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THE IMPACT OF THE FEDERAL RESERVE'S MONEY
POLICIES ON THE ECONOMY

HEARINGS
BEFORE THE

SUBCOMMITTEE ON
DOMESTIC MONETARY POLICY
OF THE

COMMITTEE ON
BANKING, CURRENCY AND HOUSING
HOUSE OF REPRESENTATIVES
NINETY-FOUKTH CONGRESS
SECOND SESSION
JUNE 8, 9, 10, AND 24, 1976
Printed for the use of the
Committee on Banking, Currency and Housing

U.S. GOVERNMENT PRINTING OFFICE
73-959




WASHINGTON : 1976

COMMITTEE ON BANKING, CURRENCY AND HOUSING
HENRY S. REUSS, Wisconsin, Chairman
LEONOR K. (MRS. JOHN B.) SULLIVAN,
Missouri
THOMAS L. ASHLEY, Ohio
WILLIAM S. MOORHEAD, Pennsylvania
ROBERT G. STEPHENS, JR., Georgia
FERNAND J. ST GERMAIN, Rhode Island
HENRY B. GONZALEZ, Texas
JOSEPH G. MINISH, New Jersey
FRANK ANNUNZIO, Illinois
THOMAS M. REES, California
JAMES M. HANLEY, New York
PAR REN J. MITCHELL, Maryland
WALTER E. FAUNTROY,
District of Columbia
LINDY (MRS. HALE) BOGGS, Louisiana
STEPHEN L. NEAL, North Carolina,
JERRY M. PATTERSON, California
JAMES J. BLANC HARD, Michigan
CARROLL HUBBARD, JR., Kentucky
JOHN J. L A F A L C E , New York
GLADYS NOON SPELLMAN, Maryland .
LES AuCOIN, Qr^gon
PAUL E. TSONGAS, Massachusetts
BUTLER DERRICK, South Carolina
PHILIP H. HAYES, Indiana
MARK W. HANNAFORD, California
DAVID W. EVANS, Indiana
CLIFFORD ALLEN, Tennessee
NORMAN E. D'AMOURS, New Hampshire
STANLEY N. LUNDINE, New York

ALBERT W. JOHNSON, Pennsylvania
J. WILLIAM STANTON, Ohio
GARRY BROWN, Michigan
CHALMERS P. WYLIE, Ohio
JOHN H. ROUSSELOT, California
STEWART B. McKINNEY, Connecticut
JOHN B. CONLAN, Arizona
GEORGE HANSEN, Idaho
RICHARD T. SCHULZE, Pennsylvania
WILLIS D. GRADISON, JR., Ohio
HENRY J, HYDE, Illinois
RICHARD KELLY, Florida
CHARLES E. GRASSLEY, Iowa
MILLICENT FENWICK, New Jersey
RON PAUL, Texas

PAUL NELSON, Clerk and Staff Director
WILLIAM P . DIXON, General Counsel
MICHAEL P . FLAHERTY, Counsel
GRASTY CREWS I I , Counsel

• ORMAN S. FiNfc, Minority Staff Director
GRAHAM T. NORTHUP, Deputy Minority Staff Director

SUBCOMMITTEE ON DOMESTIC MONETARY POLICY

STEPHEN L. NEAL, North Carolina, Chairman
JOSEPH G. MINISH, New Jersey
JOHN B. CONLAN, Arizona
MARK W. HANNAFORD, California
GEpRGE HANSEN, Idaho
JAMES J. BLANCHARD, Michigan
^WILLIS D. GRADISON, JR., Ohio
LEONOR K. (MRS. JOHN B.) SULLIVAN,
Missouri
CLIFFORD ALLEN, Tennessee
NORMAN E. D'AMOURS, New Hampshire




(n)

CONTENTS
Hearings held on—
June 8, 1976
June 9, 1976
June 10, 1976
June 24, 1976
Text of H. Con. Res. 133

_.-

1
29
115
147
12

STATEMENTS

Adams, Hon. Brock, a Representative in Congress from the State of
Washington
:__
Buckley, Hon. James L., U.S. Senator from the State of New York
Fiedler, Edgar R., vice president, economic research, general, the National
Industrial Conference Board
Jordan, Jerry L., vice president and chief economist, Pittsburgh National
Bank
Meiselman, David I., professor of economics, Virginia Polytechnic Institute
and State University
Meltzer, Dr. Allan H., Graduate School of Industrial Administration,
Carnegie-Mellon University
Partee, Hon. J. Charles, member, Board of Governors of the Federal
Reserve System
Perry, George, senior fellow, Brookings Institution
Pierce, Dr. James L., economic consultant and professor of economics,
University of California, Berkeley

13
5
31
36
55
178
115
64
149

ADDITIONAL INFORMATION SUBMITTED FOR THE RECORD

Adams, Hon. Brock, letter dated May 27, 1976, from Chairman Stephen L..
Neal, requesting testimony on specific economic questions and policy
issues
Buckley, Senator James L., prepared statement
Fiedler, Edgar R.:
''Constructing a Balance Sheet for the United States," summary of
study from the Morgan Guaranty Survey, May 1976
1
Prepared statement
Gradison, Hon. Willis D., Jr.:
"All That Worry About Fed Policy," article from the Washington
Post of June 10, 1976
"The Critics Ask: Is Monetarism Dead?" article from Business Week
magazine, June 7, 1976
Jordan, Jerry L., prepared statement with attached charts
Meiselman, David I., document submitted entitled "Money, Factor
Proportions, and Real Interest Rates," presented at the Zurich meetings
of the Econometric Society, September 10, 1964
Meltzer, Dr. Allan H., papers submitted on studies of inflation abroad:
"An Empirical Analysis of Inflation, Unemployment and Macroeconomic Policy in Open Economies," by Michael J. Hamburger
and Robert D. Reisch
"Some International Evidence on Output-Inflation Tradeoffs," by
Robert E. Lucas, Jr
(in)




13
7
105
SB
130
128
40
67

194
222

IV
Neal, Chairman Stephen L.:
"A Vote for Today's System," article by Dr. Allen H. Meltzer, from Page
the Wall Street Journal of May 19, 1976
243
"Congress and the Federal Reserve," article by Dr. Milton Friedman,
from Newsweek magazine, June 2, 1975
242
Exhibits submitted entitled "Yearly Money Supply Changes," showing percentage changes from 1 month in 1 year to the same month
in the next year with yearly changes in the cost of living occurring
23 months later
3, 4, 148
"The Coming Problem of Inflation," article by Hobart Rowen from
the Washington Post of May 13, 1976
241
"Where the Economy Goes From Here," interview with Dr. Arthur
F. Burns, Chairman of the Federal Reserve Board, from U.S.
News & World Report magazine, May 17, 1976
234
Partee, Hon. J. Charles, letter dated June 22, 1976, containing reading
references on central bank operations and the conduct of monetary policy
in other countries with attached data on high employment Federal
budget surplus or deficit (quarterly data provided from the Council of
Economic Advisers, 1952-75)
143
Pierce, Dr. James L.:
Papers submitted on monetary policy formulation:
"Monetary Aggregates and Money Market Conditions in Open
Market Policy"
162
"Quantitative Analysis for Decisions at the Federal Reserve" __ 157
Prepared statement
152




THE IMPACT OF THE FEDERAL RESERVE'S MONEY
POLICIES ON THE ECONOMY
TUESDAY, JUNE 8, 1976
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE COMMITTEE ON BANKING, CURRENCY AND HOUSING,

Washington, D.O.
The subcommittee met, pursuant to notice, at 10:01 a.m., in room
2128, Rayburn Office Building, Hon. Stephen L. Neal (chairman of
the subcommittee) presiding.
Present: Eepresentatives Neal, Hannaford, Blanchard, and
D'Amours.
Mr. NEAL. This morning the Subcommittee on Domestic Monetary
Policy will begin hearings on the impact of the Federal Reserve's
money policies on the economy. To many people, the functions of the
Federal Reserve System and its Open Market Committee, which decides the Nation's money policy, remain a mystery. Many Americans
do not know how important money policy is to the prices of the goods
they buy, the interest rates they pay, their job opportunities, wages,
and profits.
Our hearings are intended to cover several specific points which
include:
1. How money policy affects the cost of living;
2. How it affects production and employment;
3. How interest rates are affected by money supply changes, both
directly and through changes in prices, production, and employment;
4. How government spending and tax policies affect money policy
and their relationships to prices, interest rates, production, and employment; and
5. Whether Congress should set goals for economic growth, unemployment, inflation, and interest rate levels and require the Federal
Reserve to promote achieving these goals.
In preparation for these hearings, I have asked the staff to compile
statistical data on our economy's performance and the growth of money
supply, and the level of Federal Government surpluses or deficits since
1954. This work is going forward. To date, it has centered on how
money growth and Federal deficits have affected the rate of inflation
and the frequency of recessions. We have prepared an exhibit to bring
these relationships into focus. As our exhibit shows, the rate of growth
of money supply has followed a roller-coaster pattern, which tilted
upward since 1964. As a result, we have suffered periodic recessions
and since 1964, they have been imposed on waves of inflation.




(l)

Our exhibit maps the relationship between inflation measured from
1 month this year to the same month next year to money growth, also
measured over 12-month periods, occurring 23 months earlier. The
relationship between inflation and money growth was mapped with a
23-month lag because it takes time for changes in money supply to
affect the inflation rate; and the staff found, using computer studies,
that the effects of increases or decreases in money supply on the rate of
inflation peak after approximately 23 months. As the exhibit indicates,
the rate of inflation rises and falls in the wake of increases and decreases in the growth of money. About 60 percent of our inflation can be
explained by changes in money growth occurring 23 months earlier.
And this, let me emphasize, holds as much, perhaps even more, for
the 1970's as for the 1950's and 1960's.
[The exhibit referred to by Chairman Neal follows:]




EXHIBIT 1
YEARLY MONEY SUPPLY CHANGES

Percentage Changes From One Month in One Year to the Same Month in the
Next Year
Percent Change

J351 'S5 '55

' 5 7 ' 5 i '69 '60

'51 l i l '63 ' t i '55 '65 '67

'63 . ' 5 9 - '70

'71 '72

'73 '74

'75/75

EXHIBIT 1 (OVERLAY A)
RECESSION PERIODS

Percent Change
SiK Oil
'65 '57

'

ISS1 '55 '55 '57 '55 '69 ' 6 0 '61 "^ .'63




l

'•••••0!.'

OEC-N'CV.
' « '70

'

NOV. MAS.
'73
'75

'.....'..."..'..,.. !UA.,..I.,,...,J..,..^1;

h\ 'S3 ' 6 5 '57 '53 .'59 '70

!

7 I ' 7 2 '73 '74 ' 7 5 '75

EXHIBIT 1 (OVERLAY B)
YEABLY MONEY SUPPLY CHANGES

Percentage Changes From One Month in One Year to the Same Month in the
Next Year
YEARLY CHANGES IN THE COST OF LIVING OCCURRING 23 MONTHS LATER
RECESSION PERIODS

Percent Change

1951 '55 '« '57 '56 '59 '60 '61 '6i '63 '64 '55.'65 '57 '68 '69 '70 '71 '72 '73 '74 '75 '7?
EXHIBIT 1 (OVERLAY
YEARLY MONEY

SUPPLY

C)

CHANGES

Percentage Changes From One Month in One Year to the Same Month in the
Next Year
YEARLY CHANGES IN THE COST OF LIVING OCCURRING 23 MONTHS LATER
RECESSION PERIODS
FEDERAL GOVERNMENT SURPLUS OR DEFICIT

Percent Change

$ Billions

-20
D

-0

-2
'

1354 '55 '58 '5? 5ft '63 '60 '61 '61 '63 '64 '65 '65 '67 '68 '63 'TO' '7! '72 '73 '74 '7$ '76




-(60)
(CO}

E
F
I
C
I
T.

The exhibit also shows that each time our economy experienced a
recession since 1954, it occurred after the Fed moved to sharply decrease the growth of money supply. Finally, the exhibit maps the
relationships between recessions, inflation and money supply and Federal deficits. In this regard, the conclusion that emerges is that the
impact of deficits on the inflation rate and recession is weak as compared to that of money growth.
While the subcommittee will refine its work in these areas, the staff
also is studying the relationships involving unemployment and interest i^ates. We hope that the results of this work will produce a better
understanding of the ways our economy is affected by Federal Keserve policies and promote the use of responsible guidelines for coordinating monetary and fiscal policies.
This morning we are fortunate to open our hearings by receiving
testimony from our distinguished colleagues. Senator James L. Buckley and Congressman Brock Adams. We will question the witnesses
together after testimony is presented.
Senator Buckley, we will hear from you first. Senator Buckley is
on a tight schedule this morning, and we want to accommodate that
as much as possible.
Senator, welcome. We are trying to determine in a very objective
way the importance of the Federal Reserve's monetary policy to the
economy, how well that policy has been administered over the last
several years, and any recommendations our witnesses might have.
The public debate, as you know, centers on fiscal policy; and we
know that that is important. But we are trying to now determine the
importance of monetary policy.
I know you are on a tight schedule, Senator. If you would like to
summarize your statement, please do so, or proceed as you wish.
STATEMENT OF HON. JAMES I. BUCKLEY, A U.S. SENATOR PROM
THE STATE OF NEW YORK
Senator BUCKLEY. In my statement I have woven in some statements
about fiscal policy. Frankly, in terms of the perceptions in this body,
these things are interwoven. If I may, I will omit some portions of
my statement. I probably will read most of it.
Mr. NEAL. I did not mean to hurry you. We will be interested in
every word.
Senator BUCKLEY. Thank you very much, Mr. Chairman. They will
call me if I have to go for a vote. I want to express my appreciation
for the opportunity to speak before your subcommittee, Mir. Chairman.
To its credit, the Congress has established in the last 2 years, a
method for dealing with burgeoning Federal expenditures. The new
House and Senate Budget Committees have been assigned the responsibility of channeling Federal spending so as to make it more responsive
to the overall macroeconomic picture.
I am a member of the Senate's Budget Committee and believe that
there is great potential for this body to reestablish control over Federal spending and bring it in line with our national priorities and to
take a better oversight of the whole economic picture.
I am concerned, however, with the unspoken assumptions that are
reflected in much of the work performed by the new Congressional




6
Budget Office. As you know, this organization was created by the
Budget Control Act of 1974. Its mission is to provide nonpartisan
technical support for the new Budget Committees and to the Members
of both Houses.
However, the evidence suggests a disturbing bias in this Office toward
the type of economic policy which was first popularized 40 years ago
and which has since proven itself to be unrealistic and costly.
It is unrealistic and costly because it advocates the transfer of
resources from the most productive private sector to less productive
uses under the supervision of a growing Federal bureaucracy.
It should be quite clear at this point in our economic history that
larger Federal deficits will not be stimulative. Larger deficits require
large borrowing from the Nation's capital markets.
This same capital could be better employed to produce real goods
and services, instead of adding to the ranks of unproductive central
planners and public service employees.
Because of its Keynesian bias, much of the analysis emanating from
the Congressional Budget Office is shortsighted and often patently
incorrect. CBO has advised us, for example, that present inflation
rates are not affected by present policy changes.
Therefore, CBO concludes, we need not fear greater Federal spending, larger deficits, and a rapid increase in the money supply.
While CBO is correct that inflation rates are not changed this
month by a liberal dose of spending and money creation, the inflation
rates a year and a half later are determined by such policies.
A year and a half later we would bear the burden of excessive growth
in the money supply designed to help with a short-term problem in
the present.
The truth is that the impact of stimulative policies may arrive at a
time when the economic expansion is already in full swing; that the
stimulative policies supported by CBO projections would generate
unnecessary inflation and probably lead to another recession.
These are the policies that a majority in the Congress is inclined
to support, but which Presidential vetoes have kept under some sort
of rein.
I suggest that the Congress should be wary about placing too much
reliance on CBO projections, as these may prove somewhat less than
a thousand percent reliable.
CBO predicted inflation in 1976 would be in the range of 6.5 percent
to 8.5 percent, and yet we are currently experiencing an inflation rate
of about 3 percent. CBO advised against restrictive monetary policy
because, according to that Office, it would increase unemployment, and
yet the unemployment rate is now falling despite responsibly- restrictive rates of growth in the money supply.
And, the CBO warned that such a monetary policy would cause
interest rates to rise. Yet in yesterday's New York Times we find an
article attributing a rebirth of confidence in the credit markets in
part to "the decline in the Nation's narrowly defined money supply
over the last 2 weeks," and the expectation "that long-term rates could
once again begin declining."
It seems to be clear that investors are now sophisticated enough to
anticipate the inflationary effects of an expansive monetary policy,
even if the CBO computer models are not.




I go on to suggest that neither the Congress nor the administration
should take too much credit for what is happening in terms of our
recovery. Actually, because we have not been too active in terms of
monetary stimulation, the private sector has more or less taken care
of itself.
I then go on to suggest that the Congress—this is beyond the particular scope of this hearing—should concern itself about taking off
some of the burden on our productive private sector.
Real gains can be achieved through the elimination of real constraints on commerce. At least, in the longrun, fiscal and monetary
policy can only permit real growth in production and income to be
achieved; it cannot induce such growth.
It is the perception of this fact that has in part caused Dr. Burns
and the Federal Reserve Board to restrain the growth in the money
supply at a time when others have been calling for the immediate ancl
rapid growth of the monetary aggregates in a largely illusory pursuit
of lower interest rates.
There seems to be little appreciation in some sectors for the intimate relationship that exists between rapid increases in the money
supply, high irates of inflation and high interest rates.
And yet, this is one of the best documented relationships in macroeconomic theory. The relationship between rising prices and high
interest rates was noted at the turn of the century. The connection
between the money supply and price levels was established long before
that and though lost sight of in recent decades, it is no less valid.
Recent restraint by the Federal Reserve Board in the growth of
the money supply has led to reduced inflation and lower short-term
interest rates. But there is still work to be done.
Long-term interest rates remain high, and they will be reduced
only when investors have regained faith in our management of the
money supply.
My emphasis on real growth for the economy brings me logically
to discuss next the type of legislation that would be most helpful in
our present economic situation. Again I would like to emphasize the
need for reducing the economic constraints which abound in our code
of laws.
I have got a vote, Mr. Chairman. I have a terribly eloquent statement toward the end.
Mr. NEAL. I S there any chance of youtr coming back ?
Senator BTJCKLEY. Let me get a feel for the floor and if I can, I shall.
Mr. NEAL. I am interested in your comments on the relationship of
the money supply and inflation.
Senator BUCKLEY. It is recognized in House Concurrent Resolution
133.1 was cosponsor of that.
Mr. NEAL. Thank you very much for coming.
[The prepared statement of Senator Buckley follows:]
PREPARED STATEMENT OF HON. JAMES L. BUCKLEY, U.S. SENATOR FROM THE
STATE OF NEW YORK

I would like to speak today on the subject of the role of the federal government in the country's economic system, on the capabilities we have to influence
that system, and on the responsibilities that we must accept for OUT intervention
in that system.




8
We can only hope to realistically assist in the stable growth of the macroeconomic system if we fully understand our capabilities, our limitations and
our responsibilities, for we are dealing with a most delicate mechanism when
we attempt to direct the course of the economic system. Therefore, it is essential that the actions we take are those which are realistically complementary
to the rest of the decisions made in the private and public sectors.
Perhaps it would be useful, before talking about what the relationship between
the federal government and the economy should be, to note the present extent
of our expenditures. In the last five years, for example, federal spending averaged
twenty-one percent of our Gross National Product. It is quite clear that federal
spending activity is already a heavy burden for the economy.
My comments today are directed in part to the question of whether the burden
is necessary.
To its credit the Congress has established in the last two years a method
for dealing with burgeoning expenditures. The new House and Senate Budget
Committees have been assigned the responsibility of channeling federal spending
so as to make it more responsive to the overall macroeconomic picture. I am
proud to be serving as a Member of the Senate's Budget Committee and believe
that there is great potential for this body to re-establish control over federal
spending and bring it in line with our national priorities.
But this potential has not been fully demonstrated, as I believe that we can
do more toward realistically assessing the value of certain costly programs and
substituting for them policies which allow for a more efficient allocation of our
finite national resources.
One area of concern which I have watched closely in recent months has been
the development of the new Congressional Budget Office. As you know, this
organization was created by the Budget Control Act of 1974. Its mission is to
provide nonpartisan technical support for the new Budget Committees and to
the Members of both Houses. However, the evidence available to date indicates
a disturbing bias in this Office towards the type of economic policy which was
first popularized forty years ago and which has since proven itself to be unrealistic and costly. It is unrealistic and costly because it advocates the removal of
resources and initiative from the more productive private sector so that these
same scarce resources can be placed under the control of a growing federal
bureaucracy for the production of services which are far down on our nation's
list of priorities.
In the long run, Keynesian prescriptions for recovery should be recognized as
either inflationary, wasteful or unstimulative to the private sector. Econometric
analysis has shownfiscalpolicy to be ineffective.
It should be quite clear at this point in our economic history that larger federal
deficits will not be stimulative. Larger deficits require large borrowing from the
nation's capital markets. This same capital could be better employed to produce
real goods and services, instead of adding to the ranks of unproductive central
planners and public service employees.
One additional problem with the approach used by CBO is that they assume
that increases in government spending add immediately to our national product.
Therefore, under these assumptions, solving the problem of unemployment merely
requires the addition of more federal expenditures to national income. This
approach totally ignores the fact that there are lags in the fiscal system.
Under the CBO model, there is little need to worry about inflation, the exact
target for full employment levels, or the miscalculation of the timing of impact
of these fiscal initiatives. Unfortunately, each of these issues provide, in the real
world, the source of additional problems for the economy.
Because of this Keynesian bias, much of the analyses emanating from the
Congressional Budget Office are shortsighted and often patently incorrect. CBO
has advised us, for example, that present inflation rates are not affected by
present policy changes. Therefore, CBO concludes, we need not fear increased
spending, larger deficits, and a rapid increase in the money supply.
While CBO is correct that inflation rates are not changed this month by a
liberal dose of spending and money creation, the inflation rates a year-and-a-half
later are determined by such policies. A year-and-a-half later we would bear the
burden of excessive growth in the money supply designed to help with a shortterm problem in the present. The truth is that the impact of stimulative policies
may arrive at a time when the economic expansion is already in full swing; that
the stimulative policies that CBO indirectly recommends would generate unnecessary inflation and probably lead to another recession.




Wliile the Congressional Budget Office was set up as a nonpartisan organization, the analyses which it provides reflect a total dedication to a Keynesian fiscal
emphasis type of approach.
Perhaps it is this lack of analytical quality which forces the Budget Office into
the series of erroneous predictions which we have recently observed. CBO predicted in 1975 that recovery in the automobile industry would not be sufficient to
lead a strong recovery, and yet both a strong recovery and a rapid increase in
automobile production are realities.
CBO advised against restrictive monetary policy because, according to that
office, it would increase unemployment, and yet the unemployment rate is now
falling, despite responsibly restrictive rates of growth in the money supply.
Perhaps the lackluster record of CBO in making these predictions reflects the
lack of confidence in the private sector which underlies so many of the economic
proposals in the Congress and which find support in the CBO projections.
This brings us to the question of who might take credit for the present economic expansion which is solid and expected to continue through 1977. I have
watched with some amusement as some individuals on Capitol Hill take paing
to ensure that the Congress, rather than the Administration, is credited with the
recovery. At the same time, Administration spokesmen are claiming the credit
for themselves. I am reminded of the old description of monetary policy as being
like a string—you can pull on it, but you can't push. Really, all government economic policy is like that string, and the best that we can do is fail to pull on it.
I suggest then that we—along with the Federal Reserve Board—only take credit
for failing to rein in economic growth and leave the real credit for economic
expansion to the private sector where it belongs.
On the other hand, we in the Congress might best help out the recovery by
eliminating the great many structural constraints which are now imposed on the
private sector. These constraints function to reduce real gross national product
and impose heavy, yet needless costs on businesses and consumers alike. Examples of these types of constraints include unnecessary regulation by the Interstate Commerce Commission over many forms of ground transportation, which
distorts their efficiency and adds many billions annually to shipping costs;
uncalled-for regulation of airlines rates by the Civil Aeronautics Board; and there
is also the unfortunate rigidity of the minimum wage laws which do not take
into consideration the need to create differential minimums for teenagers who
are less skilled and who do not have an opportunity to be hired at the present
minimum wage rates; any employer who might find it attractive to hire these
unemployed youths at a lower wage would be in violation of the law, thus many
unemployed but ambitious teenagers are, in effect, outlawed from the labor
market
There are many more examples in this list of constraints, but my purpose
here today is to emphasize the need for real gains in the economy. Real gains
can be achieved through the elimination of real constraints on commerce. At
least, in the long-run fiscal and monetary policy can only permit real growth in
production and income to be achieved; it cannot induce such growth. It is the
perception of this fact that has in part caused Dr. Burns and the Federal Reserve Board to restrain the growth in the money supply at a time when others
have been calling for the immediate and rapid growth of the monetary aggregates to reduce interest rates in the short run.
There seems to be little appreciation in some sectors for the intimate relationship that exists between rapid increases in the money supply, high rates of
inflation and high interest rates. And yet this is one of the best documented
relationships in macroeconomic theory. The relationship between rising prices
and high interest rates was noted at the turn of the century. The connection
between the money supply and price levels has been more recent, but is no less
valid.
Recent restraints by the Federal Reserve Board in the growth of the money
supply has led to reduced inflation and lower short term interest rates. But
there is still work to be done. Long term interest rates remain high, and they
will be reduced only when investors have regained faith in our management
of the money supply.
My emphasis on real growth for the economy brings me logically to discuss
next the type of legislation that would be most helpful in our present economic
situation. Again, I would like to emphasize the need for reducing the economic
constraints which abound in our code of laws. But I fear that such attractively
labelled but counter-productive legislation as S. 50. The Humphrey-Hawkins "Full




10
Employment Bill," may prove far too tempting to the Congress. This bill is a
blueprint for catastrophe. Let me review some of its more disturbing features.
The bill would set about to achieve an unemployment rate for adults of 3 percent,
regardless of the cost. It would do this, in part, by making the government the
employer of last resort. Plans call for the creation of well-paying public service
employment jobs to artificially reduce unemployment statistics. The bill, in
effect, calls for a broad centralized planning response to solve the problems of
youth unemployment, price level inflation, efficiency in the federal bureaucracy,
and a reordering of our priorities in the fields of energy, transportation, health
care, the environment and several other key areas of concern to all of us.
While these goals are certainly laudable by any standards, the most notable
feature of the Humphrey-Hawkins proposal is that it provides us, with one
exception, no indication of how these goals are to be achieved. Thus, we stand
right where we are. The bill makes no progress in finding viable solutions to
our national problems. The one prescription which is specified in the bill is the
use of public service employment to ensure that the unemployment rate is reduced
to three percent.
How realistic is a goal of three percent unemployment, and what will it
<?ost? These are questions which must be addressed before a thorough understanding of the bill's destabilizing potential can be grasped. The last time that
our economy saw unemployment rates anywhere close to three percent was
during the height of the Vietnam War, but these same years also witnessed the
beginning of the inflation which we are still fighting. Unfortunately, given the
method of calculating the unemployment rate, a goal of three percent is unquestionably beyond reach, given any reasonable assumptions about the growth of
the money supply and sympathy for long-range goals.
Should such a goal become law, inflation rates of fifteen percent and above
could become a reality. The truth is that this legislation pays only lip-service
to the goal of fighting inflation, since monetary policy under Humphrey-Hawkins
would be used primarily to attempt to bring unemployment down to a three
percent level. Inflation would be induced by the need for large federal deficits
to pay for the millions of public service employees required to meet the employment goals and the need to monetize these deficits in order to avoid any increase
in taxes.
The public service employment, then, while providing jobs for only a few,
would have the wages of the remaining population devalued by inflation. This
would hit hardest those Americans living on fixed incomes and would generate
pressure for yet another recession.
Another, and perhaps ironic, consequence of S. 50 is that it would most likely
hurt those who the sponsors intend to help: the unemployed, unskilled labor.
The jobs "created" by S. 50 will be filled with primarily unskilled persons who
actually need jobs where training and advancement are possible. HumphreyHawkins consigns a large portion of the population, including a disproportionate
number of minorities, to a lifetime of unskilled, unrewarding public employment.
Government programs, such as Humphrey-Hawkins, would move these groups into
a permanent, second-best status and thus are cruel and socially destructive.
How does Humphrey-Hawkins plan to handle the problem of rising prices? By
developing a policy for price and wage controls. Again a policy which has never
been shown to be effective in the long run for controlling inflation!
Economists really see one limited role for price and wage controls, and this is
as a method of demonstrating dedication to the control of runaway inflation. But
this is a short-run use for these controls and is based on the logic that if people's
expectations about the future course of prices can be altered at the same time
that realistic control is established over the growth of the money supply, then the
pressure for increases in interest rates and other prices can be eliminated. But
we have long ago passed the point where anyone but the least sophisticated
observer believes that price controls alone are effective in halting inflation.
Monetary policy is not capable of controlling the inflation rate under this
legislation, inasmuch as it is being used to attempt to achieve an unemployment
rate of three percent. It is quite clear that, under any set of assumptions, controlling inflation would not be a major feature of the Humphrey-Hawkins Bill.
What, then, can be done to accommodate the real growth of the economy? I
suggest that we address our attention to the achievement of longer-range goals,
such as price level stabilization and a reduction in the present amplification of
the business cycle.




11
These goals can be achieved by a reasonable control of monetary growth and an
attempt to eliminate the large deficits presently incurred in the federal budget
Large deficits are undesirable because they either reduce the amount of capital
available in the private sector, thereby restricting real growth, or they induce
an increase in the money supply which will generate price level inflation.
Thus, fiscal policy by itself, in the form of deficit spending, has never been
shown to produce a net gain in real income. At best a deficit might induce a
temporary gain for a few months, but this gain is offset shortly by decreased
private investment when the increased interest rates in capital markets reflect
borrowing by the Treasury.
Alternatively, the use of monetary policy can have short-run positive effects
on the real income of the nation, but I must emphasize the short-run qualification
in this statement. For, while the increase in the money supply can make additional capital available to a limited extent, the unpredictability of the results of
such action can easily lead to an increase which is too rapid and inflation is the
unfortunate result. We do not have sufficient knowledge to make predictions about
the results of today's monetary policy on tomorrow's income and price levels to
use it well.
Rather, I would like to see a commitment to a fiscal policy which eliminates
deficit spending while capping the growth of government spending, and a monetary policy which limits growth in the money supply to a rate cpps^stent with
the long-term real growth potential of the economy and a legislative program
which eliminates the constraints on commerce that I noted above.
In the early part of 1975, at the nadir of the downturn, I joined with Senator
Proxmire in supporting a resolution which contained two very important points
involving monetary policy. That resolution, which passed as House Concurrent
Resolution 133, established the practice that the Chairman of the Federal Reserve
Board announce quarterly the monetary growth targets for the Open Market
Committee. But as important as this provision is, I am of the opinion that the
adoption by the Congress of a new policy by which monetary growth is guided
is more important. Under the resolution the Federal Reserve is directed to
establish targets which are in line with the economy's long-term ability to grow.
Onr problem in the past is that the Federal Reserve's monetary policy has been
constructed along lines which were only haphazardly related to this fundamentally important guideline. Monetary targeting which is set independently
of the economy's growth potential produces the kind of erratic monetary growth
policies which take us from inflationary rates to a constricting zero level, as
was the case in the latter half of 1974. It is my view that the stability and duration of the recovery is intimately linked to keeping monetary targets within
the ranges recently achieved, and not to the following of false guidelines, such
as short-term fluctuations in interest rates.

[At the request of Chairman Neal, the text of H. Con. Res. 133 is
inserted at this point in the record:]




12
94TH CONGRESS
1ST SESSION

H. CON. RES. 1 3 3

IN THE HOUSE OF REPRESENTATIVES
MARCH 24,1975

Ordered to be.printed as passed

CONCURRENT RESOLUTION
Whereas article I, section 8. of the Constitution provides that Congress
shall have the money power, namely "to coin money and regulate
the value thereof7';
Whereas Congress established the Federal Reserve Board as its agent,
and delegated to its agent the day-to-day responsibility for managing the money supply;
Whereas the United States economy is now suffering from excessivelyhigh unemployment and a decline in production and the gross,
national product, together with inflation; and
Whereas the economy's performance in part is affected by changes in
the rate of growth of the monetary and credit aggregates: Now,,
therefore, be it
. Resolved by the House of Representatives (the Senate concurring),.
That it is the sense of Congress that the Board of Governors of the
Federal Reserve System and the Federal Open Market Committee—
(1) pursue policies in the first half of 1975 so as to encourage
lower long term interest rates and expansion in the monetary
and credit aggregates appropriate to facilitating prompt economic;
recovery; and
(2) maintain long run growth of the monetary and credit
aggregates commensurate with the economy's long run potential to*
increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long term interest,
rates.
Pursuant to this resolution, and taking into account the international
flows of funds and conditions in the international money and credit,
markets, the Board of Governors shall consult witli Congress at semiannual hearings before the Committee on Banking, Housing and.
Urban Affairs of the Senate and the Committee on Banking, Currency
and Housing of the House of Representatives about the Board of
Governors' and the Federal Open Market Committee's objectives and
plans with respect to the ranges of growth or diminution of monetary
and credit aggregates in the upcoming twelve months. Nothing in this,
resolution shall be interpreted to require that such ranges of growth or
diminution be achieved if the Board of Governors and the Federal
Open Market Committee determine that they cannot or should not be
achieved because of changing conditions. The Board of Governors shall
report to the Congress the reasons for any such determination duringthe next hearings held pursuant to this resolution.




13
Mr. NEAL. Senator Buckley just gave most of his testimony. He was
called to a vote in the Senate chamber. We don't know whether he is
coming back or not. Mr. Adams, we would certainly like to welcome
you this morning.
Thank you very much for coming. This subcommittee is trying to
determine the importance of monetary policy to the economy, how
well it has been administered over the last several years, and what our
witnesses would recommend as changes for the future.
I know the public debate centers around fiscal policy and we are of
the opinion that monetary policy plays an equally important, if not
more important role in the economic health of this country.
I say again how grateful we are for your coming. Please proceed
in any way you would like.
STATEMEm: OP HON. BROCK ADAMS, A REPRESENTATIVE IN
CONGRESS PROM THE STATE OP WASHINGTON

Mr. ADAMS, AS far as public debate is concerned, the number of
editorials that have appeared around the country criticizing me for
criticizing Dr. Burns on monetary policy indicates that there is an
enormous national debate going on concerning monetary policy. I
feel strongly about it. I would like to proceed with my testimony
which answers the question raised in your letter to me, particularly
emphasizing point 5.
[The letter referred to by Mr. Adams from Chairman Neal follows:]
U.S. HOUSE OF REPKESENTATTVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY,
COMMITTEE ON BANKING, CURRENCY AND HOUSING,

Washington, D.C., May 27, 1976.
Hon.

BROCK AI>AMS,

Rayburn House Office Building,
Washington, D.C.
DEAR BROCK: The Subcommittee on Domestic Monetary Policy is scheduling
hearings on Federal Reserve policy and the economy on June 8. Many believe
that how well or badly our economy performs depends crucially on what the
Fed does and, in particular, on how fast or slow it allows the money supply
to grow.
Our hearings are intended to sharpen Congressional and public understanding
of what the Fed does and how this affects our economy's performance. In specific,
we are seeking testimony on:
1. How money policy affects the cost of living;
2. How it affects production and employment;
3. How interest rates are affected by money supply changes, both directly
and through changes in prices, production and employment;
4. How government spending and tax policies affect money policy and their
relationships to prices/interest rates, production and employment; and
5. Whether Congress should set economic growth, unemployment, inflation
and interest rate goals and require the Fed to promote achieving these goals.
We would benefit from your testimony on the above economic questions and
policy issues. If convenient, we will schedule you to appear as a witness on
June 8 at 10 a.m. in Room 2128 of the Rayburn Building. Please inform me at
your earliest convenience about your availability, or have your administrative
aide contact Dr. Robert Weintraub at 225-7315.
We look forward to hearing your testimony.
Sincerely,
STEPHEN L. NEAL,

73-959—76




Chairman.

