American Economic Association

Is There a Monetary Business Cycle?

Author(s): Christopher A. Sims
Source: The American Economic Review, Vol. 73, No. 2, Papers and Proceedings of the Ninety-
Fifth Annual Meeting of the American Economic Association (May, 1983), pp. 228-233
Published by: American Economic Association
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 Is There a Monetary Business Cycle?
By CHRISTOPHER A. SIMs*
There is a view that monetary policy is
effectively summarized by the time path of a
single variable, the money stock, and that
erratic fluctuations in the money stock gener-
ated by erratic policy decisions are a major,
even the principal source of business cycle
fluctuations. This view, which I will call
monetarism, is losing adherents among econ-
omists, for several reasons.
For one thing, rational expectations the-
ory, having shown how the Phillips curve
could emerge as a statistical regularity in an
economy where it was not exploitable for
policy purposes, can now do the same for
Granger causal priority of money and mon-
ey's strong explanatory power for future
movements in real output. Theories of en-
dogenous cyclical variation in money are
gaining attention in part because of results
which have begun emerging from the data as
new statistical techniques are applied to new
historical developments. Data from outside
the United States or outside the 1950's and
1960's do not fit the predictions of monetarist
theory.
I. CausalInfluenceof Moneyas
StatisticalArtifact
In an earlier paper (1982), I showed how a
stochastic equilibrium model could generate
Granger causal priority of the money stock
despite a kind of passive behavior of the
monetary authority. Improving on that model
slightly, it can be shown both how money
might appear Granger causally prior with
passive money, and how a policy of fixing
the money stock might shift causal priority
toward the interest rate.
First consider a simple model, containing
identical infinitely lived agents maximizing
(1) Er ci[U(Ct)+ H(MtPt)]et8adt,
where C, is consumptionat t, and Mt/Pt ,is
*University of Minnesota.
228
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real balances at t, subject to
(2) M,tPt + kt = f ( K, )-CtTt + et,
where Tt is taxes, and a given initial period
per capita stock of capital Ko. The function f
is the production function and the stochastic
process ? represents random shocks to tech-
nology. I assume government policy imposes
M,/Pt + Tt= 0. First-order conditions for
solution of this problem with respect to K,
and Ct can be written as
(3) Ut'=O,
(4) -Etft= ,(ft-8),
where ot is a random Lagrange multiplier
and Ut'= U'(Ct) is the marginal utility of
consumption at t. The left-hand side of (4),
Etft, has a special interpretation here-it is
the right derivative at t of expected future 4.
This may exist even when 4t is not a well-
defined stochastic process, as when 4, is a
Weiner process.
Equations (3) and (4) together imply E,Ct
* Ct, that is, that
Ct does not have differen-
tiable sample paths, so long as the future,
ct+s for s > 0, is not known exactly at t To
see this, note that (4) with Etot = 4t implies
- log(t=0+Jot(fs-8) ds, and if U' is
monotone in C, there will then be a function
g with g'> 0 such that Ct = g(fot(fs- 8) ds).
Substituting this into the budget con-
straint (2) gives us
(5) kt = f (Kt) - g t( fs-8) ds)+ et.
It is easy to check that this equation is
"unstable."
If we have a path K* which solves (5) for a
given Et path, and we make a small, tem-
porary increase in et, then if K is unchanged
at dates before t, the new path for K must
differ from the old path by a positive amount
which increases at least linearly in t, because
VOL. 73 NO. 2 MACROECONOMICS. MAJOR ISSUESAND DEVELOPMENTS
the right-hand side of (5) is increasing in K,
and in K's with earlier dates. Therefore a
stationary E process cannot generate a sta-
tionary K process in this system unless K has
exact dependence on the sample path of - in
the future.
We can, however, have stationary solu-
tions without dependence on the future if Ct
does not have differentiable sample paths.
For example, suppose U(Ct)= log Ct, so
log+, = - log Ct. Then one solution to (2)-(4)
satisfies
00
(6) logCt =-fEt[fs +y-6] ds+ F,
which in turn is satisfied by the stochastic
differential equation
(7) d(logCt) =-(fs'+ y-8) dt
+ (2y )1/2 dW,
where W, is a Weiner process.
A stochastic process like (7) does not have
differentiable sample paths, and a Ct satisfy-
ing (6) cannot in general have differentiable
sample paths if the future of f' is not known
in advance. Processes of this type are locally
unpredictable, in the sense that
(8) E [(Ct ,-Etct )2] as3-*O.
tJ(C1?3 t)2]
This means in particular that for data mea-
sured at small time intervals, the R2 in a
regression of C,+ - Ct on data available at t
should be close to zero. Ct will therefore
appear to be close to Granger-causally prior
in systems of equations estimated with fine
time unit data.
