Monetary Economics Theory and Policy Bennett T. McCallum Carnegie-Metion Universi ¥ oe HONTPORbI EE CHOC AEE”Copyright © 1989, Macmillan Pubishing Company, x division of Mactan, In. Printed inthe nied States of America All sighs reserved. No pat of this book maybe produced or transmitted ia any form 6x by any means, electronic or mechanics including photocopying, recording, or any information storage and retieval sistem, without permisson i weg from the pa Isher u cannes Macmillan Publishing Company oe Third Avenue, New York, New York (0022 Collier Macmillan Canada, ne Library of Congress Cataloging in Publication Data ‘McCallum, Bennett 7 “Monetary economies: theory and policyennett T, McCallum Pt Induces index ISBN OD 3784717 ‘Money 2 Monetary policy. 1. Title G23 1989 B2ddeld Printing: Year sore PREFACE The object of this book is to present a systematic treatment of mone- ary economies in a manner that is clear and nontechnical, yet accu- rately reflective 0° 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 taskhas been to begin with simple models, tointroduce 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, T 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, on monetary standards (including 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 tefore 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. ‘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 economies. The book is primarily designed for courses in monetary economies, but could alternatively serve as a textbook in macroeconomics or money and banking with analytical emphasis. It would need to be augmentedMi 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 {.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 ofthese 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 a number of economists, My thanks go particularly 10 those who read large portions of the manuscript, including David Aschauer, Michael Bordo, Martin Eichenbaum, Richard Froyen, Marvin Goodfriend, John Fiuizinga, and Dean Taylor. [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. BTM. CONTENTS Pretace v PART Rudiments of Monetary Analysis 1. An Introduction to Monetary Economics 3 LL Preliminary Remarks 3 12. A Few Historical Facts 5 13. The US. Monetary Experience of 1979-1982 9 14 A Look Ahead 12 Problems 15 References 15 2 Basic Concepts 16 2.1 The Functions of Money 16 22 Empirical Measures 19 2.3 Monetary Standards: Fiat Versus Commodity Money 22 2.4 Legal Tender 24 ; 215 Money, Credit, and Financial Intermediation 25 Problems 30 References 32 3. The Demand for Money 3 3.1 Informal Discussion 33. 3.2. A Formal Model 35 3.3. Uncertainty 41 3.4. Empirical Money Demand Functions 42 wi