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B J? *' M<*/> -eySopph{970->7z BOARD OF GOVERNORS or T H E FEDERAL RESERVE SYSTEM 2nce Date Subject; Mr, Partee November 20. 1972 Money growth during post-war business expansions____ _____ 5’iliiam. Poole & The purpose of this memo is to review the characteristics of money growth during cyclical expansions in the post-war period with a view to the relevance of the past patterns for the current cyclical situation. The present policy problem is viewed as that of fostering a balanced expansion which avoids both renewed inflation and a 'cyclical downturn. experience The first section of the memo reviews historical and the second discusses the policy implications of the historical review. Historical Review Figure 1 shews money growth and the 3-month Treasury bill rate from 1947 to mid-1972. The series for money growth is the annual rate of growth of monthly seasonally adjusted M-l averaged over sixmonth periods. For example, the observation plotted for January is the annual rate of growth from July through January; the observation for February is the rate from August through February, etc.~^ The six-month period was selected in order to smooth out noise while having a short enough period that changes in the growth rate of pos sible relevance to the business cycle can be identified. 1/ The peaks In order to make it'easier to read the chart to find the money growth rate preceding business cycle peaks, the moving average growth rate has not been centered. l HI 7P3*i Photocopy from Gerald R. Pord^ibrafy Percent Annual_ Rate j _________; G r o w t h ............ : ^ T mT T T I T l ' l i I i:ii.! ' ! ; i i ! M I i i I m I ' I I |' | ] .ji 1 1 '!' I 1 : 1.1 i ' 3 mo n t h T r e a s u r y b ill over rate iI! ■I.! : i I - 5 n - ; - ; v r'i i1 i1r.:'1'j M PI 1i t i > j M : ii i p< i !i ii !.! r i i i • ! I j j i !! II 1 ! I; \I ■ i ! i I M 1948 1947 ' i i 11| Ii M M ill! I Iil|1 ! 1949 ’ Perk i. J 1 i 1950 j 1I i I ! ! ; I I > " I j . I Jj i 1 i 11 Pi I "i i M i : r ' ; i i1-|-ip i , , I ! I -5 •■ | | P « M M M M - I ...........M 1..: .Ll . , 1965 ! ! li * !. P! i I 1966 I d l t j l p I !:jp I i ' ; ! ; I S : i!Ij11i1;iiI i I I • ! ! 1• P| I li1 ! ' I ! PM " " " M i ! .1 I L L i ; 1 ! i i l.pj i i.i. i p p i I ! i !. 1 1959 1 1960 1961 Peak ! 1967 i 1} i i ; I *•. 1 11I p i i p] i i II ! P M !i!M ■ 1963 1964 Trough IIIj! i Ijl'i! •j 1 P M M 1 i M i ! !.l-:P i. p !!i: M !iI 1 II I| 1! . I 7T1 ;| 'j p M M M P ....!\\;iJ I M I 1 / " ! ! : : .! i / 'Si T I !! I-l ■ ■ ip m i M -M M il pi ;il1 Mji i m M i l l M i l , M | |M M i I ! !..!. IP I I . i M 1968 i ii '! M il j i 1969 1970 P Mi 1971 ! i ' 1 : 1I ! | |i i | : ) 1I 1' ! 1 : I ' 1 : | ! I ! 1i ; i ; i | , 1111; ! : ! i Ll 1 i ! i M |m ' i i i M ! i M M 1M ' i ! ! M I ’ . : 1 pi ! Li I t i. J l.i Ll L 1 M L ! j t i 1 ! j I » M ' 1 M 1 M M I M I ' M i Pi ! ; j J|..;,P •,j j ' • I M 1P | 1 p P i ' ' : ' ' M i ■ ! M M 'ii ! iI P 1 ih Hi i 11 i;i11 rii! ■M ■ M .: i;im i; 1 i_H i M j LM iii ;|l : i-' '1 i■M ii|:iP-: i M i 11 i .i I '; 1 I ! M' !I !■ Ii i;i i ' P P ' M i i Ip i i / PI I i M l1 ! I ! ! II i 1962 j i j I M M i • • i ill [i t i n : ! :_ll. p -P..P.U ;..;jpPi jPJ.J_L 4J--P 1955 1954 i P U - L U " ■pi ;/ - , P. iP i 1 '|iI I I II n il I i' ! ' | 1 ! i I 1i I I I ! 1953 i|p i• i1 i |. . Pi. li M!|: m i ! ; i j , !1;ii ti 1 ! i : ' i i i I i i i i I ! I ■ I p i ..1 I i m r ; I pi I Trough 'i;i• *; -i . ■l-i I ' M r i ! •• I ! . \i ! j i i ; .i ■111.!. !I| ITT h ! i I I 1i i i -i! U ' :il IP 'M Ii! ! Li l l / M / X, \ ip/| - •) •: N; i i P IP LI. j. i-| I M-.-j | I. i •i ■ " M ! : /! : "! I ' I i J\ I ! " ' p.- I-, . ! I i • | I :\I i j , Mir-!* /ill i i i i :• M i l l \i L.i ' I.!... TT ! I I n .r, j i j i ’ I1 ! * I I j :! M 1 I! r , II ! ! !1 1 P: M M ; i IjI i i:i■jI i . I:1 !' ■M. |!.! !■ !!! 10 ' ; I I I j I I •I i i :i.;1 ! 'i !*i!.: !■1i !'i 1I1;,i 1iiiii|i• n i l l j I [i l! j j ! i j I P e a k ; [ |i|I T rough i l ; i I I I i ! I • ■" i • ! ! I ‘ ■: ; "I i I ! .I : 1952 1951 i M Pi ! P P h IP I • i i •| Pi i 1« j i 1 I .... > P i i ! S 1 » P! M i ! I *! P | j i ,! n il t ‘ I* ! :-! I U I' i h I j I i i 1' ' 1 I ! i I M i ' ‘ P : ' ■ I • ! i - l ' I Pi i 11 PPi.i. I P ! I I I I !. 1958 1956 19 5 7 ’ left) !