14
Mr. ADAMS. I thought perhaps the subcommittee might want to ask
me some questions about specific items I may not have covered in depth
in my prepared statement.
I will preface my remarks by saying that I think monetary policy
must be coordinated with, and supportive of, fiscal policy or else we in
the Congress will go through an enormous and futile exercise trying
to control Federal spending and trying to bring fiscal policy into a
coherent operation. I think what we are doing is essential to the
Nation's economic well-being, and I would hate to have our efforts
frustrated by a Federal Reserve implemented monetary policy going in
a different direction.
I think that that is wron<*. I don't think that we can continue that
kind of an operation and be at all successful, either in making the
country's economic health better or in having some type of control
over the Federal debt.
The present point of debate between myself and the Chairman of
the Federal Reserve Board is that the actions of the Fed in the field of
monetary policy can both increase our expenses in the existing mandatory Federal programs by stopping the recovery and, if the interest
rate for short-term 91-day bills is raised 1 percent it will add between
"$2 billion and $3 billion to the interest expenditures of the Federal
Government and thus bust the budget.
The elements of my debate with Arthur Burns have been misinterpreted around the country but it is a simple thing.
Mr. Chairman, members of the Subcommittee on Domestic Monetary
Policy, it is a pleasure to appear before you today. As you know, the
Congress is in the process of instituting a major reform of one of its
processes.
This year, we are fully implementing the Congressional Budget and
Impoundment Control Act of 1974. For the first time, the Congress has
the mechanism for establishing budgetary priorities and developing
a coherent national fiscal policy. We not only have the mechanism but
•we are using it. The first concurrent resolution on the fiscal 1977 budget
as we all know was passed on May 13.
In the conference report accompanying the first resolution are the
economic assumptions underlying the fiscal policy set forth in the resolution. I think this is a key point where monetary policy and fiscal
policy have to mesh.
We stated:
The fiscal policy contained in the conference substitute, in conjunction with a
supportive monetary policy, is designed to produce a 6 percent rate of increase in
total output (gross national product adjusted for inflation.)

A supportive monetary policy is extremely important to achieve the
economic goals set forth by the Congress. We have at this time no way
to ensure that fiscal and monetary policy are coordinated. A restrictive
monetary policy could off set the expansionary fiscal policy developed
by the Congress to move the economy and the country out of the
recession.
If there is not enough money to facilitate the real growth, then, of
course, the economy, not the price level will stall.
In fact, last summer the Federal Reserve tightened monetary policy,
shortly after the tax rebate, causing interest rates to rise and delaying




15
the full impact of the tax refund. More recently, during tlie month of
May 1976, the Federal Reserve again tightened monetary policy apparently in response to the rapid growth in Mt that occurred in April.
The rapid increase in Mr—^currency plus demand deposits—is very
puzzling. Commercial and industrial loans declined and large certificates of deposit—a form of loans made primarily to corporations—
also declined. Treasury deposits at the Federal Eeserve did decline
and that could explain part of the increase in Mx.
Treasury drew down some money and spent it. In response to this,
the Fed tightened up on policy and short-term interest rates rose from
the 4.9-percent range at the end of April to 5.5 percent during the
week of May 28.
This increase in interest rates occurred with the unemployment rate
still at 7.5 percent and utilization of manufacturing capacity at only
71.8 percent, up only 4.8 percentage points—that is our industrial
capacity usage—from the first quarter 1975 recession low of 67 percent.
Our plant and equipment are not nearly being fully utilized. We are
still almost at the recession level of utilization.
Efforts to increase the utilization of the plant are not inflationary.
You are trying to use what is already in place to produce more goods.
In fact it has the opposite impact on inflation because productivity
increases and more goods are available at lower unit costs.
Monetary policy is an extremely blunt instrument to deal with
most of the price increases that have occurred in the recent inflation.
The prime causes of that inflation were the OPEC-induced rise in oil
prices and large and unusual sales of grain to Russia, and yet changes
in monetary policy could not have provided a defense against either
of these. In fact, it could have exacerbated them.
Extraordinarily tight monetary policy and extremely high interest
rates were used by the Fed to stop the feverish speculation in inventories in 1974. What was really needed in this instance were selective
controls on inventory loans rather then general monetary tightness
which affected not only speculation in inventories but the entire U.S.
economy.
The monetary policy stopped the entire economy, because it is such
a blunt instrument. This was a case of using the wrong medicine for
the disease, and I sincerely hope that we don't make a similar error
again this year.
Because monetary policy can offset the congressionally determined
fiscal policy, additional mechanisms for coordinating the two are
needed.
The statement of managers that accompanied the conference report on the first budget resolution for fiscal 1977 contained nine major
economic indicators: gross national product, gross national product
adjusted for inflation (real GNP), personal income, wages and salaries, corporate profits, two unemployment rates, the annual average
and what might occur at the end of the year, the consumer price index,
and the expected rate on 3-month Treasury bills.
Additional monetary goals could also have been included in the
statement of managers. All of this is obviously too much information
to put in the resolution itself, although it is useful to put this in the
report. Many of these economic variables are interrelated.




16
Personal income, profits and wages and salaries are part of the
gross national product. The unemployment rate is related to the rate
of growth in GNP adjusted for inflation.
If the economy, or some substantial portion of it, is not operating
at full capacity, there is not enough economic activity, people are not
hired, and the unemployment rates go up. I have found in my discussions with people such as Walter Heller, that many of us concerned
with the national economic outlook find our philosophies were shaped
in an earlier generation where economics and the political activity of
the country were closely interrelated.
We find now that everything has become so specialized in economics
that we are using bigger and bigger words and dealing with more
and more esoteric specialties. All of this can often cloud some very
simple relationships such as—if the economy is not working very
well, people don't have jobs to go to whether they want to work or not.
Prices are also related to rates of growth in GNP, particularly
when unemployment rates are low. But when unemployment rates are
high and manufacturing utilization rates are low, high interest rates
do not control inflation because there is no excess demand by business
for money to expand plants, hire people, or increase inventories.
Classic inflation is usually handled by a tight money policy. We
have not had that in this country in years. We have not had the unemployment rate down into the range where it was in the sixties since
1970. We do not have too many dollars chasing too few goods.
The only time we find ourselves chasing too few goods is in a certain
number of limited bottleneck situations on raw materials or an increasein the price in oil or an increase in price in food such as occurred
when we did away with our grain reserves by selling them overseas.
But those are spot situations and you don't handle them in the classic
way by saying you can't borrow any money because of high interest
rates.
Prices may be affected by other factors: wage settlements; oil price
increases; grain deals; weather; and business speculation, to name a
few. Interest rate increases do not control these kinds of inflation
and can make it worse.
It is also extremely important that the economic goals included in
the statement of managers be realistic. Two economic targets that
should be included are a rate of growth for real GNP—that is adjusted
for inflation—and a rate of price increase, since these drastically affect
the revenues and spending total contained in the resolution.
Ideally these targets should be ranges, for example, the statement
of managers accompanying the current resolution calls for a rate of
growth in total output—GNP adjusted for inflation—of 5y2 to G1/^
percent.
We know that we cannot be precise with these targets, but will
have to keep them within a range. A range on the price target—that
is, rate of inflation—is politically more difficult to specify—especially
the lower end of the range, because ideally we would like that to liezero.
Realistically we cannot expect the inflation rate to be zero. Our
price indices are not perfect. Not all changes in quality are fully
filtered out. Thus it may be feasible to have only a price ceiling rather
than a range.




17
In other words, we should place in the resolution something to the
effect that the inflation rate should be no more than 5 percent or 4
percent, realizing that we are trying to get it down to zero.
That greatly affects fiscal policy because we now have so many
programs that are indexed to the inflation rate such as pension programs and others.
These two major economic indicators that I mentioned may be
enough to give direction to the Federal Reserve Board on monetary
policy. Monetary policy should aim to achieve the rate of real growth
in total output. However, if the rate of increase in the general price
level begins to exceed the price ceiling, it would be a signal to the
Federal Reserve to restrict monetary growth.
A third economic goal could be included—a range on the short-term
Treasury bill rate since that affects category 900 of the Federal
budget—interest costs—and has a major impact on the total business
activity in the Nation.
However, I have not yet decided whether to advocate the inclusion
of bill rate targets until we have had more experience in this area.
I would like to start with the real growth and inflation targets first
and see if they are sufficient to bring about the desired coordination
of fiscal and monetary policy. If they prove not to be sufficient, further thought must be given on how to achieve that integration.
Mr. Chairman, that completes my prepared statement. I do have,
of course, information that can respond to the other questions in your
letter but I thought we might possibly handle that in the question
and answer period.
Mr. NEAL. I would like to thank you, our distinguished chairman
of the House Budget Committee for coming. Have you given any
thought to including in the budget resolution—I don't want to say
targets, but I would like to say specific interpretations—of what
the budget resolution means in terms of levels of inflation and
unemployment ?
Mr. ADAMS. We have given thought to putting that into the budget
resolution. It has been my position that we should not do so this year
until we have put the new budget process through one Congress and
everybody has a chance to see how it works.
However, I think that eventually the budget resolution is a logical
place to include such data. That is what I was trying to address in
my prepared statement. We probably should start with the statement
of the managers on the conference and then we can build a legislative
history around it.
We can see then whether or not monetary policy responds to it. If
it does not, then perhaps we will have to take the next step.
Mr. NEAL. The reason I mentioned those goals specifically is because
it seems to me that those are goals that the Fed could deal with, could
understand and they could address these problems directly as opposed
to some other measures.
Mr. ADAMS. I think you are right. I think those are key indices
that certainly can give a coherent package to the Federal Reserve
to show them clearly what we are doing. One of the problems we get
into is that the Fed operates on a week-to-week basis, sometimes on an
almost day-to-day basis.




18
I am always concerned that they react too quickly on unexpected
movements in the market rather than not quickly enough. What is
happening today is that the Fed is reacting on an almost day-to-day
basis on what they perceive as an increase in the velocity of money.
We are operating under a budget resolution that is of course taking
us a year to complete and will go into place in October. That is why
I am having the argument with Dr. Burns. I am trying to say to him
that the 91-day bill rate should stay within the averages referred to in
the underlying materials accompanying the resolution. The reason
is that we are going to roll over nearly $200 billion worth of debt this
year and most of it will be in the short-term market.
An increase of interest rates of 1 percent starting in October and
going through the fiscal year—and that is the dilemma we are approaching—can add some $3 billion to the Federal deficit.
We assumed in the resolution an average interest rate for the year
of 5.5 percent. If the Fed increases that to an average of 6.5 percent
for next year, category 900 will go up $2.5 billion. Everyone will
wonder why the deficit has to be raised by $2.5 billion when we did
not do anything. The answer will be that the Fed did it.
Mr. NEAL. Mr. Adams, if I can, I would like to draw your attention to this chart. We have charted with the black line yearly money
supply changes in the economy.
Over that, we have superimposed a line showing the yearly change
in the cost of living occurring 23 months later. The reason for the
23-month lag is because our staff, through computer studies, found
that the maximum effects of increased or decreased money supply on
the rate of inflation occurred at that point. It wouldn't look much
different if the lag were 20 months, or 22 months, or 24 months. The
point is that the rate of inflation in the economy does not respond
immediately to changes in the money supply but responds with a lag
averaging about 23 months.
Senator Buckley, welcome back. I would like to draw your attention
to this chart also. The black line shows the yearly percentage changes
in the money supply. The red line is what I call the rate of inflation
with a time lag of 23 months.
We were just explaining the 23-month lag. And as I just stated^
our staff's computer studies show that the maximum effects of increased
or decreased money supply on the rate of inflation are evident 23
months after money supply fluctuations.
When the money supply rose dramatically, the cost of living increased rather dramatically as we charted it through time. Now the
next feature on the chart shows the recent periods of recession, shown
by the periods between the green lines. What this also shows is that
when there is a sharp decrease in the money supply, we experience
periods of recession soon after.
The most dramatic thing about the chart, I think, is its rollercoaster
nature. We have had increases and decreases in the money supply and
this seems to be reflected in the pattern of economic life in America. It
seems to be from looking at this chart—we have been working with this
now for seA^eral weeks, discussing and revising it—it appears that the
money supply is very important in determining levels of inflation and
levels of recession.




19
This orange line represents Federal budget surpluses and deficits.
Here we find a relatively weak relationship to the whole picture.
Mr. ADAMS. I was never able to find any because we charted those
factors precisefy the same way, Mr. Chairman. Obviously the deficit
can become too large and, you can overload monetary growth. But as
far as year-to-year relationships are concerned, we have never found
any.
Mr. NEAL. TO me that is very fascinating. The public debate is on
the level of budget deficits—the popular subject is that deficits are the
total cause of inflation. We find they are hardly the whole cause.
Our staff economist tells us that we can attribute statistically something like 60 percent of recent inflation to monetary policy with that
23-month lag. The deficit appears to count for no more than 30 percent.
Obviously there are other factors that affect the rate of inflation, such
as oil and food prices. But our statistics indicate that monetary policy
gyrations were primarily responsible for 60 percent of the recent levels
of inflation. Of course, this is preliminary; and we would be grateful
for your comments on these facts.
Mr. ADAMS. Let me say that we have done the same thing in terms
of charting the relationship between deficit, money supply, gross national product, and unemployment. As you heard me say many times,
I advocate that we go to a balanced budget at full employment. The
Government should live within its revenues.
That will be the thrust of our effort in the next 3 or 4 years, to accomplish that. But I do not think that that is going to solve the problem of
inflation and unemployment. I think it is simply a stabilizing factor
which is important for the whole economic climate of the United
States.
Coupled with that what we need in money supply is a matching of
the money supply to the real growth in the economy. The argument
which is being made by the Federal Reserve at the present time is that
their instruments of either their open market activities, changes in the
reserve rate, or changes in the rediscount rate all of which as I said
before are very blunt instruments, should take into account the velocity
of the money supply as well as the absolute amount.
This has led to the Federal Reserve saying Ave can tighten the
money supply because people are using their money more efficiently
and still match the growth in the economy.
I do not believe that. I don't think we know enough about the
money supply. What we are looking for in the way of monetary policy
from the Fed is that as economic growth occurs, not that MT be
pumped up and we use the money supply to stimulate the economy,
but that we not use it to crunch the economy. That argument has not
been resolved and that is something that I hope this subcommittee
will both communicate to the Federal Reserve and to the other
members.
Mr. NEAL. What you are advocating, if I understand you, is a rather
consistent rate of increase of money supply in keeping with the goals
of the budget—full employment without inflation.
Mr. ADAMS. If you will look at the period between 1960 in the middle
of your chart and continue up through the beginning of the Vietnam
war, which was February of 1965, you will see that we had a rate of




20

inflation that ran below 3 percent. Our unemployment rate was coming down. It had been at 6 percent in the early sixties. The reason I
take that particular time period is because the Vietnam war period
does distort things. In other words, if you are very conservative, you
say the only reason we got unemployment down is because we had
a war.
If you are liberal, you say that general economic policies were successful. During that period some of us were saying, and the Council
of Economic Advisers was in agreement, and the Federal Reserve and
the Congress was in agreement—that we were trying to come out of
the recession period of 1958. You also had at that time a relatively
low deficit and you had a low interest rate. I am saying that that
condition of low unemployment and low interest rates can be repeated
again and that is my personal goal.
Mr. NEAL. Senator Buckley, welcome again.
Senator BUCKLEY. I find myself in substantial agreement. I believe
there is an obvious correlation, and studies have gone further in pointing out the relationship between money supply and rate of inflation.
Way back, banks did not issue credit instruments unless you had production to match the instruments that were being handed out.
But I do agree that our goal has got to be toward creating a stable
environment, a predictable environment. We should have as a goal the
increase in money to match the increase in productivity and labor
force growth.
This will create stability in which other factors in the economy can
operate. Then we are talking about whether or not we are going to
raise taxes. We have had pressures. Whether we are going to raise
taxes to meet current higher levels of higher spending, or are we going
to in effect lower the Federal take out of the economy to leave more
behind in the private sector with which to produce the jobs.
Mr. N*EAL. YOU would advocate a moderate and steady growth in
the money supply
Senator BUCKLEY. TO match the average growth that we project
for the economy?
Mr. NEAL. If the economy is growing at the rate of 5 percent, you
would advocate a growth of 5 percent in the money supply? If the
economy's growth potential decreased, would you advocate a decrease
in money growth?
Senator BUCKLEY. Yes.
Mr. NEAL. I will now yield to the gentleman from California.
Mr. HANXAFORD. Both of you coming from different directions say
the same thing about money supply. Both of you advocate a balanced
budget perhaps with less fervor or enthusiasm. Would you apply
something of the same standard that you are applying to the growth
of the money supply and that is we would try to balance the budget
but would not get too upset about it if the growth of debts did not
grow as fast as GNP ? Senator Buckley ?
Senator BUCKLEY. Well, I personally would like to see some black
ink once in a while. My fear is that if we start talking about a permissible level of deficit which can be financed in a manner that does not
require creating money faster than projected growth, yes; we can
absorb the burden. But I recall when President Nixon unveiled the
-concept of full employment and budgetry, it started fine. But at the




21
same time it seems to me that it is awfully hard for a legislative body
to say that $12 billion of deficit is OK but $13 billion is not. I would
like us to reach black ink and over a period of years average it out.
Mr. HANNAFORD. Realistically, it is difficult to achieve a balance
between red and black ink over the long run. We would like to balance
the—between red and black ink out in the business cycle.
Has the Senator completed his statement, or did he have anything
more in the way of a formal statement ?
Senator BUCKLEY. I had one which was interrupted by a vote, and I
don't know how to pick up the pieces again. Basically, I urge that the
Congress not follow—not yield to the temptations to politicize the
Federal Eeserve—which is inherent in the Humphrey-Hawkins legislation—and that it maintain the posture it took a year ago with House
Concurrent Resolution 133, to adopt standards to guide and govern the
monetary policy.
Mr. HANNAFORD. Mr. Buckley, I guess I am a little out of step here
because the purpose of these hearings is to establish the importance of
monetary policy. I have always had a very strong feeling about its
importance.
So I am going to, I guess, shift to the politics of it. Accepting that
these facts are true and that it is of fundamental importance and that
it does contribute some 60 percent of the inflation problem, we must
follow the simple dictum that Chairman Adams suggested that we
create enough money to buy the things that need to be bought.
Also, there has to be a coordination between monetary policy and
fiscal policy if we accept these things. Do we accept that ?
Senator BUCKLEY. I would disagree. I would suggest that the role
of monetary policy is to create a stable environment by the more or less
predictable increase in the money supply to match the projected increase in production so you have a price stability which establishes the
expectations within which the private sector can operate.
Then the fiscal policy has its impact within that spectrum. If we
spend too much and the Federal Government has to borrow too much
out of the capital markets, you run up your interest rates. This ought
to be the leverage on the Congress to have self-discipline.
Mr. HANNAFORD. Well, I am bothered by the fact that Brock Adams'
statement regarding the cause of inflation recently being in relation to
increasing energy prices and food prices is diametrically opposed to
Chairman Burns' previous statement here. We had the Chairman of
the Federal Reserve Board here consistent with the requirements of
House Concurrent Resolution 133 last summer. He said he was increasing interest rates or following a more restrictive monetary policy
because of increases in commodity prices and because the tax cut which
we instituted, $22 billion, was beginning to take effect, and there were
too many dollars floating around and we had to react to that with
monetary policy. It disturbs me a great deal that we have conscious
and intelligent efforts conflicting with one another.
I don't see how we can run the economy of the country having the
left hand taking away what the right hand is doing.
Mr. ADAMS. That was precisely the reason why we have gotten into
the argument that is going on now between some of us on the Budget
Committee and the Chairman of the Federal Reserve. Simply put,




22
my statement to him is that if you are going to, in effect, soak up the
money supply after we had gone through great efforts to provide
increased fiscal stimulus to come out of the recession, you should have
told us in the first place, and we would not have bothered to pass the
tax cut.
There is just no value in going through enormous exercises hero
which are finally agreed upon between the Congress and the Executive,
and then to have our efforts frustrated in the name of independent
monetary authority. I am not saying that the Congress should be
operating on the size of the money supply. We should not be doing
that. But we should not expect that the obvious policy established is
going to be frustrated as we proceed.
I am concerned that this is about to occur again. We are concerned
that next year the economy will go into recession. That is the reason
there are several portions of the total budget package saying that
we must continue Federal assistance for a few years until we are sure
the recovery is solidly in place. And if that is frustrated by a rapid
increase in the interest rates, we should not be involved in making
such an effort in the first place.
Mr. HANNAFORD. Would both of you agree that your major criticism
of the Fed policy is that it operates in fits and starts instead of looking a long way down the road?
Senator BUCKLEY. Precisely. This is where I hope House Concurrent Resolution 133 sets some guidelines to take the longer range.
Dr. Burns has testified about the fine tuning. If you pull the string,
you just push it. I have a live quorum. I might have to leave soon.
I would like to make one observation. You were talking about the
contribution to inflation of the rising energy costs. Even though we
had wage and price controls, we reached an annual rate of 9.5 percent
inflation before the Arab oil embargo. Energy was a one-time price
increase.
We had as a result of dickering with the money supply the pressures
for that inflation that just burst through the seams.
Mr. NEAL. Mr. Hannaford, would you yield? Senator, you mentioned the problem of politicizing the Fed. I would like to ask if you
think this chart is accurate and if you think that Fed policies have
been well administered over these years ?
Senator BUCKLEY. My answer would have to be no.
Mr. NEAL. If you don't think it has been well administered what
would you suggest?
Senator BUCKLEY. I would like to think in the last year it has been
better administered than it has in the past. Before that it was always
reacting too late or too early.
Mr. NEAL. When you say you don't want to see it politicized, do you
mean you don't want to see us go further than House Concurrent
Resolution 133?
Senator BUCKLEY. I would hate to see us establish legislation of a
Humphrey-Hawkins type to manipulate the economy. I am sorry I
have to run. I appreciate the opportunity of being here.
Mr. NEAL. Thank you very much.
Mr. HANNAFORD. Mr. Chairman, I yield the balance of my time.
Before I do, though, I want to say that I am very glad that at the
time in history when we established the budget process that Brock




23

Adams was in Congress because if he had not been, I'm not sure it
would have worked.
I think it is a historic achievement which you have accomplished,
Mr. Chairman, and I thank you.
Mr. NEAL. Mr. D'Amours?
Mr. D'AMOURS. I thank the chairman for recognizing me after
Senator Buckley left. My questions were going to be directed to Senator
Buckley.
Congressman Adams has referred to a problem and I wondered,
Congressman Adams, if you could tell me what positive directions
do you think we might be taking to go beyond House Concurrent
Resolution 133 which is nice frosting but not very substantial in terms
of—it is a control but certainly not a very strict or definite control.
What can we do short of politicizing the Fed which I don't suppose
anybody wants—not that anybody does not believe it is already politicized—what kind of controls short of Humphrey-Hawkins are available to us?
Do you see any range of options?
Mr. ADAMS. I think you can consider, one, specifying to the Fed
the ranges of the money supply that we in Congress deem necessary
for the next fiscal year and that we not simply allow the Federal
Reserve to say they agree with us and then go off and do something
different. For example, the Federal Reserve indicated to this committee and the Congress originally that the range in the rate of growth
in money supply should be 4 to 7y2 percent this next year. Yet Dr.
Burns, within the last 2 months, has said no, it is going to be 4 to 7
percent. This means that we have a year's program laid out in that
budget resolution and yet one of the key assumptions, one man or the
whole Federal Reserve Board has at some point sat down and said we
are not going to do that.
Second, you can actually go to a range on interest rates. I don't
think you could call that politicizing the Fed but I certainly think
that once you establish a fiscal policy for fiscal year 1977, let's say,
from October 1, 1976, through to October 1, 1977, that you can indicate a range for interest rates and you would take off from the range
where you are now. In this way you would not be signaling to the
money markets that there is going to be some big pump up or a crunch
down, but that these ranges are necessary. That is what I was referring
to. I have not staked out a flat position to you that you ought to use
the 91-day bill as the key, but you can do that.
A third principle is this: This subcommittee should consider recommending to the full committee the potential of using selective reserve
requirements and fuller regulation of the banking system. The reason
your chart reflects an inflationary increase goes to a belief that I
personally have. Now, this is my personal opinion. A great portion of
the inflation in the past 8 or 9 years—other than the war inflation
which was obvious—came in the financial community. By financial
I mean financial tied in with business—in speculation in inventories
and in the establishment of conglomerates.
I think the formation of conglomerates has added to inflationary
pressures. It works like this. I have a glamorous electronics system
that is selling at $50 per share. You own a smelting company in Montana that is selling at $12. Without changing my plant or without




24

changing your plantyl form a conglomerate and buy you out. In buying you out, you get a rise in your stock price of anywhere from 12 to
maybe 20 points.
The drop that occurs in the merging, glamorous stock, would be
very slight. You would end up with the stock of both plants selling
at 45 which is, for your smelting plant, 30 points of pure water.
There is no more production, there are no more people working.
Nothing has changed except the total price went up. Even worse, I
don't have any money so I go out and borrow. In other words, I increase the money supply by going to my bank and signing a note for
$30 million to buy you out.
Now somebody is in there competing with me, at say, the First
National Bank of whatever town you want to go to and they are trying
to borrow for their inventory to buy enough widgits to produce for
the year ahead and they are only willing to pay 7 percent.
I have a sure-fiire deal with you so I can afford to bid that interest
rate up to 9 percent, 10 percent, 11 percent, 12 percent, because I am
going to write it off on any income tax and I am going to make the
profit out of the rise of the stock cost. So I have had a double inflationary impact.
You can also do it with inventory. I don't need any, but I think
there is going to be inflation so I go out and borrow money and I buy
up parts for my inventory, borrowing the money, not putting any
more people to work. I speculate if I buy it today, it will cost me $10
and if I buy it next year it will cost me $12. I buy up at $10 all I can
get my hands on. I stock my warehouse completely. I use borrowed
money. I write off the interest rate. If the inventory goes to $12 next
year, I shift my accounting system from first in first out to last in
first out and I pick up $2 an item on everything I have got.
There is no more production. It is pure speculation. That cannot
be controlled by simply raising interest rates because I will bid anybody out of the market on those conditions. I will bid you out as you
try to borrow money to buy a house. I will bid you out as you try
and raise money for your small business. I will bid the farmer out
for whatever he is trying to borrow in order to produce that year
because I am in the speculative end of it. The only way you can control
that is with selective reserves. You are saying to the bank well, we
will not allow more than 15 percent or 20 percent of your lending to
be done for these kinds of purposes.
That was advocated by Board Member Andrew Brimmer back in
the sixties and we fought that back and forth with the Federal Reserve
for years. They, say, well, we can't do it. But to me, raising the interest
rates does not control inflation. In fact it can feed it. Because when
I push the interest rates up to 12 percent you, in your small business,
have got to borrow at 12 percent rather than 8 percent, you have got
to tack on to your prices what you can't write off. If you are going
broke like the railroads and W. T. Grant and everyone else, you can't
write it off because you don't have any income. You have to raise
your price.
Mr. HANNAFORD. I believe we are simply talking about allocating
credit in this manner.
Mr. ADAMS. In a gross sense.




25
Mr. HANNAFORD. We have fought the same battle in this room
last year. It gave the Chairman of the Federal Reserve Board the
suggestion.
Mr, ADAMS. There are new days coming.
Mr. D'AMOURS. I have no further questions. Thank you.
Mr. NEAL. Mr. Adams, I would like to pursue your comments on
interest rates again. How would you like to see those interest rates
regulated?
Mr. ADAMS. Well, I think the best you can do is to use a range. In
other words, we don't want to have the Congress involved in saying,
all right, the interest rate on the 91-day Treasury bill will be 5 percent
in January and 5.2 percent in February and so on. Obviously the
money managers—the Fed must control that sort of thing. But I do
think—and I mentioned this in my testimony—this committee should
consider whether we should have a range of interest rates such as we
put in the statement of managers accompanying the resolution this
year, 5.5 percent average from the period of October 1, 1976, to October 1, 1977, with a trigger mechanism by which the Fed comes back
before the committee and says conditions are thus and so and we
think there should be a change in the range. At that point you
make a recommendation to the Congress. If you want to include it in
the budget package, we can go with another concurrent resolution
saying it is going to cost us this much more. I would have no objection
to our coming in and redoing it. You could get a photograph of the
economy at various points during the year.
If tilings have changed drastically in commodities or food prices,
this committee recommends to the House and the same on the Senate
side that a change is necessary to fit the new picture. We all know
what we are doing.
Mr. NEAL. The only way the Fed has of changing interest rates is
to change the money supply. Isn't that right ?
Mr. ADAMS. They can change their discount rate. They can change
their Federal funds rate through open market activities.
Mr. XEAI,. But these actions change the money supply, don't they ?
Mr. ADAMS. Yes. In the very sophisticated society, if you change
any of these factors, money supply will follow. But money is not in
and of itself. Money supply is a factor that changes by Federal Reserve policy. That is why there is this argument about velocity that
we are into now. We have so many new sophisticated financial instruments and people creating new ones all the time. But the money supply
was created by the Fed and is the underlying factor. All these other
things follow.
Mr. JSTEAL. Including interest rates probably.
Mr. ADAMS. Including the interest rates, but not on a 1-to-l factor.
In my opinion, at the present time interest rates on the short-term
bills are going up strictly from Federal Reserve, and not from anything else going on in the economy. In other words, there can be times
when the interest rates are going up because of other factors in the
economy and not the Federal Reserve. The Federal Reserve has had
in effect a loose money supply since about September 1975. But they
were pushing the string. The money supply did not ;grow during that
period because all they can do is make it available and if nobody
conies to the window and takes it away, Mi does not grow.




26

We don't know what caused Mt to rise so in April. What I am
saying to you is that bank demand was down, corporate demand has
been down and other demand has been down so the market is not
pushing up interest rates at this particular moment. The Fed is. T
think that is wrong. It does not have anything to do with the growth
of money supply right at the moment. They are not in a 1-to-l ratio.
Mr. NEAL. But by fiddling with the interest rates, they will also be
fiddling with the money supply ?
Mr. ADAMS. That is correct. The optimism in the economy or lack
of it, costs in key commodities and individual decisions made by
companies as to whether they want to have more money available
is the multiplier effect that goes with the Fed action.
Mr. NEAL. There is another interesting thing on this chart and that
is whenever we have an expansionary money supply, we have inflation.
Whenever we have contracted money supply, we have recession.
Somewhere in between it seems to me we have the right course.
Perhaps as a result of these hearings, we will be able to formulate a
target range of money growth for continued economic recovery and
avoid fighting that battle of politicizing the Fed.
Mr. ADAMS. I think politicizing the Fed is an enormous red herring.
Mr. NEAL. I think it is, too, but it has popular support.
Mr. ADAMS, It has popular support in the elitist part of the United
States. The activities that took place in 1961—and I would strongly
suggest that if you have not already contacted him that you have in
for example either Walter Heller or Charles Schultz to ;give you
specifics on it because a lot of us were involved much more peripherally
than they were.
But I think the people support the Government making a conscious
effort to see that the economy runs smoothly and well. That is a very
different political position from those who say the Government should
get out of all fiscal activity. In spite of the hammering, in spite of the
public positions, in spite of the television every night saying that
everybody hates Washington, if you go to the people and not just keep
polling the top, you will find an underlying feeling that the Government is the one place where people elect their representation. And as
bad as the Government may be in getting things done, at least people
can communicate with elected Government officials concerning somethinqr. that affects their destiny.
The people don't want to throw the Government out. They don't
want it to be dictatorial but they think it should be involved in seeingthat they have a job, that the prices are not going out of sight, and
if they want to buy a house that the interest rates are low enough
that they can afford it. I still believe that in this country, most of the
people believe the Government should have a role in that because
thev can get at the Government.
Thev can throw you and me out. But you can't throw out the head
of A.T. & T. and you can't throw out the head of the First City Bank
and you can't throw out the head of the labor unions that are involved
in your city and you can't get at anybody else. Government becomes
the forum where you can try to make your life a little better. You,
Mr. Chairman, and this subcommittee, are directly involved in one
of the key factors that people are interested in. They want to know




27

why it is they cannot buy a house today, for example, which is in the
jurisdiction of this overall committee on which you sit. They can't
understand why interest rates that they grew up with running from
4 percent to 6 percent can't ever by found anymore. I think that that
is part of our job, to produce an answer.
Mr. HANNAFORD. Would the chairman yield ?
Mr. NEAL. Certainly, the gentleman from California is recognized.
Mr. HANNAFORD. I am afraid that you are more optimistic than
I am, having had short experience on this committee. We have had
two experiences that convinced me that the Federal Reserve is so
enshrined that you can't approach it politically. We did early last
year try to get some allocation of credit action.
By the time it had gone through the influence of Dr. Burns and
the minority, we came out of this committee with something that was
a watery statement of good intentions about allocating credit. It
went to the floor of the House and I think lost by something like
2tol.
Last month, just 2 or 3 weeks ago, we had something that we called
the Federal Reserve Reform Act that we reported out of the committee. A central feature of that Reform Act was to try to bring the
Fed more within the point of view of contemporary Congress and
the administration—in other words, have the President appoint Federal Reserve presidents.
That was thought to be by the authors in the committee, the subcommittee, the central feature of that piece of legislation and that
was stricken out by the House committee and that prevailed on the
floor of the House of Representatives.
I might say I supported that view because I knew it would never
pass the House without it. But one does have to be pessimistic, Mr.
Adams, about the future in this regard.
Mr. ADAMS. Mr. Hannaford, we are in a period of divided Government. Two very conflicting philosophies are in collision and have been
for the last 8 years. If this continues, next year your frustrations will
continue. If it does not, then you may have a coordinated Government
with one economic philosophy going ahead. Then you will be successful. All I can say to you is that my frustrations have lasted longer
than yours only because I have been here a little longer.
Mr. HANNAFORD. It occurs to me if we are going to enshrine this
thing, put the whole thing in one basket and let the Fed make the
decisions regarding both fiscal and monetary policy. To give one
to us and the other to them without ever having the twains meet is
counterproductive.
Mr. ADAMS. Maybe at some point we will run the Government by
experts as opposed to elected representatives. I hope that is far in the
future. I have seen some experts in 1965 make some horrendous mistakes. I am not over-awed by expertise.
Mr. HANNAFORD. I was saying that in jest. If we are going to do
the wrong thing, we should be at least doing it consistently.
Mr. NEAL. If you could set monetary policy for next year, what
would it be ? What would the money growth figure be ?
Mr. ADAMS. I would go with a short-term bill rate of 5.5 percent
average. I would anticipate an inflationary rate of 5 percent, maybe




28

a little bit less. If speculation began to "reoccur in the financial community of volume that occurred in 1974, I would make threatening
noises. I would come to the Hill for support on those threatening
noises so we used coordinated policies against the spot inflation. My
point is there is no point in panicking and trying to raise interest
rates. I would try to maintain them on a constant level. We are coming
out of a recession and there is no reason to crunch the money supply
now.
Mr. NEAL. Would you go over the Fed?s upper money growth bound
of 7 percent ?
Mr. ADAMS. NO. If it happened for a month or two, I would not
panic. I would first determine where the velocity problem was occurring and operate on that specifically before I used the blunt instrument of increased interest rates.
Mr. NEAL. Are there any further questions?
Mr. ADAMS. I thank you, Mr. Chairman, for inviting me this
morning.
Mr. NEAL. Thank you very much.
The subcommittee stands adjourned until tomorrow morning at
10 a.m., when we will continue our hearings in this same room.
[Whereupon, at 11:20 a.m., the subcommittee adjourned, to reconvene at 10 a.m. Wednesday, June 9,1976.]




THE IMPACT OF THE FEDERAL RESERVE'S MONEY
POLICIES ON THE ECONOMY
WEDNESDAY, JUNE 9, 1976
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE COMMITTEE ON BANKING, CURRENCY AND HOUSING,

Washington, D.C.
The subcommittee met pursuant to notice, at 10:20 a.m., in room
2128, Rayburn House Office Building, Hon. Stephen L. Neal [chairman of the subcommittee], presiding.
Present: Representatives Neal, Hannaford, Allen, and Hansen.
Also present: Dr. Robert Weintraub.
Mr. NEAL. Gentlemen, I would like to thank you all for coming this
morning. The House is in session, but hopefully we will have a minimum of quorum calls and be able to proceed in an orderly way.
This morning we are continuing our hearings on the impact of the
Federal Reserve's money policies on the economy. As I stated yesterday, I will again say that the functions of the Federal Reserve System
and its Open Market Committee, which decides the Nation's money
policies, remain a mystery to many people.
Most Americans do not know how important money policy is to
the prices of the goods they buy, the interest rates they pay, their job
opportunities, wages and profits.
The hearings are intended to cover several specific points which
include:
One: How money policy affects the cost of living.
Two: How it affects production and employment.
Three: How interest rates are affected by money supply changes,
both directly and through changes in prices, production and
employment.
Four: How government spending and tax policies affect money
policy and their relationships to prices, interest rates, production and
employment, and,
Five: Whether Congress should set goals for economic growth,
unemployment, inflation and interest rate levels and require the
Federal Reserve to promote achieving these goals.
In preparation for these hearings, I have asked the staff to compile
statistical data on our economy's performance and the growth of
money supply, and the level of Federal Government surpluses or
deficits since 1954.
This work is going forward. To date it has centered on how money
growth and Federal deficits have affected the rate of inflation and the
frequency of recessions.
(29)

73-959 O - 76 - 3




30

We have prepared an exhibit to bring these relationships into focus.
As our exhibit shows,the rate of growth of money supply has followed
a roller-coaster pattern, which tilted upward after 1964. As a result,
we have suffered periodic recessions; and since 1964 they have been
imposed on waves of inflation.
Our exhibit maps the relationship between inflation measured from
one month one year to the same month the next year, to mone}^
growth also measured over 12-month periods, but occurring 23 months
earlier.
The relationship between inflation and money growth was mapped
with a 23-month lag because it takes time for changes in money supply
to affect the inflation rate; and the staff found, using computer studies,
that the effect of increases or decreases in money supply on the rate
of inflation peak after approximately 23 months.
As the exhibit indicates, the rate of inflation rises and falls in the
wake of increases and decreases in the growth of money. About 60
percent of our inflation can be explained by changes in money growth
occurring 23 months earlier, And this, let me emphasize, holds as
much, perhaps even more, for the seventies as for the fifties and sixties.
The exhibit also shows that each time our economy experienced a
recession since 1954, it occurred after the Fed moved to sharply
decrease the growth of money supply. Finally, the exhibit maps the
relationships between recessions, inflation and money supply and
Federal deficits. In this regard, the conclusion that emerges is that
the impact of deficits on the inflation rate and recession is weak as
compared to that of money growth.
While the subcommittee will refine its work in these areas, the
staff also is studying the relationships involving unemployment and
interest rates. In addition, we are endeavoring to ascertain the impact of money supply on the economy by simulations of large econometric models using different money growth patterns. Preliminary
results from these runs indicate, among other things, that the economy
is far more tolerant of interest rate fluctuations than it is of money
supply gyrations.
We hope that the results of our work will produce a better understanding of the ways our economy is affected by Federal Reserve
policies and promote the use of responsible guidelines for coordinating
monetary and fiscal policies.
This morning we will hear from four very distinguished witnesses:
Edgar R. Fiedler, who is the vice president of economic research,
general, at the National Industrial Conference Board; Jerry L.
Jordan, who is vice president and chief economist of the Pittsburgh
National Bank; David I. Meiselman, professor of economics at the
Virginia Polytechnic Institute; and George Perry, senior fellow at
Brookings Institution.
I would like for you all to proceed in any way with which you are
comfortable. If we could, it would be helpful to try to keep your remarks under 10 minutes or so, so we can leave some time for some
discussion.
At this time I would like to recognize Mr. Fiedler.