In any continuous time dynamic optimiza-
tion problem with a productive investment
technology, a control variable which can be
moved without penalty on its derivative will
tend to behave this way-attempting to track
some function of expected future develop-
ments-and will therefore tend to have the
property, which C1has here, of being locally
unpredictable. (See also my 1980c paper and
Robert Hall, 1978.)
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229
Hall showed in a discrete time model that
consumption should be a martingale. His
result depends on assuming a fixed real in-
terest rate and on consumption varying only
over a range within which the utility function
is well approximated as quadratic. I have
shown here that his result applies locally in
time under more general assumptions.
The additive separability of utility makes
the model dichotomize in a certain sense; we
can solve (2)-(4) for C and K without solv-
ing for M. To solve for M we must use the
first-order condition with respect to Mt,
which is
(9) Ht'=
=-Et ft + pt( 8 + EtPtlPt )
Using (3) and (4), this becomes
( 10) Htl Ut' = ft' + E tPt /Pt.
One possible monetary policy is to keep P,
constant, thereby keeping the nominal in-
terest rate, f' + EtPt/Pt, equal to the real
rate f '. This makes (10) reduce to
(I11) H'(Mt1Pt)1U'(Ct) = f (Kt).
Note Kt must be differentiable, since kt ap-
pears in the budget constraint (2), all of
whose other terms have well-defined sample
paths. Since Ct is not differentiable, and Pt is
fixed, (11) implies that Mt must in the short
run move directly with Ct, inheriting its non-
differentiability and, therefore, its approxi-
mate Granger-causal priority with fine time
unit data. The interest rate, depending di-
rectly on Kt, is differentiable and will not
have this short-run volatility.
To institute this "price-pegging" policy, if
the monetary authorities cannot simply in-
tervene in " the" commodity market, requires
that M be adjusted rapidly to the shifts in
demand for it arising out of C shifts. The
policy clearly puts a substantial burden on
the monetary authorities.
Suppose instead the authorities peg Mt at a
constant level. This leaves EtP/P in (10) and
that equation becomes a stochastic differen-
tial equation in P. with C and K, determined
by (2)-(4), as exogenously determined forcing
functions.
230 A EA PAPERS AND PROCEEDINGS
Since H" is naturally taken to be negative,
the partial derivative of the left-hand side of
(10) with respect to P is positive, making (10)
unstable in P. As noted above in discussing
the solution of (5) for K in terms of c, this
means that stationary solutions of the system
without perfect foresight must make P's
sample paths non-differentiable. The nomi-
nal interest rate, f' + EtP/P = H'/U', is
likely to move directly with Ct, hence to be
itself nondifferentiable.
In moving from a fixed P equilibrium to a
fixed M equilibrium, we move from a situa-
tion with the rate of growth of M showing
higher variance the smaller the time interval
over which the rate is measured to one in
which instead P shows this erratic behavior.
The fixed-P equilibrium requires the mone-
tary authority to make rapid and accurate
adjustments of the nominal stock of money
to shifts in demand for money generated by
real activity. The monetarist view might be
that the monetary authority cannot do this.
Note, though, that in looking at the histori-
cal record to decide if the authority has
succeeded in doing this in the past, we should
not expect that observing erratic and unpre-
dictable movements in the money stock,
highly correlated with subsequent move-
ments of real output, is evidence that the
monetary authority has failed. This model
predicts just such statistical results precisely
when the monetary authority is successful.
The fixed-M equilibrium requires that the
price level make rapid and accurate adjust-
ments. My view is that the nature of con-
tracting arrangements we observe in the
economy suggests that a price level which is
volatile and unpredictable over short time
intervals would impose real costs which are
ignored in this equilibrium model. These costs
are probably big enough that, with a fixed-M
policy or something close to it, we see incom-
plete adjustment of prices, generating dis-
equilibrium and inefficient responses in real
activity.
To see why this is likely, consider for
example what would happen in the model if
information emerged which implied a quickly
(but continuously) rising time path for con-
sumption over some interval. This would
mean Ut' was quickly dropping. With no
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MA Y 1983
change in the nominal interest rate, the price
level would have to drop as sharply as Ct.
