Munzi Hlavac 2011 Inflation Targeting and Its Impact on Endogenous Money Supply and Bubbles in Asset Prices

7/31/2019 Munzi Hlavac 2011 Inflation Targeting and Its Impact on Endogenous Money Supply and Bubbles in Asset Prices

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Inflation Targeting and Its Impact onEndogenous Money Supply and Bubbles

in Asset Prices

Tom Munzi, Petr Hlav

Abstract

This paper provides a theoretical framework for a thesis that the transitionto the inflation targeting regime, either explicit or implicit, may be one of the causes of the long-term latent accumulations of the financial andstructural distortions, materializing much later and with more direconsequences. Due to the long-term systematic manipulation of interestrates, within the operational framework of the stabilization of consumerprices and the output gap, as well as of anti-deflationary fundamentalism,the economy can transform itself into a kind of "black box", gradually andover time causing an "escape" of credit and monetary aggregates. Moneysupply tends to be more endogenous and elastic, changing the causalitywithin a link between the money supply and its effective economicmaterialization, both in production processes of the real economy as wellas in banking and financial services. Thereby, the economy lacks a needfuldefensive mechanism that would pull the overheating economy backthrough more exogenous and inelastic money supply, automaticallyadjusting market interest rates. We employed VECM models to show thatthe money supply was exogenous before the implicit adoption of inflationtargeting in the USA (1985), but endogenous after it.

Key words

Inflation targeting, monetary policy, endogenous money supply, assetbubbles, VECM

JEL Classification

C32, E44, E52, E58, G01


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Inflation Targeting and Its Impact on EndogenousMoney Supply and Bubbles in Asset Prices

Tom Munzi, Petr Hlav1

Theoretical part

Introduction

In his Nobel contribution to the development of theories of economiccycles, F.A.Hayek (2008 [1931]) addressed the real effects of monetary

expansion on the temporal and spatial allocation of capital, causingdistortions in its structure. Hayek was honored as one of the few whowarned of the depression on the basis of his monetary business cycletheory (Royal Swedish Academy of Sciences, 1974). In the critical study of Hayek`s monetary theories, Lawrance H. White (1999), inter alia,analyzes his criticism of the price level stabilization, based on theassumption that only a stable volume of nominal spending (MV) allowsinter-temporal price equilibrium. According to him, Hayek at the end of his career retreated from his previous position in his bookDenationalisation of Money (1978), and adhered rather to the price level

stabilization, or zero inflation of the final output.Thereby, Hayek to a certain extent denied a relevance of his businesscycle theory from the thirties. The aim of our paper is to apply thisHayek's "stabilization dichotomy" to the context of modern discussion onthe monetary policy of inflation targeting. Through our theoreticalframework, we identify certain problems that arise from a simplistic viewof a relationship between directed price level stabilization and its impacton the stability of the real output growth, neglecting a potential effect of this policy on the higher odds of financial imbalances in asset markets. Inthe empirical part of our paper, we carry out causality tests onendogenous and exogenous money supply in relation to inflationtargeting.

1 Tom Munzi is enrolled in IEL - International Ph.D. Programme in Comparative Analysisof Institutions, Economics and Law, promoted and organized by the Centre for theComparative Analysis of Law and Economics, Economics of Law, Economics of Institutions, jointly with Cornell University, cole Polytechnique of Paris, Universiteit vanGent and Universit di Torino (e-mail: [email protected])

Petr Hlav is a Ph.D. candidate at the University of Economics, Prague (e-mail:[email protected])


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Price level stabilization and its impact on the business cycle andthe financial stability

In the preface to his book Monetary Theory and the Trade Cycle, Hayek,among others, addressed a question whether targeting a stable level of prices by monetary authorities may also have a cyclical impact on the realeconomy (Hayek 2008 [1932]):

It is a curious fact that the general disinclination to explain the past boom by monetary factors has been quickly replaced by an even greater readiness to hold the present working of our monetary organizationexclusively responsible for our present plight. And the same stabilizerswho believed that nothing was wrong with the boom and it might last indefinitely because prices did not rise, now believe that everything could

be set right again if only we would use the weapons of monetary policy to prevent prices from falling. The same superficial view, which sees no other harmful effect of a credit expansion but the rise of the price level, now believes that our only difficulty is a fall in the price level, caused by credit contraction.

This Hayek's argument can be linked with private views of BenjaminStrong, the Fed chief in the twenties, on monetary policy in which headhered to the philosophy of the price level stabilization, despite the factthat this policy had never been publicly declared. 2 During the thirties,

Robbins (2007 [1934]), Philips, McManus and Nelson (2007 [1937]) werealso critical of the policy of the price level stabilization, concealing thefactual monetary expansion.

In connection with the outbreak of the financial crisis, beginning in August2007 with a critical peak in September 2008, academicians and policymakers have discussed with a much greater intensity a question of theimpact of inflation targeting on the potential emergence of speculativebubbles in asset markets. But these debates were lively well before theoutset of the financial crisis and focused primarily on the question of thepossibility of preventive actions against the growing bubbles so-called"leaning against the wind" - for instance, Bernanke and Gertler (2001),Bernanke (2002a), Cecchetti et al. (2002), Filardo (2000), Greenspan(2002), Gruen, Plumb and Stone (2005), Kohn (2006), Mishkin (2008),Posen (2006), White (2006a, 2006b).

2 that it was my belief, and I thought it was shared by all others in the Federal ReserveSystem, that our whole policy in the future, as in the past, would be directed toward thestability of prices so far as it was possible for us to influence prices . (January 11, 1925),private correspondence. Lester V.Chandler, Benjamin Strong, Central Banker

(Washington, D.C.: Brookings Institution, 1958), p.312. Quoted in: Rothbard, Murray N.: America`s Great Depression , Ludwig von Mises Institute, Auburn, Alabama, 2005.


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It is a logical transition of most central banks of the developed world,during the nineties of the twentieth century, to the policy of either explicitor implicit (e.g. the Fed) inflation targeting, or a variously defined corridorof the price level. Some critics have warned of dangers that may arisefrom such a narrow monetary policy perspective on the consumer pricebasket, not including asset prices - such as Alchian and Klein (1973),Cecchetti et al. (2000, 2002), White (2006a). Asset transactions representa large proportion of financial transactions with a direct impact on thecreation of added value. Borio and Lowe (2002) 3 argue that financialinstability can arise even in an environment of low inflation, sinceincreased demand pressures are the first to prove in credit aggregatesand asset prices, rather than in the prices of goods and services.