■11 ! I | > i i j T . j I : i I 1! I I 11 11 i Pef i k, : i | i ,p i IP.'.j i i ,i,i i ! P PPj i at rig h t) , ,i:|Ii! !Il.iP I:i!. I!.!,.l.:i 'M i ; ' p : sJ ' /' i ! I -I I ! I I i 1 ' ■\ . at T (sca le I : ! !. i ! ! i i M I i Pip! , , (sca le period | ! 1 P !.1.1..! ; I Pi ! ! I j..!.. i j I i ! i. i . !.. ! ! t 1 ! i ! ! I ! ! ! i ! 1: I1 ■ i P j'j! ! I M T rough i I I . 6 month IIP ' i n 11 J n ili m u s.! J v t r i r tr « W I pi,I i h | 1 ■ . ! | • ! r x u A ' m r }1!'i.! i .! itii:•V 1' !' 0 stock !- f i ! |■\- r|:.P... ii:i ! ! I IIP ! I i M ‘ I ! I M il P-M •/ p M ip m i/i i%p; ii ti I I I ! I j I ii ■; i I j i : I M i i'p-: ! |I | |I ! ; I i II i i i i ! M M i ! 1 lJJjJJji n n Pi-r-n-Ti L 111 M ! , M 1j ij Pi-! , |i | || j : i .'P il'T lT n Pi -i*:»p - -i-: ' 1h 1 1, tj1rI iP !IiIi|:i ,: ■.i ■ :-|-P ' !• -Pi- •. p. in ; I I n ': ’ Li 1 L -U IJ . ! LI . \ j ! . I ! 11' I I 0 mo n e y r t-jtti r "T r'i 'ff ]' |‘i I rm TT |-n y |-['Tj■] I'I i f i P e a k j I i j I ri’ r o u g h i ; I ! I ! , I { ; u T T T i i ! I ! i i i n i >i I I I'i • : •! t1 M!i i! i 1! !I ii ii i !1! iIi!1 ! ’ii : M *; i j j:! ! ! ! i I i u1 ! •!! I ; i i 1 M i| ! i .i IIIli I M I |I | l.i!1 i! j PM PM .M J ..i ! J J I ; i I I ! M 'Mi; N ! j i ' i .l 1 i M M j‘V \ i 1 1 j !_! ! i.| M.| M \ ! 5 |i11Til ■frit! of I 1 1972 HI 7P3& Ph0toc°py from Omld R. 1 Grov/th of money stock over 6 month period (scale at l e f t ) ,: 3 month Treasury b i l l rate (scale at r i g h t ) 0/ TrHTTT-r-r-'-TT T ’J 'r 'H i I! I I, TTTHTT T ITT Race [ T IT o IjljOUol u !' I Peak ; : M M : T r o u g h T TT t-M-i ! f r i t *i• ii M !!; ;;, i -j P .t i i il: ih !. : i.i ! .! ! ! I i!.S i!i: i! I m !!,'' m. : , ; • T . i i . i i 5. 0 T\ i i j i : • . : •' . j ill'! T il . : M i ! * ;. ■ ; I I M i ; ; m : ; / I !|l ! Ni l M is\ • r , : ii ' .I . i *\i m i! i II!1 ;i.i. i M i.i i 1I M 1i i X;:\ i M I • I !' I ' V > : i*• ;! *1N •! ! ill II : i ■i . ' { ; ’ I J i i i «.LiijL. J ! iJU. * u n X 1 . 1 ’ • ! " 2 .5 M l, * ;.r > I ! Ji i ?' V .._i> ! 1 • i MM 1 I i .U r ; ,I I., I.* I, ' j N-uU II . m i.i ! I! • I I t i » V f i I , hi : ! i ii I i \ m .1 ' i.i ' 1 . i .! -5 i 11 r ! j. i M i ; ; 1! : !jin jjiiit ij- ■ji !! !! ;I M MI Mi II i.i i i im ijj !|-N i.i ! I'1! i ; i I ' i I • M : iiU !I.! !.m : H i’ .1 ! -ill •1.1.• ^1i 1953 1951 1952 1950 1948 1949 1954 1955 1947 • Percent Annual IT Nttt* ITT LI‘ ' . !!iI .. TT! I M i.r ! ; ! MMI; i ■ 5i : , Peak : M 1 '!" i II Trough< i i P e r k ; | i , Trough i 11 i i\ iI! I • i.i!...! L s ! i |• { I » i • i M'M i i i I I M 1||.ii i t i ,1 i ! .Ml qi ; i r I I ! , f I I i i i : -t \ 1.i - i - r •I l.j !; j ! j | JiU-T 1.1.1 ii r 'j-!ii! .iu Ms\ i[ III.!.! ! ! l " ! ; : I ij mm! I »v Ml .....' <. '!.!••• f\i M ! !-i r.r N M M ' ■! l M i!' i :! l M ri i:i: ■| —~r y !»• M ! ! M ,i ■r i M ! i I ' i' i : r; j : j ; ; : c i- > i i ! : ii'-i-!..!-. 0 j 1i ! |>. •it ii1M ''•! !! ! : i. ; ; !.| I ’I'Lu. ! • ! i ■l.i.i I. 2 .1,1 Li1* i ir 1958 ' .1956 1957' M •! I M M ! Vi.-! : 5 Si5: i M*-Mi i i ! 'M • '! 1 ! i i ;v.! i 1 . • I ! •i* vIM• | !I! U» ! t ll( HI i ! IS:! I I I . • -5! 7t ; :n TV 1 . ..l.j : I Ml-: i/ \/A ? H 11 .M J ..L •I M 1966 1 ii ij-, I i!j il . i !' I j I I « i» ii *M* ! i i I i I i.i I 1961 1962 I!1M ! hi! i Il !l M .1-5*; Iit! !1 I j • l ‘l m ;' 1967 .L\ :M, 11-Il U LLij.LIL Li Ji-i i± U i j. Ii l l l i L111 i.l ij »..J I.J. i » i I j: ’/ M M I I I i • ' ! . I M ! i'| : ! i ; 1• i 1970 !Li iit’».iiJ !I.Ll!J Mil 1971 l ! M! * 1M I »« - i! ?•.* i»i< M ; M : i I, ! . ; *: iI !! r .!.! i1 'Mi! M M M M : M ! ! M 1 I ! f ' w i W• MM vI i-j i!i*l 1969 iIi i ..LLi, i!I 1968 1964 7. 5 M |M i .j.i. I1 * J L.i. 1963 i i j; 1f Mi ; ! Trough Pcok iI i ; 5.0 I i! i > i !i ' .“ i A/ \i l li !I: .! ! ! ‘ I! !I !.i : j.i I i: M i l i.11 il i i i 1960 I! j !• L Li I I 1965* 1959 I»! !M ii M, ! ; ! I. :.!..! ' ;. M M ! j. M . i J • i l .:!. L. : I i !. i i ; i I ;!1!I!.! . III! Ill I li. 10 i 1 ! . t !| 1\ i' I I; ! ir 5.0 • Mm ;»‘ -i • !M ; MM f: I I M. j t sill* 1972 *j ;I 2.5 -3- and troughs indicated are the NBER business cycle reference dates. With respect-to the probltm of preventing a dbwnturn,: the general conclusion from Figure 1 is that a substantial and relatively prolonged drop in money growth preceded every post^waTT busines^' cycle 2/ peak.