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Federal because and the trends In chart are masked temporary other random 1 we have plotted coefficient calculated in period following. between quarters are significant coefficients deviations. marize briefly- at 7, 8, 9, and 10 con- significant twelfth the the The most growth sixth quarters. with in chart These results correlations indicates tween the growth speed reports with results tions, reported recognize growth changing inflation may tend suppressing people If slower in rapidly Past inflation will and money expecta- fall is embodied more in con- to slow the inflation- effects of reduced money Even the most optimistic indicate a lag well in excess of one year be- reduced felt. run money effect long as four and supply on inflation. years It is possible output suggest other th at the in depends the money the non-monetary unless dated by an increasing The model supply. used money n ~ (2) U m.Mt_· t=o I + = pU _ t 1 factors a tem- accommo- supply. to generate in table 2 is given in equations (1)Pt= are aggre- However, have only they and sh ort-term the on many shocks effect defini- Both theory change level than the growth and various supply. esti- the results 1 and 2: I t (P) was re- before that estimates growth has a It may be as the full effect the negative unemployment is short- effects of the slower money growth will be substantial. However, effects are both less these short-run H: o l:m.=1 xm. n I t t SE as the rate. (U), so the was used to coefficient degrees estimate residuals in the money to fit a third-order constraints. in table 2. Some For every standard The for multiseries, the interesting monetary are results variable the error (SE) of the regression growth on of a change inflation over as the of the This price indexes in the point short here short-run criterion, error is model money the 1. All of the M-1 B best "ex- 0.883 0.905 0.885 0.864 8 1.136 1.140 1.130 1.078 20 16 12 8 1.089 1.105 1.097 1.047 and capital interest rates risen to unprecedented The or "explain" 0.707 0.712 0.700 0.639 NOTE: cent Reject if the equal to both deflator; and growth relation- GNP this this in- of the aggregates and economic see John B. Carlson and Theresa Gwazdaus- kas, "The New and Monetary Aggregates, Pol icy," Economic Economic Activity, Commentary, 10.27 11.46 12.29 11.52 1.474 1.473 1.480 1.474 1.60 1.82 1.73 0.73 13.36 14.81 15.07 10.07 1.449 1.429 1.448 1.533 1.17 1.52 1.49 0.57 -5.33 -5.33 -5.17 -3.80 Ho with p 0.637 0.639 0.637 0.657 0.562 0.553 0.558 0.685 14.33 16.01 16.88 12.77 1.417 1.403 1.416 1.486 this measure of inflation. Other Federal Reserve Bank of Cleveland, Federal March 10,1980. Research BULK RATE U.S. Postage Paid Cleveland,OH Reserve Bank of Cleveland Department P.O. Box 6387 Cleveland,OH Permit 44101 period, Reserve the 12.85 13.19 12.07 6.73 1.432 1.429 1.475 1.608 0.618 0.613 0.639 0.768 region of 5 perthan and money the supply is estimated, and operating reserves and the money less likely to change the relationship During the money Federal change, reduce initiates adjustments rates by gradually the lowering In principle, the growth of the money stock could be coneither interest rates to return desired between supply. subsequently accurately, interest The desired aggregates, gress pursuant Address correction or No. 385 money terest requested between supply, rate on federal that was estimated sired growth. This money between supply and because often money not supply adherence money changed changes to rates and the acceler- to rates control Address interest-rate targets to deviate further flation, Each its plans to Con- of 1978 and (the Hum~ Act). Because the Federal Retargets that are low enough we can expect markets. is necessary, continued To see why it is important the basic relationships between to in- interest rates, and the money supply- the topic of this Economic Commentary. caused Inflation Inflation the volume T. Gavin is an economist, Federal Reserve available is defined of money as "an increase and credit goods resulting in relative to in a substantial and Bank of Cleveland. The Please send mailing label to the Research Department, Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland, Act in the credit understand and further Change William phrey-Hawkins serve has selected this pressure by the Fed- (FOMC). to the Full Employment Growth pressure to its or, more In this environment from desired targets. D Correct as shown D Remove from mailing list Balanced Committee to slow inflation, the re- in interest enough growth. growth procedure as inflation large range with de- because interest and the in- funds in a narrow to be unsatisfactory, lationship ated "targeted" to be consistent monetary were interest then growth are chosen rates relationship and rates that tend paths, year the FOMC must report the is a ranges for each of the estimated Reserve rates and reserves supply eral Open Market Federal run than if there in bank the target monetary interest or bank reserves. Under the former operating the targets between of the new procedure money path." and may be no However, market the supply in the short the operation eventually the relation- of reserves are set for reserves. The relationship of the and by controlling new procedure, supply of the money stock. strained the between money constant-to pressures have heights, Under ship volatile. objectives have remained in the the growth proved 0.512 0.508 0.514 0.619 a critical rates that Not only have been unusually inflationary index. of turbulence markets. interest the -1.36 -1.20 -1.60 -1.81 absol ute val ue of t is greater 1.96. but one for following money level of interest activity, The period or supply a long-term M-2 20 16 12 8 policy. Reserve procedures procedure, plains" M-1A 20 16 12 8 monetary its operating has been St. Louis Base 20 16 12 6, 1979, the Federal changed change omitted. growth On October System affect that demand in Growth by William T. Gavin that of inflation. to forecast growth it is to show flation suggests been Inflation, Interest Rates,and Monetary systematic variables run have between was sig- missing from equation th rough is not This term non-monetary ~£Q,Clomic Commentary reflect the hy- parameter error 23, 1981 growth one We can reject is a quarterly 2. For a discussion standard than a period. Using the smallest money instance. are variables ship in money occurs there rather, with 16 lagged quarters; that is, the full effect a the sum of the coefficients in every of the with no endstatistics greater that February will lead to an to the autocorrelation behavior (m ) was constrained i Summary equal that coeffi- to one implies in velocity.2 2. To preserve polynomial equal the sum lagged rate of money rate nificant growth of the equal to zero in all cases. technique and to adjust of the weights point the of autocorrelation the in equation of freedom pattern in presence Cochrane-Orcutt (p) collinearity the be used include Coefficients autocorrelation regression I alternatively positive four-year o l:m.