bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

THE TRANSMISSION MECHANISM OF MONETARY POLICY 195
7.5 The money supply within an interest rate control
mechanism
Much of the debate about the nature of the transmission mechanism has
been concerned with causality and the direction of causality. The assumption
of endogenous money implies that changes in the money supply are a
consequence of economic activity and should, therefore, follow them. The
money supply does not play a causal role within the economy but is created
by the demand for loans. For monetarists, on the other hand, changes in
the money supply should precede changes in output and prices. This
appears to be something we could test empirically. Alas! It is not so easy.
Monetarists have always interpreted the empirical evidence to suggest
that changes in the quantity of money have systematically led changes in
output and inflation rather than lagging behind them. However, other interpretations
of the evidence are available. For example, Laidler (2002) notes
that the cyclical nature of output and inflation might produce misleading
appearances. Alternatively, he suggests, forward-looking agents might be
adjusting their money holdings in line with expected output and prices
before these variables actually change. In both cases, the quantity of money
might only seem to be leading.
A problem also arises from the existence of time lags. Remember that
in Section 7.3, we suggested that a reduction in interest rates would not have
its full effect on output for around twelve months and two years might
elapse before the full effect was felt on prices. However, the impact on the
money supply occurs as soon as banks meet the increase in demand for
loans consequent on the fall in interest rates. Indeed, we shall see in
Chapter 9, that one of the arguments for using the money supply as an intermediate
target of monetary policy is precisely that the time lag between the
instrument change and a change in the money supply is relatively short.
Thus, timing evidence can tell us little about causality and certainly does not
provide the basis for an attack on the endogenous money version of the
transmission mechanism.
However, Laidler and others have proposed an addition to that version.
This continues to recognize the importance of the credit channel through the
impact of changes in interest rates on borrowing and spending, but suggests
that the quantity of money might still have a role to play in transmission. In
doing this, the importance of the demand for money function is re-established.
The interest rate change is identified as the first round in the transmission
mechanism. Consider an interest rate reduction. This causes an
increase in borrowing and creates deposits and hence money. However, the