— This fact has, of course been noted by numerous economists before, and is incorporated in the equations of econometric models. With respect to the inflation problem, it is assumed that the con tribution of monetary policy can be viewed in terms of avoiding ex cessive demand pressures caused by excessive monetary growth. The pattern of money growth has been quite variable from one expansion to another. It is interesting to compare the long period of slower money growth preceding the July 1957 peak with the shorter periods of slower money growth preceding other peaks. It may well be that this difference is due to the size of the deceleration of money growth. The money growth rate--about 1 per cent--in 1956 and early 1957 was about 3 percentage points lower than the growth rate in late 1954 and early 1955. On the other hand, the deceleration preceding the May 1960 peak was especially large; money growth went from about 4.5 per cent in late 195S and the first half of 1959 to -3.0 per cent in the second half of 1959 and early i960. A detailed examination of the deceleration of money growth prior to recent business cycle peaks requires, for each episode, the 2/ While every recession was preceded by a sustained decline in money growth, not every decline in money growth was followed by a recession. For example, declines in money growth in 1362, 1966, and 1971 were not followed bv recessions, although there was a so-called "mini-recession11 in 1967. -4construetion of a trend growth path against which to measure the actual growth path of the money stock. 4 T^ie £c^_lpwing four consider ations underlie the selection of the individual cycle money stock trends used in this memo. First, the trend rate of growth of money must be calculated over a long enough period of time that short-run aberations do not significantly affect the trend. Second, the trend must be calculated over a short enough period of time that it success fully characterizes a particular business cycle expansion rather than characterizing experience over several business cycles. Third, the trend should characterize the expansion phase without being heavily influenced by the immediate pre-peak period since the purpose of the analysis is to discover if the pre-peak growth of the money stock was inappropriate. Fourth, in an effort to discover a pattern common to all four business cycle peaks it seems desirable to apply one method of defining the trend to all four episodes. These considerations led to the following method of defining the trends drawn in Figures 2 through 5 for the four most recent cycle peaks. For each month of each business cycle expansion the annual rate of growth of the money stock (M-i) over the preceding 24 months was cal culated; the highest of these growth rates for. a given expansion was then defined as the trend characterizing that expansion. Next, the trend path over the 24-month period defining the money grow7th norm was extended on either side of the 24-month period in order to define the trend path over a 60-month period prior to the cycle peak. The choice of the 24-month period reflects the first and second considerations - 5 Figure 2 Money Stock Prior to July, 129 -- 1953 Peak -- ------ Billions of Dollars 128 127 126 - Trend defined by money growth rate between ‘ _ Jan. 1950 and Jan. 1952 -(42th- and 18th months prior to cycle peak) / 125 / 124 / /» / ‘ r / * / • 123 / 122 121 / 120 / * 119 118 / / ' 117 116 // / 115 114 / 4.95 Percent Trend Line / */ 113 10/49 112 * ** / Trough * I ! 50 45. i * 111 60 55 40 35 30 25 20 15 - 6 - F igure 3 Money Stock Prior to July, 1957 Peak Trend defined by rrone;y_ ; growth rate between April 1954 and April 1956 (39th and 15th months prior to cycle peak) 139 138 / Photoc°Py ftwn Gerald R. F«d Library Billions of Dollars 140 t 137 / 136 135 134 133 / 2.80 Percent Trend Line 132 131 130 129 128 127 126 8/54 Trough 125 60 55 30 45 40 35 30 25 20 15 10 5 Months Prior to Cycle Peak July 1957 - 7 - Figure 4 Money Stock Prior- to May, 1960 Peak Billions of Dollars 148 Trend defined by money growtht rate betv/een ' . July 1957 and July 1959 (34th and 10th months prior to cycle peak) 14? 