A related problem is the measurement of inflation and the subsequentconsequences for the credibility, transparency, and efficiency of monetarypolicy - for instance Alchian and Klein (1973), Blinder (1980), Cecchetti etal. (2000), Goodfriend and King (2001), Goodhart (2001), Greenspan(1998), Johnson, Small and Tryon (1999), Shibuya (1992), White (2002).As well as it relates to a problem of the so-called "zero bound" on nominalinterest rates and a related anti-deflationary attitude (Bernanke, 2002b).

After the so-called monetarist experiment, the transition to inflationtargeting has been justified, in particular, by uncertainties in globalizedfinancial markets, the volatility of money multiplier, the instability of thevelocity of circulation of money, and thus by ambiguous causality between

monetary aggregates and the price inflation. Despite the fact that theFriedman's argument that inflation is always and everywhere a monetaryphenomenon and not a structural or institutional one has been widelyaccepted, central banks have gradually deployed the mechanism, bywhich they have given hands a little "off" the targeting of the monetaryand credit aggregates. 4 3 The combination of rising asset prices, strong economic growth, and low inflation canlead to overly optimistic expectations of the future in a similar vein to the overly optimistic expectation that can follow a stabilization program. In turn, these expectationscan generate increases in the asset and credit markets significantly beyond those

justified by the original improvement in productivity. A self-reinforcing boom can thenemerge, with increases in asset prices supporting stronger demand and sustaining, at least for a while, the optimistic expectations of the future. While the stronger demand can put upward pressure on inflation, this pressure can be masked by the improvementsto the supply side of the economy (Borio and Lowe, 2002, 21)4 We are aware that the current central banks targeting inflation (explicitly or implicitly)employ very complex and structural models in order to analyze economic processes insuch detail as they never did in the past. Despite the increasingly sophisticated models(such as models improving the forecast of inflation), the fundamental problem of themonetary aggregates exclusion from the monetary policy decisions is still present.Moreover, even Nelson (2007) in his comparative study of Friedman and Taylor`s views

of monetary policy suggests that the main difference is Friedman's doubt over the use of structural economic models, and such policy rules that respond to the final goals (i.e.inflation and output gap). In particular, Friedman assumed that the targeting of an


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Mainstream economics has gradually adopted the Post-Keynesianargument of the broad internal" money, generated by the credit creationin excess of the "narrow external money, under the direct control of central banks within their balance sheets transactions. Since then, short-term interest rates, in relation to the variously conditional inflationforecasts and the output gap have become main operational criteria forcentral banks. Monetary aggregates, as such, formally have "vanished"and have been "left" to their fate.

Hyman Minsky5, one of the major theorists of the Post-Keynesian theoryof the endogenous money supply stresses that the modern financialsystem is far more complex and behaves differently than in the past.Notably, the expected profits of businesses affect the market price of thecurrent financial contracts. Furthermore, the materialization of the profitsdetermines whether the financial commitments are met and the extent towhich financial assets act as pro formas for a negotiation of contracts(Minsky, 1992, 4).

Minsky (1992, 3) also mentions a difference between the Keynesianmonetary "veil of money", compared to its perception in the context of thequantity theory of money, which according to him does not capture thefinancing over time. Banks then act as the central players within a processof the temporal structuring of the monetary commitments.

Time and structural dynamization of the quantitytheory of money

An increase in effective money supply, according to the theory of endogenous money supply, exhibits itself particularly within the financingof new investments and in the capital markets. We will try to incorporatethis endogenous proposition into the "exogenous" quantity theory of money and thereby algebraically formalize a theoretical framework of the"dichotomy" between exogenous and endogenous influences on the

creation of money supply, for macro-economic needs of the entireeconomy.

expected future inflation, which is affected with a lag, requires too much reliance on theability of monetary authorities to assess the structural relationships that link monetarypolicy actions as such and inflation. As a result, monetary policy may be destabilizing inpractice.

5 For the purposes of our paper, it is also worth noting that Minsky is known for histheory of financial crises. Minsky sees their sources, among others, in the times of

"economic stability, which consequently result in an excessive activity in the creditmarkets (Minsky, 1982).


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Let us proceed from the original and simplified transactional Fisher`sequation of exchange, MV = PT, which has been later transformed into themore familiar equation replacing the volume of transactions with the realproduct. And precisely, the volume of the financial transactions involvingalso the asset transactions that contribute to the creating of added valuewould intuitively better fit the logic of the reality of the increasing share of the nominal financial transactions compared to the nominal income.

We will break down the prices within the processes of the real economy asfollows: the prices of the final goods P C, the prices of intermediateproducts P i, and the asset prices P A, which are directly linked to thecontribution of the financial transactions to the total economic addedvalue.

To incorporate the structure of production into the equation of exchange,we use an analogy with the disaggregation as suggested by Garrison(2005, 488):

MV = P (Qc + Q2 + Q3 + Q4 + Q5 + Q6 + Q7 +Q8 + Q9 + Q10) (1)

Garrison uses it to demonstrate the "time discount" effect in the earlierstages of production and the "derived demand effect in the later stages of production.

We analogously disaggregate the transaction equation of exchange,

among others, to represent the prolonging of production processes, in ananalogous way as Hayek (2008 [1931], 311) using a curvilinear triangle.

MCURR*VCURR+ (MBROAD MCURR)*VBROAD-CURR= P c*Qc + ( P i*Qi ) + PA*TA (2)

where

MCURR currency

VCURR velocity of circulation of the currency 6

6 We take the velocity of money as an endogenous variable. Therefore, it is always aconsequence, not a cause, which, in principle, can never be independent of the moneyitself. The velocity of money in relation to the exchange equation as is, in detail,discussed in Anderson (1917), Davenport (1930), and Marget (1932).Furthermore, Nelson (2007, 10), in this regard, stresses the difference betweenFriedman's and Taylor's attitude to monetary accommodation of the money demandshocks: Since velocity is defined residuallya velocity movement might reflect not a

permanent money demand shift, but instead a faster response of money than of nominal income to a shock that will ultimately move income by the same amount as money. Of course, holding the nominal interest rate constant in the face of a money demand shock will mean that the shock is accomodated one-for-one, but it will also mean that other

shocks which create pressure on interests rates will be accomodated Nelson (2007,10).


