Monetary Theory and Policy WIT
Bennett T. McCallum Carnegie-Mellon University
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Macmillan Macmillan Publishing Company New York
Collier Macmillan Macmillan Publishers London
PREFACE
Copyright
1989, Macmillan Publishing Company, a division of Macmillan, Inc,
Printed in the United States of America All
reserved. No p a ~ t of this book m a ~ be reproduced or transmitted in any form any means, electrome or mechamcal, .IncludIng photocopying, recording. or any l!1formatton storage and retneval system, wJlhout permission in writing from the pub hsher. r ~ g h t s
or
Macmillan Publishing Company
866 Third Avenue, New York, New York 10022
Collier Macmillan Macmillan Canada, Inc. Library of Congress Cataloging in Publication Data McCallum. Bennett T. Moneiary economics: theory and policy/Bennett policy/Bennett T. McCallum. McCallum. p. em. Includes index. ISBN 0-02-378471-7 0-02-378471-7 policv. l. Title. 1. Money. 2. Monetary policv. HG221.M42 3 1989 332.4--dc19 Printing:
7
Year:
5 6 7 8
The object of this book is to present a systematic treatment of mone tary economics in a manner that is clear and nontechnical, yet accu rately reflective of important research developments of the past 20 years. Such a task is not an easy one, since recent research has empha sized dynamic and stochastic aspects of economic behavior-aspects that involve analytical difficulties. My strategy for accomplishing the task has been to begin with simple models, to intr oduce complexities only as needed, to focus selectively on matters of fundamental importance, and to relate the discussion at each point with what has gone before. By proceeding in this fashion, I have found it possible to handle in a satisfying manner numerous topics not usually included in textbook discussions. In particular, the book is novel in its emphasis on severe inflation, inflation, o n mo netary standards (including (including commodity-money commodity-money arrange ments), and on realistic descriptions of central-bank operating proce dures. Also, there is a discussion of United States monetary history that is unusual in its coverage, as three-quarters of its length is de voted to periods before the creation (in 1914) of the Federal Reserve System. In terms of technique, moreover, the book includes extensive expositions of inflationary steady-state analysis, dynamic analysis with adaptive and rational expectations, and a systematic procedure for solving linear stochastic models with rational expectations. The book does not, on the other hand, include much institutional detail or any substantial amount of material on the subject of finance. finance. These omissions do not in my opinion constitute a weakness; an impor tant ingredient of effective instruction is selectivity in terms of cover age. Because the book emphasizes recent research topics but strives for analytical simplicity, it should be appropriate for textbook use in a variety of settings. Preliminary versions have been used successfully in advanced undergraduate and MBA courses, yet much of the material could be helpful to beginning graduate students in economics. The book is primarily designed for courses in monetary economics, but could alternatively serve as a textbook in macroeconomics or money and banking with analytical emphasis. It would need to be augmented
PREFACE
Copyright
1989, Macmillan Publishing Company, a division of Macmillan, Inc,
Printed in the United States of America All
reserved. No p a ~ t of this book m a ~ be reproduced or transmitted in any form any means, electrome or mechamcal, .IncludIng photocopying, recording. or any l!1formatton storage and retneval system, wJlhout permission in writing from the pub hsher. r ~ g h t s
or
Macmillan Publishing Company
866 Third Avenue, New York, New York 10022
Collier Macmillan Macmillan Canada, Inc. Library of Congress Cataloging in Publication Data McCallum. Bennett T. Moneiary economics: theory and policy/Bennett policy/Bennett T. McCallum. McCallum. p. em. Includes index. ISBN 0-02-378471-7 0-02-378471-7 policv. l. Title. 1. Money. 2. Monetary policv. HG221.M42 3 1989 332.4--dc19 Printing:
7
Year:
5 6 7 8
