Full text of Review (Federal Reserve Bank of St. Louis) : March/April 1990

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

3 O n M a in t a i n in g a R is in g U .S . S t a n
d a r d o f L iv in g I n t o t h e M id - 2 1 s t
C en tu ry
1 7 T h e F O M C in 1 9 8 9 : W a l k i n g a
T ig h tro p e
3 6 A M e t h o d o lo g i c a l A p p r o a c h to
C h a o s : A r e E c o n o m i s t s M is s in g
t h e P o in t?
4 9 T h e L eg acy o f th e M o n e ta rist
C o n tro v ersy

THE
FEDERAL
A RESERVE
RANK of
ST.lJtM IS

F ederal R eserve B ank o f St. Louis
R e v ie w
M arch/April 1990

In This Issue . . .

As population grow th in the United States declines, the average age of
the population is rising. In the first article of this Review , "On M aintain
ing a Rising U.S. Standard of Living into the Mid-21st C entury,” Keith M.
Carlson exam ines w hether this com bination of slowing population and
rising age composition bodes ill for maintaining a continuing rise in the
nation's standard of living into the next century.
Using Bureau of Census population projections through 2050, along
with historical relationships among population, employment, capital
stock and output, Carlson calculates the grow th rates of the capital
stock that would be required to achieve certain rates of increase in the
standard of living as m easured by GNP per capita. He concludes that
achieving a rising standard of living like the one we experienced from
1948 to 1989, 1.9 percent grow th in GNP per capita, does not appear
possible. A rising standard of living in the 1 to 1.5 percent range does
appear achievable, however.
*

In the second article of this issue, “The FOMC in 1989: W alking a
Tightrope,” Michelle R. Garfinkel exam ines the econom ic factors that in
fluenced the Federal Open M arket Committee’s deliberations and deci
sions in 1989. In reviewing the FOMC’s long- and short-run policy deci
sions, Garfinkel emphasizes how the FOMC sought to balance the risk of
g reater inflationary pressures against that of a w eakening economy.
At the beginning of the year, the th reat of a w orsening of the under
lying trend in inflation drove the form ulation of policy. As evidence of a
w eakening econom ic expansion accum ulated and the outlook for infla
tion appeared m ore promising, the FOMC shifted its prim ary focus to
the possibility of a future slowdown in econom ic activity. The effect of
this shift on policy, however, did not em erge immediately, for the FOMC
understood that its interpretation of econom ic data was subject to great
uncertainty, and it did not want to jeopardize eith er the progress that
had been made tow ard achieving its ultim ate goal of long-run price
stability or its credibility as an inflation-fighter.
*

A new theory, called chaos, w hich offers an explanation fo r the seem
ingly random behavior of econom ic and financial variables, has stirred
up considerable interest recently.
In the third article of this Review, “A Methodological Approach to
Chaos: Are Econom ists Missing the Point?” Alison Butler looks at how

MARCH/APRIL 1990

econom ics is traditionally modeled and discusses w hy many of these
models exclude, a priori, the possibility of chaotic behavior. Chaos is
defined and its properties illustrated. The advantages and pitfalls of in
corporating chaos into econom ic modeling are then discussed.
Butler finds that the study of nonlinear dynamics in general, and
determ inistic chaos in particular, may eventually provide econom ists
w ith a determ inistic explanation fo r variables that appear to be random.
*

In the last article of this issue, we print the Fourth Annual Homer
Jones Memorial Lecture. This y ear’s speaker, David Laidler, a professor
of econom ics at the University of W estern Ontario, reviews "T h e Legacy
of the M onetarist C ontroversy.” Laidler’s paper has tw o broad themes.
The first is that people working in m onetary econom ics in the 1960s
and ’70s lost sight of the fundamental issues under debate. For example,
while original m onetarist argum ents stressed long-run relationships b e
tw een changes in the money stock and oth er variables, a generation of
young econom ists re-estim ated traditional relationships with quarterly
data, found instability, and concluded that m onetarist propositions had
been rejected. Laidler views this conclusion to be misplaced because
m onetarists had never argued they could (or should) model the com
plicated short-run dynamics that lead to the long-run relationship of
interest.
Laidler’s second them e is that ideas from New-classical econom ics,
which w ere seen originally as supporting m onetarist thought, actually
subverted it. In particular, the transm ission m echanism betw een
changes in m oney and oth er variables proposed by m onetarists was dif
feren t in fundam ental ways from that proposed by New-classical
analysis, and em pirical studies eventually rejected im portant Newclassical ideas. But by that time, Laidler argues, many econom ists had
confused traditional m onetarist principles with those of New-classical
analysis. Laidler concludes that the legacy of the m onetarist controversy
is an uncom fortable one, w ith im portant issues yet to be resolved.

FEDERAL
RESERVE BANK OF ST. LOUIS

Keith M. Carlson
Keith M. Carlson is an assistant vice president at the Federal
Reserve Bank of St. Louis. Thomas A. Pollmann provided
research assistance.

On M aintaining a R ising U.S.
S tand ard of Living Into th e
M id-21st C en tu ry

I n EARLY 1989, the Bureau of the Census
released its latest population projections for the
United States through 2080, showing slow er
growth in the total population from 1990 through
2035 and little grow th th e rea fter .1 At the same
time, the median age of the U.S. population is
projected to continue rising. The rising median
age prim arily reflects the aging of the babyboom generation, those born betw een 1946 and
1964. Given these projections, it is natural to
ask w hether the United States will be able to
maintain its standard of living into the next cen
tury. A typical example of such con cern recen t
ly appeared in the "Labor L etter" colum n of the
W all Street Jo u rn a l:2
GRIM FORECAST: Most baby boomers “will find
retirement at age 65 unaffordable" when they
get there starting in 20 years, a survey of North
American actuaries finds. They blame inadequate
savings, tax incentives and too few workers.
1Bureau of the Census (1989).
2Wall Street Journal (1989). For a general discussion of the
challenges facing the U.S. economy in the future, see
Council of Economic Advisers (1990), chapter 4.
3For a discussion of the forecast accuracy of population
projections, see Bureau of the Census (1989), pp. 14-16.

The purpose of this article is to explore the
arithm etic that underlies the broad econom ic
implications o f these population projections.
This involves deriving projections of the civilian
labor force and employment from the popula
tion projections. Achieving certain rates o f in
crease in the standard of living m eans achieving
certain rates of grow th of the U.S. capital stock.
The feasibility of these various capital stock re
quirem ents is exam ined in light of historical ex
perience to assess the prospects for future
econom ic grow th.

P O P U L A T IO N PRO JECTIO NS TO
2050
The Census Bureau has prepared population
projections fo r the United States fo r the last 30
y ears .3 In its most recen t report, the Bureau
constructed th ree basic projection series using
The bureau reports that, for a projection period of 15
years, the root-mean-square error of previous projected
growth rates is 0.40 percentage points. The difference be
tween the growth rate for its highest (lowest) projection
series and the middle series for 1990 to 2005 is 0.34
(0.28) percentage points.

MARCH/APRIL 1990

Table 1
Historical and Projected (Middle Series) Population
Growth: 1950-2050

Period
Actual:
1950 to 1960
1960 to 1970
1970 to 1980
Projected:
1980 to
1990 to
2000 to
2010 to
2020 to
2030 to
2040 to

1990
2000
2010
2020
2030
2040
2050

Growth
rate

1.72%
1.27
1.06
0.95
0.69
0.52
0.41
0.21
0.04
-0 .0 7

three d ifferent assumptions about fertility rates,
life expectancy and net im m igration .4 The dif
feren ces in the fertility assumptions are chiefly
responsible fo r m ost of the d ifferences in the
projections. T he highest, middle and lowest
series reflect the highest, middle and lowest
assumptions, respectively, fo r each of these
components.
T he Census Bureau em phasizes that its
highest and low est population projections do not
rep resen t estim ated confidence intervals based
on statistical analysis. Instead, they are referred
to simply as a “reasonable” high and low p rojec
tion. T he num erical exercises in this article con
cen trate on the middle series projection because
the Census Bureau considers it the “m ost likely.”
In addition, the horizon of the population pro
jections is the year 2050; this enables the Study
to focus on the retirem ent years of the babyboom generation.
T he Bureau of the Census projections are
sum marized in table 1 and figure 1. Declining
population grow th is not something new; it has

4By combining the assumptions in all possible ways, there
are 27 different population projections. In addition, the
Census Bureau prepares three series with a zero netimmigration assumption. The middle series for net im
migration starts with 600,000 persons per year and is
reduced and kept at 500,000 persons per year after 1997.
Compared with the zero net-immigration case, this in

FEDERAL RESERVE BANK OF ST. LOUIS

Medial age
in years
(end of period)

Percentage
of population
65 and over
(end of period)

29.4
27.9
30.0

9.2%
9.8
11.3

33.0
36.4
38.9
40.2
41.8
42.6
42.7

12.6
13.0
13.9
17.7
21.8
22.6
22.9

been under way fo r a num ber of years. The
total population grew at a 1.7 percent annual
rate from 1950 to 1960, then slowed to a 1.3
p ercent rate in the 1960s, b efo re slowing even
fu rth er in the 1970s and 1980s. From 1990 to
2040, the Census Bureau projects a positive, but
steadily declining population grow th rate; after
2040 the population level itself is projected to
decline.
As table 1 shows, one notable feature of the
projections is the expected aging of the popula
tion. The median age reached a post-1960 low
of 27.9 years in 1970 and is estim ated to reach
33 years in 1990, b efo re clim bing to 4 2.7 years
by 2050. Hand in hand with this overall aging
of the population is the rising proportion of the
population that is age 65 and older.
T he m ajor issue of con cern is w h eth er slow
ing grow th in the population, com bined with
the rising age composition, bodes ill fo r main
taining a continuing rise in the nation's standard
of living.

creases the population estimate for 2050 by 49 million per
sons, or 19.5 percent. Each 100,000 net immigrants per
year has the effect of increasing the 1990-2050 average
population growth rate by about 0.05 percent. After 1998,
the low net-immigration assumption levels out at 300,000
persons per year, and the high assumption levels out at
800,000 per year.

Figure 1
Population Projections 1
Ratio Scale
Millions of Persons
450

Ratio Scale
Millions of Persons
450

150
1950
1970
’ Total population

1990

PROJECTIONS OF L A B O R FORCE
A N D EM PLO YM ENT T O 2050
Unfortunately, the Census Bureau and the
D epartm ent of Labor do not provide labor force
and em ploym ent projections as fa r into the fu
tu re as the year 2050. T h erefore, such p rojec
tions must be estim ated in some m anner. Such
projections requ ire inform ation about the rate
at w hich the population will participate in the
civilian labor force and the rate at w hich this
labor fo rce will be employed. These rates, in
turn, depend on the age and sex composition of
the population and the labor force.
5Fullerton (1989).
6The effects of an alternative set of participation rate
assumptions based on a continuation of recent trends
were also examined. In particular, labor force participation
of females between the ages of 16 and 64 was assumed
to continue rising throughout the 2000 to 2050 period, with

2010

2030

150
2050

Participation Rates
Table 2 sum marizes historical and projected
participation rates fo r 1 0 age-sex groups for
10-year periods from 1950 through 2000. The
projected figures fo r 1990 and 2000 are based
on estim ates made by the D epartm ent of Labor .5
For purposes of this analysis, these same agesex group projections for 2 0 0 0 are assumed to
hold constant through 2 0 5 0 .6
Even though the participation rates are held
constant fo r each age-sex group, the total p ar
ticipation rate changes quite dramatically in the
the participation rate of all females 3.7 percentage points
above the basic assumption by 2050. These alternative
assumptions increased the overall participation rate by
about 2 percentage points by 2050 and reduced the re
quired growth rate of the capital stock (for a given stan
dard of living scenario) from 1990 to 2050 by 0.2 percent.

MARCH/APRIL 1990

Table 2
Historical and Projected Paticipation Rates1: 1950-2000
1950

1960

1970

1980

1990

2000

Males:
16 to 19
20 to 24
25 to 54
55 to 64
65 and over

63.2%
87.9
96.5
86.9
45.8

56.1%
88.1
97.0
86.8
33.1

56.1%
83.3
95.8
83.0
26.8

60.5%
85.9
94.2
72.1
19.0

58.0%
85.4
93.6
67.3
16.4

59.0%
86.5
93.0
68.1
14.7

Females:
16 to 19
20 to 24
25 to 54
55 to 64
65 and over

41.0
46.0
36.8
27.0
9.7

39.3
46.1
42.9
37.2
10.8

44.0
57.7
50.1
43.0
9.7

52.9
68.9
64.0
41.3
8.1

54.4
72.9
74.3
45.4
8.3

59.6
77.9
81.4
49.0
7.6

Total, 16 and over

59.2

59.4

60.4

63.8

66.7

69.0

’ Civilian labor force as a percent of civilian noninstitutional population, which equals total
population minus armed forces, institutionalized persons and persons under 16 years of age.

Figure 2
Participation Rate Projections 1
Percent
70.0

Percent
70.0

65.0

57.5
1950
1970
1990
2010
''Civilian labo r fo rce as a percent o f civilia n n o n in s titu tio nal p o pulation

Digitized FEDERAL RESERVE BANK OF ST. LOUIS
for FRASER

2030

57.5
2050

Figure 3
Population and Employment
Ratio Scale
Millions of Persons

1950

Ratio Scale
Millions of Persons

1970

1990

projection period because o f the aging trend in
the population (see figure 2). This projected
decline in the participation rate after 2 0 0 0 raises
doubts as to w hether the general standard of
living can be sustained by a w ork fo rce that is
shrinking relative to population.

Total Civilian Em ploym ent
One m ust also m ake a projection of total em
ployment, given the projections of population
and the labor force. Neither the Census Bureau
n or the Departm ent of Labor m ake employment
projections by age-sex group. So, fo r purposes
o f this analysis, 1989 employment rates are as
sumed to hold constant throughout the p rojec
7An age-sex adjusted employment (unemployment) rate is
also derived. For the middle series population projection,
the age-sex adjusted employment rate rises slowly from
94.7 percent in 1989 to 95 percent in 2050. The adjusted
unemployment rate falls from 5.3 percent in 1989 to 5 per

2010

2030

2050

tion period for each of the 1 0 age-sex groups.
Applying these employment rates to the chang
ing age distribution of the labor force yields
projections of total civilian em ploym ent .7 The
result of these total em ploym ent projections is
charted in figure 3 along w ith the middle-series
population projection from figure 1. The ratio
of total employment to total population is shown
in figure 4. Continuing a trend that began in
the 1960s, the w orking proportion of the popu
lation is projected to rise until 2005; it then
declines until 2030 b efore leveling off in 2050.
Changes in the employment-population ratio
after 2 0 0 0 reflect only the changes in the agesex distribution of the population.
cent in 2050. The resulting implications for capital stock
growth are not very sensitive to these employment rate
assumptions. For example, a 97 percent employment rate
assumption in 2050 would reduce the required growth in
the capital stock by about 0.1 percent.

MARCH/APRIL 1990

Figure 4
Employment-Population Ratio 1
.525

.500

.475

.450

.425

.400

.375

.350
1950

1970

1990

2010

2030

.350
2050

1Total civilian employment relative to total population

A LT E R N A T IV E STAND AR D - OFLIV IN G ASSU M PTIO NS
To assess the econom ic implications of these
projections on the standard of living, one must
define and m easure the standard of living. An
admittedly crude, but commonly used, m easure
o f the standard of living is GNP per capita. It
does not capture changes in the distribution of
real incom e among the population, but, for an
econom ically advanced country like the United
States, it is deemed useful in sketching the pro
spects fo r future econom ic grow th. T h ree sce
narios are developed:
Scenario 1: what grow th in the nation’s capital
stock would be required to keep
real GNP/capita growing at about
“ Note that graphing scenario 3 gets ahead of our story:
with regard to GNP per capita, it is a result rather than an
assumption.

Digitized FEDERAL RESERVE BANK OF ST. LOUIS
for FRASER

1.85 percent per year, its actual
grow th rate from 1948 to 1989?
Scenario 2: what grow th in the nation’s capital
stock would b e requ ired if real
GNP/capita rem ained constant at its
1990 value? In this case, th ere would
be zero grow th (no change) in the
nation’s standard of living.
Scenario 3: w hat would the grow th in GNP/capita
be if the capital stock grew at its
1948-89 tren d rate? This is an in
term ediate case, betw een scenario 1
and 2 .
Figure 5 depicts these alternative standard-ofliving assumptions graphically .8

Figure 5
Real GNP Per Capita
Ratio Scale
Thousands of 1982 Dollars
60

Ratio Scale
Thousands of 1982 Dollars
60

1950

1970

1990

Capital Stock Implications

2010

2030

2050

nent of grow th equal to 0.81 percent per year
because of an implicit time tren d .9

Deriving the capital stock or GNP per capita
specified in the scenarios described above re
quires the use of an estim ated production fun c
tion. The function chosen was developed by
Rasche-Tatom (1977) and updated in Tatom
(1988). This production function is Cobb-Douglas
in form and includes an implicit time trend
(proxy fo r technical change) and the relative
price of energy (for details, see appendix). Based
on this estim ated production function, each
standard-of-living assumption includes a com po

The derived results fo r the capital stock are
summ arized in table 3 and shown in figure 6 .
Table 3 decomposes the grow th of GNP per
capita in two ways: (1 ) its simple com ponents,
GNP and population, and (2) the contribution of
resource inputs and the employment-population
ratio. The decomposition fo r the 1948-89 period
shows that GNP per capita grew rapidly, in
part, because em ploym ent grow th dramatically
exceeded population grow th. For the 1990-2050

9This estimate of technical progress is of critical importance
in deriving the estimates of capital stock requirements.
The estimate of 0.81 per year is optimistic; estimating the
production function with a zero-one dummy suggests that
technical progress has been only 0.45 percent annually

since 1968.
Energy price shocks have important effects on GNP and
the standard of living, but for these projections the relative
price of energy is assumed to be unchanged from its 1989
value. Generally, such shocks cannot be predicted.

MARCH/APRIL 1990

Table 3
Decomposition of Per Capita GNP Growth1
Projected: 1990-2050
Historical
1948-89
Real GNP growth
Minus: population growth
Equals: per capita GNP growth
Or
Real GNP growth
Technical progress
Plus: employment contribution
Employment growth
Times: elasticity
Plus: capital stock contribution
Capital stock growth
Times: elasticity
Minus: employment growth
Plus: change in employment-population ratio
Employment growth
Minus: population growth
Equals: per capita GNP growth3

3.27%
1.30
1.972
3.27
0.81
1.36
1.72
(0.79)
0.76
3.60
(0.21)
1.72
0.42
1.72
1.30
1.972

Scenario 1
Trend growth
in GNP/capita

Scenario 2
Zero growth
in GNP/capita

2.17%
0.30
1.872

Scenario 3
Trend growth
in capital stock

0.30%
0.30
0.00

2.17
0.81
0.21
0.26
(0.79)
1.14
5.45
(0.21)
0.26
-0 .0 4
0.26
0.30
1.872

1.78%
0.30
1.48

0.30
0.81
0.21
0.26
(0.79)
-0 .7 0
-3 .3 3
(0.21)
0.26
-0 .0 4
0.26
0.30
0.00

1.78
0.81
0.21
0.26
(0.79)
0.76
3.60
(0.21)
0.26
-0 .0 4
0.26
0.30
1.48

1 Some components do not add to total because of rounding or production function error.
2 Rates calculated from initial year to terminal year, which differs from rate in text which is trend rate fitted to 1948-89.
3 X - P = (X-L) + (L-P), i.e., productivity growth plus change in employment-population ratio. The contribution of the change
in the relative price of energy was zero historically, and zero by assumption for the projection period.

Figure 6
Capital Stock Requirements1
Ratio Scale
Trillions of 1982 Dollars

Ratio Scale
Trillions of 1982 Dollars
100.00
75.00

50.00

25.00

10.00

7.50
5.00

.50
1950

1970

1990

<Net real nonresidential fixed capital stock

Digitized FEDERAL RESERVE BANK OF ST. LOUIS
for FRASER

2010

2030

2050

period, the em ploym ent and population p rojec
tions place a g reater burden on capital stock
grow th in achieving GNP grow th.
As figure 6 shows, the d ifferences in the
necessary capital stock among the alternatives
are huge by 2050. Expressing these requ ire
m ents in term s of rates of change of the capital
stock from 1990 to 2050 (also shown in table 3),
the differences are m ore understandable. To
achieve the 1948-89 trend grow th rate in real
GNP per capita, given the population-employm ent projections, would requ ire a 5.45 percent
average rate of grow th in the capital stock,
m uch faster than the 3.60 percent tren d rate of
grow th from 1948-89.
The second alternative of no grow th in real
GNP per capita implies a steady decline in the
capital stock. This reflects most clearly the role
of technical change in the production function.
A com bination of declining capital stock and
continuing grow th in technical change is quite
implausible, how ever. If the rate of technical
progress w ere zero, the capital stock would
have to rise slightly at a 0.44 percent average
rate, rath er than fall, to keep the standard of
living constant at the 1990 level.

Investment Ratio
An alternative way of examining these results
is to look at the annualized first d ifference of
the capital stock relative to GNP, that is, the in
vestm ent ratio .10 The annualized d ifference of
the capital stock rep resen ts the flow of n et real
nonresidential fixed investm ent in plant and
equipment. The investm ent ratio averaged 3.06
percent during 1948-89, with a maximum value
of 4.29 percent in 1966.
The impossibility of maintaining a rise in the
standard of living at the 1948-89 tren d rate
becom es obvious in figure 7; it would require a
sharp and continuing increase in the investm ent
ratio after 2000. The investm ent ratio averages
16 percent from 1995 to 2050.
The no-growth alternative, of course, implies
a steady decline in the capital stock and a nega

10Since the projections were for every fifth year starting with
1995, investment was calculated as:
AK, = ( (K,/K,_ 5 2- 1 ) • K, .
)°
This was divided by the level of GNP in year t to get the
investment ratio.

tive investment-GNP ratio. If technical progress
w ere zero, how ever, the capital stock req u ire
m ents would be higher. An average investm ent
ratio of 0.42 p ercen t would be required for
1995-2050 under such assumptions.
The final alternative—a capital stock that con
tinued to rise at its 1948-89 trend rate—implies
a slowly rising investm ent ratio that reaches 1 0
p ercen t by 2050, still well above any value it
reached during 1948-89. For this scenario, the
grow th of per capita real GNP varies over the
projection period depending on the projected
grow th rate of employment; how ever, it aver
ages about 1.48 p ercen t from 1990 to 2050 (see
figure 5).

O TH ER A N A LY T IC A L R ATIO S
Productivity o f Labor
A nother way to assess the likelihood of alter
native assumptions is to exam ine their implied
productivity trends relative to historical ex
perience. These trends are shown in figure 8 .
Scenario 1 implies a grow th rate for productivi
ty of 1.90 percent from 1990 to 2050, m uch
faster than its 1.52 percent trend rate of grow th
from 1948-89. The no-grow th scenario requires
only a 0.04 percent rate of increase in produc
tivity. Scenario 3 yields a grow th rate of p ro
ductivity of 1.52 percent, or the same as the
trend rate from 1948-89.11

Capital-Labor Ratio
An examination of capital-labor ratios can also
be used to assess the feasibility of the th ree
standard-of-living alternatives. The implied capi
tal-labor ratios for these scenarios, summarized
in figure 9, m ust be interpreted with care. Over
the 1948-89 period, the capital-labor ratio rose
slowly, at a 1.85 p ercent annual rate. M ore sig
nificantly, how ever, its rate of increase has de
clined over this period, from a 3.2 percent
grow th rate from 1948-58, to a 2.1 p ercen t rate
from 1958-75, to a 0.6 percent rate of grow th
since 1975. W ith this pattern in mind, calcula
tion of capital-labor ratios for the alternative
scenarios does not yield clear-cut conclusions.

11ln general, implied productivity trends shed little light on
feasibility because they follow from the per capita GNP
assumptions; productivity growth differs from per capita
GNP growth by the difference between projected popula
tion growth and employment growth.

MARCH/APRIL 1990

Figure 7
Investment Ratio1

-.10

- .1 0

1950

1970

1990

2010

2030

2050

'C hange in net real capital s to c k divided by real GNP

Figure 8
Productivity1
Ratio Scale
Thousands of 1982 Dollars

Ratio Scale
Thousands of 1982 Dollars

110

20
1950
1970
'Real GNP per worker

FEDERAL RESERVE BANK OF ST. LOUIS

1990

2010

2030

2050

Figure 9
Capital-Labor Ratio1
Ratio Scale
Millions of 1982 Dollars

Ratio Scale
Millions of 1982 Dollars
.800

.002

1950
1970
1990
'Net real capital stock per employed worker

Scenario 1 requires a rise in the ratio to 5.18
p ercen t a y ear from 1990 to 2050, m uch faster
than that which occu rred even during the 194858 period. The zero-grow th case does not m atch
historical experience at all. T he trend-growth-ofcapital scenario requires a rise in the capitallabor ratio of 3.34 p ercen t per year. W hile this
is in line with the early post-war experience, it
is m uch faster than the m ore recen t experience.

C A P IT A L REQUIREM ENTS FOR
ALT E R N A T IV E P O P U L A T IO N
PROJECTIONS
The capital stock requirem ents associated with
the Census Bureau’s high and low population
projections are sum m arized in table 4. T he basic
assumptions about participation rates, unem
ployment rates and the production function are
the same as used above fo r the middle-series
population projection. The high-series popula
tion projection is 38 p ercent higher than the

2010

2030

2050

middle projection in 2050, while the low-series
projection is 23 p ercen t lower. Despite this wide
variation in population, the capital requirem ents
do not differ greatly from those derived with
the middle-series projection. T he differences are
relatively small because, as shown in figure 1 0 ,
the pattern of m ovem ent of the employmentpopulation ratio over the 1990-2050 period dif
fers very little across the alternative projections.
This ratio is the key factor underlying the cru
cial im portance placed on capital stock grow th
in achieving the particular grow th rates in per
capita incom e that w ere examined. In fact, the
high series population projection requires the
largest capital stock, because its projected age
distribution has the smallest proportion of the
population actually working.

