Customer Reviews

Monetary Theory and Policy

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This is the best book length treatment of the state of the art in academic thinking about inflation and central banking, a lot of what economics is about to lay people and politicians. While this is a graduate text in macroeconomics, in no way is it unnecessarily abtruse. You'll need to be comfortable with little more than algebra, linear difference equations, and the sort of elementary statistics practical economists do. Amazingly, this book has no obvious competitors because first rate economists wrongly disdain writing books.

If this book were a car, its selling would long have been forbidden! The "typos and corrections" offered by Carl E. Walsh's homepage have by now reached 10 pages. Chapter 6.5 "A Basic Open-Economy Model" has this way been completely revised by the maître. So, in case you are determined to read this book, start with a download of those typos and corrections! The publisher does not give the slightest hint of this problem within the book (Maybe, because the standard "errata-note" would have become an "errata-booklet"). This is really annoying, since you may lose a lot of time by trying to understand mathematical derivations, which are simply wrong. Weak consolation: the "typos and corrections" of Michael Woodford's supposed to be classic "Interest and Prices" sum up by now of 8 pages (Or should we say 38 pages, since "certain equations" of Woodford's chapter 5 are corrected in a separate paper? Unfortunately, I'm not kidding). However, Walsh's book does also suffer from contents-related problems: Throughout the book he derives all results based on the social planner solution of his models. He never even discusses the problem of this approach in the presence of the "wedge of inefficiency" that the usage of money can introduce in such models (Lucas, 1987, Models of Business Cycles). So after having yourself worked through Walsh's book and his typos and corrections, you cannot be sure that the conclusions and policy recommendations he draws will also hold for the market solution of his models.

This book deals with most of the modern monetary theory issues. Eventhough it clearly says it is written for graduate students, undergraduate ones with good algebra and calculus levels could accomplish the basic acknowledgement of the book. The second edition has been improved a lot as I see it. Bonds have been added to the agent's budget constraint. This is very helpful for the interpretation of the first order conditions. Chapter 4, mainly the first part was rewritten in a most comprehensible way. There are a few things to highlight about the dark sides: In chapter 3, Professor Walsh did not include bonds in the budget constraint which would have been really useful. Besides there are a few mistakes in the appendix regarding the expected values. Chapter 7, "Macroeconomic Implications" is not very clear which assumptions have been made to approximate around the steady state. Despite there are still a few little mistakes, the book is excellent, I guess the best in Monetary Theory and Policy. Totally recommendable!!!

This book provides a good grounding on monetary theory and the questions it wants to answer. It is easy to follow whilst providing covering most recent development. Its only drawback is that it uses the HP filter as the benchmark which any model should replicate, without accounting for the fact that there are several problems with that filter.

This great book helped me to get a better understanding of modern monetary theory, and so I thought I'd make a few comments on that, perhaps couched in easier to understand language and more mundane examples than in this much more sophisticated and technical book.

Basically, the question is what really is the value of money in a country's economy, and how do fluctuations in the value of the currency and the amount of the currency in circulation affect the overall economy? That might seem simple at first, but consider the following.

You may know the story of the hyperinflation that occurred in Germany in the post-WWII years. Germany was saddled with some serious war debts and reparations, and so the government started printing money in order to pay them off. There's even some suspicion that they did this deliberately in order to pay them off faster with inflated dollars, which royally annoyed the French, who were basically getting stiffed. Very sneaky, if true. And clever--if you can make it work. However, it's also very risky, because there are few things more ruinously inflationary than the government printing money, and eventually those pigeons usually come home to roost, which they did in the case of the German economy with a vengeance. So the situation got out of control, and soon it almost took wheelbarrows full of money to buy a loaf of bread.

However, the most interesting thing is how the German monetary authorities stopped the hyperinflation and got things back to normal. What they did was start buying back the worthless paper Deutschemarks with gold. This reduced the supply of Marks, and when people saw that they could get real gold for the paper money, they cashed in in droves. Eventually, the German Deutsche Bank, basically their Federal Reserve, pulled enough money out of circulation to get the inflation under control.

This brings up the interesting question of whether one needs gold backing for your currency. Well, in the modern world, it's no longer necessary, since countries like Japan have very little gold backing for their currency, and yet the Yen is one of the so-called "hard currencies." Contrast that with the former Soviet Union, which at least in the past had a lot of gold backing for their currency, and yet it wasn't worth much. What really determines the value of your currency in the modern international economy is it's value on the international monetary exchanges, which is basically what people will pay to buy it in order to buy your goods and exports and so on, and to do business with you, not how much gold backing it has.

