties of Taylor’s rule and several of its variants. Two different approaches have been followed: a model-based approach and a historical
approach. The method of the model-based approach, also referred to as
the “new normative macroeconomics” (Taylor, 2000a, p. 61), is to simulate stochastically a model with different simple monetary policy rules
(SMPR) and then look for the rule that works best. In turn, “one monetary policy rule is better than another policy rule if it results in better
economic performance according to some criterion such as inflation or
the variability of inflation and output” (Taylor, 1999a, p. 320). Examples
of this approach include the econometric policy evaluation research in
Bryant et al. (1993), Bernanke and Mishkin (1997), and Taylor (1999a,
1999b). The following three points of agreement emerging from this
literature can be highlighted. First, simple Taylor-type policy rules work
well, and their performance is very close to that of fully optimal policies. Second, SMPR are more robust than complex rules across different models; that is, they minimize the loss function of central banks in a
variety of competing environments (Taylor, 1999a, pp. 10–11; 1999b, p.
657). Finally, if any interest rate policy rule is to provide a “nominal
anchor” and stabilize the economy, then the short-term nominal interest
rate should vary more than proportionally (so as to make the ex ante real
interest rate pro-cyclical) to variations in the inflation gap (defined as
the difference between current or expected inflation and the inflation
target).
The historical approach complements the model-based approach. The
method is to choose a benchmark policy rule or baseline specification,
which usually has a central bank adjusting the nominal short-term interest rate in response to gaps between current inflation and output, and their
respective targets. The benchmark rule is assumed—on the basis of both
earlier model-based and historical analysis—to provide the standard of a
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“good” policy rule (see Taylor, 1999a, p. 321). The benchmark policy rule
is then estimated for different periods in order to detect either shifts in the
specification of the policy rule or changes in the values of the estimated
reaction coefficients. Since the benchmark rule is presumed to represent a
good policy, any deviation in the estimated policy rule from the benchmark rule in a given period is interpreted as a policy “error.” Examples of
this approach include the studies by Clarida et al. (1998, 2000), Judd and
Rudebusch (1998), Taylor (1999a, ch. 7), Muscatelli et al. (2000),
McCallum (2000), Nelson (2000), and Fair (2001). The richness and variety of results obtained so far is promising. One result is of particular
interest: there is a significant correlation between policy rules and macroeconomic performance.
According to Clarida et al. (1998), since 1979, the central banks of
Germany, Japan, and the United States have pursued an implicit form of
IT. Overall, they find that the baseline specification of their policy rule
does quite a good job of characterizing post-1979 monetary policy for
these countries. The kind of rule that emerges is one where, in response
to a rise in expected inflation, central banks raise nominal interest rates
sufficiently enough to push up real rates. As highlighted by several authors (for example, Allsopp and Vines, 2000, p. 11; Taylor, 1999a, pp.
331–332), this rule is a requirement of a monetary policy framework
that aims to provide a “nominal anchor.” Furthermore, according to
Clarida et al. (1998, p. 1035), this behavior is statistically significant
and quantitatively important for several countries. Clarida et al. also
find that holding expected inflation constant, central banks adjust interest rates in response to the state of output. Finally, they show that in the
inflationary pre-1979 period, real interest rates did not rise in response
to a rise in the gap between expected and target inflation.
These findings are confirmed in Clarida et al. (2000), where it is argued that the interest rate policy in the Volcker-Greenspan period appears to have been much more sensitive to changes in expected inflation
than in the pre-Volcker period. A similar finding appears in Judd and
Rudebusch (1998), although differences in the estimated policy reaction function for the Volcker and Greenspan period are identified. Finally, Taylor (1993) accompanied the proposal to use his rule as a
guideline for setting short-term rates with empirical evidence. He shows
a good fit between the path of the U.S. federal funds rate derived from
his rule and its actual path. A similar finding is also derived for the
United Kingdom until the exit from the European exchange rate mechanism (Stuart, 1996).
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In the most comprehensive historical analysis for the U.S. economy
using Taylor’s rule (Taylor, 1999a, ch. 7), the above results are widely
confirmed. It is argued that a constant growth rate of the money stock,
an informal policy of leaning against the wind, and an explicit quantitative policy of interest rate setting all tend to generate positive responses
of the interest rate to changes in inflation or real output. For instance,
under a money-targeting regime, and for a given rate of growth of money
supply, a rise in either the rate of inflation or the growth rate of real
income increases money demand, thereby raising the level of the shortterm interest rate that clears the money market. The same pattern of
behavior of short-term interest rates is clearer in the remaining two
monetary policy regimes.
