3 EMPIRICAL EVIDENCE
3.2 Empirical Evidence based on Single Equation Techniques
A number of studies have reviewed the empirical work undertaken on the impact of monetary policy within the ‘inflation targeting’ (IT) framework.
This work uses single equation econometric techniques normally. The studies reviewed ask a number of questions with the most pertinent being the follow- ing: whether IT improves inflation performance and policy credibility, and whether the sacrifice ratio, that is, the cost of lowering inflation, does not increase significantly over the period of IT implementation. In the mid- 1990s, Leiderman and Svensson (1995) reviewed the early experience with IT, with, however, a rather limited number of observations. Later studies (Bernanke et al., 1999; Corbo et al., 2001, 2002; Clifton et al., 2001; Arestis et al., 2002; Johnson, 2002; Neumann and von Hagen, 2002) inevitably afforded longer periods and more data. A reasonably comprehensive review of the empirical literature on IT (Neumann and von Hagen, 2002) concludes in the same manner as the other studies before it had done, and just cited.
These conclusions can be summarized quite briefly. This evidence supports the contention that IT matters. Those countries which adopted IT managed to reduce inflation to low levels and to curb inflation and interest rate volatility.
Indeed, ‘of all IT countries it is the United Kingdom that has performed best even though its target rate of inflation is higher than the inflation targets of most other countries’ (ibid., p. 144).10
The evidence, however, is marred by three weaknesses (Neumann and von Hagen, 2002): the first is that the empirical studies reviewed fail to produce convincing evidence that IT improves inflation performance and policy credibility, and lowers the so-called ‘sacrifice ratio’ (ratio of change in unemployment relative to change in inflation). After all, the environment of the 1990s was in general terms a stable economic environment, ‘a period friendly to price stability’ (ibid., p. 129), so that IT may have had little impact over what any sensible strategy could have achieved; indeed, non-IT countries also went through the same experience as IT countries (Cecchetti and Ehrmann, 2000). The second weakness is that, despite the problem just raised of lack of convincing evidence, the proponents argue very strongly that non-adoption of IT puts at high risk the ability of a central bank to provide price stability (for example, Bernanke et al., 1999, ‘submit a plea’
for the Fed to adopt it; also Alesina et al., 2001, make the bold statement that the European Central Bank could improve its monetary policy by adopting IT; neither study provides any supporting evidence, though. And yet both the Fed and the European Central Bank remain highly sceptical
(Gramlich, 2000, and Duisenberg, 2003a, do not actually regard IT as appropriate for the USA and the euro area, respectively). The third weak- ness refers to the argument that in a number of countries (for example, New Zealand, Canada and the UK) inflation had been ‘tamed’ well before intro- ducing IT (Mishkin and Posen, 1997), an argument that implies that the role of IT might simply be to ‘lock in’ the gains from ‘taming’ inflation, rather than actually being able to produce these gains. Bernanke et al.
(1999) admit as much when they argue that ‘one of the main benefits of inflation targets is that they may help to “lock in” earlier disinflationary gains particularly in the face of one-time inflationary shocks. We saw this effect, for example, following the exit of the United Kingdom and Sweden from the European Exchange Rate Mechanism and after Canada’s 1991 imposition of the Goods and Services Tax. In each case, the re-igniting of inflation seems to have been avoided by the announcement of inflation targets that helped to anchor the public’s inflation expectations and to give an explicit plan for and direction to monetary policy’ (p. 288).
Neumann and von Hagen (2002) produce further evidence which enables them to conclude that IT has proved an effective ‘strategy’ in the fight against inflation. This is based on the argument that, whenever IT was adopted, countries experienced low inflation rates, along with reduced volatility of inflation and interest rates. However, the evidence produced by the same study cannot support the contention that IT is superior to money supply targeting (for example, the Bundesbank monetary targeting between 1974 and 1998) or to the Fed’s monetary policy in the 1980s and 1990s, which pursues neither a monetary nor an inflation targeting policy. A further finding of Neumann and von Hagen’s paper is that Taylor rules suggest that central banks focus more on the control of inflation after adopting inflation targeting, thereby implying that price stability will be achieved, a result supported by the VAR evidence, which indicates that the relative importance of inflation shocks as a source of the variance of interest rates rises after adoption of inflation targeting.
Mishkin (2002a) in discussing Neumann and von Hagen (2002), however, points out that, since both short-term and long-term coefficients on inflation in the Taylor rules estimated relationships are less than one, the inflation process is highly unstable, the implication here being that, when inflation rates rise, the central bank increases the rate of interest by a smaller amount, thereby reducing the real rate of interest. This is of course an inflationary move by the central bank when the opposite was intended. This is also true for the non-IT countries, like the USA, a result that is again contrary to Taylor’s (1993) finding, which argues that for the USA it is greater than one in the post-1979 period when allegedly monetary policy performance im- proved relative to the pre-1979 period.
