The Changed Nature of Monetary Policy

 Abstract: In 1968 Andersen and Jordan published a strong regression result relating money growth to the economy, specifically nominal GDP. Graph 1 shows an even stronger relation of money and real GDP. But, in 2015, Lucas and Nicolini noted that, “Long standing empirical relations connecting monetary aggregates like M1, M2, and the monetary base to movements in prices and interest rates began to deteriorate in the 1980s and have not been restored since”. In 2017, Xi Wang of Washington University found that, “It appears that the period 1955-80 is the only period during which the QTM (Quantity Theory of Money) fits data well — It starts to breakdown when we go beyond this period”. Our regressions of their time periods: 1985-2015 and 1985-2017 plus 1985-2020 agree with the breakdown as the GDP-M relation turned from strongly positive to negative. We think we have an explanation as to why the GDP-M relation changed. Graph 2 shows that Fed behavior during recessions changed radically in the last three (2000-2001, 2008-2009, 2020) compared to those of 1948-1949 to 1981-1982 and also 1937-1938. Prior to 1981-1982 recessions were Fed induced, presumably to combat inflation. In the last three recessions the Fed made rescue attempts to lessen the effects of the dot.com crash, the CDO-Lehman “Great Recession”. financial crash, and the Covid-19 Pandemic. The 1990-1991 recession behavior was a transition. The Fed has always been concerned with controlling interest rates. Three weeks after the Lehman bankruptcy on September 15, 2008 at the heart of the Great Recession, the Fed began paying interest on bank reserves (IOR) as a new way to control short term rates, radically changing the nature of monetary policy. Then came ZIRP (zero interest rate policy), difficulties at the ZB (zero interest rate bound), and QE (Quantitative Easing). Japan has been at the ZB and so has the U.S. in 1938-1940, 2010-2016, and 2020. What are the consequences?

Key words: monetary policy; banking in economic stabilization; interest rate policy

         JEL code: E