Question: Define and Describe Monetary Analysis and Real Rate of Interest?

Monetary Analysis
The monetary analysis focuses on a longer-term horizon than the economic analysis. It
exploits the long-run link between money and prices. The monetary analysis mainly serves as a
means of cross-checking, from a medium to long-term perspective, the short to medium-term
indications for monetary policy coming from the economic analysis.

Introduction
These days, few economists would disagree with the statement that inflation is a monetary
phenomenon in the long run. Indeed, this statement is one of the central tenets of economic theory.
The long-run relationship between money and prices has been confirmed by an impressive number
of empirical studies, both across countries and across time. Moreover, the ability to implement
monetary policy ultimately hinges on a central bank’s monopoly control over the creation of base
money. Given the fundamental money-prices relationship and their monopoly power over the legal
tender, the monetary authorities have a natural interest in monetary developments. At a more
practical level, monetary data are collected in a timely manner and are more accurate than many
other economic indicators. All these factors explain why money plays a prominent role in monetary
policy-making and thus why the monetary analysis undertaken at central banks is both necessary
and important.

Explanation
The monetary policy recognizes the monetary nature of inflation by assigning a prominent
role to money in the formulation of monetary policy decisions aimed at the maintenance of price
stability. This prominence is signaled by the announcement of a quantitative reference value for
the growth rate of the broad monetary aggregate. A detailed analysis of monetary developments
with the aim of extracting the information relevant for monetary policy decisions represents the
first “pillar” of the monetary policy strategy. Among other things, this analysis includes an
investigation of the deviation of monetary aggregate growth from the reference value. Monetary
analysis begins with the very definition of a key monetary aggregate. As such, this aggregate has
the properties required to define the reference value and thus to signal the prominent role of money
in monetary policy. To a large extent, monetary analysis represents the analytical work necessary
to determine from the available monetary data the underlying relationship between money
Foreword. Monetary developments may be subject to a host of special influences and distortions
which render the relationship between money and prices complex in the short run. This analysis is
demanding, since it requires both a strong command of economic theory and a detailed knowledge
of the institutional environment. In particular, monetary analysis should always encompass a close
monitoring of financial innovation as this may affect the fundamental relationship between money
and prices.
 Monetary analysis can provide many kinds of information. Used as an indicator, monetary
developments may signal risks to future price stability. Furthermore, monetary analysis may also
be useful to monitor (and possibly offset) macroeconomic risks which are not directly related to
price stability, but which may nevertheless have important consequences. For instance, historical
experience has shown that booms and busts in capital markets, often associated with phenomena
of excessive enthusiasm or excessive pessimism about the future, have typically been accompanied
by large swings in monetary and credit aggregates.

Indeed, many issues remain unsettled in economics literature and definitive answers are
not easy to find. Nevertheless, there can be no doubt that monetary analysis should be assigned an
important role in shaping the monetary policy debate.

Real Rate of Interest

A real interest rate is an interest rate that has been adjusted to remove the effects
of inflation to reflect the real cost of funds to the borrower, and the real yield to the lender. The
real interest rate of an investment is calculated as the amount by which the nominal interest rate is
higher than the inflation rate.

Introduction
The real interest rate plays a central role in many important financial and macroeconomic
models, including the consumption-based asset pricing model, neoclassical growth model, and
models of the monetary transmission mechanism. A key stylized fact is that postwar real interest
rates exhibit substantial persistence, shown by extended periods when the real interest rate is
substantially above or below the sample mean. The finding of persistence in real interest rates is
pervasive, appearing in a variety of guises in the literature.

Explanation
The real rate of interest is a central concept in economics. It represents the price of the
intertemporal allocation of goods and thereby determines saving, investment and, ultimately,
economic growth. Despite the importance of the real rate for our understanding of intertemporal
choice, operationalizing the concept turns out to be difficult. First of all, in a world of nominal
contracts, real rates usually cannot be observed directly. This problem is particularly important in
the case of long-term real rates in which long-term inflationary expectations come into play.
Second, it is not clear to which extent monetary policy can affect real interest rates. Although the
central bank sets nominal interest rates, by doing so it will also affect short-term real rates as long
as rigidities prevent prices from adjusting immediately. It is much less clear whether monetary
policy has much of an effect on medium- to long-term real interest rates. Third, even if we did
have information on the level of real interest rates and if the central bank could affect it, we still
need a benchmark in order to assess the current level of the real rate, for example to determine the
stance of monetary policy. The quest for such benchmarks actually predates the definition of the
real rate and goes back to the work on the natural rate of interest.

Given these two problems, it comes as little surprise that policy oriented research on real
interest rates has mostly concentrated on the short end of the term structure. This concentration on
the short end of the term structure is at odds with the fact that both saving and investment decisions
tend to be inherently medium- to long-term. It seems unlikely that policy-induced fluctuations in
short-term real interest rates will have much impact on the real economy unless they also affect
long-term real rates.