The object of this book is to present a systematic treatment of mone tary economics in a manner that is clear and nontechnical, yet accu rately reflective of important research developments of the past 20 years. Such a task is not an easy one, since recent research has empha sized dynamic and stochastic aspects of economic behavior-aspects that involve analytical difficulties. My strategy for accomplishing the task has been to begin with simple models, to intr oduce complexities only as needed, to focus selectively on matters of fundamental importance, and to relate the discussion at each point with what has gone before. By proceeding in this fashion, I have found it possible to handle in a satisfying manner numerous topics not usually included in textbook discussions. In particular, the book is novel in its emphasis on severe inflation, inflation, o n mo netary standards (including (including commodity-money commodity-money arrange ments), and on realistic descriptions of central-bank operating proce dures. Also, there is a discussion of United States monetary history that is unusual in its coverage, as three-quarters of its length is de voted to periods before the creation (in 1914) of the Federal Reserve System. In terms of technique, moreover, the book includes extensive expositions of inflationary steady-state analysis, dynamic analysis with adaptive and rational expectations, and a systematic procedure for solving linear stochastic models with rational expectations. The book does not, on the other hand, include much institutional detail or any substantial amount of material on the subject of finance. finance. These omissions do not in my opinion constitute a weakness; an impor tant ingredient of effective instruction is selectivity in terms of cover age. Because the book emphasizes recent research topics but strives for analytical simplicity, it should be appropriate for textbook use in a variety of settings. Preliminary versions have been used successfully in advanced undergraduate and MBA courses, yet much of the material could be helpful to beginning graduate students in economics. The book is primarily designed for courses in monetary economics, but could alternatively serve as a textbook in macroeconomics or money and banking with analytical emphasis. It would need to be augmented
vi
Preface
with additional material on consumption, investment, and fiscal policy (in the former case) or on financial markets and institutions (in the latter). A synopsis of the material in each chapter is provided in Sec tion 1.4 on pp. 12-15. In expressing thanks to those who have been helpful to me in writing the book, I will begin with two organizations. First, the Graduate School of Industrial Administration (GSIA) at Carnegie-Mellon Uni versity has provided an excellent intellectual atmosphere plus the pos sibility of combining research and teaching activities. Second, the Research Department of the Federal Reserve Bank of Richmond, with which I have been associated for several years, has provided the opportunity of learning from its members about monetary issues in general and the Federal Reserve System in particular. Needless to say, none of the views expressed in the book should be attributed to either of these institutions. Many individuals have contributed in a variety of ways. Excellent typing was provided by GSIA's word-processing department and by my secretaries, Sue Sholar and Gerri Carrozzi. At Macmillan, Ken MacLeod and Elaine Wetterau were helpful in their roles as Editor and Production Supervisor, while special thanks go to Jack Repcheck for crucial support and encouragement in the initial and intermediate stages of the project. Helpful comments on various chapters have been provided by number of economists. My thanks go particularly to those who read large portions of the manuscript, including David Aschauer, Michael Bordo, Martin Eichenbaum, Richard Froyen, Marvin Goodfriend, John Huizinga, and Dean Taylor. I regret that time pressures have kept me from incorporating more of their thoughtful suggestions. Final thanks go to my wife, Sally, whose support has been extra ordinary. She deserves substantial credit for anything that I manage to accomplish. B.T.M.
CONr!'ENTS
Preface ____________________
P A R T I - - - - - - - - - - - - - - --- - - - -
Rudiments of Monetary Analysis Analysis An
