The dispute between President Trump and Fed Chairman Jerome Powell over interest rates reflects a widespread belief that monetary policy equals central bank policy rates. Modern central banks and most economists present monetary stance through an overnight policy rate, and markets focus intensely on rate decisions. Neo-Keynesian DSGE models have reinforced the centrality of interest rates in policy analysis for decades. Monetarists, by contrast, assert that broad money movements primarily determine nominal GDP. Empirical evidence is presented as favoring the quantity theory of money over interest-rate-centered neo-Keynesian models.
The ongoing feud between President Trump and Fed Chairman Jerome Powell centers on interest rates. This tells us more about the near-universal view of what constitutes monetary policy than it does about Trump or Powell. While Trump and Powell might quibble over the proper level for the Fed funds rate, they both think monetary policy is all about interest rates.
Today, central bankers organize monetary policy around the overnight interest rate set on reserves supplied by central banks. Indeed, nearly every central bank these days describes its stance on monetary policy in terms of its policy rate. It's not surprising, therefore, that most bankers, market analysts, economists, and financial journalists also embrace the view that monetary policy is all about central banks' policy rates. That's why markets wait with bated breath before each central bank policy rate decision.
Why the obsession over interest rates? One reason hinges on the fact that for over the past 30 years or so, macroeconomic models are neo-Keynesian extensions of dynamic stochastic general equilibrium (DSGE) models. These put interest rates front and center. Armed with these models, economists and central bankers believe that monetary policy has its impact on the economy via changes in central banks' policy rates.
But that's not what monetarists, who embrace the quantity theory of money, tell us. Unlike the neo-Keynesian macroeconomic models that exclude money, the quantity theory of money states that national income or nominal GDP is primarily determined by the movements of broad money, not by changes in interest rates. As it turns out, the data talk loudly and support the quantity theory of money. They do not support the neo-Keynesian models which are centered on changes in interest rates.
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