31
STATEMENT OF EDGAR R. FIEDLER, VICE PRESIDENT, ECONOMIC
RESEARCH, GENERAL, THE NATIONAL INDUSTRIAL CONFERENCE
BOARD

Mr. FIEDLER. I am pleased to be here and have a chance to participate in these hearings. I can summarize the full statement which is
available for the record. I can summarize some of the major points
fairly quickly.
Mr. NEAL. We will insert your statement in its entirety in the record.
Mr. FIEDLER. Thank you, sir.
The economy is in a moment of cyclical tranquility. We are past
the last effects of the recession and everybody now recognizes there
is a recovery in process but we are not yet in the later stages
of prosperity, and the later stages of the business cycle where some of
the distortions come into view.
We are betwixt and between. We still have a below average rate of
resource utilization in the economy. The key analytical aspect of this
is how much capacity there is in the economy. We run into trouble
immediately with the analytics and the measurement here because
capacity is one of the slipperiest concepts and measurement problems
we have in economics.
Most people think of how much room there is to grow in the economy
simply by looking at the unemployment rate. Certainly the labor
markets are one of the key dimensions of the economy, of how much
capacity there is, but only one of several dimensions. At this point
it seems to me, in this particular series of years that we are in now,
the key dimension of capacity is the productive facilities available to
process raw materials, the first processing of raw materials: steel,
nonferrous metal, basic chemicals, paper and so forth.
This is where we ran into the bottlenecks in 1973-74. This is also
where we are now closest to full utilization of our resources. If we
run into the limits of capacity in this cycle sometime in the year or
two coming up, it will not be in the labor markets, it will not be in
the advance processing industries, it will be in those major materials
industries.
My guess is given the vigorous recovery that I expect to continue,
we have about another year, maybe 18 months, before we hit the
limits of capacity to expand.
I claim no expertise. Not much exists. I labeled this in my statement
as a guess but it is my best guess. It is too important an issue to ignore.
If that judgment is correct, given the lags in monetary policy, we
would have some possibility of applying a more stimulative monetary
policy for the short run to obtain a more rapid growth of economic
activity and put more people back on the payroll sooner.
That would be a respectable bit of advice. I would like to express
a couple of points of caution about that idea, however. One is that a
faster rate of growth in monetary expansion now would imply that
rather soon given the lags again, we would have to cut back even
further on it.
This kind of scenario, experience suggests to me, has given us a
lot of trouble in the past. It is what economists have come to call
"fine tuning" of monetary policy and it implies an ability to forecast
and a delicate touch on the monetary policy levers that is probably
beyond our ability to handle.




32

It also suggests that it won't be very long if you raise the rate
of monetary expansion now, temporarily, before you would have to
make an abrupt downward adjustment and that would raise questions
and uncertainties about the possibility of that leading into a recession.
So here, I believe, these kinds of considerations lead me to suggest
caution on this idea of adding more monetary stimulus at the present
time.
Second, we have our shortrun goals of fostering as vigorous a
recovery as we possibly can. We have a longrun goal of reducing
inflation, which is still high by historical standards. The longrun goal
calls for the opposite prescription for policy, namely reducing the
rate of monetary expansion.
There is no way to reconcile the two prescriptions instantly and
automatically. In the past we have paid too little attention to the
longrun goals and we ought to give them at least equal weight, and
this, too, argues for caution.
I would like to add one more point about capacity. The fact that
we run out of capacity in terms of the major materials industries
indicates an imbalance between capital facilities available in our
economy and the labor. In other words, when we hit the limits of
our ability to expand and we still have an unemployment rate high
by historical standards. This argues in my mind for policies—not
necessarily monetary policies though they could play a role—policies
that will foster a vigorous expansion in capital formation so we can
avoid hitting those bottlenecks at too early a point in terms of
unemployment.
When we get to prosperity we ought to shoot for a balance between
the capital facilities and the labor facilities so everything is fully
utilized as is consistent with a smoothly operating, efficiently operating
economy. If you have to have an imbalance, however, it ought to be
the opposite way. We ought to have idle machines and not idle men.
This argues strongly for some kind of policies, incentives for saving
and investment over the next few years. This is not a shortrun, thisyear, next-year policy suggestion. It is for the long run: 5, 10, 15
years.
Finally, I would like to make a comment about the relationship
between fiscal and monetary policy. In my statement there is a
table I would like to refer to.
It points to what I would regard as the divergence between the
relative status of fiscal policy and monetary policy at the present
time. Normally, I think it is fair to say, fiscal and monetary policy
usually point in generally the same direction.
In 1972 both were overly stimulative. At the present time, however,
it seems to me we have a divergence with fiscal policy relatively more
expansive, monetary policy more moderate. The table shows monetary
policy—that the Federal Reserve target growth rate for the narrowly
defined money supply, Mi, 6 percent.
I would compare that with 1972, also the second year of a business
cycle recovery, where the growth in the narrowly defined money
supply was over 9 percent.
The Federal Reserve's target for policy at this time is therefore
clearly more cautious than it was in 1972. If one were to take account
of the fact that the base rate of inflation that is built into the system




33

at the present time is a couple of percentage points higher than it
was back in 1972, that suggests an even more striking comparison
in those terms that our monetary policy is now more restrictive, more
cautious, more moderate than it was in 1972—and I would regard
1972 as having been a vigorous, stimulative policy.
Fiscal policy is a different story. If we look at fiscal 1976 and 1977,
we have budget deficits estimated at 4.7 and 2.8 percent of GNP
respectively for those 2 years. Back in fiscal 1972 and 1973 we had
deficits of 2.1 and 1.2 percent.
I am sure there is not a perfect relationship or a perfect parallelism
between 1972 and 1976 but I believe that in a general way it is an
appropriate comparison. I regard fiscal policy as too stimulative in
1972. It is more stimulative now. Here we have monetary policy more
constrained and fiscal policy more stimulative. There is a serious
divergence between the two.
It raises some questions, more than I have answers for, but the
questions are nevertheless interesting. As long as this divergence lasts,
it suggests that we will have some upward pressures on interest rates,
particularly short term rates, which are always unsettling to the
economy in general.
Second, we have the question of whether this divergence can last
indefinitely. I doubt that it can. Then we have to figure out whether
the reconciliation between fiscal and monetary policy is going to take
place with both of them coming together in a compromise or whether
it involves a more expansive monetary policy to fall into line with fiscal
policy, which would raise questions about a new outbreak of inflation
and all the problems of a boom or an excessive boom of economic
activity a year or two or three down the road, or in turn whether fiscal
policy pulls back, becomes more cautious and gets into line with
monetary policy.
This would raise questions in people's minds about the expansion
for the next year or two. I don't know if there is any way to decide
specifically that one way is appropriate and the other is not to reconcile
this divergence of policies.
But it seems to me to be an interesting question and raises a lot of
uncertainties about the next few years. I think that is all the summary
I need to give you. We can go into any other parts of the statement
later as you wish, Mr. Chairman.
[Mr. Fiedler's prepared statement follows:]
PEEPAEED STATEMENT OF EDGAE R. FIEDLER, VICE PRESIDENT, ECONOMIC
RESEAECH, THE CONFEEENCE BOAED

This Subcommittee is studying some of the most fundamentally important,
the most interesting and the most difficult issues of economic policy, and I am
glad to have an opportunity to participate.
The main focus of this investigation, the impact of monetary policy on economic activity and inflation, is an extraordinarily complex matter about which our
understanding is very imprecise and incomplete. One of the few aspects of this
topic that seems reasonably well established is the long-term relationship between
monetary growth and inflation. In the very long run, say a decade or two, the
growth of money is clearly the dominant factor determining the rate of inflation;
the faster money increases, relative to total economic output, the faster prices
will rise. This association is not perfect for all times and all places and there is
some uncertainty about the precise definition of money, but by and large the long
run relationship between money growth and inflation is impressively close and
consistent.




34
At the same time, although perhaps this is not so well established, there appears
to be very little long-run relationship between money growth and economic
activity.
In the short run, however—say one to two years—monetary policy has a significant impact on both inflation and economic activity, but in varying and highly
uncertain proportions. I have no doubt that the effect of an expansionary monetary
policy on real activity is more pronounced (and the effect on inflation less pronounced) when resource utilization in the economy is, as now, below average.
But I have great doubts that anyone can tell you the extent to which that is true.
How much impact monetary policy will have on output vs. inflation depends on
many factors including, importantly, the state of peoples' expectations about the
economy. Consequently, how much additional output would be generated by a
more stimulative monetary policy in the near term, as against how much additional inflation, is a highly uncertain proposition.
If the short run were all we had to worry about, the low current rate of resource
utilization in the economy would surely tempt us to recommend a more rapid
growth of money on the expectation that it would speed up economic expansion,
and in particular put more workers back on the payrolls sooner, at an acceptably
moderate risk of exacerbating inflation.
There are, however, two points that must be raised about such a policy move.
First, it is not enough simply to demonstrate that a low rate of resource utilization
exists currently. It is also necessary, because of the significant lags in the implementation and impact of policy shifts, to be persuaded that the economy will
still require an additional boost about a year ahead. For this purpose a series of
forecasts are needed: forecasts of the level of economic activity and how fast it
will be expanding at that time, and also forecasts of the total capacity of the
economy and how fast capacity will be expanding.
Here, too, we run into great analytical uncertainty. What constitutes economic
capacity is very difficult to conceptualize and even more difficult to measure.
Most people, when they think about the limits of capacity and how much room
there is left in the economy for continued expansion, tend to think of this question
only in terms of the unemployment rate. With 7.3 percent unemployment at
present and with the labor force expanding by 1.5-2 percent per year, it seems
rather obvious that the economy has plenty of room to grow.
However, the labor markets represent only one dimension of our economic
capacity—a very important dimension, but only one of several. The key dimension
these days appears to be in the materials processing industries—steel, nonferrous
metals, paper, basic chemicals, and other industrial materials. This was the
sector where the U.S. economy, indeed the entire world economy, ran into the
limits of its ability to expand in 1973-74, and where we are most likely to do so
again in the current cyclical upswing. If we are destined for another collision
with capacity in the present cycle, it is not likely to come in the labor markets,
or in the financial markets, or in the advanced processing industries; it is likely,
rather, to take the form of a new round of shortages and bottlenecks and price
pressures in the major materials industries.
There is already some talk that we are now closing in on full capacity operations
in paper, steel and chemicals, and will reach our productive limits before the
year is out. My own guess (I make no claim to expertise, but there isn't much of
it around) is that with a few bearable exceptions there is probably enough materials
processing capacity to support a continued cyclical upswing in the economy for
twelve to eighteen months more.
If that be an accurate judgment, it suggests that there might be a little room
for additional near-term monetary stimulus without taking too much risk of
accelerating inflation, but not very much. Indeed, it appears that the capacity
limits of the economy (focused in the major materials industries) are close enough
that we will soon have to be thinking in terms of slowing down the cyclical expansion to something approximating a normal long-run rate of growth.
Before leaving this discussion of capacity, there is one further aspect of it that
needs to be emphasized. The fact that the limiting element in our economic
expansion is the major materials industries means that we have a serious imbalance
between capital and labor. That is, we reach our capacity limits when the unemployment rate is still significantly higher than it would otherwise have to be,
which is a terrible human cost. For this reason, I believe it is of the utmost importance to redress the balance between capital and labor by fostering a rapid
expansion of new capital formation, especially in the materials industries. Hopefully, then, in the next round of prosperity when the next cyclical expansion reaches




35
full capacity, the limiting factor will be the availability of labor rather than the
availability of capital facilities. If there are any productive resources that must
remain idle during prosperity, let them be idle machines rather than idle workers.
LONG-RANGE GOALS

But to return to the hypothesis I put forth earlier that a more rapid growth
of money in the near term might add to economic expansion without adding very
much to the inflation rate, there is a second point to be raised, namely, that we
cannot ignore our long-range economic goals. A primary long-term goal is to help
create a prosperous noninflationary economy by gradually reducing the growth
of money to a rate consistent with the long-run growth of physical economic
output. The policy prescription for this goal is thus just the opposite of the policy
prescription (more monetary stimulus) called for by our primary short-run goal
of fostering vigorous economic recovery.
In the past we have consistently given a very low priority to this long-term
objective. Indeed, we ignored it almost entirely on occasions. The result was severe,
persistent, unyielding inflation. In the process we failed completely to achieve
sustainable prosperity. Instead, the inflation was accompanied by the familiar
boom-bust rollercoaster for economic activity. In the future, I hope we can give
due consideration simultaneously to both near and more distant goals.
Some economists would argue in this situation for a "fine tuning" of monetary
policy: temporarily increase the rate of monetary expansion now, and then
reduce it even farther a little later. Under ideal circumstances, this might be a
respectable scenario, but past history strongly suggests it would require a forecasting accuracy and a delicate touch on the policy levers that are beyond our
abilities. In addition, such a process would seem to require at some not too distant
point a significant tightening of monetary policy on a fairly abrupt schedule that
would seriously raise the spectre of recession. In other words, although the idea
would be to gently brake the momentum of expansion down to a sustainable rate,
the process would run a serious risk of breaking the expansion altogether.
POLICY COORDINATION

Another important issue that is worth discussing is the relationship between
fiscal policy and monetary policy. Most of the time the two operate in tandem;
both tend to be stimulative together, or neutral, or restrictive. On occasions,
however, the fiscal and monetary policy positions diverge significantly for a time,
although because there is no common denominator for measuring both of them
it is not always easy to recognize such a development on a current basis.
I suspect that a divergence of policies is now taking place, with fiscal policy
relatively expansive and monetary policy decidedly more moderate. To illustrate
this divergence, it is useful to compare 1976 with 1972, which was also the second
year of a business cycle upswing. I believe many economists would agree that both
fiscal and monetary policy were rather stimulative in 1972, perhaps (as is my view)
too much so. (It might be argued that 1976 and 1972 are not quite comparable
in that the economy in 1976 is at a somewhat lower level of resource utilization
than in 1972. While there may be some validity to that argument, I believe there
is more similarity than difference, and thus that the comparison of policies for the
two years is an appropriate one.)
FRB target, calendar 1976
midpoints
M-l growth
M-2 growth
Monetary policy (percent)-.

6

9

Calendar 1972
M-l growth
M-2 growth
9.2

11.4

Unified budget deficits as a percent of GNP, fiscal year—
1976
Fiscal policy

1977

1972

1973

4.7

2.8

2.1

1.2

The 1976 target growth rates for money, either narrowly or broadly defined,
are 2}£-3 percentage points below the 1972 experience. Thus monetary policy is
clearly less expansive this year (assuming the targets are met) than it was in 1972.




36
Furthermore, this comparison is even more striking if one takes account of the
fact that the rate of inflation is a couple of percentage points higher in 1976 than
in 1972.
On the other hand, with budget deficits equal to 4.7 percent of GNP in fiscal
1976 and 2.8 percent infiscal1977, compared to 2.1 percent in fiscal 1972 and 1.2
percent in fiscal 1973,fiscalpolicy is much more stimulative at the present time
than it was four years ago.
This divergence of the stance of fiscal policy from monetary policy raises
several interesting questions. For one thing, as long as the divergence continues,
it suggests upward pressures on interest rates, especially short-term rates. Another
question is whether these divergent policy positions can continue very long.
Historically, that has not happened; after a time one policy has adjusted to be
consistent with the other. If, in the present circumstances, fiscal policy were to
adjust to monetary policy by moving toward significantly less stimulus, serious
questions would be raised about the vigor of the business uptrend. On the other
side, if monetary policy were to become substantially easier, to conform more
closely to the present position of the budget, fears of a new acceleration of inflation
would be generated. Thus any reconciliation of the two divergent positions is
sure to raise many economic doubts and uncertainties.
CONCLUDING REMARKS

Throughout this discussion I have stressed the limitations of economic forecasting the shortcomings of analysis, and the difficulties of implementing monetary
policy in a precise and ideal way. That is, I believe, an appropriate emphasis.
In expressing these doubts, however, I trust I will not be misinterpreted. I do
so not out of any belief that monetary policy is ineffective or otherwise doomed
to failure, but rather in the hope of imparting some realism to our expectations
about what monetary policy can achieve. Policy makers, politicians and economists
have all oversold bothfiscaland monetary policy during the past couple of decades.
I would hope we can correct that situation. I would hope we can understand that
there are no easy answers.
Let us use our monetary and fiscal tools vigorously. But let us use them with
care. Most important, let us use them with a proper understanding of both their
value and their limitations.
Mr. NEAL. Thank you very much indeed, Mr. Fiedler. Mr. Jordan?
Mr. JORDAN. Thank you, Mr. Chairman.
Mr. NEAL. Well, why don't you let us catch this vote?
We will be back shortly.
[Voting recess.]
Mr. NEAL. What we have been trying to do here—and I want to
make this clear to all of you and to anyone else interested in this
hearing—is to start by asking questions about the economy with no
preconceptions about what has been right or not and let the facts
unfold as they are, so we might objectively understand what has been
going on in our economy.
This chart is a result of asking those kinds of questions. It is preliminary. We would very much appreciate you all at the appropriate
time looking at it and seeing if you see any problems with it at this
point. See if you think we are painting a picture of these relationships
that does not exist. (See exhibit 1 and overlays A-C, pages 3-4.)
If you see any flaw, please let us know. It would be helpful to us if
all of you would examine the exhibit and give us your suggestions.
Let's go on now and at this point hear from Mr. Jordan.
STATEMENT OF JERRY I. JORDAN, VICE PRESIDENT AND CHIEF
ECONOMIST, PITTSBURGH NATIONAL BANK
Mr. JORDAN. Thank you, Mr. Chairman. I will not read my statement. I appreciate this opportunity to give my views on the conduct of
monetary policy since it is now at the center of the debate about




37

appropriate stabilization policies for dealing with our inflation problem and unemployment at the same time.
Now, in contrast to a decade ago, most economists acknowledge
that monetary policy is important. It is my view that the growth rate
of the money supply is the most reliable indicator of the thrust of
monetary policy actions. There is still a large number of economists
who emphasize interest rates, and in public discussions it is generally
held that the level of interest rates is still a very important measure
of the tightness or ease of monetary policy. I want to address specifically that point.
In my view, interest rates can be a misleading indicator. In recent
weeks, the rise in interest rates that we have seen in the short-term
money markets has led some people to say that the Fed is tightening
policy prematurely. I don't think that is correct. I think the sharp
acceleration in monetary growth that we have had at the same time
is an indication of an expansionary policy—not a more restrictive
policy—in spite of the rise in interest rates. I don't think monetary
policy should be viewed as a choice between high interest rates and
rapid money growth, or between slow money growth and low interest
rates. You have to set targets for the future in order to have the interest rates you want in the future.
Before discussing this relation further, I want to comment on the
relationships between the money supply, inflation, output, and unemployment. I have brought a few charts to illustrate the basic relationships.
The basic analysis is that fluctuations in the growth of the money
supply are related to fluctuations in output and unemployment, and
the trend growth of the money supply determines the trend of prices
or inflation.
The heavy, solid line in the top tier of chart I l shows the growth
rate of the narrowly defined money stock, Mi, over two quarters or
6-month periods. The fine line is the average growth in money over
5-year periods. The second tier on the chart shows the average growth
of prices over 5-year periods. The third tier shows the fluctuations in
output over two quarters. The gray shaded areas are the recession
periods when real output declined. On the third tier, you see that
real output contracted sharply and unemployment rose sharply
during recessions. The contraction in money growth shown at the
top [the decline in the dark, heavy line] coincided with contractions in
real output growth, precipitating the recessions.
The continuing rise in the trend growth of money over the sixties
and seventies has been accompanied by a rise in the trend of inflation.
Now we have an average growth of the money supply of about 6
percent, so we have an average inflation that seems to be built into
the economy in the range of 5 to 6 percent.
Some economists are arguing that we should have twice as rapid
growth in money as the Fed wants, maybe 10 or 12 percent. That
would raise the solid line at the end of the top tier on the chart up
off the top of the chart. Once that has occurred, the Fed would be
faced with two choices at the end of this year or going into 1977. If
high growth in money is maintained, the trend will rise and that will
raise the trend of inflation. But if money growth is contracte , you
1

The chart referred to may be found at the end of Mr. Jordan's prepared statement.




38

are going to precipitate a recession. The only time you can fight
recession is during the previous expansion. To me, money is sort of
like a narcotic—the economy can get hooked on too much of it and if
it does, it has got to face going through withdrawal symptoms
eventually.
Let's look at chart II, 1 the relationship between inflation and interest rates. The top line is simply a series of high quality corporate
bonds. The lower line is the average rate of inflation over a 5-year
period, similar to the second tier on the first chart. The idea is that
there is an inflation premium in market interest rates, there is a real
yield—a real return on capital and people's savings after taking account of inflation. Borrowers are willing to pay a premium for what
they expect inflation to be, and lenders are demanding it in order to
compensate them for inflation.
Some people would like to see a decline in the long-term bond yield
in order to encourage capital expansion or growth in investment, and
maybe a stronger housing market. It is tempting to try to push interest rates down to help the economy. My point is, it would be selfdefeating because investors in the market would look at the rapid
growth of the money supply and would expect future inflation to be
higher, and they would try to protect themselves from the losses in
capital markets that would accompany another round of accelerating
inflation and rising interest rates. They would invest in short-term
assets. They would avoid long-term commitments. Long-term interest
rates would rise. You would get rates rising, not declining. The only
way I think we are going to get lower long-term interest rates is simply
to wait it out until we get an average rate of inflation down to something much lower than seems to be built in. The 8- to 9-percent level
of long-term interest rates implies the markets expect about a 5- to
6-percent rate of inflation, and only when they can expect a lower rate
of inflation than that can we expect to get a decline in interest rates.
Short-term interest rates are shown on chart III. 1 I think that
chart speaks for itself. The solid line is the interest rate, the prime
commercial paper, a series I picked to illustrate a relationship. The
dotted line is the rate of inflation. It shows how the market responds to
inflation in the short run.
Mr. NEAL. May I interrupt you? Can we pick up on this chart
when we return? We have to make it to the vote.
Mr. JORDAN. Yes.

[Voting recess.]
Mr. NEAL. Mr. Jordan?
Mr. JORDAN. Thank you, Mr. Chairman. Let me proceed in the
following way. Suppose the Federal Reserve achieves its targets
for the growth rate of the money supply, what can be expected, and
what sort of alternatives are there and what would they imply? If
they do not exceed their midpoints for growth of the money supply,
we will have a durable, healthy growth in real output, and a further
decline in the unemployment rate. Growth in total employment has
been stronger than people would have believed, and the unemployment rate has declined more than most people would have expected.
1

The chart referred to may be found at the end of Mr. Jordan's prepared statement.




39
We can continue to see that kind of development. If so, then we also
would not expect a reacceleration in inflation nor a rise in long-term
interest rates.
Mr. NEAL. I am sorry. If what?
Mr. JORDAN. If the Federal Reserve does not exceed the midpoints
for its money supply growth targets. In the past, we have seen rapid
monetary growth in an election year followed by a year of more
restrictive policy—slower money growth and higher interest rates.
We can and should avoid that kind of pattern.
However, if the economy continues to strengthen, you are going
to have upward pressure on short-term interest rates. They will
rise toward the level of long-term rates. This is a natural, cyclical
phenomenon. It should not be resisted by rapid money growth.
The alternative is not to expand money rapidly to hold interest
rates down until we get full employment. The alternative would be
to hold it down this year, and pay the price next year. I think that
can and should be avoided.
Let me turn to congressional oversight. Concurrent Resolution
133 is a valuable contribution to monetary policy. Oversight by
Congress of monetary policy is desirable. But I do think there are
dangers of excessive involvement in the formulation and implementation of policy. The primary role should be to maintain the checks
and balances that are inherent in the whole political system.
Certainly the Federal Reserve should be held accountable for their
actions. Congress should scrutinize the actions of monetary policy
to insure that they are not used to achieve short-term political gain.
But, there is a risk of asking too much from monetary policy—asking
more than it can deliver in terms of offsetting the mistakes inherited
from others, or trying to correct for some of the real shocks to the
economy, such as agriculture, quadrupling of oil prices, and some
other things.
You can ask the monetary policy actions not be destabilizing as
they have been in the past. They have caused worse recessions and
more unemployment than we otherwise would have had. I think it is
possible to avoid destabilizing actions and Congress should use its
oversight to hold the Fed accountable on that ground.
Two things that oversight can do. It can insure that monetary
policy actions promote conditions of stability to minimize the uncertainty in the markets so the real economy can adjust most easily
and rapidly to its natural full employment, full capacity state. They
can prevent the accelerations and decelerations that have occurred
in the past that have caused credit crunches and waves of higher
interest rates.
There are two objectives in setting money targets that the Federal
Reserve should be held to. One is to gradually lower the trend growth
of money so you lower the rate of inflation, and the other is to eliminate
the fluctuations in money growth so that it does not contribute to
fluctuations in unemployment that occur.
Thank you.
[The prepared statement of Mr. Jordan, along with the charts referred to, follows:]




40
DOMESTIC MONETARY POLICY
Testimony By
Jerry L. Jordan
Vice President & Chief Economist
Pittsburgh National Bank

Mr. Chairman and members of the Sub-Committee:
I am pleased to have this opportunity to present
my views on the conduct of monetary policy, and how it affects
production, employment, and the cost of living.
The conduct of monetary policy, and especially the
growth rates of the nation's money supply, has moved to
the center of the debate about appropriate stabilization
policy actions at a time of simultaneous inflation and high
unemployment.

Even economists who have spent much of their

careers arguing that monetary policy was not important,
and that especially the money supply was irrelevant, are
now advocating specific growth rates of money supply in
the present circumstances.

It appears safe to conclude

that we have established that "money matters" and all that
we are doing is haggling over the growth rates.
However, the role of interest rates remains very
much an issue among economists as well as in public discussions.
Let me state at the outset that I am one who finds it most




41

useful to gauge the stimulus or restraint emanating from
monetary policy actions by the growth rate of the money
supply.

There is substantial evidence, both in the U.S.

experience and around the world, that the level of market
interest rates can be a false indicator of the tightness
or ease of monetary policy.
Yet, in recent weeks, some members of the economics
profession have cited the rise in short-term market interest
rates as an indication of a move by the Fed towards "tight
money" even though there has been a pronounced acceleration
in the growth rate of money supply.

In a few moments I

will elaborate on my view that monetary policy actions should
not be viewed as a choice involving rapid money growth versus
high interest rates, nor slow money growth versus low interest rates.

But first I will direct my attention to the

relation between monetary policy and inflation, production,
and employment.
I draw your attention to Chart I.

One of the corner-

stone propositions of monetary analysis is that fluctuations
in the growth of the money stock around its underlying trend
result in fluctuations in output and employment, whereas
the trend growth of the money stock determines the trend
growth of prices.

A substantial body of empirical evidence

has demonstrated repeatedly that an acceleration in the
growth of the money stock initially will have an expansionary effect on output and employment, but, subsequently,
prices will begin to rise (over an extended period of time)




42

as the trend growth of money also rises.

The corollary

is that a contraction in the growth rate of the money stock
relative to its trend will result in a contraction in the
growth of output and employment.
The heavier line on the top tier of Chart I is the
growth rate of the money stock over a two-quarter or sixmonth interval, while the trend line is the average rate
of increase of money over a five-year period.

The second

tier shows the rate of increase of the GNP implicit price
deflator over a five-year period and the third tier shows
fluctuations in the growth of real output over two-quarter
periods.

The basic point is that fluctuations in money

growth around the underlying trend, as shown in the top
tier, are reflected in fluctuations in real output.

The

average rate of inflation reflects the trend growth of the
money stock.
The average growth in the money supply in recent
years has been around 6 percent.

The center of the Federal

Open Market Committee's target growth for Ml is also about
6 percent and, therefore, is a policy of returning to and
maintaining the prevailing trend growth of money over the
next year.

As long as that policy is continued, something

around a 5 to 6 percent average rate of inflation should
be expected.

In order to make progress towards further

reducing the rate of inflation, it will be necessary to
gradually reduce the trend growth rate of the money supply.
Ultimately, if we are to ever return to the rate of inflation




43

that prevailed on balance in the 1950s and early 1960s,
it will be necessary to reduce the trend growth of the narrow
definition of the money stock to only about 2 percent.
However, the immediate problem in pursuing that
objective is that there is still an unacceptably high rate
of unemployment in the economy, and there is every reason
to expect that the strengthening credit demands that will
occur as the recovery continues will produce upward pressure
on short-term market interest rates.

Because of this, there

are economists who advocate increasing the money stock twice
as rapidly as the announced targets of the Federal Reserve
(if necessary) in order to prevent increases in market interest
rates before a much lower rate of unemployment is achieved.
It is my view that if the Federal Reserve were to
allow the money supply to increase at a 10 to 12 percent
rate the balance of this year, in order to prevent interest
rate increases and to promote a higher level of employment
and capacity utilization, they would be left with a very
unpleasant dilemma next year.

The pursuit of "low interest

rate policies" would prove to be self-defeating.

At some

point the monetary authorities would be faced with two choices.
They could sustain those extremely high growth rates, but
that would raise the trend and cause quite high rates of
inflation.

Or they could produce a marked contraction in

the growth of money as we approached a higher level of resource
utilization which, in turn, would necessitate an economic
contraction.




44

In other words, if a low interest rate policy were
to result in double digit money growth for the balance of
this year, then we would be faced with either double digit
inflation or another credit crunch and major recession within
two to three years.

This paradox of low interest rate policies

resulting in high interest rates stems from the fact that
inflation and high market interest rates are both a product
of excessive monetary growth.
It is a myth that rapid money growth can maintain
low interest rates r except in the very short run.

The reason

Switzerland has low interest rates is because they have
had moderate money growth.

The reason Brazil has high interest

rates is because they have had rapid monetary growth.
Chart II shows the yield on high-quality corporate
bonds plotted along with the average rate of inflation over
a five-year period.

Most people accept the idea that the

level of long-term interest rates includes some "premium"
for the average rate of inflation that is expected to prevail over the life of the bond.

Lenders demand compensation

for the erosion in purchasing power that takes place when
there is inflation, and borrowers are willing to pay the
premium because they are aware they will pay off their debts
with "cheaper dollars."
The prevailing level of long-term bond yields reflects
expectations of about an average 5 to 6 percent rate of
inflation in the future.

There is no reason to expect long-

term interest rates to decline until there is reason to




45

believe that inflation will be less than the 5 to 6 percent
that seems to be the consensus view.

It is tempting to

seek a more rapid decline in long-term interest rates in
order to foster conditions conducive to increased private
investment and lower mortgage rates to stimulate housing
demand.

However, to the extent that investors pay attention

to the growth rate of the money supply in forming their
expectations about future inflation, policy actions by the
Federal Reserve that resulted in sharply higher growth rates
in the money supply would cause long-term interest rates
to rise, rather than fall.

This is because managers of

investment funds would attempt to avoid incurring a capital
loss that would occur when the price of long-term bonds
declined as the inflation premium in bond yields was revised
upwards.

The precautionary actions by investors in the

money and capital markets would thwart actions of the central
bank designed to aggressively push interest rates down.
Turning to short-term market interest rates, Chart
III shows the relation between the average rate of inflation
over six-month periods and the short-term commercial paper
rate. I think that the chart speaks for itself.

The way

to avoid a return to the level of short-term interest rates
that was reached in 1974 is to avoid the kind of acceleration
in inflation that occurred at that time.

This leads us

back to the role of monetary policy in avoiding another
inflationary outburst.

73-959 O - 76 - 4




46

It is useful to distinguish between inflation as
an ongoing process, and a change in the price of one or
more commodities or a one-time increase in the average level
of prices.

A continuous inflation is the result of aggregate

demand rising more rapidly than aggregate supply over a
prolonged period of time.

That development usually has

occurred as a result of the growth of the nation's money
supply being excessive so that we have a case of "too much
money chasing too few goods."
Some economists argue that the high rate of unemployment and low rate of capacity utilization indicates that
there is no danger of a spill-over of excess demand into
renewed inflation in the immediate future.

I disagree with

them on the grounds that the economically usable capacity
is smaller than the capacity utilization or potential GNP
data indicate.

Most people attribute a large share of the

economic problems of the past few years to the following
factors:

the major crop failures in 1972 and 1974, the

two devaluations of the dollar, the after-effects of wage
and price decontrol, the increased production costs associated
with devoting a greater proportion of our resources towards
cleaning up our environment, the production of safer products
and providing an improved environment for workers, and the
very pervasive effects of the quadrupling of the price of
petroleum energy. These forces resulted in a loss of wealth
and a decline in the real economic capacity in our economy
and a temporary bulge in the.rate of inflation.




I am suggesting

47

that the major initial forces contributing to the long and
deep recession were shocks to the supply side of the economy
that left us with both a higher level of prices and a lower
real output potential.

Consequently, the dangers of reigniting

inflationary pressures are much greater than conventional
measures of economic capacity might suggest.
There is no doubt in my mind that if the growth
in the money supply does not exceed the mid-points of the
target ranges announced by the Federal Reserve, a healthy,
durable economic recovery will continue and renewed
pressures will be avoided.

inflationary

However, as a natural cyclical

phenomenon, short-term market interest rates will rise as
strengthening private sector credit demands compete with
government borrowing.

But it would be a mistake to interpret

the rising short-term interest rates as a sign of restrictive
monetary policy at a time when the quantity of money is
also increasing at a historically high trend rate.
The alternative to a natural rise of short-term
interest rates of as much as 2 or 3 percentage points over
the next year is not to simply hold them down through more
rapid monetary growth.

The alternative is to artificially

suppress the level of short-term interest rates during 1976
through excessively easy policies, and then pay the price
in 1977 and 1978 in terms of even higher interest rates
and eventually another credit crunch and recession.




48

Congressional Oversight of Monetary Policy
I believe that Concurrent Resolution 133 has made
a desirable contribution to the monetary policy process.
However, I also believe that former Congressman and Speaker
of the House, Sam Rayburn, was correct in warning of the
dangers of excessive Congressional involvement in the formulation and implementation of monetary policy actions.
I would think that one of the primary roles of Congressional oversight of the Federal Reserve would be to maintain the
checks and balances that have been a central ingredient
of our entire system of government and were very much a
part of the Congressional deliberations that created the
Federal Reserve over sixty years ago.

Our independent and

decentralized system of Reserve Banks has served us very
well, and the safeguards against potential abuse of power
to create money must be preserved.

>

It seems that Congress would want to scrutinize
actions of the Federal Reserve to insure that monetary policy
actions are not used to achieve short-term political gain.
I would not want to see members of the Federal Open Market
Committee adopt policies designed to achieve political objectives either of their own choosing or as a result of
pressure from the executive branch, the legislative branch
of government, or other political groups.
Regarding the setting of economic goals, I think
that the Federal Reserve should promote conditions conducive
to full employment, minimum inflation, and low interest




49
10

rates.

And I think that every member of the Federal Open

Market Committee and every professional economist, as well
as the general public, would agree.

