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THE FED’S ANTI-INFLATIONARY STRATEGY:
IS IT ADEQUATE?
Addrexs by
Robert P. Blbck
President, Federal Resewe Bank of Richmond
to the
National Rrsociation BusinessEconomists
of
San Francisco Bay Chapter
June 18, 1987

It’s a pleasure to be with you this afternoon to
discuss some of the longer-run issues the Fed is
confronting in conducting monetary policy. I am
particularly happy to have the opportunity to appear
before a group of economists who are actively engaged in business and commerce. The monetary
policy decisions we make at the Fed have important
effects on all business firms-industrial and other nonfinancial companies as well as financial institutions.
Consequently,
it is important that executives and
managers in all sectors of the economy be at least
generally familiar with the principal continuing issues
and problems with which the Fed is grappling.
This is, of course, a particularly interesting period
in our nation’s recent economic history. On the one
side, we continue to face a number of serious
economic difficulties. The federal budget deficit, the
trade deficit, and the international debt problem are
perhaps the most obvious of these, but there are
several others as we are all aware. At the same time,
I think most people would agree that we’ve made
considerable progress on a number of economic fronts
since the tumultuous early years of this decade. We
are now midway through the fifth year of the current business upswing, which is well beyond the
average length of postwar expansions. Approximately
14 million new jobs have been added to the employment rolls during this period, and the unemployment
rate has declined 4.8 percentage points from its
recession high of 10.8 percent to its present level
of 6.0 percent. Further, after peaking somewhere in
the neighborhood of 10 percent in 1980 and 198 1,
the underlying trend rate of inflation has declined to
about 4 percent.
Inflation as a Problem
I would like to focus particularly on inflation today, because I believe that the System has a special

responsibility regarding the national goal of extending and then maintaining the recent progress against
inflation. It is now almost universally agreed among
economists that monetary policy has a substantial
effect on the inflation rate over time, although there
is still some disagreement over the significance of
other factors. Moreover, many economists, including
this one, believe that the inflation rate is the only
economic variable the Fed or any other central bank
can influence systematically over the long run and
would therefore argue that price stability should be
the preeminent goal of monetary policy.
Before we congratulate ourselves too vigorously
about our success on the inflation front, let me make
two points to help put this progress in perspective.
First, even though the current underlying inflation
of about 4 percent is certainly an improvement over
the much higher rates of a few years ago, it is not
a particularly admirable performance when judged
against longer-run standards. Most of you probably
recall that the Nixon Administration imposed a comprehensive wage and price freeze on the country back
in 1971 when the inflation rate was actually a little
less than 4 percent.
Second, and perhaps more importantly, there is
no particular reason to expect this progress to
continue automatically. Not too many months ago,
it was not uncommon to hear some of the more
optimistic in our midst proclaim that inflation had
been conquered and was dead. It was as though the
high inflation of the late seventies and early eighties
had been some sort of exotic disease that had been
eradicated by a new wonder drug. But clearly there
is no good reason to believe that anything like this
has happened. It doesn’t matter whether one believes
that inflation is caused by excessive growth in the
money supply, or rising oil prices, or high labor
costs, or whatever: there has been no fundamental

FEDERAL RESERVE BANK OF RICHMOND

3

institutional change in our economy that would
guarantee that inflation won’t accelerate again. For
example, if one believes that rapid money growth
causes inflation, there has been no really basic institutional change in the monetary regime, such as
a return to the gold standard or the adoption of some
kind of Constitutional amendment, that might reduce
the probability of sustained excessive monetary
growth in some definitive way.
Some of the earlier apparent lack of concern about
inflation has been replaced more recently with a
rather sharp revival of concern, as evidenced by
rising inflationary expectations in financial markets

“

this question of whether the Zonger-mn
strategy of monetary poZicyshodd be
discretionary . . . or based on a de of
sonzekind is without any doubt the most
important standing issue in the #et2 of
monetary poZicy t0d&
”
. * .

and corresponding increases in long-term interest
rates. Some observers think these worries do not
reflect a true increase in the underlying rate of
inflation and are instead a premature reaction to the
recent upswing in oil prices and the short-run effects
of the depreciation of the dollar. This may be right,
but, quite frankly, I was happy to see this evidence
that the earlier “inflation is dead” mentality is on the
wane.
If I am right in my assessment that inflation is still
a problem, what does this continuing risk of inflation imply? Well, obviously it means that we need
to take whatever preventive steps are necessary to
keep inflation under control. The correct steps to
take, in turn, depend on what factors are most
likely to cause another round of high inflation. Let
me confess right up front that I’m one of those
people who believes that the evidence supports
Milton Friedman’s famous dictum that inflation is
always and everywhere a monetary phenomenon.
Consequently,
I think the most effective thing we
can do to reduce the risk of inflation is to take a hard
look at the present strategy of Fed monetary policy
and determine what we can do to improve it and,
if necessary, repair it. Against this background, I’11
focus the remainder of my comments on our strategy

4

at the Fed. I’ll begin with a brief description of the
strategy. Then I’ll make a few comments about things
I personally believe might be done to make it more
effective. I should emphasize that the views I’ll
express are my own and don’t necessarily reflect the
views of anyone else in the Fed.
Federal Reserve Operating Strategy
Let me begin with just a quick overview of the
current strategy, which has been in place in one form
or another since the mid-1970s. The essence of the
strategy is that we try to control the growth of
certain monetary aggregates over time in order to
hold inflation in check and create the kind of stable
monetary and financial environment that is conducive
to high employment
and steady growth in real
economic production. As you know, the Federal
Open Market Committee sets annual target ranges
for the growth of several monetary aggregates-the
familiar “M’s” that get widespread attention in the
financial media. The Committee establishes these
ranges each year at its meeting in February for the
year ahead. It then reevaluates the ranges at its
meeting in July and makes any adjustments that
appear appropriate in the light of events during the
first half of the year. During the course of the year,
the Committee seeks generally to hold the growth
of the aggregates within their respective ranges,
although the firmness of the Committee’s efforts to
achieve this objective may be affected by emerging
developments in other areas of the economy. Because
the Committee has no means of controlling the
aggregates directly, it does so indirectly using
certain short-run operating “instruments.” These
instruments change from time to time, but they are
all indicators of the relative ease or stringency with
which the Fed is supplying reserves to depository
institutions. Under the present procedure, which has
been in place since the fall of 1982, the operating
instrument has been the aggregate level of seasonal
and adjustment borrowing at the discount window.
The Committee sets a short-run objective for this
instrument at each of its regular meetings, which are
held at five- to six-week intervals.
That’s a quick overview of the strategy. Now let
me make three important points about the strategy,
and then I’ll go into a little more detail on each point
in turn. The first point is that this procedure belongs
to a particular class of strategies referred to as
“intermediate target” strategies. In these strategies,
as the name implies, the Fed does not set specific
quantitative objectives for the final goal variables of
economic policy, such as the rate of growth of real
GNP, the price level, and the unemployment rate.

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

Instead, targets are set for variables that occupy an
intermediate position between these goal variables
and those we can control directly, such as the Federal
funds rate or the rate of growth of reserves of
depository institutions. The monetary aggregates the
Fed currently targets are intermediate variables in
this sense. We can’t control them directly and precisely, nor are they final goal variables of monetary
policy. I consider the use of monetary aggregates as
intermediate targets especially appropriate because
it is well established that there is a close relationship between the rate of growth of the money
supply and the rate of inflation over the longer haul.
Rapid money growth, in particular, leads to high
inflation, while moderate
growth is generally
associated with low inflation.
The second point about the strategy is that we’ve
been having some technical problems with it in
recent years. The predictability of the statistical relationship between the key monetary aggregate known
as Ml, on the one side, and the growth of current
dollar (or “nominal”) GNP and the rate of inflation,
on the other, has diminished significantly.’ In any
case, very rapid growth in M 1 in both the 1982-83
period and more recently in 198.5 and 1986 has not
been followed-at least not yet-by the usual lagged
rise in the rate of inflation. The reduced predictability
of this relationship prompted the Fed to drop the
Ml target in 1987, but I believe that this decision,
even though it may be justified as a technical
matter, has weakened the strategy because the Ml
target has traditionally been one of the most important elements of the strategy.
The final point about the strategy is that it is and
for many years has been a discretionary strategy as
opposed to a strategy based on a rule, even though
at a superficial level it has some of the appearances
of a rule. It is discretionary in two senses. First, we
do not use any predetermined mechanical formula
in determining how to adjust the settings of our
instrument variables to deviations of the monetary
aggregates from their target ranges. Second, we do
not give exclusive weight to such deviations in determining our instrument settings. On the contrary, we
have taken into account the behavior of a number of
other financial and economic indicators, includingat one time or another-long-term
interest rates,
foreign exchange rates, conditions in labor markets,
and general business confidence. The relative weights
we give the monetary aggregates and these other
* Ml includes the public’s holdings of currency and coin,
demand deposits, and interest-bearing transactions deposits such
as NOW accounts.

indicators in making our short-run policy decisions
vary over time in an ad hoc, discretionary way.
Indeed, the degree of discretion used in conducting
policy is so great at present that a case could be made
that the monetary targeting procedure is now more
a broad framework than a true strategy.
Implementation of the Strategy
Let me now elaborate a little on each of the three
points I’ve just made.
Intemediate Target Strategies The first point was
that targeting monetary aggregates is one of a class
of intermediate target strategies. Some economists
have argued that intermediate target strategies are
inferior to other kinds of strategies because they
insert a redundant intermediate target variable between the instrument variables that the Fed controls
directly and the goal variables of policy in which we
are really interested. Why not simply set a target for
the unemployment
rate, say, and then use an
econometric
model to determine what level of
borrowed reserves is most likely to be compatible
with that objective?
There are obviously several problems with such
a strategy. At an operational level, the linkages between the Fed’s instruments and the goal variables
of policy are lengthy and complex. It is not at all clear
that these relationships could be captured by
econometric models accurately enough to make them
operationally useful. The relationships between the
instruments and the monetary aggregates, in contrast,
are simpler and more direct, and they have been
analyzed exhaustively over a long period of time.

“

there is no compeZZing
reason to
bedieve that the defeguZationof interest
rates and the othr &weZopments recent
of
years hawe niwde it pemanentdy and
genmaZZy
inzpracticaZ target monetary
to
aweiates. ”
. . .

More fundamentally, as I have already suggested,
many economists believe that the Fed cannot
systematically
influence real variables like the
unemployment rate and real GNP over time. Following this line of reasoning, the only goal variables
the Fed can influence systematically over time are
the price level and inflation. Building a strategy

FEDERAL RESERVE BANK OF RICHMOND

5

directly around the relationship between instrument
variables and the inflation rate is probably possible
in principle, and it may well be the best strategy
available in a period when institutional or other
changes have temporarily reduced the effectiveness
of other strategies. But such a strategy might be
difficult to implement permanently in practice, since
the lag between the time the Fed changes one of its
instrument settings and the time the move affects
the price level is long and variable. Viewed in this
light, the introduction of intermediate variables such
as the monetary aggregates has considerable appeal,
both from an operational standpoint and from the
standpoint of explaining the strategy to the public.
My personal feeling is that, as a practical matter, our
best option is to stick with some form of intermediate
target strategy.
Recent Technical Pd&ms in Targeting Apgates
This brings me to the second point I mentioned
above: the technical problems we’ve encountered
recently with our strategy of targeting monetary
aggregates. As I’ve already noted, the predictability
of the empirical relationship between (1) the growth
of Ml and (2) the growth of nominal GNP and
inflation has diminished significantly in the 1980s.
Another way of saying this is that the “velocity” of

“

important t/reoreetziZpapers
publ~s~~
by Robert Barn and David Gordon in
1983 . . . concZudedthat discretionary
strateghs are inherentdyinferior to those
based on m?es since they inevitably
pfi9h6-6 more infiation over time with no
compensating fzdkzion in 24nempZoyment.
”
. . .

