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FEDERAL RESERVE BANK
OF SAN FRANCISCO
ECONOMIC REVIEW
ALTERNATE STRATEGIES
TOWARD INFLATION
1I!!i.--~LL
18
The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by the Bank’s
Research and Public Information Department under the supervision of Michael W. Reran, Senior
Vice President. The publication is edited by William Burke, with the assistance of Karen Rusk
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necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of
the Board of Governors of the Federal Reserve System.
For free copies of this and other Federal Reserve publications, write or phone the Public
Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco,
California 94120. Phone (415) 544-2184.
2
Alternate Strategies
Toward Inflation
I.
Introduction and Summary
4
II.
The Phenomenon of Inflation, and the Prospects for AntiInflation Policy
Michael Bazdarich
6
... The im portance of m onetary fa ctors in in itia tin g a n d /o r sus
ta in in g in fla tio n suggests the need fo r a sustained reduction in
the g ro w th rates o f the m onetary aggregates.
III.
Conducting Effective Monetary Policy: The Role of Operating
Instruments
John P. Judd and John L. Scadding
23
...P o lic y m a k e rs are like ly to co n tro l th e ir chosen operating
instrum ent in a ca u tio u s m anner, reflecting uncertainties about
the econom y and the im pact of p o licy actions.
IV. Optimal Control and Money Targets: Should the Fed Look At
“Everything”?
Kenneth C. Froewiss and John P. Judd
38
. . . O nce policym akers take a cco u n t of g ro w th in m oney, they can
gain little a d d itio n a l in fo rm a tio n about aggregate dem and from
bank cre d it and interest rates.
V.
Exchange-Rate Policies and Inflation: Theory and Evidence
Hang-Sheng Cheng
. . . “ S u b -o p tim a l” exchang e-rate po licies in fo u r Pacific Basin
co u n trie s have in cu rre d costs in term s of h igher-tha nnecessary in fla tio n rates.
E ditorial co m m ittee fo r th is issue:
M ichael Bazdarich, Randall Pozdena, D onald Roper, and H erbert Runyon
3
50
The United States remains mired in the worst
peacetime inflation of its entire history, following a 90-percent upsurge in the general price level
over the past decade, and many other industrial
nations exhibit similar records. We must carefully examine the causes ofthis severe problem, and
then determine the best way of returning the
nation to relative price stability-hence this issue
of the Review. The first article evaluates the
theoretical and empirical evidence on the causes
and costs of inflation-as well as the costs of
anti-inflation policy-as a means of determining
which policy has the most reasonable chance of
sustained success against inflation. The next two
articles provide a rationale for the Federal Reserve's October 6 shift in monetary policy-a
shift which promises greater control over price
fluctuations, through its increased emphasis on
the control of the monetary aggregates. The final
article utilizes the experiences of Japan and three
other fast-growing Far Eastern economies to
examine the relationship between exchange-rate
policy and inflation.
Michael Bazdarich, in the first article, employs
a simple macroeconomic analysis to present
statements of both monetary and cost-push (or
income-share) theories of inflation. He concludes that all these theories require an accompanying increase in the money supply to provide
a consistent account of continuing inflation. "It
follows that the various theories can explain
sustained inflation, such as we have experienced,
only to the extent that they can explain systematic increases in the money supply."
Turning to the formulation of an effective
anti-inflation policy, Bazdarich notes several
questions which policymakers must face. First,
should inflation in fact be slowed? "We argue
that the costs of inflation are considerable and
recurring, whereas the output costs of stopping
inflation, while considerable, are temporary, and
would be almost wholly absorbed by the economy within a three-to-five year period following a
sustained effort to reduce the rate of inflation."
Next he asks, what policy instruments should be
used if we decide to slow inflation? "The import-
ance of monetary factors in initiating and/ or
sustaining inflation implies that an effective antiinflation policy must include a sustained reduction in the growth rates of the monetary aggregates. This is true even if one holds to a strict
cost-push view of inflation."
Finally, he asks, how rapid a reduction in
inflation should policymakers try to attain?
"Though political forces may push for a 'quick
fix', the lags from monetary policy to inflation
make it impossible to achieve an immediate
reduction in the inflation rate. Moreover, attempts to eliminate inflation quickly would
make a deep recession inevitable, which would
tend to shift political sentiment from fighting
inflation to reducing unemployment, and thus
could lead to stimulative policies and another
inflationary cycle."
John P. Judd and John L. Scadding next turn
to the crucial role of monetary policy, specifically to consider the implications of the recent
major shift in the focus of short-run policy
procedures. First there is the strategic question
of translating ultimate stabilization goals, such
as price stability and full employment, into
intermediate targets for the monetary aggregates. Next, there is the tactical question of
choosing an operating instrument as a means of
reaching the desired monetary targets. Until
recently, this two-step procedure consisted formally of a Federal-funds rate operating instrument designed to achieve intermediate targets for
the monetary aggregates. But the authors contend that the reality of policy differs significantly
from its appearance. Specifically, they argue that
the Federal Open Market Committee (FOMC)
operates in such a way to ensure the linkage of
operating instrument and intermediate target, so
that they cannot in practice be separated in the
way suggested by the formal description. This
reflects the fact that there are two dimensions to
the operating-instrument decision-the choice
of instrument, and also the choice of methods of
employing the chosen instrument.
Judd and Scadding argue that the FOMC is
likely to control whatever operating instrument
4
control argument is theoretically unassailable,
but argue that it cannot be considered relevant to
policymakers without reference to a related
empirical question: which variables, if any, contain information about aggregates in addition to
the policy variables on which policymakers naturally rely? Froewiss and Judd reply, "The statistical tests indicate that, once policymakers take
account of growth in money (especially M 2), they
can gain little additional information about
aggregate demand from such variables as bank
credit (and its components), interest rates, and
flow-of-funds variables."
it chooses in a cautious manner. This rational
approach follows naturally from apparently
unavoidable uncertainties about the actual state
of the economy and the impact of policy actions.
This cautiousness means that the choice of operating instrument largely pre-ordains the effective choice of intermediate targets. Cautious
control of the funds rate means that the FOMC,
in effect, uses interest rates as its intermediate
target, whether or not it has official aggregates
targets. An interest-rate approach is most nearly
optimal when real-sector disturbances are smaller than monetary-sector disturbances, and when
inflation is not a major problem. Cautious control of reserves means that the FOMC uses the
monetary aggregates as its intermediate target,
which is most nearly optimal when real-sector
disturbances are larger than monetary-sector
disturbances, and when inflation is a serious
source of concern. These conclusions thus suggest two guidelines: 1) Choose the most nearly
optimal intermediate target, on the basis of the
available empirical evidence; and 2) Choose the
operating instrument which, when controlled
cautiously, orients policy as much as possible
around the chosen intermediate target.
Generally speaking, Froewiss and Judd find
little evidence to support the view that the Federal Reserve should not target money because this
involves "throwing away" significant financialmarket information. "Furthermore, these results
reconfirm the robustness of the association between money and aggregate demand."
Hang-Sheng Cheng, in a final article, analyzes
the relationship between exchange-rate policies
and domestic inflation. He shows that, in an
open economy, any inflationary disturbance
from whatever source always manifests itself as a
pressure in the foreign-exchange market, in the
form of a reserve change or an exchange-rate
adjustment (or a combination of the two). He
also shows that the essence of an exchange-rate
policy lies in a deliberate policy choice regarding
the distribution of the "exchange-market pressure" between reserve changes and exchangerate adjustments. From this analysis, he derives a
policy rule for minimizing domestic inflationpermit exchange appreciation and resist depreciation, regardless of the source of inflationary
disturbances.
"Monetary policy", they conclude, "should
lean more toward a pure aggregates strategy than
a pure interest-rate strategy. Given the uncertainties and other constraints on FOMC actions,
the reserves approach recently adopted will
automatically imply an aggregates orientation of
monetary policy. This will be a distinct improvement over former policies which, despite official
aggregates targets, were really oriented around
interest rates."
Kenneth C. Froewiss and John P. Judd next
consider whether it is wise to single out one
variable-the money supply-from among all of
those on which the Fed might focus its attention.
"Indeed, to confer primacy on 'money' goes
against a long Fed tradition of 'looking at everything' in attempting to gauge the direction of the
economy and the correspondingly appropriate
monetary policy." Moreover, that tradition has
some support in the theory of "optimal
control"-a theory which implies that monetary
policy is unlikely to be optimal if available
information about goal variables is not used.
Froewiss and Judd agree that the optimal-
Cheng then applies this rule to assess the
actual exchange-rate policies and inflation experiences of Japan, the Philippines, Korea and
Taiwan during the 1968-78 period. "All four
countries exhibited a strong aversion to currency
appreciation and a strong preference for currency depreciation-an attitude exactly opposite to
what our policy rule would prescribe." Cheng
notes that this attitude may have stemmed from
other policy objectives, such as export competitiveness and income growth. "A 'sub-optimal'
exchange-rate policy incurs a cost in terms ofa
higher-than-necessary inflation rate."
5
Michael Bazdarich*
Inflation is currently judged to be the American economy's number-one problem by President Carter, Chairman Volcker, and most other
prominent government officials, not to mention
the American public. And reducing inflation, of
course, is a primary goal of Federal Reserve
policy. Clearly, then, the development of an
effective anti-inflation policy is a crucial issue.
In order to address this issue, one must first
analyze the nature of the inflation process itself,
as well as the underlying economic causes of
inflation. This is the aim of the present paper. We
will evaluate the available theoretical and empirical evidence on the causes and costs of inflation
as well as on the costs of anti-inflation policy. We
will then use the results of this analysis to determine which anti-inflation policy has the most
reasonable chance of sustained success.
To this end, in Section I we employ a simple
macroeconomic analysis to present comparable
statements of both monetary and cost-push (or
income-share) theories of inflation. On the basis
of that analysis, we conclude that all these
theories require an accompanying increase in the
money supply in order for them to provide a
consistent account of continuing inflation. It
follows that the various theories can explain
sustained inflation, such as we have experienced,
only to the extent that they can explain systematic increases in the money supply.
In Section II, we use these points to discuss
what a meaningful test of the competing theories
of inflation should show, and evaluate the empirical evidence on these terms. We see ample
evidence there of a strong positive effect of the
monetary aggregates on the price level, but find
very little evidence that U.S. monetary policy has
systematically reacted to accommodate cost-
push or monopoly-pricing factors. Also, despite
mixed evidence, we find some signs of effects of
government spending and federal deficits on the
monetary aggregates. These results suggest that
U.S. fiscal and monetary policies have had a
substantial role in initiating and sustaining inflation over the last two decades.
In Section III, we discuss the economic costs
of inflation. Besides increasing uncertainty and
redistributing wealth, inflation also causes people to shift out of holding money balances into
shopping more often, stockpiling goods, and
making speculative investments-all of which
lead to inefficient allocations of resources. Also,
because of government tax regulations written in
terms of nominal amounts, inflation distorts
private decisionmaking. We conclude, then, that
the costs of inflation are indeed significant.
The rest of our analysis concerns the costs of
anti-inflation policy and the choice of the best
policy to achieve that end. In Section IV, we
discuss the output-employment costs of antiinflation policy by considering current evidence
on the Phillips curve inflation-unemployment
tradeoff. The available evidence suggests that
significant amounts of output and unemployment would be lost under any anti-inflationary
fiscal and monetary policy. Still, it is doubtful
that alternative or additional policy actions can
avoid such costs while still slowing inflation.
In Section V we consider the implications of
this analysis for the formulation of an effective
anti-inflation policy. Here we attempt to answer
three questions facing the policymaker: 1)
Should inflation in fact be slowed? 2)What
policy instruments should be used if we decide to
slow inflation? and 3) How rapid a reduction in
inflation should policymakers try to attain?
The answer to the first question might seem to
be a foregone conclusion, yet it's useful to con-
*Economist, Federal Reserve Bank of San Francisco
6
push forces, and partly because such policies
have historically tended to substitute for rather
than complement monetary restraint.
Finally, with respect to the third question, the
crucial issue in deciding how quickly to stop
inflation is how the costs of stopping inflation
can be least painfully imposed. Though political
forces may push for a "quick fix", the lags from
monetary policy to inflation make it impossible
to achieve an immediate reduction in the inflation rate. Moreover, attempts to eliminate inflation quickly would make a deep recession inevitable, which would tend to shift political
sentiment from fighting inflation to reducing
unemployment, and thus could lead to stimulative policies and another inflationary cycle. This
strongly suggests that restrictive policies should
be implemented slowly enough to avoid a deep
recession, but resolutely enough to have some
lasting effect on inflation. That is, policymakers
must avoid expansionary temptations once their
policies begin to work in slowing inflation.
Naturally, such a passive policy course could be
politically unpopular, and thus hard to maintain.
Nevertheless, it may be the only course of action
that can generate a sustainable reduction in
inflation without severely distorting or disrupting the workings of the American economy,
sider the pros and cons formally. We argue that
the costs of inflation are considerable and recurring, whereas the output costs of stopping inflation, while considerable, are temporary, and
would be almost wholly absorbed by the economy within a three-to-five year period following a
sustained effort to reduce the rate of inflation.'
In this light, the costs of stopping inflation do not
appear to outweigh the costs of inflation itself.
Also, given the substantial responsibility of fiscal
and monetary policymakers for originally causinginflation, it can be argued that they should
direct their efforts toward reducing the inflation
problem today.
With respect to the second question, the importance of monetary factors in initiating and/ or
sustaining inflation implies that an effective antiinflation policy must include a sustained reduction in the growth rates of the monetary aggregates. This is true even if one holds to a strict
cost-push view of inflation. At the same time, we
argue that tighter fiscal policy and the removal or
easing of governmental regulatory burdens may
successfully augment monetary policy by mitigating its contractionary effects on various sectors of the economy. However, we see no useful
role for incomes policies in our anti-inflation
strategy, partly because there is no clear evidence
that wage and price restraints can mitigate cost-
I. Inflation in Macroeconomic Theory
For our purposes, theories of inflation can be
divided into two major groupings: monetary
theories and cost-push~or more precisely, what
Charles Schultze has called "income share"~
theories of inflation) Monetary theories cite
accelerations in the growth of various monetary
aggregates as the primary inciting and sustaining
factor in inflations. Cost-push or income-share
theories, on the other hand, stress the importance of supply factors, such as autonomous
increases in important wages or prices, in generating continuing wage-price spirals. Usually,
such autonomous increases are. said to occur
when firms or labor unions exercise their perceived monopoly power in an attempt to increase
their profits or wage· incomes, respectively.3
Their actions subsequently lead to price and
wage increases throughout the entire economy.
As stated here, both types of inflation theories
provide only partial explanations of the inflation
process. Monetary approaches provide a reasonably complete description of how the money
supply operates through demand and supply to
effect an increase in the price level. However, the
pressures~political or otherwise~which cause
policymakers to allow the money supply to
increase in the first place often are not described
or documented as fully as are the effects of
money on prices. On the other hand, incomeshare theories generally provide descriptions of
the economic and sociological forces leading to
cost-push behavior. However, most of these
discussions do not provide a cogent enough
analysis of how the momentum of cost-generated
wage-price spirals can continue without severe
disruptions of output and employment. These
7
Of course, in the short-run, before prices have
adjusted fully, a higher money supply will induce
higher output and employment, and other real
effects. However, these will disappear once the
economy has adjusted fully to the higher money
supply.6 Furthermore, continuing increases in
the money supply will exert continuing upward
pressure on nominal demand, and so can cause
continuing inflation.
respective analytical problems are discussed
further below.
Economists typically define inflation as a
sustained increase in the average price level, and
thus in the money price of virtually all goods.
However, industry-specific phenomena-such
as bankruptcies, mergers, technological development, and changes in consumer tastes or supply
conditions-typically change prices in one industry relative to another, but do not have much
effect on the price level in general. Rather, such
relative price changes serve as signals to the
economy to shift resources among industriesand to shift consumption habits among goodsin order to promote economic efficiency. Some
prices will rise and others will fall, but prices on
average need not change at all. Under inflation,
however, the dominant characteristic is an increase in virtually all money prices, with resource
shifts either non-existent or primarily due to
factors unrelated to the inflation itself. Thus,
there is a fundamental conceptual difference
between factors which lead primarily to relative
price changes and those which lead primarily to
absolute price-level changes, or inflation. 4
There is also a distinction between factors
which cause continuing inflation and those
which cause only one-time movements in the
price level. Thus, some factors can have a broad
enough impact to raise the general price level
once-and-for-all, but cannot cause continuing
price increases. Therefore, these factors cannot
seriously be considered as causes of sustained
inflation such as the United States and other
countries have experienced.
Inflation has been linked to increases in the
money supply at least since the writings of David
Hume some two hundred years ago. 5 The reason
is that increases in currency and deposit holdings
by the public serve to increase demand~andso
money prices-for all goods rather than to shift
demand from one good to another. Moreover,
an increase in the money supply serves tojn~
crease nominal demand for goods butdoes not
change underlying real supply conditions (i.e.,
technology and factor supplies). Such. an increase ultimately affects only prices, without
necessarily inducing resource shifts from one
industry to another.
In the days of the gold standard, monetary
analyses explained secular increases in the supply of specie (gold)-and thus inflation-largely
through expropriations or discoveries of gold
and silver. In modern economies with fiat monies, the supply of currency and deposits is largely
under the government's control, so a complete
monetary theory of inflation must explain why
the government would, in effect, choose to inflict
inflation on an economy by expanding the money supply.
One obvious explanation is the political pressure to maintain high-employment and output
conditions. Since prices and resources are not
perfectly flexible in the real world, central banks
are constantly under pressure to insure that their
domestic money supply grows at least as fast as
money demand. (Otherwise, there would be
general downward pressure on prices, which
could lead to depressed business conditions if the
economy did not react immediately.) In such a
case, the money supply inevitably would grow
faster than money demand, and thus impart an
inflationary bias to the economy.
Also, the lags from monetary expansion to
inflation are longer than those from monetary
expansion to increases in output. This naturally
causes conflict between those with short-term
time horizons, who are concerned with output
and employment here and now, and those with
longer horizons, who are more worried about
long-term problems such as inflation and stable
gro\vth. When short··term problems are especial-
ly pressing, or when those short-run concerns
gain superior political force, monetary expansion will accelerate, thus leading to accelerated
inflation later on.
Another oft-cited explanation of inflationary
monetary expansion is the tendency for higher
government expenditures to be financed by
8
money creation rather than by higher taxes or
bond sales to the public. The higher spending
therefore leads to faster money-supply growth,
which then eventually leads to accelerated inflation. It is important to realize that the same level
of government spending would be much less
inflationary when financed fully by taxes or
bond issues to the public. Higher taxes would in
effect shift demand from the general public to the
government, so that the higher spending could be
accomplished with a small one-time increase in
the price level. Public bond issues would either
shift demand from investors to the government,
or would tend to increase interest rates in credit
markets, in either case mitigating price rises. 7
However, when money creation finances government spending, this serves to augment rather
than offset the higher government demand for
goods. What's more, the money supply will tend
to continue growing as long as spending remains
at a high level, so that a continuing inflation can
occur.
All the phenomena discussed in this context
are primarily sources of relative price change. By
themselves, they represent, at most, temporary
or one-time pressures on the price level. The
typical problem for these theories is to explain
how such one-time, industry-specific factors can
induce a continuing, general inflation without
disrupting equilibrium levels of output and employment.
Consider, for example, an increase in wages in
an industry due to union demands. If all other
wages and prices in the economy then increase by
like amounts in order to maintain real incomes,
real wealth will decline due to the lower purchasing power of cash and other assets with fixed
money values. Therefore, demand would be
insufficient to maintain full-employment output,
so that either the price level would fall towards its
previous level or the economy would go into
recession. In other words, if all prices rise, but
aggregate demand conditions remain unchanged, the new set of prices could not be an
equilibrium and so could not be sustained.
Thus, for cost-push types of disturbances to be
a source of continuing inflation-but not of
continuing unemployment-there must be an
accompanying stimulus to aggregate demand, as
would be provided by an increasing money
supply. Accommodative monetary policy in such
a situation might occur if policymakers increased
the money supply in order to avoid even the
temporary losses in output and employment
resulting from inflexible prices and inputs.
Equilibrium output levels could then be maintained, because the increased money supply
would serve to increase the equilibrium price
level up to the level of actual prices, and thus to
validate the higher prices.
This type of accommodating increase in the
money supply must occur to sustain any inflation
triggered initially by cost-push influences. An
income-share struggle or supply shock would
provide the initial spark, and the increasing
money supply would provide the fuel to support
the continuing inflation. Though analyses of this
type emphasize various conflicts and shocks, and
hardly even mention the money supply, an accommodative monetary policy nevertheless
plays an essential role in sustaining such wageprice spirals.
In summary, increases in the monetary aggregates can be seen to lead to the general type of
price increases which we have defined as inflation. Monetary theories also cite various political factors which can lead to the initial excessive
monetary expansion.
Income-share theories attribute inflation to
the struggles of business firms, labor unions, and
other groups to increase their share of the economic pie. Initially, these groups attempt to
exploit their perceived monopoly power to raise
the prices of their goods or services. When higher
wages raise costs and prices in an industry
and/ or when higher commodity prices raise the
costs of producing other goods and of maintaining living standards, other firms and unions
attempt to keep pace by raising their own prices,
which can then cause a wage-price spiral to
emerge. Various versions of this approach include cost-push, wage-push and sellers' inflation
theories, as described in the writings of John
Kenneth Galbraith, Abba Lerner, Edward Bernstein, and others. Similar theories cite shocks to
particular industries-such as the OPEC oil
price hike of 1973 or various crop failures-as
the first causes which raise costs and so generate
continuing inflationary spirals. 8
9
increases merely symptoms of a general inflationary situation-or are wage and price increases typically autonomous forces, with faster
money growth validating higher prices in order
to prevent business slumps?9 An analysis of the
empirical evidence can provide some evidence on
this issue.
The debate between monetary and incomeshare theories of inflation can therefore be
couched in terms of which is more effective in
explaining the actual expansion of the monetary
aggregates. That is, does the money supply
typically increase because of fiscal-and
monetary-policy decisions, with wage and price
II. Inflation in Fact
Since 1964, consumer-price inflation in the
United States has averaged 5.75 percent per year,
and has tended to accelerate, and manufacturing
wage rates have shown much the same behavior
(Chart 1). Relative price changes have indeed
occurred over this period, but, as documented in
Fama and Schwert (1977), they apparently have
not been systematically related to observed inflation. 1O Nor have business slumps and unemployment followed every wave of price increases, or
worsened as inflation continued. Rather, the
price level has moved inexorably upward
throughout the period, during booms and serious recessions, and during shortages and surpluses for important commodities like food,
steel, and oil. In other words, we have experienced a classic inflation, with actual price behavior generally characterized by accelerating rates
of increase of all prices rather than by periodic
changes in a few dominant commodity prices.
Again, relative price changes and inter-industry
shocks have occurred, but have not represented a
Chart 1
Changes in Money Supply and Federal Debt
Change (%)
18
17
c-
Year· to· year change
16~
15
14
13
12
11
10
9
8
7
10
the more traditional evidence used to support
income-share inflation hypotheses. Over the last
few decades, several articles have documented a
relation between various factors (such as wage
increases and changes in industrial concentration) and inflation rates, both secularly and at
various points in the cycle. IZ As Levy (1979)
points out, however, all these studies have two
serious defects: their results are not shown to be
inconsistent with a monetary theory of inflation,
and the phenomena they cite are not shown to be
sources of autonomous shocks rather than reactions to already existing inflationary forces. In
any inflation, as we have seen, all nominal
variables inevitably rise together. Therefore,
merely documenting a statistical correlation
between, say, wages and prices, does not rule out
the possibility that both are being driven by a
third factor, such as the money supply. In the
jargon of statistics, tests of the cost-push theory
have been of very low power, with little or no
ability to rule out competing hypotheses.
A meaningful way to test between monetary
and income-share theories would be to acknowledge the long-run monetary nature of inflation,
and then to analyze the factors which cause
monetary expansion, and so serve to generate or
perpetuate inflation, as the case may be. If
dominant characteristic of the continuing U.S.
inflation.
Over this same period, the monetary
aggregates-'such as M I and M z -have also
grown at an accelerating rate (Chart 2), as has
virtually every nominal variable that one could
name. This concomitant increase in money and
prices is consistent with our argument that the
money supply must increase for inflation to
continue. What is more impressive is the massive
amount of statistical evidence which documents
a systematic link between various money-supply
measures and price levels over a wide range of
economic experiences. For example, a recent
study found that fluctuations in the M I measure
were able to explain over 60% of quarterly
fluctuations in U.S. consumer prices over lfhe
1959-78 period. 11 Thanks to such results, economists nearly unanimously acknowledge the importance of money-supply growth in sustaining
inflation.
As discussed earlier, however, these results do
not explain what factors lead to the initial monetary expansion, and so do not necessarily rule
out cost-push-cum-accommodation theories.
Still, some studies have directly addressed these
issues.
But first, it may be useful to consider some of
Chart 2
Changes in Manufacturing Wages and Consumer Prices
Change (%)
13
12
Year-to-year change
11
10
9
8
7
6
5
4
~
Consumer prices
3
2
11
income-share or cost-push factors have typically
been the initial causes of inflation, then there
should be a systematic effect of these factors On
monetary policy-and so on the money supply__
if the process is to continue. On the other hand, if
ambitious
political
programs-operating
through increased government deficits or expansionary monetary policies-have typically been
the source of money-supply growth and inflation, this link too should be identifiable.