=O I growth inflation pothesis supply H: steady growth was in the equation 1, the GNP deflator A sum Various rates of change). indicated might distribution cients. results emerged. . that the (approx- 8, 12, 16, and 20) were used on the defined and liminary lowest E criteria St. Louis base, M-1A, M-1B, and M-2. Pre- given +Ut· of the logarithm continuous supply by taking M-1B growth. significant price money of lower in- supply expectations. growth fore evidence we have ip between (quarter-to-quarter) t how long will depend which in money their that the are of time be- of slower rates. Precisely quickly. tions of the money presented period and subsequent tracts the relationsh that we should ex- achievement change analysis, Table 2 Estimates of the Price Equation 1964: 110 - 1980: 1110 pect to wait a substantial adjust mated In equation The evidence the supply, the 1. on the money regression on in- through Conclusion flation Using = 16 lagged growth. on past values of the money All variables were transformed lags (n porary best fitting including of money in lagged consistent of the definition supply impacts occur using reTo sum- used-the are those of money flation results in the appendix. supply specifications quarters some regardless of the money (M). imating gate analysis gressed rate of the GNP deflator Only level. gression adverse growth. than Appendix in the at a 95 percent We have included the of fast money less enduring price effects the first difference M-1 B growth Few of the correlation are greater than two standard calculated and long-run in period t and the 16 quarters the correlations certain the correlation t and each of the changes GNP deflator fidence by cycl ical fluctuations. Reserve Bank of Cleveland author OH 44101. opinions and Reserve Governors not Bank stated herein necessarily of Cleveland are those those or of of of the the Federal the Board of the Federal Reserve System. of 1. For the "The a detailed new discussion operating New Procedure," of the procedure, Economic Reserve Bank of Cleveland, mechanics see E.J. Review, forthcoming. of Stevens, Federal continuing rise in the general price level" (Webster's New Collegiate Dictionary, 1973 ed.). More precisely, inflation is a substantial and continuing increase in the volume of money and credit relative to available resulting in a substantial in the general tant a popular and continuing price level. There distinction between measured is an impor- that results from price the general by assessing price level is prices of individual goods and services and constructing such as the consumer wholesale price deflator. think Through (WPI), and the GNP so that labeled we tend to as an increase of inflation in the price "inflation." increases WPI are not any increase the many As an ex- in 1980 farm decreased products. In one sense, of food caused inflation. important we do not sense, the In another they Inflation the not likely price a continuing will an increase level. Such in is unless it causes or is ac- by a substantial to available goods. reflected in the prices and credit Moreover, in- of all goods and examina- in prices in the past two decades demonstrates. inflation rate for the United States since 1961 is shown in table to 9.9 percent The 1, column grown rather steadily Ex post real interest rate 1.9 1.2 2.5 3.2 3.8 4.7 4.6 4.5 4.6 4.6 3.7 3.2 4.6 5.2 5.0 4.0 4.3 5.2 5.5 5.2 5.3 5.8 6.5 7.4 1.6 2.6 1.9 2.2 8.5 3.5 1971 1972 1973 1974 1975 4.6 4.0 7.2 10.5 7.2 5.4 7.9 7.6 7.8 9.0 9.6 3.3 3.6 0.6 -1.5 2.4 1976 1977 1978 1979 1980 4.7 6.1 7.9 8.5 9.9 4.8 5.8 6.8 7.9 7.2 9.0 8.4 4.3 2.3 9.1 10.1 12.8 1.2 1.6 2.9 5.9 6.8 6.0 5.5 average annual 2. In 20 years, in the GNP deflator from 1 percent in 1980. this in so shall not a subject economists. relationship many has policy include of contro- To been ignored recommendations, a discussion we of interest rates est rates funds. demand. two The premium life of the the expected Open market Reserve funds. is maintained money has money supply many rate minus are a major determinant supply A purchase function of for loanable of government securities measure used, because reserves bank have the The has in 1961 low rates in probably istration's reported the multiple riods. Even individual the growth money there short-run trend the over the three and the 3. is no clear relationship changes price in the level. money However, the over time are clearly correlated. long-run supply relationsh and the ip between price will rise (see table corresponds between inflation, growth rate and years is shown in table 1, column As is evident, The supply continues inflation in the bond deflator. that as the minus the Viewed level is well reflects the fact interest have grown too versing this trend rate rise in the short and immediate real interest real interest average increase corporate in the real interest rate is independent is no trend GNP it is evident rates have not standards. There High been high In the long run, the and money of both supply in the real interest series, as there is in the other series. re- growth. rate stage rapidly in the on how quickly in money come to believe that and decreases and slow growth reduced, aggre- interest Correlations fects to th is question, of slower money the of funds second deflationary rates will difficult Reserve and Future and third pol icy. to discern recent re- experi- deflationary supply show up in lower reported in the ag- to wait bewill lower rates? While there is no defin- ence suggests that significant growth M-1B Growth growth growth inflation efwill rates in years following the Changes in trend are from the data in table 1, - 1975:1110 Correlation between we expect money inflation itive answer empirical run. If the Federal Chart 1 smaller. reduced ported pre- Inflation Rates 10 12 coefficient 0.45 0.40 0.35 0.30 0.20 0.15 0.10 0.05 supply growth it will persist. inflation expectations a substantial and in and In other -0.10 interest rates marginal -0.15 decrease When money supply growth are crowded -0.05 will not drop continual in the face of continuing rise and o Moreover, people recognize reduced mands markets fore inflation on prices. The lag between and variable. is recognized. Re- rates to run, but it will not have an growth until in today past. will cause interest in money words, theoretical price level. With the supply rise in the short to rate by lower- suggest that slowing money to credit mium becomes however, 0.25 al i of the aggregates is lengthy the reduction differ- inflation inflation it depends inflation will not immediately gregate to fall