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(MBROAD MCURR) broader monetary aggregate beyond the currency 7

VBROAD-CURR velocity of circulation of (MBROAD MCURR)

Pc * Qc monetary value of the final production( Pi * Qi) monetary value of the intermediate production

processes without the final production 8

TA transactions with assets (especially real estates,financial instruments)

PA asset prices

A purely monetarist causality "Money Matters" is built on the belief thatthe central bank influences the nominal product and ultimately the realproduct by its "exogenous" monetary transmission. The central bank hasan exogenous impact on the money supply to such an extent, to which itis able to influence the credit process of the commercial banks in excess of its balance sheets operations. The money endogeneity hypothesisconversely suggests that a vast majority of the multiplicative moneycreation is mediated by the credit mechanisms of the private banks, andtherefore is beyond the reach of an influence by the central bank. We

should ask a question to what extent the monetary transmissionprocesses, and production processes in the real economy are to change if the central bank forgoes the direct influence of monetary aggregates.

An intuitive explanation may be such that the monetary policy of inflationtargeting through influencing the short-term interest rates affects, to amuch greater extent, such processes in the real economy, which "push"ahead a subsequent rise in the price level of the final production. Thegrowth of monetary aggregates is then caused mainly by the outputgrowth, and not vice versa. The monetary expansion firstly materializesitself, to a much greater extent, in asset prices, raw materials, andintermediate production transactions due to the more and longer stages of production, and therefore, much later, in consumer prices. The growth of monetary aggregates is then increasingly mediated through the"endogenous" credit creation in the real and financial sector, and therefore

7 quasi-money - all the money beyond the "high-powered money that cannotdisappear by a repayment of the loan.

8 Phases of the production and manufacturing processes could be captured through the

famous so-called Hayek`s triangle and thereby interest rate r can be incorporated intothe value of intermediate goods see Hayek (2008 [1931], 311).


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not through the purely direct "exogenous" increase in money supply,subsequently affecting the income.

The development and volatility of the credit aggregates, asset prices, andthe real estate, in comparison to the growth of consumer prices in mostdeveloped countries, indicate that the "new money is not actuallydiffused homogeneously within various transactions, as stated in ourdisaggregated transactional equation of exchange.

Development of credit aggregates and asset prices can be an importantindicator of impending financial imbalances (Borio and Lowe, 2002; Borioand Drehmann, 2009). In this context, it is important to mention theinfluence of the interest rates manipulation on the evolution of the assetprices within the central bank's inflation targeting regime. In this case, weshould emphasize the so-called wealth effect and the inertial, self-reinforcing nature of inflating financial imbalances in the asset markets. Itmay be magnified even more by the use of the so-called mark-to-marketaccounting valuation, which inflates the market appraisal during the timeof a persistent boom compared to the historical exercise transaction in thereal market. The assets of the businesses are thus inflated regardless of the initial transactional reality.

Let us assume that for the successive analysis, the asset prices P A can befreely substituted by the expression

= +m

j j

e j

r R

1 )1( (3)

where

R je expected return on assets

(1 + r ) j discount factor

Expressing Pc*Qc from the equation (2), we get

Pc*Qc = MCURR*VCURR+ (MBROAD MCURR)*VBROAD-CURR- ( Pi*Qi ) - (PA*TA) (4)

After expressing P c from (4), we get

)5(Q

)T*(P- )*P( -V*)M-(MV *M

c

AAiCURR -BROADCURR BROADCURR CURR += ic

Q P

Qc can be expressed as our modification of the Cobb-Douglass productionfunction, allowing us to incorporate into the analysis the technological


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advances, the globalization increase in the division of labor, thespecialization, and the entrepreneurship

)6()K (*)L(*A -1ii =C Q

Expression (7) can be written, if the capital intensity of manufacturing, forsimplification, is the same everywhere, and the technological constant A isuniform for all manufacturing.

Technological progress, deflation, and the business cycle

Substituting expression (6) into expression (5), we get

)7( )K (*)L(*A

)T*(P- )*P( -V*)M-(MV *M-1

ii

AAiCURR -BROADCURR BROADCURR CURR

+= ic

Q P

In the context of the inflation targeting mechanism (stabilizing the growthof Pc), the main operational criterion for monetary policy is the short-terminterest rate r, and none of the components of the cumulative monetary

aggregate M CURR+ (MBROAD MCURR). Assuming a decrease in interest ratesand the growth of exogenous technological progress, we can infer fromexpression (7) channels pushing for drop in P c, and thus allowing, ceterisparibus, a higher inflation of (M BROAD MCURR), just compensating for thedownward pressures on P c. A simultaneous combination of the rapidgrowth of the technological progress, productivity, asset prices, realeconomic income, and the optimistic expectations about the future caneffectively mask the inflationary pressures on the final production, whilstendogenously materializing in an increase in money supply. Borio andLowe (2002, 21) 9 argue in an analogous way.

Following our theoretical framework, we introduce five channels leading,ceteris paribus, to a downward pressure on the prices of the finalproduction:

1. i (increase in stages of production). According ABCT10, anartificial decrease in interest rates, not due to increasedvoluntary savings leads to an extension of production, namely to

9 See quotation in footnote 3. 10

Austrian Business Cycle Theory (ABCT) see Hayek (2008 [1931]), or Mises (1953[1912]).


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an increase in various stages of production and itsroundaboutness. Expression (P i*Qi) can also algebraicallyrepresent "expanding" the Hayek's triangle after a fall in interestrates, thus increasing the total monetary value of theintermediate production in the real economy.

