Comparison of Interwar and Postwar Business Cycles: Monetarism Reconsidered

When monthly data on production, prices, and the money stock are interpreted, via a vector autoregression, as generated by dynamic responses to "surprises" in each of the variables, a remarkable similarity in dynamics between interwar and postwar business cycles emerges, though the size of the "surprises" is much larger in the interwar period. Furthermore, the money stock emerges as firmly causally prior, in Granger's sense, in both periods and accounts for a substantial fraction of variance in production in both periods. When a short interest rate is added to the vector autoregression, the remarkable similarity in dynamics between periods persists, but the central role of the money stock surprises evaporates for the postwar period. While there are potential monetarist explanations for such an observation, none of them seem to fit comfortably the estimated dynamics. A non-monetarist explanation of the dynamics, based on the role of expectations in investment behavior, seems to fit the estimated dynamics better. That this explanation, which is consistent with a passive role for money, could account for so much of the observed postwar relation between money stock and income may raise doubts about the monetarist interpretation even of the interwar data.