As an explanation for the inflation we’ve experienced I think this fits the actual data better than the single fact of strong household money growth during the pandemic. It’s always possible, at least with the benefit of hindsight, to construct an alternative path for monetary policy over the past that would have kept inflation on target, even in the face of these subsequent shocks. But that’s not the same thing as saying that the actual policy was “inevitably” going to result in excessive inflation. Simulations suggest that, had that alternative (much tighter) policy path been followed, and then had Russia failed to invade Ukraine, inflation would now be materially below target. Anyhow, what follows is a walk – rather a long walk, I’m afraid – through these various points. Less ink is spilled on the second question, concerning QT: should the MPC not include in its forecasts some identifiable and separate effects of asset sales on activity and inflation? Having argued that the policy is transmitted to demand and inflation largely via asset prices my answer to this will be “no”. The Committee has said that the size of the Asset Purchase Facility (APF), the vehicle through which QE and QT are conducted) will be reduced gradually and predictably and, to that end, announced last September the exact planned reduction of the APF over the following twelve months. As such, it’s reasonable to suppose that the impact of QT, even in prospect, is already captured in the prices of assets on which we condition our forecasts.
The implication would be that central banks can control broad money more or less directly and as precisely as they do their own balance sheets. In practice, however, as we saw in the introduction, the two have behaved rather differently. I’ll discuss this more fully in a moment. Monetarist objections to IS-LM None of this is fatal for IS-LM. The model can be adapted and expanded to accommodate some of these complications. And, during the debates about inflation control in the 1960s and 1970s, most economists – of all persuasions – would have accepted that Chart 7 captured an important part of the transmission of policy (open-market operations, at least). But the “monetarists” raised a deeper objection – and it concerned precisely this assumption that an increase in the supply of money worked only by lowering the level of interest rates. They argued that it could also affect spending more directly. In essence, if one is at least to preserve the language of the model, their point was that a rise in the supply of money – broad money at least – should shift not just the “LM” curve to the right but the “IS” curve as well (Chart 8). Chart 8: Monetarists argued that money affected spending directly, not just via interest rates and asset prices  Imagine something like Friedman’s “helicopter drop” – a sudden, windfall addition to everyone’s bank account. On its own, if nothing else happened, this would push up household wealth (the “W” term in [1]).