Monetary Theory and Policy.

By Carl E. Walsh. Cambridge, MA: The MIT Press, 1998; Pp. xvi, 528. $55.00.

Carl Walsh has done a great service by writing such an excellent graduate-level textbook that masterfully surveys the current state of monetary theory. While I do have some concerns that are discussed below, I should note at the outset that I now use this text for my masters-level course in monetary theory. While imitation may be the highest form of flattery, appearing on the syllabus must be a close second.

The text begins with a discussion of empirical evidence on the monetary-transmission mechanism, with a major emphasis on the past decade's vector autoregression (VAR) approaches. Walsh succinctly summarizes a fundamental difficulty in this work: "If policy is completely characterized as a feedback rule on the economy, so that there are no exogenous policy shocks, then the VAR methodology would conclude that policy doesn't matter . . . [but] it does not follow that policy is unimportant; the response of the economy to nonpolicy shocks may depend importantly on the way monetary policy endogenously adjusts" (page 33). This policy endogeneity issue is an important theme throughout the text.

Chapters 2-4 survey standard issues in the welfare cost of inflation, seigniorage, and Friedman's optimum quantity of money. Walsh utilizes a general equilibrium money-in-the-utility-function (MIUF) environment but also includes a discussion of shopping-time, transactions cost, and cash-in-advance models (there is also a brief discussion of the Kiyotaki-Wright search models of money). The text repeatedly makes the important point that all of these aggregative monetary models can be mapped into an MIUF environment but that each modeling assumption places restrictions on the form of the utility function.

Unfortunately, Walsh does not take this modeling implication seriously, as he utilizes preference specifications that are hard to justify either empirically or theoretically. For example, in the calibration-simulation experiments in Chapter 2, Walsh uses a preference specification (equation 2.38) that implies that the money demand interest and income elasticities are the same and are both equal to unity. There is no theoretical reason to link these two elasticities, and I know of no empirical estimate of the interest elasticity that is this high. I would have much preferred a more general preference specification that could be calibrated to empirical estimates of money demand. This is a book in monetary theory, and more care should be taken in calibrating the monetary side of the economy. The preference assumption is vitally important for many issues, including the possibility of real indeterminacy and of multiple equilibria (an issue that I will return to below).

The issue of sticky prices and short-run nonneutrality is introduced in Chapter 5 (Chapter 6 provides an open-economy analogue). This chapter illustrates the up-to-date nature of the book: There is a nice discussion of the influential Chari, Kehoe, and McGratten (1996) working paper that conducts a general-equilibrium analysis of a sticky-price model with overlapping contracts. However, this general equilibrium analysis is soon abandoned (too soon for my taste) and is replaced with a more traditional IS-LM model with an exogenous dynamic price adjustment equation. This reduced-form model is the workhorse for most of the remainder of the text. The difficulty with this move to reduced-form models is that it is far from clear what aspects of the pricing mechanism are invariant to policy regime changes.

The final four chapters of the text survey selected topics in monetary theory. Financial imperfections and the credit channel of monetary policy are discussed in Chapter 7. The game-theoretic models of monetary policy inspired by Kydland and Prescott (1977) and by Barro and Gordon (1983) are discussed in Chapter 8. This is one of the longest chapters in the book and thus covers a lot of ground, including the celebrated inflation bias result, recent work by Walsh and others on the optimal incentive contract for the central banker, and the empirical evidence on the importance of central-bank institutions. The text concludes with two chapters (9 and 10) on monetary-policy operating procedures, with a special focus on the issues that arise when the central bank uses a nominal interest rate target. This discussion is also wide-ranging, from the reduced-form IS-LM analysis of Poole (1970) to the general-equilibrium analysis of Carlstrom and Fuerst (1995).

There are several other nice features of the book that are linked to the fact that it is a textbook. First, there are lengthy appendices that carefully walk through standard linear approximation methods and provide a rudimentary discussion of calibration methods. These appendices will be particularly useful for graduate students who are learning these methods. Second, there are problems at the end of the chapters that provide a nice review of the concepts developed in the chapter. Finally, the reference list for the text is incredibly exhaustive and helpful - it has already become the first place I look for a relevant citation.

