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Employing a model of the Walrasian or Arrow-Debreu economy to rescue underdeveloped monetary theory has in the past led to fundamental conceptual confusions. For example, if the medium of exchange function is introduced, via a cash-in-advance or in-arrears constraint, money appears to be a welfare reducing innovation or a friction when history and common sense tells us that money was a welfare enhancing innovation that helped to reduce the frictions of barter. | Federal Reserve Bank of Minneapolis Research Department Interest Rates and Inflation Fernando Alvarez Robert E. Lucas Jr. and Warren E. Weber Working Paper 609 January 2001 Alvarez The University of Chicago Lucas The University of Chicago and Federal Reserve Bank of Minneapolis Weber Federal Reserve Bank of Minneapolis. We would like to thank Lars Svensson for his discussion Nurlan Turdaliev for his assistance and seminar participants at the Federal Reserve Bank of Minneapolis for their comments and suggestions. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. 1. Introduction A consensus has emerged about the conduct of monetary policy that now serves as common ground for discussion of the specific policies called for in particular situations. The central elements of this consensus are that the instrument of monetary policy ought to be the short term interest rate that policy should be focused on the control of inflation and that inflation can be reduced by increasing short term interest rates. For monetary economists participating in discussions where these propositions are taken as given would seem to entail the rejection of the quantity theory of money the class of theories that imply that inflation rates can be controlled by controlling the rate of growth of the money supply. Such a rejection is a difficult step to take because the systematic evidence that exists linking monetary policy inflation and interest rates and there is an enormous amount of it consists almost entirely of evidence that increases in average rates of money growth are associated with equal increases in average inflation rates and in interest rates. Under the quantity theory rapid money growth is the defining characteristic of monetary ease and it is associated with high interest rates as well as with high inflation. Evidence from the postwar period from the United States and elsewhere .