2. (k/ ). Which expresses the divergence between thestatistical consumer basket, measuring the price level of the finalproduction, and the real dynamics of the development of theconsumer items, in the context of a permanent replacement anda sprawl of the actual weights based on the changes inconsumers' preferences, an advances in technology, and thecorresponding permanent structural and qualitative changes inthe production processes further from the consumption. A greaterweight in the consumer basket is through time given to the oldergoods. However, the demand is much more dynamically shiftingto the newer goods appearing in the statistical consumer basketwith a systematic lag. Over time, a greater drop materializes inprices of the older goods, being on the market longer. 11 Letsdenote w 1, w2, ,wk as factual weights in the real consumerbasket, and the u 1, u 2, .., u as weights in the statisticalconsumer price basket used for the purposes of the monetarypolicy. Then, a qualitative divergence between w 1, w2, ..,wk and u 1, u 2, .., u , and a quantitative mismatch (k > ) lead to asystematic underestimation of the actual aggregate rate of

consumer inflation, corresponding to the dynamic changes in thereal economy. 12

3. (Ki /Li). We can express a certain modification of theclassical Ricardo effect. Production processes, thanks totechnological advances become more capital-intensive due to thegrowth of real wages in the early stages of the productionfurthest from the consumption. That phenomenon pushesentrepreneurs to a greater substitution of capital for labor. Again,that increases the self-reinforcing pressure on an increase in

transactions in the initial stages of the production process. Themonetary transmission is then reflected asymmetrically and withsome lags in the consumer prices. Time discount and derived

11 We consider this effect in a globalized and highly competitive economy as moreimportant than the opposite effect of improving the quality of traded goods that isincorrectly identified as inflation. 12 See the above mentioned remark related to the problems with consumer pricesinflation and their impact on the credibility and consistency of the monetary policy seeAlchian and Klein (1973), Blinder (1980), Cecchetti et al. (2000), Goodfriend and King

(2001), Goodhart (2001), Greenspan (1998), Johnson, Small and Tryon (1999), Shibuya(1992), White (2002).


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demand effect is also simultaneously materialized. 13 The Ricardoeffect and its relation to the changes in the relative prices arediscussed in detail in Hayek (1969).

4. (PA*TA). We can freely substitute with expression (3). Areduction in interest rates means a drop in the total discount inthe economy, therefore, an increase in the expected discountedprofits.14

5. A. Technological advances, the impact of globalization,international trade competition, deregulation, privatization, andentrepreneurship. 15

In detail, we can express this formalized causality A [ i ^ (Ki /Li) ^ (k/ )] PC fear of deflation r [(PA*TA) ^ ( Pi*Qi)] demand for money (M D) (MBROADMCURR)

By extending the production, its sophistication, and its roundaboutness,the "exogenous" technological progress leads, ceteris paribus, to adownward pressure on the price level of the final production. The centralbank, to prevent deflation in consumer prices, proceeds to a decline in the

short-term interest rates.16

That leads to price increases in asset markets,13 Consideration of time discount draw resources into early stages of production.Further, in gauging the profitability of early-stage activities, the derived-demand effect itself can be augmenting rather than offsetting. Here, the entrepreneurial element comesinto play in a special way. What counts as the relevant derived demand is not based onthe current demand for goods of the first order but rather on the anticipated demand at some future time (Garrison, 2005, 487). In: Brian Snowdon and Howard R.Vane:Modern Macroeconomics, Its Origins, Development and Current State, Edward EdgarPublishing, Inc., Cheltenham, UK, 2005. 14 Also thanks to the mark-to-market accounting valuation, balance sheets are ofteninflated regardless of the inter-temporal fundaments and the historical exercisetransactions on the real market. At the same time, we can point out the other self-reinforcing aspects of an increase in the total aggregate (P A*T A ), leading to the excessivegrowth in financial intermediation when compared to the financial capacity in the realeconomic processes. The international globalization, the augmenting internationalcompetition, and the financial engineering increase the quantity and sophistication of thevarious types of financial assets, real assets, related derivatives, and securitizedtransactions. An increase in the volume of added value is then driven by higher utilizationof the financial assets and a widespread use of the financial leverage.15 See below mentioned Rogoff (2003), Greenspan (2004). Borio and Filardo (2007).

16

In case of the "zero bound" problem of the nominal interest rate, the central bank caneven proceed to the so-called non-standard tools, namely to the quantitative easing see, for example, Bernanke (2002b).


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especially those that are most sensitive to the volatility of the short-terminterest rates. 17 As a result of the wealth effect, along with the investmenteuphoria, the transaction and speculative demand for money grows.

In the case of the unlimited endogenous multiplication of money 18, themoney supply is perfectly elastic. Simultaneously, after increasing thedemand for money M D, the broader money supply (M BROAD MCURR) almostautomatically readjusts itself. Moreover, if the central bank reduces itsinterest rates further to fight the potential deflation, it may lead to thefurther credit multiplication of the new money magnified at a muchhigher pace. This leads to further pressures on self-reinforcing speculativefinancial imbalances.

If the money supply was much more "exogenous" and less elastic, then anincrease in money demand would lead to an increase in the interest rateson assumption that the central bank lets the interest rates to readjust onthe market for the loanable funds, and that the money supply staysunchanged. This effectively prevents the money supply from materializingin the bubbles in the asset markets, outside the productive sectors of thereal economy. This would immediately cool down the "overheating"economy from the very beginning. 19

The fundamentalist anti-deflationary sentiment then remains to be one of the crucial moments, which could lead to a permanent trend in inflatingthe financial imbalances. Therefore, this would also confirm Hayek's

original argument, as cited in the introduction of this paper (Hayek, 2008[June 1932]). It would also arise certain analogies between non-inflationary price developments in the 1920's and the so-called period of the "Great Moderation" during last two decades, before the Financial Crisisof 2008.

Deflation, and its impact on the economic growth, has become the objectof many different analyses. Atkeson and Kehoe (2004), for example, showthat except for the Great Depression, a majority of deflation periods arenot associated with a decline in the economic activity. In the eyes of some

economists, however, there is still a fundamentalist approach, at least

17 especially real estates and obligations

18 In other words, the central bank, through its monetary policy in the context of thefractional reserve banking and potentially unlimited liquidity measures of the lender of last resort, facilitates the highly elastic money supply, as a result of the endogenouscredit creation from "inside" the real and financial sectors.

19 In this context, we can mention, in particular, a period of the gold standard. When themoney supply is exogenous to the system, systematically restricted and independent

quantity of money always prevents against inflating and cumulating of the financialimbalances. Most of the financial excesses appear whenever the State proceeds to issueof money not backed by gold or any other prospective constitutional warranty.


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since the work of Fisher (1933) was published, analyzing especially theeffects of the so-called secondary deflation during a deep economic crisis.Bernanke (1995, 2002b) is the best-known representative of thiswidespread view, in which a contraction of prices, as a result of theprevious monetary expansion is seen as the greatest evil.