We then estimate the effect of monetary and fiscal policy on long-term real interest rates.
Monetary policy is proxied by the short-term real rate, and fiscal policy by government net
borrowing and public debt. The panel econometric techniques applied exploit both the time
dimension and the cross-country variation of our data set. Specifically, this strategy allows us to
perfectly control for “world factors”, which in this setting can be interpreted as a pure time effect.
This, in turn, enables us to analyze whether a change in a country’s monetary or fiscal policy
relative to the rest of the world influences the deviation of its long-term real interest rate from the
world level.

We find that country-specific monetary policy is an important factor determining real rates,
although the evidence suggests that it has become less important since the late 1990s. Instead, it
seems that monetary policy has generally become more synchronized across countries, leaving
less room for differences in national long-term real rates. The second important determinant of
long-term real interest rates is fiscal policy. In general, high debt or government borrowing tend
to be associated with high long-term real interest rates, although the recent Japanese experience of
low real rates and very high debt provides a counter-example. In contrast to the case of monetary
policy, we do not find evidence that country-specific fiscal policy has become less effective over
time. Our work extends the existing literature especially in two dimensions: one is the use of
inflation forecasts to construct ex anti medium- and long-term real rates. The other is the use of
panel data methods that allow us to concentrate on cross-country differences while perfectly
controlling for “world factors”

Nevertheless, our methodology is not without its own problems. The small size of our
sample makes it impossible to use sophisticated econometric methods that permit us to better
identify causality. As a consequence, reverse causation cannot be ruled out, although we argue that
the problem is unlikely to be so large as to render our results useless. Moreover, the small size of
our data set prevents the estimation of richer econometric models, such as dynamic panel models.
As so often in empirical work, the alternative is to live with the shortcomings or not to use the data
at all. Our work should therefore rather be interpreted as a complement to the existing literature,
not as a substitute for it.
Question: Write a short note on Cantillon’s Essay?

Introduction
Following a century of neglect, William Stanley Jevons, in the first blush of discovery, proclaimed
Cantillon’s Essai,“the cradle of political economy.” Subsequent growth and development of
economic thought has not really alerted us to the subtleties of this succinct appraisal. A cradle
holds new life; and there can be little doubt that the Essai added new life to the organizing
principles of economics. But “political economy” does not accurately describe the subject
Cantillon addressed. Indeed, he scrupulously avoided political issues in order to concentrate on the
mechanics of eighteenth-century economic life. When confronted by “extraneous” factors, such as
politics, Cantillon insisted that such considerations be put aside, “so as not to complicate our
subject,” he said, thus invoking a kind of ceteris paribus assumption before it became fashionable
in economics to do so. This is merely one way in which Cantillon was ahead of his time. He
preceded Adam Smith by a generation. Both writers made important foundational contributions to
economics, but from perspectives that were quite different. Smith was a philosopher and educator.
His approach to economics reflected the concerns and approaches of philosophic inquiry stretching
back to Thomas Hobbes. The Hobbesian dilemma was how to secure peace and prosperity without
submitting to an all-powerful central government. Smith gave an answer based on the nature and
function of an exchange economy operating under a rule of law. The Wealth of Nations is full of
useful advice to those who hold political power. Hence, Smith earned his sobriquet “father of
political economy.” Cantillon was a businessman and banker. His approach to economics reflected
the concerns of practical men who set about making a living, and his analysis concentrated on the
structure and mechanics of an emerging market economy. The economy he described was an
enterprise economy, not a political one, in which certain individuals played key roles, some passive
and some active. Government, as we know it, was relatively passive in Cantillon’s economy. The
most active and central participant was the entrepreneur, who motivates the entire economic
system. Unlike any previous writer, Cantillon explicated the vital role of the entrepreneur with
perception and vigor. Hence, he deserves to be called “the father of enterprise economics.”

Explanation
Early in his career, Cantillon worked for a war profiteer in the British government and later for
John Law in the Mississippi Company scheme. His first job enabled him to establish a bank in
Paris from which he grew rich. Cantillon made a fortune on the value of his shares in the company
during the Mississippi Bubble. Subsequently he made more money by selling shares short during
the bust and by taking advantage of changes in exchange rates that he correctly anticipated. After
the Bubble, he was one of the wealthiest private individuals in the world. Not unlike the modern
day financial scandals, Cantillon was hounded by lawsuits and criminal charges, so much so that
his biographer, Antoin Murphy, suggests that rather than being murdered in 1734, Cantillon
actually faked his death and made off with his money to South America. Based on the book itself
and other evidence, we are now reasonably confident that Cantillon completed the manuscript in
1730. It could never have been published under the harsh French censorship laws that prevailed
throughout the first half of the 18th century and, as a result, it only circulated privately in hand-
copied manuscripts. Only after the censorship laws were relaxed waist published in 1755, and even
then, it was published anonymously under the name of a defunct foreign publisher.