Ml has been behaving unpredictably. The velocities
of the broader M2 and M3 aggregates have also been
more difficult to predict, although the deterioration
here has been less than in the case of Ml. Considerable research has been done within the Fed and
elsewhere to determine what has caused this problem. This research has not yet yielded definitive
results, but it has produced several plausible partial
answers. First, the removal of restrictions on the
interest ceilings on most classes of deposits is
believed to have increased, at least temporarily, the
responsiveness or “elasticity” of the public’s demand
for money balances to changes in short-term market
6

interest rates. Thus, movements in interest rates now
generate a proportionately greater change than earlier
in the demand for money. Such changes in money
demand affect the growth rates of the monetary
aggregates resulting from particular settings of the
Fed’s instrument variables. Further, M 1 now includes
a large proportion of interest-bearing accounts that
the holders probably use for saving and investment
as well as transactions purposes. Consequently, the
demand for Ml balances probably responds differently to changes in household wealth, interest rate
spreads, and other variables now than it did a few
years ago when Ml consisted primarily of currency
and non-interest-bearing
demand deposits and was
therefore a fairly undiluted measure of transactions
balances. Finally, the sharp and largely unanticipated
reduction in inflation in the early eighties may have
increased the public’s appetite for money balances,
in relation to its desire to hold other liquid assets,
since lower inflation erodes the real value of money
balances more slowly.
Any or all of these factors may explain at least in
part the change in the observed relationships between the growth of the monetary aggregates and
other economic variables. In any event, these
developments raise pressing questions regarding the
continued viability of our strategy of targeting the
aggregates, at least in its present form. We obviously need to know whether the reduced predictability of the relationships between the aggregates
we’ve been targeting and the economy is a temporary
phenomenon that is part of the transition to a less
regulated, less inflationary environment or a more
permanent development. The answer to this question just isn’t very clear yet. My personal guess, for
whatever it’s worth, is that the relationships will
become more predictable again after the transition
is further behind us. For example, the practices
banks and other depository institutions follow in
setting interest rates on interest-bearing transactions
deposits are likely to become more settled and
systematic in relation to movements in market rates
than they are at present, which would increase the
predictability of the reaction of the monetary aggregates to movements in market rates. In these circumstances, we should be able to continue focusing
on the traditional monetary aggregates, including Ml.
If I’m wrong, however, and the predictability of
some or all of these monetary relationships remains
low, we may have to make changes. This could
occur in several ways. As I’ve already suggested, the
reduced predictability of the relationship between

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

the narrow M 1 aggregate and the economy has been
especially troublesome. The decline in the predictability of relationships between the broader M2 and
M3 aggregates and the economy has been less
dramatic, presumably because some of the short-run
shifting of funds between different classes of deposits
and other liquid assets that affects the behavior of
Ml washes out in the case of the broader measures.
This is why the Fed has continued to target M2 and
M3 this year, even though we’ve dropped the Ml
target for the time being. If this situation continues,
we could simply drop Ml permanently and focus
henceforth on M2 and M3, although many of us
would be disappointed by such a step since both M2
and M3 are rather amorphous collections of assets
that lack the intuitive appeal of the less-cluttered M 1
measure and are likely more difficult to control.
If all three of the aggregates on which we’ve traditionally focused continue to give us trouble, we may
have to seek other alternatives. A number of possibilities exist. One is the monetary base, which is
loosely the sum of currency and coin outside
depository institutions and total reserves at the
Federal Reserve. Another is what is now called
Ml A-non-interest-bearing
demand deposits held by
the public plus currency and coin outside depository
institutions. MlA corresponds closely to what we
used to call M 1 before we redefined M 1 a few years
ago to include the interest-bearing
transactions
deposits that have become so popular in the 1980s.
The predictability of the velocity of MlA, like that
of the other aggregates, dropped sharply in 198 1 and
1982, which was the period in which the initial
deregulation of interest rate controls on transactions
deposits occurred. There is evidence, however, that
the velocity of M 1A, unlike the velocities of M 1, M2
and M3, has resumed a more normal and predictable
pattern. My personal feeling is that this evidence
suggests that we in the Fed should take a close look
at the possibility of establishing a formal target for
MlA.
The main point I want to make in this context,
however, is not that one particular aggregate is
better than another. The important point is that there
is no compelling reason to believe that the deregulation of interest rates and the other developments
of recent years have made it permanently and generally impractical to target monetary aggregates. The
close positive relationship between the growth of the
money supply and the rate of inflation over time is
one of the longest-standing and most reliable relationships in economics. I see no reason to believe
that this relationship has been destroyed in any permanent way by events in the 1980s. This implies

that even if M 1, M2 and M3, as they are currently
defined, have all been rendered less useful as
monetary targets, there is still some monetary
aggregate out there somewhere that we a&? be able
to rely on once the dust settles. What we have to
do is identify it, and I’m confident we have the means
to do that.
Th DismtihnaryNaturnof PO&y Let me turn now
to the third point I made earlier about our present
monetary policy strategy-its
highly discretionary
nature. This may surprise some of you mildly, since
there has been a lot of loose talk in the financial

“My own feehzg, however-, is that the
adoption of some fom of rude, with the
precofnnzitnzent mZe wOuza
a
entad, wouza
a0more to imprwe our strategy, enhance
our Credibilityas an infZation
fighter,
and maintain our recent progress against
infZationthan any other singZechange we
might make. ”

press in recent years about how the Fed has adopted
a “monetarist” approach to policy, which would involve, of course, emphasis on adhering to preestablished rules in conducting monetary policy.
Much of this comment has been inaccurate or at
least misleading. This is not the place to go into a
detailed technical review of the recent conduct of
monetary policy, but let me make a couple of quick
comments that I hope will help clarify the situation
in case any of you have been misled. All the talk
about the Fed “going monetarist” started in October
of 1979, when, in the face of rapidly accelerating
inflation,
rising inflation
expectations,
and
deteriorating conditions in both domestic and international financial markets, the Federal Open Market
Committee decided to change its operating procedures in order to improve its performance in controlling M 1 and the other monetary aggregates. The
basic change was to drop the Federal funds rate as
the principal operating instrument for controlling the
monetary aggregates and replace it with nonborrowed
reserves. There’s no doubt in my mind that the Committee made a more determined effort to control the
growth of the aggregates in late 1979 and in certain
periods during the early 1980s than it had earlier.

FEDERAL RESERVE BANK OF RICHMOND

7

Further, the new operating procedure using nonborrowed reserves had some features that at times permitted money market conditions to tighten in a
semiautomatic way in reaction to above-target growth
in the aggregates. But these changes did not by any
means amount to the adoption of a monetary policy
rule in the sense in which monetarists, or other
economists for that matter, use the term. Further,
the semiautomatic features of the nonborrowed
reserve operating procedures used between 1979 and
1982 are not present in the current operating regime,
which, as I pointed out earlier, uses the level of
seasonal and adjustment borrowing as the operating
instrument.
Conclusion
Now let me say as clearly as I can that this
question of whether the longer-run strategy of
monetary policy should be discretionary, in the sense
in which I defined the term earlier, or based on a
rule of some kind is without any doubt t/re most
important standing issue in the field of monetary
policy today. Fed monetary policy has been essentially discretionary ever since the famous Accord
between the Fed and the Treasury in 195 1. This
revealed preference for a discretionary strategy is easy
to understand. In reality the Fed is under continuous
pressure from the political establishment and other
quarters to take or not take particular actions, despite
the institutional safeguards designed to shield the Fed
from such pressures. In this kind of environment the
leadership of the Fed understandably finds useful the
flexibility afforded by a discretionary strategy.
The case for the adoption of a rule, however, is
growing stronger. A great deal of new research has
been done on this rather old topic in recent years,
and the results of a majority of these studies favor
a rule. In particular, important theoretical papers
published by Robert Barro and David Gordon in
1983, which built on earlier research by Finn Kydland
and Edward Prescott, concluded that discretionary
strategies are inherently inferior to those based on
rules since they inevitably produce more inflation over
time with no compensating reduction in unemployment. The general ideas underlying this result are,
first, that discretionary
policies affect the real
economy only to the extent that policymakers are
able to surprise the public-that
is, take actions that
the public doesn’t anticipate-and,
second, that the
ability to surprise the public dissipates over time.
Against this background, many economists believe
that the contribution the Fed can make to the
nation’s economic stability would be enhanced by the

8

adoption of a rule, and I’m inclined to agree with this
conclusion. Exactly what form such a rule should take
and how it should be institutionalized, of course, are
major practical issues that would have to be re:solved before any rule could be adopted, and I have
no quick and easy answers to these questions. I would
point out, however, that the best rule might not
necessarily be a constant money growth rule, which
is what discussions of a rule often bring to mind.
There are other kinds of rules, many of which
permit more activist responses to deviations of important economic variables from their desired paths.
For example, the rule might tell the Fed to adjust
the target ranges for the aggregates if the inflation
rate or some other important economic variable began
to go off track. Whatever the form of the rule, it
would be essential, of course, that it be built around
and derived from our overriding objective of controlling inflation.
Let me just say that I’ve been intrigued by the issue
of discretion versus rules in the conduct of monetary
policy for many years. My instinct has always been
that some kind of a rule would give us better results,
no matter how noble our intentions might be in
pursuing a discretionary approach, because of the
precommitment
a rule would involve and the
beneficial impact this precommitment
would have
on the credibility of our anti-inflationary strategy. I
don’t pretend to comprehend all of the technical
aspects of the recent research in this area, but I
understand enough of it to be impressed by it, and
what I do understand has reinforced my conviction
that the adoption of a rule would be beneficial. I
suspect the main problems in adopting and implementing a rule would not be technical but political.
A procedural change of this magnitude would require
at least the tacit support of a majority of the members
of Congress as well as the key people in the Executive
Branch. Getting this support would undoubtedly be
difficult because the adoption of a rule by the Fed
would almost certainly be seen as presenting political
risks. In this bicentennial year of the Constitution,
however, it is perhaps not yet unrealistic to believe,
as I do, that our nation is still capable of putting
institutional constraints on itself when they are clearly
in the public interest. And, as I’ve indicated, the
evidence is building that a monetary rule is in the
public interest. I can think of no other reform that
would do more to help us maintain the progress we’ve
made in reducing inflation over the last five years.

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

Summary
That’s all I wanted to say, so let me just briefly
review the main points I’ve tried to make. First, I
noted that the possibility of a revival of inflation is
still a major risk in the economy. I concluded that
this risk justifies a careful reevaluation of the strategy
of Fed monetary policy to determine how it might
be changed, if necessary, to ensure that it is an
effective anti-inflationary
weapon. Against this
background, I then went on to describe the present
strategy, and I discussed several of its important
aspects. First, I pointed out that the present strategy
is an intermediate targeting approach, and I expressed
support for this general set of procedures despite its
criticism by some economists. Second, I described
some of the technical problems we are currently experiencing with the monetary aggregates we have
been using as intermediate target variables, and I
discussed some alternative variables we might con-

sider substituting for these aggregates if this becomes
necessary. Finally, and perhaps most importantly,
I pointed out that the current strategy is a discretionary one, as opposed to one based on a rule. I
then concluded that recent research has strengthened the case for a rule, but I cautioned that any serious
effort to institute a monetary policy strategy based
on a rule would confront some thorny practical issues.
My own feeling, however, is that the adoption of
some form of rule, with the precommitment
a rule
would entail, would do more to improve our strategy,
enhance our credibility as an inflation fighter, and
maintain our recent progress against inflation than
any other single change we might make. I personally hope that we shall begin to move in this direction
soon. The time to confront the risk of another round
of high inflation is now, when the rate is still relatively
low. Once the rate begins to accelerate, it will be
too late.

