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money growth rule for one or another
of the monetary aggregates, with most
choosing Ml. The targeting of Ml is
based on the constraint imposed by
current regulations, as well as on theoretical and empirical considerations.
Ml is defined to include assets that are
mainly held for transaction purposes.
The theory of the transactions demand
for money is more highly developed
than theories of the demand for money
in its other uses, such as a store of
value or a unit of account. Furthermore, empirical studies done both
inside and outside the Federal Reserve
prior to the 1980s showed that the
demand for Ml was more predictably
related to movements in interest rates
and economic activity than were the
broader aggregates. As shown above,
these "predictable" relationships have
not survived in the 1980s.
The monetarist policy prescription became more and more popular as inflation
accelerated and as more experience suggested that Ml velocity was stable and
predictable. Monetarism became associated with the notion that short-run
changes in money were closely and systematically related to short-run changes
in GNP and that velocity would continue to grow 3 percent a year, no matter what the Federal Reserve did.
When that short-run relationship
disappeared, monetarism naturally lost
popularity among economists and policymakers, who viewed monetarism as a
justification for fine-tuning nominal

GNP growth. However, this emphasis
on the short-run relationship between
money and economic activity is not
fundamental to the basic monetarist
principles that bear on the efficient
conduct of monetary policy.
While monetarism means different
things to different people, most monetarists agree that the framework for
monetary policy should be structured
so as to create the optimal environment
for economic growth and efficient allocation of resources." Further, monetarists agree that, in such a framework,
policy actions should be predictable and
should be expected to produce a stable
price environment. Monetarists think
that attempts to use discretionary
changes in the money growth rates in
order to smooth the business cycle or to
promote higher employment will either
destabilize the economy or lead to inflation or both.
In the Full Employment Act of 1946,
Congress gave the federal government
(and indirectly, the Federal Reserve)
the responsibility to " ... use' all practicable means ... to promote maximum employment, production, and purchasing
power." While much of the willingness
to tolerate accelerating inflation can be
traced to legitimate concerns about production and employment, new advances
in macroeconomic theory support the
monetarist contention that there is no
long-run tradeoff between inflation and
these real variables." In this regard,
the monetarists have an important message for policymakers when they argue

Conclusion
The recent instability of Ml velocity is
due to forces that were set in motion by
economic policies of the past. Attempts
to change important monetary or bank
regulatory policy are likely to lead to a
temporary period of instability in velocity. Even when this period of transition
is over, we should expect Ml velocity to
be more variable in a regime of stable
prices (or stable inflation) and deregulation of deposit interest rate ceilings
than it was during the period of accelerating inflation. To conduct policy
efficiently in such an environment, it is
important to develop institutions that
allow the Federal Reserve to commit to
long-run price stability. At the same
time it must retain the short-run flexibility to respond to technological
advances and other shocks to the structure of financial markets.

New England Economic Review, Marchi April
1975, pp. 21·30, and the proposal to stagger
reserve maintenance periods among groups of
banks in Albert H. Cox, Jr. and Ralph F. Leach,
"Defensive Open Market Operations and the

Reserve Settlement Periods of Member Banks,"
Journal 0/ Finance, vo1.19 (March 1964), pp.76-93.

The Structure 0/ Monetarism, W. W. Norton &
Co., 1978, pp. 1-46.

8. For a discussion of what is meant by the term
monetarism, see William Poole, Money and the
Economy: A Monetarist View, Addison-Wesley
Publishing Co., 1978, pp. 1-4, or Thomas Mayer,

9. For a discussion of these issues see James G.
Hoehn, "Monetary Policy Debates Reflect Theoretical Issues," Economic Commentary, Federal
Reserve Bank of Cleveland, May 1, 1986.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

that the way to provide the best environment for long-run economic growth
is to provide a stable price level.
In retrospect, attempts to use active
stabilization policy have been associated with accelerating inflation.
Chart 4 shows the wholesale price index from 1895 to the present. The period from 1895 (actually, the same holds
true from the end of the eighteenth
century) to World War II was one of
relative price stability. The price level
rose and fell about at an average that
was last seen approximately in 1940.