However, the magnitude of these coefficients differs depending on how
monetary policy is run. The author shows that, for the U.S. economy,
the size of these coefficients has increased over time. The monetary
policy rule had very low interest rate responses during the gold standard
era; it had high responses during the 1960s and 1970s; and it had higher
responses in the late 1980s and 1990s. It is argued to now be close to
Taylor’s rule (Taylor, 1999a, p. 330).1 Finally, the author maintains, that
if one properly controls for the beneficial external influences of the gold
standard on long-run inflation during the 1879–1914 period, “one obtains an unambiguous correlation between monetary policy rule and macroeconomic stability” (Taylor, 1999a, p. 333).
Other studies also lend support to the view that the behavior of shortterm nominal interest rates in industrialized countries can be well captured by one form or another of the Taylor-type monetary policy rule.
For instance, the traditional claim that the Bundesbank was a moneytargeter has received a skeptical response in recent empirical work.
Bernanke (1996) argues that the Bundesbank was better described as an
inflation-targeter than as a money-targeter. This claim is also supported
by Muscatelli et al. (2000). Similarly, according to Mishkin (1999, p.
588), the Bundesbank missed its money targets 50 percent of the time.
These findings have led to the claim that the Bundesbank strategy is
better described as “inflation targeting in disguise” (Svensson, 1999, p.
641). Other studies show that a modified version of Taylor’s rule predicts reasonably well the path followed by short-term nominal interest
1 According
to Taylor (1999a, ch. 7), compared with the 1960s and 1970s, the
coefficients on real output tripled in size by the 1987–1997 period, whereas the
coefficient on inflation doubled in size.
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rates in Germany (Clarida and Gertler, 1996). Finally, Gerlach and
Schnabel (2000) find that average interest rates in the European Monetary Union (EMU) countries in 1990–1998, with the exception of the
period of exchange market turmoil in 1992–1993, followed very closely
changes in average output and inflation gaps, as suggested by Taylor’s
rule.
IT has been defined as “a framework for monetary policy characterised
by the public announcement of official quantitative targets (or target
ranges) for the inflation rate over one or more time horizons, and by
explicit acknowledgement that low, stable inflation is monetary policy’s
primary long-run goal” (Bernanke et al., 1999, p. 4). Additional features
are efforts to communicate with the public about the objectives of the
monetary authorities and mechanisms that strengthen the external accountability of central banks. Throughout the 1990s, IT, in one form or
another, was adopted by a number of industrialized countries including
New Zealand, Canada, the United Kingdom, Sweden, Finland, Israel,
Spain, and Australia. It has also been adopted by the new European Central Bank (ECB).
Although the reaction function under IT will, in general, not be a Taylor-type reaction function, inflation and output gaps may be seen, however, as proxies of important short- and long-run concerns (Judd and
Rudebusch, 1998, p. 6). IT is thus very much a “look at everything”
strategy, albeit one with a focused goal (Bernanke et al., 1999). As actually practiced, it confers a considerable degree of discretion on policymakers to vary interest rates in response to new information coming out
of a large set of economic indicators and of particular social and political circumstances. Unlike SMPR, which typically directs the attention
of central banks to a single key indicator, IT encourages monetary authorities to make use of all relevant information. Therefore, IT is not a
strict rule, but a policy framework that allows for the exercise of “constrained discretion” (Bernanke et al., 1999, p. 300).
Bernanke et al. provide three reasons for justifying the adoption of an
IT approach (Bernanke et al., 1999, ch. 2). The first reason is a reduced
confidence in activist policies. They argue that activist monetary policies were grounded on the assumption of a long-run trade-off between
inflation and unemployment. But as the events of the 1960s and 1970s
showed, those policies were neither capable of controlling rising rates
of inflation nor of avoiding recessions (such as, the severe economic
crises of 1973–1974 and 1981–1982). Bernanke et al. also mention three
theoretical developments that crucially contributed to the reduced confidence in activist policies. First, the argument by Friedman that mon-
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etary policy works with “long and variable lags.” Second, the argument
by Friedman and Phelps that “there is no long-run trade-off between
inflation and unemployment” (Bernanke et al., 1999, p. 12). Third, the
argument by Kydland and Prescott, and several subsequent authors, that
“even if it wants to keep inflation low, an activist central bank will often
have a strong incentive to increase the rate of inflation above the level
expected by the public” (Bernanke et al., 1999, p. 14). This argument
suggests that central banks will tend to be inflation prone in practice.
