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Monetary policy and economic activity
Journal of Monetary Economics 6 (1980) 303-307. 0 North-Holland Publishing Company
BOOK REVIEWS
S.F. Frowen, A.S. Courakis and M.H. Miller, eds., Monetary Policy and Economic Activity in West Germany (Surrey University Press, London, 1977) pp. xviii + 268, f 15.00. This volume consists of ten papers, most of which were presented at the Surrey Conference on German Monetary Development. These papers, as well as the bibliography included in the volume, provide useful information about monetary institutions, behavior and policy in West Germany. Given the increasing importance of Germany in the world economy, such a compendmm of papers and references on these aspects of the German economy is certainly needed. Unfortunately - and this may be due to a +biication lag -- a number of the contributions seem to be out of date in that they do not cover important aspects of the current German monetary system. Several of the papers deal with monetary aggregates without making any reference to the aggregate used by the Bundesbank in the conduct of monetary policy since 1974, namely, the stock of central bank money. Furthermore, with one notable exception (the paper by Beenstock), very little attention is given to the financial linkages of Germany with the rest of the world. Finally, all the authors assume a world of fixed parities. Because of these omissions, the volume is not as helpful to our understanding of current German monetary phenomena as one might wish. The first two contributions in the volume are, however, exceptions to this statement. Helmut Schlesinger, a directcr of the Bundesbank, describes recent developments in West German monetary policy in the volume’s first paper. One of the most important of these developments described by Schlesinger is the shift in 1974 in the Bundesbank’s orientation away from banks’ ‘free liquid reserves’ to a monetary aggregate called ‘central bank money’. The former measure consists of those assets which the Bundesbank is obliged to purchase at any time up to the limit set by rediscount quotas, and the latter concept includes currency and required reserves held against domestic deposits calculated using fixed reserve ratios. Schlesinger maintains that the reirson the Bundesbank abandoned the free reserve concept was that banks used their liquid reservesto expand credit in an unrestrained fashion, which forced the Bundesbank to restrict free liquid reserves to practically zero, so that this measure no longer registered the expansive or restrictive effect of monetary policy. One can certainly understand why a central bank would I want to move away from a monetary indicator that is characterized by almost infinite elasticity between reserve and non-reserve components. The reason why the Bundesbank switched to the particular aggregate called central bank money is, however, explained rather less convincingly. The theoretical and empirical basis for this decision is never presented, so that one is left wondering why in fact the Bundesbank rejected the more common varieties of monetary aggregatessuch as MI and Mt. Further discussion of the concepts of free iquid reserves and central bank money is contained in tile volume‘s second contribution entitled ‘Monetary Thought and Stabilization Policy in the Federal Republic of Germany 1960-1976’ by Anthony Courakis. This paper also provides a lucid summary of the instruments of monetary policy empioyeid by the Bundesbank. Two of the more interesting points made by Courakis, however, have to do with central bank money. First, he argues - correctly in the reviewer’s mind -- that there is no compelling reason why, in a measure of money, currency should have a weight of 1.0 and demand deposits a weight equal to a fixed reserve-requirement-ratio. Second, Courakis observes that movements in the stock of central bank money do not provide any additional predictive or informational content over aud above that contained in changes in the components of central bank money. West
Manfred Willms, in his paper ‘MonetarJ indicators in the Federal Republic of Germany’, llnfortunately does not include the stock of central bank money as one of the candidates, which arc confined to the monetary base, MI and M2, bank credit. free liquid reserves. and a calculated credit maximum. Using a simplified model of the economy consisting of a goods market and credit market, Willms derives a reduced form expression for the change in the goal variable, namely, real income, and then examines the extent t.0 which the various monetary indicators deviate from this expression. Peter Bull has a number of useful co&ments on Willms paper. In particular. he points out that there are a number of puzzling partial derivatives in the equations that comprise the model. It should also be noted that Willms’ entire analysis is conducted on the assumption that Germany is a closed economy. Finally, in his summary Willms concludes that Mf is the best monetary indicator, yet from his discussion it is by no means clear why MI should be preferred to the monetary base. Wilhns also provides an empirical evaluation of alternative monetary indicators, but the relationship