146 / / 145 144 i« / 143 142 141 / / 140 / 139 138 137 // / 136 2.70 Percent Trend Line 135 4/58 >8 Trough 134 133 60 ;; 55 50 45 40 35 30 25 20 15 10 5 Months Prior to Cycle Peak May 1960 0 Figure 5 8 Money Stock Prior to Nov. 1969 Peak Billions of Dqll^r-s 2 0 2 200 Trend defined by money growth rate between Jan. 1967 and Jan. 1969 (34th and LOth months prior. to cTycle; peak) 198 196 194 192 190 188 186 184 182 180 178 176 .174 172 170 7-32 Percent Trend Line 168 166 50 45 40 30 1 Months 20 15 10 5 d ^ v v c l e Pcvak j;ov. 0 -9- mentioned in the previous paragraph, while the choice of the highest growth rate over a '24-monfch *p<eri<?d refleets !the third consideration. A close examination of Figures 2 through 5 suggests that the method used to define the trend is not unreasonable; in each o£ the figures the trend lines might logically have been drawn a little more rr a little less steeply than those actually used. Of the four bus iness cycle expansions examined, all but the last were less than 60 months long and so the figure for each of these expansions includes 3 /4 / at least part of the previous recession.--By measuring the money stock as a per cent of trend, the ‘four different episodes plotted in Figures 2 and 5 can be compared in a convenient manner. This procedure is illustrated in Figure 6. Figure 6 suggests the generalization that the money stock has typically remained in a 1 per cent band around trend during the cyclical expan sion except for the year prior to the peak during which time the money stock has fallen continuously to a point 3-4 per cent below trend at which time the cycle peak occurred. With the aid of hindsight it can be said that the growth of the money stock in the months preceding 3V The last expansion includes the mini-recession of 1967. Using the trough in the Industrial Production Index as a criterion, the trough of the mini-recession is March 1967, which is the 31st month prior to the cycle peak in Figure 5. 4/ An alternative method of defining the trend would have been to draw a line between the money stock in the trough of the reces sion and the month when deceleration of money grovth occurred. This method, however, would: a) havo made essentially no dif ference in Figures 2 and 5; b) have been difficult to apply in Figure 3 because the month of deceleration is not clearly de fined; and, c) have delirad a trend over only 15 months in Figure 4. u n QJ 101 Figure 6 Money Stol*hot»€oji^f.-,flrftfti(j^r^ |§ i o r to Four B u s i n e s s Cycl e l’eak T T T p rrT — r n i 1 i | f'T' iTI : !T T P — P ----- 'P T " 1— 'r ~ '—F T P ” f I1 TTTT I iT T T T T T TTTT7 l rhh ! 1:1 -t! [ f i t -l~ I-I'J !l-i i ! I Mil I t !: P ■ —f I I H -M ’ 11-4- ■i i -i ______: trend growth 4.95%; cycle peak m H — —r ~l7vr 1—j July 1953 \±V\ !-l I-Ml ..... : trend growth 2.807o; cycle peak i v I-' July 1957 mi; I i ! ----- . trcnci growth 2.70%; cycle peak i ;.i. '.rrt~ J. I i..! May 1960 1 ! t II f l i •it III! .t 0000 »e: Lrend growth 7.32%; cycle peak H I I ;..j> -UL — -r r-t*j November 1969 iH r tit tt -I--H .1 M: Ii I / ! I i i i j 1 1 1 II m f t -! ti MM I M ! > II.! ! i:j:]. i i ii I ;1 i...I. .1 1 M i M~ 1 ! = i i-; i 1 ! I — u u l M . »-~!,| j T T T : i.~ i • ; " 1! I1i M i i j i ■ i *.\! j .■,! 1 !1 i *I 'i " •: 1 —t• i •! i t ■ i I ; I i i r , ... h i ■T V - f t - --•H ' r i T1 I i V 1 / I ! ! I | i i I I . ! i ! -| j H ; .1 ■ ii• , !I J'i ! ill i I , .! i 1 m m I / ! MJ .! M. r frii !L ![] _l.l : M i l i-l | f • ! . i i ■* !IIi 1 1!i !M i 1 i i i ,m I • I!1 •M l 1 (! i !• f i i ; M ir i : i 444-' TT II 4 -i i i o l ! t ! i j I I •ri[ I 1 I !/ i 1 Li. i iI M j i | 1; !i t \r r. ! i M \ 11 j, , • !! ■rT ! i .!.!. I !i \! ' I I- !■ •• 1 1 \ I ! _!‘ _ M_ l — r .i I 4 . Mi! I ; 1h T ,■ /} I ii! I i i ii ! 4. '- U ......... |_ LI -f "i—: i L -+T itv iI I ; r h ! M. ! M! iI l I : }V! •i I 1 II M ! m m : ! iV iMi : 11 L ili 1 i'* ; r I I I I I I i] M l| ! I I ! M ! i I ! • ■1 M T H T Tit II j j IM : Ij m■ m"i Ml i M • | i jl I | i i I M i Ii M M I( ! IM’M j_I. —I —[ -i— 1 —l - —i—! -j— i■ TT i i } . . 11 . i ' M M M . M M •( i ! ;. i : ! i I 1. TT . 11. i ii Mi.; ii ' I ■' ! ! ! ! 111 lit ij lit I1 i i .j. 'I * •:~r t I ! •I I ii m i ii ■M i ■M !1I I’i ! I ! i !I ! i I 1 Iljll J J - U - i. ;! • T T I’ T T I ! ! :.! : ; I ■ -[-! ji I 1 1 I I » ! i-1-41ii .!. i. M M i II i i •r i r!r 100 LL I 4 99 m 98 ■ 97 I i yjj ; mi t I n ;T 1 ■l! i ... 