According to Bernanke et al., a second reason for justifying the adoption of an IT framework is a growing belief that low inflation promotes
economic efficiency and growth in the long run (Bernanke et al., 1999,
p. 16).2 Similarly, Bernanke et al. suggest that an IT framework is useful to contain persistent increases in inflation due to, say, adverse supply shock (accelerationist thesis). For example, they refer to the lack of
second- and third-round inflationary effects of the tax increase in Canada
in 1991. However, when Bernanke et al. argue that inflation is detrimental to the economy, they also accept that more modest inflation,
such as, below 10 percent a year, may not be necessarily harmful. Thus,
they argue that the strongest argument for advocating an IT framework
is that it can help to provide monetary policy with a “nominal anchor.”
They maintain that, in the absence of this nominal anchor, both inflation and inflation expectations could become unstable (Bernanke et al.,
1999, p. 20). This is the third reason for justifying the adoption of an IT
framework.
A commitment to long-run price stability is just a nominal anchor,
“since (given the current level of prices), a target rate of inflation communicates to the public the price level the central bank is aiming to
achieve at specified dates in the future” (Bernanke et al., 1999, p. 20). In
turn, inflation targets improve planning in the private sector and increase
the external accountability of central banks (Bernanke et al., 1999, p.
23). In addition, by linking monetary policy to medium- and long-term
horizons, but without undermining centrals banks’ ability to respond to
short-run factors, IT provides a fair balance between the discipline and
accountability of strict rules on one side, and the flexibility of a more
discretionary approach on the other side (Bernanke et al., 1999, p. 25).
In short, the nominal anchor property is, in the view of these authors, the
most essential argument for justifying the adoption of an IT framework.
2
See Cecchetti (2000, pp. 47–49) for a summary of the theoretical arguments for
price stabilization.
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Endogenous money theory and monetary policy
The monetary policy rule approach discussed above represents at least
prima facie a significant departure from the traditional view held by
mainstream economists like Friedman (1968), and a major rapprochement with the practice of central bankers across the world (De La Genière,
1981, p. 271; Goodhart, 2001). More important, the increasing focus on
short-term interest rates as the instrument with which to conduct monetary policy marks an unexpected and mostly unexplored convergence
with the policy implications of the endogenous money approach. Endogenous money is a general word for the contributions of those economists that aim to provide an integrated theory of money, production, and
speculation (Fontana, 2000). It draws on a long tradition of economic
thought that includes the works of Schumpeter (1934), Wicksell (1936),
and Keynes (1973a, 1973b, 1973c). More recently, endogenous money
theory has been promoted by the works of Kaldor (1970), Minsky (1982),
and especially Moore (1988).
The basic tenet of this theory is that at any given time changes in the
stock of money in a country are the outcome of the loans–deposits supply process. In modern capitalist economies, it is argued, monetary
changes mainly originate in shifts of the economic variables that affect
the level of productive or speculative activities. Monetary changes thus
lie within the economic system. They are the result of the normal activities of economic agents.
The story usually unfolds as follows: for the sake of simplicity, endogenous money theorists often consider a pure overdraft economy composed of firms, banks, wage earners, and a central bank. Firms must be
able to get command of an appropriate quantity of credit for the organization of productive and speculative activities. Banks are then the providers of liquidity in the form of loans, at a markup price (of their own
choice) on the bank rate set by the central bank. Wage earners are the
suppliers of labor services in exchange for firms’ payments. If internal
transactions between firms are ignored, then the wage fund is nothing
but the newly created flow of liquidity. Wage earners use part of that
liquidity on the commodities markets and save the remaining. The most
liquid component of those savings represents the change in the stock of
money of a country. In a nutshell, the money stock is credit-driven and
demand-determined (Fontana, 2001).
From this simple representation of endogenous money theory it is
possible to derive two of its main propositions for conducting monetary
policy. First, the main control instruments of central banks are (a) the
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basic short-term interest rate, or bank rate (repo rate in the United Kingdom), and (b) direct credit controls. However, (selective) direct credit
controls are politically unpopular and hence rarely used (Lavoie, 1996,
pp. 539–540; Rousseas, 1986, ch. 6; Wray, 1990, ch. 10). Thus, changes
in the bank rate are the most powerful way to influence base rates and
indirectly the loans–deposits supply process.