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

Federal Reserve Bank of Cleveland

[SSN 0428-1276

ECONOMIC
COMMENTARY
The Federal Reserve has once again
decreased emphasis on the Ml target as
a guide for short-run policy actions. In
the first half of 1986, Ml growth averaged 11.8 percent, while nominal gross
national product (GNP) growth averaged only 4.6 percent and inflation continued to be lower than expected. Policymakers and economists, including
leading monetarists, argue that Ml is
no longer an appropriate short-run
guide for monetary policy.'
This Economic Commentary discusses
the apparent breakdown in the relationship between Ml and economic activity. The first part of this essay makes a
claim that is quite simple, although
perhaps controversial; namely, that the
breakdown of the relationship between
Ml and nominal GNP is only apparent.
The illusion of stability between Ml
and nominal GNP that prevailed after
World War II resulted from the accelerating inflation and interest rate regulations that uniquely characterized that
period. Such stability should not be
considered to be the norm.
In fact, as the first part of this essay
shows, the recent variability of Ml velocity, while large in comparison to our
experience after World War II, is still
small relative to our experience before
that war. The monetarist call for a constant money growth rule followed an extensive study of this prewar experience,
and was not based on the postwar stability of Ml velocity. The second part of
this essay presents a monetarist critique of recent experience.
Historical Perspective
To understand the challenge for monetary policy, it helps to take a long historical perspective. We live in a unique
time. For the four thousand years before

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

Address Correction Requested: Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

October 1, 1986

William T. Gavin is an economic advisor at the
Federal Reserve Bank 0/ Cleveland.
The views stated herein are those 0/ the author
and not necessarily those 0/ the Federal Reserve
Bank 0/ Cleveland or 0/ the Board 0/ Governors 0/
the Federal Reserve System.

Chart 1 Velocity of Ml and
the Commercial Paper Rate,
1950-1985
Percent

16r-------------------------,
14
12

10
8
6

4L_~rr'v'
2

1950 1955 1960 1965 1970 1975 1980 1985
SOURCE: Board of Governors of the Federal
Reserve System.

the 1900s, monetary systems were based
on commodity standards, usually metals. There h'ave been paper money systems in the past (the first recorded
instance of state-issued paper money occurred in China in the ninth century),
but they always degenerated with high
inflation and consequently disappeared.s
While metallic standards were often
suspended during wars and national
emergencies, they were usually reinstated soon after the emergency ended.
The United States adopted a modified gold standard in the Bretton Woods
Agreement after World War II. The dollar remained tied to gold until the late
1960s or early 1970s. Officially, the dollar was freed from gold when President
Nixon suspended convertibility for
other central banks on August 15, 1971.
But, effectively, the dollar had already
been freed from a gold constraint in
1968 when Congress removed the "gold
1. One notable exception was the late Michael].
Hamburger (Wall Street Journal, July 8, 1986, p.
30) who argued that his money-demand equation,
specified two decades ago, continued to explain
the relationship between Ml and nominal GNP.
Note, however, that he implicitly recommended a

Monetarism and
the Ml Target
by William T. Gavin

cover" linking currency issue to the
government's gold stock.
The problem for the Federal Reserve,
both then and now, is how to maintain
price stability in a monetary system
with unbacked paper money; no society
has ever succeeded in doing so. Contrary to the suggestions offered in textbooks and treatises by monetary reformers, experience shows that it is no
easy matter to stabilize the price level
with a paper money system.
The monetarist solution to this problem is to protect the value of money by
limiting its quantity. The intellectual
foundation for this solution is the
Quantity Theory of Money. As reformulated by Milton Friedman (Studies
in the Quantity Theory of Money, 1956),
it is essentially a theory of money
demand, that is, a theory about why
people want to hold money balances."
The most important factor determining the demand for Ml is the level of
transactions. It is common practice to
use nominal GNP as an approximate
measure of transactions because aggregate transactions data are not available.
Over a relatively short period (say three
months to a year), quantity theorists
expect the demand for money to rise or
fall in a predictable fashion with a rise
or fall in GNP. The ratio of nominal
GNP to the amount of money is termed
the velocity of money, in reference to
the turnover per year, or the velocity of
circulation, of money.
Of course, velocity is not a constant.
There are seasonal and other variable
factors affecting money demand and
there is error in measuring income and
money. Of the nonseasonal factors, the
most important are probably interest
rates and technological innovations affecting the efficiency of the payments system.
procedure based on a constant growth rule for
nominal GNP, not a constant growth rule for M1.
2. See Elgin Groseclose, Money and Man, Frederick Ungar Publishing Co., 1961, p. 118, or Rupert
]. Ederer, The Evolution 0/ Money, Public Affairs
Press, 1964, p. 91.

When interest rates rise, people economize on non-interest-bearing currency
and on checking balances, and then velocity rises. When interest rates fall,
people are more willing to leave funds
idle as cash balances, and velocity falls.
Of course, interest rates change every
day, but firms and households do not
adjust their money balances to every
short-run change in interest rates. It
takes time and resources to rearrange
our monetary affairs. Therefore, the
adjustments will be made when it is
convenient, or when there is a significant change in the level of interest
rates that people expect to be permanent.
We have also seen a rise in velocity
(decline in the demand for money) with
the advance of technology and innovations in the banking industry. For
example, households use credit cards
for transactions, reducing average balances that are kept in checking accounts. Firms have developed a wide
array of cash management techniques.'
The technological innovations were
partly spurred by rising interest rates;
when interest rates fall, some of these
cash management methods will become
uneconomical, but others, with lower
marginal costs, will remain.

