Money, rules and causality

Money, rules and causality
During the 1970s a key debate keynesians and monetarists was about the causality in macroeconomic models or more specifically about whether changes in the money supply caused changes in nominal spending or whether nominal spending changed caused changes in the money supply. Both sides of the argument produced endless numbers of econometric studies to show that they were right. This together equally large amount of studies of the interest rate elasticity of money demand got to be the biggest waste of time in the history of the economic profession. Where most of these studies completely failed was that they did not in anyway account for changes in policy regimes. Unfortunately this defect is also very common in many of the econometric studies being published in economic journals today. Unfortunately the praxis of doing econometrics without economics continues to this day. The failure to account for regime changes in my view to a large can explain why economists and particularly central bankers during 1980s and especially the 1990s lost faith in the money supply as a reliable indicator for the development in nominal spending and inflation. We can illustrate that with a very simple model. First we have a money demand function: (1) md = p + y Where md is the growth of the money demand, p is inflation and y is the growth rate of real GDP. I am basically assuming that the money demand is given by the equation of exchange and I have assumed that money-velocity is constant (the growth of velocity is zero). Our second equation is an equally simple Phillips curve: (2) y = a*p Here positive inflation shocks (increases in p) will increase the growth of real GDP. a is a coefficient. Our last equation makes sure the supply of money (ms) is equal to the demand for money (md). ms is assumed to be exogenous: (3) md = ms  


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