as the expected How long should rates of the monetary all of the evidence gradually policy may be committed the long-run ing the growth gates, rates begins to decrease. Even though slowing will come The growth, to slow and interest and in- target-setting that effect of this policy as inflation pol icy. money inflation interest differences decreases by historical inflation respond However, formulation. interest in th is way, ported the policy in inflation 5, the ex post is calculated rate to ex- anti-inflationary in slowing we can expect can vary, as many of can be observed the ex- supply growth. In column rate bond trends in the 4). The in the 1, column corporate to the past money connection and current supply pand, premium and moves to technology, trends benefits an adjustment pe- income. into of persists unemployment, the temporary adopt aggregate components respect in long-run money to long run, the trends in the corporated inflation the cvcl ical each of the aggregates may be the case. pected Reserve seasonal and and in circulation with cost lead to increased represents 1964:10 monetary in defin ing over rates, will accelerate of which 0.50 Each differently of of reserves sup- variable The deposit targets. with the accompanying of world oil prices. average money trends The high of those controls increase illustrate past money supply admin- rates in 1973 th rough 1975 the relaxation quadrupling between the Nixon wage and price controls. inflation temporary previous reflect government on Federal the long run, the opposite 1971-72 base is often of currency problems led ently rates to fall. In in theoretical Reserve System. the interest (M-2). As a and a control plus Federal supply authorities. sum of the savings and various it represents monetary in will cause plus check- the monetary ply of fiat money the In in the supply the money sup- as currency of the money and leads to an increase reserves will be used. As a meabalances, models, the on the also are included deposits of loans that banks can make. run, this increase depends time banking the short is calculated word way function, Reserve system The store-of-value by the Federal the amount adds reserves to the the (M-1 B). As a measure Practical Federal variable able deposits premium. of the because meanings. base is the The real in- interest operations System so that the contract. inflation the short-run empirically, economic rate. The pre- lent rate is the market rate has is the amount must pay lenders funds inter- in supply for expected inflation of the over the terest prices, interest and the real interest real value in markets changes market for expected that borrowers a. The inflation rate is measured as the average annual percent change in the GNP deflator. b. This is a moving average of the past three years of M-l B growth. For example, the 1980 figure, 7.2, represents the average annual growth in M-1B for 1978, 1979, and 1980. c. This interest rate is a simple average of the interest rates on Moody's Aaa, Aa, A, and Baa corporate bonds. with components-a inflation define is a difficult ply usually is defined Like other fluctuate and mium to This may supply sure of transaction rates are determined for loanable The money way the calculations Interest Rates and Inflation Interest The Money Supply understand in our analvsis. 3.7 2.6 3.0 3.2 2.2 1966 1967 1968 1969 1970 and among why 1.0 2.0 1.5 1.4 2.4 To in corresponding as even the most cursory tion of the upsweep the rate of increase Corporate bond interest rate, percentC 1961 1962 1963 1964 1965 reflect and continuing relative services, of increase in the vol ume of money movements price of food increase is generally and if understood versy Money supplY b growth Inflation Year ratea in Prices, Money, level. to occur companied If Trends If the component causes general flation did not. in 1981 return to its previous that increased have a drought farm-product the As food else is unchanged, everything the CPI or the food. and more the the rose, so did all the price indexes include prices individual inflationary. drought of many affect truly ample, in an index is Yet that supply prices (CPI), the this procedure, indexes price indexes, price index index and the general to measure level. By necessity, rise this definition misconception our attempts goods, Table 1 Long-Run and Interest Rates is inflation, credit de- out of the marketplace. -0.20 o NOTE: The standard 2 deviation 3 4 5 is calculated line is drawn at two standard deviations. 6 7 8 9 11 13 14 15 16 as one over the square root of the sample size. The dotted continuing rise in the general price level" (Webster's New Collegiate Dictionary, 1973 ed.). More precisely, inflation is a substantial and continuing increase in the volume of money and credit relative to available resulting in a substantial in the general tant a popular and continuing price level. There distinction between measured is an impor- that results from price the general by assessing price level is prices of individual goods and services and constructing such as the consumer wholesale price deflator. think Through (WPI), and the GNP so that labeled we tend to as an increase of inflation in the price "inflation." increases WPI are not any increase the many As an ex- in 1980 farm decreased products. In one sense, of food caused inflation. important we do not sense, the In another they Inflation the not likely price a continuing will an increase level. Such in is unless it causes or is ac- by a substantial to available goods. reflected in the prices and credit Moreover, in- of all goods and examina- in prices in the past two decades demonstrates. inflation rate for the United States since 1961 is shown in table to 9.9 percent The 1, column grown rather steadily Ex post real interest rate 1.9 1.2 2.5 3.2 3.8 4.7 4.6 4.5 4.6 4.6 3.7 3.2 4.6 5.2 5.0 4.0 4.3 5.2 5.5 5.2 5.3 5.8 6.5 7.4 1.6 2.6 1.9 2.2 8.5 3.5 1971 1972 1973 1974 1975 4.6 4.0 7.2 10.5 7.2 5.4 7.9 7.6 7.8 9.0 9.6 3.3 3.6 0.6 -1.5 2.4 1976 1977 1978 1979 1980 4.7 6.1 7.9 8.5 9.9 4.8 5.8 6.8 7.9 7.2 9.0 8.4 4.3 2.3 9.1 10.1 12.8 1.2 1.6 2.9 5.9 6.8 6.0 5.5 average annual 2. In 20 years, in the GNP deflator from 1 percent in 1980. this in so shall not a subject economists. relationship many has policy include of contro- To been ignored recommendations, a discussion we of interest rates est rates funds. demand. two The premium life of the the expected Open market Reserve funds. is maintained money has money supply many rate minus are a major determinant supply A purchase function of for loanable of government securities measure used, because reserves bank have the The has in 1961 low rates in probably istration's reported the multiple riods. Even individual the growth money there short-run trend the over the three and the 3. is no clear relationship