Working Paper: CEPR ID: DP6098
Authors: Günter Beck; Volker Wieland
Abstract: The European Central Bank has assigned a special role to money in its two pillar strategy and has received much criticism for this decision. In this paper, we explore possible justifications. The case against including money in the central bank's interest rate rule is based on a standard model of the monetary transmission process that underlies many contributions to research on monetary policy in the last two decades. Of course, if one allows for a direct effect of money on output or inflation as in the empirical 'two-pillar' Phillips curves estimated in some recent contributions, it would be optimal to include a measure of (long-run) money growth in the rule. In this paper, we develop a justification for including money in the interest rate rule by allowing for imperfect knowledge regarding unobservables such as potential output and equilibrium interest rates. We formulate a novel characterization of ECB-style monetary cross-checking and show that it can generate substantial stabilization benefits in the event of persistent policy misperceptions regarding potential output. Such misperceptions cause a bias in policy setting. We find that cross-checking and changing interest rates in response to sustained deviations of long-run money growth helps the central bank to overcome this bias. Our argument in favour of ECB-style cross-checking does not require direct effects of money on output or inflation.
Keywords: European Central Bank; Monetary Policy; Monetary Policy under Uncertainty; Money; Phillips Curve; Quantity Theory
JEL Codes: E32; E41; E43; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| money growth (O42) | inflation (E31) |
| misperceptions of potential output (E23) | systematic deviations from targets (E61) |
| long-run money growth in interest rate rule (E43) | better policy outcomes (D78) |
| ECB-style cross-checking (E58) | counteract biases (D91) |
| money growth (O42) | adjustment of interest rates (E43) |
| adjustment of interest rates (E43) | correct policy stance (E63) |