CONCLUSIONS
The grow th of the nation’s output depends on
the grow th of its labor force, its capital stock

MARCH/APRIL 1990

Table 4
Achieving Historical Trend Growth of Real GNP Per Capita in
1990-2050: Alternative Population Projections_____________
Low population
series
Population
Total civilian employment
Real GNP
Capital stock
Investment ratio1

-0.13%
-0 .1 7
1.73
4.89
13.69

Middle population
series

High population
series

0.30%
0.26
2.17
5.45
16.02

0.83%
0.74
2.70
6.17
19.93

1 Change in capital stock as a percent of real GNP: average for 1995-2050

Figure 10
Employment-Population Ratios: Alternative
Population Projection Series

FEDERAL RESERVE BANK OF ST. LOUIS

and technical progress. The Census Bureau has
released projections of U.S. population into the
21st century. T h eir middle projection shows
slowing grow th in the population through 2040,
followed by a slight decline in the population
itself for the rest of the outlook period. They
also project that the median age o f the popula
tion will rise steadily, implying that the w ork
force as a proportion of the total population will
eventually decline. Can a rising standard of liv
ing be achieved in the face o f such projections?
The conclusions derived from the study are as
follows:
(1) Achieving a rising standard of living at the rate
experienced from 1948-89 does not appear
possible. Based on an estimated technical pro
gress of 0.8 percent per year, the nation’s capi
tal stock would have to grow at a 5.5 percent
average annual rate from 1990 to 2050, well
above its 3.6 percent rate of growth from 1948
to 1989. Achieving this higher capital stock
growth would require an investment-GNP ratio
that reaches 33 percent by 2050.
(2) Maintaining the 1990 standard of living at a
constant level requires that the capital stock
decline at a 3.3 percent rate. This case was not
intended to be taken seriously; it is presented
solely to show, given this analysis, why zero
growth (or less) is an unlikely possibility.
(3) Continued growth in the capital stock at its
1948-89 trend rate yields a growth rate in per
capita real GNP of 1.5 percent. However, to
achieve this would require a steadily rising
investment-GNP ratio that reaches 10 percent

12Demographic projections should produce a rise in the saving rate as the baby-boom generation matures, before falling as they reach retirement age. Such projections are

by 2050. While achieving this ratio would be
unusual, the required ratio would be within
the range of historical experience until 2015.

Left unexam ined in this study is an analysis of
the prospects fo r saving .12 Capital stock req u ire
m ents will not be achieved unless resources are
released for investm ent by abstaining from p re
sent consum ption. By using historical trends in
realized investment-GNP ratios, how ever, an ap
proxim ate determ ination of feasible grow th
paths was possible. Increasing the standard of
living at the 1948-89 pace appears impossible.
On the oth er hand, achieving a rising standard
o f living in the 1 to 1.5 p ercen t range appears
achievable in light of historical experience.

REFERENCES
Aaron, Henry J., Barry P Bosworth, and Gary T. Burtless.
.
Can America Afford to Grow Old? (Brookings Institution,
1989).
Bureau of the Census, U.S. Department of Commerce. Pro
jections of the Population of the United States, by Age, Sex,
and Race: 1988 to 2080 (GPO, 1989).
Council of Economic Advisers. Economic Report of the Presi
dent (GPO, 1990).
Fullerton, Howard N., Jr. “ New Labor Force Projections,
Spanning 1988 to 2000,” Monthly Labor Review (November
1989), pp. 3-12.
Rasche, Robert H., and John A. Tatom. “ Energy Resources
and Potential GNP,” this Review (June 1977), pp. 10-24.
Tatom, John A. “Are the Macroeconomic Effects of Oil-Price
Changes Symmetric?” Stabilization Policies and Labor
Markets, Carnegie-Rochester Conference Series on Public
Policy, Vol. 28 (Spring 1988), pp. 325-68.
Wall Street Journal, November 7, 1989.

tenuous, however, as pointed out by Aaron, Bosworth and
Burtless (1989), p. 139: “ Demographic trends appear to
bear little relation to past rates of private saving . . . ”

MARCH/APRIL 1990

Appendix
Production Function
The production function used in this study is
a version of the one originally developed by
Rasche and Tatom (1977) and modified and up
dated in Tatom (1988). It is a Cobb-Douglas
function w ith labor, capital and energy specified
as resource inputs. GNP (in 1982 dollars) was
estim ated as a function of total civilian employ
ment, net real nonresidential fixed capital stock
adjusted for capacity utilization and the relative
price of energy. Using annual data for 1954-89
(omitting the early post-w ar years and the Kor
ean W ar), the following estim ate was obtained
w here din is the first d ifference of the loga
rithm (t-values in parentheses):
din (
= .0081309 + .787 din (
VKU;
(3.88)
(19.85)
V K U;
- .041 din P
( - 2 .3 5 )

RESERVE BANK OF ST. LOUIS
FEDERAL

R 2 = .930
SE = .010

DW = 1.952
e = .189

X = GNP in 1982 dollars
K = net nonresidential fixed capital stock in
1982 dollars
U = Federal Reserve capacity utilization rate
(manufacturing)
L = total civilian employment
P = relative price of energy (ratio of produ
cer prices of fuel, related products, and
pow er to the GNP implicit price deflator)
This estim ated production function was solved
fo r In KU and used to derive estim ates of the
capital stock for the alternative assumptions
making use o f the GNP estim ates implied by
those alternatives and the total employment
estim ates derived from the population p rojec
tions. The 1989 values of the relative price of
energy ( = .577) and the capacity utilization rate
( = .839) w ere held constant during the p rojec
tion period in the derivation of the n et real
capital stock.

Michelle R. Garfinkel
Michelle R. Garfinkel is an economist at the Federal Reserve
Bank of St. Louis. Scott Leitz provided research assistance.

The FOMC in 1 9 8 9 : W alking a
T ig h tro p e

1
111 FEDERAL Open M arket Committee
(FOMC) sought to balance the risk of infla
tionary pressures against that of a weakening
econom y in 1989, the seventh year of the cu r
ren t econom ic expansion .1 The changing relative
intensity of these risks, as perceived by the
FOMC (hereafter, the Committee), influenced
the course of m onetary policy throughout the
year.
Because the Committee believed that long-run
price stability is necessary to prom ote maximum
sustainable econom ic grow th over time, the
perceived risks of inflationary pressures greatly
influenced its decisions early in the year. As the
year progressed, how ever, it becam e increasing
ly apparent to the Committee that the econom ic
expansion was weakening. At the same time,
the Com m ittee’s perception of the tren d in infla
tion becam e slightly m ore optimistic. According
ly, the weight that the Committee attached to
reducing the risks of a slowdown in econom ic
activity increased somewhat throughout the se
cond half of 1989. Nevertheless, the Committee’s
con cern about future price pressures and the
im portance of maintaining its own credibility as

NOTE: Citations to the Record refer to the “ Record of
Policy Actions of the Federal Open Market Committee” as
published in various issues of the Federal Reserve Bulletin.
Citations to “ Report” refer to the “ Monetary Policy Report
to the Congress,” which is also published in the Federal
Reserve Bulletin.

an inflation-fighter rem ained in the fo refro n t of
its deliberations.
This article review s the form ulation of m one
tary policy by the Committee in 1989. T he dis
cussion focuses on how changing econom ic con
ditions influenced the Comm ittee’s decisions as
it balanced the risk of futu re inflation against
that of a futu re slowdown in econom ic activity.

LO NG-R UN OBJECTIVES
The Board of Governors of the Federal
Reserve System rep orts to Congress tw ice a
year on its annual grow th rate targets for the
m onetary and debt aggregates. The one-year
target periods run from the fourth q u arter of
the previous y ear to the fou rth q uarter of the
cu rren t year. These rep orts are mandated by
the Full Employment and Balanced Growth Act
of 1978 (or the Humphrey-Hawkins Act). A fter
its first m eeting of the year in February, the
Committee submits a report on its m onetary
and debt grow th objectives fo r the cu rren t
year. In July, upon reviewing the progress it
has made tow ard achieving its objectives for the

'See the shaded insert on pages 18 and 19 for a description of the Committee’s membership during 1989.

MARCH/APRIL 1990

Organization Of The Committee
T h e Federal Open M arket Committee
(FOMC) consists of 12 m em bers, including the
seven m em bers of the Federal Reserve Board
o f Governors and five of the 12 Federal
Reserve Bank presidents. The chairm an of
the Board o f Governors is traditionally
elected chairm an of the Committee. The
president of the New York Federal Reserve
Bank, also by tradition, is elected the Commit
tee’s vice chairm an. All Federal Reserve Bank
presidents attend Committee m eetings and
present their views, but only those who c u r
rently are m em bers of the Committee are
perm itted to vote. In previous years, the four
m em berships that rotate among the Bank
presidents w ere held fo r one-year term s com
m encing M arch 1 of each year. In 1989,
how ever, the m em berships w ere only for 1 0
m onths so that, starting in 1990, the one-year
term s would be on a calendar-year basis. The
president of the New York Federal Reserve
Bank is a perm anent voting m em ber of the
Committee.
M em bers of the Board of Governors at the
beginning of 1989 included Chairman Alan
Greenspan, Vice Chairman Manuel H. Johnson,
W ayne K. Angell, H. Robert Heller, Edward
W. Kelley, Joh n P. LaW are and M artha R.
Seger. Mr. Heller resigned as a m em ber of
the Committee during the year. His position
was not filled during 1989.
The following Bank presidents voted at the
meeting on February 7-8, 1989: E. Gerald
Corrigan (New York), Robert P. Black (Rich
mond), Robert P. Forrestal (Atlanta), W. Lee
Hoskins (Cleveland) and Robert T. Parry (San
Francisco). In M arch, the Committee m em ber
ship changed and the presidents’ voting posi
tions w ere filled by E. Gerald Corrigan (New
York), Roger Guffey (Kansas City), Silas Keehn
(Chicago), Thom as C. M elzer (St. Louis) and
Richard F. Syron (Boston).
The Committee m et eight tim es at regularly
scheduled m eetings during 1989 to discuss
econom ic trends and decide the future course
of open m arket operations .1 As in previous
1No meetings were held in January, April, June or
September.

FEDERAL RESERVE BANK OF ST. LOUIS

years, telephone consultations occasionally
w ere held betw een scheduled meetings. At
the end of each scheduled meeting, a direc
tive was issued to the Federal Reserve Bank
of New York. Each directive contained a
short summary of econom ic developments,
the general econom ic goals sought by the
Committee, its long-run m onetary grow th ob
jectives, and instructions to the M anager for
Domestic Operations at the New York Bank
fo r the conduct of open m arket operations
during the new interm eeting period. These
instructions w ere stated in term s of the
degree of pressure on reserve positions to be
sought or maintained. The reserve conditions
stated in the directive w ere deemed consis
tent with specific short-term grow th rates for
M2 and M3 w hich, in turn, w ere considered
consistent with desired long-run grow th rates
for these m onetary aggregates. T he Commit
tee also specified interm eeting ranges fo r the
federal funds rate. These ranges provided
one m echanism fo r initiating consultations
betw een m eetings w henever it appeared that
the constraint on the federal funds rate was
inconsistent w ith the objectives for the
behavior of the m onetary aggregates.
The M anager for Domestic Operations has
the prim ary responsibility fo r formulating
plans regarding the timing, types and
amounts o f daily buying and selling of
securities in fulfilling the Comm ittee’s direc
tive. Each m orning the M anager and his staff
plan the open m arket operations fo r that day.
This plan is developed on the basis of the
Com mittee’s directive and the latest develop
m ents affecting m oney and credit m arket
conditions, the grow th o f m onetary aggre
gates, and bank reserve conditions. T h e Man
ager also consults with the Board’s staff. Pre
vailing m arket conditions and open m arket
operations that the M anager proposes to exe
cute are discussed each m orning in a tele
phone con feren ce call involving the staff at
the New York Bank, one voting president at

another Reserve Bank and staff at the Board.
O ther m em bers of the Com m ettee may par
ticipate and are inform ed of the daily plan by
internal memo or wire.
The directives issued by the Committee and
a summary of the discussion and reasons for
Committee actions are published in the
"Record of Policy Actions of the Federal Open
M arket Com m ittee.” T he “Record” fo r each
m eeting is released a few days after the next
scheduled Committee meeting. It subsequent
ly appears in the F ed era l R eserv e Bulletin. In
addition, “Records” fo r the entire year are
published in the annual rep ort of the Board
of Governors. T he record fo r each meeting in
1989 included:
(1 ) a staff sum m ary of recen t econom ic
developm ents—such as changes in
prices, employment, industrial produc
tion and com ponents of the national
accounts—and projections of general
price, output and employment
developments for the year ahead;

first half of the year, the Committee decides
w h eth er to adjust or retain its target fo r the
cu rren t y ear and establishes tentative targets
for the following year. Shortly after the July
meeting, a rep ort of the Com m ittee’s decisions
is submitted to Congress. Table 1 sum m arizes
the Committee's long-run m onetary grow th ob
jectives for 1989 as reported to Congress.
As was the case in the previous two years,
the Committee did not establish a targ et range
for M l in 1989. T he Committee believed that
the unpredictable relation o f M l to econom ic
activity and prices did not w arran t reliance on
this aggregate as a guide to the im plem entation
of m onetary policy .2
To u nderscore its com m itm ent to resist future
inflationary pressures and to m ake progress
tow ard reasonable price stability, the Committee
reaffirm ed the 1989 targets for M2 and M3, 3
to 7 p ercen t and 3Vz to 7Vz percent, respective

2Record (May 1989), pp. 357-58. See Hafer and Haslag
(1988), who discuss the Committee's decision to omit a
target range for M1.

(2 ) a sum m ary of recen t international
financial developments and the U.S.
foreign trade balance;
(3) a sum m ary of open m arket operations,
grow th of the m onetary aggregates and
bank reserves and m oney m arket condi
tions since the previous meetings;
(4) a sum m ary of the Committee’s discus
sion of the cu rren t and prospective
econom ic and financial conditions;
(5) a sum mary o f the m onetary policy
discussion of the Committee;
(6 ) a policy directive issued by the Commit
tee to the Federal Reserve Bank of New
York;
(7) a list o f the m em bers’ votes and any
dissenting com m ents; and
(8 ) a description of any actions regarding
the Committee’s oth er authorizations
and directives, and reports on any ac
tions that might have occu rred betw een
the regularly scheduled meetings.

ly, that had been set tentatively in July 1988.3
These target ranges for M2 and M3 w ere 1 and
Vz percentage points, respectively, low er than
those established for 1988.
The Committee also decided to m aintain the 4
percentage-point spreads betw een the upper
and low er bounds o f the target ranges for the
tw o broad m onetary aggregates. Until tw o years
ago, this spread had been 3 percentage points.
The w ider ranges w ere adopted in 1988 w hen
the Committee concluded that the relations of
M2 and M3 grow th to econom ic grow th and in
flation had becom e considerably m ore variable
and, therefore, that estim ates of grow th rates
fo r these aggregates that would be consistent
with the Com mittee’s objectives for the econom y
w ere subject to greater uncertainty. Forecasting
the appropriate grow th rates was made more
difficult by the Com mittee’s uncertainty about
the impact of future developments on th rift in
stitutions and the subsequent effect on the
3Report (March 1989), p. 108.

MARCH/APRIL 1990

Table 1
The FOMC’s Long-Run Operating Ranges
Ranges
Date of meeting

Target period

June 29-30, 19881
February 7-8, 19892
July 5-6, 1989

IV/1988-IV/1989
IV/1988-IV/1989
IV/1988-IV/1989

3-70/o
reaffirmed
reaffirmed

3.5-7.5%
reaffirmed
reaffirmed

July 5-6, 19893

IV/1989-IV/1990

3-7%

3.5-7.5o/o

1 Ms. Seger dissented. She wanted to retain the 4-8 percent target ranges for M2 and M3 at that
time in light of the uncertainty about the economic outlook.
2 Mr. Hoskins dissented. He believed that money growth should be toward the low end of the
ranges if any reasonable progress were to be made in reducing inflation. In his view,
establishing lower target ranges would emphasize the System's perseverance in reducing infla
tionary pressures.
3 Mr. Keehn dissented. He favored reducing the target ranges to communicate the System’s
adherence to its anti-inflationary commitment.

grow th of the m onetary aggregates .4 The wider
target ranges w ere intended to give the Com
m ittee leeway to achieve its long-run objectives
of maximum sustainable econom ic grow th and,
eventually, price stability.

Table 2
Target Ranges and Actual Money
Growth in 1989

By the early July m eeting, M2 and M3 w ere
growing at rates at or below the low er bounds
of their respective target ranges. Through June,
M2 grow th was estim ated to be 1 percentage
point below its range and M3 grow th was
estim ated to be at the low er end of its range.
Nevertheless, in the context of recen t declines
in m arket interest rates, the Board’s staff
forecasted that the stronger grow th exhibited
by these aggregates since the middle of May
would continue, thereby bringing the grow th
rates of M2 and M3 com fortably w ithin their
target ranges by the fou rth quarter. Because it
believed that these expected grow th rates would

be compatible with its objectives fo r econom ic
grow th and progress tow ard price stability, the
Committee reaffirm ed its 1989 targets for M2
and M3 in the July R eport .5

4Record (May 1989), p. 357. The wide range of possible ef
fects of future developments on thrift institutions and
subsequent effects on money growth made the staff’s
money growth forecasts subject to considerable uncertain
ty. See Garfinkel (1989) for a discussion of the Commit
tee’s motivation for adopting the wider M2 and M3 target
ranges.

5Report (August 1989), pp. 528-29. Also see Record
(October 1989), p. 693. It should be noted that all money
growth rates reported here are revised figures, as of
February 21, 1990, incorporating the February 1990 ben
chmark and seasonal revisions. The reported numbers for
M2 growth also incorporate the redefinition of M2 that now
includes thrift overnight repurchase agreements.

Digitized FEDERAL RESERVE BANK OF ST. LOUIS
for FRASER

Aggregate
M2
M3

Target range1

Actual

3-70/0
3.5-7.5

4.6%
3.3

1
The target period for M2 and M3 growth is from IV/1988 to
IV/1989.
:r

Figure 1
Money Stock (M2)
B illio ns o f do llars
3320

S easonally A djusted
M onthly Averages o f D aily Figures

B illio n s o f do llars
3320

3280

3240

3200

3160

3120

3080

3061.8
3040

3040

Nov

Dec
1988

The July Report also stated that the 1989
target ranges fo r M2 and M3 would be extended
tentatively to 1990. W hile the Committee recog
nized that a fu rth er reduction in the grow th of
the m onetary aggregates would be m ore consis
tent w ith attaining price stability over time,
many m em bers believed that m ore rapid M2
grow th might be necessary to prom ote
reasonable grow th in econom ic activity in 1990.
Reductions in the ranges would increase the like
lihood of making policy appear unpredictable by
increasing the possibility of a reversal later or of
having to tolerate grow th rates exceeding the
low er target ranges. The targets for 1990 could
be adjusted in February, if appropriate .6
Table 2 indicates that the actual rate of grow th
in M2 during 1989, 4.6 percent, was close to
the middle of its target range. The actual rate
of grow th in M3, 3.3 percent, how ever, was
slightly below the low er bound of its target
range. T he grow th rates varied considerably

Nov

Dec

1989

during the year as illustrated in figures 1 and 2 ,
w hich show the monthly averages of (revised)
daily figures, respectively, for M2 and M3. As dis
cussed below , these variations had some in
fluence on the Com mittee’s short-run policy
decisions.

SH O RT-R UN PO LIC Y OBJECTIVES
Each year, the Committee holds eight regular
ly scheduled m eetings to review incoming data
and assesses the cu rren t econom ic environm ent
and the prospects fo r the future course of the
economy. Based on this inform ation, the m em
b ers determ ine w hat changes, if any, should be
made in short-run m onetary policy to achieve
the Committee’s long-term goals. At the close of
each meeting, the Committee issues a domestic
policy directive to the Federal Reserve Bank of
New York. This directive serves as the basis for
day-to-day im plem entation of policy in the inter-

6Record (October 1989), pp. 693-94.

MARCH/APRIL 1990

Figure 2
Money Stock (M3)
Billions of dollars

4250,

Seasonally Adjusted
Monthly Averages of Daily Figures

Billions of dollars

4250

7.5% 1

4200

4150

4100

3.5%

4050

—■■
■■

4050

4000

3950

3900

3901.9

3850

•;

m eeting period by the M anager for Domestic
Operations, w ho is responsible for executing the
directives. As usual, the directives issued during

procedure, an instruction to increase the degree
of pressure on reserve positions would imply a
higher target for borrow ed reserves (adjustment

1 9 8 9 prim arily em phasized the d egree of r e

plus seasonal borrow ings) and a h igh er fed eral

straint on reserve positions (maintain, increase or
decrease) that was considered by the m em bers
to be consistent with the Com m ittee’s money
grow th targets and goals for the economy.

funds rate for a given discount ra te .7

Maintaining the approach used since O ctober
1982, the Federal Reserve System followed a
borrow ed-reserves operating procedure. This
procedure translates the degree of reserve re
straint specified in the directive into a target for
borrow ed reserves (reserves borrow ed from the
Federal Reserve Banks). For example, under this

H'he positive relation between borrowed reserves and the
federal funds rate follows from economic theory.
Specifically, the demand for borrowed reserves (the “ bor
rowings function” ) is negatively related to the opportunity
cost of borrowing from the discount window. This cost
equals the spread between the discount rate (the interest
rate paid by depository institutions for borrowed reserves

RESERVE BANK OF ST. LOUIS
FEDERAL

Tow ard the end of 1988 and continuing into
1989, how ever, this operating procedure was
com plicated by the unstable relation betw een the
demand for borrow ed reserves and the federal
funds rate. Specifically, the willingness of deposi
tory institutions to borrow reserves, fo r given
federal funds and discount rates, was declining
unexpectedly. At the D ecem ber 1988 meeting,
the Committee considered the possibility of ad
justing the operating procedure to shift the focus

from Federal Reserve Banks) and the federal funds rate
(the interest rate paid for reserves borrowed from other
depository institutions). For a discussion of the implemen
tation of monetary policy under the borrowed-reserves
operating procedure, see Gilbert (1985) and Thornton
(1988).

of policy im plem entation to the federal funds
rate, but the m em bers generally agreed that ad
hering to the cu rren t procedure would be ap
propriate given its advantages .8 N evertheless, the
Committee believed that the u ncertainty about
the relation of borrow ings to the federal funds
rate w arranted flexibility in implementing m one
tary policy. Hence, some of the directives issued
in 1989 w ere w ritten with the understanding
that flexibility would be perm itted in conducting
day-to-day policy so as to achieve the Commit
tee’s objectives, given the changing conditions in
the m arket fo r borrow ed reserves.
Fu rtherm ore, the Committee maintained the
flexibility in short-run policy adopted in previous
years because of u ncertainty about the relations
of m onetary aggregate grow th to output grow th
and inflation. T he Committee believed that shortrun policy should be decided not only on the
basis of the behavior of the m onetary aggre
gates, but on the basis of indicators of infla
tionary pressures, econom ic grow th and the
changing conditions in domestic financial and
foreign exchange m arkets .9
In addition to the desired degree of reserve
pressure, the directives indicated potential
modifications in the interm eeting period, and
the expected grow th rates of M2 and M3 condi
tional on the desired reserve restraint. Each
directive also established a m onitoring range for
the federal funds rate. T he Chairman could in
itiate a Committee consultation if, during the in
term eeting period, the federal funds rate w ere
to move out of that range. Over the past several
years, how ever, such consultations have been
initiated because of unexpected econom ic and
financial developments.
The following discussion review s each FOMC
m eeting chronologically. It focuses on the im
portant econom ic developments of 1989, show
8Record (April 1989), pp. 295-96. Also see, for example,
Record (May 1989), p. 359. The particular advantage of
the current operating procedure mentioned in the Commit
tee’s discussion was that it permits “ greater scope for
market forces to determine short-term interest rates.”
[Record (April 1989), p. 296.] Such a procedure, however,
can be less effective in maintaining short-term control over
the money stock if the borrowings function is subject to
unexpected shifts that are not quickly identified and
reflected in changes to the borrowings assumption. See
Thornton (1988) for a discussion on the advantages and
disadvantages of this procedure.
9Report (March 1989), p. 108.

ing how they influenced the Com mittee’s form u
lation of short-run policy objectives. Table 3
sum m arizes the directives issued in 1989. Table
4 shows the actual (revised) intra-year grow th
rates in M2 and M3, as well as those rates ex
pected by the Committee.

February 7-8 Meeting
Econom ic data review ed at this m eeting sug
gested that, abstracting from the direct im pact
of the previous y ear’s drought, econom ic
grow th continued at a fast pace. The m arked
increase in total nonfarm payroll employment in
Jan uary w as widespread and the civilian unem
ployment rate of 5.4 p ercent was only m arginal
ly above D ecem ber’s rate of 5.3 percent. Indus
trial production rose sharply in D ecem ber and
Jan uary and the industrial capacity utilization
rate in January exceeded its average rate over
the fourth qu arter of the previous y e a r .10
Indicators of inflation at the beginning of
1989 showed hardly any change from 1988. Al
though the producer price index rose sharply in
D ecem ber, the behavior of the consum er price
index, excluding food and energy, was perceived
to be in line with its pattern in 1 9 8 8 .11 Labor
costs, particularly wages and salaries, rose appre
ciably faster than one year earlier, however.
As instructed by the Committee’s last directive
in 1988, the degree of pressure on reserve posi
tions was increased at the beginning of the p re
vious interm eeting period. During this period,
the average level of adjustm ent plus seasonal
borrow ings was slightly above $500 million and
the federal funds rate rose to about 9 percent
from about 8 V2 percent. As oth er m arket in ter
est rates rose, the grow th of the broader
m onetary aggregates, particularly M2, weakened
in Jan u ary .12
in December and January. The Board’s measure of the
total industry capacity utilization rate in January was 84.3
percent, up from the previous quarter’s average of 84.1
percent.
"Ibid., pp. 353-54. The annual growth rate of the seasonally
adjusted producer price index for finished goods was 3.3
percent in December, while the seasonally adjusted con
sumer price index for all urban consumers rose at an an
nual rate of 4.1 percent. Excluding food and energy, the
latter index rose at an annual rate of 4.9 percent.
12lbid., p. 354. In January, M2 rose sluggishly at an annual
rate of 0.5 percent and M3 rose at an annual rate of 2.4
percent.