These issues have been addressed in independent work by Gordon and Bazdarich, with much
the same results. Gordon (1977) tested for causal
effects from various cost-push or supply-shock
variables to the money supply, using data from
seven major industrialized countries over the last
two decades. Only for the United States did he
find any systematic evidence of monetary accommodation, and even this evidence was extremely
weak. 13 Over a similar period, Bazdarich tested
for monetary accommodation of wages and
prices in the Pacific Basin (1978), and for monetary accommodation of a range of cost-push or
supply-shock variables in the United States
(1979). He found no significant evidence that the
narrow money supply (M I ) or the monetary base
systematically reacted to any of these factors.
The wider money-supply measure (M 1 ) reacted
systematically only to a few highly cyclical variables, such as steel prices, which may have
tracked the cyclical nature of M 1 due to disintermediation and similar effects. For an overwhelming majority of the variables, the typical
result was strong effects from the various monetary aggregates to the "cost-push" measure, but
virtually no reverse effects.
In other work on the U.S. economy, Gordon
(1978) concluded that only the acceleration of
inflation in 1974 could be attributed to nonmonetary factors-in this case to food and oilprice shocks. Still, Bazdarich (1979) found that
even this period could be reasonably well explained by 1971 ~75 money-supply growth and by
the 1972-73 removal of wage-price controls. 14
One might argue that the twenty~year data
periods used in these studies are too long to pick
up the possibly temporary effects of various costpush factors. Yet it is also true that such effects
lose reliability and applicability if they' do not
hold up over extended periods of time. For
example, a statement that monetary policy reacted to wage pressures, say in 1964, is not testable
at all, since we have only one observation-and
that was in fact already used to formulate the
hypothesis! Futhermore, even if we could prove
this assertion, it tells us little about what caused
inflation in 1978, or what will cause inflation in
1981. In other words, a theory must be general
and have predictive power if it is to have any
practical applicability, and the tests of various
versions of cost-push inflation have revealed
little evidence of these qualities.
As for the effects of government spending and
deficits, Gordon (1977) found evidence that
Vietnam War financing in the U. S. could explain some of the money-price phenomena in the
U.S. and abroad in the late 1960's. Bazdarich
(1979) also found evidence of systematic effects
of both government spending and government
deficits on M I and M 1 as suggested by Chart 2,
although these results had some unsatisfactory
features. IS In unrelated attempts to measure
money-supply "reaction functions," Barro
(1976) and others have found effects of fiscalpolicy measures and monetary-policy goal variables on various money-supply measures.
These studies identify systematic effects transmitted from various measures of fiscal and
monetary policy to money-supply growth, and
thence to inflation. Yet on the same terms, they
generally fail to find such effects for cost-push
variables such as wages, unit labor costs, and
various commodity prices. Obviously,
monetary-oriented theories cannot explain every
wiggle in money supplies and prices, but over
extended periods of time-over all phases of the
business cycle-they appear to have significantly
greater explanatory power for inflation than
cost-push or income-share th·~ories.
Still, the question may arise whether there
really is a basic distinction between the two
theories. While income-share theories cite business and labor pressures on the central bank as
creating expansionary policies, monetary theories cite political pursuit of economic goals as
leading to monetary expansion. Given the similar political undertones, does it make much
difference which description is most accurate? If
nothing else, the way in which we have contrasted these theories helps to illuminate the impor12
and the political process in which they operate
have served to generate as well as perpetuate
much of our recent inflation, which is an important consideration in our later discussion of antiinflation policy.
tance of the money supply and monetary policy
in the inflation process. Moreover, the evidence
suggests that Congress and the Federal Reserve
have been more than merely passive agents swept
along on a wave of inflation. These institutions
III. Economic Costs of Inflation
cal analyses of inflation. Still, wealth redistributions due to inflation represent returns based on
chance rather than effort. These therefore distort
the public's psychological incentive to prosper
from thrift and hard work, rather than from
speculative ventures. Similarly, the "losses" in
purchasing power are real enough to families
with expectations of future prosperity. These
costs are very real to the voting public, and
cannot be as easily dismissed by policymakers as
they are by economists.
Furthermore, there are very real economic
costs imposed by inflation, some of which show
up even in theoretical analyses, and some of
which are endemic to real-world economies with
laws and contracts written in nominal terms. For
example, inflation causes individuals; to economize on cash holdings, and thus to substitute
more time shopping and bartering for the convenience of using cash or financial instruments.
The faster that prices rise, the faster money loses
its value, and so the more costly it is to hold. This
causes individuals to utilize inefficient means of
transaction in order to hold as little money as
possible.1 6 These phenomena have been deemed
"shoe leather costs of inflation", as the public
spends more time (wearing out shoes) in stores,
between stores, or waiting in line, rather than
holding more cash and spadngshopping trips
farther apart.
Similarly, busmesses typicallY attempt to
avoid taxes on inflation-expanded profits by
hiring extra accountants and tax consultants to
devise (say) exotic depreciation or tax-shelter
schemes. Furthermore, as inflation rises, the
public experiences greater losses from not anticipating it correctly, and thus devotes moreresources to research and information on inflation
prospects and less to the production of tangible
goods. The growth of T-bill futures, GNMA
futures, and the gold market, and the growth of
various forecasting services, are testimony to the
Economists are often criticized, and rightly so,
for underestimating the costs of inflation. This
reflects the fact that most of the "costs" of
inflation recognized by the public either represent redistributions of wealth among different
groups, with little net cost to society, or arise
from popular misconceptions. For example, if
an increased money supply leads to higher prices,
people on fixed nominal incomes, holders of
cash, and creditors will lose. On the other hand,
debtors will gain, as will also the beneficiaries of
government activities financed by the money
creation. Similarly, if inflation were caused by a
wage-push-cum-accommodation set of events,
those negotiating the higher settlement would
gain, while creditors and those on fixed incomes
would suffer. These direct gains and losses in
wealth due to inflation roughly offset each other,
leading to a redistribution of income, but not
necessarily to a decline in national income.
Similarly, the public tends to perceive inflation as causing a decline in living standards as
household incomes apparently fail to keep up
with rising prices. Again, however, real incomes
do not typically decline during inflations, and so
no loss in real purchasing power occurs for the
economy as a whole. Rather, perceived losses
typically occur because consumers believe. their
nominal incomes are rising because of their own
merit, and not because of any general inflationaryphenomena. Thus, they believe their $2Q,OQO
incomes would have accrued to them even if
prices had not risen, so that they see a 108S in
purchasing power compared to what they would
have had with $20,000 incomes but lower prices.
This naturally leads them to feel that they have
been cheated, despite the inconsistencies of their
underlying reasoning.
Economists often neglect the redistributions
of wealth and increased misperceptions that are
inherent in any real-world inflation, because
these phenomena are not important in theoreti13
vigor of attempts to learn abotlt and hedge
against inflation. These efforts largely stem from
the increased variability of the inflation rate,
more than from an increased level of inflation,
but typically, higher inflation is accompanied by
a higher variability of inflation as well. 17 These
phenomena may not lower measuredGNP,bpt
they reduce living standards by drawing valuable
resources (viz., leisure and financial expertise) to
socially less efficient uses.
How important are these costs? Rose (1979)
cites estimates that every one-percentage"point
rise in the inflation rate costs between $1 to $3
billion in current dollars per year in extra transaction costs, or between 0.1 to 0.2 percent of real
GNP per year. Moreover, these costs continue to
accrue with continuing inflation. If we discount a
permanent flow of such costs at a 2-percent real
rate,IS the present value of the costs of each
permanent percentage-point increase in the inflation rate would approximate $100 billion, or 5
percent of GNP. These are very rough estimates
of the real costs involved. Still, these costs can
clearly be enormous-probably on the same
order of magnitude as the temporary losses in
employment and output caused by an antiinflationary monetary policy.
Perhaps the most controversial question
about the costs of inflation concerns its effect on
economic growth. Some economists have concluded that inflation speeds growth by reducing
money holdings and so encouraging saving and
investment. Such results have typically been
obtained in models where all unconsumed output necessarily went to productive investment.
However, in the real world, when inflation
causes consumers to decrease cash balances and
consumption, they often substitute inventories
of storeable commodities or precious meta.ls
rather than productive investment. Thus,· the
growth process might be unaffected ·oreven
impeded by inflation. 19
The behavior of stock prices and comrnodity
prices provide some evidence on this issue. If
higher inflation increas.es thedernand for capita.l
investment, we would expect strong prices in
periods of accelerating inflation. However,· if
higher inflation merely encourages commodity
speculation, we would expect weak stockpI"ices
and volatile commodity prices duringstlch peri-
ods. Gorham's (1979) findings were mixed on the
relation between commodity prices and inflation. However, they showed a strong negative
effect of inflation on stock prices, a.nd no reliable
sign of a positive effect of inflation on investment. Moreover, a casual look at the numbers
suggests that the decade-long acceleration of
inflation has coincided with slower growth in
output and productivity.
All these costs occur even in simple theoretical
analyses of inflation, but many more costs of
inflation occur due to the nominal-value orientation of the U.S. legal system. A prominent
example is the progressive income tax, where
marginal tax rates are calibrated by dollar increments of income. If a worker's salary rises to
"keep up" with inflation, the higher salary pushes
him into a higher tax bracket, so that a larger
fraction of his pre-tax income goes to taxes.
Thus, he is left with a lower after-tax real income
despite the "cost of living" adjustment. Since
actual tax rates are not indexed regularly, inflation therefore can reduce after-tax real income
for extended periods of time. Similarly, if the
nominal value of productive capital rises due to
inflation, the nominal rise will be treated as a real
capital gain by the tax system and taxed accordingly. Therefore, inflation systematically lowers the after-tax real rate of return on capita1,2°
Since the government receives these extra tax
revenues, there is no immediate social loss.
However, the tax system together with inflation
lowers the effective returns to labor and capital
investment-so that this lowers the incentives to
work and invest, lowers the supplies oflabor and
capital to the economy, and so puts a drag on the
growth of domestic outpUt. 21
Similar effects can occur because of deposit
interest-rate ceilings (Regulation Q). When inflation pushes up nominal interest rates on other
investments, interest-rate ceilings on deposits cut
off funds for deposit institutions. This serves to
restrict financing to sectors, such as housing,
which depend on a steady flow of funds to
deposit institutions. The interaction ofra.te ceilings and inflation thus impedes the efficient
functioning of these sectors.
To summarize, even in an ideal econorny with
full information and perfect flexibility, inflation
imposes significant costs by discouraging the use
14
resources. These costs, together with the psychological strains caused by inflation, make inflation a very expensive experience for the national
economy.
of money in financing transactions and otherwise encouraging socially inefficient use of resources. In addition, real-world impedimentssuch as laws written in nominal terms-combine
with inflation to further distort the allocation of
IV. The Inflation-Unemployment Trade-off
Friedman asserted that a fully anticipated
inflation will not cause unemployment to drop
below normal levels, so that there is no trade-off
between anticipated inflation and unemployment, and no sustainable trade-off between
actual inflation and unemployment. These insights explained not only the Phillips curve
trade-off, but also the deterioration in the tradeoff over time. Furthermore, the subsequent
acceleration in U.S. inflation concurrent with
rising unemployment insured the existence of a
receptive audience for his ideas.
Following ten years of research on this
"natural-rate hypothesis," the economics profession has largely agreed on the importance of
inflation expectations in correctly specifying the
Phillips curve relation. 23 Economists also widely
acknowledge that no permanent inflationunemployment trade-off exists. The remaining
debate centers on three issues affe~ting the nature of the short-run Phillips trade-off: first, how
quickly expectations adjust to new phenomena,
specifically to changes to policy; second, how
quickly unemployment returns to its natural rate
once expectations have adjusted; and third, how
much the natural rate varies in response to
exogenous shocks. 24
The first two issues are clearly concerned with
the extent of short-run gains or losses in output
and employment that would accrue from a shift
in monetary and fiscal policy. The third issue is
also related, since higher (or lower) unemployment levels may persist for long periods of time
foilowing policy shifts if the unemployment
changes represent shifts in the natural rate as
well. Therefore, estimations of adjustment lags
which do not allow for shifts in the natural rate
could conceivably be biased upward.
Unfortunately, because expectations cannot
be observed directly, we cannot easily distinguish
among the three types of adjustment lags consid-
Numerous and diverse costs are incurred by an
economy during inflation. On the other hand,
the costs of stopping inflation can be charaCterized mainly by the losses in output and employment which anti-inflation policies are likely to
impose. These costs can be discussed in terms of
the current economic wisdom on the Phillips
curve-the supposed inverse relationship between unemployment and inflation.
Samuelson and Solow (1960) first proposed
the Phillips curve as an instrument of policy,
partly in the belief that higher rates of inflation
would allow the economy to achieve permanent
reductions in unemployment. 22 This belief
stemmed from the then-observed empirical stability of the Phillips relation, despite the fact that
economic theory had never achieved a satisfactory explanation of why such a trade-off should
exist. However, once policymakers started to
exploit this relationship, its stability began to
disappear. High inflation rates failed to prevent
higher and higher unemployment rates from
occurring.
Friedman (1968) argued that no permanent
trade-off actually exists between inflation and
unemployment. Rather, he asserted that higher
inflation temporarily leads to higher output and
lower unemployment solely because, during any
inflation, prices initially rise faster than people
expectthemto. Thiscausesthepublicto confuse
the general inflation process with a higher demand. and higher relative prices for the· goods
they produce, so that they respond by increasing
output and hiring more workers. Once the public
has adjusted to the higher rates ·of inflation,
unemployment will return to its "natural rate",
or perhaps even to a higher natural rate due to
the distortions discussed above. At that point, an
even higher level of inflation will be required to
again confuse the public and thence reduce unemployment.
15
points. For one thing, his estimates ofthe length
of the adjustment period following. policy
changes are longer than those in many monetary
analyses, although his lags are similar to those
found in other studies. 27 A more vulnerable
conclusion is his argument that incomes policies
can mitigate the output effects of tighter policy.
Presumably, the wage-price rigidities causing
Perry's long lags could result from monopolistic
behavior by firms and unions. Yet incomes
policies would not directly attack these monopoly powers. For example, a union might exert
monopoly power by controlling the supply of
skilled labor that a manufacturer needs, or by
persuading (contractually) a manufacturer to
eschew non-union sources. An incomes policy
might moderate the explicit wage that the union
could charge the manufacturer, but it would not
prevent the union from exploiting its monopoly
power by demanding a myriad of non·wage
benefits, including better health and pension
plans, longer vacations, stricter seniority rules,
etc. These would serve to increase unit labor
costs as much as equivalent wage increases, and
so would have much the same effects on output
and employment under an anti-inflation monetary policy.
Therefore, just as price controls do not prevent
queuing and other implicit costs from equilibrating supply and demand, incomes policies need
not prevent firms or unions from exercising their
monopoly power in other ways. Thus, they may
not help-and may even hurt-the adjustment
process to slow inflation. 28 Advocates of income
policies virtually ignore these issues, but they can
present a damaging argument against the efficacy of such policies.
The evidence on balance suggests that a substantial period of slow growth will follow any
serious attempt to slow the rate of inflation.
Furthermore, it is not clear whether incomes
policies or the like can shorten this period. While
the seriousness of these output costs varies across
different studies, it would be hopelesslyoptimistic to believe that inflation could· be slowed
without some temporary losses in production
and jobs.
ered here. Most studies merely attetnptto esti..
mate the lag from changes in prices to changes in
output or employment. Pigott (1979) and McElhattan (1979), in evaluating these studies, both
conclude that the empirical evidence roughly
supports the long-run natural-rate hypothesis
(i.e., that there is no long-run trade-off between
unemployment and inflation), but they also find
substantial lags from changes ill policy-to
changes in inflation. 25
Pigott, however, also presents a somewhat
conflicting analysis of recent international experience. Germany and Japan's slow growth during
the 1970's has commonly been attributed to their
anti-inflationary policies, whereas the U.S.'
faster-than-normal growth has been attributed
to a weaker anti-inflation policy. YetPigott finds
output actually high in the German and Japanese
economies, when compared to that in the U.K.,
Sweden, Canada, and Italy, even though these
other industrialized countries have made little or
no inroads into inflation. In other words, a
comparison of Germany and Japan with the
U. S. alone suggests that large output costs are
associated with slowing inflation. However, a
comparison with a number of other industrialized countries leads to a less forthright conclusion. Persistent slow growth abroad may have
been due to anti-inflation policies, or perhaps
more likely, to some common occurrence such as
the rising relative price of energy.
Still, studies involving U . S. data have typically found that a contractionary monetary and
fiscal policy will reduce output and raise unemployment over a subsequent three-to-five< year
period. Perry (1978) concludes that a contractionary policy which increased unemployment
by one percentage point will require three years
to shave one percentage point offtheinflation
rate. 26 Perry attributes these long lags torigidities in nominal wages and prices, slowness in the
adjustment of expectations, and the existence of
cost-push factors prolonging inflation.• Consequently, he suggests the need for sotnesortof
incomes policies to retard thecost-pushptocess
and so ameliorate the output costs of slowing
inflation.
Perry's analysis can be questioned on several
16
V. Stopping Inflation-Odysseus at·the Helm
Our conclusions can be used to discuss three
basic policy issues: I) Should inflation be reduced; 2) what instruments should be used in an
anti-inflation policy; and 3) how quickly should
we attempt to slow inflation.
With respect to the desirability of reducing
inflation, a rough cost-benefit calculation can be
devised. The costs of slowing inflation include
the temporary declines in output and employment discussed in Section IV. The benefits include the removal of the recurrent costs of
inflation discussed in Section III.
Perry's (1978) analysis suggests that one
percentage-point higher unemployment for three
years would be needed to slow inflation by one
percentage point. Even if we assumed that each
unit of labor contributes a constant share to
GNP, these losses in present-value terms amount
to less than a 3-percent reduction in GNP to slow
inflation by one percentage point. Yet the losses
from the continuing inefficient allocation of
resources ("shoe leather costs," etc.) due to
inflation were estimated at 5 percent of GNP for
one percentage point of inflation, in presentvalue terms.
Consider also the likely sources of error in
these calculations. Again, Perry's lags from tight
policy to lower inflation are longer-and so his
implied output losses from slowing inflation are
higher-than those in monetary analyses of
inflation. Moreover, it may be incorrect to assume that each percentage-point change in unemployment means a constant one percentagepoint effect on GNP. This assumption abstracts
from the productive input of capital and other
factors in GNP, and also ignores the lower
productivity of marginally employed labor,
which would be the first to become unemployed.
Thus, the output costs of slowing inflation are
probably overstated. It could be argued in rebuttal that the costs of inflation are also overstated.
However, our calculations included. only efficiency losses and ignored other costs of inflation.
Also, a 5-percent after-tax real rate of returnwas
used to obtain our 2-percent discount rate, which
is absurdly high, and so further understates the
costs of inflation. 29
To be sure, these are very rough estimates of
the costs and benefits of slowing inflation. Nevertheless, they cast substantial doubt on the
argument that inflation is best left alone-that
the "cure is worse than the disease." Moreover,
given our earlier conclusion that Federal government and Federal Reserveaetions have been
responsible for much of the problem, and given
the public's increasing distaste for inflation, it
would seem incumbent on policymakers to face
up to the task of slowing the price spiral.
If, then, we conclude that a serious attempt
should be made to slow inflation, what instruments should be directed to the task? Our earlier
analysis clearly implied that slower growth in the
monetary aggregates is a necessary part of any
anti-inflation strategy. This is true whatever
inflation theory one holds, since no type of
inflation can continue without a sustaining
monetary expansion. Deregulation of various
industries, liberalization of tax laws, or even
lower government spending financed by lower
taxes (leaving money growth unchanged) would
allow one-time declines in the pricelevel, but by
themselves could not permanently overcome
persistent inflation such as the nation has recently experienced.
The evidence does not indicate which monetary aggregate the Federal Reserve should focus
on. M i , M 2 and the monetary base all display
similar statistical effects on prices. What would
seem more important is that the Federal Reserve
concentrate on a particular aggregate of its
choice and not switch among aggregates when
they give conflicting signals. 30 Otherwise, the
Fed might be tempted to choose whichever
aggregate was displaying the most" convenient
signal at a given time.
Actions to reduce government regulations, to
liberalize (or index) tax laws, to reduce protective tarriffs, and other such moves could help
mitigate the. contractionary effects of slower
money growth, and could also provide a quick
(albeit temporary) reduction in inflation.Thes.e
steps thus could serve a useful role in augmenting
or complementing an anti-inflationary monetary
policy. But since these are supplementary actions, the basic question about them is whether
they would be intrinsically good for the econo17
my, rather than how much of a temporary
reduction in inflation they could effect.
before.
This apparently is what happened in 1974-76.
With inflation at 12 percent in 1974 (see charts),
the decline in M 2 growth to 7 percent signified
very restrictive policy. This shift, together with
the oil-price hike, plunged the economy into a
deep recession in 1975. But shortly thereafter,
following public consternation over high unemployment, M 2 growth began to accelerate
again-and it has since been the prime factor in
causing the currently high rate of U.S. inflation.
In sum, the temporary costs of slowing inflation, and the temptation to avoid these costs
through expansionary means, provide strong
enticements to abandon anti-inflationary
policies-even when these are seriously installed.
Like the Sirens of the Odyssey, the short-run
trade-offs facing policymakers with short-term
horizons have a call that requires more than
good intentions to resist. 32
It would seem that the surest way to reduce
inflation on a permanent basis is to avoid the
large cyclical swings in policy that create swings
in public opinion as well. Thus, the rate of
growth in the FOMC's chosen aggregate should
be lowered slowly, say by 1 to I Y2 percentage
points per year, over a four-to-six year period. 33
Though increases in unemployment would stiB
occur, these would be smaller than under a more
drastic policy, and so would be less unpopular.
Of course, the gains in inflation would also
come more slowly. Also, even during a mild
slowdown, policymakers might be tempted to
expand policy and so accelerate output growth.
These pressures are not easy to abide, but they
are nevertheless inevitable under any serious
attempt to slow inflation. Like Odysseus, the
policymaker will have to "tie his hands to the
mast" until the progress of his policy takes him
safely away from the "Siren's calL" Reductions
in inflation come slowly under such a policy, but
they will not come at all unless the policy is
maintained steadfastly for an extended period of
time. Perhaps the pressuresto"reflate" can be
mitigated by introduction of supplementary
measures such as those discussed above, which
would likely reduce the output costs of slowing
inflation.
In a sense, such a policy would involve some of
the worst of both worlds. It will not achieve the
A more vital supplementary policy. would
involve lower government spending and deficits.
As we have seen, federal spending and deficit
increases historically have apparently helped
stimulate monetary expansion through the
monetization of federal debt. A slower moneygrowth rate unaccompanied by lower deficits
would eventually depress the whole economy,
but would initially affect housing and sirnilar
sectors most heavily because of their vulnerability to high interest rates. Lowering the deficit
along with money growth would reduce the
strain on credit markets, and would probably
allow a smoother approach to lower inflation
rates.
A case could be made for incomes policies if
one could show that cost-push factors have
played a major role in generating inflation, but
there is little compelling evidence on that score.
Moreover, there is no evidence that incomes
policies could successfully counter true monopoly power wherever such occurs. Finally, history
suggests that incomes policies, when employed,
have tended to license renewed growth in the
money supply.3! The proponents of such policies
usually emphasize that they are intended as a
complement to slower money growth. Nevertheless, as a practical matter, policymakers typically
become tempted to expand monetary policy
when incomes policies can be relied upon to hold
down prices temporarily. For these reasons,
incomes policies apparently can do little good
but much harm, and so probably should i>e left
unused in formulating plans to slow inflation.
Finally, how fast should we try to reduce
inflation? Recent history suggests that a policy of
rapid reduction in money growth and inflation
cannot be maintained for very long. A drastic
reduction in money growth can cause a quick
and deep recession. Once the resulting llnernployment becomes severe, politicalse~titllent
shifts from concern about inflation toworry over
unemployment. In that situation,policYtnakers
may yield to short-run pressures and expand the
money supply anew. After a brief decline, inflation would then accelerate once more a.nd the
situation would become as bad as (or worse than)
18
but steadily maintained attempt to slow inflation
runs the middle ground, and should elicit growing support as the public perceives that it is being
followed. Although not a happy alternative, it
appears to present the best choice available to the
Federal Reserve, the Congress, and the Executive Branch.
rapid declines in inflation which are politically
desirable, and unfortunately it will create some
losses injobs and production which are politically painful. Yet as we have seen, a "quick fix" to
inflation is unlikely to be maintained, while a
"do-nothing" policy leaves inflation at levels that
increase with each cyclical expansion. A gradual
FOOTNOTES
does not intrinsically affect real factors like tastes,
industrial capacity, or demographics, and that a equiproportional change in the magnitudes of all nominal
assets and prices would leave real conditions unchanged. Therefore, in the long run, the level of the
money supply should have no effect on real magnitudes, but only on prices.
1. We say "permanently" here, because temporary
attempts to reduce inflation that are rescinded by
subsequent policy changes would periodically subject
the economy to slow growth and lost jobs every time a
tight policy is imposed.
2. See Schultz (1959), as well as the reference to this
designation in Levy (1979).
