1999 Chapters (Layout Features)

A Frictionless View of U.S. Inflation

Cochrane, John H.; Bohn, Henning; Woodford, Michael

From page 323 -- 'The standard, quantity-theoretic approach to the price level is based on a transactions demand for money. Financial innovation challenges the foundations of this monetary theory: More and more transactions are handled electronically or via credit and debit cards, while ATMs, sweep accounts, and banking by computer have a major influence on cash management. Meanwhile, a wide array of privately provided, liquid, interest-paying, and often nonreservable assets have been created, leaving the supply of transaction-facilitating assets beyond the Fed's control. The quantity theory has also not had much success in describing the history of postwar U.S. inflation: Inflation seems to have very little to do with the history of monetary aggregates or interest rates. Money demand relations are dominated by velocity shocks, unrelated to changes in financial structure. Recent inflation has been remarkably stable despite continuing financial innovation.
Motivated by these observations, I ask: Can we understand the history of U.S. inflation using a framework that ignores monetary frictions? Until recently, there was no coherent way to think about this question: some friction seemed necessary to determine any value for unbacked fiat money. Recently, however, a series of authors including Leeper (1991), Sims (1994, 1997), and Woodford (1995, 1996, 1997) have advocated a fiscal theory of the price level. The analytical content of the fiscal theory is just the government's intertemporal budget constraint, versions of nominal debt divided by price level equals present value of real surpluses.'