25 '.0 *-hs Pi ■>i i 1, : j l:! \j l;;, Li 96 I rtr 15 ' Hvcle Peak 10 - 1 1 - every post-war cycle peak was inappropriately low. Policy Implications In discussing the policy implications of the above analysis it is convenient to proceed as follows. First is a discussion of the impact of monetary policy on aggregate economic activity under the assumption that the rate of inflation is given. ^ Then this assumption is relaxed and the discussion turns to the impact of policy on the rate of inflation. Organizing the analysis in this way seems natural be cause past experience suggests that monetary policy affects economic activity with a substantially shorter lag than it affects the infla tion rate. With respect to economic activity, the conclusion I draw from the historical record is that it is not advisable to permit a sharp, sustained deceleration of money growth during a cyclical ex pansion. The argument is that a deceleration of money growth may be excessively contractionary because even a steady (modest) rate of growth of money produces a restraining influence on a rapid business expansion. Nominal GNP growth can be excessive either because the in flation rate is too high or because the real growth rate is too high thereby producing excessive demand pressures and the likelihood of greater inflation in the future. Assuming that the money growth rate is consistent with the des ir ed growth in nominal GNP, excessive growth 5/ This assumption uoes not imply that the rate of inflation is con stant but rather that the rate of inflation, whether constant or changing, is independea t of vnone tary po 1icy . -12- in nominal GNP implies upward pressure on interest rates as a result of the rise in velocity.— ^ The upward movement of interest rates tends to restrain the growth of’ nominal GNP. If, instead, money growth decelerates when nominal GNP-growth becomes excessive, then there is the danger that the upward pressure on interest rates may become excessive and that as the lags work through the economy re cessionary forces may get underway. The conceptual basis of this argument is that a world with out long-run growth in real income appropriate measures of Government policy variables would be the level of the full employment budget surplus and the level of the money stock. In a growing economy it is still the levels that are important but the levels of both variables should be continuously adjusted for normal growth; the budget surplus should be taken as a percentage of full employment GNP and the level of the money stock should be taken relative to a long-run growth norm. Under this view, money growth below the norm involves an increasingly restrictive policy because the level of the money stock drops further and further below the trend level. The difficulty in the practical application of this view is that inherited inflation, which is still assumed to be given at this st£ge of the analysis, affects the measurement of both monetary and fiscal stimulus with respect to aggregate activity and, therefore, affects the determination 6/ If interest be that the it would be growth rate rates do not rise, then a possible explanation would demand for money function has shifted. In this case necessary to reconsider the analysis of V7hat money was consistent with the desired growth in GNP. -1 3 - of the optimal growth norms for monetary and fiscal variables; In terms of the impact on aggregate activity, with an inherited inflation the money norm might be, for example, a 6 per cent growth path and the fiscal norm adjusted to account for the growth -in revenues due to -I - - - forecasted inflation 7i For an example of the application of this argument, consider the cyclical expansion following the 1953-54 recession. From the second quarter of 1956 to the second quarter of 1957 nominal GNP rose by about 5.7 per cent while real GNP rose by only 1.7 per cent. But during the expansion the maximum rate of money growth over a 24-month period was 2.8 per cent from April 1954 to April 1956. With nominal income growing at almost 6 per cent in 1956-57, 2.8 per cent money growth would have had a restraining influence; instead, the money growth rate fell to about 1 per cent in 1956-57. The 5 per cent rise