changes price in the level. money However, the over time are clearly correlated. long-run supply relationsh and the ip between price will rise (see table corresponds between inflation, growth rate and years is shown in table 1, column As is evident, The supply continues inflation in the bond deflator. that as the minus the Viewed level is well reflects the fact interest have grown too versing this trend rate rise in the short and immediate real interest real interest average increase corporate in the real interest rate is independent is no trend GNP it is evident rates have not standards. There High been high In the long run, the and money of both supply in the real interest series, as there is in the other series. re- growth. rate stage rapidly in the on how quickly in money come to believe that and decreases and slow growth reduced, aggre- interest Correlations fects to th is question, of slower money the of funds second deflationary rates will difficult Reserve and Future and third pol icy. to discern recent re- experi- deflationary supply show up in lower reported in the ag- to wait bewill lower rates? While there is no defin- ence suggests that significant growth M-1B Growth growth growth inflation efwill rates in years following the Changes in trend are from the data in table 1, - 1975:1110 Correlation between we expect money inflation itive answer empirical run. If the Federal Chart 1 smaller. reduced ported pre- Inflation Rates 10 12 coefficient 0.45 0.40 0.35 0.30 0.20 0.15 0.10 0.05 supply growth it will persist. inflation expectations a substantial and in and In other -0.10 interest rates marginal -0.15 decrease When money supply growth are crowded -0.05 will not drop continual in the face of continuing rise and o Moreover, people recognize reduced mands markets fore inflation on prices. The lag between and variable. is recognized. Re- rates to run, but it will not have an growth until in today past. will cause interest in money words, theoretical price level. With the supply rise in the short to rate by lower- suggest that slowing money to credit mium becomes however, 0.25 al i of the aggregates is lengthy the reduction differ- inflation inflation it depends inflation will not immediately gregate to fall as the expected How long should rates of the monetary all of the evidence gradually policy may be committed the long-run ing the growth gates, rates begins to decrease. Even though slowing will come The growth, to slow and interest and in- target-setting that effect of this policy as inflation pol icy. money inflation interest differences decreases by historical inflation respond However, formulation. interest in th is way, ported the policy in inflation 5, the ex post is calculated rate to ex- anti-inflationary in slowing we can expect can vary, as many of can be observed the ex- supply growth. In column rate bond trends in the 4). The in the 1, column corporate to the past money connection and current supply pand, premium and moves to technology, trends benefits an adjustment pe- income. into of persists unemployment, the temporary adopt aggregate components respect in long-run money to long run, the trends in the corporated inflation the cvcl ical each of the aggregates may be the case. pected Reserve seasonal and and in circulation with cost lead to increased represents 1964:10 monetary in defin ing over rates, will accelerate of which 0.50 Each differently of of reserves sup- variable The deposit targets. with the accompanying of world oil prices. average money trends The high of those controls increase illustrate past money supply admin- rates in 1973 th rough 1975 the relaxation quadrupling between the Nixon wage and price controls. inflation temporary previous reflect government on Federal the long run, the opposite 1971-72 base is often of currency problems led ently rates to fall. In in theoretical Reserve System. the interest (M-2). As a and a control plus Federal supply authorities. sum of the savings and various it represents monetary in will cause plus check- the monetary ply of fiat money the In in the supply the money sup- as currency of the money and leads to an increase reserves will be used. As a meabalances, models, the on the also are included deposits of loans that banks can make. run, this increase depends time banking the short is calculated word way function, Reserve system The store-of-value by the Federal the amount adds reserves to the the (M-1 B). As a measure Practical Federal variable able deposits premium. of the because meanings. base is the The real in- interest operations System so that the contract. inflation the short-run empirically, economic rate. The pre- lent rate is the market rate has is the amount must pay lenders funds inter- in supply for expected inflation of the over the terest prices, interest and the real interest real value in markets changes market for expected that borrowers a. The inflation rate is measured as the average annual percent change in the GNP deflator. b. This is a moving average of the past three years of M-l B growth. For example, the 1980 figure, 7.2, represents the average annual growth in M-1B for 1978, 1979, and 1980. c. This interest rate is a simple average of the interest rates on Moody's Aaa, Aa, A, and Baa corporate bonds. with components-a inflation define is a difficult ply usually is defined Like other fluctuate and mium to This may supply sure of transaction rates are determined for loanable The money way the calculations Interest Rates and Inflation Interest The Money Supply understand in our analvsis. 3.7 2.6 3.0 3.2 2.2 1966 1967 1968 1969 1970 and among why 1.0 2.0 1.5 1.4 2.4 To in corresponding as even the most cursory tion of the upsweep the rate of increase Corporate bond interest rate, percentC 1961 1962 1963 1964 1965 reflect and continuing relative services, of increase in the vol ume of money movements price of food increase is generally and if understood versy Money supplY b growth Inflation Year ratea in Prices, Money, level. to occur companied If Trends If the component causes general flation did not. in 1981 return to its previous that increased have a drought farm-product the As food else is unchanged, everything the CPI or the food. and more the the rose, so did all the price indexes include prices individual inflationary. drought of many affect truly ample, in an index is Yet that supply prices (CPI), the this procedure, indexes price indexes, price index index and the general to measure level. By necessity, rise this definition misconception our attempts goods, Table 1 Long-Run and Interest Rates is inflation, credit de- out of the marketplace. -0.20 o NOTE: The standard 2 deviation 3 4 5 is calculated line is drawn at two standard deviations. 