09 - Josh Hendrickson on Measuring Money in the Economy

Episode Summary

Executive Summary: Josh Hendrickson argues that money still matters for macroeconomics, but it has been obscured by poor measurement and weak theory. He defends Divisia aggregates over simple-sum measures, links monetary instability to crises like the Great Recession, and favors models that generate money from microfoundations such as search and exchange frictions rather than ad hoc utility or constraint devices.

Main Topics: How Hendrickson entered macroeconomics (Priority: 3/5): He became interested in macro after learning about the Great Depression and the Friedman-Schwartz money-supply explanation, which challenged conventional stories and sparked his focus on monetary economics. Social media, blogging, and academic life (Priority: 3/5): Hendrickson sees blogging and Twitter as tools for learning, debate, networking, and branding, while also emphasizing the need to pause online activity when research demands it. Why money disappeared from mainstream macro (Priority: 5/5): The profession moved away from money because empirical studies using simple-sum aggregates often found little predictive power for inflation or output, encouraging model builders like Woodford to abstract from money. Divisia aggregates vs. simple-sum money (Priority: 5/5): He argues that Divisia measures, which weight assets by liquidity/user cost, better capture the economic services of money and overturn many findings that money is irrelevant. Reassessing monetary policy and the Great Moderation (Priority: 4/5): Hendrickson contends that stability in nominal GDP growth better explains the Great Moderation than Taylor-rule inflation responses alone, and that policymakers effectively responded to nominal spending growth. The Great Recession and shadow-banking money (Priority: 5/5): He views the crisis as a collapse in broad, transaction-relevant money—especially safe assets used in repo and shadow banking—leading to a sharp fall in nominal spending. Problems with standard money-in-the-model approaches (Priority: 5/5): He criticizes money-in-utility and cash-in-advance models for treating money as a friction or extra constraint, then promotes monetary search models as more realistic microfoundations.

Key Arguments: Simple-sum monetary aggregates are theoretically weak because they assume perfect substitutability among assets; Divisia aggregation is grounded in standard demand theory and liquidity differences. The failure of money to predict inflation/output in older empirical work may largely reflect mismeasurement, not irrelevance of money itself. Using Divisia aggregates, Hendrickson finds that money growth predicts inflation, real money balances predict future output gaps, and money demand is stable over long periods. Broad monetary indicators should be used as intermediate guides for policy, especially when the ultimate target is nominal GDP, which is only observed quarterly. Velocity instability in the 1980s may be an artifact of poor aggregation and financial innovation rather than a genuine breakdown in money demand. The Great Moderation can be interpreted as a shift toward more stable nominal GDP growth and more systematic policy responses to nominal spending pressures. The Great Recession was driven in part by a collapse in the value and liquidity of safe assets used as transaction media in shadow banking, causing a contraction in broad money. Money-in-utility and cash-in-advance models do not properly explain why money exists or why different monetary assets coexist; search models better capture these mechanisms.

Data Points: Great Moderation period: Early 1980s to 2007 - Described as a time of relatively stable macroeconomic outcomes and mild recessions. Conventional monetary aggregate used: M2 - Referenced as the textbook/simple-sum aggregate still commonly taught and downloaded from FRED. Broad Divisia measures mentioned: M3 and M4 - Center for Financial Stability aggregates extend beyond standard retail money to include instruments used by institutions. Policy regime comparison: 1970s vs. post-Greenspan era - Taylor-rule estimates differ markedly across these periods in the standard literature. Data frequency: Quarterly nominal GDP - Used to justify why monthly Divisia aggregates can be helpful as intermediate indicators. Conference venue: Annual Chicago Fed conference - Noted as a gathering focused on monetary search models. Time period: Early 80s - Money market mutual funds were added to aggregates, creating spikes in simple-sum money measures. Time period: Past 20 years - Hendrickson notes a large rise in institutional demand for safe assets and repo-like money instruments.

Pivotal Quotes: ""there's no money in monetary policy, so there is no money in monetary policy"" — David Beckworth: Summarizing the profession’s tendency to model policy without monetary aggregates. ""money is not helping us to predict fluctuations in output"" — David Beckworth: Describing the empirical findings that helped push money out of mainstream macro models. ""money growth did predict inflation"" — Josh Hendrickson: Summarizing his Divisia-based reappraisal of earlier empirical work.

Implications: The conversation suggests policymakers and researchers should pay more attention to broad, liquidity-adjusted money measures and to models that explain how money is created and used. Ignoring measurement errors and shadow-banking money can lead to weak policy signals and poor crisis diagnosis.