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ByUlrich Fritsche

Stable growth in a overwhelming number of countries, sound monetary and rapidly improving fiscal policies, market deregulation, globalization and — as as I personally would add — under the usage of these beautiful micro-founded macroeconomic models effectively in place in most modern central banks, a financial crisis of such a proportion can arise.

In the post, the authors argue that — given a higher proportion of internationally determined domestic prices — the inflation is showing up in the remaining non-tradable goods, i.e. in inflated wealth prices, house or stock prices. This in turn might lead to the existence and later bursting of bubbles with strong real economy spillovers. Furthermore, the authors argue that a goal of a medium-term monetary aggregate — as the ECB has with the second pillar of the strategy — might have helped other central banks as the Fed to avoid the development of the problem.

There are several issues:

  1. Is the reference to the second pillar of the ECB justified or is de facto and de jure monetary policy a different thing?
  2. If money is ignored, why is this the case and what are the dangers?
  3. Central bank money, and possible bubbles: the case for money and ex ante versus ex post strategies?
  4. How to deal with the subprime crisis effects?

@ 1: The de facto monetary policy of the ECB

The facts: the ECB announced a target at the beginning of EMU which was never reached in a reasonable way. In fact, the monetary aggregates grew faster for at least 5 years in a row. The first round of discussions was concerned with “special reasons” (e.g. the stock market turbulence of 2001) for missing the target. A series of investigations reported instabilities in the money demand function which could be fixed by adding measures of financial market uncertainty (Carstensen, 2006, Lemke and Greiber, 2005). Another line of argument refers to the role of low inflation rates. Given a store-of-value function of money, stable and low inflation rates should increase money demand (Größl and Fritsche, 2006). In the refinement of the monetary policy strategy, the ECB did in fact weaken the importance of the money pillar in the de facto strategy. In practice, money does not play a dominant role, as an influential paper by Lucrezia Reichlin (ECB’s chief research economist) and others showed. So, to refer to the ECB as a role model is a misnomer if we respect de facto policy as a benchmark.

@2: The New Keynesian model and money

To understand this ignorance of money, it is interesting to read the discussions in the ECB conference on money in the strategy. Michael Woodford, Jordi Galí and Harald Uhlig — three of the most influential monetary macroeconomists of our time — argued that money is important in conducting monetary policy insofar as it contains information about future inflation which is not in the other variables (as the output gap for instance).

This is a direct implication of the predominance of the New Keynesian DSGE approaches elegantly modeled as a cashless economy (see Woodford’s famous book, named “Interest and Prices: Foundations of a Theory of Monetary Policy”. For those who like “history of economic thought” this is Patinkin without money or Wicksell without cumulative processes). For didactic purposes and in a world of no turbulence (‘fair weather’), this model contains a lot of nice Keynesian features: the central bank sets an interest rate according to inflationary pressures and the stance of the cycle (which in turn is a proxy for labor market conditions which in turn define inflationary pressures tomorrow). Sticky prices and or wages allow to a have a non-vertical short run aggregate supply curve. On the other hand, the model is bounded to a strict neoclassical equilibrium concept with the distinction that potential output differs from full employment output because of the existence of monopoly power.

In a recent paper, Charles Goodhart nicely showed, what might be the problem with the New Keynesian model under the existence of demand and supply side shocks. The cashless model might be observationally equivalent to a world with money and demand shocks only but it begins to break down if someone relaxes the assumptions of the model in a reasonable way. The model is based on the argument, that a representative agent maximizes utility over life time under the assumption, that all debts are ultimately paid in full. As earlier Nobel prize winners as James Tobin showed, relaxing this extremely harsh assumption leads to the fact, that stocks (money, wealth, house prices, stock prices) have non-trivial repercussions in the system. To put it differently: The now-called “New Keynesian” arguments are stated in way that defines away a lot of the arguments which were already labeled “New Keynesian” in the early nineties.[1]

@ 3: What can we learn for the monetary policy strategy in general and for now?

The first lesson to be learned deals with the role of money in the conduct of policy.

Goodhart gives two examples:

  • In an old-fashioned setting consumption is largely determined by income. In the “New Keynesian” standard model, this problem is defined away. This, however, does not mean that the problem does not exist. As Goodhart nicely argued for the time being consumption on most countries is constrained by the willingness of banks to lend to the private sector. As Goodhart put it:

“So, shifts in bank willingness to extend such loans, as banks become more, or less, risk averse, will have the effect of shifting the constraints affecting the economy. In particular, when the growth rate of the money stock is declining, whole segments of the economy that were previously not income constrained may suddenly become so, and at a time when income is probably also dropping.” (Goodhart, 2007, p. 60)

  • Furthermore, as the second strand on New Keynesian models investigated, the credit channel, risk aversion and asymmetric information give raise to non-trivial interactions.

“Furthermore, when default becomes possible, risk premia come into play. There ceases to be one single interest rate, as in the basic Neo-Keynesian model, but a whole schedule of interest rates, depending on the perceived riskiness of the borrower. Generally in depressions interest rates on safe, liquid government debt instruments decline, but risk premia rise. It can then be ambiguous whether, overall, interest rates have risen, or fallen. The reverse is true in booms; the official policy rate may rise, but risk premia may fall. Against this background it would be short-sighted not to cross-check for the combined effect that a combination of official policy measures and changing risk aversion may have by looking carefully at the time path of the monetary aggregates.” (Goodhart, 2007, p. 60)

If supply side repercussions can not be easily ignored, money should be watched carefully and monetary policy has a reason to be concerned.