However the rapid fall in the price level
would require a drop in the nominal interest
rate, since the other component of the nomi-
nal interest rate, f'( K), cannot change
rapidly, and the drop in the nominal interest
rate would further increase the demand for
real balances, thereby further increasing the
required price level increase. The result is
that the price level must move down more
sharply than consumption moves up to pre-
serve equilibrium. In fact, if P and C are to
have continuous paths, equilibrium will re-
quire that the rate of change of expected P
and C both be differentiable functions of
time, even though the levels of P and C are
not differentiable. In other words, P and C
levels both adjust so quickly to their new
equilibrium levels that expectations of fur-
ther change in the same direction are not
justified. But suppose P is sluggish, moving
in the right direction for equilibrium but not
fast enough. Then an expectation of defla-
tion will emerge, demand for money will
increase faster than deflation is increasing
real balances, and real activity is likely to be
inefficiently depressed. In a pegged-M world,
good news about future consumption possi-
bilities, not accomodated by the monetary
authorities, paradoxically generates a defla-
tionary contraction.
A modified nominal interest rate-pegging
policy is possible. Fixing a constant nominal
interest rate of po converts (10) to
(12) po=ft+?Et Pt/pt
This equation does not yield a determinate
value for the current price level. However, if
the nominal rate is even slightly responsive
to the price level, so the rate is set at, say
po + aP, with a positive, the price level is
determinate. It is a function of the condi-
tional distribution of future capital stocks
and once again has nondifferentiable sample
paths.
An interest rate pegging policy forces the
price level to anticipate future levels of real
returns to capital, while an M-pegging policy
requires the price level to anticipate the gap
between the value of the services of real
VOL. 73 NO. ? MACROECONOMICS: MAJOR ISSUES AND DEVELOPMENTS 231

balances and the real return to capital. It is
not clear a priori which is likely to produce a
more erratic time path for the price level.
The model from which these conclusions
are derived is special in some respects.
Monetary policy could have real effects
without the occurrence of disequilibrium if
motivations for holding money are not well
represented by separable utility, which they
probably are not.
The time separability of the utility func-
tion in the model, though conventional, may
not be realistic. The delayed response of
output to surprise changes in the interest rate
which appears in empirical work described
later in this paper and elsewhere would be
easier to explain if instantaneous utility
depended on the first and second derivatives
of consumption as well as on its level (see
Alfonso Novales, 1982). If this were true,
consumption would no longer be locally un-
predictable. However, the denominator in
(10), instead of moving directly with C, would
instead move directly with the highest-order
derivative of C entering the utility function,
which would remain locally unpredictable.
To change the model's conclusions about the
short-run volatility of M under a price-peg-
ging policy would require introducing some
kind of inertia in holdings of money bal-
ances. But the costless adjustability of money
balances is one of their principal distinguish-
ing characteristics.
across economic agents, a phenomenon not
present in the models of this paper. A ra-
tional expectations monetarist perspective
makes large unpredictable movements in the
money stock evidence of bad monetary
policy, and it implies that if the money stock
could be made to grow in a smoothly pre-
dictable way, real fluctuations would be
smaller.
Some monetarists accept the possibility
that much or most variation in M is passive
response of the money stock to business con-
ditions, but argue that cyclical fluctuations
in output would nonetheless be reduced if M
were kept more stable. We do not have equi-
librium models which explain why this should
be so, but it is not an untenable view.
III. Statistical Evidence
Table 1 shows standard deviations of an-
nual changes in the log of the industrial
production index and standard deviations of
the change in the log of the money stock for
five large, wealthy countries and two ap-
proximate decades (1960-70 and 1971-82).
There is no relation across countries, and the
two countries which reduced money volatil-
ity, France and the United States, showed
the largest increases between decades in pro-
duction volatility.
To retain the opinion that policy-induced
reduction in the variance of annual rates of

II. MonetaristAlternatives
TABLE 1-MONEY GROWTH VARIABILITY AND OUTPUT
VARIABILITY ACROSS DECADES AND COUNTRIES
The model in the preceding section is one
in which a strong statistical relation between 1971-82 1960-71
fluctuations in money and future output
0M 1alp aM ?IP
fluctuations exists, yet stabilizing the rate of
growth of money will not reduce fluctuations United States .0151 .0795 .0185 .0426
in output. The most explicit monetarist alter- United Kingdom .0557 .0642 - -

native is the recently influential rational ex- Germany .0422 .0682 .0247 .0638
France .0281 .0564 .0516 .0328
pectations version of monetarism. This view .0707 .0447 .0462 .0440
Japan
insists that unpredictable shifts in the money
stock are primarily generated by random Notes: All data are from OECD Main Economic Indi-
policy decisions, not systematically related cators. Listed statistics are standard errors of changes in
to contemporaneous private-sector develop- logarithms taken over June-to-June 12-month intervals,
ments. As represented in the work of Robert except that for France, because of the drastic effect of
political disturbances on June production during two
Lucas (1972) and others, models supporting summer months of the 1960-70 period, January-to-
this version of monetarism depend on intro- January changes were used for both M and IP for that
ducing persistent informational asymmetries period.