in velocity could not continue indefinitely without growing fiscal stimulus. Unfortunately, the growth in velocity did slow as nominal income declined during the 1957-58 recession. The slow rate of money growth in this period is properly interpreted as involving an everincreasing degree of monetary restraint on real activity because the level of the money stock fell further and further below the 2.8 per cent growth path as shown in Figure 3 and by the dotted line in Figure 6. _7/ For a discussion of the problems in measuring the full employment surplus during cm inflationary period, see Arthur M. Okun and Nancy H. Teeters, "Th- Full Employment Surplus Revisited," in Brookings Papers on E c o n o m i c Activity: 1970:1. It probably would have been better if the decision to have a* less .expansionary mqnetjiry policy to fTfightlf the "creeping" ins * z flation of 1956-57 had simply led to the maintenance of the trend growth of money at about 3 per cent. This rate was already well be- low the rate of growth of nominal income. With such a policy it is probable that some economic slack would have developed and the rate of inflation would have gradually declined. If an even tighter policy had been desired, the level of the money stock might have been reduced gradually to a point, say, 1 per cent below the old trend path and then the 3 per cent trend rate of money growth resumed. Given the 'trend rate of growth of potential real GNP near 4 per cent, the 3 per cent trend rate of money growth was probably not far from the rate consistent with a stable price level in the long run. To complete the analysis it is necessary to drop the assump tion of a given rate of inflation and to recognize that the trend growth of the money stock affects the trend rate of inflation. If, for example, the trend rate of growth of the money stock is de creased significantly, the initial impact is to reduce the level of economic activity since the level of the money stock falls below the old trend path. But eventually the rate of inflation falls. As adjustments in economic behavior to the lower inflation rate become widespread, the impact of money on real activity comes to depend on deviations of the level of the money stock from the new lower trend path that has been established. To reduce the rate of inflation it is necessary to avoid -1 5 - 8 / excessive demand pressures.— But a recession is also to be avoided. Suppose it appeared t;hat;an -unemployment ifate; in the neighborhood of were consistent with the avoidance of excessive demand pressures. With this assumption, a useful way of organizing policy analysis might be as follows. as an interim norm. First, select the inherited money growth trend All other things equal, if unemployment were currently U^, and if the economy were fully adjusted to this trend rate of money growth, then with continuation of this money growth rate unemployment would tend to stay in the neighborhood of and the inflation rate would stay about at the inherited level. If the level of the money stock were permitted to deviate significantly above (below) this path unemployment would tend to fall (rise) and the inflation rate would tend to rise (fall). Nov; suppose that the money stock were targeted to follow on average a path that in the first year reached a level, say, 2 per cent beloitf an interim norm path and in the second year remained 2 per cent below the norm path. If the norm path had a 6 per cent growth rate, the target rate of growth of the money stock would be 4 per cent the first year, and 6 per cent the second year. Assuming that the norm path had been properly selected, the unemployment rate would tend to rise above and the rate of inflation would tend to decline. unemployment stabilized only a little above 8/ If and especially if it In this context the contribution of wage and price controls may be viewed as possibly increasing the level of economic activity at which excess demand begins to become a problem. -16-. showed signs of falling, then the process could be repeated by re ducing the money stock another 2 per c.ent %below* trend / If the unem-- ployment situation did not appear favorable, then the second reduction in the target money stock trend below the interim norm path would "have to be