FEDERAL RESERVE BANK OF RICHMOND

9

THE CASE FOR RULES IN THE CONDUCT OF
MONETARY POLICY: A CONCRETE EXAMPLE
Bennett T. McCallum*

Introduction
The purpose of this paper is to provide a
nontechnical but reasonably up-to-date description
of the case for rules, as opposed to discretion, in the
conduct of monetary and fiscal policy. Special attention will be paid to the current state of macroeconomic theory and to the experiences of developed
economies in the postwar (i.e., post-World War II)
era. A feature of the paper is the proposal of a specific
rule for monetary policy, one that is not open to objections typically made by opponents of rules. Some
evidence regarding the potential effectiveness of this
particular rule is reported.
Basic Considerations
The first thing that needs to be emphasized is that
the issue of rules vs. discretion is not the same as
the issue of activist vs. nonactivist policy. That a
policy rule can be activist-i.e.,
can be one that adjusts the value of a policy instrument in response to
prevailing economic conditions-is
a sufficiently
elementary point that it has been clearly expressed
in the widely used undergraduate macroeconomics
textbook of Dornbusch and Fischer (1984) for almost
a decade.’ Yet it needs to be emphasized, as leading
economists2 and policymakers
continue to argue
H. J. Heinz Professor of Economics, Carnegie-Mellon University, and Research Advisor, Federal Reserve Bank of
Richmond.
This paper was originally prepared for the Kiel Conference
of Iune 1987. “Macro and Micro Policies for More Growth and
Employment:” The author is indebted to Allan Mekzer for helpful
suggestions and to Robert J. Gordon for constructive criticism.
l

1 The example provided by Dornbusch and Fischer (1984,
pp. 342-43) is a policy rule that sets the money-stock growth
rate equal to 4.0 + Z(u-5.0), where u is a recent unemployment rate. Both u and the (annualized) money-stock growth rate
are here measured in percentage points.
2 Tobin (1983) recognizes the analytical validity of the distinction, but refuses to accept it as a practical matter.
3 See, for example,
10

Volcker (1983).

in a fashion that muddles together the two distinct
issues, and sometimes even proceeds as if rules could
be discredited in general by listing disadvantages of
a particular type of rule that calls for a constant growth
rate of the money stock.
What then is the nature of the rules vs. discretion
distinction? It is I think widely agreed among
macroeconomic researchers that the crucial distinction is the one illustrated in the seminal paper of
Kydland and Prescott (1977)4 and elaborated upon
by Barro and Gordon (1983a). But precisely how to
characterize this distinction is not so clear. Many
economists
use the term “precommitment”
to
describe policymaking by rules,s and often continue
by discussing the difficulty or impossibility of achieving binding precommitment.
Now in the context of
monetary and fiscal policy, it would appear that literal
and full precommitment
is in fact virtually impossible. But it is not impossible for a monetary authority
to select policy actions that conform to the “rule” sequence in the Kydland-Prescott example, so it must
be concluded that precommitment
cannot be the
crucial characteristic. Instead, policymaking according to a rule exists when the policymaker chooses
not to attempt optimizing choices on a period-byperiod (or case-by-case) basis, but chooses rather to
implementin each period (or case) a formula for sel:ting his instrument that has been designed to apply
to periods (cases) in general, not just the one currently at hand. Thus the policymaker’s efforts toward
optimization enter in the design of theformula to be
utilized in a large number of periods, not in the actions selected in each period.6
4 Which constitutes an application to macroeconomic
a point developed previously by Kydland (1975).

policy of

5 Examples are Barro and Gordon (1983b) and Grossman and
Van Huyck (1986).
6 This characterization is consistent with Friedman’s (1962, pp.
‘239-41) analogy to the constitutional protection of free speech.

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

To provide an example of this distinction, and also
to begin our analysis of the adeanfage of rules over
discretion in the context of monetary policy, let us
briefly review the basic model laid out by Kydland
and Prescott (1977). In this setup, the monetary
authority’s objectives are represented by a loss function in which the arguments are the squared deviations of unemployment
and inflation from values
determined by considerations of allocational efficiency.’ It will simplify matters without distortion of
the argument, however, to simply take the loss function to LL decreasing in the current money-growth
sz~$rise (since unanticipated money growth reduces
unemployment)
and increasing in the square of
money growth itself (since money growth induces
inflation) .8 There are also discounted values of similar
terms for all future periods, but for present purposes
these can be ignored. If, with this objective function, the monetary authority were to adopt a policy
m~2by choosing among constant money growth rates,
he would recognize that with moderately rational
agents the surprise values will average to zero
whatever,his choice; thus the chosen money growth
rate would be zero. For the same reason, moreover,
an avwoge growth rate of zero would be implied by
the optimal choice of a (possibly activist) rule when
a broader class of rules is considered.
But suppose that, instead, the authority executes
policy in a period-by-period or discretionary manner,
i.e., by selecting each period’s money growth rate
on the basis of a fresh optimization calculation. Then
in each period the prevailing expected money growth
rate is taken by the authority as a given piece of

’ Our conclusions will depend upon the plausible assumption
that deviations of inflation from the optimal rate are increasingly costly at the margin; use of the squared deviation reflects
th%.requirement in a tractable manner. The unemployment term
is of the form (u, - k U.)r. with 5, the natural-rate value of LL
and with k < 1. The latter condition expresses the assumption
that the monetary authority’s target value for II, is below the
natural rate. Barro and Gordon (1983a) interoret this as reflecting some externality and consdquendy claim that there is no
discrepancy between the policymaker’s objectives and private
agents’ preferences.
The analysis would remain the same,
however, if the k < 1 condition were interpreted as merely reflecting a desire by the policymaker for an excessively low rate of
unemployment.
Indeed, all that is necessary is that the
policymaker values marginal reductions of unemployment in the
vicinity of its natural-rate value.
8 In the cited literature, “money growth” and “inflation” are often
used interchangeably. In my opinion, it is preferable to think
in terms of money growth as unemployment is in fact more
closely related to money than price level surprises. In addition,
inflation actually responds to money growth only slowly, so current money growth affects expectations
of future inflation.
Recognition of this point overturns the argument of Grossman
and Van Huyck (1986) to the effect that the Kydland-Prescott
setup is misspecified.

data-a new “initial condition.” The current surprise
then appears to the authority to be under his control, so the loss-minimizing choice of the current
money growth rate is that value which just equates
the marginal benefit of surprise money growth to the
marginal cost of money growth per se. With the objective function as described, this seemingly optimal
value will clearly be positive. But since moderately
rational private agents will come to understand this
process, their expectations regarding money growth
will be correct on average. Thus the surprise
magnitude will be zero on average, over any large
number of periods, even though the magnitude within
each period is under the control of the monetary
authority. Consequently, there will on average be no
benefit-no
extra employment-materializing
from
surprises. On average, then, the discretionary regime
will feature more money growth (i.e., inflation) but
the same amount of surprise money growth (i.e.,
unemployment) as with a well-designed rule based
on the same objectives. Thus the objectives will be
more fully achieved with the adoption of a rule than
with period-by-period
attempts at optimization.
It should be noted that the foregoing line of argument does not require that the economy actually be
one in which monetary surprises induce temporary
output and employment gains. Nor is it necessary
that private sector expectations are fully rational.
What is required is that the monetary authority
be&ewes
that unusually rapid monetary growth will induce output/employment gains and that expectations
are rational enough to avoid any permanent bias.
Also, the economy must be one that satisfies the
weak version of the natural-rate hypothesis: output
and employment must be independent over long
spans of time of the economy’s average inflation rate.9
To this point it has been argued that the conscientious attempt to avoid both inflation and unemployment will lead to an excessive amount of the former,
with no reduction in the latter, when monetary policy
is conducted in a discretionary manner. Is there any
empirical evidence to suggest that this theoretical
proposition is in fact descriptive of the workings of
actual central banks and actual economies?
To my mind, the most impressive evidence in this
regard comes from straightforward examination of the
postwar inflationary experience of the industrialized
nations of Europe and North America. Specifically,
price levels are now in all these nations several times
as high as they were in 1950. Even in Germany the
9 For additional discussion of related issues, including reputational models, see McCallum (1987). Alternative surveys are
provided by Barro (1986) and Cukierman (1986).

FEDERAL RESERVE BANK OF RICHMOND

11

value of the currency is now less than a third of its
1950 level, while the comparable magnitude is less
than one-tenth for France, Italy, and the United
Kingdom. (A few figures are reported in Table I.)
While there have been no episodes of extremely rapid
inflation, price levels have risen steadily and substantially. The relevant question is, therefore, why has
the experience been one ofpositive inflation in most
years in all of these countries? The populations,
governments, and central banks of these nations do
not enjoy inflation-indeed,
they regard it as
something absolutely undesirable on its own. Also,
there is little reason to believe that the policymakers
in these nations are of the opinion that there is any
permanent stimulative effect on employment or output of positive inflation rates. They know that
employment and output growth were not enhanced
by the inflation and rapid money growth of the 1970s.
So why have price levels not moved downward about
as often as upward, leaving current prices about the
same as in 1950?
My suggestion, of course, is that the Barro-Gordon
theoryi
provides an answer to these questions,
namely, that discretionary policymaking has been exercised in the postwar era by central bankers who
wish to avoid inflation but who also have employment or output concerns. The plausibility of this
suggestion is enhanced, I believe, by a comparison
of the postwar experience with that of an earlier era
in which monetary policy was circumscribed by
-formal rules. Here the reference is, of course, to the
period before World War I when the countries under
discussion maintained commodity-money standards.
As all readers probably know, price levels at the start
of World War I were roughly the same as they had
been in the middle 1800s-or
in the late 17OOs,
before the start of the Napoleonic Wars. For easy
reference, a few relevant figures are reproduced in
Table II.

Table

I

CONSUMER PRICE INDICES, POST-WORLD WAR II
Nation

CPI, 1950

CPI, 1985

Belgium

30.1

140.5

0.214

France

15.6

157.9

0.099

Germany

39.2

121.0

0.324

Italy

13.9

190.3

0.073

Netherlands

23.9

122.7

0.195

United

Kingdom

13.4

141.5

0.095

United

States

29.2

130.5

0.224

Source:

I MF, International

Financial

Ratio

Statistics.

In previous writings, I have emphasized four principles that should be respected in the design of a
monetary rule (McCallum, 1984, 1983, which are
as follows. First, the rule should dictate the behavior
of a variable that the monetary authority can control
directly and/or accurately. To specify behavior of
some magnitude that is not itself controllable-such
as the Ml measure of the money stock, for
instance-would
be to leave the task of rule design
seriously incomplete. Second, the rule should not rely
in any essential way upon the presumed absence of
regulatory

change

and technical

progress in the finan-

cial industry. While these processes may not produce
as much turmoil in the future as they have in the
recent past, it would be unsafe to-presume that they
wilI not be present again to a significant extent. Third,
neither money stock nor (nominal) interest rate paths

Table II
WHOLESALE PRICE INDICES, PRE-WORLD WAR I
Belgium

Britain

France

Germany

United
States

1776

na

101

na

na

84

1793

na

120

na

98

100

1800

na

186

155

135

127

1825

na

139

126

76

101

1850

83

91

96

71

82

1875

100

121

111

100

80

1900

87

86

85

90

80

1913

100

100

100

100

100

Year

A Specific Rule for Monetary Policy
Instead of continuing the discussion of rules vs.
discretion in the abstract, let us now turn to the consideration of a specific rule for the conduct of
monetary policy. Examination of a concrete proposal
should help to reveal weaknesses in the rule-based
approach, if they exist, or to attract support for the
rule, if its desirable properties are convincingly
impressive.
lo While the model outlined above was developed by Kydland
and Prescott (1977), its use as apositiwe theory of policy behavior
was pioneered by Barro and Gordon (1983a).
12

Sources: B.R. Mitchell, European Historical Statidics;
Bureau of
the Census, Historical Statistics of the United States.

