Direct effects of base money on aggregate demand: theory and evidence

Meltzer (The transmission process. In Deutsche Bundesbank (ed.), The Monetary Transmission Process, 2001) shows that real monetary base growth is a significant determinant of consumption growth in the US, controlling for the short-term real interest rate. In this paper, I show that the same property of base money holds for total output (relative to trend or potential) in both the US and the UK. The standard optimizing IS-LM model cannot account for this result, but I show that it can once the long-term nominal interest rate is included in the money demand function. Because the long-term real rate matters for aggregate demand, the presence of the long-term nominal rate in the money demand function increases the effect of nominal money stock changes on real aggregate demand when prices are sticky. (C) 2002 Elsevier Science B.V. All rights reserved.