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  • Writer's picturePete Jonson

How monetary policy affects the economy.

Updated: Aug 1, 2020

The classic economic ‘story’ about how the money supply influences how economies work was outlined by Milton Friedman at a large conference in Japan in, I think, 1962.

'The essence of the quantity theory of money is the distinction between the nominal quantity of money and the real quantity of money. ... 'the theory ... regards the nominal quantity of money as determined by the conditions of supply and the real quantity of conditions of demand. Though the variables affecting supply and the variables affecting demand are interrelated they are largely independent of each other.' ...

'An unanticipated increase or decrease in the quantity of money tends to effect total nominal spending some 6-9 months later in the United States, Japan and Great Britain. The initial effect is primarily on output rather than prices. Prices tend to be affected only 18-24 months later...'

During my time at the London School of Economics in the early 1970s we had a visit from two highly ranked young economists from Friedman’s university. Their names were Jacob Frenkel and Rudiger Dornbush. Now Frenkel is currently the Chairman of JPMorgan Chase International, which executes the international strategy of the American financial services firm. He also serves as Chairman and CEO of the Group of Thirty (G-30), which is a private, nonprofit, consultative group on international economic and monetary affairs.

Jacob Frenkel has served in many distinguished posts, most important perhaps between 1991 and 2000 serving two terms as the Governor of the Bank of Israel. He is credited with reducing inflation in Israel and achieving price stability, liberalizing Israel’s financial markets, removing foreign exchange controls, and integrating the Israeli economy into the global financial system. (Source Wikapedia)

And Rudi Dornbush? Throughout Rudi's career his main focus was on international economics, especially monetary policy, macroeconomic development, growth and international trade. According to some of his students and associates his talent was to extract the heart of a problem and make it understandable in simple terms. For example, he explained fluctuations in prices and exchange rates with great clarity (notably with his ‘Overshooting model’). Sadly he died aged 60, from cancer. (Source Wikapedia.)

The group I was part of hosted these young men and our group effort was to build a state-of-the art econometric model. Our approach was led by Dr Clifford Wymer, who with Rex Bergstrom had pioneered new-style models with one and two degree dynamic non-linear equations to produce models of whole economies.

Every Monday we met from 9 AM and argued vehemently about the model, rarely getting past the first equation, which was meant to explain household spending. Dornbush always argued that our equations were definitionally incorrect by their assumption that economies required lags for appropriate specification.

Rudi used say we were working on ‘a giant wave making machine’. When I produced my version of a model of the British economy from 1880 to 1970, a young monetarist economist dismissed it as nonsense because its lags implied it was describing ‘geological time’. Despite this excellent crack, I was appointed an honorary member of the ‘International Monetary Conspiracy’ run by Professors Brunner and Meltzer. My supervisor was Harry Johnson and he expressed no complaints about lags in my model of the UK economy from 1880 to 1970.

I now, of course, wish I had found Milton Friedman’s comments in paragraph three above. 'An unanticipated increase or decrease in the quantity of money tends to effect total nominal spending some 6-9 months later in the United States, Japan and Great Britain. The initial effect is primarily on output rather than prices. Prices tend to be affected only 18-24 months later...'

This is all about lags, certainly not of glacial or geological nature. However, after a third of my adult life constructing models of the sort pioneered by Bergstrom and Wymer I now vary Friedman’s approach by asserting that monetary policy of course is influenced by Friedman’s unanticipated growth of monetary supply, and by modern central banks’ cash interest rates. But in my view a more general influence is what I call ‘monetary disequilibrium’, which is how my Phd work developed it. My recent work with Clifford Wymer on a long term UK model (data from 1855 to 2014) includes effects of monetary disequilibrium on household consumption, consumer price equation, share price inflation and market interest rates.

These linkages define an approach not unlike the ‘channels’ defined by David Hume 250 years ago in his essay on ‘The balance of trade’. The algebra is expressed as follows:

MDE = (M/P - md) where M is money supply, P is the consumer price index and md is real money demand, which is where interest rates enter the game.

Soon Clifford and I will be publishing our results for the UK and then, health allowing, we shall move on to include the USA.

I am aware that this essay may be esoteric, even uninteresting to most readers, but there may be one or two people on my readership list who finds it of interest. The implications of this work should be of extreme relevance to central banks and gurus like Professor Jacob Frenkel.

With money supply greatly expanded by near zero cash rates and ‘Quantitative easing’ do these variables or monetary growth accurately represent the full effect of current monetary policy?

Jacob, Philip (Lowe) call me if you would like to hear more.

And Fiona Prior celebrates another brilliant thinker here.

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