OilfWEY
HD28
.M414
no.
MONEY, OUTPUT, AND PRICES:
EVIDENCE FROM A NEW MONETARY AGGREGATE
by
lulio J. Rotemberg, John C. Driscoll,
and James M. Poterba
Latest Revision: July 1991
Working Paper No. 3326-91-EFA
MASSACHUSETTS
INSTITUTE OF TECHNOLOGY
50 MEMORIAL DRIVE
CAMBRIDGE, MASSACHUSETTS 02139
4r
MONEY, OUTPUT, AND PRICES:
EVIDENCE FROM A NEW MONETARY AGGREGATE
by
Julio J. Rotemberg, John
C.
Driscoll, and James M. Poterba
Latest Revision: July 1991
Working Paper No. 3326-91-EFA
Ofe'V'jy
UM.
SEP
UBRMMES
199)
1
ftBCBVB)
MONEY, OUTPUT, AhfD PRICES:
EVIDENCE FROM A NEW MONETARY AGGREGATE
Julio
J.
Rotemberg
MIT & NBER
John C. Driscoll
Harvard University
James M. Poterba
MIT & NBER
May
1991
Revised July 1991
ABSTRACT
This paper develops a new utility-based monetary aggregate which
equivalent aggregate.
households
monetary
to obtain the
assets.
It
r^
,
is
label the currency-
same
liquidity services that they get
from
their entire collection of
equals
I
where
we
This aggregate equals the stock of currency that would be required for
the rate of return
on a zero
'b,t
liquidity asset, while
represent the yield and stock of monetary asset
i
at
time
t.
rj
We
,
and
nij
t
respectively
compare the
ability
of the
aggregate and conventional aggregates, such as Ml and M2, and other indicators of
monetary policy to forecast real activity. The CE aggregate has more predictive power for
output and prices than standard aggregates, and the time path of the estimated output
response is more consistent with broad classes of theoretical models.
new
We
are grateful to the National Science Foundation for research support, to Michael
Board and the NBER 1991
William Bamett, Anil Kashyap, Richard
Porter, Brian Reid and Piyu Yue for providing us with data. This research is part of the
NBER Programs in Economic Fluctuations and Financial Markets and Monetary Economics.
Woodford and seminar
Summer
participants at the Federal Reserve
Institute for suggestions, as well as to
1
How
monetary shocks
macroeconomics.
The
have been explored in
in
affect prices
and real activity are two of the central questions in
implications of various theoretical models addressing these issues
literally
what money does, there
hundreds of empirical papers.
which
studies use relatively arbitrary rules in deciding
By choosing
not.
to study
how
activity, researchers implicitly
the monetary base, or
made judgments about
Narrow defmitions of money, such
liquidity services.
GNP
A more
M2,
Broader defmitions, such as
This
is
at predicting
or
M2,
GNP.
and
affects prices
real
the identity of monetary assets.
give equal weight to a variety of assets
in different industries!
by the value of the
This principle underlies Bamett's (1980) derivation of
The continued widespread use of conventional aggregates
In this paper
shown Divisia aggregates
we propose
currency-equivalent (CE) aggregate, which
is
Ml,
and which are
hardly more defensible than constructing a
particularly surprising, since research has repeatedly
aggregate
assets are monetary,
attractive approach involves weighting different assets
Divisia monetary aggregates.
good
Most previous empirical
by adding together the physical volume of output
monetary services they provide.
as
is.
as the base, exclude a variety of assets that provide
with arguably quite different liquidities.
measure of
money
consensus on what
is little
Despite the substantial interest
is
a
new monetary
to
be
is
at least
aggregate, the
related to the Divisia aggregates.
The
CE
a time-varying weighted average of the stocks of different monetary assets, with
weights which depend on each asset's yield relative to that on a benchmark "zero liquidity"
asset.
One
it is
attractive feature of the
CE
aggregate
the stock of currency that yields the
same
is that it
has a straightforward interpretation:
transactions services as the complete
2
constellation of
monetary
Thus, currency gets a weight of one in our aggregate.
assets.
Other assets with higher rates of return get a smaller weight because their marginal liquidity
services are lower.
After deriving our aggregate and summarizing
Divisia aggregates,
output.
We
changes
in various
We
we
first test
use
it
to
its
relation to both conventional and
develop new evidence on the correlation between money and
whether, in post- 1959 U.S. data, there
any correlation between
is
monetary aggregates, including CE, and subsequent movements
then study whether these correlations suggest that changes in
in output.
money cause changes
in
output.
Most models where exogenous changes
this effect will
be short lived and
one percent increase in prices.
in
money have an
that, eventually,
Thus
to
leads to a
effects. Indeed,
monetary shocks
responds permanently to them are probably
Rather, money-income correlations of this type can easily be interpreted as being
monetary endogeneity with respect
income.
money
that
the impulse response function of output with respect to
that fail to display this property, so that output
due
on output predict
a one percent increase in
monetary shocks ought to exhibit pronounced, short lived
not causal.
effect
Our evidence suggests
to either
that shocks to the
income or other variables which
CE
affect
aggregate are both more strongly
correlated with subsequent changes in output, and have a shorter lived "effect" on output,
than shocks to
more
traditional
monetary aggregates.
Several recent papers, for example
Bemanke and Blinder (1990) and Friedman and
Kuttner (1990) have suggested that interest rates and interest rate spreads are better indicators
of monetary policy than the monetary aggregates themselves.
We
therefore
compare
the
3
predictive
power of
comparison
CE
is
aggregate.
these variables to the predictive
CE
the
CE
This
aggregate.
of particular interest because some changes in interest rates directly affect the
We
fmd
that the correlation
and subsequent movements
the
power of
aggregate.
On
between
interest rates,
and
in output is stronger than the correlation
interest rate spreads,
of these variables and
the other hand, the impulse responses of output to these variables do
not correspond to the pattern one would expect
if the
economy were responding
to
a
monetary disturbance.
This paper
is
divided into five sections.
monetary aggregate and compares
it
The
first
derives the currency-equivalent
with existing Divisia aggregates.
the data inputs needed to construct our aggregate, and reports
univariate time series properties.
causes real output, and compares
monetary policy.
It
The
its
third section tests
Section two describes
summary
statistics
on
its
whether the new aggregate Granger-
predictive performance to that of other indicators of
also tests the long run neutrality of
money with
respect to output.
Section four presents a parallel analysis of the effect of monetary shocks on prices,
comparing the findings for the currency equivalent aggregate with those for more
measures.
There
is
traditional
a brief conclusion which sketches the implications of our findings for
competing theories of the monetary transmission mechanism.
4
The Currency-Equivalent Monetary Aggregate and
1.
1
1
Its
Properties
Derivation
Some
assets can readily be used for transactions. Individuals
pay for the liquidity
that
these assets offer by foregoing the higher expected returns that are available on other, less
liquid assets.
account, and
assuming
Holding one dollar
it
in
currency costs more than holding one dollar in a
presumably generates greater liquidity services.
that individuals derive utility
from holding
We
certain assets.
NOW
formalize this idea by
Our
results could also be
obtained by assuming that individuals and firms incur transactions costs which depend
volume of
negatively on asset-holdings and positively on the
We
consider an individual whose expected lifetime
transactions.
utility in
period
t is
given by
V=E,J2^%j
(1)
y-0
where Ej takes expectations
as of time
the level of instantaneous utility at
and the levels of n monetary
currency holdings
at
t.
We
t.
t, /3 is
This instantaneous
assets, mjt.
assume
an intertemporal discount factor, and Ui gives
that
We
let
i
utility
range from
depends on consumption, C„
to n-1,
U, equals U(Ct,Li), which
is
and define
concave
in
mo,, as
both
arguments, where
The
function f
Any
is
an aggregator function for liquidity services.
desirable monetary aggregate
under two assumptions about
this
must
in
some way correspond
to L,.
We
show
that
aggregator function, L, equals the currency equivalent (CE)
5
Our
monetary aggregate introduced by Rotemberg (1991).
aggregator function
is
homogeneous of degree
one.'
assumption
first
Second,
we assume
is
that the
that f is additively
separable in currency and other monetary assets:^
f{mQf,m^f,m2f,...) = h{mQ,) + k{m^f,m2t,...)
