The monetarist view makes a series of simplifying assumptions that taken at face value appear to be quite reasonable. However, as the positive methodology taught by Milton Friedman tells us, you don’t judge a model by its assumptions. Rather you judge it by its predictive or explanatory power. Before we evaluate the monetarist model, it is worthwhile to review the textbook assumptions associated with the monetarist model:

As discussed, these assumptions are necessary and sufficient conditions to justify the conclusion that the Fed controls the quantity of money. These are very important assumptions for if the Fed controls the quantity of money; changes in the quantity of money reflect only supply shifts allowed by the Fed. That is why the monetarists are in the habit of calling the market clearing quantity of money the money supply.

An obvious question to ask is which aggregate is the one that the Fed is most likely to control? When the Fed buys bonds, it increases the amount of high powered or base money in circulation. When the Fed sells bonds, it reduces the amount of base money in circulation. It is clear that, under the current structure, the Fed controls the monetary base to the decimal point. A clear exception to this would be the specification of a mechanism such as a domestic price rule or an exchange rate rule that forces the Fed to conduct open market operations depending on market conditions. In that case, it would be the private sector who would have complete control of the monetary base. Hence, short of a formal price or exchange rate rule, it seems reasonable to assume that the monetary base is the aggregate most likely to be controlled by the Fed.

Given the assumption that the Fed controls the monetary base, we move on to ask whether the Fed controls the higher monetary aggregates. The answer to the question is that it depends on whether the Fed controls the money multiplier. Thus, to address the issue, we need to expand the expression describing the quantity of money and replaced it with the base and the money multiplier. We now specify the monetary aggregate as:

where B denotes the monetary base and m the money multiplier.

Replacing the expanded definition of the monetary aggregates into the left side of the equation, the expanded equation of exchange now becomes:

Supply-siders agree that the monetary base is under the control of the Fed. Through open market operations (i.e., purchase and sale of government bonds), the Fed can control the base to the penny. Control of the money multiplier marks the first source of disagreement between the monetarists and supply-siders. Banks hold excess reserves and changes in the cash/deposit, demand deposit/time deposit ratios all affect the money multiplier whether these changes offset or magnify the changes in the monetary base is outside the control of the Fed. Differential rates of returns, shifts in expectations etc. alter the relative attractiveness of narrowly defined money. In technical economic parlance, the expected rates of returns differential will generate a shift in the demand for money.

The argument for a floating exchange rate assumes that local residents transact only in their country’s currency. That is US residents transact only in US dollars etc. The assumption means that domestic money will never leave your country and foreigners will never hold it. Alternatively stated, there is no foreign transaction demand for our currency. Thus, demand shifts emanating from abroad will only affect the exchange rate and have no impact on the domestic money supply. While the assumption that local residents transact only in local dollars may be a good approximation for the United States, the same cannot be said for the rest of the world. We know that the dollar is used as a medium of exchange all over the world. Hence it is reasonable to assume that changing economic conditions in the rest of the world will alter the demand for US dollars. Dollars will flow in and out of the United States, hence the rest of the world could generate a shift in US money demand.

To truly control the quantity of money circulating in the economy, the Fed would have to account and offset undesired changes in the multiplier changes in expected rates of returns, as well as changes in the economic conditions outside the United States. Each and every one of these sources can generate a shift in the demand for US money. While the Fed may be able to offset any undesired changes over the long run, in the short run, the task is not that easy. The monetarists already concede this when they argue in favor of rules over discretion. However, we are saying more than that. Attempts by the Fed to control a variable that it does not truly control only leads to undesirable and or sub-optimal results.

The Monetary Base: We already used one degree of freedom when we argued that the monetary base is the one aggregate most likely to be under the complete control of the Fed. So all we have left are two degrees of freedom and they relate to the money/credit multiplier and the velocity of money.