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

are important for their own sake; these variables are
relevant only to the extent that they are useful in
facilitating good performance in terms of inflation and
output or employment magnitudes. Fourth, a welldesigned rule should recognize the limits of macroeconomic
knowledge.
In particular, it should
recognize that neither theory nor’ evidence points
convincingly to any of the numerous competing
models of the interaction of nominal and real
variables. The economics profession does not have
a reliable quantitative or even qualitative model of
aggregate supply (or “Phillips curve”) behavior. In
other words, the profession does not have accurate
knowledge of the way in which changes in nominal
GNP will be divided, on a quarter-to-quarter basis,
between real output growth and inflation.” Thus
any rule whose design depends upon some particular
model of that division warrants very little confidence.
In one of these earlier papers (McCallum, 1984),
I proposed in qualitative terms a rule that respects
all four of these principles. My proposal began with
the specification of a target path for nominal GNP
that grows evenly at a prespecified rate that equals
the economy’s prevailing long-term average rate of
real output growth. For the United States the
appropriate figure is about 3 percent per year. Since
this magnitude will be virtually independent
of
monetary policy over any extended period (say, 20
years or more), keeping nominal GNP growth at the
appropriate value-henceforth
assumed to be 3 percent per yearlz-should
yield approximately zero
inflation over any such period. Furthermore,
the
prevention of fluctuations in nominal GNP growth
should help to prevent swings of real output from
its trend path. l3 While some output fluctuations
would continue to occur even with a perfectly smooth
growth path for nominal demand, they would probably be as small as can feasibly be obtained, given
the absence of a reliable Phillips curve model.
*I On this topic again see McCallum (1987).
12 Designation of the trend value of real output growth is, of
course, part of the rule’s specification. It should be based on
the economy’s actual real growth record over the past several
decades and should be changed very infrequently -say, once
every ten years. Any error in setting this rate will obviously lead
to an error of equal percentage magnitude (but of opposite’ sign)
in the inflation rate induced bv the rule. Fortunatelv. the conceivable magnitude of such errors is quite small-probably
less
than 1 percent per year-for
developed economies.
I3 The workings of the rule are independent of the currently
prominent issue concerning the nature of output trends. Thus
the target path for nominal GNP should be set to grow at the
value y whether real output growth occurs according to y, =
a! + Yt + E, or to y,-y,-,
= y + .s,. (Here et denotes white
noise.)

To complete the rule, an operational mechanism
must be specified for keeping (nominal) GNP growth
close to the prespecified 3 percent growth path.14
My 1984 suggestion was to adopt as an instrument
the monetary base, a variable that can be accurately
set on a day-by-day basis by the central bank of any
political entity with a floating exchange rate.
Specifically, the rule “would adjust the base growth
rate each month or quarter, increasing the rate if
nominal GNP is below its target path, and vice
versa” (McCallum, 1984, p. 390).
The algebraic form implicit in this description is
as follows, where b, = log of monetary base (for
period t), xr = log of nominal GNP, and x,’ = targetpath value for xI:
(1)

Ab, = Ab,-1 + X,(x:_, - x*-l),

x,>o.

In this formula, the magnitude of Xi would have to
be chosen so as to (a) provide adequate responsiveness of base growth to departures of x, from its
target path but (b) without inducing dynamic instability of the type that can prevail when feedback
effects are too strong. Presuming this value is satisfactorily chosen, one attractive feature of the scheme
summarized in (1) is that it would automatically
adjust the b, growth rate, in a fashion that would yield
zero inflation on average, in response to alterations
in base “velocity” stemming from technical or regulatory changes. Even in the face of drastic changes
of this type it would remain true that an increase in
Ab, would be expansionary, and a decrease contractionary, in terms of aggregate demand-and
more
knowledge than that is not required for the appropriate type of adjustment.
I have recently become persuaded,i5 however, that
a somewhat different specification would have
better properties. Instead of (l), then, I would now
r4 By virtue of its emphasis on this operational mechanism, the
current proposal is quite different from other schemes involving “nominal GNP targeting’ such as those of Gordon (1985),
Hall (1983), and Taylor (1985). This difference is clearly exemplified by Gordon’s (1985, p. 77) reference to “controlling
growth in nominal GNP. . . ra&rthun controlling the monetary
base” (emphasis added). Much of Gordon’s discussion, incidentally, is concerned with a difficulty not elsewhere discussed
in the present paper, namely, that of starting up a rule like (2)
from initial conditions with nominal GNP growth substantially
different from 3 percent. In this regard my own inclination would
be to begin with a path that adjusted gradually toward the 3 percent figure, attaining the latter after (say) three years. Another
objective of Gordon’s is to argue the desirability of final sales
over GNP as a nominal demand variable; I have no desire to
quarrel with that argument.
I5 In part by discussions

FEDERAL RESERVE BANK OF RICHMOND

with Allan Meltzer.
13

like to propose
adjustments:
(2)

the following

Ab, = 0.00739
- b,-, + b,+]

rule for quarterly

- (l/16) [x,-i + X,(x:_, - x,-l),

x,-17

X,>O.

Here the constant term 0.00739 is simply a 3 percent annual growth rate expressed in quarterly
logarithmic units, while the second term subtracts
from this the growth rate of base velocity, calculated
as an average over the previous four years.16
Finally, the thiid term adds an adjustment in response
to departures of GNP from its target path. Again the
only parameter value to be determined is that for the
response coefficient, in this case denoted X2. Again
it is possible to induce dynamic instability by
setting the value of X2 too high. But as the response
is now applicable to Ab, rather than its change, Ab,
- Ab,+, the danger of instability is lessened. My proposed value for X2 is 0.25, which implies an extra
1 percent base growth per -year for each 1 percent
deviation of nominal GNP from its target path.
Properties of the Proposed Rule

’

To determine how this rule would work, one needs
to experiment
with it. Since experiments
with
actual economies can be very expensive to the
societies involved, such experimentation needs to be
done with a model. The problem, of course, is that
there is no agreement as to the appropriate model.
My conjecture,
however, is that rule (2) with
= 0.25 will perform well for a wide variety of
x2
quantitative models of developed market economies
such as the United States, United Kingdom, Germany, Italy, France, or the Netherlands. Let me
immediately be clear, however, about what is here
meant by the term “perform well.” Specifically, the
criterion involves only the time path of nominal GNP;
as we do not know how changes in GNP will be
divided among inflation and output growth, the rule
should not be judged on the basis of any particular
model’s predictions in that regard. Subject to that
stipulation, it is my conjecture that application of the
rule (2) in place of actual historical policy would yield
simulated nominal GNP paths that are smoother than
those actually experienced,i7
as well as implying
growth at noninflationary rates. This type of result
16 Note that x,+ - x,-~, - b,-, + b ,--1, =

: (Ax,,
j=l

- Abe-J.

17 Here I am assuming simulations that feed in random errors
of the same magnitude as seem to occur in actuality; see the
discussion below.
14

will obtain, I believe, whether the models utilized
are constructed along Keynesian or classical lines provided that they are not strongly inconsistent with the
natural-rate hypothesis.
Such simulations with a wide variety of models
have yet to be conducted. But I can report results
based on two extremely simple models that are
merely atheoretic regressions of nominal GNP on
past values of itself and values of the monetary base. **
The first such model, pertaining to the U.S. economy
for 1954.1-1985.4,
consists of the following estimated regression equation:
(3)

Ax, = 0.00749 + 0.257 Axt-1
(0.002 1) (0.079)
+ 0.487 Ab, + e,
(0.121)
RZ = 0.23

S = 0.010

DW = 2.11

Here e, denotes the residual, i.e., the estimated
disturbance, for period t. Simulated values for b, and
xt have been calculated for 128 periods by means
of equations (2) and (3), with initial conditions corresponding to 1954.1 and with e, residual values fed
in each period as shock estimates. This procedure
is analogous to one stochastic simulation of (2) and
(3) with shocks drawn from a population with mean
0 and standard deviation 0.010.
Results of this simulation exercise are shown in
Chart 1, where TAR denotes the target path x:.
Clearly the rule induces xt to follow the target path
quite closely. To put this behavior into perspective,
the result of this simulation is compared with simulations using alternative policy rules in Table III. There
the first numerical column reports root-mean-squarederror (RMSE) values-i.e.,
square roots of the mean
over 128 simulated quarters of the squared deviations of xr from xJ . The RMSE value of 0.0197 in
line 1 indicates that the root-mean-squared deviation
of nominal GNP from its target path is roughly 2.0
percent under rule (Z), since log deviations are approximately equal to percentage deviations divided
by 100. That figure can be compared with a RMSE
value of about 22 percent when the policy rule is one
that sets the monetary base growth rate at zero
throughout the period (line 3). This surprisingly high
1s Since drafting this paper I have also obtained results for a
model that consists of a 4-variable vector autoregression (VAR)
system, the variables being four lags each of the 90-day Treasury
bill rate and the logs of real GNP, the GNP deflator, and the
monetary base. The RMSE value with X1 = 0.25 in rule (2)
is 0.0219, almost the same as for model (4).

ECONOMIC REVIEW. SEPTEMBER/OCTOBER 1987

Chart

SIMULATION
WITH POLICY

1

RESULTS
FOR 1954 - 1985
RULE
(2) AND MODEL
(3)

7.00

6.75

TAR

6.50

6.25

6.00..

Note:

The target
path
TAR increases
from
the
actual
value
of 5.909
360.3,
while
368.3
is
nominal
dollars
(annual
rate,
seasonally

magnitude obtains because base velocity has grown
enough during the period 1954-85 that no growth
in the base would have permitted a significant amount
of inflation!i9 The base growth rate needed to yield
zero inflation-literally
to yield 3 percent nominal
GNP growth-with model (3) is Ab, = -0.0041 (i.e.,
about - 1.6 percent per year). With that rate held constant for 128 periods, the RMSE is about 3.6 percent (see line 4), which is only about twice as large
as with policy rule (2). But it is important to recognize
that the correct constant value of Ab, embodied in
the “rule” of line 4 could not have been known ex
ante, before the experience of 1954-85 had been accumulated, for it is calculated on the basis of model
I9 That this is the case can be seen from the model reported
in equation (3). Setting both Ab, and e, at zero for all t yields
Ax, = .00749 + 2.57 Ax,-,, which has a steady-state value of
.00749/(1-257) = .OlOO. Thus with zero base growth, nominal
GNP would grow at about 1 percent per quarter or 4 percent
per year. With 3 percent per year real GNP growth, we would
then have about 1 percent per year inflation.

by 0.00739
each
quarter,
for
1953.4.
Here
5.909
GNP measured
in billions
adjusted).

starting
= log
of

(3).20 By contrast, our preferred rule (2) is not
based on any parameter estimated in the model.
In response to the last claim, it could be said thatwhile not precisely based on model (3)-the
parameter value X2 = 0.25 in rule (2) is to some
extent based on ex post knowledge. Consequently,
it is of interest to know how rule (2) would perform
with different values used for &--in particular, with
X2 = 0. Results for that case, which corresponds in
spirit but not in detail to the rule proposed by Meltzer
(1984, 1987), are reported in line 5. There we see
that performance is less good than in line 1, but still
rather impressive. Shifting X2in the other direction,
to a value of 0.5, yields results (not tabulated) that
are even better than in line 1. Also reported in Table
III is one result pertaining to the policy rule (l), which
I had previously proposed. Specifically, line 6 shows
that with X1 = 0.02 the RMSE would be about
*O Specifically, by solving Ax = .00749 + 2.57 Ax + .487 Ab
for Ab with Ax set equal to .00739.

FEDERAL RESERVE BANK OF RICHMOND

1.5

4.2 percent, which is not too bad. But using instead
X1 = 0.05 would result in explosive fluctuations.
Finally, the foregoing RMSE figures can be compared to those that actually obtained during 1954-85,
i.e., with actual Federal Reserve policy. Because of
the substantial amount of inflation that occurred, the
RMSE value is enormous in comparison-the
value
is .77 11, over 30 times as great as in line 1. Perhaps
more interesting, however, is the extent of actual
nominal GNP ~~riabi&~ about its (inflationary) trend
path. Consequently, the RMSE value for xt relative
to a fitted linear trend is also reported in line 2. That
value is 6.2 percent per period, somewhat higher than
in lines 5 and 6, and just over three times as great
as in line 1. Thus the first-column indications of
Table III are that our proposed rule would not only
prevent inflation but also yield less variability in
nominal GNP growth than actual Fed policy.
The foregoing estimates
are all predicated,
however, on the “model” of GNP behavior given in
equation (3). The extreme simplicity of this specification arguably tends neither to favor nor harm the
simulated performance of our rule (2). But there is
one aspect of specification (3) that is questionable
and that works in our favor-namely,
the inclusion
of the.current-period
value of Ab, as an explanatory
variable. To some extent the estimated effects, a
critic might claim, could be due to the sample-period
response of Ab, to Axt, rather than the causal direction presumed in (3). Consequently,
results are
reported in column two of Table III for simulations
like those of column one except that the “model” is
as follows:
(4)

Ax, = 0.00506 + 0.199 Ax-1
(0.0020)
(0.083)
+ 0.529 Ab,+ + e,
(0.127)
R* = 0.23

6 = 0.010

DW = 2.05

Here, non,~of the current-period connection between
Ab, and Ax, is attributed to the direction going from
policy to GNP. This specification should be expected
to sharply deteriorate the rule’s performance, as it
introduces a full two-quarter lag between target
departures xZ1 - x,-~ and corrective effects.
Indeed, as inspection of Table III will readily
indicate, the performance of rules (2) and (1) both
deteriorate. The former remains superior, nevertheless, to any of the other possibilities considered,
and continues to yield substantially less GNP
variability than observed in actual U.S. experience.
Since there is probably some within-quarter response
16

Table III
SIMULATION RESULTS FOR ALTERNATIVE RULES
RMSE
Model (3)

1.