between the regression equations he used and his theoretical model is not obvious. The basic difficulty is that the regression equations are not derived from the model, which is given by equation 3.4 (p. 52). This expression involves a number of parameters and those interest rates controlled by the central bank. It is not explained how ihese parameters enter the regression equations, and the interest rates are completely absent. Unlike Willms. Manfred Neumann does employ an open-economy model in his contribution ‘A Theoretical and Empirical Analysis of the; Germany Money Supply Process’. His point of departure is the Brunner-Meltzer non-linear money supply hypothesis, which he elaborates with a wealth of institutional detail, so that his entire discussion provides useful insights into the German monetary system. These insights are more valuable for this reviewer than his comparison of two variants of the monetary base. Some problems do arise in his analysis, however. First, because of the need to force all expressions into an elasticity mold, Neumann’s specifications of certain equations have undesirable properties. For example, equations 4.45 through 4.48 (p. 85) imply that $VV~~II demands for domestic deposits are functions of d~>~)lcsticdemand deposits! Second, if a money supply function is so long (p. 89) that the author does not write out all the terms, it is not clear how useful the equation is as an analytical device. Finally, Neumann admits that the estimated interest rate functions (p. 105) look ‘very bad’, which they do. One wonders, then. how much faith sne can have in the theory. A much simpler approach to the money supply process is contained in the paper by Stephen Frowen and Philip Arestis entitled ‘The Demand for and Supply of Money in the Federal Republic of Germany: 1965-1974’. The money supply is specified as a linear function of the short-term interest rate, the discount rate, and the stock of central bank money. Given that Neumann‘s comprehensive analysis of the money supply process is included in the volume, the authors should have at least referred to his paper and indicated the simplifying assumptions needed to derive their equation. If they had done this, they probably would have discovered that actual required reserve ratios are needed as an additional determinant of the money supply, since central bank money is computed using fixed ratios. In their empirical analysis the authors add free liquid reserves to the stock of central bank money to form some kind of cxpandcd hi variable. but this formulation is hard to justify: why should the current money stock depend directly on the stock of liquid assets held by banks‘? On the demand side, the authors specify and estimate fairly standard demand-for-money functions based on stock-adjustment and perm;lnent-income hypotheses. As Marcus Miller points out in his comments, there are difficulties in discriminating between these two hypothcse(; in the model used by Frowen and Arestis. Miller also has an interesting discussion of the use of a price variable as a separate variable in the demand-for-money function. In the shortest piece in the volume ‘Price Expectations and Interest Rates in the Federal Republic of Germany’, Juergen Siebke inverts a demand-for-money function to explore the extent to which t&e rate of interest reflects the expected rate of inflation. In his comment Michael Parkin objects to this procedure, arguing that if bonds and t-Cal assets are perfect substitutes, then it is inappropriate to add the anticipated rate of infl;!;ion as an additional argument in the demand function for real balances, since it is already there once we put the nominal rate of interest into the equation. Another problem is that Siebke’s equation implies
that the stock demand for money depends on the cltange in income, which is a specification that is hard to justify. A welcome departire from the reduced-form approach common to most of the papers in the volume is the contnoution by H. Koenig, W. Gaab and .I. Wolters entitied ‘An Econometric Model of the Financial Sector of the Federal Republic of Germany’. Their model consists of nineteen structural equations and nine identities. Because it is a structural model, the specific behavioral assumptions of the different agents in the German monetary sector are more transparent than in other contributions. In most cases the specifications and empirical results seem reasonable, but a brief discussion of the key features of each behavioral equation would have been helpful. In addition. the presentation of the results of multiplier experiments to supplement the in-sample and forecasting results given in the paper would have been useful for an evaluation of the model. If there is one general criticism of the model, it is that the impact of the balance of payments. and specifically, international capital flows, on the monetary system does not appear to be well articulated. In contrast to the structural approach taken by Koenig. tiaab and Walters, Nikolaus Laeufer uses reduced forms in his paper ‘Further Evidence on the Relative Importance of Fiscal and Monetary Actions in the Federal Republic of Germany’. He follows the work of Andersen and Jordan and regresses current income