Monetary policy is not about interest rates; The liquidity effect and the Fisher Effect

Abstract

The purpose of this paper is to clarify the relation between money and interest rates. Section 1 examines the empirical validity of Keynes’s claims for his liquidity preference theory by looking at the relation between changes in interest rates and changes in the quantity of money. Section 2 considers Irving Fisher’s findings. Fisher, whose studies had mostly preceded Keynes, had shown that over any longer-term horizon the relation between money and interest rates was exactly the reverse of Keynes’ hypothesis of short-term liquidity preference. A reconciliation is proposed that treats Keynes’ theory as a short-term, liquidity effect, and Fisher’s results, which incorporate the effect of inflation or inflation expectations, as the longer-term determinant of interest rates. Section 3 applies the resulting combined theory of the relation between money and interest rates to five case studies in recent decades: two from Japan, and one each from the Eurozone, the U.K. and the U.S. The conclusion is that interest rates are a highly misleading guide to the stance of monetary policy; it is invariably better to rely on the growth rate of a broad definition of money when assessing the stance of monetary policy.

Keywords. Unconventional Monetary Policy; Quantitative Easing; Fisher effetc.

JEL. E52, E58, G14.