Least you think the Essai is a dry technical practitioner’s guide to the economy, it should be
stressed that Cantillon deals with a wide variety of fundamental and philosophical issues such as
the nature of property, the distribution of income, the origin of money, and the role of government.
He even criticized an early version of the Malthusian Population theory and offered an accurate
prediction of the population of the United States in the 19th century.

Cantillon began his challenge to accepted doctrine on page one when he showed that money was
just a medium of exchange and that wealth was not money, but the ability to consume. He
demonstrated that the best way to produce consumer goods was to allow free markets where
entrepreneurs could be counted on to make self-interested judgments on what would best please
their consumers.

Cantillon began his challenge to accepted doctrine on page one when he showed that money was
just a medium of exchange and that wealth was not money, but the ability to consume. He
demonstrated that the best way to produce consumer goods was to allow free markets where
entrepreneurs could be counted on to make self-interested judgments on what would best please
their consumers. Cantillon’s model of the isolated estate is a conceptual analysis of the emergence
of the market economy from feudalism. It is the inspiration for Adam Smith’s invisible hand
because it demonstrates that entrepreneurial self-interest will regulate the economy of the isolated
estate just as well or better than if the estate owner continued to make all the decisions.

Cantillon’s contributions span the entire gamut of economics including entrepreneurship,

methodology, theory, microeconomics, macroeconomics, international trade and finance,
economic policy, and even areas such as population theory, economic geography, and transport
economics. If you want to know the scientific “magic” of the market, here is the man who literally
wrote the book. The case for the book is compelling and so is the case for a new English translation.
First, the Essai presents material that is brilliant, but difficult. Even the original French manuscript
must have appeared incredibly complex to his early readers, a point noted by Cantillon himself in
the text. After all, this was a new science that was fully born in one long stroke of his pen.
Remember further that Cantillon died shortly after writing the book and that it was not published
until long after his personal associates had died, so there was no one to clarify matters. Second,
the English translation by Henry Higgs is a faithful interpretation, but one that is wholly out of
date and which provides little guidance for the reader. In the introduction to the first English edition
of the Essai sur la Nature du Commerce in Général, published in 1931, Henry Higgs states that his
translation “follows the French text of 1755 with all faults of grammar, spelling, accent and
punctuation.” Higgs chose faithfulness over beauty, sometimes perhaps to the detriment of
readability.

Second, the English translation by Henry Higgs is a faithful interpretation, but one that is wholly
out of date and which provides little guidance for the reader. In the introduction to the first English
edition of the Essai sur la Nature du Commerce in General, published in 1931, Henry Higgs states
that his translation “follows the French text of 1755 with all faults of grammar, spelling, accent
and punctuation.” Higgs chose faithfulness over beauty, sometimes perhaps to the detriment of
readability. Throughout history, translators have wrestled with the same question or dilemma:
balancing faithfulness with beauty. Much as with English, the French language has changed
tremendously since the early 18th century, when Cantillon wrote the Essai. A faithful translation,
therefore, renders the text in a language that is no longer in use. Our goal differs from that of Higgs
in that we want Cantillon’s book to be accessible to the modern reader.

Third, we provide explanatory footnotes that describe the people, places, events, weights, measures
and currency values that Cantillon used, and which are no longer commonly understood, as well
as descriptions and rationales for any substantive changes from the Higgs translation. Fourth, we
provide abstracts for chapters and provide titles for the sections. We also provide graphic
illustrations for some of Cantillon’s important contributions, such as the circular-flow diagram of
the economy, in order to aid comprehension. We liken the process to restoring a painting or fine
piece of furniture—not changing the original—just cleaning it, fixing a few scratches, and putting
on a new coat of varnish. This new translation, we hope, will appeal to new readers and seasoned
economists alike and give Cantillon’s Essai the attention that it well deserves. The task of
retranslating the Essai sounded like a simple and straightforward project for which we completely
underestimated the time and difficulty involved. It has taken several years and unknown hours of
work to complete, and we fully acknowledge that it could be better. Finally, we would like to
acknowledge the assistance and encouragement of historians of economic thought William Breit,
Robert Ekelund, Guido Hülsmann, and especially of Robert Hébert. Historians Donna Bohannon,
Joseph Stromberg, and Thomas Woods were also of great assistance. We thank Paul Wicks for
copyediting the manuscript. We wish to thank Paul Wicks for copy editing the manuscript and our
family and friends, especially Bill Curlee for their support.