6 7 8 9 11 13 14 15 16 as one over the square root of the sample size. The dotted continuing rise in the general price level" (Webster's New Collegiate Dictionary, 1973 ed.). More precisely, inflation is a substantial and continuing increase in the volume of money and credit relative to available resulting in a substantial in the general tant a popular and continuing price level. There distinction between measured is an impor- that results from price the general by assessing price level is prices of individual goods and services and constructing such as the consumer wholesale price deflator. think Through (WPI), and the GNP so that labeled we tend to as an increase of inflation in the price "inflation." increases WPI are not any increase the many As an ex- in 1980 farm decreased products. In one sense, of food caused inflation. important we do not sense, the In another they Inflation the not likely price a continuing will an increase level. Such in is unless it causes or is ac- by a substantial to available goods. reflected in the prices and credit Moreover, in- of all goods and examina- in prices in the past two decades demonstrates. inflation rate for the United States since 1961 is shown in table to 9.9 percent The 1, column grown rather steadily Ex post real interest rate 1.9 1.2 2.5 3.2 3.8 4.7 4.6 4.5 4.6 4.6 3.7 3.2 4.6 5.2 5.0 4.0 4.3 5.2 5.5 5.2 5.3 5.8 6.5 7.4 1.6 2.6 1.9 2.2 8.5 3.5 1971 1972 1973 1974 1975 4.6 4.0 7.2 10.5 7.2 5.4 7.9 7.6 7.8 9.0 9.6 3.3 3.6 0.6 -1.5 2.4 1976 1977 1978 1979 1980 4.7 6.1 7.9 8.5 9.9 4.8 5.8 6.8 7.9 7.2 9.0 8.4 4.3 2.3 9.1 10.1 12.8 1.2 1.6 2.9 5.9 6.8 6.0 5.5 average annual 2. In 20 years, in the GNP deflator from 1 percent in 1980. this in so shall not a subject economists. relationship many has policy include of contro- To been ignored recommendations, a discussion we of interest rates est rates funds. demand. two The premium life of the the expected Open market Reserve funds. is maintained money has money supply many rate minus are a major determinant supply A purchase function of for loanable of government securities measure used, because reserves bank have the The has in 1961 low rates in probably istration's reported the multiple riods. Even individual the growth money there short-run trend the over the three and the 3. is no clear relationship changes price in the level. money However, the over time are clearly correlated. long-run supply relationsh and the ip between price will rise (see table corresponds between inflation, growth rate and years is shown in table 1, column As is evident, The supply continues inflation in the bond deflator. that as the minus the Viewed level is well reflects the fact interest have grown too versing this trend rate rise in the short and immediate real interest real interest average increase corporate in the real interest rate is independent is no trend GNP it is evident rates have not standards. There High been high In the long run, the and money of both supply in the real interest series, as there is in the other series. re- growth. rate stage rapidly in the on how quickly in money come to believe that and decreases and slow growth reduced, aggre- interest Correlations fects to th is question, of slower money the of funds second deflationary rates will difficult Reserve and Future and third pol icy. to discern recent re- experi- deflationary supply show up in lower reported in the ag- to wait bewill lower rates? While there is no defin- ence suggests that significant growth M-1B Growth growth growth inflation efwill rates in years following the Changes in trend are from the data in table 1, - 1975:1110 Correlation between we expect money inflation itive answer empirical run. If the Federal Chart 1 smaller. reduced ported pre- Inflation Rates 10 12 coefficient 0.45 0.40 0.35 0.30 0.20 0.15 0.10 0.05 supply growth it will persist. inflation expectations a substantial and in and In other -0.10 interest rates marginal -0.15 decrease When money supply growth are crowded -0.05 will not drop continual in the face of continuing rise and o Moreover, people recognize reduced mands markets fore inflation on prices. The lag between and variable. is recognized. Re- rates to run, but it will not have an growth until in today past. will cause interest in money words, theoretical price level. With the supply rise in the short to rate by lower- suggest that slowing money to credit mium becomes however, 0.25 al i of the aggregates is lengthy the reduction differ- inflation inflation it depends inflation will not immediately gregate to fall as the expected How long should rates of the monetary all of the evidence gradually policy may be committed the long-run ing the growth gates, rates begins to decrease. Even though slowing will come The growth, to slow and interest and in- target-setting that effect of this policy as inflation pol icy. money inflation interest differences decreases by historical inflation respond However, formulation. interest in th is way, ported the policy in inflation 5, the ex post is calculated rate to ex- anti-inflationary in slowing we can expect can vary, as many of can be observed the ex- supply growth. In column rate bond trends in the 4). The in the 1, column corporate to the past money connection and current supply pand, premium and moves to technology, trends benefits an adjustment pe- income. into of persists unemployment, the temporary adopt aggregate components respect in long-run money to long run, the trends in the corporated inflation the cvcl ical each of the aggregates may be the case. pected Reserve seasonal and and in circulation with cost lead to increased represents 1964:10 monetary in defin ing over rates, will accelerate of which 0.50 Each differently of of reserves sup- variable The deposit targets. with the accompanying of world oil prices. average money trends The high of those controls increase illustrate past money supply admin- rates in 1973 th rough 1975 the relaxation quadrupling between the Nixon wage and price controls. inflation temporary previous reflect government on Federal the long run, the opposite 1971-72 base is often of currency problems led ently rates to fall. In in theoretical Reserve System. the interest (M-2). As a and a control plus Federal supply authorities. sum of the savings and various it represents monetary in will cause plus check- the monetary ply of fiat money the In in the supply the money sup- as currency of the money and leads to an increase reserves will be used. As a meabalances, models, the on the also are included deposits of loans that banks can make. run, this increase depends time banking the short is calculated word way function, Reserve system The store-of-value by the Federal the amount adds reserves to the the (M-1 B). As a measure Practical Federal variable able deposits premium. of the because meanings. base is the The real in- interest operations System so that the contract. inflation the short-run empirically, economic rate. The pre- lent rate is the market rate has is the amount must pay lenders funds inter- in supply for expected inflation of the over the terest prices, interest and the real interest real value in markets changes market for expected that borrowers a. The inflation rate is measured as the average annual percent change in the GNP deflator. b. This is a moving average of the past three years of M-l B growth. For example, the 1980 figure, 7.2, represents the average annual growth in M-1B for 1978, 1979, and 1980. c. This interest rate is a simple average of the interest rates on Moody's Aaa, Aa, A, and Baa corporate bonds. with components-a inflation define is a difficult ply usually is defined Like other fluctuate and mium to This may supply sure of transaction rates are determined for loanable The money way the calculations Interest Rates and Inflation Interest The Money Supply understand in our analvsis. 