If It Were A Snake, It Would Have Bitten You: Money In The New Keynesian Model

Abstract

The New Keynesian literature focuses on rules-based interest rate policies, abstracting from the role of monetary aggregates. In the background, though, the quantity equation must hold — every transaction requires money, with money units used in multiple transactions within a period. What is often overlooked is that imposing a rules-based interest rate policy is equivalent to assuming a particular money velocity specification. Using this alternative specification, we derive the efficient money supply rule and show that determinate equilibria exist with money supply policy and a fixed nominal interest rate. We estimate a New Keynesian model with either conventional interest rate policy or our money market reinterpretation of the model, accounting for the policy rate lower bound (PRLB). The money market estimates exactly match the PRLB duration in the data, whereas the conventional estimates fall short by four years.

Keywords: New Keynesian model, Taylor rule, velocity of money, money demand, quantity equation, optimal monetary policy, Bayesian estimation, policy rate lower bound

JEL Classification: E40, E50, E52