The Velocity of Money: Most money demand models assume a stable money demand or velocity of money. A special case of stable money demand is that of a constant velocity as commonly assumed in textbook representations. Unfortunately, the constant velocity assumption does not hold water empirically (Fig. 25.1). However, the fact that velocity varies over time does not necessarily rule out a stable money demand or stable velocity. A changing cost of holding money balances and the availability of less convenient substitutes is capable of generating substitution effects or movements along the money demand curve that result in predictable changes in the velocity of money.

Take the case of interest bearing deposits. Its rates adjust to market conditions and as a consequence these deposits will offer some protection against inflation. That is, when the inflation rate increases, so do the interest rates paid on these deposits thereby protecting the money against inflation. Hence the competitive interest payment is a mechanism by which the banking system indexes these deposits against inflation. At the other end of the spectrum, we have noninterest bearing money, such as currency, which offers little or no protection against inflation. So, when inflation increases, the purchasing power of noninterest bearing money will decline more than that of the interest bearing money. To protect themselves against the deterioration of purchasing power, money holders will attempt to switch to interest bearing money. An increase in the opportunity cost of holding transaction money would induce a movement along the “stable” demand curve. Given the variety of possible substitutes, we considered three different measures of the opportunity costs, the Fed funds rate (Fig. 25.2A), the 10 year government bond yields (Fig. 25.2B), and Baa corporate bond yields (Fig. 25.2C). While the fit between the velocity of MZM and the various measures of the opportunity costs of holding MZM vary, the data clearly shows the predicted correlation between the two. So, it appears that we are on the right track. Inspection of the different relationships suggests that the 10 year government bond yields offer the tightest fit to the MZM money velocity (Fig. 25.2B).

The magnitude of the change in velocity or money demand depends on two factors: The magnitude of the change in opportunity cost and the elasticity of the demand function. All of this leads to an interesting sidebar: A constant velocity is only a special case of a stable demand function where there is no substitution effect. This can come about in one of two ways. The first one being that interest is paid on money and the opportunity cost of holding is zero (i.e., the money is effectively indexed). The second option is that it is very expensive to substitute out of money (i.e., there are no substitutes). These two conditions can generate what some may define as an “inelastic” money demand function. As we know that the velocity of money has changed in the past, we can safely rule out inelastic demand and argue that a period of stable demand for money and relatively constant velocity of money is the result of a monetary policy that keeps the opportunity cost of holding interest bearing money relatively constant.

The Money Multiplier: Now, on to new and related insights. The ability to use other countries’ currencies and the creation of “near money” substitutes by financial institutions has increased the ability to replace the narrowly defined domestic monetary aggregates. In turn, these switches produce unintended consequences in the credit markets. Let’s consider the case of an increase in the underlying inflation rate. As the inflation rate increases, people will move out of noninterest paying money into interest paying deposits and that, in turn, will affect the credit creation ability of the banks. In other words, the money creation and credit creation ability of the banks are intertwined and one affects the other. Some simple money and banking calculations will illustrate our point.

Let’s assume that the Fed prints out $10 worth of money. Let’s also assume a 10% reserve requirement for bank deposits. This means that the banking system can support $100 worth of deposits if $10 worth of base money is used as bank reserves. Looking at the financial institution’s assets and liabilities, we find $100 worth of deposits on the liability side and $10 worth of reserves and $90 worth of loans on the asset side. So the $10 worth of base money could support a maximum of $100 worth of deposits and $90 worth of loans. If the $10 is used as reserve, then there is no currency in circulation and the quantity of money will be exactly equal to the deposits created or $100 and the money multiplier will be 10 and the credit multiplier 9.

At the other end of the spectrum, we have the possibility that the $10 worth of base money is used solely as currency in circulation. If that is the case, then no deposits will be created, nor will any loans be created by the banking system. Hence the credit multiplier will be zero. The only money in the economy will be the $10 worth of currency in circulation and the money multiplier will be 1.

