Stabilization Policies in a Growing Economy

In a recent paper,3 Professors Stein and Nagatani (SN) have examined monetary stabilization policies in a full employment nonlinear monetary growth model. Specifically, they try to give a " rigorous answer " to the question of which should be the correct control variable of monetary policy; i.e., money supply growth, interest rates, or some other variable. The model used is of the Keynes-Wicksell variety (a name used by Stein to distinguish it from the neoclassical growth models). The method of stabilization is linear feedback control, where the money supply and/or the interest rate are regulated according to fluctuations in the proportional rate of price change. The method of analysis is to substitute expressions for government regulated money supply and interest rate into the model and see how stability is affected according to the Routh-Hurwicz ~r i ter ion .~ Three general policies are mentioned by SN (proportional, integral, and derivative), but only derivative policy is seriously considered on the basis that no other policies are more stabilizing or less stabilizing.' Using this technique SN arrive at several interesting conclusions, most notably: (1) regulation of the money supply alone cannot affect the stability of the model, (2) a combination of money supply policy and interest rate policy is necessary to affect the stability of the system and (3) using interest rate policy the monetary authorities can control the nominal rate of interest in the long run. These conclusions have obvious policy implications for the current debate over what should be the correct control variable of monetary policy. This paper argues that these conclusions result from (1) an inconsistent model which does not consider all equilibrium conditions and which has an unrealistic specification of interest rate policy, and (2) a restrictive definition of money supply control. By correcting these deficiencies and explicitly specifying the behaviour of the monetary authorities, we will show how the money supply policy alone can stabilize the system and that a specific interest rate policy is extraneous as a stability tool.