The Velocity Breakdown
in the 1980s
During the 1970s, many came to believe that these other factors (interest
rates and innovations in cash management) didn't matter too much for the
purpose of choosing the Ml target.
While velocity growth was quite variable from quarter to quarter, these fluctuations were largely offsetting. Over
periods of a year or two, Ml velocity
usually seemed to grow at its trend rate
of 3 percent, regardless of what happened in the short run to interest rates
and advances in cash management.
Indeed, one of the debates among economists was whether the Federal
Reserve's monetary targets should take
account of changes in interest rates
and other factors affecting money
demand. Monetarists said no, claiming
that while interest rates mattered in
theory, they did not seem to matter
much in practice. A look at velocity and
interest rates in the period from 1950 to

3. See Milton Friedman, "The Quantity Theory
of Money - A Restatement," in Studies in the
Quantity Theory of Money, University of Chicago
Press, 1956, pp. 3-21. While Friedman advocated
alternative measures of money (M2 in his early
work and, n:ore recently, the monetary base), we

Chart 2 Velocity of M1 and
the Commercial Paper Rate,
1895-1985
Percent

16

Percent
8

14
12
10
8

6
4
2

Chart 3 M1 Velocity Growth,
1895-1985
Percent change. annual rate

15r-----,-------------------,
11.90

10
5
0
.5
·10
·15

~#

~
SOURCE: Federal Reserve Bank of Cleveland.

1980 seems to confirm the monetarist
position (See chart 1).
Velocity rose in a smooth fashion
from 2.52 in 1950 to 7.11 in 1981. The
interest rate shown in chart 1 is the
short term (4-6 month) commercial
paper rate. This interest rate rose from
1.45 in 1950 to 14.76 in 1981; however,
its rise was not smooth. While the
trends in both velocity and interest
rates were rising, there does not appear
to be much quarter-to-quarter or yearto-year co-movement between these
variables. Consequently, there did not
seem to be much reason to make the
monetary targets conditional on the
outcome for interest rates. Furthermore, given the relation between velocity and interest rates from 1950 to
1981, one would not have predicted an
abrupt decline in velocity, even knowing the actual outcome for interest
rates in the early 1980s.
The smooth rise in velocity occurred
during a period with steadily rising
trends in inflation and interest rates. Federal Reserve System Regulation Q prohibited banks from paying interest rates
on checking deposits, and the rising interest rates on alternative assets reflected
rising opportunity costs to depositors.
Had banks been allowed from the beginning to pay interest on checking
deposits, we might not have seen such
a runoff of deposits and such a rapid
rise in velocity. But banks were not

use the term money to refer to balances held
primarily to conduct transactions. This corresponds to the definition of money known as Ml.
M1 includes currency, travelers' checks, demand
deposits, and other checkable deposits such as
NOW accounts and credit-union share drafts. For
a more precise definition, see any recent issue of
the Federal Reserve Bulletin, page A3.

"

~
~

SOURCE: Federal Reserve Bank of Cleveland.

allowed to pay interest on checking
until 1981. The effective deregulation
of interest-rate ceilings on demand deposits by regulatory approval of nationwide NOW and Super-NOW accounts
was therefore an important factor in
changing the velocity trend. The
deregulation effect has worked to lower
velocity, as has the perceived permanent decline in interest rates. Deregulation also has confounded attempts to
quantify the effect that falling interest
rates are having on the velocity trend.
This departure from the 3 percent
growth trend, illustrated in chart 1,
represents the apparent breakdown in
Ml velocity that is the source of the
current disaffection with the Ml
target. As stated earlier, this appearance of breakdown results from a
myopic view of history that includes
only the period after World War II.
However, when we take a longer
view, we see that this latest decline in
velocity is not atypical; rather, it is
consistent with a long-standing relationship between Ml, GNP, and interest rates (See chart 2). While transitory
changes in interest rates did not seem tc
be closely related to Ml velocity, it
appears that changes in the trend of
interest rates have been associated
with changes in the trend of velocity.
When the trend in the interest rate
was flat, from 1895 to 1929, the trend

