DP2666 Direct Effects of Base Money on Aggregate Demand: Theory and Evidence

Author(s): Edward Nelson
Publication Date: January 2001
Keyword(s): Monetary Base, Monetary Policy Rules, Monetary Transmission Mechanism, Money and Interest Rates
JEL(s): E32, E40, E51, E52
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2666

Meltzer (1999a) shows that real monetary base growth is a significant determinant of consumption growth in the United States, controlling for the short-term real interest rate. In this paper, I show that the same property of base money holds for total output (relative to trend or potential) in both the United States and the United Kingdom. The standard optimizing IS-LM model cannot account for this result, but I show that it can once the long-term nominal interest rate is included in the money demand function. Because the long-term real rate matters for aggregate demand, the presence of the long-term nominal rate in the money demand function increases the effect of nominal money stock changes on real aggregate demand when prices are sticky.