10Record (May 1989), p. 353. Industrial production rose at
annual rates of 4.4 percent and 3.5 percent, respectively,

MARCH/APRIL 1990

Table 3
The FOMC’s Short-Run Operating Ranges for 1989
Expected
growth
rates
M2
M3

Degree
of
reserve
pressure1

Intermeeting
federal
funds
range

Date of
Meeting

Target
period

February 7-8,
19892

December 1988March 1989

3V2°/o

maintain
(+)

7-11%

March 28, 19893

March-June

maintain
(+)

8-12

May 16, 19894

March-June

V/2

maintain

8-12

July 5-6, 1989=

June-September

slightly reduce

7-11

August 22, 19896 June-September

maintain
(-)

7-11

October 3, 19897 SeptemberDecember

6V2

4V2

maintain
(-)

7-11

November 14,
19898

SeptemberDecember

71
/2

41/2

maintain
(-)

7-11

December 18-19,
1989^

November 1989March 1990

81
/2

51
/2

slightly reduce

6-10

1A ‘ + ’ indicates an expectation that during the intermeeting period developments were more
likely to warrant an adjustment toward restraint than toward ease. The opposite is true for a
2Messrs. Hoskins and Parry dissented. Mr. Hoskins thought that an immediate move toward
greater monetary restraint would be appropriate to put policy on a course toward price stability
in the longer run. Mr. Parry stressed that, since economic growth had exceeded its long-run,
noninflationary rate, inflationary pressures were already increasing. In their view, without an
immediate increase in restraint on reserve positions, inflationary pressures would intensify and
thereby make the task of achieving the Committee's anti-inflationary goal more difficult.
3Ms. Seger dissented. Although maintaining the existing degree of reserve pressure was ap
propriate in her view, she believed that the bias toward monetary restraint was undesirable in
light of the lagged effects of appreciable tightening that had been undertaken earlier along
with current indications of slower economic growth.
4Mr. Melzer dissented, advocating prompt action to ease the degree of reserve pressure slight
ly. Pointing to the past two years of slow money growth, he stressed that the current high in
flation would be reduced eventually and that, in the absence of an easing action, the risks of
a recession would be augmented. Reaching the System’s non-inflationary goal would be
hampered if, in response to a recession, monetary policy were to aim at a quick recovery.
5Ms. Seger dissented. She favored a greater degree of easing that, in her view, would be
necessary to promote reasonable economic growth in the following years.
6Mr. Guffey dissented. He could accept an unchanged policy. But he believed that a directive
that was biased toward ease was not appropriate given that the chances of a weakening of
the economic expansion appeared to be essentially the same as the chances of a strengthen
ing of the expansion while, in his view, the current and expected future inflation rates were
not acceptable. Furthermore, such a bias toward ease could lessen confidence in the Commit
tee’s commitment to achieve long-run price stability.

FEDERAL
RESERVE BANK OF ST. LOUIS

Table 3 continued
The FOMC’s Short-Run Operating Ranges for 1989_________
7Mr. Guffey and Ms. Seger dissented. Mr. Guffey believed that the bias toward easing reserve
pressure in the inlermeeting period was not appropriate, for he was concerned that inflation in
the future would remain unacceptably high. Ms. Seger pointed to signs of a weakening
economy and indicated that some immediate easing would be necessary to sustain the expan
sion. She believed that such a policy would be consistent with the Committee’s long-term ob
jective of price stability.
eMs. Seger dissented. In her view, signs of a weakening in economic activity, particularly in the
manufacturing sector, warranted an immediate further easing of reserve pressure.

9Messrs. Angell and Melzer dissented, favoring an unchanged policy. Mr. Angell believed that a
policy of easing reserve restraint based on recent indications of a weakening in economic ac
tivity was not warranted. To the extent that the impact of monetary policy is realized with a
lag, in his view, policy should be based on forward-looking indicators of economic activity.
Further, he believed that an easing of policy at this time, given past policy, could have an un
favorable impact on the System’s credibility in pursuing a goal of price stability. Mr. Melzer
noted that policy had been eased considerably over the past six months and, given the suffi
cient liquidity in the economy, he did not believe that further easing was desirable. He also
was concerned that, in light of the current and projected growth of the monetary aggregates,
easing of policy at this time would hamper the System’s ability to make progress toward its
long-term goal of price stability.

Table 4
Actual and Expected Rates of Money
Growth
M2
Period

Expected Actual Expected Actual

December 1988March 1989

1.9%

31 %
/2

4.0%

March 1989June 19891

1V2-3

1.9

4-5

2.9

June 19897-9
September 19892

8.2

2.7

September 19896V2-7V2
December 19893

7.7

4V2

3.2

1 the May 16 meeting, the Committee lowered its ex
At
pectation for M2 and M3 to 1V2 percent and 4 percent,
respectively, from 3 percent and 5 percent.
2 the August 22 meeting, the Committee’s expecta
At
tions for M2 growth were revised from 7 percent to 9
percent.
3
The Committee’s expectation for M2 growth was revised
from 61/2 percent to IV i percent at the November 14
meeting.

T he Board’s staff expected that econom ic acti
vity would continue expanding in 1989 at a m ore
modest pace than it had in 1988. Assuming that
m onetary policy would attem pt to contain the
inflationary pressures predicted by the staff, the
staff’s forecast pointed to pressures in financial
m arkets that would tend to dampen grow th in
domestic spending. In addition, the staff ex
pected that foreign demands would provide less
of an impetus to dom estic output grow th than
in 1988. Given the relatively low m argins of
unutilized labor and high capacity utilization
rates, the staff predicted additional price pres
sures in the cu rren t y e a r .13
In the Committee’s discussion of policy imple
mentation, many m em bers indicated that eco
nomic grow th appeared to be balanced, but most
m em bers expressed con cern about the prospect
of greater inflation. A m ajority of the m em bers,
however, saw no need for an immediate change
in policy in light of the data available for review,
the appreciable recen t tightening in policy and
their perception that the credibility of the Com
m ittee’s com m itm ent to fight inflation was high.
These m em bers w ere willing to wait for addi
tional evidence confirm ing their fears of greater
inflation b efore tightening policy fu rth e r .14

13lbid., pp. 354-55.
14lbid., p. 358.

MARCH/APRIL 1990

Some m em bers advocated an immediate tight
ening of reserve conditions to contain any future
inflationary pressures. In their view, w ithout im
mediate action, the task of achieving price
stability could becom e m ore difficult. O ther
m em bers expressed con cern that additional
pressure on reserve positions could aggravate
the financial conditions of many th rift institutions
and highly indebted firm s. In addition, fu rth er re
straint might add to the recen t unusual strength
of the dollar .15 Although the recen t slow grow th
of the m onetary aggregates was thought to indi
cate future restrain t on price pressures, some
m em bers cautioned that a shortfall from
targeted ranges would be a m atter of co n cern .16
At the end of the meeting, the Committee
adopted a directive that called for an unchanged
degree of pressure on reserve positions, with a
possible increase or decrease depending on fo rth
coming inform ation about inflationary pressures,
the strength of business expansion, grow th in
the m onetary aggregates and developments in
foreign exchange and domestic financial m arkets.
As table 3 indicates, how ever, th ere was a
“bias” tow ard restraint, and the m em bers called
fo r "rem aining alert to potential developments
that might requ ire some firm ing during the in
term eeting period .”17 In light of the continuing
u ncertainty about the relation of the demand
fo r borrow ed reserves to the federal funds rate,
the directive was issued w ith the explicit under
standing that flexibility would be needed in implem entating m onetary policy. Given the con
templated reserve conditions, the Committee ex
pected the annual grow th rates for M2 and M3
to be around 2 percent and 3Vz percent, respec
tively, from D ecem ber to M arch. The directive
left the range for the federal funds rate un
changed at 7 to 11 p ercen t .18

March 28 Meeting
During the interm eeting period, additional
pressure was placed on reserve positions, in

15lbid., pp. 358-59. As a measure of the relative strength of
the dollar in foreign exchange markets, the Federal
Reserve Board constructs a trade-weighted index using
the currencies of Belgium, Canada, France, Germany, Ita
ly, Japan, the Netherlands, Sweden, Switzerland and the
United Kingdom. The trade-weighted index rose about 6
percent over the intermeeting period.
16lbid.
17lbid., p. 359.
18lbid., pp. 359-60.
19Record (July 1989), p. 503. M2 rose at annual rates of 1.8
percent and 3.5 percent, respectively, in February and

RESERVE BANK OF ST. LOUIS
FEDERAL

light of incoming data indicating g reater infla
tionary pressures. Also, on February 24, the
Board of Governors approved a 50 basis-point
increase in the discount rate to 7 percent. From
the time o f the increase in the discount rate to
this meeting, the federal funds rate rose nearly
75 basis points to slightly above 9% percent.
O ther m arket interest rates, especially those on
shorter-term securities, also rose. As the de
mand for borrow ed reserves appeared to fall,
the borrow ings assumption was lowered as a
technical adjustm ent. The average of adjustm ent
plus seasonal borrow ings during the six-week
period just b efore this meeting fell to about
$450 million. Although the m onetary aggregates
appeared to gain some strength in February and
M arch, their grow th was viewed as sluggish re
lative to that in the previous y e a r .19
T he inform ation available fo r review at this
m eeting suggested that econom ic activity ex
panded considerably in the first quarter. Total
nonfarm employment advanced sharply in
February and the civilian unem ploym ent rate
fell to 5.1 percent. Only part of the employment
gain was attributed to the unusually mild w eath
er during the first two m onths of the y e a r .20
T h ere w ere, how ever, indications of a slight
w eakening of the econom ic expansion. For ex
ample, prelim inary data suggested that industrial
production rem ained flat and capacity utilization
rates fell slightly in Feb ru ary .31 Furtherm ore,
grow th in consum er spending slowed in the
first two m onths of the year from its vigorous
pace during the last q uarter of 1988. Although
the data indicated that the nom inal U.S. m er
chandise trade deficit improved in January, the
value of exports fell. But the observed net rise
of the trade-weighted value o f the dollar over
the interm eeting period was attributed largely
to the rise in m arket in terest rates stemming, in
part, from restrictive actions taken during that
period .22

March. M3 rose at annual rates of 3.3 percent and 6.2
percent, respectively, during those same two months.
20lbid., p. 502. The civilian unemployment rate in February
has been revised upward to 5.2 percent.
2 Ibid. Revised data indicate that industrial production ac
1
tually fell in February at an annual rate of 2.5 percent.
22lbid., pp. 502-03. The trade-weighted index of the value of
the dollar in foreign exchange markets rose approximately
1.5 percent over the intermeeting period.

Price pressures appeared to gain some
strength in the first two m onths of 1989. The
observed increases in price indexes w ere
thought to be due chiefly to energy and food
prices. Even excluding these com ponents, how
ever, the producer and consum er price indexes
rose sharply in Jan uary and Febru ary .23
The Board’s staff predicted that the pace of
econom ic expansion would slow considerably
from the pace in 1988. The forecast assumed
that m onetary policy would restrain the infla
tionary tendencies in the econom y. Such a policy
could put additional pressure on financial m ar
kets and involve slow er grow th in consum er
spending and business fixed investm ent .24
T he m em bers generally agreed that, in light of
mixed evidence about the strength of econom ic
expansion and the uncertain prospects for the
future, an unchanged policy would be accept
able. Some m em bers, who p referred an immedi
ate tightening of reserve conditions, believed
that inflationary pressures could intensify given
the apparent m om entum in econom ic activity.
These m em bers, how ever, w ere willing to wait
fo r additional inform ation that tended to confirm
their fears. Most m em bers believed that the
unusual strength of the dollar in foreign ex
change m arkets would dampen price pressures.
Furtherm ore, as suggested by earlier ex
perience, the sluggish grow th in the m onetary
aggregates lessened the likelihood that inflation
could gain m uch strength in the fu tu re .25
As table 3 shows, the Committee adopted a
directive that did not call fo r a change in policy
but that perm itted a policy adjustm ent during
the interm eeting period m ore readily toward
restrain t than ease. Open m arket operations
w ere to be conducted w ith some degree of flex
ibility because of the continuing uncertainty
about the relation of the demand of borrow ed
reserves to the federal funds rate. Growth in
M2 and M3 w ere expected to b e around 3 p er
cent and 5 percent, respectively, from M arch to

23lbid. The seasonally adjusted producer price index for
finished goods rose at annual rates of 13.9 percent and
7.8 percent, respectively, in January and February; ex
cluding food and energy prices, it rose at annual rates of
6.2 percent and 7.2 percent, respectively, in January and
February. Similarly, the seasonally adjusted consumer
price index for all urban consumers rose at annual rates of
7.2 percent and 5.1 percent, respectively, during the first
two months of the year; excluding food and energy, this
index rose at annual rates of 5.9 percent and 4.8 percent.
24lbid., p. 504.

Ju n e. The interm eeting range fo r the federal
funds rate was increased 1 percentage point to
8 to 1 2 percent, "in light of the tightening of
reserves since the February m eeting and the
related increase in the federal funds ra te .”26

M ay 16 Meeting
Aside from the slightly firm er reserve condi
tions due to the greater-than-expected reserve
flows related to April tax payments, reserve
conditions hardly changed in the interm eeting
period. During this period, the average of adjust
m ent plus seasonal borrow ing rose to about
$565 million, while the rate at w hich federal
funds traded rose slightly to around 9-7/8 p er
cent. O ther m arket interest rates, especially
short-term rates, fell over the interm eeting
period, however. Estimated grow th of the m one
tary aggregates was sluggish, with the cum ula
tive grow th o f M2 since the fou rth q uarter of
1988 well below the low er bound of the Com
m ittee’s target range and that of M3 just above
the lower limit of its target ran ge .27
Econom ic data reviewed at this meeting sug
gested that the expansion of econom ic activity
had m oderated in recen t months. Growth in
total nonfarm employment edged downward in
M arch and April, while the civilian unemploy
m ent rate climbed from 5.0 percent in M arch to
5.3 percent in April. In addition, grow th in con
sum er spending maintained the m uch slower
pace established in the first part of the year
relative to that in 1988. Industrial production
grew in April, but, from D ecem ber to April, it
grew m ore slowly than it had in 1988. Much of
the April grow th was attributed to an increase
in automobile assem blies after a w eak first
qu arter and a rebound in the output of other
consum er goods. Although the total capacity
utilization rate rose slightly in April, it rem ained
below its January ra te .28
T h ere w ere indications, how ever, that the
momentum in econom ic activity had not been en-

25lbid., p. 505.
26lbid., p. 506.
27Record (September 1989), pp. 626-27. In April, M2 and M3
grew at annual rates of 1.0 percent and 2.6 percent,
respectively.
28lbid., p. 625. The annual growth rate in the industrial pro
duction index rose from 1.7 percent in March to 8.9 per
cent in April. During that month, the total capacity utiliza
tion rate rose 0.4 percentage points from the previous
month to 84.2 percent.

MARCH/APRIL 1990

tirely lost. Capital business spending rebounded
after falling in the last q uarter of 1988. F u rth er
m ore, although the nominal U.S. m erchandise
trade deficit widened in February, the average
deficit fo r the first tw o m onths of 1989 rem ain
ed below that fo r the fou rth q uarter of 1988,
w ith the value of exports grow ing m ore rapidly
than that of imports. Despite the slight deteriora
tion in the external trade balance in February
and the general downward m ovement in interest
rates m ore recently, the dollar gained fu rth er
strength in the interm eeting period .29

w ere sufficiently restrictive to contain futu re in
flationary pressures without precipitating an ex
cessive slowing of econom ic grow th rem ained
unclear. Although one m em ber believed th at an
immediate easing of reserve pressure would be
both necessary and desirable to improve the
prospects for adequate m onetary grow th to sus
tain the econom ic expansion, others feared the
risks associated with such a policy—that is, of
having to reverse the easing if the m onetary ag
gregates w ere to accelerate unduly and price
pressures w ere to intensify later .32

The recen t behavior of the price indexes did'
not ease the m em bers’ fear of future inflation.
Rather, price level m ovements w ere interpreted
by the m em bers as an indication that inflation
ary pressures w ere rooted deeply in the econo
my. Although the producer price index grew
m ore slowly in M arch and April than in the
earlier two m onths of the year, the consum er
price index grew at a slightly faster pace in the
first q uarter of 1989 than in the previous
quarter. Increases in food and energy prices
contributed to the observed increases in m ea
sured inflation, but w ere not the sole driving
fo rce of the perceived upward tren d in infla
tion .30

In the discussion about possible adjustm ents to
m onetary policy in the interm eeting period, most
m em bers agreed that no bias—eith er toward
restrain t or ease—would be appropriate. W hile
one m em ber believed that policy should be par
ticularly alert to behavior of the m onetary aggre
gates that could w arran t some easing, others
believed that the deeply rooted inflationary
pressures called for a bias tow ard restraint. A
n um ber of m em bers expressed con cern that the
absence of a bias tow ard restrain t might give an
in correct signal that the Committee was moving
away from its anti-inflationary com m itm ent .33
At the end of this m eeting, the Committee
issued a directive that called fo r an unchanged
degree of pressure on reserve positions. D epen
ding on forthcom ing inform ation, a move to
some restrain t or ease would be acceptable dur
ing the interm eeting period. T he Committee
believed that continuing u ncertainty about the
relation of the demand fo r borrow ed reserves
to the federal funds rate w arranted continuing
flexibility in the im plem entation of m onetary
policy. The Committee expected that the contem
plated reserve conditions would be consistent
with M2 and M3 growing at IV 2 and 4 percent
annual grow th rates, respectively, from M arch
to June. The interm eeting range for the federal
funds rate was kept at 8 to 1 2 p ercen t .34

The sta ffs projection changed little from that
prepared fo r the previous meeting. Grow th in
econom ic activity was expected to b e slow er
than in 1988. T he forecast indicated that prices
at both the consum er and producer levels
would increase at somewhat faster rates in 1989.
In the staff's view, m onetary policy that at
tempted to contain such inflationary pressures,
should they m aterialize, would imply greater
pressure on financial m arkets. In addition to a
continuation of sluggish grow th in consum er
spending, the staff expected that grow th in busi
ness capital spending would retreat from its fast
pace in the first q u arter .31
U ncertainty about the im pact of previous re
strictive policy actions on inflation and the pace
of econom ic grow th dominated the discussion at
this m eeting. W h ether m onetary conditions

“ Ibid., pp. 625-26. The value of the dollar relative to the
other G-10 currencies appreciated about 4 percent over
the intermeeting period.
30lbid., p. 626. The seasonally adjusted consumer price in
dex for all urban consumers rose at annual rates of 6.1
percent and 8.1 percent, respectively, in March and April.
Excluding food and energy prices, this price index rose
4.8 percent and 2.9 percent. The producer price index for

FEDERAL RESERVE BANK OF ST. LOUIS

July 5-6 Meeting
Late in the interm eeting period, incoming in
form ation tended to confirm earlier indications

finished goods, excluding food and energy, rose at annual
rates of 2 percent and 1 percent.
3 Ibid., p. 627.
1
“ Ibid., pp. 628-29.
33lbid., p. 629.
^Ibid.

that the econom ic expansion had slowed so that
the prospect of w eakening inflationary pressures
seemed m ore promising. Fu rtherm ore, the m on
etary aggregates continued to exhibit slow
grow th and the dollar had gained considerable
strength earlier in the interm eeting period. Ac
cordingly, a slight lowering of the pressure on
reserve positions was sought. Before this easing,
however, a technical upward revision had been
made to accom m odate unusual strength in sea
sonal borrow ing. Over the six-week period end
ing Ju n e 27, the average of adjustm ent plus
seasonal borrow ings was around $550 million,
and the federal funds rate edged down to 9%
percent. O ther m arket in terest rates, especially
those on long-term securities, also fell. The ob
served decline in the level of the broader m one
tary aggregates during May was interpreted as
a reversal of the tem porary rise in transaction
accounts related to April tax paym ents .35
Confirming earlier evidence, the inform ation
available fo r review at this meeting suggested
that the econom ic expansion had slowed consid
erably from its pace in 1988. W hile the civilian
unemploym ent rate fell to 5.2 p ercen t in May,
grow th in total nonfarm em ploym ent was rela
tively weak. Prelim inary data indicated that, in
May, grow th in industrial production was modest
and the total capacity utilization rate had fallen
back to its M arch level .36 W hile business capital
spending appeared to m ake fu rth er gains in the
second quarter, grow th in consum er spending
rem ained sluggish. Further, the significant im
provem ent in the nominal U.S. m erchandise
trade balance during April stem m ed chiefly
from a considerable drop in im ports with only a
slight increase in exports .37
Price pressures persisted despite the indica
tions of slowing econom ic expansion. Increases
in food and energy prices, how ever, made large
contributions to the increases in the producer
price index and, to a lesser extent, in the con
35Record (October 1989), p. 691. Revised data indicate that
in May, M2 declined at an annual rate of 1.6 percent and
M3 rose sluggishly at an annual rate of 0.2 percent. In
June, the annual growth rates in M2 and M3 rebounded to
6.5 percent and 6.0 percent, respectively.
36lbid., p. 689. Revised data indicate that the industrial pro
duction index fell at an annual rate of 0.8 percent in May,
while the total capacity utilization rate in May, which fell to
84.0 percent from 84.2 percent in April, was above the
rate of 83.8 percent in March.
37lbid., pp. 689-90. Despite the improvement in the external
balance, the value of the dollar relative to the other G-10
currencies fell on net about 3 percent over the in

sum er price index .38 Nevertheless, the grow th in
labor costs appeared to have maintained its
momentum from the middle of 1988.
The Board’s staff revised its forecast for
econom ic grow th in the second half of the year
downward from that made earlier in the year.
The staff's forecast now suggested less inflation
than was previously expected, though m ore in
flation than had been experienced in 1988, and
continued grow th in labor costs in 1989. This
inflation outlook took account of the persistent
strengthening o f the dollar that was expected to
dampen inflationary pressures. T he forecast,
how ever, also pointed to slightly m ore favorable
inflationary conditions in 1990 than w ere
previously expected .39
In the context of a w eaker outlook for
econom ic grow th, the m em bers generally believ
ed that a fu rth er reduction in the degree of
pressure on reserve positions would be ap
propriate. Although th ere was some disagree
m ent about the timing and the extent of such
easing, most m em bers agreed that they could
accept an immediate slight reduction in reserve
pressure. In the view of many m em bers, a
greater move tow ard ease could have an unde
sirable effect on inflationary expectations, th e re
by putting upward pressure on long-term in ter
est rates. A substantial move tow ard ease might
have to be reversed if inflationary pressures
subsequently intensified.
Nearly all believed, how ever, that the easing
should be implem ented immediately given the
slowing pace of econom ic expansion and the
sluggish grow th o f the broader m onetary aggre
gates. Although some m em bers p referred a direc
tive that was biased tow ard restrain t to main
tain the credibility of the Com mittee’s anti-infla
tionary com m itm ent despite the easing of policy,
others advocated a bias tow ard ease to com
m unicate the Com mittee’s belief that the risks
termeeting period. After having risen sharply in the first
half of the period, the trade-weighted index of the value of
the dollar declined appreciably over the second half.
Mlbid., p. 690. But, even excluding food and energy prices,
the seasonally adjusted producer price index advanced
sharply, rising at annual rates of 7.2 percent and 8.2 per
cent, respectively, in May and June. Similarly, the
seasonally adjusted consumer price index, excluding food
and energy components, rose 5.8 percent and 2.8 percent,
respectively, in May and June.
Mlbid., p. 691.

