Faugere, Christophe (2010): Macrofoundations for A (Near) 2% Inflation Target.
This is the latest version of this item.
Download (586Kb) | Preview
Economists have argued that a long-term inflation target near 2% is optimal (Summers, 1991; Fischer, 1996; Goodfriend, 2002; Coenen et al., 2003; Bernanke, 2003). However, these arguments are really about why a low positive inflation rate is ideal to avoid a deflationary trap, not explaining why the specific value of 2% (or a value near it) happens to be the optimal long-run inflation rate. In line with the transaction motive literature (Baumol, 1952 and Tobin, 1956), I postulate that new forms of money and technological progress generate cost savings in the transaction technology by comparison to barter. I derive the optimal velocity of money, which depends on real GDP/capita and the net return on depository institutions’ assets. As long as progress is on average biased towards new forms of money, the velocity of money will grow at a pace slower than long-term real GDP/capita growth; i.e. less than 2%. The empirical tests using Johansen’s (1995) VECM approach for the U.S. over the period 1959-2007 confirm that this is indeed the case. Along with a parameter representing the type of bias in the technical progress affecting transactions, the depository institutions’ overall mean leverage ratio also appears as a key parameter in the long-run equilibrium equation describing the behavior of the velocity of narrow money (M1, M1RS and M1S). I show that a ‘naïve’ Friedman k-percent monetary rule that aims at growing the money supply at the same rate as real GDP naturally leads to a rate of inflation equal to the rate of velocity growth. Hence, setting an inflation target near but below 2% makes economic sense. In spite of previously held beliefs, a money growth objective is compatible with an interest-targeting objective; i.e. a derived Taylor (1993) type rule. A Taylor rule that embeds the optimal inflation target defined here is more flexible to account for possible changes in velocity vs. a pure money growth rule.
|Item Type:||MPRA Paper|
|Original Title:||Macrofoundations for A (Near) 2% Inflation Target|
|Keywords:||Inflation target; velocity of narrow money; M1; M1RS; M1S; real GDP per capita growth; barter; financial leverage|
|Subjects:||E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E40 - General|
|Depositing User:||Christophe Faugere|
|Date Deposited:||25. Jun 2010 06:31|
|Last Modified:||24. Feb 2013 13:44|
Abel, Andrew B. 1987, “Optimal Monetary Growth,” Journal of Monetary Economics, 19: 437-450.
Adrian, Tobias, and Hyun Song Shin, 2009, “Prices and Quantities in the Monetary Policy Transmission Mechanism,” Federal Reserve Bank of New York Staff Report 396.
Alvarez, Fernando, Robert E. Lucas and Warren E. Weber, 2001, “Interest Rates and Inflation,” The American Economic Review, 91 (2): 219-225.
Ausubel, L.M., 1997, “Credit Card Defaults, Credit Card Profits, and Bankruptcy,” The American Bankruptcy Law Journal, 71: 249-270.
Baba, Yoshihisa, Hendry, David F. and Ross M. Starr, 1992, “The Demand for M1 in the U.S.A., 1960-1988,” The Review of Economic Studies, 59 (2): 25-61.
Barro, Robert J., 1970, “Inflation, the Payments Period, and the Demand for Money”, Journal of Political Economy, 78 (6) (November/December): 1228-1263.
Barro, Robert J, 1989, “Interest Rate Targeting,” Journal of Monetary Economics, 23 (January): 3-30.
Baumol, William J., 1952, “The Transactions Demand for Cash: An Inventory Theoretic Approach,” Quarterly Journal of Economics, 66: 545-556.
Benhabib, Jess, Stephanie Schmitt-Grohe, and Martın Uribe, 2001, “The Perils of Taylor Rules,” Journal of Economic Theory, 96: 40-69.
Bernanke, Ben S., 2003, “Remarks by Governor Ben S. Bernanke At the 28th Annual Policy Conference: Inflation Targeting: Prospects and Problems, Federal Reserve Bank of St. Louis, St. Louis, Missouri October 17, 2003,” http://www.federalreserve.gov/Boarddocs/Speeches/2003/20031017/default.htm
Bernanke, Ben and Alan S Blinder, 1988, “Is it Money or Credit, or Both, or Neither? Credit, Money, and Aggregate Demand,” American Economic Review, 78: 435–439.