These two extreme cases describe the boundaries for money and bank credit creation in the economy. Any combination of the two is possible. The $10 could support anywhere from $10 worth of money and no loans to $100 worth of money and $90 worth of loans. Which combination is chosen depends a great deal on the demand for money and for bank credit. The opportunity cost of holding the money and the price of credit changes to insure money and credit market clearing. Getting back to basics, we have argued that changes in the opportunity cost of holding money elicit substitution effects that alter the demand for money (i.e., velocity of money) and the credit creation ability of the banks in a clear and predictable direction.

Fig. 25.3 shows the MZM money multiplier and velocity of money. The figure shows a few things that we already knew. The first one is that the MZM velocity exhibited a secular uptrend leading up to the early 1980s and since then it has been on a secular downward trend. The secular trend for the MZM velocity is easily explained by the 10 year bond yields which during the 1960s and 1970s was on a secular uptrend and since Paul Volcker changed the Fed’s operating procedures the bond yield have been on a secular downtrend (Fig. 25.2B).

Another interesting feature is the negative correlation between the cyclical fluctuations in the two variables. When the velocity of money abruptly changes relative to trend, the money multiplier abruptly changes in the opposite direction. This is consistent with the view that unanticipated shocks to the money multiplier will have an impact on the quantity of money and in the short term, to make due and carry the same amount of transaction, the MZM velocity has to increase. This interpretation of the data suggests that the deviation from trend by the money multiplier and velocity of money are related, that they are not random events and are reacting to changing economic conditions. In short, the Fed does not have complete control over either of these two variables.

In Fig. 25.4 we show the trailing four-quarters MZM growth and US inflation rate. During the nonprice rule period when the Fed targeted the quantity of money, notice the secular uptrend in the US inflation rate. The data also illustrates a negative correlation between spikes in the inflation rate and MZM growth. Assuming that the monetary authorities controlled the quantity of money, MZM, the correlation is the opposite of what a strict monetarist interpretation of the data would produce. Another disturbing result is that during the 1980s MZM growth seems to be as high as or higher than the MZM growth during the 1970s, yet the inflation rate was much lower. Changes in the velocity of money or demand for money easily explain these correlations however, we still need to come up with an explanation or the causes for the changes in the velocity of MZM. All of this leads one to the obvious conclusion, that the monetary authorities do not fully control the quantity of money. Therefore, we need to look beyond the monetarist view.

The price rule yields some interesting implications regarding the relationship between money growth and inflation. First, since the price rule automatically adjusts for changes in money demand while keeping the inflation rate within the target range, it follows that under a price rule, fluctuations in money growth will be uncorrelated with the underlying inflation rate and positively correlated with real GDP growth. Another implication is that as the inflation rate converges to the price rule target rate and the volatility of the inflation rate declines, the moneyness of money increases and so does the demand for money. In plain language, the velocity of money will decline during the price rule period and will be related to the underlying inflation rate during the nonprice rule period. Looking at Fig. 25.5, we find some support for the price rule arguments. During the price rule period the velocity declined as expected, a major blow to the textbook strict monetarist view that assumes a constant velocity. Here, we argue that the organization of the monetary system is capable of explaining why we have high money growth during both the high inflation rate period (the quantity rule period) and the price rule period. In the latter, we have an increase in the demand for money (i.e., a decline in the velocity), while in the former, fast money growth is associated with rising inflation and a decline in velocity that further accelerated the inflation rate.

One common criticism of the Fed’s behavior leading to the financial meltdown is that the Fed was too easy as it expanded its balance sheet which lead to an explosion in the growth of the monetary base, see Fig. 25.6. Recall that some of the Fed’s critics used to argue that inflation would be coming down the pike. Our view then and now is that the critics focused solely on the expansion of the monetary base. Given this information, the critics inferred that there was too much money in the system. While we agree that inflation is a monetary phenomenon, we are not willing to concede that the money growth was excessive. Here is why. If the Fed was, in effect, following a price rule, the money growth would simply reflect increases in money demand. If that is the case, the inflation rate should remain within the Fed’s target range. In fact, as shown in Figs. 25.7 and 25.8, that was the case. MZM growth accelerated prior to the recession, yet its growth rate did not explode as the monetary base and neither did the PCE inflation rate. The latter dipped briefly and quickly rebounded to remain within the price rule range.