4. For a detailed description, see John B. Carlson,
"Methods of Cash Management," Economic
Commentary, Federal Reserve Bank of Cleveland,
April 5, 1982.
5. Friedman recommends a 4 percent constant
money growth rule in Chapter 4 of Milton Fried-

in Ml velocity was flat. When interest
rates fell, velocity fell. After World War
II, rates began to rise - approximately
doubling every decade to 1980 - and ve
locity also rose. If the decline in interest
rates since 1982 is regarded as a perrna
nent decline, then it should be associated
with a decline in the velocity trend.
From this perspective, what seems
unusual is not the experience of the
1980s, but rather the apparent stability
of velocity from 1950 to 1980. It is
likely that this relative stability was
made possible by a combination of two
atypical circumstances. The first was
the accelerating inflation and rising
interest rates of the period. The other
was the prohibition against paying
interest on deposits. These two circumstances, which combined to produce the
steady rise in velocity, were both eliminated in the early 1980s.
Not only was there a change in the
growth trend of Ml velocity in the
1980s, but there was also an increase in
the variability as measured by changes
in the level. This measure of the variability in Ml velocity is shown in chart
3, which illustrates annual percent
changes in Ml velocity from 1895 to
1985. Once again, we see that the different pattern for Ml velocity in the
1980s is not so different if we take a
longer historical perspective. The variability in recent years pales in comparison to the variability in the period
before World War II.
It is likely that the data for this early
period are of low quality. But these are
data that Milton Friedman collected
and studied as he developed the monetarist rule of constant money growth.t
Using these data, Friedman concluded
that the short-run (quarter-to-quarter
or year-to-year) relationship between
money and the economy was so unpredictable that monetary policy could not
be used to fine-tune the path for nominal GNP. He also went to some lengths
to argue that the major episodes of
instability in velocity were due to a
failure to maintain stable growth in the
money supply."
Friedman argued that the social costs
of having the economy adjust to money
demand disturbances would be less than
the social costs of having the economy
adjust to the uncertain environment as-

man, A Program for Monetary Stability, Fordham
University Press, 1959.
6. See Milton Friedman and Anna J Schwartz, A
Monetary History of the United States: 1867·1960,
Princeton University Press, 1963. For example, in

socia ted with discretionary monetary
policy. While one cannot prove or disprove the proposition that money demand would be stable if money supply
were stable, the proposition is a fundamental assumption leading to the
call for a constant money growth rule.

Chart 4 Wholesale Price Index,
1895-1985
1967=100
350r-----------------------~
300
250

A Monetarist Critique
of Recent Experience
When we take the longer perspective,
we see that it was a mistake to expect
so much of Ml in the first place. The
monetarist philosophy, which forms
the intellectual basis for monetary targeting, was developed with this longer
perspective in mind. The most basic
tenet of the monetarist philosophy is
that the economy will function most
efficiently if government institutions
and policies are structured to permit
market forces to operate with as little
day-to-day interference from government as possible.
Monetarists think that if monetary
institutions are properly structured the
economy is inherently stable, and will
tend toward full employment even
when buffeted by outside shocks such
as weather and changes in population,
technology, or tastes. Consequently,
monetarists tend to attribute long periods of slow growth and periods of large
economic fluctuations to inefficient
government institutions or to inappropriate policy actions.
Given efficient and stabilizing institutions, monetarists conclude that the
best that the monetary authority can do
is to supply the monetary base at a constant growth rate. The monetary base
is government-supplied money. This
would be expected to lead to fairly stable and predictable growth rates for different types of bank deposits, for nominal GNP, and for the overall price level.
As a practical matter, our monetary
control institutions are not well-suited
for setting a constant growth rule for
the supply of base money. For example,
money demand is quite unpredictable in
the very short run, say within the period
of one month. Yet current rules require

Chapter 7, Friedman and Schwartz attribute the
steep decline in velocity to the severity of the
depression which, they contend, was due to the
35 percent decline in the stock of money between
August 1929 and April 1933.

200
150
100
50

o
~-"'<-;,~iP@~*_~r..<-;,rj;:>
~ ~ ~ ~ ~ ~ ~

~

~ ~

SOURCE: Federal Reserve Bank of Cleveland.

that banks adjust their portfolios to
meet average reserve requirements
every two weeks. This only makes sense
if one wants to force the economy to
adjust to a fixed path for Ml, no matter
what the cost. Such an arrangement is
not likely to be optimal, however, if we
view the money stock as a buffer to
help lower transactions and other marketing costs associated with mismatched income and commodity flows.
Setting a constant growth rule for
the monetary base under current regulations could lead to highly volatile
interest rates. To avoid sharp swings
in interest rates, the Federal Reserve
would have to monitor constantly the
demand for reserves and attempt to
counter shifts in this demand with
offsetting changes in the supply of
reserves. The discount window provides another safety valve that supplies
reserves whenever there is an unexpected increase in demand. Current
reserve requirement regulations would
have to be changed before the Federal
Reserve could make operational a rule
for the monetary base.?
When asked to make monetary policy
recommendations based on our current
regulations, monetarists have
responded by recommending that the
Federal Reserve adopt a constant

7. There have been proposals for reserve
requirement reforms that would make a monetary base target operational. For two examples,
see the proposal for an expanded reserve carryforward system in William Poole, "The Making
of Monetary Policy: Description and Analysis,"