This approach is primarily based on the conviction that the monetarycontraction was the main cause of the Great Depression of the 1930's(Friedman and Schwartz, 1963). On the other hand, there are also viewsarguing that the critical extension and deepening of the Great Depressionwere largely caused by regulatory measures, which affected the flexibilityof the prices and wages. That delayed a natural readjustment in the realeconomy after the previous bubble of the monetary excesses. Cole andOhanian (2004), for example, analyze the impact of the nominal wagerigidity as a result of government pressures on the industrialists that leadto an increase in real wages, loss of competitiveness and efficiency, andconsequently to a growth in unemployment. They compare it with therapid healing of the U.S. economy during the recession in the years 1920-1921. Hayek (2008 [1932]), Mises (1949), Philips, McManus and Nelson(2007 [1937]) and Robbins (2007 [1934]) deal mainly with an impact of excessive monetary expansion on the inter-temporal distortions in thestructure of the economy as the main cause of the Great Depression.Deflation is thus regarded as a symptom of the remedial readjustment,not as the cause of the problem.

Borio and Filardo (2004) also look into the past, and they emphasize thatat the end of the 19th century, deflation was not associated with aneconomic decline, and they differentiate between a good deflation drivenby productivity, and a bad one driven by a credit contraction. Bordo etal.(2004) and Sma (2004) argue in an analogous way. And even WilliamWhite (2006b, 2), the former head of the economic research in the Bankfor International Settlements, "the bank of the central banks", suggeststhat if mild deflationary pressures resulting from the positive supplyshocks are not tolerated, far greater problems in the future may occur asa potential alternative.

Globalization and disinflation in prices of the final production

However, opinions were heard among the economists during the pre-crisis"stability" that during the "Great Moderation", significant changes in thestructure and symmetries of causalities affecting the long-termsustainability of economic development without significant cyclicalchanges had been materializing. Events associated with the outbreak of the financial crisis of 2008 suggest that significant shifts in the worldeconomy with a critical impact on monetary policy have really occurred.Rogoff (2003) analyzes the impact of globalization, competition,deregulation, privatization, and the technological growth in productivity on


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the global disinflationary pressures. Greenspan (2004, 33), Borio, andFilardo (2007) also assert globalization, international trade, andcompetitive pressures on the increase in productivity emphasizing that acourse of the inflationary process in the real world has significantlychanged. Overall, it can have the fatal impact on the policies of thenational central banks, which can systematically underestimate theinflationary pressures, and thus systematically target the lower interestrates. 20

Precisely this aspect of the potential impact of the global competition andproductivity growth on the disinflationary pressures is crucial for thispaper. It is important to emphasize, however, that in this context, we aretalking about the inflation in the prices of the final production. Themonetary policy of the price-level stabilization of consumer goods, or anexplicit inflation targeting has, in this respect, an even more substantialimpact. Targeting the short-term interest rates in an effort to minimizethe output gap and also to meet the inflation target becomes the mainmechanism for the central banks.

The foregoing analysis suggests that the changes in causalities of themonetary transmission themselves can have a significant impact on theunderestimation of the monetary expansion due to the fact that the effectof the consumer price inflation is "endogenously" neutralized and that it ismaterialized with much longer lags. An endogenous creation of quasi-money occurs over time mainly in the asset prices in the context of the

structural and the inter-temporal changes and developments in theintermediate production processes, and in the nominal wages in theeconomic sectors that are the furthest from the final consumption.

Mankiw and Reis (2002, 24) also point it out by criticizing the use of thestandard Consumer Price Index (CPI) for the monetary policy purposes.They suggest that if the central banks monitor only the CPI and not thenominal wage growth, it can lead to a much greater monetary expansionthan in case of defining another price index of stability. The data fromthe United States between 1995 and 2001 explicitly show that the

development of the nominal wages was faster than that of CPI. Inconclusion of their paper, Mankiw and Reis consider whether a moretimely monetary tightening would have prevented the dot-com bubble andthe subsequent recession.

20 Under these conditions, the influence of real developments such as increases in productivity growth or potential output could result in inflation coming in below forecasts,and possibly below desired rates. With respect to globalization, systematic underestimation of the influence of growing global capacity on domestic prices could lead

to systematic overprediction of inflation and, as a result, a downward trend in policy rates to counteract it (Borio and Filardo, 2007, 3).


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Very crucial, in this respect, are the minutes of the Federal Open MarketCommittee (FOMC) of the 28 January 2004. 21 From today's perspective, itwas a critical meeting at which the FOMC decided to maintain the FederalFunds Rate at a historically record level of one percent, and it kept themat this level for the next six months. For instance, Taylor (2009) considersthese record low interest rates per se the main cause of the surge in thenew units under construction, and he documents it on the empirical data.The views of the FOMC members significantly diverged at that time.Different signals were coming from the real economy, and they could beinterpreted in different ways. A certain number of FOMC membersadmitted that the disinflationary pressures associated with the rapidproductivity growth should not be seen as a threat. In addition, theexpected strength of the aggregate demand through the ultra-loosemonetary policy should have kept the extensive disinflation under control.This dichotomous approach is a clear demonstration that the Fed failed toclearly and credibly identify what was actually happening in the economyand what long-term consequences it could have on the economy. But thetheoretically and empirically non-rigorous, but rather ideological fear of the deflationary pressures that arose from the complex and dynamicchanges in the more globalized and competitive economic processes wasthe fundamental aspect of this inexcusable policy failure.

Manipulation of interest rates and exogenous/endogenous moneycreation

Due to the systematic manipulation of the short-term interest rates, whichwas as a result of a wrong and opaque understanding of economiccausalities, the systematic price, inter-temporal, and allocativeinconsistencies may arise over all processes among different productionand consumer sectors in the real economy. Within the central bankingbased on the fractional reserve system, short-term interest ratestargeting, and no explicit monetary aggregates monitoring, the apparentprice stability environment may lead to an excessive growth in credit

21 Some members commented, however, that the relationship between the output gapand inflation was quite loose and that the outlook for productivity remained uncertain.