Eq.(2),

2.

Actual

XI = .25
historical

RMSE
Model (4)

.0197

.0217

.7711

.7711

(.0616)*

Policy

(.0616)*

3.

Ab, = 0

.2258

.2302

4.

Ab, = -a0041

.0358

.0391

5.

Eq.(2),

.0499

.0502

6.

Eq.(l), X1 = .02

.0424

.0671

X1 = 0

*This is RMSE relative to fitted trend rather than target path.

of Ax, to Ab, in actuality, this brief investigation
suggests results intermediate to those of columns one
and two. For rule (‘Z), they are clearly excellent.
Criticisms
At this point it will be useful to consider some
possible objections that might be raised by critics.
Three that will be discussed in turn pertain to (i) the
Lucas critique, (ii) the natural-rate hypothesis, and
(iii) our neglect of open-economy
considerations.
With respect

to (i) the point is, of course,

that the.

parameters of our models (3) and (4) might change
with an alteration in policy from that actually experienced to that of the hypothesized rules. Since
these “models” are not structural, this objection is
in principle correct. I would suggest, however, that
the Lucas critique is much more important quantitatively for equations relating real to nominal
variables-e.g., Phillips curves-than for ones relating
nominal demand to nominal policy variables. If this
conjecture is correct, then equations (3) and (4:)
should be virtually immune to the critique, as it has
been found to be rather hard to detect empirically
even in Phillips-curve relations. [See, e.g., Gordon
and King (1982).]
Next, there is the issue of the natural-rate
hypothesis, which has recently come under attack
as a result of extremely high and persistent European
unemployment
rates. 2’ But in the context of the
present discussion, the issue is not whether unemployment promptly reverts following a shock to some
“natural” level, but whether the trend growth rate of
real output is essentially independent of monetary
2’ See, for example, Fitoussi and Phelps (1986) and Blanchard
and Summers (1986).

ECONOMIC REVIEW. SEPTEMBER/OCTOBER 1987

policy. If the recent experience is thought to provide evidence against this relevant proposition, it is
unclear how the posited relationship would go. Proponents of the notion that nominal demand behavior
affects the trend output rate usually hypothesize a
positive relationship, i.e., that real output growth is
stimulated by more rapid growth of nominal demand.
But in fact nominal GNP growth has been mm rapid
in Europe during the 1970s and 1980s than it was
during the 1950s and 1960~,~~ yet it is the more
recent period that has featured high unemployment
and reduced real growth.
Finally, let us briefly address the issue of how our
proposed rule should be modified to take account
of open-economy considerations, i.e., large import
and export sectors. In this regard the relevant principle to keep in mind is that the most constructive
thing that monetary policy can accomplish is to
induce nominal aggregate demand to grow smoothly
and at a noninflationary rate. Thus the only modification required to our rule is the possible replacement
of nominal GNP with some other measure of nominal
aggregate demand. My first inclination would be to
use real GNP multiplied by the consumer price
index. But the main point is that steady growth in
some such aggregate constitutes a more reasonable
objective for the monetary authority than either maintaining a fixed exchange rate or following a target path
for any measure of the money stock. These are
variables that are neither instruments nor ultimate
22 For Europe as a whole, nominal GDP grew at an average rate
of 14 percent over the period 1955-69 and 24.6 percent over
1969-83 (IMF, InternationalFinancial Statistics).

targets. While the same is true of nominal aggregate
demand, it is a magnitude that is more closely related
to output and inflation variables-which
are ultimate
targets.
Conclusion
Let us now conclude with a brief summary of the
foregoing argument. The paper begins by reiterating
that a policy rule can be activist; the distinction between rules and discretion depends upon the stage
at which optimization calculations enter the policy
process-in
the design of a formula (rule) to be implemented each period or in each period’s (discretionary) selection of a policy action. Next, the
Kydland-Prescott (1977) example is used to illustrate
the tendency for discretionary monetary policy to produce more inflation than would result from a rule,
with no additional employment obtained in compensation. Then a specific monetary rule is proposed,
one that sets the monetary base-a
controllable
instrument-each
period in a manner designed to
keep nominal aggregate demand growing smoothly
at a noninflationary rate. Some simple simulations
are conducted which suggest that this rule would have
worked well in the United States, over the period
1954-85, if it had been in effect. The basic idea is
that, since economists do not understand how
nominal demand changes are divided between inflation and output growth, the most useful thing that
monetary policy can accomplish is to keep nominal
demand growing smoothly at a noninflationary rate.
This can apparently be well achieved by means of
a rule such as the one proposed.

References
Barro, Robert J. “Recent Developments
in the Theory of
Rules versus Discretion.” Economic Journal 96 (Supplement, 1986): 23-37.
,

Barro, Robert J., and David B. Gordon. “A Positive Theory of
Monetary Policy in a Natural Rate Model.” Journ ofPolitical
Economy 91 (August 1983): 589-610. (a)
. “Rules, Discretion, and Reputation in a Model
of Monetary Policy.” Journal ofMonetaryEconomics12 (July
1983): 101-21. (b)
Blanchard, Olivier J., and Lawrence H. Summers. “Hysteresis
and the European Unemployment
Problem.” In NBER
Macroeconomics
Annual 1986, edited by S. Fischer. Cambridge, Mass: The MIT Press, 1986.
Cukierman, Alex. “Central Bank Behavior and Credibility: Some
Recent Theoretical Developments.” Federal Reserve Bank
of St. Louis, Reekw 68 (May 1986): 5-17.

Dornbusch, Rudiger, and Stanley Fischer. Manaeconomics,3rd
ed. New York: McGraw-Hi11 Book Company, 1984.
Fitoussi, J.P., and E.S. Phelps. “Causes of the 1980s Slump in
Europe.” Brwkings Papers on Economic Activity (2: 1986),
pp. 487-513.
Friedman, Milton. “Should There Be an Independent Monetary
Authority?” In In Sea& of a Monetary Constitution,
edited
by L.B. Yeager. Cambridge, Mass: Harvard University
Press, 1962.
Gordon, Robert J. “The Conduct of Domestic Monetary Policy.”
In Monetary Pohy in Our Times, edited by A. Ando,
H. Eguchi, R. Farmer, and Y. Suzuki. Cambridge, Mass:
The MIT Press, 1985.
Gordon, Robert J., and Stephen R. King. “The Output Cost
of Disinflation in Traditional and Vector Autoregression
Models.” BrookingsPapers on Economic Activity (2: 1982),
pp. 205-72.

FEDERAL RESERVE BANK OF RICHMOND

17

Grossman, Herschel I., and John B. Van Huyck. “Seigniorage,
Inflation, and Reputation.“Jouma~ofMonetaryEconohcs 18
(July 1986): 21-31.
Hall, Robert E. “Macroeconomic
Policy Under Structural
Change.” In Indu.ssrria/
CkangeandPubh Policy.A symposium
sponsored by the Federal Reserve Bank of Kansas City,
1983.
Kydland, Finn E. “Noncooperative
and Dominant Player
Solutions in Discrete Dynamic Games.” IntemationaL
Economic Re&w 16 (June 1975): 321-35.

. “Inflation: Theory and Evidence.”
NBER
Working Paper No. 2312, July 1987. Forthcoming
in
HandbookofMonetaryEconomics, ed. by B.M. Friedman and
F.H. Hahn. Amsterdam: North-Holland.
Meltzer, Allan H. “Overview.” In PriceStabilityand&b& Poiiy.
A symposium sponsored by the Federal Reserve Bank of
Kansas City, 1984.
“Limits of Short-Run Stabilization
Econonzic&wiry 25 (January 1987): 1-14.

Policy.”

Kydland, Finn E., and Edward C. Prescott. “Rules Rather than
Discretion: The Inconsistency of Optimal Plans.” Journal
of Po/itia! Economy 85 (June 1977): 473-91.

Taylor, John B. “What Would Nominal GNP Targetting Do ro
the Business Cycle?” CameghRockester Conference Series
on Public Policy 22 (Spring 1985): 61-84.

McCallum, Bennett T. “Monetarist Rules in the Light of
Recent Experience.” Am&an Economic Rtiew 74 (May
1984): 388-91.

Tobin, James. “Monetary Policy: Rules, Targets, and Shocks.”
Journal of Monq, Cmdit, and Banking 15 (November 1983 ):
506-18.

. “On Consequences and Criticisms of Monetary
Targeting.” Journal of Money, Cmdit, and Banking 17
(November 1985, part 2): 570-97.

Volcker, Paul A. “Statement before the House Committee on
Banking, Finance and Urban Affairs.” Feaha1Resrr.w Buleth
69 (August 1983): 617-21.

18

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

THEAUSTRALIAN
MONEY
MARKET THE
AND
OPERATIONS THERESERVE
OF
BANK AUSTRALIA:
OF
A COMPARATIVE
ANALYSIS
Michael Domy

I.
Introduction
This paper provides a comparative analysis of
monetary policy in Australia and the United States.
It concentrates on the day-to-day conduct of policy
and on the influence that the structure of overnight
money markets has on the transmission of monetary
policy through open market operations. The regulatory structure of any market affects the behavior
of agents who trade in that market and, therefore,
can also influence the results of government actions.
In particular, the efficiency of monetary control may
depend on the rules and institutional arrangements
that characterize a country’s overnight money market.
The analysis indicates that there are significant
institutional differences between the Australian and
United States money markets and that these differences are important in determining the relative efficiency of monetary control under different operating
procedures.
There are three major elements that differ between
the United States and the Australian money markets.
One is the nature of reserve requirements, while
another involves the lending procedures used by the
respective central banks. The third is that certain
money market dealers bank at the Reserve Bank of
Australia rather than with private banks. These
differences affect monetary control. Further, the
interaction between the structure of the money
The research for this paper was conducted while the author was
visiting the Reserve Bank of Australia. I am deeply indebted to
Ian Macfarlane, Ric Battellino, and Brian Gray for their help and
encouragement.
My colleagues Marvin Goodfriend,
Tony
Kuprianov, and Alan Stockman have also provided valuable comments. Colleen Mitchell and Peter Skib of the Reserve Bank
of Australia and Rob Willemse of the Federal Reserve Bank of
Richmond provided expert research assistance. Needless to say,
the opinions expressed in this paper are solely those of the author
and do not necessarily express the views of the Reserve Bank
of Australia, the Federal Reserve Bank of Richmond, nor the
Federal Reserve System.

market and monetary control is influenced by use
of the interest rate as the instrument of monetary
policy in both countries.
To compare the overnight money markets, it is
essential to define terminology and explain their structure. This is done in Section II. Since the structure
of the U.S. money market is relatively familiar and
is examined in depth elsewhere, the discussion will
focus primarily on Australia.’ Section III presents the
mechanics of open market operations in Australia and
describes the operating procedures of the Reserve
Bank of Australia. Based on this description, a
theoretical
model examining the efficiency of
monetary control is explored in Section IV. A brief
summary is given in Section V.

II.
The Official Money Market in Australia
Overview
This section describes the structure of the official
money market in Australia. It also examines the roles
of the major participants-dealers,
trading banks, and
the Reserve Bank-and
describes how funds are
distributed among them. Various similarities and
differences between this market and the U.S. federal
funds market are highlighted. A basic comparison in
terminology is summarized in Table I, while the
major institutional differences are summarized in
Table II.
Market Structure
The official money market in Australia is basically analogous to the U.S. federal funds market.
It allocates funds that receive same-day credit in
i For a detailed treatment of the U.S. money market, see
Cook and Rowe (1986). In particular the article by Goodfriend
and Whelpley makes an in-depth study of the federal funds and
overnight RP market.