But disagreement would

arise over the weighting to be assigned to each objective
in the near term, and the time frame in which the goals
are to be pursued, as well as the tools and techniques that
are to be employed.
There is a risk of asking more of monetary policy
than it can deliver.

I believe that a market-oriented economic

system is naturally resilient and inherently stable at a
high rate of capacity utilization, including full employment
of labor.

But the system is frequently subject to destabi-

lizing shocks, sometimes from monetary and fiscal policy
actions and sometimes from uncontrollable natural forces.
We can and should ask that monetary policy not be
destabilizing, but should the monetary authorities be asked
to try to correct the mistakes made in the implementation
of fiscal policy?

When the economy is subject to the dis-

ruptive effects of unsound financial policies of a major
city or state government, should monetary policy be used
to try to offset these effects?

Should we try to counter

the adverse real economic effects of social policies, such
as

cleaning up the environment and providing safer products

and safer working conditions by monetary policy actions?
Should monetary policy be used to try to offset the wealth
loss associated with a quadrupling of oil prices or failure
of the wheat crop?




50
li

I do not believe any of these efforts would be successful, even if they were desirable.

I think it is possible

to avoid destabilizing actions, and certainly the central
bank should be held accountable for any actions that contribute
to a worse situation.

And I do believe that in the past

monetary policies have resulted in worse recessions and
worse inflation than would otherwise have occurred.

Congres-

sional oversight can insure that monetary policy actions
are designed to promote stable monetary conditions and to
minimize the uncertainty in financial markets in order that
the real economy can adjust most easily and rapidly to its
natural full employment, stable price condition.
It is my hope that Congressional scrutiny of monetary
policy actions will prevent the erratic accelerations and
decelerations in monetary growth that have occurred through
most of our history.

I think that Concurrent Resolution

133 will contribute towards that objective.
I would like to make a suggestion that I think would
help Congress to oversee achievement of money supply growth
targets.

The growth rates for the money supply announced

by the Federal Reserve should be used to set the upper and
lower levels for the stock of money that the FOMC thought
appropriate in the one-year-ahead quarter.

Once the upper

and lower levels for the aggregates are set for a quarter,
they would remain in effect unless specifically changed.
As each quarter passed, the shifting base would be used
only to establish the upper and lower bounds for the money




51
12
stock in the quarter one-year ahead.

But the target levels

for the intervening quarters would not be affected.

It

would be desirable to use narrower target growth ranges
than the 2-1/2 to 3 percentage points that the Fed has been
using in the past year.

Otherwise, if money moved from

the lower limit in one quarter to the upper limit in the
subsequent quarter, (and the reverse) as each successive
quarter passed, a very high variance in the growth rate
of money would occur.
The approach I propose in interpreting the Fed's
long-run money supply growth targets would prove most useful
in dampening fluctuations in money growth if a single target
growth rate were announced for each measure of the money
supply or if a very narrow growth range, such as one percentage point, were used.

In analyzing the procedures for

setting money growth targets, it must be kept in mind that
two objectives are being pursued.

One is to bring about

a lowering in the trend growth of the money supply in order
to reduce the average rate of inflation in the economy.
The second is to minimize fluctuations in money growth around
the underlying trend in order to minimize any adverse impact
on output and employment.




52
Chart I
Trends and Fluctuations of Money, Prices, Output, and Unemployment
1952 1953 1954

1955 1956

1957

1958 1959 1940

19*1 1962 1963

1964

1965

1966

1967 1961 1969 1970 1971

1972

1973

1974

1975 1976 1V77

195? 1953 1954 1955 1956 1957 1958 1959 I960 1961 1962 1963 1964 1965 1966 196/ 1961 1969 1970 1971 1972 1973 1974 1975 19)6 1977
The shaded areas represent periods of business recessions as defined by the National Bureau of Economic Research.
* A 'mini-recession' occurred in 1/1967.
Catest data plotted: 1st quarter.
^ ^
PITTSBURGH NRTIONOL BONK







Chart II
Inflation and Interest Rates

Percent
12

Percent
12

A
/
Corporate Aaa Bonds

j

«^—

/

y

/

********

»—-"- -

/

Rate of Inflation U
_

1961

1962

1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975 1976

[1_Rates of change in consumer prices over the previous five years.
Latest data plotted: Aaa-May preliminary; Inflation-April
yST

PITTSBURGH NATIONAL BANK

Or

54
Chart I I I
Inflation and Short-Term Interest Rates
Percent
13

Percent
13

tk

12

12
i

11

n

10

HZ

Prlnu Commer clal
Paper Rate 1

v

V\ i

8

/

7

v

10

i
i
i
i

9
\

8

\

J
6

K
\

11

i
i

\

m l /

9

1

\I

A

5

J

A

7

\\r\

j
/

4

L

i
i

4

r\\f

3

Rate of Inflatior

2

2

1

1969

1970

1971

1972

1973

1974

1975

1976

H.Yield on 4- to 6-Month Prime Commercial Paper.
12. Rates of change in consumer prices over the previous six months.
Latest data plotted:




5

/

r

3

6

C Rate- M y preliminary
P
a
Inflation- April

PITTSBURGH NflTIONRL BONK

55
Mr. NEAL. Thank you very much. Now we will hear from Mr.
Meiselman.
STATEMENT OF DAVID I. MEISELMAN, PROFESSOR OF ECONOMICS,
VIRGINIA POLYTECHNIC INSTITUTE AND STATE UNIVERSITY
My name is David Meiselman, and I am a professor of economics at
Virginia Polytechnic Institute and State University where I am also
director of its new Northern Virginia graduate program in economics
located in Reston, Va. I am also a consultant to Bache Halsey Stuart,
Inc. The views I express today are my own.
I have devoted most of my professional career to the study of money
and its relationship to economic and financial conditions. I appreciate
the opportunity to appear before the Subcommittee on Domestic
Monetary Policy of the House Committee on Banking, Currency and
Housing to present my views on the important questions you are
examining in these hearings on monetary policy and the economy.
The Congress, and especially this subcommittee and its counterpart
on the Senate side, has unique responsibilities in guiding and monitoring the conduct of monetary policy because of the constitutional
provision that "The Congress shall have the power to coin money and
regulate the value thereof."
The Congress created the Federal Reserve and delegated to it
vast powers to control the Nation's money supply and thereby the
value of money. The Federal Reserve was given a large measure of
independence, but the independence of the Federal Reserve is to be
interpreted only in the sense that under the law the Federal Reserve
is independent of the executive branch of the Government, but not
the legislative branch. The Fed is a creature of Congress and reports
to the Congress. In that sense, the Federal Reserve is different from
most agencies of Federal Government which are involved in making
and carrying out public policy, especially where economic policy is
concerned. To fulfill its constitutional responsibilities, the Congress
must exercise close and continuing oversight of the Federal Reserve,
and these hearings are a most welcome part of the process.
Although the past record of Congress in monitoring the actions of
the Federal Reserve has not been a good one, in the past several years
there has been heightened awareness of the importance of monetary
policy and of the unique role of Congress in the conduct of monetary
policy. One result was the passage, in 1975, of House Concurrent
Resolution 133 requiring that the Federal Reserve report to Congress
on its intended targets for money change.
The resolution has facilitated systematic congressional oversight of
monetary policy which has contributed significantly in turning the
economy around in the past year during which we have seen a progressive decline in the pace of inflation at the same time that the unemployment rate has been falling, a happy combination of events many
economists, excluding some on this panel, hardly believed possible.
I therefore support H.R. 12934 which makes the concurrent resolution
a permanent part of the law.
Before commenting on the specific questions which have been put
before this panel, I wish to make one general observation about the
role of monetary policy. The best attainable goal of monetary policy
is to avoid the problems caused by poor monetary policy. The best




56
attainable monetary policy does not produce goods and services,
employ willing workers, promote efficiency or generate economic growth
and progress, but poor monetary policy can, and has disrupted and
destroyed both freedom and plenty in country after country. Belief
that monetary policy can either offset or paper over the consequences
of poor public policies which create unemployment by reducing incentives to work or to employ labor, or which discourage economic
growth by imposing differentially high taxes on saving and investment, has been a major factor in the inflationary bias of monetary policy over the past decade, the consequences of which have been
both more unemployment and less economic growth and progess
than would have been the case had we continued the moderate and
steady policies of the early 1960's during the Kennedy administration.
Appropriate Federal Reserve policy can eliminate the scourge of
inflation and attain the desirable goal of stable prices. In turn, stable
prices will increase employment, speed growth and lower interest
rates, but stable prices or the best possible monetary policy cannot
solve all our problems. I know of no informed or responsible student
of monetary affairs who asserts that money matters, that monetary
policy is important, who has ever claimed otherwise.
By contrast, inflationary monetary policy can only temporarily
reduce interest rates or increase employment but at the later costs of
higher interest rates, more unemployment and less growth than before
the hyp. Repeated experience with excessive monetary expansion has
taught enough people about its effects that these lags have become
shorter and shorter. In some instances, there is no lag at all, and
financial markets adjust almost instantaneously to the latest information and statistics of Federal Reserve actions.
The Fed has announced that it intends to achieve stable prices by
gradually slowing the rate of monetary expansion. The Congress
would do well to monitor and to support this wise and attainable
policy.
I turn now to the specific questions of this set of hearings. Monetary
policy is the single most important factor determining the average
level of all prices, the cost of living. Monetary policy is mainly concerned with the quantity of money. The Federal Reserve controls
the money supply and could do so more effectively if it also did not
attempt to control other things at the same time, such as short-term
interest rates. The relationship of money to prices, especially longperiod or secular changes in prices, is perhaps the single most tested
and validated proposition in all of economics, covering a wider range
of economic experience in time, place and circumstances than any
other, and with essentially the same results.
Prices depend on a ratio of money to output. The rule is that prices
rise when money grows faster than output, prices fall when money
declines relative to output, and prices tend to stable when money
grows at the same pace as output. I know of no important exception
to these rules in at least the past 400 years of recorded history.
Because it is generally easier to change the quantity of money than it
is to alter output, the quantity of money rather than the volume of
output tends to dominate price movements. Recent experience both
in the United States and around the world is consistent with these
historic norms. There is no basis at all for recent contentions that, at




57
least for this area, the old laws of economics no longer work. Indeed,
over the past 15 years the connections between money and prices
have been closer than tended to be the case in the past. Chart 1
shows the close connection, since I960,,between the U.S. Consumer
Price Index and the ratio of money to output using the broad M2
measure of money.
.>•-•
CHART 1
United States
Money and Prices, 1960-1975
Index numbers
(1965=100)

'

/ ' • • • • • • • . ] • : • . .

: •

• .

:

: - :

:

: ; : .

:

i :

....

Key:

M 2 /real GKP

.I

CPI

100-

~T

1
1970

71

There is another way of looking at the same phenomena. There is a
close connection between the quantity of money and nominal GNP.
This is true for both the narrow Mx measure of money, currency and
demand deposits, and M2, the broader measure of money, currency
and all bank deposits less large Certificates of Deposit. Chart 2 shows
the close connections between M2 and GNP since 1960. Income
velocity, the ratio of GNP to the M2 measure of money, has been
essentially constant for M2 since at least 1960. There has also been a
close connection between Mx and GNP over the same period, except
that there has been an upward drift in the ratio of GNP to Mi. It
has been rising at the rate of approximately 2.7 percent per year
for Mu typically rising faster than trend during business cycle expansions and slower than trend during business cycle declines. (See
chart 3.)
In the past year the behavior of monetary velocity has conformed
to these historic norms, M2 velocity remaining constant, Mx velocity
rising above its 2.7 percent trend increase.




58
Nominal GNP depends on the nominal stock of money, but nominal
GNP has two component parts, the one is the volume of output, real
GNP, and the other is the prices of goods and services measured by the
GNP deflator or some other price index. This is the reason that for
given nominal GNP, the higher output, the lower prices, and vice
versa. Because nominal GNP is essentially fixed by nominal money,
it is equivalent to stating that prices depend on the ratio of money to
output.
CHART 2
United States
Index Numbers of Honey (NL)
c
and GNP, 1960-1975
(1965 = 100)

G. .P.
?00-

• 73
100-

•72
160-

•71
©70

140-

68

100-

r 65
.•".'

ao-

%64

.•62'

• 61
• 60 .
•:::«::•!••:::•:•

6000




100

120

110

1G0

100

200 H,

59
220
•75

210-

" *. • :
•••

i :"-::

•

CHART 3
United States
Index Numbers of Money (M,)
and GHP, 1960-1975
'

200-

•74

(1965=100)
190-

*

-73

•
180-

•

.

.

•

170-

<72

160*
•71
. . . .

150-

•70 ^
140••69
:

-

130-

•

•68
120• 67110-

•66

100-

.

»65

':

.

'

• 64

90-

. *

• 63

•

*

•C2

80-

•6i

' '

•

''•

:

' . • . . •
.

.

'

:

:

.

'

60
7000

1

90

1

loo




1

no

1

»

130

\

MO

150

\

1GO

r

170

K

>

60

For a given stock of money, which fixes nominal GNP, an increase
in spending for one class of goods means that there must be a decrease
in the spending for other goods. Thus, for given money, an increase
in Government expenditures tends to be at the expense of a decrease
in private expenditures. The public sector crowds out the private
sector. Alternatively, a decrease in Government expenditures, given
the quantity of money, generally makes it possible for the private
sector to expand. If more Government expenditures are financed
by an increase in the public debt, the resulting higher interest rates
bear most heavily on expenditures most sensitive to interest rates
such as housing. Government crowds out housing. If Government
expenditures are financed by higher taxes, the specific results are
more difficult to generalize because different taxes have different
effects. In any event, when allowance is made for the quantity of
money, the short-run stabilization impact of changes in fiscal policy,
that is variations in the size of the budget or in the schedules of tax
rates have been either minor or absent. Moreover, I know of no country
which has brought inflation under control by means of fiscal policy
alone, that is, without correspondingly limiting the stock of money.
Indeed, many countries have tried, but as far as I know, none has
succeeded.
Taxes and expenditures should be determined by considerations
of long-run efficiency and equity. I see no useful purpose in varying
tax rates or expenditures to achieve hoped-for stabilization results,
especially in the face of overwhelming evidence of the ineffectiveness
of fiscal policy, especially of the fine-tuning variety. To vary the old
saw, if money policy is properly used, fiscal policy is unnecessary.
If money policy is not properly used, fiscal policy won't do any good.
I briefly turn to the question of interest rates and the relationship
of interest rates to monetary policy. Although there is growing
understanding of the connections between money and interest rates,
there is still widespread confusion between money and credit and
between cause and effect. Market interest rates have two components,
the real rate of interest and the inflation premium, the expected rate
of change of prices. It turns out that an expansionary monetary policy
tends to drive up market interest rates, not lower them, and a contractionary policy tends to lower market rates, not raise them. The
main reason is that more money leads to more spending. In turn, more
spending means higher output or higher prices, or some combination
of the two. If the increase in aggregate spending increases only output
and employment, business becomes more profitable. The productivity
of capital rises, inducing more borrowing, which pushes up real interest
rates. On the other hand, if the increase in aggregate spending merely
drives up prices, interest rates rise to incorporate the inflation,
especially as people come to anticipate more future inflation. Concerning both effects, expansionary monetary policy leads to higher
interest rates as in recent years, contractionary monetary policy
causes lower interest rates, as in the great depression of the 1930;s.
In other words, easy money leads to tight credit. Tight money leads
to easy credit. I have done extensive statistical and theoretical studies
of these relationships and will submit some of them for the record.
I understand that at yesterday's hearing there was some support
expressed by Congressman Adams for a policy that would require




61
that the Federal Reserve peg the Treasury bill rate at b% percent,
partly to hold interest costs of the public debt within budget totals.
This policy is certain to lead to disaster, either of cumulative and
explosive inflation, or cumulative and implosive deflation. If free
market interest rates are above 5% percent, the Federal Reserve
can initially force them down to 5% percent by creating additional
Federal Reserve credit and thereby additional bank reserves to bid
up bill prices (bid down bill yields). But once the new money was
out in the economy, following the mechanism I have just summarized,
the increased quantity of money would cause both more inflation and
still higher interest rates than before the attempt to lower rates.
The longer the Federal Reserve tried to maintain the artificially low
rate, the more inflation and the higher interest rates would go.
If free market rates were less than b% percent, trying to force rates
up or keep them up would require cumulative decreases in money,
and a corresponding downward spiral of prices and interest rates.
In the process, output and employment would also suffer.
I turn finally to the relationships between money and employment.
It is important to distinguish the initial from the later impacts of
monetary change. When there is an increase in the stock money which
correspondingly causes an increase in aggregate spending, in many
markets the first impact is seen in an initial set of events that includes
increased sales and rising output and employment before later changes
in prices. In other words, there are quantity adjustments before price
adjustments. Thus, as in 1972, expansionary monetary policy leads
first to the good results of increased output and employment before
the later bad results of higher prices, whereas monetary restraint
may, as in 1974 and 1975, lead to the bad results of reduced output
and employment before the later good results of moderating inflation,
as in 1976. This asymmetry has been one of the major sources of
widespread myopia about the inflation process and of the inflationary
bias of public policy.
I may add that I see no evidence for the contention, usually labeled
the Phillips Curve, that inflation is not only helpful, but necessary,
to achieve and maintain high levels of employment 1and growth.
(See chart 4.) Indeed, I have recently argued elsewhere that, on the
contrary, more inflation leads to more unemployment. The initial
burst of inflation may temporarily reduce unemployment in the first
instance if it comes as a surprise because product or output prices
rise relative to labor costs, thereby inducing an increase in the demand
for labor. If inflation continues, the entire economy, including all
wages and prices, adjusts to the ongoing inflation. Because there are
no permanent surprises, there are no permanent employment gains.
I suppose I could quote Abraham Lincoln at this point.
To affect output and employment, inflation must be unanticipated.
For public policy to use inflation to make employment and output
different from what it would otherwise be means that public policy
must be directed at fooling people—which is hardly a proper or effective basis for public policy in the first place. But as time goes on,
it becomes progressively more difficult to fool people. This is why
this kind of policy leads to greater and greater instability, heaped on
top of more and more inflation. In the stop-go policies, the "stops"
and "go's" inevitably become more pronounced.
1
David Meiselman, "More Inflation: More Unemployment," Tax Review (Tax Foundation, January 1976).

73-959 O - 76 - 5




62
Chart4: The Inflation Rate and the Unemployment Rate, 1048-197S
Inflation f late
(Porccrit por Year)

12

10

0

1V /
\

6

I \^ \ \

\

4
\

/

u

O 72

\
2

S

\|

\\
/

-

.

A

V

—

49O

-

f
0

1
2

(

1

1

4
Unomplo/mont Rato

1
6

1
8

fewer Drptrtnwnt of l*U>r. 6wttmj o» L*bo« Sutulic*

Trying to fool participants in one area of the economy by the use
of policies affecting the entire economy leads to a vast widening of
the range of uncertainty about future events, which undermines the




63

efficiency of intertemporal decisionmaking involving saving, investment, a,sset management, and the like. It also effectively destroys
economic information essential to the efficient operation of the
economy.
The price system which characterizes the market economy is a very
efficient means for conveying large amounts of information. One of the
characteristics of variable and unanticipated inflation is that people
effectively have less information about current prices and markets.
Individuals and business firms tend to learn about prices and markets
in a sequential manner. As they keep receiving new information, old
information is revised or discarded.
Large-scale unanticipated inflation impairs the orderly learning
and adjustment process. The loss of information can be overcome by
devoting more resources to data gathering, updating price lists and
the like. Doing so uses time and resources, and is costly. Information
and search costs rise, which alone cause an increase in unemployment,
a decrease in efficiency, and a deadweight loss to the economy. One
manifestation of how inflation destroys information is that ordinary
accounting statements mean less and less as the inflation process
proceeds.
The increased uncertainty and lack of information about future
events weakens the basis for rational and efficient decisionmaking and
economic activity. It becomes more difficult, and in many respects
impossible, to plan for the future including making provisions to
accumulate real resources for retirement, for sending children to
college, for contingencies and for all the other reasons people wish
to save so they can attain and depend on future real income and real
wealth. For the same reasons, even highly skilled financial managers
cannot plan efficiently, business managers have less firm bases for
making judgments about future products, labor and materials markets
and capital outlays—partly because the effects of inflation are not
uniform.
Unfortunately, there is no effective way to hedge against inflation,
to insure against its consequences, or to make contracts in units of
stable purchasing power.
Thus, the continued process of variable, unanticipated inflation
does not increase employment. Rather, it has a cumulative and negative impact on efficiency and on resource allocation. Returns to both
labor and capital suffer. This, taken together with the distortions of
the inflation process, impairs the flexibility of markets and thereby
causes an increase in unemployment. And, when rising unemployment
has called forth public policies that lead to still more inflation, the
unemployment rate ends up still higher, even though there may be
some initial and temporary improvement.
These are some of the reasons it is essential to abandon the deliberate
use of inflation as an instrument of public policy, even for short periods
of time. To avoid abrupt shocks to the economy, the inflation should
be slowed gradually and eliminated over a 3- to 5-year period. The
maintenance of general price stability will require steady, noninflationary courses for monetary and for fiscal policies. For monetary
policy this means a long-term growth of money in the range of 2
percent to 4 percent per year for M1 or 4.5 percent to 6.5 percent for
M 2 ; for fiscal policy, relatively stable taxes and expenditures close
to or at a balanced budget.




64

In the past year, Federal Reserve policy has been consistent with
these goals and targets. The Congress would make a great contribution
to the Nation's welfare if it continued its close and informed oversight of Fed activities to help achieve the attainable goal of price
level stability.
Thank you.
Mr. NEAL. Thank you for your testimony. Just one question.
How did you arrive at that goal?
Mr. MEISELMAN. TWO to 4 percent?
Mr. NEAL. Right.
Mr. MEISELMAN. I explained that in detail before this subcommittee a year and a half ago. First, long-term economic growth of the
United States has been in the range of 3.5 to 4.5 percent per year.
Second, the Consumer Price Index is generally acknowledged to
have an upward bias in the range of 1.5 to 2 percent. Because of
quality improvements and related technological factors not adjusted
for in the statistical construction of the index, consumers have just
about as much purchasing power for each one of their dollars when
the official index is increasing in the 1.5- to 2-percent range.
This was generally the situation that prevailed in the first half of
the 1960's. Third, on the other side, the income velocity of Mx, the
ratio of gross national product to Mi, has been drifting up at about
2.5 percent per year. For M2, the ratio of gross national product to
M2 has been essentially constant since at least 1960. Taken together,
we get a range of 2 to 4 percent for Mx, and 4.5 to 6.5 percent for M2.
(A study submitted by Professor Meiselman appears on page 67.)
Mr. NEAL. NOW we will hear testimony from Mr. Perry.
STATEMENT OP GEORGE PERRY, SENIOR PELLOW, BROOKINGS
INSTITUTION
Mr. PERRY. It is a pleasure and a privilege to testify before this
subcommittee today on the important issue of monetary policy and
the economy. You raised several specific questions that you were
interested in, and my answers to these questions will be very brief.
I shall, of course, be happy to expand on them or on any other questions you may have.
Questions 1 and 2: How Monetary Policy Affects the Cost of Living,
Production and Employment.
I have grouped the first two questions into one because they are
best answered together. Monetary policy is a potent instrument for
affecting the level of aggregate demand in the economy. Its impact
on the economy is transmitted through interest rates and falls most
heavily on private demands that depend heavily on borrowing, such
as the demand for autos, business investment, and housing.
It also influences other spending by affecting equity prices and
hence consumer wealth and possibly consumer sentiment.
The effect of monetary policy on prices, production and employment follows from its effect on total demand. But how any change
in total demand is divided between a change in prices, on the one
hand, and a change in production and employment, on the other,
basically has nothing to do with monetary policy.
It is determined by a great many other things, such as how tight
labor and product markets are and what expectations about inflation
are. Our understanding of this inflation process is far from perfect.




65
But the evidence is clear that, how a given GNP growth is
achieved—whether the spur is a push from fiscal policy, a rise in
demand from abroad for our exports, a consumer love affair with the
automobile models, or a lift from monetary policy—the consequences
for inflation and production are generally the same.
There is simply no evidence of what I call the X-ray theory of
monetary policy whereby it affects the price level directly without
affecting the real economy along the way.
Next your question 3: How Interest Rates are Affected by Money
Supply Changes.
Basically interest rates bring the demand for money in line with
the supply. If either real output or prices rise, the demand for money
will rise. If the supply of money is not increased enough to meet this
higher demand, interest rates will be driven up. Then this will
restore the balance between demand and supply in two ways: First
by causing individuals and businesses to hold less of their liquid assets
as money and more of their assets in some interest bearing form; and
second, by curtailing the demand for goods in the economy and thus
curtailing the rise in GNP.
To the extent that a rise in prices enters expectations about future
inflation rates, it enters the picture in a second way; by raising the
level of interest rates that is associated with any given level of real
output in the economy.
Your question 4: How Government spending and tax policies
enter the picture.
Government spending and tax policies taken together constitute
fiscal policy, which is the other arm of Government stabilization
policy. Changes in fiscal policy influence aggregate demand just as
changes in monetary policy do. The two can substitute for each other
or can complement each other at any particular time.
And just as with monetary policy, how a given increase in aggregate
demand divides up between higher prices and higher production does
not depend on whether that rise in demand prices arises from fiscal
policy or from some other source.
Your question 5: Should Congress set economic targets?
Particularly at a time when we face both high unemployment and
inflation, and the goal of policy is to reduce both, the conduct of
stabilization policy is difficult because measures affecting demand
can only promote the achievement of one goal at the expense of the
other. It seems entirely proper for the Congress to again set priorities
between these goals and to ask that the Fed respect those priorities.
However, the Fed cannot solve the dilemma that is posed by conflicting goals. Nor can it necessarily pursue economic targets while
constrained to follow some particular path for the money supply.
Nobody knows, with any useful degree of accuracy, what growth
in the money supply would be needed to achieve a particular growth
rate of GNP over the coming year. However, it seems reasonable to
ask the Fed to aim for some agreed upon targets for the economy,
as opposed to targets for money supply, and to explain any policy
moves that do not contribute to hitting that target.
Thank you. Would you like us to comment on your chart at this
time?




66

Mr. NEAL. I would. I want to thank you all for your excellent,
thoughtful testimony. It will be a great help to us. Mr. Meiselman,
you mentioned some statistical work you have done and offered to
submit that for the record. I think that would be most helpful. The
work you mentioned concerns the long-term relationships between
money supply and inflation.
Mr. MEISELMAN. The connections between inflation and interest
rates and also the connections between changes in the stocks of
money and changes in inflation, on the one hand, and changes in
interest rates, on the other.
Mr. NEAL. The subcommittee would appreciate copies of that
work, and without objection I request that it be inserted in the
record at this point.
[The material submitted for the record by Mr. Meiselman follows:]




67
MONEY, FACTOR PORPORTIONS, AND
REAL INTEREST RATES*
David I. Meiselman
Virginia Polytechnic Institute and State University
Res ton, Virginia

Introduction
I shall argue that an increase in the quantity of money when
an economy is not fully employed leads to an increase in the real
rate of interest in theory as well as in fact.

I shall also argue

that attempts to raise rates of interest by means of monetary restriction will cause interest rates to fall.

The theory is generated

by an old friend, the Law of Variable Proportions.

The facts have

been generated by much sad experience.
The apparatus invented by J.R. Hicks in his famous article,
"Mr. Keynes and the Classics," has become standard equipment
for economists for the analysis of a wide range of macro phenomena.
As pure apparatus, the Hicksian constructs of the LM and the IS
curves are generally taken to be devoid of empirical content.

Of

course, some cases are ruled out on the basis of stability considerations.

Unstable situations, while possible, are not sufficiently

characteristic of free markets, and because markets ordinarily do not
behave as if they are unstable, we separate the formal conditions which
are consistent with this observed behavior in free markets from those
which are not.
Presented at the Zurich Meetings of the Econometric Society, September
10, 1964. Preliminary versions were presented at the Johns Hopkins University,
the University of Chicago, Northwestern U., the University of Minnesota,
and Columbia.




68
It is in this spirit that many students of macro phenomena have
tended to postulate that the slope of the Hicksian IS curve typically
has a negative slope, but may in principle range between zero and o o .
Thus, given conditions of less than full employment, the standard
analysis would assert that a shift to the right of the LM curve, an increase
in the stock of money, moves along the negatively sloped IS curve so that
at the new equilibrium we will have higher income and lower interest
rates, provided, of course, that there is no "liquidity trap" and that
either investment and/or saving have non-zero interest elasticities.
This is to say that the LM curve is not infinitely elastic and the IS
curve is not perfectly inelastic with respect to the rate of interest.
Also, a shift to the right of the IS curve, a "real" disturbance, will
lead to both higher income and interest rates as we move along the
positively sloped LM curve, and vice versa for a downward shift of the
IS curve.

This, in brief, is "traditional" post-Keynesian theory.

The facts of cyclical change appear to be that the chang€'.s in the stock
of money lead business cycle turning points.

On the other hand, interest

rates, and also private investment spending, are generally synchronous with
the cycle, but with some tendency to lag behind business cycle turns.

The

facts do not appear to square with traditional theory.
Moreover, if, indeed, money is the principal determinant of business
cycles, why do we observe that interest rates appear to end up at higher
rather than lower levels after a monetary expansion, and vice versa for a
monetary contraction?




69
One approach to this problem has been to emphasize the role of price
expectations in the determination of market yields on fixed nominal value
obligations,

but these considerations have little bearing on real rates of

return or on short period changes over the cycle.

In addition, interest

rates in money terms, and often in ex post real terms too, end up at higher
rather than lower levels after monetary expansions which start at periods of
less than full employment, with the opposite change for a monetary contraction .
These facts in the context of the standard analysis have been used to
try to distinguish between monetary and real sources of cyclical change—
which is to say, whether the LM or the IS curve has shifted.

The procedure

follows the familiar lines of examining price and quantity data to identify
whether the observed change in price stems from a shift of supply or of
2
demand.
The identification process appears to suggest several paradoxes,
both for those who maintain that shifts of the LM curve generally arising
from changes in the stock of money are the source of cyclical change and
for those who assert that changes in "real" factors summed up in the IS
curve, especially investment spending, dominated the cycle.
"Monetarists" can, and do, point to the cyclical lead of money and the

1.
2.

See D. Meiselman, "Bond Yields and the Price Level: The Gibson Paradox
Regained," in Banking and Monetary Studies in Commemoration of the
Centennial of the National Banking System, ed. D. Carson (1963).
For example, see J.L. Stein, "A Method of Identifying Disturbances
which Produce Changes in Money National Income, " IPE , February 1960.




70
general conformity of the magnitude of monetary change and income change
as supporting their case.

They also cite the lag of investment and perhaps

the lack of a statistically dependable link between investment and income
as weakening the case of the "realists."

"Monetarists" may also argue

that the lag of investment behind money is also indicative of the direction
of effect.
Yet, if monetary change is the principal contributor to cyclical change,
why are interest rates high in boom times and low in depressions?

The

"realists" have no problem here because they easily explain the cyclical
association of income and interest rates as stemming from the same source,
the shift in investment.

However, "realists" may also be in trouble because

of the cyclical lead of money and the occasional lag of investment.

Although

many "realists" assert that changes in interest rates cause corresponding
changes in the money supply, they cannot explain the cyclical lead of
money over both interest rates and income.
The purpose of this paper is to show that the usual assumptions regarding the IS curve in the standard analysis are unnecessarily restrictive
and may lead to analytically erroneous results, such as the requirement
3
that the IS curve have a negative slope for stable general equilibrium.
3.

There are other problems with the apparatus which are beyond the current
scope of this paper, among them the lack of distinction between real and
nominal interest rates, the specification of equilibrium especially with
respect to "time," and the implied requirement that an initial change in
the money supply shifts the LM curve which moves along the given IS
curve. This is a formal way of stating that only the "bond" market is
used to adjust actual to desired cash. If money shares a margin with
goods, a shift of the LM curve may cause a short-run shift of the IS
curve in the same direction. In other words, disequilibrium on money(cont'd)




71
First, I shall examine the formal conditions for a positively sloped IS
curve, and I shall show that these are consistent with the range of plausible
assumptions regarding the values of the parameters determining the slope of
the IS curve.

The paper will go on to suggest how the facts of cyclical

change cited above can be rationalized in the context of elements of a
theory of business fluctuations which follow from this critique.

The theory

also suggests processes—in some respects strikingly similar to Wesley
Mitchell's—by means of which monetary change may lead to important
changes in real variables which are often held constant in the standard
analysis.
The Slope of the IS and LM Curves
Consider the Hicks model presented in "Mr. Keynes and the Classics"
for the joint determination of income and the rate of interest.
I = I(r,Y)
S =S(Y,r)
L =L(Y,r)
where I, S, and L are desired or ex ante investment spending, saving
(current income not spent for consumer goods), and the quantity of money
demanded, respectively.

Y is current real income or output and r is the

rate of interest.
3.

account ought to be arguments in the short-run consumption and
investment spending functions. In addition, the LM and IS curves
may not be independent. For a given IS curve, a shift in the LM curve, by
causing income to change in this period may lead to a shift of the IS curve
in the same direction, which may be another way of discussing a positively
sloped IS curve. However, for purposes of this paper let us wear Hicks' hat.




72
General equilibrium requires that
I

=

S •

and
L =M
where M is the stock of money.

To avoid complications not directly

pertinent to this discussion, assume static expectations with respect to
prices.

The more general analysis requires real rates of return in the

goods equations and money rates of interest incorporating price level
expectations in the money equations.
The LM curve is defined as the locus of points of alternative
combinations of Y and r where L = M, and the IS curve is similarly
defined for I = S.

(The schedules are usually drawn for Y on the

horizontal axis and r on the vertical axis.)

The simultaneous clearing

of both "goods" and "money" markets is at the point of Intersection of
the two curves, and this point shows the equilibrium values of r and Y
for the system.
Consider first the slope of the LM curve, dr . Each point on the
dY
schedule is defined so that L = M. If L = M, dL = dM.
Also,
dL = dL dr + <3 L dY
and
dM =

^
O M dr + ^

M dY, the least restric-

tive formal assumptions about M in the present context.




Therefore,

73
Solving for

dr
dY

when all variables are functions of r and Y we have

^

d M

-

dr
dY

^

By hypothesis

M

_ .^ L

and

M --> 0
O
d
so that the denominator is

<=, 0.

Because it is usually assumed that

O
O

L

the denominator becomes <^ 0.
In the numerator, by hypothesis,
~*d M

=

0

^
^ Y
and o Y ' ^ n
L
~£)
making the numerator also <C^0With both numerator and denominator<Co,

dr
for the LM curve becomes
dY
varying directly with the income and inversely with the

^ > 0, with

dr
dY
interest elasticity of the demand for money.

Similarly, the slope of the IS curve can also be determined.
on the IS schedule is defined so that I = S, or dS = dl.
Now

and

JC

_

O S

dl =
Solving for




7) Y
dr
dY

dY.

as above, we have

Each point

74
s_
^>Y

dr
dY

^)r

Regarding the terms in the denominator, by hypothesis
Q I <^0~~()

The sum in denominator must be

^>

3 S ^ > 0 and

0 as a formal matter,

r

but let us rule out the zero value, the popularity of the extreme Keynesian variant
of Stigler's Law notwithstanding, making the denominator ^?> 0
under the usual assumptions.

A clear case for the sign of the expression in

the numerator cannot be made, even though many economists have
erroneously done so.

By hypothesis,

greater than or equal to 0.

c) I

7) Y

and

CL_S_

"2) Y

are

both

Therefore,

dr - ^ n
~~dY~ ~ > °

if 3 _ l
\
?)~Y~X
iC

••

0

and
u i

Cj ••
*

Many have ruled out the case where _2)_JL_ " ^

3 S

because they presumed

that this situation was not consistent with stability, it is taken to mean that
the marginal propensity to spend out of income, the sum of the marginal propensity to consume plus the marginal propensity to invest (desired "induced"
investment) was greater than unity and thereby explosive.
general equilibrium is consistent with

0 I ^

1)

Y

T^ S

^ ~^>

Yet, stable

provided the slope of

Y

3a. According to Stigler's Law, "All Demand Curves are Inelastic, and AU Supply
Curves are Inelastic Too." See "Stigler's Law" in George J. Stigler, The
Intellectual and the Market Place and Other Essays.




75
the LM curve is greater than the slope of the IS curve, which is to say,
that the LM curve cuts the IS curve from below.

Under these circumstances,

shifts of either schedule are possible without unstable effects.

Except

for the unlikely case where the IS and LM curves coincide, a case
of metastable equilibrium, if the schedules are linear there
is but one combination of income and the rate of interest consistent
with equilibrium.

If points off the equilibrium are examined it will be

found that the set of forces summed up in the curves will drive the
system towards the point of intersection.