This assumption gives a central role to currency, since
liquidity services
assets
by holding
sufficient currency.
might be controversial,
it is
it is
While
(3)
possible to obtain any level of
the inessentiality of other
consistent with the fact that circulating
monetary
media of exchange
appear to predate the introduction of other liquid assets.
Our assumption
that the aggregator function f has constant returns to scale implies that
Lt =
E fum„
(4)
/-o
where
fj
i
is
the partial derivative of f with respect to the quantity of monetary asset
evaluated in period
t.
i
Since (3) implies fo,t=ho,„
'The key part of this assumption
is
that f
be homothetic since
it
can then be converted into a
homogeneous function by transforming U. As shown by Samuelson and Swamy(1964), homotheticity
considerably simplifies the construction of index numbers.
It is
required for Divisia aggregates to be
path independent as well as to ensure that the true economic index lies between the Paasche and the
Laspeyres index.
^e would obtain
identical results if
we
treated currency as a collection of disparate assets
(denominations) which provide different types of liquidity.
of type
j at t,
f
would have
to
Letting
Cj
,
denote the holding of currency
be given by
9i^.t'^.t'-) ^ Km-ij,m2t,...)
so that f
is
additively separable in a function that depends
function that depends on the other monetary assets.
on the various currency
assets
and a
hirriQf)
The
first
This implies that h
is
all
^5)
fo^m^r
equality in (5) implies that the derivatives of h
must be equal, so the second and
zero.
= h^frnQf =
and of
with respect to
ho.,mo,,
higher derivatives of h with respect to
a linear function, and that the derivatives
h<),
nio,,
and
hIq
,
must be
fgi
are
constants.'
Our assumptions
thus imply that currency does not lose
the quantity of currency rises.
appear, because
fiinction
We
U
is
it
does not imply
concave
also
assume
and t+1
known with
focus on a particular asset of
certainty at time
rb,i.
ability to provide liquidity as
not as disturbing as
might
it
that overall utility is linear in currency.
that there are assets that
we
nominal return equal
is
in total liquidity so that, indirectly,
simplicity,
is
This implication
its
t."
it is
concave
in
do not provide monetary
at first
Rather, the
currency as well.
services.
For
this
form whose nominal return between time
We
call this the
In our empirical work,
benchmark
we measure
r^
,
asset
and
t
let its
by the return on prime
'Interpreting traditional simple-sum monetary aggregates as equalling total liquidity services also
requires linearity assumptions
on
f
but these are
much
stronger than those implies by our separability
and homogeneity assumptions. In particular, the function f must be linear in all its arguments with
equal coefficients for each. But this implies that all monetary assets provide the same remrn.
•Even
apply.
if all
actual assets without liquidity services had stochastic returns, the analysis
However, the benchmark return would have
liquidity services
and with a nonstochastic payoff
in
to
would
be the return on an imaginary asset with no
period t+1.
^
7
grade commercial paper.
The benchmark
return has the standard property that
where
P,
Equation
-r,,)E,^^LPi^^M:^
- (1
UJ,C„Lr)
measures the price of a unit of consumption
consumer
(4) says that the
profile and a profile in
indifferent
is
which he increases
in
terms of currency
between
his holdings
(6)
at date
his current (optimal)
t.
consumption
of the benchmark asset by reducing
current consumption and uses the proceeds to increase future consumption.
Monetary
assets
do not share
their stock raises the level
utility
property of the benchmark asset because increasing
this
of liquidity services received by the consumer.
from lowering current consumption
by further
liquidity services.
In particular, for monetary asset
Substituting the expectational term
'We chose
from
(1
the loss in
by both additional future consumption and
is offset
UJ,C„Lt) - U,{C„Lr)ht -
Thus
i
-r^,)E,^tPi^^Li:^.
(6) into (7),
we
(7)
obtain
the commercial paper rate because the market for prime grade commercial paper
is
broad and the instrument is fairly safe. We also tried the Federal funds rate, which pertains to an
even safer (though less widely held) instrument. The results were identical, so we only report the
results for
commercial paper.
We did
not use Treasury
1980 period, these yields were below the
accounts would appear to be
puzzling.
Our own
more
interest rates
bill
returns because during
much of the 1960-
on passbook saving accounts. Since saving
useful for transactions purposes than T-bills, this behavior
tentative explanation
is
that
Treasury
bills
provide other types of services.
is
They
are well understood throughout the world, they can easily be used as collateral and they can be posted
as
margin
services
in financial transactions.
we do
Because
we
not include Treasury bills in L.
our analysis as long as the
utility
function
is
think these services are different from transactions
The
existence of these services does not invalidate
separable in consumption, L, and these services.
1
ULh.
^
-
'
This says that the consumer
by one
unit,
and increasing
is
indifferent
his holdings
(81
Uc.
'b.t
between reducing
his holdings
of monetary asset
of the benchmark asset by (l+r; J/(l+ri,i).
change leaves the value of the individual's portfolio
at the
i
This
beginning of period t+
However,
unaffected, so that future consumption can remain unaffected as well.
this
portfolio change allows the individual to raise his current consumption by (rb.rr,,t)/(l+r,,,).
The
gain in
utility
from
his reduced holdings of
For currency,
Since
U
is
this
consumption increase must therefore equal the
monetary asset
an arbitrary concave function,
equations (8) and (9)
now
from
i.
the analogue of equation (8)
normalization ensures that
fall in utility
total liquidity,
we
L,
is:
can normalize
is
measured
f so that
in units
fo,,
equals one.
of currency.
This
Combining
yields
=
ikiA'.
(10)
/i,
The
level of the liquidity aggregate L,
^
=
from equation
(4) then satisfies
E-^'"<,-cf,
'
^b.t
This expression defines the currency-equivalent monetary aggregate.
(11)
9
Actually, our derivation has considered an individual's holding of monetary assets so
that L, in (11) is the level
in individual asset holdings, the
to
However, because (11)
of liquidity held by an individual.
aggregate asset holdings.
sum of
the L's held
by
all
individuals
is
linear
simply (11) applied
is
Thus CE, provides an accurate measure of the sum of the
individual L's even if the aggregator functions f differ for different individuals.
CE
The
as currency
aggregate has the attractive property that assets which do not pay interest, such
and
travelers' checks, are
added together with weights of unity.
Other assets are
added with weights between zero and one, with higher-yield assets receiving lower weights.
This makes intuitive sense since these assets must, given their higher returns, provide smaller
liquidity services.
The benchmark
asset, in particular,
provides no liquidity services.
Therefore, by the same logic, assets whose returns equal or exceed those of the benchmark
asset
do not contribute
CE
The
new
assets,
to the
currency equivalent aggregate.*
included in the monetary aggregate
One
shows
that
is
are introduced, they can be added to the
is
are "liquid enough" to be
resolved by reference to their interest yield.
interesting interpretation of this aggregate is developed in
assuming
static expectations,
expenditures on liquidity services.
which
NOW accounts,
such as interest-bearing
The problem of deciding whether such accounts
aggregate.
When
aggregate also adapts easily to changes in the financial environment.
the total
amount of
He
CE, equals the expected present discounted value of
These expenditures
interest
Bamett (1991).
in period
t
equal Ej
(r^
,
- fj
Jm;,,
foregone by holding monetary assets instead of the
'Although many assets promise yields greater than those on the benchmark
necessarily evidence that liquidity services are provided
simply reflect differential risk across assets.
by the benchmark
asset, this is
asset.
Rather,
it
not
could
10
benchmark
asset.
their level divided
1.2
Under
static expectations, the
by the
rate of return
CE
Propenies of Divisia and
on the benchmark
asset, yielding
closely resembles the Divisia monetary aggregates
Both types of aggregates attempt
derived from monetary assets.
CE.
Aggregates
The currency equivalent aggregate
proposed by Bamett (1980).
present value of these expenditures equals
to
measure the
sub-utility, L,,
This sub-section compares these two approaches to monetary
aggregation.
The
principal advantage of Divisia aggregates
is
that their derivation requires
assumptions only that the aggregator function f be homogeneous of degree one.
weak assumption and
in a continuous time setting without uncertainty, the
Divisia aggregate gives the exact value for the change in L,.
