A Note on Money and the Conduct of Monetary Policy

Prior to the …nancial crisis mainstream monetary policy practice had become disconnected from money. We outline the basic rationale for this development using a simple model of money and credit in which we explore the conditions under which money matters directly for the conduct of policy. Then, drawing on Goodfriend and McCallum’s (2007) DSGE model, we examine the circumstances under which money becomes more closely linked to in‡ation. We …nd that money matters when the variance of the supply of lending dominates productivity and the velocity of money demand. This is because amplifying the role of loans supply leads to an expansion in aggregate demand, via a compression of the external …nance premium, which is in‡ationary. We consider a number of alternative monetary policy rules, and …nd that a rule which exploits the joint information from money and the external …nance premium performs best. JEL Classi…cation: E31; E40; E51. Keywords: money, DSGE, policy rules, external …nance premium. We thank Qi Sun at the CDMA at the University of St Andrews for excellent research assistance. This paper was presented at the MMF/Bank of England conference on ‘Money and Macro Models’ in November 2007, at the University of Kent, Cambridge Faculty seminar, at the University of Birmingham and we thank participants at these seminars for their helpful comments. In particular, we thank Philip Arestis, Germana Corrado, Charles Goodhart, Miguel Leon-Ledesma, Marcus Miller, Ed Nelson, Huw Pill, Katsuyuki Shibayama and Peter Sinclair for helpful discussions and comments. This paper was orginally issued in 2008 as Reconnecting Money to In‡ation: The Role of the External Finance Premium as KDPE0861 and CWPE0852.