PDF Ebook Money, Prices, Interest Rates and the Business Cycle
The positive correlation of nominal money and real economic activity over the course of many business cycles is a key empirical fact about the U.S. economy. Further, there is a dynamic dimension to this covariation so strong and stable that a monetary variable has long been included in the Commerce Department’s Index of Leading Economic Indicators. While this pattern of cyclical comovement is widely agreed upon, its interpretation is not. Some macroeconomists view money as purely passive, with its positive response to varying levels of economic activity producing the positive correlation. Others view changes in the quantity of money as an important, perhaps dominant, source of economic fluctuations. Frequently, the real effects of monetary changes are suggested to arise from frictions in commodity, labor or financial markets. In economic theories that describe the influence of these frictions, the transmission mechanism from monetary changes to real activity is typically viewed as involving interest rates and the price level.
The primary goal of this paper is to evaluate three models that explain the link between money, prices, interest rates and the business cycle. We do this in three steps. First, we document the cyclical behavior of money, prices and interest rates in the U.S. over the postwar period. Second, we construct three quantitative rational expectations models of macroeconomic activity: (i) a real business cycle model with endogenous money; (ii) a model of commodity market frictions that involves non-neutralities of money arising from gradual adjustment of goods prices; and (iii) a model of financial market frictions that involves non-neutralities of money arising from gradual adjustments of portfolios. Finally, we compare that models’ prediction for the business cycle behavior of money, prices, and interest rates with the data. In exploring the predictions of these models, we take the stock of money to be one of several exogenous variables in the system. Thus, all of our models are capable of generating a forecasting role for money relative to real economic activity, similar to that found in the U.S. data. In the real business model, monetary changes can forecast real activity because both productivity and money are related to many underlying sources of shocks and because economic agents know the relationship between money and these real shocks. In the models with “sticky prices” and “liquidity effects” (short-hand names for the models with frictions in the commodity and financial markets, respectively), monetary changes have an additional direct positive effect on aggregate output.
The model economies have diverse successes and failures, some of which are surprising such as the sticky price model’s prediction of a countercylcical price level. However, we find that all of the models are highly deficient in the predictions that they make about the relationship of real and nominal rates to the business cycle. Notably, none of the models captures the fact that increases in both the real and nominal interest rate preceded every post-war recession, which is highlighted in our empirical description of post-war U.S. business cycles.
The outline of the paper is as follows. First, the remainder of this introductory section is devoted to a summary of our main findings. Section 2 describes the data and documents its’ business cycle characteristics. Section 3 outlines the three macroeconomic models, and Section 4 discusses the quantitative versions of the models including practical issues relating
to linearization and parameterization. Our main empirical results are presented in Section 5, and Section 6 concludes. Finally, detailed discussion of the models is contained in the appendices.
Download
PDF Ebook Money, Prices, Interest Rates and the Business Cycle
Posted in :