MARCH/APRIL 1990

of an undesirable shortfall in econom ic grow th
w ere substantial. Most m em bers agreed that,
given the prevailing uncertainty, they could ac
cept an unbiased directive .40
As table 3 shows, the directive issued by the
Committee at the close of this meeting called
for an immediate and slight reduction in the
degree of reserve pressure. Fu rth er easing or
some tightening was considered to be ap
propriate depending on future developments.
Conditional on the contem plated reserve condi
tions, the Committee expected that both M2 and
M3 would grow at an annual rate of 7 percent
from Ju n e to Septem ber. Given the easing of
reserve pressure in early June and that
specified in this directive, the m onitoring range
for the federal funds rate was lowered 1
percentage point to 7 to 11 p ercen t .41

August 22 Meeting
As instructed by the Committee at the close of
the previous m eeting, the degree of pressure on
reserve positions was reduced at the beginning
of the interm eeting period. Tow ard the end of
July, the degree of reserve restraint was eased
fu rth er, in light of incoming data that indicated
a continued w eaker econom ic expansion and a
slight reduction in inflationary pressures. At the
beginning of the interm eeting period, however,
the assumed level of adjustm ent plus seasonal
borrow ing was increased as a technical revision
prompted by a projected rise in seasonal b o r
rowing during the sum m er months. Hence, the
average of adjustm ent plus seasonal borrow ings
over the six-week period ending August 22 rose
to approxim ately $600 million despite the easing
actions taken during this period. Nevertheless,
the federal funds rate fell 50 basis points to
around 9 percent. Prelim inary data indicated
that, in July, grow th in the m onetary aggregates
gained considerable strength, w hich appeared to
continue into August .42

40lbid., p. 695.
4 Ibid., p. 696. In this instance, there was no mention of the
1
uncertainty revolving around the relationship between bor
rowings and the federal funds rate and, therefore, no
reference to flexibility in monetary policy implementation.
42Record (December 1989), p. 813. Growth in M2 ac
celerated from 6.5 percent in June to 10.3 percent in July.
The annual growth rate in M3 rose less dramatically from
6.0 percent in June to 6.9 percent in July.
43lbid., p. 812. Revised data, however, indicate that in
dustrial production rose at an annual rate of 3.4 percent in

FEDERAL RESERVE BANK OF ST. LOUIS

The data reviewed at this meeting reinforced
the earlier evidence of a m oderate econom ic ex
pansion. The data, how ever, suggested less w eak
ness in the expansion than they had tow ard the
end of July. Nonfarm payroll em ploym ent made
considerable advances in Ju n e and July. T he ci
vilian unemployment rates for these months, 5.3
percent and 5.2 percent, respectively, w ere
close to the average unem ploym ent rate during
the first five m onths of the year. In addition,
prelim inary data indicated that industrial produc
tion rebounded in July after having fallen in
May and Ju n e .43 Industrial capacity utilization
maintained its high rate, although the rate for
m anufacturing in July was well below that in
January. M oreover, grow th in consum er spend
ing in the second qu arter was stronger than ori
ginally estimated, and the observed narrow ing
of the nominal U.S. m erchandise trade deficit
reflected not only a notable decline in the value
of imports, but a m arked jump in the value of
exports .44
T he recen t behavior of price indexes sug
gested somewhat less inflation prim arily
because of appreciable declines in food and
energy prices. Prelim inary data indicated that,
while the consum er price index rose in both
Ju n e and July, the increases w ere modest, and
the producer price index for finished goods
fell .45 W age grow th over the past several
m onths did not appear to deviate from previous
ly established trends.
The staff expected that, during the rest of the
year, grow th in the nonfarm econom y would
maintain its pace from the first h alf of the year
and then grow m ore slowly in 1990. W ith in ter
est rates falling since the spring and the recen t
ly observed substantial job gains, consum er
spending was expected to exhibit greater
strength in the coming months. The forecast in
dicated that business capital spending would
continue to make a large contribution to econom
ic grow th. Partly because of the earlier strength-

June and fell at an annual rate of 0.8 percent in July. The
July civilian unemployment rate has been revised upward
to 5.3 percent.
“ Ibid., pp. 812-13.
45lbid., p. 813. The seasonally adjusted producer price index
for finished goods rose at an annual rate of 1.1 percent in
June and fell at an annual rate of 4.1 percent in July. But,
excluding the food and energy prices, this index rose at
an annual rate of 8.2 percent in June and fell at an annual
rate of 1.9 percent in July.

ening of the dollar in foreign exchange m arkets,
how ever, foreign trade was not expected to be
a significant source of econom ic grow th. In ad
dition, although expected fu rth er declines in
food and energy prices suggested that price
pressures could w eaken in the coming quarter,
the staff expected no substantial im provem ent
in the inflationary trend through 1990.46

3 indicates. Despite some m em bers' reserva
tions, the directive included a bias tow ard ease.
The Committee expected M2 and M3 to grow at
annual rates of about 9 percent and 7 percent,
respectively, from Ju n e to Septem ber. T he intermeeting range for the federal funds rate was
kept at 7 to 11 p erce n t .49

W ith evidence that the econom ic expansion
had stabilized at a “provisionally acceptable pace”
and that inflationary pressures w ere not gaining
strength, the m em bers generally believed that
the cu rren t degree o f reserve pressure should
be maintained, at least in the early part of the
interm eeting period. An unchanged course for
policy was also justified by the observation that
grow th in M2 and M3 recently had gained suffi
cient strength to place these aggregates in their
target ranges .47

O ctober 3 Meeting

Discussing possible adjustm ents in policy dur
ing the interm eeting period, many m em bers ex
pressed the belief that, if futu re developments
w ere to w arran t a change in policy, the direction
of change would m ost likely be tow ard some
ease. Some m em bers, how ever, p referred not to
incorporate such a presum ption in the directive.
In their view, the "risks to the econom y w ere
m ore evenly balanced.” That is, the direction of
change in policy justified by developments in
the interm eeting period was just as likely to be
tow ard restraint as it was tow ard ease. Further,
these m em bers believed that a bias tow ard ease
could “lead to a m isreading of System policy in
the context of an unacceptably high rate of in
flation .”48
The directive issued at the end of this meeting
specified no immediate change in policy, as table

46lbid., p. 814. Over the intermeeting period, the value of
the dollar relative to the other G-10 currencies rose ap
proximately 2.7 percent, almost offsetting the previous net
decline. Even so, the trade-weighted value of the dollar
was below the highs reached in June.
47lbid., pp. 815-16. Although the staff predicted that M2 and
M3 growth would slow considerably from the current pace,
the growth in the aggregates was expected to remain com
fortably within their target ranges. These forecasts for
money growth as well as those made subsequently in
1989, however, were subject to great uncertainty as a
result of the uncertainty revolving around the resolution of
thrift institution insolvencies and the responses of thrift in
stitutions to recently enacted legislation. These factors
were expected to dampen growth in the broader monetary
aggregates, particularly that in M3. Thus, any observed
weakness in the growth of these aggregates would not be
interpreted as evidence of a slowing economy. Ibid., p.
816.

Over the interm eeting period, reserve condi
tions displayed no noticeable change. The aver
age o f adjustm ent plus seasonal borrow ing dur
ing the fou r weeks ending Septem ber 20 fell
slightly to about $550 million, and the federal
funds rate fluctuated within a narrow range
centered around 9 percent. Although M2
grow th was strong, M3 grow th had unexpected
ly lost some of its strength in August and prelim
inary data suggested that this slow er grow th
had continued into Septem ber .50
T he data available fo r review at this meeting
reaffirm ed earlier projections, that the econom ic
expansion had continued at a m oderate pace in
the third quarter. Nonfarm payroll employment
generally made considerable advances after al
lowing fo r the effects of strike activity. Neverthe
less, there w ere hardly any job gains in m anu
facturing industries, and the civilian unemploy
m ent rate in August and Septem ber was close to
5 V4 percent. Further, after increasing m oderate
ly in August, industrial production fell slightly
in Septem ber .51 T he industrial capacity utiliza
tion rate, how ever, rem ained relatively high.
W hile grow th in business capital spending
seemed to have slowed in the third quarter, con
sum er spending continued to exhibit consider
able strength. W ith the value of im ports declin-

48lbid., p. 816.
49lbid., pp. 816-17.
50Record (January 1990), pp. 18-19. The slowing of the
growth of the monetary aggregates was especially evident
in M3. M2 grew at annual rates of about 7.8 percent and
6.5 percent, respectively, in August and September; M3
grew at an annual rate of 1.4 percent in August and was
flat in September.
5 Ibid., p. 17. The annual rate of growth of the industrial pro
1
duction index fell from 5.2 percent in August to -1.7 per
cent in September. Revised data indicate that the civilian
unemployment rate in August and September was 5.3
percent.

MARCH/APRIL 1990

ing by m ore than the value of exports, the U.S.
m erchandise trade deficit im proved fu rth er in
Ju ly .52
The price indexes continued to indicate a
low er rate of inflation. In August, producer
prices fell and the consum er price index was
unchanged .53 The upward trend in labor costs,
however, did not appear to change on a year-toy ear basis.
The staff’s forecast fo r econom ic grow th in
the rem aining part of 1989 and 1990 w ere es
sentially unchanged from those made for the
previous m eeting. Growth in business capital
spending was expected to slow from its pace in
the first half of the year, how ever .54 Most m em
b ers believed that, although econom ic activity
would continue to expand in the coming quar
ters, the pace of the expansion would m ore like
ly slow than build m omentum. W hile the m em
b ers generally expected some w eakening in in
flationary pressures, only a few thought this
w eakening might b e appreciable. A num ber of
m em bers expressed con cern that progress
would be constrained considerably if econom ic
activity w ere to build m omentum. Furtherm ore,
the m em bers believed that the recen t fall of the
value of the dollar in foreign exchange m arkets
would add to future upw ard pressure on
p rices .55
Most m em bers thought that an unchanged
policy would be appropriate in the near term .
The focus of policy continued to be that of
gradually reducing inflation over time and a
steady policy course seemed consistent with
that objective, at least for the time being .56

“ Ibid., pp. 17-18.
53lbid., p. 18. The decline in producer prices, however, was
driven largely by a continued decline in energy prices. In
August, the seasonally adjusted producer price index for
finished goods fell at an annual rate of about 3.1 percent,
but, excluding energy and food, this index rose at an an
nual rate of 6.1 percent. The seasonally adjusted con
sumer price index excluding energy and food, however,
rose only 1.9 percent in August. In their discussion about
the outlook for inflation, the members commented that the
recent declines in food and energy prices that had
dampened price inflation might be temporary. Ibid., p. 20.
S'Hbid., p. 19.
55lbid., pp. 19-20. The trade-weighted value of the dollar
relative to the other G-10 currencies fell 2.7 percent over
the intermeeting period. A fall in the value of the dollar,
holding all else constant, increases the attractiveness of
U.S.-produced goods to foreign importers and U.S. in
dividuals. The resulting shift in demand can create
domestic price pressures. A fall in the value of the dollar

FEDERAL RESERVE BANK OF ST. LOUIS

Growth in the m onetary aggregates was ex
pected to m oderate from the rapid pace since
the middle o f the year, given an unchanged
policy. Most m em bers believed, how ever, that
future developments would m ore likely require
ease than restrain t in the interm eeting period.
Nevertheless, the recen t depreciation of the
foreign value of the dollar w arranted caution in
undertaking any easing adjustm ents .57
The directive issued at the end of this meeting
was w ritten with the understanding that a
downward technical adjustm ent to the b orrow
ings objective might be appropriate, if, as ex
pected, seasonal borrow ings w ere to drop in
the interm eeting period. T he reserve conditions
contem plated by the m em bers w ere thought to
be consistent with M2 and M3 growing at an
nual rates of 6 V percent and 4 V2 percent,
2
respectively, betw een Septem ber and D ecem ber.
The monitoring range fo r the federal funds rate
was unchanged at 7 to 11 p ercen t .58

N o v e m b e r 14 Meeting
Reserve conditions w ere eased in mid-October.
For a short period after the sharp drop in stock
prices on O ctober 13, an accommodative provi
sion of reserves was undertaken while financial
m arkets rem ained highly sensitive and volatile.
Around the same time, in keeping with the
previous m eeting’s directive, a decision was
made to implement some easing on a m ore p er
m anent basis. Incoming data, indicating an in
creased risk of a w eakening in the business ex
pansion, also prompted additional easing early
in November. Furtherm ore, in light of a p er
ceived decline in adjustm ent plus seasonal bor-

can also increase the costs of production for those U.S.
firms relying heavily on imported intermediate goods,
thereby creating additional price pressures. See Hafer
(1989) for a detailed discussion of the link between infla
tion and a dollar depreciation.
56lbid., p. 20. There was also a concern that, given the re
cent G-7 meeting, an easing of policy would be mistakenly
interpreted as an action to lower the value of the dollar.
The Committee believed that monetary policy should not
be used as an instrument for achieving a given objective
for the dollar in foreign exchange markets if that objective
were not compatible with domestic policy objectives. In the
view of some members, if recent intervention by G-7 and
other nations were to result in a lower value of the dollar,
the inflationary consequences would hamper the Commit
tee’s ability to achieve its long-run goal of price stability.
Ibid., pp. 20-21.
57lbid., p. 21.
58lbid., pp. 21-22.

rowings, several technical adjustm ents in the
borrow ing assumption w ere made during the in
term eeting period. From early O ctober to this
meeting, actual borrow ings fell from about $635
million to about $200 million. W ith most m arket
interest rates falling, the federal funds rate de
clined from about 9 percent to 8 V percent in
2
the interm eeting period and grow th in the m on
etary aggregates gained strength in O ctober .59
The data review ed at this m eeting indicated
that the econom ic expansion had continued at a
m oderate pace. Nonfarm em ploym ent gains
w ere considerable in O ctober and the civilian
unem ploym ent rate did not budge at 5.3 p er
cent. The data also suggested, however, that the
strength of expansion was not evenly distributed
throughout the econom y. For example, most
employment gains occu rred in the service sec
tor, while m anufacturing employment declined.
In addition, industrial production dropped appre
ciably in O ctober, though m uch of the decline
was attributed to several incidents that tended
to disrupt production tem porarily (the Boeing
strike, the earthquake and the h u rrican e ).60 The
data also showed that retail sales had fallen and
the grow th of business capital spending had
weakened. Fu rtherm ore, w ith the value of im
ports rising and the value of exports falling in
August, the U.S. m erchandise trade deficit had
risen to its highest level thus fa r in 1989.61
The recen t behavior of price indexes w ere
consistent w ith a slight reduction in inflationary
pressures. The percentage rise in producer
prices fell in O ctober and, excluding energy and
food, had hardly changed .62 But the data did not
suggest any slowing in the grow th of labor
costs.
In light of the tem porary disruptions to pro
duction, the staff’s forecast pointed to a fu rth er
slowing in grow th in the fourth qu arter and a
rebound in the first qu arter of 1990. On net,

59Report (February 1990), p. 56. The annual rates of growth
of M2 and M3 rose to 7.1 and 1.4 percent, respectively, in
October. This acceleration was not as pronounced as that
in M1 whose annual growth rate rose from 3.9 percent in
September to 8.3 percent in October.
60lbid., p. 55. The industrial production index fell at an an
nual rate of about 4.1 percent in October.
6 Ibid., pp. 55-56.
1

the staff predicted that econom ic grow th would
continue at a sluggish pace in the coming quar
ters. Although continuing grow th in consum er
demand was expected to contribute to econom ic
activity in the near term , consum er demand
was expected to w eaken subsequently. Further,
the forecast indicated that the sluggish pace in
the grow th o f business capital spending would
continue and that n et exports would not m ake a
significant contribution to the econom ic expan
sion. The sta ffs forecast did not suggest, how
ever, any substantial im provem ent in the u nder
lying trend in inflation .63
Most m em bers agreed that the data pointed,
on balance, to a sustained econom ic expansion,
although grow th had w eakened recently. But
th ere was no strong consensus among the m em
b ers about the future outlook. W hile some m em
b ers expected that the risks of a stronger-thandesirable expansion and a w eaker expansion
w ere evenly balanced, others expected a greater
likelihood of eith er a stronger or considerably
w eaker econom ic expansion activity, and still
others believed that the chances of an econom ic
expansion close to the econom y’s potential in
the future w ere not rem ote .64 Similarly, some
m em bers believed that progress on improving
the underlying inflation trend might be achieved
given the recen t behavior of the price level in
dexes and oth er factors, though others saw that
such progress, if any, would be small over the
next several q u arters .65
Although the econom ic expansion appeared to
be slowing, most m em bers advocated a steady
policy with no immediate change in the degree
of pressure on reserve positions. Such a policy
was considered to be consistent w ith the Com
m ittee’s goals of promoting a sustained econom ic
expansion while making progress tow ard reduc
ing inflation in the long run. M oreover, m em bers
believed that the recen t and expected grow th in
the m onetary aggregates did not w arran t any

“ Ibid., p. 57.
^Ibid., p. 57. The recent depreciation of the dollar in foreign
exchange markets was expected by some members to
provide a source of improvement in the nation’s trade
deficit, especially in light of the observed strength in
economic activity experienced recently by other industrial
nations. Such an improvement would provide additional
strength to the U.S. economic expansion.
65lbid., pp. 57-58.

62lbid., p. 56. Revised data indicate that the seasonally ad
justed producer price index for finished goods rose at an
annual rate of 6.5 percent in October. Excluding food and
energy components, it rose at a 2.0 percent annual rate.

MARCH/APRIL 1990

adjustm ent in policy. Hence, as table 3 shows,
the directive issued at the close of this meeting
did not call fo r any change in policy .66
Most m em bers, how ever, believed that the
possibility of w eakening in the econom ic expan
sion exceeded the possibility of excessive
grow th and, accordingly, that future econom ic
developments would m ore likely w arran t subse
quent easing actions than tightening actions in
the interm eeting period. Those m em bers who
believed that the likelihood of excessive grow th
was evenly balanced against the likelihood of
w eakening in the expansion indicated that they
could accept a directive containing a bias tow ard
ease in the interm eeting period. But some em
phasized the need for approaching possible eas
ing adjustm ents w ith caution so as not to
detract from any progress that could be made
in eventually approaching the Com m ittee’s goal
of reasonable price stability .67
The m em bers expected M2 and M3 to grow at
annual rates of 7Vi and 4 V2 percent, respective
ly, betw een Septem ber and D ecem ber. The m on
itoring range for the federal funds rate was
m aintained at 7 to 11 p ercen t .68

D ec em b er 18-19 Meeting
During the interm eeting period, policy aimed
to maintain a steady (or unchanged) degree of
reserve restraint. Technical adjustm ents in the
borrow ings assumption w ere made tw ice in the
period in light o f ongoing declines in seasonal
borrow ing. During the first tw o weeks of De
cem ber, adjustm ent plus seasonal borrow ings
averaged about $130 million, down from the
average of about $400 million during the two
previous w eeks. Meanwhile, the federal funds
rate rem ained at about 8 V2 percent and other
m arket interest rates changed little during most
of this period. Prelim inary data indicated that
the grow th in the broader m onetary aggregates
picked up during November and rem ained ro
bust in the first part of D ecem ber .69
66lbid., p. 58.
67lbid., pp. 58-59.
68lbid., pp. 59-60.
69Record (Federal Reserve Press Release, February 9,
1990), pp. 4-5. The annual rate of growth in M2 increased
slightly to 7.5 percent in November, while the annual
growth rate in M3 nearly tripled to 4.0 percent.
70lbid., p. 1. The annual growth rate of the industrial produc
tion index rose to 3.4 percent in November. It should be
noted that the November civilian unemployment rate has
been revised to 5.3 percent.

FEDERAL RESERVE BANK OF ST. LOUIS

T he inform ation available fo r review at this
meeting suggested that the econom ic expansion
in the fourth q uarter had slowed from its pace
earlier in the year. Although total nonfarm pay
roll employment made considerable gains in
November, these gains w ere concentrated in the
service, trade and financial sectors, w ith conti
nuing losses in m anufacturing. The November
civilian unemploym ent rate, 5.4 percent, was at
its highest level since January. Industrial pro
duction in November rebounded from its p re
vious decline driven by earlier strike activity
among oth er facto rs .70 Upon adjusting for these
factors, industrial production appeared to have
fallen, on average, in recen t months. In ad
dition, although nominal retail sales rebounded
in November, sales had hardly changed from
their average in the third quarter, and data in
dicated a w eakening in business capital spend
ing. W ith im ports up sharply and exports virtual
ly unchanged, the nom inal U.S. m erchandise
trade deficit rose considerably in O ctober after
having fallen slightly in Septem ber .71
Estimated movements in price indexes contin
ued to suggest a slight w eakening in inflationary
pressures. For example, the producer price in
dex, based on prelim inary data, fell in November.
This decline, how ever, was partly attributable
to sharp reductions in energy p rices .72 Although
average hourly earnings had fallen in November,
the underlying trend in labor cost grow th was
not expected to change given the results of the
recen t collective bargaining activities .73
The staff’s forecast had not changed substan
tially from the previous meeting. It pointed to a
slowing in the econom ic expansion in the fourth
qu arter with a rebound in the first q uarter of
1990. The magnitude of the rebound was ex
pected to be limited by anticipated declines in
m otor vehicle production. Econom ic grow th for
the rest of 1990 was expected to be driven pri
marily by m oderate grow th in consum er spend
ing. Net exports w ere expected to m ake a small
71lbid., p. 2-3. Total industry capacity utilization having not
changed in November from October at 83.1 percent was 1
percentage point below its level a year earlier.
72lbid., pp. 3-4. Revised data indicate that the seasonally ad
justed producer price index actually rose at an annual rate
of 1.1 percent in November. Excluding food and energy,
this index rose at an annual rate of 3.0 percent.
73lbid., p. 4.

contribution to the econom ic expansion in 1990.
Further, while the staff anticipated that pres
sures on labor and other resources fo r produc
tion would lessen slightly, no large changes in
the underlying trend of inflation w ere ex
pected .74
The m em bers generally agreed that th ere was
considerable evidence that the econom y’s
grow th had w eakened and would likely rem ain
at a sluggish pace in the n ear term . Although a
num ber of m em bers thought that some strength
ening in the econom ic expansion in 1990 was a
reasonable expectation, most believed that the
chances of a w eakening w ere "sufficiently high
to justify an immediate move to slightly easier
reserve conditions .”75 Those advocating this poli
cy change believed that such a move would not
jeopardize the System ’s credibility of adhering
to its long-run goal of price stability, as price
pressures and business conditions appeared to
have weakened.
Others less optimistic about the potential pro
gress tow ard reducing inflation favored an un
changed policy. Skepticism about this progress
was partly driven by the recen t decline of the
dollar and the possibility that, if econom ic activi
ty w ere to rebound in the next year, inflationary
pressures could gain considerable stren gth .76
Those advocating an unchanged policy em pha
sized that m aintaining cu rren t reserve condi
tions would be sufficient to ensure a continua
tion of the expansion with an easing of pressure
on productive resources, and that “fu rth er eas
ing might overcom pensate fo r cu rren t w eakness
in the econom y at the cost of delaying progress
toward price stability .”77 Nevertheless, most of
these m em bers, recognizing the risks of an ad
ditional w eakening in the econom y, could ac
cept a policy that sought an immediate but
slight easing of the degree of pressure on re
serve positions. In their view, given such a poli
cy, it was highly unlikely that fu rth er easing
would be w arranted during the interm eeting
period .78
As indicated in table 3, at the close of this
meeting, the Committee issued a directive call
ing fo r a slight easing of reserve conditions.

74lbid., p. 5-6.

This directive did not reflect a presumption
about the direction o f possible adjustm ents in
the interm eeting period. The Committee ex
pected that the annual rates of grow th of M2
and M3 would be 8 V2 percent and 5 V2 percent,
respectively, from November 1989 to M arch
1990. In addition, given the easing of reserve
conditions in recen t m onths and the fu rth er
easing stipulated in this directive, the Committee
lowered the monitoring range for the federal
funds rate 1 percentage point to 6 to 1 0 p er
cen t .79

CONCLUSIONS
During 1989, the econom ic data available for
review at FOMC m eetings prompted Committee
m em bers to shift th eir prim ary con cern from
the risks of inflation to the risks of a slowdown
in econom ic activity. At the beginning of the
year, the th reat of a w orsening in the underly
ing inflationary tren d drove the form ulation of
policy. As the evidence of a w eakening economic
expansion accum ulated and the outlook for in
flation appeared to becom e less threatening, the
Committee becam e m ore sensitive to the risks
of a future slowdown in econom ic activity.
Because the Committee understood that its in
terpretation of the data was unavoidably subject
to great uncertainty, how ever, it took what it
perceived to be a conservative approach to re
acting to this inform ation in an effort to balance
these risks. This approach was also motivated
by the Com mittee’s ultim ate goal of eventually
achieving reasonable price stability and its desire
to maintain its own credibility as an inflationfighter.

REFERENCES
Garfinkel, Michelle R. “ The FOMC in 1988: Uncertainty’s Ef
fects on Monetary Policy,” this Review (March/April 1989),
pp. 16-33.
Gilbert, R. Alton. “ Operating Procedures for Conducting
Monetary Policy,” this Review (February 1985), pp. 13-21.
Hafer, R.W. “ Does Dollar Depreciation Cause Inflation?”
this Review (July/August 1989), pp. 16-28.
Hafer, R.W., and Joseph H. Haslag. “ The FOMC in 1987:
The Effects of a Falling Dollar and the Stock Market Col
lapse,” this Review (March/April 1988), pp. 3-16.
Thornton, Daniel L. “ The Borrowed-Reserves Operating Pro
cedure: Theory and Evidence,” this Review (January/
February 1988), pp. 30-54.

77lbid., p. 10.

75lbid., p. 10.

78lbid., pp. 11-12.

76lbid., pp. 9-10. Over the intermeeting period, the tradeweighted value of the dollar relative to the other G-10 cur
rencies fell about 2.8 percent.

79lbid., pp. 13-15.

MARCH/APRIL 1990

Alison Butler
Alison Butler is an economist at the Federal Reserve Bank of
St. Louis. Lora Holman provided research assistance. The
author would like to thank William Barnett and Jennifer Ellis
for helpful comments and suggestions.

A M ethodological A p proach to
Chaos: Are E con om ists M issing
th e P oin t?
"A very slight cause which escapes our notice determines a considerable
effect which we cannot fail to see, and then we say that this effect is
due to chance.”
t
—Poincare

T h e r e IS INCREASING interest among econ
omists in a new field of study that may offer
an alternative explanation for the seemingly
random behavior of many economic variables.
This research, which originated in the physical
and biological sciences, concerns a phenomenon
called deterministic chaos.1
Contrary to the common usage of the word,
chaos in this context describes the behavior of a
variable over time which appears to follow no
apparent pattern but in fact is completely deter
ministic, that is, each value of the variable over
time can be predicted exactly. In fact, one
"chaologist” describes chaos as
. . lawless
behavior governed entirely by law."2
To demonstrate the difficulty in determining
whether a variable is random or chaotic, figures
la and lb show two time series of a variable;
one series is a random variable, whose actual
value cannot be known with certainty, and the
'The terms “ deterministic chaos” and “ chaos” are used interchangeably here, although deterministic chaos is the
more precise description.

FEDERAL RESERVE BANK OF ST. LOUIS

other is a chaotic variable, whose value can be
predicted with certainty. Even the most prac
ticed observer, however, would have difficulty
determining which of these series, if any, is not
random. As a result, most economists would
model or estimate both time series as random
processes. The chaotic series is described by a
very simple deterministic equation and identified
later in this paper.
Often, behavior that cannot be explained by
standard theories and modeling techniques is at
tributed to random forces, even when there is
no theoretical reason to do so. This paper argues
that economists are perhaps not using the ap
propriate types of models and empirical techni
ques to explain the behavior of some economic
variables and that the choice of methodology
needs to be more closely examined.
The study of chaos is a recent phenomenon in
the biological and physical sciences and is just
2Stewart (1989), page 17.

Figure 1

Random or Chaotic?

MARCH/APRIL 1990

now beginning to be applied to econom ics. Un
fortunately, many of the em pirical tests for
chaos are im precise and, because of m athem ati
cal constraints, the theoretical models used to
generate chaos are generally limited to systems
w ith only one or tw o explanatory variables.
Both of these factors restrict the usefulness of
applying chaos to econom ic systems. N everthe
less, the theory of determ inistic chaos has at
tracted a great deal of attention, both in the
popular press and in academ ic circles. The dis
cussion that follows attem pts to clarify some of
the issues and suggests some ways to incorporate
chaos into econom ics.
This article first review s how econom ic vari
ables typically are modeled by describing and
evaluating several techniques of econom ic m odel
ing using a simple model of output and popula
tion grow th .3 Next, chaos is defined and its pro
perties dem onstrated. The advantages and pit
falls of applying the theories o f chaos to eco
nomics are then discussed and illustrated.

ECONOM IC M ODELING
T h ere are m any d ifferent ways to build
econom ic models. Four such possibilities are ex
amined h ere fo r the case in w hich all variables
are com pletely determ inistic .4 The types of mod
els exam ined h ere are static linear, static non
linear, dynamic linear and dynamic nonlinear. A
fu rth er distinction, w hich proves to be signifi
cant, is also draw n betw een discrete and contin
uous tim e dynamic models. A simple model of
output, w h ere labor is the only input, is used to
illustrate each approach to modeling as well as
the restrictiveness of many com m on modeling
techniques. In addition, focusing on econom ic
modeling allows us to show that chaotic dynam
ics can only arise in certain types of models
that have often been excluded, a priori, by
econom ists.

