International Review of Applied Economics,

Vol. 18, No. 1, 2541, January 2004

Monetary Policy Uncovered: Theory and Practice

GIUSEPPE FONTANA* & ALFONSO PALACIO-VERA**

*Department of Economics, University of Leeds, UK,
**Departamento de Economa Aplicada III, Facultad de Ciencias Econmicas y Empresariales,
Universidad Complutense de Madrid, Madrid, Spain
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ABSTRACT This paper discusses the current new consensus view on monetary policy
and the theoretical framework on which that practical view relies, namely, the targets-
and-instrument approach. We argue that in the modern world of financial innovation
and liability management central banks cannot choose between an interest rate-targeting
policy and a money-targeting policy. A money-targeting regime is not desirable, if not
unfeasible. In addition, in the context of Pooles approach to the instrument problem, the
implementation of a money-targeting regime would raise the expected value of the loss
function of the central bank and would thus shift the balance in favour of an interest-rate
targeting regime.

K EY WORDS: Monetary policy; Pooles approach; Post Keynesian economics;

endogenous money

Central bankers and even some monetary economists talk knowledgeably of using
interest rates to control inflation, but I know of no evidence from even one economy
linking these variables in a useful way, let alone evidence as sharp as that displayed
in figure 1 [showing a simple correlation between inflation and money growth]. The
kind of monetary neutrality shown in this figure needs to be a central feature of any
monetary or macroeconomic theory that claims empirical seriousness (Robert E.
Lucas, Nobel Lecture, 1996).

Introduction
In a recent issue of the Journal of Economic Perspectives, De Long (2000, pp. 8384)
has claimed that the influence of monetarism over current macroeconomics is
profound and widespread. In particular, he argues that the emergence of mone-
tary policy as one of the most critical government responsibilities is the result of
the triumph of classic monetarism as developed, for example, by Friedman &

Correspondence Address: Alfonso Palacio-Vera, Departamento de Economa Aplicada III, Facultad de

Ciencias Economicas y Empresariales, Universidad Complutense de Madrid, Madrid, 28223, Spain.
Email: apv@ccee. ucym.es

ISSN 0269-2171 print; ISSN 1465-3486 online/04/010025-17 2004 Taylor & Francis Ltd.
DOI: 10.1080/0269217032000148627
26 G. Fontana & A. Palacio-Vera

Schwartz (1963). A similar sort of evocation of monetarism is also at the core of a

recent paper by Laidler on the transmission mechanism (Laidler, 2002).
Some policy-makers would find comfort in these assessments. They would see
them as providing further evidence to the view that modern monetary policy is
monetarist in nature despite some degree of play-acting, even deception, by
modern central bankers. For instance, Pianalto, first vice president of the Federal
Reserve Bank of Cleveland has argued that central bankers have finally abandoned
the impulse to control fluctuations in national output and movements in the rate
of unemployment. Economic policymakers, monetary and otherwise, are replac-
ing their business cycle focus with a longer-term perspective (Pianalto, 2001, p. 3).
Thus, according to Pianalto, current central banking practice would seem consis-
tent with Milton Friedmans prescription that monetary authorities should avoid
fine-tuning policies (Friedman, 1982).
However, critics of monetarism would disagree with these conclusions. They
would, for instance, recall another of Milton Friedmans prescriptions, namely the
dismissal of interest rates as a policy instrument. Experience has demonstrated
that it is simply not feasible for the monetary authority to use interest rates as
either a target or as an effective instrument. Hence, there is now wide agree-
ment that the appropriate, short-run tactics are to express a target in terms of
monetary aggregates, and to use control of the base, or components of the base, as
an instrument to achieve the target (Friedman, 1982, p. 101). Those critics would
thus argue that the adoption of an interest rate policy by modern monetary
authorities marks, if any, the collapse rather than the triumph of the monetarist
position on policy.1 They would also contend that the current practice of central
banking is at least in part consistent with Keyness theory and policy prescrip-
tions. For instance, Dalziel (2002) has shown that the cornerstone of monetarism,
the quantity theory of money, is no longer used by central banks. He maintains
that, today, monetary policy is aimed to maintain aggregate demand growth
compatible with supply-side capacity growth, a framework that he traces back to
Chapter 21 of Keyness (1936) General Theory. Other critics, such as Sawyer, have
emphasised that modern monetary policy is supposed to operate through interest
rates, which influence aggregate demand and thereby inflation. However, accord-
ing to Sawyer, this is the way Keynes (1930) used the fundamental equations in
the Treatise on Money for explaining the movement of prices (Sawyer, 2002; also
Fontana, 2003). Does current monetary policy then mark the triumph of Friedman
and monetarism, or is it rather the triumph of Keynes and his policy prescrip-
tions? This paper invites a non-dualistic response to the question, and in this way
aims to uncover the tension between the theory and the practice of modern central
banking.
The structure of the paper is as follows. The second section reviews the current
practice of central banks. The third section discusses the theoretical framework on
which that practice relies, namely, the targets-and-instrument approach and its
core element, Pooles approach to the instrument problem. The fourth section
focuses on the theoretical and practical problems faced by money-targeting
regimes, and offers a Post Keynesian critique of them. The fifth section then shows
that the implementation of a money-targeting regime would inevitably raise the
relative variance of shocks to the monetary sector and, through changes in the
co-variances of shocks to the commodity and monetary sectors, it would thus shift
the balance in favour of an interest rate-targeting regime. The final section
concludes.
 Monetary Policy Uncovered 27