In other words, when one

considers total rather than partial derivatives the marginal propensity
to spend need not be greater than unity.
Although the adjustment patterns are by no means clear, a positively
sloped IS curve does mean that an increase in the stock of money or a
decrease in the demand for money ultimately leads to a rise in both
interest rates and income, and a decrease in the stock of money or an
Increase in the demand for money leads to both lower interest rates
and lower income.

Shifts of the IS curve follow the standard analysis

because we would be moving along the same positively sloped LM curve.
Therefore, shifts of either positively sloped schedule lead to movements
in the same direction of both income and the rate of interest.
The reason for these apparently bizarre results is that desired investment is more responsive to income than is desired saving when interest
rates are held constant.

In other words, a shift to the right of the LM

curve, by causing income to rise initially, somehow causes a shift in




76
desired investment which is greater than the induced rise in saving
for given interest rates.

As we shall see below, it is not unlikely

that this is the case under a broad range of plausible real world
assumptions.
Factor Inputs, the Law of Variable Proportions, and Investment
Let us now move on to consider the source of a shift in the
marginal efficiency of investment.

It is generally agreed that sticky

money wage rates are a principal cause of the cyclical variability of
employment, and thereby output.

Further, it is also generally accepted

that shifts in aggregate demand induce corresponding short-run shifts in
employment and output by changing the relationship between money wage
rates and other prices, which is to say, the real wage rate.

To iso-

late some of the consequences of the usual analysis of the labor
market, assume the following:
1.

Money wage rates are fixed.

2.

Unemployment exists, and the supply of labor is infinitely
elastic at the money wage rate.

3.

The stock of capital is fixed and is equal to the desired
stock of capital for all firms.

4.

The production function is Cobb-Douglas with constant
returns to scale, and is given.

5.

All goods are produced by both capital and labor, and
relative prices of goods are given.

6.

The flow supply schedule of capital goods is infinitely
elastic at its real price.




77
7.

The demand for money is a function of both income and interest rates.

8.

All values are "permanent" in the sense that everybody expects
today's prices and quantities to persist beyond the relevant
horizons.

These assumptions will be relaxed at later stages in the analysis.
Consider an increase in aggregate demand stemming initially from an
increase in the stock of money - a shift to the right of the positively
sloped LM schedule.

The higher level of aggregate demand will tend to

raise product prices relative to labor costs, thereby inducing a movement
along the demand schedule for labor, where the quantity of labor demanded
4
is a function of the real wage rate and the marginal product of labor.
If
the production function is Cobb-Douglas and markets are competitive, the
elasticity of demand for labor is given by
share and (1-a) is the the capital share.

1
, where a is the labor
1 - a
If a is 2/3, the elasticity of demand

for labor with respect to the real wage rate is 3.

Therefore, a 1 percent

decline in the real wage stemming from a 1 percent rise in prices will
increase employment by 3 percent, which in turn will increase output by
2 percent.
cent.

Money income will therefore rise by slightly more than 3 per-

In other words, the elasticity of the aggregate supply curve with

respect to the price level is
4.
5.

a
1 - a

; here two.

Note also that average variable costs in real terms fall, an important
element in the business cycle theories of Mitchell and many others.
In the process some capital will be added to the pre-existing stock, but
the relative change in the capital stock will be small so that for the
time being we may safely overlook it.

73-959 O - 76 - 6




78
As more labor is added to the fixed capital stock, the marginal product
of labor declines by a factor of (1-a) times the percentage increase in the
labor input.

In the above example, the 3 percent rise in employment would

be associated with a 1 percent fall in the marginal productivity of labor,
which is also the decline in the real wage rate.

Total payments to labor in

real terms will rise by 2 percent, and in money terms by slightly more
than 3 percent.
The increase in the ratio of labor to capital will increase the productivity of capital, the other side of the Law of Variable Proportions coin.
It is this change, some manifestations of which run through the literature on
the Acceleration Principle, which is the source of the corresponding shift in
the demand for capital goods and investment spending.

The marginal product

of capital will rise by a factor of (a) times the percentage increase in the
labor input.

To continue the example, when employment rises by 3

percent and the capital stock is fixed, the marginal product of capital,
as well as total payments to capital in real terms, increase by 2 percent,
which is also the percentage increase in output.

The rise in the

productivity of capital, a source of higher interest rates, follows from a
decline in the real wage rate when capital and labor are substitutes in
production, as they are in the Cobb-Douglas production function.
In other words, the endogenous change in the productivity of capital is
the endogenous basis for a change in the desired stock of capital in order
to arrive at an optimum stock under the new conditions.




79
In turn, the rise in the desired stock of capital will tend to increase
the marginal efficiency of investment and thereby induce a rise in
investment expenditures, and a further sequence of higher income, a
rise in employment and in the ratio of labor to capital, a further shift
in the marginal efficiency schedule, and so forth.
As investment and income rise there will be upward pressure on
interest rates, causing a rise in income velocity as we move along
the given LM curve.

The rise in rates will be tempered by the additions

to the stock of capital, velocity changes, and a rise in induced saving.
To answer the question whether rates will end up at a higher level than
before the once for all monetary change, one must also include the
initial partial effects of the increase of money, which would be
consistent with lower rates.

Taken together, it is not at all clear

where the rate of interest will finally come to rest when we return to
simultaneous equilibrium in the "money" and "goods" markets.
Starting from equilibrium, a mirror image of this sequence would take
place when the stock of money was reduced in the presence of sticky money
wage rates - the initial rise in rates perhaps, the fall in aggregate demand,
reduced employment and a rise in average variable cost, a rise in the
ratio of capital to labor and a corresponding decline in the productivity of
capital, and so forth, until perhaps we end up with interest rates at lower
levels than before the monetary contraction that caused the downturn.
6.

If the cumulative expansion proceeds far enough, there will also be
pressure on wage rates and the relative prices of capital goods,
further moderating the expansion.




80
To help focus on the specific formal problem, let us hold the interest
rate constant and examine the partial effects, "income" effects, of the
increase in the money supply.

If

a I

v^

~^> S

it means that the pre-

existing rate of interest, rQ , is below its new equilibrium value.

On

the other hand, if
to say, that rates would end up lower after the monetary expansion.
To move from considerations of the marginal productivity of capital to
the value of

O I

consider the variables K*, A, and B, where K*

is the desired stock of capital, A is the partial derivative of K* with
respect to income,

O K* , and B is an adjustment coefficient denoting

the rate per period at which the economy desires to close the gap between
K* and K, the actual stock of capital.

B is measured in the same units of

time as Y.
Neither A, B, nor —£— can properly be considered constants. A
and B will vary inversely with the rate of interest and will also depend
on such variables as technological factors, supply conditions, expectations,
and cost conditions associated with "capacity" discussions, and so,forth.
B may also depend on the size of the "gap," (K*-K).
desired capital output ratio,

K*
Y

Similarly, the

, where Y is "permanent" or "expected"

income is not a constant but will depend upon the production function
and will also vary inversely with the rate of interest and the uncertainty
and other equalizing difference adjustments required to equate the
expected rates of return per period on all a s s e t s .




81
Under my assumptions, where K* = K before the increase in the
stock of money, A =

—
—

for a given rate of interest; it is larger

for rates below r o and smaller for rates above r Q .
holds for

£^— .

The same relationship

This means that the assumption of a given ratio of the

desired capital stock to expected income associated with holding
interest rates constant will tend to bias the analytical conclusions
towards a lower value for the responsiveness of desired investment
spending to a change in income.

Because desired saving may vary

directly with the rate of interest, holding rates constant will tend
to overstate the responsiveness of desired saving to the initial change
in income and its associated decline in interest rates, thus biasing
the results in the same direction.

These biases work against my case.

Thus, if
dY = f(dM), 7
^

and

we have

or,

^

->. „ .

=A,

~ B,

-=r

:

_2Ll—

= (A) (B).

0
Because A - —~— when r = r_,
7.

J2••

= (B)

Note that income can also change initially because of other factors.




82
Therefore, the IS curve has a positive slope if (R)(
where

K

)\

O S

,

V S is the marginal propensity to save, holding interest

rates constant.
Consider high and low guesses regarding the values of B and
8
K in the U . S . ; for B 0.4 and 0.1 and for _K_ 3.5 and 2 . 5 . Pairing the
Y
Y
high and low guesses for each variable we find that the entire range for
~\
I of from 1.40 to .25 may well be higher than (•' S which is
?) Y
?> Y
usually taken to be in the neighborhood of a range from 0.1 to 0.2
when expenditures for consumer durables are included in the consumption
function.
that

0

In other words, under these assumptions it is not unlikely
I ^^

d

s . which is to say, that the IS curve has a

positive slope.
What prevents the economy from exploding, even under these highly
restrictive assumptions?

It is essentially the limitation placed on the

expansion of income by the fixed money stock plus the relative interest
inelasticity of the demand for money.

As income and interest rates

rise there may be some increase in income velocity, but it will not be
sufficient to permit income to expand indefinitely.

Moreover, the

rise in rates will dampen desired investment and encourage desired
saving until the two return to equilibrium." If, however, the demand for
money is sufficiently interest elastic so that the slope of the LM curve
is less than the slope of the IS curve, velocity would be more highly
sensitive to interest rates, tempering the rise in rates.

Thus interest

rates would never rise fast enough to overtake the investmentFor more precise estimates see A. Harberger, The Demand for Durable
Goods, and S. Kuznets, Capital in the American Economy.




83
saving disequilibrium.

Moreover, even if the demand for money

were highly interest inelastic, this system may still explode if the IS
curve had a still lower interest elasticity.

In the case of the stable

system, if the monetary authorities continue to increase the stock of
money, possibly in order to keep rates from rising or because of
devotion to some form of the "real bills" doctrine, income would
continue to expand and equilibrium interest rates would be still higher.

g

(Rates "pegged" too long will cause the system to explode.)
Perhaps much of the essence of business cycles has been set
aside in the assumptions I have made to isolate some of the mechanisms
of short-run fluctuations.

In modifying or relaxing each of them we

can see other forces containing and shaping the apparent cumulative forces
in booms and recessions, even granted the simplifying assumptions
regarding homogeneity among industries and a given technology.

First,

the supply of labor cannot long be taken as infinitely elastic at the money
wage rate, particularly in the face of a substantial reduction in unemployment.

If the expansion progressed far enough or long enough

one would expect to find wage rates rising in both money and real terms,
increasing variable costs and reducing incentives to change the ratio of
labor to capital which was the source of the desired expansion in capital
goods in the first place.

Second, the supply schedule of capital goods

cannot long be taken as infinitely elastic either, particularly in the
length of run covered by a typical business cycle, so that a
substantial shift in the demand for capital goods would lead to higher
9.

Thus, it would seem that those who hold that multiplier and accelerator
values are large may need the Quantity Theorist's traditional assumption
of a low interest elasticity of the demand for money to keep their
formal systems from blowing up—or down—but not vice versa.




84
prices, postponements, etc.

Third, additions to the stock of capital

would change factor proportions and lower the productivity of capital.
Fourth, the assumption of static expectations may bias the analytical
conclusions in the direction of making some elements of the theoretical
system even more subject to instability than they, in fact, are.

For

example, if the initial rise in income is viewed as largely temporary,
desired investment will be lower and desired saving will be higher than
if the same change in measured income is taken to be a permanent change.
If, however, the demand for money is a function of permanent rather than
current income, small changes in the stock of money will have greater
consequences for spending, and changes in income will be associated
with smaller changes in the quantity of money demanded.

At this point

it is difficult to see what the net analytical bias is for the aggregate
or for the mechanisms I have discussed.
In addition, the initial capital stock may not be the desired one.
If, before the disturbance, the desired capital stock was greater than
the actual stock,

the same analysis would seem to follow.

However,

if the desired stock was less than the actual stock, a not unlikely deepdepression phenomenon, the increase in the productivity of capital may
merely bring the two somewhat closer together but not spill over into a
shift in the demand for additions to the stock.
cv I

In other words, perhaps

was so low during the 1930's that the IS curve generally

has a negative slope at that time. (The same factors may also have made




85
investment relatively unresponsive to changes in interest rates too.)

More

recent experience with long periods of relatively full employment conditions may be consistent with a positively sloped IS curve.
Further, in moving to a more powerful and general analysis undoubtedly
one must also take into account more explicit roles for lags, adjustments,
expectations, and more complex dynamic and other interactions.
A positively sloped IS curve and the adjustment processes generating
it may also explain the procyclical behavior of measured income velocity.

If,

as this analysis indicates, monetary expansion leads to increases in both income and interest rates, and if the demand for money is inversely related to
nominal interest rates, then it follows that rising interest rates resulting
from monetary expansions will cause velocity to rise and declining interest
rates following monetary contractions will cause velocity to fall.
These patterns would appear to be consistent with the observed empirical business cycle regularities that money, interest rates and velocity
all tend to be procyclical, with money tending to lead business cycle turns
and interest rates to lag them. These mechanisms not only explain why an
expansionary monetary policy generally leads to an increase in nominal and
real interest rates but also why an expansionary (contractionary) increase (decrease) in the stock of money causes velocity to rise (fall) as well, thus amplifying the initial impact of monetary change on aggregate nominal expenditures.
Finally, let us briefly consider elements of several analyses which
crucially depend on the assumption of a negatively sloped IS curve.
First, many critiques of the contribution of the monetary authorities to




86
cyclical change generally come down to attempts to identify which of
the schedules has shifted.

If the IS curve Is taken to have a negative

slope and if the monetary authorities are understood to affect the LM
curve, it looks easy indeed, and even intellectually defensible under many
circumstances, to point to high interest rates in booms and low interest
rates in recessions as stemming from shifts of the IS curve, not the LM
curve.

It is no less difficult to interpret interest rate changes or credit

market conditions as consistent with stabilizing shifts of monetary policy
towards "tightness" in booms and "ease" in recessions when, in fact,high
interest rates of booms and low interest rates of the recessions more
accurately reflect the high or low productivity of capital and the good
or poor business conditions brought about by the procyclical change in the
money supply.

This confusion is one of several reasons why the stock of

money, not interest rates or credit market conditions, is the appropriate
policy variable for the monetary authorities and for any critique of
their effectiveness.
Second, the assumption of a negatively sloped IS curve is a central
feature of many analyses of balance-of-payments adjustment processes.
This assumption helps to provide the theoretical basis for the presumption
that monetary policy must take into account an inevitable trade-off

10.

For example, see R.A. Mundell, "The Appropriate Use of Monetary
and Fiscal Policy for Internal and External Stability," I.M.F. Staff
Papers (March, 1962).




87
between the quantity of money and interest rates, and perhaps between
income and interest rates. It leads to the conclusion that expansionary
monetary policy will deteriorate a country's balance of payments on
capital account, especially in a regime of fixed exchange rates. My
analysis suggests that this conclusion may be in error; if so, an error
of serious consequences. No doubt the initial effect of more money is
to lower rates. But, by ringing down the curtain after the first scene
in the drama, the standard analysis neglects the remainder of the story.
We would do well to recall that pursuit of a restrictive monetary
policy in 1931 in order to raise interest rates for the purpose of moderating the U.S. balance of payments deficit and external gold drain, by
causing the ensuing economic collapse, lowered interest rates for many
years thereafter.

More recently, repeated attempts to lower interest

rates by expanding money have been major factors in the contemporary
era of inflation and high interest rates.




88
Mr. NEAL. Please, if you would, take a look at our exhibit. It is
self-explanatory. I find the conclusions mapped in the exhibit astounding. The public debate has centered around fiscal policy almost
entirely, it seems to me. Yet these charts indicate that monetary
policy has had a much greater impact on inflation and recession.
Several of you alluded to that in your testimony.
How about just commenting on the chart? Do you see any problems with it? Is it inaccurate, in your opinion, in any way?
Would it bear out what your experience is? Mr. Perry?
Mr. PERRY. The chart has several parts. In the first place, the
chart on the budget deficit clearly points out that deficits are not
quite the scary thing that they are sometimes made out to be.
The fact is that the big swings in the budget are largely induced
swings. They are not changes that represent active movements in
the budget designed to move the economy in a particular way. Rather,
they reflect the automatic stabilizers of the budget. This is very
clear today when the huge deficits we are looking at represent a weak
economy with its reduced levels of profits and income rather than
any great runaway spending propensities on the part of the Congress
or the administration.
So the budget deficits as actually experienced mainly mirror the
health or the lack of it in the economy rather than anything else and
that fact is shown up clearly. In particular, they don't show the sort
of correlation that the public frequently imagines between inflation
and deficits.
Mr. NEAL. In fact, quite the opposite.
Mr. PERRY. That is right. You get the huge deficits when you have
a very soft economy, when markets are weak and therefore when the
pressure on prices is at a minimum. Furthermore, inflation raises
Government revenues. It is not a particularly good way to raise them
but it has that effect and therefore you get the healthiest looking
budget surpluses at times like 1973 when the economy is strong and
we have some inflation.
I find the other aspects of the chart, in particular the apparent
connection between money supply growth rates and inflation rates,
somewhat misleading. Let me outline what I see as the relation of
money growth and inflation.
There is a well-established relationship, wedded in theory and documented again and again empirically that the higher the price level,
the correspondingly greater the demand for money. If the price level
were 1 percent higher this year, everything else being equal, the
demand for money in the economy would be 1 percent higher.
As inflation proceeds, whatever its source, the Fed is faced with the
fact that the demand for money is larger. It has one of two choices.
It either accommodates that extra demand for money, keeping the
real impact of monetary policy unchanged, or it refuses to accommodate it and thereby tightens the real impact of the money supply
on the economy.
If, as in 1973, and 1974, you got an extraordinary burst of inflation
and the Fed did not accommodate it at all, pursuing the same monetary policy it would have in the absence of that inflation, then in real
terms, monetary policy will have Severely tightened.




89
Historically it has always confronted this choice, whether Federal
policy was conducted by a feel of the market, whether it was oriented
to interest rates and the housing industry, or whatever, it could not
avoid the choice to A, accommodate the inflation, whatever it may
have been at that moment or B, if not accommodate it, tighten money
in real terms.
I think this is basically what we see reflected in these historical
relationships.
Mr. NEAL. Perhaps I did not point it out, but there is a time lag
of 23 months between the rate of inflation and the growth in the
money supply.
Mr. PERRY. I appreciate that but these are smooth series and by
and large what I think we are picking up is a rather substantial
trend in the two that is common. If we look at
Dr. WEINTRAUB. If we dropped every month but January for
prices and every month but February for money and then let the
first differences in prices be related to the first difference in money
two Februaries ago, we get the same results.
So although you are quite correct that the way this experiment was
formed, there is obvious serial correlation. The same result occurs if
you just use one month and without serial correlation.
Mr. PERRY. That's not enough. Let me just say that the rate of
inflation very gradually increases and though we can find a place
it peaks, by and large it is gradually increasing. It is not that you
have cycles and can identify lags very sharply with them. The other
thing to note is that money influences future inflation; but in a
different way than is implied by the chart.
Dr. WEINTRAUB. I think if you look at the chart, you will see
that the inflation rate has subsided as well as gone up in the period
since 1964. Although there is a trend, there is a roller coaster pattern
around the trend.
Mr. PERRY. If you put the real state of the economy into an equation
Dr. WEINTRAUB. We have done that.
Mr. PERRY. And you do a conventional attempt to explain inflation—relying on how tight the market is, what is the history of
inflation—you don't add to the explanation by adding the past
money supply.
Since money matters very much in determining GNP, you will
still get relationship between monetary growth and the subsequent
inflation rate but you will not get a relationship that, as sometimes
is suggested or implied, operates without affecting the real economy.
I would like to make this point as clear as I possibly can. Monetary
policy matters very much. If monetary policy is very expansionary
and pushes the economy very far very fast, the consequences of that
will be more inflation. But the inflation arises because the real economy
has been pushed too far too fast, not because of any magical property
of the money supply.
Mr. NEAL. What pushes the economy too far?
Mr. PERRY. It can be any number of things. It can be a boom
originating in the budget. I think when defense spending in the budget
in 1966 suddenly stepped up sharply, we were pushing the economy
basically because of fiscal policy. It could also be a surge in demand
from monetary policy or from the animal spirits in the private sector.




90

Mr. MEISELMAN. Why was there a recession in 1966?
Mr. PERKY. I am not aware there was one.
Mr. MEISELMAN. There was a recession at the end of 1966 and the
beginning of 1967.
Mr. PERRY. There was a slowdown but it has never been called a
recession before to my knowledge. But the point is not that monetary
policy isn't very potent and that monetary policy does not track GNP
very well and therefore is not closely associated. The point is, whatever our real goal—an unemployment goal or an output goal, we do not
choose between achieving it without inflation by making the money
supply grow slowly or achieving it with inflation by making the money
supply grow fast. Rather, we have to concern ourselves with what it is
that makes the economy inflation prone and try to deal with that.
If we succeed, then we can resolve the dilemma between output goals
and inflation goals. We don't resolve that dilemma by pretending that
the particular setting of a dial on money growth rate is going to solve
it for us. That will just give us a particular combination of inflation
and output.
Mr. NEAL. Mr. Jordan?
Mr. JORDAN. Thank you. This is a very interesting discussion, in
part because we have been through it before.
I would like to go back to 1966, 1967 and 1968. 1966 was a year of
very expansionary fiscal policies by most conventional measures. There
was a sharp contraction in the rate of monetary growth in the last
9 months of that year. Some people said the economy would be strong
at the end of 1966 because of fiscal stimulus. Others said that, in view
of the slower monetary growth, we were going to have rising unemployment and maybe a recession. We did have a sharp contraction in
output in the first quarter of 1967, as is shown on my chart I. It was
not considered long enough by the National Bureau to be called a real
recession, so it was referred to as a mini-recession. Then the argument
was advanced that restrictive monetary policy could slow the economy
in spite of the expansionary fiscal policy, but "you can't push on a
string." Rapid monetary growth can't keep the economy going if you
have restrictive fiscal policies.
The test of that proposition came in the second half of 1968. In 1968
you had a very rapid growth in the money supply. The Federal Reserve
kept talking about restrictive monetary policy as measured by the
level of interest rates. The public record shows that they voted for
restrictive policy, but they felt it was restrictive because the level of
short-term market rates was rising even though the money supply was
growing very rapidly.
We had a surtax that year. President Johnson imposed a 10-percent
surtax on personal and corporate income, and a reduction in the growth
of Government expenditures. There was concern about overkill of the
economy because of the fiscal restraint. The Federal Reserve decided
to offset, in part, the fiscal restraint through monetary ease. The
money supply kept growing rapidly, interest rates declined in the
second half of that year, and we continued to have a strong economy.
It was only in 1969, after the Federal Reserve moved to a sharp
contraction in the growth of money, did you get true restraint that
brought about the recession in 1970. Then, in 1971 and 1972, we had
expansionary monetary policies.




91
Now people are telling us that rapid monetary growth would not
spill over into a new round of inflation until we reach some threshold
of full employment or full capacity by the conventional measures.
They argue that we have a sufficient amount of slack that we don't
have to worry about a danger of excess demand causing inflation until
we get to a higher level of employment and capacity. My argument
there is that this comes from a view that most of the oscillations in
the economy were due to accelerations and decelerations in demand
relative to supply. Aggregate supply was viewed as growing at a
steady trend rate. If this excess capacity and high unemployment had
been caused only by a contraction in aggregate demand, then the
appropriate cure would be to expand aggregate demand, to put the
people and the capital back to work.
Most of us agree that the shocks to the economy during the last
few years came initially on the side of supply, the failures in agriculture
in 1972 and 1974, the devaluations of the dollar, and especially the
quadrupling of energy prices. Energy is an important input to production at all levels as well as being a consumer good. This reduced
our real economic capacity, our ability to meet demand, to produce
goods and services profitably at prevailing output prices. The basic
phenomenon was much like the Irish potato famine. It was a contraction of the real economic ability of the economy to produce,
relative to the demand, at a time when demand continued to grow.
The reason we had a sharp acceleration in inflation and a sharp
drop in real output was not because of restrictive monetary and fiscal
policies, but because we had a contraction in the real economy.
That leads me to believe that the capacity utilization numbers that
we see, and the so-called gap between real output and potential GNP,
are misleading. We cannot return to producing at those former rates
and volumes of output, given the much higher cost of production
associated with the cost of energy and also because we are devoting
more of our resources toward social goods. We want to close the gap
between the social costs and private costs of production. We want to
clean up the air and the water, provide safer working environments
and safer products, and that takes resources. Because of this, we
should not try to push the economy back toward the levels of output
that we saw a few years ago.
It is my view that our upper limit on real economic capacity is
closer than the conventional measures indicate, and we are in danger
of tipping over into a new round of inflation if the Federal Reserve
were to expand the money supply rapidly to try to get unemployment
down too quickly.
Mr. NEAL. Let me ask you, if I can, to comment on the chart
specifically. Do you have any problem with that relationship between
money policy and inflation?
Mr. JORDAN. N O ; I don't at all The basic relationship is one that
I think is correct.
Mr. NEAL. Let me make very clear that if there is another element
that we ought to have in the equation, we want to get it in there.
Mr. Perry?
Mr. PERRY. Mr. Jordan has said much that I agree with. I did
not say we have no inflation ahead for a long time. I think I said we
have a choice between being more vigorous in our pursuit of output




92

and employment goals and thereby taking the risk of more inflation,
or going the other direction.
Mr. Jordan pointed out carefully and clearly that it is a question of
what capacity is in the real economy, of what cost increases are
coming from conditions the real economy that is going to govern how
far we can go before running the risk of a lot more inflation. That is
precisely the way I would analyze the problem myself.
I would remind you that that analysis he gave you did not say the
rate of growth of Mx causes these real capacity problems that he is
worried about. Those happen from real things in the economy and
they should be analyzed that way.
The relationship I think you should be looking at here in place of
the one that relates simply Mi to the inflation rate is one that deals
with real economy capacity problems, both of labor and capital, and
then tries to see whether, knowing what you do about those things,
the sort of things Mr. Jordan was talking about, you get more information by putting money in one of the equations. Some attempts to
do this appeared in recent articles by Modigliani and Papademos
and by R. S. Gordon in Brookings Papers on Economic Activity in
1975.
The point I am making is not that Mx is not very important in
this process. The periods when we have run ourselves into inflationary
situations have usually been periods when Mx has grown rapidly. In
growing rapidly, it pushed the real economy up fast and far and ran
us into inflation.
That is the distinction that I am trying to make. There is not a
magical relationship between Mx growth and inflationary problems.
Mx growth is associated with how far and fast the economy is going
at any point in time.
Mr. NEAL. Mr. Fiedler?
Mr. FIEDLER. I would like to comment on the relationship between
money and inflation by drawing a distinction between the short run
and the long run and also by distinguishing in what may be partially
an artificial way, but nevertheless valid, between three types of
inflation.
One I call a basic built-in rate of inflation. It represents an accumulation of past experience reaching back a decade and more, often
related to bad economic policies over the longer term. Second, a
cyclical inflation, an acceleration or deceleration of that basic built-in
rate of inflation, depending on the degree of resource utilization,
whether we are in prosperity or recession.
Third, special factor inflation, the kinds of food, fuel, devaluation,
and price controls events that have temporary impact—events that
are big enough and important enough to have an impact on the overall
rate of inflation but one which is essentially temporary. I think this
last component of inflation that I am talking about, special-factor
inflation, is illustrated on your chart at least in part by the fact that
your rate of inflation line, the red line on that chart in 1973-74, gets
up well above the money line.
Those are sort of one shot impacts, or what we might call inflationary accidents. The distinction I want to make is that the relationship in the long run that you are referring to, it seems to me, is very
well established.




93
There is a casual relationship, that is, the more rapid rate of increase
in money over any decade is clearly going to be reflected on the
average over that decade in a more rapid rate of price inflation.
I think most of the testimony you have heard here today is consistent with that long-term kind of relationship. Then in the short
run, what happens within a given year and whether the inflation
accelerates from the base rate or decelerates, depends, it seems to me,
on the questions of the sort that Mr. Perry has raised, such as how
close are we to full utilization and what are the expectations of the
economy.
It is important to appreciate that distinction between long-run
impact and short-run impact. I would add that when we say that
there is a casual relationship in the long run between money and
inflation, we should also recognize that money is only the proximate
cause, the mechanism through which inflation is created.
The original causes, the fundamental causes, it seems to me, are in
the political and social goals that the people of America have that
tend to cause us to try to achieve a great deal more than the economy
has capacity to achieve in any short-run period.
We really have to go back to social and political things when we
want to look for the reason why monetary growth does get too rapid
in some periods and tends to impart that kind of an inflationary
bias to the economy.
It seems to me that the 23-month lag that you have built into the
chart is something that you should not view as a highly specific,
accurate, precise kind of a thing. Certainly the lag is variable. In one
business cycle, it would be longer, and in another business cycle, it
would be shorter, depending on a lot of different things.
There is no magic in that relationship. Also I would like to comment
on your conclusions that you have reached here tentatively. I am glad
you are cautious about the conclusions. Your conclusion is that the
deficit in the budget is much less important or less of a factor in causing
inflation or recession. I have some doubts because it seems to me that
we are dealing here with a situation where all of the factors—money,
budget and inflation-recession—all react on each other and it is
difficult to mathematically disentangle all the relationships.
The position of the Federal budget is important not only to what is
happening to the economy but also^—not necessarily more important
but also very important—to what is happening to the supply. I mentioned in my testimony that there is a divergence now between fiscal
and monetary policy stances. I also mentioned that most of the time
those two move in concert.
Any time you can say that monetary policy has a relationship as
close as this chart suggests to the rate of inflation, that would also
suggest that fiscal policy has a role. How much the role of fiscal policy
is independent of monetary policy and how much the role of monetary
policy is independent of fiscal policy is something that I do not think
our analytical tools are sufficient to properly disentangle.
There was some testimony by Secretary Simon about a year and a
half, 2 years ago, if I remember correctly, before one of the Budget
Committees that stressed the relationship between inflation and the
budget deficits properly adjusted to what is known as the full employment or high-employment budget.
73-595—76

7




94
That testimony, it seems to me, stresses that there is an impact of
Federal deficits that does not show on your chart and does not come
out in your conclusion. You might want to test not simply the budget
deficit in billions of dollars as you have here but look at that highemployment budget deficit.
There are many difficulties in calculating such a budget figure. But
I think that would be a fruitful area for further research.
Mr. NEAL. We will certainty look at that. Do you see some problem
with the way that we have shown this on the chart? Obviously there
is no apparent relationship using the deficits. We might want to chart
not only the deficits but the levels of the budget itself.
Mr. FIEDLER. I think that is correct. I would suggest that you look
at—for example, try the budget calculated as a high-employment
deficit as a percentage of GNP and see if that chart does not give
you some correlation, not within the cycle but over a 5-year span.
Mr. MEISELMAN. In Mr. Jordan's article he asks a question involving what the separate effects of the stock of the money and of
changes in the budget measured either by the high employment figures
for expenditures taken separately or the figures on expenditures and
taxes taken together.
The results of his research, which came as a great surprise to large
numbers of people, was essentially that fiscal policy measured either
way at most has only a very temporary and weak effect on GNP.
Some research I did jointly with Milton Friedman several years
earlier had come to much the same conclusion, and was also received
with a great deal of suspicion and disbelief.
Both pieces of research provoked a huge amount of research.
There are many economists who are skeptical of the research
findings, who felt there was something wrong either with the calculations or the analysis. It turned out that neither was the case. The
main thrust still stands.
Mr. PERRY. I feel I should set the record straight on that. There is
a good deal of analysis that disputes that conclusion. The most recent
I have seen has been by Professors Blinder and Solow who reviewed
it and found that fiscal policy is a potent instrument and monetary
policy is a potent instrument as well.
Mr. JORDAN. Fiscal policy is a very important factor in determining
the real economic growth over time, and how much of the economy is
in the public or Government sectors versus the private sector. As
economists we make suggestions to the lesser developed countries of
the world, how they can use fiscal policies to tax current consumption
and promote investment. Fiscal policy can have an effect on standards
of living and on the distribution of income in society.
But what it cannot do is independently determine the level of
prices unless you take account of the stock of money. You can finance
deficits, or increase spending, either by selling the bonds to the people
or by selling them to the central bank.
Mr. NEAL. There are two separate questions, is that right?
Mr. JORDAN. Right.
Mr. NEAL. All we are dealing with in this chart is the one question.
Mr. JORDAN. Right. Also you should ask whether it is possible to
relate the size of the deficit to monetary growth. In a study a few
years ago, we first tested the proposition to find out if you can make a




95
statement about fiscal stimulus if you ignored monetary policy. You
cannot.
The second question is can 3^011 draw a relationship between the
size of the deficits and monetary growth? There is an indirect link.
The Federal Reserve formerly used a concept called "even keeling/'
When there was borrowing by the Treasury, there would be temporary
upward pressure on short-term market interest rates. The central
bank had a responsibility to steady the market. The way they did that
was to buy securities in the market at the same time the Treasury
was selling their securities, maintaining the prevailing level of interest
rates. This was a dominant part of policy in the record for the Federal
Reserve in 1967 and 1968. One of the reasons there was such expansionary monetary growth was an indirect result of the deficit spending
associated with the Vietnam war.
Sometimes the fiscal influence is in the same direction as monetary
policy. The important test is not where they are going in the same
direction, but in opposite directions. The record is clear that where
monetary and fiscal policies diverge and go in opposite directions, the
monetary impulse will dominate. That was our conclusion from the
experience in late 1966 and again at the end of 1968 where they
diverged.
If you don't finance deficits b y monetary growth you will not
produce the kind of inflation we have had. If you have rapid monetary
growth, even if you have balanced budgets or surpluses in the budget,
you are going to have inflation. The growth of the money supply will
determine the level of prices, independent of the size of the deficit.
Mr. NEAL. Would you agree with that, Mr. Perry?
Mr. PERRY. NO; I would not. But I hate to keep repeating myself.
Mr. NEAL. It would be of great help to me in trying to understand
this.
Mr. PERRY. Both fiscal policy and monetary policy can have effects
on the level of demand and therefore the level of GNP. This is my
reading of the most careful statistical analyses. It is also what you
would get out of most of the carefully constructed large econometric
models.
Granting that there are many ways for GNP to rise—strong
fiscal policy, strong export demand from abroad and so forth—there
are various ways that policy can pull in opposite directions. You can
have a strong rise coming from one area and monetary policy can head
this off. Monetary policy in that sense is potent.
It can confront strongly rising demands* refuse to supply the
money that corresponds to the demand, drive interest rates up
sharply, break the housing industry, cause a recession and the demands
will not materialize. There is no disagreement on that point.
But now, granted that GNP can rise and can be influenced by a
variety of factors, how that rise divides between inflation and real
output is something which basically rests with an analysis elsewhere in
the system, not with the question of how much Mi accompanied that
rise.
If the rise occurs, then you start asking how inflationary is it going
to be. But whether Mx growth is very rapid or not in the process of
generating that rise is not the thing which tell you how inflationary it
is going to be.




