Divorcing Money from Monetary Policy

Monetary policy has traditionally been viewed as theprocess by which a central bank uses its influence overthe supply of money to promote its economic objectives. Forexample, Milton Friedman (1959, p. 24) defined the tools ofmonetary policy to be those “powers that enable the [FederalReserve] System to determine the total amount of money inexistence or to alter that amount.” In fact, the very termmonetary policy suggests a central bank’s policy toward thesupply of money or the level of some monetary aggregate.In recent decades, however, central banks have moved awayfrom a direct focus on measures of the money supply. Theprimary focus of monetary policy has instead become the valueof a short-term interest rate. In the United States, for example,the Federal Reserve’s Federal Open Market Committee(FOMC) announces a rate that it wishes to prevail in the federalfunds market, where overnight loans are made amongcommercial banks. The tools of monetary policy are then usedto guide the market interest rate toward the chosen target. Forthis reason, we follow the common practice of using the termmonetary policy to refer to a central bank’s interest rate policy.[...]