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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. 04 fontana.pmd 547 04/30/2002, 3:35 PM 548 JOURNAL OF POST KEYNESIAN ECONOMICS 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): 04 fontana.pmd 548 04/30/2002, 3:35 PM MONETARY POLICY RULES: WHAT ARE WE LEARNING? 549 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 04 fontana.pmd 549 04/30/2002, 3:35 PM 550 JOURNAL OF POST KEYNESIAN ECONOMICS “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). 04 fontana.pmd 550 04/30/2002, 3:35 PM MONETARY POLICY RULES: WHAT ARE WE LEARNING? 551 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. 04 fontana.pmd 551 04/30/2002, 3:35 PM 552 JOURNAL OF POST KEYNESIAN ECONOMICS 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- 04 fontana.pmd 552 04/30/2002, 3:35 PM MONETARY POLICY RULES: WHAT ARE WE LEARNING? 553 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. 04 fontana.pmd 553 04/30/2002, 3:35 PM 554 JOURNAL OF POST KEYNESIAN ECONOMICS 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 04 fontana.pmd 554 04/30/2002, 3:35 PM MONETARY POLICY RULES: WHAT ARE WE LEARNING? 555 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- 04 fontana.pmd 555 04/30/2002, 3:35 PM 556 JOURNAL OF POST KEYNESIAN ECONOMICS 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. 04 fontana.pmd 556 04/30/2002, 3:35 PM MONETARY POLICY RULES: WHAT ARE WE LEARNING? 557 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. 04 fontana.pmd 557 04/30/2002, 3:35 PM 558 JOURNAL OF POST KEYNESIAN ECONOMICS “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 04 fontana.pmd 558 04/30/2002, 3:35 PM MONETARY POLICY RULES: WHAT ARE WE LEARNING? 559 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. 04 fontana.pmd 559 04/30/2002, 3:35 PM 560 JOURNAL OF POST KEYNESIAN ECONOMICS 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. 04 fontana.pmd 560 04/30/2002, 3:35 PM MONETARY POLICY RULES: WHAT ARE WE LEARNING? 561 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 04 fontana.pmd 561 04/30/2002, 3:35 PM 562 JOURNAL OF POST KEYNESIAN ECONOMICS 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 04 fontana.pmd 562 04/30/2002, 3:35 PM MONETARY POLICY RULES: WHAT ARE WE LEARNING? 563 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 04 fontana.pmd 563 04/30/2002, 3:35 PM 564 JOURNAL OF POST KEYNESIAN ECONOMICS ‘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 04 fontana.pmd 564 04/30/2002, 3:35 PM MONETARY POLICY RULES: WHAT ARE WE LEARNING? 565 conventional datum, at least in part independent of objective technical conditions of production? d. Is money really neutral in the long run? 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