On money neutrality

Refuting money neutrality

What is the effect of monetary policy on the long-run productive capacity of the economy? Jordà and al., in this paper, test for monetary neutrality with a three pillar approach:

• Data – they use two new macro-history databases spanning 125 years and 17 advanced economies to construct measures of total factor productivity (TFP);
• Identification – they use the trilemma of international finance to examine a rich array of spillover mechanisms. This framework allows for contagion via financial linkages, deviations from uncovered interest rate parity, and partial control over monetary policy through small exchange rate interventions;
• Econometric approach – they use local projections in order to get more accurate estimates of the impulse response function at longer horizons

Their findings suggest that monetary policy affects TFP, capital accumulation, and the productive capacity of the economy for a very long time.

The Long-Run Effects of Monetary Policy
Authors: Òscar Jordà, Sanjay R. Singh, Alan M. Taylor
From: Federal Reserve Bank of San Francisco, University of California, Davis

Expectations trump neutrality?

In this paper, Eggertsson and Giannoni looked at the New Classical Phillips curve which exhibits full monetary neutrality in the medium run, and considered deviations from this benchmark, which produce a medium-run trade-off between inflation and output.

A key conclusion of this paper is that the closer the aggregate supply side is to exhibiting medium- or short-term money neutrality, the more likely the model is to exhibit a very large output contraction at the ELB, or non-existence of the equilibrium. In addition, the case for expansionary monetary policy at the ELB is even stronger, and the stimulative effects of monetary policy are also larger, the closer the model is to exhibit money neutrality. This may seem deeply counter-intuitive. […] as expectations become more ingrained the effect of a stimulus becomes larger, rather than smaller.

Medium-Term Money Neutrality and the Effective Lower Bound
Authors: Gauti B. Eggertsson, Marc Giannoni
From: Brown University, Federal Reserve Bank of Dallas