96
There really is quite—if one looks at it carefully, there is quite a
lot of evidence of that in the chart before us. We have had a very
modest sort of Mi growth for the last 2 or 3 years and we have had
historically huge gyrations in the inflation rate and in the real economy.
I think that I understand how much of this happened. My explanation does not rest on what was happening to Mi. The rise in the price
of oil caused a lot of price increases and it really is not true that OPEC
read the St. Louis bank statement on Mx growth before they did that.
The rise in the price of food is a similar story. These things are a
legitimate way to look at the huge inflation that we ran into. None of
them had anything to do with rates of growth of Mi.
Mr. NEAL. Our calculations indicate that money supply accounts
for something like 60 percent of the rate of inflation. We see this jump
in the rate of inflation over the money growth rate in the period that
you mentioned earlier when there were dramatic increases in oil and
food prices. Our chart captures these effects as well as the impact of
money.
Let me ask now, would you say that monetary policy has been well
administered over the period of time charted here? Whatever your
answer is, what would be your prescription for the future?
Mr. JORDAN. I think that monetar}/" polic}^ in the post-war period
was procyclical making the inflations worse than they would have
been, making the recessions and the unemployment worse than they
would have been.
My prescription would be stop trying to use monetary policy to
solve problems, but to let it be the one steady thing that the real
economy and other policies revolve around. That would be indicated
by a steady rate of monetary growth. The first thing is to achieve
steadiness and the next thing is to reduce the trend growth. The sharp
fluctuations we have had have caused the fluctuations in interest
rates and the housing market. I would not want to see us try and put
the housing market through another quick feast-famine cycle by
expansionary policies this year and restrictive policies next year.
Mr. NEAL. It was suggested by someone yesterday that we might
want to arrive at a formula for the money growth. It would be something like a percentage measure of gross national product. If we said
the GNP ought to be 5 percent, then the money growth ought to be
5 percent.
Mr. JORDAN. There should be a relationship between growth rate
in the money supply and nominal GNP. You can make a projection
of what the nominal growth of GNP will be in a year. We are concerned with what kind of economy we are going to have in the future.
What your chart shows is that with the 2-year lag, approximately,
between inflation and money growth, you have to go out into 1978
to trade off the costs of more rapid money growth. If you expand
money more rapidly now because you want more nominal GNP,
how do policymakers evaluate whether it is worthwhile, a good idea,
in terms of the higher inflation in 1978?
It is easy to say we will worry about that problem 2 years from
now. Because of the long lag that your chart illustrates between
inflation and money growth, it is very hard to make this judgment.
I think because of our past experience with stop and go policies,
swinging first to restraint and then toward expansion, I think we




97
should err on the side of more stable, slower monetary growth, and
be willing to be wrong, rather than to err on the side of easier monetary
policies like in 1972 and 1973 and pay the terrible cost of readjustment,
both in inflation and unemployment, to get back down again.
We are starting this business cycle expansion with the highest
level of ongoing inflation we have ever had. We continue to reach
upward to higher and higher levels of inflation and interest rates.
That disturbs me to begin the expansion with this level of inflation
built in, and to talk in terms of more rapid monetary growth and not
worry about the implications a couple of years from now. The midpoints of the Federal Reserve's range would be adequate.
We would like to have the kind of expansion that occurred in the
sixties. Fiscal was active, but monetary was stable. We did have a
brief slow-down at the end of 1962. I do not see any prospects of
that at the present time.
I think we have a chance for 1977 to look much like the early
sixties. But there is also a risk it will look like 1971-72. We would
prefer to have the sixties kind of expansion rather than the seventies
kind of expansion. It depends almost completely on what the rate
of the growth of money supply is this year.
Mr. NEAL. Mr. Meiselman?
Mr. MEISELMAN. The hour is late. I wish to note that I am in
general agreement with Mr. Jordan's analysis. I would like to add
that we now have a great deal of inflation already built into the
system because of poor public policies in the past.
I believe the best way to achieve price stability is to eliminate the
remainder of the inflation gradually, step by step, not abruptly.
This would avoid the shocks that cause unemployment. I w^ould
start with the Federal Reserve's current target for monetary growth
and recommend that it be lowered by something like 1 percent each
year.
That means that several years down the road, we will be within the
targeted range for monetary growth that I mentioned before, which,
based on historic evidence, would give us stable prices.
Once we achieve stable prices, we should and can stay there by remaining in the range of moderate and steady monetary growth. I
would urge the Congress and the Federal Reserve to resist vigorously
any attempts to move outside that range. To do so would start this
whole stop-go cycle again that does nobody any good.
Mr. NEAL. Mr. Fiedler?
Mr. FIEDLER. My judgment on the monetary policy of the past
two decades is that it was very much better than the previous two
decades. Monetary policy still left quite a bit to be desired and did, as
Mr. Jordan suggested, on occasions make some things worse than
they otherwise would have been.
The monetary policy has been part of the process over the past
decade where we have had a continuous acceleration in this base,
built-in rate of inflation where we have gotten up from the early
1960's of 1 percent, virtually zero and now we are up to 5 percent or
6 percent.
That is unfortunate, but perhaps we should have some sympathy
for policy authorities who are dealing with very difficult processes
which are not well understood.




98
As to the future, there was a suggestion in the prescriptions offered
by both Mr. Jordan and Mr. Meiselman that we should pursue a very
steady rate of increase in money and credit growth.
While I would like to see more steadiness in the future than in the
past, I think we can carry that prescription too far. I do believe
that at any given time, monetary policy must take account of not
only some fixed, long term-goals, but also the short-term goals and
that some kind of an accommodation does have to be made between
those two often conflicting sets of goals.
The idea of gradually reducing the rate of increase in money has
great appeal. I would not try to put it on a specific 1 percentage point
a year basis. I would be very cautious in doing it at the present time.
At the present time, my own inclinations are for the upper range
of the current Federal Reserve targets.
Mr. NEAL. Thank you.
Mr. Perry?
Mr. PERRY. I would say that monetary policy has been conducted
reasonably well over the period you have charted. Its worse marks
probably come during periods of recession when the Fed has allowed
money growth to slow very sharply.
This has been a characteristic of all the recession periods we have
had. It could have been fighting harder against downturns. In recent
years, it has been confronted with impossible problems.
It has been asked to deal with inflation that it could not possibly
deal with and the results have been very mixed. And, depending on
how one views what is important, you can end up thinking the Fed
has done very well or very poorly.
For now, there are two issues regarding monetary targets. One is
that you still face the problem of inflation and unemployment and
you are not sure exactly where you are going to come out on that.
A year from now, we could be looking at 6-percent inflation. If so,
low money growth rates could easily lead to another recession.
A second issue is that the money demand relationship has been
wildly unstable over the past 2 years.
Money demand, based on the sort of estimates that most researchers
work with, has shown enormous errors from past historical relationships which take account of the influence of interest rates and the
influence of prices and real output on money demand.
The error that has accumulated is in the neighborhood of 8
percent over the last couple of years. You can shop around for an
equation with a 7-percent error or another one that has a 9-percent
error. But any of them is a huge error.
If the equation had been error-free, it would have required 9
percent more money today than we have gotten to achieve the
same situation in the economy. We do not know whether the source
of that error is going to unwind or reverse itself over the next year
or two. It is possible.
Research has tried to track down where those errors have come
from. Partly they have come from the fact that there are a great many
substitutes for money and new institutional arrangements being made
between banks and their customers.
We cannot predict the future of these, but if we tie ourselves to a
number for a thing called Mi and if some of these institutional




99
arrangements start to go the other way, the Fed could find itself
driving interest rates through the roof and causing another recession
in the name of sticking to an Mi target when the demand for that
thing called Mj has reversed itself and gotten strong.
Therefore, I think what we ought to be doing is setting some kind of
economic targets for the Fed and asking them to pursue those economic targets as best it can. If that means getting out of the target
range on Mx on the upside or the downside, then let it.
If the money demand function is very unstable, it is very important
to look at interest rates. I think we are now in the period when monetary policy, all things considered, has been quite easy.
Interest rates are at fairly modest levels. A modest rise in interest
rates would be appropriate. But if it turns out that, to hold an Mx
target, you have to drive interest rates up sharply, I would find that
unjustified.
I think it is more important for the Congress to come to some understanding with the Fed about the economic goals that are being pursued
and leave the nuts and bolts of how to conduct its operations more to
the Fed itself. If what it is doing seems to be contrary to the economic
goals, it should answer for its actions and explain why it has pursued
the path it has.
I believe that is the most important oversight that the Congress
could make of the Federal Reserve's activities.
Mr. NEAL. Thank you very much.
I would like to yield to the gentleman from Tennessee.
Mr. ALLEN. Thank you, Mr. Chairman.
Mr. Jordan, you mentioned some mismanagement in monetary
policy in recent years by the Fed. Do you agree that the present
economic recession was precipitated in large measure because of the
tight money policy and the high interest rate policy adopted by the
Fed about 2}{ to 3 years ago. Was this what precipitated the downturn?
Mr. JORDAN. I would say "no" to the word "precipitated." The
monetary policy remained quite stimulative until mid-1973. There was
a moderate slowing from mid-1973 to mid-1974—in the appropriate
direction, in my mind.
My third chart shows the relationship between the short-term rate
of inflation and the level of short-term interest rates. There is a good
correlation there.
What happened was, you had shocks to the supply side of the
economy plus the after effects of wage and price controls in which
prices were artificially suppressed. Inflation accelerated sharply in
1973. You had credit demand building very strongly in the economy,
bidding up interest rates to high levels.
The contraction in output and moderate rise in unemployment we
had through mid-1974 (up until August or September of 1974, I
think) were not initially or primarily due to excessively tight monetary policies.
I do believe in the second half of 1974 that monetary growth contracted much too sharply, as is shown on my chart I, and was too
late and too much. Monetary policy became overly restrictive bringing
a demand induced recession right on the heels of a very severe contraction in aggregate supply. As a result, the recession was deeper and
longer than it would have been if the Federal Reserve had not allowed
this sharp contraction in the growth of the money supply.




100
Early in 1975, they turned sharply, growth of the money supply
accelerated rapidly, and it has continued to be uneven and erratic
over the past year. I guess the word "precipitate" I would not agree
with.
Mr. ALLEN. YOU are arguing about semantics, really. When Dr.
Arthur Burns was sitting in the middle chair there sometime back, I
asked him the question about whether or not he agreed with the accepted premise of most economists that if we sought to bring about a
sharp reduction in unemployment, that it would precipitate—I am
using that word again—and rekindle the fires of inflation.
I asked him the specific question of whether or not he agreed with the
economists who say that we cannot afford to have as our goal 2-percent
or 3-percent or 4-percent unemployment.
His answer was, "I think that if properly handled, our goal should
be zero unemployment so long as those who are employed are gainfully and productively employed."
In answer to my questions and suggestions, he agreed that if they
are gainfully employed, it would offset any inflationary pressures.
Those words came from Dr. Arthur Burns.
I am asking you gentlemen here what do you suggest, monetary
policywise or otherwise, that we can do to substantially reduce unemployment and put back to work in gainful and productive employment
the millions of people today who are unemployed, many of whom are
being paid money not to produce but simply to consume, which, of
course, is obviously an inflationary force in our society, being given
spending power for not producing.
That, I guess, you agree, is inflationary. If, for what you receive
in wages you are producing in services or commodities that are being
on the market for sale, then it is not inflationary.
Now, this is what I want to know: What approach do any one of
you gentlemen have to suggest about getting at the root cause of our
whole problem and that is getting back to work the millions of
unemployed in this country into gainful and productive employment?
To my mind, you talk about wasted government money. The most
indefensible waste that is going on in this country today is the failure
of this economy and this society to utilize to the fullest the talents
and the energies of all of its people who are able to work and contribute
to the wealth of this Nation.
Do any one of you gentlemen want to respond?
Mr. MEISELMAN. Congressman, I would like to comment on that.
I think it is important when you are talking about reducing unemployment that we be very clear about the means that we select
to achieve that end.
There are certain things that monetary policy can do and certain
things it can't do. As I discussed in my prepared testimony, belief
that speeding up the printing press would put people to work has been
one of the primary sources of the inflation and also the rising unemployment.
This policy does not work, even though initially and temporarily
there may be some additional jobs. The main goal of monetary policy
ought to be the achievement of stable prices. If there is excessive
unemployment, we have to ask ourselves very serious questions about
conditions in the labor market rather than focus almost exclusively
on monetary and fiscal policy.




101
Why is it that we have so many people who are not working?
Millions of people are out of work, not because of the dislocations of
the business cycle, but because of permanent changes in the incentives
to work or to hire labor that have resulted in a permanently higher
level of unemployment.
If you want to get into these tremendously important questions
of the labor market—you must have to think along these lines. For
example, the Congress has passed large numbers of bills that essentially pay people more not to work. Consequently, fewer people want
to work. Congress has also passed large numbers of bills which make
it more expensive to hire people.
When you put the two together, there are going to be more people
out of work. For many people it just does not pay to work. In fact
I keep a running poll among my economist friends and colleagues to
ask them to explain to me not why the unemployment rate is so high
but why are so many people working in this country? Under current
incentives, that is the intriguing intellectual puzzle.
Mr. JORDAN. The first thing that should be done would be to
decide not to use aggregate demand policies, not to use stimulative
overall monetary policies and to rely on that to achieve it. Don't
leave it to the Federal Reserve to promote those goals. Don't use
the shotgun. Let's use the rifle approach. Find out who the unemployed are, where they are, and provide job training and relocation
of workers. Also, exempt teenagers from the minimum wage or have
a special lower apprentice minimum wage until they get some experience, and get people employed.
The national rate of frictional unemployment is about 3 percent.
I have no problem in thinking in terms of a 3-percent unemployment
rate. What I do have a problem with is trying to achieve it this year
or maybe even next year through excessively rapid monetary growth.
Mr. ALLEN. I am not suggesting that in any way. I am asking you
how do we go about it. You are the economists.
Mr. MEISELMAN. I believe that unemployment compensation is
too high for too long for too many people. That is a huge incentive
for people not to work. It is a huge incentive for employers to depend
systematically year after year on people working part of the year.
We are subsidizing seasonal employment and seasonal unemployment.
Mr. PERRY. Have you looked at the unemployment statistics before
unemployment compensation was invented? We had unemployment
then and before we had welfare. This is not what causes unemployment. You had rates much higher then in the postwar period 50
years ago.
Mr. FIEDLER. I would like to offer some suggestions. Since the end
of 1974 general public economic policy, fiscal and monetary policy
has tended to be expansionary in an effort to reduce the unemployment associated with the recession.
The unemployment rate has come down a good ways. There is still
a good deal farther that we can go by the use of those positive, stimulative money and fiscal policies. What we have been arguing today
is how fast we change. But it seems to me there is further cyclical
expansion that can take place and is taking place that will reduce the
rate of unemployment and my tenuous guess is that we can get the
unemployment rate down to 5% percent to 6 percent by that means.




102
I would encourage us to avoid trying to do too much too fast for
fear of undoing what we are accomplishing that way. The second
suggestion I would have relates to my point in my testimony about
the imbalance that now exists between capital and labor where there
is not enough capital stock and capital facilities particularly in the
major materials industries to permit the economy to operate in a
way that would get unemployment down to where it could otherwise
be before it would run into the bottlenecks associated with the labor
market itself.
I would think that a program that would foster rapid capital
formation over the next 5 to 10 years would permit us to take that
5}i percent unemployment rate and reduce it to 4% or maybe even 4.
The third point I would try to do simultaneously with these others,
is several structural measures to which there has been reference here,
a separate minimum wage for teenagers, some change in the unemployment insurance system, perhaps making that compensation taxable, a negative-income-tax type of welfare reform with a careful
look at the disincentives to which reference has been made.
I don't think those reforms can do a great deal. Maybe they can
lower the unemployment rate by a few tenths. That is still worth
pursuing.
Fourth, further experimentation with manpower training. We are
spending about $5 billion per year for manpower training in this
country. There is no evidence to my knowledge that those programs
have been particularly successful in achieving the provision of the
unskilled with the skills to be productively e m p ^ e d in today's
economy.
But we should keep trying. We should keep trying to shape those
manpower training programs to hopefully be able to achieve that.
We should not give up. I don't think we should have any major
expansion of them, but I think we should not give up in those efforts.
Finally, I would echo the point that I think Mr. Meiselman made a
minute ago that we should not attempt to get to zero unemployment
because there is such a thing as voluntary unemployment that shows
up in the unemployment rolls, people changing jobs, willing to work in
seasonal trades that mean they are unemployed for part of the year,
willing to take extra time off between jobs. That is one of the measures
of the success of our economy, the high standard of living that the
American people enjoy. We should not be shooting for zero.
Mr. ALLEN. I don't think Dr. Burns meant that every single individual who was able and willing to work should be working 5 days a
week 52 weeks out of the year. He meant that our objective should
be that every person who is able and willing to work should be able to
find gainful and productive employment in this society.
And to the extent that this society and this economy does not
provide that opportunity to that extent we are failing.
Mr. FIEDLER. I agree, sir.
Mr. ALLEN. NOW with respect to inflation—of course, inflation is
devaluation of the dollar. Devaluation of the dollar is devaluing, of
course, the amount of the outstanding debts. Is that not true?
Mr. JORDAN. It is reducing the real debt; it is an indirect hidden
tax on the consumer.
Mr. FIEDLER. It devalues the money that is in circulation.




103
Mr. ALLEN. IS it not true this society's present financial system—I
am not speaking about just the Federal Reserve but our whole
financial system is predicated on the proposition that the assets of
insurance companies and banks and savings and loan associations
and all the rest must increase year by year.
Do you agree with that?
Once you find particularly let's say insurance companies whose
assets are not increasing, you have got a danger flag in that that
insurance company is heading for real financial trouble.
Isn't that true?
Mr. JORDAN. The principle you are referring to is involved in
pension funds and in the New York City problem. It is also involved
in the social security system of the United States, in the sense that
you are drawing in new participants and new contributors faster than
you are paying the recipients.
Mr. ALLEN. All the assets of these financial institutions are in one
form or another debts of society to those financial institutions. Isn't
that true?
Mr. MEISELMAN. That is why interest rates rise during inflation to
adjust to that loss, to gain on interest account what is lost on capital
account.
Mr. ALLEN. But when a portion of the price of everything must
be calculated to take into account interest and also to put back into
circulation the money that goes into insurance premiums and savings
and loan associations and so forth, in order to get that back into circulation, society has to go deeper and deeper in debt by going back to these
same banks and pension funds and reborrowing the same money
we put in it at interest.
Isn't that true?
Mr. JORDAN. It is, but the interest rate on that borrowing depends
on everybody's expectations about inflation. When a financial
institution agrees to lend someone some money, the interest rate it is
charging reflects expectations about inflation. It if turns out that
inflation is more rapid than they expected, the value of those assets—
the market value—declines.
Mr. ALLEN. In view of this, is there any way we can operate and
function without going into a catastrophic depression except by a
moderate rate or an ever increasing rate of inflation, thereby devaluing
the debts to devalue the dollars and the currency in which those
debts are payable?
Mr. FIEDLER. I don't agree at all with that proposition. It seems to
me we will incur more debt as the economy grows. There is every
reason to do so. It is part of the process of saving and investment
that is a fundamental component of our progress, a fundamental part
of the increase in productivity, efficiency and the standard of living
of the American people.
There is no reason that that debt has to grow more rapidly than the
total economy and no reason that therefore has to produce any
catastrophic consequences.
Mr. ALLEN. In other words, you think we can function prosperously
in this society with zero inflation. Is that what you are telling me,
sir?




104
Mr. FIEDLER. Yes, sir. I think we can function prosperously with
5 percent inflation or minus 2 percent inflation. I don't know how
far I would want to go out, but there is a considerable range, I believe,
in which we can operate because people do in fact get used to a continuing rate of inflation.
It seems to me that for the most part our economy presently is
used to a built-in rate of something on the order of 5 or 6 percent.
Most people are compensated for it. Social security is indexed and we
can get along.
Mr. ALLEN. Social security and other obligations are going up.
Wages have to go up. The entire cycle is over every time the wheel
turns over, we have higher prices, higher wages and thereby reduce
the debts to the extent that the value of the dollar in which those
debts are payable is devalued.
' Mr. FIEDLER. Yes, sir. But the higher interest rate being paid on
those debts compensate. If I am a lender and lend you $1,000 and
you pay me 7 percent interest and we have 5 percent inflation, I am
getting that 5 percent inflation back plus 2 percent real interest.
I am willing to do that, as a general proposition.
Mr. JORDAN. The volume of debt—both Government and public—and the interest rate associated with that debt tell us something about
our economy, our society's preferences and choices about current
consumption and consumption in the future. You are identifying a
long-run problem of future liabilities of these institutions at a time
when Government policy has been geared toward encouraging people
to spend and consume now. The tax rebate and the other policies we
have had show this. They are saying "don't preserve for the future,
but go ahead and live it up now and let the future worry about itself."
But the high interest rates that the financial institutions are demanding is a way to try and bid the funds away from doing what Government policy has been trying to encourage people to do in the first
place. If the inflation rate turns out to be less than the market has
expected and discounted, the financial institutions would find that they
are better off. In the past, they were worse off year after year finding
inflation was worse than they had planned on, and they kept trying
to recoup and catch up with this. We could be on the other side of that
and have less inflation than the markets expect and they will find
that they are in an improved position and better able to meet their
liabilities.
By so doing it would be an indication that the behavior of the
people of the country has become more conservative, that we have
gotten away from the attitude of the sixties, that we will have guns
and butter and therefore we won't have investment.
We are concerned about our future, about capital formation, about
the growth of standards-of-living in the future, and not just our
consumption this year. That would be a very healthy thing. In that
way I think we could return to both stable prices and viable financial
institutions with a much lower level of interest rates.
Mr. ALLEN. I am interested in reducing the interest rates by whatever means necessary, because interest rates affect prices and it is
compounded five times by the time it gets to the merchant's shelf.
But do any one of you economists have in your minds the round
figures of the latest census study or study by any other agency of the
Federal Government of the total appraised value or the total value of




105
all tangible property in the United States as against the total public
and private debts and how they compare?
Do any one of you have those figures?
Mr. FIEDLER. NO, sir. I can't remember them, Mr. Allen, but The
Conference Board has just published a study on the national wealth
of the United States. I may have something in my bag. Dr. John
Kendrick, consultant to the Board has published a study. There is
certainly some information along that line.
Mr. ALLEN. Would you expect to find that the total public and
private debt far exceeds the value of all the tangible property today?
Mr. JORDAN. That would surprise me.
Mr. ALLEN. I am speaking of the tangible wealth.
Mr. MEISELMAN. It would not surprise me at all because there are
many kinds of debts that are counted over and over again. So, if in
fact you counted all the debt, my hunch is that it is substantially
larger than the tangible assets.
For example, if I have a mortgage on my house and if I got the
mortgage at a savings and loan, that is one debt. At the same time
the savings and loan borrows it from other sources. The other side of
the balance sheet of my mortgage may well be a whole string of debts
as people borrow and lend to finance the mortgage.
The same would be true if I financed the purchase of a car. You
could have a sales finance company that has the paper, the sales company borrows from somebody else who in turn borrows from somebody
else.
There is an elaborate financial network. I believe it is impossible to
measure all those numbers. Twenty years ago when I was a young
researcher at the National Bureau of Economic Research, we tried to
do that. We did the best we could but at that time we didn't even
get the total debt.
Even official U.S. statistics cannot calculate the total debt. There
is always double or triple or quadruple counting. Unfortunately, many
people who look at the statistics come away with the impression that
there is an excessive amount of debt because the ratio is overstated.
Mr. JORDAN. When making that comparison you would want to net
out air triple counting of the debt.
Mr. MEISELMAN. Once you start netting out double counting there
is no good way you can draw the line. At one extreme, private debt is
essentially zero, we owe it to ourselves, That is wiry some people
conclude, if net private debt close to zero, don't worcy about it.
Mr. FIEDLER. There is a summary of the study I mentioned a
moment ago printed in the May 1976, "Morgan Guaranty Survey"
the monthly letter. I will, with the chairman's permission, submit
that for inclusion in the record.
[The summar}^ of the study submitted by Mr. Fiedler follows:]
[From the Morgan Guaranty Survey, May 1976]

1

CONSTRUCTING A BALANCE SHEET FOR THE UNITED STATES

A national balance sheet for the United States combining the tangible wealth
estimates with financial asset and liability data prepared by the Federal Reserve
Board has been constructed for 1973 and is presented in the accompanying table
(balance sheets for other years have not yet been completed). Holdings of domestic
U.S. financial assets are shown by major categories, along with a single figure
representing U.S. ownership of foreign financial assets, including U.S. equity
interest in direct investments abroad. To these are added monetary gold and
domestic tangible assets comprising inventories, structures, equipment, and land,




106
in order to obtain total assets. From these are subtracted liabilities and corporate
equities (since stock values were included with assets) in order to calculate net
worth.
The domestic financial assets and liabilities to U.S. residents cancel one another
so that national net worth equals tangible assets, plus monetary gold, plus net
foreign assets (financial claims on foreigners less foreign claims on U.S. residents).
This is what economists understand as national wealth. On the one hand, it is
the net worth of the nation. On the other hand, it is the productive tangible
resources of the country plus our net claims on the productive resources of other
countries. The equality between net worth and productive resources at the
national level is, of course, not matched by equality in individual sectors. The
personal sector's net worth is generally larger than its tangible assets, since its
financial claims exceed liabilities. The opposite is true of business which is a debtor,
on balance.
To be consistent with gross national product (GNP), which is valued in market
prices or approximations thereto, national and sector balance sheets and the
tangible wealth components must be valued likewise rather than at acquisition
or original costs as is customary in corporate balance sheets. In the case of tangible
assets, land is valued at market prices. Inventories have been revalued from book
to current market replacement costs. Newly purchased equipment and structures
are valued at market. But since most aging fixed assets are not traded in organized
markets, their values are estimated in terms of depreciated replacement costs as a
proxy for market values. Theoretical^, market values represent the present (discounted) value of the expected net income from the capital goods over their lifetimes. Obviously, depreciated replacement costs are only a rough approximation
of true values. Also, for purposes of relating capital to production, we estimate
capital on a gross basis (that is, with no subtraction of depreciation), since the
current productive capacity of fixed assets generaly does not decline in step with
depreciated value.
Real wealth (i.e., wealth in constant prices) grows as a result of saving and investment. In the case of depreciable capital goods, the change in net wealth between successive dates equals gross investment less depreciation charges during
the period; the change in gross wealth equals gross investment less retirements
(all in constant prices). In fact, depreciable wealth is generally estimated by the
"perpetual inventory" method, whereby real net investment by type is cumulated
over time, and then revalued to current prices. In current prices, changes in wealth
reflect not only net investment but also price changes.
The Commerce Department defines investment narrowly to include only business
capital formation, residential construction, and net foreign investment. This
analysis defines tangible investment and the resulting wealth more broadly to
include purchases of structures and equipment and inventory accumulation © all
f
sectors—households and governments as well as business.
Combined balance sheet of the United States on December SI, 197S
Assets:
Billions Assets:
Billions
Demand
deposits and
Structures
1,042. 1
currency1
$296.0
Equipment
2,202.1
Time and savings acLand
848.4
counts
703.1
Insurance and pension
Total
9, 922. 2
reserves
458. 1
=
Corporate equities
896. 7 Liabilities and net worth:
Government obligations._
612. 1
Liabilities:
Corporate bonds
247. 4
To U.S. residents 3__ 4, 142. 9
Mortgages
429. 8
To foreigners
163. 5
Other credit instruments.
788.8
Corporate equities
896.7
Security and trade credit261. 6
Net worth (or net naOther 2
346. 0
tional wealth)
4, 719. 1
U.S. foreign assets
213.7
Monetary gold
11.7
Total
9,922.2
Inventories
$564. 6
1
Includes Treasury currency and IMF position.
2
Includes interbank claims, taxes payable, and miscellaneous.
3
The breakdown of this aggregate is the same as shown for domestic financial assets
owned by U.S., residents, except for corporate equity shares, which are shown separately.
Sources : Tangible assets (net of depreciation reserves) are estimates of The Conference
Board. The foreign assets, liabilities, and monetary gold estimates are from the U.S.
Department of Commerce, Survey of Current Business, October 1975. The other estimates
are derived from the Federal Reserve Board, Introduction to Flow of Funds, February 1975.




107
Mr. ALLEN. DO you have the totals there?
Mr. FIEDLER. I don't have any part of the study with me.
Mr. ALLEN. I suggest that you are going to find that the ratio of
public and private debt to the value of the property in this country
has increased and has had to increase every year under our financial
type of system and that the only way that you can continue to
function is by continuing to increase the debt, increase the amount
of interest that is having to be paid and undertaking to meet those
debts by deflating the value of the dollar through inflation.
Mr. NEAL. I am interested in Mr. Perry's suggestions on lowering
the levels of unemployment. The other three members of our panel
have already presented their views on this topic.
Mr. PERRY. I pretty much agreed with some of the very sensible
comments that Mr. Fiedler was making. Here I guess the one thing
I would add is that the main barrier to our reducing unemployment,
not to zero, but to much lower levels than it is today is the fact that
we have this ongoing inflation.
I think you can't separate the achievement of one goal from the
achievement of the other. Therefore anything we can do to deal
directly with the inflation would permit us to pursue higher employment levels at the same time.
Now the list of things that one could do to deal directly with the
inflation problem and slow down this merry-go-round that we are on
at the moment, which we inherited from the past, is not terribly long.
It would be frankly experimental. There is a great deal of feeling
against experimenting in this way.
I have in mind some new attempt to do a better incomes policy
than we have had in the past. If we can get wages to rise more slowly
and prices to rise more slowly, we will be freer to pursue our employment goals.
Right now we confront a problem. All of the things that anyone has
mentioned to me that would expand employment substantially,
reducing unemployment substantially, run the risk of perhaps worsening the inflation rate that we now have or at least not slowing to a
rate that is acceptable to people.
I think we are in a position where the inflation rate is gradually
slowing. If we are prepared to wait what may be a very long time, it
will probably go away. But that is a very long time and it runs into
the problem you raise and that we have not faced up to nearly as
much as we should have in the last few years—what are we going to
do about having this societ}' provide all the job opportunities that
people want?
Fundamentally that is the most important problem before us.
I think it really gets
Mr. ALLEN. It is the No. 1 priority.
Mr. NEAL. HOW specifically would you do it? Would you keep
money growth at some level?
Mr. PERRY. I am not really concerned with money growth. If I
could have an incomes policy—let me be hypothetical—have an
incomes policy under which all the labor unions and large companies
in the country agree they were going to trim 3 percent off the rate of
increase of their wages and prices from what they were over the last
12 months, then I would feel much more comfortable and have no




108
inhibitions about pushing demand further to create more jobs and
lower the unemployment rate.
That would involve more money growth than would a slower
path for the economy. It would involve less money than the one
we are contemplating now. To lower the spiral would mean you
would not have to feed the system money just to stay even.
I would guess we could get by with less money growth if we could
slow down inflation and at the same time get more real output. This
is hypothetical. I don't know of any way of getting all these decisionmakers together and getting them to agree to slow down the wage
and price increase by 3 percent.
I do know those people are not looking at Mi. When the rubber
workers go out on strike, that is not what they are looking at. When
their settlement comes in, that is not what determines their settlement. In a long run sense, if we keep this economy very slack, we
will find that unions are settling for less and companies are shaving
their margins.
That happens to be a long, painful process, and completely ignores
what should be a very strong commitment to low unemplo3^ment
and high employment opportunities.
Mr. NEAL. Would you pursue a more stimulative fiscal policy?
Mr. PERRY. If you grant me my hypothetical exercise, then we
have options. We can pursue stimulative policies by undertaking
goals that we might like in the public sector or by reducing taxes.
There is room to use some tax reductions to help reduce the inflation rate. I am speaking specifically of those taxes that get directly
into the price level such as the sales taxes at the State and local
level and the payroll taxes on employers that we now have.
Those are directly in the price level. When you talk about an
ongoing wage-price spiral, anything you can do to buy yourself 2
points less inflation this year is going to have some permanent effect
of lowering inflation in the future.
Those would be specifically fiscal policy moves and in the conventional sense that we measure it, they would be stimulative fiscal
policy measures. But at the same time we might want iio take some
of this added room out in the form of a more expansionary monetary
policy, pushing money growth more and encouraging investments.
You have a choice. If you got yourself the working room so you
can raise output 3 percent more next year than you otherwise would
have, you have a lot of leeway to do a lot of things. Some of them
would involve fiscal steps. Some would involve more expansionary
monetary policy. In other words, we have got 3 percent of output
and can decide what to do with it—private sector consumption,
public need, energy independence or whatever.
One does not lack for where to expand if we were prepared to give
ourselves 3 percent more real output next year. The expansion could
involve fiscal changes. It might very well involve more expansionary
money policy.
Mr. NEAL. YOU have all commented—several of you commented
o i capital formation problems. Now how do they relate to monetary
li? y
Mr. JORDAN. The greatest disincentive to long-term capital formation now to investors is not the fear that short-term money market
interest rates are going to go up this year, but that we are going to




109
repeat these waves of inflation and high interest rates that are shown
in your chart. They are concerned that there will be so much stimulus
this year and next year that we will have to have very restrictive
policies, in one form or another, in another couple of years, precipitating another recession, high unemployment, and that by the time any
new investment that is undertaken now gets on stream producing a
product, we will be in a recession and there won't be a market.
The greatest thing that could be done to encourage businessmen to
engage in more long range planning, more investment expenditures to
expand capital, and to plan for an increase in employment would be to
insure them that we are going to have stability, continued growth like
in the 1960's that is going to last for a few years.
I would like to comment on the possible use of incomes policy or
wage and price controls. It is tempting to think that you can get some
shortrun gain by, in a sense, shortening the lag to bring about a condition in the near term that would not otherwise occur for 2 or 3 years.
We have had more restrictive monetary policies in the past which
was supposed to bring inflation down. We recently have had much
more stimulative monetary policies trying to get output and employment up. The idea would be that through some proper use of wage
and price controls you can achieve (this year, or at least next year)
both full employment and stable prices that otherwise would not
happen for a few years.
This is the kind of thinking that was going on in 1971. I admit that
if there were ever ideal conditions for playing that game and using
controls trying to get you there faster, 1971 was a good time to try it.
And they did. But the problem with controls is that their existence
reduces the perseverance on the part of monetary authorities, and
even fiscal authorities, in getting the trend of money down and getting
the real fundamental inflationary force out because you have another
weapon for dealing with inflation.
This frees up monetary policy to pursue full employment and full
capachy goals. That is what happened in 1972. You had a tendency
to resist market rate increase as interest rates were rising during the
expansion. Money supply grew very, very rapidly, mainly because
this other tool was dealing with the inflation problem.
Well, inevitably controls broke down, inflation erupted, and the
price level went back to where it would have been anyway. The only
way controls would work in theory was if you had appropriate money
and fiscal policies, monetary growth being constrained.
Then, of course, the controls are not necessary. But the existence
of the controls makes it less likely that you will get appropriate
monetary policies (winding down the trend of money and the trend of
inflation) for the kind of reason Mr. Perry cites. Then monetary policy
is "free to be stimulative," to do these other things. I think that is a
very dangerous approach to take.
Mr. MEISELMAN. In terms of your question about the relationship
of monetary policy and inflation, there are several things about the
inflation process that are clear to us, especially after the experience
of the last few years.
When the inflation rate goes up, it is as if the inflation itself is an
excise tax on business property because under the law, the profits
of a business firm are calculated on the basis of historic costs. That
73-959—76




8

110
means that when profits are calculated, the profits are overstated
because a business firm does not take the correct amount of depreciation in order to replace its capital used up in the production process.
The costs of replacing inventories are not adequately taken into
account either, so it is as if the inflation per se is a form of an excise
tax on business activity.
That by itself would reduce capital formation, both in fixed plant
and equipment and in inventories. At the same time, the inflation
throws people now into higher tax brackets, even when their real
incomes are unchanged and are falling. My own effective tax rate
has gone up very substantially because of the inflation, even though
my real income has not increased. When people get thrown into
higher marginal tax brackets, the incentive to save is changed, and
people have less because the returns to saving fall. Instead people try
to accumulate assets in a form that does not yield them any money
income that is taxable.
In addition to high marginal tax brackets there is the fact there
is no way to hedge against inflation, although we have talked about
several mechanisms which result in some protection against inflation
in the form of market adjustments involving higher interest rates.
These go only part of the way. There is no way that a person can
typically get complete or sufficient protection.
The usual way that you Accumulate assets is through saving and
making funds available to business enterprises and the Government.
But saving and investment are subject to differentially higher taxes.
So one of the things that happens during inflation is that large numbers of people want to protect themselves and they tend to accumulate
all kinds of other assets. Among them are durables, houses, gold,
antiques, jewels, and so forth. You see this especially in countries
that have a large amount of inflation over long periods of time.
We are starting to see similar events in the United States, with
people buying all kinds of junk which they call "collectibles" because
it is something?tangible. That is really just a small indication of what
would happen if we continue this process.
Both from the standpoint of saving and investment, even a steady
rate of inflation produces these economic impacts. Steady inflation
makes a country as a whole much less efficient. Stop and go policies
make it even worse.
Under conditions of erratic inflation, people have less information
about the current prices of many goods and of their market conditions.
They also have less certainty atout what the future will bring. Thus,
you cannot make the kind of contemporaneous price comparisons that
are necessary to know whether a pair of shoes at $50 is such a good buy
or that one you ought to run in and buy two pairs of shoes or whether
the price is much higher than the prices of shoes available elsewhere.
At the same time, you cannot make efficient comparisons between
today's cost of capital goods and what returns the capital will yield
in the future. You cannot have efficient capital management.
Inevitably there are more and more mistakes.
Inflation, especially variable inflation, makes the economy as a
whole much less efficient. Those are some of the reasons that the kind
of stop-go policy envisaged as necessary to offset an erratic private
sector ends up being bad for jobs, bad for growth, bad for the economy
as a whole.




Ill
After many, many years of it, we really ought to ask ourselves what
we have to show for the last decade of inflation? We have a higher
unemployment rate and much reduced economic growth. What had
been a good situation with respect to growth in the private sector
in the mid-1960's and even the growth of the public sector, has, in
most respects fallen apart right under our feet.
Mr. PERRY. I am going to have to excuse myself, Mr. Chairman.
I have an appointment at 2 o'clock at the other end of town. I am
sorry.
Mr. NEAL. I am sorry to go on so long.
Thank you for coming. This has been fascinating and most helpful.
Mr. Allen.
Mr. ALLEN. If a constitutional amendment or any other means
should be provided that would prohibit any and every government
from the Federal to the State to the local government from spending
more than it collects in taxes, what would happen to this economy?
Mr. JORDAN. I think if it happened overnight, we would have a
little bit of transition problem. But I think, ultimately, it not only can,
but should be done. I think I would add an amendment, if I could
propose one, that not only they can't spend more than they raise in
taxes, but they can't spend more than a certain percent of personal
income of that State—or the national income. At a minimum, this
freezes the proportion of our economy that is government and
maintains the proportion in the private sector. It would be desirable
to have a gradual reduction in State, local and Federal spending as a
percent of income so we can free resources to be emploA^ed in the private sector. That is where 3^011 get efficiency and improvement in
people's standards of living.
Mr. FIEDLER. I share some of the goals, the long-term goals that
were implicit and in some cases explicit in Mr. Jordan's answer,
but I would give a completely different answer. The constitutional
amendment of the sort you proposed
Mr. ALLEN. However
Mr. FIEDLER. I think that would be a disaster. There are many
occasions when governments do need to increase their debt. There are
many occasions when capital investment by the public sector is stimulative to the improvement of the standard of living of the American
people.
I want that freedom to exist when it is appropriate to do so. I
share the goal of less government as a percent of the total economy.
I share the goal of more appropriate management of the public debt
and the inflation and monetary policy and all the rest.
But I don't think we can achieve that by any strict prohibition on
deficits.
Mr. ALLEN. Maybe I stated it wrong. Let's say that every single
governmental agency in the United States from the local community,
city, county, State, Federal government levels should decide tomorrow that we are going to live within our tax revenues collectible each
year.
What would happen? Would it not precipitate a plunge, an economic
plunge?