Central Banking in Practice: the New Consensus View

The main tenet of the so-called new consensus view in macroeconomics is that
monetary policy is the major direct determinant of inflation (Bernanke et al., 1999,
p. 3). According to a prominent monetary economist, this means that if one were
to discuss monetary policy with a representative group of central bankers they
would undoubtedly start to discuss their policies in terms of the following expres-
sion (Laidler, 2002, p. 3):

dP dM dV dY
+ (1a)
dt dt dt dt
The logarithmic growth rate of prices Pthat is, the inflation rateis equal to the
logarithmic rate of growth of some representative monetary aggregate M, plus the
logarithmic rate of change in the velocity of circulation of money V, minus the
logarithmic growth rate of real income Y. According to Laidler (2002), those central
bankers would also argue that in the long run changes in real income and the
velocity of circulation of money are exogenous and, therefore, outside their control
so that expression (1a) can be written in the following way:

dP dM
(1b)
dt dt
For what matters, expression (1b) is perfectly compatible with standard monetarist
propositions. Causality is read from right to left, the independent and causal vari-
able being the monetary aggregate M and the dependent variable being the price
level P. Thus, any change in the money supply that monetary authorities succeed
in bringing about manifests itself in the long run in higher prices but not in higher
real output.2 But does it really matter that expression (1b) could be made consistent
with a monetarist approach to monetary policy?3 What do central bankers really
do in the day-to-day setting of monetary policy? Again, according to Laidler, the
same central bankers would surely agree that in the short run they use roughly a
set of three equationsnamely, an expectations-augmented Phillips curve, an IS
curve, and a Fisher equation:

e
dP dP
= g Y Y
dt dt
( ( (2)

Y Y = h (r, X ) (3)

e
dP
r =i (4)
dt
where (Y Y*) measures the output gap (for the problematic nature of the compu-
tation of potential output, see Dalziel, 2002), (dP/dt)e is the expected value of the
inflation rate, X is a vector of variables that shift the IS curve, and r and i are the
real and nominal rates of interest, respectively.
However, as Laidler promptly recognises, there is an unresolved tension over
the way the new consensus literature approaches the setting of monetary policy.
28 G. Fontana & A. Palacio-Vera

Expression (1b) seems to make money all important for inflation in the long run
while equations (24) treat it as irrelevant in the short run. From a monetarist
perspective, equation (3) is a Trojan horse in the citadel of the quantity theory of
money. What a true monetarist would like to see in its place is the following equa-
tionnamely, a positively sloped LM curve:

M
= m ( i, Y ) (5)
P
where (M/P) indicates the equilibrium real money balances of our economy and M
is assumed to be exogenously determined. Of course, there is a good, though often
neglected, reason for using an IS curve as in equation (3) rather than an LM curve.
It is related to the so-called instrument problem, a major component of the
targets-and-instrument approach that is currently used by most central bankers
(Blinder, 1998). The debate around the instrument problem began with Pooles
seminal work (Poole, 1970). In Pooles approach, the analysis was conducted in
the context of a stochastic IS-LM framework where the money supply was
assumed to be controllable by the monetary authorities. The crux of the matter
was to determine the conditions under which an interest rate r policy was
preferred to a monetary aggregate M policy. The main result of the debate was
that, in theory, the latter policy tends to represent an optimal choice of monetary
policy when ceteris paribus the variance of shocks to the commodity market is
larger than the variance of shocks to the monetary sector. However, in practice,
monetary targets were often missed and, in addition, at least in the US during the
mid-to-late 1980s, fluctuations in money growth ceased to anticipate fluctuations
in either output or prices. Central banks were thus led to interpret the empirical
evidence as suggesting that the theoretical conditions for an interest rate policy
had actually arisen. In a recent study using the VAR methodology, Friedman &
Kuttner (1996, pp. 115116) provide support for this view and, in addition, they
show that in the US economy the variance of shocks to the monetary sector rose
substantially relative to the variance of shocks to the real sector in the mid-to-late
1980s. Thus, the controversy between advocates of r targets and advocates of M
targets was settled in practice. As argued by Blinder (1997, p. 7), these [theoreti-
cal] conditions then arose in practice, and one central bank after another aban-
doned M targets in favour of r targets.
This is all well known, and the controversy over the optimal choice of monetary
policy instruments is now history. However, there is a problem with this argument
and the often-quoted successful interaction between theory and practice of central
banking. Consistency with the targets-and-instrument approach requires that,
were the relative size of the variance of shocks to the commodity market to be
larger than the variance of shocks to the monetary sector, it might again be appro-
priate to use monetary aggregates as intermediate targets. This possibility may
justify, among other things, keeping the base money-multiplier approach as the
essential tool for explaining the money supply process in standard textbooks.
Indeed, this seems to be the view of the president of the Federal Reserve Bank of
New York, who is not short of praise for using monetary aggregates as a targeting
framework for monetary policy (see also Volcker, 2002). According to him, it is
only the momentary absence of a stable and predictable relationship between the
money target and nominal income that prevents the adoption of that policy frame-
work in modern times (McDonough, 1997, p. 4; also Taylor, 1995, p. 12, n. 1).
 Monetary Policy Uncovered 29