Accordingly, while members agreed that changes in core consumer price inflation werelikely to be limited, there was some divergence of opinion about the most probabledirection. In the view of many, some modest further disinflation appeared to be the most likely prospect. A few members noted that such disinflation, if it was associated withrapid growth in productivity, could be viewed as non-threatening. Moreover, the expected strength in aggregate demand would curb the extent of disinflation over timeThe Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of anunwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. With inflation quite low and resource use slack, the

Committee believes that it can be patient in removing its policy accommodation Retrieved from http://www.federalreserve.gov/fomc/minutes/20040128.htm


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The changes of causalities of the transmission mechanism and the natureof the money supply that affects the structural changes in the financialintermediation in the economy are essential. The new quasi-money starts "facilitating" new economic processes through the credit operationsof the financial institutions. Moreover, if the central bank targets theshort-term inter-bank interest rates, it may inflate the balance sheetsalthough not reflecting directly the actual monetary transactions. It thusreduces the non-market discount and consequently increases the expecteddiscounted profits throughout the economy. The quasi-money creationtends to have a causally opposite direction. Due to the increasedmanipulation of the short-term interest rates, the money supply tends tobe more endogenous. In other words, the economy as such, through thecredit creation, endogenously "monetizes" its production processes andeconomic growth. In the empirical part of this paper, we test thistheoretical aspect of the elastic money supply in the context of the implicitinflation targeting system.In his work on the relationship between the monetary policy and the "risk-taking channel", and through empirical data, Gambacorta (2009) shows asignificant impact of the behavior of the short-term interest rates onreducing the risk aversion of banks, materializing, in particular, in morerelaxed lending standards and narrower spreads of corporate bonds BBB-AAA. Furthermore, he asserts a role of the so-called financial accelerator,which through the impact on the valuation and cash flow influences theinflation of asset values and collateral. This further modifies the estimates

of the default probability, reducing price volatility, and the threshold of risk perception. Bernanke and Gertler (1995, 12) also emphasize theimportance of the financial accelerator for endogenous pro-cyclicalmovements in the balance sheets of economic subjects.

In his study on the evolution of inflation targeting in the U.S., Goodfriend(2003) in contrast suggests that the interest rates manipulation has agreat advantage. Above all, the credible price stability gives the Fed morefreedom to reduce the short-term interest rates in case of a financialcrisis, or to stabilize the output gap over time. In an environment of low

consumer price inflation, the central bank does not have to worry about ahigher inflation or inflation expectations in the bond market. Therefore, itcan afford a more aggressive and activist approach, and simultaneouslystabilize both the inflation and the output gap, in the face of shocks in theaggregate demand. He explicitly mentions the decline in interest rates inthe aftermath of 2001 (Goodfriend, 2003, 18-19). However, we know thatthis loose monetary policy has been one of the pieces in the puzzlecreating critical financial imbalances, subsequently materializing after thebursting of the so-called mortgage bubble.

In this context, it is interesting to mention John Taylor, the father of thefamous instrumental Taylor Rule for inflation targeting. He now stronglycriticizes the Fed's policy during the pre-crisis period for deviating from his


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rule, thus allowing the real estate bubble to inflate to the fatal extent(Taylor, 2009). Taylor thus acknowledges that any short-term deviationcan have dire long-term consequences.

It may seem as somewhat paradoxical that the Great Depression and thefinancial crisis after September 2008 occurred after the periods of higheconomic growth and low price inflation. An intuitive explanation may liein the fact that precisely low consumer price inflation allowed the centralbanks to carry out more countercyclical policy without worrying about theimmediate price increases. It frees hands, and the central banks have amuch greater tendency to eradicate the inter-temporal imbalances for thesake of pushing economy to everlasting prosperity. This phenomenon islikely fundamental. The countercyclical policy in time of an apparently"eternal" stability becomes paradoxically very pro-cyclical, allowing toaccumulate partial imbalances over time and thus also to systematicallymarginalize them. The accumulated imbalances are not so critical, whenyou let them fizzle out in the very beginning.

Black box of inflation targeting

We should ask whether and to what extent a policy of inflation targeting,and the subsequent "endogenous" causality changes in the transmissionmechanism may influence the potentially higher risk of speculativebubbles and financial imbalances, even in an environment of the low

consumer price inflation. In this regard, we should analyze the argumentsof the main supporters of the "discretionary" inflation targeting.

For example, Bernanke and Miskhin (1997) 23 suggest, in particular, that acertain degree of discretion is needed for the unexpected andunpredictable events. Therefore, they rather speak of a policy frameworkof inflation targeting mechanism than of the rigid Friedman monetary rule,or even of the gold standard itself.

The theory, and especially the practice of inflation targeting, from today's

perspective, clearly suggest that it is a systematic discretionary policywith a hint of a certain monetary policy rule, but with a flexible option tointervene at any time in case of problems. The dichotomy between "rules"

23 Unfortunately, the interpretation of inflation targeting in terms of some long-standing debates in monetary economics has also been the source of confusion. For many years the principal debate about the best approach for monetary policy was framed as an opposition between two polar strategies, termed "rules" and "discretion."

Advocates of rules - such as the fixed rule for money growth proposed by MiltonFriedman, or a gold standard - argued that "tying the hands" of policymakers will prevent the monetary authorities from implementing counter-productive attempts at short-run

stabilization and will thus eliminate the inflationary bias inherent in discretionary monetary policy (Bernanke and Mishkin, 1997, 104).


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risk premium included in the interest rate affects simultaneously both theasset prices and the corporate investment, and hence the growth trend.Bernanke and Gertler (1995,12-13) in their article also analyze the impactof monetary policy on the external financing premium through the wealtheffect. Moreover, Smaghi (2009, 5-6) notes that the unreliability of theestimates of the output gap and of the subsequent revisions, according toOECD and IMF data, are eye-striking. It has obviously a great influence onthe consistency and the credibility of monetary policy, which is principallybased on a construct of the output gap.

The phenomenon of interest rates is much more complex than that usedfor monetary policy under the inflation targeting regime. Interest ratesexpress not only the price for the lending of money. Central bankersusually tend to artificially lower just this dimension of the interest rates.This is precisely one side of the coin only. The other side of the coin isrepresented by the discount rate, the rate of return, the risk premium,and the opportunity cost. Through all these interconnected dimensions,the time preferences of the economic agents and the relative prices arepermanently and dynamically adjusted, thus enabling rational economiccalculations and planning both in time and in space. We cannot concedewithin a complex system of the inter-temporal allocation of the capitalthat by isolating the lending price of money in the inter-bank market, wecould unilaterally reduce it, and thereby we may grasp the reality andfoster the economic growth. As we know well, it necessarily has a long-term structural impact on the market mechanism, artificially starting off

an economic cycle as a result of inefficient business projects, which wouldhave never been launched otherwise under the conditions of the non-distorted market interest rates.

