But it’s less obvious, at least to me, what macroeconomic developments I should expect if risk premia rose due to an “exogenous” rise, say due to reduced market making, in the volatility of asset prices. We also need to be able to make sense of shifts in relative risk premia on different asset classes. We need models that can say something useful about the compression, and then widening, in credit and liquidity risk premia that in some ways define the current financial turmoil. We need to know whether or not those shifts reflect changes in fundamentals, or unwarranted “exuberance” or “fear” in the markets; and whether or not they have implications for demand and supply conditions in the real economy. Second, very little has been said about how, or whether, the supply of money (or monetary policy) may affect risk premia. Years ago Brunner and Meltzer set out a view 20 of how shocks to the supply of base money were transmitted to the economy through effects on asset prices over and above the impact on the risk-free discount rate, but through liquidity (and maybe other risk) premia. More recently, some policymakers, 21 have conjectured that swings in the supply of broad money (via bank lending) can be associated with shifts in risk premia too. The thought is that in a world in which different assets are not perfect substitutes for each other, whether money is over or under-supplied can affect the relative value of other financial assets.
But there is no denying an adverse feedback loop between tightening credit conditions, the macro slowdown, and the perception that that will in time impair banks’ asset portfolios. So it seems timely to revisit some of the issues of “money and credit”. The Taylor-rule framework for thinking about policy It is well over a decade since John Taylor set out what has become part of the current orthodoxy of monetary economics. His rule looks something like this: *  *  *  i = Π +r + a(Π – Π ) +b(y -y ) t t t t t t t This is, at its roots, a Wicksellian view of the world. 4 By fixing the short-run nominal rate, the central bank can, given stickiness in prices over the short run, shift the short real interest rate – both in absolute terms and, more particularly, relative to the short-run real rate that would equilibriate demand and supply. 5 So that gap between the short real rate and its “equilibrium” can be thought of as representing the stance of monetary policy, which should be chosen by the central bank in the light of the extent to which inflation deviates from target, and to which aggregate demand deviates from the supply capacity of the economy. Implicit in this rule is  3  See Tucker, PMWT (2008) “ Money and credit: banking and the macroeconomy”, Bank of England Quarterly Bulletin, 2008 Q1 pp 96-106. 4  See Wicksell, K, 1898, “Interest rates and Prices”.