3.7 2.6 3.0 3.2 2.2 1966 1967 1968 1969 1970 and among why 1.0 2.0 1.5 1.4 2.4 To in corresponding as even the most cursory tion of the upsweep the rate of increase Corporate bond interest rate, percentC 1961 1962 1963 1964 1965 reflect and continuing relative services, of increase in the vol ume of money movements price of food increase is generally and if understood versy Money supplY b growth Inflation Year ratea in Prices, Money, level. to occur companied If Trends If the component causes general flation did not. in 1981 return to its previous that increased have a drought farm-product the As food else is unchanged, everything the CPI or the food. and more the the rose, so did all the price indexes include prices individual inflationary. drought of many affect truly ample, in an index is Yet that supply prices (CPI), the this procedure, indexes price indexes, price index index and the general to measure level. By necessity, rise this definition misconception our attempts goods, Table 1 Long-Run and Interest Rates is inflation, credit de- out of the marketplace. -0.20 o NOTE: The standard 2 deviation 3 4 5 is calculated line is drawn at two standard deviations. 6 7 8 9 11 13 14 15 16 as one over the square root of the sample size. The dotted Federal because and the trends In chart are masked temporary other random 1 we have plotted coefficient calculated in period following. between quarters are significant coefficients deviations. marize briefly- at 7, 8, 9, and 10 con- significant twelfth the the The most growth sixth quarters. with in chart These results correlations indicates tween the growth speed reports with results tions, reported recognize growth changing inflation may tend suppressing people If slower in rapidly Past inflation will and money expecta- fall is embodied more in con- to slow the inflation- effects of reduced money Even the most optimistic indicate a lag well in excess of one year be- reduced felt. run money effect long as four and supply on inflation. years It is possible output suggest other th at the in depends the money the non-monetary unless dated by an increasing The model supply. used money n ~ (2) U m.Mt_· t=o I + = pU _ t 1 factors a tem- accommo- supply. to generate in table 2 is given in equations (1)Pt= are aggre- However, have only they and sh ort-term the on many shocks effect defini- Both theory change level than the growth and various supply. esti- the results 1 and 2: I t (P) was re- before that estimates growth has a It may be as the full effect the negative unemployment is short- effects of the slower money growth will be substantial. However, effects are both less these short-run H: o l:m.=1 xm. n I t t SE as the rate. (U), so the was used to coefficient degrees estimate residuals in the money to fit a third-order constraints. in table 2. Some For every standard The for multiseries, the interesting monetary are results variable the error (SE) of the regression growth on of a change inflation over as the of the This price indexes in the point short here short-run criterion, error is model money the 1. All of the M-1 B best "ex- 0.883 0.905 0.885 0.864 8 1.136 1.140 1.130 1.078 20 16 12 8 1.089 1.105 1.097 1.047 and capital interest rates risen to unprecedented The or "explain" 0.707 0.712 0.700 0.639 NOTE: cent Reject if the equal to both deflator; and growth relation- GNP this this in- of the aggregates and economic see John B. Carlson and Theresa Gwazdaus- kas, "The New and Monetary Aggregates, Pol icy," Economic Economic Activity, Commentary, 10.27 11.46 12.29 11.52 1.474 1.473 1.480 1.474 1.60 1.82 1.73 0.73 13.36 14.81 15.07 10.07 1.449 1.429 1.448 1.533 1.17 1.52 1.49 0.57 -5.33 -5.33 -5.17 -3.80 Ho with p 0.637 0.639 0.637 0.657 0.562 0.553 0.558 0.685 14.33 16.01 16.88 12.77 1.417 1.403 1.416 1.486 this measure of inflation. Other Federal Reserve Bank of Cleveland, Federal March 10,1980. Research BULK RATE U.S. Postage Paid Cleveland,OH Reserve Bank of Cleveland Department P.O. Box 6387 Cleveland,OH Permit 44101 period, Reserve the 12.85 13.19 12.07 6.73 1.432 1.429 1.475 1.608 0.618 0.613 0.639 0.768 region of 5 perthan and money the supply is estimated, and operating reserves and the money less likely to change the relationship During the money Federal change, reduce initiates adjustments rates by gradually the lowering In principle, the growth of the money stock could be coneither interest rates to return desired between supply. subsequently accurately, interest The desired aggregates, gress pursuant Address correction or No. 385 money terest requested between supply, rate on federal that was estimated sired growth. This money between supply and because often money not supply adherence money changed changes to rates and the acceler- to rates control Address interest-rate targets to deviate further flation, Each its plans to Con- of 1978 and (the Hum~ Act). Because the Federal Retargets that are low enough we can expect markets. is necessary, continued To see why it is important the basic relationships between to in- interest rates, and the money supply- the topic of this Economic Commentary. caused Inflation Inflation the volume T. Gavin is an economist, Federal Reserve available is defined of money as "an increase and credit goods resulting in relative to in a substantial and Bank of Cleveland. The Please send mailing label to the Research Department, Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland, Act in the credit understand and further Change William phrey-Hawkins serve has selected this pressure by the Fed- (FOMC). to the Full Employment Growth pressure to its or, more In this environment from desired targets. D Correct as shown D Remove from mailing list Balanced Committee to slow inflation, the re- in interest enough growth. growth procedure as inflation large range with