By contrast, to the policy prescriptions of mainstream theory, endogenous money theorists maintain that central banks have very limited
power to impose, via the monetary base multiplier, any quantitative constraint over changes in the stock of money. The targeting of monetary
aggregates is per se an inefficient monetary policy rule. The growth of
monetary aggregates is in fact the residual of the economic process and
as such it can hardly be used to control key economic variables like
inflation, output, and employment. More precisely, monetary aggregates
are effects rather than cause of price and output growth (Goodhart, 2001,
pp. 14–16; Lavoie, 1996, p. 534). Their rate of expansion is a function
of the level of aggregate net deficit spending in the economy, which in
turn, is a function of the level of base rates (Moore, 1988, ch. 12). But if
monetary aggregates are effects of the behavioral functions of economic
agents, the search for a stable relationship between reserves, monetary
aggregates, and money income rests on poor foundations. A stable relationship is more likely to be the result of pure chance rather than of a
solid statistical regularity (Fontana and Palacio-Vera, forthcoming). The
modern phenomena of financial innovation—the adoption of liability
management practices by banks together with its corollary of increased
lending capacity and the ability to avert central-bank-imposed reserves
constraints through endogenous variations in the money multipliers (see
Palacio-Vera, 2001; Palley, 1996, ch. 7)—is further evidence for this
conclusion. In short, the level of reserves and monetary aggregates is
determined at the end of a complex process mostly driven by banks,
financial institutions, and firms’ concerns with, and reactions to, the
level of bank rate set by central banks.
Second, the interest rate of relevance to firms and their investment decisions is the loan rate. It is this rate, and its relationship with the bank rate
and other base rates, that should enter into the public debate of what monetary policy can and cannot do. The level of the loan rate is via a markup
approach strictly related to the bank rate set by central banks. However,
the loan rate is also one of the main control instruments of banks. Whether
or not the bank rate is changing, loans and deposits fluctuate as a result of
normal economic activities. Furthermore, as money and financial markets develop, banks are increasingly led to actively manage the composi-
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tion and the size of their balance sheets (Chick, 1986; Wray, 1992). All
this means that the channels of influence of the interest rate policy rule
are rather complex (such as, a “credit channel” versus a “money channel”) and not often properly understood (Laidler, 2001, pp. 26–32).
For instance, wage earners are also indirectly affected by, and bring
pressure on (such as, through the influence of wage claims on the amount
of credit demanded), the loan rate (Arestis and Howells, 1996; Fontana,
2001, pp. 25–31; Lavoie, 1999). Changes in the money stock are influenced by variations of the bank and loan rates. Now, as Cottrell explained, “when the money stock is above or below the level desired by
private agents, this is likely to have effects on expenditure decisions and
hence on nominal income (prices and/or output) and interest rates”
(Cottrell, 1986, p. 23). Thus, shifts in the loan rate are likely to produce
variations in the money stock, and thereby changes of prices and interest differentials as a mechanism to reconcile the flow of bank lending
with the demand for money (Arestis and Howells, 1996; Dalziel, 2001,
ch. 10; Lavoie, 1999).3
At a more basic level, the loan rate is the basis of, and responds to the
outcome of, the investment decisions of firms. More generally, payments
of interest rates on loans are a pure rent that banks extract from firms
because of their exclusive power of creating liquidity. As firms seek
ways of reducing the negative effects of those payments on their own
share of income, they may fuel an inflationary process (Fontana and
Venturino, 2001; Graziani, 1989, p. 17). In the simple pure overdraft
economy described above, once all economic activities are completed,
banks should get back the initial flow of credit plus accrued interest rate
for their services, and firms should have realized their productive and
speculative plans. But if the only money existing in the economy is equal
to the wage fund, how can firms find the amount of money for paying
the interest rate? A realistic assumption to make is that, in exchange for
the transfer of real resources (such as, direct and indirect sales of commodities), banks provide the extra liquidity to cover interest rate payments. An important conclusion from this assumption is that firms may
seek to increase their share of income by raising the output price. In that
way they can reduce both the level of real product wage paid to their
workers and the negative impact on their balance sheets of interest rate
payments (“rent-shifting effect”). However, this initiative may trigger
an inflationary process fueled by continuous increases in nominal inter3
Similar outcomes could also be produced by supply shocks like fluctuations in
“animal spirits” or productivity shocks.
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est rate and wage rate payments (Bossone, 2001, p. 873; Graziani, 1994,
pp. 125–126). Thus, the loan rate and the output price are the main variables affecting the distribution of final product between firms and banks.