When interest rates rise, people economize on non-interest-bearing currency
and on checking balances, and then velocity rises. When interest rates fall,
people are more willing to leave funds
idle as cash balances, and velocity falls.
Of course, interest rates change every
day, but firms and households do not
adjust their money balances to every
short-run change in interest rates. It
takes time and resources to rearrange
our monetary affairs. Therefore, the
adjustments will be made when it is
convenient, or when there is a significant change in the level of interest
rates that people expect to be permanent.
We have also seen a rise in velocity
(decline in the demand for money) with
the advance of technology and innovations in the banking industry. For
example, households use credit cards
for transactions, reducing average balances that are kept in checking accounts. Firms have developed a wide
array of cash management techniques.'
The technological innovations were
partly spurred by rising interest rates;
when interest rates fall, some of these
cash management methods will become
uneconomical, but others, with lower
marginal costs, will remain.

The Velocity Breakdown
in the 1980s
During the 1970s, many came to believe that these other factors (interest
rates and innovations in cash management) didn't matter too much for the
purpose of choosing the Ml target.
While velocity growth was quite variable from quarter to quarter, these fluctuations were largely offsetting. Over
periods of a year or two, Ml velocity
usually seemed to grow at its trend rate
of 3 percent, regardless of what happened in the short run to interest rates
and advances in cash management.
Indeed, one of the debates among economists was whether the Federal
Reserve's monetary targets should take
account of changes in interest rates
and other factors affecting money
demand. Monetarists said no, claiming
that while interest rates mattered in
theory, they did not seem to matter
much in practice. A look at velocity and
interest rates in the period from 1950 to

3. See Milton Friedman, "The Quantity Theory
of Money - A Restatement," in Studies in the
Quantity Theory of Money, University of Chicago
Press, 1956, pp. 3-21. While Friedman advocated
alternative measures of money (M2 in his early
work and, n:ore recently, the monetary base), we

Chart 2 Velocity of M1 and
the Commercial Paper Rate,
1895-1985
Percent

16

Percent
8

14
12
10
8

6
4
2

Chart 3 M1 Velocity Growth,
1895-1985
Percent change. annual rate

15r-----,-------------------,
11.90

10
5
0
.5
·10
·15

~#

~
SOURCE: Federal Reserve Bank of Cleveland.

1980 seems to confirm the monetarist
position (See chart 1).
Velocity rose in a smooth fashion
from 2.52 in 1950 to 7.11 in 1981. The
interest rate shown in chart 1 is the
short term (4-6 month) commercial
paper rate. This interest rate rose from
1.45 in 1950 to 14.76 in 1981; however,
its rise was not smooth. While the
trends in both velocity and interest
rates were rising, there does not appear
to be much quarter-to-quarter or yearto-year co-movement between these
variables. Consequently, there did not
seem to be much reason to make the
monetary targets conditional on the
outcome for interest rates. Furthermore, given the relation between velocity and interest rates from 1950 to
1981, one would not have predicted an
abrupt decline in velocity, even knowing the actual outcome for interest
rates in the early 1980s.
The smooth rise in velocity occurred
during a period with steadily rising
trends in inflation and interest rates. Federal Reserve System Regulation Q prohibited banks from paying interest rates
on checking deposits, and the rising interest rates on alternative assets reflected
rising opportunity costs to depositors.
Had banks been allowed from the beginning to pay interest on checking
deposits, we might not have seen such
a runoff of deposits and such a rapid
rise in velocity. But banks were not

use the term money to refer to balances held
primarily to conduct transactions. This corresponds to the definition of money known as Ml.
M1 includes currency, travelers' checks, demand
deposits, and other checkable deposits such as
NOW accounts and credit-union share drafts. For
a more precise definition, see any recent issue of
the Federal Reserve Bulletin, page A3.

"

~
~

SOURCE: Federal Reserve Bank of Cleveland.

allowed to pay interest on checking
until 1981. The effective deregulation
of interest-rate ceilings on demand deposits by regulatory approval of nationwide NOW and Super-NOW accounts
was therefore an important factor in
changing the velocity trend. The
deregulation effect has worked to lower
velocity, as has the perceived permanent decline in interest rates. Deregulation also has confounded attempts to
quantify the effect that falling interest
rates are having on the velocity trend.
This departure from the 3 percent
growth trend, illustrated in chart 1,
represents the apparent breakdown in
Ml velocity that is the source of the
current disaffection with the Ml
target. As stated earlier, this appearance of breakdown results from a
myopic view of history that includes
only the period after World War II.
However, when we take a longer
view, we see that this latest decline in
velocity is not atypical; rather, it is
consistent with a long-standing relationship between Ml, GNP, and interest rates (See chart 2). While transitory
changes in interest rates did not seem tc
be closely related to Ml velocity, it
appears that changes in the trend of
interest rates have been associated
with changes in the trend of velocity.
When the trend in the interest rate
was flat, from 1895 to 1929, the trend