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232 A EA PAPERS AND PROCEEDINGS
growth in money stock would reduce the
variance of the rate of growth of output, one
evidently has to interpret these data with
some sophistication. It could be that there
has been little policy-induced difference in
M volatility across these countries or peri-
ods. Yet since there has been substantial
variation of actual M volatility, the conclu-
sion must be that much of M volatility is due
to the influence of things other than policy.
If these other influences are developments in
the private sector, it suggests the importance
of modeling why money responds to these
influences before concluding that eliminating
the responses would be a good idea. If these
other influences are simply measurement er-
ror, then doubt is cast on the reasonableness
of basing policy on targeting a variable so
poorly measured.
Lucas's 1973 paper on the Phillips curve, it
might be noted, made a point very similar to
that being made here. He observed that vari-
ance of inflation rates bore no relation, in his
international cross section, to variance in
output; this suggested that policy-induced
changes in inflation did not produce changes
in output. I am making the same point with
money stock in the role of prices.
Rational expectations monetarist models
do conclude that it is not variation in the
money stock itself which generates business
cycle fluctuations, but unpredictable varia-
tions. One could imagine that the countries
with large variances in the annual rate of
growth of money stock nonetheless have more
of that variance predictable than in the coun-
tries with smaller money volatility and large
output volatility. This would lead to the con-
clusion, though, that targets for the rate of
growth of money stock which vary a lot from
year to year are as often associated with
more predictable money stocks as not.
This paper's model has no difficulty ra-
tionalizing substantial changes in M volatil-
ity with the absence of associated changes in
output volatility. Changes in monetary policy
in this model leave the equilibrium stochastic
process for output unchanged, yet could well
have large effects on money volatility.
Even the within-country predictive rela-
tion of MI to output is inconsistent across
countries. As I (1980a, 1982) and Robert
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MAY 1983
Litterman and Laurence Weiss, among oth-
ers, have pointed out, the Granger-causal
priority of money stock to output, which
emerges strongly in money-output-price sys-
tems fit to postwar U.S. data, is much weaker
in those data when interest rates are intro-
duced into the system. Furthermore, results
prepared for this paper (available from the
author) are consistent with the conclusion of
Michael Darby and James Lothian, using a
different statistical approach, that in most
countries, other than the United States, a
relation of surprise movements in the money
stock to real output is harder to discover.
IV. Conclusions
The matching of theory with evidence in
this paper has been informal. Models of en-
dogenous money of the type presented in the
first part of this paper are difficult to esti-
mate directly. Work now underway by
Novales suggests that more formal testing of
these models against data is possible, how-
ever, and he has constructed stochastic equi-
librium models in which interest rates are
dynamically related to output in the way that
actual interest rates are in the systems esti-
mated in this paper.
Despite the need for further work in this
direction, the weight of evidence against the
rational expectations monetarist view of the
origin of the business cycle seems quite
strong. There is little consistency across
countries or time periods in the relation of
money volatility or of money surprises to
production. In all countries, money stock
and output move smoothly together, money
slightly in the lead, after interest rate
surprises. That it is precisely these smooth,
predictable joint movements in production
and money which account for most of the
correlation of those two variables seems to
contradict the rational expectations monetar-
ist position.
A monetarist view that accepted the endo-
geneity and predictability of money stock
fluctuations, but argued that better results
would be achieved if the authorities prevented
these fluctuations, does not conflict as
sharply with the evidence as does the ra-
tional expectations monetarist position. It is
VOL. 73 NO. 2 MACROECONOMICS: MAJOR ISSUES AND DEVELOPMENTS
hard to see, from this point of view, why
prices if anything tend to increase following
interest rate increases, while money de-
creases. If the authorities are paying too
much attention to stabilizing nominal inter-
est rates, one would expect a different result.
That the cross-country and cross-decade
relations of money and production volatility
are so weak seems incompatible with any
version of monetarism which leads to a policy
conclusion that we should focus policy on
stabilizing annual growth rates of the money
stock.
The conclusion then is that there is proba-
bly no monetarist business cycle. Of course,
that is not the same thing as saying there is
no influence of monetary policy on the busi-
ness cycle.
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Litterman,Robert and Weiss, Laurence,"Mon-
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