Bernanke, Ben S. and Frederic Mishkin, 1992, “Central Bank Behavior and the Strategy of Monetary Policy: Observations from Six Industrialized Countries,” NBER Macroeconomics Annual, 7: 183-228.
Bernanke, Ben S., Reinhart, Vincent R. and Brian Sack, 2004, “Monetary Policy at the Zero Bound: An Empirical Assessment,” Brookings Papers on Economic Activity, 2: 1-78.
Blanchard, Olivier, Dell’Ariccia, Giovanni and Paulo Mauro, 2010, “Rethinking Macroeconomic Policy,” IMF Staff Position Note, SPN/10/03.
Bordo, Michael D. and Lars Jonung, 1987, “The Stochastic Properties of Velocity: A New Interpretation,” NBER Working Paper 2255.
Bordo, Michael D. and Andrew Filardo, 2005, “Deflation in a Historical Perspective,” BIS Working Paper No. 186. Brunner, Karl and Allan H Metzler, 1989. Monetary Economics. Oxford: Basil Blackwell.
Burdekin, Richard C. and Pierre L. Siklos, 2002. “Fears of Deflation and Policy Responses Then and Now,” Working Paper Claremont McKenna College.
Carlson, J.B., Hoffman D.L. and B.D. Keen, 2000, “Results of a Study of the Stability of Cointegrating Relations Comprised of Broad Monetary Aggregates,” Journal of Monetary Economics, 46 (2): 345-83.
Carlstrom, Charles T. and Timothy S. Fuerst, 2003, “The Taylor Rule: A Guidepost for Monetary Policy,” Federal Reserve Bank of Cleveland Economic Commentary (July).
Clemente, J., Montañés, A., and M. Reyes, 1998, “Testing for a Unit Root in Variables with a Double Change in the Mean”, Economics Letters, 59: 175-182.
Clouse, James, Henderson, Dale, Orphanides Athanasios, David Small and Peter L. Tinsley, 2000, “Monetary Policy When the Nominal Short-Term Interest rate is Zero,” Working Paper Board of Governors of the Federal Reserve System.
Coenen, Gunter, Orphanides, Athanasios and Volker Wieland, 2003, “Price Stability and Monetary Policy Effectiveness When Nominal Interest Rates are Bounded at Zero,” ECB Working Paper Series, 231, May.
Dickey, D.A and W. A. Fuller, 1979, “Distributions of the Estimators for Autoregressive Time Series with a Unit Root”, Journal of American Statistical Association, 74 (366): 427-481.
Dotsey, Michael, 1984, “An Investigation of Cash Management Practices and Their Effects on the Demand for Money,” Federal Reserve Bank of Richmond Economic Review, 70 (September/ October): 3- 12.
Dutkowsky, Donald H. and Barry Z. Cynamon, 2003, “Sweep Programs: The Fall of M1 and Rebirth of the Medium of Exchange,” Journal of Money, Credit and Banking, 35 (2): 263-279.
Dutkowsky, Donald H., Cynamon, Barry. Z., and Barry E. Jones, 2006, “US Narrow Money for the Twenty-First Century,” Economic Inquiry, January: 142-52.
Engle, Robert F, and Clive Granger, 1987, “Co-integration and Error Correction: Representation, Estimation, and Testing,“ Econometrica 55 (March): 251-76
Evans, George W. and Seppo Honkapohja, 2003, “Friedman’s Money Supply Rule vs. Optimal Interest Policy,” Working Paper University of Oregon.
Faugere, Christophe and Julian Van Erlach, 2009, “A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination,” Financial Markets, Institutions and Instruments, 18 (1): 27-88.
Festre, Agnes, 2006, “Knut Wicksell, and Ludwig Von Mises on Money, Interest and Price Dynamics,” Journal of the History of Economic Thought, 28 (3): 333-357.
Fischer, Stanley, 1996, “Why Are Central Banks Pursuing Long-Run Price Stability,” in Achieving Price Stability. Federal Reserve Bank of Kansas City: 7-34.
Freixas, Xavier, Martin, Antoine, and David Skeie, 2009, “Bank Liquidity, Interbank Markets, and Monetary Policy,” Federal Reserve Bank of New York Staff Report 371.
Friedman, Milton, 1951, “Commodity-Reserve Currency,” The Journal of Political Economy, 59 (3): 203-232.
Friedman, Milton. 1960. A Program for Monetary Stability. New York: Fordham University Press.
