Policy Implications

Abstract

An effective monetary policy involves stability in two linkages: the linkage between the target and economic activity (“predictability”) and the linkage between the target and the policy instrument (“controllability”). The flow-of-funds framework singles out financial flows as having a closer relationship to final expenditures than interest rates or the money stock.¹ Interest rate changes do not predict changes in nominal income because such variation may either signal movements in the same or opposite direction. It depends on whether or not interest rate changes are due to shifts on the demand side of credit markets or the supply side. In the case of a positive relation between interest rates and nominal income, sums raised in credit markets may be going up (indicating no policy restraint) at the same time that interest rates are going up (signaling restraint). The relationship between money and nominal income is similarly unstable. The evidence is in the search for ever wider M_i categories.² More controversial is the question of controllability. The chapter will explore the strengths and weaknesses of money and credit targeting from the standpoint of both linkages.