Reconnecting Money to Inflation: The Role of the External Finance Premium

We re-connect money to inflation using Goodfriend and McCallum’s (2007) model where banks supply loans to cash-in-advance constrained consumers on the basis of the value of collateral provided and the monitoring skills of banks. We show that when shocks to monitoring and collateral dominate those to goods productivity and the velocity of money demand, money and the external finance premium become closely linked. This is because increases in asset prices allow banks to raise the supply of loans leading to an expansion in aggregate demand, via a compression of financial interest rates spreads, which in turn tends to be inflationary. Thus money and financial spreads are negatively correlated when banking sector shocks dominate. We suggest a simple augmented stabilising monetary policy rule that exploits the joint information from money and the external finance premium.