However, critics like Moore (1988) and Wray (1990) as well as leading monetary
practitioners like Goodhart (2002) have talked openly about the myth of the money
multiplier. In particular, these authors have denounced the ex-post tautological
nature of the multiplier and thus its uselessness for forecasting purposes. The
money multiplier seems to ignore both modern liability management practices
implemented by banks and the effects of the loan demand by the non-bank private
sector. As shown in the next sections, these critics thus maintain that a money-
targeting strategy is neither feasible nor desirable.
Before moving to the problems of the current use of the targets-and-instrument
approach, it is worthwhile noting that there is much more than a numerical substi-
tution in having an IS curve rather than a positively sloped LM curve in the set of
equations (2)(4). For the day-to-day setting of monetary policy, central bankers
seem to have lost any confidence in the ability of targeting monetary aggregates in
order to deliver price stability.4 It is the central banks key interest rate that is now
seen as the policy instrument for achieving the desired inflation rate through its
effects on aggregate demand (Bank of England, 1999). Recent work by Arestis &
Sawyer (2002) on current monetary policy in the United Kingdom confirms this
view. They argue that interest rate-targeting policy has little to do with monetary
aggregates. In the basic macroeconomic models of the Treasury and the Bank of
England, the supply of money is not even mentioned. More importantly, the
demand for money is either viewed as unstable or is treated as a residual. Simi-
larly, in the macroeconomic model of the US economy used by the Federal
Reserve, shifts in monetary policy are fully captured by innovations to the federal
funds rate, with no role for monetary aggregates (Federal Reserve Board, 1996).
Thus, what Laidler (2002) defines as an unresolved tension in the modern setting
of monetary policy is simply evidence of the large bridge that has, for long time
now, separated theory from practice. As Wray (1998, p. 98) explains, the central
bank never has controlled, nor could it ever control, the quantity of money; neither
can it control the quantity of reserves in a discretionary manner. For the current
setting of monetary policy, the monetarist interpretation of expression (1b) is then
simply a relic of what theorists suggested that central banks should do, and what
these same central banks could not do. Therefore, a more general or encompassing
interpretation of expression (1a) would be that, in the long run and in the absence
of significant changes in the velocity of circulation of money, the money supply
will move in line with nominal income. Similarly, the implied direction of causa-
tion, if any, in expression (1b) would then be from changes in nominal income to
changes in the stock of money.5

Conventional Theories of Central Banking: the Instrument Problem

Framework
The instrument problem of monetary policy arises because of the need to specify
how central banks implement open market operations. In particular, the instru-
ment problem consists of the choice of a variable that will be set directly by central
bankers via the purchase or sale of securities in financial markets. A central bank
may buy or sell a certain amount of securities, thereby providing or withdrawing
the equivalent amount of bank reserves. Alternatively, a central bank may
purchase or sell whatever amount of securities other market participants want to
exchange at a specified price. In this case, central banks would let the market deter-
mine the quantity of bank reserves to be held at that price. Beginning with Poole
30 G. Fontana & A. Palacio-Vera

(1970), the literature regarding the choice of monetary policy instruments has laid
down the conditions under which a price variable, for instance an interest rate, was
to be preferred to a quantity variable like borrowed (BOR) or non-borrowed
(NBOR) bank reserves.
In Pooles seminal contribution (Poole, 1970) a stochastic ISLM framework is
formulated where the commodity and monetary sectors are subjected to exoge-
nous random shocks. The monetary policy strategy that minimises a loss function,
presented as the quadratic deviation of current Y from desired level of output Y,
will be the preferable one:

( )
L = E Y Y
2
(6)

If m is the standard deviation of disturbances to the monetary sector, u the

standard deviation of disturbances to the commodity sector, and 1 the income
elasticity of the demand for money, a sufficient condition for a money-targeting
regime to be superior to an interest rate-targeting regime is (m / u < 1 (Poole,
1970, p. 206). In the context of the stochastic IS-LM framework used by Poole,
targeting money supply damps the impact on income of disturbances to aggregate
demand (i.e. to the IS function), whereas targeting the interest rate damps the
impact of disturbances to the demand for money (i.e. to the LM function).
In general, the choice of the monetary policy instrument depends on the values
of m and u, the structural parameters of the model determining the slopes of the
IS and LM functions, and the covariance of disturbances to the commodity and
monetary sectors. Given the values of the behavioural parameters of the model
and the covariance of shocks, a larger variance of disturbances to the commodity
sector makes the money stock more likely to be the preferable instrument, and vice
versa. As a result, the policy choice is inherently empirical. In recent years more
complicated models have brought in other factors, yet both the logic and essential
results of Pooles approach have remained unchallenged (Friedman, 1990,
pp. 11991200).
Notwithstanding the merits of Pooles approach, it suffers from several prob-
lems (see Palley, 1996a, p. 593), not least that it ignores the interdependence
between the commodity market (IS function) and the money market (LM func-
tion).6 The focus of this paper is on only two issues. First, Pooles analysis implic-
itly assumes that central banks can have full control of the money supply, if they
choose to. However, most of the money used by the public, either as a means of
payment or as a liquid store of value, represents the liabilities of private depository
institutions. Central banks have some influence over the lending activity of these
institutions, but they cannot fix the stock of money in a country. The money supply
is not an exogenously set policy variable. Rather, it is the result of the income and
portfolio decisions of the bank and non-bank private sector (Wray, 1998; Fontana,
2000). This is what Post Keynesians mean when they say that the money supply is
endogenously determined as a residual of the economic process (Palley, 2002).
Indeed, the increased ability of banks to avert central bank-imposed reserve
constraints has led to the view that, under the current institutional framework,
central banks can only affect money supply growth indirectlythat is, through
variations in short-term nominal interest rates.7 For instance, Goodhart (1995, p.
252) suggests that, with a few possible exceptions, no central bank has ever run a
true system of monetary base control and that instead, central banks sought to
 Monetary Policy Uncovered 31

