Getting Monetary Policy Right: Targeting The Money Supply Can Still Be Effective

Monetary targeting, the favoured macroeconomic policy of the first Thatcher government, has long been abandoned as a means of managing inflation. Apparent instability in the relationship between money demand and the economy made traditional monetarist strategy ineffective. But new evidence presented by Leigh Drake in the September 1996 issue of the Economic Journal indicates that the fault lay in the method of estimating monetary aggregates. He demonstrates that a model of money demand incorporating relative prices of durable goods, non durables and services is considerably more powerful than traditional tools. He recommends a radical reassessment of official monetary estimates, and suggests that this may well lead to an important new policy role for monitoring and targeting the money supply.

Drake begins by noting that the UK economy has suffered three serious recessions since the Bretton Woods monetary regime ended in the early 1970s. Few doubt that these episodes were made worse by mistimed and excessive monetary policy interventions by the UK monetary authorities.

The demand for money function has long been one of the central behavioural relationships in macroeconomic models. Its simplicity and alleged stability was at the centre of monetarist claims in the 1970s and early 1980s that monetary targeting should be the backbone of a non-inflationary policy stance. The strategy of targeting growth rates of specific monetary aggregates was designed to avoid damaging swings in monetary policy. The targeted monetary aggregate was supposed to be a leading indicator of impending inflation so that timely reactions would avoid boom and bust. But monetary targeting failed, primarily because the chosen aggregates no longer appeared
to have a stable relationship with the economy. This apparent money demand instability resulted in the abandonment of formal monetary targeting and a shift towards exchange rate targeting and more recently inflation targeting.

Within this macroeconomic context, Drake presents new evidence that strongly indicates that traditional money demand functions may be seriously mis-specified. Most importantly, conventional money demand studies usually assume that the demand by individuals for real money balances can be modelled as a simple function of interest rates and real income. Drake demonstrates both theoretically and empirically that relative commodity prices (the
relative prices of durable goods, non-durables and services) should also be included in estimated models of money demand. He also shows that, unlike conventional broad money (cash, current and deposit accounts) demand specifications, his relative price money demand specification is highly stable over a period from the late 1970s to the 1990s. And it appears convincingly to outperform a specification that excludes relative prices.

Other possible mis-specifications in conventional money demand models relate to the choice of monetary assets included in the targeted aggregate and the way in which these assets are aggregated. The aggregates traditionally monitored by the Bank of England have typically been narrow (cash plus current accounts) or broad (the former plus various types of deposit accounts) with the various assets simply being added together without weighting. In the context of broad monetary aggregates, for example, this effectively assumes that all assets provide the same level of transactions services. Cash and building society deposits, for example, clearly do not.

Drake avoids these mis-specifications: first, by using a technique which can reveal which assets individuals treat as money and which can therefore be safely aggregated. Second, the assets are not combined in a simple sum but using a technique known as Divisia aggregation, which correctly weights the component assets by the level of transactions services they provide. Hence, cash receives a high weight whereas building society deposits, which tend to be primarily interest-bearing investments, receive a lower weight. This approach to the construction of the monetary aggregates may well explain the stability and robustness of Drake''s estimated money demand specifications in contrast to the broad money demand instability observed in official monetary aggregates in the UK since the 1970s.

Although the Bank of England has recently begun to monitor Divisia (weighted) monetary aggregates, this has been in the context of the official broad money definition, M4. The results presented by Drake, however, suggest an important and wider future research agenda, both for academics and policy-makers: reassessing official monetary aggregates in terms of components and weightings; and re-specifying and re-estimating the money demand functions that incorporate these aggregates.

In particular, the results suggest that attention should be given to the role of relative commodity prices in estimated money demand functions. The completion of such a research agenda may well result in a re-evaluation of the role and value of monetary targeting following its decline in popularity with policy-makers after the mid-1980s.

''Relative Prices in the UK Personal Sector Money Demand Function'' by
Leigh Drake is published in the September 1996 issue of the Economic Journal. Drake is at
Loughborough University. Funding for his research was provided by the Economic and
Social Research Council.