Static M odels
T he simplest type of econom ic model is a
static linear model, in w hich variables do not

3There is a growing body of theoretical literature incor
porating chaos into many different types of economic
models. These models include Benhabib and Day (1981),
Deneckere and Pelikan (1986), Grandmont (1985), De
Grauwe and Vansanten (1990), Kelsey (1988), Day and
Shafer (1985) and Stutzer (1980). For surveys of the
theoretical literature, see Kelsey (1988) and Baumol and
Benhabib (1989).
4There is also a burgeoning field in stochastic (random)
modeling, which incorporates the assumption of random

FEDERAL RESERVE BANK OF ST. LOUIS

change over tim e and are related in a propor
tionate m anner. Consider, fo r example, the
following simple production function, w hich has
only labor as an input:
(1) Y = AN A > 0,
w here Y is output, w hich is com pletely consum ed
by w orkers (there is no saving or investment), N
is labor employed and A is the productivity
param eter. This equation states that output is
positively related to the amount of labor em
ployed. Given the value of A and the labor sup
ply, the exact value of output can be determined.
This type of model is highly restrictive; any
change in labor changes output by a constant
percentage. Hence, the production function ex
hibits constant retu rn s to scale.
Allowing the model to be nonlinear (that is,
not necessarily proportionate) provides a m ore
general model in w hich equation 1 is a special
case. An example of a nonlinear production
function is given by:
(2) Y = ANa

A > 0, a > 0.

If a = 1, this model is identical to the one
shown in equation 1. By not restricting a to
equal one, how ever, this model can be used to
examine the case in w hich output can vary
disproportionately w ith respect to changes in
labor. This is illustrated in figure 2, w hich
shows the relationship betw een output and labor
for different values of a (for simplicity, A = 1).
Notice that if a is betw een zero and one, the
production function exhibits decreasing retu rns
to scale (that is, output increases less than p ro
portionately w ith resp ect to a change in labor);
if a is greater than one, production is ch aracter
ized by increasing retu rn s to scale (output in
creases m ore than proportionately with respect
to an increase in labor). Em pirical tests of actual
production relationships can be perform ed to
determ ine if a is actually different from or
equal to one.

ness used in econometric models into the theoretical litera
ture. Recent papers also look at the properties of chaos in
the presence of a random component [see, for example,
Kelsey (1988)]. For simplicity, this paper focuses only on
purely deterministic systems.

Figure 2
Linear vs. Nonlinear Production
Functions
Y = ANa

w h ere C and D are constants, and a dot over a
variable m eans the change in the variable with
respect to a very small change in time. This
type of equation is called a differential equation.
Equation 3 states that the percentage rate of
change of the labor fo rce [N(t)/N(t)l, w h ere time
is continuously changing, equals the difference
b etw een the rate of birth, C, and the rate of
death, given by DN(t)/Y(t), w h ere N(t)/Y(t) is the
num ber of individuals who have to subsist on
each good at tim e t.
Using the linear production function given in
equation 1 and substituting it into equation 3
provides a linear specification of the percentage
change in the population:
(4) N(t)/N(t) = C -D /A .
Notice that w hen the production function is
linear the rate of death, D/A, is constant.
Solving equation 4 yields the following solu
tion fo r the population:
(5) N(t) = Ke(c‘D )t<
/A

Linear Dynam ic M odels
One disadvantage of these static models is that
they can be used to describe the relationship
b etw een output and em ploym ent only if the
labor force or population rem ains constant over
tim e .5 Suppose instead that we w ant to examine
the behavior of output over time as it is related
to a continuously changing labor force. A stan
dard equation borrow ed from Haavelmo (1954),
used to describe the grow th of the labor force
w here that grow th is dependent on the level of
output, is given by:
(3) N(t)/N(t) = C —
DN(t)/Y(t)

C > 0, D > 0,

5For expositional ease, the terms “ population” and “ labor
force” are used interchangeably.
6Equation 4 is solved by the variable separable method of
solving differential equations found in most calculus books.
K is the constant of integration, which can be determined
by choosing an initial condition.
7ln fact, stability is an important issue which is frequently
ignored or abstracted from in economics. Stability is impor
tant because, for example, an unstable equilibrium is not a
sustainable equilibrium. Stability is also important in the
choice between linear and nonlinear models. Linear models

w h ere K is an arb itrary constant .6
This solution has the property that, unless the
rate of birth (C) is exactly equal to the rate of
death (D/A)—in w hich case the population will
equal K—the population will either rise exponen
tially or fall to zero. This result is highly restric
tive, how ever, because the likelihood of either
the two rates being identical or the population
increasing infinitely is, in reality, very small. In
other words if C # D/A, the system is u nstable .7
Unfortunately, in models of oth er types o f eco
nomic variables, results that greatly restrict the
possible values of the param eters of the models
are not uncommon. In addition, because of the
complexity of many econom ic models, the im
plications of restricting the value of the param e
ters to determ ine the solution or to ensu re a

have three possible cases: stable converging dynamics
(such as when C = D/A in the model above), unstable
dynamics (when C * D/A) and cyclical dynamics, which is
the least common of the three. In nonlinear models, how
ever, cyclical dynamics are far more common, and ex
ploding dynamics may not occur. Thus, it is also important
to consider the desirable and realistic stability properties
when choosing a model. Obviously the nonlinear case is
more general and the most realistic for variables that ex
hibit cyclical variation. For the purpose of this paper,
however, the issue of stability is ignored.

MARCH/APRIL 1990

stable solution are not always as obvious as in
the population grow th model. Because linear dif
ferential equations are fa r sim pler to solve than
nonlinear differential equations, and because
th eir solutions are m ore often stable and easier
to interpret, how ever, they are used in econom
ic models m ore often than may be appropriate.

dynamic models are called d iffe r e n c e equations;
they m easure time in distinct intervals rath er
than the d ifferen tia l equations used above, w hich
m easure tim e continuously. Equation 6 can be
transform ed into a difference equation by let
ting the rate of change of N (previously given
by N) equal the difference betw een the value of
N at tim e t and t + 1. Thus, equation 6 becom es

Nonlinear Dynam ic M odels

(7) (Nt+ 1 - N t)/N, = C - D(Nt/Yt),

Combining the nonlinear production function
given by equation 2 w ith the description of
population grow th given in equation 3 provides
a less restrictive model of population growth:

w h ere Yt = AN,".
Combining these equations and simplifying the
result yields:
(8 ) Nt+I = N, [(1 + C) - DN,‘ -“/A] ,

(6 ) N(t)/N(t) = C - DN(t)‘ "7A .
Unlike equation 4, equation 6 allows the labor
fo rce to vary m ore or less as the cu rren t labor
fo rce changes. Unfortunately, the price of the
generality provided by such nonlinear d ifferen
tial equations is that most either cannot be solved
or have solutions so com plex the results cannot
be interpreted. Not surprisingly, econom ists
often avoid these types of models.
The model used here, however, was chosen for
its tractability and can be solved for the value of
labor at any time t .8 All that is necessary for a
stable solution is that the production function ex
hibits decreasing returns to scale (0 < a < 1 ).
Regardless of the value of the oth er param eters,
if a is betw een zero and one, the population
will reach a stable equilibrium level. Hence, in
contrast to the dynamic linear model discussed
previously, the results of this model are m ore
realistic and provide a m ore general description
of population and output growth.

Discrete M odels
One problem w ith using continuous time
models in econom ics is that data are available
only in distinct intervals (daily, weekly, monthly,
etc.). One approach typically taken by econom
ists, th erefore, is to convert these continuous
tim e models into discrete tim e models. D iscrete

8For the solution and discussion of this model, see
Haavelmo (1954), pp. 24-29.
9
Allowing N, = [A(1 +C)/D],/(I“,) X, only changes the scale
of the population and has no effect on the general charac
teristics of the solution. For further discussion of this pro
cedure and the solution, see Stutzer (1980).
10Although the model given by equation 6 is stable in con
tinuous time, it is not necessarily stable in discrete time

RESERVE BANK OF ST. LOUIS
FEDERAL

w hich, following Stutzer (1980), can b e rew ritten
using a change of variables as
(9) Xt+1 = k Xt( l - X / " ) ,
w h ere k = 1 + C .9
The models shown in equations 8 and 9 de
scribe the m ost general specification of popula
tion and output grow th given the assumptions
made above. Behavior is not restricted to being
linear, n or is population or output restricted to
rem aining constant over time. On the other
hand, as noted earlier, these m ore general
models often cannot be solved or have solutions
w ithout any econom ic interpretation. Neverthe
less, unless th ere are theoretical reasons for
assuming relationships are static or linear,
dynamic nonlinear models, w hich provide the
most general specification of behavior, should at
least be considered in econom ic analysis. Al
though generality fo r its own sake is not a de
sirable goal, using a m ore general model would
be appropriate w hen sim pler models have solu
tions that are highly unrealistic or w hen param
eters have to be restricted beyond reason (as in
the model presented here). In addition, if eco
nomists w ant to test th eir models and results
empirically, then these variables should be
modeled in the form in w hich they are esti
m a te d -d iscre te form .10 As it turn s out, these
types of nonlinear dynamic models can exhibit
chaos.

since in discrete time this model can generate chaotic
dynamics for certain parameter values. Differential equa
tions can also exhibit chaos, although only in more com
plicated models. This is discussed in greater detail later.

A N IN T R O D U C T IO N T O THE
T H E O R Y OF CHAOS
The possibility that chaos exists in econom ic
variables has strong implications fo r the w ay in
which econom ics is modeled. For example, some
variables that appear to be random processes,
like one of the variables shown in figure 1 ,
might in fact not be random at all; instead it
might be com pletely explained using the ap
propriate determ inistic model. This section
dem onstrates the properties of chaos, using a
simple model.

Figure 3
The Logistic Growth Curve For
Various Values of k
Xt+1 = kX t ( 1 - X t )

In the m ost general sense, the term chaos is
used to describe the behavior of a variable over
tim e that appears random but, in fact, is d eter
ministic; m ore precisely, given the initial value
of the variable, all future values of the variable
can be calculated w ith exact precision .11 In con
trast, the value of a random variable can never
be predicted w ith certainty.
M ore formally, a function is chaotic if, for
certain param eter values, the following two con
ditions hold: First, the function never reaches
the same point tw ice under any defined interval
o f time. In this case, the function is said to ex
hibit ap erio d ic behavior. Second, the time path
is sensitive to changes in the initial condition, so
that a small change in the value of the initial
condition will greatly alter the tim e path of the
function .12
Chaos only arises in certain types of nonlinear
dynamic systems, although not all nonlinear dy
namic equations are chaotic. M oreover, equa
tions that can be characterized as chaotic need
not exhibit chaos for all param eter values. Rath
er, functions that can exhibit chaos will do so
only for certain param eter values. This is ex
plained by example below.

And N o w f o r Something
Completely Different . . .
The properties of chaos can be dem onstrated
using a simple m athem atical equation, called the
logistic grow th equation. W hile this model has
no particular econom ic interpretation, it is the
1 For simplicity, only single-variable equations are discussed.
1
Although chaos exists in multivariate economic systems,
tests for chaos in these systems are just beginning to be
developed, and the mathematics of such systems are ex
tremely complex.
12There are many different characterizations of deterministic
chaos, but they all include the one used here. For more
rigorous definitions and discussion of the different defini-

simplest model that exhibits chaos and provides
reasonably interpretable graphical results. This
equation is given by:
(10) X t+1 = k Xt( l - X t), 0 < X, <

1, 0 < k < 4.

Equation 10 describes the tim e path of a vari
able, X (which fo r expositional purposes is called
a population), that is a function of its previous
value and a param eter k. To dem onstrate chaotic
behavior in this simple fram ew ork, the value of
X can only take on values betw een zero and one.
The value of k, the only param eter in the equa
tion, is called the “tuning” param eter; it deter
m ines the steepness o f the function. Figure 3
shows the function given in equation 1 0 for
various values of k. Increases in the popula
tion below X increase futu re values of X more
than proportionately. Past this point, the popula
tion begins to d ecrease .13 For larger values of k,
tions, see Li and Yorke (1975), Brock and Dechert (1988)
and Melese and Transue (1986). For a good mathematical
description of chaos and the mathematical tools used in
the theory of chaos, see Devaney (1989).
13This behavior is similar to that of a total product curve
where, once the marginal product becomes negative, fur
ther increases in an input decreases output.

MARCH/APRIL 1989

Figure 4
A Stable Tim e Path for a
Logistic Growth Curve
Xt+1 = 3 X t ( 1 - X t )
X0 = .20 t = 1 to 500

xt+
i

xt
the absolute value of the rate of change of X is
larger.
For certain values of the tuning param eter
(k < 3), the system is stable; this m eans the
population will reach some sustainable steadystate value w hich differs from X.
Figure 4 illustrates how the tim e path fo r X t+1
is solved graphically. The parabola represents
equation 1 0 w hen k is equal to three; all values
of X, and Xt+1 m ust lie on this curve. The 45degree line depicts the points w here X t+1 = X„

14Notice that X1+l, which must always lie on the parabola,
can be either above the 45-degree line (as in point D) or
below it (as in point F). For precision, the equation is
solved numerically and then graphed.

RESERVE BANK OF ST. LOUIS
FEDERAL

w hich is required fo r a steady-state equilibrium.
In this example the initial value (when t = 0) is
.20. To determ ine the value of X,, draw a line
betw een the initial value (X0) and the parabola
(line segm ent X 0B). To find the value of X2, set
X, = Xj by drawing a line from point B to the
45-degree line (point C). T h en draw a straight
line from point C to the parabola. This is the
value of X 2 (point D). This process, called itera
tion, can be used to determ ine as many subse
quent values of X as is desired, once the initial
value is determ ined .14 As we can see in figure 4,

the population appears to be converging to a
steady-state equilibrium value at 2/3 (X*).
If the value of k increases past three, how
ever, the equilibrium point becom es unstable
and the time path exhibits a two-period cycle,
w here the variable alternates betw een two
values. Fu rth er increases in k produce a fourperiod cycle (that is, the tim e path repeats the
same sequence of num bers every fifth iteration),
then an eight-period cycle, and so on, w ith the
periodicity increasing by 2° (n = 1,2,3, . . .). If k
increases past a certain point called the “point
o f accum ulation” (for this function, it occurs at
k = 3.5700), the tim e path en ters into a region
in w hich the function can exhibit chaos .15 In the
chaotic region (3.57 < k < 4 for this function),
th ere can be both an infinite num ber of periodic
cycles and an infinite num ber of initial condi
tions that produce an aperiodic tim e path .16 Us
ing this simple example, we can dem onstrate
some of the properties of chaos in graphical
form .

Figure 5
A Logistic Growth Curve
Exhibiting Chaos
Xt+1 = 3.82840 Xt ( 1 - Xt )
X0 = . 0 1 0 1 t = 1 to 500

xt.i

Properties o f Chaos
An example of aperiodic behavior is seen in
figure 5. The first 500 iterations are shown in
this figure (that is, t = 1, 2, . . . 500), and no
single poin t is ev er re a c h ed tw ice . 17 In fact, no
m atter how m any tim es this equation is iterated,
X, never has the same value tw ice .18 If the data
are plotted as a tim e series, it would look similar
to figure la , the chaotic series in figure 1 , and
one might conclude that the data are generated
by a random process, such as figure lb , because
they follow no obvious pattern. This is not the
case here; the data in figure l a and figure 5
w ere generated from models w ithout a random
com ponent and th erefo re are completely
determ inistic.
The oth er ch aracteristic of a chaotic function
is that its tim e path is sensitive to the choice of
initial values. An example o f how changing the
15This process of increasingly complex periodicity is called
bifurcation and is discussed in most papers on chaos. For
a nontechnical discussion of bifurcation, see Gleick (1987)
and Stewart (1989). For a more analytical treatment of
bifurcation, see May (1976) and Baumol and Benhabib
(1989). A more rigorous discussion of the relationship be
tween bifurcation and chaos is given in Li and Yorke
(1975).
16Notice that not every initial condition gives rise to an
aperiodic time path.

0.0

0.5

1.0

initial condition can affect the time path is
shown in figure 6 . In this figure, the values of
X, are plotted against time, as in figure 1. This
diagram dem onstrates how changing the initial
value, X0, at the fou rth decimal place (from
.0 1 0 1 to .0 1 0 0 ) causes the time paths generated
by equation 1 0 to deviate substantially from
each o th er .19 Although not all sections of the
time path differ as dram atically as the one
shown here, figure 5 graphically dem onstrates
that the choice o f an initial condition or, for
forecasting purposes, the choice of a time in ter
val (that is, determ ining w h ere to start the sam
ple), can greatly alter the results. In fact, despite
icity is required for chaos, tests for chaos in actual data
take a different approach, thus avoiding the problem.
1
8The time path can avoid having repeat values because the
number of possible points between zero and one is infinite.
19Although it sometimes looks like the function is periodic,
this appearance is a result of the lack of precision of the
printer and the scale of the graph. In fact, there are no
periodic points in this function.

1 This property is unlikely to be found in actual data, how
7
ever, because of rounding. Although theoretically, aperiod-

MARCH/APRIL 1989

Figure 6
A Segm ent of the Time Trend Showing Sensitivity
to Initial Conditions
Xt+ = 3.82840 Xt ( 1 - X t )
1
Xo=.0101 Xo=.0100

seemingly trivial differences in the initial condi
tions, the time path produced by one initial value
will not necessarily be similar to the time path
generated by a marginally different initial value.
In general, the two time paths that arise from the
different initial values will have periods during
which they are arbitrarily close together and
periods during which they deviate substantially.
Chaotic functions also exhibit sensitivity to
very small changes in the param eter values. A
third- or fourth-order change in the value of a
param eter can alter the tim e path from stable
to chaotic or vice versa.
20Recall that when a function is in a chaotic region (that is,
when the parameters are such that the function can ex
hibit chaos), there can be both periodic and aperiodic time
paths.

FEDERAL RESERVE BANK OF ST. LOUIS

Sensitivity to changes in the param eter values
is illustrated in figure 7. Here, a fifth-order
change in the value of the tuning param eter
(from 3.82840 to 3.82844) produces not only a
substantially different tim e path from the one in
figure 5, b u t also one that exhibits periodic
rath er than chaotic behavior .20

A re Attractors Strange?
Another feature often found in chaos,
although neith er necessary or sufficient for
chaos, is a strange a ttra cto r .21 The properties of
attractors and strange attractors are best illus21The only examples of chaos without the presence of a
strange attractor are found in certain types of dissipative
systems.

Figure 7
A Logistic Growth Curve With
Periodic Points
Xt+1 = 3.82844 Xt ( 1 - X t )
X0 = .0101 t = 1 to 500

Figure 8
The Strange Attractor for a
Chaotic Function
Xt+1 = 3.82840 Xt ( 1 - Xt )
X0 = .0101 t = 1 to 1500

x,.,

0.0

trated by example. In a stable system, the time
path converges to an equilibrium point (for ex
ample, X* in figure 4). T he equilibrium point is
also called the attractor, because the tim e path
is "attracted ” to the equilibrium point. A nother
possibility is that the tim e path has two attract
ors, and the system oscillates betw een them,
never rem aining at one equilibrium point. This
is found in predator/prey population models,
w h ere the population grow s until it is so large
it begins to die o ff and then shrinks to a level
so small it begins to grow again.
A "strange a ttracto r” is the nam e given to the
case w here th ere is a region, rath er than a
finite set of points, that attracts the tim e path
o f the variable. That is, after some num ber of
iterations, w hich varies depending on the fu n c
tion, the time path of the variable is completely
contained in this region (the strange attractor).
Thus, even though the path is aperiodic and

22Another definition of a strange attractor is an attractor with
fractal dimension. In fact, if a strange attractor exists, the
variable has fractal dimension. Random variables have in
finite dimension, however. As a result, tests for dimension
are one of the main ways data are tested to determine if

0.5

1.0

th erefo re never reach es an equilibrium in the
standard sense, it also never leaves the strange
attractor and th erefo re is not unstable (for ex
ample, never goes to positive or negative infini
ty). An example of this is shown in figure 8 ,
w hich takes the same num erical example as in
figure 5, but iterates it 1500 rath er than 500
times. In this picture, the values of X are still
contained in the same area as in figure 5, but
the distribution of points is becom ing denser.
T he bounded region (shown by the dotted line
in figure 8 ) is the strange attractor fo r this
function. If the function is iterated fu rth er, the
area w ithin the bounded region would appear
to be a solid block, although the function would
never have the same value tw ice. In fact, the
existence of a strange attractor is an im portant
way to distinguish betw een a random and
chaotic tim e path .22

they are chaotic. For the purpose of this paper, however,
the issue of fractals and fractal dimension will be ignored
For a discussion of these topics, see Mandelbrot (1983)
and Gleick (1987).

MARCH/APRIL 1989

LESSONS FROM CHAOS
Although econom ists are beginning to in cor
porate chaos into their econom ic and econo
m etric models, th ere has been little discussion
of the ways in w hich chaotic dynamics are use
ful or realistic fo r econom ic models. Clearly,
chaos holds considerable appeal fo r econom ists
who are looking fo r a determ inistic explanation
of the apparent random ness in econom ic vari
ables. Econom ists frequently assum e random ness
w hen they are unable to explain the behavior of
an econom ic variable empirically. T he presence
of an alternative explanation, chaos, will require
them to consider m ore carefully the rationale
behind their assumptions.
One problem with incorporating chaos into
econom ics is that, while econom ists can either
postulate an equation and test it for the presence
of chaos or, alternatively, see if the data them
selves are chaotic, it is especially difficult to
identify the co rre ct functional form that ch arac
terizes the data. T he choice of a functional form
is always a problem in econom ics, but, as p re
viously discussed, it is particularly difficult to
model nonlinear dynamics. This problem is ex
acerbated because, as a result of the m athem at
ics required, the study o f nonlinear dynamics
has, until recently, been relatively limited in
general and largely ignored in econom ics .23
Even w hen it is possible to estim ate nonlinear
dynamic equations, the models them selves often
cannot be solved analytically. W ithout explicit
solutions to these models, their usefulness is ex
trem ely limited. Obviously, the difficulty of de
term ining the "tru e” underlying model from a
data series is a problem w hether or not chaos
exists. The "discovery” of chaos, how ever, has
focused m uch m ore attention on this problem,
especially if the data are nonlinear.

E conom ic M odeling and Chaos
The study of chaos em phasizes the im por
tance of rigorously modeling the dynamics of a
system ra th er than m erely taking a static model
(like equations 1 and 2 ) and adding time sub

23For recent work in nonlinear dynamics, see Grandmont
(1987).
24The “ order” of an equation refers, for a differential equa
tion, to the highest power attained by the derivative and,
for a difference equation, the highest degree of differen
cing. For a more complete discussion, see Chiang (1984).

FEDERAL RESERVE BANK OF ST. LOUIS

scripts and an erro r term . Although these sim
pler models may be m ore likely to have solutions
with explicit results that can be tested em pirical
ly, the dynamics that arise may not capture the
behavior of the variable of interest. T he richness
of a model may be found in explaining the b e
havior of a variable over time as m uch as in the
direct, tim e-independent (or time-constant) rela
tionship betw een the variables.
In addition, the study of determ inistic chaos il
lustrates some of the pitfalls of first d ifferen
cing a dynamic model to convert it to discrete
time, as was done in the model of population
grow th presented above. This practice is com
mon in econom ics because data are only
available in discrete intervals.
As is shown in Stutzer (1980) and dem on
strated here, th ere are first-order differential
equation models (such as equation 6 ) w hich con
verge to a steady-state equilibrium th at are cha
otic w hen expressed in discrete tim e (equation
9). Thus, the dynamic properties of the discrete
analog o f a differential equation cannot be as
sumed to be the same. In fact, it has been
shown that, although chaos can arise in firstorder d iffe r e n c e equations, it can only arise in
third-order or higher d ifferen tia l equations .24 As
a result, an econom ist m ust be carefu l about
either converting a continuous tim e dynamic
model into a discrete model (such as converting
equation 6 into equation 7), or taking a static
model and simply adding a tim e subscript,
rath er than postulating a model that is dynamic
(in eith er discrete or continuous time) and esti
mating or solving it in that form . The choice of
the appropriate type of model should depend on
the econom ic variables being described rath er
than analytical convenience. This issue is partic
ularly im portant if a continuous-tim e dynamic
model is estim ated in discrete time using the
steady-state equilibrium properties of the
continuous-tim e solution. The discrete-tim e equa
tion that is being estim ated m ay not reach a
steady state at all, or the solution could differ
qualitatively from th at found in the continuous
time version of the model.

Empirical Applications of Chaos in Economics
T h ere are generally tw o approaches used in
the em pirical literature to test for the pres
en ce of determ inistic chaos in econom ic and
financial data. The first approach tests for
the presence of nonlinearities in the data .1
Since chaos only arises in nonlinear systems,
finding nonlinearities in the data suggests
that testing directly fo r the presence of chaos
is appropriate. In addition, the presence of
nonlinearities in the data provides inform a
tion to theorists modeling these types of
econom ic systems. Because testing fo r nonlinearities in the data is m uch sim pler (and
less controversial) than testing fo r chaos,
these tests are often perform ed first.
Many m acroeconom ic tim e series have been
found to behave in a nonlinear m anner. Brock
and Sayers (1988) find such evidence in data
for quarterly em ploym ent (1950-83), quarterly
unemploym ent (1949-82), monthly post-war
industrial production and pig-iron production
(1877-1937). Nonlinearities have also been
found in the Divisia M l m onetary aggregates .2
O ther studies have found nonlinearities in
financial data as well. For example, Hinich
and Patterson (1985a, 1985b) find strong evi
dence o f nonlinearity in daily stock returns.
The second approach is to test directly for
the presence of chaos .3 T h ere are many pro
blems with testing directly fo r chaos using
econom ic data, how ever. The most obvious,
and perhaps the m ost im portant, is the sen
sitivity of chaotic systems to small changes in
the param eter values and initial conditions.