7. Theory specifies that in a full-employment economy,
equal increases in government spending and taxes
would raise prices, mainly because the lower after-tax
level of private wealth would lower money demand.
This higher price level would be consistent with the fact
that, because of higher government spending, less
goods would be left over for private consumption.
What's more, this is a once-and-for-all increase in the
equilibrium price level, rather than a continuing inflation.
Barro (1974), reflecting David Ricardo, also asserts
that bond finance of a deficit is merely a substitution of
future taxes for present taxes, since future taxes will
need to be higher in order to service the government
debt. Therefore, bond financing of spending should
have identical effects as tax financing. Bailey (1971, p.
60 ff) and Buchanan (1976) also discuss these issues.
While most economists do not accept this extreme
specification, it's reasonable to believe that bond issues
do raise expectations of future taxes somewhat, in
which case they would still be less inflationary than
monetization of government debt.
3. We say "perceived" monopoly power, because in
many studies it appears to make little difference whether the monopoly power actually exists or not. Given a
slow reaction of demand to higher prices, as well as
downward. price rigidity elsewhere in the economy, a
price increase even in a competitive industry could
generate the type of inflation spiral propounded by
cost-push theorists.
4. As shown in Section II, real-world inflations have
typically been characterized by such general absolute
price increases.
5. In fact, inflation traditionally has been defined as an
increase in the money supply, and only recently have
rising prices been associated with the word. Thus,
Webster's New International Dictionary, 2nd Edition,
1936, defines inflation as a:
Disproportionate and relatively sharp and sudden increase in the quantity of money and
credit, or both, relative to the amount of exchange business. Such increase may come as a
result of unexpected additions to the supply of
precious metals, as in the period following the
Spanish conquests in Central and South America or the period following the opening up of
large new gold deposits; or it may come in times
of business activity by expansion of credit
through the banks; or it may come in times of
financial difficulty by governmental issues of
paper money without adequate metallic reserves and without provisions for conversion
into standard metallic money on demand. In
accordance with the law of the quantity theory
of money, inflation always produces a rise in
the price level.
8. For further documentation and discussion of these
analyses, see Levy (1979) or Bronfenbrenner and Holzman (1963). Gordon (1977) also discusses the possible
effects of 1973 oil-price increases and crop failures on
prices.
9. It may appear that income-share conflicts and political pressures for higher growth and employment are
only slightly different manifestations of the same sociological forces, and that the various theories are therefore little different. Nevertheless, the different approaches to inflation do make a difference, as is
discussed toward the end of the next section.
10. They found a predominantly uniform effect of
inflation on prices in various commodity groups. That
is, movements in the consumer price index hadsystematic effects on prices in individual commodity classes
that were generally not significantly different from
unity. Therefore, CPI movements do not appear to be
related systematically to relative price changes. The
exceptions to this result were in the Categories of rent,
homeownership, and utilities prices. These exceptions
were found by the authors to be due to special factors,
such as measurement problems (rent), as well as non-
Whatever the quality of economic analysis in this
definition, it is interesting to note that it describes
inflation as causing an increasing price level. The
definitional association of inflation with rising prices, as
documented in newer editions of Webster's dictionary,
has apparently arisen in English usage primarily
through historical experience.
6. This assertion embodies the concept of "neutrality of
money." The idea is that the nominal supply of currency
19
market pricing of property taxes (homeownership) and
of government-regulated monopolies (utilities prices).
sign of tight monetary policy over this period (e.g.,
Heller 1977 and Ackley 1979). Yet over such a long
period of time, with the large price-level increases
experienced, it seems more realistic to regard this
phenomenon as largely induced by the demand for real
balances. Thus, in a period where real GNP. grew 20
percent, which by itself would suggest a rise in realbalance demand, the acceleration in inflation and in
inflation expectations apparently led to a much larger
drop in real-balance demand than would have occurred
otherwise. Using regression analysis, Gorham also
finds systematic evidence that inflation has lowered
real balances (demanded) in the U.S. economy.
11. This quantitative result is from Bazdarich (1979). As
for the traditional work on money and prices, two
hallmark works are the empirical studies by various
authors in Friedman (1956) and the study by Friedman
and Schwartz (1963). Important work can also be found
in Meiselman (1970) and in a ser.ies of articles by Karl
Brunner and Allan Meltzer, as well as many other
monetary studies. Our emphasis on recent monetary
work is not meant to downplay the importance of earlier
analyses by Clark Warburton, Lloyd Mints, and many
others, but to concentrate on the more sophisticated
statistical analyses of the last twenty years.
17. If an acceleration in inflation meant that the average
rate of inflation increased, but that the variability of
inflation around that average stayed much the same,
then inflation would not imply an increase in uncertainty. In fact, however, the historical incidence of inflation
is as described in the text. Sjaastad (1975) presents a
theoretical explanation of this coincidence in the mean
and variability of inflation.
12. Early empirical research was done by Means (1935),
among others. More recent studies are found in Means
(1972), the Cabinet Committee on Price Stability
(1969), Wachtel and Adelsheim (1976), Eckstein and
Brinner (1972), and Perry (1978). Levy (1979) surveys
most of these results.
13. Gordon's technique used a Granger causality-test
which measured the effects of wages on money-supply
growth at lags of one to four quarters. Only at the third
lag was the estimated effect significant for the U.S.
Taken as a whole, these results did not show a significant effect. The one significant lag would be reliable
evidence only if Gordon were testing the hypothesis
that wages affect money at the third lag and at no other.
The weaker hypothesis, that wages have some effect on
money, however, is not supported by these results; that
is, its alternative hypothesis that wages have no general
effect is not refuted by this evidence.
18. Rose obtains the 2-percent discount rate in the
following manner: He assumes a 5-percent after-tax
real rate of return (clearly a very high estimate) and then
subtracts an assumed 3-percent annual rise in "shoe
leather" costs, reflecting a 3-percent expected annual
rise in real GNP. Thus, present costs should be discounted at a 2-percent (5-3) rate. A lower real rate of
return would result in a lower discount rate, which
would result in even higher present values of these
shoe-leather costs for each percentage point of inflation.
19. Tobin (1965) analyzed the general effects of inflation on growth. Using a consumption function that
depended on the rate of inflation, rather than prices, he
reached a presumption that inflation speeds growth.
Sidrauski (1967), using utility maximization to derive
consumption behavior, found no such effect. These
and other studies are summarized in Dornbusch and
Frenkel (1973).
14. While it's true that world crop failures occurred in
1973 and that oil prices jumped astronomically in 1974,
it's also true that monetary expansion accelerated in
1971-72 in the U.S. and elsewhere. Also, in the U.S.,
price controls in 1971-73 served to suppress much of
the inflationary pressure of this fast money growth,
postponing it until after the controls were lifted in mid1973. Bazdarich (1979) estimates that most of the
inflation postponed by the controls should have occurred by late 1975. Consequently, he estimates the
consumer price level for late 1975 using only moneysupply data through 1975. This estimate differed from
the actual price level by only three percentage points,
suggesting that money-supply behavior could explain
much of the total movements in prices over that fouryear period.
20. Suppose a unit of capital yields a real rate of return r
based on productivity, depreciation, etc. With an inflation rate 11', the price of the good that the unit of capital
produces wil rise, as will the nominal value of the capital
itself. Abstracting from relative price changes, then, the
combination of real returns and inflation premia sum to
a total pre-tax nominal rate of return of r+rr, so that the
pre-tax real rate of return (r+rr-rr = r) is unchanged by
inflation. However, the inflation premia and the real
return are both treated as income and so taxed by the
government. With a tax rate t, then, the after-tax nominal rate of return is (l-tHr+rrl. If we then subtraCt the rate
of inflation, the after-tax real rate--or the effective
rate-of return of capital is (l-t)r-rrt, which declines as
inflation rises (or 11' increasesl. Thus, because of the tax
on inflationary capital gains, effective returns to capital
will fall as inflation rises, thus discouraging investment.
Of course, the investor can postpone payment of these
inflationary capital gains, but he must eventually pay
them.
15. Though government spending had significant effects on money-supply growth, the effects did not
become positive until the fifth-quarter lag. Yef()ne
would expect spending financed by money creation to
have a much quicker effect on the money supply.
Similarly, for statistical reasons (the use of seasonally
adjusted data), the results for the effects of the government deficit on the money supply, though ostensibly
significant, may not be reliable. See Bazdarich (1979)
for details.
16. As evidence of the empirical importance of these
phenomena, Gorham (1979) points to a 7-percentdecline in real balances (i.e., the M1 moneysupplydeflated by prices) in the U.S. over the period 1973-78.
Keynesian economists have generally taken this as a
21. The Council of Economic Advisors (1979) itself has
recognized a slowdown in the U.S. sustainable rate of
growth. The Council cites as contributing factors the
declines in productivity growth and in research and
20
development, both of which clearly could be reactions
to unfavorable changes in after-tax returns due to
higher inflation.
slower money supply growth will affect inflation with a
lag of generally two years.
28. Incomes polices could hurt the adjustment process
because the fringe benefits or tie-in schemes unions
and firms might pursue are generally inefficient means
of exploiting market power, compared to explicit wage
or price increases. Thus, by fostering inefficient,
second-best types of arragements, the effects of monopoly power could be even worse under incomes
policies.
22. Discussion of these and other points in this section
can be found in McElhattan (1979) and in Pigott (1979).
23. See Phelps et al. (1970) for seminal work on the
expectations explanation of the Phillips curve.
24. In this respect, the existence of long-term contracts
and other fixed commitments could allow unemployment to differ from the natural rate for a while even after
expectations adjust. See Poole (1974) as well as McEIhattan (1979). By the same token, however, these
factors could also be seen as sources of changes in the
natural rate.
29. See footnote 18 for details.
30. The question arises as to whether current Federal
Reserve operating procedures should be relied upon to
effect this slower growth in the FOMC's chosen aggregate, and/or what alternative operating procedures
would be suitable. These questions are addressed in
Judd and Scadding's article in this issue of the Review.
25. Also, see Gordon (1976) for a detailed survey of the
theory and evidence on the Phillips Curve.
26. This estimate is provided by William Poole, in the
discussion following Perry (1978): "If Perry's estimates
are taken at face value, a monetary policy that kept the
unemployment rate 1 percentage point above the natural rate would be consistent with a decline in the
inflation rate by 0.3 percentage point each year."
31. In the United States, money-supply growth actually
declined in 1970 and early 1971, but then accelerated
shortly after the imposition of price controls in August
1971. At the present time, also, it would be hard to argue
that the Administration's wage-price guidelines have
induced any significant slowing in the growth of M1 or
27. In Perry's analysis, the lag from unemployment to
inflation is based on a "mainline" structural model
involving aggregate demand, supply, etc. Policy variables affect inflation and unemployment in this model
only through their effect on aggregate demand and
supply. This framework is unquestionably correct in
theory, but such an indirect method of estimation
conceivably could bias the estimated reduced-form
effects of the money supply on inflation and unemployment. That is, if Perry's hypothesized reduction in
unemployment is to be effected through slower money
growth, it's likely that a direct, reduced-form estimation
of the effects of money on inflation and unemployment
would produce shorter estimates of the lags than are
contained in Perry's analysis. This is because the
reduced-form effects are combinations of a number of
structural effects. By estimating each structural effect
individually, Perry may be introducing extra sources of
error in estimating the reduced form than if he had
estimated it directly. Thus, Bazdarich (1979), for example, finds much shorter lags from money to inflation and
unemployment. The latter are more consistent than
Perry's with the common "monetarist" dictum that
M2.
32. In Homer's Odyssey, Odysseus and his men prepare
to pass through the straits of the Sirens, whose call no
man can resist. He ties rags around his men's ears so
that they won't be able to hear. Since someone must be
available to signal to his men when it is safe, he leaves
his own ears unbound, but has his arms tied tightly to
the ship's mast, where he has to endure the agony of
being unable to answer the Siren's call.
33. At present, underlying rates of change appear to be
about 7 percent for M 1 and 9 percent for M 2 , although
historically M2 has tended to grow about 3 percentage
points faster than M 1 . Also, available existing moneyprice evidence suggests that growth rates of zero for M1
and 3 percent for M 2 are roughly consistent with the 3percent per year inflation suggested by the HumphreyHawkins bill. Therefore, if we take this level as a goal,
and reduce M 1 and/or M2 growth by 1 to 1%percentage
points a year, zero M 1 growth and 3-percent M2 growth
would be achieved in four to six years, with 3 percent
CPI inflation achieved in about six to eight years.
REFERENCES
Ackley, Gardner. "Two Views of the Federal Budget."
The AEI Economist. February, 1979.
Bailey, Martin J. Nationai Income and the Price level,
2nd Edition. McGraw-Hili Books. 1971.
Barro, Robert J. "Are Government Bonds Net Wealth?"
Journal of Political Economy., November, 1974. pp.
1095-1117.
Bazdarich, Michael J. "Inflation and Monetary Accommodation in the Pacific Basin." Federal Reserve
Bank of San Francisco, Economic Review. Summer, 1978. pp. 23-36.
_____. "Current Theoretical and Empirical Perspectives on the Relation Between the Money
Supply and Inflation." FRBSF Staff paper, 1979.
Bronfenbrenner, Martin and Holzman, Franklyn. "Sur-
vey of Inflation Theory," American Economic Review. September, 1963, pp. 592-661
Buchanan, James M. "Barro on the Ricardian Equivalence Theorem." Journal of Political Economy.
April; 1976; pp. 337-342
Cabinet Committee on Price Stability. Staff Study, U.S.
Government Printing Office, 1969.
Dornbusch, Rudiger and J. Frenkel. "Inflation and
Growth," Journal of Money, Credit and Banking.
February, 1973, pp. 141-156.
Eckstein, Otto and R. Brinner. "The Inflation Process in
the U.S.," A Study Prepared forthe Joint Economic
Committee, 92nd Congress, 1972.
Fama, Eugene and G. William Schwert. "The Behavior
of Relative and Money Prices of Consumption
21
Goods." Manuscript, University of Chicago, 1977.
Friedman, Milton. "The Role of Monetary Policy." American Economic Review. March, 1968, pp. 1-17.
_ _ _ _. (ed.) Studies In the Quantity Theory of
Money. University of Chicago Press, 1956.
Friedman, Milton, and Anna Schwartz., A Monetary
History of the United States 1867-1960. Princeton
University Press, 1963.
Gordon, Robert J. "Recent Developments in the Theory
of Inflation and Unemployment." Journal of Monetary Economics 2, 1976, pp. 185-219.
_ _ _ _. "World Inflation and Monetary Accommodation in Eight Countries." Brookings Paper on
Economic Activity, 1977, pp. 185-219.
_ _ _ _. Macroeconomics. Boston: Little, Brown,
and Co, 1978.
Gorham, Michael. "The Cost of Inflation: A Review."
FRBSF Staff Paper, 1979.
Heller, Walter W. "Monetary Policy at the Crossroads."
Wall Street Journal. October 14, 1977, p. 18.
Judd, John and Scadding, John. "Conducting Effective
Monetary Policy: The Role of Operating Instruments." FRBSF Staff Paper, 1979.
Levy, Yvonne. "A Critique of the Cost-Push Explanation
of Inflation." FRBSF Staff Paper, 1979.
McElhattan, Rose. "Where We Stand on the
Unemployment-Inflation Tradeoff." FRBSF Staff
Paper, 1979.
Means, Gardiner. "Industrial Prices and Their Relative
Inflexibility." A Report to the Secretary of Agriculture. Senate Document #13, 74th Congress, 1935.
_ _ _ _. "The Administered Price Thesis Reconfirmed." American Economic Review, June, 1972,
pp. 292-306.
Meiselman, David (ed). Varieties of Monetary Experience. University of Chicago Press, 1970.
Perry, George L. "Slowing the Wage-Price Spiral: The
Macroeconomic View." Brookings Paper on Economic Activity, 1978, pp. 259-299.
Phelps, Edmund, et. al. Microeconomic Foundations of
Employment and Inflation Theory. Norton, 1970.
Pigott, Charles, "Inflation-Unemployment Tradeoffs:
Some International Evidence." FRBSF Staff Paper,
1978.
Poole, William. "Rational Expectations in the Macro
Model." Brookings Papers on Economic Activity 2,
1976, pp. 463-514.
Rose, Sanford. "Commentary-The High Costs of Shoe
Leather." Money Manager, May 7, 1979, p. 2.
Samuelson, Paul A. and Solow, Robert. "The Problem
of Achieving and Maintaining a Stable Price Level:
Analytical Aspects of Anti-Inflation Policy." American Economic Review. May, 1960, pp. 177-194.
Schultz, Charles. "Recent Inflation in the United
States," Joint Economic Committee Study of Employment, Growth, and Price Levels. 86th Congress, September, 1959.
Sidrauski, Miguel. "Inflation and Economic Growth."
Journal of Political Economy. May, 1967, pp. 796810.
Sjaastad, Larry A. "Why Stable Inflations FaiL" In J.M.
Parkin and A. Zis (ed's.), Inflation in the World
Economy. Manchester University Press, 1975.
Tobin, James. "Money and Economic Growth." Econometrica. October, 1965, pp. 671-684.
Wachtel, Howard M., and P.O. Adelsheim. "The Inflationary Impact of Unemployment: Price MarkUps
during Postwar Recessions, 1947-70." Study Paper
#1, Achieving the Goals of the Employment Act of
1946-Thirtieth Anniversary Review. A Study Prepared for the Joint Economic Committee, 94th
Congress. U.S. Government Printing Office, 1976.
22
John P. Judd and John L. Scadding*
Events have a way of carrying things before them. Thefollowing article is a case in point. Its
purpose originally was to make the casefor why we thought monetary control would be improved
by the Federal Reserve concentrating on bank reserves rather than the Federal-funds rate in the
day-to-day conduct of monetary policy. On October 6, even while our paper was being prepared
for distribution to the Federal Open Market Committee, the Federal Reserve announced in a press
release that it would place "a greater emphasis in day-to-day operations on the supply of bank
reserves and less emphasis on confining short-termfluctuations in the Federal-funds rate." We are
heartened by this step and believe it will prove ultimately to make a significant contribution to
economic stability. In the meantime, we think it is important to understand precisely what the
move entails, and why it is potentially fundamental and far reaching. This article is designed to
provide just sl-'ch an understanding.
employment, into intermediate targets for the
It is now generally recognized that an effective
monetary aggregates, and then of choosing an
monetary policy is a crucial element in controlling inflation and avoiding recessions. This can
operating instrument as a means of reaching the
be seen clearly in the large body of theoretical
desired targets. Until recently, the Fed used the
and empirical work which addresses the question
funds rate for this purpose; in other words, the
of what makes for "effective" policy. Until reprocedure consisted formally of a funds-rate
cently most of this work distinguished two separtactic designed to achieve a monetary-aggregates
ate points. The first, broader, issue was whether
strategy.
We have been careful to insert qualifiers like
the impact of monetary policy on ultimate tar"formally" and "officially" throughout the last
gets, like prices and employment, could be more
paragraph, because we believe that the reality of
accurately gauged by movements in interest rates
Federal Reserve policy is different from its
or in the monetary aggregates. This is often
appearance. Specifically, we argue that the Fedreferred to as a problem of strategy, because it is
eral Open Market Committee (FOMC) operates
concerned with the appropriate general framein such a way to ensure the linkage of tactics and
work within which monetary policy should operstrategy, so that they cannot in practice be
ate. The second, seemingly narrower, issue was
separated in the way suggested by. formal dewhether, with a given monetary-aggregates
scription. This is because there are really two
strategy, the Federal-funds rate or reserves
dimensions to the tactics decision. The first is the
would allow more accurate control of the aggrechoice of operating instrument-Federal-funds
gates. This is a problem of tactics-of how to
rate or reserves. The second, and equally imporchoose an operating instrument to best carry out
tant decision, is choosing the method of employthe desired strategy.
ing the instrument.
Current Federal Reserve procedure formally
reflects this compartmentalized approach to
The point is illustrated by the cautious way in
monetary policy. Official Federal Reserve procewhich the FOMC formerly moved the funds rate:
dure consists first of translating ultimate stabiliit moved the rate only slowly, or by small
zation goals, such as price stability and full
amounts, when confronted with less than complete evidence that policy should be changed. Of
*The authors are, respectively, Senior Economist, Federal
course,
cautious control of the operating instruReserve Bank of San Francisco, and Economist, Federal
Reserve Bank of San Francisco.
ment (whether funds rate or reserves) represents
23
partmentalized. Additionally, in view of the
effective linkage of tactics and strategy (through
cautious control),feasible policy alternatives are
likely to exclude the optimal-control solutions.]
a rational response to the considerable uncertainty which FOMC members face in conducting
policy, and to certain institutional factors which
constrain their actions. But our main point is
this: given a procedure of cautious control, the
FOMC's choice of the funds rate as its operating
instrument effectively represented a commitment to an interest-rate strategy. But the reverse
is also true. With the FOMC's adoption of a
reserves operating instrument (with a wide-band
Federal-funds rate constraint), it is likely to
pursue something close to a monetaryaggregates strategy. Thus, the choice of operating instrument dictates the choice of strategy,
and in this sense it is impossible, as a practical
matter, to compartmentalize Federal Reserve
policy.
Two further implications are worth considering. First, the pertinent tactical question is not
whether interest rates or reserves allow more
accurate control of the monetary aggregates.
Given the feasibility of using either reserves or
the funds rate in an aggregates strategy, the
choice of an operating instrument depends on
whether an aggregates or interest-rate strategy
comes closer to achieving the Federal Reserve's
ultimate stabilization goals. Second, it misses the
point to say that the compartmentalization of
Federal Reserve procedure prevents it from
carrying out policy as effectively as it might with
so-called optimal control policies. We have already argued that policy is not in practice com-
The plan of the paper is as follows. In Section
I, we review the problem of choosing the right
strategy, because of the importance of that issue
in determining whether policy will be effective or
not. Next, in Section II, we show how and why
the FOMC typically used the funds rate in a
cautious manner in the past. On the basis of that
evidence, we conclude that cautious control is
independent of the choice of operating instruments, and hence that the FOMC is likely to
control reserves cautiously in the future. Also,
we present evidence to show that cautious control of the funds rate has most of the hallmarks of
an interest-rate strategy as far as its impact on
money and GNP growth is concerned. We then
argue that a reserves operating instrument would
have produced something close to an aggregates
strategy, which leads back to the original pointnamely, that operating procedures must be evaluated in terms of which entails the more appropriate strategy. In Section III, we survey the
evidence on alternative strategies, which supports the choice of an aggregates strategy over an
interest-rate strategy. This leads to our conclusion, in Section IV, that the use of reserves as the
operating instrument is likely to improve the
effectiveness of monetary policy.
I. Choice of Strategy-Basic Conceptual Issues
The following discussion summarizes in nontechnical terms the basic conceptual issues involved in choosing a strategy for monetary
policy. The reader who is familiar with. the
literature on this topic can safely skip to Section
II without losing the thread of the argument. 2
A strategy is defined as an overall plan designed to accomplish some ends. In the case of
monetary policy, the ends, called ultimate targets
or goal variables, are the traditional onesstable prices, full employment and stable exchange rates. The aim of monetary policy is to
keep departures in prices, employment (or output) and the exchange rate from their desired
levels as small as possible-to stabilize those
variables about their targets, in other words. To
do that effectively requires: (a) being able to
monitor closely the goal variables for any indication that they are going off track, so that remedial action can be taken before the departure
becomes serious; and (b) being able to gauge
quickly and accurately whether the monetarypolicy actions taken are having their desired
effect. However, data on the ultimate targets are
not received quickly enough for them to be used
directly in the formation of policy. Instead, some
intermediate variables must be found, which are
available on a more timely basis, and which also
contain enough information about the ultimate
targets for use in monitoring indirectly what is
24
happening to those ultimate targets. The choice
of strategy is simply a decision about what
intermediate variable(s) is (are) best for this
purpose.
We can illustrate these rather abstract points
by focusing on the problem of stabilizing real
GNP, as most of the academic debate has done.
Within this context, the choice of strategy has
typically been cast in terms of whether to use
interest rates or the monetary aggregates to
gauge the influence of monetary policy on real
GNP. In some ways this is a useful approach; in
other ways, not. On the plus side, this approach
has a great deal of practical relevance, given the
very real concern of monetary policy with the
problem of promoting high and stable levels of
output and employment. Moreover, the problem
can easily be analyzed with the use of standard
macroeconomic theory. On the minus side, however, by concentrating exclusively on real magnitudes and thereby largely ignoring prices, this
approach slights what has become a serious
threat to macroeconomic stability-a stubbornly high and disturbingly erratic rate of inflation.
In so doing, it tends to misrepresent those strategies which are effective in promoting overall
stability-that is, stability of both output and
prices. This point is of more than academic
interest, because of the two strategies typically
considered-interest rates and aggregates-only
the latter has been seriously advocated as a viable
strategy for containing inflation. Thus, by focusing on real GNP and ignoring inflation, we can
bias the analysis against an aggregates strategy.3
A strategy problem exists, as we have seen,
because data on the ultimate targets are collected
with too long a lag to permit direct monitoring of
those targets. For example, monthly data on real
GNP do not exist, while preliminary quarterly
data are not available until nearly a month after
the end of the quarter, and often these preliminary estimates are significantly revised over a
period of three years or more. Ideally, policy
actions should respond quickly to unforeseen
events which push GNP away from its target.
