Why The Quantity Of Money Still Matters

Abstract

The operating procedure of Federal Reserve policy focuses almost exclusively on interest rates, in particular short term rates such as the federal funds rate. Conventional wisdom today interprets a low federal funds rate as an indicator of an expansionary monetary policy, and a high federal funds rate as indicative of a contractionary policy.

Our thesis is that this conventional wisdom is flawed. We develop a quantity theory model to illustrate how changes in the real money supply can impact both the price level and real output. We present data showing that when the Fed slows the rate of growth of the monetary base to approximately the growth rate of GDP, that this slowdown also impacts real variables. However, according to comments, the Federal Reserve pays little attention to the quantity of money.

Finally we asked: Since the Federal Reserve pays little attention to the quantity of money, what variables does the FOMC likely consider in deciding to alter the federal funds rate? The answer, perhaps not surprisingly, appears to be variables readily measured and easily related to by the general public – prices and capacity.