Hayek (2008 [1932]) used analogous insights in the thirties. He pointed tothe inherent errors in the arguments of price "stabilizers", as wementioned at the beginning of our paper. Hayek was awarded the NobelPrize for his theoretical explanation that the economy is not any aggregate"black box" but a complex of structural and inter-temporal processes.Hayek's "price stabilization" shift in the seventies, in which he has

somewhat denied its theoretical outputs from the thirties (White, 1999),remains an interesting theoretical aspect of monetary economics. Andeven more so now that the World is barely recovering from the biggestglobal economic shock since the Great Depression. The current slump hasmaterialized again after a termination of the long-term prosperity,accompanied by the accumulation of hidden structural and financialimbalances, and in an environment of stable consumer prices.


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approach, which can be called behavioral and which is rathermicroeconomic, states that money supply is exogenous if the central bankis capable of determining the desired (by central bankers) volume of money. Otherwise, the money supply is an endogenous variable. Thisapproach requires that the behavior of all relevant subjects on the moneymarket should be analyzed. But the results of this approach would be toostructured and too multilayered for our objectives.

Therefore, we are going to decide the nature of the money supply by adifferent approach, which can be called macroeconomic. In this case, themoney supply is considered to be exogenous, if the changes of variableson the left side of the equation of exchange induce changes of thevariables on the right side of the equation. Money endogeneity is statedotherwise. Thus, it is necessary to detect the causal relations, which is,strictly speaking, not possible by a statistical analysis. However, tests of Granger causality can work well in this case.

Tests of exogeneity and endogeneity of the real money supply inthe USA employing VECM

In order to test the direction of causality and to detect whether thereexists any causality, the VAR models and Granger causality tests are oftenemployed. However, these tests are appropriate only for assessing short-run causality. Our work rather focuses on a long-run causality. Therefore,we add error-correction terms to VAR models, which effectively meansthat we use vector error-correction models (VECM).

We chose the seasonally adjusted quarterly data from 1960 to 2006. Theyear 1960 was selected because of the availability of the data in FRED2 31 database. The year 2006 was chosen because it was the last time themonetary aggregate M3 was tracked by the FED. The time series was splitinto two parts: 1960-1985, and 1987-2006. The border year 1985 waschosen as the year in which the implicit inflation targeting started to beeffective. As a representative of the real money, the monetary aggregateM3 adjusted by deflator of GDP was picked (M3r). In our opinion, thisaggregate captures the best the dynamics of the money supply,corresponding also with our theoretical framework. The second variable toenter the models was the real GDP (GDPr).

For the period 1960-1985 the model with two lags was chosen based onthe Akaike information criterion. The model includes an unrestrictedconstant. The variables were used in the logarithmic form.

31It is the database of time series of macro aggregates maintained by Federal ReserveBank of St. Louis.


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1960-1985 VECM system, lag order 2

Maximum likelihood estimates, observations 1960:3-1985:4 (T = 102)Cointegration rank = 1

Case 3: Unrestricted constantbeta (cointegrating vectors, standard errors in parentheses)

l_M3r_85 1.0000(0.00000)

l_GDPr_85 -1.2265(0.032556)

alpha (adjustment vectors)

l_M3r_85 -0.023117l_GDPr_85 0.10466

Log-likelihood = 706.30196Determinant of covariance matrix = 3.3149866e-009

AIC = -13.6530

BIC = -13.3956HQC = -13.5488

Equation 1: d_l_M3r_85

Coefficient Std. Error t-ratio p-value

const -0.0510551 0.0589828 -0.8656 0.38883

d_l_M3r_85_1 0.696934 0.0815775 8.5432


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l_M3r_06 1.0000(0.00000)

l_GDPr_06 -1.5401(0.21917)

alpha (adjustment vectors)

l_M3r_06 -0.021399l_GDPr_06 -0.0012673

Log-likelihood = 591.29753Determinant of covariance matrix = 7.3281224e-010

AIC = -14.8908BIC = -14.3429HQC = -14.6717

Equation 1: d_l_M3r_06


const -0.111069 0.0368344 -3.0154 0.00359 ***

d_l_M3r_06_1 0.402804 0.111546 3.6111 0.00057 ***d_l_M3r_06_2 0.131861 0.123715 1.0659 0.29021

d_l_M3r_06_3 0.216641 0.110509 1.9604 0.05399 *

d_l_GDPr_06_1 -0.379606 0.150781 -2.5176 0.01414 **

d_l_GDPr_06_2 0.0107796 0.149482 0.0721 0.94272

d_l_GDPr_06_3 0.274164 0.153735 1.7834 0.07893 *

EC1 -0.021399 0.00703953 -3.0398 0.00334 ***

Mean dependent var 0.007950 S.D. dependent var 0.010008

Sum squared resid 0.002636 S.E. of regression 0.006181

R-squared 0.653719 Adjusted R-squared 0.618589

rho -0.070479 Durbin-Watson 2.139532

Equation 2: d_l_GDPr_06


const -0.00217871 0.0296292 -0.0735 0.94160

d_l_M3r_06_1 0.00362116 0.0897265 0.0404 0.96792

d_l_M3r_06_2 0.0132915 0.0995146 0.1336 0.89414

d_l_M3r_06_3 0.0479686 0.0888918 0.5396 0.59119

d_l_GDPr_06_1 0.175989 0.121287 1.4510 0.15131

d_l_GDPr_06_2 0.320636 0.120241 2.6666 0.00954 ***

d_l_GDPr_06_3 -0.155995 0.123663 -1.2615 0.21139

EC1 -0.00126731 0.00566251 -0.2238 0.82357

Mean dependent var 0.007674 S.D. dependent var 0.005204

Sum squared resid 0.001706 S.E. of regression 0.004972

R-squared 0.171329 Adjusted R-squared 0.087261

rho 0.016887 Durbin-Watson 1.944684

The resulting equation for the real money supply has high enoughadjusted R-squared. This is not the case of the second equation. Ljung-Box tests of autocorrelation of residuals confirm that the autocorrelation isnot present. According to Dornik-Hansen test, the residuals are at the


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same time normally distributed. According to tests with six ARCH terms,the ARCH-effect is not present.