L
only under stronger assumptions,
However,
it
it
would appear
D„
be
Under
change
CE
this
in the
aggregate equals
strictly inferior in this case.
has five advantages in comparison with divisia aggregates.
First, in discrete time, the Divisia
while the
to
Since the
weaker
CE
aggregate tends to drift
away from
The Theil-Tomquist approximation
aggregate does not.
the level of
L
to the Divisia index,
is
logD, = logD,., + j;
Kt-n^f^u
(
i''b.t-^-n.t-^)mu-^
,
^
VJ^^i.t^
log
k'^i.mj
\
J
J
(12)
11
Diewert (1976) shows
change
in
L
if f
change
that the
in this
index from one period to another
has the translog functional form.'
Since
introduces an approximation error.
becomes unboundedly
large.
The
CE
this error is
A
its
arguments remain bounded,
CE
second advantage of the
a
random walk with
aggregate
it
CE
in international
liquidity held
A
index
drift, it
eventually
comparisons of
If f
does
aggregate exact, but the derivatives of
is that its
level has a defmite
meaning.
L,.
They cannot
liquidity, or to evaluate the different levels of
by different individuals.
third,
and perhaps the most important, advantage of the
easily handle situations
where the function
f
changes over time.
CE
assets changes constantly.
their liquidity properties,
assume instead
For example, when
and therefore
that the utility
NOW accounts
their respective
f^,
aggregate
is that it
Such changes
of the most important challenges of monetary aggregation since the
set
can
constitute one
of available monetary
eliminate charges on checks,
change.
Divisia aggregates
provided by each asset remains immutable.
The
CE
aggregate
deals with changes in asset characteristics by incorporating the idea that, for asset holdings
not to change,
(rb,,-rj_i)/rb,,
interprets increases in
must
rise as
(rb,t-ri.i)/rb
,
much
as
fj.
The
CE
aggregate thus correctly
with an unchanged asset stock as an increase in the assets'
liquidity services.
because
f
from L.
will not drift arbitrarily far
Divisia indices seek to measure the changes in the sub-utility from assets,
be used
in the
equal to the
aggregate does not suffer from this problem.
not satisfy the linearity restriction that makes the
with respect to
Otherwise each change
is
the translog
Divisia aggregate
is
is itself
a quadratic approximation to any
homogeneous function
"superlative" in the terminology of Diewert (1976).
f,
the
12
The
function f changes most dramatically
when new
While these
assets are introduced.
introductions cannot be addressed using Divisia aggregates, they present no difficulty for the
CE
As equation
aggregate.
changes
(12) shows, the change in the Divisia index is based on the
of
in the logarithms
its
is
incorporate
A
Bamett and
introduced.
new
is
minus
his collaborators therefore use a different index
method
to
assets.
fourth advantage of the
consumers.
Because the logarithm of zero
growth rate of the Divisia aggregate equals infmity when an
infinity, (12) implies that the
asset
components.
CE
aggregate concerns aggregation across different
Equation (12), which defines the change
approximation to the change
in
in the Divisia
an individual's liquidity.
aggregate,
is
a good
However, the version of
(12) that
uses the aggregate value of the components does not generally bear any relationship to an
It
does so
other individuals.
While
individual's L.
paradigm
is
if
each individual's asset holdings are proportional to those of
this is
implied by the representative individual paradigm, this
unattractive in the case of
monetary assets because monetary transactions
generally involve a payment from one individual to another.
individual's
money
is linear in asset
Such transactions reduce one
holdings while raising those of someone else.
holdings,
it
all
remains equal
sum of
to the
Because the
individual L's even
CE
aggregate
when
individuals engage in transactions with each other.
A
final
research,
is
advantage of the
that
it
aggregate, which
simplifies the estimation of
to one, equation (9) can be
individual's
CE
demand
we hope
will provide the basis for future
money demand
equations.
With ^, normalized
viewed as a conventional money demand equation relating an
for total liquidity, L,, to the "market" interest rate
and a measure of
his
13
transactions, in this case consumption.
across individuals if either
utility
function
often use the
is
all
This equation applies directly to the
commercial paper
rate,
which
to
Estimates of
some degree
paper as our benchmark asset. However, conventional
interest rates
have no role
In contrast to the
Our
restriction
on
in the estimation
of
CE
interest rate to include in a
aggregate, which
money demand
additional unit of the Divisia aggregate
is
justifies
The
first
our use of commercial
equations often add
f implies the testable proposition that other
(9).
makes a simple
prediction about the appropriate
equation, the foregone interest cost of holding an
a complicated function of
many
interest rates.
different, equally valid,
can be computed using a formula analogous to that for the Divisia
quantity index applied to prices, while the second is obtained
liquidity
money demand equations
money demand
Moreover, for a given Divisia quantity aggregate, there are two
price indices.
the L's
individuals have identical L's and C's or if each individual's
quadratic with the same parameters.
other interest rates as well.
sum of
by the Divisia quantity index.
by dividing expenditure on
Serletis (1991) estimates systems of
demand
equations for Divisia aggregates using the latter approach.
Before closing
have many things
in
this sub-section,
common. Changes
extent that their rate of return
broker-dealer
are in
M2
it is
is
worth remembering that Divisia and
in
asset.
Thus, changes in
funds and in time deposits at commercial banks, which
but essentially yield the commercial paper
on either aggregate.
aggregates
monetary assets affect both aggregates only to the
lower than that of a benchmark
money market mutual
CE
significant
impact
This contrasts with the conventional wisdom, which holds that
money
rate,
do not have a
market accounts can be used for making payments and so must be "like" checking accounts.
14
The conventional view confuses average and marginal
money market accounts do provide
dollars invested in broker-dealer
individuals are likely to write checks on them.
The
liquidity services.
first
few
liquidity services since
Because these accounts pay
interest rates
equal to those on zero-liquidity assets, however, they also attract additional funds which will
not be used to
make payments
in the near future.
changes in these asset stocks do not affect
One
difficulty with this
portfolio of all assets.
argument
total liquidity services.
is that
Some consumers
So, starting from the equilibrium holdings,
not
all
consumers
consumers are only slowly
money market accounts do not
For these consumers,
consumers already enjoy.
"regular" checking accounts into
to
money's monthly growth
1.3
money market
rate,
As
Other
these consumers convert their
accounts, their liquidity does not
accounts
is
is
not too severe
gradual since
whatever form of aggregation
is
it
if the
then has
fall
as the
conversion
little
effect
on
used.
Comparison with Other Methods of Monetary Aggregation
There are two alternatives
the
money market
and Divisia aggregates would imply. This problem
from regular checking
raise their liquidity.
further
drifting into such assets, thereby gaining the inframarginal
liquidity services the optimizing
CE
by holding the optimal
are very sophisticated and hold their wealth in assets
that provide liquidity services with negligible losses in return.
increases in their holdings of
start
CE
aggregates.
The
first is
to the sort of aggregation that underlies both the Divisia
and
the estimation of a parametric utility function along the lines
of Chetty (1969) or Poterba and Rotemberg (1987).
Armed
with the
utility function's
parameters, one can obviously construct a measure of the utility derived from liquidity
15
services.
While we are sympathetic
to this approach, Spindt (1985) correctly argues that
it
copes poorly with changes in the liquidity characteristics of the underlying assets.
A
second approach, introduced by Spindt (1985),
is to
measure the
provided by various monetary assets using data on their turnover.
The
liquidity services
idea
is that assets
with large turnover must be more useful in transactions and so have higher liquidity services.
The problem
is that
turnover need not be a good measure of liquidity services.
For
relatively small denominations
of currency turn over more quickly than larger ones.
one would not want
money
outstanding changes.
to say the
The reason
services at the margin.
rarely
large
1.4
Slow
is that
one expects
when
all
fact that they are used only
when one must
carry
cash.*
Portfolio Adjustment
their portfolios in
will not always hold
variations in
fj.
difficulty if individuals are
response to interest rate changes.
and the variations
This problem
in (rb
is likely to
i-ri,J/rb,t
slow
to
In this case, equations (6)-(8)
do not necessarily correspond
to
be important, particularly since our benchmark
on monetary
is
quite volatile while the rates
is
not very useful in predicting output or prices.