on current and lagged values of indicators of monetary and fiscal polic>, and adds - since Germany is an open economy current and lagged exports to measure exogenous impulses originating abroad. The problems with this approach are notorious. For example. numerous relevant variables are omitted. and it is difficult to see how all the instruments of monetary and fiscal policies can be squeezed into an indicator. The only satisfactory way to appraise the relative effectiveness of monetary and fiscal policy is to perform multiplier experiments using a structural model. It is regrettable that the results of such experiments do not appear in this volume. The last two contributions deal explicitly with the international linkages of Germany with other countries. in a paper entitled ‘Monetary Independence under Fixed Exchange Rates: the Case of West Germany 1958 1972’. Michael Beenstock argues that because his estimaks indicate a low interest-rate elasticity of short-term capital flows, Germany enjoyed a high depee oil’ monetary insulation. This conclusion is curious. for at least two reasons. First. BzenstocL himself finds a Leigh interest-rate sensitivity for long-term capital flows. Second, he seems to be unaware of the reason why Germany switched to a floating exchange rate, namely to insulate itself from international capital flows. The last paper. ‘Dynamic Multipliers and the Trade Balance’ by Ulrich Schliefer and Patrick McMahon, deals with the following interesting question: to what extent does the ~‘iltc’(!/‘~llt~11~40 in aggregate demand affect the trade balance? While the authors construct an ingenious model to answer this question, it is not sufficiently developed. and the empirical results are too crude. to warrant any conclusion about the desirability of changes in government expenditures. All in all, we do learn a great deal about the German monetary system from this volume. but let us hope the editors arrange another conference soon that deals with current aspects of the German economy so that we can learn more.
Board of Governors
Jiirg Nichans. The Theory of Money London, 1978) pp. xi + 3 12, $17.95.
(The Johns
Hopkins
Peter B. CLARK of the Federal Reserve System
Unlb,l4ty
Press, Baltimore
and
It is rare to see good economic theory presented with a comprehensive overview. related to the ideas of earlier writers, and presented not just as a set of theorems but with the author’s considered opinions on the validity of the assumptions. the sc)plicability of the results, and the possible influence of factors too difficult to incorporate with much precision. Professor Niehans has done all this in his book, which he accurately describes as a treatise on monetary fheory.
BOOK REVIEWS
S.F. Frowen, A.S. Courakis and M.H. Miller, eds., Monetary Policy and Economic Activity in West Germany (Surrey University Press, London, 1977) pp. xviii + 268, f 15.00. This volume consists of ten papers, most of which were presented at the Surrey Conference on German Monetary Development. These papers, as well as the bibliography included in the volume, provide useful information about monetary institutions, behavior and policy in West Germany. Given the increasing importance of Germany in the world economy, such a compendmm of papers and references on these aspects of the German economy is certainly needed. Unfortunately - and this may be due to a +biication lag -- a number of the contributions seem to be out of date in that they do not cover important aspects of the current German monetary system. Several of the papers deal with monetary aggregates without making any reference to the aggregate used by the Bundesbank in the conduct of monetary policy since 1974, namely, the stock of central bank money. Furthermore, with one notable exception (the paper by Beenstock), very little attention is given to the financial linkages of Germany with the rest of the world. Finally, all the authors assume a world of fixed parities. Because of these omissions, the volume is not as helpful to our understanding of current German monetary phenomena as one might wish. The first two contributions in the volume are, however, exceptions to this statement. Helmut Schlesinger, a directcr of the Bundesbank, describes recent developments in West German monetary policy in the volume’s first paper. One of the most important of these developments described by Schlesinger is the shift in 1974 in the Bundesbank’s orientation away from banks’ ‘free liquid reserves’ to a monetary aggregate called ‘central bank money’. The former measure consists of those assets which the Bundesbank is obliged to purchase at any time up to the limit set by rediscount quotas, and the latter concept includes currency and required reserves held against domestic deposits calculated using fixed reserve ratios. Schlesinger maintains that the reirson the Bundesbank abandoned the free reserve concept was that banks used their liquid reservesto expand credit in an unrestrained fashion, which forced the Bundesbank to restrict free liquid reserves to practically zero, so that this measure no longer registered the expansive or restrictive effect of monetary policy. One can certainly understand why a central bank would I want to move away from a