However, the long lag and preliminary character
of initial GNP data make it difficult to detect
such occurrences. In lieu of up-to-date or "timely" data on GNP, policymakers must try to infer
what is happening to GNP by using indirect,
readily available evidence. Theoretical discussion has focused almost exclusively on two such
intermediate - information variables - interest
rates and monetary aggregates. Clearly, both of
these variables have considerably smaller data
lags than GNP. Interest-rate data are available in
published form daily. Money-stock data are
available on a somewhat unreliable basis with a
one-week lag, and with considerably more reliability with a lag ofless than a month. Additionally, interest rates and the monetary aggregates
provide information about future GNP as well,
since changes in GNP typically react with a lag to
changes in current interest rates and money
stock. Hence they are doubly timely, in the sense
that they provide information about values of
GNP which will not be observed until much
later.
Besides their timeliness, candidates for strategy variables must bear some systematic and
predictable relationship to the goal variable;
otherwise they would be incapable of providing
information about the latter, which is, after all,
their raison d'etre. Again, both interest rates and
monetary aggregates are natural candidates on
this criterion. First, both theory and evidence
point towards interest rates as an important
determinant of real aggregate demand, and
therefore of the level of output. Thus, ceteris
paribus, it is possible to associate with each level
of interest rates (i) a level of output (y); and
conversely, to associate with each level of output
a level of interest rates that would produce just
the right level of real aggregate demand. This
relationship between interest rates and real GNP
is enshrined in the standard IS curve of macroeconomic theory, or less formally, by the dualdirection arrow between i and y in Figure 1
below.
Figure 1
Intermediate Targets and Strategy Choice
Strategy (Intermediate Target)
•
(a) interest Rates (i)
(b) Monetary Aggregates ( M ) .
Link
Aggregate Demand (is)
Money Demand (LM)
25
Ultimate Target
GNP (y)
GNP (y)
Money and real GNP are connected through
the money-demand function, which posits that
(ceteris paribus) for each level of the money
stock (M), a level of real income exists at which
the public is willing to hold that stock. Conversely, each level of real income determines an
amount of money demanded. This relationship
between money and real GNP is embodied
formally in the standard LM curve, or less
formally, by the two-way arrow between M and
y in Figure 1.
This stabilization model requires modification in one respect. In Figure I, we assume that
the relationships between interest rates and
money, on the one hand, and GNP on the other,
are completely predictable, so that it is possible
to associate with each level of i or M a unique
level of y, and vice versa. In practice this is not
so because (a) we only have estimates of the
relationships, and these are subject to sampling
error, and because (b) the relationships depend
on other variables which our imperfect knowledge does not allow us either to specify or
predict precisely. Hence it is more accurate to
think of the relationships as specifying a link
between ranges of possible outcomes for i and
M and ranges of possible outcomes for y. This
idea can be seen by associating sets of intermediate and final targets rather than single points, as
illustrated in Figure 2, where the circles denote
sets of outcomes.
Consider the problem of using observations
on i and M to predict and attempt to control
what is happening to y. Let y* be the target for
GNP, and let i* and M* be the interest rate and
money stock, respectively, that are most likely
to be associated with y*. These "best guesses"
are shown as points in Figure 2. Now suppose
that policy successfully operates to achieve i*
but that the money stock turns out to be lower
than M*. How do we interpret this result? Two
extremes bound the possibilities:
• The aggregate-demand relationship is
"tight," so that for given i*, the range of possible
outcomes of y is relatively small. On the other
hand, the money-demand relationship is relatively "sloppy," so that an outcome for M is
consistent with many different outcomes for y.
In this case, it is rational to assume that M is
lower than expected because money demand
has unexpectedly fallen, not that GNP is too
low. The appropriate response is to keep i at i*
and allow money to remain at its new lower
level.
• The money-demand relationship is relatively
exact, while the aggregate-demand relation is
susceptible to frequent and significant disturbances which greatly weaken the link between
interest rates and output. In this case, it is
sensible to treat the observation on M as strong
prima facie evidence that y is weaker than
desired, and to operate to bring M back to M*,
even though this will mean lowering interest
rates.
This example clearly shows that policy choices
are determined by one's view of the world-in
particular, by how one regards the relative tightness of the two (interest rate and money) links to
income. A choice of interest rates as the intermediate target implies that policymakers are pursuing an interest-rate strategy, while a concentration on the aggregates implies an aggregates or
money-supply strategy. The issue at root is an
empirical one: Which relationship is the more
Figure 2
Unpredictability and Strategy Choice
Strategy (Intermediate Target)
(a)
1~~1.*R.at2t-
(b)
A,_g",._at_e_s
I
Link
-;(d
.
Ultimate Target
Aggregate Demand_:
Predictable Part
_
and
"-'l---------- Unpredictable Part - - - - - - - - - - -
j*• .....)
G.NyP*
:::::~;:::.-----------~
~ -~-------Unpredictable part-----------~
.....
26
stable in the sense of yielding a small predicted
range for GNP? In the extreme cases outlined
above, where instability (unpredictability) is
confined entirely to either one or the other of the
relationships, the instability criterion by itself is
sufficient to determine the choice of strategy.
Thus an interest-rate strategy dominates where
money demand is unstable, while an aggregates
strategy dominates where the instability is in the
aggregate-demand relation. In the general case,
where both relationships are unpredictable, the
criterion must also take account of the interest
sensitivity of money demand and aggregate
demand, because these considerations affect the
extent to which (unexpected) shifts in money
demand or aggregate demand translate into
changes in real GNP. As a general rule, the more
interest sensitive aggregate demand is, and the
less interest sensitive money demand is, the more
likely is it that an aggregates strategy will dominate.
Neither strategy, as a theoretical matter,
necessarily produces the smallest possible variation of GNP around its target that policymakers
could attain. Each is essentially a defensive
strategy, designed to prevent the intermediate
variables from straying too far from preassigned
targets. In general this is not a fully efficient
procedure, because evidence that the intermediate variable is going off track provides useful
information that the intermediate targets themselves need to be revised. Strategies which use
this "feedback principle"-optimal control or
combination policies-generally produce greater stabilization than the so-called "pure" strategies that we have examined. 4 However, these
more efficient strategies typically require more
aggressive manipulation of interest rates and the
aggregates than we think is feasible, given the
FOMC's cautious-control procedures. We have
concentrated on the pure strategies because, as
we argue below, the FOMC's operating procedures are more likely to lead to a pure strategy
than to an optimal combination strategy.
II. Impact of Operating InstNments on Strategies
Given our choice of strategy, the problem of
tactics asks how we can operate to keep our
intermediate target on track. Typically the literature on this subject makes no distinction
between interest rates at the strategy level and
interest rates as an operational variable (the Fed
funds rate), so that the tactical problem of
implementing an interest-rate strategy would be
trivial. The literature suggests that the same
would not be true for an aggregates strategy,
since the money stock can be targeted either
with interest rates, operating through the demand function for money, or with reserves,
operating through the supply of money. Hence
the tactical question generally has focused on
whether interest rates or reserves are the better
operating instrument for controliing money.
In this compartmentalized view, the tactical
question is treated as subsidiary andsubordinate to the question of strategy (Figure 3A). But
we argue here that this approach gets things
backwards-that because of cautious control of
the operating instrument, the choice of tactics
determines the choice of strategy (Figure 3B).
Cautious Funds Rate Control
According to Federal Reserve public statements as well as empirical evidence, the FOMC
attempted as far back as 1970 to control money
growth by changing the Federal-funds rate. 5
This attention to the aggregates has been formalized into explicit longer-run target ranges,
which are reported periodically to Congress. 6
But the evidence also shows that the FOMC
generally has moved its funds-rate operating
instrument very cautiously in attempting to
achieve these targets. In other words, funds-rate
changes have generally not been large enough
nor timely enough to stabilize money growth
(Chart 1). Except in 1970 and mid-1973, growth
in the funds rate and money were highly correlated, and both were positively associated with
the business cycle.
It should be noted that, ceteris paribus, money demand is influenced negatively by the funds
rate and positively by GNP. Thus if the FOMC
actively moved the funds rate to hit its money
targets, we would observe a positive association
between funds-rate movements and the business
27
cycle, together with fairly constant money
growth, as interest rates rose and fell enough to
offset the cyclical effect of income on money.
Instead, we observe that money growth has
been procyclical, increasing and decreasing with
GNP. Although the funds rate also has risen
and fallen with GNP, these changes have not
usually been large enough to stabilize money
growth. Two exceptions may be noted: the
rapid drop in the funds rate in the 1970 reces
sion, which caused Mi to accelerate, and the
rapid rise in the funds rate in the mid-1973
boom, which caused Mi to decelerate. But
otherwise, throughout the rest of the 1970’s,
procyclical changes occurred in both the funds
rate and money growth.
An analysis of the timing of funds-rate rever
sals also shows that this operating instrument
has primarily followed the business cycle rather
than counteracted it. As shown in Chart 1,
changes in direction of funds-rate movements
have usually been delayed until after a new
phase of the business cycle was underway. The
funds rate was still being sharply reduced in the
first quarter of the 1971 and 1975 recoveries,
when an aggregates strategy would have called
for a less expansionary policy, given the resur
gence in the demand for money and credit as
business improved. By the same token, the
funds rate was being increased sharply just prior
C h a rt 1
C hanges in th e Federal Funds Rate
and in th e N arrow Money S u p ply (M-|)
(A nnual ra te s, 1970-79)
to and shortly after the business-cycle peak in
1973/Q4, when an aggregates strategy would
have produced an “easier” policy.
A recent econometric study has also found
evidence of cautious funds-rate control during
Figure 3A
Compartmentalized View
of monetary Policy
Figure 3B
Cautious Control and
Policy Choice
(a)
Interest Rates-=s—
Aggregate
Demand
GNP
(a) Cautious
Control of
Interest
Rates
Or
(b)
..
.
^ Money
Monetary A ggregates-!-
T
Reserves
—
(b) Cautious
Control of
Reserves
Money Supply__Monetary
Process
Aggregates
Or
(ii)
Interest Rates
Money
Demand
im plies------ ►-
Interest
Rate
Strategy
implies------ ►-
Monetary
Aggregates
Strategy
Or
GNP
Tactics (O perating Instrument)
(i)
Strategy
(Interm ediate
Target)
Tactics
(O perating
Instrument)
Strategy
(Interm ediate Target)
Monetary
Aggregates
28
C h a rt 2
the 1970-74 period.7 This research involved
directly estimating the FOMC’s funds-rate reac
tions to deviations of Mi from its targets. The
results indicated that the FOMC, while attempt
ing to control the growth in the money stock,
actually moved the funds rate by only 8 to 9
basis points per month in response to undesired
money growth.
This conclusion is reinforced by evidence that
the FOMC has been more successful in keeping
the funds rate inside the boundaries of its
tolerance limits than it has been in keeping Mi
growth inside its short-run and/or long-run
ranges. Each month the FOMC Directive to the
Trading Desk has specified both a funds-rate
range and so-called tolerance ranges for Mi and
M2 growth over the current and following
months (e.g., at January meetings, tolerance
ranges would be specified for the JanuaryFebruary period). Thus the tolerance ranges
would express the FOMC’s short-run aggre
gates objectives, as distinct from the longer-run
objectives expressed by the longer-run target
ranges. During the January 1975-April 1979
period, the funds rate almost always remained
in the center of its target ranges, on a monthly
average basis, but Mi growth often fell outside
both its short-run and long-run ranges (Chart
2). This tendency of the funds rate to remain
within range may be attributed partly to the fact
that the FOMC sometimes adjusted the range
when market pressures drove the funds rate to
either limit on a weekly basis. Nevertheless,
changes in the funds rate have frequently been
too small to keep the aggregates on target.
Short-Run Tolerance Ranges, Longer-Run Targets, and Actual Values
for M-j Growth and the Federal Funds Rate
Percent
^^
M-j Growth
t i l - 1 1 u 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 i n 1 1 i i i i i l l 1 11.1.L1 n
un
i .u .ju
Note: For quarterly Mi growth (top panel), dashes represent
actual growth rates; for bimonthly Mi growth (middle
panel), dots represent overlapping two-month growth rates,
and solid lines represent overlapping tolerance ranges; and
for Federal funds rate (bottom panel), dots represent actual
monthly rates.
Constraints on FOMC Actions
eliminated in the near future. Under these cir
cumstances, the rational policymaker, even with
the best available information, should react
cautiously in changing the operating instrument
when money appears to be off target.9 Since the
impact of potential policy actions is uncertain,
the fact that the economy functioned “tolerably”
well last month is an important piece of evidence
in favor of not substantially changing the operat
ing instrument this month. In this way, large
swings in policy are quite rationally delayed
“until next month.”
Several institutional factors also have contri-
There are a number of reasons why the FOMC
stabilized the funds rate when it was used as an
operating instrument, and why it is likely to
stabilize reserves now that a reserves regime has
been adopted.8 The FOMC is faced with a good
deal of uncertainty concerning the current condi
tion of the economy and the precise timing and
impact of policy actions. Uncertainty governs
the linkages, first, from money and interest rates
to the economy, and second, from reserves or the
funds rate to money and other interest rates. This
uncertainty reflects the current state-of-the-art in
the economics profession, and is not likely to be
29
the funds rate applies also now that the FOMC
uses reserves as its operating instrument. Thus
the FOMC is likely to control reserves cautiously
under its new operating procedures.
buted to cautious control of the Committee's
operating instrument. First, in addition to its
stabilization goals, the FOMC may quite reasonably desire to provide a stable policy framework,
one which causes as little disruption of the
private economy as possible. ChangesiinFederal
Reserve policy have profound implications for
private-sector planning and forecasting. Thus,
the Fed tends to avoid making frequent changes
in policy direction because such changes increase
the frequency and uncertainty of private-sector
decisions and are detrimental to aggregateeconomic performance. 1O
Second, policy is made by committee, and the
inevitable compromises that result sometimes
lead to only modest changes in the operating
instrument. The need for compromise will often
be greater near business-cycle turning points,
when uncertainties about the current and immediate future condition of the economy are greatest. At such a time, opinions regarding the
proper setting for the operating instrument may
vary widely. Thus the Committee's compromise
decisions may be biased toward no substantial
reversal until the economy is already in a new
phase of the business cycle.
Third, the FOMC is appropriately sensitive to
Congressional and public opinions about the
effectiveness of monetary policies. In fact, Congress has mandated such a concern, through
Joint Resolution 133 in 1975 and the FullEmployment and Balanced Growth Act of 1978
(the so-called "Humphrey-Hawkins Act"). Under this legislation, the Federal Reserve Chairman goes before Congress periodically to explain and justify past and future monetary
policies. In this highly visible forum, mistakes of
commission elicit larger negative reactions than
mistakes of omission-perhaps because such
errors can be more easily identified with the
FOMe. For example, if the discount-rateiri~
crease of November 1978 had not been such a
success, Congressional and other complairits
would have been much louder than if the discount rate had wrongly been leftunchanged.l l
For these reasons, the FOMC quite naturally
may tend to pursue a status quo policy· until
considerable evidence is available to justifY a
change.
Each of these reasons for cautious control of
Interest Rate Variability
It may be argued that operating-instrument
stability was pursued to a greater extent under
the funds-rate regime than it will be now under a
reserves regime, on the grounds that the FOMC
has an ultimate objective of avoiding "excessive"
interest-rate variability. Interest-rate variability
would, of course, increase with a cautiously
controlled reserves operating instrument, and
several econometric studies suggest that the
added variability would be substantial. 12
However, these estimates may have substantially overstated the problem. First, the data
unavoidably came from an environment where
the funds rate had been stabilized by the Federal
Reserve. But we know that rational financialmarket participants will smooth short-term rates
to some extent in a reserves-targeting environment. For example, banks may learn to borrow
in advance of periods of heavy seasonal demand,
while lenders may delay supplying funds to
coincide with periods of heavy expected demand.
Both kinds of actions will dampen short-term
interest-rate fluctuations.
More importantly, under a reserves operating
instrument, funds-rate fluctuations will probably not be transmitted to other money-market
rates to the same extent as before. I3 New York
Trading Desk operations under the funds-rate
regime produced a close association between the
(overnight) Federal-funds rate and longer-term
money-market rates. The Desk rarely missed its
funds-rate targets, and rarely reversed the direction of funds-rate changes, so that the current
funds rate provided substantial information
about its future levels. In this regard, it should be
noted that longer-term rates tend to equal
weighted averages of expected shorter-term rates
Over the life span of the longer~term instruments.
The 90-day Treasury-bill rate, for example,
should equal some weighted average of90 future
one-day funds rates (plus or minus adjustments
for risk, liquidity, and other factors). Since
former Desk behavior allowed market participants to forecast future funds-rate levels on the
30
Table 1
Average Absolute Day-to-day Changes,
basis of· current rate movements,.· short-term
changes in the funds rate almost immediately
became reflected in "longer" term money-market
rates. But now, under the reserves operating
instrument, day-to-day and week-to-week
changes in the funds rate should convey less
information about its future levels, and should
have a smaller impact on longer-term moneymarket rates.
German experience confirms this
hypothesis-for example,during the January
1973-June 1974 period, when the central bank
did not peg very short-term interest rates. In that
period, absolute weekly changes in the interbank
(overnight) call-money rate varied by an average
of 345 basis points, while the (longer term) threemonth interbank loan rate varied by an average
of only 39 basis points (Chart 3).14
A second piece of confirmatory evidence
comes from recent U.S. data on daily rate movements (Table 1). Under the funds-rate regime,
the Trading Desk pegged the Federal-funds rate
to the target rate every day of the week except
Wednesday, which is reserve-settlement day for
member commercial banks. Since the funds rate
1977-78
(in basis points)
Monday
Tuesday
Wednesday
Thursday
Friday
Chart 3
127.0
19
;.Call.Money
Rate
18
17
16
15
14
13
12
11
10
9
5
4
3
0
~
1973
gO-Day Treasury
Bill Rate
7.6
5.5
5.0
4.4
5.9
primarily reflected private market forces on
Wednesdays, the large changes which often
occurred on those days were not perceived by
market participants as containing significant
information about FOMC intentions. Since
these changes were not very useful in forecasting
future funds-rate movements, Wednesday variability was not in general transmitted to longerdated money-market rates. The funds rate and
the 90-day Treasury-bill rate showed similar
variability on Monday, Tuesday, and Friday,
but funds-rate variability was significantly larger
on Wednesday when this rate often diverged
from its target, and on Thursday when it returned to target.
Finally, under the funds-rate procedure, the
FOMC was in the position of being publicly
responsible for interest rates. It thus came under
considerable pressure to keep rates down, especially when they were near Regulation Q ceilings
and might trigger disintermediation. But while
the FOMC can keep interest rates down in the
short-run, this is not true in the long-run. Attempts to lower rates in the face of strong money
and credit demands result in fast money growth
and ultimately inflation. 15 Indeed, with nominal
interest rates reflecting a premium for inflation,
attempts to resist interest-rate increases in the
short-run often cause higher rates in the longrun. But now, by targeting reserves, the FOMC
may be able to divest itself of part of this
publicly-perceived responsibility for interest
rates, and thus promote a more accurate public
perception of the extent to which it can, in fact,
control these yields. With the funds rate being
more clearly "endogenous" in the reserves regime, the FOMC can more convincingly argue
that it is just one of many factors (including
private behavior) causing variations in moneymarket yields.
German Interbank Call-Money Rate Versus
the Three -Month Interbank Loa" Rate
Percent
Federal
Funds Rate
7.4
8.3
20.5
16.9
5.2
1974
31
money demand—which means a shift from Msi
to Ms2 (points S to CR in panel 1, and S to Cl in
panel 2). In this case the procyclical error in the
money stock (M-M*) is much larger if the funds
rate is used than if reserves are used. The reasons
are clear: under a funds-rate target, money
demand is fully accommodated at that funds
rate, while under a reserves target, demand is
accommodated only to the extent that the behav
ior of banks and the public partially offsets
Federal Reserve behavior.16
Thus, under the FOMC’s former tendency to
make only cautious movements in the funds rate,
deviations of money from target were largely
accommodated—which is characteristic of an
interest-rate strategy. This strategy is most near
ly optimal when money is deviating from target
mainly because of disturbances in the monetary
sector of the economy. Now that the FOMC is
using a reserves operating instrument, its partial
responses will result in a strategy which is close to
a pure aggregates approach, where money is not
allowed to deviate from target. This strategy is
most nearly optimal when the disturbances are
coming mainly from the real sector.
In view of the likelihood that the FOMC will
continue its rational approach of cautiously
using its operating instrument, the two con
strained policies just described are the feasible
alternatives for monetary policy. While neither
of these strategies is optimal in the theoretical
context of optimal control, they represent the
Strategy Outcomes
The FOMC is likely to use either type of
operating instrument cautiously in controlling
money, so that the choice of operating instru
ment effectively determines the more important
choice of monetary policy strategy. It would be
theoretically possible, of course, to control the
money supply as accurately with a Federal funds
rate as with a reserves operating instrument
(Figure 4). As income rises during recoveries and
falls during recessions, money demand also rises
and falls procyclically. An increase in moneydemand in a cyclical expansion, illustrated by the
shift from Mdi to Md2 , can be fully offset either by
raising a funds-rate target or reducing a reserves
target, as represented by the shift from Msi to
MS2 * (point S to M in both panels). The use of
either instrument to eliminate deviations of
money from target would constitute the pure
aggregates strategy discussed in the preceding
section. Alternatively, a pure interest-rate strate
gy, which involves pegging the funds rate and
thus accommodating all deviations of money
from target, could in theory be achieved with
either a funds-rate or a reserves approach.
As we have argued above, the FOMC is likely
to follow neither of these “pure” strategies pre
cisely, but rather to move its operating instru
ment cautiously. To see what this means for
monetary control, assume that each operating
instrument is moved only one-fourth of the way
to levels which fully offset cyclical movements in
Figure 4
M o n e ta ry C o n tro l E rro rs U nder A lte rn a tiv e O p e ra tin g In s tru m e n ts
2. Federal Funds Rate
1. Reserves
32
alternatives from. which rational policymakers
normally choose in practice. Thus the FOMe
must decide which of these two constrained
policies leads to the most nearly optimal results
for the economy.
m. Empirical Issues in the Choice of Strategy
The question of the optimul11 strategyinterest rates or monetary aggregates-is ultimately an empirical one. Theory can point to the
relevant issues-the relative unpredictability of
the aggregate demand and money-income relations and their interest elasticities-but it cannot
itself resolve them. Our intention is not to give an
exhaustive catalogue of relevant empirical results, but instead to survey briefly what we think
are the major areas of investigation and their
major conclusions. 17 As one might expect, much
of the empirical evidence is indirect, suggestive
rather than definitive, and seldom totally unambiguous. Nevertheless, given the variety of approaches and data sources involved, the sum of
evidence may be considered more compelling
than the individual parts if it shows any sort of
consensus. Such is the case here, we believe, with
the evidence arguing for an aggregates strategy.
The first piece of evidence is the large accumulation of statistical work, covering the pre1974 period, showing a highly stable relationship between the demand for money and GNP
and interest rates (Item I b, Table 2).18 This
work draws on a long historical record for the
U.S. as well as many other countries. It is hard
to think of another macroeconomic relationship, with the possible exception of the consumption function, which has stood up to such
exhaustive and intensive scrutiny.
Since mid-1974, the demand function for Mt,
the narrowly-defined money supply, has apparently shifted, and the continuing uncertainty
about the cause of this shift has obviously
increased its unpredictability.19 Consequently,
some observers have concluded that an aggregates strategy is no longer appropriate, whatever the case might have been for it previously.
This seems to us an extreme position. In the first
place, the instability in M 1 does not appear to
have infected M2 and the other aggregates
nearly as severely.20 Many people appear
wedded to the idea of M 1 as the definition of
money, and resist the idea of conducting policy
in terms of M2. Nevertheless, until 1975, it has
been difficult to detect any differences in the
stability of demand functions for M 1 and M 2,
and thus in their respective abilities to predict
GNP (Item 3b). Hence, pursuing an M2 strategy
may not produce seriously inferior results com-
Table 2
Major Issues in Survey of Empirical Evidence
(b)
(a)
For an Interest Rate Strategy
For an Aggregates Strategy
(1 b)
Is the demand function for money stable?
(2b)
Is the interest elasticity of demand for
money low?
(3b)
What is the appropriate definition of
money?
(4a)
How well does the aggregate-demand relation by itself predict GNP?
versus
(4b)
How well does the money-demand relation
by itself predict GNP?
(5a)
How well do interest rates predict GNP?
versus
(5b)
How well do the aggregates predict GNP?
(6a)
Do policy variables which operate
through the aggregate-demand relation,
such as government spending, exert a
significant and predictable impact on
GNP?
versus
(6b)
Do such variables provide. any help in
predicting GNP, above and beyond what
the monetary aggregates tell us?
(7a)
Do simulations of an interest-rate strategy
show that it contributes to stabilizing
GNP?
versus
(7b)
Do simulations of an aggregates strategy
show that it contributes •to stabilizing
GNP?
33
reduced the predictability of the aggregatedemand relation.
The successive oil-price shocks experienced
since 1973-74 have also served to underline the
point that the aggregate demand (and supply)
relation is vulnerable to large unpredictable
shifts. The vagaries of international politics can
have an important impact on domestic inflation, and we still do not fully understand how
oil price increases work their way through prices
and the real economy. This suggests that predicting GNP through the aggregate-demand
relation is going to be a chancy exercise for the
foreseeable future.