The main thrust of this argument is that inflation is, at least in part, a
cost–push phenomenon. If IT is a “framework” for monetary policy,
then particular attention should be devoted to the dynamic relationship
between bank rate, loan rate, and other base rates.
Toward a converging view on monetary policy?
An endogenous money perspective
Several theoretical features implicit in the literature on monetary policy
rules and IT are of particular interest for endogenous money theory.
These features are: (i) a recognition that under an interest rate policy
rule the money supply is endogenous, (ii) the adoption of a demand–
pull inflation theory (that is, inflation is caused by excess demand), (iii)
the assumption of the existence of a real interest rate compatible with a
“neutral” long-run monetary policy, and (iv) the belief in the long-run
neutrality of money.
According to Taylor (2000b, p. 90), monetary policy can be summarized in terms of an interest rate policy reaction function, which indicates how central banks react to shocks and contingencies that inevitably
hit the economy. This approach is clearly different from the standard
textbook view of the money supply process embedded in the base moneymultiplier model. The textbook view implicitly assumes stability of both
the money supply process and demand-for-money functions. The first
condition guarantees that changes in the volume of nonborrowed bank
reserves, implemented by central banks through open-market operations, have predictable effects on the money supply (however defined).
The second condition ensures that changes in the money supply have
predictable effects on money income. However, Allsopp and Vines (2000)
have explained well that neither of these two claims holds. The control
instrument of central banks is the short-term interest rate, and its major
impact is on the loan rate set by banks. Allsopp and Vines then suggest
reversing the causal explanation of the standard textbook view: the
money supply rather than being the target of monetary policy is the
final product of the economic mechanism. Rather, it is “the interestrate instrument [that] can affect the amount of money, which is endogenous” (Allsopp and Vines, 2000, p. 7). Along these lines, Taylor points
out that an endogenous money view of the money supply process goes
hand in hand with a policy reaction function analysis of the bank rate.
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“The money supply is endogenous because the central bank must vary
[accommodate?] the money supply in order to achieve its desired interest rate settings” (Taylor, 1999b, p. 661). Similarly, Svensson has argued that in the view of the monetary policy transmission mechanism
associated to the policy reaction function approach, “the central bank
simply supplies whatever quantity of money that is demanded at the
preferred level of the short interest rate. Money becomes an endogenous variable” (Svensson, 1999, p. 611).
The monetary policy rules and IT literature reveal the existence of a
consensus around the view that money targeting is not a viable strategy
for most industrialized economies. A common justification for the abandonment of that strategy is the perception that in most countries, and
against early claims, the ratio of nominal gross domestic product (GDP)
to the money stock (that is, the income velocity of money) has proved to
be highly unstable (Bernanke et al., 1999, p. 305; Friedman, 1988;
Goodhart, 1989). Related to it there is the observation that monetary
targets were frequently missed. Under those circumstances, any attempt
to run a money-targeting policy rule is bound to lead to severe short-run
volatility in interest rates and perhaps even in money supply growth
(see, for example, Friedman, 1988, on the monetarist experiment in the
United States). In turn, the breakup of the relationship between money
and nominal GDP has been attributed to the effects of liability management practices and financial innovation (for example, De Cecco, 1987;
Fontana and Palacio-Vera, forthcoming; Goodhart, 1984, ch. 3; 1986;
Hester, 1981; Podolski, 1986).
There is also another explanation for the abandonment of a money
supply targeting policy. Even if central banks meet their money supply
growth targets, pro-cyclical variations in the income velocity of money
will tend to smooth the foreseeable pro-cyclical fluctuations in nominal
interest rates that result from money targeting. Interest rates may move
pro-cyclically, but real interest rates, as opposed to nominal interest rates,
may not necessarily follow a strong enough pro-cyclical pattern (Taylor,
1999a, p. 326). As Taylor says, “in Greenspan’s view the interest rate
elasticity of income velocity is so large that the interest rate would respond by too small an amount to an increase in output” (Taylor, 1999a,
p. 326). As a result of it, an increasingly popular view among practitioners and academic specialists is that, once central banks set short-term
interest rates, the main determinant of bank lending to the nonbank private sector is the (intended) ex ante rate of growth in aggregate demand.
In turn, net bank lending (that is, bank lending minus loan repayment) is
the main determinant of money supply growth. Therefore, causation runs
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from loans to deposits and then to reserves, and not, as in the standard
textbook story, from reserves to loans via deposits.