monetary indicator that is characterized by almost infinite elasticity between reserve and non-reserve components. The reason why the Bundesbank switched to the particular aggregate called central bank money is, however, explained rather less convincingly. The theoretical and empirical basis for this decision is never presented, so that one is left wondering why in fact the Bundesbank rejected the more common varieties of monetary aggregatessuch as MI and Mt. Further discussion of the concepts of free iquid reserves and central bank money is contained in tile volume‘s second contribution entitled ‘Monetary Thought and Stabilization Policy in the Federal Republic of Germany 1960-1976’ by Anthony Courakis. This paper also provides a lucid summary of the instruments of monetary policy empioyeid by the Bundesbank. Two of the more interesting points made by Courakis, however, have to do with central bank money. First, he argues - correctly in the reviewer’s mind -- that there is no compelling reason why, in a measure of money, currency should have a weight of 1.0 and demand deposits a weight equal to a fixed reserve-requirement-ratio. Second, Courakis observes that movements in the stock of central bank money do not provide any additional predictive or informational content over aud above that contained in changes in the components of central bank money. West
Manfred Willms, in his paper ‘MonetarJ indicators in the Federal Republic of Germany’, llnfortunately does not include the stock of central bank money as one of the candidates, which arc confined to the monetary base, MI and M2, bank credit. free liquid reserves. and a calculated credit maximum. Using a simplified model of the economy consisting of a goods market and credit market, Willms derives a reduced form expression for the change in the goal variable, namely, real income, and then examines the extent t.0 which the various monetary indicators deviate from this expression. Peter Bull has a number of useful co&ments on Willms paper. In particular. he points out that there are a number of puzzling partial derivatives in the equations that comprise the model. It should also be noted that Willms’ entire analysis is conducted on the assumption that Germany is a closed economy. Finally, in his summary Willms concludes that Mf is the best monetary indicator, yet from his discussion it is by no means clear why MI should be preferred to the monetary base. Wilhns also provides an empirical evaluation of alternative monetary indicators, but the relationship between the regression equations he used and his theoretical model is not obvious. The basic difficulty is that the regression equations are not derived from the model, which is given by equation 3.4 (p. 52). This expression involves a number of parameters and those interest rates controlled by the central bank. It is not explained how ihese parameters enter the regression equations, and the interest rates are completely absent. Unlike Willms. Manfred Neumann does employ an open-economy model in his contribution ‘A Theoretical and Empirical Analysis of the; Germany Money Supply Process’. His point of departure is the Brunner-Meltzer non-linear money supply hypothesis, which he elaborates with a wealth of institutional detail, so that his entire discussion provides useful insights into the German monetary system. These insights are more valuable for this reviewer than his comparison of two variants of the monetary base. Some problems do arise in his analysis, however. First, because of the need to force all expressions into an elasticity mold, Neumann’s specifications of certain equations have undesirable properties. For example, equations 4.45 through 4.48 (p. 85) imply that $VV~~II demands for domestic deposits are functions of d~>~)lcsticdemand deposits! Second, if a money supply function is so long (p. 89) that the author does not write out all the terms, it is not clear how useful the equation is as an analytical device. Finally, Neumann admits that the estimated interest rate functions (p. 105) look ‘very bad’, which they do. One wonders, then. how much faith sne can have in the theory. A much simpler approach to the money supply process is contained in the paper by Stephen Frowen and Philip Arestis entitled ‘The Demand for and Supply of Money in the Federal Republic of Germany: 1965-1974’. The money supply is specified as a linear function of the short-term interest rate, the discount rate, and the stock of central bank money. Given that Neumann‘s comprehensive analysis of the money supply process is included in the volume, the authors should have at least referred to his paper and indicated the simplifying assumptions needed to derive their equation. If they had done this, they probably would have discovered that actual required reserve ratios are needed as an additional determinant of the money supply, since central bank money is computed using fixed ratios. In their empirical analysis the authors add free liquid reserves to the stock of central bank money to form some kind of cxpandcd hi variable. but this formulation is hard to justify: why should the current money stock depend directly on the stock of liquid assets held by banks‘? On the demand side, the authors