Friedman, Milton. 1969. The Optimum Quantity of Money and Other Essays. New Jersey: Transaction Publishers, New Brunswick, New Jersey.
Getter, Darryl E., 2008, “The Credit Card Market: Recent Trends, Funding Cost Issues, and Repricing Practices,” Congressional Research Services Report for Congress, RL34393.
Goodfriend, Marvin, 2000, “Overcoming the Zero Bound on Interest Rate Policy,” Journal of Money, Credit and Banking, 32 (4) Part 2: 1007-1035.
Goodfriend, Marvin, 2002, “Monetary Policy in the New Neoclassical Synthesis: A Primer,” International Finance (Summer): 165-191.
Goodfriend, Marvin, 2005, “Inflation Targeting in the United States?” in B.S. Bernanke and M. Woodford, eds., The Inflation-Targeting Debate. University of Chicago Press for NBER.
Goodfriend, Marvin, 2007, “How the World Achieved Consensus on Monetary Policy,” Journal of Economic Perspectives, 21 (4) (Fall): 47-68.
Greenspan, Alan. 2007. The Age of Turbulence. New York: The Penguin Press.
Guerrero, Federico and Elliott Parker, 2006, “Deflation and Recession: Finding the Empirical Link,” Economics Letters, 93 (1): 12-17.
Hetzel, Robert L. 2007, “The Contributions of Milton Friedman to Economics,” Economic Quarterly, 93 (1): 1-30. Humphrey, Thomas M., 1993, “The Origins of Velocity Functions,” Federal Reserve Bank of Richmond Economic Quarterly, 79 (4).
Ireland, Peter N., 1994, “Money and Growth: An Alternative Approach,” The American Economic Review, 84 (1): 47-65.
Ireland, Peter N., 1995, “Endogenous Financial Innovation and the Demand for Money,” Journal of Money, Credit and Banking, 27 (1): 107-123.
Ireland, Peter N., 2008, “On the Welfare Cost of Inflation and the Recent Behavior of Money Demand,” NBER Working Paper 14098.
Johansen, Soren, 1988, “Statistical Analysis of Cointegration Vectors,” Journal of Economic Dynamics and Control, 12 (June-September): 231-254.
Johansen, Soren, 1991, “Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models.” Econometrica, 59 (November): 1551-1580.
Johansen, Soren, 1995. Likelihood Based Inference in Cointegrated Vector Autoregressive Models. Oxford University Press: Oxford.
Kahn, George A. and Scott Benolkin, 2007, “The Role of Money in Monetary Policy: Why Do the Fed and ECB See It So Differently?” Federal Reserve Bank of Kansas City Economic Review, (Third Quarter): 5-36.
King, Robert G., Plosser, Charles I., Stock, James H., and Mark W. Watson, 1991, “Stochastic Trends and Economic Fluctuations,” American Economic Review, 81 (4) (September): 819-840.
Kiyotaki, Nobuhiro and Randall Wright, 1993, “A Search-Theoretic Approach to Monetary Economics,” American Economic Review, 83 (1): 63-77.
Kohn, Donald, 2005, “Comment,” in B.S. Bernanke and M. Woodford, eds., The Inflation-Targeting Debate. University of Chicago Press for NBER.
Kozicki, Sharon, 1999, “How Useful Are Taylor Rules for Monetary Policy?” Federal Reserve Bank of Kansas City Economic Review, (Second Quarter): 5-33.
Lucas, Robert E., Jr., 1988, “Money Demand in the United States: A Quantitative Review,” Carnegie-Rochester Conference Series on Public Policy, 29 (Autumn): 137-167.
Lucas, Robert E., Jr., 2000, “Inflation and Welfare,” Econometrica, 68, March: 247-274.
McCallum, Bennett T., 2003, “Monetary Policy in Economies with Little or No Money,” Carnegie Mellon University working paper.
McCallum, Bennett T., 2006, “Inflation Targeting for the United States,” Carnegie Mellon University working paper.
Marty, Alvin L., 1999, “The Welfare Cost of Inflation: A Critique of Bailey and Lucas,” Federal Reserve Bank of St. Louis Review, January/February: 41-46.
Mehra, Yash P., 1989, “Velocity and the Variability of Money Growth: Evidence from Granger-Causality Tests Reevaluated,” Journal of Money, Credit and Banking, 21 (2): 262-267.
Meltzer, Allan, 2003. A History of the Federal Reserve, Volume 1: 1913-1951. Chicago: The University of Chicago Press.