*We do
currency to provide the same
in certain circumstances, such as
The currency-equivalent aggregate does encounter
change
Yet,
the composition of currency
Large denominations make up for the
by being particularly useful
sums of
supply changed
instance,
assets tend to
change sluggishly.' Because
rate
this
not pursue the empirical properties of this index here because Serletis (1988) shows that
'Of course, violations of the consumer's
properties of Divisia aggregates.
individual portfolios
it is
first
it
order conditions also degrade the approximation
do not lead to rebalancing of
are smaller than CE's because changes in
In the case of interest rate changes that
possible that Divisia's errors
16
sluggish adjustment
changes
is
in (rbt-rj J/r^
,
due
in part to regulatory inertia,
it is
hard to attribute the resulting
changes in the assets' liquidity services.
to
When
individuals
rebalance their portfolios only occasionally, they choose a portfolio of monetary assets such
that the each
fj's
at
f;
is
close to the
(rb-rj/ri,
expected to prevail
any moment therefore depend on the current,
in current
past, as well as
The
and future periods.
expected future values of
the interest rate differentials.
CE
In implementing the
by constructing averages of
is
aggregate,
(rb,,-ri J/rb.,
we
address the problem of slow portfolio adjustment
and using them
to
Our benchmark
measure CE.
We
also
which the
(rt,-
constructed using weights corresponding to a 13-month centered moving average.
consider a 37-month centered moving average, as well a "fixed weight"
ri.t)/rb,t's
2.
CE
in
case
are replaced by overall sample averages.
Data and Summary
Statistical Properties
Data Construction
2.1
We
include eight component assets in the currency equivalent aggregate.
currency (CUJ, travelers' checks (TCJ, and demand deposits
The
interest
paying assets are other checkable deposits (OCDt) such as
savings accounts at
thrift institutions (SSL^),
money market accounts
interest rates
(DDJ ~ do
at
have a bigger
Three
not yield interest.
NOW accounts,
savings accounts at commercial banks (SCBJ,
commercial banks (MMCB^) and money market accounts
effect
on the
latter.
~
at thrift
17
institutions
aggregate
(MMSL,).'° Using these symbols as subscripts
to identify returns, the
given by:
is
CEf
=
CUf
TCf + DD,
+
+
{^-!^£2d)OCDf
+
(l-^')SSZ.,
'cp.f
^CP.t
For the reasons given
in the previous section,
Because even
this aggregate's
frequency interest rate changes,
weights currency equivalent."
rate spreads with the overall
we
rate, are
(13)
^CP,t
our benchmark estimates of the currency
moving averages of
interest rate spreads as
short-term fluctuations are sensitive to high
also consider a second aggregate, labelled the "fixed
In this aggregate
we
replace the 13-month average interest
sample average differentials.
Data on the quantities of various monetary assets
commercial paper
+
'cp.f
^CP,t
equivalent aggregate use 13-month centered
weights.''
CE
that enter equation (8), as well as the
drawn from Federal Reserve Board
Statistical
Release H.6.
The
data are available at a monthly frequency, seasonally adjusted, for the period since January
1959.
Data on
available.
Our measure of
'"Ml equals the
deposits.
M2
monetary
interest rates corresponding to the
sum of
includes
all
roco.t.
the interest rate
on other checkable
currency, travellers checks,
monetary
assets in
Ml
assets are not as readily
demand
deposits, is an average
deposits and other checkable
plus savings deposits, small denomination time
deposits, short-term (overnight) repurchase agreements and Eurodollar deposits, and
mutual fund shares.
We
assume
that the last
and consequendy give them no weight
in
our
two components of
CE
aggregate.
this aggregate yield
M3,
a
still
money-market
market returns
broader aggregate, includes
large-denomination time deposits and term repurchase agreements and Eurodollar deposits.
"We
replace, for example, rocD./rcp.t with
its
13-month average centered
months of the sample, we use the average
months instead of the centered moving average.
the first (last) 13
in
month
t.
For each of
interest rate ratio for the first (last) 13
18
across various types of interest-bearing accounts
The
interest rate
on savings accounts
accounts, t^cba, fMMCB.i
^d
r^MSL,,
at
computed by the Federal Reserve Board.
commercial banks as well as those on money market
constructed the interest rate on savings accounts at thrifts,
1986,
when
interest rates at thrifts
these accounts, as reported
maximum
relating the
occasional
FHLBB
r^sut, in
two
parts.
were deregulated, we use the average
by the Federal Reserve Board.
rates for thrifts using rates at
We
were also provided by the Federal Reserve Board.
Our imputation
commercial banks.
allowable interest rates
Before 1986,
relies
Since mid-
interest rate paid
we impute
on
interest
on regulations
and commercial banks, as well as
at thrifts
surveys of average interest rates paid at these
institutions.'^
For part of
our sample, the interest rate on passbook savings accounts exceeded that on commercial
We
paper.
assume
that these interest rates
were equal
in these cases, thereby setting the
weight on the associated asset stock to zero.
Figure
1
plots
Ml
and the currency-equivalent aggregate defined
aggregates are drawn on the
are generally similar.
In particular,
OCD,
is
difference between the
much more
periods.
When
While
same
CE
includes
more
given a smaller weight in
two aggregates
sharply than
Ml
in
is that
assets,
CE
Mi's
some periods and
These pronounced changes
in
CE
rate of
The two
and growth rate
that their size
many of
than in
CE
these are given small weight.
Ml. The most
growth
is
striking
smoother.
CE
rises
also declines steadily during certain
are associated with changes in interest rates.
the commercial paper rate changes, the rates
'^or the 1959-1970 period, we assumed r^sL,
1970-1973. For the 1973-1979 period we assume
make crude
shows
scale so the Figure
in (13).
=
on regulated monetary
t^ce.i
Tssui
+
-75.
= 5.24%,
assets often
This additive factor was .50 for
and for the 1979-1986 period,
estimates using occasional surveys of interest rates paid.
we
19
change
less than proportionately.
Thus, as an example, declines in the commercial paper
on OCD,
rate tend to raise rocoVrcp,, so that the weight
falls.
The
result is that aggregate
itself falls as well.
Stationaritv Properties of Alternative Aggregates
2.2
The
apparently cyclical behavior of
CE
raises the question
traditional aggregates exhibit different stationarity properties.
CE
of whether
This issue
and
important because
is
part of our subsequent analysis will focus on the long-run effects of monetary shocks on the
level of
economic
Table
two
CE
1
activity.
reports standard Dickey-Fuller tests of the null hypothesis that
aggregates contain unit roots.
These
tests are
Ml, M2, and
the
equivalent to testing whether in an
equation of the form
log/If, =
the 7i's
sum
to one.
The
trend, to equal to zero
reported in the
first
and also
^t^Y,U
^''^^
Y/"ogA^M ^ ^f
tests
allowing
it
be unrestricted.
column, suggests that the hypothesis
the hypothesis that there
that the
^
table reports tests constraining B, the coefficient
rejected for any of the aggregates.
aggregates.
a
By
contrast
when B
a unit root can be rejected for
is
CE
on high frequency movements
rejection of nonstationarity.
are
a unit root cannot be
unrestricted (the second column),
CE, though not
for the other
This rejection reflects the cyclical patterns displayed in Figure
dependence of
linear
The former, which
that there is
is
on the
in interest rates
1,
and suggests
accounts for the
20
These
to
compare
the properties of
specifications, for
CE
has one unit root as well.
assume instead
of CE.
to treat the stationarity
with those of the traditional aggregates.
We
wish
Conventional
example Kormendi and Meguire (1984) and Stock and Watson (1989),
treat the latter as nonstationary.
3.
how
results leave us with a choice as to
that
CE
is
Our
basic specifications will be therefore
However, we
will also discuss
how
the results
assume
that
CE
change when we
stationary.
Testing Methods
Developing a new monetary aggregate
is
of some
about the evolution of the money supply in the United
differ
from previous aggregates
real activity. '^
We
in the
evidence
it
intrinsic interest for
States.
what
it
reveals
The new aggregate may
also
presents on whether monetary shocks affect
follow the tradition of Sims (1972) and perform causality tests to see
whether various measures of money and monetary policy have significant predictive power
for future output realizations.
