24.2 How Important Is Monetary Policy?

Early Keynesians believed that monetary policy did not matter at all because they could not find any evidence that interest rates affected planned business investment. Milton Friedman and Anna Schwartz, another monetarist, countered with a huge tome called A Monetary History of the United States, 1867–1960 which purported to show that the Keynesians had it all wrong, especially their kooky claim that monetary policy during the Great Depression had been easy (low real interest rates and MS growth). Nominal rates on risky securities had in fact soared in 1930–1933, the depths of the depression. Because the price level was falling, real interest rates, via the Fisher Equation, were much higher than nominal rates. If you borrowed $100, you’d have to repay only $102 in a year, but those 102 smackers could buy a heck of a lot more goods and services a year hence. So real rates were more on the order of 8 to 10 percent, which is pretty darn high. The link between interest rates and investment, the monetarists showed, was between investment and real interest rates, not nominal interest rates.

As noted above, the early monetarists relied on MV = PY, a reduced-form model. To strengthen their conviction that causation indeed ran from M to Y instead of Y to M or some unknown variables A…Z to M and Y, the monetarists relied on three types of empirical evidence: timing, statistical, and historical. Timing evidence tries to show that increases in M happen before increases in Y, and not vice versa, relying on the commonplace assumption that causes occur before their effects. Friedman and Schwartz showed that money growth slowed before recessions, but the timing was highly variable. Sometimes slowing money growth occurred sixteen months before output turned south; other times, only a few months passed. That is great stuff, but it is hardly foolproof because, as Steve Miller points out, time keeps on slipping, slipping, slipping, into the future.http://www.lyricsfreak.com/s/steve+miller/fly+like+an+eagle_20130994.html Maybe a decline in output caused the decline in the money supply. Changes in M and Y, in other words, could be causing each other in a sort of virtuous or pernicious cycle or chicken-egg problem. Or again maybe there is a mysterious variable Z running the whole show behind the scenes.

Statistical evidence is subject to the same criticisms plus the old adage that there are three types of untruths (besides Stephen Colbert’s truthiness,http://en.wikipedia.org/wiki/Truthiness of course): lies, damn lies, and statistics. By changing starting and ending dates, conflating the difference between statistical significance and economic significance,http://www.deirdremccloskey.com/articles/stats/preface_ziliak.php manipulating the dates of structural breaks, and introducing who knows how many other subtle little fibs, researchers can make mountains out of molehills, and vice versa. It’s kinda funny that when monetarists used statistical tests, the quantity theory won and money mattered, but when the early Keynesians conducted the tests, the quantity theory looked, if not insane, at least inane.

But Friedman and Schwartz had an empirical ace up their sleeves: historical evidence from periods in which declines in the money supply appear to be exogenous, by which economists mean “caused by something outside the model,” thus eliminating doubts about omitted variables and reverse causation. White-lab-coat scientists (you know, physicists, chemists, and so forth—“real” scientists) know that variables change exogenously because they are the ones making the changes. They can do this systematically in dozens, hundreds, even thousands of test tubes, Petri dishes, atomic acceleration experiments, and what not, carefully controlling for each variable (making sure that everything is ceteris paribus), then measuring and comparing the results. As social scientists, economists cannot run such experiments. They can and do turn to history, however, for so-called natural experiments. That’s what the monetarists did, and what they found was that exogenous declines in MS led to recessions (lower Y*) every time. Economic and financial history wins! (Disclaimer: One of the authors of this textbook [Wright] is a financial historian.) While they did not abandon the view that C, G, I, NX, and T also affect output, Keynesians now accept money’s role in helping to determine Y. (A new group, the real-business-cycle theorists associated with the Minneapolis Fed, has recently challenged the notion that money matters, but those folks haven’t made it into the land of undergraduate textbooks quite yet.)