control the level of interest rates in order to affect the rate of monetary expansion
indirectly. An important implication of this argument is that control of the rate of
expansion of the money supply ultimately rests on the ability of central banks to
affect bank lending to the non-bank private sector. This is a proposition that has
long been advocated by Post Keynesians like Kaldor & Trevithick (1981), Moore
(1988), Niggle (1990, 1991), Arestis & Howells (1992), Dow (1993) and Chick (1995).
Within a Post Keynesian framework, the key question is how variations in interest
rates impinge on the decisions to deficit-spend by the non-bank private sector and
the willingness to lend by the banking system. In this respect, Arestis & Howells
(1992, p. 149) argue that it is clear that the UK authorities now see interest rate
changes as having an impact upon aggregate demand through a number of diverse
channels. These include the cost of borrowing, income and wealth effects, and the
exchange rate. In summary, the type of institutional arrangements characteristic
of modern economies with developed financial markets make it very unlikely that
both the theoretical and practical conditions necessary to run a money-targeting
regime will be fulfilled.
In an extension of Pooles analysis by Modigliani et al. (1970), the money supply
process incorporates two types of disturbances. First, there are the standard shocks
affecting the aggregate demand function and the money demand function. Second,
and importantly, the model also includes shocks affecting the relationship
between high-powered money and the money supply. The difference with Pooles
analysis is that targeting interest rates now damps the impact on income of mone-
tary disturbances that could consist of variations in the money multiplier as well
as shocks to the money demand function. On the other hand, targeting high-
powered money now damps to a lesser extent than in Pooles model the impact on
income of shocks to the IS function. This is because aggregate demand shocks may
be accompanied, for instance, by variations in the money multiplier, thus leading
to changes of the same sign in the LM function. We will return to this point below.
Secondly, another feature of Pooles approach is that the standard deviation of
shocks to the monetary sector m and the covariances of shocks to the commodity
and monetary sectors are assumed to be exogenous and, therefore, independent of
the monetary policy regime implemented. But these parameters, and this is our
main contention, are likely to be a function of the monetary policy regime pursued
by a central bank. In particular, it will be argued below that the implementation of
a money-targeting regime will raise m and vary the covariance terms in such a
way as to shift the balance in favour of an interest rate-targeting regime. As a
result, the choice of a money-targeting regime is likely to be self-defeating. Would
then its implementation raise m and vary the value and sign of the covariance
terms as much as to make an interest rate-targeting regime preferable? The expe-
rience with money-targeting regimes is not helpful here because, in practice, no
central bank has ever succeeded in determining money growth with precision over
a reliable period of time (Bernanke et al., 1999, p. 304). This fact raises serious
doubts about the possibility of a central bank ever being able to implement
successfully a money-targeting regime.8 For instance, Friedman and Kuttner (1996,
pp. 8093) present evidence showing that the Federal Reserve did for a while genu-
inely use money growth targets to conduct monetary policy in the sense that it
varied either the federal funds rate or NBOR in response to observed fluctuations
of either M1 or M2 that departed from the corresponding target. However, around
the mid-1980s, the Federal Reserve started to ignore monetary aggregates
although legislation calling for their use remained in force for much longer. As
32 G. Fontana & A. Palacio-Vera

argued in Bernanke (1996), even those countries traditionally associated with

money-targeting regimes, such as Germany and Switzerland, often missed the
announced monetary targets. In addition, the announced monetary targets were
adjusted from year to year to reflect economic conditions and competing objectives
of the monetary authorities.

Monetary Aggregates Targeting: a Post Keynesian Perspective

According to Post Keynesians, money-targeting regimes are undesirable, if not
infeasible. For a money-targeting regime to be viable, at least two conditions must
be met: (a) central banks need to have full control of the money supply and (b) the
relationship between the money supply and nominal income needs to be stable. In
turn, if the first condition is to hold, two additional sub-conditions must be
fulfilled. First, central banks need to have full control of the level of bank reserves
or so-called monetary base (a1). Secondly, a stable relationship between the mone-
tary base and the money supply has to hold once the money-targeting regime is
implemented, i.e. the money-multiplier needs to be stable (a2). The discussion
below intends to show that, in practice, most (if not all) of these conditions do not
hold in economies with modern financial systems.

Do Central Banks Have Full Control of the Money Supply?

The first type of problem for a money-targeting policy is related to the effective-
ness of quantity control of bank reserves. Central banks may not indeed have full
control of bank reserves (condition (a1)). Cramp (1970) and Kaldor (1985, p.10)
were among the first modern economists to argue that central banks cannot close
the discount window, since the maintenance of the solvency of the banking system
is their most important function. More recently, several economists have high-
lighted several institutional features of the US and UK monetary policy frame-
works that make attempts at controlling bank reserves ineffective, at least in the
short run. For example, Goodhart (1994, p.1425) has argued that:

If the CB [central bank] tried to run a system of monetary base control, it would fail.
Much, perhaps most, of the time it would still be accommodating the day-to-day
demand of the banking system for reserves at a penal interest rate of its own choice,
whenever its Mo [monetary base] target was below the systems demand for reserves.
Otherwise when its target was above the systems demand, overnight rates would fall
to near zero.