4. For a detailed description, see John B. Carlson,
"Methods of Cash Management," Economic
Commentary, Federal Reserve Bank of Cleveland,
April 5, 1982.
5. Friedman recommends a 4 percent constant
money growth rule in Chapter 4 of Milton Fried-

in Ml velocity was flat. When interest
rates fell, velocity fell. After World War
II, rates began to rise - approximately
doubling every decade to 1980 - and ve
locity also rose. If the decline in interest
rates since 1982 is regarded as a perrna
nent decline, then it should be associated
with a decline in the velocity trend.
From this perspective, what seems
unusual is not the experience of the
1980s, but rather the apparent stability
of velocity from 1950 to 1980. It is
likely that this relative stability was
made possible by a combination of two
atypical circumstances. The first was
the accelerating inflation and rising
interest rates of the period. The other
was the prohibition against paying
interest on deposits. These two circumstances, which combined to produce the
steady rise in velocity, were both eliminated in the early 1980s.
Not only was there a change in the
growth trend of Ml velocity in the
1980s, but there was also an increase in
the variability as measured by changes
in the level. This measure of the variability in Ml velocity is shown in chart
3, which illustrates annual percent
changes in Ml velocity from 1895 to
1985. Once again, we see that the different pattern for Ml velocity in the
1980s is not so different if we take a
longer historical perspective. The variability in recent years pales in comparison to the variability in the period
before World War II.
It is likely that the data for this early
period are of low quality. But these are
data that Milton Friedman collected
and studied as he developed the monetarist rule of constant money growth.t
Using these data, Friedman concluded
that the short-run (quarter-to-quarter
or year-to-year) relationship between
money and the economy was so unpredictable that monetary policy could not
be used to fine-tune the path for nominal GNP. He also went to some lengths
to argue that the major episodes of
instability in velocity were due to a
failure to maintain stable growth in the
money supply."
Friedman argued that the social costs
of having the economy adjust to money
demand disturbances would be less than
the social costs of having the economy
adjust to the uncertain environment as-

man, A Program for Monetary Stability, Fordham
University Press, 1959.
6. See Milton Friedman and Anna J Schwartz, A
Monetary History of the United States: 1867·1960,
Princeton University Press, 1963. For example, in

socia ted with discretionary monetary
policy. While one cannot prove or disprove the proposition that money demand would be stable if money supply
were stable, the proposition is a fundamental assumption leading to the
call for a constant money growth rule.

Chart 4 Wholesale Price Index,
1895-1985
1967=100
350r-----------------------~
300
250

A Monetarist Critique
of Recent Experience
When we take the longer perspective,
we see that it was a mistake to expect
so much of Ml in the first place. The
monetarist philosophy, which forms
the intellectual basis for monetary targeting, was developed with this longer
perspective in mind. The most basic
tenet of the monetarist philosophy is
that the economy will function most
efficiently if government institutions
and policies are structured to permit
market forces to operate with as little
day-to-day interference from government as possible.
Monetarists think that if monetary
institutions are properly structured the
economy is inherently stable, and will
tend toward full employment even
when buffeted by outside shocks such
as weather and changes in population,
technology, or tastes. Consequently,
monetarists tend to attribute long periods of slow growth and periods of large
economic fluctuations to inefficient
government institutions or to inappropriate policy actions.
Given efficient and stabilizing institutions, monetarists conclude that the
best that the monetary authority can do
is to supply the monetary base at a constant growth rate. The monetary base
is government-supplied money. This
would be expected to lead to fairly stable and predictable growth rates for different types of bank deposits, for nominal GNP, and for the overall price level.
As a practical matter, our monetary
control institutions are not well-suited
for setting a constant growth rule for
the supply of base money. For example,
money demand is quite unpredictable in
the very short run, say within the period
of one month. Yet current rules require

Chapter 7, Friedman and Schwartz attribute the
steep decline in velocity to the severity of the
depression which, they contend, was due to the
35 percent decline in the stock of money between
August 1929 and April 1933.

200
150
100
50

o
~-"'<-;,~iP@~*_~r..<-;,rj;:>
~ ~ ~ ~ ~ ~ ~

~

~ ~

SOURCE: Federal Reserve Bank of Cleveland.

that banks adjust their portfolios to
meet average reserve requirements
every two weeks. This only makes sense
if one wants to force the economy to
adjust to a fixed path for Ml, no matter
what the cost. Such an arrangement is
not likely to be optimal, however, if we
view the money stock as a buffer to
help lower transactions and other marketing costs associated with mismatched income and commodity flows.
Setting a constant growth rule for
the monetary base under current regulations could lead to highly volatile
interest rates. To avoid sharp swings
in interest rates, the Federal Reserve
would have to monitor constantly the
demand for reserves and attempt to
counter shifts in this demand with
offsetting changes in the supply of
reserves. The discount window provides another safety valve that supplies
reserves whenever there is an unexpected increase in demand. Current
reserve requirement regulations would
have to be changed before the Federal
Reserve could make operational a rule
for the monetary base.?
When asked to make monetary policy
recommendations based on our current
regulations, monetarists have
responded by recommending that the
Federal Reserve adopt a constant