specify and estimate fairly standard demand-for-money functions based on stock-adjustment and perm;lnent-income hypotheses. As Marcus Miller points out in his comments, there are difficulties in discriminating between these two hypothcse(; in the model used by Frowen and Arestis. Miller also has an interesting discussion of the use of a price variable as a separate variable in the demand-for-money function. In the shortest piece in the volume ‘Price Expectations and Interest Rates in the Federal Republic of Germany’, Juergen Siebke inverts a demand-for-money function to explore the extent to which t&e rate of interest reflects the expected rate of inflation. In his comment Michael Parkin objects to this procedure, arguing that if bonds and t-Cal assets are perfect substitutes, then it is inappropriate to add the anticipated rate of infl;!;ion as an additional argument in the demand function for real balances, since it is already there once we put the nominal rate of interest into the equation. Another problem is that Siebke’s equation implies
that the stock demand for money depends on the cltange in income, which is a specification that is hard to justify. A welcome departire from the reduced-form approach common to most of the papers in the volume is the contnoution by H. Koenig, W. Gaab and .I. Wolters entitied ‘An Econometric Model of the Financial Sector of the Federal Republic of Germany’. Their model consists of nineteen structural equations and nine identities. Because it is a structural model, the specific behavioral assumptions of the different agents in the German monetary sector are more transparent than in other contributions. In most cases the specifications and empirical results seem reasonable, but a brief discussion of the key features of each behavioral equation would have been helpful. In addition. the presentation of the results of multiplier experiments to supplement the in-sample and forecasting results given in the paper would have been useful for an evaluation of the model. If there is one general criticism of the model, it is that the impact of the balance of payments. and specifically, international capital flows, on the monetary system does not appear to be well articulated. In contrast to the structural approach taken by Koenig. tiaab and Walters, Nikolaus Laeufer uses reduced forms in his paper ‘Further Evidence on the Relative Importance of Fiscal and Monetary Actions in the Federal Republic of Germany’. He follows the work of Andersen and Jordan and regresses current income on current and lagged values of indicators of monetary and fiscal polic>, and adds - since Germany is an open economy current and lagged exports to measure exogenous impulses originating abroad. The problems with this approach are notorious. For example. numerous relevant variables are omitted. and it is difficult to see how all the instruments of monetary and fiscal policies can be squeezed into an indicator. The only satisfactory way to appraise the relative effectiveness of monetary and fiscal policy is to perform multiplier experiments using a structural model. It is regrettable that the results of such experiments do not appear in this volume. The last two contributions deal explicitly with the international linkages of Germany with other countries. in a paper entitled ‘Monetary Independence under Fixed Exchange Rates: the Case of West Germany 1958 1972’. Michael Beenstock argues that because his estimaks indicate a low interest-rate elasticity of short-term capital flows, Germany enjoyed a high depee oil’ monetary insulation. This conclusion is curious. for at least two reasons. First. BzenstocL himself finds a Leigh interest-rate sensitivity for long-term capital flows. Second, he seems to be unaware of the reason why Germany switched to a floating exchange rate, namely to insulate itself from international capital flows. The last paper. ‘Dynamic Multipliers and the Trade Balance’ by Ulrich Schliefer and Patrick McMahon, deals with the following interesting question: to what extent does the ~‘iltc’(!/‘~llt~11~40 in aggregate demand affect the trade balance? While the authors construct an ingenious model to answer this question, it is not sufficiently developed. and the empirical results are too crude. to warrant any conclusion about the desirability of changes in government expenditures. All in all, we do learn a great deal about the German monetary system from this volume. but let us hope the editors arrange another conference soon that deals with current aspects of the German economy so that we can learn more.
Board of Governors
Jiirg Nichans. The Theory of Money London, 1978) pp. xi + 3 12, $17.95.
(The Johns
Hopkins
Peter B. CLARK of the Federal Reserve System
Unlb,l4ty
Press, Baltimore
and
It is rare to see good economic theory presented with a comprehensive overview. related to the ideas of earlier writers, and presented not just as a set of theorems but with the author’s considered opinions on the validity of the assumptions. the sc)plicability of the results, and the possible influence of factors too difficult to incorporate with much precision. Professor Niehans has done all this in his book, which he accurately describes as a treatise on monetary fheory.