In this case, the potential tension within the endogenous money approach is that the endogeneity of the money supply process is seen as a
logical necessity rather than an institutional feature of some modern
economies (Graziani, 1989; Lavoie, 1996, p. 533; Moore, 1988, p. xi;
but also Chick, 1986; Howells, 1995). In other words, in the endogenous money approach there is a natural association between productive and speculative activities on one side, and the creation, circulation,
and holding of money on the other side. For example, how could the
sequential stages of a process of production ever start without a transfer
of newly created bank deposits from firms to wage earners? Similarly,
how could financial speculation ever be a significant phenomenon without the support of a growing volume of liquidity?
The literature reviewed above also deviates in another important respect from the position advocated by endogenous money theorists. The
second theoretical feature of the monetary policy rules and IT literature is
in fact the adoption of a demand–pull inflation theory. This, in turn, justifies the need to control the level of aggregate demand. But is it always the
case that inflation (or deflation) is due solely to an excess (or deficiency)
of aggregate demand? A positive answer would make the policy rule of
central banks extremely simple. “During inflations, raise nominal interest
rates; during deflations, lower nominal interest rates. Period” (Moore,
1988, pp. 269–270). But it is well known that the struggle for a larger
share of output among firms and workers could produce a wage and price
spiral, even in a situation of deficiency of aggregate demand. More generally, inflation may be cost–push through the effects of world prices (such
as energy), shortages in specific sectors (such as food prices), or increase
in interest rates (such as “rent-shifting effect”). The recent failure of the
ECB to meet the 2 percent inflation target is an example of where the
monetary authorities have ascribed the overshoot to energy and food prices.
The standard position against inflation is nevertheless just what was
described above as a simple reaction function—that is, to do it through
variations in real interest rates (for example, Bank of England, 1999).
For example, in Taylor’s rule the output gap is used as a proxy for excess
aggregate demand. Furthermore, according to Svensson (1999), the insertion of an output gap component in monetary policy reaction func4 As shown in Alonso-González and Palacio-Vera (2002), this would only be the
case if the central banks’ forecasts of the output gap and the equilibrium or neutral
real interest rate are correct. If this is not the case, the observed rate of inflation will
not converge to its target.
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tions eliminates any potential inflation bias, since output capacity is the
output target of central banks.4 Finally, output capacity is assumed, presumably under a perfect competition framework, to be consistent with
the natural-rate hypothesis. According to this literature, monetary policy
cannot systematically affect either the average rate of unemployment or
the average level of capacity utilization (Svensson, 1999, p. 626).
Similarly, the “nominal anchor” property of IT usually takes the form
of a commitment to an inflation target. This property is, in principle,
independent of the theory of inflation advocated.5 However, the validity
of an IT framework necessarily rests on the acceptance of a demand–
pull inflation theory (and on the long-run neutrality of money). The underlying assumption of IT literature is in fact that any deviation of current
output from its potential level will be temporary; that is, potential output is independent of the level of aggregate demand. Thus, in the aftermath of a disinflationary process, output will eventually return to its
initial potential path. In this way the benefits of providing the economy
with a nominal anchor may exceed the costs of a temporary deviation of
current from potential output.6 However, if disinflation lowers the potential output path, the costs of implementing an IT framework in the
presence of cost–push inflation may significantly exceed the benefits.
In contrast, endogenous money theorists generally claim that inflation
is also, if not mainly, a cost–push phenomenon associated to conflict
over income distribution (Davidson, 1994, ch. 9; Lavoie, 1996, p. 536).
Thus, in the simplest exposition of endogenous money theory the proximate determinant of inflation is the rate at which money wages rise in
excess of the growth of average labor productivity (for example, Moore,
1979, p. 133; 1988, p. 381). In turn, this proposition is supported by the
fact that money wage growth has been found to be the most significant
explanatory variable of money supply growth (for example, Moore, 1985,
p. 17; but see also Arestis and Biefang-Frisancho Mariscal, 1995).
In addition to the distributive conflicts between banks, firms, and wage
earners, changes in the level of base rates have differential impacts on
types of expenditure (such as, consumption versus investment), on regions and on sectors (such as, via the exchange rate on tradable versus
nontradable goods sectors). The monetary policy rules and IT literature
5 In practice, the support for pro-cyclical interest rates depends on a particular
theory of inflation. For instance, cost–push inflation would not lead to pro-cyclical
interest rates.
6 Even if this scenario holds, it could still be argued that the benefits might not
exceed the costs. This could be the case if the sacrifice ratio was very high—that is,
the output loss caused by a disinflationary process was very large.
