The relation between money and economic activity changed in the mid-1980s

From the opening paragraph of Monetary Cycles, Financial Cycles, and the Business Cycle, a New York Fed Staff Report by Tobias Adrian, Arturo Estrella, and Hyun Song Shin:

A traditional view in monetary economics is that interest rates are transmitted via the money demand function, and that the level of interest rates affects real consumption and investment. However, beginning in the mid-1980s, the relationship between money and economic activity became highly unstable as rapid changes in the financial system started to change the nature and composition of monetary aggregates.

The relation between money and economic activity changed in the mid-1980s.

The authors continue:

As a result, theories of monetary transmission that explicitly include quantities have lost prominence. Instead, attention has turned to expectations-based channels of monetary policy, which emphasize the expectations theory of the yield curve and the role of expected future short term interest rates in determining the long-term interest rate.

In this paper, we re-examine the transmission of monetary policy to the real economy ...

And that's as much as I read of that.

The relation between money and economic activity changed. "As a result," they say, the quantity theory has lost prominence and expectations have gained in importance. In the paper, the authors focus on the changed relation.

I have to go to their conclusion to make sure I know what they are talking about. Here's their last sentence:

Liquidity matters---but, in our framework---liquidity should be defined as the growth rate of assets on key intermediary balance sheets, not the quantity of money.

After the change, they say, the quantity of money still matters; but the money itself is different.


What do I say all the time? We use credit for money. In the good old days we used money for money, but now we use credit for money.

I ran into Positive Money the other day describing the UK economy:

97% of the money in the economy today is created by banks, whilst just 3% is created by the government.

Government money is money. Bank money is credit.

It's a simplification, but imagine that government money has no interest cost and bank money has a 5% interest cost. In an economy with 100% government money we start with zero interest cost. In an economy with 100% bank money we start with an interest cost equal to 5% of the quantity of money.

As time goes by, money goes into savings and money goes out of the economy. The money gradually disappears, but the debt still exists. The economy needs more money. People need more money, and borrow more. And then there is more debt than money.

Time goes by for 30 years or so, and then there is a lot more debt than money. Eventually, this changes the economy -- as the paper describes. Time goes by for another 30 years or so, and people can no longer afford the debt. And then you have a crisis.


What's wrong with that New York Fed paper? What's wrong is that the relation between money and economic activity changed in the mid-80s, and the authors don't consider that to be the problem.