Under the assumption
exogenous monetary impulses, these
We
measure
for married men.
real activity
The
latter is
tests
by both
that the residuals in (14),
e*^,,
are
inform us about the influence of money on output.
industrial production and
by the unemployment
rate
a particularly useful measure of labor market tightness
because, unlike other unemployment rates which are partly contaminated by decisions to
leave the labor force, very few married
When we
men withdraw from
the labor force.
use industrial production as our measure of activity y, the estimated equations
are of the form
"Blanchard (1990) surveys the voluminous prior
literature
on
this issue.
21
AIny, = a + 6f + p(Z.)Alny,.i +
The polynomials
/3(L)
vCqAlnm,
and 7(L) are of 12th order which seems natural given
analyzing monthly data.
When we
industrial production has a unit root.
to
use
its
level, not its first difference, in (15)
be stationary.
we assume
in industrial production.*'*
is
money.
This
we have
with output.
shocks.
These are changes
changes
in the
demand
directly
and
would be
exogenous changes of
that, if these
money
itself
first
likely
included a
difference
has a unit root for, in
it
makes sense
to
on output.
judge monetary aggregates
In practice, there exist three separate kinds of monetary
in central
bank policy, changes
for monetary assets.
The
first
two
justifiable to treat the correlations
this type
e*'','s
in the financial
system and
affect the supply of
were the only influence on the stock of money.
were the only disturbances,
theoretically
data, the inclusion of this trend has a relatively
money
of money and output as causal
We now
more appropriate monetary
aggregates ought to be more closely linked to output than other aggregates.
"For our
more
monetary shocks of (14) are functions only of current and lagged differences in
their correlation
argue
if
Equation (15) can thus capture the causal effect of the
it
is
are explaining the behavior of the change
reasonable
This brings us to the question of whether
by
because the unemployment rate
when we
is
of
study the behavior of the unemployment rate
Equation (15) assumes that only the logarithmic
correlated with output.
this case, the
are
that the logarithm
Following the suggestion of Stock and Watson (1989)
deterministic trend in this regression even
of money
we
that
Industrial production enters the equation in logarithmic first
differences because, following Nelson and Plosser (1982),
we
05)
+ ef.
minor
effect,
however.
After making
if
22
this case,
we
return to the issues that plague the interpretation of all studies of money-output
correlations.
Both changes in central bank policy and changes
economy only through
their effect
interest rates
and economic
these shocks
on economic
that
the
more
activity.
L
L
which, via the
money demand
L
Therefore, measures of
activity.
closely approximate
economy. In
on
in financial institutions affect the
equation
summarize the
(9), affects
effect of all
This means that one should fmd that monetary aggregates
ought
be more closely linked to subsequent changes in
to
particular, they should be
more closely linked
to output than arbitrary
aggregates or even than variables which are more strongly influenced by the central bank,
These variables would be particularly poor proxies
such as the monetary base.
exogenous changes
in
L
if
the monetary authority chooses
its
for
policy to neutralize
some of
the
changes in financial institutions.
Any
money
study of the correlation of
is set
endogenously.
money with output
In particular,
faces the problem that the level of
when money demand changes exogenously, money
supply probably accommodates the change in
money demand
cannot be fully resolved without a structural model of the
assets
which
is
well beyond the scope of this paper.
neglect of this endogeneity
this
may
is
some
extent.
demand and supply
This problem
for liquid
While our, and our predecessors',
mainly a matter of expedience
it is
important to point out that
not be a very large problem in practice.
Endogeneity has two components.
that
to
money demand
rises
The
when economic
first,
stressed
activity rises
by King and Plosser (1984),
exogenously and
that the
money
is
23
money demand.'* One expects
supply then accommodates the increased
increases in economic activity to lower prices so this story
monetary shocks.
rise less rapidly after positive
be the case, so
type of endogeneity
this
may
We
these exogenous
would predict
show below
would
that prices
that this
does not seem to
The second form of
not be very important.
endogeneity arises when there are increases in money demand that are unrelated to
exogenous changes
money supply
In the absence of any
in output.
response, these ought to
have the same effect as monetary contractions, reducing output and prices.
supply
endogenous and responds
is
partially, the resulting increases in
associated with subsequent reductions in output and prices.
associated with both price and output increases,
With these provisos, we
by
changes in money affect economic
and issues pertaining
rigidities
7(L)
to explain
money ought
to
be
Insofar as monetary increases are
problem may be minor as well.
=
activity.
and
we
interpret rejections as suggesting that
There are many
to the distribution
factors,
such as nominal
of newly supplied monetary
could make monetary shocks non-neutral in the short run.
however,
money
absence of correlation between money and output
test for the
testing the null hypothesis that
this
If the
It is
much more
permanent, lon g-run effects of money on output.
assets, that
difficult,
Insofar as monetary
,
shocks do affect output in the long run, the interpretation that the money-income relationship
represents true causation
more
either
from money
to
income
is
called into question.
likely that the relationship is a statistical fluke or is the result
income
"We
itself
problem
to
some
it
becomes
of responses of money
or to third variables which affect income as well.
deal with this
Instead
This endogeneity
to
extent by excluding the contemporaneous change in
from our regressions although this exclusion has no material effect on our results.
money
24
could well be a serious problem for conventional aggregates
if
non-monetary shocks which
affect output also affect the subsequent allocation of assets for a given level of overall
liquidity.
In the case where both output and the monetary indicator have a unit root, our test for
monetary neutrality corresponds
this case, (15)
to the
one proposed
in
Kormendi and Meguire (1984).
In
can be rewritten as
'
1-P(L)
So, a one permanent one percent increase in
percent.
money
by
raises long-run output
(I-/3(l))"'7(l)
Testing long-run neutrality' therefore requires testing whether the estimated value of
this quantity is significantiy different
One
from
issue that arises at this point is
given the criticism levelled by
McCallum showed, Lucas'
why
(1980) method
McCallum's (1984)
our
McCallum (1984)
coefficients in a regression of output on
method.
zero.'*
is
tests
of long run neutrality
at the earlier
criticism of this
lags of
money and
the
sum of
same
is
all
the
is
stationary.
So, as argued by Fisher
itself.
and Seater (1990), measuring the response to a once and for
As
true of our
method applies only when money
Then, monetary shocks have no long run effect on money
sense
attempt by Lucas (1980).
equivalent to computing the
many
make
increase in
money
is
then
impossible because such increases never occur in practice.
""Note that long run neutrality
They
will fail to be cointegrated
shocks do.
if
is
perfectly possible even
if
money and output
monetary impulses have no long run
effect
are not cointegrated.
on output but other
25
Suppose however
one percent
raises
money has
that
money
at
t
a unit root.
plus infinity by
Z
Then a shock
percent.
that raises
money
at
t
by
The quantity Z can be estimated
from univariate regressions of money growth on lagged values of money growth using
standard methods.
to a
once and for
The
quantity
neutrality.
From
Then
sum of
increases in
all
Z
the
is
coefficients
money
method works because an event analogous
actually takes place every period.
generally not equal to one but this does not matter for testing long run
(15) and the univariate regressions for
things: Z, the long run response of
money
money growth we can compute two
to a unit innovation in
money. Thus, under
'7(1 )Z, the long run response of output to a unit innovation in
that
Z
is
nonzero (so that money
is
money growth and
non stationary), long run neutrality prevails only
(1-/3(1))"
the null
if
(1-/3(1))-'7(1) is zero.
A
certain
effects,
form of long run
can be tested even
of what would happen
output
If
is itself
one accepts
if
neutrality,
when money
money
stationary, then
is
whether monetary shocks can have permanent
stationary.'^
it is
output have a unit root.
For the reasons stressed
which
is
Instead,
analogous
what
to (15)
money have no
closely related.
If
real effects.
is
we
in
of the long run effects
McCallum
required
is
a simultaneous analysis of
to the current
monetary neutrality means only
This hypothesis can obviously be tested only
shocks have permanent effects on the level of money.