FEDERAL RESERVE BANK OF RICHMOND

19

Table

I

TERMINOLOGY
United States

Australia
Market for funds receiving
same-day credit in accounts
with central bank

Official

money market

Federal

funds market

held

Institutions that deal directly
with the central bank

Authorized dealers and
occasionally trading
banks

Primary dealers, some
of which are banks

Inventory

of same-day

Bank loans to dealers

Excess reserves

Reserves
account

held at central

Statutory reserve
deposits CSRD) and exchange
settlement funds

Reserve

Methods
lending

of central

Rediscounting
of
government securities
and lender-of-last-resort
loans (LLR) to authorized
dealers

Discount window
borrowing

funds

bank

accounts held by trading banks and dealers at the
Reserve Bank of Australia. These accounts, which
are used for clearing funds, are called exchange
settlement
accounts. Australia also has an unofficial money market that handles all money market
transactions in which banks do not receive same-day
credit in their exchange settlement accounts.
In short, Australia has two types of funds. The first
consists of same-day funds or exchange settlement
funds that accrue to exchange settlement accounts
at the Reserve Bank. These include direct dealings
with the Reserve Bank, transactions with authorized dealers, and yesterday’s check clearings. Funds
of the second type are those transferred by bank
checks. These are next-day funds because checks
presented against banks in Australia are cleared
through the Australian Clearing House and do not
affect the exchange settlement accounts of banks until
the following morning.
Participants in the Official Money Market
De&~
Dealers play a pivotal role in the daily
functioning of the official money market. For one
thing, the Reserve Bank deals almost exclusively with
authorized dealers so that, with the exception of rediscounting, all movements
in same-day funds are
initiated through the accounts of dealers at the
Reserve Bank of Australia. Another reason relates
to the timing convention for debiting and crediting
the exchange settlement accounts of dealers. These
accounts are credited and debited on a same-day basis
which gives dealers the central role in distributing
exchange settlement funds throughout the banking
20

bank balance

system. The interbank market also plays a role, but
it is only through transactions with dealers that
systemwide shortages or excesses can be transferred from one day to the next. That official money
market dealers bank at the Reserve Bank of Australia
and that their transactions receive same-day credit
are the key features distinguishing the Australian from
the U.S. money markets.
The timing convention of crediting exchange set:tlement accounts of dealers on the same day allows
the banking system to transfer same-day funds from
one day to the next through the use of interday float.
This is done by holding a stock of loans with dealers.
Because transactions with dealers receive same-day
credit while checkable funds take one day to clear,
loans to official money market dealers occupy a
special place in the operation of the official money
market. If the banking system as a whole has insufficient exchange settlement funds, it can call in loans
to dealers. (Note that dealers cannot make loans to
banks.) The banking system gets immediate credit
on this transaction and the transaction also leaves
dealers short of same-day funds. Unlike banks,
however, dealers can sell a government security to
the nonbank public and receive same-day funds.
Although dealers receive same-day funds, the check.
written to the dealer will not be cleared until tomor-,
row and will not affect the balances in the banking
system’s exchange settlement accounts until then.
Essentially, the timing convention allows the banking system to make use of float (that is, cash items
in the process of collection) by transferring exchange
settlement funds through time. This also implies that

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

Table

II

MAJOR CHARACTERISTICS OF OVERNIGHT MONEY MARKETS FOR RESERVABLE FUNDS
Australia

United

States

Reserve Requirements
Current reserve requirements
are
based on last month’s deposits and
are therefore lagged. These requirements are held in a special account
called a statutory reserve deposit
account (SRD) and earn a below-market
rate of interest.

Reserve requirements
in the United States
are almost contemporaneous.
Required
reserves for a two-week maintenance
period ending on a Wednesday are
based on deposits for the two-week
period ending on a Monday.

Clearing Balances
Balances held at the Reserve Bank
for the purpose of clearing checks are
called exchange settlement funds. The
exchange settlement
account pays no
interest and can not be negative
at the end of the day.

Banks clear funds through their reserve
account at the Fed. This account can
not have a negative balance at the end
of the day.

Dealers
There are 9 authorized dealers in
Australia. They bank at the Reserve
Bank of Australia.

There are 37 primary dealers in the
United States, some of which are banks.
Nonbank dealers do not bank with the Fed.
Central Bank Lending

There are two forms of lending, one is
to authorized dealers through a line of
credit and is referred to as a lender-oflast-resort loan (LLRI. The other is
through rediscounting government securities (CGS). This is not technically a
loan, but is analytically equivalent to
a loan over the securities’ remaining
maturity. Both means of acquiring funds
usually involve rates that are above market
rates.

bank loans to dealers are a source of same-day liquidity to the banking system and serve the same
purpose as excess reserves do in the United States.
I

Trading Banks Trading banks in Australia are
banks that are authorized to clear checks. Nonbanks
are allowed only indirect access to the check clearing system either by holding accounts with trading
banks or by having an agency arrangement with a
trading bank. For understanding the workings of the
official market, however, there is no loss in assuming that all checks are issued by trading banks.
The important regulations that affect bank behavior
in the official market are the structure of reserve
requirements,
access to rediscounting (discussed
later), and the same-day availability of funds lent to
dealers. Banks maintain required reserves in a special

The Fed lends money to banks through its
discount window. These loans are
typically made at a subsidized rate and
therefore involve some sort of rationing
process.

account called a statutory reserve deposit account
(SRD). These reserves are based on last months
deposits and earn a below-market rate of interest,
implying that the SRD requirement acts as a tax on
the banking system. For check clearing purposes
banks also maintain an exchange settlement account
whose balance cannot be negative at the end of the
day. This is equivalent to requiring that banks meet
their reserve requirement on a day-to-day basis.
In the United States, banks need only meet their
reserve requirements on average and, therefore, have
some flexibility in determining the profile of their required reserve balances. In Australia, flexibility arises
through the use of float produced by the differential
timing in debiting and crediting the accounts of
dealers and banks.

FEDERAL RESERVE BANK OF RICHMOND

21

Th ResemeBank ofAmah
The monetary policy
of the Reserve Bank of Australia is conducted through
its exchange settlement position with the banking
system. To influence the cash position of the banking system the Reserve Bank actively uses open
market operations consisting of outright purchases
and sales of government securities and repurchase
and reverse repurchase agreements. As with most
central banks that essentially use an interest rate
instrument, the volume of trading is many times the
actual change in portfolios. For example, in 198.5186
the Reserve Banks gross purchases amounted to
approximately $29.7 billion while its gross sales were
approximately $28.4 billion, yielding only a small net
increase in its portfolio. The same type of financial
churning typifies U.S. experience. As documented
by Friedman (1982) and by Levin and Meulendyke
(1982), the Federal Reserve made gross transactions
on its own account of $393 billion while only adding
$4.5 billion to its portfolio.
Open market operations in Australia are almost
exclusively implemented through transactions with
authorized dealers, although in unusual circumstances
the Reserve Bank may transact directly with banks.
Unlike open market operations conducted by the
Fed, those carried out by the Reserve Bank of
Australia do not supply same-day funds to the banking system. This is a direct result of dealers banking
with the Reserve Bank. In the United States the Fed’s
purchase of a security from a dealer immediately provides the dealer’s bank with reserves. By contrast,
in Australia the dealer receives funds immediately
but the banking system only acquires funds on the
next day when the dealer’s check clears.
Most of the open market operations in Australia
are defensive. That is, in order to maintain a desired
interest rate the central bank attempts to offset flows
of funds that, by affecting the cash position of trading
banks, would otherwise cause rates to move. For conditions that are’deemed to be short-term or seasonal,
repurchase agreements are frequently employed,
while outright purchases and sales are more often
used to offset longer-term market conditions that
do not accord with desired policy.
Central Bank Lending
Another major way for the banking system in
Australia to acquire exchange settlement funds is
through loans from the central bank. These funds
can reach the banking system in two distinct ways.
One, called a lender-of-last-resort loan (LLR), is indirect and occurs through a line of credit extended
to authorized dealers. The other is through the redis22

counting of specific Treasury notes at the Reserve
Bank.* Rediscounting is not a loan. However, it is
analytically equivalent to borrowing at the effective
rediscount rate (defined below) for the remaining
term of the security rediscounted.
Lender-of-last-resort
loans are made with a term
of 7-10 days. The minimum term is seven days with
dealers having the prerogative of choosing which day
they will repay the loan (as long as it is repaid by
the tenth day). The rate on lender-of-last-resort loans
is usually above going market rates. However, since
dealers can always acquire same-day funds by borrowing from nonbanks, dealers will borrow only if
overnight rates are expected to rise to the level of
the lender-of-last-resort loan rate. Also, since market
rates fluctuate, the LLR rate is adjusted frequently.
Because an LLR loan is for a minimum term of seven
days, the decision to borrow depends not only on
current market rates but on expected market rates
over the term of the loan.
With respect to the rediscounting of government
securities, the Reserve Bank stands ready to purchase
securities at a price P, determined by
P = 100 (1 -nr/365)
where r is the rediscount rate and n is the number
of days to maturity on the note. As Poole (1981.)
points out, this procedure produces an effective rediscount rate of r *, commonly known as the “give-up
yield,” given by
r* = (365/n) ((loo-P)/P)

= r [l-nr/365]-*.

This formula states that the effective rediscount rate
r* is larger than the discount rate r and varies inversely with the number of days n to maturity on the
rediscounted note. Lie the LLR rate, the redisc0un.t
rate is usually above the market rate. The pattern
of money market rates is shown in Chart 1.
Borrowing and rediscounting behavior by banks
and dealers is depicted in Charts 2a and 2b and in
Table III. The data show (1) that large volumes of
rediscounting usually occur when unofficial market
rates slightly exceed the rediscount rate, but (2) that
the rediscount rate is usually above official market
rates. The behavior of lender-of-last-resort
loans is
also similar with dealers borrowing when rates are
expected to rise above the LLR rate. These lending
methods differ significantly from the operation of the
2 The rediscount facility is available to any noteholder
primarily used by banks and authorized dealers.

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

but is

Chart 1

AUSTRALIAN

Percent

21

19

REDISCOUNT

-

20

------,

OFFICIAL

INTEREST RATES

Percent

21

LLR LOAN RATE

---I

SHORT-TERM

--

RATE

20

RATE

UNOFFICIAL

RATE

I9

1
.\

18

18

17

17

16

16

15

JFMAMJ
1984

discount window in the United States.3 In the United
States, discount window loans are usually made at
a subsidized rate. Therefore, controlling their volume
involves some sort of nonprice rationing. Since redis3 A detaikd analytical treatment
be found in Goodfriend (1983).

J&S ON0 JFMAMJ
1986

1985

of the discount window can

counting involves a penalty rate and excess sameday funds are allowed to earn market rates of interest
through loans to dealers, the central bank lending
facilities in Australia are quantitatively less important
than those in the United States. Also, bank loans to
dealers in Australia are proportionately greater than
excess reserve holdings in the United States. A large

Chart 2b

Chart 2a

LLR LOANS
(Monthly

$ Millions

REDISCOUNTS

Average)

$ Millions

Monthly

Average)

35
200

30

160

25
20

720

15
60
10
40

6

0

0
1984

1985

1986

1984

FEDERAL RESERVE BANK OF RICHMOND

1965

1966

23

Table

III

INSTANCES OF LARGE REDISCOUNTINGS

FROM

THE RESERVE BANK (1986)

Date

l/17/86
3/l l/86
418186
6110186
l/ 16187

Rediscounts

63
115
85
83
110

Rediscount
Rate

19.0
18.0
16.5
14.6
14.6

Official
Market
Rate

Unofficial
Market
Rate

18.7
17.5
16.3
14.1
12.4

19.0
17.9
17.8
15.4
16.0

quantity of these loans implies that a substantial
draining of reserves would be required in order to
induce banks in Australia to use the rediscount
facility.
Although the use of rediscounting
and LLR
facilities may not be as great as discount window use
in the United States, they still strongly influence the
behavior of banks and dealers. Since these facilities
represent a cost of acquiring same-day funds, the
rediscount rate and the rate on LLR loans play an
important role in determining the supply of bank
loans to dealers and the demand for short-term funds
by dealers. In essence, the penalty rate charged for
same-day funds represents the cost of being caught
short of those funds and will therefore be an important determinant for banks in deciding how much of
an inventory of same-day funds they should maintain.

