Greg Ip seems to have a pretty low regard for monetarists:
But in the real world, the Fed sets a fixed interest rate and lets the money supply adjust. Back in 2000 David Romer proposed modifying the IS-LM model to reflect this reality. In his IS-MP model, the upward sloping LM curve is replaced by a horizontal MP curve.
. . .
The Fed influences the level of output by changing its interest rate, i.e. shifting the MP curve up or down. At any given interest rate the money supply is infinitely elastic, which simply means it is determined by demand, rather than the other way around, as monetarists think. I wish undergraduate courses used Mr Romer’s IS-MP model instead of the IS-LM model; students would have a much easier time applying their class work to the real world.
God help us if there are any monetarists out there who don’t understand that the money stock becomes endogenous when the Fed pegs interest rates.
Greg Ip continues:
This essentially explains why no major central bank targets the money supply. The money supply does matter, but for narrow, technical reasons.
Ip is right that central banks choose not to target the money supply, but it’s not for the reasons he suggests. The real problem is that the demand for money (or velocity, if you prefer) is not stable. Thus targeting the money supply might leave prices and/or NGDP quite unstable. And the money supply matters for broad macroeconomic reasons, not narrow technical reasons.
Because the demand for money is unstable, and because there are lags between changes in monetary policy and observed changes in NGDP data, most central banks rely on intermediate targets like interest rates or exchange rates. But these are still targets, monetary policy consists of control of the money supply. Here’s how it works:
1. The central bank determines a policy goal–say 2% inflation.
2. The central bank doesn’t know how much money is required to generate 2% inflation, so they set targets for interest rates and exchange rates, and then adjust those targets as needed to stabilize inflation.
3. Suppose a central bank sees inflation rising too fast. They might decide to raise interest rates. But higher interest rates don’t lower inflation, they raise inflation. That’s because as interest rates rise, velocity rises. Higher velocity raises inflation, it doesn’t lower it. So why do central banks talk about “raising interest rates” to control inflation?
4. Here’s what’s really going on. Suppose the central bank sees inflation rising too rapidly. They realize that the need to reduce money growth. But they don’t want to target money growth, as that makes other variables too volatile. So they they raise the target short term interest rate enough so that the money supply (now or later) will have to be reduced in order to hit the interest rate target. They hope the reduction in the money supply reduces inflation.
Let me repeat, higher interest rates are inflationary. They increase velocity. If you don’t believe me, check out interest rates and velocity during any extremely high inflation episode. When rates rise, inflation usually rises. Higher interest rates are inflationary. Repeat 100 times. But the thing the Fed uses to generate higher short term interest rates—a reduction in the money growth rate—is deflationary. To reduce inflation you must reduce money growth. Interest rate targeting (or exchange rate targeting) is simply a tool. It is changes in the money growth rate that actually drive macro nominal aggregates up and down.
It is precisely because students were taught IS-LM and IS-MP that we are in this mess. Both models teach students that easy money reduces interest rates. So 99.999% of people in 2008-09 inferred that the Fed was easing monetary policy, even as they adopted the tightest policy since 1938.
Woodford and Bernanke are right; the stance of monetary policy depends on outcomes like NGDP growth and inflation, not interest rates and the money supply. But that is NOT what students are being taught.
PS. I said money is endogenous when the central bank pegs interest rates. It’s not endogenous in any long run sense when they target interest rates. That’s because targets are adjusted to change the money supply.