These doubts about the stability of the
aggregate-demand relation should be remembered when so much attention has been focused
on alleged recent instability in the demand for
m~~ey. The preoccupation with money-demand
inSta:;bility has tended to obscure one important
point: what matters is not whether the predictability of money demand has deteriorated per se,
but rather whether it has deteriorated enough to
make a money-stock strategy no longer appropriate. To do that would require showing that
aggregate demand and supply are stable enough
to make an interest-rate strategy workable. So
far this has not been demonstrated.
Moreover, the evidence of current instability
in the demand for M 1 should be placed in its
proper context. Surely the massive evidence for
the historical stability of money demand counts
for something. In particular, it argues for a
skeptical attitude toward new and still inconclusive evidepce that money has suddenly begun to
behave quite unpredictably. Uncertainty argues
for cautious changes in a policy when policyrnakers are confronted with fragmentary evidence, as
past experience demonstrates. In 1971, for example, it was widely claimed that the demand for
money had shifted. Subsequent analysis showed
that this had been a false alarm-that the putative shift was well within the normal range of
historical experience. 24
And finally, as mentioned earlier, an aggregates strategy clearly has an edge when we turn
our attention from the problem of income stabilization to the problem of combatting inflation. 25
While some evidence indicates that market rates
of interest contain information about future
pared to what M 1 would have yielded had it
continued to be well-behaved.
The well-documented finding of a low
interest-elasticity of money demand (Item 2b)
predicts that money is capable of exerting a
significant effect on prices and output. This
expectation has been amply confirmed in extensive single-equation tests, which have shown
that current and lagged changes in money exert
a sizable and predictable influence on GNP
(Items 4b, 5b, and 6b). In contrast, similar
attempts to explain GNP using interest rates
and or measures of autonomous spending frequently (in some instances, almost uniformly)
yield inferior results (Items 4a, 5a and 6a).2 1
Again, as Froewiss and Judd show in this issue
of the Economic Review, interest rates contain
little or no information about GNP over and
above that contained in M 1 or M 2 (Item 5a).
Furthermore, these findings have not been
contradicted by simulation experiments, using
both small- and large-scale macroeconomic
models, which indicate that the money stock
provides a more reliable indicator of the thrust
of monetary policy than interest rates, and that
an aggregates strategy produces smaller variation in GNP than an interest-rate strategy
(Items 7a and 7b).22
Other evidence, of a more inferential nature,
tends to question the supposed stability of the
aggregate-demand relation. One piece of evidence is the rediscovery of Irving Fisher's distinction between the nominal and real rates of
interest, which expl~ins the difference by the
anticipated rate of inflation. 23 This reempha. sizes the point that aggregate demand is a
function of real rates of interest, which are
unobservable. Hence attempts to predict GNP
using interest rates run up against the problem
oEhow to measure real rates of interest. This in
turn requires making some estimate of the
anticipated rate of inflation-a difficult task in
a world where current inflation rates are substantially different from most of our historical
experieIlce, and where the problem has worsened con.siderably over the past decade. The
failure to resolve this question in a conclusive
way has a.dded to our uncertainty about the
relationship between aggregate demand and
market rates of interest, and in so doing has
34
inflation,26 it does not follow that an interest-rate
strategy-especially the usual type of cautious,
defensive strategy-will help to keep inflation
under control. Indeed, a telling criticism against
an interest-rate strategy is its tendency to accentuate or prolong inflation by (inadvertently)
setting up a vicious spiral. The spiral may begin
with inflation expectations stimulating rising
interest rates, which the Federal Reserve initially
attempts to resist. The result is faster money
growth and eventually even more inflation. In
contrast, an aggregates strategy dampens inflationary impulses by refusing to finance the increases in expenditures that are necessary to keel>
inflation going.
IV. Policy Implications
From this analysis, we may conclude:
• The FOMC is likely to control whatever
operating instrument it chooses in a cautious
manner. This rational approach follows naturally from apparently unavoidable uncertainties
about the actual state of the economy and the
impact of policy actions.
• Cautious control of the funds rate means that
the FOMC, in effect, pursues a strategy which is
most nearly optimal when real-sector disturbances are smaller than monetary-sector disturbances, and when inflation is not a major
problem. Cautious control of reserves means
that the FOMC pursues a strategy which is most
nearly optimal when real-sector disturbances
are larger than monetary-sector disturbances,
and when inflation is a serious source of concern.
This decision-making sequence should be
followed unless monetary control were seen to
be technically infeasible with the chosen operating instrument. Since empirical evidence indicates that both reserves and funds-rate operating instruments represent technically feasible
alternatives,27 the crucial decision should be
based on which operating instrument produces
the most nearly optimal strategy.
We have argued that monetary policy should
lean more toward a pure aggregates strategy
than a pure interest-rate strategy. Given the
uncertainties and other constraints on FOMC
actions, the reserves approach recently adopted
will automatically imply an aggregates orientation of monetary policy. This will be a distinct
improvement over former policies which, despite official aggregates targets, were really
oriented around interest rates.
With the switch to a reserves operating instrument, the F~deral Reserve has made a serious
attack on inflation while promoting the stabilization of the business cycle. The new operating
procedures mean that the FOMC's rational
responses to the uncertainties it must face will
translate into a more effective monetary policy.
These conclusions suggest the following
monetary-policy guidelines:
• Choose the most nearly optimal strategy on
the basis of the available empirical evidence.
• Choose the operating instrument which, when
controlled cautiously, brings policy as close as
possible to the chosen strategy.
35
FOOTNOTES
about financial-market reactions to policy changes
than goods markets reactions, which tend to be more
delayed and thus less directed at specific FOMC actions.
1. An excellent exposition of the argument that a twostage procedure is inefficient can be found in Benjamin
M. Friedman, "The Inefficiency of Short-Run Monetary
Targets for Monetary Policy," Brookings Papers on
Economic Activity (1977): 293-335. It is perhaps worth
repeating here the point we argue later on, that given
considerable uncertainty about the precise impact and
timing of FOMC actions on macroeconomic activity, it
is not clear that the cautious strategies we concentrate
on are necessarily suboptimal.
11, On November 1, 1978, the Federal Reserve raised
the discount rate by one percentage point, and imposed
a supplemental reserve requirement of two percent on
large time deposits.
12. Richard G. Davis, "Short-Run Targets for Open
Market Operations," and John H. Ciccolo, "Is ShortRun Monetary Control Feasible?", in Monetary Aggregates and Monetary Policy, Federal Reserve Bank of
New York, 1974, pp. 40-59 and 82-91, respectively.
2. The classic work in this field is William Poole, "Optimal Choice of Monetary Policy Instruments in a Simple
Stochastic Macro Model," Quarterly Journal of Economics, 84 (May, 1970): 197-216. A good summary of
relevant issues in the literature can be found in Benjamin M. Friedman, "Targets, Instruments and Indicators of
Monetary Policy," Journal of Monetary Economics, 1
(1975): 443-473.
13. Raymond Lombra and Frederick Struble, "Monetary
Aggregate Targets and Volatility of Interest Rates: A
TaxonomiC Discussion," Journal of Money, Credit and
Banking, August 1979, pp. 284-300.
3. Michael Bazdarich, in his contribution tothis issue of
the Economic ReView, has d()cumented the important
role for the aggregates in effectively fighting inflation.
The reader should keep in mind that this evidence
makes a case for an aggregates strategy independent of
the evidence we discuss here.
14. Hang-Sheng Cheng, "The Variability of the Federal
Funds Rate and the Stability of Money Market Conditions," unpUblished paper, Federal Reserve Bank of
San Francisco, 1979.
4. A good exposition of the issues involved here can be
found in Stephen LeRoy and David L. Lindsey, "Determining the Monetary Instrument: A Diagrammatic Exposition," American Economic Review, 68 (Dec, 1978):
929-934.
16. For a discussion of the various ways in which this
can happen see Albert E. Burger, The Money Supply
Process, Wadsworth Publishing Company, Belmont,
California, 1971.
15. Milton Friedman, "The Role of Monetary Policy,"
American Economic Review, March 1968, pp. 1-17.
17. Some of the evidence summarized here is discussed
in more detail in John Scadding, "Optimal Strategy:
Interest Rates or Aggregates?", unpublished paper,
Federal Reserve Bank of San Francisco, 1979.
5. In early 1970, the language in the FOMC's published
directives to the Federal Reserve Bank of New York's
Open Market Trading Desk switched from emphasizing
conditions in the credit markets to focusing on the
monetary aggregates and the funds rate. See Richard
G. Davis, "Implementing Open Market Policy with
Monetary Aggregates Objectives," Monetary Aggregates and Monetary Polley, Federal Reserve Bank of
New York, 1974, pp. 7-19. In addition, econometrically
estimated Federal Reserve reaction functions appear to
have shifted in 1970. See Paul DeRosa and Gary H.
Stern, "Monetary Control and the Federal Funds Rate,"
Journal of Monetary Economics, April 1977, especially
pp. 218-219.
18. A good summary of the secular evidence is given in
David E. W. Laidler, The Demand for Money: Theories
and Evidence, 2nd ed., New York: Don Donnelley, 1977,
Chap. 7. Postwar evidence is summarized in Stephen M.
Goldfeld, "The Demand for Money Revisited," Brookings Papers on Economic Activity, 3 (1973): pp. 577638.
19. The shift is well documented, though the precise
reasons for it remain elusive. See Stephen M. Goldfeld,
"The Case of the Missing Money," Brookings Papers on
Economic Activity, 3 (1976): pp. 683-740, and Jared
Enzler, Lewis Johnson and John Paulus, "Some Problems of Money Demand," Brookings Papers on Economic Activity, 1 (1976): pp. 261-280.
6. The Federal Reserve currently is required by the
Humphrey-Hawkins Act to report target ranges for M1,
M2, M3, and bank credit for periods beginning in the
fourth quarter of the preceding year and ending in the
fourth quarter of the current year.
20. See, for example, Goldfeld, op. cit., p. 725. Note,
incidentally, Goldfeld's reluctance to believe that M2 is
an appropriate aggregate despite evidence of its stability.
7. DeRosa-Stern (1977), op. cit., pp. 217-230.
8. This point is briefly mentioned in William Poole,
"Discussion and Comments," to Benjamin M. Friedman, "The Inefficiency of Short-run Monetary Targets
for Monetary Policy," op. cit., p. 342.
21. The source of the evidence on single-equation tests
of the relation between monetary aggregates and fiscal
variables on the one hand, and GNP on the other, is
Leonall C. Anderson and Keith M. Carlson, "Monetary
and Fiscal Actions: A Test of Their Relative Importance
in Economic Stabilization," Federal Reserve Bank of St.
Louis Review 50 (November, 1968): pp. 11-24. The
evidence of the links between interest rates and GNP is
reviewed in Michael Gorham, "Money or Interest Rates:
Which is the Better Indicator of Monetary Policy?"
9. William Brainard, "Uncertainty and the Effectiveness
of Monetary Policy," American Economic Review, May
1967, pp. 411-425.
10. The financial markets are usually the first to react
negatively to frequent policy changes, simply because
they feel the impact of these changes almost immediately. Thus the FOMC may tend to be more concerned
36
gy would have produced smaller variability in GNP.
"The Choice of Optimal Intermediate Targets," Amerl·
can Economic Review, 60 (May 1970): pp. 40-46. A
similar experiment, done more recently, is reported in
Benjamin M. Friedman, "The Inefficiency of Short-Run
Monetary Targets for Monetary Policy," op. cit., pp.
293-335.
unpublishEldpaper, FederalReserve Bank ofSan Francisco, 1979. The literature on the relationship between
autonomous spending and GNP begins with Friedman
and Meiselman's investigation of the relative stability of
the multiplier versus velocity: Milton Friedman and
David Meiselman, "The Relative Stability of Monetary
Velocity and the Investment Multiplier in the United
States, 1897-1958," in Commission on Money, Credit
and Stabilization Policies, Prentice Hall: New York,
1963. That article spawned a running controversy
whose record is scattered throughoutthe literature. A
partial summary and update of the evidence is provided
in William Poole and Elinda B. F. Kornblith, "The
Friedman~MeiselmanCMC Paper: New Evidence on an
Old Controversy," American Economic Review, 63
(Dec. 1973): pp. 908-17- Postwar evidence using quarterly data is provided in Moshin S. Khan, "The Relative
Stability· of Velocity and the Investment Multiplier:
Some Further Tests," Journal of Monetary Economics,
4 (Jan. 1978): pp. 103-120.
23. Irving Fisher. The Purchasing Power of Money, New
York: MacMillan, 1918,pp. 56-58.
24. The episode .is discussed in Michael Hamburger,
"The Demand for Money in 1971: Was There a Shift?"
Journal of Money, Credit and Banking, (May 1973): pp.
720-725.. See also Hamburger's skepticism about the
seriousness of the shift in M1 demand since mid-1974 in
"Behavior of the Money Stock: Is there a PUZZle?"
Journal of Monetary Economics, 3 (1977): pp. 265-288.
25. See Bazdarich's article in this issue.
26. See, for example, Eugene F. Fama, "Short-Term
Interest Rates as Predictors of Inflation," American
Economic Review, 65 (June 1975): pp. 269-282.
22. Richard Zecher examined the indicator properties
of money and interest rates in four macro-economic
. models. See his "Implications of Four Economic Modelsfor the Indicators Issue," American Economic Review, 60 (May 1970): pp. 47-54. Robert Holbrook and
Harold Shapiro used a small macroeconomic model to
examine whether a money-stock or interest-rate strate-
27. John P. Judd, "Federal Funds Rate or Reserves:
Which Allows for the More Precise Monetary Control?"
unpublished paper, Federal Reserve Bank of San Francisco, October 1979.
37
Control and Money Ta,-oe1:s:
"Everything"?
Fed Look At
Kenneth C. Froewiss and John P. Judd*
the use of targets as being wasteful of information, which, if properly employed, would permit
policymakers to be more successful in the pursuit
of their economic goals. While we do not dispute
the theoretical basis of this optimal-control
position, we intend to assess its empirical significance within the context in which it is likely to be
used. Specifically, we ask this question: Do those
financial-market variables which are frequently
cited as being important for the determination of
monetary policy convey reliable information
about aggregate spending in the economy beyond that contained in the movements' of the
money supply?
In Section I, we set out the basic principles of
optimal-control theory, and then review how
these ideas have been used to criticize a policy of
monetary targeting. Also, we examine the use of
information in the context of "real-world" policymaking. In Section 11, we translate these
theoretical considerations into econometric tests
of the information -about aggregate demand
contained in a large number of financial-market
variables-bank credit and its components, interest rates, and flow of funds-over and above
monetary policy aggregates targeted by the Federal Reserve. From these tests, we conclude that
once policymakers look at a monetary aggregate,
they can gain little additional information about
nominal GNP by also looking at other financialmarket variables. These conclusions, as well as
some limitations of the study, are summarized in
Section III.
Target rates of growth for the monetary aggregates have played an increasingly prominent role
in discussions of Federal Reserve policy over the
last decade. The Federal Open Market Committee (FOMC) first incorporated the notion of
monetary targets into its policy directives in
1970. More recently, the establishment of such
targets has been mandated by Congress, first in
Joint Resolution 133 in 1975 and then in the Full
Employment and Balanced Growth Act of 1978
(the so-called "Humphrey-Hawkins Act").
While virtually all economists agree that the
behavior of the money supply has an important
effect on economic activity, many question the
wisdom of singling out this one variable from
among all of those on which the Fed might focus
its attention. Indeed, to confer primacy on money goes against a long Fed tradition of "looking
at everything" in attempting to gauge the direction of the economy and the correspondingly
appropriate monetary policy. Fed spokesmen
have, in fact, maintained that they do not interpret the announced monetary targets in any
rigid, mechanistic way.l Rather, they view these
targets as broad guides to policy which may be
revised as necessary in the light of new economic
information.
The intuitive argument that the Fed should
"look at everything" in setting policy instead of
slavishly aiming at preannounced monetary targets has found support in the theory of "optimal
control".2 Described in more detail below, the
optimal-control literature essentially criticizes
I. Optimal Control and Monetary Policy
the problems confronted by economic policymakers. The most inexorable problem is uncertainty. In theory, we can think ofthe economy as
being accurately described by a large number of
so-called structural equations. This "true model"
of the economy includes equations specifying all
of the relationships which make up the structure
Although the theory of optimal control has its
origin in the engineering literature, its fundamental ideas can be easily explained in terms of
*The authors are, respectively, Associate Economist, Morgan Guaranty Trust Company of New York, and Senior
Economist, Federal Reserve Bank of San Francisco. Patrick
Weber, Ladan Amir-Aslani, and Thomas Klitgaard provided
research assistance for this study.
38
of the economy-such as consumption behavior,
the demand for money, and so on. Even if
policymakers were confident that they knew the
"true" model of the economy, in the sense of
knowing which variables belong in each equation, the equations of that model would still
contain random components which cannot be
empirically estimated with complete precision.
In fact, policymakers' problems are compounded by a lack of certainty about the underlying structure of the economy.
Another problem is the general inability of
available policy tools to affect directly the variables of ultimate concern, such as employment,
inflation, and real-output growth. In the language of optimal control, the policy tools are
known as "instruments" and the variables such
as employment are known as "goal variables."
The policymaker, then, chooses settings for the
instruments believed consistent with the desired
values of the goal variables, while recognizing
that the link between the two is uncertain.
The situation is further complicated by the fact
that the resulting actual values of the goal variables may not be immediately observable. There
may be lags in the transmission of policy. For
example, a change in the rate of growth of the
money supply may not be fully reflected by a
change in the rate of inflation for a period of up
to two years. 3 Moreover, there may be further
lags in the gathering ofdata. Figures for GNP are
not available until after the end of the quarter to
which they refer, and the initial figures are
routinely revised, often by substantial amounts.
As a result of these lags, the economy could veer
off course for some time without policymakers
being aware of the situation. Indeed, this possibility is not purely hypothetical. In 1974, a large
revision in the inventory-valuation adjustment
sharply changed perceptions regarding the overaccumulation of inventories and, hence, the
likely severity of the ensuing recession. It is
conceivable that, had policymakers access to
better information in 1974, their decisions would
have been different.
Of course, policymakers need not wait for the
release of GNP data to learn about the economy,
because monthly figures on personal income,
industrial production, retail sales, etc., provide
clues as to how the economy is evolving. Based
on the observation of these "information variables," they can draw inferences about the unobserved goal variables, and reset instruments if
that appears warranted. "Optimal control"
makes an important contribution by showing
policymakers how to make the most effective use
of the feedback from information variables when
deciding whether to change the setting of the
instruments. The process is "optimal" in the
sense of minimizing some measure of the deviation of the actual paths of the goal variables from
their desired paths. 4
The formal mathematics of optimal control
theory is complex and will not be presented here.
But the underlying logic is simple: In order to
achieve optimal settings of the policy instruments, it is necessary to utilize all available
information on the unobserved goal variables. 5
Thus, the adherents of an optimal-control approach argue that a policy of monetary targeting
inherently wastes information. We now turn to
an appraisal of that criticism.
Monetary Policy Targets
As mentioned at the outset, the Federal Reserve has repeatedly stressed in official statements that it does not formulate short-run monetary policy mechanistically, according simply to
the criterion of whether the money supply is
growing on target. Thus, although we present
here a highly stylized representation of monetary
targeting, we do not intend this to be used as a
description and assessment of how the Fed
currently conducts its affairs. Instead, we intend
it simply as an expositional device to help highlight some of the key issues in the debate over the
virtues of formal money targets. 6
Consider the situation faced by monetary
policymakers at the time targets are initially
established. They wish to see the goal variables of
unemployment, inflation, and real income
growth follow certain desired paths over the
planning period for which targets are to be set.
For simplicity, these three distinct goal variables
can be grouped under the single rubric of "income."7 On the basis of historical empirical
relationships, policymakers then choose growth
targets for the monetary aggregates which they
believe will be consistent with achievement of the
desired path for income.
39
While all of these questions are important for
the implementation of a targeting procedure,
they can be safely ignored for purposes of this
study. Here, the concern is with two more
fundamental issues. First, can a policy which
relies solely on the information contained in
money to infer the behavior of income ever be
optimal? And second, would a policy which
consisted of mechanically moving reserves to
bring money back on target whenever it went
off track represent an optimal use of the information in money itself? According to the adherents of the optimal-control approach, the answer to both of these questions is, "No."
The logic of the response is intuitively appealing in the case of the first question. Data on a
whole host of economic variables other than
money are available on a more timely basis than
are national-income statistics. For example, the
I'ederal Reserve publishes weekly numbers on
bank loans at the same time that it releases its
money-supply figures. A large body ofeconomic
literature suggests that these numbers should
provide important clues to the strength of economic activity.9 Similarly, interest rates on a wide
range of securities can be monitored on a continual basis (as the Open-Market Desk of the
Federal Reserve Bank of New York indeed
does). To the extent that interest rates are an
important link in the transmission of monetary
policy, they presumably provide another valuable source of information about income. A
priori, it is hard to understand why policymakers
should choose to ignore such information.
The reasoning behind the optimal-control
position on the second issue raised abovewhether automatically bringing money back on
track, onceit has strayed, represents the best use
of the information conveyed by the money
supply-is less obvious though easily explainable. We look to money for information on
income because of the assumption that there is a
stable relationship between the two through the
money-demand function. If money demand is
subject to random disturbances, however, deviations of money from target may merely reflect
these random influences, and need not indicate
that income is off its desired path. If, for example, the Federal Reserve were to offset a random
downward shift in money demand that was
However, the money supply is not a variable
over which the Federal Reserve has direct control, i.e., it is not an "instrument." The Fed can
control directly the availability of reserves to the
banking system or alternatively it can influence
even this variable indirectly by setting a value for
the Federal funds rate and providing whatever
quantity of reserves is necessary to maintain that
rate. 8 Under present Federal Reserve regulations, member banks must hold certain percentages of their various deposit categories in the
form of reserves. This means that deposit growth
is ultimately constrained by the rate at which
reserves are allowed by the Fed to expand. On
October 6th, the Fed announced a change in its
operating procedures which would involve directly setting the volume of bank reserves (rather
than the previous method of using the Federalfunds rate) to attempt to achieve its monetaryaggregates targets. Thus the Fed is now using
reserves as its instrument, whereas up to October
6th the instrument was the Federal-funds ratesee the article by Judd and Scadding in this issue.
But it would not be appropriate to call money the
instrument under either regime.
In the terminology of optimal control, money
is an information variable. Observations on the
money supply are available on a more timely
basis than are observations on income. More
importantly, changes in the rate of growth of
the money supply tend to lead changes in
overall economic activity. If the rate of money
growth is observed to be deviating from its
target, we may assume that income is (or will
be) deviating from its desired path, since the
money target was expressly chosen to be consistent with the latter. In this situation, strict
adherence to a policy of monetary targets would
require that the supply of bank reserves be
altered to bring money growth back on target.
This simple description of the workings of a
money-targeting policy begs a host of real-world
issues. For example, what is the proper time
period over which to compare actual and targeted money growth? One week? One month? Furthermore, what should the policy response be
when one measure of the money supply is exceeding its target while another is below target?
And should forecasts of money growth be given
any weight, or only actual money growth?
40
unrelated to income, the result would be an
excess of money supply over demand, which if it
persisted would lead to inflation. If, on the other
hand, the drop in money were caused by a
random decrease in real economic activity, an
increase in the money supply by the Federal
Reserve to raise aggregate demand would be
appropriate. Furthermore, if other variables
than income enter the money-demand equation,
policymakers must consider the response of
money to these variables when formulating the
optimal policy reaction to a deviation of money
from target. Since money demand apparently is
both subject to stochastic disturbances and responsive to changes in interest rates, it follows
that mechanically moving money back to target
will not, in theory, be the optimal policy. This is
true even if money is used as the sole source of
information about income. 1O
The empirical analysis in the remainder of
this article focuses only on the first of these two
separate issues-that monetary targets waste
information. Further, we restrict our attention
to financial-market variables as possible supplements to the information on income contained
in money. We do not assume that "real" variables convey no information on income. Rather, we limit his study to financial variables
because of their prominence in the literature on
the transmission of monetary policy to economic activity. An investigation of potential realsector information variables could be the subject of another long paper. Furthermore, our
choice of variables is meant to reflect the natural inclination of monetary policymakers to
look to the financial markets for a reading on
the economy.
Finally, restricting the analysis to financial
variables does not undermine the practical relevance of this study. In early 1979, for example,
money growth as measured by both M 1 and M2
was sluggish, while bank lending was growing
rapidly. Policymakers were forced to decide
whether the money-supply figures accurately
reflected the imminence of a period of slack in
real economic activity, despite the surge in bank
loans. J J In fact, the empirical estimation in the
next section is based on the kind of analysis
which policymakers at least implicitly perform
when confronted with such divergent trends.
Information Variables: Policy Context
We noted previously that one of the problems
faced by policymakers is their lack of knowledge
of the "true model" of the economy. If they knew
the equations of that model (or even the variables
involved), they would presumably be able to
extract information about income out of currently available data. But their uncertainty about
the true model leaves them little choice but to
rely on a few variables which in their experience
have been correlated with GNP in the past, and
which are available on a timely basis. Because of
differences in jndividual judgment and experience, differences also occur in policymakers'
choices of variables to watch. Not surprisingly,
then, policy briefings tend to involve the presentation of the latest figures from a wide range of
economic time series, from which each policymaker can choose the two or three variables
which he or she believes convey the most information about economic activity.