112
Mr. MEISELMAN. There would be problems with adjusting to that
because we alread3^ have large deficits. In the area of fiscal policy as in
monetary policy, I think it is wise that we change direction in a way
that is not too abrupt.
But we have to keep our eye on the ball with respect to where we
want to be. If the Federal Government isr now running a deficit in
the order of $70 billion or $80 billion per 3 ear, and you propose that
the deficit be eliminated overnight, it is a question of how that is to
be accomplished. If expenditures were reduced to eliminate the
deficit, there would be some adjustment because there would be people
who would temporarily be without jobs.
But the typical person who works for the Federal Government
has more education and training and is relatively more mobile than
the average worker. They would seem to be, on the average, among
the most capable of finding alternative employment. It would be
difficult for some of them just as it might be costly to me if I lost the
major source of my income as a professor of economics.
In view of the fact that there is some implied commitment between
an employer and employee that lasts beyond the week or two of the
current pay period, the honorable thing to do would be to change
.gradually, but systematically.
However, I don't think that these considerations touch on an
important problem. The important question that you bring up, which
is crucial for much of current discussion of public policy reflects the
fact that, on average, the goodies from expenditures come first and
the costs come later.
Mr. ALLEN. I am not recommending any such thing as that.
Mr. MEISELMAN. NO; but I think it is clear that there is an imbalance of incentives for those who vote the expenditures and vote
the taxes. As you know, you are a hero in your district if you get some
expenditures that are particularly favorable to them. At the same time
the taxes to pay for the spending are highly diffuse. So, there is a bias
in the procedures of the Congress as between expenditures and taxes.
The economic effects of going into debt which are also very diffuse.
I t takes a trained eye to see them. Many trained eyes claim they
can't see them at all. Put it all together, it suggests that there is art
inevitable bias toward more spending, more debt and larger government as well as a deferral of the diffuse costs.
These are some of the reasons that some people who are very
concerned about the size of the public sector and who don't believe
that people are getting their taxes worth—and I am one of them—
have asserted that one way to help bring expenditures under control
as well as have an efficient size of government—not to get rid of
government but to have an efficient size of government—is to have a
closer link between taxes and expenditures. You do the same thing in
your own budget when you are effectively led to make a comparison
between the cost of an item and the value you receive for it. That is
essential for efficient choice. But, that element is missing in the way
governments make choices because there are other ways to finance
expenditures.
The other ways are print new money or incur vast debt. I live in
the Commonwealth of Virginia and in Virginia, we have no public
debt. For many years, people in other parts of the country used to




113
laugh at Virginia's pay-as-you-go policies. But I do not think they are
laughing any more. I suspect that there are now many people in New
York and the State of my birth, Massachusetts, that now think that
Virginia was wise all along.
Mr. ALLEN. The real purpose of my question was to point out one
thing and that is that we cannot consider monetary policy just within
the sphere of how it may be influenced by the Fed.
But this is monetary policy, too, the operation of all of your various
agencies of Government, whether or not they are undertaking to live
within their budgets. Whether that is inflationary or deflationary.
I do not see how you can consider the whole question of monetary
policy without taking that into account.
Mr. FIEDLER. Yes, sir. I agree.
Mr. NEAL. In your opinion, if I understand you all correctly, are
you saying big Federal spending and big Federal deficits are not to
be desired not because the}^ are especially inflationary, but for other
reasons?
Mr. FIEDLER. Yes, sir.
Mr. MEISELMAN. In terms

of the inflationary impact, it depends
primarily on how the deficit is financed. If the deficit is financed by
"monetizing" the new debt, then it is inflationary.
If you have a larger government, it is inflationary to the extent
that resources are generally taken from the private sector, where
they are more efficiently used, and brought into the public sector
where the}" are less efficiently used.
This means that a larger budget per se is inflationary. There would
be even more inflation if it were financed by newly vested money.
Mr. NEAL. Can you put a number on that?
Mr. MEISELMAN. There is no way, except to evolve some assumption about the true value of government services, most of which
have no market where prices and values can be recorded.
Mr. NEAL. Would you agree with our conclusion that the rate of
money growth is responsible for approximately 60 percent of our
inflation?
Mr. MEISELMAN. In that one episode when there was a sharp
reduction in the supply of certain kinds of goods, that itself was an
independent supply element in the inflation. I did make some ballpark estimates in testimony before this subcommittee 2 years ago
about the inflationary impact of the devaluation of the dollar between
1971 and 1973.
I do not have the numbers offhand. But for a given stock of money,
if the output goes down, the supply of money goes up. My calculations at that time which were very rough, were that the major factor
in the inflation was the sharp increase that money had taken in 1972
and 1973 rather than the reduction in output.
Mr. NEAL. Let me thank you all for coming. I apologize for keeping
you so long, but this session really has been quite informative.
Let me announce that Governor Partee of the Federal Eeserve
Board will testify tomorrow at 10 a.m.
The subcommittee will now be adjourned until tomorrow morning
at 10 a.m., when we will continue our hearings in this same room.
[Whereupon, at 1:43 p.m., the hearing was adjourned until 10 a.m.,
Thursday, June 10, 1976.]




THE IMPACT OF THE FEDERAL RESERVES MONEY
POLICIES ON THE ECONOMY
THURSDAY, JUNE 10, 1976
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE COMMITTEE ON BANKING, CURRENCY AND HOUSING,

Washington, D.C.
The subcommittee met, pursuant to notice, at 10:06 a.m., in
room 2128, Rayburn Hoxise Office Building, Hon. Stephen L. Neal
[chairman of the subcommittee], presiding.
Present: Representatives Neal, Hannaford, and Gradison.
Mr. NEAL. Let us go ahead, please. I am afraid we will have a
quorum call before too long.
The hearing this morning on the impact of the Fed's money policies
on the economy marks the third day of such hearings being held by
this subcommittee. I am pleased to say that the six witnesses who
have already testified before the subcommittee have greatly contributed to our attempts to get a handle on the responsible conduct of
monetary policy, and its relationship to fiscal policy, inflation and
unemployment.
While there is not one right answer that will solve our economic
problems, testimony presented before the subcommittee has indicated
past money policy deficiencies and errors and put forth constructive
suggestions on restoring stable prices with continued recovery.
Just as we hope that these hearings will help to promote sound
economic policies, we also hope that they will prove to be educational.
We are trying to ask questions about the importance of monetary
policy as it relates to the whole economy, how well it has been administered in the past, and what, if anything, we might want to do
to bring about a change in it for the future.
We are trying to be just as objective as we possibly can, trying to
let the facts unfold as they are without prejudice. We really are making
every effort to do that to the best of our ability.
We are pleased to receive as our witness today Governor Partee
of the Federal Reserve Board. Governor Partee, I welcome you to
our hearing.
Please proceed as you wish.
STATEMENT OF HON. J. CHARLES PARTEE, MEMBER, EOARD OF
GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Governor PARTEE. Thank you, Mr. Chairman.
I am pleased to participate in these hearings on monetary policy
and its effects on the economy. During the past year, aided by the




(115)

116
implementation of House Concurrent Resolution 133, a contructives
dialogue has developed between the Federal Reserve and Congress
on the course of monetary policy. I am hopeful that this morning's
session, which I understand to be exploratory and educational in
nature, will help further our mutual understanding of the issues
involved. I would like to begin with some brief, comments on the
monetary policy process, based on my experience over the years
working in this area, and then I shall be happy to respond to any
questions the members of the subcommittee may have.
Although economists differ in their theoretical approaches to the
channels through which monetary policy works, there is little or no
disagreement in the profession that monetary conditions have a
profound impact on the performance of the economy. One view is
that monetary policy influences economic events primarily by changing the stock of liquidity—particularly, the supply of money and nearmoney substitutes—and thereby the willingness of consumers and
businesses to spend and invest out of these more, or less, ample balances. Another view is thai the influence of monetary policy stems
mainly from its effects on the money and capital markets; by affecting
the cost and availability of credit, policy actions will tend to encourage
more, or less, consumption and investment based on the use of credit.
In fact, these theoretical approaches are not contradictory. They
both find that an expansive monetary policy will tend to encourage
more spending while a restrictive policy will tend to restrain it. But
they do approach the process from different vantage points, and the
quantitative measures they suggest we look to in monitoring the conduct of monetary policy differ sharply. The liquidity approach emphasizes the rates of growth in the various measures of the money
supply—Mi, M2, M3, and still broader definitions encompassing successively larger proportions of what might be considered to be the public's total stock of liquid financial assets. The credit approach to monetary policy, on the other hand, emphasizes changes in the flows of
credit through banks, other financial institutions, and the securities
markets, as well as changes in the terms—including interest rates—on
which such credit is made available. This difference in measurement
technique, I believe, gives rise to much of the confusion and disagreement in the evaluations of current monetary policy that one often encounters in the press and elsewhere.
The fact is that observed monetary measures, regardless of current
policy intent, will always reflect also the interaction over time of
monetary policy with underlying conditions in the economy. Output,
employment, and prices are affected directly by powerful forces apart
from monetary policy, such as governmental tax and spending policies,
the attitudes and spending proclivities of businessmen and consumers,
the wage increases being obtained by labor and the pricing policies
of business firms, the availability of foodstuffs, energy supplies and
essential industrial raw materials, and economic conditions and developing trends abroad. In these circumstances, whether interest rates
are comparatively high or low, or whether the demand for credit is
strong or weak, will depend on many factors other than the rate at
which the Federal Reserve is providing reserves to the banking
system—the basic policy instrument at its disposal. Indeed, even the
observed pace of expansion in the various measures of money supply




117
may reflect short-run variations in the public's demand for such balances or longer-run changes in liquidity preference in response to
technological innovations in financial management, the level and trend
of interest rates, and present and prospective rates of inflation.
It is important also to recognize that the impact of changes in monetary policy on various aspects of the economy tend to be reflected
with differing time lags. If financial conditions tighten, for example,
the effects are likely to appear much more promptly in securities
market values, and hence on such wealth-sensitive variables as consumer purchases of durable goods, than in business-fixed capital outlays, which require long lead times from planning to fruition. Similarly,
the effects of a change in financial conditions will be more pronounced
in markets that are heavily dependent on the use of credit—such as for
housing and other large investments—than in markets where demand
is financed mainly b}^ current income flows, such as for consumer soft
goods and services. Ultimately, of course, these areas of the economy
too will be affected by induced changes in the income flows themselves.
There is one further timing aspect that requires especially careful
evaluation in the formulation and conduct of monetary policy. As I
have already noted, the economic influence of monetary conditions—
whether measured in aggregate or financial market terms—will be to
encourage either faster or slower expansion in spending, depending on
whether such conditions are easing or tightening. But this effect on the
nominal GNP does not distinguish between real activity and inflation.
In my view, a shift in monetary policy can be expected to affect real
activit}^, as demands for goods and labor tend to be augmented or
restricted, before it reflects itself in the rate of inflation. This is because
it ordinarily takes some time for business and labor to adjust wage
and price policies to changing market conditions. The time lag involved, and the intensity of the inflationary effect, will depend on the
initial state of the econonry and the sensitivity of expectations. But
the inflationary effects will sooner or later develop, and this argues
strongly against a policy course that calls for large injections of liquidity into the economic system as a temporary panacea. In theory, it
might be possible to withdraw the excess liquidity in time, before the
inflationary forces begin importantly to work. But in practice this will
likely be very difficult—if not impossible—to do.
The complexity of the relationship between monetary policy and
the economy, and the need to move cautiously in modulating financial
conditions as economic circumstances and investor and saver attitudes
change, indicate clearly the importance of flexibility in the conduct of
monetary policy. House Concurrent Resolution 133 fully recognizes
this need. Under this resolution, the Board reports quarterly on
economic and financial developments, and specifies the current
expectations of the Federal Open Market Committee for the probable
growth rate ranges in a variety of monetary aggregates, alternately
before the House and Senate Banking Committees. This procedure
is one that permits frequent revaluation, and appropriate adjustments
in current monetary policy aims to the economy's changing needs,
which I believe to be a highly desirable attribute. Quarterly accounting
for the stewardship of monetary policy also implicitly recognizes the
difficulty of projecting economic developments very far into the
future with any high degree of confidence—an assessment with which,
on the basis of experience, I heartily concur.




118
In the congressional deliberations leading to the present wording
of House Concurrent Resolution 133, and in further discussions
since then, a recurring issue has been the question of whether monetary
policy intentions should be specified in terms of interest rates as well
as monetary aggregates. The resolution does of course require that the
Board specify 12-month growth ranges for the various monetary
aggregates, and it provides ample leeway for adjustment of such
ranges as conditions change. In my view, this approach is far preferable
to any attempt to specify interest rate objectives.
While it is theoretically possible to specify the course of monetary
policy in terms of interest rate levels as well as the monetary aggregates, it must be recognized that interest rates are particularly exposed
to the influence of many variables external to the scope of monetary
policy, and that there is thus a large risk of specification error. The
announcement of interest rate intentions or expectations could lead
borrowers and lenders to believe that the Federal Reserve could—and
in practice would—guarantee particular levels of interest rates. But
the System does not have the power to do so, for interest rates are
influenced not only by the interaction of demands for credit with the
available supply of funds, but also by the strength of the economy and
public's willingness to defer current consumption in order to save for
the future. Interest rates are also importantly affected by the expectations of both borrowers and lenders about the rate of inflation.
If the Federal Reserve did nevertheless attempt to maintain
selected interest rates at some predetermined level, the effort could
well lead to inappropriate rates of growth in bank reserves and the
money stock. If interest rates came under upward pressure because of
rising demands for funds, for example, System efforts to prevent
interest rate increases would inevitably generate more rapid monetary
expansion, thereby feeding new inflationary pressures. If, on the
other hand, interest rates came under downward pressure because of
slackening business activity and declining demands for funds, System
efforts to prevent the decline in rates would inevitably retard monetary
growth rates and quite possibly exacerbate the recessionary problem.
Thus, any serious effort to specify monetary policy aims in terms
of interest rate intentions or expectations could well prove inconsistent with stated objectives for growth rates in the monetary
aggregates. Of course, the central bank might attempt to hold to the
interest rate objectives, regardless of the performance of the monetary
aggregates. But even in this extreme case the result would very likely
be self-defeating, as lenders and borrowers moved to protect themselves against the prospect cf accelerating inflation or deepening
recession, foreshadowed by what might be very high or very low
monetary growth rates. Needless to say, these effects would be quite
perverse from the standpoint of economic stabilization.
In closing, I would like to stress that monetary policy alone cannot
be expected to deal with all of the Nation's economic problems.
Fiscal policy has a powerful influence on the course of economic
activity, and outsized deficits can and do contribute to inflation.
Monopolistic behavior with respect to the setting of wages or prices
lies outside the scope of monetary policy, and strongly influences the
character of the inflationary bias also. Restrictive trade practices,
whether imposed by private power or government regulation, serve




119
to limit productivity and raise costs to the same end. It will require
the efforts of all elements of our complex society if healthy economic
growth is to be sustained, unemployment reduced to appropriately
low levels, and inflation brought under control.
Mr. Chairman, at your request, I have tried to be brief in my
treatment of a very complicated topic. It may be that I have raised
more questions than I have answered. But I will be glad to respond
to questions that subcommittee members have.
Mr. NEAL. I thank you for your very thoughtful statement and
for coming this morning.
Let me draw your attention to this chart, if I may. We have mapped
the yearly money supply changes, shown by the black line, from 1954
up to this year.
Governor PARTEE. That is the narrow money supply, I assume.
Mr. NEAL. That is right.
I would like to ask you a couple of questions about it.
From your knowledge, would you say that that is essentially
accurate?
Would you have any questions about the chart itself?
Governor PARTEE. Well, it looks roughly right. I would have no
way of knowing whether there would be inaccuracies. We do revise
the figures. There has been a benchmark revision in recent weeks that
affected 1975 and 1976 data, so there probabry are small differences;
but I do not think they are significant, sir.
Mr. NEAL. I think we have included the revisions that have been
published in these figures.
In looking at that chart, what I see, of course, is a roller-coaster
type of pattern. I have to ask the question, has that been beneficial
to our economy?
Please respond to that. Would you say that that has been beneficial?
Governor PARTEE. Mr. Chairman, I do not think you can just
look at a chart in the abstract and draw a conclusion from it.
There are two features of that chart that stand out to me and I am
quite sure stand out to you. One is that there seems to be an upward
trend in the rate of money growth over a period of time spanning
many years. The second is that there is a good deal of volatility in
the series; that is, shortrun sweeps up and down in the rate of growth.
But it must be recognized that those changes reflect a host of circumstances that affect not only the economy, but the observed rates
of increase in money supply.
In a recession, for example, the tendency is for the demand for
money to decline sharply. Interest rates also decline sharply at that
time, and often the tendency will get ahead of the Federal Keserve
and there will be a period of slow growth in the money supply before
the basis for increases in money growth is restored. In periods of boom,
of high level activity, the demand for money will be very strong.
There will be very strong upward pressures on interest rates. There
will also be a great deal of anguish about the effect of tight credit
on housing, on automobile dealers, on farmers, on small businesses,
and at those times there is a tendency, because of the rate at which
interest rates have increased, for the money supply to grow more
rapidly. In that environment, the Federal Eeserve would be trying
to hold back the rate of growth, but nevertheless there can be a period




120
where money supply growth is more rapid. So that, accounts, I think,
for a large amount of the fluctuation that occurs—the shortrun
fluctuation.
Now, so far as the upward trend is concerned—and I would note
that it does appear from the chart that it has been interrupted over
the last couple of years—I think what is reflected there is the fact
that society has required, legitimately in my opinion, that economic
activity be reasonably good and that employment be reasonably
strong. We have had a growing labor force. We have had to have
rising business activity. We have had to have rising opportunities
for jobs. But, given the social structure that has provided large wage
increases well in excess of productivity gains, and given the structure
of business which has permitted these wage increases and other cost
increases to be passed through in the form of higher prices, there has
been an inflationary bias—I believe a growing inflationary bias—in the economy.
Had the money supply not grown in that kind of environment,
the result in the first instance would have been reduced levels of
economic activity, higher unemployment, and a good deal of difficulty
with the economy. So, it is not that I am disagreeing with what the
chart shows; I just wanted to explain the background.
Mr. NEAL. It was the volatile nature of the chart that particularly
interested me.
Governor PARTEE. Yes. I addressed that in my first comments.
Mr. NEAL. YOU state that without an increase in the money supply
during these years we could not have increased our gross national
product and so on. There is no question about that. But could the
Fed have kept the growth of money supply on a more even keel if it
so desired?
Governor PARTEE. Yes. It could have been done; that is, in abstraction. What would then have been required would be a willingness to
see larger interest rate changes than did occur; that is, during those
periods when that line on the chart is going down—periods which
tend to occur very late in the boom or very early in the recession—•
in order to prevent that line from going down, interest rates would
have declined much more sharply than in fact they did. When the
line goes up, as it did, for example, in 1967 and 1968, and again in the
early seventies, it would have required much higher interest rates
than in fact developed during that period in order to keep the line
from moving that high.
It is a question of the tradeoff between the interest rate effects
and the credit availability effects and what they do to the structure
of the economy, and the desire to keep money growth relatively constant. That is our continuing problem.
Mr. NEAL. SO, you would assume that the economy is much more
tolerant of swings in the money supply than it is of interest rate
changes?
Governor PARTEE. NO ; I cannot reach that judgment.
I would say that one has to take into account the effect of interest
rate changes and credit availability changes on the economy and that
one cannot have as his only objective a growth rate in the monetary
aggregates that is stable over time, or moving in a stable manner




121
over time, because there are times when the interest rate movement
required is something that society simply will not tolerate.
As I explained at the beginning, there are monetarists and there are
nonmonetarists in the economic profession. I have never chosen up
sides, and the Federal Reserve tends to blend the two points of view.
There were many other things going on. We have had different
boards of governors and different Federal open market committees
during the period to which the chart refers. We have had different
administrations; we have had wars and nonwar periods; and all of
those affect the environment with which we are dealing. The point is
that one must deal in practical terms on a day-by-day basis with what
is going on in the economy, and often the price—the shortrun price—•
of holding monetary growth stable is more than society will tolerate.
Mr. NEAL. YOU mentioned interest rates. Is there a demonstrable
relationship between the level of interest rates and the level of increases in prices—the level of inflation?
Governor PARTEE. I think the causality runs from inflation to
interest rates; that is, I do not think that high interest rates make a
very material contribution to inflation. But a high rate of inflation
over a sustained period, and the expectation that there will be future
inflation, does affect interest rates simply because lenders are not
willing to see the real value of their wealth decline, and therefore they
want an interest rate that will compensate for inflation. Borrowers are
willing to pay the rate because they feel that what they invest in
with the proceeds is going to go up in value, too.
Mr. NEAL. If I understand the process—and I would like for you
to respond to this—if }^ou set targets for short-term interest rates,
then you change the growth of the mone}^ supply; if you increase
the growth of the money supply to keep interest rates down for the
short term, you increase the likelihood of inflation, as I understand it.
Is that essentially right?
Governor PARTEE. Mr. Chairman, we prefer to say that when we
restrict the growth of reserves, which is what we provide to the
banking system, in an environment where demand is strong the
result will be rising interest rates. We do not put interest rates up,
but by holding down on the supply of reserves, the effect is to put
interest rates up. If we do permit overly large sustained increases
in the money supply, I have no doubt that that eventually leads to
inflation with a lag, and that the inflation will in the end put interest
rates higher.
Mr. NEAL. What is emerging here is fascinating to me. Our chart
maps the increase in the yearly changes in the cost of living occurring
23 months after fluctuations in money supply—Mi. A consistent
relationship is shown here, indicating that the sharp growth or
contraction in Mx is reflected in the level of prices.
According to this exhibit the rate of growth of money supply has
resulted in increased inflation.
Governor PARTEE. Mr. Chairman, I do not disagree with the thrust
of that chart. I am sure that you will understand when I say that it
is not an elaborate analytic chart. It is simply an arithmetic exercise.
If one, say, were to have plotted the change in unit labor costs and
compared them with the Consumer Price Index, you would find a
high correlation also.




122
There are some possible statistical difficulties with the chart. But
I think that it is true that a rate of increase in the money supply
above a minimal rate that would be associated with real growth in the
economy, given our limited capacity to increase output in real terms
in the economy over the years will in time bring an inflation. In
effect what is being measured here is the subsequent cost of the
earlier decision to try to keep the economy going at a reasonable rate.
There is a process being described here and you are measuring the
cost side. I am very mueh in favor of your doing that because I think
so often the inflationary consequences of an expansive monetary
policy are lost sight of because of the lag effect; and I think it is very
constructive to examine it. But I would point out that there is an
entire process involved. If in looking at this chart, you tend to conclude
that had the money supply not gone up we would not have had inflation—everything else would have been just the same and we
would not have had the inflation—that is a wrong conclusion because
in fact the economy would have been for a time—perhaps for a time
be}^ond the willingness of the public to see it—the economy would
have been much weaker in the process.
What would have to happen in order to reduce that rate of inflation
23 months hence is that wage increases, cost increases, price increases,
and profit shares for companies would have had to be held down. That
process is very difficult to deal with in our economy—that is, the
tendency for costs to rise more than productivity in the economy.
Mr. NEAL. Let me repeat that we are not attributing 100 percent
of our inflation level to the growth of money supply—M2. Our estimates show that about 60 percent of inflation can be traced to the
growth of Mi. We are fully aware of the consideration that must be
given to the dramatic increase in oil and food prices, the aftermath of
wage and price controls, large wage settlements, and a host of other
factors. The astounding thing that is emerging, though, is the magnitude of the influence of Fed policy. We see that one component in
all of this—the Fed's money policies—accounts for 60 percent of the
rate of inflation.
Governor PARTEE. Mr. Chairman, I do not quite know how to go
about explaining this. Let me try again.
I do not mean to say that monetary policy is not very important.
I do not mean to say that Federal Reserve action does not have a lot
to do with the rate of inflation in the economy in subsequent periods.
Mr. NEAL. Sixty percent.
Governor PARTEE. But I can add the contributions of other variables to come to more than 100 percent—by using various components
more than 100 percent of the variation in the rate of inflation can be
explained. If I take unit labor costs as an explanatory variable, I am
sure I will get more than 60 percent out of that. If I take some kind of
measure of world demand and availability of industrial supplies, I
think I can get some percentage there.
My point is that one tends to measure things—one of which is the
rise in the money supply—that have a lot of the same causes in them,
and are associated with the economic situation of the time, and do
contribute to later inflation. I do not disagree; but I would not say the
60 percent flows purely from the money supply to the rate of inflation.




123
You mentioned the federal deficit. I think we must recognize that
the Federal deficit's inflationary effect may well show up in monetary
policy, in the monetary aggregates, because a large Federal deficit
will, other things being equal, put substantial upward pressure on
interest rates and it will tend to induce a faster rate of monetary
expansion just in order to hold the system together. Therefore, a
large Federal deficit may—not as a deliberate matter, and not because
the Secretary of the Treasury says it must be so—it may give you a
higher monetary growth rate, and then the monetary growth rate is
later reflected in inflation.
What I am saying is you cannot just separate the sources of inflation into finite separate pieces.
Mr. NEAL. Let me ask this question if I might. You mentioned
wage increases several times as being highly inflationary. Why were
wage increases relatively moderate during the early sixties? What
would explain that?
Governor PARTEE. That is a very interesting question. I have
thought long and hard about how to reestablish those conditions.
I think as a matter of fact that the economy is closer to doing so now
than it has been for the whole decade that has gone by.
My view of the matter is that we had a period of very slow growth
in the economy in the latter part of the fifties. We had a number of
recessions—in 1953, 1954, and in 1957, 1958 and in 1960 and early
1961. It was a painful process—and I might say that monetary policy
was very widely blamed for the poor performance of the economy
in the latter half of the fifties. But, as a result of that process, expectations and aspirations did tend to fall back and expectations of inflation
tended to moderate so that we found ourselves in the early sixties
with moderate growth rates in wages, quite slow increases in consumer
prices, good increases in profits based not on rising profit margins
but on rising volume—a very decent situation. I think that is what we
are trying to restore at this time.
Mr. NEAL. Also during this period you had a very moderate
and steady monetary policy.
Governor PARTEE. But we could have that, you see, because the
other parts of the economy were not performing badly.
I was on the Board's staff in the early sixties and I remember well—
we would argue about this or that detail of the movement in interest
rates, but in fact credit availability throughout the period was very
good. Kates were not trending up. They moved up somewhat cyclically
in the early sixties, but not a great deaL The economy was performing
well. We had a set of conditions that did not call for a great deal of
increase in the money supply, and were really quite suitable except
that there was a degree of unutilized resources in the economy that
was gradually being absorbed during that period. It is not unlike, as
I say, the current situation.
Mr. NEAL. That is right. It is also interesting to note that when
there is a rapid increase in the money supply, you have a corresponding increase in the level of prices, with about a 2-year lag.
Now, when you suddenly turn your supply of money off, we have
recessions. Would you agree with that?




124
Governor PARTEE. I would agree that the two are associated.
You are reading a cause-and-effect relationship into this that is
stronger than I would like to agree to.
I think that when there is a boom in the economy, that is, when
there are all kinds of demand increases and sizable wage settlements
are being given, there exist conditions that tend to create both inflation
and strong demand for a rapidly rising money stock. When there is a
recession in the economy, there tends to be a decline in the demand
for money, so that it is easier to have smaller money growth.7 In fact,
there is the danger of too low a growth rate in the mone} ' supply
during such periods. Also, during those periods the inflationary pressures tend to come off the economy.
There is an association here that is very strong. And if we have the
will to hold monetary growth within reasonable ranges—and I do not
mean at any fixed number, month by month, or even quarter by
quarter, but within reasonable ranges—if we can have the will to do
that I think we can reduce the instability in the economy. And we can
gradually reduce the rate of inflation in the economy. But you must
recognize that this runs the risk that business profits will be poor at
times; that wage increases will be hard fought and hard to get. There
will be long strikes such as we are now having in the rubber industry.
There may be periods of unemployment, regionally or nationally, that
are very offensive to the sense of social justice of the modern U.S.
economy. These are the issues that we are always struggling with.
Mr. NEAL. AS I understand it, though, you are saying that there
is a very strong relationship. In other words, if we do moderate the
growth of money supply, we could expect a lessening of the rate of
inflation and also should not expect these recessions.
Governor PARTEE. If we could moderate the growth over a significant period of time, we should expect a lessening in the rate of inflation.
But we might very well have during that period of time an economy
that is not performing well from the standpoint of providing employment opportunities, from the standpoint of profits, that kind of thing.
Mr. NEAL. Well, why? We had that in the sixties.
Governor PARTEE. Yes; but the conditions resulted from an economy that previously had not performed up to many people's expectations. And you need to have the precondition of ample resource
availability, I believe, in order to have the basis for sustainable,
noninflationary expansion.
As I said in my statement—and I think it is a very important thing
for you to keep in mind—the effect of greater or lesser monetary provision in the economy falls on the nominal GNP. And the break that
occurs between prices and real activity is unfavorable in the first
instance. That is to say, if you lower monetary growth rates you will
have in the first instance an effect on real activity that is unfavorable.
And only after a lag—and the lag may be short compared with what
it used to be—only after a lag will you start to get the benefits of a
lower rate of inflation. If you expand the rate of monetary growth, I
think the initial effect will be stronger markets, more employment,
better conditions, all of things that are extremely favorable. But you
will, again with a lag—and the lag may be shorter than before—with
a lag you will be setting the conditions for heightened inflation.




125
It is that conflict between short run and longer run effects that has
always been extremely difficult for us to deal with in explaining ourselves to the public.
Mr. NEAL. I am sorry to take so much time. Let me make one more
point and I will be happy to yield to the gentleman from Ohio.
You started to comment on the deficits. We also charted the
Federal deficits, and we see far less significant relationship between
the level of deficits and the rate of inflation or recession than between
Mi growth and inflation and recession. And in fact as you know, at
this point we have the biggest deficits in our history and one of the
lowest rates of inflation.
I had always assumed that there was a strong relationship between
the level of Federal deficits and the rate of inflation, and I never
understood it; so I find this quite interesting.
Would you agree with this sort of conclusion? What kind of comment
would you have on that?
Governor PARTEE. If you will bear with me for a moment while I
find the table, I think I can make a contribution to this. I really have
two points to make. One I already alluded to, and I will come back to it.
The first point is that deficits tend to be high in times of recession
when the economy is not providing the revenue that one would ordinarily expect it to provide. But in such times of recession, you also
have a decline in private credit demand. In effect, a deficit or a large
part of the rise in the deficit simply substitutes for what previously
was a private credit flow. And the total credit flow, the total credit
expansion in the economy is not much different than before.
The Federal Reserve keeps quite elaborate figures on credit market
flows by major sectors which are called the flow of funds accounts.
Realizing that this would probably be a question, I had my assistant
put together a table that compares credit flows; that is, the rate of
credit expansion relative to the GNP by year for the nonfinancial
sectors of the economy. We exclude the financial sectors to remove
double accounting. For example, the banks have debts but they also
make credit available, and to include both sides would be double
accounting.
Let me just give you four figures from that table. In relation to the
total GNP, the U.S. Government deficit in 1973 amounted to seventenths of 1 percent. And in 1975, it amounted to 5.7 percent. That is,
it was 5 percent of the GNP larger in 1975 than in 1973. But if you
look at the total flow of funds in relation to the GNP in 1973, the
relationship was 14.3 percent. That is, the total increase in credit
amounted to 14.3 percent of the GNP, and in 1975, when you had this
very large Government deficit, the total was 13.6 percent of GNP
lower than it had been in 1973.
I would argue therefore that the kind of deficit that simply substitutes for private credit demand and reflects basically the inability
of the economy to provide the revenues to the Government that might
ordinarily be expected, is not inflationary, and it does not tend to
raise interest rates. Indeed, that was the case in 1975, and again this
year there has been no upward trend in interest rates even though
the Government is borrowing a great deal of money.
Therefore, I think you ought to try another chart. While I have no
analytic trust in the particular level of any full employment deficit
7S-959—76




9

126
number, I do think the changes that it shows from one period to another are significant. And I think you ought to try a chart using the
full employment deficit or something like a full employment deficit
concept.
Mr. NEAL. Excuse me a second. Do you have the series?
Governor PARTEE. Well, we have a series. There are various high
employment surplus or deficit series. We have one that we keep
within the shop.
There are some hard decisions to be made in working up a series
as to what constitutes full employment, and also what to do with
rates of inflation which have a powerful effect on revenues and how
you wash them out in the figures. But I can provide the numbers to
Dr. Weintraub.
Mr. NEAL. I wish you would.
Governor PARTEE. The second point which is more fundamental
is the one I made before—I have to be very careful in stating this
because I do not mean to imply political pressure or anything else by
this. It is that when the deficit is pressing very strongly on credit
availability and causing tight credit conditions in the economy and
sharply rising interest rates—and we have had some occasions when
that has been true—because interest rates are rising so sharply, and
because there is so much structural impact occurring from this, there
is a tendency to let monetary growth go a little faster than would
otherwise be the case. Therefore, to the extent that the Government
deficit constrains, if you will, policymakers to do what they judge to
be in the best interest of the economy—to have a somewhat faster
monetary growth rate—why the inflation effect of the deficit is
showing up indirectly through that money growth rate.
Mr. NEAL. But if I understand it correctly that is still a relatively
minor influence.
Governor PARTEE. I do not think it is so minor.
Mr. NEAL. Well, you know, the Fed does not always react the way
you are saying that the public would like it to react or the way the
Congress might like it to react.
Governor PARTEE. NO.
Mr. NEAL. Could you possibly try to quantify that effect?
Governor PARTEE. NO, I cannot really quantify it.
Mr. NEAL. Well, let's try to get something that would help in the
public debate. You know, if we go on in this country assuming that
Federal spending and the Federal deficit are the major causes of
inflation, and they are not, then, you know, we will be fighting straws
in the wind.
Governor PARTEE. Mr. Chairman, I do not think it can be quantified because the difficulty is that it is just a part of the whole picture.
Mr. NEAL. What kind of part? A very minor part?
Governor PARTEE. At times it is a strong part. It was a very strong
part in 1965 and 1966 and during the beginning of the Vietnam W a r And at other times it is not an important part. It varies from time
to time. It varies also depending on the political attitudes of Washington, and so forth, during the period.
But I do argue that it is a very real potential danger. Indeed, the
fear that one could just print money in order to finance deficits is
the reason why we have an independent Federal Reserve System.