Meltzer, Allan, 2009. A History of the Federal Reserve, Volume 2: 1951-1986. Chicago: The University of Chicago Press.
Miyao, Ryuzo, 1996, “Does a Cointegrating M2 Demand Relation Really Exist in the United States?” Journal of Money, Credit, and Banking, 28 (3) Part 1 (August): 365-380.
Mulligan, Casey B. and Xavier X. Sala-i-Martin, 1996, “Adoption of Financial Technologies: Implications for Money Demand and Monetary,” NBER Working Paper 5504.
Mulligan, Casey B. and Xavier X. Sala-i-Martin, 1997, “The Optimum Quantity of Money: Theory and Evidence,” Journal of Money, Credit and Banking, 29 (4) Part2: 687-715.
Munro, John, “Mint Outputs, Money, and Prices in late-Medieval England and the Low Countries,” in Eddy Van Cauwenberghe and Franz Irsigler, eds., Munzpragung, Geldumlauf und Wechselkurse / Minting, Monetary Circulation and Exchange Rates, Trierer Historische Forschungen, Vol. VIII, (Trier, 1984): 31-122.
Nelson, Edward, 2008, “Friedman and Taylor on Monetary Policy Rules: A Comparison,” Federal Reserve Bank of St. Louis Review, 90 (2) (March/April): 95-116.
Norman, Ben, Shaw, Rachel, and George Speight, 2006, “The History of Interbank Settlement Arrangements: Exploring Central Banks’ Role in the Payment System,” Working Paper Bank of England.
Orphanides, Athanasios, 2007, “Taylor Rules,” Working Paper Board of Governors of the Federal Reserve System.
Park, Albert, 2006, “Risk and Household Grain Management in Developing Countries,” The Economic Journal, 116 (514): 1088-1115.
Poole, William, 2006, “The Fed’s Monetary Policy Rule,” Federal Reserve Bank of St. Louis Review, 88 (1) (January/February): 1-11.
Reynard, Samuel, 2006, “Money and the Great Disinflation,” Swiss National Bank Working Paper 2006-7.
Rotemberg, J. J., Driscoll, J.C. and J. M. Poterba, 1995, “Money, Output and Prices: Evidence from a New Monetary Aggregate,” Journal of Business and Economic Statistics 13 (1): 67-83.
Sims, Christopher, 2004, “The Limits to Inflation Targeting” in B.S. Bernanke and M. Woodford, eds., The Inflation-Targeting Debate. University of Chicago Press for NBER.
Summers, Lawrence, 1991, “Price Stability: How Should Long-Term Monetary Policy Be Determined?” Journal of Money, Credit and Banking 23 (3) Part 2: 625-631.
Taylor, John B., 1993, “Discretion versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, 39 (December): 195-214.
Taylor, John B., 1998, “An Historical Analysis of Monetary Policy Rules,” NBER Working Paper 6768.
Telyukova, Irina A. and Randall Wright, 2006, “A Model of Money and Credit, with Application to the Credit Card Puzzle,” University of Pennsylvania Working Paper.
Thornton, Daniel L., 2005, “When Did the FOMC Begin Targeting the Federal Funds Rate? What the Verbatim Transcripts Tell Us,” Federal Reserve Bank of St. Louis Working Paper 2004-015B.
Tobin, James, 1956, “The Interest Elasticity of Transactions Demand for Cash,” Review of Economics and Statistics, 38 (3): 241-247.
Tobin, James, 1992, Money -- for New Palgrave Money and Finance, Cowles Foundation Discussion Paper 1013.
Van De Mieroop, M., 2005, “The Invention of Interest,” in The Origins of Value: The Financial Innovations that Created Modern Capital Markets, W. N. Goetzmann, and K. G. Rouwenhorst eds: 17-30. Oxford University Press, USA.
Wicksell, Knut. 1936. Interest and Prices. London.
Wolman, Alexander L., 1997, “Zero Inflation and the Friedman Rule: A Welfare Comparison,” Federal Reserve Bank of Richmond Economic Quarterly, 83 (4) (Fall): 1-21.
Available Versions of this Item
Macrofoundations for A (Near) 2% Inflation Target. (deposited 04. Jun 2010 10:26)
- Macrofoundations for A (Near) 2% Inflation Target. (deposited 25. Jun 2010 06:31) [Currently Displayed]