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December 9, 1977

The Debate:Keynesians
In a recent article in the Christian Science Monitor, David Francis summarized the current debate over
rnonetary policy:
again, as in the
1960's, there is a debate between two
schools of economists known as
'monetarists' and 'neo-Keynesians.'
The monetarists believe that strict control of the nation's money supply is
the best means for achieving a steady
growth pattern in the economy. The
neo-Keynesians hold that monetary officials must pay more attention to interest rates than changes in money
supply when setting credit policy. But
the scope of the debate is even
broader than Francis indicates, extending beyond disagreement over
how policy should be set to differing
views on where the economy is now
and where it should be heading.

Recent statistics provide conflicting
evidence on the state of the economy. Real GNP grew at a 4.7 percent annual rate in the third quarter, down
sharply from the first half's average
rate of 7.0 percent. Does this
slowdown portend the end of the recovery, or is it merely a healthy reaction to the earlier unsustainably high
growth? Inflation, as measured by the
GNP deflator, declined to a 5.0 percent
rate in the third quarter (from 7.0
percent in the previous quarter). However, most published forecasts suggest that the underlying inflation rate is
around 6 percent, which is clearly disturbing. Similarly, the overall unemployment rate continues to hover
near an unacceptably high 7 percent.

should they be more concerned about
the danger of a new recession or
about the danger of continuing high inflation? This dilemma is compounded
by the apparent change in some of the
economic relationships - involving
the money supply, and interest
rates - which are crucial to the formulation of monetary policy. Since the
start of 1976, the broadly-defined
money supply (M2) - which consists of
currency plus commercial-bank and
time deposits (except large negotiable
time certificates) - has been growing
at a 10.7 percent average rate. That
rate is high by historical standards.
Over the last six months, the narrowlydefined money supply (M1) - consisting only of currency and demand deposits - has also been expanding at a
rapid (9.2-percent) rate. On the basis
of past experience, one would expect
such strong monetary stimulus to lead
to a booming economy. Yet the most
recent GNP figures, although above
the long-term trend, are relatively low
in the context of the unused resources
remaining in the economy.
The ratio of GNP to the money supply - called the "velocityN of money measures the rate of turnover of money. In past businesscycles, increases in •
velocity in the early stages of the recovery have usually been associated
with rising interest rates. In 1975 and
1976, however, the velocity of M 1
grew rapidly while interest rates generally declined. In the last six months, the
situation has changed, with velocity
growing slowly and short-term interest rates rising rapidly.

Policy dilemma
Taken together, these statistics pose a
dilemma for monetary policy makers:

In this letter, we present the Keynesian
view on how to interpret the recent
(continued on page 2)

Opinions expressed in this newsletter do not
necessarily reflect the views of the management of the
Federal Reserve Bank of San Francisco, nor of the Board
of Governors of the Federal Reserve System.

movements in GNP,the money supply, velocity, and interest rates. In the
next weekly letter, we will present the
monetarist view, along with an examination of how recent Fed policy has
attempted to forge a compromise between these two opposing positions.

The Keynesian position has been expressed in the majority report of the
Joint Economic Committee, The 1977
Midyear Review of the Economy, and
also in articles by Walter Heller, the
former chairman of the Council of Economic Advisers. Writing recently in
the Wall Street Journal Heller dec1ared:
the Open Market
Committee meets next Tuesday, it will
face a hard choice, implicitly if not explicitly, between money supply and interest rate targets. Mounting evidence
suggests that its choice will not have
much impact on inflation in a still slack
economy. But it could be the margin of
difference between a sustained and a
fading recovery in the year ahead. According to this view, the major risks
now are on the downside, judging
from the recent slowdown in real GNP
growth and the lack of signs of an impending investment boom. The
reason for this perceived softness is
the insufficient stimulus provided by
government policies - both fiscal and

Keynesians note in particular, that
short-term interest rates have risen almost two percentage points since last
spring. They interpret that rise as
prima facie evidence of a tight monetary policy. So far, the rise in shortterm rates has had very little impact on