de- because interest and the in- funds in a narrow to be unsatisfactory, lationship ated "targeted" to be consistent monetary were interest then growth are chosen rates relationship and rates that tend paths, year the FOMC must report the is a ranges for each of the estimated Reserve rates and reserves supply eral Open Market Federal run than if there in bank the target monetary interest or bank reserves. Under the former operating the targets between of the new procedure money path." and may be no However, market the supply in the short the operation eventually the relation- of reserves are set for reserves. The relationship of the and by controlling new procedure, supply of the money stock. strained the between money constant-to pressures have heights, Under ship volatile. objectives have remained in the the growth proved 0.512 0.508 0.514 0.619 a critical rates that Not only have been unusually inflationary index. of turbulence markets. interest the -1.36 -1.20 -1.60 -1.81 absol ute val ue of t is greater 1.96. but one for following money level of interest activity, The period or supply a long-term M-2 20 16 12 8 policy. Reserve procedures procedure, plains" M-1A 20 16 12 8 monetary its operating has been St. Louis Base 20 16 12 6, 1979, the Federal changed change omitted. growth On October System affect that demand in Growth by William T. Gavin that of inflation. to forecast growth it is to show flation suggests been Inflation, Interest Rates,and Monetary systematic variables run have between was sig- missing from equation th rough is not This term non-monetary ~£Q,Clomic Commentary reflect the hy- parameter error 23, 1981 growth one We can reject is a quarterly 2. For a discussion standard than a period. Using the smallest money instance. are variables ship in money occurs there rather, with 16 lagged quarters; that is, the full effect a the sum of the coefficients in every of the with no endstatistics greater that February will lead to an to the autocorrelation behavior (m ) was constrained i Summary equal that coeffi- to one implies in velocity.2 2. To preserve polynomial equal the sum lagged rate of money rate nificant growth of the equal to zero in all cases. technique and to adjust of the weights point the of autocorrelation the in equation of freedom pattern in presence Cochrane-Orcutt (p) collinearity the be used include Coefficients autocorrelation regression I alternatively positive four-year o l:m.=O I growth inflation pothesis supply H: steady growth was in the equation 1, the GNP deflator A sum Various rates of change). indicated might distribution cients. results emerged. . that the (approx- 8, 12, 16, and 20) were used on the defined and liminary lowest E criteria St. Louis base, M-1A, M-1B, and M-2. Pre- given +Ut· of the logarithm continuous supply by taking M-1B growth. significant price money of lower in- supply expectations. growth fore evidence we have ip between (quarter-to-quarter) t how long will depend which in money their that the are of time be- of slower rates. Precisely quickly. tions of the money presented period and subsequent tracts the relationsh that we should ex- achievement change analysis, Table 2 Estimates of the Price Equation 1964: 110 - 1980: 1110 pect to wait a substantial adjust mated In equation The evidence the supply, the 1. on the money regression on in- through Conclusion flation Using = 16 lagged growth. on past values of the money All variables were transformed lags (n porary best fitting including of money in lagged consistent of the definition supply impacts occur using reTo sum- used-the are those of money flation results in the appendix. supply specifications quarters some regardless of the money (M). imating gate analysis gressed rate of the GNP deflator Only level. gression adverse growth. than Appendix in the at a 95 percent We have included the of fast money less enduring price effects the first difference M-1 B growth Few of the correlation are greater than two standard calculated and long-run in period t and the 16 quarters the correlations certain the correlation t and each of the changes GNP deflator fidence by cycl ical fluctuations. Reserve Bank of Cleveland author OH 44101. opinions and Reserve Governors not Bank stated herein necessarily of Cleveland are those those or of of of the the Federal the Board of the Federal Reserve System. of 1. For the "The a detailed new discussion operating New Procedure," of the procedure, Economic Reserve Bank of Cleveland, mechanics see E.J. Review, forthcoming. of Stevens, Federal Federal because and the trends In chart are masked temporary other random 1 we have plotted coefficient calculated in period following. between quarters are significant coefficients deviations. marize briefly- at 7, 8, 9, and 10 con- significant twelfth the the The most growth sixth quarters. with in chart These results correlations indicates tween the growth speed reports with results tions, reported recognize growth changing inflation may tend suppressing people If slower in rapidly Past inflation will and money expecta- fall is embodied more in con- to slow the inflation- effects of reduced money Even the most optimistic indicate a lag well in excess of one year be- reduced felt. run money effect long as four and supply on inflation. years It is possible output suggest other th at the in depends the money the non-monetary unless dated by an increasing The model supply. used money n ~ (2) U m.Mt_· t=o I + = pU _ t 1 factors a tem- accommo- supply. to generate in table 2 is given in equations (1)Pt= are aggre- However, have only they and sh ort-term the on many shocks effect defini- Both theory change level than the growth and various supply. esti- the results 1 and 2: I t (P) was re- before that estimates growth has a It may be as the full effect the negative unemployment is short- effects of the slower money growth will be substantial. However, effects are both less these short-run H: o l:m.