Other important relationships can be found in the different figures. For example, the relationship identified in Fig. 25.9 shows that. The money multiplier declined, yet the velocity of money does not show an abrupt change. It merely continued its downward trend. Fig. 25.10 shows that the expansion of the monetary base eliminated the negative impact of the decline in the money multiplier, leaving the MZM essentially unchanged. The Fed did a great job in providing liquidity, that is, transaction money to the economy. In fact, we can say more than that the fact that the inflation rate did not creep up with the expansion of the base, if anything it did decline, see Fig. 25.9, this means that if anything the Fed was a bit cautious or tight.

More often than not the expansion of the money multiplier is associated with declines in velocity or increases in the demand for money. This suggests that the money and credit supply and their prices do adjust to bring about a new equilibrium in response to the changing market conditions. The fact that the Fed was able to offset the negative impact of the decline in the money multiplier on MZM does not mean that the Fed took care of everything in the financial markets. Yet, it did provide transaction money, but what about the credit markets. The decline in the money multiplier would significantly reduce the credit creation by the banking system and that would have a negative impact on the credit markets. Fig. 25.5 shows how, as expected, the yield on the lower quality credit increased and perhaps in a flight to quality the yield on the higher quaintly corporate declined. As a result, the spread between the Baa and the Aaa bonds widened during the crisis.

Based on the framework outlined here and the previous chapter, we can make inferences regarding the possible impact of different shocks to the economy on the supply of credit and MZM as well as on the opportunity cost of holding MZM. More importantly, we can also show that the inference process is reversible. From the changes in the opportunity costs and the total amount of credit and money, we can clearly identify the nature of the shock. A few comments illustrate these points and put the monetary situation in perspective.

Let’s say that for some reason the banks stopped lending. In that case, the credit creation will collapse to zero. The credit contraction will have an unintended effect; it will lead to a decline in the money and credit multiplier and, as a result the quantity of money will decline too (Figs. 25.7 and 25.10). That is exactly what happened during the financial crisis. If left to the market clearing mechanism, prices change to bring about a new equilibrium. The excess demand for money leads to a decline in the inflation rate (Fig. 25.8). That is exactly what happened in 2008. The question is whether the Fed overdid it? Our answer is simple. Some people would look at MZM growth. We would look at the inflation rate. Looking at Fig. 25.8, we can see that in the aftermath of the crisis MZM grew in the mid-teens on a year over year basis while the inflation rate declined. All of this suggests that the expansion of the monetary base barely offset the collapse in the money multiplier.

The credit market is another story. While the increase in the base added the needed transaction balances, it did not address the credit issue. A shortage of credit will lead to an increase in the price of credit and the spread between corporate and government bonds. That is exactly what happened in 2008 (Fig. 25.11).

An attempt by the government to fill in the credit void was not as successful. However, this was not for lack of trying. The Fed intervened at the long and short end of the yield curve. The Fed went back to its low Feds funds rate and even though the flight to quality led to lower bond yields, the slope of the yield curve increased.

The point we want to make is that the money and credit markets interact with each other. If the Fed is to control the left side of the equation of exchange, it has to simultaneously manage the credit markets and the demand for money. These two objectives require at least two policy instruments on the part of the policy makers. The monetary base and the credit restraints (i.e., reserve requirements, etc.) should suffice. The velocity of money is also affected by inflation expectations and the opportunity cost of holding money. As long as we assume that the demand for money is stable, we can describe a systematic relationship between the multiplier, velocity, and the inflation rate. If inflation is to flare up, we expect to see an increase in the velocity of money and the money and credit multipliers. Those are the markers that we need to watch.