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overlook these issues by not modeling the loan-creation process and by
overaggregation with one aggregate demand equation that does not distinguish between different types of expenditures.
Unfortunately, the complex and possibly unstable relationship between
the bank rate, the loan rate, and other base rates represents for endogenous money theorists a major difficulty in implementing monetary
policies. For instance, assuming that all information necessary to determine the “fair” bank rate is available, how could central banks make
sure that the corresponding “fair” base rates would prevail in the financial and money markets? Surely, banks could in part bypass the strictness of central banks by either borrowing from nonbank financial
institutions or by setting up credit arrangements between themselves.
An alternative monetary policy would be to impose direct credit control. Nonetheless, the previously described risk of disintermediation is a
reminder that there are also problems with this policy.
A third theoretical feature of the monetary policy rules and IT literature is the assumption of the existence of an “equilibrium” or “natural”
real interest rate compatible with a neutral long-term monetary policy.
This “equilibrium” rate plays a crucial role in the setting of the interest
rate in the policy reaction function of central banks. This is explicit in
Taylor’s writings (Taylor, 1993, p. 202), where the assumption that r n is
close to the steady-state growth rate denotes the underlying classical
proposition that in the long run the real interest rate is determined by the
marginal product of capital. When the output and inflation gaps are nil,
central banks should set the bank rate equal to the real interest rate (r n )
at which investment is equal to saving (that is, loanable funds theory).
But, apart from the theoretical problems of conflating the bank rate with
the rate that clears the loanable funds market, endogenous money theorists reject the notion of a natural real interest rate (for example, Moore,
1998, p. 349). Drawing on Keynes’s theory (Keynes, 1973c, p. 293),
they argue against the classical dichotomy between the real and monetary sectors. They advocate a monetary theory of the interest rate in
which changes in real income bring the level of saving in line with the
level of investment.
Related to this point is the question of the causality between the level
of bank rate set by central banks and the rate of return on investment
projects. Against the standard Wicksellian interpretation of the natural
rate of interest, endogenous money theorists would suggest that the interest rate is a historical and conventional datum. Furthermore, the real
rate of return on capital is not a technological given (Seccareccia, 1998).
Again, drawing on Keynes’s theory (Keynes, 1973a), they argue that the
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real rate of return on capital relies on the profit expectations of firms,
and hence it is at least in part independent of the objective technical
conditions of production.
Keynes used this idea to introduce the potential conflict between domestic and external objectives of central banks. In the case of low profit
expectations, as is the case for severe depressions, central banks may
not be able to afford effective reductions in the base rates without causing a large outflow of domestic currency (Fontana, forthcoming). More
generally, to the extent that deflation leads to extrapolative expectations
of further deflation, cheap monetary policy would not be effective. In
those situations, “low nominal interest rates would represent ex ante
neither cheap money to prospective borrowers nor low returns to prospective lenders. Anticipated deflation raises both the ex ante real costs
of borrowed funds and the ex ante real return on money balances. The
reduction in demand for bank credit (aggregate deficit spending) and
increase in demand for bank deposits (aggregate surplus spending) both
serve to depress effective demand for currently produced goods and services” (Moore, 1988, p. 248). Leaving aside these general considerations,
it is still the case that firms would use base rates to determine the rate of
return on their investment projects. Thus, assuming a constant relationship between bank and loan rate, an increase of the bank rate is likely to
raise the required return on real assets, and conversely, a reduction of it
is likely to reduce the required return on capital (Moore, 1998, p. 350).
