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Economic SYNOPSES short essays and reports on the economic issues of the day 2009 ■ Number 21 Can Monetary Policy Affect GDP Growth? Yi Wen, Assistant Vice President and Economist he Fed has taken unconventional measures over the 2-quarter horizon), money base growth is slightly negthe past 18 months to contain the financial crisis atively associated with GDP growth. However, around the and limit ramifications for the broader economy. typical business cycle horizon (say within the horizon of 8 These measures have resulted in an extraordinary increase to 16 quarters or 2 to 4 years), money base growth has a in reserve balances at commercial banks—which is a key significant positive relation with GDP growth. In particucomponent, along with currency, of the monetary base. lar, at the 12-quarter horizon, for every 1 percent increase John Taylor of Stanford University estimates Economist in money base growth, there is about 0.4 percent correthe current programs proposed by the Fed should increase sponding increase in GDP growth. Such a positive relation reserves by about $2.285 trillion—nearly a 300-fold increase disappears again in the very long run beyond the typical compared with the $8 billion level in early September 2008.1 business cycle, perhaps because in the long run money Many analysts have raised concerns that the increased growth is inflationary, which leads to higher prices and reserves will ultimately increase inflation and the price lower output. level. One might also expect such an enormous increase in reserves to stimulate aggregate output, thereby mitigating We merely want to see whether, the adverse effects of the financial crisis on the economy. historically, fast growth of the But can such an impact be estimated quantitatively? Historically, we can look at postwar U.S. data and see monetary base has been associated how much gross domestic product (GDP) growth can be with faster growth of real output. associated with or forecasted by the growth rate of the monetary base. Note that such a statistical association is not Therefore, historical data tell us that if there is any pos“causal.” We merely want to see whether, historically, fast growth of the monetary base has been associated with faster itive association between money growth and GDP growth, growth of real output. One approach is to use an analysis the impact comes about 3 years after an initial acceleration of base growth. Such a long lag suggests that an observed that captures the impact of current and past increases of and expected increase in the monetary base may not have the monetary base on current GDP growth, taking into consideration the influence of the history of GDP on its own future growth. This estimation can be done at different horizons using Impact of Monetary Base on GDP Growth statistical tools. Estimated Impact The chart shows the association of mone1.0 tary base growth with GDP growth at different horizons, where the horizontal axis is the 0.5 number of quarters and the vertical axis indi0.0 cates the estimated impact of money base –0.5 growth on output growth. The solid line is the estimation and the dashed lines are one–1.0 standard-error bands, which quantify the 2 4 8 12 16 24 256 Quarters uncertainty of the estimation. The chart indicates that in the very short run (say at T Economic SYNOPSES Federal Reserve Bank of St. Louis a very large effect on output growth. Of course, the big caveat is that there has never been such an extraordinary increase in base growth. Therefore, the evidence based on historical data is not conclusive, but only a rough guide. ■ 1 Taylor, John B. “Monetary Policy and the Recent Extraordinary Measures Taken by the Federal Reserve.” Testimony before the Committee on Financial Services, U.S. House of Representatives, February 26, 2009; www.stanford.edu/~johntayl/House%20FSC%20testimony%20Feb%2026.pdf. Posted on April 24, 2009 Views expressed do not necessarily reflect official positions of the Federal Reserve System. research.stlouisfed.org 2
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