Similarly, talking of the experience of the United States, Moore (1988, p. 122) has
argued that, by keeping an unsatisfied demand of NBOR, the Fed controls the
amount of discount-window borrowing and, indirectly, it sets the federal funds
rate. As the demand for BOR rises, the marginal effective total cost (discount rate
plus frown costs) of obtaining reserves rises above the discount rate. As a result,
the federal funds rate rises pari passu above the discount rate. Increases in NBOR
relative to total reserves (TR), with TR = BOR + NBOR, operate in the opposite
direction, reducing BOR and, therefore, short-term interest rates. Regarding the
newly created institution of the European Central Bank (ECB), its deposit and
lending facilities set a lower and upper bound to overnight rates in the euro-zone.
To the extent that, in principle, there is no explicit limitother than the assets used
 Monetary Policy Uncovered 33

by banks as collateralto the amount individual banks can borrow (lend) through
the lending (deposit) facilities, the ECB cannot closely control the amount of total
aggregate reserves. Thus, more generally, it is fair to claim that central banks only
set the supply price of reserves. As a result, the reserve supply function is horizon-
tal in the market period, at an interest rate exogenously administered by central
banks.
Secondly, the money-multiplier is not stable (condition (a2)). The explanation
for the instability and, hence, for the uncertainty attached to any forecast of money
multipliers, were a money-targeting regime ever be implemented, relies on the
idea that the money supply in modern monetary production economies is credit-
driven and demand-determined. Credit-money is created when loans are granted
by the banking system to the non-bank private sector, and is extinguished when
loans are repaid, so that the level and the rate of expansion of the money supply
are ultimately a decision of the private sector of the economy. The rate of monetary
expansion is thus determined by the level of planned aggregate deficit-spending
net of loans repayment. Thus, for instance, if a central bank increases NBOR
through open market operations, banks may voluntarily opt not to increase lend-
ing if they do not identify any profitable outlet, and, instead, increase their level of
excess reserves (ER). According to several authors, this was the behaviour of US
banks in the aftermath of the Great Depression. Similarly, non-bank private sector
unitsthat is, firms and householdscan easily dispose of any unwanted money
balances through loans repayment (the reflux mechanism). In these cases, an
increase in NBOR will be offset by a rise in the aggregate reserve-deposit ratio and,
therefore, a decrease in the money multiplier. Thus, any attempt by central banks
to impose a high rate (relative to the rate desired by the private sector) of monetary
expansion through, for instance, an increase in NBOR will be ineffective. This rate
is ultimately determined by lending and/or net deficit-spending decisions of the
private sector.
Likewise, attempts by central banks to restrain the level of bank reserves below
either the level of required reserves (RR), where TR = BOR + NBOR = RR + ER, or
TR will encourage banks to look for reserves elsewhere. For instance, banks may
borrow from the discount window or on the inter-bank market. In any case, inter-
bank market interest rates will tend to rise and banks will only be able to obtain
additional reserves at a higher cost. As a result, banks will be encouraged to imple-
ment portfolio adjustments on the liability side of their balance sheets by searching
for alternative sources of funds with lower reserve requirements. These adjust-
ments are commonly known as liability management practices (Earley & Evans,
1982; Evans, 1984; Goodhart, 1984, Ch. 3; Podolski, 1986; De Cecco, 1987).
As these funds are obtained, banks transform their balance sheets, allowing
them to increase their loan/reserve and deposit/reserve ratios (Pollin, 1991;
Palley, 1996a, 1996b, 1998; Moore, 1998). As profit maximisers, banks continually
seek to raise their deposit/reserve ratio by discovering new financial products and
procedures, thus making money multipliers and money velocityespecially for
narrow definitions of moneyexhibit an upward trend.9 However, with rising
interest rates and increasing returns on non-reserve assets, banks will have an
additional incentive to minimise average holdings of excess reserves (Davidson,
1990b, pp. 387388). Furthermore, as interest rates rise (fall), banks feel more (less)
pressure to search for alternative sources of funds with lower reserve requirements
such that, other things being the same, the rate of financial innovation will tend to
speed up (slow down) (Palacio-Vera, 2001). As a result of these two processes,
34 G. Fontana & A. Palacio-Vera

money multipliers (as well as the velocity of circulation of narrow money) will also
exhibit a pro-cyclical pattern. In this way, financial innovation loosens the connec-
tion between reserves and bank lending (Earley & Evans, 1982; Evans, 1984,
p. 444). Since central banks cannot know in advance either the rate or the pattern
of financial innovation, they will not be able to predict accurately the rate of
growth of reserves necessary to obtain a given growth rate of the monetary aggre-
gate selected as an intermediate target variable (Pierce, 1984). For instance, in the
context of a stochastic IS-LM model, financial innovations will shift both the slope
and the position of the LM curve in an uncertain and unpredictable way. Notwith-
standing, it may well be the case that under a sufficiently elastic supply of reserves,
money multipliers remain stable. This is the case when the central bank fully satis-
fies the demand for reserves of banks at a constant short-term interest rate. Thus,
the issue of the stability of money multipliers is independent of the direction of
causality between reserves and deposits.

Is the Velocity of Circulation of Money Stable?