The second lesson is less trivial. Should a central try to avoid a possible bubble or not?

The interaction of macroeconomic policy and wealth effects in the literature is mainly analyzed under the topic of boom-bust-cycles initiated or accommodated by macroeconomic (mainly monetary) policy. Asset markets tend to produce bubble from time to time and it is one of the most disputed issues what role monetary easing plays in the development of bubbles (Kindleberger and Aliber, 2005).

But how to deal with extraordinary asset price booms is also very much under dispute: Whereas some authors (Bernanke and Gertler, 2001) argue, that asset price developments should be considered by monetary authorities only insofar, as there is a direct link to inflation, other authors (Cecchetti et al. 2000) see a potential role for monetary policy to avoid overshooting asset price booms. Why should especially monetary authorities care about asset price cycles? Due to financial fragility and systemic stability, central banks might face a trade-off between inflation and output gap stabilization on the one hand and asset price stabilization on the other hand (Dupor 2001). This argument is made even stronger if credit constraints depend on the value of a collateral and shocks might be amplified (Kiyotaki and Moore 1997). Cycles have therefore asymmetric effects and central banks aim to avoid bursting bubbles. In practice central bankers have chosen different strategies to deal with this delicate balance (Greenspan 2002, Bean 2003): a pro-emptive approach and a reactive approach. There are arguments for both approaches: The reactive approach might face moral hazard problems as analyzed recently (Illing 2001). But especially under the existence of uncertainty, policy has to decide if an asset price boom must be classified as a bubble or not. This is the most important argument I think: as Charles Kindleberger ever and ever explained, a bubble is always blamed to be a bubble ex post but never ex ante (in fact under fundamental uncertainty it is impossible to identify a bubble ex ante). Should a central bank always restrict expansion by being focused on a stable money demand — and we know that this a theoretical fiction — or should the central bank try to navigate using the full set of instruments and limit the damage afterwards?

@ 4: How to deal with the crisis: Nullum crimen, nulla poena sine praevia lege poenali

There is a interesting maxim in European legal thinking, which was codified in 1813 in Bavaria (after the Napoleonic wars). Nullum crimen, nulla poena sine praevia lege poenali: no crime (can be committed), no punishment (can be imposed) without (having been prescribed by) a previous penal law.

I think this applies to monetary policy under uncertainty as well. If bubbles are not detectable since every bubble can only be labelled as such ex post instead of ex ante, there is no other way to deal with the issue as Greenspan did. Being aware but not preemptive. Now, we are facing a subprime market turbulence and even New Keynesians start to claim that the old Austrian economists were forgotten. This is case of an ex post interpretation. The point is, that nobody can be sure ex ante if an extraordinary expansion is due to fundamentals or due to a bubble.

Saying this I also support the claim, that money has a role to play beyond the role given in the New Keynesian standard model. It is time to re-read the literature of the eighties and early nineties again to find out at which point, the new canonical model lost its empirical relevance and why.

[1] James Tobin was a self-labeled “Old Keynesian”. But see the content of the two volumes on “New Keynesian Economics” by David Romer and Gregory N. Mankiw, published in 1991. In fact, the modern “New Keynesian” model refers to vol. 1 only (sub-titled “imperfect competition and sticky prices”), volume 2 (sub-titled: “coordination failures and real rgidities”) is largely ignored.

ReferencesBean, Charles (2003): Asset Prices, Financial Imbalances and Monetary Policy: Are Inflation Targets Enough? Reserve Bank of Australia 2003 Conference,

Bernanke, B., and M. Gertler (2001). Should Central Banks Respond to Movements in Asset Prices? American Economic Review Papers and Proceedings 91: 253-257.

Carstensen, Kai (2006): Stock Market Downswing and the Stability of European Monetary Union Money Demand, Journal of Business and Economic Statistics 25(4), 395-402, 2006.

Dupor, William (2001): Nominal Price versus Asset Price Stabilization. Working Paper. The Wharton School, Pennsylvania.

Greenspan, Alan (2002), Economic Volatility, remarks at a symposium sponsored by the Fed of Kansas City, Jackson Hole, Wyoming, 30. August 2002. .

Größl, Ingrid and Ulrich Fritsche (2006): The Store-of-Value-Function of Money as a Component of Household Risk Management (= DEP Discussion Papers. Macroeconomics and Finance Series 6/2006).

Illing, G. (2000). Financial Fragility, Bubbles and Monetary Policy. Mimeo. University of Frankfurt.

Kiyotaki, N., and J. Moore (1997). Credit Cycles. Journal of Political Economy 105(2): 211-248.

Kindleberger, Charles P., and Robert Z. Aliber (2005): Manias, Panics, and Crashes: A History of Financial Crises, 5th edition, Palgrave Macmillan.

Lemke, W. and Claus Greiber (2005): Money demand and macroeconomic uncertainty, Deutsche Bundesbank, Discussion Paper Series 1: Economic Studies No 26/2005