III.
The Operating Policy of the
Reserve Bank of Australia
Before investigating the general operating strategy
of the Reserve Bank of Australia, it is necessary to
look at the mechanics of an open market operation.
Doing so will help to clarify the important information contained in the level of bank loans to dealers,
information similar to that communicated by the level
of discount window borrowing in the United States.
Open Market Operations
The mechanics of open market operations can best
be illustrated by means of a numerical example.
Suppose that the exchange settlement accounts of
banks have a zero balance and that banks have loans
outstanding with dealers of $900 million, Also,
assume that taxes of $600 million are being paid
by the public to the Treasury. At approximately
24

9:30 a.m. the Reserve Bank announces the system’s
opening cash figure resulting from the previous day’s
check clearings. In this example the figure is zero.
At the same time, the Bank also indicates its dealing intentions.
As mentioned, banks’ loans to dealers represent
an inventory of same-day funds available to the banking system. The greater this inventory the lower the
probability that banks will be forced to rediscount
government securities. Although banks are not short
of exchange settlement funds today, they are aware
that tax payments will be leaving the system and,
as a result, they will have a cash deficit of $600
million tomorrow morning. Reserves leave the
system because the Treasury
keeps all of its
accounts with the Reserve Bank. Under the assumptions in this example, banks have enough loans
outstanding with dealers to cover the shortfall, but
the resulting loss in dealer loans would certainly be
greater than banks desire at the existing interest rate.
Therefore, individual banks will try to acquire nextday funds by bidding for deposits or selling securities
to dealers or nonbanks and rates will rise. While any
one bank can acquire funds in this manner, the
system as a whole can only acquire funds (1) if the
Reserve Bank provides accommodation by buying
securities from dealers, (2) if dealers finance the purchase of securities through central bank borrowings,
or (3) if someone uses the rediscount facility of the
Reserve Bank.
If the Reserve Bank does not desire any upward
pressure on rates, it can add funds today and allow
the system to transfer the funds from today to
tomorrow. The banks and dealers will make such
transfers because exchange settlement funds do not
earn interest. For example, suppose the Reserve
Bank buys $300 million in repurchase agreements
from authorized dealers. Dealers’ exchange settlement accounts will be up $300 million, augmenting
their ability to purchase interest-earning securities
from nonbanks (or banks) either outright or under
repurchase agreements.
Because dealers’ accounts are debited (or credited)
on the same day, their exchange settlement funds
will now be square. Nonbanks will deposit the
dealers’ checks with a bank and the funds will be
credited to the banking system’s exchange settlement
accounts on the next day. Therefore, although the
accounts of dealers and banks at the Reserve Bank
will not change as a result of the open market operation, float will increase by $300 million, as will
deposits held with the banking system. In effect, the
$300 million has spilled over to the next day so that
banks will only have to reduce the net amount of

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

I

loans with dealers by $300 million rather than $600
million. In this case, the rise in the interest rate will
be lessened.
It should also be noted that if the Reserve Bank
does not provide additional funds on the day that tax
payments leave the banking system, bank loans to
dealers will continue to decline. As a result of the
tax payment, banks have been forced either to reduce
their loans to dealers by $300 million or to rediscount
$300 million of securities. As long as the effective
rediscount rate is above market rates, banks will call
in dealer loans. Calling in a dealer loan results in $300
million being credited to the banking system’s exchange settlement accounts. The exchange settlement accounts of dealers are now deficient by $300
million. Dealers must either take out an LLR loan
or sell securities from their portfolio. The sale of
securities results in immediate credit to the dealers’
exchange settlement account even though the check
will not be presented against the banking system until
tomorrow. Float is, therefore, negative and the
system has essentially borrowed money from the next
day. On the next day the check clears and the banking system is once again short $300 million and
deposits have declined by $300 million. The process will continue until banks’ loans to dealers have
been driven to zero. At this point, arbitrage implies
that the official market rate will have reached the
effective rediscount rate.
This transmission mechanism is quite different
from that in the United States. In the above example, there has been no change in balances held at
the Reserve Bank, since exchange settlement accounts are virtually zero-balance accounts. There is
negative float, but the change in the portfolios of
dealers and the banking system can be many times
the initial $300 million withdrawal of funds. In the
United States, under lagged reserve requirements,
there would be a once-and-for-all decline in free
reserves (excess reserves minus borrowed reserves)
without any need for continuing adjustments. The
monetary base in the United States would have
changed by $300 million and the federal funds rate
would have adjusted. In Australia, the $300 million
shortfall appears to set off a continual adjustment
process without any continuing changes in the
monetary base. This process occurs because loans
to dealers change and these loans represent an inventory of funds that allow the banking system to
postpone rediscounting. In the absence of any subsequent actions by the peserve Bank, banks eventually
must rediscount to keep their exchange settlement
account from becoming negative. In U.S. terminology, holding loans with dealers is analogous to

banks postponing the need to satisfy reserve requirements with non-interest-bearing
reserves.
There is also a similarity between excess reserves
in the United States and bank loans to dealers in
Australia. Both assets represent a source of sameday funds. In Australia, the greater the spread between the effective rediscount rate and the overnight
interest rate, the greater the penalty of being caught
short of same-day funds. As a result, banks will make
more loans to dealers when the overnight rate is low.
For given expectations of future open market operations, there will be a strong relationship between the
amount of dealer loans and overnight rates.
Although the preceding example emphasized the
difference in the transition path of bank balance sheet
items in Australia and the United States, the steadystate equilibrium will be the same. At some point,
say with a reserve requirement of 10 percent and no
currency drain, a $300 million contraction of central bank liabilities will lead to a $3 billion decline
in bank deposits, a corresponding $300 million fall
in required reserves, and a $2.7 billion decline in bank
assets. In order for the U.S. system to follow a
transition path similar to that followed in Australia,
the Federal Reserve would have to vary nonborrowed
reserves so that excess reserves followed a qualitatively similar path to dealer loans in Australia. The
bizarre nature of such a policy is one reason that
the Reserve Bank of Australia does not sit on the
sidelines for any extended period of time. Protracted
contractions and expansions of bank loans to dealers
are not usually allowed to occur.
The above example also highlights a particular
feature of Reserve Bank behavior that does not seem
to be fully appreciated. Specifically, maintaining the
current level of short-term interest rates does not
imply that the Bank should merely offset daily injections of funds into the system. Since bank behavior
in bidding for funds depends on the expected flows
of cash over subsequent days, the Reserve Bank’s
operations must also recognize likely flows of cash
in the future. Otherwise, needless variations in interest rates would arise. Therefore,
to ascertain
whether the Reserve Bank is seeking to move market
rates requires a detailed examination not only of conditions existing on the current day but conditions that
are liable to arise in the near future.
The one-day lag between transactions that provide
exchange
settlement
funds to banks reduces
forecasting errors since banks start each day with a
known cash position. If interbank settlement were
on a same-day basis, the Reserve Bank would have

FEDERAL RESERVE BANK OF RICHMOND

25

difficulty forecasting banks’ needs for cash and this
could lead to larger swings in overnight interest rates.
Of course there is always the possibility that banks
would just hold additional loans with dealers.
However, an optimal inventory strategy would not
cover all contingencies. Also, the ability to borrow
and lend across days allows the system to adjust more
gradually to movements, especially temporary ones,
in settlement funds. Given that the Reserve Bank
is averse to sharp swings in interest rates, this is a
desirable characteristic. In the United States, the
regulation that banks only need to meet their reserve
requirements on average has much the same effect.
Although the accounting procedures in Australia
provide the system with some ability to adjust to
temporary reserve pressures without significant
movements
in rates, a concerted effort by the
central bank to move rates will result in a gradual
and continued change in loans to dealers. In the case
of a tightening in policy, dealers will be forced to seek
funds by borrowing from nonbanks or selling
securities. These actions place upward pressure on
rates. Eventually, the necessary exchange settlement
funds can only come from two sources, lender-oflast-resort loans to dealers and the rediscounting of
government securities.

showed more volatility in 1984, but that may have
been due to a learning process on the part of the
Reserve Bank staff. Currently, daily rate movements
are on the order of 20-60 basis points in each country. The figures on daily volatility coupled with the
large amount of financial churning in each central
bank’s portfolio constitutes strong evidence that both
monetary authorities are using the interest rate as an
instrument, but that the interest rate is allowed a certain amount of flexibility.
As a practical matter, one would like to know how
the monetary authority is able to obtain a desired
average value for the interest rate and yet allow for
daily fluctuations. One would also like to know the
economic effects of this type of policy as compared
to a policy of adhering to an adjustable interest race
peg. In Australia, policy is achieved by targeting bank
loans to authorized dealers, while in the United States
the Fed targets the level of borrowed reserves. As
shown below, both policies are essentially an indirect
interest rate instrument (see also McCallum and
Hoehn (1983) and Dotsey (1987a,b)). In practice,
however, if hitting the targeted level of loans to
dealers forces the interest rate outside its prescribed band, then the target is readjusted. The result
is a discontinuity in policy. Loans to dealers are

Reserve Bank Policy
The major aim of the Reserve Bank’s domestic
market operations is to maintain the official market
interest rate at a level consistent with the objectives
of monetary policy. This type of policy, which uses
the interest rate as an operating instrument, has been
implemented since the floating of the exchange rate
in December 1983. Note, however, that while the
Reserve Bank uses an interest rate instrument, it does
not peg the rate. Rather, its policy is similar to that
of the Fed. The Reserve Bank basically tries to maintain interest rates within some desired band. Fluctuations within this band are tolerated while
movements outside the band indicate a change in
policy. Band widths vary, but are probably on the
order of 100-200 basis points.
The daily volatility of both the official rate in
Australia and the federal funds rate in the United
States are displayed in Tables IV and V. The measure
of volatility is the average squared first difference in
daily rates. Table IV displays this measure for selective sample periods chosen so as to remove the contaminating influence of a general policy-induced trend
in rates. Table V reports monthly averages. The
message
of the two tables is the same. Both central
banks allow daily rates to fluctuate and the amount
of fluctuation is roughly similar. Australian rates
26

Table

IV

VOLATILITY IN THE DAILY OFFICAL RATE AND
THE DAILY FEDERAL FUNDS RATE
(Measured by the average squared first difference
of daily rates over selected sample periods)

Australian

Official

Rate

July 2, 1984

-

Feb.

19,

Feb. 20,

1985
1985
May 1, 1985
Nov. 12, 1985
Feb. 25, 1986
Apr. 29, 1986
Jul. 29, 1986
Oct. 31, 1986

-

Apr.

1, 1985

Apr. 2,

-

Apr. 30,

-

Nov.

Feb. 24,

-

Apr.

U.S.

1979
1, 1983
1, 1984
1, 1985

Oct. 8,
Feb.
Mar.
Jan.

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

-

-

-

1985

11, 1985
1986

1986
Jul. 28, 1986
Oct. 30, 1986
Dec. 30, 1986

Federal
-

1985

28,

Funds

Rate

1983
Feb. 29, 1984
Dec. 31, 1984
Jan. 30, 1987
Jan.

31,

.72
.40
.04
.30
.14
.44
.53
.ll
.03

.61
.08
.18
.25

Table V

VOLATILITY IN THE DAILY OFFICIAL RATE AND THE DAILY FEDERAL FUNDS RATE
(Measured

Australian

Official

1984

Jan.

3.10

Feb.

2.97

1980

.24

.04
.08
.23
.74
.91
.24
.33
.29
.03
.02
.04
.03

.38
1.59
.56
2.24
1.24
.54
.18
.37
.29
.43
.73
1.55

.85

1.78

1.58

May

.64
2.54
.52
.68
.85
.47
.50
-72

.34
.lO
.16
.73
.50
.17
.25
.04
.33
.12

Average of monthly

squared

Sep.

Oct.
Nov.
Dec.