(1984) this
used in the case where both
and relates output growth
'^Fisher and Seater (1990) feel instead that long run
in
it is
that industrial production has a unit root, then analysis
(14) and the equation
changes
not identical to the question
impossible for monetary shocks to have long run effects.
cannot be tested by the sum of the coefficients method
all
is
rose and stayed higher forever but
of monetary shocks becomes interesting.
money and
This
that
if
and
once for
monetary
26
past levels of
money. Using both these equations simultaneously one can compute
the
impulse response function of output with respect to monetary shocks and analyze the long run
response to these shocks.
We
carry out these tests for our currency-equivalent aggregate, which
stationary.
We
also apply this test to
two
variables,
which may also be
may be
stationary, that
have
recently been proposed as measures of monetary policy: the federal funds rate and the spread
between the yield on commercial paper and the yield on Treasury
is
If
bills.
monetary policy
indeed the predominant force acting upon these variables, then their changes ought not to
have any long run effects on output.
We
also test
whether money has any
effect
on prices by considering regressions of the
form
Ainp, = a' +
where we measure the price
hypothesis that
there are
b't +
p'(/.)Alnp, +
level (pj as the
money has no
no plausible theories
effect
that
YU)Alnn7,
+ ef
Consumer Price Index.
We
on prices by testing whether 7'(L)
imply
this null hypothesis.
analyze the long run response of prices to monetary shocks.
(1990) this can be done using the same method to the one
run effect on output.
In the case
equals one.
money
then
=
0.
thus of
As shown by
test the null
Admittedly,
more
interest to
Fisher and Seater
used for measuring the long
where money and prices both have a
hypothesis that permanent increases in
(1-/3'(1)) '7'(1)
we
It is
^V)
unit root, the
eventually raise prices one for one implies that
27
4.
Money and Output
4.1
Granger Causality Tests
We
first
8
first
report tests of whether
rows of Table 2 reports the
between current
The
results
null of
the Divisia
By
real activity.
monetary neutrality
M3
all in
is
equations such as (15).
rejection p-values for the null hypothesis of
do not yield a consistent
on
matters at
and past money for a range of
real activity
significant effect
money
pattern, except for
When
has a statistically
activity is industrial production, the
contrast, in the case of the
M2
nor
M2
rejected at high levels for both ordinary and Divisia
aggregate proposed by Bamett and his co-authors, but not by
but neither Divisia
no link
monetary aggregates.
M2, which always
measure of
the
traditional
unemployment
M3, nor
rate,
M3,
ordinary
we
The
Ml
obtain high rejections for
and
or M3.'^
Ml
and M2,
yield strong rejections of neutrality.
Other conventional monetary aggregates yield even weaker evidence against neutrality.
For currency and the money
multiplier,
either industrial production or the
rejected
when we focus on
Our benchmark
CE
the
we do
not reject the null of monetary neutrality for
unemployment
unemployment
aggregate, which
is
rate.
rate,
For the monetary base, the
but not for industrial production.
based on a 13-month moving average of interest
rate spreads, yields strong evidence against neutrality regardless of
we
activity
of
this
CE
rejections
analyze; this rejection pattern resembles that for
which index of
M2. Because
real
the current value
aggregate depends on future interest rate spreads, the interpretation of these
might be viewed as problematic.
'*The ease with which
Stock and Watson (1989)
our results are different
when we
null is
is
In particular,
it
we can accept that Ml has no effect on
who show that Ml does affect output in
that
our sample
is
longer than theirs.
restrict attention to the period before 1985.
might be thought that these
industrial production contrasts with
specifications like (13).
We
obtain the
same
The reason
results as
them
28
future spreads simply contain information about future output and that this is the cause of our
significant correlations.
We
CE
"fixed weight"
interest rates but, leaving aside
changes
aggregate from one month to the next
months before
to 18
months
Thus
it
is
in the
The
This too uses future information
component
change
stocks, the
in this
CE
influenced only by the change in yields from 18
after the current period.
money growth from one month
months.
first is the
which uses the overall sample average yield spreads as weights.
second uses a three-year moving average of yield spreads.
on
The
consider three variations which are not subject to this problem.
As we
to the next affect output
below, changes
in
growth only for approximately 6
seems implausible that the yield changes
through their inclusion of future information on output.
will see
in the
The
3-year
final
CE
CE
is
contemporaneous yield spreads and would be the appropriate aggregate
affect output only
based only on
in the
absence of
costs to portfolio adjustment.
As can be
The
seen in Table 2 the results are fairly robust to these changes in specification.
"fixed weight"
CE
leads to strong rejections of neutrality for both industrial production
and unemployment. The "3-year"
its
effect
on
CE
industrial production is
also leads to rejections at conventional levels though
weaker.
Finally, the
contemporaneous CE, which
is
very volatile, only affects industrial production.
The remaining rows of Table 2 present Granger
proposed alternative measures of monetary policy.
causality tests for several recently
Bemanke (1990) argues
that shifts in
policy are captured by the yield spread between commercial paper and Treasury
correlation of this spread with subsequent output
was
first
bills.
The
demonstrated by Friedman and
29
Kuttner (1990).
We
rejections of 7(L)
too find strong correlations with output.
=
when we use
find similarly strong
the federal funds rate suggested
Blinder (1990) or the commercial paper rate
One important
We
itself as
by Bemanke and
a measure of monetary policy.
limitation of the interest-rate based measures of
monetary stance
the estimated effects of these aggregates are sensitive to the time period in question.
the
CE
is that
Using
aggregate, within-sample stability tests for the coefficients in (15) for industrial
production, for example, do not reject the null hypothesis that 7(L) and /3(L) are identical for
the pre- and post- 1980 period.
By
contrast, this hypothesis is rejected at the .01 level for
the commercial paper-Treasury bill yield spread.
for
Ml
and
M2
The evidence
also weak, suggesting that these aggregates
is
against sub-sample stability
behave more
like the
CE
aggregate.
The
results in
Table 2 suggest that the
CE
aggregate provides stronger and more
consistent evidence against the monetary neutrality hypothesis than
measures of the money supply.
predictors of output.
whether
CE
Since
CE
However,
many, but not
Table 3 addresses
that all coefficients
this
in
based on interest rates this raises the question of
is partially
money
or
an equation for output.
question by reporting p-values for the F-tests of the hypothesis
on the lagged values of
other indicators of monetary stance.
The
CE
are zero in equations which already include
findings suggest that
CE's information content
remains even after the other measures of money or monetary policy are controlled
most surprising finding
other
the interest rate variables are actually better
has any incremental explanatory power once the other measures of
monetary policy are included
all,
in the table is that
CE
for.
The
remains a significant explanator of industrial
30
Ml
production (though not of the unemployment rate) after controlling for both
commercial paper
benchmark
4.2
CE
rate.
and the
This suggests that the variations in interest rates that affect the
are not solely responsible for
its
explanatory power.
Long Run Neutrality
We now
the long run.
whether once and for
We
thus measure (1-/3(1))'7(1), the percentage increase in long run output
all
increases in
when money
increases by one percent, and test whether
measure and
its
The
money change
test
standard error for conventional,
results
CE
it
output significantly in
Table 4 displays
equals zero.
and Divisia aggregates.
provide strong evidence against long-run neutrality for Ml, M2, and both
the Divisia aggregates
M2
and M3.
Not only
the hypothesis that (1-/3(1))'7(1) equals zero
is
rejected for all these assets'' but the point estimates exceed one; they suggest that a
percent increase in the asset raises real output by
Even
for
this
M3, where
more than one percent
in the
one
long run.
the hypothesis that (l-i3(l))"'7(l) is zero cannot be rejected, the point
estimate exceeds 0.5.
In contrast, the null cannot be rejected for the
contemporaneous weights variants.
CE
aggregate nor for
its
3-year and
For the benchmark CE, the point estimate of the long-
run elasticity of output with respect to
money
is
very small (.05).
For
and three year versions the point estimates are somewhat larger but
the
still
contemporaneous
On
below 0.15.
other hand, the long run response of output to a one percent change in the fixed weight
similar to that of output to
Ml. The
point estimate of this response
is
"Fisher and Seater (1990) also report rejections of long run neutrality for
longer time series.
near one and
Ml
using a
is
much
the
CE
is
31
significantly different
from zero.