1.1 1.2 1.3 1.4
Introduction to Monetary Economics Preliminary Remarks A Few Historical Facts
The U.S. Monetary Experience of 1979-1982
A Look Ahead Problems 15
12
References
9
15
16
Basic Concepts 2.1 2.2 2.3
Th Functions of Money 16 Empirical Measures 19 Monetary Standards: Fiat Versus Commodity
2.4 2.5
Money 22 Legal Tender 24 . Money, Credit, and Financial IntermedlatlOn Problems 30 Referen ces 32
33
The Demand for Money 3.1 3.2 3.3 3.4
25
Informal Discussion 33 A Formal Model 35 Uncertainty 41 Empirical Money Demand Functions vII
42
viii
Contents
3.5 3.6
Contents
Velocity 47 The Baumol- Tobin Model
7
48
53
References
54
4 The Supply of Money 4.1 4.2 4.3 4.4 4.5 4.6
55
Introduction 55 Basic Relationshi ps 56 Monetary Control 60 Alternative Control Procedures 63 Algebraic Analysis 67 Conclusions 71 Problems 72 References 73 PARTII
8
6.1
6.7 6.8
8.4 Properties of the Solution 153 8.5 Examples of Rational Expectation Solutions 8.6 Models with Lagged Variables 157 8.7 Multiple Solution s 158 Appendix: Mathematical Expectation: A Review Problem s 172 References 173
155
160
9
Inflatio n and Unemployment: Alternative Theories 9.1 Dynamics and the Keynesian Model 174 9.2 The Original Phillips Curve 177 9.3 The Augmented Phillips Curve 181 9.4 Lucas's Monetary Misperceptions Theory 9.5 Taylor's Relative-Prices Theory 188 9.6 Fischer's Sticky-Wage Theor 189
174
185
192
9.8
Conclusions 196 Probl ems 197
References
199
109
Introduction 109 Real Versus Nominal Intere st Rates 112 Inflation in the Classical Model 113 Compar ative Steady States 117 Analysis with Real-Balance Effects 120 Output The Welfare Cost of Inflation
148
77
5.1 Introduction 77 5.2 The IS Function 78 5.3 The LM Function 83 5.4 The Aggregate Demand Function 85 5.5 The Classical Aggreg ate Supply Function 89 5.6 The Classical Model 93 96 5.7 The Keynesian Aggregate Supply Functio 5.8 The Keynesian Model 100 Appendix: I S - L M and Maximizing Analysis 102 Problems 107 References 108
6.2 6.3 6.4 6.5
145
145 Basic Prop ertie Application to the Cagan Model 151
Monetary Macroeconomics
Steady Inflation
142 144
Rational Expectations 8.1 8.2
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ ___
The Static Classical and Keynesian Models
133
Inflationary Dynamics 7.1 The Cagan Model 133 7.2 Hyperinflation Episodes 135 7.3 Cagan's Estimates 136 7.4 Stability Analysis 139 7.5 Weakness of Adaptive Expectations Problems 144 Reference
52
Problems
Ix
122 124
Concluding Comments 130 Problems 131 References
131
10
Money and Output:
An
Analytical Framework
10.1 Introduction 201 10.2 Aggre gate Supply: Basic Model 203 10.3 Normal Output 208 10.4 Multip eriod Pricing 211 10.5 Rati onal e for Price Stickiness 214 10.6 Conclusions 215 Problems 217 References 217
201
Contents
Contents
PART
15
III
Monetary Policy 11
Analysis of Alternative Policy Rules
12
Rules Versus Discretion 12.1 12.2 12.3 12.4 12.5
13
16
Monetary Policy
237
Distinctions 237 Rules Versus Discretion: An Example 239 Effects of Rules Versus Discretion 241 Extensions of the Basic Model 244 Evidence 245 Problems 248 References 248
Introduction 249 Basic Model 250 Analysis with Basic Model 255 Dynamic Analysis with Rational Expectations Bimetallism 263 Conclusions 267 Problems 267 References 268
Open-Economy Monetary Analysis 14.1 14.2 14.3 14.4 14.5 14.6 14.7
16.1 16.2 16.3 16.4
Index
Introduction 269 Basic Open-Economy Model 271 Properties of the Model 275 Extensions 280 Fixed Exchange Rates 285 The Balance of Payments 288 Fixed Versus Floating Exchange Rates 293 Problems 296 References 297
249
258
269
in U.S.
Monetary History
298
Introduction 298 Money in Colonial America 299 309 From the Revolution to the Civil War to World War I 31 From the Civil 324 From 1914 to 1944 Conclusion 331 Probl ems 333 Referenc es 334
A Strategy for Monetary Policy
Fundamental
The Gold Standard: A Commodity-Money System 13.1 13.2 13.3 13.4 13.5 13.6
14
in
15.1 15.2 15.3 15.4 15.5 15.6
221
11.1 Introduction 221 11.2 Monetary Policy Ineffectiveness? 221 11.3 The Lucas Critique 228 11.4 Money Stock Control 230 11.5 Conclusions 235 Problems 236 References 236
Episodes
xi
Basic Considerat ions 336 A Specific Rule 339 Performance of Proposed Rule 34 Conclusions 348 Proble ms 350 Reference s 350
352
Monetary Analysis
