True or False?
It might well make sense for the central bank of a big country like the United States to maintain a constant rate of growth of the stock of liquidity, although that rate would have to be adjusted from time to time in response to changes in the rate of growth of the demand for liquidity---these changes could result from changes in the rate of output and real income growth or from changes in the underlying cost of holding a given stock of liquidity.
Unfortunately, however, there is no single measure of the stock of liquidity. What we observe are the stocks of base money, M1, M2 and sometimes M3, depending on the country. And, as was shown in Figure 1, the growth rates of these measures of liquidity differ significantly in variability and tend to be rather uncorrelated with each other. So which monetary aggregate should be made to grow at a constant rate? And how do we know that the aggregate so chosen is a good measure of the stock of liquidity in the economy?
While it therefore makes no sense to maintain a constant growth rate of a particular monetary aggregate, it does make sense to maintain stable monetary conditions that will produce an appropriate and constant rate of domestic inflation. To do this we need to look not so much as the year-over-year growth rates of the particular monetary aggregates but their trends and deviations from those trends. The desirability of this will become evident in the next Topic of this Lesson. Again, it is clear that central bankers need to use judgment rather than imposed rules. Any substantial deviations of both M1 and M2 in the same direction from their trends of the past few years should prompt an analysis of the reasons for these movements. In some cases it may be necessary to moderate or expand the growth of the stock of base money, which the central bank controls, to moderate or eliminate such deviations of M1 and M2 from their recent trends.
In the small open economy there is the further problem that significant discrete changes in base money may lead to undesirable overshooting changes in nominal exchange rates, so attempts to change the rate of base money growth must involve moving the nominal exchange rate up or down by an appropriate moderate degree for an interval of time. The problem the authorities then face is the difficulty of determining the extent to which observed movements of the nominal exchange are the result of their actions rather than consequences of independently occurring exogenous shocks to the underlying real exchange rate.