Can monetary policy affect inflation or the real economy? 55 Mishkin (2002a) identifies another interesting problem, which relates di- rectly to the VAR approach. This is that, since this approach does not contain any structural model of dynamics, the interpretation that inflation shocks contribute to the variance of interest rates need not imply necessarily in- creased focus on the control of inflation. This is so since, if inflation shocks contribute to interest rate variability in an IT era, inflation expectations will prevent inflation from deviating much from the inflation target; this would imply that the central bank is less focused on inflation, not more. Conse- quently, this would clearly suggest ‘that the VAR evidence in the paper, tells us little about the impact of inflation targeting on the conduct of monetary policy’ (ibid., p. 150).
Ball and Sheridan (2003) measure the effects of IT on macroeconomic performance in the case of 20 OECD countries, seven of which adopted IT in the 1990s. They conclude that they are unable to find any evidence that IT improves economic performance as measured by the behaviour of inflation, output and interest rates. Note that better performance was not evident for the IT countries. Clearly, inflation fell in these countries and became more stable;
and output growth stabilized during the IT period as compared to the pre-IT period. But then the same experience was evident for countries that did not adopt IT. Consequently, better performance must have been due to something other than IT. When performance is compared, the fall in inflation is larger for IT countries than for non-IT countries, a result that is similar in many ways to that of Neumann and von Hagen (2002); the latter see it as a further benefit of IT.11 Ball and Sheridan (2003), however, suggest that the evidence they produce, and by implication that of Neumann and von Hagen (2002), does not support even this modest claim of IT benefit. This is explained by resorting to further evidence of countries with unusually high and unstable inflation rates where this problem disappears irrespective of their adoption of IT. Indeed, controlling for this effect, the apparent benefit disappears alto- gether. The apparent success of IT countries is merely due to their having
‘high initial inflation and large decreases, but the decrease for a given initial level looks similar for targeters and non-targeters’ (Ball and Sheridan, 2003, p. 16). The same result prevails in the case of inflation variability and inflation persistence. As to whether IT affects output behaviour and interest rates, Ball and Sheridan conclude in the same vein that IT does not affect output growth or output variability, nor does it affect interest rates and their variability.
A recent study by Bodkin and Neder (2003), examines IT in the case of Canada for the periods 1980–89 and 1990–99 (the IT period). Their results, based on graphical analysis, clearly indicate that inflation over the IT period did fall, but at a significant cost to unemployment and output, a result which leads the authors to the conclusion that a great deal of doubt is cast ‘on the theoretical notion of the supposed long-run neutrality of money’, an impor-
tant, if not the most important, ingredient of the theoretical IT framework.
They also suggest that the ‘deleterious real effects (higher unemployment and
… lower growth) during the decade under study suggests that some small amount of inflation (say in the range of 3 to 5 percent) may well be beneficial for a modern economy’ (p. 355).
4 SUMMARY AND CONCLUSIONS
This chapter has been concerned with the impact of monetary policy on the real economy, within the NCM and IT. Within this approach, monetary policy becomes identified with interest rate policy, with little or no reference to the stock of money (on any measure of money).12 It has generally been the case that setting an inflation target is the main (and often the only) objective of monetary policy. Indeed, monetary policy can be seen as aggregate demand policy in that the interest rate set by the central bank is seen to influence aggregate demand, which in turn is thought to influence the rate of inflation.
Monetary policy has become the only policy instrument for the control of inflation, but it can at best only address demand inflation.
One of the key issues of this approach is the recognition of the many channels through which monetary policy is seen to operate. This means that the chain from a change in the central bank discount rate to the final target of the rate of inflation is a long and uncertain one. In light of the relationship between the exchange rate and the interest rate expressed in the interest rate parity approach, there are constraints on the degree to which the domestic interest rate can be set to address the domestic levels of aggregate demand and inflation. In view of the central place given to monetary policy in macro- economic policies and the length of the chain from central bank interest rate to rate of inflation, it is important to consider the empirical estimates of the effects of monetary policy. We have summarized results drawn from the euro zone, the USA and the UK, and have suggested that these empirical results point to a relatively weak effect of interest rate changes on inflation. We have also suggested that on the basis of the evidence adduced in this chapter, monetary policy can have long-run effects on real magnitudes. This particular result does not sit comfortably with the theoretical basis of the NCM and IT monetary policy.
