Monetary Policy and the Interest Rate: Reflections on Allan Meltzer's Contributions to Monetary Economics

Abstract

The monetary framework developed by Karl Brunner and Allan Meltzer emphasized the interaction between the supply and demand for money and the supply and demand for credit. In a general equilibrium setting, the money market and the credit market jointly determine the short term interest rate and the price level of real assets. Open market operations change the composition of assets and, in turn, the price level of real assets and the interest rate. The effect of monetary policy on real activity depends on both the change in the interest rate and the change in the price level of real assets. The Brunner-Meltzer model therefore emphasizes the role of changes in relative prices of financial and real assets in response to changes in monetary policy. In recent years, the Federal Reserve has moved to a system that uses the interest rate on reserves as the primary tool of monetary policy. In doing so, the Federal Reserve has implicitly accepted the idea that monetary policy is entirely transmitted through the short term nominal interest rate. In this paper, I present Brunner and Meltzer's view of monetary transmission and their critique of monetary models that exclusively focus on the interest rate. In addition, I argue that the lack of evidence in support of the interest rate channel in conjunction with the change in the Federal Reserve's operating procedures presents an opportune time to revisit the Brunner-Meltzer critique.