=1 xm. n I t t SE as the rate. (U), so the was used to coefficient degrees estimate residuals in the money to fit a third-order constraints. in table 2. Some For every standard The for multiseries, the interesting monetary are results variable the error (SE) of the regression growth on of a change inflation over as the of the This price indexes in the point short here short-run criterion, error is model money the 1. All of the M-1 B best "ex- 0.883 0.905 0.885 0.864 8 1.136 1.140 1.130 1.078 20 16 12 8 1.089 1.105 1.097 1.047 and capital interest rates risen to unprecedented The or "explain" 0.707 0.712 0.700 0.639 NOTE: cent Reject if the equal to both deflator; and growth relation- GNP this this in- of the aggregates and economic see John B. Carlson and Theresa Gwazdaus- kas, "The New and Monetary Aggregates, Pol icy," Economic Economic Activity, Commentary, 10.27 11.46 12.29 11.52 1.474 1.473 1.480 1.474 1.60 1.82 1.73 0.73 13.36 14.81 15.07 10.07 1.449 1.429 1.448 1.533 1.17 1.52 1.49 0.57 -5.33 -5.33 -5.17 -3.80 Ho with p 0.637 0.639 0.637 0.657 0.562 0.553 0.558 0.685 14.33 16.01 16.88 12.77 1.417 1.403 1.416 1.486 this measure of inflation. Other Federal Reserve Bank of Cleveland, Federal March 10,1980. Research BULK RATE U.S. Postage Paid Cleveland,OH Reserve Bank of Cleveland Department P.O. Box 6387 Cleveland,OH Permit 44101 period, Reserve the 12.85 13.19 12.07 6.73 1.432 1.429 1.475 1.608 0.618 0.613 0.639 0.768 region of 5 perthan and money the supply is estimated, and operating reserves and the money less likely to change the relationship During the money Federal change, reduce initiates adjustments rates by gradually the lowering In principle, the growth of the money stock could be coneither interest rates to return desired between supply. subsequently accurately, interest The desired aggregates, gress pursuant Address correction or No. 385 money terest requested between supply, rate on federal that was estimated sired growth. This money between supply and because often money not supply adherence money changed changes to rates and the acceler- to rates control Address interest-rate targets to deviate further flation, Each its plans to Con- of 1978 and (the Hum~ Act). Because the Federal Retargets that are low enough we can expect markets. is necessary, continued To see why it is important the basic relationships between to in- interest rates, and the money supply- the topic of this Economic Commentary. caused Inflation Inflation the volume T. Gavin is an economist, Federal Reserve available is defined of money as "an increase and credit goods resulting in relative to in a substantial and Bank of Cleveland. The Please send mailing label to the Research Department, Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland, Act in the credit understand and further Change William phrey-Hawkins serve has selected this pressure by the Fed- (FOMC). to the Full Employment Growth pressure to its or, more In this environment from desired targets. D Correct as shown D Remove from mailing list Balanced Committee to slow inflation, the re- in interest enough growth. growth procedure as inflation large range with de- because interest and the in- funds in a narrow to be unsatisfactory, lationship ated "targeted" to be consistent monetary were interest then growth are chosen rates relationship and rates that tend paths, year the FOMC must report the is a ranges for each of the estimated Reserve rates and reserves supply eral Open Market Federal run than if there in bank the target monetary interest or bank reserves. Under the former operating the targets between of the new procedure money path." and may be no However, market the supply in the short the operation eventually the relation- of reserves are set for reserves. The relationship of the and by controlling new procedure, supply of the money stock. strained the between money constant-to pressures have heights, Under ship volatile. objectives have remained in the the growth proved 0.512 0.508 0.514 0.619 a critical rates that Not only have been unusually inflationary index. of turbulence markets. interest the -1.36 -1.20 -1.60 -1.81 absol ute val ue of t is greater 1.96. but one for following money level of interest activity, The period or supply a long-term M-2 20 16 12 8 policy. Reserve procedures procedure, plains" M-1A 20 16 12 8 monetary its operating has been St. Louis Base 20 16 12 6, 1979, the Federal changed change omitted. growth On October System affect that demand in Growth by William T. Gavin that of inflation. to forecast growth it is to show flation suggests been Inflation, Interest Rates,and Monetary systematic variables run have between was sig- missing from equation th rough is not This term non-monetary ~£Q,Clomic Commentary reflect the hy- parameter error 23, 1981 growth one We can reject is a quarterly 2. For a discussion standard than a period. Using the smallest money instance. are variables ship in money occurs there rather, with 16 lagged quarters; that is, the full effect a the sum of the coefficients in every of the with no endstatistics greater that February will lead to an to the autocorrelation behavior (m ) was constrained i Summary equal that coeffi- to one implies in velocity.2 2. To preserve polynomial equal the sum lagged rate of money rate nificant growth of the equal to zero in all cases. technique and to adjust of the weights point the of autocorrelation the in equation of freedom pattern in presence Cochrane-Orcutt (p) collinearity the be used include Coefficients autocorrelation regression I alternatively positive four-year o l:m.=O I growth inflation pothesis supply H: steady growth was in the equation 1, the GNP deflator A sum Various rates of change). indicated might distribution cients. results emerged. . that the (approx- 8, 12, 16, and 20) were used on the defined and liminary lowest E criteria St. Louis base, M-1A, M-1B, and M-2. Pre- given +Ut· of the logarithm continuous supply by taking M-1B growth. significant price money of lower in- supply expectations. growth fore evidence we have ip between (quarter-to-quarter) t how long will depend which in money their that the are of time be- of slower rates. Precisely quickly. tions of the money presented period and subsequent tracts the relationsh that we should ex- achievement change analysis, Table 2 Estimates of the Price Equation 1964: 110 - 1980: 1110 pect to wait a substantial adjust mated In equation The evidence the supply, the 1. on the money regression on in- through Conclusion flation Using = 16 lagged growth. on past values of the money All variables were transformed lags (n porary best fitting including of money in lagged consistent of the definition supply impacts occur using reTo sum- used-the are those of money flation results in the appendix. supply specifications quarters some regardless of the money (M). imating gate analysis gressed rate of the GNP deflator Only level. gression adverse growth. than Appendix in the at a 95 percent We have included the of fast money less enduring price effects the first difference M-1 B growth Few of the correlation are greater than two standard calculated and long-run in period t and the 16 quarters the correlations certain the correlation t and each of the changes GNP deflator fidence by cycl ical fluctuations. Reserve Bank of Cleveland author OH 44101. opinions and Reserve Governors not Bank stated herein necessarily of Cleveland are those those or of of of the the Federal the Board of the Federal Reserve System. of 1. For the "The a detailed new discussion operating New Procedure," of the procedure, Economic Reserve Bank of Cleveland, mechanics see E.J. Review, forthcoming. of Stevens, Federal
