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6.12 Real Business Cycle Theory and the Neutrality of Money

Real business cycle theorists claim that recent research relating to the stylized

facts of the business cycle support the general predictions of ‘real’ as

opposed to ‘monetary’ theories of fluctuations. But, as we noted earlier, the

correlation between money and output is an accepted stylized fact. How do

real business cycle theories deal with the apparent causal influence of money?

Monetary neutrality is an important property of real business cycle models.

In such models neutrality applies to the short run as well as the long run. In the

late 1970s, leading representatives from the other major schools of thought,

such as Tobin, Friedman and Lucas, all agreed that the rate of growth of the

money supply has real effects on the economy and plays an important role in

any explanation of output fluctuations. There was of course considerable disagreement

on the nature and strength of the relationship between money and

output and on the relative power of monetary and fiscal policy, but economists

of all persuasions took it for granted that monetary phenomena were crucial to

business cycle research. The accepted business cycle stylized fact that money

and output exhibit positive correlation, with money leading output, was taken

by many as strong evidence of causality running from money to output (Sims,

1972). The research of Friedman and Schwartz (1963, 1982) added further

weight to the monetarist claim that monetary instability lies at the heart of real

instability. However, the well-established positive association between money

and aggregate output may simply indicate that the money supply is responding

to economic activity rather than the reverse. In such a situation money is

endogenous and the money-to-output correlations that we observe are evidence

of reverse causation; that is, expectations of future output expansion lead to

current increases in the money supply. According to real business cycle theories,

the demand for money expands during business expansions and elicits an

accommodating response from the money supply, especially if the monetary

authorities are targeting interest rates (see Barro, 1993, chap. 18). The impetus

to downgrade the causal role of money was also given support from the evidence

emerging from vector autoregression analysis which indicated that, once

interest rates were included among the variables in the estimated system,

money ceased to have strong predictive power. The contributions from Sims

(1980, 1983) and Litterman and Weiss (1985) provided important evidence

which advocates of the real business cycle approach point to in support of their

preference for a non-monetary approach to business cycle modelling (see also

Eichenbaum and Singleton, 1986).

Initially real business cycle models were constructed without monetary

features. Kydland and Prescott (1982) originally set out to construct a model

which included only real variables but which could then be extended to take

into account nominal variables. But after building their real model Kydland

and Prescott concluded that the addition of a monetary sector may not be

necessary since business cycles can be explained almost entirely by real

quantities (see Prescott, 1986). Although the Long and Plosser (1983) model

contains no monetary sector, King and Plosser (1984) explain the historical

association between money and output as reflecting an endogenous response

of money to output. Building on the work of Black (1987) and Fama (1980),

King and Plosser reject the orthodox monetarist interpretation of money-tooutput

causality. In their model, ‘monetary services are privately produced

intermediate goods whose quantities rise and fall with real economic developments’.

King and Plosser view the financial industry as providing a flow of

accounting services that help to facilitate market transactions. By grafting a

financial sector on to a general equilibrium model of production and consumption,

King and Plosser show how a positive correlation between real

production, credit and transaction services will arise with the timing paths in

these co-movements dependent on the source of the variation in real output.

Their model implies that the volume of inside money (bank deposits) will

vary positively with output. Furthermore, the fact that financial services can

be produced more rapidly than the final product means that an expansion of

financial services is likely to occur before the expansion of output. The stock

of bank deposits is therefore highly correlated with output and a leading

indicator in the business cycle.

The money–output correlation noted above corresponds with the evidence

presented by Friedman and Schwartz (1963) but from an entirely different

perspective. Whereas in monetarist models exogenous changes in the quantity

of money play an important role in causing movements in output, King and

Plosser stress the endogenous response of deposits to planned movements in

output. In effect the output of the financial sector moves in line with the output

of other sectors. However, by the end of the 1980s, despite the progress made

by REBCT in explaining the money–output correlation, Plosser’s (1989) view

was that ‘the role of money in an equilibrium theory of growth and fluctuations

is not well understood and thus remains an open issue’.

Paradoxically the REBCT argument that money is endogenous is also a

major proposition of the Post Keynesian school (see Kaldor, 1970a; Davidson,

1994). For example, with respect to this very issue of money-to-output causality,

Joan Robinson (1971) suggested that the correlations could be explained

‘in quantity theory terms if the equation were read right-handed. Thus we

might suggest that a marked rise in the level of activity is likely to be

preceded by an increase in the supply of money.’ In an unholy alliance, both

Post Keynesian and real business cycle theorists appear to agree with Robinson

that the quantity theory equation (MV = PY) should be read in causal terms

from right to left. Orthodox Keynesians have also raised the issue of timing

in questioning money-to-output causality. Tobin (1970) showed how an ultra-

Keynesian model could be constructed where the money supply is an

endogenous response to income changes. In this model changes in real economic

activity are preceded by expansions of the money supply as firms

borrow funds from the banking sector in order to finance their planned

expansions. Tobin demonstrated that to infer from the timing evidence that

changes in the money supply are causing changes in real economic activity

was to fall foul of the post hoc ergo propter hoc (after this therefore because

of this) fallacy. However, although Tobin used this argument to challenge

what he considered to be the exaggerated claims of monetarists relating to the

power of monetary forces, he certainly did not conclude that money does not

matter for business fluctuations (see also Cagan, 1993).

Kydland and Prescott (1990) have questioned the whole basis of this

debate on timing and causality by rejecting one of the ‘established’ stylized

facts of the business cycle relating to monetary aggregates. They argue that

‘there is no evidence that either the monetary base or M1 leads the cycle

although some economists still believe this monetary myth’. Clearly such

claims represent a serious challenge to conventional views concerning the

role of money. This ‘blasphemy’ has been rejected by Keynesian and monetarist

economists alike who, as a result of real business cycle analysis, have

been thrown into an alliance which would have seemed unthinkable during

the intense debates that took place between Tobin and Friedman during the

1960s and early 1970s. (For a defence of the earlier Friedman and Schwartz

research, see Schwartz, 1992.)