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Faculty of Economics

Friday, 21 April, 2023

Professor Vasco Carvalho has picked up on Milton Friedman’s famous dictum concerning ‘long and variable lags’, that monetary actions affect economic conditions only after a lag that is both long and variable, for example with a rise in interest rates.

However, in the new research Carvalho and Professor Corsetti who was previously in the Faculty, plus co-authors Gergely Buda, Joao Duarte, Stephen Hansen, Afonso Moura, Alvaro Ortiz, Tomasa Rodrigo, José Rodríguez Mora and Guilherme Silva debate that monetary policy’s identified long lags do not rule out it also having short-run effects.

Among academics, decades of research have shown that the transmission mechanism of monetary policy is complex and plays out over multiple channels that unfold at medium and long horizons.

Therefore, to look at the short term effects the Janeway Institute Working Paper’s authors look at three novel daily-frequency measures of economic activity for Spain, including daily consumption, daily corporate sales, and daily employment.

They note that the effects of monetary policy shocks can be detected already in a matter of days, and that total household consumption begins to decline five days after a contractionary monetary policy shock.

Professor Carvalho says that “60 years ago, when the influential long and variable lags dictum came about, Friedman was working in a relatively data-poor environment, with sparse and infrequent data. However, we can now use much more granular data than was available in previous decades, and we can see that monetary policy shocks affect spending very much in the short term. For example, there is a significant impact in more durable and luxury goods, such as transport, restaurants and hotels, compared to essential goods such as food, communication and health, and that more downstream sectors such as wholesale and retail trade react more quickly to monetary policy shocks than more upstream sectors such as energy and construction.”

He adds “Importantly, we also find that when researchers and policy makers have access to only infrequent data - say quarterly - they, like Friedman early on and many since, will only find effects of monetary policy at long lags. So, what is really at stake here is that the lack of granular high frequency data on key outcomes - like aggregate consumption, gross output or employment - is consequential for both researchers and policy makers and may distort their conclusions.”

Vasco Carvalho is Professor of Macroeconomics in the Faculty of Economics at the University of Cambridge, and a Fellow of Jesus College. Professor Giancarlo Corsetti was previously at the Faculty of Economics, and is the Pierre Werner Chair at the European University Institute, and a Fellow of Clare College.

Read the research:

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