The Impact of Monetary Volatility on Investment in Classical and Keynesian Models: Theory and Evidence

Abstract

In the past several decades, monetary policy has gained increased popularity as a means for affecting the direction of the economy. For example, in the early 1980's the Federal Reserve's active intervention in the economy squeezed out the double-digit inflation; however, it also reduced Investment and produced a recession. Traditional Classical and Keynesian theories of Investment describe different factors which influence firms' investment decisions. These models do not account for the influence of monetary policy, beyond the direct effects of money supply shifts on interest rates. This paper describes a model for both theories which explains the indirect influence of monetary policy on Investment through its impact on uncertainty. When the central bank pursues an active monetary policy, it generates uncertainty about future interest rates and price levels, which indirectly depresses Investment, regardless of the direction of the policy. Data from 1967 on are used to examine the impact of monetary volatility. This period reflects increased monetary volatility due to external shocks and increasing activism on the part of the Federal Reserve. Both Investment theories are modelled to include the impact of monetary volatility, measured by percentage changes in M2. The regression results suggest that monetary volatility has a significant negative impact on Investment.