The idea of a stable relationship between the money supply and nominal income
(condition (b)) has not enjoyed much empirical support in recent times. Beginning
in the 1970s, the instabilities showing up in money demand functions in the United
States, in the United Kingdom, and in many other countries, led academics and
policy makers alike to conclude that a money-targeting regime was not a viable
option. For instance, in an influential study, Estrella & Mishkin (1997) conclude
that in the case of the United States and Germany the empirical relationships
involving monetary aggregates, nominal income, and inflation are not sufficiently
strong and stable to support a straightforward role for monetary aggregates in the
conduct of monetary policy. Similar results are presented by Friedman & Kuttner
(1992, 1996). A common explanation for the abandonment of money-targeting
regimes is thus the notion that the relationship between the money supply and
nominal income has proven to be unstable. In more formal terms, the unstable
nature of the relationship between monetary aggregates and nominal income
shows up in the empirical observation that the various monetary aggregates are
not co-integrated with nominal incomethat is, velocity is non-stationary
(Goodhart, 1989, p. 316). 10
In turn, the break-up of this relationship is attributed to a combination of dereg-
ulation of financial markets, improvements in transactions technology, and finan-
cial innovation (Hester, 1981; Minsky, 1982, Ch. 7; Goodhart, 1984, Ch. 3, 1986,
1989; Podolski, 1986; De Cecco, 1987; Arestis & Howells, 1992; Clarida et al., 1999,
p. 1685). It is now commonplace to conclude that changes in financial markets in
the last three decades have made the growth rate of the money supply much less
controllable and predictable. For instance, financial institutions have substantially
increased their capacity to circumvent restrictive policies of the central bank by
operating in wholesale markets. In particular, liability management practices have
allowed banks to capture non-deposit funds in wholesale markets by paying
market interest rates. In turn, as argued before, the ways these non-deposit funds
alter the structure of the liability side of the balance sheets of banks is uncertain
and unpredictable (Pierce, 1984; Podolski, 1986, p. 164). In short, financial innova-
tion and liability management practices have made both the relationship between
reserves (or monetary base) and deposits (or money supply) and the relationship
between deposits and nominal GDP an unstable one. Under such circumstances,
 Monetary Policy Uncovered 35

any attempt to run a money-targeting regime is bound to lead to severe short-run

volatility in interest rates and, perhaps, even in money growth, as the monetarist
experiment in the United States revealed (Friedman, 1984, 1988, p. 55).

Money-Targeting, Liability Management, and the Instrument Problem

A closely related explanation for the loss of stability of the moneyincome relation-
ship is Goodharts Law (Goodhart, 1984, p. 96). According to this, any observed
statistical regularity tends to collapse once pressure is placed upon it for control
purposes. In the field of monetary policy, Goodharts Law implies that the adop-
tion of a money-targeting regime that exploits the (previously) observed stability
of the relationship between nominal income and a specific monetary aggregate
will lead to increasing instability and unpredictability in that relationship. In the
context of the discussion on the instrument problem presented above, Goodharts
Law and the ability of banks to avert central bank-imposed reserve constraints by
adopting liability management practices means that, were a central bank ever to
adopt a money-targeting regime m would tend to rise.11 Similarly, the covariance
of shocks would vary in a way as to shift the balance of preference towards an
interest rate-targeting regime. One reason is that, as experience has revealed, the
implementation of a money-targeting regime substantially increases volatility in
short-term interest rates (Friedman, 1988, p. 55). This volatility raises the degree of
uncertainty about the expected value of the marginal lending costs, thereby
encouraging banks to hedge against it. Since loan rates are determined prior to the
determination of the lending costs, Cukierman (1991) argues that unanticipated
credit or money demand shocks after banks have entered into loan commitments
create a negative correlation between competitive deposit rates and bank profits
(Cukierman, as quoted by Goodfriend, 1991, p. 14). As a result, the policy of
smoothing short-term interest rates protects banks against the risk of widespread
insolvency. In the absence of interest rate smoothingas would be the case under
a money-targeting regimeresorting to liability management practices allows
banks to reduce this uncertainty but, as shown above, this in turn increases insta-
bility in the relation between reserves and the money supply on one hand, and
between money and nominal income on the other hand. According to Goodhart
(1995, p. 259), the likely outcome of short-term volatility in interest rates would be
the development of a mechanism for shifting financing flows between banks and
non-bank intermediaries. In turn, such developments would facilitate stabilisation
of money growth rates at the price of inducing greater variability in the relation-
ship between money and nominal income.
Another reason why m would tend to rise and the covariance of the different
types of shocks to change dramatically is that, under a money-targeting regime, if
the income-velocity of money and loan demand are not sufficiently interest-elastic,
implementation of a money-targeting regime will not only cause short-run volatil-
ity in interest rates but may also lead to higher real interest rates. This will occur if,
for instance, the central bank attempts to impose on the private sector a rate of
monetary growth that is lower than its desired rate. Interestingly, Mishkin (1998,
pp. 489490) argues that, in reality, the Fed monetarist experiment in the period
197982 was a smokescreen that was used by Paul Volcker to divert attention away
from interest rates. In this way, the setting of targets for the growth rates of mone-
tary aggregates allowed the Fed to set interest rates high enough to bring inflation
down. Similarly, Goodhart (1989, p. 296; 2002, pp. 1618) argues that the policies
36 G. Fontana & A. Palacio-Vera

