Doing Without Money: Controlling Inflation in a Post-Monetary World

Central banks now generally agree that conventional monetary aggregates are of little use as targets or even indicators for monetary policy, owing to the instability of money demand relations in economies with well-developed financial markets. But monetary theory has provided little guidance for the analysis of policies that are not formulated in terms of a path for the money supply, and a stable money demand relation is generally assumed as a central element of a theoretical analysis. This paper, instead, shows that it is possible to analyze equilibrium inflation determination without any reference to either money supply or demand, as long as one specifies policy in terms of a “Wicksellian” interest-rate feedback rule. The paper’s central result is an approximation theorem, showing the existence, for a simple monetary model, of a well-behaved “cashless limit” in which the money balances held to facilitate transactions become negligible. The relations that determine equilibrium inflation in the cashless limit also provide a useful approximate account in the case of an economy in which monetary frictions are present, but small. The approximation remains valid in the case of time variation in the monetary frictions, including variation of a kind that may result in substantial instability of money demand in percentage terms. Inflation in the cashless limit is shown to be a function of the gap between the “natural rate” of interest, determined by the supply of goods and opportunities for intertemporal substitution, and a time-varying parameter of the interest-rate rule indicating the tightness of monetary policy. Inflation can be completely stabilized, in principle, by adjusting the policy parameter so as to track variation in the natural rate. Under such a regime, instability of money demand has little effect upon equilibrium inflation, and need not be monitored by the central bank. ∗This is a revised draft of a talk given as a keynote address at the annual meeting of the Society for Economic Dynamics and Control in Mexico City, June 1996. I would like to thank Julio Rotemberg, Manuel Santos, and Lars Svensson for helpful discussions, the National Science Foundation for research support through a grant to the National Bureau of Economic Research, and the Institute for International Economic Studies, Stockholm, for its hospitality during the preparation of this draft. 1 Monetary Policy without Money Throughout the English-speaking world, at least, central bankers have abandoned the notion that any of the conventional monetary aggregates constitute a suitable intermediate target for monetary policy. This has resulted from the discovery that these aggregates no longer appear to have any very reliable relationship, at least in the short run, with the variables, such as inflation and real activity, about which policymakers actually care, 1 This development is often attributed to the rapid transformation of financial arrangements since the early 1980’s, due both to deregulation and financial innovation. But there is reason to fear that the instability of conventional money demand equations may not relate solely to a transitory period of institutional turbulence, in which an old set of arrangements give way to a new, more rational set, that should then be expected to result in stable econometric relationships once again. For from the standpoint of economic theory, there is no reason to believe that there is any uniquely rational or efficient set of arrangements that result in any stable demand for money at all. Instead, because the demand for an asset that is dominated in terms of its purely pecuniary return depends upon the existence of transactions frictions that people benefit, individually and jointly, by overcoming, there is every reason to expect further innovations, due to improvements in information processing and to increased creativity in the evasion of the remaining regulatory constraints, that continually reduce the quantity of the monetary base that needs to be held (on average) in order to carry out a given volume of transactions. The only natural limit to this process is an ideal state of frictionless financial markets, in which there is no positive demand for the monetary base at all, if it is dominated by other financial assets, and no determinate demand for it if it is not. See, e.g., Friedman and Kuttner (1996) and Estrella and Mishkin (1996).