So, the utility based aggregates that do
characteristics vary over time, such as the fixed weight
CE
let asset
and the Divisia aggregates,
fail to
This suggests that changes in the liquidity characteristics of assets
be long run neutral.^"
are important.
4.3 Impulse Response Functions
In this sub-section
monetary shocks.
stationary.
do
For these we
estimates of (15).
impulses.
We
we
We
From
present impulse response functions of output with respect to
this first for the
monetary indices which are arguably non-
report the effects of a
these
we
once and for
all
increase in
money
learn the time profile of the effects of these
using the
monetary
then study the impulse response functions for the indicators of monetary
policy which appear stationary.
These impulse response functions, which are based on
simulating the analogues to equations (14) and (15) simultaneously, also serve to test the long
run neutrality of these shocks.
Figures 2a through 2c display these impulse response functions for the effects on
industrial production of a
also report
1% once and
for all increases in
one standard-error bands on
Ml,
M2
and CE.
either side of the point estimates.
the cumulative effect of a shock to the monetary variable on real output.
The
figures
Each figure shows
Long run
neutrality
therefore implies a zero effect at long horizons.
^"The same
true of an aggregate
is
our
CE
aggregate.
that
our
menu of
We
we
created by simply adding together
created this aggregate to
see whether our
results
all
were
the
components of
attributable to the fact
included assets does not correspond to any conventional aggregate.
32
The impulse response
M2
to the predictions of standard models.
do not correspond
money on
output rises for the
no reduction
virtually
functions (IRFs) of industrial production with respect to
in the
first
The cumulative
fourteen months after a monetary shock.
Ml
and
effect of
There
is
cumulative output effect thereafter, which leads to the finding
in
Table 4 of strong evidence against the long-run neutrality hypothesis.
The IRF
pattern is substantially different for the currency equivalent aggregate.
innovation in the
money
to increase for seven
stock raises industrial production, and the cumulative
months
after the shock.
shock.
By
is
continues
after the shock, the total
estimated to be only one tenth as large as seven months after the
eighteen months after the shock, the point estimate of the cumulative
effectively zero.
positive
After this point, however, the lagged monetary
shock has a negative effect on output and by fourteen months
increase in real output
IRF
A
This suggests not only that the long-run effects of the
CE
IRF
is
aggregate are
consistent with monetary neutrality, but also that any non-neutralities implied
by these
estimates are resolved in a relatively short time span.
We
now
turn to the effect of the stationary monetary impulses.
functions for shocks to the commercial paper-Treasury
rate are given in Figures
2d and 2e.
bill
The impulse response
spread and to the federal funds
Figure 2d shows that a 100 basis point increase
spread between the annualized yield on commercial paper and that on Treasury
permanently lowers industrial production by 5 %
a monetary shock since the maximal reduction
months)
is
.
It is
bills
hard to interpret this as a response to
in output
essentially equal to the long run reduction.
in the
(which occurs after about 10
Figure 2e shows a similar pattern for
the response of output to a 100 basis point increase in the annualized Federal funds rate.
33
Output
falls steadily
and becomes about
5%
lower
in the
This too seems hard
long run.
to
reconcile with typical analyses of monetary contractions.
We
also
assuming
that
and (15)
We
e^.
in
which
The
is
stationary.
CE
In other
CE
CE
industrial production to shocks in
words we considered the system of equations (14)
enters only in levels and
results are
Increases in
root.
5.
CE
computed the response of both variables
suggest that the
CE
aggregate might be
very similar to those obtained when
CE
is
did this because the results of Table
stationary.
no
computed the impulse response of
first raise
1
assumed
to
to
have a unit
output significantly and then lower output so that they have
significant long run effect.
Money and
Prices
The new currency equivalent aggregate can
also be used to
examine the
effects of
monetary shocks on the price
level.
shocks and velocity
prices should rise one-for-one with increases in the
stock.
This section
is stable,
tests
In the long run, if output
is
not affected by monetary
whether monetary impulses Granger-cause changes
money
in the price
and investigates the long-run price-level effects of monetary shocks.
level,
The
first
column
in
Table 5 reports
tests
of Granger-causality between traditional
monetary aggregates, other indicators of monetary policy, and the price
correspond to p-values for rejecting the null hypothesis that 7'(L)
of the
CE
=
level.
The
entries
in equation (17).
All
aggregates except that with time-invariant weights display strong predictive power
for future
movements
traditional
monetary aggregates.
in the price level.
The Granger
The monetary base
is
causality results are
much weaker
the only such aggregate for which
for
we
34
can reject the null hypothesis of no effect.
The
last
three
Federal Funds rate and the commercial paper rate do
changes
commercial paper-Treasury
bill yield
show
predictive
that the
power
for
spread.
Table 5 presents our estimates of the long-run effects of
in
The
monetary shocks on prices.
relative merits
show strong
table
while the null hypothesis of no causality cannot be rejected for the
in the price level,
The second column
rows of the
results
do not permit us to draw sharp conclusions about the
of the various monetary aggregates.
For
all
of the monetary aggregates
consider, the hypothesis that in the long run prices rise proportionately to the rise in
we
money
cannot be rejected at conventional significance levels. The standard errors are large,
however, and the point estimates for the long-run
range from
permanent
.3 to 3.7.
1%
of price with respect to money
Figures 3a and 3b report estimates of the CPI's response to a
increase in
Ml
and CE. In the case of
reached three years after the monetary shock.
respond to monetary shocks
6.
elasticity
is
relatively
CE
half of the long-run effect (.62)
is
This implies that the process by which prices
slow and gradual.
Conclusions
This paper develops a
liquidity services.
We
compare
monetary aggregate, other
monetary policy
new monetary
aggregate based on the amount households spend on
the performance of this "currency-equivalent"
traditional
(CE)
monetary aggregates, and various other indicators of
in forecasting real activity.
The
than any of the traditional monetary aggregates.
CE
aggregate has more predictive power
While some other indicators of monetary
policy based on nominal interest rates can forecast output as well as the
CE
aggregate, they
35
money. This suggests
also suggest long-run non-neutrality of output with respect to
changes
assets.
in the
CE
that
aggregate are a more plausible indicator of changes in the supply of liquid
This result
in turn supports the idea that the
best measure monetary shocks
the
is
monetary aggregate with which one can
one which measures the
utility (or the services) that
people derive from their liquid assets.
Our
results also contain
The
disturbances affect output.
rigidities are important,
some information on the channel through which monetary
literature
make people
lowers investment.
hold the
new
According
initially
is
important.^'
money
findings provide
some support
view,
there
for the
situation
where the
A
According
to the
a direct reduction in investment
is
to curtail the
"money" view.
stock which has the most plausible effect on output
point of view of holders of money.
whether nominal
This increase in interest rates then
which comes about because monetary contractions force banks
Our
issues:
reduce money balances and interest rates must
constellation of assets.
to the "credit"
two
this topic stresses
and whether "money" or "credit"
"money" view, monetary contractions
rise to
on
We
one
is
volume of
have shown
that
loans.
that the
makes sense from the
monetary expansion can thus be thought of as a
level of liquid assets is high, at least for
some consumers.
In the "credit" view, the level of consumers' liquid assets does not matter, except
insofar as
it is
The
correlated with funds available for loans.
correlated with broad aggregates like
M2
than with the
CE
latter are
aggregate.
presumably more
From
the point of
^'The distinction between the "money" and the "credit" view has been stressed mainly by authors
working with models of sticky prices, including Bernanke and Blinder (1990), Gertler, Hubbard and
Kashyap (1990), Kashyap, Stein and Wilcox (1990) and Romer and Romer (1990). However, this
distinction
is
just as important
if
nominal
rigidities are absent
and money matters only because
different people carry out financial transactions at different times.
Grossman and Weiss (1983) and Rotemberg (1984) and Fuerst
This can be seen by comparing
(1990).
36
view of
accounts
credit availability,
at
whether banks raise
zero interest, or through expensive
suggest that this distinction
is
their funds
CD's
is
through "regular" checking
probably irrelevant.
Because the data
important for the subsequent evolution of output they also
suggests that the "credit" view
is
incomplete.
37
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Number and Aggregation Theory,
,
1983,
New
Indices of
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,
&
Money
Economic
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Journal of Econometrics 14. 11-48.
