Studies in Monetary Economics

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This project continues work on important issues in the field of monetary economics and business cycle theory. The project consists of four parts: 1) research on how well simple regularities or laws captured by the quantity theory of money can account for movements in prices, exchange rates and interest rates; 2) development of a theory for explaining the large observed differences between movements in asset prices and movements in their associated fundamentals; 3) estimating the fraction of output variability that can be attributed to monetary as opposed to real disturbances; and 4) estimating the social cost of preventable economic instability. Previous work by the investigator demonstrated that there was a remarkably stable, simple relationship between an economy's money supply, its long run inflation rate and the average level of nominal interest rates. Yet so many other forces impinge on prices and interest rates in the short run that agreement on these long run average relationships imply virtually nothing about immediate questions of macroeconomic policy. This project builds on this past work by extending the study of long run regularities to include exchange rates and by studying the "residuals," the movements in prices, interest rates and exchange rates that are unexplained by the economy's money supply. This work should provide important new insights into the role played by money in the macro-economy. The investigator relates the observation that interest rates are much more variable in the short run than predicted by the long term relationship between money and interest rates to a growing body of evidence that stock market prices are more variable than predicted by movements in their fundamentals. Why are financial markets so volatile? This project develops a new theory of "liquidity constrained" trading in financial markets that could explain these puzzles and also provides a framework for systematic study of such important events as the stock market crash in October, 1987.