In effect, each policymaker replaces the (unknown) full structural model with a singleequation model, in which income is explained by
several variables on which he has focused his
attention. These variables generally include
monetary-policy and fiscal-policy measures, but
are not limited to them. Since many financialmarket measures are "endogenous" (i.e., determined in the full model), the single equation is
properly called a "semi-reduced form," to distinguish it from a "reduced form" in which only
"exogenous" or policy variables are used to
"explain" movements in income. Also, these
equations do not necessarily represent the optimal way for policymakers to use indirect information about aggregate demand. Instead, they
are designed to represent a reasonable approximation to the way policymakers use such information in practice.
In this sense, and only in this sense, we use
such equations to establish a strong presumption
for the existence of (or lack of) "information"
about aggregate demand in the variables tested.
Given the use of this concept of "information,"
the problem reduces to searching for correlations
between potential information variables and
nominal GNP. Where such correlations are
found to be statistically significant, we conclude
that available information is sufficiently reliable
41
clude (1) bank credit and its major components,
(2) interest rates of various maturities, and (3)
aggregate activity in the credit markets. In selecting variables for testing, we tried to be theoretically agnostic: to "run the gamut" of financial
variables which are commonly 1.lsed in economicpolicy briefings, and which might logically flow
from either Keynesian or Monetarist theories.
Contemporaneous values of these variables
were entered in the equations, even though
policymakers lack access to some current information because of lags in the data. Thus our
equations test for information in the variables
themselves, and do not determine whether policymakers actually have access to such information. This is no problem for interest rates, where
there are no effective data lags. Also it is only a
minor problem for monetary and banking data,
where the lags are only a week--but where
revisions are occasionally substantial. In the
case of flow-of-funds data, however, the lags
exceed one quarter, so that any potential information involves the use of either forecasts or
lagged data. Since our basic tests may overstate
the amount of accessible information in the
flow-of-funds variables, we include additional
(forecasting) regressions to determine whether
our basic results with these particular variables
would be affected.
to be potentially usable by policymakers.
Any search for information variables would
logically begin with measures of monetary and
fiscal policy. Examples would include the policy
variables for which the Federal Reserve currently reports targets to Congress (M], M 2 , M 3 , and
bank credit). The Fed presumably believes that
these aggregates contain significant information
about GNP, and besides, it is required under the
Humphrey-Hawkins Act of 1978 to specify
growth ranges for them in conducting monetary
policy. Our basic equations express growth in
nominal GNP as functions of growth in several
monetary-policy variables (M], M 2 , and bank
credit)-and in addition, as a function of a fiscalpolicy variable (high-employment federal expenditures),12 These basic equations are the
familiar St. Louis equations, which have been
widely discussed in the economics literature,'3
generally as measures of the relative importance
of monetary and fiscal policy. However, we
employ these equations in a completely different
way. We add various information variables to
these equations and ask the qu~stion: Do these
financial-market variables contain anyadditional information about aggregate demand not
already contained in variables measuring monetary and fiscal policy?
The financial-market variables examined in-
II. Testing for Financial Market Infonnation
The preceding discussion conceptually defined
the empirical tests conducted for the information
content of financial-market variables. We next
describe the particular form of these tests, which
are based on econometric estimates of semireduced form equations. As mentioned earlier,
the equations are designed to determine whether
or not the financial-market information variabIes add significantly to the precision with
which monetary-and fiscal-policy variables
by themselves explain aggregate demand. Specifically, we use F-tests to determine if standard
errors from aggregate-demand equations including only the policy variables are significantly
higher than standard errors from equations
which also include financial-market variables.
The estimating equations are described in (1)
below.
The policy variables include those that would
normally be found in standard St. Louis
equations I4 -high-employment government expenditures as the fiscal-policy variable, 15 and M 1 ,
M 2 , and bank credit alternatively as the
monetary-policy variable. Bank credit, although
having less operational significance for monetary policy at present than the monetary aggregates, has received strong support as an alternate
policy measure, especially during the extended
debate on this subject in the early 1970'S.16 In
agnostic fashion, we have simply performed our
tests with all three monetary-policy aggregates.
4
4
4
(1)
Yt = a + k biM t-i +k CiFr-i + k dJt-i
i=O
i=O
i=O
where all variables are entered approximately as
percentage changes l7 and are defined as follows.
42
See Appendix 1 for data sources and glossary.
regressions (see Appendix 2 for a description of the instruments used).
Y = nominal gross national product.
M = monetary-policy aggregates.
M I = currency plus commercial-bank
demand deposits adjusted
M 2 M 1 + commercial-bank saving and
time deposits except large negotiable
certificates of deposit
total bank credit (BC)
F = fiscal-policy variable = high-employment
Federal expenditures.
I = financial-market "information" variables.
commercial-bank variables
total bank credit (BC)
loans to nonfinancial business (BL)
ratio of total loans to total bank credit
In choosing particular series within each of the
financial-market categories, we tried to include
variables which are systematically involved in
the process by which Federal Reserve openmarket operations influence the economy. Our
purpose was not to advance particUlar hypotheses, but rather to test as many credible variables as possible. It should be noted that bank
credit enters the equations in two roles. This
variable appears as a monetary-policy aggregate
in conjunction with financial-market information variables, and, alternatively, as a financialmarket information variable in conjunction with
M I and M 2.
The end-point for the sample period was
chosen as 1977.4 because later data were influenced by changes in the monetary aggregates,
brought about by recent changes in banking
regulations. IS Indeed, an even earlier end-point
could have been chosen, because some evidence
showed that the demand for money (especially
Md actually began shifting in 1974.3. 19 But
preliminary estimates indicated that the inclusion of 1975-77 in the sample period uniformly
raised the standard errors of the equations estimated (with and without information variables)
and thus did not change any of our conclusions.
Meanwhile, the beginning point of the sample
period was chosen as 1961.1, because that
marked the beginning of some well-documented
changes in bank behavior (i.e., the development
of liability management).20
As mentioned earlier, the equations are semireduced forms, in that they include exogenous
policy variables which belong in the reduced
form of nominal GNP21 and, in addition,endogenous financial variables. In order to avoid
the statistical problems associated with estimating equations with endogenous explanatory variables, we used an instrumental variables approach with respect to the contemporaneous
values of the financial-market information variables. Actually, the results from ordinary leastsquares (OLS) regressions are presented in the
text, since these results are very similiar to those
obtained with instrumental variables, and thus
do not affect the article's conclusions. The
=
(P)
interest rates
Federal funds rate (RFF)
4-6 month prime commercial-paper
rate (RCP)
Moody's Aaa corporate-bond rate
(RCB)
flow-of-funds variables
total outstanding credit extended to all
nonfinancial sectors (TCE)
total outstanding credit extended to
the household sector (TCE/ HH)
total outstanding credit extended to
the nonfinancial business sector
(TCE/NFB)
liquid assets, nonfinancial business
sector (LA! N FB)
Sample period:
1961:1-1977:4 (quarterly observations).
Distributed lags:
fourth-degree Almon distributions
over times t through t-4 where coeffients at times t+ 1 and t-5 are tied to
zero.
Serial correlation:
first degree Cochrane-Orcutt adjustment, where serial correlation was indicated.
Instrumental variables:
contemporaneous values of nonpolicyinformation variables replaced by fitted values from instrumental-variables
43
instrumental-variables results are shown in Appendix 3, and the instruments are described in
Appendix 2.
None of the three bank-credit information
variables-aggregate bank credit, bank loans to
nonfinancial borrowers, and the ratio of total
bank loans to bank credit-passed either test.
None of the three contained information in
addition to M I , and M 2 , while the latter two
credit variables did not significantly reduce the
standard errors from the St. Louis equation with
bank credit as the monetary policy variable. 22
Similarly, the various long- and short-term
interest rates tested were not found to contain
additional information in the M I , and Ml equations. But in the bank-credit equation, both the
funds rate and the commercial-paper rate significantly reduced the standard errors. Thus tests of
eight bank-credit and interest-rate variables (and
combinations thereof) against three measures of
monetary policy (23 regressions in all) produced
only two cases in which additional information
was found. Both of these cases involved shortterm interest rates as information variables, and
bank credit as the measure of monetary policy.
In contrast, the tests of the flow-of-funds
variables (last four rows of Table 1) produced a
number of cases in which information existed
over and above that in the policy variables. Total
outstanding credit extended to households was
significant for M j , M 2 , and Be. Liquid assets of
nonfinancial business significantly reduced the
standard errors in the M I and Be equations,
Empirical Results
The top row of numbers in Table 1 represent
the standard errors from three "St. Louis" equations with nominal GNP regressed on highemployment government expenditures and a
monetary-policy variable (alternatively, M I , M 2 ,
and bank credit), and no financial-market information variables. The standard errors from
regressions which include information variables
were compared with those from the St. Louis
equations, by means of 5-percent and I-percent
F-tests, to see if the information variables could
reduce the standard errors in the respective St.
Louis equations by a statistically significant
amount.
Table 1
Standard Errors of Regressions
1961.1-1977.4
(Ordinary Least Squares Regressions)
Policy Variables
Information
Variables
M1,F
M2,F
BC,F
None
2.95
2.89
3.16
MI
M2
N/A
2.92
2.92
N/A
2.99*
2.91**
BC
BL
P
2.99
3.00
2.95
2.90
2.90
2.93
N/A
3.16
3.09
,P,RCP
RCP
RtF
RCB
RCIl,RCP
2.94
2.89
2.88
2.94
2.91
2.89
2.82
2.80
2.96
2.84
3.03
2.97*
2.97*
3.20
3.00
TCE
TCE/flH
TCE/NFB
LA/NFB
2.93
2.50**
2.86
2.81*
2.88
2.53**
2.87
2.84
2.98*
2.58**
3.09
2.90**
Table 2
Standard Errors of Regressions
1961.1-1977.4
(Instrumental Variables Regressions)
Policy Variables
* Indicates standard errors which are significantly lower (at
Information
Variables
M1,F
M2,F
BC,F
None
2.95
2.89
3.16
TCE
TCE/HH
TCE/NFB
LA/NFB
2.95
2.68**
2.93
3.01
2.89
2.65**
2.89
3.04
3.02"
2.97"*
3.18
3.11
* Indicates standard errors which are significantly lower (at
5 percent)than those of corresponding regressions with no
information variables.
** Indicates standard errors which are significantly lower (at
I percent) than those ofcorresponding regressions with no
information variables.
N/ A ::: not applicable
5 percent) than those of corresponding regressions with no
information variables.
** Indicates standard errors which are significantly lower (at
I percent) than those ofcorresponding regressions with no
information variables.
44
while outstanding credit extended to all nonfinancial sectors passed the F-test in the BC
equation. 23 Thus additional information was
detected in six out of the twelve equations estimated with flow-of-funds variables.
Because of the time lag in the availability of
flow-of-funds data, the results probably overstate the usable information in those variables.
To try to extract the necessary information,
policymakers would presumably attempt to forecast contemporaneous values of flow-of-funds
variables. The instrumental variables regressions
provide a convenient approximation to this
forecasting situation. In these regressions, the
contemporaneous values of financial-market
information variables are replaced by in-sample
estimates from first-stage equations. Since insample estimates are generally more accurate
than out-of-sample forecasts, the instrumentalvariables regressions perhaps overstate the
amount of usable information in flow-of-funds
variables. Nevertheless, they should do a better
job than the ordinary least-squares regressions
summarized in Table 1.
These more realistic results (see Table 2) fail
to detect additional information in liquid assets
of nonfinancial business in the M 1 and BC
regressions, as did the OLS tests. The significance of outstanding credit extended to households (with M 1, M 2 , and BC), and the same
measure for all nonfinancial sectors (with BC)
hold up in the instrumental-variables runs. As
for the M1and M 2 equations, it is difficult to say
why credit extended to the household sector
would contain additional information, while the
same measure for all nonfinancial sectors and
the nonfinancial business sector do not.
The results in Table 1 can also be used to assess
the Federal Reserve's practice of targeting more
than one monetary-policy aggregate. Is the explanatory power of a single aggregate improved
when a second aggregate is also considered? Our
results indicate that BC can be improved upon by
also looking at M] or M 2 , but that the reverse is
not true.
Table 3
long-Run Elasticities of Y with Respect to M
1961.1-1977.4
(Ordinary least Squares Regressions)
M j and M 2 thus outperform BC as a measure
of monetary policy, as can be seen from the fact
that the St. Louis equations yield somewhat
lower standard errors with M 1 and M 2 (2.95 and
2.89 respectively) than with BC (3.16). In addition, only one of the thirteen information variables tested improved upon the M 1 and M 2
equation, while there were seven such variables
for Be.
Policy Variables
Information
Variables
None
MI
M2
M1,F
.74**
M2,F
.84**
BC,F
.32*
NjA
.73*
.08
NjA
BC
BL
P
.79**
.80**
.68**
.91**
.90**
.74**
P,RCP
RCP
RFF
RCB
RCB,RCP
.70**
.75**
.74**
.73**
.73**
.72**
.74**
.74**
.88**
.90**
.43*
.47**
.45**
.24
.58**
TCE
TCEIHH
.36
.51*
1.10**
.39
.56
,48*
.88**
.58*
.08
21
.69**
.11
TCEjNFB
LA/NFB
-.03
-.13
NjA
1.91
.35*
Further evidence is presented in Table 3,
which shows the long-run elasticities of nominal
GNP with respect to the monetary-policy variable indicated at the top of each column, when
the information variable(s) indicated for each
row is (are) also in the regression. M 2 maintains
its highly significant coefficient when M 1and BC
are separately added to the equation. M 1retains
its significant coefficient when BC is included in
the equation, but becomes insignificant in the
presence ofM 2 • Finally, the significance of BC is
eliminated by both monetary aggregates. When
the entire list of information variables is considered, the long-run coefficients on M 1 and M 2 are
significant in all but a few cases, while this is true
for BC in only six of thirteen cases.
* Indicates long-run elasticities which are significantly different from zero at the 5-percent level.
** Indicates long-run elasticities which are significantly different from zero at the I-percent level.
Nj A not applicable
45
3. M 2 uniformly outperformed M 1 which, in
turn, outperformed bank credit as a measure of
monetary policy. We found that Be contained
no information over and above that in either M 1
or M2 , while both of the latter variables contained information in addition to Be.
The empirical results can be summarized as
follows:
I. After testing a large number of potential
information variables measuring various aspects
of bank credit, interest rates and flow of funds,
we found only one variable (total credit extended
to households) which contained information
about aggregate demand in addition to M 1 and
M 2 (1Vhen separately paired with a fiscal-policy
variable).
This study thus has accumulated a great deal
of negative evidence on the information content
of credit-market variables. But in doing so, it has
produced one very strong positive result: once
money (especially M 2 ) is included in an
aggregate-demand equation, there is little to be
gained by also looking at credit-market variables, or for that matter, at other monetarypolicy variables.
2. When bank credit was used as the measure
of monetary policy, we found that two interest
rates (on commercial paper and federal funds)
and two flow-of-funds variables (total credit
extended to nonfinancial sectors and to the
household sector) contained additional information.
III. Conclusions
tary policy is conducted on a month-by-month
basis, so that we may be missing some information from credit-market variables about very
short-run changes in aggregate demand. Third,
we have not investigated the possibility that
only the unexpected portion of movements in
financial-market variables contain information
about GNP. Finally, as noted earlier, we have
not addressed the question of how the Federal
Reserve should respond to deviations in money
from target-which is an important question if
money is used as the sole source of information
about aggregate demand. Despite these caveats,
we believe that the present research has put the
burden of proof on those who argue that the
Federal Reserve should not target money because this involves "throwing away" significant
financial-market information. Furthermore,
these results re-confirm the robustness of the
association between money and aggregate demand.
Optimal-control theory implies that monetary
policy is unlikely to be optimal if available
information about goal variables is not used.
While this conclusion is theoretically unassailable, it cannot be considered relevant in practice
without determining which variables, if any,
contain information in addition to the policy
variables on which policymakers naturally rely.
This article addresses that important policy
question for a representative set of financialmarket variables. The statistical tests indicate, in
particular, that once policymakers take account
of growth in money (especially M2), they can
gain little additional information about aggregate demand from such variables as bank credit
(and its components), interest rates, and flow-offunds variables.
The study has several limitations. First, we
have not tested potential information variables
from the real sector of the economy. Second,
our study uses quarterly data, whereas mone-
46
APPENDIX 1
Variable Names and Sources of Data
BC
BL
Total loans and investments .of all commercial banks (FR Board)
= Loans to nonfinancial business of all commercial banks (Flow of Funds Accounts)
Constant term
Bigh-emt>loyment federal expenditures (FRB S1. Louis)
=
Liquid
as&ets of the nonfinancial business sector (Flow of Funds Accounts)
LA/NFB
M1
= Currency plus demand deposits adjusted (FR Board)
M2
= M 1 + time and savings deposits at commercial banks other than large negotiable
certificates of deposit (FR Board)
P
= Total bank loans of all commercial banks/ BC (FR Board)
RCB
Moody's Aaa bond rate (Moody's Investors Service)
R CP
4-6 month prime commercial paper rate (FR Board)
RFF
Federal funds rate (FR Board)
TCE
= Total credit extended to nonfinancial sectors (Flow of Funds Accounts)
TCE/HH = Total credit extended to the household sector (Flow of Funds Accounts)
TCE/NFB = Total credit extended to the nonfinancial business sector (Flow of Funds Accounts)
Y
= Nominal gross national product
C
F
APPENDIX 2
Instrumental Variables Specifications
The following equations were used to generate the instrumental variables used in the instrumental
variables regressions. See Appendix 3 for those regression results.
2
It = a
+I
2
biIt-i
i=1
+I
i=l
2
c[M t-i
+I
i=l
2
d[RFFN t_i + I e[Ft-i + f'POpt-1
i=1
where all variables are measured in changes in natural logarithms, and
I
M1
RFFN
pop
=
=
financial market information variables as defined in the text.
currency plus demand deposits adjusted.
federal-funds rate, unless I = federal-funds rate, in which case RFFN = 90-day prime
commercial-paper rate.
high-employment federal expenditures.
total U.S. population.
47
APPENDIX 3
Results from Instrumental Variables Regressions
Table 1A
Standard Errors of Regressions
Table 2A
Long-Run Elasticities of Y with Respect to M
1961.1-1977.4
(Instrumental Variables Re.gressions)
1961.1-1977.4
(Instrumental Variables Regressions)
Policy Variables
Policy Variables
M1,F
M2,F
BC,F
Information
Variables
None
2.95
2.89
3.16
None
MI
M2
N/A
2.92
2.92
N/A
2.99*
2.91**
MI
M2
N/A
.08
.73*
N/A
-.08
-.11
BC
BL
P
3.00
3.21
2.95
2.91
3.15
2.94
N/A
3.17
3.09
BC
BL
P
.83**
1.00**
.65**
.89**
1.17**
.72**
N/A
1.90
.36
P,RCP
RCP
RFF
RCB
RCB,RCP
2.95
2.90
2.88
2.95
2.91
2.92
2.83
2.80
2.97
2.85
3.06
2.99*
2.98*
3.21
3.01
P,RCP
RCP
RFF
RCB
RCB,RCP
.73**
.78**
.76**
.73**
.75**
.79**
.76**
.76**
.88**
.90**
.48*
.51**
.49**
.25
.60**
TCE
TCE/HH
TCE/NFB
LA/NFB
2.95
2.68**
2.93
3.01
2.89
2.65**
2.89
3.04
3.02*
2.75**
3.18
3.11
TCE
TCE/HH
TCE/NFB
LA/NFB
.30
.48
1.29**
.26
.51
.37
.93**
.42
.08
.21
.49
.02
Information
Variables
* Indicates standard errors which are significantly lower (at
5-percent level) than those of corresponding regressions
with no information variables.
** Indicates standard errors which are significantly lower (at
I-percent) than those of corresponding regressions with no
information variables.
N/ A = not applicable
M1,F
.74**
M2,F
.84**
BC,F
.32*
* Indicates long-run elasticities which are significantly different from zero at the 5-percent level
** Indicates long-run elasticities which are significantly different from zero at the I-percent level.
N/ A = not applicable
FOOTNOTES
1. This position was first made clear by Arthur Burns in
his "Testimony before the Joint Economic Committee",
July 23, 1970, and has since been reiterated on a
number of occasions.
6. On the question of the usefulness of this simplified
description, see B. Friedman (1977), pp. 294-295.
7. The assumption that there is only one goal variable
avoids the problem of whether in fact there are sufficient instruments available to achieve several independent goals.
2. See in particular Benjamin M. Friedman, "The Inefficiency of Short-Run Monetary Targets for Monetary
Policy", Brookings Papers on Economic Activity
(1977:2), pp. 293-335.
8. The Fed can, of course, affect the volume of reserves
through changes in the discount rate, and can alter the
effective level of reserves through changes in reserve
requirements. These complications are not important
for the analysis here, however.
3. Milton Friedman and Anna Jacobson Schwartz, A
Monetary History of the United States, 1867-1960 (princeton, 1963).
4. In particular, the variance of the difference between
the actual and desired values of the goal variable(s)
over time is generally used.
9. See, for example, the discussion in Tim Campbell,
"Monetary Policy and Bank Portfolio Composition,"
Journal of Money, Credit, and Banking, 2 (May 1978),
pp. 239-251.
5. While this condItIon is necessary for optImal control,
it is clearly nolsufficient. As discussed in the next subsection, optimal-control adherents also criticize
monetary-polley targets for causing inappropriate responses to the information contained in money about
GNP.
10. For a fuller development of this issue, see B. Friedman, (1977), pp. 311-314.
11. See William Poole, "The Monetary Deceleration:
what Does It Mean and Why Is It Happening?", Brook-
48
IngsPapers orlEconOl1llcAetlvlty,1 (1979), pp. 231~
240, for a discussion and analysis of the monetary
deceleration.
found to have superior statistical properties than dollar
changes in standard St. Louis equations estimated over
1953-1976.5.ee Carlson (1978).
12. A long debate exists inthe eConomics literature over
the statistically and conCeptually superior measure of
fiscal policy. Ifany consensus hasdevEllpped, itfavors
the high-employment federal expenditures measure.
See "Technical Notes for Estimates of the HighEmployment Budget" Federal Reserve Bank of. St.
Louis, unpublished paper, March 1968, for a description of this variable. Also see footnote 13 for papers
using this variable.
18. See Thomas D. Simpson, "AProposal for Redefining the Monetary Aggregates," Federal Reserve Bulletin (January 1979), pp.13-42.
19. See Richard D. Porter, Thomas D. Simpson and
Eileen Mauskopf, "Financial Innovation and Monetary
Aggregates," Brookings Papers on Economic Activity
(1:1979), pp. 213-229. A paper disputing that a shift
occurred is Michael Hamburger, "Behavior of the Money Stock: Is There A Puzzle?" Journal of Monetary
Economics (April 1978), pp. 151-192.
13. See Leonall Anderson and Jerry Jordan, "Monetary
and FiSCal Actions: A Test of Their Relative Importance
in Economic Stabilization," Federal Reserve Bank of St.
Louis Review (November 1968), pp. 11~24, Benjamin M.
Friedman, "Even the St. Louis Model Now Believes in
Fiscal Policy," Journal of Money, Credit, and Banking
(May 1977). pp. 365~67; and Keith M. Carlson, "Does the
StLouis Equation Now Believe in Fiscal Policy?,"
Federal Reser.ve Bank of St. Louis Review (February
1978). pp. 13-19.
20. See Jack Beebe, "A Perspective on Liability Management and Bank Risk," Federal Reserve Bank of San
Francisco, Economic Review (Winter 1977) pp. 12-25.
21. Several researchers have shown that money is
exogenous with respect to nominal GNP. A recent
example is Y.P. Mehra, "Is Money Exogenous in MoneyDemand Equations," Journal of Political Economy
(1978:2), pp. 211-228.
22. Cambell (1978) obtained significant results with the
composition of bank credit in an equation similar to our
"P,RCP" equation shown in Table 1. However, he used
the 1953-72 sample period, and the raw government
surplus for a fiscal variable. The reverse-causation bias
in this variable in aggregate-demand equations was the
major reason. for the development of the highemployment government expenditures variable in
Anderson-Jordan (1968).
14. See footnote 13.
15. See footnote 12.
16.. See the series of papers by Michael Hamburger,
Frederick Schad rack, and Fred Levin under the heading, "The Choice of Intermediate Targets," in Monetary
Aggregates and Monetary Policy, the Federal Reserve
Bank of New York, 1974. A summary discussion of
those results may be found in Benjamin Friedman,
"EmpiriCal Issues in Monetary Policy," Journal of
Monetary Economics (1977:3), pp. 87-101.
23. The insignificance of this variable in the M1 and M2
equations is consistent with the results in Richard G.
Davis, "Broad Credit Measures as Targets for Monetary
Policy," Quarterly Review (Federal Reserve Bank of
New York), pp. 13-22.