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Supply and the Flexible Laurent
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1991, Reply, in Michael T. Belongia, ed. Monetary Policy on the 75th Anniversary
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Kluwer Academic), 1991.
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Monetary Aggregates, Journal of
Bemanke, Ben
Spreads,
S., 1990,
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Bemanke, Ben
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On
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the Predictive
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Working Paper 3486.
and Alan Blinder, 1990, The Federal Funds Rate and the Channels of
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Blanchard, Olivier
J.,
1990,
NBER
Why
Working Paper 3487.
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A
Survey, in B. Friedman
and F. Hahn, eds.. Handbook of Monetary Economics (Amsterdam: Elsevier Science
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Chetty, V. Karuppan, 1969,
On Measuring
the
Neamess of Near-Monies, American
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Diewert, E., 1976, Exact and Superlative Index Numbers. Journal of Econometrics 4. 115-45.
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Fisher,
Mark
ARIMA
E. and John
J.
Seater, 1990,
Long-Run Neutrality and Supemeutrality
in an
Framework, mimeo, Federal Reserve Board of Governors.
Friedman, Benjamin
M. and Kenneth N.
Kuttner, 1990,
Money, Income,
Prices and Interest
38
Rates after the 1980s, Federal Reserve Bank of Chicago Working Paper
Fuerst,
Timothy
S, 1990. Liquidity,
Loanable Funds, and Real Activity, mimeo,
J.L. Kellogg Graduate School of
Gertler,
Management, Northwestern University.
Mark, R. Glenn Hubbard and Anil Kashyap, 1990,
An
Constraints and Investment Fluctuations:
NBER
Working paper 3495
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Interest Rate Spreads, Credit
Empirical Investigation
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Grossman, Sanford and Lawrence Weiss, 1983,
A
Transactions Based Model of the
Monetary Transmission Mechanism, American Economic Review 73, 99-122.
.
Kashyap, Anil, Jeremy Stein and David Wilcox, 1990, The Monetary Policy Transmission
NBER
Mechanism: Evidence from the Composition of External Finance
Working Paper
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King, Robert and Charles Plosser, 1984, Money, Credit and Prices in a Real Business Cycle,
American Economic Review 74, 363-80.
.
Kormendi, Roger and Phillip Meguire, 1984, Cross-Regime Evidence of Macroeconomic
Rationality, Journal of Political
Lucas, Robert E.
Jr.,
Two
1980,
Economy
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92, 875-908.
Illustrations of the
Quantity Theory of Money, American
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McCallum, Bennett T., 1984, On Low Frequency Estimates of Long-Run Relationships
in
Macroeconomics, Journal of Monetary Economics 14, 3-14.
Poterba, James
M. and
Julio
J.
Empirical Implementation,
Rotemberg, 1987,
in
W. Bamett
Money
in the Utility Function:
and K. Singleton, eds.,
New
An
Approaches
Monetary Economics (Cambridge: Cambridge University Press), 219-240.
.
Poterba, James
M.,
Julio
J.
Rotemberg and Lawrence H. Summers,
A
Tax-Based Test
to
39
for
Nominal
Rigidities.
American Economic Review 76, 659-675.
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Romer, Christina D. and David H. Romer, 1990,
New
Evidence on the Monetary
Transmission Mechanism, Brookings Papers on Economic Activity
Rotemberg, Julio
1984,
J.,
Journal of Political
A
149-98.
Monetary Equilibrium Model with Transactions Costs,
Economy
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92, 40-58.
1991, Monetary Aggregates and Their Uses, in
,
.
M.
Belongia, ed.. Monetary Policy
on the 75th Anniversary of the Federal Reserve System (Boston: Kluwer Academic),
224-232.
Samuelson, Paul A., and
S.
Swamy,
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Serletis,
Apostolos, 1988, The Empirical Relationship Between Money, Prices and Income
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Spindt, Paul, 1985,
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Stock, James H. and
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Mark W. Watson,
causality, Journal of Econometrics
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the Equations
93, 175-204.
1989, Interpreting the Evidence of
40, 161-82.
Money-Income
Table
1
:
Unit Root Tests for Various Monetary Aggregates
Aggregate
^=
Unrestricted
Ml
.999
.429
M2
.994
.750
Divisia
M2
.988
.591
Divisia
M3
.977
.669
.993
.012
CE
Notes: Each entry reports the confidence leveKbased on Fuiier(1976)) at which the
= in the regression
that K
MnMj=a*^t+ylnMf,^ ^d{L)MnM,,^ ^e^
can be rejected. The regressions are estimated using monthly data for the 1960:2-
1989:6
period. d(L)
is
a twelfth-order lag polynomial.
null
hypothesis
Table 2: Causality Tests: Monetary Aggregates and Real Activity
Monetary
Aggregates
Traditional
Industrial Production
Ml
.205
M2
.003
M3
.160
Monetary Base
.174
Money
.223
Multiplier
.517
Currency
Divisia
Aggregates
Divisia
M2
.013
Divisia
M3
.025
Alternative Indicators of
Monetary Policy
Commercial Paper
Federal Funds Rate
Commercial Paper-Treasury
Bill Yield Spread
Currency Ecuivalent
Aggregates
Currency Equivalent
<. 00001
.001
<. 00001
Table 3 incremental Explanatory Power of Different Monetary Aggregates
Incumbent
Industrial
Unemployment
Production
Rate for Married
Men
.002
.011
.003
.005
.023
.009
.015
.006
.002
.003
Table 4: Long-Run Effects of Monetary Shocks on Industrial Production
Traditional
Monetary Aaqreaates
Estimated Long-Run Effect
1.04
Ml
(0.44)
M2
1.57
(0.52)
M3
0.53
(0.50)
Monetary Base
1.42
(0.63)
Money
0.99
Multiplier
(0.61)
Currency
0.13
(0.61)
Divisia
Divisia
Aggregates
M2
1.31
(0.53)
Divisia
M3
1.15
(0.44)
Currency Eouivalent Aggregates
Currency Equivalent
0.05
(0.10)
Fixed-Weight Currency Equivalent
1
.08
(0.28)
0.17
Three-Year Currency Equivalent
(0.16)
Contemporaneous Currency Equivalent
-0.10
(0.09)
Notes: Each entry reports the long-run effect of a unit shock to the monetary aggregate on the
logarithm of industrial production. The estimates are computed as i{^,y) = ('\-p{L))'WiU evaluated at
L
=
l,
where the
lag
polynomials are estimated
in
Alny,=a+5f+p(Z.)Alny,+Y(/.)Aln/77,+e^.
Standard errors, which are shown
Summers(1986) as
in
parentheses, are calculated as in Poterba, Rotemberg and
di/dyV where Vifi.y) is the variance-covariance matrix
[di/dff di/dy]*V{fi.y)*ldi/dff
of the estimated parameters.
Table 5: Causality Tests and Long-Run Effects: Monetary Aggregates and Prices
Traditional Aaoreaates
Ml
Causality
.241
Long-Run Effect
2.42
(2.02)
M2
.394
0.86
(0.87)
M3
.693
0.95
(0.70)
Monetary Base
.003
2.49
(1.06)
Money
.439
Multiplier
1.75
(2.35)
Currency
.159
1.52
(0.55)
Divisia
Divisia
Aggregates
M2
.802
0.94
(1.07)
Divisia
M3
.640
1.21
(1.34)
Currency Eauivalent
Aggregates
Currency Equivalent
.002
0.62
(0.38)
Fixed-Weight Currency
.141
Equivalent
3.71
(7.68)
Three-Year Currency
.002
Equivalent
0.81
(0.42)
Contemporaneous Currency
.046
Equivalent
0.31
(0.17)
Alternative Indicators of
Monetary Policy
Commercial Paper
.0004
<. 00001
Federal Funds Rate
Commercial Paper-Treasury
Bill Yield Spread
.666
Notes: Entries in column 2 are p-values for Granger-Causality tests of the sort reported in table 2,
while entries in column 3 are long-run responses of the price level to shocks in the growth rate of
the monetary aggregates, whose analogue for industrial production was reported in table 3.
Standard errors are
in
parentheses.
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of
Current Dollars
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