But getting back to the German situation, something very similar happened here back in the early 80s when the prime interest rate hit 21%, because the government was printing money due to the Vietnam war and the deficit spending of the late 60's and 70's. With that level of inflation per year, funny things start happening. For example, it's in the interest of capital-intensive industries or businesses requiring large on-hand inventories-- such as retail stores or firms selling big-ticket equipment items and so on--to buy as much inventory as possible on credit, and then to pay the debt off with increasingly inflated dollars, which reduces your overall cost-- essentially, not so different from what the Germans were doing.

This might sound strange since you're talking about the "price" or cost of money and how inflation affects it, but inflation has the interesting effect of making future money payments less expensive to the borrower, so they have a vested interest in loading up on goods on credit and then paying it off over time. The longer the horizon or loan term the better they make out as long as inflation continues.

In other words, with inflation running at 21%, in two years, the business paying back the loan gets a 42% discount on their cost of capital, assuming the interest rate is fixed, which is usually the case in business loans or at least businesses with good credit. Of course, lenders such as banks and savings and loans know about these tricks but surprisingly, there's very little they can do to hedge and protect themselves. This is one reason so many savings and loans went out of business back in the 80's.

Now all of this might make inflation sound like the ultimate economic evil, but actually, and here's another odd fact about monetary economics--the reverse situation is actually worse--which is known as deflation. Recessions usually don't go into serious deflation, but a real bona fide depression will. This is what is really happening in a depression.

In the case of a serious depression or deflationary spiral, the money supply contracts to the point where the total amount of money circulating isn't enough to keep the economic wheels of the country greased and operating smoothly thru what is known as the bank reserve ratio and negative multiplier effect. In other words, there is a systemic shortage of liquidity. Unfortunately, this situation is extremely difficult to correct, much more so than the inflationary situation.

That's because with interest rates falling and/or very low, no-one has any incentive to lend dollars since, as in the case during the Great Depression, banks get their money from private depositors, and with banks failing, and interest rates at almost zero, no one has any incentive to put the money in the bank if the bank might fail, or if the business that took out the loan could go bankrupt and fail, as many do during depressions. So people stuff it in the proverbial mattress. Hence, there's no money to lend, and so businesses which depend on loans and outside financing (which is about 99% of big and medium size businesses in the U.S.) can't get the money to operate and the economy grinds to a standstill. The government can even print all the money it wants, but nothing happens, since the prime lenders don't want to borrow the money at the so-called Federal Reserve Discount Window and pass it on to borrowers and risk losing it for some measly return and interest rate. In other words, the risk/reward ratio just isn't worth it.

To give you a better perspective on this, I can give you a fascinating fact. The average person tends to think of the stock market as synonymous with the overall economy, because it gets all the press and publicity, and that's true to some extent, but the truth is the bond markets operating behind the scenes which get much less press and attention (well, bonds are pretty boring compared to stocks) are actually ten times the size of the stock market and have a much greater impact than even the stock market on the overall economy. With no money to lend for loans and bonds, the economy grinds to a stop, until someone like the government "primes the pump" to restart it, the policy mechanism that the great economist, John Maynard Keynes, became famous for explaining, among other things. That's what happened back in the 1930's, but we really had to wait for the huge government spending of WWII to turn the situation around.

So during deflation, money is tight and scarce, but the value of the currency keeps going up--just the reverse of inflation. So those who have money have more than they had before. But since deflation causes serious unemployment and underemployment and poverty, most people don't have excess dollars, so they're still poor. So you just can't win. That's why economics is sometimes called "the dismal science." :-)

If this all sounds strange, just think of what happens with a resource or a commodity when there's a shortage of supply--such as with oil right now--it goes up in price, right? That's just normal supply and demand. Same thing in deflation. With a shortage in the supply of greenbacks, the value goes up just like in the case of any material good, except it's confusing to think of lots of money causing a lack of purchasing power as in the case of inflation, and a lack of money creating more purchasing power as in the case of deflation. In practical terms, the dollar's worth more--but no-one is spending them! Hence, paradoxically, money is worth more in a stagnant economy where no one has any incentive to spend it. You might wonder how something can be worth more when no one wants it, since, in most cases, what determines the value of something is the demand for it, but this is where monetary theory parts with normal intuition and common sense about how supply and demand should work, and that's just the way it is.

Anyway, that's not a bad little summary of monetary economics. If you understand that you actually have most of the important points. As you can see, it's strange stuff in some ways, but fun once you get the hang of it since it is powerful and explains some puzzling issues.

This book is helpful in understanding the current theories and practices in monetary theory and policy. The only thing that could make this book complete is to include overlapping generations models in the theories that prevailed during the last two decades.

i like this book..
Good detail, easy to understand, and nice examples..
well written... for all readers...
You even get to read a little about Mr. B.B.

If you want to find the book about the theory of monetary or finance, this is the one you should have it.

One of the best books about Monetary Theory and Policy.