long-term rates, which have remained
near their levels of six months ago. But
the Keynesian fear is that any further
rise in rates at the short end of the maturity spectrum would be transmitted
to the long end as well. Should longterm rates rise significantly, the already none-too-strong investment sector would be hurt.
Keynesians do not ignore the growth
of the money supply in their discussions of monetary policy. However, in
judging the adequacy of money
growth, they tend to focus on the real
(i.e., inflation-adjusted) money supply.
Thus, the Joint Economic Committee
staff report concluded that monetary
policy had been extremely tight over
the last five years, on the basis of a decline in the real money supply over that
period. Even over the last twelve
months, the real money supply grew
less than 1 percent despite a rapid 7percent rate of actual M1 growth. In
the words of one Keynesian, Albert
Sommers of the Conference Board,
the inflation has "'devoured Iiquidity.
The business recovery has been relativelystrong until now, despite "'tight
money, because of a rapid increase in
the velocity of money. In other words,
a given stock of money is now consistent with a much higher level of GNP
than it used to be. Most analysts, whatever their persuasion, agree that velocity has increased because of various
innovations in financial technology
and institutions, which have enabled
households and corporations to conserve on their holdings of cash balances. (Examplesinclude telephonic
transfers of funds, computerized cash

management, N OW accounts, and
money-market mutual funds.) Keynesians believe that the economy has
now adjusted to these innovations,
and that the rapid increases in velocity
of the recent past will not be repeated.
The velocity of M1 continued to increase, but only slightly, during the
third quarter, as M1 grew at a 9.3percent rate while nominal GNP grew
at a 10.0-percent rate. When interest
rates rise as they did last quarter, one
would expect to see velocity increase
more,since higher interest rates induce
people to hold less of their wealth in
the form of M 1, which bears no explicit
interest. Keynesians believe that the
modest rise in velocity in the face of
the steep climb in interest rates implies
a possble increase in the demand for
money. Thus, they don't view the rapid growth in the (nominal) money supply as inflationary: the Fed is not
pushing out excess money to chase
after too few goods and worsen inflation, but is merely meeting the desires
of the public to hold more assets in
the form of M1 .
Keynesians maintain that money
growth could even be increased considerably with little danger of increased inflation. Their argument turns
on the existence of substantial slack in
labor markets and a still-comfortable
amount of excess capacity in the nation's factories. They estimate that the
gap between actual and
GNP may be as high as $100 billion. As
long as actual GNP is so far below potential, the reasoning goes, stimulative
policies will result mainly in increased
real output, not in more inflation.

Keynesian prescription
This Keynesian analysis leads to a forthright policy prescription: monetary
policy should become more stimulative in order to fight unemployment,
especially since this can be done without worsening inflation. The growth
of the money supply at rates well
above the Fed's long-run specified
growth ranges can safely be ignored.
In particular, interest rates should not
be allowed to rise further as a means of
bringing money growth back to its
specified range.
The Keynesians claim that attempts to
fight inflation by reducing money
growth are doomed to failure. The
price increases due to the excess-demand pressures of 1972-73 and to external shocks (such as the OPEC price
hike) have now worked their way
through the system, leaving the economy with its present hard-core (6
percent?) rate of inflation. Various
features of modern industrial economies - concentrated industries, labor unions, Federallymandated price floors, wage escalators - make it almost impossible for
monetary policy to deal with this inflation. A reduction in money growth
would lead to a reduction in real output - i.e., a recession - but would not
stop prices from rising. Or, at least, the
public would not tolerate the type of
prolonged recession necessary to
achieve this price goal. Instead, monetary policy should be used to sustain
real output by insuring adequate
stimulus to investment, while other
measures could be devised to remove
or ameliorate the structural features
causing inflation.
Kenneth Froewis§


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(Dollar amounts in millions)
Selected Assets and liabilities
large Commercial Banks

Loans (gross, adjusted) and investments*
Loans (gross, adjusted)-total
Security loans
Commercial and industrial
Real estate
Consumer instalment
U.s. Treasury securities
Other securities
Deposits (less cash items)-total*
Demand deposits (adjusted)
U.s. Government deposits
Time deposits-total*
Statesand political subdivisions
Other time depositst
Large negotiable CD's
Weekly Averages
of Daily Figures
Member Bank Reserve Position
ExcessReserves( )/Deficiency (-)
Net free(+)/Net borrowed (-)
Federal Funds-Seven large Banks
Interbank Federal fund transactions
Net purchases(+)/Net sales(-)
Transactionswith U.s. security dealers
Net loans (+)/Net borrowings (-)






- 2,716
- 2,653
- 2,361
+ 138
- 103
- 1,149
- 1,138
+ 445
+ 232
+ 362'

Week ended

Change from
year ago
+ 12,472
+ 10,890
+ 520
+ 1,921
+ 5,484
+ 2,099
+ 1,536
+ 10,324
+ 2,932
+ 7,491
+ 2,361
+ 3,979
+ 2,629

Week ended




+ 1,455








• Comparable
year-ago period







*lncludes items not shown separately. tlndividuals, partnerships and corporations.
Editorial comments may be addressed to the editor (William Burke) or to the author, . .•
Information on this and other publications can be obtained by calling or writing the Public Information
Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184.