Along with the choice of topics included, Walsh's text is also defined by what he omits, and one's preference for the book will surely by driven by one's preference for the omissions. I will focus the remainder of this review on two important omissions: (i) overlapping-generations (OLG) models of money and (ii) real indeterminacy and sunspot equilibria.

The most compelling reason for the OLG omission is that standard OLG models ignore the medium-of-exchange role of money. To the extent that money is defined to be the substance that alleviates trading frictions, then OLG models are not models of money. One could, of course, use familiar methods (e.g., MIUF) to add this medium-of-exchange role to OLG models. But in this case, many of the OLG model's implications are essentially the same as in the corresponding representative agent (RA) model so that convenience suggests that we use the simpler RA model. The only advantage of the OLG model is its inherent ease of handling of heterogeneity such as the distribution of wealth, but to the extent that these issues are irrelevant for monetary issues, we are once again led to the simpler RA setting.

A second omission from Walsh's text is any discussion of multiple equilibria, real indeterminacy, and stationary sunspot fluctuations (there is one exception - a brief discussion of nonstationary equilibria on pages 58-60 of the text). In contrast to the OLG omission, I view this choice as unfortunate for at least two reasons.

First, many quantitative general-equilibrium studies of monetary models conclude that there are exceedingly modest welfare gains of switching from a simple k% money growth rule to the optimal monetary policy. These models suggest that even the fifth-best monetary policy is not all that bad. However, these models do have the implication that under some proposed policies, there is real indeterminacy, so that stationary sunspot equilibria are possible. A reasonable conclusion from this literature is that we should downplay the significance of the first-best policy and instead should concentrate our efforts on ensuring that a policy does not introduce sunspot equilibria. Walsh's choice of omitting coverage of real indeterminacy makes this type of policy discussion impossible.

Second, there is a long tradition in monetary economics that emphasizes animal spirits or sunspots as the driving force of business cycles. It is arguably this tradition that leads one to conclude that business cycle fluctuations are necessarily bad. This is in sharp contrast to the real business cycle (RBC) tradition, in which the business cycle is an efficient response to real shocks buffering the economy. Monetary versions of the RBC model often conclude that optimal monetary policy should be procyclical and thus magnify output variability (e.g., Carlstrom and Fuerst 1995). In contrast, the animal spirits tradition leads to the exact opposite conclusion - that output variability should be minimized by countercyclical policy. In short, without a discussion of the source of the business cycle, it is difficult to think about optimal policy. For most of the text, Walsh uses the shortcut of assuming a preference function for the central bank that includes a desire to minimize the variance of output. Why would the central bank want to minimize output fluctuations? The obvious structural interpretation of these reduced-form preferences is that the fluctuations are a manifestation of sunspot equilibria and should thus be eliminated by the benevolent central banker. But Walsh makes such a discussion impossible by omitting real indeterminacy from the text.

In summary, if I had written this book, the previous suggests that I would have made a few different choices. But I did not write the book - Walsh did - and he did a splendid job. I recommend it to you.

References

Barro, Robert J., and David B. Gordon. 1983. A positive theory of monetary policy in a natural rate model. Journal of Political Economy 91 (4):589-610.

Carlstrom, Charles T, and Timothy S. Fuerst. 1995. Interest rate rules vs. money growth rules in a cash-in-advance economy. Journal of Monetary Economics 36(2):247-67.

Chari, V. V., Patrick J. Kehoe, and Ellen R. McGrattan. 1996. Sticky price models of the business cycle: Can the contract multiplier solve the persistence problem? NBER Working Paper No. 5809.

Kydland, Finn, and Edward Prescott. 1977. Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy 85(3):473-91.

Poole, William. 1970. Optimal choice of monetary policy instruments in a simple stochastic macro model. Quarterly Journal of Economics 84(2):197-216.

Timothy S. Fuerst Bowling Green State University