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Ben S. Bernanke

Alan S. Blinder

Working Paper No. 2534


Cambridge, MA 02138
March 1988

The research reported here is part of the NBER's research program in Economic Fluctuations. Any opinions expressed are those of the authors and not those of theNational Bureau of Economic Research.

NBER Working Paper #2534 March 1988


Money, and Aggregate Demand


Standard models of aggregate demand treat money and credit asymmetrically; money is given a special status, while loans, bonds, and other debt instruments are lumped together in a "bond market" and suppressed by Walras' Law. This makes bank liabilities central to themonetary transmission mechanism, while giving no role to bank assets.
We show how to modify a textbook IS-UI model so as to permit a more balanced treatment. As in Tobin (1969) and Brunner-Meltzer (1972), the key assumption is that loans and bonds are imperfect substitutes. In the modified model, credit supply and demand shocks have independent effects on aggregate demand; the nature of themonetary transmission mechanism is also somewhat different. The main policy implication is that the relative value of money and credit as policy indicators depends on the variances of shocks to money and credit demand. We present some evidence that money-demand shocks have become more important relative to credit-demand shocks during the 1980s.

Ben Bernanke Woodrow Wilson School Princeton UniversityPrinceton, NJ 08544

Alan Blinder Department of Economics Princeton University Princeton, NJ 08544

Whether or not they use the name, most macroeconomists use something
like IS/LM to organize their thinking about how various events affect

aggregate demand. No one boasts about the microfoundations of this simple model, no one Interprets it literally, and no one thinks It directly suitablefor econometric estimation. But its utility for telling simple yet coherent stories about the transmission of monetary, fiscal, and other shocks is evident. Furthermore, IS/LN analysis often does seem to describe what happens
to the economy, at least In a rough way.

Of course, any simple model may sometimes be too simple. A case in
point is the IS/LM model's asyninetric treatment of money andcredit. The LM curve treats money as a special asset while assuming that all debt
instruments can be lumped together in a "bond market,N which Is conveniently

suppressed by Wairas' Law. This approach makes bank liabilities central to
the monetary transmission mechanism, while giving no role to bank assets.

There are both theoretical and empirical reasons to question this asyninetrictreatment. A growing theoretical literature stresses the

importance of intermediaries In the provision of credit. According to this
alternative view, banks and other credit-granting institutions specialize in gathering Information and monitoring the performance of borrowers In ways that elude the anonymous auction market. Because they can finance activities that cannot be financed in the bondmarket, loans by banks and other Intermediaries acquire a special status. If financial Intermediation Is reduced, either by rationing or by price, aggregate supply and demand may be

affected.1 Empirically, the well—documented instability of econometric
money-demand equations, itself probably a product of deregulation and innovation by financial intermediaries, has reduced the utility of money as a1

measure of and guide to central bank policy. Finally, a series of papers by
Benjamin Friedman has argued that a particular measure of credit correlates

with nominal GNP as well -—


as badly -- as money does. All of this

suggests that the traditional focus on money may be inappropriate. However, credit will not mount a serious challenge to money as a
transmission mechanism...
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