1.31

.40

of daily rates)

Federal

Funds Rate

1982

1983

1984

1985

1986

.87
.30
.60
1.07
1.11
1.21
.72
.42
.54
.24
.ll

.27
.45
.37
.66
.17
.07
.23
.15
-36
.19
.05
.14

.28
.04
.14
.17
.02
.16
.04
.02
.09
.06
.02
.13

.06
.02
.13
.23
.21
.12
.09
.04
.14
.55
.05
.20

.06
.06
.ll
.06
.05
.05
.lO
.06
.08
.09
.17
1.18

.03
.Ol
.07
.05
-01
.05
.04
.Ol
.05
.06
.18
3.38

.69

.26

.lO

.15

.17

.33

1981

1.03

deviations

.25

only used as a guide when the interest rate produced by the procedure remains within specified
bounds. The same is true of a borrowed reserve target
in the United States.
Modeling this type of policy discontinuity would
not be easy. Nevertheless, one can model the procedures that span it. These include an interest rate
instrument that is varied only periodically and a policy
of targeting either loans to dealers (Australia) or discount window borrowing (U.S.). A model of those
procedures may tell us something about the effectiveness of monetary control.

therefore, be accomplished through the interest rate.
This rate can be used directly as an instrument or
indirectly through the targeting of bank loans to
dealers. Although actual policy does not exactly conform to either method, these methods seem to span
policy. Therefore, an investigation of the effects that
market structure has on the monetary-control powers
of a direct versus an indirect interest rate instrument
should reveal information regarding the effectiveness
of actual policy. That different results are obtained
for the United States and Australia shows that market
structure is relevant when analyzing the efficiency
of monetary policy.
The Market for Reserves

IV.
The Economic Model

/

first difference

U.S.
1986

1.16

Aug.

squared

1985

Mar.

Jul.

average

Rate

Apr.
Jun.

by the monthly

Overview
The purpose of this section is to consider the
effectiveness of two different operating procedures
for controlling money. Given that the Reserve Bank
employs lagged reserve requirements,
the basic
instrument of monetary control must be the official
market rate. With lagged reserve requirements,
today’s required reserves are based on last period’s
deposits and there is no way for current policy to
affect history. The control of the money stock must,

Capturing the major attributes of the Australian
money market in an analytically tractable manner
requires a degree of abstraction. It is, therefore, important to isolate the key features that characterize
the market for reserves. These features include
(1) the presence of lagged reserve requirements,
(2) the requirement that exchange settlement accounts be nonnegative, and (3) the intertemporal
decisions involved in rediscounting, lender-of-lastresort loans, and bank loans to dealers. The intertemporal nature of bank behavior can be illustrated by
assuming that the average maturity of a rediscounted

FEDERAL RESERVE BANK OF RICHMOND

27

security is two periods of a week each. Similarly,
central bank loans to dealers are assumed to be for
two periods. One may also wish to think of the
reserve maintenance period as being two periods in
length, although this is not crucial. It will be evident
that, for the two alternative operating procedures
analyzed, the particular reserve accounting regime
is irrelevant.
The Demand for Money
The intuition behind the results concerning the
effectiveness of monetary control (as measured by
the squared deviation of money from its target value)
can be understood without a detailed description of
the economy.4 Since monetary control is being
examined, it will be necessary to discuss the demand
for money.
The real demand for money is assumed to be
positively related to income and negatively related
to the nominal interest rate. When output is high,
individuals tend to spend more. The resulting increase in their transactions requirements implies that
more real money balances are desired. Conversely,
as nominal interest rates rise the opportunity cost of
holding money balances increases and individuals
economize on their money holdings. The demand
for money also depends on a stochastic element that
may be thought of as representing
unobserved
changes in transactions costs brought about by
innovations in cash management procedures. This
random element is assumed to show some persistence and for simplicity is characterized by an AR1
process. That is, the shock to money demand, xt,
is equal to exrl +vI, where 0 < e < 1, and v, is white
noise. This means that any current disturbance to
the demand for money will also affect the future
demand for money, although the effect will dampen
over time. Some element of persistence is needed
to make interesting the comparison between targeting
loans to dealers in Australia (borrowed reserves in
the United States) and an interest rate instrument.
Otherwise, an interest rate instrument would trivially
dominate the loans-to-dealer target (and similarly a
borrowed reserve target in the United States) as a
means of controlling money (see McCallum and
Hoehn (1983) and Dotsey (1987a, b)). An AR1
process for the money demand shock represents the
simplest way of incorporating persistence and allows
the analysis to proceed at an intuitive level.5
4 For a detailed presentation see McCalhrm and Hoehn (1983)
or Dotsey (1987a, b). The model used represents a closed
economy. Extending the result to open economy would be of
interest but the basic mechanism that drives the results does
not seem to be sensitive to such an extension.
5 A degree of permanence could be modeled for the other
variables without affecting the qualitative results.
28

An Interest Rate Instrument
One basic means for controlling money is a policy
of directly using the interest rate. The efficiency of
this policy is measured by the expected squared
deviation of money from its target, rnz The targeted
level of money could arise from some complicated
feedback mechanism on past and expected values
of various economic variables that are chosen to
satisfy broader policy objectives. However, the actual choice of m,‘is not crucial (see McCallum and
Hoehn (1983)), and for simplicity it is assumed that
the targeted level of money is a constant.
In order to use an interest rate instrument, the
Reserve Bank would peg the current interest rate at
a level that will produce an expected value of money
equal to rn*TGraphically, the demand for money can
be drawn as a negatively sloped curve with respect
to the interest rate. This is depicted in Figure (la),
where rn: is the expected demand for money based
on past information that includes observations on last
period’s economic disturbances. The Reserve Bank
then chooses the interest rate r,‘that it anticipates
will equate current money demand with its targeted
value.
If the economy does not encounter any shocks,
then the demand for money will exactly equal its
target. Disturbances, however, will generally occur.
For example, the demand for money could be unexpectedly high or there could be a shock to aggregate
supply that would affect income and consequently
the demand for money. The dashed lines in Figure
(lb) reflect two possible demands for money that
could occur in the presence
of unanticipated
economic disturbance,s. If the demand for money
were unexpectedly high, then actual money would
be rnf and the Reserve Bank would miss its target.
Similarly, if money demand were lower than anticipated, actual money would end up lower than the
target.
Pegging the interest rate therefore does not produce perfect period-by-period control of the money
stock. However, since the errors in controlling money
are not systematic, the high and low misses will
cancel out over a long enough period. The same is
true when the variable targeted is loans to dealers.
Thus, in comparing the effectiveness of the two
operating procedures, one needs to examine the
relative variability in money’s deviation from target.
Targeting Bank Loans to Dealers
Alternatively, the Reserve Bank could attempt to
achieve a desired level of money by aiming at a
desired level of bank loans to dealers. As mentioned, this variable indicates the amount of sameday funds available to banks. For simplicity, it will
be assumed that bank loans to dealers are supply-

ECONOMIC REVIEW. SEPTEMBER/OCTOBER 1987

Figure 2a

Figure la
Interest

Interest Rates (rt)

Rate (rt)

1

l
-rt

dc

--\

c

dl;

Bank Loans & Dealers

Real Money Balances

Figure lb
Interest

Figure 2b

Rate (r,)
I

a
mt

l

mt

b
mt

dlt+

determined with dealers accepting any amount of
loans at the going rate. Banks hold loans with dealers
because funds in exchange settlement accounts do
not earn interest. The inventory of same-day funds
will be based on the cost of running short. Specifically, if a bank must rediscount a two-period security in order to obtain exchange settlement funds,
the cost is the effective rediscount rate minus the
expected yield on the security rediscounted. In order
to avoid this cost, banks will have a well-defined
demand for an inventory of same-day funds. These
funds are acquired by making loans to official money
market dealers. As market rates rise to the level of
the effective rediscount rate, there is no longer any
advantage to holding loans with dealers since rediscounting no longer involves a penalty. Therefore, the
supply of dealer loans is indirectly related to the
offical market rate.
Under lagged reserve requirements the procedure
of targeting banks’ loans to dealers amounts to an
indirect interest rate instrument, as does targeting

borrowed reserves in the United States. This can be
seen by examining Figure (Za). Figure (Za) represents
the anticipated supply of loans, dl”, as an inverse function of the interest rate. As interest rates rise and
approach the effective rediscount rate, the penalty
associated with rediscounting declines. There is,
therefore, less reason for holding same-day funds with
dealers.
How should the Reserve Bank choose a target for
dealer loans, dl: given that it is interested in achieving a quantity of money equal to rn: ? As in the case
of an interest peg, the Reserve Bank must choose
r,*in exactly the same manner. Then, given rZ it will
choose dl:at a level that it anticipates will be consistent with r: If there are no economic disturbances,
using open market operations to induce banks’ loans
to dealers to equal dl: will result in an interest rate
of Cand money demand equal to rn:: It is in this sense
that using a reserve instrument amounts to using an
indirect interest rate target.

FEDERAL RESERVE BANK OF RICHMOND

29

Now assume that the supply of bank loans to
dealers is also affected by a random component, and
that no other random disturbance impinges on the
economy in the current period. In this case, the
actual supply of loans could be depicted by either
of the dashed lines in Figure (Zb). For the case in
which the supply is unexpectedly high, maintaining
the reserve target at dl:results in an interest rate of
r: and money demand of m:. With no disturbances
to money demand, aggregate supply, or aggregate
demand, the Reserve Bank would still miss its
monetary target. The targeting of bank loans to
dealers would be unambiguously worse than using
the interest rate directly if there were no persistence
in the economy.6
To see how persistence can potentially alter the
analysis, one can examine the case of a positive
money demand disturbance. Individual banks will
perceive part of this disturbance by observing
movements in the interest rate and an increase in
money balances in its depositors’ accounts which are
positively correlated with aggregate movements in
money. Because the money demand disturbance
shows persistence, banks realize that next period’s
demand for money will be high and the next period’s
interest rate will have to rise if the Reserve Bank
expects to achieve its monetary target. An expected
rise in the interest rate will lessen the expected
opportunity cost of rediscounting securities with
maturities of two periods and longer and will,
therefore, affect this period’s supply of bank loans
to dealers. Given the structure of the Australian
market for reserves, the supply of loans will decline
and today’s interest rate will fall. The fall in the
interest rate will work to further increase the money
balances held by the public and exacerbate the deviation of money from target. This means that using
bank loans to dealers is unambiguously worse than
an interest rate instrument for controlling money in
Australia.
The preceding analysis implies that, from the
standpoint of monetary control, targeting bank loans
to dealers is likely to be inferior to an interest rate
target in Australia. The practical importance of this
finding is that the Reserve Bank of Australia should
be more concerned with the interest rate than with
6 Another necessary condition for a reserves instrument to
potentially outperform an interest rate instrument is heterogeneity
of information among agents (see Dotsey (1987a)).

30

bank loans to dealers. When applied to the United
States the results may be different. This difference
occurs because discount window borrowing is
generally subsidized and thus must be rationed in
some way.7 Banks attempt to take advantage of their
borrowing privilege when rates are expected to be
high. In the case of a partially perceived positive
money demand disturbance, banks in the United
States (as in Australia) expect that next period’s
interest rate will rise. Assuming an unchanged borrowing (discount) rate, they therefore attempt to
postpone borrowing today with the result that a
higher funds rate is required to induce them to
borrow the targeted amount. This higher funds rate
reduces the quantity of money demanded and causes
the actual level of money to be closer to target than
it would be under an interest rate instrument.
Targeting borrowed reserves can, therefore, improve
monetary control if the demand for borrowing is not
too volati1e.s

V.
Summary
This paper presents
a comparison
between
operating procedures and money market institutional
arrangements in Australia and the United States. The
conclusion is that, although the central banks of both
countries use similar operating procedures, differences in institutional structure affect the relative
efficiency of policy. The most important institutional
differences are the administration of central bank
lending and the fact that official money market dealers
bank at the Reserve Bank. The use of lagged reserve
requirements in Australia as opposed to contemporaneous reserve requirements is not an important
difference under current operating procedures. The
use of an interest rate instrument, either directly or
indirectly, makes the reserve accounting regime
irrelevant. Other aspects of the money market such
as different rules for satisfying reserve requirements
in Australia and the United States are likely to take
on more importance under contemporaneous reserve
requirements and reserve targeting.
7 For more detail see Goodfriend

(1983).

* For a more complete

see Dotsey

ECONOMIC REVIEW, SEPTEMBER/OCTOBER 1987

treatment

(1987a).

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FEDERAL RESERVE BANK OF RICHMOND

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Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102