7. There have been proposals for reserve
requirement reforms that would make a monetary base target operational. For two examples,
see the proposal for an expanded reserve carryforward system in William Poole, "The Making
of Monetary Policy: Description and Analysis,"

money growth rule for one or another
of the monetary aggregates, with most
choosing Ml. The targeting of Ml is
based on the constraint imposed by
current regulations, as well as on theoretical and empirical considerations.
Ml is defined to include assets that are
mainly held for transaction purposes.
The theory of the transactions demand
for money is more highly developed
than theories of the demand for money
in its other uses, such as a store of
value or a unit of account. Furthermore, empirical studies done both
inside and outside the Federal Reserve
prior to the 1980s showed that the
demand for Ml was more predictably
related to movements in interest rates
and economic activity than were the
broader aggregates. As shown above,
these "predictable" relationships have
not survived in the 1980s.
The monetarist policy prescription became more and more popular as inflation
accelerated and as more experience suggested that Ml velocity was stable and
predictable. Monetarism became associated with the notion that short-run
changes in money were closely and systematically related to short-run changes
in GNP and that velocity would continue to grow 3 percent a year, no matter what the Federal Reserve did.
When that short-run relationship
disappeared, monetarism naturally lost
popularity among economists and policymakers, who viewed monetarism as a
justification for fine-tuning nominal

GNP growth. However, this emphasis
on the short-run relationship between
money and economic activity is not
fundamental to the basic monetarist
principles that bear on the efficient
conduct of monetary policy.
While monetarism means different
things to different people, most monetarists agree that the framework for
monetary policy should be structured
so as to create the optimal environment
for economic growth and efficient allocation of resources." Further, monetarists agree that, in such a framework,
policy actions should be predictable and
should be expected to produce a stable
price environment. Monetarists think
that attempts to use discretionary
changes in the money growth rates in
order to smooth the business cycle or to
promote higher employment will either
destabilize the economy or lead to inflation or both.
In the Full Employment Act of 1946,
Congress gave the federal government
(and indirectly, the Federal Reserve)
the responsibility to " ... use' all practicable means ... to promote maximum employment, production, and purchasing
power." While much of the willingness
to tolerate accelerating inflation can be
traced to legitimate concerns about production and employment, new advances
in macroeconomic theory support the
monetarist contention that there is no
long-run tradeoff between inflation and
these real variables." In this regard,
the monetarists have an important message for policymakers when they argue

Conclusion
The recent instability of Ml velocity is
due to forces that were set in motion by
economic policies of the past. Attempts
to change important monetary or bank
regulatory policy are likely to lead to a
temporary period of instability in velocity. Even when this period of transition
is over, we should expect Ml velocity to
be more variable in a regime of stable
prices (or stable inflation) and deregulation of deposit interest rate ceilings
than it was during the period of accelerating inflation. To conduct policy
efficiently in such an environment, it is
important to develop institutions that
allow the Federal Reserve to commit to
long-run price stability. At the same
time it must retain the short-run flexibility to respond to technological
advances and other shocks to the structure of financial markets.

New England Economic Review, Marchi April
1975, pp. 21·30, and the proposal to stagger
reserve maintenance periods among groups of
banks in Albert H. Cox, Jr. and Ralph F. Leach,
"Defensive Open Market Operations and the

Reserve Settlement Periods of Member Banks,"
Journal 0/ Finance, vo1.19 (March 1964), pp.76-93.

The Structure 0/ Monetarism, W. W. Norton &
Co., 1978, pp. 1-46.

8. For a discussion of what is meant by the term
monetarism, see William Poole, Money and the
Economy: A Monetarist View, Addison-Wesley
Publishing Co., 1978, pp. 1-4, or Thomas Mayer,

9. For a discussion of these issues see James G.
Hoehn, "Monetary Policy Debates Reflect Theoretical Issues," Economic Commentary, Federal
Reserve Bank of Cleveland, May 1, 1986.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

that the way to provide the best environment for long-run economic growth
is to provide a stable price level.
In retrospect, attempts to use active
stabilization policy have been associated with accelerating inflation.
Chart 4 shows the wholesale price index from 1895 to the present. The period from 1895 (actually, the same holds
true from the end of the eighteenth
century) to World War II was one of
relative price stability. The price level
rose and fell about at an average that
was last seen approximately in 1940.

