Money supply is linked to the monetary base by the money multiplier. Macroeconomic textbooks tell you that the central bank cannot control the money supply, but it can control the monetary base
As a result, you decide to specify a distributed lag equation of the growth in the money supply on the growth in the monetary base. One of your peers tells you that this is not a good idea for modeling the relationship between the two variables. What does she mean?
What will be an ideal response?
Answer: Although the monetary base is one of the determinants of the money supply, there are other factors, such as interest rates, that have an effect on the money multiplier. Hence there is the problem of omitted variables. If interest rates are correlated with the monetary base, then the OLS estimator will be inconsistent. Furthermore, it is likely that due to financial innovations, dynamic causal effects have changed over time. Finally there is the concern of simultaneous causality bias. If the Federal Reserve changes the monetary base as a result of changes in the money supply, perhaps as a result of targeting, then the monetary base becomes endogenous.
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