17. Specifically, the equations are estimated in changes
in logarithms, which is similar to using data expressed
as percentage changes. Percentage changes have been
49
Hang-Sheng Cheng
During the last decade, inflation has become a
worldwide concern. At the same time, with the
abandonment of pegged exchange rates under
the Bretton Woods system, member countries of
the International Monetary Fund (IMF) have
become free to choose their exchange-rate policy
under general IMF surveillance. I How to exercise this freedom so as to minimize domestic
price inflation is obviously a question of considerable policy interest.
The purpose of this paper is to utilize economic analysis and empirical evidence to shed
light on the subject of exchange rates and domestic inflation. We start with a simple model of a
small two-sector ec.onomy-a tradable-good
sector and a nontradable-good sector. With this
model, we compare how various types of disturbances to the national economy (e.g., world
inflation, capital flows, domestic wage increases,
crop failures, monetary expansion) affect the
domestic price level under fixed and flexible
exchange rates. A large number of cases are
analyzed, corresponding to the various alleged
causes of inflation, to see if the choice of
exchange-rate policy makes a systematic difference in the extent to which the domestic price
level is affected by various internal and external
disturbances.
The analysis shows, first, that in an open
economy, any inflationary disturbance from
whatever source always manifests itself as a
pressure in the foreign-exchange market, in the
form of a reserve change or an exchange-rate
adjustment (or a combination of the two). The
analysis also shows that the essence of an
exchange-rate policy lies in a deliberate policy
choice regarding the distribution of the
"exchange-rate market pressure2" between re-
serve changes and exchange-rate adjustments.
Depending on the source of inflation, the
exchange-market manifestation may be an upward pressure on the national currency (i.e.
exchange appreciation or reserve accumulation)
or a downward pressure (exchange depreciation
or reserve depletion). In the case of an upward
pressure, exchange appreciation would always
result in less domestic-price increase than reserve
accumulation; in the case of a downward pressure, on the other hand, reserve depletion would
always result in less domestic inflation than
exchange depreciation. Thus, an optimal
exchange-rate policy for minimizing domestic
inflation would be to permit exchange appreciation and resist depreciation, regardless of the
source of inflationary disturbances. Since the
manifestations of the exchange-market pressure
are readily observable, and the exact nature of
the underlying inflationary disturbances is not,
this policy rule would make policy choices considerably easier and more operational than having to decide about the sources of inflationimported or of domestic origin, demand-pull or
cost-push, attributable to monetary or real factors.
We have applied the rule to assess the actual
exchange-rate policies and inflation experiences
of four Pacific Basin countries: Japan, the Philippines, Korea, and Taiwan, during the 1968-78
period. Buffeted by both internal and external
disturbances, the four countries experimented
with a variety of exchange-rate policies during
this period. Japan floated in 1973; the Philippines nominally floated in 1970 but in fact
pursued a flexible-peg approach; Korea originally floated but then shifted to a pegged rate in
1972; and Taiwan maintained a pegged rate until
the very end of the period, when it adopted a
floating rate.
* Assistant
Vice President and Economist, Federal Reserve
Bank of San Francisco.
50
the face of internal and external disturbances. As
important as that objective may be, policymakers might well have other objectives in mind,
e.g., domestic income stabilization and economic growth. Hence, although a less-than-optimal
exchange-rate policy in the present context
means a higher domestic inflation rate than
otherwise, it does not necessarily imply a wrong
policy. Second, the recommendation for resisting depreciation as an anti-inflation policy is
predicated on the assumption that the exchangemarket pressure is transitory, or that appropriate
adjustment mechanisms can work rapidly
enough to restore balance in the nation's international payments before its foreign reserves or
foreign-credit facilities are seriously depleted.
Specifically, it is not an endorsement of a pegged
exchange rate under continuing domestic inflation, with the exchange rate sustained byextensive trade and exchange restrictions. Third, the
assumption of a "small open economy," defined
in the next section, should be underscored. This
implies that foreign repercussions of the country's policy actions can be ignored. The analysis
is particularly inapplicable to large economies
such as the United States, whose economic
activities significantly affect the rest of the world.
Despite the variety of avowed exchange-rate
policies, all four countries except Japan exhibited a greater readiness to depreciate the currency
than to appreciate. Even in Japan's case, both
appreciations and depreciations were tempered
by a "leaning-against-the-wind" policy, whereby
the Bank of Japan intervened in the market to
slow down or moderate the extent of exchangerate fluctuations. 3 The aversion to currency
appreciation resulted in rapid money growth and
inflation in a number of episodes, notably for
Japan during 1970-72, Korea during 1975-77, the
Philippines during 1972-73, and Taiwan during
1972-73 and 1976-78. Actual currency depreciations meanwhile resulted in higher domesticprice increases than would have occurred under
fixed-rate regimes, in Japan during 1973-75, the
Philippines during 1970-71, and Korea in 197072 and 1975-77.
This informal survey of inflation experiences
indicates that domestic inflation in the four
countries might have been lower had they adopted optimal exchange-rate policies.
Finally, several caveats are in order. First, it
should be borne in mind that the "optimality" of
exchange-rate policy is defined in this paper
solely in terms of reducing domestic inflation in
I. Framework of Analysis
The analytical framework presented in this
paper is one familiar in the literature on policy
choice for maintaining internal and external
balance. This approach, pioneered by Robert
Mundell, Marcus Fleming and others, is simplified here by assuming full-employment output
and no bond market, so as to focus on the
relationship between the exchange rate and the
domestic price level. 4 Those who are not interested in formal economic analysis may skip to the
next section, where the analytical results are
summarized.
We also assume in this analysis that the country is a price taker in the world market for both
its exports and its imports. That is to say, it
possesses no monopolistic power over its exports
and no monopsonistic power over its imports, so
that the world demand for its exports and the
supply of its imports are both perfectly elastic.
Moreover, terms-of-trade changes are ignored,
so that the country's exports and imports are
regarded as one good, a "tradable good," in
distinction to another good, the "nontradable
good."
Both the tradable good and the nontradable
good are produced and consumed by the residents of the country. The production of each
good is assumed to depend only on the relative
prices of the two, while the demand depends on
real income, relative prices, and real money
balances. The price of the nontradable good is
determined by the domestic demand and supply
conditions in that market. The price of the
tradable good, on the other hand, is equal to its
given foreign price multiplied by the exchange
rate, which is defined as the price of the foreign
currency in terms of the national currency.
Under flexible rates, the exchange rate is determined by supply and demand in the foreignexchange market, which in turn depends on the
51
The stability of the two-sector model requires
that the marginal propensity to spend on either
good (the real income effect) be less than unity,
and that the real-balance effect on demand of a
price change in one sector be algebraically smaller than the sum of its relative-price effects on
both the demand and the supply in that sector.
Finally, the model assumes that changes in the
nominal money supply are determined partly by
changes in the central bank's foreign reserves and
partly by domestic credit expansions or contractions.
World Price Increase. Under a fixed exchange
rate, the domestic price of the tradable good will
rise in proportion to the rise in its world price.
Through the relative-price effect, which by assumption outweighs the real-balance effect, the
domestic output of the tradable good will rise
and the demand for it fall, resulting in an improvement in the nation's trade balance, an
increase in its reserves, and domestic monetary
expansion. The monetary expansion, through
the real-balance effect, implies an increase in the
demand for both goods, thus raising the price of
the nontradable good and reducing the trade
surplus. Final equilibrium will be attained in
both markets when both prices have risen proportionately to restore the same relative prices as
at the initial equilibrium; and the trade surplus is
completely eliminated.
Under flexible exchange rates, on the other
hand, a world price increase will result in an
appreciation of the national currency in proportion to the world price increase, thus leaving the
domestic price of the tradable good unchanged.
There is neither a relative-price effect nor a realbalance effect. Hence, there is no change in the
domestic price level.
Thus, a fixed exchange rate exposes a country
to inflation pressures from abroad, while upward
flexibility of the exchange rate insulates the
domestic price level from such pressures. In both
cases, the world inflation pressures are manifested in the foreign-exchange market-in the form
of a reserve accumulation in the fixed-rate case
and of exchange-rate appreciation in the
flexible-rate case.
Domestic Credit Expansion. Domestic credit
expansion will result in an increase in the money
supply and, through the real-balance effect, in an
nation's trade balance and exogenously-given
net capital flows. Under fixed exchange rates, the
exchange rate is by definition set by the monetary authorities through exchange-market interventions, with resultant changes in the central
bank's foreign reserves and the domestic money
supply.
Finally, in order to simplify the analysis,.we
assume that both consumers and producers are
devoid of "money illusion"; that is to say, the
demand and supply of each good are dependent
only on real magnitudes and relative prices, so
that proportionate changes in all prices and the
money supply would leave both demand and
supply unaffected. 5 This money-neutrality assumption, which is standard in neo-classical
economic theory, insures the same proportionality of all price changes as a given change in the
money supply.6
Consider now various sources ofinflation, and
compare how the aggregate price level-defined
as a weighted average of the two commodity
prices-would be affected under fixed and flexible exchange rates. FouF types of disturbances
may be distinguished: foreign price increases,
domestic credit expansion, autonomous changes
in domestic demand or supply in the two goods
markets, and net international capital flows.
Obviously, these four types cover a very large
variety of disturbances which can be sources of
inflation in a country open to international trade
and capital flows.
The four types of disturbances affect the
domestic price level through their effects on the
demand and supply of tradable and nontradable
goods. Three types of impacts are considered in
this model: a "relative price effect," a "real
balance effect," and a "real income effect." The
first refers to the response of the domestic demand and supply of the two goods to a cha.nge in
their relative prices: the quantity supplied is
postulated to rise, and the quantity demanded to
fall, with a rise in the price of the good relative to
that of the other good. In addition, the model
assumes that demand is positively related to both
real income and the real money balance held by
the public-the latter being defined as the nominal money supply adjusted for changes in the
domestic price level-such that an increase in
either will increase the demand for both goods.
52
increase in domestic demand in both tradablegood and nontradable-good markets. Under a
fixed exchange rate, only the nontradable-good
price will rise, as the price of the tradable good is
fixed by its world price and the pegged exchange
rate. As relative prices change, the supply of the
tradable good will fall and its demand rise, thus
bringing about a trade deficit and hence a decline
in foreign reserves and in the domestic money
supply. Through the real-balance effect, demand
will fall back in both markets, until the
nontradable-good price returns to its original
level and the trade deficit is eliminated. Full
equilibrium will be restored when the two prices
and the money supply all fall back to their
respective initial levels. In the end, the only
consequence of the domestic credit expansion is
an exchange of domestic assets for foreign assets
in the central bank's portfolio, with no net effect
on either absolute or relative prices, domestic
output or expenditures.
Under a flexible exchange rate, on the other
hand, whenever domestic credit expansion
brings about an increase in the money supply, the
real-balance effect will raise domestic demand in
both tradable-good and nontradable-good markets, as in the fixed-rate case. However, because
the exchange rate can now fluctuate, the prices of
both goods are flexible, so that under domestic
demand pressure the prices of both goods will
rise. Full equilibrium will be restored when
prices have risen in proportion to the increase in
the money supply, in accordance with the
money-neutrality assumption.
Thus, when a domestic credit expansion
creates inflation pressure, a fixed exchange rate
relieves that pressure through a trade deficitand also sets off an adjustment mechanism,
through reserve depletion and monetary contraction, which reduces both the inflation pressure and the trade deficit. A flexible exchange
rate, on the other hand, through exchange depreciation, seals up the inflation pressure at home,
so that the full strength of that pressure is exerted
on the domestic price level, as in a closed economy. Again, in both cases, the inflation pressure is
manifested in the foreign-exchange marketreserve drain in the fixed-rate case and exchange
depreciation in the flexible-rate case.
Autonomous Demand or Supply Changes.
Disturbances of this type can occur in either of
the two goods markets. Instead of analyzing all
such cases, we shall consider only the case of a
supply increase-say, due to successful adoption
of advanced technology-in the tradable-good
sector, and briefly summarize all the other possibilities.
Under a fixed exchange rate, an output expansion in the tradable-good sector will result in an
improvement in the nation's trade balance, an
accumulation of reserves, and a monetary expansion, with no effect on the domestic price of
the tradable good. However, because of the
higher real income and the induced monetary
expansion, domestic demand for both goods will
rise, leading to a rise in the price of the nontradable good and a reduction in the trade surplus.
Full equilibrium will be restored when the
nontradable-good price has risen sufficiently for
the relative price-effect to completely offset the
combined real-income and real-balance effects,
and when the trade surplus is completely eliminated. In the end, the domestic price level will be
higher than at the initial equilibrium.
Under a flexible rate, on the other hand,
output expansion in the tradable-good sector
will lead instead to an appreciation of the national currency and a consequent reduction in the
domestic price of the tradable good, with no
effect on the trade balance and the money supply. Through the relative-price effect, which by
assumption mlJ.st be greater than the realbalance effect, supply will rise and demand will
fall in the nontradable-good sector, but demand
for the nontradable good will rise because of the
real-income effect arising from the output expansion. The net effect on the price of the
nontradable-good is indeterminate. But regardless of the effect on the nontradable-good price,
the aggregate price level will definitely be lower
than at the initial equilibrium.?
Thus, a supply increase in the tradable sector
results in a rise in the price level under a fixed
exchange rate but a decline under a flexible rate.
These different results arise because the disturbance leads to a reserve accumulation in the
fixed-rate case and to exchange appreciation in
the flexible-rate case. Again, the form in which
the disturbance manifests itself in the foreignexchange market, as determined by the
53
exchange-rate policy, makes a critical difference
in its impact on the domestic price level.
Without going through the analysis, we shall
merely note that a supply increase in the nontradable sector will result in a decline in the
domestic price level under both a fixed and a
flexible exchange rate. The decline will be smaller under the former than under the latter, the
difference again being due to the resultant reserve accumulation (hence monetary expansion)
in the fixed-rate case and to exchange appreciation in the flexible-rate case. Moreover, as would
be expected, the results of supply decreases are
symmetrical (i.e., of opposite signs) to those of
supply increases, and those of demand changes
symmetrical to those of corresponding supply
changes.
Capital Flows. Capital flows affect the domestic price level indirectly through their impact
on the exchange rate or on foreign reserves.
Under a flexible rate, a net capital outflow will
result in a depreciation of the national currency,
thus directly raising the price of the tradable
good and indirectly raising that of the nontradable good through the relative-price effect. The
domestic price level will definitely be higher.
Under a fixed rate, on the other hand, the capital
outflow will result in a reserve loss, monetary
contraction, and (through the real-balance effect) in a reduction in demand for both goods. At
the final equilibrium, the domestic price level will
be lower than at the initial equilibrium. A net
capital inflow will have exactly the opposite
results. Again, the exchange-rate policy makes a
critical difference in the response of the domestic
price level to the given disturbance, depending
on whether the exchange-market pressure is
manifested in exchange-rate adjustments or in
reserve changes.
II. Analytical Results
So far, we have examined the impact on the
domestic price level of four types of disturbances: foreign price increases, domestic credit
expansions, domestic demand or supply shocks,
and international capital flows. A large number
of cases have been analyzed, because in reality
inflation can be attributed to a variety of causes.
Our purpose is to construct a model that can
analyze the impact on the domestic price level of
all such disturbances, and see if any generalization could be derived from the results that might
be useful to policymakers. The results are summarized in Figure 1.
Figure 1
Impact of Disturbances on Domestic Price level
Fixed Exchange Rates
Type of Disturbance
Foreign price increase
Credit expansion
Domestic supply changes
Expansion, tradable good
Expansion, nontradable good
Contraction, tradable good
Contraction, nontradable good
Capital flows
Net outflow
Net inflow
Symbols:
"0"
"+"
"++"
"-"
"--"
denotes
denotes
denotes
denotes
denotes
Flexible Exchange Rates
Exchange
Price
Rate
Level
Reserve
Change
Price
Level
Increase
Decrease
+
0
Appreciation
Depreciation
Increase
Increase
Decrease
Decrease
+
+
Appreciation
Appreciation
Depreciation
Depreciation
+
Depreciation
Appreciation
Decrease
Increase
no change in the domestic price level.
a rise in the domestic pricelevel.
a larger rise in the domestic price level than would occur under the fixed-rate case.
a fall in the domestic price level.
a larger fall in the domestic price level than would occur under the fixed-rate case.
54
o
+
+
++
+
In an open economy, as shown in Figure I, any
disturbance to the economy is always reflected in
the foreign-exchange market, either as a reserve
change under fixed exchange rates or as an
exchange-rate adjustment under flexible exchange rates. Moreover, the various types of
disturbances may result in either an upward
exchange-market pressure on the national currency (i.e. a reserve increase or an exchange
appreciation) or a downward pressure (i.e. a
reserve decrease or an exchange depreciation).
Where the exchange-market pressure is
upward-as in the case of a foreign-price increase, an expansion in domestic supply of either
good, or a net capital inflow-a flexible-rate
policy permitting appreciation would in every
case result in a smaller price increase or a larger
price decline than would occur under a fixed-rate
policy. Conversely, where the market pressure is
downward-as in the case of a domestic credit
expansion, a contraction in domestic supply in
either market, or a net capital outflow-a fixedrate policy drawing down reserves would in every
case lead to a smaller price rise or a larger price
decline than would occur under a flexible-rate
policy. Thus, an exchange-rate policy designed
to minimize domestic price inflation should
permit exchange appreciation and resist depreciation, regardless of the source of inflation.
The rationale behind this policy rule can be
better understood by considering the relationship between the exchange-market pressure and
changes in the domestic price level. The foreignexchange market is like a set of valves adjusting
the reciprocal excess demand or supply of national currencies through changes in their exchange rates. An upward pressure signals an
excess demand for the national currencies by the
holders of foreign currencies, because of their
desire to acquire the goods, services, and financial assets denominated in the nation's currency.
(For brevity, call it the "foreign" excess demand,
even though it refers to that of the holders of
foreign currencies, be they domestic or foreign
residents.) A fixed-exchange-rate policy would
keep the adjustment valves wide open, thus
allowing the foreign excess demand to spill fully
into the domestic market and raise the domestic
price level. A flexible-rate policy, on the other
hand, would shut off the valves by making the
national currency dearer in terms of foreign
currencies, thereby discouraging the foreign
excess demand from the national market. Under
these circumstances, a flexible-rate policy permitting exchange appreciation is clearly to be
preferred.
A downward pressure, on the other hand,
signals an excess demand for foreign currencies
by the holders of the national currency, because
of their desire to acquire goods, services,and
financial assets denominated in foreign currencies. (Term it the "domestic" excess demand.) A
flexible-rate policy would again turn off the
valves by making the foreign currencies dearer in
terms of the national currency. This would shut
in the domestic excess demand and compel it to
apply all its pressure on the domestic price level.
A fixed-rate policy, on the other hand, would call
for the central bank to draw down foreign
reserves so as to satisfy the domestic excess
demand for foreign currencies. This would keep
the valves open and thus would channel the
domestic inflation pressure toward foreign
goods, services and financial assets, and away
from the domestic market. In the process, the
central bank would reduce the amount of the
national currency in the public's holdings, and
thus erode the basis of the excess demand for
foreign currencies. Under such circumstances, a
fixed-rate policy would help reduce the domestic
inflation pressure.
This interpretation helps bring out several
implications of the proposed exchange-rate policy. First, the policy rule means a deliberate
attempt to shield the nation from foreign inflation pressures and to direct domestic inflation
pressures toward the rest of the world. Obviously, this asymmetrical policy can be operative only
for those nations that do not have to worry about
repercussions from the rest of the world. Foreign
countries, for instance, might react by appreciating their currencies against the nation's currency,
in effect sealing the inflation pressure within the
nation from which it originates. Alternatively,
where the inflating nation depends on foreign
borrowings to finance its deficits, the foreign
lenders could progressively make their terms of
lending more onerous. As for the second implication, the proposed downward exchange-rate
rigidity presumes ample reserves in relation to
55
Impeding the adjustment process by continued
domestic monetary expansion, for instance,
would ultimately destroy its usefulness.
the reserve drain, as well as an effective adjustment process for reducing the reserve drain. The
policy is merely a short-run stop-gap measure.
III. Experiences of Pacific Basin Countries
With this policy rule in hand, we now turn to
examining the inflation and exchange-rate experiences of four Pacific Basin countries-Japan,
Korea, the Philippines, and Taiwan--during the
1968-78 period. We assess the appropriateness of
their policies from the viewpoint of minimizing
domestic inflation, to see if the policy rule can
help interpret actual events in the period studied.
The data for the four countries are selected on
the basis of the economic analysis presented
above (Tables 1-4 and Charts 1-2).
Japan
The Japanese yen was at first pegged to the
U.S. dollar, drifted up after August 1971, and
then officially floated in February 1973. After
that, it fell during the oil crisis and world recession of 1974-75, and then rose sharply in 1976-78.
During the fixed-rate period of 1968-70, the
exchange-market pressure was relatively mild.
The overall balance-of-payments surplus averaged a relatively small $1 billion a year. During
1971-72, the payments surplus leaped to an
average of $6.7 billion a year, in spite of the 18percent yen appreciation from 1970 to 1972. The
Bank of Japan responded to this strong upward
pressure with a combination of exchange-market
interventions and exchange-rate adjustments. As
a result of the market interventions, the annual
money-growth rate rose from an average of 17
percent in 1968-70 to an average of 27 percent in
1971-72 (Chart 2). As shown in the central bank's
balance sheet (Table 1), the 1971-72 increase in
total assets, amounting to ¥2.8 trillion, was
more than explained by a rise of ¥3.9 trillion in
its foreign-asset holdings. Given the lag between
monetary expansion and price increases8 , the
high money-growth rate of 1971-72 set the stage
for the double-digit price inflation in 1973-74.
The 1973-74 inflation thus can be traced, at least
in part, to the 1971-72 exchange-rate policy.9
Under heavy exchange-market pressure, the
yen officially floated in February 1973 and
appreciated by 12 percent on a year-to-year
average basis. However, during 1973 the
Table 1
Japan: Inflation, Exchange Rates, Balance of Payments and Money, 1968-78
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
Inflation Rate'
4.4
6.0
7.8
5.4
4.5
16.5
24.5
8.5
9.4
6.2
3.4
Exchange Rate 2
Balance of Payments'
Current Account
Capital Account
99.5
100.1
100.1
103.0
118.3
132.2
123.0
120.8
120.9
133.6
170.4
1.0
-0.2
2.1
-1.4
2.0
-0.8
5.8
4.6
6.6
-3.6
-0.1
-6.2
-4.7
5.9
-0.7
0.1
3.7
0.1
10.9
-4.4
17.5
-7.5
Money Growth Rate'
Central Bank Assets S
Total
Foreign Assets
Claims on
Government
Claims on Banks
13.4
20.6
16.8
29.7
24.7
16.8
11.5
11.1
12.5
8.2
13.4
0.91
0.32
0.92
0.27
1.08
0.43
0.25
3.03
2.51
0.89
2.04
-1.89
2.44
0.39
1.57
-0.22
1.19
1.17
2.24
1.94
n.a.
n.a.
0.48
0.12
0.32
0.33
0.33
0.32
-l.i6
-1.62
-0.54
2.17
0.47
3.45
2.48
-0.44
3.56
-1.77
-0.33
0.35
-0.47
0.77
1.77
0.27
I Percentage change in consumer-price index, fourth quarter to fourth quarter.
2 Exchange rate vs. U.S. dollar, annual average, June 1970=100.
3 Balance on current and capital accounts, in billions of U.S. dollars.
4 Percentage change in M I (currency plus bank demand deposits), year end to year end.
5 Change in assets, in trillions of yen, year end to year end.
Source: International Monetary Fund, International Financial Statistics, various issues.
56
exchange-market pressure reversed its direction,
as the current-account balance turned into a
small deficit, and a large net capital outflow
occurred. The Bank of Japan intervened heavily
to support the yen, so that its foreign-exchange
holdings fell from $16.5 billion to $10.2 billion
between year-end 1972 and year-end 1973, while
the money-growth rate dropped from 25 percent
to 17 percent between 1972 and 1973. The central
bank's total assets rose by ¥2.0 trillion, while
foreign assets declined by ¥ 1.9 .trillion. .The
exchange-market interventions played a significant role in reducing money growth in 1973, and
thus contributed to the reduction of inflation
pressures in subsequent years.
The yen continued to decline in 1974 and 1975.
The Bank of Japan persisted in its policy of
reducing the money-growth rate, bringing it
Chart 2
Chart 1
Exchange Rate Pressures
Money - Growth and Inflation Rates
30
Percent
$ Billions (u.s.)
Japan
June 1970-100
Japan
/\
10
170
~owth
8
150
,
130
20
6
Exchange
--. Rate
\
10
4
2
110
100 _ ....
=--....-=....I!-lI__...., o
__
-lI~I!-l
o 1968
30 Percent
90 s..",:-...t.,..."L---I.;~lI-k,.L---',;;~-':;n-;o'
1976
197B- 2
19m
1972
1974
1976
1978
Philippines
$ Billions (U.S.)
1.00
20
.80
Philippines
June 1970=100
.60
160
-
Reserve
... Change
140
120
10
.40
.20
100 '=--=....N~IlII-----~-=;;;--;;;;;;-..,
o
1978
50
80 1,.19-';6~B--..J,1;;o97"'0l--S19""72f------.l,19"""4L::::r;19:;;;76F:::I;;19;;76J-.20
Korea
40
$ Billions (U.S.)
