The Channels of Monetary Effects on Interest Rates
In this study Phillip Cagan clarifies and analyzes two old theories in monetary economics, the credit and quantity (portfolio) theories of money. These two traditional views of the channels of monetary effects are examined both theoretically and empirically. Although their differences have often been blurred in the literature, these two approaches to monetary theory and policy imply two different patterns of monetary effects on interest rates. In this volume, the differences are emphasized so that their separate roles in monetary disturbances can be tested.
A statistical analysis is developed to test the two theories by studying their implied effects on interest rates. Interest rates are regressed on two variables representing two sources of monetary growth, one associated with credit expansion of the monetary system, the other with all other components of monetary growth such as gold flows and Treasury budget deficits financed by creating money. The regression of interest rates on these two main sources of monetary growth indicates the extent to which each on accounts for the inverse association.
The results of these regressions show that the portfolio effect accounts for most of the association. The credit effect is not usually statistically significant when measured separately while the portfolio effect uniformly proves so. However, when taken all together, these estimates provide tentative evidence that the credit effect has a separate existence.
The author notes that "the first-round effects of money creation associated with an expansion of credit are but the tip of an iceberg." He finds that the initial impact of particular financial markets is outweighed by the subsequent rounds of portfolio adjustments, and that monetary growth produces and effect on interest rates no matter how the new money is created. Therefore, the effects are not confined to particular markets, but range widely throughout the economy.