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Updating Friedman: monetary policy also has short-run effects

College Fellow and Acting Director of Studies Professor Vasco Carvalho is a co-author of a paper published in VoxEU which examines the short-term effects of changes to monetary tightening and finds that it does have notable impacts in the short term.

Vasco has picked up on Milton Friedman’s famous dictum concerning ‘long and variable lags’: that monetary actions affect economic conditions only after a lag that is both long and variable, for example with a rise in interest rates.

However, in the new research, Vasco and his team debate that monetary policy’s identified long lags do not rule out it also having short-run effects.

Among academics, decades of research have shown that the transmission mechanism of monetary policy is complex and plays out over multiple channels that unfold at medium and long horizons.

Therefore, to look at the short-term effects, the Janeway Institute Working Paper’s authors look at three novel daily-frequency measures of economic activity for Spain, including daily consumption, daily corporate sales, and daily employment.

They note that the effects of monetary policy shocks can be detected already in a matter of days, and that total household consumption begins to decline five days after a contractionary monetary policy shock.

Vasco said: “60 years ago, when the influential long and variable lags dictum came about, Friedman was working in a relatively data-poor environment, with sparse and infrequent data. However, we can now use much more granular data than was available in previous decades, and we can see that monetary policy shocks affect spending very much in the short term.

“For example, there is a significant impact in more durable and luxury goods, such as transport, restaurants, and hotels, compared to essential goods such as food, communication, and health, and that more downstream sectors such as wholesale and retail trade react more quickly to monetary policy shocks than more upstream sectors such as energy and construction.”

He added: “Importantly, we also find that when researchers and policy makers have access to only infrequent data - say quarterly - they, like Friedman early on and many since, will only find effects of monetary policy at long lags.

“So, what is really at stake here is that the lack of granular high frequency data on key outcomes - like aggregate consumption, gross output, or employment - is consequential for both researchers and policy makers and may distort their conclusions.”

You can read the research here.

This is based on an article originally published by the Faculty of Economics. It is reproduced under a Creative Commons Attribution 4.0 International License.