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Narrow money, broad money, and the transmission of monetary policy

  • Economics


dcaabroadmoneyfrbaug19.dvi Narrow Money, Broad Money, and the Transmission of Monetary Policy Marvin Goodfriend∗ Federal Reserve Bank of Richmond August 19, 2004 Abstract The paper investigates the role of broad liquidity—the supply and demand for bank deposits—in the transmission of monetary policy. The model integrates deposit demand, loan production, asset pricing, and arbitrage between banking and asset markets. Broad liquidity conditions must be taken into account in the pursuit of interest rate policy for two reasons: (1) they influence the link between the interbank rate and market rates through their effect on the external finance premium, and (2) they affect the behavior of market rates that the central bank must target in order to maintain price stability. The paper shows how the production and use of broad liquidity influences the “neutral” interbank rate consistent with balanced growth and stable inflation. It shows how and why interbank rate policy actions must be modified in light of broad liquidity considerations to stabilize inflation in response to shocks. 1 Introduction Monetary policy is commonly examined in the context of models with a simplified mon- etary transmission mechanism without any role for money itself.1 There is nothing necessarily wrong in this. Interest rate rules for monetary policy have been shown to deliver coherent outcomes for the price level and real variables, even in models that ignore the demand and supply for monetary aggregates completely.2 Moreover, central ∗Senior Vice President and Policy Advisor. The paper was prepared for a Federal Reserve Board conference “Models of Monetary Policy: Research in the Tradition of Dale Henderson, Richard Porter, and Peter Tinsley,” March 2004. Discussions with Kartik Athreya, John Duca, Greg Hess, Bob Hetzel, Bob King, Ben McCallum, and Steve Williamson have greatly improved the paper. The views expressed are the author’s alone and not necessarily those of the Federal Reserve Bank of Richmond o

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