The empirical work undertaken on IT has also been critically assessed. It would appear that Mishkin’s (1999) premature statement that the reduction of inflation in IT countries ‘beyond that which would likely have occurred in the absence of inflation targets’ (p. 595), is not supported by any theoretical reasoning or empirical evidence. We would therefore conclude overall, along with Ball and Sheridan (2003), that the recent ‘low-inflation’ era is not
Can monetary policy affect inflation or the real economy? 57 different for IT and non-IT countries. Consequently, IT has been a great deal of fuss about really very little.
NOTES
1. The proceedings of the conference have been published in the Federal Reserve Bank of New York Economic Review, 8(1), 2002 issue.
2. The construction of Figure 4.1 has been strongly influenced by comparable figures in Monetary Policy Committee (1999, p. 1) and in Kuttner and Mosser (2002, p. 16).
3. The assumption of credit market frictions is important in that it is normally hypothesized that lending and borrowing are indifferent amongst internal funds, bank borrowing and equity finance. This assumption relies on a frictionless world, where lenders and borrow- ers have the same information about risks and returns, costlessly monitor the use and repayment of borrowed funds in the case of lenders, and are not faced with search and transaction costs. In addition to these agency costs, lenders and borrowers have no con- cerns about corporate controls, and there is no tax discrimination of sources of finance. In the real world of credit markets, frictions are abundant, so that the heroic assumptions of frictionless credit markets do not generally hold.
4. See Federal Reserve Bank of New York (2002) for more details on the problems and issues discussed in the text.
5. The VAR estimates are taken from Peersman and Smets (2001). Their Graph 1 indicates that the upper 90 per cent confidence interval on prices is at or above zero (compared with the base case); that is, prices may not decline at all.
6. It would also be possible to vary other aspects of the simulation, for example by altering the assumptions about how expectations are formed. However, it should be emphasized that, even for a given set of assumptions, the effects of a change in interest rates are highly uncertain, because of uncertainty about the value of the parameters underlying the model and about the specification of the model itself.
7. The precise figures depend on assumptions concerning the subsequent reactions of the setting of interest rates in response to the evolving inflation rate.
8. The same macroeconometric models are utilized in the ECB (2002e) study as ours, namely, EMM and AWM, with the difference that the ECB study also incorporates the multi-country model of the National Institute of Economic and Social Research (NIGEM).
The inclusion of results from the latter does not change in any way the general thrust of the argument.
9. The three estimates being those of AWM, EMM and NIGEM (see note 18).
10. Anecdotal evidence has also been propounded to make the IT case. Bernanke (2003b) suggests that ‘central banks that have switched to inflation targeting have generally been pleased with the results they have obtained. The strongest evidence on that score is that, thus far at least, none of the several dozen adopters of inflation targeting has abandoned this approach’ (p. 1).
11. It is actually viewed by Neumann and von Hagen (2002) as evidence of ‘convergence’, in that, on average, IT countries converge to the inflation rates of the non-IT countries in the targeting period.
12. It could also be added that there is no attempt to control other variables such as credit availability.
58
causal significance?
1 INTRODUCTION
In the ‘new consensus macroeconomics’ discussed in earlier chapters, it was evident that the stock of money is seen to operate as a mere residual in the economic process. Others have commented on the absence of the stock of money in many current debates over monetary policy. For example, Laidler (1999) states that ‘the Quarterly Projection Model which nowadays provides the analytic background against which Bank [of Canada] policies are de- signed, includes no variable to represent this crucial aggregate [stock of money]’ (p. 1). King (2002) makes the case in even stronger language; he argues that, ‘as price stability has become recognised as the central objective of central banks, the attention actually paid to money stock by central banks has declined’. Surprisingly perhaps, ‘as central banks became more and more focused on achieving price stability, less and less attention was paid to movements in money. Indeed, the decline of interest in money appeared to go hand in hand with success in maintaining low and stable inflation’ (p. 162).
This has prompted a number of contributions that, wittingly or perhaps un- wittingly, have attempted to ‘reinstate’ a more substantial role for money.
In this chapter we argue that these attempts to ‘reinstate’ money in current macroeconomic thinking entails two important implications. The first is that they contradict an important theoretical property of the ‘new consensus’
macroeconomic model, namely that of dichotomy between the monetary and the real sector. The second is that some of these attempts either fail in terms of their objective or merely reintroduce the problem rather than solving it. We include in the first category the class of models that rely on ‘frictions’ in credit markets (for example, Bernanke and Gertler, 1999), and in the second category the contributions by Meyer (2001b), McCallum (2001) and Laidler (1999).
We proceed by rehearsing the argument of missing money, along with a number of attempts to ‘reinstate’ money, and then assess these four attempts to ‘reinstate’ money (see also Arestis and Sawyer, 2003a).
Does the stock of money have any causal significance? 59