adopted in the early 1980s allowed the authorities freedom to raise interest rates to
levels that could subdue inflation. However, several authors have argued that high
real interest rates stimulate financial innovation. In turn, a higher rate of financial
innovation reflects a higher m. For instance, Hester (1981, p. 183) argues that the
one clear lesson from recent history is that financial institutions innovate when-
ever customer relationships are jeopardised by slow monetary growth.12 Like-
wise, Minsky (1982, pp. 171172) argues that high interest rates are likely to
stimulate institutional changes that lead to an increasing lending ability of the
banking system. Porter et al. (1979, p. 217) c also show that high market interest
rates in 197374, 1978 and early 1979 increased the incentive for managers to
implement new cash-management techniques. In turn, the implementation of
these techniques led to a reduction in their average holdings of bank deposits
beyond what could be expected from higher interest rates according to any stan-
dard model of the demand for money by firms.
All the arguments provided above can be formally presented by resort to an
extension of Pooles original model developed by Modigliani et al. (1970) and
intended to allow for some degree of endogeneity of the money supply. The model
is made up of the following three equations:

y = 1r + u (7)

m = 1 y 2 r + (8)

m = 1h + 2 r + q (9)

where y is real output, m is the money supply, h is high-powered money, and u, v

and q are random terms with zero-mean which capture shocks to the commodities
markets, the demand for money and the relation between high-powered money
and the money supply, respectively. Following the discussion above, it will be
assumed that q and v capture respectively shocks to the money multiplier and the
demand for money brought about by the implementation of liability management
practices by banks.
Therefore, equation (7) is an IS function, equation (8) is an LM function, and
equation (9) is the relationship between high-powered money and the money
supply. In principle, no assumption is made about the policy instrument of the
central bank. It could be either r or h. Thus, the model is compatible with both an
exogenous or an endogenous money supply approach. In the former case, h and
the money supply will be the operating and intermediate-target variable of the
central bank, respectively.13 In the latter case, the interest rate will be the operating
target, and the total amount of deposits will be determined by the demand for
loans of the non-bank private sector. Since there is no credit market in the IS-LM
model, equation (8) would then measure the residual of the loan supply process in
terms of real money balances willingly held by the public. As shown in Friedman
(1990, pp. 11901202), the minimum expected loss caused by output volatility
under an interest rate-targeting regime is:

( )
E y2
r
= u2 (10)

where u2 is the variance of shocks to the commodities sector.

 Monetary Policy Uncovered 37

Similarly, the minimum expected loss caused by output volatility under a

money-targeting regime is:

( 2 + 2 )2 u2 + 12 v2 + 12 q2 2 1 ( 2 + 2 ) uv + 2 1 ( 2 + 2 ) uq 212 vq
( )
E y2 = (11)
( 1 1 + 2 + 2 )
h 2

where 2u is the variance of shocks to the demand for money, 2q is the variance of
shocks to the relation linking h to the money supply, and 2uv, 2uq, and 2vq are the
corresponding co-variance terms.
There are two considerations to make. First, the adoption of liability manage-
ment practices by banks or the adoption of cash-management techniques by firms
cannot be fully captured by increases in q and v, respectively. In particular, the
behaviour of banks and firms will lead, along the lines of the discussion above, to
structural change in equations (8) and (9). However, it may be argued that, for
policy purposes the consequences of structural change are akin to a rise in q and
v, i.e. the forecasting ability of the central bank is hindered. Secondly, the discus-
sion above has not made a distinction between v and q. We do so below. Now, a
rise in aggregate demand by the private sector (u>0) stimulates the demand for
loans and this, in turn, leads to a rise in the demand for reserves. Under a money-
targeting regime, and in a static context, the central bank would keep h unchanged
at its target value. As a result, interest rates in the money markets would rise. As
interest rates increase, banks have incentives to restructure the liability side of their
balance sheets in order to maintain or enhance their lending capacity. In other
words, banks encourage their customers to move from high-reserves liabilities into
low-reserves liabilities. In turn, the transformation of the liability side of the
balance sheets of banks would cause a fall in RR. Thus, for a broad measure of
money, q>0 in equation (9) so that uq should generally be positive in equation (11).
For a narrow measure of money, however, the restructuring of the liability side of
the balance sheets of banks does not have such a clear-cut effect upon the corre-
sponding money multiplier. As the public shifts away from high-reserves depos-
its, the narrow measure of money contracts but, as banks reduce RR and
subsequently increase their lending, new deposits are created such that the narrow
measure of money expands. The net effect is uncertain.
Regarding the sign of uv, the expansion in lending brought about by the fall in
RR will lead to an expansion in the supply of both narrow and broad money. Since
there has been a previous shift away from high-reserves into low-reserves bank
liabilities, the demand for narrow money relative to its supply has, in principle,
fallen so that v<0, but the demand for broad money relative to its supply would
have changed in an uncertain way. As a result, for the broad money case the values
of uv and qv in equation (11) are uncertain. In the narrow money case, it is quite
likely that v<0 so that uv should be negative under normal circumstances.
However, the value of qv is uncertain. Therefore, under a money-targeting regime
2q and 2v will tend to go up, thereby raising the value of the minimum expected
loss in equation (11). In addition, and in the broad money case, the changes
occurred in the covariance terms may raise that value even further since uq>0
while the signs of qv and uv are uncertain. Similarly, in the narrow money case, it
is likely that uv<0, whereas the signs of uq and qv are uncertain. In short, the
implementation of a money-targeting regime tends to increase the value of the
minimum expected loss in equation (11) relative to the value of (10) thereby shift-
ing the balance in favour of an interest rate-targeting regime.
38 G. Fontana & A. Palacio-Vera

