Monetary Policy and Economic Theory

This article is a follow through of two earlier articles on money & inflation and monetary policy published on this blog. Those two articles aimed to explain how money and monetary policy impacts us individually and GDP and employment in the economy as a whole. That being said, the main message of this current blog article is that economists know that monetary policy (or interest rates) has an impact on the economy’s GDP and employment, but haven’t yet understood fully how it happens. If you have never learned economics, this article may require further reading of the hyperlinks within the article to understand. I must admit that in the interest of brevity, I have not explained everything in its entire details.

Money, an object initially intended to facilitate exchange has transformed itself in form and scale. To give a sense of the scale, currency in circulation in India amounted to Rs. 21.40 trillion as of March 2019, which is 11.23% of the GDP (On 4 Nov 2016, four days before demonetisation, the currency in circulation was lower at Rs. 17.98 trillion). Taking a slightly broader definition of money M3 (currency + all deposits including fixed deposits with banks + few other things), India in 1950-51 had M3 equivalent to 20% of the country’s GDP which by 2014-15 rose to over 80%. Money, as we know it today has transformed the way human activities are conducted. Establishment of central banks to issue and regulate fiat money has been a wonderful innovation for mankind.

Money and Economic Theory

While money seems to be at the heart of economies, it is sometimes given a step-brotherly treatment in economic theory. Theory acknowledges money and its usefulness and how its absence can be disastrous, but says that it is of no real significance. That is it cannot impact real variables like employment, real GDP etc. and can only impact nominal variables like price level and nominal wages (In economics parlance, money neutrality). Such real variables which are more important for people are affected by factors like technology, labour productivity etc. Keep in mind that this conclusion is formed on some assumptions regarding the economy like flexibility of wages and prices. These assumptions have been criticised and economic models with price and wage stickiness have been introduced that show that changes in money supply have an impact on real variables also, at least in short run. Notwithstanding the inconclusiveness of theory, it has been shown in empirical research that monetary policy has an impact on GDP and employment, at least in short run. This divergence between theoretical predictions and evidence can be viewed as an indication that we are seeing only the tip of the iceberg. Some elements that are important in actual economies may be missing in classical monetary models.(Gali, 2015). Even though theory to back empirics isn’t strong, central banks use econometric models on aggregate variables to predict output or inflation and also to help in setting the ideal policy rates. But a major criticism to this practice was dealt by Nobel winning economist Robert Lucas with his Lucas critique (it challenged the ability of econometric models to predict outcomes for macroeconomy).

Macroeconomics is Microeconomics aggregated

Now, one of the things I have heard more than once in economics circles is “Microeconomics has excellent methods, but less interesting questions while Macroeconomics has many challenging questions but not well developed means”. To counter the Lucas critique and to build a better theory to explain the working of the macroeconomy, economists realised the need to build a theory from individual optimisation exercises and then aggregate it. That is, given the choices that a single producer/consumer faces and assuming that they act rationally, what will their actions be. And what will the overall outcome be when one aggregates these individual decisions. To build models that capture such aggregation of individual actions, macroeconomics research has turned to dynamic optimisation in General Equilibrium.

Dynamic optimisation is about making optimal choices in a problem that is spread over multiple time periods. An example is a person deciding how much of his income to save and consume today taking into account its implications for tomorrow, day after and so on. General equilibrium is when you consider equilibrium in multiple markets (goods market, labour market, money market etc.) simultaneously. Dynamically optimising to attain general equilibrium, macroeconomic theory is now rife with a new methodology known as Dynamic Stochastic General Equilibrium (DSGE) models. These models build an understanding of the aggregate economy’s working as a result of individuals optimising their actions. This is as opposed to initial developments in macroeconomics where we begin with some equations describing the behaviour of aggregate markets (Eg: economy wide labour supply/demand curve in labour markets or aggregate production function in the goods market). With DSGE, behavioral equations describing aggregate variables were replaced by first-order conditions of intertemporal problems facing individual consumers and firms. This change in methodology is what is called as providing micro foundations to macro economics. These theoretical models provide a means to compare different policies and its implications without being subject to the Lucas critique that empirical studies suffer from.


Beyond doubt, money impacts real variables. Therefore, a key goal of monetary theory is to provide us with an account of the mechanisms through which those effects arise, i.e., the transmission mechanism of monetary policy. Till then, predicting outcomes of output or employment as a result of a policy rate or symmetrically deciding the ideal policy rate given the current state of economy are tasks economists will continue to do, albeit imperfectly.

Predicting output or employment as the outcome of a policy rate or symmetrically deciding the ideal policy rate given the current state of economy are tasks economists will continue to do, albeit imperfectly.

Works Cited

GalĂ­, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.

This article benefited from comments by Rishav Roy and Divyanshu Jain, cohabitants at VKRV Rao Hostel.

One comment

  1. A tough and generally ignored part of the topics of micro and macro for students from examination point of view and for teachers from a derivation / reference point of view that comes in between Consumer and producer topics.. Nicely put the explanation of equilibrium models, but needs more relation to the main topic (linking money to real variables). Looking forward to more Sebin. Thanks

    Liked by 2 people

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