The Role of Money: Empirical Evidence Money in the Long-Run

Monetary Theory University of Bern

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Aims and Goals

• Give an overview of the role of money in the long-run • What shall we explain? • What restrictions we should impose on a model in the long run?

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Money, Prices and Output in the Long-Run

• Simple paper by McCandless–Weber (1995) • Examine LR correlations between money growth and economic variables • Why? • 2 main reasons • Institutional • Pragmatism

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Money, Prices and Output in the Long-Run: Institutions

• The congress instructs the Fed to maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates (FR Board 1990, p. 6) • So the FED (and most central banks) has some long–run targets! • Legitimate question: Is it successful?

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Money, Prices and Output in the Long-Run: Pragmatism

• Many economists and policymakers have strong reservations about the ability of monetary policy to hit short-run targets for either inflation or output. I don’t try to forecast short-term changes in the economy. The record of economists in doing that justifies only humility. (M. Friedman)

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Money, Prices and Output in the Long-Run: Methodology

• Cross–country analysis Why? • Looking at one sole country would involve a strong dependency of correlations to policy. • Avoids the dependency of the results to policy rules, as many different experiences.

• Calculate long–run geometric average rate of growth for • real GDP, • consumer price level, • M0, M1, M2

• Long–run average gets rid of short–run fluctuations.

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The inflation–Money Growth Relationship • Average Annual Growth • M2 • Consumer Prices

• 110 Countries, Period: 1960–1990 • Clear positive relationship

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The inflation–Money Growth Relationship

Sample 110 countries 21 OECD countries 14 Latin American countries

M0

M1

M2

0.925 0.894 0.973

0.985 0.940 0.992

0.950 0.958 0.993

• Strong correlation: close to 1. • Robust across definition of money. • Robust across subsamples.

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The inflation–Money Growth Relationship

• Brings to mind the Quantity Theory of Money M×V = P×Y • In the LR, a 1% increase in money translates into a 1% increase in prices. • Not causal!

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The Output Growth–Money Growth Relationship

• Average Annual Growth • M2 • Output (GDP)

• 110 Countries, Period: 1960–1990 • No relationship

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The Output Growth–Money Growth Relationship

Sample 110 countries 21 OECD countries 14 Latin American countries

M0

M1

M2

-0.027 0.707 -0.171

-0.050 0.511 -0.239

-0.014 0.518 -0.243

• No correlation in whole sample. • Robust across definition of money. • Not robust across subsamples. • Again: Not causal

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The Output Growth–Money Growth Relationship

• Kormendi–Meguire (1984) (50 countries), Geweke (1986) (USA), Boschen and Mills (1995) (USA): No effect of money growth on output (Growth/level) • Dwyer and Hafer (1988) , Barro (1995,1996): negative relationship • Not so clear evidence! • Tends to indicate money neutrality and super–neutrality.

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Be careful! Output Growth–inflation

• Mild negative correlation between output growth and inflation (-0.243) • Indicate that other phenomena/shocks may matter

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Money Growth–Interest Rate

• Based on Monnet–Weber (2001) • Similar methodology to McCandless–Weber (1995) • Simple cross-country correlation analysis

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Money Growth–Interest Rate • Money Growth vs Government Bond Yields • 43 countries (20 dev., 23 under.), 1961–1998 • Clear positive relationship

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Money Growth–Interest Rate • Money Growth vs Money Market Rate • 43 countries (20 dev., 23 under.), 1961–1998 • Clear positive relationship

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Money Growth–Interest Rate

Correlations Sample All Developed Developing

SR Money Market Rate

LR Gov. Bond Yields

0.71 0.81 0.62

0.87 0.70 0.84

• Strong positive correlation. • How to explain that? Contradict the standard liquidity effect • BUT we are in the LR 17

The Role of Money in the Long Run

• Fisher equation: 1 + it = (1 + rt )(1 + πte ) ⇐⇒ it ≃ rt + πte • Real returns are independent from expected inflation (Mon. pol.) • An increase in it should be accompanied by an increase in πte . • πte increases one–for–one with money growth in LR

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The Role of Money in the Long Run: Summary Main Results: • Prices increase one for one with money growth =⇒ Quantity Theory of Money • Money growth does not exert any effect on output =⇒ Money Neutrality • Money growth and nominal interest rates are positively correlated =⇒ Fisher equation • Any model should satisfy these facts. • What about the Short–Run? 19