Conclusions
This paper has shown that there is a not fully resolved tension in the modern
setting of monetary policy. In the long run, money is made all-important for infla-
tion, but in the short run it is treated as irrelevant. However, this tension is quickly
resolved when a distinction is made between what some academics have
suggested that central banks should do and what these same central banks felt
right to do. In the first part of the paper we have analysed the theoretical founda-
tions for the current practice of central banking, namely, the targets-and-instru-
ment approach whose core element is Pooles approach to the instrument problem
(Poole, 1970). This approach provides a criterion for choosing between a money-
targeting regime and an interest rate-targeting regime.
We have then argued that the endogenous money hypothesis, i.e. the proposi-
tion that the level and rate of expansion of the money stock is ultimately deter-
mined by the demand for loans of the private sector (the demand for money of the
latter being also relevant notwithstanding), precludes the implementation of a
money-targeting regime. In addition, we have discussed several arguments
whereby the implementation of a money-targeting regime will tend to raise the
relative variance of shocks to the monetary sector and vary the covariances
between shocks to the commodity and monetary sectors in such a way as to shift
the balance in favour of an interest rate-targeting regime. The main result of our
analysis is thus that the implementation of a money-targeting regime is undesir-
ableon the basis of Pooles approachif not unfeasible.

Acknowledgements
The authors are grateful to the editor of this journal and an anonymous referee for
stimulating comments. We are also grateful for comments and suggestions from
Philip Arestis, David Laidler, Tom Palley, Randall Wray and participants at the
First ADEK International Conference, held at the University of Bourgogne, Dijon,
France, in November 2002. A previous version of the paper was written when
Giuseppe Fontana was visiting research scholar at both C-FEPS and Economics
Department, University of Missouri Kansas City, Kansas City, USA. He would like
to express appreciation to members of those institutions for providing a stimulating
and pleasant working environment and to David Foster for proofreading the text.

Notes
1. Indeed, as a referee has pointed out, current central banking practice can be characterized as hyper
fine-tuning policy, with central banks potentially changing short-term nominal interest rates
monthly (or even more frequently) in pursuit of a medium-term inflation target.
2. This equation is a long-run relation as seen by monetarists. As a referee has noted, this equation
does not say anything about real aggregate demand. Presumably, the equation only says that, in
the long run, aggregate demand passively adjusts to aggregate supply, the latter being exogenously
given. As a result, a higher rate of growth of money supply can only, as far as monetarists are
concerned, lead to a higher rate of inflation in the long run.
3. Of course, in posing this question, this paper breaks away from Lucass policy recommendation as
expressed in his Nobel Lecture and quoted at the beginning of this paper (Lucas, 1996).
4. For instance, the ECB (European Central Bank, 2001, p. 47) remarks that although most empirical
studies for the euro area support the view that there is a stable (long-run) money demand relation-
ship linking M3 to the price level and other macroeconomic variables the reference value [for M3]
is not a monetary target. The ECB does not attempt to keep M3 growth at the reference value at any
particular point in time by manipulating interest rates.
 Monetary Policy Uncovered 39

5. In an empirical study for the period 195085, Hoover (1991) shows that, for the US economy, the
balance of evidence supports the view that money does not cause prices, and that prices do cause
money.
6. For an earlier example of this critique, see Davidson (1990a), and further developments by Rochon
(1999, pp. 132139) and Palley (2002, pp. 166176). In the context of Pooles framework, this inter-
dependency could, in principle, be accounted for by the covariance of shocks to the commodities
and monetary sectors as we show above. However, Poole assumes this covariance to be random
and exogenous.
7. In this respect, Goodfriend (1991, p. 8) comments: except for the period from 1934 to the end of the
1940s when short-term interest rates were near zero or pegged, the Fed has always employed either
a direct or an indirect Federal funds rate policy instrument.
8. Indeed, as argued in Goodhart (1984), both the low short-run interest elasticity and instability of
loan demand make it extremely difficult for a central bank to fine-tune aggregate demand growth
so as to hit annual money growth targets.
9. However, this upward trend is not a universal prediction. As shown in Pollin and Schaberg (1998),
the spectacular increase in non-GDP transactions (financial and real state market trading) in the US
economy since the early 1980s explains, at least partially, the so-called velocity puzzle, i.e. the fact
that M1 velocity stopped rising in the early 1980s and has been falling since then.
10. According to Howells & Hussein (1999) the lack of co-integration of money and nominal income is
also due to the growth of the money stock being influenced by non-GDP transactions. The latter
have grown more rapidly than income in recent years.
11. As a referee has noted, not only may m tend to rise, but whatever monetary aggregate is used for
policy control purposes, it will lose its previous meaning and, in effect, there should now be some
other monetary aggregate which is being targeted.
12. Hester (1981) identifies two waves of financial innovation in the US economy, respectively 19669
and 19735, which, according to him, were induced by restrictive monetary policies and high inter-
est rates.
13. If the central bank instrument is assumed to be high-powered money, we then have that, in prac-
tice, the central bank varies the level of high-powered money to achieve a certain rate of interest
which, in turn, determines the level of aggregate demand and, ultimately, (through equation (8)
and together with the level of real income) the amount of money demanded by the public. Indeed,
if we substitute equation (8) into (9) for the money supply, the resulting expression provides the
level of high-powered money required (for a given level of real income) to set a certain interest rate,
the money supply thus being a residual with no casual significance. Therefore, in this first case, the
central bank would only use equations (8) and (9) for computation purposes. In the case where the
interest rate is explicitly assumed to be the instrument, the central bank does not pay any attention
to equations (8) and (9) and simply injects or withdraws high-powered money in order to set the
interest rate which, in turn, affects the level of real aggregate demand.

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