Finally, closely linked to the notion of an “equilibrium” real interest
rate is the acceptance in the monetary policy rules and IT literature of
the proposition that, in the long run, money is neutral. The acceptance
of this proposition is again evident in the output gap component of
Taylor’s rule and in the implicit identification of trend output with potential output. It is thus accepted that, in the long run, (a) the level of real
GDP and the rate of employment is supply-side-determined, and (b) the
supply of capital and the supply of labor (as well as the rate of technical
progress) are not significantly influenced by the time path of aggregate
demand. In this context, all monetary policy can do in the long run (its
short-run stabilization role is not thrown into doubt) is to determine the
level of inflation. At the aggregate level, this means that a nonaccelerating
inflation rate of unemployment (NAIRU) exists and that it is independent of the level of aggregate demand. However, the notion of the NAIRU
and its nature as a supply-side-determined equilibrium rate of unemployment has been openly criticized by several endogenous money theorists like Galbraith (1997) and Sawyer (2001, 2002). In particular, Sawyer
(2002) has shown that the level of the NAIRU is only compatible with a
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particular level of aggregate demand and that in most models of the
NAIRU, the level of aggregate demand is measured in terms of the level
of real money balances. Thus, in the absence of a central bank that implements an interest rate policy reaction function with a view to guaranteeing price stability, the adjustment of aggregate demand to the
supply-determined level of output must rest upon the adoption of a real
balance adjustment mechanism, and of an exogenous money supply
approach. The acceptance of this adjustment mechanism is a rather problematic, though rarely discussed feature of the NAIRU. As Sawyer explains, the adoption of a real balance adjustment mechanism runs against
the fact that in modern economies money is mainly credit-driven and
demand-determined (Sawyer, 2002, p. 67). Now, in both the mainstream
and endogenous money literatures, aggregate demand and supply are
reconciled through CB-induced changes in short-term interest rates. However, in the mainstream literature on monetary policy changes in interest rates only affect aggregate demand—so that it is aggregate demand
that adjusts to aggregate supply—whereas in the endogenous money
literature they may also affect aggregate supply through their impact on
capacity output. As a result of it, in the mainstream literature (nominal)
money balances are endogenously determined, whereas real money balances are exogenously fixed at the long-run supply-determined level of
output. By contrast, in the endogenous money literature, nominal and
real money balances are both endogenously determined.
The nonneutrality of money is a nonissue in the endogenous money
literature in which the creation of money always has real effects. The
reason is that endogenous money theorists start their macroeconomic
analysis from the basic idea that a flow of bank loans is a necessary
condition for financing any productive or speculative activity. More generally, the way in which loans are created necessarily influences the
level and structure of aggregate demand, and hence the output capacity
of the economy. It is only at the abstract level of general equilibrium
models that the question of whether or not money is neutral could be
addressed. But to say that money is neutral requires some standard so as
to judge whether or not money is indeed neutral. In this regard, it is
really difficult to imagine what the benchmark world would be. A further problem with those neutral money models is that it is extraordinarily difficult to adapt their hypothetical conclusions to real-world monetary
economies. By contrast, as Schumpeter says, once money is introduced
as a fundamental component of a model, we are led step by step to acknowledge that monetary conditions enter into motives and decisions of
economic agents in a way that soon “we doubt that money can ever be
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‘neutral’ in any meaningful sense” (Schumpeter, 1994, p. 278). In short,
the proposition that money is not neutral is strictly related to the analysis of the nature and origin of money and the consequent role of banks
as creators of liquidity for financing productive and speculative activities (see, for example, Davidson, 1974; Dow and Rodríguez-Fuentes,
1998, p. 15; Graziani, 1989).
Conclusions
The 1990s witnessed a convergence around the world in both the goals
and methods used to conduct monetary policy. In turn, this development
has narrowed the gap between monetary policy practitioners and mainstream academics. The prevailing consensus is that low inflation must
be a primary objective of monetary policy and that short-term interest
rates should be the main policy instrument.
The purpose of this paper was to explore the potential for a constructive dialogue on monetary policy between mainstream academics and
endogenous money theorists. Recent mainstream literature has been reviewed, and similarities and differences have been subsequently identified. The main conclusion is that any process of convergence between
the monetary policy rules and IT literature on one side and the endogenous money literature on the other side have to confront the following
four critical areas and related questions: (a) the meaning of endogenous
money, (b) the theory of inflation, (c) the theory of interest rates, and
(d) the long-run neutrality of money.
a. It has now been largely accepted that under a modern IT monetary
policy regime, the money supply is endogenous. But is endogenous money only the result of particular historical and institutional circumstances that make other monetary policy strategies
inappropriate for the time being? Or rather, is endogenous money
a logical necessity of monetary production economies?
b. Is inflation exclusively a demand–pull phenomenon, and hence
can short-term interest rates be safely used as the primary tool of
stabilization policy? Or rather, is inflation, at least in part, a cost–
push phenomenon? And in this case, what should be the role of
interest rates?
c. Does there really exist a long-run interest rate determined in the
real sector that may be used to set short-term interest rates in the
monetary sector? Or rather, is the interest rate a historical and
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conventional datum, at least in part independent of objective technical conditions of production?
d. Is money really neutral in the long run? Is it thus sound to assume
that all monetary policy can do is to determine the inflation rate?
Or rather, in modern economies in which nearly all money is creditdriven and demand-determined, is money never neutral? Can then
a change in the money supply affect the output capacity of the
economy?
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