delayed. The procedure outlined above involves the adjustment of the money stock above or below the interim trend in order to obtain the desired level of economic activity. If over several years this pro cedure leads to an actual money stock that appears to be gradually drifting further and further below the interim norm path without ill effects on activity, then a new interim norm path with a lower growth rate could be adopted. This approach permits the trend rate of growth of money to be gradually adjusted in stages toward a long-run norm of, say, 3 per 9/ cent — with the length of each stage dictated in part by the .per formance of the economy in real terms. The interim norm path is merely a device to promote clear analysis by emphasizing that the level of the money stock is the more appropriate variable for assess ing monetary impacts on income and employment while the trend rate of growth of the money stock is the more appropriate variable for assess ing monetary impacts on the rate of inflation. 9/ The figure of 3 per cent is used for illustrative purposes but is not unreasonable since it xvculd be consistent with a zero infla tion rate if the trend rates of growth of real GNP and velocity were 4 per cent and 1 per cent, respectively. -1 7 - From the historical review summarized in Figure 6 in the previous section it would appear risky to permit the .level of £ h $ . i money stock to fall relative to the interim norm path by more than ' about 2 per cent in one year. And if the money stock does fall 2 per cent relative to the norm in one year, the results should prob ably be observed for a year before an additional decline relative to the interim trend is permitted. To apply this analysis to the current economic situation it would be necessary to first select an interim growth norm for the money stock based on actual money growth over the past few years. plot of the money stock 1960-72 appears in Figure 7. A Also in the figure is a 6 per cent growth path the level of which is arbitrarily positioned to pass through the December, 1971 level of the money stock. From the figure it is clear that the 6 per cent trend fairly accurately reflects average money growth over the last two years and, indeed, over a period extending as far back as to late 1966. It would appear, therefore, that an extension of this 6 per cent trend might serve as an appropriate interim norm path. If the money stock in 1973 were to fluctuate.around the 6 per cent trend drawn in Figure 7, then it seems probable that nominal GNP could not continue for long to grow at the 10 per cent rate that prevailed on average from 1971:3 through 1972:3. Nominal income growth of 10 per cent with money growth at 6 per cent implies veloc ity growth of 4 per cent. An increase in velocity of this magnitude over the next year would probably require an increase in interest D elia Figure 7 Money Stock 1960-1972 4f & w q n Pioj x piBiao iuoij XdoDojoqj - 19 - rates sufficient to raise doubts about the likelihood of income actually growing at a 10 per cent rate. If this argument is correct, then little further progress in reducing unemployment could be expected over the next year with 6 per cent money growth. This outcome would be acceptable if it were felt that unemployment near the current level were required to avoid excess demand and retain downward pressure on the rate of inflation. It might well be argued--and this would be my personal position--that a lower unemployment rate is consistent with a further reduction in inflation. If so, nominal GNP growth averaging about, say, 9 per cent over the next four quarters and then declining in 1974 might be appropriate. With an allowance for a velocity trend of 1-2 per cent, the appropriate money growth rate would be 7-8 per cent in 1973. sustained money growth as high as 8 per cent may be un acceptable because such a rate seems likely to lead eventually to a resurgence of inflation. The employment and inflation considerations may be reconciled by emphasizing the level of the money stock. appears likely that the level of the money stock along the If it current 6 per cent growth path would not be consistent with a high enough level of economic activity, then the money stock should be moved to a higher level but not a higher