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Working Paper 2004-026B

"The Monetary Instrument Matters"
by William T. Gavin, Benjamin D. Keen, and Michael R. Pakko

This paper revisits the issue of the money supply versus the interest rate as the instrument of monetary policy. Using a dynamic stochastic general equilibrium framework, we examine the effects of alternative monetary policy rules on inflation persistence, the information content of monetary data, and real variables. We show that inflation persistence and the variability of inflation relative to money growth depend on whether the central bank follows a money growth rule or an interest rate rule. With a money growth rule, inflation is not persistent and the price level is much more volatile than the money supply. Those counterfactual implications are eliminated by the use of interest rate rules whether prices are sticky or not. A central bank’s utilization of interest rate rules, however, obscures the information content of monetary aggregates and also leads to subtle problems for econometricians trying to estimate money demand functions or to identify shocks to the trend and cycle components of the money stock.

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Category > Monetary Policy/Macroeconomics
Author > William T. Gavin
Author > Michael R. Pakko
Research Papers and Publications: JEL Code > E31
Research Papers and Publications: JEL Code > E32
Research Papers and Publications: JEL Code > E42