Money, the economy, and monetary policy

Date of Completion

January 2008


Economics, General




Since the days of David Hume (1711–1776), if not even earlier, economists have been studying monetary economics. To this day, monetary economists continue to analyze how money and monetary policy impacts and responds to inflation and output, and how best to predict future monetary policy. This dissertation shows that money can influence the real economy in the short-run because of credit market frictions, that (good) monetary policy responds to inflation and output in a non-linear way, and that optimal predictions of future monetary policy are based purely on past monetary policy decisions. ^ The first chapter "Does the Federal Reserve Follow a Non-linear Taylor Rule?" employs the smooth transition regression model and asks the question: does the Federal Reserve change its policy rule according to the level of inflation and/or the output-gap? I find that the Federal Reserve does follow a non-linear Taylor rule and, more importantly, that the Federal Reserve followed a non-linear Taylor rule during the golden era of monetary policy, 1985-2005, and a linear Taylor rule throughout the dark age of monetary policy, 1960-1979. ^ The second chapter "How the Bundesbank Conquered Inflation" analyzes the monetary policy of the Bundesbank. Did the Bundesbank achieve its remarkable inflation record because it changed its policy rule according to the level of inflation? The answer is yes. As inflation passed a certain threshold, the Bundesbank began to respond more forcefully to inflation and the real economy. An augmented version of the non-linear Taylor rule, furthermore, shows that the Bundesbank did not respond to money growth, but did respond to the exchange rate. ^ The third chapter "Predicting the Fed" attempts to predict future U.S. monetary policy. We employ a Markov transition process and show that this model outperforms the federal funds futures market in predicting the target federal funds rate. This suggests that the federal funds futures market lacks efficiency. The market allocates too much weight to current (possibly unclear) Federal Reserve communication and other real-time macro events, and allocates too little weight to past monetary policy behavior. ^ The fourth chapter "Money and the Economy" explains why a monetary shock causes the real economy to deviate from its trend line. To explain this phenomenon, this paper introduces a friction in the credit market: small firms and banks must search for credit, and only a random fraction gets matched each period. Money injections from the central bank cause credit, production, and the banks' vault cash positions (un-matched funds) to increase. New rounds of credit and production expansion continue until all funds in the banking sector's vault have been allocated. ^