BULK RATE
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Permit No. 385

Federal Reserve Bank of Cleveland

[SSN 0428-1276

ECONOMIC
COMMENTARY
The Federal Reserve has once again
decreased emphasis on the Ml target as
a guide for short-run policy actions. In
the first half of 1986, Ml growth averaged 11.8 percent, while nominal gross
national product (GNP) growth averaged only 4.6 percent and inflation continued to be lower than expected. Policymakers and economists, including
leading monetarists, argue that Ml is
no longer an appropriate short-run
guide for monetary policy.'
This Economic Commentary discusses
the apparent breakdown in the relationship between Ml and economic activity. The first part of this essay makes a
claim that is quite simple, although
perhaps controversial; namely, that the
breakdown of the relationship between
Ml and nominal GNP is only apparent.
The illusion of stability between Ml
and nominal GNP that prevailed after
World War II resulted from the accelerating inflation and interest rate regulations that uniquely characterized that
period. Such stability should not be
considered to be the norm.
In fact, as the first part of this essay
shows, the recent variability of Ml velocity, while large in comparison to our
experience after World War II, is still
small relative to our experience before
that war. The monetarist call for a constant money growth rule followed an extensive study of this prewar experience,
and was not based on the postwar stability of Ml velocity. The second part of
this essay presents a monetarist critique of recent experience.
Historical Perspective
To understand the challenge for monetary policy, it helps to take a long historical perspective. We live in a unique
time. For the four thousand years before

Material may be reprinted provided that the
source is credited. Please send copies of reprinted
materials to the editor.

Address Correction Requested: Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

October 1, 1986

William T. Gavin is an economic advisor at the
Federal Reserve Bank 0/ Cleveland.
The views stated herein are those 0/ the author
and not necessarily those 0/ the Federal Reserve
Bank 0/ Cleveland or 0/ the Board 0/ Governors 0/
the Federal Reserve System.

Chart 1 Velocity of Ml and
the Commercial Paper Rate,
1950-1985
Percent

16r-------------------------,
14
12

10
8
6

4L_~rr'v'
2

1950 1955 1960 1965 1970 1975 1980 1985
SOURCE: Board of Governors of the Federal
Reserve System.

the 1900s, monetary systems were based
on commodity standards, usually metals. There h'ave been paper money systems in the past (the first recorded
instance of state-issued paper money occurred in China in the ninth century),
but they always degenerated with high
inflation and consequently disappeared.s
While metallic standards were often
suspended during wars and national
emergencies, they were usually reinstated soon after the emergency ended.
The United States adopted a modified gold standard in the Bretton Woods
Agreement after World War II. The dollar remained tied to gold until the late
1960s or early 1970s. Officially, the dollar was freed from gold when President
Nixon suspended convertibility for
other central banks on August 15, 1971.
But, effectively, the dollar had already
been freed from a gold constraint in
1968 when Congress removed the "gold
1. One notable exception was the late Michael].
Hamburger (Wall Street Journal, July 8, 1986, p.
30) who argued that his money-demand equation,
specified two decades ago, continued to explain
the relationship between Ml and nominal GNP.
Note, however, that he implicitly recommended a

Monetarism and
the Ml Target
by William T. Gavin

cover" linking currency issue to the
government's gold stock.
The problem for the Federal Reserve,
both then and now, is how to maintain
price stability in a monetary system
with unbacked paper money; no society
has ever succeeded in doing so. Contrary to the suggestions offered in textbooks and treatises by monetary reformers, experience shows that it is no
easy matter to stabilize the price level
with a paper money system.
The monetarist solution to this problem is to protect the value of money by
limiting its quantity. The intellectual
foundation for this solution is the
Quantity Theory of Money. As reformulated by Milton Friedman (Studies
in the Quantity Theory of Money, 1956),
it is essentially a theory of money
demand, that is, a theory about why
people want to hold money balances."
The most important factor determining the demand for Ml is the level of
transactions. It is common practice to
use nominal GNP as an approximate
measure of transactions because aggregate transactions data are not available.
Over a relatively short period (say three
months to a year), quantity theorists
expect the demand for money to rise or
fall in a predictable fashion with a rise
or fall in GNP. The ratio of nominal
GNP to the amount of money is termed
the velocity of money, in reference to
the turnover per year, or the velocity of
circulation, of money.
Of course, velocity is not a constant.
There are seasonal and other variable
factors affecting money demand and
there is error in measuring income and
money. Of the nonseasonal factors, the
most important are probably interest
rates and technological innovations affecting the efficiency of the payments system.
procedure based on a constant growth rule for
nominal GNP, not a constant growth rule for M1.
2. See Elgin Groseclose, Money and Man, Frederick Ungar Publishing Co., 1961, p. 118, or Rupert
]. Ederer, The Evolution 0/ Money, Public Affairs
Press, 1964, p. 91.