Economics Update (October-December 1998)

Evaluating the Power of Monetary Policy

M onetary policy may be a great deal more powerful in the long term than most academic economists believe, concludes Marco Espinosa-Vega in a recent Economic Review article (Third Quarter 1998). The notion that monetary policy is powerful only in the short run is deeply embedded in daily applications of economics and finance principles, from evaluating Fed actions on the domestic front to analyzing exchange rate determination. But if indeed monetary policy has significant effects in the economy both in the short and long run, says the Atlanta Fed senior economist, then concepts such as the desirability of zero inflation of interest rate parity would have to be reconsidered.

Espinosa-Vega reexamines the view that monetary policy affects real (inflation-adjusted) economic variables in the short run but that its powers to affect real variables fade quickly — that is, that money is "superneutral" in the long run. The better known long-run superneutrality view relies on the assumption that monetary policy effects are achieved only via "money illusion" — by creating changes in the price level that are misunderstood by households and firms and cause them to make bad economic decisions. But if monetary policy can affect real economic activity by other means, then it may be possible for money to be nonsuperneutral in the long-run.

From his review of several studies, Espinosa-Vega finds that the empirical evidence on the long-run superneutrality of monetary policy is not overwhelming, as some analysts and policymakers believe. This finding suggests that monetary economists who view monetary policy's effects as results of money illusion may have spent too much time trying to forge direct links between changes in monetary policy and the unemployment rate. By linking monetary policy with the supply and demand of credit, the models reviewed in the article can study an alternative mechanism for evaluating the long-run effects of monetary policy that does not rely on money surprises, such as an unexpected change in a central bank's monetary policy.

Espinosa-Vega challenges economists and policymakers to investigate alternative explanations for the real effects of monetary policy as well as the possibility that monetary policy has substantial long-run effects.

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