The error-correction term in the first equation is statistically significant,which means that the real GDP caused the real money supply in the long-run. The short-run dynamics is ambiguous because the signs of thecoefficients of the lags of the real GDP are different. In the secondequation the error-correction term is not statistically significant. Moneywas therefore endogenous in the tested period . In the case of thefirst equation, the low absolute value and the sign of the alpha coefficientsuggest that the system has a tendency to correct the error of theprevious period by the adjustment of the real money supply towards theequilibrium, but this process is relatively slow.

Employing Choleski decomposition we derived impulse-response functions,which depict reaction to the shock of one standard deviation of the bothvariables. Since the second equation is not statistically significant, theimpulse-response functions do not have to be necessarily valid. The realmoney supply apparently reacts to a shock in the real GDP by a fall in thebeginning but later, it returns to its previous values, and even later, itboldly exceeds its previous values, whereas the speed of growth does notdiminish even after ten periods.

Graph 2 impulse-response functions for the period 1987-2006


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Conclusion

The crisis events of the last years since August 2007, culminating with a

critical peak in September 2008, confirm a presumption that even theallegedly stable conditions of low consumer prices over time do notnecessarily mean a long-term sustainable development in the frameworkof financial and structural balance of the entire economy. Our paperprovides a theoretical framework for a thesis that the transition to theinflation targeting regime in most of the developed countries, eitherexplicit or implicit, may be one of the causes of long-term latentaccumulations of financial and structural distortions, materializing muchlater and with more dire consequences due to the long-term manipulationof aggregate demand.

One of the motivations for our paper was to newly elaborate Hayek`scritique of price stabilizers in his book on the economic cycle, publishedat a time of the deep worldwide crisis (Hayek, 2008 [1932]). Since in theseventies, Hayek partially denied his previous views, the objective of ourpaper was to apply his "stabilization dichotomy to the context of themodern disputes over the monetary policy of inflation targeting. We haveidentified the major theoretical problems arising from a too simplistic viewof the relationship between the directed stabilization of the price level andits impact on the stability of the real output growth within the long-termeconomic cycle.

This approach systematically neglects the possibility of an impact of thisstabilization policy on a higher probability of credit excesses, creatingspeculative bubbles in the asset markets. The mechanism of inflationtargeting dramatically manipulates short-term interest rates, trying toeliminate the output gap in the context of a counter-cyclical economicpolicy. In an environment of low interest rates and low consumer pricescaused by deflationary pressures due to the ever growing globalization of trade, international competition, deregulation, and technologicalproductivity, a really lethal cocktail can be mixed up, handling theaggregate demand to such an extent that the policy of inflation targetingbecomes inherently highly pro-cyclical, with the accompanying negativecontext.

Due to the long-term systematic manipulation of interest rates, within theoperational framework of the stabilization of consumer prices and theoutput gap, as well as of anti-deflationary fundamentalism, the economycan transform itself into a kind of "black box", gradually and over timecausing an "escape" of credit and money aggregates, with criticalimplications for the financial and structural economic distortions. Areversal of causality of the nature of the money supply is primarily one of


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the important phenomena, strengthening the monetary transmissionthrough the balance sheets of financial institutions.

Following the introduction of an inflation targeting mechanism, the moneysupply tends to be more endogenous and elastic changing the causalitywithin a link between the money supply and its effective economicmaterialization, both in the production processes of the real economy andin banking and financial services. A systematic manipulation of interestrates within a framework of the inflation targeting regime leads to a muchgreater elasticity of the money supply causing much greater flows of monetary aggregates and financial intermediation as a consequence of any change in the money demand.

Thereby, the economy lacks a necessary defensive mechanism that wouldpull the overheating economy back through a more exogenous andinelastic money supply, which would automatically adjust the marketinterest rates. Similar situation was in the past, especially in case of thegold standard, or as it could be in a softer scope the case of the classicalFriedman rule of the monetary growth. In this regard, we quoteFriedman's strong objection to any manipulation of interest rates(Friedman, 1982, 101).

From the perspective of maintaining long-term financial and structuralbalances, the targeting of short-term interest rates by central banks onthe money markets is really manipulative, directly attacking the role of

the market interest rates for an inter-temporal allocation of the capitaland for adjusting the relative prices and the time preferences of theeconomic agents. The allegedly long-term systemic "stability" under theveil of low consumer prices, allowing an accumulation of financialimbalances and a manipulation of aggregate demand has the potential tomaterialize into a real "perfect storm", which we have witnessed inSeptember 2008. Within the framework of fractional reserve banking, withunlimited fiat money supply and under the inflation targeting regime,money tends to be more endogenous and much less sound, and evenmore fiat.

In the empirical part of our paper, we showed via VECM models thatmoney was exogenous before the implicit adoption of inflation targeting inthe USA, but it was endogenous after it.

Our policy recommendation reflects our theoretical and empiricalconclusions. Thus, the monetary policy should be less accommodative andensure more exogenous and less elastic money supply. This wouldfundamentally alleviate the likelihood that the financial and structuralimbalances could be fully "monetized" and so could be then materializedmuch worse and covertly in the bubbles in asset markets. Within thatsystem, short-term interest rate and time preference along the entireyield curve would not be distorted. Thus, banks would behave more like


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players in the real economy and would not be allowed to "monetize" theunsustainable economic development. Consumption and saving wouldreadjust within the cyclical development over time. As a result of it, onlyeconomically rational projects would be financed during the boom phaseof the economic cycle. Furthermore, a certain systemic "dichotomy"between the real and the financial sectors would be corrected. Thedynamics of economic variables would be aligned again both in time andin space .


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Data for the empirical part

Database of time series of macro aggregates maintained by FederalReserve Bank of St. Louis

http://research.stlouisfed.org/fred2/

Websites

http://www.federalreserve.gov/fomc/fundsrate.htm

http://www.federalreserve.gov/pubs/bulletin/1997/199711lead.pdf

Documents

Munzi Hlavac 2011 Inflation Targeting and Its Impact on Endogenous Money Supply and Bubbles in Asset Prices