For these tests to be accurate, the data need
to be especially exact. This degree of preci
sion presents a particular problem fo r eco
nom ics, w h ere controlled experim ents are
essentially impossible, especially on the m acro
level. Data collection is far from perfect, and
the quality of the data declines as the degree
of aggregation increases, introducing m easure
m ent e rro r in the data. In addition, because
o f rounding, the data are not as precise as
they should be. For this reason, tests fo r chaos
are not simply tests for aperiodicity.
The quantity o f high-quality data is also ex
trem ely im portant. Even if the results show
aperiodicity fo r a sample of 1 0 0 observations,
the system need not b e aperiodic. The existing
em pirical tests fo r the presence of chaos re
quire an extrem ely large num ber of highly
accurate data. Rarely are both of these avail
able to econom etricians. As a result, any evi
dence from tests for chaos should be viewed
w ith caution.
Given these caveats, some statistical tests,
originating in the physical sciences, do look
fo r the presence o f chaos in econom ic data.
These tests are run on variables that have
long tim e series available, are not aggregate
variables, and are thus m ore likely to provide
accurate results. T ests have found evidence
consistent w ith chaos in exchange rates (Ellis,
1990), daily gold and silver prices on the Lon
don m arket (Frank and Stengos, 1988) and in
the Divisia m onetary aggregates (Barnett and
Chen, 1988).4

'For a discussion of the tests used, see Brock and Sayers
(1988), as well as the other papers cited above.

drawbacks, see Barnett and Hinich (forthcoming), Brock
(1986) and Ramsey (1989).

2For a definition and discussion of the Divisia monetary
aggregates, see Barnett and Spindt (1982).

4This is by no means a comprehensive survey of the
empirical literature applying chaos to economic and
financial data. For a more comprehensive discussion of
the empirical work on chaos, see Barnett and Hinich
(forthcoming) and Ramsey (1989).

3A description of the actual empirical techniques used to
test for chaos is beyond the scope of this paper. For a
description of the tests available for chaos and their

Econom etrics and Chaos
The study of determ inistic chaos also offers
several lessons for econom etricians. If forecast
ing is a goal of econom ic modeling, inappropriate
modeling techniques in the presence of chaos
becom e m ore costly. If the data are chaotic,

forecasting is close to impossible since a small
erro r in the value o f the initial condition can
lead to highly inaccurate predictions (see, for
example, figure 6 ). Similarly, an erro r in any
param eter value can also produce in correct fore
casts (see figures 5 and 7). Thus, it is im portant

MARCH/APRIL 1989

to realize the limitations of econom ic forecasts
in the presence of chaotic variables.
Chaos does not have to be present in the data
to find the sort of fluctuating behavior (although
w ithout any clearly defined periodicity) that is
often found in econom ic data. Nonlinear nonchaotic models often can generate time paths
that appear random , and testing for nonlineari
ties is the likely next step fo r future research in
this area. In fact, em pirical econom ists are b e
ginning to test fo r both nonlinearities and chaos
in econom ic data (see insert on page 47). As a
result, m ore w ork needs to be done in und er
standing nonlinear estim ation so that econom ic
models can describe a g reater variety of b e
havior and be m ore accurate as well. In addi
tion, the existence of chaos suggests that econo
mists might w ant to try nonlinear specifications
of a variable b efore resorting to modeling it as a
random variable. This in tu rn will help to im
prove the quality o f econom ic forecasts in the
presence of nonlinear variables.
In addition, the use of a random com ponent
in estim ation does not necessarily imply that the
variable itself is random, but rath er that other
relevant variables might be excluded from the
regression. Although each of these oth er vari
ables could have a small influence on the system
by itself, the total effect of these excluded vari
ables could be substantial. Given both the diffi
culty in detecting w hat these missing variables
might be and data limitations, such a complex
system might best be approxim ated by a random
variable, even if th ere is no tru e random ness in
the variable being estimated. In fact, some argue
(see, for example, Kelsey, 1988) that, since eco
nom ic models do not include such (chaotic) phe
nom ena as w eather and other biological factors
w hich can influence econom ic variables, it
"seem s inevitable that we will have random
term s in our equations .”25

CONCLUSION
The study of determ inistic chaos and its subse
quent application to econom ics has opened a
new realm of possibilities for econom ists trying
to explain cyclical or erratic behavior in eco
nomic variables. As discussed above, chaos has
implications for both theoretical modeling and
em pirical applications in econom ics. By illustrat

25Kelsey (1988), p. 12.

FEDERAL RESERVE BANK OF ST. LOUIS

ing explicitly how restrictive the assumption of
linearity can be, the study of chaos emphasizes
the im portance of allowing fo r the possibility of
nonlinear behavior. T he use of chaos in econom
ics also has offered new explanations fo r behav
ior that, until recently, has been able to be ex
plained only by random forces.
The techniques that have arisen from the
study of chaos in the physical and biological
sciences are in th eir infancy. As these tech ni
ques becom e m ore refined, and econom ists b e
com e b etter trained in working with these types
of models, their ability to explain the behavior
of variables such as exchange rates, business
cycles and stock prices is likely to improve.
That possibility alone is sufficient reason for
econom ists to take a closer look at determ inistic
chaos in particular and nonlinear dynamics in
general.

REFERENCES
Barnett, William A., and Ping Chen. “ The AggregationTheoretic Monetary Aggregates are Chaotic and have
Strange Attractors: An Econometric Application of
Mathematical Chaos,” in William A. Barnett, Ernst R.
Berndt, and Halbert White, eds., Dynamic Econometric
Modeling, Proceedings of the Third International Sym
posium in Economic Theory and Econometrics (Cambridge
University Press, 1988), pp. 199-245.
Barnett, William A., and Melvin J. Hinich. "Has Chaos Been
Discovered with Economic Data?” in Ping Chen and
Richard Day, eds., Evolutionary Dynamics and Nonlinear
Economics (Oxford University Press, forthcoming).
Barnett, William A., and Paul A. Spindt. “ Divisia Monetary
Aggregates: Compilation, Data, and Historical Behavior,”
Board of Governors of the Federal Reserve System, Staff
Studies 116 (May 1982).
Baumol, William J., and Jess Benhabib. “ Chaos: Significance,
Mechanism, and Economic Applications,” Journal of
Economic Perspectives (Winter 1989), pp.77-105.
Benhabib, Jess, and Richard H. Day. “ Rational Choice and
Erratic Behaviour,” Review of Economic Studies, (July 1981),
pp. 459-71.
Brock, W. A. “ Distinguishing Random and Deterministic
Systems: Abridged Version,” Journal of Economic Theory,
(October 1986), pp. 186-95.
Brock, W. A., and W. D. Dechert. “ Theorems on Distinguish
ing Deterministic from Random Systems,” in William A.
Barnett, Ernst R. Berndt, and Halbert White, eds., Dynamic
Econometric Modeling, Proceedings of the Third Interna
tional Symposium in Economic Theory and Econometrics
(Cambridge University Press, 1988),
pp. 247-65.
Brock, W. A., and Chera L. Sayers. “ Is the Business Cycle
Characterized by Deterministic Chaos?” Journal of
Monetary Economics, (July 1988), pp. 71-90.

Chiang, Alpha C. Fundamental Methods of Mathematical
Economics, 3rd ed. (McGraw-Hill Book Company, 1984).
Day, R. H., and Wayne Shafer. “ Keynesian Chaos,” Journal
of Macroeconomics (Summer 1985), pp. 277-95.
De Grauwe, Paul, and Kris Vansanten. “ Deterministic Chaos
in the Foreign Exchange Market,” Discussion Paper Series
No. 370, Centre for Economic Policy Research, 1990.
Deneckere, Raymond, and Steve Pelikan. "Competitive
Chaos,” Journal of Economic Theory (October 1986),
pp. 13-25.
Devaney, Robert L. An Introduction to Chaotic Dynamical
Systems (Addison-Wesley Publishing Company, Inc., 1989).
Ellis, Jennifer M. “Are Exchange Rates Chaotic?” mimeo,
University of Oregon, 1990.
Frank, Murray, and Thanasis Stengos. “ Chaotic Dynamics in
Economic Time-Series,” Journal of Economic Surveys
(Vol. 2, 1988), pp. 103-33.
Gleick, James. Chaos: Making a New Science (Penguin
Books, 1987).
Grandmont, Jean-Michel, ed. Nonlinear Economic Dynamics
(Academic Press, 1987).
Grandmont, Jean-Michel. “ On Endogenous Competitive
Business Cycles,” Econometrica (September 1985),
pp. 995-1045.
Haavelmo, T. A Study in the Theory of Economic Evolution
(Amsterdam: North-Holland Publishing Company, 1954).
Hinich, Melvin J., and Douglas M. Patterson. “ Identification
of the Coefficients in a Non-Linear Time Series of the

Quadratic Type,” Journal of Econometrics (November
1985a), pp. 269-88.
________ "Evidence of Nonlinearity in Daily Stock Returns,”
Journal of Business and Economic Statistics (January
1985b), pp. 69-77.
Kelsey, David. “ The Economics of Chaos or the Chaos of
Economics,” Oxford Economic Papers (March 1988),
pp. 1-31.
Li, Tien-Yien, and James A. Yorke. “ Period Three Implies
Chaos,” American Mathematical Monthly (December 1975),
pp. 985-92.
Mandelbrot, Benoit B. The Fractal Geometry of Nature (W. H.
Freeman and Company, 1983).
May, Robert M. “ Simple Mathematical Models With Very
Complicated Dynamics," Nature (June 10, 1976),
pp. 459-67.
Melese, Francois, and William Transue. “ Unscrambling
Chaos Through Thick and Thin,” Quarterly Journal of
Economics (May 1986), pp. 419-23.
Poincare, Henri. Science and Method, translated by Francis
Maitland (Dover Publications, Inc., 1952), pp. 67-68.
Ramsey, James B. "Economic and Financial Data as Non
linear Processes,” in Gerald Dwyer and R. W. Hafer, eds.,
The Stock Market: Bubbles, Volatility, and Chaos (Kluwer
Academic Publishers, 1989).
Stewart, Ian. Does God Play Dice?: The Mathematics of Chaos
(Basil Blackwell, Inc., 1989).
Stutzer, Michael J. “ Chaotic Dynamics and Bifurcation in a
Macro Model,” Journal of Economic Dynamics and Control
(November 1980), pp. 353-76.

David Laidler
David Laidler is a professor of economics at the University of
Western Ontario and is affiliated with the C.D. Howe Institute.
This paper, the fourth annual Homer Jones Memorial Lecture,
was delivered at the Federal Reserve Bank of St. Louis on
April 11, 1990.

The L egacy Of The M on etarist
C o n tro v ersy

IN T R O D U C T IO N
,
It is not quite true, as one (hostile) com m entary
, ,
„
.
,
,
, ,
has asserted, that M onetarism was developed by
» i.
•
t, • .
i t-« j
it,
t>
.
Milton Friedm an at the Federal Reserve Board
(sic) o f St. Louis,” but it is nevertheless the case
that the intellectual environm ent created at this
Bank by Homer Jones ensured that the doctrine
took root and flourished h ere w hen it was very
m uch a m inority taste elsew h ere .1 And indeed,
at least two early and seminal contributions to
the M onetarist controversy, Andersen and Jordan (1968) and of course Bru nner (1968), w hich
gave the controversy its label, first appeared in
the Bank’s R eview . The M onetarist controversy,
therefore, is surely a suitable topic for this lecture. Now M onetarism has been m uch defined
and debated over the years, to the point at
w hich one may find authority fo r applying the
term to almost any econom ic and/or political
doctrine one likes, or m ore probably dislikes.
However, it is not so m uch my purpose h ere to
define that doctrine in detail y et again, as it is
to discuss the consequences fo r the developm ent of m onetary econom ics, both in theory
and practice, of the debates to w hich it gave
°
rise during the 1960s and 1970s.
°
In this lecture, I shall first of all describe the
issues that w ere at stake at the outset of those

debates. I shall show that although the Monetarist policy agenda was very different from
. x £ .
. , x
that o f what we might call Keynesian ortho,
,
. .
....
.
doxy, the positive differences in econom ic analyJ
S1S whlch underlay the P °hcy debate w ere at
first em pirical in nature, raising no fundam ental
questions of econom ic theory. I shall also show,
how ever, that, w h eth er it was logically necessary
or no*' theoretical considerations o f profound
im portance did get introduced into the Monetarist controversy as it progressed. Although
these at first seemed to strengthen the Monetarist position, I shall go on to argue that these
very considerations in the longer run undermined it, leaving M onetarism w ithout distinct
theoretical foundations, and incapable of coping
with the em pirical difficulties w hich it began to
encounter from the m id-1970s onward. Furtherm ore, I shall suggest that most, though not all,
Qf those em pirical problem s stemmed from an
attempt by "Keynesian” orthodoxy to adapt Monetarist ideas to its own use. Finally, I shall argue
that though the M onetarist controversy was to
all intents and purposes over by the early 1980s,
,,
, . , .. ,
, .
the problem s w hich it bequeathed to m onetary
.
..
, .
„
.
.. ,
econom ics continued to affect theoretical,
empirical- and policy-oriented aspects of the
sub-discipline into the 1980s, with results which

'See Gould, Mills and Stewart (1981), p. 26.

MARCH/APRIL 1990

I cannot help but view w ith considerable
discom fort.

THE M O N E TAR IST C O N TR O
VERSY IN THE 1960s
The M onetarist controversy concerned the
role played by m onetary variables in general,
and the quantity of money in particular, in the
m acroeconom y. D ifferent exponents of M one
tarism stressed d ifferent propositions, but it
would be fair to say that, from the point of
view of the non-academ ic observer whose main
con cern was the conduct of econom ic policy,
M onetarism involved first a theory of inflation,
second a theory of the cycle, and third, as a
corollary of these, a recom m endation for the
conduct of m onetary policy. Specifically, infla
tion was said to b e explicable in term s o f the
rate of grow th of the money supply, and the
cycle, or m ore precisely its turning points, in
term s of changes in that rate o f grow th. From
these propositions, it immediately seem ed to
follow that both inflation and cycles could be
avoided by choosing an appropriate rate of
grow th for the m oney supply, and binding the
m onetary authorities to deliver it y ear in and
year out by imposing upon them some quasi
constitutional rule of conduct. T he cen tral item
on the M onetarist policy agenda was thus to
eliminate inflation and stabilize the real econom y
by taking discretionary pow er away from the
cen tral b an k .2
W hatever position may b e taken about its
validity, this M onetarist agenda is nowadays
treated as having been (and perhaps as still b e
ing) w orthy of serious discussion. It was not so
25 or 30 years ago. Then, though the Phillips
curve, about w hich I shall have m ore to say
below , was coming onto the scene, the predom i
nant view treated inflation as largely a m atter
of "cost-push” forces. The cycle was regarded as
having its roots in investm ent fluctuations, and
some m ixture of wage-price guidelines and fiscal
m easures was thought best able to cope with

2ln an earlier essay, Laidler (1982), Ch. 1., I analyzed the
essential characteristics of Monetarism from an academic
perspective, concentrating there on the role of a stable de
mand for money function and the expectations-augmented
Phillips curve in defining the doctrine. As the reader will
see, these relationships play a large part in the following
discussion, and I regard this essay as supplementing
rather than in any way contradicting this earlier piece.
3Thus Laidler (1969) used this framework to motivate its
discussion of the significance of the demand for money

RESERVE BANK OF ST. LOUIS
FEDERAL

the policy problem s the tw o phenom ena
presented. M onetary tools had at best a m inor
role to play in the conduct of m acro policy, and
the relevant variables w ere, in any event,
thought to b e not the quantity of money, but
the level and stru ctu re of nominal interest
rates. In 1960, say, that as yet un-named body
o f doctrine w hich we now know as M onetarism
was hardly debated for the simple reason that it
was regarded as quite outlandish. This was
strange indeed, because at that time no funda
m ental questions of econom ic theory separated
proponents of the conventional m acroeconom ic
wisdom of the early 1960s from their M onetarist
critics. Each side in the debate that was to
follow could, and did, derive their views from
specific quantitative hypotheses about relation
ships embodied in what was, nevertheless, quali
tatively speaking, essentially the same m acroeco
nomic model, that staple o f the contem porary
textbooks, the Hicks-Hansen IS-LM fram ew ork .3
The first stage of the M onetarist controversy
was about the em pirical nature and stability of
the demand fo r m oney function, or, as it was
then thought equivalently, the relationship deter
mining m oney’s velocity of circulation. As early
as 1956, Friedm an had advanced the hypothesis
that the demand fo r m oney was a stable fun c
tion of a few argum ents, and by 1959 had pro
duced em pirical evidence w hich seem ed to
show that, as far as real m oney balances w ere
concerned, "few " m eant "one”: namely, perm a
nent real incom e. The implications of this result
w ere startling, because, once fed into the IS-LM
fram ew ork, they suggested that if the quantity
of m oney was held to an appropriate constant
grow th rate, th ere would b e essentially no
scope for shocks originating on the real side of
the econom y, fo r example, in the investm ent
com ponent of aggregate demand, to bring about
any significant fluctuations in nominal income.
Nor would th ere be any role fo r fiscal m easures
to play in influencing that variable. Fu rth er
m ore, a slightly later, but essentially com plem en
tary, study by Friedm an and M eiselman (1963)

function, while Friedman (1971) also used it as an ex
pository device. Note, however, that Brunner and Meltzer
(e.g., 1976), because of their insistence on the importance
of credit market effects in the generation of the money
supply, were led to extend this framework to a point at
which it became sufficiently different in its characteristics
to make it misleading to treat it as simply one more variant
on IS-LM.

seemed to confirm directly the irrelevance of
variations in autonomous expenditure, while at
the same time attributing a considerable in
fluence on m oney incom e’s behavior to the
grow th rate of the money supply.
The appealing simplicity of these results did
not long survive fu rth er em pirical investigation.
A num ber of studies soon found a role for in ter
est rates to play in influencing velocity, hence
re-opening the theoretical possibility of variables
other than m oney affecting the time path of
m oney incom e, and the Friedman-M eiselman re
sults w ere not robust in the face of small
changes in the way in w hich the Keynesian con
cepts of autonomous and induced expenditure
w ere m easured .4 Nevertheless, from a practical
point of view, the m odifications to the basic
M onetarist position required by these results
w ere rath er minor. The quantity of m oney did
seem to be an econom ic variable o f potentially
strategic im portance; and real shocks originating
in the private sector, not to m ention impulses
coming from fiscal policy, did seem to play a
potentially less im portant role in determ ining
money incom e’s tim e path than the conventional
wisdom of about 1960 would have had it. By
1967 results such as these w ere sufficiently well
established and widely accepted that it was pos
sible for the present w riter to begin w ork on a
supplem entary textbook (Laidler, 1969) which
summarized the em pirical evidence on the de
mand fo r m oney function, and explicitly in ter
preted it in term s of the above-m entioned IS-LM
model along ju st such lines as these.
Now the read er will b e w ell aw are that our
earlier confidence in the em pirical stability of
the demand fo r m oney function has not been
entirely justified by subsequent experience. I will
take up this m atter below. For the m om ent it is
m ore im portant to con cen trate upon another
anomaly in this aspect of the M onetarist con tro
versy, namely that em pirical evidence on the
stability of the demand for money function,
though relevant to M onetarist propositions
about the causative role of m oney vis a vis both
inflation and the cycle, and hence also to pro
posals to tie down m onetary policy by w ay of a
grow th rate rule, stops fa r short of establishing
them . Thus, if m onetary elem ents in the gen era
4Among early papers finding a significant interest elasticity
of demand for money were Meltzer (1963) and Laidler
(1966). Both Ando and Modigliani (1965) and De Prano
and Mayer (1965) showed that fairly small changes in the
definition of “ autonomous" expenditure led to rather large

tion of inflation on the one hand, and the cycle
on the other, are to b e discussed coherently, one
requires m ore than a link betw een the time path
of money and money income. One also needs a
theory of how fluctuations in money incom e are
divided up betw een its price level and real in
come com ponents. M oreover, a stable demand
fo r money function is quite compatible with the
existence of cost-push inflation and a cycle
w hose origins lie in the private sector of the
econom y, provided only that institutional a r
rangem ents are such as to ren d er the supply of
m oney as an essentially passive variable.
Empirical evidence about the stability o f the
demand for money function, that is to say, got
M onetarist analysis taken seriously enough for
it to becom e controversial, but it could not in
and of itself guarantee its victory in a debate
w hich rath er centered on the two issues raised
above. The first issue becam e known as the
problem of Friedm an’s "missing equation,” and
debate about it overlapped heavily w ith discus
sions o f the "Phillips curve,” otherw ise known
as the "inflation-unem ploym ent trade off." As to
the second, it was addressed by such w orkers
as Philip Cagan (1965), and Bru nn er and M eltzer
(e.g., 1964, 1976) who opposed th eir findings to
the then "new view” of money propounded by
Jam es Tobin (eg., 1969) and his associates. It
will be helpful to discuss these tw o aspects of
what we might term the second stage of the
M onetarist controversy in turn.
The problem of decomposing variations in
money incom e into th eir real and price level
com ponents was a longstanding one in m acroeco
nomics, dating b ack at least to Hicks' original
(1937) form ulation of the IS-LM fram ew ork as a
model of the determ ination of money income.
Though subsequent developments of this system
reinterpreted it as dealing with real income,
that still left prices unexplained. Here, the usual
solution was to have them determ ined by the
behavior of the m oney wage, and as I have al
ready noted, to treat the latter variable as being
driven by exogenous "cost-push” factors. How
ever, this is not the w hole story, fo r "demandpull” explanations of inflation also had th eir ad
herents, and the Phillips (1958) curve relating
the rate of m oney wage inflation inversely to
effects on the assessment of its influence on aggregate
demand. Strangely enough, at this stage of the Monetarist
controversy, questions about vagueness in the definition of
money were not raised.

MARCH/APRIL 1990

the level of unem ploym ent soon cam e to be
seen as a device fo r synthesizing these two
points of view. W age inflation, according to the
Phillips curve w as proxim ately caused by an ex
cess demand fo r labor, for w hich variable the
unem ploym ent rate was a proxy. Such excess
demand could eith er result from "pull” forces
shifting the labor demand curve, or "push” in
fluences shifting the supply curve. In either
case, how ever, price inflation would b e d eter
mined by the d ifference betw een wage inflation
and labor productivity grow th. Hence there
seemed to exist a stru ctu ral inverse trade-off
b etw een inflation and unemploym ent, or equiva
lently a positive relationship betw een the level
of real output and inflation .5
From the point o f view of m icroeconom ics,
the above analysis was fatally flawed, being
based on a theory w hich had the supply and de
mand fo r labor determ ine the m oney, ra th er
than the real, wage, and it was not long b efore
Phelps (1967) and Friedm an (1968) indepen
dently pointed this out. The latter, m oreover,
brought his critique into the cen ter of the Mon
etarist controversy, by noting, first that the o r
thodox Phillips curve predicted that an inflation
ary m onetary policy could generate perm anent
gains in real incom e, and second, that w hen its
underpinnings w ere corrected to take account
of the m oney wage-real wage distinction, the
inflation-unem ploym ent trade-off was reduced
to a tem porary phenom enon at most. Hence, a
key ingredient of the theory w hich yielded the
characteristic M onetarist propositions about
money grow th affecting only prices in the long
ru n but quantities too, in the short run, was
created a ft e r the em pirical observations upon
w hich those propositions w ere based had been
published, and turned out to be a theory not of
money, but of labor m arket behavior. It seem ed
to be, m oreover, in its original form , a m odifica
tion of a device borrow ed from one b ran ch of
the orthodoxy to w hich M onetarism was oppos
ed. As a practical m atter, rath er than replace it
with some alternative equation, the PhelpsFriedm an critique o f the Phillips curve simply
added the expected inflation rate to the relation
ship’s right-hand side, w ith a coefficient of
unity.
5Phillips’ original analysis was much elaborated by Lipsey
(1960), but responsibility for explicitly treating the Phillips
curve as a structural relationship constraining policy
choice probably rests with Samuelson and Solow (1960).
6
The relevant empirical literature was voluminous, but is
surveyed by Laidler and Parkin (1975).

FEDERAL RESERVE BANK OF ST. LOUIS

As w ith M onetarist propositions about the de
mand fo r m oney function, then, questions raised
by the M onetarist "co rrectio n ” to the Phillips
curve seemed to be inherently em pirical. Either
the labor fo rce was immune to m oney illusion
in the long run, so that th ere was no perm anent
inflation-unem ploym ent trade-off, or it was not,
in w hich case such a perm anent trade-off ex
isted. This question generated m uch em pirical
w ork in the late 1960s and early 1970s, and it is
a fair generalization that as m ore and m ore evi
dence was added by the passage of time, the
m ore the w ork in question cam e to support the
M onetarist position. Evidence from the 1950s
and early 1960s was com patible w ith the ex
istence of an inflation-unem ploym ent trade-off,
but the experience of higher inflation rates
from the m id-1960s onw ard made this hypothe
sis harder and harder to support .6 Once again,
though, th ere was no reason why this result
could not b e incorporated into the fram ew ork
of a suitably extended IS-LM model. However,
tw o factors militated against so simple and h ar
monious an outcom e to this stage of the Mone
tarist controversy.
To begin with, the original Phelps-Friedman
critique of the Phillips curve had been advanced
on theoretical grounds, and b efo re em pirical
evidence seem ed to requ ire econom ists to change
their notions about labor m arket behavior.
W hen confronted with a choice betw een what
em pirical evidence seemed to show, and what
elem entary econom ic theory required to b e the
case, Phelps and Friedm an had chosen the lat
ter. E^-post, they w ere vindicated by em pirical
evidence, and this vindication served notice on
m acroeconom ists that they would b e wise to pay
m ore attention to the m icroeconom ic foundations
of their em pirical generalizations than had typi
cally been the case up until then. Second, Fried
m an’s version of the critique had been accom
panied by a b rief account of labor m arket b e
havior, part of w hich was quite incom patible
w ith the then conventional interpretation of
real incom e and em ploym ent fluctuations as
m anifestations of variations in excess demand in
the economy.

