A new study in the Journal of Money, Credit and Banking examines the leading arguments for assigning an important role to tracking the growth of monetary aggregates when making decisions about monetary policy. The analysis finds that none of the arguments provides a compelling reason to assign a prominent role to monetary aggregates.

Michael Woodford of Columbia University reviews several of the most important arguments that have been made for paying attention to money, considering both the omissions of an analysis without money and the advantages of the information revealed by monetary trends.

While they do have their uses, Woodford contends that monetary aggregates should not be used as policy targets or assigned a prominent role in monetary policy strategy.

The economy’s current condition and projected evolution under alternative policy paths may depend on a large number of unobserved variables. Monetary aggregates, along with other indicators, can be used to provide information about these unobserved variables, though there is little theoretical or empirical ground to think that these measures are especially revealing about any of the unobserved variables that are most crucial for accurate projections. Monetary aggregates thus may help to determine the appropriate policy, but only along many other variables and not in a way that would make them targets in the conduct of policy.

“When one examines the reasons that have been primarily responsible for the appeal of the idea of money growth as a simple diagnostic for monetary policy, one finds that they will not support the weight that they are asked to bear,” Woodford notes

One motivation for our interest is Japan’s recent experience. In spite of massive increases in monetary base and a zero nominal interest rate, economic growth has remained low and deflationary pressure has not abated. These events are raising new questions about the effectiveness of monetary policy under a zero nominal interest rate policy. Eggertson and Woodford (2003) argue that a monetary authority can still influence economic activity when nominal interest rates are zero by taking actions that affect market expectations about the future time path of variables such as interest rates, inflation or exchange rates. One way to assess the ability of a central bank to affect expectations is to look retrospectively and ascertain the extent to which previous monetary policy surprises have affected bond yields of different maturities. If monetary policy is indeed a potent tool for altering expectations then this should show up in the responses and variance decompositions of medium and long-term bonds yields to suitably identified shocks to monetary policy.

In order to isolate the effects of monetary policy on the yield curve we must first identify monetary policy shocks. Our strategy for identifying monetary policy combines zero restrictions as in Christiano, Eichenbaum, and Evans (1996), Bernanke and Mihov (1996), Leeper, Sims, and Zha (1996), Miyao (2002), and Shioji (1997) with sign restrictions on the impulse response functions as in Faust (1999) and Uhlig (1999). An advantage of our empirical strategy is that it is straightforward to investigate the robustness of any conclusions to the maintained assumptions about how monetary policy affects the macro-economy.

We consider two distinct maintained hypotheses. The liquidity, effect hypothesis maintains that a surprise tightening in monetary policy increases short-term nominal interest rates, and lowers output, prices, and monetary aggregates. This hypothesis reflects the consensus view about how monetary policy affects the U.S. economy [see e.g. the recent survey article by Christiano, Eichenbaum, and Evans, 1999]. We also consider the costly price adjustment hypothesis. This hypothesis maintains that a surprise tightening in monetary policy lowers interest rates, money supply, output, and prices. It is consistent with the implications of costly price adjustment models with monopolistic competition as in: Rotemberg (1996), Christiano, Eichenbaum, and Evans (1997), Ireland (1997), and Aiyagari and Braun (1998). Braun and Shioji (2002) find that Japanese data are more consistent with the costly price adjustment hypothesis. Here we report results under each of the two maintained hypotheses in order to compare their implications for the Japanese yield curve.

The choice of maintained hypothesis has important implications for the interaction of monetary policy and the yield curve. Under the liquidity effect hypothesis innovations in monetary policy have highly transient effects on short-term interest rates and the slope and curvature of the yield curve. Moreover, monetary policy shocks only account for a small fraction of the long-run variance in yields. Under the costly price adjustment hypothesis, in contrast, there is a rich set of interactions between monetary policy and the yield curve. Monetary policy shifts the level of the yield curve and produces large hump-shaped responses in yields of all maturities. Monetary policy also accounts for a substantial fraction of the long-term variance in long-term yields.

Our analysis is related to recent work by Ang and Piazzesi (2003) and Evans and Marshall (2001). Ang and Piazzesi (2003) consider the role of alternative macroeconomic shocks in explaining movements in U.S. Treasury yields using an affine model of the term structure and find that economic activity accounts for only a small fraction of the variance in long-term bonds. Evans and Marshall (2001), in contrast, use a common factor model of the term structure and identify a variety of macroeconomic shocks. They find that demand shocks account for a significant fraction of the variance in long-term bonds. Our work complements these papers in several ways. We describe how the implications of monetary policy for the yield curve vary across alternative maintained hypotheses about the economic effects of monetary policy shocks. We also consider the role of financial shocks in explaining movements in macroeconomic variables. Finally we investigate these issues for Japan, which has a different institutional and economic environment from the United States.

First, let us discuss the difference of fiscal policy to monetary policy. Fiscal policy pertains to the power of the government with congresses or parliament’s consent to increase or decrease tax rates. To increase tax rates, would mean to take away the disposable income of civilians. Think of it this way, the economy is a wheel. The movement of money makes the wheel turn. When people spend less money, the economy turns slowly. So the government increases taxation. The extra money the government collects is then spent on projects that will pour money back into companies for government mandated projects. These companies in turn will give them back to the people by employing more employees or by paying their existing ones with more. Such spending is also known as “pump-priming” activities.

Another instrument of fiscal policy would be for the government to borrow money for its expenditures. They do this so as not to over tax their citizens and provoke protest actions against their management. However, borrowing is not always an option. Lenders do not easily part with their funds. The general economic environment is placed into consideration.

But enough about fiscal policy, we are here to discuss the influence of monetary policy on interest rates. Now, bearing in mind that the economy is a wheel with money as the gas, monetary policy is the power of the government to control the flow of money in its society. When interest rates are high, the tendency of people is to control their spending and as much as possible stay away from borrowing money. This in turn slows down the movement of money in society. So one strategy the government employs is to lower down the interest rates, to attract people to borrow money and spend them on projects or businesses. Who among us would not suddenly think of purchasing houses, cars or expansion of current businesses when very low interest rates prevail? Such interest rates would make you think your money will earn more by investing it where yields are higher. When the economy is in danger of overheating (when growth is too fast, threatening a rise in inflation), the government increases interest rates to make access to excess money more expensive and arrest spending. Normally, such policies are implemented by a central bank that has more influence with creditors such as banks and other financial institutions.

The main reason that governments undertake such measures is to spur or to impede the economic growth through introduction of the monetary policy. Interest rates become a tool to help manage the economy.

In effect, the monetary policy can be gleaned to be tied up with interest rates. However, just as stated earlier, there are a lot of macroeconomic factors that affect interest rates. Inflation, supply and demand for money and other general economic indicators are normally related to one another, which in turn dictates which interest rate to peg.