1.40
30
Korea
1.00
Reserve :-Change
,
Percent
20
.60
10
.20
o
o 1968
50
1970
Percent
Taiwan
40
Taiwan
30
20
.30
10
.20
o
1972
__-
o 1968
.10
1970
>-
1978
Note: Money-growth changes calculated on a
year-end to year-end basis, and inflation rates ona
fourth-quarter to fourth-quarter basis.
1974
57
with our exchange-rate policy rule and probably
contributed significantly to the reduction in
Japan's inflation rate. In addition, heavy
exchange-market interventions allowed foreign
excess demand to affect domestic markets, but
the Bank of Japan-through a tight monetary
policy-was able to offset both the direct market
impact and the secondary monetary impact. This
experience suggests that our policy rule is by no
means absolute. Other policy measures, such as a
steady application of tight monetary policy, can
bring inflation under control with little assistance from this source.
The Philippines
After sustaining a deteriorating payments
deficit since 1967, the Philippines abandoned
fixed exchange rates in February 1970-at which
point the peso depreciated 39 percent over a
seven-month period. Since September 1970, the
Philippine Bankers Association has set a daily
"guiding rate" for all foreign-exchange transactions, and the central bank has intervened to
keep the peso-dollar rate within the range set by
the Association. Nominally, the daily guiding
rate is free to float, but in fact it has remained
stable and has been adjusted from time to time
only in small steps. For practical purposes, the
down further to 11 percent in 1975. The inflation
rate finally came down from 24 percent in 1974to
8 percent in 1975. However,exchange-ratepolicy apparently contributed little to anti-inflation
policy during this period, with little central-bank
intervention to moderate the yen depreciation.
From 1975 to 1978, the situation again
changed as the yen came under heavy upward
pressure in the exchange market. Japan's
current-account balance swung from a deficit of
$0.7 billion in 1975 to a surplus of$17.5 billion in
1978. Again, the Bank of Japan adopted a
"leaning against the wind" policy of attempting
to moderate the yen's appreciation by heavy
exchange-market interventions. In 1977-78,
while the yen appreciated by 40 percent, the
Bank of Japan added $16.5 billion to its foreign
reserves. Although this action went against our
exchange-rate policy rule, the Bank of Japan was
able to hold the money-growth rate at 11 percent
during the 1977-78 period-about the same as
during 1974-76, but only about half the rate of
the 1971-73 period. As a result, the inflation rate
dropped precipitously from 25 percent in 1974 to
only 3 percent in 1978.
To summarize, Japan's 40-percent exchange
appreciation during 1977-78 was in accordance
Table 2
Philippines: Inflation, Exchange Rates, Balance of Payments and Money, 1968-78
Inflation Rate'
Exchange Rate'
Balance of Payments 3
Current Account
Capital Account
Money Growth Rate'
Central Bank Assets'
Total
Foreign Assets
Claims on
Government
Claims on Banks
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
0.5
2.8
18.7
13.6
5.2
22.6
29.8
1.8
6.7
9.7
8.6
159.3
159.3
102.4
96.4
92.7
91.8
91.4
85.4
83.4
83.8
84.2
-0.27
0.18
-0.25
0.19
-0.05
0.13
0.00
0.13
0.01
0.20
0.48
0.19
-0.21
0.80
-0.92
0.93
-1.10
1.05
-0.83
0.80
-1.22
2.12
2.9
22.5
7.3
16.3
29.1
12.3
24.0
14.5
17.1
23.7
13.4
0.3
--0.1
0.5
-0.2
0.7
0.7
0.7
0.6
2.1
1.0
4.0
4.3
6.2
3.6
3.2
-0.4
2.0
2.3
-1.0
-0.7
8.3
2.7
0.2
0.2
0.5
0.2
0.3
-0.3
0.1
0.0
0.8
0.3
0.3
0.6
1.1
1.5
-!.l
4.7
0.9
-1.2
0.7
-1.0
1.5
4.1
I Percentage change in consumer-price index, fourth quarter to fourth quarter.
2 Exchange rate vs. U.S. dollar, annual average, June 1970=100.
3 Balance on current and capital accounts, in billions of U.S. dollars.
4 Percentage change in M I (currency plus bank demand deposits), year end to year end.
5 Change in assets, in billions of pesos, year end to yearend.
Source: International Monetary FUnd, International Financial Statistics, various issues.
58
ing depreciation agreed well with our policy rule.
But there was one important exception: Foreign
borrowings enabled the central bank to add toits
reserves, and thus thwarted the adjustment process for restoring balance-of-payments equilibrium through reserve. depletion and monetary
contraction, as envisaged in our model. Prolonged continuation of this policy could exacerbate inflation pressure in the Philippines.
peso/dollar rate remained unchanged from 1975
to 1978 (Chart I).
After the 1970 devaluation, exchange-market
pressures turned upward on the peso. In 1971
and 1972, the current-account deficits of past
years were eliminated, while net capital inflows
continued. Aided by a world commodity boom,
the current-account balance showed a substantial surplus of $480 million in 1973. In the
following year, the world oil crisis turned it into a
deficit of $210 million, but the deficit was more
than offset by a $800 million net capital inflow.
All this would have led one to expect an appreciation of the peso from 1970 to 1974; in fact, it
depreciated by II percent. The explanation lies
in the central bank's foreign-exchange purchases, which raised its foreign-exchange reserves from $200 million at the end of 1970 to
$1.4 billion at the end of 1974. 10
This policy of achieving currency depreciation
in the face of upward exchange-market pressures
is, of course, exactly opposite to what our policy
rule would suggest for reducing domestic inflation. The central bank did not try to use currency
appreciation to discourage foreign excess demand from spilling into the domestic market, but
rather encouraged this process through deliberate depreciation. Consequently, the moneygrowth rate increased from II percent in 1968-70
to 20 percent in 1971-74 (Chart 2). The central
bank's balance sheet shows that 73 percent of the
increase in its total assets during the 1971-74
period was due to foreign-asset accumulation.
Thus, the central bank's exchange-rate policy
apparently aggravated the rapid monetary
growth in 1971-74 and was at least partly responsible for the high inflation rate-averaging 26
percent a year-in 1973-74.
This policy of deliberate depreciation was
abandoned after 1974. As the current-account
balance deteriorated to an average deficit of
about $1 billion a year in 1975-78, the peso was
kept stable largely through heavy foreign borrowings. Although the money-growth rate remained as high as 17 percent, the inflation rate
declined sharply to an average annual rate of 7.5
percent from 30 percent in 1974. Since apart
from foreign borrowings, the exchange-market
pressure during the period was clearly downward, the nation's exchange-rate policy of resist-
Korea
Korea maintained a flexible exchange rate
from March 1965 to August 1972, with the wondollar exchange rate being set daily by a group of
designated government-owned exchange banks.
But between August 1972 and December 1974,
Korea maintained the won at a fixed rate of
W400 to the dollar, and then devalued to.W484
(Chart I).
From 1968 to 1971, the exchange-market
pressure was downward on the won, as the
currency depreciated steadily with little official
intervention, except for a period in 1971 when
the Bank of Korea attempted to slowthe rate of
depreciation. The source ofthe exchange-market
pressure was an upsurge in monetary growth (32
percent a year) due to domestic credit expansion.
Surprisingly, the central bank's asset portfolio
showed significant increases in foreign-asset
holdings during this period (Table 3).. However,
since Korea's major banks were all governmentowned, the distribution offoreign assets between
the central bank and the commercial banks was
not as meaningful as it would have been in other
countries. From an examination of the balance
sheet of the consolidated banking system, it
becomes clear that the banking system's foreign
assets actually declined during the period, and
that all of the rapid monetary growth was due to
banking credits extended to the domestiC sector.
Apparently, Korea's authorities pursued a
policy of liberal credit expansion to finance
domestic economic development, and coupled
this with a flexible exchange rate to free the
authorities from balance-of-payments concerns.
The policy succeeded in providing the country
with a lO-percent annual average growth rate. of
real output during those years. However, it also
led to an II-percent inflation rate during the
1968-71 period~the highest among all four
countries during that period (Chart 2).
59
result of the oil-price increase and world recession. The move was perhaps inevitable in view of
Korea's exceedingly slender foreign reserves!!
and its continued domestic credit expansion.
Nevertheless, inflation might have been lower in
1975 had Korea been able to resist devaluation
through, for instance, larger foreign borrowings.
Aside from its inflation effect, the devaluation
helped set the stage for a remarkable strengthening of Korea's international-payments situation.!2 While foreign borrowing continued at a
high rate, the current account improved dramatically from an annual average deficit of $2.0
billion in 1974-75 to a small surplus in 1977. With
the exchange rate fixed against upward
exchange-market pressure, the central bank's
foreign assets rose rapidly in 1976 and 1977, and
this accounted for 70 percent of the central
bank's asset increase and 35 percent of the
consolidated banking system's total credit extension in those years. Meanwhile, the moneygrowth rate rose from 25 percent in 1975 to 41
percent in 1977. The fixed-exchange-rate policy
under mounting upward exchange-market pressure was clearly incompatible with domestic
Korea abandoned the floating exchange rate
in 1972, and accompanied this move with strict
price controls. The nominal consumer-price
index rose only 5 percent in 1973. Moreover, asa
result of vigorous export growth, the currentaccount deficit dropped sharply from $850 million in 1971 to an average of only $340 million in
1972-73, while net capital inflows continued at
the rate of $700 million a year. The resultant
reserve increases added directly to domestic
money growth and indirectly also encouraged an
acceleration of domestic credit expansion (Table
3). The result was a 43-percent annual moneygrowth rate in 1972-73, compared to 19 percent
in 1970-71. The way was thus paved for a steep
price rise, averaging 28 percent a year, in 197475. Since the increase in foreign assets accounted
for about one-fourth of the banking system's
total credit expansion of the 1972-73 period, it
appears reasonable that that period's exchangerate policy contributed significantly to the subsequent rapid inflation.
The 21-percent devaluation of the won in
December 1974 was a reaction to the sharp
deterioration in Korea's current account as a
Table 3
Korea: Inflation, Exchange Rates, Balance of Payments and Money, 1968-78
Inflation Rate'
Exchange Rate 2
Balance of Payments'
Current Account
Capital Account
Money Growth Rate"
Central Bank Assets'
Total
Foreign Assets
Claims on Gov't
Claims on Banks
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
10.2
11.4
13.9
9.7
10.3
5.1
26.6
30.0
8.7
10.8
16.8
111.8
107.2
99.5
88.2
78.6
77.7
76.3
64.0
64.0
64.0
64.0
-0.44
0.48
-0.55
0.71
-0.62
0.68
-0.85
0.71
-0.37
0.70
-0.31
0.70
-2.03
1.81
-1.89
2.21
-0.30
1.65
0.01
1.35
-1.09
1.25
44.5
41.8
22.1
16.4
45.1
40.6
29.5
25.0
30.7
40.7
24.9
42
36
-I
7
71
44
II
16
80
22
3
55
-5
-24
-3
22
195
-16
144
68
265
136
28
101
393.7
163.9
17l.1
386.5
646.3
264.7
362.0
19.6
686.3
560.4
125.6
0.3
213
5
208
304
22
282
216
5
211
206
-71
277
428
68
360
671
197
474
674
-417
1091
939
-57
996
1389
475
914
736.7
959.1
586.3 -200.1
210.7 292.0
644.8
162.1
Banking System Assets'
Total
Foreign Assets (Net)
Domestic Credit
I Percentage change in consumer-price index, fourth quarter to fourth quarter.
2 Exchange rate vs. U.S. dollar, annual average, June 1970= 100.
3 Balance on current and capital accounts, in billions of U.S. dollars
4 Percentage change in MI (currency plus bank demand deposits), year end to year end.
5 Change in assets, in billions of NT dollars, year end to year end.
Source: International Monetary Fund, International Financial Statistics, various issues.
60
1852
666
1186
2584
-254
2838
price stability during the 1968-78 period.·Except
for the 1973-74 period, the consumer inflation
rate averaged 4.5 percent a year during the
period, compared to 6.2perc:ent for Japan, 7.5
percent for the Philippines, and 10.8 percent for
Korea (Chart 2).
Taiwan was also the only country among the
four that consistently maintained· a fixed
exchange-rate policy. Throughout the elevenyear period, the New Taiwan dollar (NT) was
pegged to the U.S. dollar~except for a revaluation from NT40 to NT 38 in February 1973, and
another revaluation to NT36 in July 1978 (Chart
1). The 1978 revaluation was accompanied by a
decision to float the currency, which was put into
effect on February 1, 1979, thus officially abandoning the long-standing fixed-rate policy.
Taiwan's exchange-rate policy presents another example of the difficulty of maintaining a
fixed exchange rate under mounting upward
exchange-market pressure. Since 1968, the country's current account improved steadily because
of a rising export surplus, except for a major
break in trend that occurred during the oil crisis
and world recession of 1974-75.
monetary stability. The inflation rate thus rose
from 8 percent in 1976 to 17 percent in 1978.
Under these circumstances, our policy rule
would call for currency appreciation to relieve
the inflation pressure. Korea, however, took a
different route. Instead of currency appreciation,
it chose the path of trade liberalization to reduce
its payments surplus, with such measures as tariff
reductions, abolishment of import quotas, and
official foreign purchases. These measures have
led to a shift in the nation's current account,
resulting in a $l.l-billion deficit in 1978. Moreover, from the viewpoint of long-run economic
growth, the trade-liberalization measures should
stimulate improvement in productive efficiency
through enhanced competition. However, greater productive efficiency in the Korean context is
likely to mean an accelerated export-growth
rate. Unless import growth can keep pace, sooner or later Korea may have to face up to the need
for an appropriate exchange-rate policy to reduce its very high domestic inflation rate.
Taiwan
Among the countries examined, Taiwan was
the most successful in maintaining domestic
Table 4
Taiwan: Inflation, Exchange Rates, Balance of Payments and Money. 1968-78
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
Inflation Rate'
8.9
8.5
0.1
1.9
1.6
23.6
34.8
2.2
1.5
8.4
7.1
Exchange Rate'
Balance of Payments 3
Current Account
Capital Account
100
100
100
100
100
104.7
105.4
105.4
105.4
105.4
108.1
-0.12
0.01
-0.03
0.01
0.0
0.18
0.18
-0.10
0.52
-0.18
0.57
-0.49
-1.11
1.18
-0.59
0.58
0.32
0.12
0.98
-1.12
1.74
-1.68
9.4
11.1
11.4
24.6
37.9
49.3
7.0
26.9
23.1
29.1
34.1
4.0
0.7
1.0
2.3
3.8
5.9
--0.4
-1.7
8.9
8.8
0.3
..0.2
6.2
6.7
··2.4
1.9
24.2
23.9
-0.2
0.5
25.7
-2.5
1.9
26.3
29.7
0.7
5.3
23.7
20.3
10.1
-2.0
12.2
44.6
19.1
3.1
22.4
52.2
-6.0
-2.0
60.2
77.9
0.8
-1.4
78.5
6.9
-1.3
8.2
12.8
2.6
10.2
21.0
8.6
12.4
27.9
5.7
22.2
45.8
24.5
21.3
64.3
21.4
42.9
61.9
-21.6
83.5
74.0
-6.9
80.8
94.5
38.4
56.0
148.2
45.9
102.3
196.6
69.5
127.1
Money Growth Rate'
Central BsrikAssets'
Total
Foreign Assets
Claims on Gov't
Claims on Banks
Banking Assets'
Total
Foreign Assets (Net)
Domestic Credit
I Percentage change in consumer-price index, fourth quarter to fourth quarter.
2 Exchange rate vs. U.S. dollar, annual average, June 1970=100.
3 Balance. on current and capital accounts, in billions of U.S. dollars.
4 Percentage change in M I (currency plus bank demand deposits), year end to year end.
5 Change in assets, in billions of won, year end to year end.
Source: International Monetary Fund, International Financial Statistics, various ·issues.
61
In addition, there were steady net· capital
inflows, although that is not obvious from the
published balance-of-payments data. As in Korea, Taiwan's major commercial banks. are
government-owned and operate under. thecentral bank's direction. At times (e.g., 1973 and
1977), the central bank reduced its foreign-asset
holdings, but the commercial banks increased
their holdings by much larger amounts. These
increases by convention are considered as private
capital outflows, so that published. balance-ofpayments data show a substantial net capital
outflow in both years (Table 4). However, the
data are misleading since the balance sheet of the
consolidated banking system shows large increases in the banking system's foreign assets in
both years.
Thus, from 1968 to' 1973, Taiwan attempted to
maintain a fixed exchange rate under mounting
upward exchange-market pressure. At first, the
pressure was relatively small, so that the money
supply increased at 10.5 percent a year during
1968-70-remarkably low considering that real
output increased almost as. fast during that
period. The relatively low money-growth rate of
1968-70 helps to account for the sustained low
inflation rate, averaging 1.2 percent a year,
during 1970-72 (Chart 2). However, from 1970
on, the money-growth rate accelerated steadily
and steeply to reach 49 percent a year in 1973.
During the four years 1970-73, foreign assets
accounted for 38 percent of the total credits
extended by the consolidated banking system;
even more remarkably, from 1969 to 1972, foreign assets accounted for more than the total
credits extended by the central bank. After
considerable lag, the accelerating money growth
finally hit the economy, and the consumer price
index jumped 24 percent in 1973. The 1973
revaluation of 5.3 percent was apparently too
small to be effectual, as foreign assets continued
to accumulate in the banking system and money
growth continued to accelerate throughout that
year.
The oil shock and the world recession in 197475 saved Taiwan from the need for further
currency revaluations, by bringing to an end the
steady string of current-account surpluses. The
$1.1 billion current-account deficit in 1974
helped the money-growth rate to drop precipitously from 49 percent in 1973 to only 7 percent
in 1974. But the rapid money growth of prior
years continued to exert its toll, as the inflation
rate rose to 35 percent in 1974. Nevertheless, the
monetary contraction of 1974 helped bring
about a sharp deceleration in inflation, with the
inflation rate declining to only 2.2 percent a year
in 1975.
But with the subsequent world economic recovery, Taiwan resumed its steady export
growth, so that its current account swung from a
deficit of $0.6 billion in 1975 to a $1.7-billion
surplus in 1978. As reserve accumulation resumed and the money-growth rate accelerated to
23 percent in 1978, the stage was set for are-run
of the scenario that had precipitated the currency
revaluation of February 1973
In July 1978, the central bank again responded
with a small currency appreciation of 5.5 percent, but this time also announced a decision to
abandon the fixed rate. The decision was officially implemented on February 1, 1979, although de
facto changes in the exchange rate have since
been very small. A replay of the earlier story
remained a distinct possibility, until the 1979 oilprice increases again disrupted the upward trend
in the current-account surplus.
IV. Conclusion
The exchange-rate and inflation experiences
of the four Pacific Basin countries during the
1968-78 period provide a wide range of casesfor
testing the validity and relevance of the mOdel
presented in this paper. Even though we have not
attempted a formal statistical testing, We have
obtained several useful insights from this survey.
First, in a number of episodes, exchange-rate
policies affected domestic price levels in an
important way. In particular, all four countries
experienced rapid monetary growth during
1971-73-the exact years varying from country
to country-as a result of their resistance to
currency appreciation during a period of strong
upward exchange-market pressures. In all cases
except Korea, reserve accumulation apparently
62
accounted for most of the rapid monetary
growth. (Korea's monetary growth was dominated by domestic credit expansion, although
foreign-asset accumulation was also an important factor.) Given the lags between moneygrowth changes and their impact on the price
level, it appears reasonable to infer that the 197173 exchange-rate policies of the four Pacific
Basin countries aggravated their inflation problem in 1974-75.
Second, in the case of downward exchangemarket pressures, our analysis suggests resisting
jepreciation and using reserve depletion to help
bring about a monetary contraction. All four
countries experienced strong downward pressures during 1974-75; but all except Taiwan
responded by letting their currencies depreciate.
Taiwan, in contrast, relied on a heavy reserve
drain to effect a sharp drop in its money-growth
rate, from 49 percent in 1973 to 7 percent in 1974.
It paid dearly for the monetary contraction, as
real output grew only 2.2 percent in 1975, compared to its lOA-percent average growth during
the 1963-73 period. 13 But on the other hand,
Taiwan's inflation rate dropped precipitously
from 35 percent in 1974 to only 2 percent in 1975.
Third, the evidence suggests that our policy
rule is not a necessary condition for domestic
price stabilization. Japan intervened heavily in
the exchange market to moderate yen appreciation in 1968-78. Nevertheless, Japan also
managed to hold down the money-growth rate,
and thus successfully wound down inflation over
a several-year period. Korea similarly was unwilling to appreciate its currency in the face of
mounting exchange-market pressure; but
through drastic trade-liberalization measures, it
was able to reduce its payments surplus in 1978
and win at least a temporary respite from the
exchange-market pressure. Thus, our policy rule
is by no means absolute. The same anti-inflation
policy objective could be achieved through measures other than an appropriate exchange-rate
policy.
Finally, the suggested policy rule must be
taken in its proper context. For analytical purposes, we assume that reducing domestic inflation is the only policy objective, that adequate
foreign reserves or international credits are available on reasonable terms for financing temporary payments deficits, and that policymakers can
permit an effective adjustment process (including monetary contraction) to correct a sustained
payments imbalance. But in reality, not all of
these conditions can be satisfied. For example,
Korea probably had no choice but currency
depreciation in 1968-71 and again in 1974, given
the small size of her foreign reserves and a credit
policy which was designed to promote domestic
investment. Moreover, all four countries exhibited a strong aversion to currency appreciation
and a strong preference for currency
depreciation-an attitude exactly opposite to
what our policy rule would prescribe. Presumably, their policy attitudes stemmed from other
objectives, such as export competitiveness and
income growth. Whether such an attitude is
rational or not is a separate issue. What is
relevant is that a "sub-optimal" exchange-rate
policy incurs a cost in terms of a higher-thannecessary inflation rate.
FOOTNOTES
his "The Appropriate Use of Monetary and Fiscal Policy
for Internal and External Stability," InternationatMonetary Fund Staff Papers, March 1962, reprinted in his
International Economics, 1968, Ch. 16, pp. 233-239.
Marcus J. Fleming, "Domestic Financial Policies
Under Fixed ahd Under Floating EXChange Rates,"
International Monetary Fund Staff Papers, November
1962, pp. 369-380.
For a survey of tMearlycontributions, see Marina
v.N. Whitman, Policies for Internal and External 8al"
ance, Special Papers in International Economics, NC>. 9,
Princeton University, December 1970.
For a recent stUdy that also deals with the relationship between the exchange-rate policy and tMdomest-
1. See International Monetary Fund, Annual Report
1977, Appendix II, "Surveillance Over Exchange Rate
Policies," pp.107-109.
2. See Lance Girton and Don Roper, "A Monetary Model
of Exchange Market Pressure Applied to the Postwar
Canadian Experience," American Economic Review,
September 1977, pp. 537-548.
3. See Peter Quirk, "Exchange Rate Policy in Japan:
Leaning Against the Wind," International Monetary
Fund Staff Papers, November 1977, pp. 642-664.
4. Robert A. Mundell, "The International Disequilibrium
System," Kyklos, 1962, pp. 153-170, reprinted in his
International Economics, 1968, Ch. 15, pp. 217-232; and
63
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ic priCe level, see Stanley W. Black, Exchange Policies
for Less Developed Countries In a World of Floating
Rates, Essays in International Finance, No. 119, Princeton University, December 1976.
money expansion and price inflation in Japan was
about eight quarters on the basis of 1958-1977 data.
9. A complete explanation of Japan's inflation of 197374 lies outside the scope of this paper. That inflation
can be considered as part of the world inflation phenomenonwhich was analyzed in four articles in this
Review, Spring 1975, by Edward S. Shaw, Michael W.
Keran, Hang-Sheng Cheng and Nicholas P. Sargen,
and Joseph Bisignano.
5. The analysis is comparative-static and thus does not
consider any short-run effect of monetary changes on
real output.
6. See Don Patinkin, Money, Interest, and Prices, 1956,
p. 59 and Mathematical Appendix 4:b-c, pp. 309-311.
10. International Monetary Fund, International Financial Statistics Yearbook, 1979.
7. The proof in terms of money-market analysis is quite
simple. Although the money market is not expressly
considered, it is nevertheless subsumed in the model
involving the goods markets only. By Walras'Law,in
the absence of a bond market,the goodsmarkets are a
mirror image of the money market; Whatever holdsfor
the goods markets must also hold for the money market, and vice versa. In the presentclise, the output
expansionin the tradable-good sector correspondst()a
rise in the demand for money balances in thernoney
market as a result ofincreased real income or wealth.
Given the unchanged money supply, equilibrium in the
money marketcanbe restored only through adecline in
the aggregate price level.
11. Attheendof1974,the Bank of Korea held only $277
million in foreign reserves, while other domestic banks
had $774 million in foreign assetsagainst$1,073 million
in foreign. liabilities, The current-account deficit
amounted to $2.0 billion in 1974. International Monetary Fund, International Financial Statistics, September
1979.
12. For a study oftherole of the 1974won devaluation in
theimproVementof Korea's trade balance, see HangSheng Cheng, "Alternative Balance-of-Payments AdjustmentExperiences: Korea and Taiwan, 1973-77,"
this Review, Summer 1978, pp. 37-48.
8. According to unpublished regression results obtained by Michael Bazdarich, the average lag between
13. Ibid.,p. 44.
64
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