Conventionally enough by the standards of
the 1960s Friedm an described the early stages
o f the econom y’s response to a m onetary expan
sion in the following term s .7
...much or most of the rise in income will take the
form of an increase in output and employment
rather than in prices. People have been expecting
prices to be stable, and prices and wages have been
set f o r some tim e in the fu tu r e on that basis. It takes
time for people to adjust to a new state of demand.
Producers will tend to react to the intitial expansion
in aggregate demand by increasing output, employees
by working longer hours, and the unemployed by
taking jobs now offered at former nominal wages.
This much is pretty standard doctrine, (p. 103, my
italics)

However, Friedm an immediately w ent on to
elaborate this account of the m echanism s that
brought about short-term fluctuations in incom e
and employment:
Because the selling prices of products typically res
pond to an unanticipated increase in nominal de
mand faster than prices of factors of production, real
wages received have gone down—though real wages
anticipated by employees went up, since employees
implicitly evaluated the wages offered at the earlier
price level. Indeed, the simultaneous fall ejc-post in
real wages to employers and rise e^c-ante in real
wages to employees is what enabled employment to
increase, (pp. 103-04)

Unemployment fluctuations in the conventional
view of the Phillips curve had been treated as
m anifestations of variations in the pressure ex
erted by excess demand in goods and labor
m arkets characterized by less-than-perfect price
flexibility, and h ence likely to b e operating out
of equilibrium in the w ake of any shock to ag
gregate demand. The first passage quoted above
is quite compatible w ith this view. In the second
passage quoted, how ever, em ploym ent fluctua
tions are explicitly pictured as arising from vol
untary decisions taken in response to price
changes and, in the case of the suppliers of
labor, on the basis of faulty expectations w hich
would in due course be corrected.
Thus Friedm an’s critique of the Phillips curve
potentially involved m uch m ore than the addi
tion of an extra variable to the right-hand side
of an equation. It also pointed tow ard a funda
m ental reinterpretation of the labor m arket
behavior underlying it. Viewed with hindsight,
it provides as an unm istakable sketch of the
m icrofoundations of the short-run aggregate
7Friedman’s (1969) Optimum Quantity of Money reprints
many of his seminal contributions, and the page

supply curve w hich w as to becom e the central
analytic device of New-classical econom ics. As
we shall see below, this device would in due
course, and quite paradoxically, not strengthen
but thoroughly underm ine the very M onetarist
explanation of the business cycle to w hich Fried
m an’s analysis of inflation-unemployment in ter
action was particularly addressed.
The analysis of inflation-unemployment in ter
action was by no m eans the only area in w hich,
during the 1950s and 1960s, m acroeconom ists
w ere seeking to strengthen the m icroeconom ic
foundations of their analysis. A whole set of
questions concerning the determ ination of the
money supply, and the m echanism s w hereby
m onetary changes might in teract w ith aggregate
demand in the economy, w ere also addressed in
such term s, both by adherents of the conven
tional Keynesian m acroeconom ic wisdom of the
time, and by M onetarists. Here as elsew here,
the contentious issues w ere m ore em pirical than
theoretical. As H arry Johnson noted as early as
1962, th ere was no debate in principle betw een,
say, Bru nner and M eltzer on the one hand and
Jam es Tobin on the other about the basic nature
of the linkages betw een the m onetary and real
sectors of the economy. Both saw these as in
volving disturbances to the stru ctu re of the port
folios of the banking system and the non-bank
public generating changes in the relative rates
of retu rn on various assets, financial and real,
w hich would in tu rn provoke attem pts on the
part of agents to resto re equilibrium by way of
sales and purchases of various assets. Both sides
also agreed that financial institutions and the
non-bank public alike should be analyzed as
maximizing agents.
W hat defined the M onetarist position h ere
was not its general approach, but rath er a set
of specific hypotheses about the quantitative
nature of the responses in question. First, as far
as the non-bank public w as concerned, M one
tarists took a broad view of the array of assets
whose rates of retu rn w ere relevant to what we
might term the transm ission m echanism of m on
etary policy. Specifically, they argued th at m one
tary policy would have effects not just on rates
of retu rn born e by financial assets, but also on
the implicit rates of retu rn yielded by producer
and consum er durables. Hence they saw its ef
fects as being both m ore pervasive, and quantireferences here and elsewhere to quotations from his work
are to this source unless otherwise noted.

MARCH/APRIL 1990

tatively m ore significant too, than did proponents
o f the Tobinesque "new view.” Fu rtherm ore,
w hile not denying that disturbances originating
in the private sector of the econom y would im
pinge upon the behavior of financial institu
tions, so that the quantity of m oney was un
doubtedly in this sense an endogenously d eter
m ined variable, they nevertheless strongly re
sisted the idea that the endogeneity in question
also involved that variable being passively
demand-determ ined, even w hen the m onetary
authorities used short-term in terest rates as
th eir policy instrum ent.
Such an outcom e was logically possible, to be
sure. If in terest rate changes disturbed only the
m argin betw een financial assets (let us call them
bonds) and money, then a reduction, say, in in
terest rates would lead to the public simply of
fering bonds to the banks in exchange fo r m on
ey with no fu rth er consequences. However, con
sistent w ith their broad view of the range of
assets relevant to the transm ission m echanism ,
B ru nn er and M eltzer argued that the principal
m argin likely to be disturbed by a change in in
terest rates was that betw een bonds and
physical capital, including consum er durables.
T he public would sell bonds to the banks, of
course, but as p art of a process of replacing
those bonds with physical capital. Furtherm ore,
and crucially, this would be only a first-round
effect, fo r the sale of bonds to the banks would
b e in exchange fo r newly created money which
would have to be accom m odated in the port
folios of the non-bank public. Since the banks
had presum ably changed interest rates fo r a
reason in the first instance, the possibility of
their simply acquiescing in the destruction of
newly created cash by the public discharging
debts to them could be discounted. Hence, fu r
th er substitution effects, changes in aggregate
demand, and ultim ately in the price level, would
be set in motion.
M onetarists’ theoretical position vis-a-vis the
behavior of the quantity of money in circu la
tion, then, may be described succinctly as fol
lows. Rather than being a passive dem and-deter
m ined variable, m oney also had a separate sup
ply function w hich was derivable from analysis
of the interaction o f banks and the public in the
m arket for bank credit. In turn, the quantity of
8Perhaps the best known of early econometric studies of
the money supply function is Brunner and Meltzer (1964).
The standard historical study is that of Cagan (1965).
Brunner’s (1968) St. Louis Review piece contains perhaps

FEDERAL RESERVE BANK OF ST. LOUIS

credit w hich banks w ere willing to grant, as
well as the term s on w hich they would m ake it
available, w ere both subject to a strong (though
not unique) influence flowing from the quantity
of reserves w hich the central bank made avail
able to them . The quantity of m oney was an en
dogenous variable, certainly, arising from a
complex set of interacting portfolio choices, but
it was nevertheless controllable by the
m onetary authorities. This theoretical position,
m oreover, was supported by a good deal of em
pirical evidence, some yielded by form al
econom etric studies, and some by less-form al
historical w ork to the effect that the behavior
of bank reserves, or m ore precisely of the quan
tity of high-powered money, was the principal
determ inant of the quantity of money in circula
tion and that variations in the ratio of highpow ered money to the m oney supply proper
could be modeled as the outcom e of systematic
maximizing portfolio choices .8

THE SUBVER SIO N OF MONE
TAR ISM B Y NEW -CLASSICAL
ECONOMICS
In the previous section of this essay, I have
described the main elem ents of M onetarist doc
trine, and have tried to show that they w ere all
reasonably well-developed in the academic
literature by the end of the 1960s. However, it
took the inflationary experience of the early
1970s, particularly in the United States and
Britain, to draw popular attention to th at doc
trin e by providing, during its early stages, some
thing as close to a controlled experim ent as one
ever gets in econom ics. In both countries, m one
tary expansion preceded an inflation w hich the
authorities attributed to cost-push forces and
attem pted to control w ith wage-price control
program s, and in both countries those program s
failed. Though the OPEC-led energy price in
creases of 1973 contam inated the later stages of
the experim ent by introducing an extraneous
cost-side impetus to the upward progress of
prices, the early 1970s was nevertheless the last
time that wage-price controls w ere deployed as
an alternative to m onetary restrain t in an anti
inflation policy. M oreover, the fact that the high
his single best exposition of the Monetarist position on the
generation of the money supply, and of the characteristics
distinguishing it from the Tobinesque “ new view.”

inflation of the 1970s was com bined with an
obvious deterioration in real econom ic p erfo r
m ance, rath er than an im provem ent, ensured
that M onetarist ideas about the absence of a
long-run inflation-unem ploym ent trade-off quick
ly becam e conventional wisdom.
At the very tim e at w hich M onetarist ideas
w ere gaining popular acceptance, how ever, their
academ ic foundations began to shift dangerous
ly as New-classical econom ics was developed. I
have suggested elsew here that the w ork of
R obert E. Lucas, Thom as Sargent, Neil W allace
and Robert Barro is m ore usefully treated as
separate and distinct from M onetarism, and for
w hat I still regard as good reason s .9 However,
this was and rem ains, something of a minority
viewpoint; and the fact rem ains that the two
central characteristics of New-classical econom
ics, namely the interpretation of the Phillips
curve as a reflection of an aggregate supply rela
tionship, and the rational expectations hypothe
sis, w ere quickly adopted by leading Monetarists.
This was unfortunate, because as the M onetarist
controversy moved into the 1970s and 1980s, it
increasingly becam e, as a m atter of fact, a con
troversy about New-classical econom ics. T he m a
jority o f econom ists failed to distinguish betw een
M onetarism and New-classical econom ics, and
accepted Jam es Tobin’s characterization of Newclassical econom ics as M onetarism M ark II .10
W hen New-classical econom ics was academically
discredited, so too was M onetarism in general,
leading to what, as I shall argue in the final sec
tion of this paper, is a dangerous gap in the
stru ctu re of contem porary m onetary econom ics.
I have already noted that Friedm an’s 1968
analysis of the inflation-unem ploym ent trade-off
relied on tw o incom patible theories of labor
m arket behavior. In the passages quoted earlier,
we had quantities moving in stead o f wages and
prices, w hich had already been set and hence
w ere unable immediately to change; and we
also had quantities moving in resp o n se to asym
m etrically perceived m oney-price changes. W e
had, in short, both an inform al account of the
effects of wage and price stickiness w hich was,
as Friedm an said, "pretty standard d octrine” in
the m acroeconom ics o f the 1960s; but we also
9This argument is developed in some detail in Laidler
(1982), Ch. 1.
10This characterization of Tobin’s is developed and defend
ed by him in Tobin (1981), in a paper prepared for the
same conference as the above mentioned Laidler (1982),
Ch. 1.

had an unm istakable sketch of an aggregate sup
ply curve interpretation of the short-run Phillips
curve in w hich money-wage and price flexibility
was of the essence.
T h ere is little point in speculating about the
extent to w hich Friedm an was aw are of the ten
sions inherent in his analysis in 1968; but it is
interesting to note that, at that time, he ch arac
terized Phillips’ w ork as "...containing a basic
defect—the failure to distinguish betw een n om i
nal wages and rea l w ages...” (p. 102, Friedm an’s
italics) w hereas in 1975 he referred not only to
this point, but also attributed to Phillips an e r
ro r in having "...taken the level of em p loy m en t
[instead of the rate of change of prices] as the
independent variable...” in the relationship. By
1975 Friedm an clearly was aw are that th ere was
a choice to be made concerning the m icroeco
nomic underpinnings of the Phillips curve and
had explicitly rejected that w hich hinged on in
terpreting the unemploym ent rate as a proxy
variable fo r some excess demand fo r labor con
cept. Bru nner and M eltzer made a similar choice
concerning the modeling of the linkages betw een
output and price-level variations in designing
the basic fram ew ork w hich they and th eir asso
ciates used to analyze the inflationary process
in a num ber of countries in the mid- 1970s.
Like Friedman too, they chose to model expecta
tions as being form ed not adaptively but, follow
ing Lucas and Sargent and W allace, rationally,
as the inflation forecast of the "tru e model” of
the econom y under analysis .11
These developments seemed at the tim e to be
in no sense revolutionary. I have already re
m arked that the Phelps-Friedman critique of the
Phillips curve initially involved using simple mi
croeconom ic analysis to mount a theoretical at
tack on what at the tim e seem ed like an hypothe
sis well-supported by em pirical evidence; and in
the event, m icroeconom ic principles proved a
sounder guide than what turned out to be some
misleadingly special observations. To show that
price-output interaction could b e derived from a
supply and demand apparatus w ithout reso rt to
purely em pirical generalizations about price
stickiness, and to show that the analysis in ques11The relevant work here is contained in Brunner and
Meltzer, eds. (1978). Note that the details of their formula
tion of the aggregate supply curve, with output’s rate of
change rather than level playing a major role, set it apart
from the standard Lucas (e.g., 1973) formulation. These
matters, discussed by McCallum (1978), are not central to
the matter under discussion here.

MARCH/APRIL 1990

tion was com patible with agents making use of
"all available" inform ation in a utility m aximiz
ing fashion, simply seem ed to be making even
m ore secu re the m icroeconom ic foundations of
a particular piece of m acroeconom ics, and hence
to be rendering it less prone to excessive
dependence on theoretically unsupported em
pirical observations of a type that had proved
so misleading in the recen t past.
Also, and crucially, New-classical m acroeconom
ics still seem ed to yield M onetarist implications,
nam ely that inflation in the long ru n was a m on
etary phenom enon, and that, in the short run,
so was the cycle. To be sure, it broadened the
m enu of m onetary rules that would enable the
cycle to be avoided to any that the general pub
lic could understand and th erefo re use as a basis
for expectations form ation, but a constant
grow th rate rule w as still a particularly simple,
and th erefo re viable, item on the m enu in ques
tion, and it was of course a particularly appro
priate choice if price stability in the long run
was added to the elimination of the cycle as a
proper goal fo r m onetary policy.
Even in the m id-1970s, it should have been
apparent that the attem pt to underpin the M one
tarist position with New-classical foundations
was dangerous. As early as 1958, Friedm an had
suggested that m onetary policy affected the
econom y w ith a "long and variable” time lag.
T he evidence w ith w hich he supported this sug
gestion identified a change in m onetary policy
as a change in the rate of grow th o f the quanti
ty of money in the econom y; and it showed that
dow nturns in that rate of grow th occu rred on
average 16 m onths b efore the corresponding
upper turning point o f the cycle, while upturns
in money grow th led cyclical troughs by about
twelve months. Fu rtherm ore, as Friedman
(1987) was later to note m ore explicitly, the e f
fect of changed money grow th on nominal
incom e 12
...typically shows up first in output and hardly at all
in prices. If the rate of monetary growth increases
or decreases, the rate of growth of nominal income
and also of physical output tends to increase or de
crease about six to nine months later, but the rate of
price rise is affected very little...the effect on prices
comes some 12 to 18 months later...(p. 17)
12The reader’s attention is drawn to the recent (1987) vin
tage of this statement. I have not been able to find so
clearcut and concise an exposition of the point in Fried
man’s earlier work, though I believe that the basic message
contained in the passage quoted here can be distilled from
the evidence presented in Friedman (1969), Chs. 10-12.

RESERVE BANK OF ST. LOUIS
FEDERAL

In 1963, Friedm an and Schw artz had presented
a m ore elaborate analysis of m oney’s role in
generating the cycle, in the course of w hich
they explained the length of the tim e lags in
volved in term s that amounted to an inform al
sketch of a dynamic version of the M onetarist
version of the transm ission m echanism w hich
Bru nner and M eltzer w ere also expounding at
the time.
The central element in the transmission mecha
nism...is the concept of cyclical fluctuations as the
outcome of balance sheet adjustments, as the effects
on flows of adjustments between desired and actual
stocks. It is this interconnection of stocks and flows
that stretches the effects of shocks out in time, pro
duces a diffusion over different economic categories,
and gives rise to cyclical reaction mechanisms. The
stocks serve as buffers or shock absorbers of initial
changes in rates of flow, by expanding or contracting
from their "normal” or "natural” or "desired” state,
and then slowly alter other flows as holders try to
regain that state, (p.234)

The em pirical evidence referred to here, and
particularly that part of it dealing with the tim
ing of output responses relative to those in
prices, and an explanation of that evidence in
term s of a transm ission m echanism involving
portfolio disequilibria w orking them selves slow
ly out over real historical time are quite incom
patible with New-classical analysis. Since both
the evidence in question and the above explana
tion of it w ere available and well established
b efore the development of New-classical ideas,
the incompatibility in question ought to have
prevented those ideas from being adopted as a
basis for M onetarist propositions, but it did not.
W h ether this was because the problem was not
fully appreciated at the time, or because that
shift in methodological priorities away from em
pirical evidence and tow ard "sound" theoretical
foundations upon w hich I have already com
m ented caused those who w ere aw are of it to
opt for the latter is hard to say. I suspect that a
strong elem ent of the latter consideration must
have been at work, though, since the inconsisten
cy in question is hardly subtle .13
To begin with, the price flexibility postulate of
New-classical econom ics creates problem s fo r the
13Though I do not claim to have understood this matter fully
from the outset, I did discuss it in some detail as early as
1978 in an essay reprinted as Chapter 4 of Laidler (1982).

M onetarist account of the transm ission m e
chanism . Slow adjustm ent of portfolios in the
wake of a m onetary disturbance is of the very
essence here, and it is usual to explain the slow
ness in question in term s of transactions costs.
But if the price level moves freely and instanta
neously to keep m arkets cleared it also, in the
process, eliminates portfolio disequilibria quite
costlessly fo r agents. According to Friedm an and
Schw artz, excessive m oney holdings develop b e
cause, w hen m oney grow th increases, the rate
of inflation does not respond immediately. But
according to New-classical econom ics it does,
and so increased m oney grow th cannot cause a
tem porary rise in buffer-stocks of m oney as a
prelim inary to increased expenditure flows. The
conflict h ere betw een traditional M onetarism
and New-classical analysis concerns rival th eo ret
ical constructions. Much m ore serious is the
conflict betw een theory and evidence which
arises w hen the New-classical aggregate supply
curve is confronted w ith the em pirical evidence
concerning the interaction of money, output
and prices over the course of the cycle, evidence
upon w hich traditional M onetarism laid con
siderable stress.

should have led m onetarists to reject that theory
from the outset, did eventually underm ine it. So
long as em pirical w ork was confined to testing
the proposition that output and employment
fluctuations could be modeled as responses to
"unanticipated” money, all seemed well. How
ever, Robert J. B arro (1978) noted that the theo
ry in question made specific predictions about
the relationship betw een m onetary shocks and
price level changes as well. W hen he cam e to
test the latter predictions, he found that, in
order to reconcile them w ith his data, the price
level’s response to unanticipated m onetary shocks
had to be characterized by a rath er slowmoving distributed lag process, in an econom y
in w hich, how ever, prices could respond with
no lag to anticipated money. Fu rtherm ore, his
results also seemed to require that the aggregate
demand fo r m oney display a greater sensitivity
to transitory than to perm anent changes in in
come, the very opposite result to that implied
by a wide variety of oth er studies. New-classical
analysis could be forced to fit the data generated
by the U. S. econom y, that is to say, only by
way of some extrem ely implausible subsidiary
assumptions.

As is well known, the New-classical aggregate
supply curve explanation of the decomposition
o f nom inal incom e changes into th eir real and
price-level com ponents hinges upon the distinc
tion betw een demand side shocks whose price
level effects can be anticipated by agents, and
those that cannot. The w ord “anticipated” nor
mally m eans "expected an d a cted u pon ,” but
since the New-classical model is one in w hich
flexible prices always move costlessly and in
stantly to equate supply and demand in all m ar
kets, the second phrase is redundant in its con
text. If a price level change is anticipated by
agents, th ere will be no quantity changes associ
ated w ith it; but if it is not, then the specific
money-price changes in particular m arkets that
are associated w ith it will be m isinterpreted as
reflecting relative price changes and voluntary
responses in quantities of goods and services
supplied will occur. Cyclical fluctuations in real
variables may th erefo re be interpreted as the
consequence of unanticipated price level changes.
The trouble h ere is that it is hard to see how
output and employment fluctuations can be re
sponses to price level fluctuations i f th ey p r e c e d e
th o se p r ice level flu ctu ation s; but the em pirical
evidence tells us that they do just that.

Nor did the results of subsequent em pirical
w ork enhance New-classical econom ics’ claim to
be taken seriously. Mishkin (1982) repeated Barro ’s tests of the irrelevance of anticipated
m onetary shocks fo r output using m ore sophisti
cated econom etric techniques, and found that
this resulted in a reversal of the initial results—
apparently anticipated m onetary changes did
have real effects. Boschen and Grossman (1982)
noted that m oney supply estim ates are published
weekly, and that only the erro rs in these esti
mates properly can be regarded as constituting
the unanticipated com ponent of the m oney sup
ply. They fu rth er noted that the latter w ere im
plausibly small to form the basis o f a m onetary
explanation of the cycle, and that output changes
w ere in fact correlated w ith m onetary changes
about w hich inform ation had previously been
published.

This inconsistency of the timing o f data with
the basic stru ctu re o f New-classical theory, which

In addition to these problem s raised by aca
demic w ork, of course, th ere was the experience
of the early 1980s recession, w hich played the
same role in publicly discrediting New-classical
econom ics, as did the inflation of the 1970s in
undermining "Keynesian" theory. New-classical
econom ics discounted the im portance of real
world wage and price rigidities, and placed con
siderable faith, th erefore, in the public’s will
ingness to react immediately to a well-publicized

MARCH/APRIL 1990

anti-inflation policy based on m onetary con trac
tion in such a w ay as to reduce inflation without
serious real incom e and employment conse
quences. T h e policies in question certainly did
reduce inflation, but the recession w hich accom
panied that reduction was, in some respects, the
w orst since the 1930s. M oreover, the United
Kingdom and Canada carried out similar experi
m ents at about the same time with similar
results. By the m id-1980s, the New-classical de
velopm ent o f the M onetarist account of the role
of m oney generating the business cycle was
thus widely recognized to have failed in its en
cou nter w ith em pirical evidence. This could
have led to a revival of interest in m ore tradi
tional M onetarist analysis; but it did not, because
the very postulate that had established the re
spectability of that analysis in the first place,
namely a stable aggregate demand fo r money
function, had also ru n into difficulties.

THE KEYNESIAN A D O P T IO N OF
THE STABLE D EM AN D FOR
M ONEY FUNCTION
The early studies of the aggregate demand for
money function, w hich established M onetarism ’s
respectability, w ere carried out using long runs
of U.S. data, some stretching back into the 19th
century. M oreover, the data them selves w ere
highly tim e aggregated. Thus Friedm an’s (1959)
seminal study covered the years 1869-1956, and
used cycle averages of variables in estim ating its
basic equation. One business cycle, th at is to
say, lasting on average about fou r years, provid
ed one observation. Later studies, such as those
of M eltzer (1963) or Laidler (1966) dealt with
essentially the same time period, but used an
nual observations. It was an obvious enough ex
tension of such w ork to test the hypotheses at
stake in it against data drawn from other coun
tries and also against m ore tim e disaggregated
data too, and such extension proceeded apace in
the 1960s mainly at the hands of people far
m ore interested in exploiting new data and com
puting techniques than furthering any par
ticular policy agenda.

portion to the general price level—displayed
rem arkable robustness; so m uch so that, by the
early 1970s, the demand fo r money function
was a prim e candidate to becom e the c en ter
piece of stabilization policy, m uch as had the
Keynesian consumption function or the Phillips
curve at earlier times. For the demand fo r m on
ey function’s full potential fo r such a use to be
exploited by policy m akers, detailed knowledge
of the function’s contem porary form was ob
viously needed, and in the early 1970s a rem ark
ably simple version of the equation seemed to
be able to deal with quarterly U. S. data with a
high degree of precision. This relationship,
nowadays know n as the "Goldfeld equation” after
its m ost carefu l exponent (Goldfeld, 1973), had
the long-run average value of m oney holdings
determ ined by real incom e and in terest rates,
but involved the hypothesis that w hen some
disturbance took money holdings away from
this long-run average, they would move back
tow ard it slowly over time, w ith the speed of
adjustm ent in question being proportional to the
size of the gap to be closed .14 The Goldfeld
equation fitted U. S. data well, appeared to be
stable over time, and crucial for policy pur
poses, dealt w ith data at a relatively low degree
of time aggregation. It did indeed appear to be
so policy relevant that, in his Presidential ad
dress to the Am erican Econom ic Association,
Franco Modigliani (1977) argued that it could,
and should b e used as the basis of an activist
m onetary stabilization policy in the Keynesian
mold.

At first the hypotheses in question—that the
demand fo r m oney varied w ith some real in
com e or w ealth m easure, some m easure of the
opportunity cost of holding money, and in pro

Modigliani’s address in fact appeared after the
first signs of trouble with the relationship had
appeared. Before dealing w ith that, how ever, it
is w orth reiterating that the progress of the de
mand fo r m oney function so briefly dealt with
above was by no m eans synonymous w ith the
progress of M onetarism, but rath er it involved a
com ponent of M onetarism being taken over by
the Keynesian opposition. Ju st as the association
of M onetarist ideas about the cycle w ith those
of New-classical econom ics was to prove de
structive, so too was this association, and once
m ore this could have been, but was not, dis
cerned at the tim e in the light of evidence then
available. That the association in question was
indeed being form ed was, o f course, obvious
enough once Modigliani made the existence of a

14Though the relationship in question is now irrevocably
known as the “ Goldfeld Equation,” it was in fact used
before him in studies of the demand for money by, among

others, Teigen (1964) and Chow (1966). Goldfeld, be it ex
plicitly noted, did not claim originality for the relationship
in question.