growth rate once the new level is reached. If the level of the new money growth path is to be 2 per cent above the current 6 per cent growth path, then it is only a relatively minor issue as to how fast the money stock should be pushed to its new -20growth path. It should make relatively little difference*whether the money stock reaches the new path by growing at an 8 per cent rate for four" quarters and then a 6 per cent rate thereafter, or,a 10 per cent rate for two quarters and a 6 per cent rate thereafter. It must be emphasized, however, that repeated, changes in the level of the money stock relative to the 6 per cent trend will eventually establish a new trend. Giveti the progress already made in reducing inflation, it would probably be wise to be wary about per mitting the money stock to drift more than about 2 per cent above the 6 per cent norm path over the next two years. The approach outlined in this memo is supported by the re sults of simulation experiments performed on the quarterly model by Jerry Enzler, Roger Craine, and Art Havenner. The aim of the simula tions was to find*a money growth path over the next three years that, given the likely course of fiscal policy, produced the most satisfactory possible trade-off between unemployment and inflation.— ^ satisfactory money paths from these experiments were: The two most 1) 8 per cent money growth from 1972:3 through 1973:2 and 6 per cent money growth from 1973:3 through 1975:2; 2) 10 per cent money growth for 1972:3 and 1972:4 and 6 per cent money growth from 1973:1 through 1975:2. At the end of the simulation period, both money paths produce a simulated un employment rate of about 4.5 per cent and an inflation rate (fixed weight deflator) of about 3.8 per cent. 10/ In these simulations both the In these simulations novallowance was made for the effects of wage and price controls. -21- unemployment rate and the inflation rate average a bit higher in 1973 :than* ia ~197A- 75. ? Significantly, the simulation experiments were done com pletely independently of the historical review discussed earlier, and both approaches settle on a 6 per cent money growth norm but with the level of the money stock 2 per cent higher than recent levels0 Less important than the agreement in the numbers is the agreement in the approach. Changes in fiscal policy and in the business outlook will no doubt alter the numbers; so also will different views on the nature of the inflation-unemployment trade-off, both in terms of feasibility and in terms of desirability. It should be emphasized that the purpose of selecting a money growth norm is not to select a policy path per se but rather to construct an appropriate method for measuring the level of the money stock in a growing economy. For policy purposes, the level of the money stock in a given period could then be targeted to average, say, 98 per cent of the trend path. This procedure has two important advantages. First, it makes clear that a sustained deceleration of money growth is increasingly restrictive because the level of the money stock is drop ping further and further below trend. Second, it draws attention away from the largely meaningless very short-run fluctuations in the growth rate of money. These short-run growth rate fluctuations are unimportant because they produce negligible fluctuations in the level of the money stock relative to trend. f -22- In summary, a useful approach would seem to be to view present policy, in therms q£ a 6 per centjgrqWjth path norm for the money stock. A decision to move -to a more or less expansionary policy would take the form of adopting as a target money growth path above or below, but parallel to, the 6 per cent norm path. Concern we r money market stability can be met by accepting a percentage range in the money stock around the target path. This approach has the advantage of emphasizing that it is the level rather than the rate of growth of the money stock that is important for assessing the im pact of monetary policy on economic activity. Two subsidiary ad vantages are the reduced emphasis on very short-run fluctuations in money growth and the reduced possibility that errors in achieving policy targets will inadvertently be permanently built into the level of the money stock.