RESERVE BANK OF ST. LOUIS
FEDERAL

stable demand for money function an im portant
part of the basis o f his case for m onetary finetuning, a policy stance to w hich Monetarism
was root and b ran ch opposed; and I am not
here claiming otherw ise. However, I am also
claiming that the equation fitted by Goldfeld,
and the interpretation he put upon it, w ere
quite antithetical to earlier M onetarist ideas
about the demand fo r m oney function in par
ticular, and the role of money in the econom y
in general.
To begin with, the demand for money fun c
tion fo r w hich Friedm an had initially claimed
stability was the "long ru n ” relationship. In 1959
he had tested it against cycle average data,
among other reasons, in ord er to abstract from
the complex interactions among money, output,
prices and interest rates that characterized the
cycle, and which would tend to obscure the
underlying stability of the relationship in ques
tion. Nor was such a procedure a quirk of one
particular paper: the em pirical w ork of Fried
man and Schw artz’s M onetary T ren ds..., though
not published until 1982, was largely completed
in the late 1960s and was based upon cycle
phase average data. The apparent stability of
demand for money functions such as Goldfeld’s,
w hich used quarterly data and hence w ere
dominated by within-cycle interactions among
variables, should have been a source of puzzle
m ent to Monetarists, therefore, not of
satisfaction.
M onetarists should also have seen that
Goldfeld’s interpretation of his equation ran
quite counter to th eir ideas about the transm is
sion m echanism .15 He used the m oney supply as
the dependent variable of his relationship, and
treated it as responding passively, albeit w ith a
distributed lag, to variations in the argum ents of
his demand for money function. It is of the
very essence of the M onetarist view that there
exists a supply function of money that is in
dependent of the demand function, and that the
interaction over time of the m oney supply, in
come, interest rates and the price level involves
15The first sign of discomfort about this matter that I can
find in my own writings appears on pp. 143-44 of the se
cond (1977) edition of my Demand for Money, where I refer
to there being a fallacy of composition involved in pro
ceeding from the individual to the market experiment when
analyzing adjustment processes in the demand for money
function. Chapter 2 of Laidler (1982) developed my doubts
about all this in much more detail.
16And this decline in velocity was associated with rapid
money growth failing to produce renewed inflation in the

causation running predominantly, though not
uniquely, from m oney to the oth er variables.
Goldfeld’s w ork on the demand fo r money, and
many oth er studies in the same vein, w ere thus
based implicitly on the "new view" of the money
supply process discussed above, of w hich Brun
n er (1968) had been so critical. And indeed, in
the 1970s, as central banks becam e interested in
controlling the tim e path of m onetary aggre
gates, their procedures involved m easuring or
forecasting the values of all the right-hand-side
variables of a Goldfeld-style equation except the
interest rate, and then setting the latter in order
to achieve a value of the quantity of money
demanded equal to the money supply target.
Clearly such a procedure left no room for tak
ing account o f the subtle interactions among
m arkets for money, credit and equity that lay at
the h eart of the M onetarist view of the m atter.
Be that as it may, the stability of the Goldfeld
short-run demand fo r money function that
ought to have puzzled M onetarists did not last
long. By 1976 he was inviting his readers to
solve "The Case of the Missing Money,” while
by the early 1980s, a num ber of com m entators
w ere contem plating an unexplained decline in
m oney’s velocity of circulation.16 Nor w ere pro
blems with the demand fo r money function a
uniquely Am erican phenom enon; Canada and
the United Kingdom too had problem s with bad
ly behaved demand for money functions in the
same years; so did Australia and New Zealand a
little later; and this list is far from exhaustive.
T h ere is little point h ere in attempting a survey
of the voluminous literature generated by these
events. Suffice it to say that a wide variety of
a d h o c explanations, often relying upon par
ticular institutional changes w ere proposed, and
often (not always) proved fragile. The upshot
was that in the eyes of the m ajority of com m en
tators the postulate of a stable aggregate de
mand fo r m oney function was discredited, and
along with it the very foundation of
Monetarism.
recovery from the 1982 recession. Monetarists should not
have predicted renewed inflation then, because actual and
expected inflation fell dramatically in the preceding
downswing, and hence should have led to an increase in
the demand for real balances which could be met only by
a falling price level or a growing nominal money supply.
What ought to have been done, and what was done,
however, are different matters, and careless Monetarist
predictions at this time did help to discredit the doctrine.

MARCH/APRIL 1990

Of course this upshot was preposterous. The
stability that M onetarism had from the outset
attributed to the demand for m oney function
was long ru n in nature, and the relationships
that collapsed w ere short-run form ulations,
espoused by Keynesian econom ists intent on
establishing a basis fo r a policy of m onetary
fine-tuning. M oreover, those relationships w ere
based on a view of the money supply process
w hich M onetarists had vigorously opposed from
the earliest stages o f the controversy. An alter
native in feren ce to b e made from the collapse
of the em pirical stability of short-run demand
fo r money functions from the m id-1970s on
w ard was that this was the result of their
failure to model the dynamic relations among
the quantity o f money, interest rates, real in
com e and prices as the outcom e of the in terac
tion of an independent supply o f money fun c
tion with the argum ents of the demand fun c
tion; that the problem stem m ed not from in
stability of the latter relationship at all, but
from the inability of simple single equation
distributed lag techniques to com e to grips with
the dynamic com plexities involved in the
transm ission m echanism of m onetary policy.
Those of us w ho advanced the latter explana
tion, how ever, did not find m uch of a sym
pathetic audience, even among M onetarists. No
doubt this was partly because w e did not make
our case as clearly as w e might have done. But
it was mainly because the case in question had
as a key com ponent the notion that m arkets
failed to clear instantaneously in the m anner
demanded by New-classical econom ics. Rather, it
was argued that the transm ission m echanism
w orked along the portfolio disequilibrium lines
sketched by Friedm an and Schw artz (1963) in
the passage quoted on page 56. In the w ake of
the success of the Phelps-Friedman critique of
the Phillips curve, M onetarism had com e to at
tach great im portance to adhering to "sound”
m icroeconom ic foundations, so m uch so that it
had, as we have seen, becom e intertw ined with
New-classical econom ics; and New-classical eco
nom ics was unable to tolerate such “disequilib
rium ” analysis.17 As has already been noted, the
failure of New-classical business cycle theory in
the early 1980s was widely regarded as a failure
17Some of the problem here stemmed from semantics. If
“ disequilibrium” behavior is read as synonymous with
“ unplanned” behavior, then it is understandable that an
economist would not wish to rely on it in constructing an
economic model. If it means merely behavior incompatible
with the existence of continuous competitive equilibrium in

FEDERAL RESERVE BANK OF ST. LOUIS

of the M onetarist view of the phenom enon; and
w hat I am now arguing is that this same associa
tion with New-classical ideas prevented M one
tarism from deploying its own earlier analysis
o f the transm ission m echanism as a defense
against an attack on another of its key com po
nents. Em pirical evidence about the instability
o f the short-run demand for money function
ought not to have been interpreted as u nd er
mining M onetarist propositions about the stabili
ty of the long-run relationship, but it was. By
the early 1980s, the M onetarist controversy was
over, w ith M onetarism discredited in the eyes
of most observers.

THE LEGACY OF THE
CO NTR O VER SY
The M onetarist controversy was concerned
with policy, but the issues involved in it did, at
the time, pose questions w hich defined a fro n
tier of academ ic research in m onetary theory.
Fu rtherm ore, and again at the time, the latest in
econom etric techniques w ere applied to the in
vestigation of the em pirical questions w hich the
controversy raised. T h ere was nothing special
about all this. T he Keynesian revolution too had
been simultaneously about theory, em pirical
evidence and policy, and so had virtually every
previous debate in the history of m onetary eco
nomics. The end of the M onetarist controversy,
how ever, ushered in a period during w hich
m onetary econom ics began to disintegrate into
relatively self-contained bodies of theoretical
w ork on the one hand and em pirical policy-related w ork on the other. W h eth er this disinte
gration is a tem porary or perm anent phenom e
non, only tim e will tell.
New-classical econom ics was underpinned by
a strong methodological p referen ce on the part
of its exponents for grounding m acroeconom ic
theorizing on explicit m icroeconom ic founda
tions. Such foundations, how ever, are capable
of yielding a w ider variety of m acro models
than the m onetary explanations o f the business
cycle that lay at the h eart of the w ork of Lucas
and Sargent and W allace. Thus the em pirical
failure of those models did not lead to the abanall markets, then it is surely more acceptable. The fact re
mains that those of us who used it in the latter sense were
read as using it in the former, and were not sufficiently
careful to explain ourselves. The result was a considerable
amount of unconstructive debate and confusion among
Monetarists.

donm ent of the methodological agenda which
had produced them , but m erely to an attem pt
to replace them w ith an alternative explanation
of the cycle w ith equally well, o r even better,
defined m icro prem ises. I re fe r h ere to that
body of research know n as "real business cycle
theory” w hich is based on a stochastic version
of the New-classical grow th model of Meade,
Swan and Solow, and attributes cyclical fluctua
tions to exogenous shocks to the aggregate pro
duction function, in m uch the same way as,
over a century ago, Jevons attributed the cycle
to fluctuations in agricultural productivity
associated with sunspot activity.
T he exponents of real-business cycle theory,
though hostile to econom etric testing, n everthe
less do not ignore em pirical evidence, and have
begun to address the question why, if it is not a
causative factor in cyclical fluctuations, th ere
are nevertheless system atic relations among the
quantity of m oney and oth er variables. The
very m anner in w hich the question is posed vir
tually dictates the answ er offered, nam ely that
the relations in question are the result of
reverse causation running from the cycle to
money, ra th er than vice versa. Thus, in what is
surely one of the g reater ironies in the recen t
history of econom ics, a research agenda which
is widely regarded as a direct descendant of the
M onetarism of the 1960s has ended up adopting
a view of the role of m oney in the econom y di
rectly opposed to that of its intellectual antece
dent, and virtually identical to that of the most
extrem e form of "post-Keynesian” econom ics.18
This is no accident, fo r a view of the world
w hich has m arkets functioning perfectly and
w ithout friction leaves no m ore room fo r m oney
to play an im portant role than does a view in
w hich m arkets do not function at all.
Though one im portant group among the aca
demic heirs of M onetarism has thus system atical
ly adopted hypotheses that downgrade the im
portance of m onetary phenom ena, and has also
abandoned traditional econom etric m ethods as a
basis for em pirical research , this does not mean
that econom etric w ork on m onetary econom ics
ceased in the early 1980s. On the contrary, a
diverse body of contributors, including unrepentantly old-fashioned M onetarists, econom etri
cians in search of an area in w hich to try out
new techniques, not to m ention econom ists as
18l refer here to King and Plosser (1984) which uses a form
of the old “ money-income-causes-money” hypothesis to

sociated with central banks in various countries
w hich do, after all, still have to carry out m one
tary policy regardless of the state of academic
opinion concerning its im portance, have gen er
ated an extensive em pirical literature on the de
mand for m oney function during the 1980s. The
literature in question has been lively and, as I
shall now argue, productive in tw o lines of
inquiry.
First, questions arising from the fact of in
stitutional change in the m onetary sector have
b een examined using both historical and con
tem porary data. In both cases, this phenom enon
has been found to be sometim es im portant. Thus
Bordo and Jonung (1987), using data going back
to the 19th century fo r five countries, have
shown that the slow decline in velocity which
occu rred largely b efore the first world w ar
seems to have b een associated w ith the increas
ing degree of m onetization of the econom ies in
volved, and its later rise w ith the increasing ef
ficiency of m onetary exchange. Closer to our
own time, the sharp increase in the velocity of
M l balances in Canada that occu rred at the
tu rn of the 1980s has been shown, beyond
reasonable doubt, to have been associated with
the simultaneous spread of daily in terest ch eck
ing accounts. As to the United States, the w ork
of Barnett (e.g., 1990) using Divisia aggregates,
provides evidence that various instances of
financial deregulation have produced shifts in
the demand fo r m ore conventionally m easured
aggregates; w hile the very fact that it proved
necessary not so long ago to redefine those ag
gregates is itself testim ony to the im portance of
institutional developments.
The other line of inquiry to w hich I refer
above has involved the application of far m ore
sophisticated techniques than w ere previously
available, both to the explicit modeling of the
so-called short-run demand fo r money function,
and closely related, to the task of extracting in
form ation about the underlying long-run rela
tionship from data w ith a high degree of time
disaggregation. Here the results have been quite
startling. Short-run dynamics dominate q u arter
ly data and have to be modeled w ith a great
deal m ore care than exponents of, say, the
Goldfeld equation brought to b ear or, given the
state of econom etric technique, could have been
expected to bring to bear, on the task. Never-

reconcile monetary phenomena with a productivity-shock
theory of fluctuations in real variables.

MARCH/APRIL 1990

theless, once this is done, stable long-run rela
tionships, very m uch like those w hich w ere first
estim ated by Friedm an (1959), M eltzer (1963) or
Laidler (1966), are after all to be found buried
in those data. This same result em erges with
pow erful simplicity from a recen t "low -tech”
study by Robert E. Lucas (1988), w ho shows
that data fo r the last 25 years or so of United
States history are still scattered (albeit widely,
and w ith com plex serial correlation) around a
velocity function directly derived from M eltzer’s
(1963) estim ates of the long-run demand for
money. Nor are results of this sort confined to
the United States. Similar conclusions arise
w hen British, Canadian or Japanese data are
analyzed.
As yet, this em pirical evidence has not at
tracted the academ ic attention it deserves, large
ly, I suspect, because the treatm ent of the
short-run dynamics in the studies which
generate it has been based m ore on econom etric
technique than econom ic theory. Exponents of
the so-called "bu ffer-stock” approach to model
ing the demand for money, w ho have of course
followed up the analysis of the transm ission
m echanism of Bru nner and M eltzer as well as
Friedm an and Schw artz, have tried to bridge
this gap. They have tended to ground their ex
plicit analysis on rath er simple special cases,
how ever, w hich have not proved empirically
robust; and this in tu rn has led to an identifica
tion of the general approach with those special
cases and a tendency to dismiss prem aturely the
broad insight w hich it yields: namely that the
dynamics of w hat we have learned to call the
short-run d em a n d f o r m o n ey fu n ctio n are not
the property of a structural relationship at all,
b ut rath er reflect that complex interaction of
the quantity of money with other variables to
w hich the M onetarists of the 1950s and 1960s
used to re fe r as a transm ission m ech an ism s u b
je c t to long a n d variable lags.19
The M onetarist controversy was about theory
and em pirical evidence, to be sure, but it was
also about m onetary policy; and h ere it has left
its strongest m ark. To begin with, the idea that
19For an informal but more complete exposition of the
arguments involved here, see Laidler (1987). One of the
better known pioneering special case empirical formula
tions of the approach is that of Carr and Darby (1981),
who refer to it as a “ shock-absorber” approach.
20Let it be clear, however, that I do not regard “ real
business cycle theory” as a total waste of time, and that I
do think it merits policymakers’ attention. Though I find it
hard to believe that shocks to technology will turn out to

FEDERAL RESERVE BANK OF ST. LOUIS

inflation is fundam entally a m onetary phenom e
non, so outlandish in the 1950s, has by now
becom e something close to conventional wisdom.
W e nowadays h ear very little about cost-push
forces and the need to control them w ith wage
and price guidelines, controls and so on. Closely
related, cen tral banks routinely pay attention to
the behavior of m onetary aggregates in design
ing their anti-inflation policies. Though even
such hard-core M onetarists as Brunner and
M eltzer (1987) no longer argue that the domi
nant impulse driving the business cycle is always
the quantity of money, neither they, nor the
practitioners of m onetary policy, have shown
the slightest sign of taking the productivity shock
hypothesis of the real business cycle theorists
seriously.20 Rather, the exclusively monetary inter
pretation of the cycle has been replaced by an
eclectic approach in w hich m onetary factors
have an always potentially im portant, and som e
times an actually im portant, role to play. That is
why the pursuit of price stability by m onetary
means is tem pered by caution concerning the
short-term costs that could b e in cu rred if the
pursuit in question was to becom e too vigorous.
And eclecticism about the causes o f cyclical in
stability has not been accompanied by a revival
of interest in the use of fiscal policy fo r stabili
zation purposes—though this probably has as
m uch to do with the fiscal deficits that are the
legacy of supply-side econom ics as with any les
sons learned during the M onetarist controversy
itself.
A superficial reading o f the above record
might suggest that, w hatever its academ ic stand
ing, M onetarism is alive and well in policy cir
cles. That it has left a lasting m ark in those cir
cles is beyond doubt, but its success on the poli
cy fron t has b een fa r from com plete. Indeed, on
one interpretation of the evidence, M onetarism ’s
partial success h ere may have b een w orse than
failure. The M onetarist agenda, after all, involved
establishing the im portance of the quantity of
money as a policy variable a s a prelim in ary step
to rem ovin g fr o m the m on etary au thorities their
d iscretion ary con trol o v er it; and the record
be the sole or even main source of real world cyclical fluc
tuations, it is nevertheless the case that, from a theoretical
point of view, such shocks as do originate in such
phenomena are likely to be welfare improving. The
valuable message of real business cycle theory, then, is
that we should not take it for granted that stabilizing the
cycle is always and everywhere desirable. It might not be
in particular instances. That reminder is surely worth
having.

shows that only this prelim inary step was com
pleted. M onetary policy plays a fa r m ore im por
tant role in m acroeconom ic affairs now than it
did 30 years ago, but those in control of it have,
as a result, m uch m ore pow er than previously,
not less, as the M onetarist agenda intended.
This cannot really be helped, because part of
the academ ic legacy of the M onetarist con
troversy has been a g reater appreciation of the
role of institutional change in influencing veloci
ty’s long-run behavior; but once that role is ad
mitted, the case fo r tying down m onetary policy
w ith rules becom es fa r m ore difficult, perhaps
impossible, to make.
All this, though, poses a challenge. If m onetary
policy cannot be tied down by rules, then the
next-best solution is to subject it to the discipline
of constant public scrutiny and criticism . Aca
demic econom ics has a large role to play here,
in providing the intellectual basis fo r such ac
tivity, but at the m om ent it is not in good condi
tion to do so. W e do have, as I have noted
above, a large and growing body of em pirical
w ork w hich points to the long-run stability (not
constancy, note) of m oney’s velocity, institution
al change notwithstanding. That same body of
w ork, how ever, tells us that the short-run dy
nam ics of that function are at least as complex
as anyone thought they w ere 30 years ago; and
we are no fu rth er forw ard now than we w ere
then in understanding just why this is the case.
At the same time, the gap betw een theoretical
w ork on the role of m oney in the economy, and
our em pirical knowledge in the area, w hich was
opened up w hen the M onetarist controversy
becam e a debate about New-classical econom ics
and began to pay m ore attention to m icrofoun
dations than to data, still rem ains. Intellectual
vacuum s of this sort rarely rem ain unfilled for
long, but until this one attracts m ore attention
than it has to date, the M onetarist controversy’s
legacy must be judged to be a distinctly uncom
fortable one. The controversy weakened the
links betw een academ ic research and contem
porary policy w hich in the past made such r e
search a natural source of constraining criticism
of the conduct of policy, while simultaneously
enhancing the discretionary pow ers of policy
m akers. That is hardly what its participants
intended.

Ando, A., and F. Modigliani. “ The Relative Stability of Mone
tary Velocity and the Investment Multiplier,” American
Economic Review (September 1965), pp. 693-728.
Barnett, W. A. “ Developments in Monetary Aggregation
Theory,” Journal of Policy Modeling (forthcoming).
Barro, R. J. “ Unanticipated Money, Output, and the Price
Level in the United States,” Journal of Political Economy
(August 1978), pp. 549-80.
Bordo, M. D., and L. Jonung. The Long-Run Behavior of
the Velocity of Circulation: The International Evidence (Cam
bridge University Press, 1987).
Boschen, J. F., and H. I. Grossman. “ Tests of Equilibrium
Macroeconomics Using Contemporaneous Monetary Data,”
Journal of Monetary Economics (November 1982), pp.
309-33.
Brunner, K. “ The Role of Money and Monetary Policy,” this
Review (July 1968), reprinted in this Review (September/Oc
tober 1989), pp. 4-22.
_______ and A. H. Meltzer. “ Some Further Investigations of
Demand and Supply Functions for Money,” Journal of
Finance (May 1964), pp. 240-83.
_______ a n d ________. “An Aggregative Theory for a Closed
Economy,” in J. Stein, ed. Monetarism (Amsterdam: North
Holland, 1976), pp. 69-103.
_______ a n d _______ . “ Money and the Economy: Issues in
Monetary Analysis,” The 1987 Raffaele Mattioli Lectures,
Carnegie Mellon University, mimeo.
_______ a n d ________ “ The Problem of Inflation,” in K.
Brunner and A. H. Meltzer, eds., The Problem of Inflation,
Carnegie-Rochester Conference Series on Public Policy
(Vol. 29, 1988), pp. 137-68
Cagan, P Determinants and Effects of Changes in the Stock
.
of Money, 1875-1960 (Columbia University Press, 1965).
Carr, J., and M. R. Darby. “ The Role of Money Supply
Shocks in the Short-Run Demand for Money,” Journal of
Monetary Economics (September 1981), pp. 183-99.
Chow, G. “ On the Long-Run and Short-Run Demand for
Money,” Journal of Political Economy (April 1966),
pp. 111-31.
DePrano, M., and T. Mayer. “ Tests of the Relative
Importance of Autonomous Expenditures and Money,”
American Economic Review (September 1965), pp. 729-52.
Friedman, M. “ The Quantity Theory of Money — A Restate
ment,” in Studies in the Quantity Theory of Money (Universi
ty of Chicago Press, 1956), pp. 3-21.
_______ “ The Demand for Money: Some Theoretical and
Empirical Results,” Journal of Political Economy (August
1959), reprinted in Milton Friedman, The Optimum Quantity
of Money and Other Essays (Aldine Publishing Co., 1969),
pp. 111-39.
_______ “ The Role of Monetary Policy,” American Economic
Review (March 1968), reprinted in Milton Friedman, The
Optimum Quantity of Money and Other Essays (Aldine
Publishing Co., 1969), pp. 95-110.
_______ The Optimum Quantity of Money and Other Essays
(Aldine Publishing Co., 1969).
_______ “A Monetary Theory of Nominal Income,” Journal
of Political Economy (March/April 1971), pp. 323-37.

REFERENCES

_______ Unemployment versus Inflation? An Evaluation of
the Phillips Curve (London: Institute of Economic Affairs,
1975).

Andersen, L. C., and J. L. Jordan. “ Monetary and Fiscal
Actions: A Test of their Relative Importance in Economic
Stabilization,” this Review (November 1968), pp. 11-24.

_______ . “ The Quantity Theory of Money,” in J. Eatwell,
M. Milgate and P Newman, eds. The New Palgrave—A Dic
.
tionary of Economics (London: Macmillan, 1987).

MARCH/APRIL 1990

_______ and D. Meiselman. “ The Relative Stability of Mon
etary Velocity and the Investment Multiplier in the United
States, 1897-1958,” in Commission on Money and Credit
Stabilization Policies (Prentice-Hall, 1963).
_______ and A. Schwartz. “ Money and Business Cycles,”
Review of Economics and Statistics (February 1963),
reprinted in Milton Friedman, The Optimal Quantity of
Money and Other Essays (Aldine Publishing Co., 1969),
pp. 189-235.
_______ a n d _______ Monetary Trends in the United
States and the United Kingdom (University of Chicago
Press, 1982).
Goldfeld, S. M. “ The Demand for Money Revisited,” Brookings
Papers on Economic Activity (1973:3), pp. 577-638.
_______ “ The Case of the Missing Money,” Brookings
Papers on Economic Activity (1976:3), pp. 683-730.
Gould, B., J. Mills and S. Stewart. Monetarism or Prosperity?
(London: Macmillan, 1981).
Hicks, J. R. “ Mr. Keynes and the ‘Classics’: A Suggested In
terpretation,” Econometrica (April 1937), reprinted in J. R.
Hicks, Critical Essays in Monetary Theory (Oxford: Claren
don Press, 1967), pp. 126-42.

United Kingdom, 1862-1957: A Further Analysis,”
Economica (February 1960), pp. 1-31.
Lucas, R. E. Jr. “ Some International Evidence on OutputInflation Tradeoffs,” American Economic Review (June
1973), pp. 326-34.
_______ . “ Money Demand in the United States: A
Quantitative Review,” in K. Brunner and B. T. McCallum,
eds., Money, Cycles and Exchange Rates: Essays in Honor
of Allan H. Meltzer, Carnegie-Rochester Conference Series
on Public Policy (Vol. 29, 1988), pp. 137-68.
McCallum, B. T. "Inflation and Output Fluctuations: A
Comment on the Dutton and Neumann Papers,” in K.
Brunner and A. H. Meltzer, eds., The Problem of Inflation,
Carnegie-Rochester Conference Series on Public Policy,
(Vol. 8, 1978), pp. 277-88.
Meltzer, A. H. "The Demand for Money: The Evidence from
the Time Series,” Journal of Political Economy (June 1963),
pp. 219-46.
Mishkin, F. “ Does Anticipated Monetary Policy Matter? An
Econometric Investigation,” Journal of Political Economy
(February 1982), pp. 22-51.

Johnson, H. G. “ Monetary Theory and Policy,” American
Economic Review (June 1962), pp. 335-84.

Modigliani, F. “ The Monetarist Controversy or, Should
We Forsake Stabilization Policy?” American Economic
Review (March 1977), pp. 1-19.

King, R. G., and C. I. Plosser. “ Money, Credit, and Prices in
a Real Business Cycle,” American Economic Review (June
1984), pp. 363-80.

Phelps, E. S. “ Phillips Curves, Expectatons of Inflation and
Optimal Unemployment over Time,” Economica (August
1967), pp. 254-81.

Laidler, D. “ The Rate of Interest and the Demand for Money
— Some Empirical Evidence,” Journal of Political Economy
(December 1966), pp. 545-55.

Phillips, A. W. “ The Relation Between Unemployment and
the Rate of Change of Money Wage Rates in the United
Kingdom, 1861-1957,” Economica (November 1958), pp.
283-99.

_______ The Demand for Money: Theories and Evidence
(International Textbook Publishing Co., 1969).
_______ Monetarist Perspectives (Harvard University Press,
1982).
_______ “ 'Buffer-Stock' Money and the Transmission
Mechanism,” Federal Reserve Bank of Atlanta Economic
Review (March/April 1987), pp. 11-23.
_______ and J. M. Parkin. “ Inflation: A Survey,” Economic
Journal (December 1975), pp. 741-809.
Lipsey, R. G. “ The Relation Between Unemployment
and the Rate of Change of Money Wage Rates in the

FEDERAL RESERVE BANK OF ST. LOUIS

Samuelson, P.A., and R. M. Solow. “Analytical Aspects of
Anti-Inflation Policy,” American Economic Review (May
1960), pp. 177-94.
Teigen, R. “ Demand and Supply Functions for Money in the
United States: Some Structural Estimates,” Econometrica
(October 1964), pp. 476-509.
Tobin, J. “A General Equilibrium Approach to Monetary
Theory,” Journal of Money, Credit and Banking (February
1969), pp. 15-29.
_______ . “ The Monetarist Counter-Revolution Today— An

Appraisal,” Economic Journal (March 1981), pp. 29-42.

Federal Reserve Bank of St. Louis
Post Office Box 442
St. Louis, Missouri 63166

The Review is published six
times per year b y the Research
and Public Information
Department o f the Federal
R eserve Rank o f St. Louis.
Single-copy subscriptions are
available to the public f r e e o f
charge. Mail requests f o r
subscriptions, back issues, o r
address changes to: Research
and Public Information
Department, Federal R eserve
Rank o f St. Louis, P.O. Rox 442,
St. Louis, Missouri 63166.
The views expressed are those
o f the individual authors and do
not necessarily reflect official
positions o f the Federal Reserve
Rank o f St. Louis o r the Federal
R eserve System. Articles herein
may b e reprinted provided the
source is credited. Please provide
the Rank’s Research and Public
Information Department with a
copy o f reprinted material.