127
It has happened in many countries in the world at different points
in time, and it could happen here.
Now it has been proposed by some that we ought to be very careful
to see that monetary policy decisions do not in any way affect the
fiscal policy intent of the Congress. And usually that proposal is
stated in terms of maintaining interest rates—having a target for
interest rates that does not change. Thus if the Congress decides that
it wants to have a very much larger deficit as a matter of public
policy, that will not tighten up the private sector at all; well, if you
do that it means that you may get a rapid monetary expansion and
that you will have the inflationary effect of that policy. It is precisely
undoing what the concept of independence is intended to guard
against.
Mr. NEAL. Let me say that I certainly share that concern and that
I could not agree with you more that by monetizing deficits we were
just kidding ourselves and the inflation problem was made worse.
Governor PARTEE. Right.
Mr. NEAL. May we catch this vote and then we will be right back.
I know that Congressman Gradison has some questions and Congressman Hannaford has just come. I am sure that he will want to
talk with you. We will be back in just a few minutes.
Governor PARTEE. That is quite all right.
[A brief recess was taken.]
Mr. NEAL. Let's see, you were commenting about the full employment budget and you were going to supply us with your series on that.
We do not have those figures. Are you suggesting that we would see a
significantly different relationship between Government deficits and
inflation by using your series?
Governor PARTEE. I am not sure, Mr. Chairman. That would be
something I would want to test because from the standpoint of analysis
one would think that there would be more impact using the full
employment deficit. It is a part of the whole and it seems to me that it
is the whole of credit demand, if you will, that is important. We can
speak of the deficit either in terms of its spending effects or in terms
of its financing effects, but it is the whole of credit demand that does
determine the kinds of pressures that develop and, subsequently, the
rate of inflation. The independent contribution of the Federal deficit is
better stated, I think, in terms of full employment financing.
Mr. NEAL. Well we will get that. But, I would still like for you to
comment on the accuracy of the relationship our exhibit shows between the deficit and the rates of inflation.
Governor PARTEE. The full employment numbers would look
entirely different than those, entirely different.
For example—let me see if I can find it here—in calendar year 1975,
the actual Federal deficit on a national income basis was almost $75
billion.
Mr. NEAL. I am sorry, I did not hear that.
Governor PARTEE. The Federal deficit this last year on a national
income basis—that is, the actual deficit but in national income
terms—was $75 billion, and the full employment deficit was $10
billion. So, there is a $65 billion difference. There was a shift from a
surplus of $18 billion in 1974 on our figures in the high employment




128
series to a deficit of $10 billion in 1975, which is quite a sharp shift. I
just do not know how the results would look. We have not done it.
Mr. NEAL. Well, let me return to this in a minute. Mr. Gradison
has to leave, and so I would like to yield to him at this timeMr. GRADISON. Thank you, Mr. Chairman.
Mr. Chairman, first of all I want to recognize the fact that the
subjects we are discussing today are not only important to us but
there is a lot being written about them, and I would ask unanimous
consent to include in the record at this point two recent articles.
One is from the June 7, 1976 issue of Business Week in their economic
section under the title, "The Critics Ask: Is Monetarism Dead?"
And, the second is from today's, June 10, 1976 Washington Post,
an article by Hobart Rowen, under the title, "All That Worry About
Fed Policy."
These both are related to what we are discussing and therefore I ask
unanimous consent that they be included in the record.
Mr. NEAL. Without objection, so ordered.
Mr. GRADISON. Thank you, Mr. Chairman.
[The articles referred to by Mr. Gradison follow:]
[From Business Week magazine, June 7, 1976]
T H E CRITICS ASK: I S MONETARISM DEAD?

Money alone sets all the world in motion—Publilius Syrus, circa 42 B.C.

Monetarists who, like Publilius, consider the money supply the prime mover in
the economy, received a sharp jolt last week. The Commerce Dept. revised its
estimate of the growth of the gross national product (adjusted for inflation) in
the first quarter from an already high 7.5% to 8.5%. The monetarists had been
hoping that the revision would be in the opposite direction—and for good reason.
Although it has speeded up since (page 18), from the third quarter of 1975 through
this year's first quarter the nation's money supply had grown at an anemic 2.5%
annual rate. In the monetarists' view this could mean only one thing—the recovery would be slow and might even peter out. Instead, the continued strong
growth of the economy despite meager money growth means to nonmonetarist
William Nordhaus of Yale University that "the simplistic relationship that
money determines national income has fallen apart."
The meaning.—If Nordhaus is right, then the impact of the monetarists on
policy will be severely blunted. Since the late 1960s the monetarists have gained
an important voice in Washington. Today the money supply numbers are watched
by bankers, brokers, and bureaucrats alike. Even the Keynesians, the arch rivals
of the monetarists, use the money supply in their forecasts. But if monetarism
continues to prove a feeble guide to forecasting, it will cast doubt about the use
of the money supply as a key policy objective in controlling both real output and
inflation. The result may be a return to an emphasis on interest rates and fiscal
measures as the best tools in the economic arsenal.
Furthermore, the Keynesians have been taking it on the chin since the late
1960s. The debate between them and the monetarists, after lying largely dormant
since the Keynesians caved in, once again is very much alive.
Some Keynesians, to be sure, also missed the strong upsurge in the economy.
However, as Nordhaus notes, "Keynesians look at money, interest rates, inventory levels, tax cuts, rebates and consumer savings, among other things."
The monetarists "put all their bets on their money equation, and when that goes
down the drain it means the whole ballgame."
MONETARISTS DEPENDED ON GROWTH IN MONEY SUPPLY AND MISSED THE RECOVERY

The fact that the equation linking money and national income has gone down
the drain, at least temporarily, is undeniable. For example, on Mar. 8, Dudley D.
Johnson, a monetarist economist at Citibank, presented his forecast for 1976
to the Shadow Open Market Committee, a group of monetarists who meet twice
a year to advise the Federal Reserve. Based on his money model, Johnson projected




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a first-quarter real GNP growth rate of .69%. The actual increase was 12 times as
great. Clearly, the monetarists blew it, and the question is: was it a reflection of
fundamental fault in theory or interesting aberration? The answer lies in the
nature of the demand for money.
What went wrong.—The cornerstone of monetarist thinking is that the demand
for holding money by companies and consumers alike is basically stable and
depends critically on the level of national income. This means that if the amount of
money increases then the public will find itself with excess cash and will therefore
step up the level of spending until the balance between money holding and
national income is once again struck.
Thomas Mayer, a monetarist economist at the University of California, now
worries "whether there has been a shift in the demand for money." What Maj^er
means is that now a relatively smaller stock of money is supporting a relatively
larger GNP. Monetarists have traditionally maintained that the velocity of
circulation—the number of times money turns over relative to national income—
does not change drastically from period to period. Therefore, once the stock of
money is known, the level of GNP is foreordained. But if velocity, is shifting and
unpredictable, then there is little that a monetarist can say about where and at
what speed the economy will be headed.
Allan II. Meltzer, a monetarist theorist at Carnegie-Mellon University, argues,
however, that even if the demand for money has shifted, monetarists are in no
real trouble if it is a one-time shift. "If, however," he says, "the demand for
money keeps shifting, then all economists, not only monetarists, will have a
tough time explaining what is happening in the economy." Meltzer believes that
velocity, which has been increasing at more than three times its historical growth
trend, will "very soon move back to trend."
Another monetarist, Jerry L. Jordan, economist for Pittsburgh National Bank,
agrees with Meltzer. "Velocity should show only a 2% increase in the current
quarter, down sharply from the more than 9% increase in velocity in the first
quarter," says Jordan. And he estimates that, because of the 2.7% increase in
money stock in the first three months of the year, real GNP should slow to less
than half the 8.5% rate in the current quarter. "But if it's as strong this quarter,
then I would rethink the linkage between the money supply as measured bj r Mi
and income," Jordan says.
Monetarists have often been chided for the difficulty they have in agreeing on
a definition of the money supply. Such monetarists as Meltzer, Jordan, and
Johnson insist on using Mi, which includes currency and checking account balances. Milton Friedman, on the other hand, often uses M2, which adds time
deposits at commercial banks. Indeed, the definitions of the money supply go as
far as M7, which also includes mutual savings bank deposits, savings and loan
and credit union shares, large CDs, short-term government securities, savings bonds,
and short-term commercial paper.
Over the past year, M 2 growth has accelerated much more than the rate of
Mi. Those who, like Friedman, use M2 in defining the money supply have a lot
less to explain in the economic recovery. And Meltzer concedes that if "we continue to get these kinds of movements in M2 relative to Mi, I would reconsider
which money aggregate is the most accurate indicator." Says Franco Modigliani,
president of the American Economic Assn. and a leading critic of monetarism:
"That's just the point. They don't tell us which M to choose, and when Mi and
M2 diverge, they don't tell us what to do." Says James L. Pierce, economist on
the House Banking Committee, "It seems to me, given the importance of money
to the monetarists, that unless monetarism is some sort of religion, then they
ought to be able to define money and stick with the definition."
THE LINK BETWEEN MONEY AND THE NATIONAL INCOME HAS GONE
DOWN THE DRAIN

A mystery.—Aside from the difficulties in choosing the precise measure of the
monejr supply, the monetarists' explanation of the channels through which,
money growth causes nominal GNP to increase remains shrouded in mystery.
In the monetarist scenario an increase in the stock of money has spill-over
effects on spending in every nook and cranny of the economy, from the purchase of printing presses to pretzels.
On one level, Friedman has compared the link between money and spending
to a helicopter raining down money on people. Even Robert H. Rasche, a monetarist at the University of Michigan, finds that this makes little sense. He says:
"In that case we are talking about an increase in consumer wealth, which of
course affects spending. When it comes to the Fed's market operations it's another




130
story." When the Fed buys bonds the sellers end up with more money but with
fewer bonds, so there is no material increase in wealth.
On a more sophisticated level, Friedman argues that the process operates
through a ripple effect of changes in relative prices. When the Fed buys bonds
in the open market, the price of bonds rises, and other assets like stocks become
cheap relative to bonds. This stimulates the purchase of stocks and raises their
prices, making other assets more attractive. The process continues down the
line to all goods and services until the economy as a whole has adjusted its
increased money to a new and higher level of income and prices.
To Mayer this transmission needs rethinking and testing. "It's not a fiction,"
he says, "however, I would like to see these steps laid out clearly in detail so that
we could test and watch the process all along the way. So far the monetarists
have not done this."
But to many Keynesians, the Friedmanian process is indeed a fiction—a
black box. And their view of how monetary policy works differs sharply from
the monetarists. They say the major impact of an increase in the money supply
is on interest rates and the availability of credit. When the Fed buys bonds,
interest rates fall because the price of bonds rises and the banks have more funds
to lend when the bond sellers deposit their checks. The decline in rates and the
infusion of reserves makes credit more available and cheaper, stimulating spending
on capital investment and inventories.
As the Keynesians see it, the impact of increasing the money supply on prices
depends critically on the level of utilization in the economy. Therefore, they
argue, with unemployment at 7.5 percent and industry operating well below
capacity, there is little danger of rekindling inflation, even if money growth
accelerates.
Another split.—Here, too, the monetarists part company with the Keynesians.
Because, according to them, an increase in the money supply signals that price
increases are on the way, inflationary expectations quickly force interest rates
up—especially but not exclusively on long-term bonds. Trying to lower interest
rates by hyping the money supply is self-defeating, because rates will rise instead.
Moreover, says Meltzer, "Given anticipations, the level of capacity utilization
in the economy makes little difference. An increase in the money supply in the
1930s would have had the same impact on prices as a similar increase in the
1960s." Pierce finds Meltzer's position completely unacceptable. "It's mindboggling," he says. "It defies all common sense."
The debate between the Keynesians and the monetarists may have been going
on under other labels perhaps as far back as Publilius. And it may take that long
to resolve the issues. But if the recovery in the next few quarters is robust, then
the monetarists may suffer the same skepticism that befell the Keynesians in
the late 1960s.
[From the Washington Post, June 10, 1976]
ALL THAT WORRY ABOUT F E D POLICY

(By Hobart Rowen)
Until very recently, the Federal Reserve Board, under the skilled hand of
Chairman Arthur F. Burns, had been enjoying something of a honeymoon.
Interest rates and inflation were trailing off, and the economy and stock market
were moving up together.
The economy continues to move forward at a moderate rate, and the inflation
numbers are still the envy of the rest of the industrial world. But interest rates
have started to edge up—and the stock market, ultrasensitive to money rates, has
started down.
What Wall Street would like to know, of course, is just what Chairman Burns
has in mind. Is he fearful that the recovery has already generated too much steam?
Will he drive interest rates up even more, to ward off the threat of a resurgent
inflation?
Worse, is he so sensitized to charges that in 1972 the Fed followed too easy a
money policy, that he will now over-compensate, and—willy-nilly—pursue an
austerity course in this campaign year?
Rep. Brock Adams (D-Wash.) recently articulated some of these fears by accusing Burns of tightening up money in small, almost imperceptible steps that he
said were frustrating congressional policy.




131
"The Congress, through the medium of the Budget Resolution," Adams said
in a speech to the House, "has provided Mr. Burns with a clear and unambiguous
signal—-don't drive up the interest rates; we need them kept low to maintain the
recovery and prevent its disruption."
It is clear from the actions of the Federal Open Market Committee that Burns
has clamped down on what he considers to be an excessive rate of growth of about
9 per cent in the money supply since February. Key short-term interest rates have
risen about one full percentage point.
But there is reason to believe that the money and stock markets have read
into Fed actions a willingness to take extreme steps to curb the growth of the
economy that doesn't match the intentions of the canny chairman of the U.S
central bank.
Although the Ford administration, for political reasons, is making the current modest recovery sound like a boom, the Federal Reserve Board believes that the economic upturn so far is mild, fairly well-balanced, and not at
all sharp. "It's just an average recovery," says one insider at the Fed.
The notion put forward by Treasury Secretary William E. Simon as an excuse
for "Rambouillet II"—the summit meeting in Puerto Rico at the end of June—
is that the recovery has accelerated beyond expectations, and that one must worry
about latent inflationary consequences. This view is greeted with total skepticism
at the Fed.
The recovery just about matches Burns' predictions. Moreover, given the
amount of persistent excess capacity and high unemployment, the Fed doesn't
think that the economy is getting out of hand.
I'm aware that this is not the conventional picture of the Fed one gets from
market letters and some other partially informed sources on the Fed.
The fact is that much of the conventional wisdom and current criticism about
the Fed has been floated by devotees of monetarist theory. They look only at
one number—the growth of the money supply—to try to figure out what Arthur
Burns is doing.
Yet, with only a small growth in the money supply in the last 9 or 10 months, the
economy has moved up to a level that the monetarists failed to predict.
Chances are that Burns will try to squeeze back an excessive rate of money
supply growth—more because of the public relations impact of these numbers
than anything else. But that shouldn't be read on Wall Street as a sign that the
Fed has plans to put the economy through a wringer. The Fed is very close to the
view expressed by many liberal Democratic forecasters that the recovery has a
long way to go.
To sum it up, the time hasn't come to worry about the rate of growth in the
economy, if I read Fed policy correctly. That won't arrive until consumer credit
starts exploding, plant capacity is stretched, and labor markets are tight. Until
those conditions are present, and none of them is yet in sight, thefinancialcommunity ought to put its worries about the Fed aside, and concentrate on more
important issues, like the problems of the British pound, and the total absence of
a federal energy policy.
Mr. GRADISON. Governor Partee, I recognize the significance of
your statements about the reason that the Fed at times would perhaps
like to see the interest rates somewhat higher in order to send a signal
to the economy that the Fed is not going to sit idly by at a time that
there might be a resurgence of inflationary pressures or inflationary
expectations. We seem to be in a period like that now.
I am interested in the way in which this message is transmitted or
the way in which it is interpreted. It appears that the message has
been sent and it has been interpreted in such a way that there has
been a substantial weakening in the securities market, certainly the
equity market, as well as an increase in short-term interest rates.
Do you think that this reaction is overdone? Are you disturbed by
the extent of change that has taken place in the equity values or
interest rates during the last month, taking into account the relatively
small changes in the Fed funds rates which have triggered these
reactions?




132
Governor PARTEE. Mr. Gradison, I do not know that I would ever
want to seek a particular interest rate level or a particular change in
interest rates as a signal. It is a dangerous game to be involved in,
and, I am not sure that I would want to characterize policy in that
way.
I would say that in recent months, in February and March, there
was a good increase in monetary growth rates, and then in April
there was a very large increase in monetary growth, and if you put
the period together, you get a rather high rate of expansion. In the
case of the Mi, for example, it is close to a 9-percent annual rate over
the period, which is above the target ranges that we have given to
the House Banking Committee and the Senate Banking Committee.
And I would rather say that the increase in the Federal funds rates
has occurred because we were trying to hold back somewhat in the
provision of reserves as a reaction to this strength in the monetary
aggregate.
Now the change in interest rates—market interest rates—has been
rather substantial for the changes that have occurred in these monetary
conditions. The funds rate is up only a little less than three-quarters
of a percent, and yet the interest rate changes in the market have been
quite substantial, in the long-term market as well as in the short-term
market.
I think the main reason for this is the expectational influence;
before, people were surprised that rates were as low as they were and
that they were turning down, but they began operating on that basis.
And, then when the rates turned, people tried to anticipate the future
again and decided that rates would be still higher in the period to
come, so they had better make their adjustments quickly. It seems
to me that this anticipation of the future could very well be wrong.
It has been wrong before. Or, the intensity of the movement that is
expected in the market could be wrong, and so we very well might
get a correction in those rate levels.
In the long-term market there is no real reason for rates to move
upward. I think what we have had is a sympathetic reaction to the
short-term rate movement. Given the demand for funds, which is
substantial but not overwhelming in the long market, and given the
reduction in the rate of inflation that has occurred, it seems to me
that there is little reason for long rates to be higher. We could have
just seen a sympathetic reaction that will now be corrected in that
area.
I happened to read Bart Rowen's column this morning; I thought
it was an interesting column, and I agreed with the thrust of it.
We at the Board do not like to prejudge what is going to happen
to interest rates in the future and we do not like to prejudge them
because we do not know what events will transpire. The market is
prejudging, to a degree, interest rates in the future, and it may be as
wrong as we can be if we try to do it.
Mr. GRADISON. My understanding of what you have just said is
that you believe that the market may have overreacted.
Governor PARTEE. Yes, I think it may have. There is a rhythmic
cyclical thing here that the market people are looking at. That is,
when we have business recoveries and they become more vigorous as
they extend over a period of time, one expects interest rates to go




133
higher simply because there is more tension in the credit markets and
more credit demand.
I think it is that cyclically-oriented analysis that has led to the
strong reaction, and it may or may not be right.
Mr. GRADISON. Governor Partee, the charts that we have had do
not appear to take into account the factor of velocity.
Chairman Burns in his appearances before us has indicated that
during a cyclical recovery it is not unusual for velocity to increase,
indeed it has increased rather sizably, maybe even faster than might
have been anticipated during this recent recovery. Do we not have
to take velocity into account in interpreting these charts?
Governor PARTEE. Yes, I think so. Of course, the charts have to
do with retrospective data and velocity would fall out arithmetically
from the lines in those charts.
Indeed, velocity over the whole range of the year shown in that
chart has been pretty predictable. It is only in the last six quarters or
seven quarters that velocity has moved really quite a bit more than
one would have anticipated. Let me give an example of that from
recent experience. As a part of its research activity the Board maintains
a quarterly econometric model, which was developed to show maximum monetary influence on the economy. As a part of that model
one can forecast the relationship between interest rates, nominal GNP
and the money supply.
In terms of forecasting accurac}^ that model has roughly been on
target. However, in the last six quarters, given the realized nominal
GNP and given the level of interest rates, the model, as of the first
quarter of this year, had made a cumulative error, overpredicting the
money stock by $20 billion. Now, that is almost 7 percent of the money
stock.
That is a massive error as these things go. What really bothers
people is not so much the cyclical movements in velocity which can
be expected and understood, but the possibility that something more
fundamental may be going on that may change the relationship
between money and GNP.
It is a highly technical issue, but it shows the looseness in relationships that in fact exists.
Mr. GRADISON. I want to ask just one more question. Really, this
gets back to the discussion which you had with the chairman. My
understanding is that you were suggesting that the economy can have
a direct effect on the money supply just as the money supply can
have a direct effect on the economy and therefore, as we look at these
charts, we had best recognize, when we think of cause and effect, that
we cannot be necessarily sure which is the cause and which is the
effect, that it may work both ways.
I am not trying to oversimplify it at all. I just want to make sure
I understand you.
Governor PARTEE. I think I would agree with that completely.
In abstraction one might say we will not let the economy have an
effect on the money supply, we will simply hold money supply growth
to a predetermined rate. That is usually the basis for most of the
academic approaches to this subject, and it is reasonable to say that.




134
But one has to recognize that if you do that there will be effects on
the economy that can be quite substantial and quite adverse from the
standpoint of political and current social and economic perception.
Therefore, I do believe that the money supply, if you will, is to a
high degree, a captive of the economy.
Mr. GRADISON. I notice on page 2 you refer to differences in measurement technique between the monetarists and fiscalists, if that is
the word. Did you really mean technique, measurement technique or
did you just mean maybe they are putting greater emphasis on different factors, one on the measurements of monetary growth and one
perhaps more on credit flows and changes of interest rates? I was not
quite sure what you meant by measurement techniques.
Governor PARTEE. I do think there is a tendency to exaggerate the
differences. At exactly the same point in time you can read in the
paper that monetary policy is, let's say, stimulative because the
monetary aggregates are growing rapidly; and then you can turn the
page and read an article that says the monetary policy is restrictive
because interest rates are rising. It happens all the time. Sometimes I
believe the newspapers, you know, shift over from the one to the other
argument so that monetary policy will always be shown as being
wrong. At one time the amount of supply is not going up, or it is going
up too fast; and at another time, the interest rates are not moving
appropriately.
That is the variation in measurement technique to which I referred.
What I really meant to say—and I am sorry, I do not think I captured
it well at the very beginning of the statement—is that all these
measurements are a part of one economic system. That is, there is a
logical relationship between monetary aggregates, GNP interest
rates and credit flows. It should be possible to take any one of those
and then specify the rest. And so, the tendency is for the monetarists
to take the money supply and specify the rest, and for those who are
more credit market oriented, to take interest rates and specify the
rest.
But, in practice, I have found that the error that you may make is
a good deal more substantial when you try to specify interest rates
than when you specify monetary aggregates.
The reason for that is not any superiority in the monetary aggregate
technique, but simply that we have a lack of knowledge about how
the economy works in all its relations. Having been through a period
on the staff of the Board when we were looking principally at credit
conditions and interest rates, and then through a period where we
were looking more at monetary aggregates, I am inclined to say you
may not always get the optimal result by looking at the aggregates
but you tend to minimize the chance of major mistakes.
Mr. GRADISON. Thank you, Governor Partee, thank you, Mr.
Chairman.
Mr. NEAL. Thank you. We have another vote but we will be right
back if you would please stay with us.
Governor PARTEE. Certainly.
[A brief recess was taken.]
Mr. NEAL. Thank you for waiting for us, Governor, I would like
to yield now to the gentleman from California, Mr. Hannaford.




135
Mr. HANNAFORD. I was not here for your testimony, and frankly
I have not yet had time to read it either.
Let me just touch on some general questions. We were discussing
3^esterday during a discussion on the current full employment bill,
the record of unemployment in some of the countries of Western
Europe. This is not precisely related to our subject, but is their record
not dramatically better than ours? The record of unemployment of
something like to 1 to 2 percent, is that in your field of expertise?
Governor PARTEE. Well, I do not have particular knowledge about
each of those unemployment statistics, Mr. Hannaford, but I would
say that there are measurement differences in a good many countries
that make direct comparisons difficult.
There are structural differences among economies also that sometimes hide unemployment. To give you some examples, in Japan the
unemployment rate is always low. But that is because there is a
movement of people back into the countryside—into agriculture—
when the jobs are not there, so you do not get a rise in recorded unemployment. In the case of Germany, there is a lot of foreign labor.
And that foreign labor is exported when the demand for labor is not
there, so it does not show up in their unemployment rate. There are
things like that.
It certainly was true earlier in the postwar period that the perceived unemployment rate was lower elsewhere. It is now not so much
the case. England, for example, has over 5 percent. In most of the
continental countries it ranges between 4 and 7 percent. The differential between the United States and other industrialized countries
is much less marked than they were earlier in the postwar years.
Mr. HANNAFORD. I asked the question simply because you regard
the money supply, the monetary policy as a central feature in that;
and I was wondering if it was related to the differences in the way
those countries and ours handle their money supplies?
Governor PARTEE. I do not think so, no.
Mr. HANNAFORD. YOU mentioned the unpredictability of velocity
in the last 6 months or so. Is that perhaps because of mechanical
changes in the greater use of credit cards and other instruments for
larger transactions in industry, and so on?
Governor PARTEE. We think that is a factor. Credit cards; overdraft checking, which lets you keep a smaller balance, for if you
write checks in excess of your balance there will just be an automatic
credit; the development of NOW accounts in quite a number of
States; the bill-paying service that is done now through savings
accounts at savings and loans and banks, all are factors. I have to
tell you that we have spent a great deal of time and effort—or our
staff has—on this question. And we do not have a fully satisfactory
explanation for what is going on.
My own view—and I do not have the advantage of strong, analytic backup for it—but my own view is that what has happened has
in part been a change in attitude in the economy—toward a more
expansive, optimistic frame of mind after a long period of depression
in 1973 and 1974. That has meant that we get more spending relative
to the money stock measure; people have been more willing to spend;
and they are less conservative than they have been in the past. I
believe that people are much more optimistic and much more comfortable about the future than they were when we were having double




136
digit inflation, rising unemployment, political difficulties in Washington, all of those kinds of things that affected attitudes.
Mr. HANNAFORD. I see, a combination there of the mechanics, plus
the optimism.
Governor PARTEE. Yes.
Mr. HANNAFORD. If you could remove the politics from it, do you
think it would be desirable to have monetary policy and fiscal policy
being made by the same hand?
Governor PARTEE. That is a very important qualification.
Mr. HANNAFORD. Yes it is, is it not, almost an absurd qualification?
Governor PARTEE. I do not think I would favor it. Now let me tell
you why.
There is no reason, in principle, that good analysts could not manage
both fiscal policy and monetary policy in the best interest of the economic health of the country. But I am afraid there would come times
when, even as analysts, people would want to have a monetary policy
that would confirm what they had done in the fiscal end or a fiscal
policy that would confirm what was done in the monetary end. And I
think there would be a slippage—a slopover of attitude between the one
field and the other which eventually could get us into difficulty.
It often is asked, Mr. Hannaford, what is wrong with having the
Secretary of the Treasury determine monetary policy? After all, it is a
financial activity and the Secretary or the Minister of Finance is the
chief financial executive of a country's government. Why not have
him do it? Well, he might ordinarily do it very well. But there might
come the day when, in order to succeed in his latest bond issue or in
order to keep the budget down by having lower interest rates, he would
decide to take a monetary policy action that was not truly in the
interest of the country. I think we have something of the same sort
of problem here.
Mr. HANNAFORD. Our testimony has indicated the general feeling
that there is too much fussing done with monetary policy and shortterm adjustments, and that we are something like the overly protective parent that suffocates the child; that, if we could take monetary
policy and set money growth at a constant rate that would allow for the
real growth in GNP. And maybe everyone would step back and let it
go. Do you think we do a bit too much of that fits-and-staxts kind of
adjustment?
After all, the main problem with inflation is its unpredictability.
If we could predict inflation at a given rate of 3, 4, or 5 percent and
knew what it was going to do and could read everything into it, then
a lot of the inequities could be read out of it.
Governor PARTEE. Well, Mr. Hannaford, I have never been a
believer in a rule calling for a constant rate of growth in the money
supply because I have been too concerned that it would not take
into account structural changes in the economy, which would require
different rates of input. A rule would give up entirely any countercyclical influence that monetary policy could contribute in dealing
with holding back the economy when it was booming, or bringing it
back up when it was in recession. It also would run the risk of changes
of a kind that I was just talking about in the relationship of the
observed measures, money supply and GNP. If people should come
to perceive the money supply differently, and 3^011 do not realize it,




137
one would be running on the wrong rule. So I have always felt that
there should be more flexibilit}^ than a constant rule would impose.
I have two more comments on this subject. I would have to say
in retrospect that there has been more variation in the rate of monetary growth over the postwar period than I think would have been
desirable. That is, as I look back, if I could do it over and I were the
dictator, I would do it a little differently. There would be more
stability than the chart that has been before us through these 3 days
of hearings has demonstrated. I would rather have a little more
stability than that shows.
My final comment is that I think the reasons for these variations
in money suppfy growth, and the tolerance of the variations of the
money supply growth, are to be found principally in the behavior of the
economy and the behavior of interest rates. There are times when
the economy requires a more expansive growth in the money supply
because it is doing very poorly and every pressure there is is on the
Federal Reserve to follow a more expansionary policy. There are
also times when interest rates are rising sharply, the distribution of
funds among various sectors of the economy—housing, consumers,
businesses, and Government—is chaDging and hurting various parts
of the economy. When that rapid increase in interest rates is so
antagonistic to what people perceive as their shortrun interest, there
often is some tolerance for a higher monetary growth rate—simply
in order to not have the rates go all the way up.
The very peak in short-term rates during the postwar period was
in the summer of 1974, when the prime rate at banks was 12 percent.
That was regarded as an extraordinarily high rate; and I think it
was an extraordinarily high rate for business, borrowers and consumer borrowers to deal with. But the more stability you induce in
the monetary growth rate, the more likely it is that you will have
wide fluctuations of that kind in interest rates. I think most people
perceive them as being adverse to their interests.
Mr. HANNAFORD. Yes. Is this increase in velocity that has been
rather dramatic more recently—that no doubt is one of the factors
of the more restraining monetary policy of recent months. I suppose
it would be.
Governor PARTEE. DO you mean in terms of monetary growth
rate?
Mr. HANNAFORD. Yes.
Governor PARTEE. Yes.

We constantly analyze what is going on
in the economy, the fact that the economy was doing well, that the
indicators were good, that our projections of the future weie quite
satisfactory in terms of real growth, and that all of this was being
accomplished with stable to declining interest rates and a lower rate
of monetary growth, made us tolerant of that lower rate of monetary
growth.
If the outlook had been different, if pioblems had been developing,,
or had interest rates been behaving differently, we might have wanted
to step up the monetary growth rate. But in these circumstances,
it seemed appropriate.
Mr. HANNAFORD. One last question. I am very sorry I missed your
statement. Would you just give me a little primer on how the economy
influences the money supply, this relationship of the one influencing
the other?




138
I understand the money supply on the economy, but how does
the change in the economy cause a change in the growth of the money
supply? It should be obvious, I suppose.
Governor PARTEE. Well, it is a very complicated subject. Let me
give you two illustrations of it.
One is that the increase in the GNP, the nominal dollar GNP,
tends to bring with it a need for an increase in money in order to
service, if you will, the expanding volume of transactions that occur
in the economy. Thus, if economic activity is rising rapidly, the
nominal GNP is going up rapidly, one would expect the demand for
money to be quite strong simply because the economy itself was
expanding. And therefore, other things equal, the result would be
an accelerated increase in the money supply in a time like that.
The accelerated growth can be stopped over time—not immediately, but over time—by holding back in the provision of reserves
that are required to support that money supply. But that brings
a rise in interest rates. And so interest rates, at a time like that, would
rise pretty sharply if the Federal Reserve were following a constant
money supply target.
Let me give you an even more basic example. The nominal GNP
is a function of costs and prices and real volume. Costs are things
like wage rate increases that unions and employees negotiate; the
cost of raw materials which is affected by supplies like foodstuffs;
international demand for goods. There may well be a situation
in the country in which there is a tendency to produce rather large
increases in costs, for example, wage costs far exceeding productivity
gains. In that case, that part of the increase in nominal GNP is, in the
short run, rather fixed.
If, let's say, that produces an inflation of 6 or 7 percent, which it
has in the past year, and we want to have real growth in the economy
sufficient to reduce unemployment, say 6 or 7 percent, then we must
have a nominal GNP as a matter of arithmetic that rises by 12 to 14
percent. It may be that in order to get that nominal GNP, there
needs to be an increase in the money supply in excess of a predetermined normal amount.
Many economists say—and I would tend to agree—that if there
were no inflation in the economy, one would want to have an increase
in money supply somewhat slower than the growth in real capacity
to produce, which is about 4 percent. We would want perhaps a 2or 3-percent increase in the money supply. But as a practical matter,
in order to keep the economy going, given the wage deals that are
being made and the cost pressures that exist, you may have to settle
for a larger increase in the money supply.
That is why I say that the economy affects the money supply.
Mr. HANNAFORD. YOU say that the money supply should expand
slightly slower than the nominal GNP.
Governor PARTEE. Yes. There is a trend increase in velocity. It
is not clear exactly what it is, but it is about 1 or 2 percent
Mr. HANNAFORD. A trend of increase in velocity would cause you
to adjust the money supply increase?
Governor PARTEE. SO if we have zero inflation and are operating
at a satisfactory level of unemployment, the increase in population,
labor force, and productivity would give us the latitude for about a




139
4-percent increase in real output each year. We would normally
expect a somewhat smaller increase in the money supply that would
be consistent with that steady state condition.
Mr. HANNAFORD. NOW, if you thought that the economy was behaving independently of your action in an inflationary way, that is,
wage demands were too great or what have you, you would try to
restrain them. Fed policy would try to restrain them with tightening
up of monetary policy. Is that right?
Governor PARTEE. In a general way, Mr. Hannaford. Strong
actions at a time like that are likely to topple the economy. Monetary
policy gently exerts pressure on the system to try to moderate it
over time.
Mr. HANNAFORD. The problem that I have—and we have discussed
this with your chairman—is that there are some things that would
respond to that, perhaps wage rates or some such, and there are other
things which more recently do not appear to respond to it, such as
costs of fuel and food.
Governor PARTEE. Yes.
Mr. HANNAFORD. It is hard to say how we can allow or have a
monetary policy that restrains those things that will yield and subject
themselves to such restraint and not turn back the whole economy.
It seems that we are punishing two different subjects. And one of
them is innocent and the other one needs the punishment. Is that
accurate?
Governor PARTEE. Well, it is a little harsh. But the fact of the
matter is that monetary policy is an aggregate policy. It affects the
economy as a whole. You cannot direct it toward one thing or another
thing because it falls like rain on everyone. And so there is something
to what you are saying.
Analytically, you might say that if there is a source of inflation
that is external to the operation of the economy—let's say crop
failure, or a quadrupling in oil prices by the OPEC countries—that
you could make provision for that by having a little faster increase
in the money supply than you otherwise would think was appropriate.
That is a sound position, I think, simply because otherwise there
would be a shortage of funds relative to the higher prices and the
level of real demands needed to keep the economy employed.
It is an extremely treacherous operation, though, for if more
money is provided and continues to be provided, we will start to
validate the inflation that will be spiraling, that will be accumulating
from those initial external forces. That is, if food prices go up the
next thing is that wage increases need to be larger in order to keep
people's incomes in real terms moving ahead. If people had their way,
they would like to have growing real incomes. If you also validate
that wage increase by having more money expansion, then you are
on the way to an increase in inflationary forces. So it is a very delicate
business.
But in principle, where there is an external source, an identifiable,
clear, external source of price pressure, there can be a compensation
made for it.
Mr. HANNAFORD. The dollars being released by your policy do not
know what they are being released for and they do not know to run
over and buy oil with it instead of paying higher wages.
Governor PARTEE. NO.




140
Mr. HANNAFORD. Governor, I appreciate your responses and your
patience for my not having been with you earlier. Thank you very
much, Mr. Chairman.
Mr. NEAL. Thank you, Mr. Hannaford.
I am curious about another subject. What precisely did the Fed
and the Treasury do the other day, do to help Great Britain? Did
they buy pounds? Was it a purchase of pounds?
Governor PARTEE. NO, sir. There is a standing set of agreements
between central banks called the swap network, that in effect provides
a line of credit among central banks for borrowing currencies as they
need to do so.
So far as the Federal Reserve was concerned, what happened was
that we activated $1 billion of that $3 billion line of credit that the
Bank of England had with us, and the Treasury also provided another
$1 billion line of credit, and other countries provided another $3.3
billion line of credit.
In fact, that money has not been borrowed, but it is a tap. That is
to say, if England comes to need the funds, the funds will be there
to the extent of $5.3 billion. There is an obligation, on the part of
England to repay it with interest, of course, and to repay it in dollar
terms so that there is no foreign exchange risk for the United States.
What I would say has happened is that the English, in an effort
to defend their currency and get their house in order, have arranged
for a line of credit.
Mr. NEAL. IS that qualitatively different than the Federal Government's relationship with New York?
Governor PARTEE. The difference is that it is a short-term borrowing and there is a firmer basis for repayment by the English;
namely, the English can get funds from the International Monetary
Fund by agreeing to their terms and conditions, I presume, and therefore the potential creditors involved in this arrangement can be taken
out.
In the case of New York there just was not any near-term prospect
of repayment short of substantial changes in the fiscal management
of the city of New York. Now, those changes are in process. It still
is not a short term prospect of repayment, but there is now, I would
say, some prospect for repayment.
Mr. NEAL. IS there some requirement for Great Britain to do
things differently than it has been doing as a part of this?
Governor PARTEE. It has been working hard, I am sure. As you
know the British have had an incomes policy for a year. They are going
into a second year of incomes policy and are attempting to obtain an
agreement that would hold wage-rate increases to about 4.5 percent.
They have had some success with the unions; in England, labor is
very highly organized, so that is very important. It so happens that
this week the coal miners voted for it and the coal miners are one of
the more militant groups calling for large wage increases. So there is,
at least in terms of the management of the wage deal, quite an effort
going on to reduce the rate of inflation in England, and to improve their
circumstances.
There is also, I think, a general recognition of the need to reduce
national governmental expenditure or at least the proportion of
national government expenditure relative to the total outlays in the




141
country. There is not so much occurring in the short run on this issue,
but I think there is a recognition that the governmental role needs to
be moderated.
So, there are a number of constructive developments occurring in
the British situation, I believe.
Mr. NEAL. The comparison between the public responses to the
fiscal problems of New York City and Great Britain seems very
interesting. Although Great Britain's fiscal dilemma was fairly well
publicized, there was no particularly political outcry similar to the
one we had when New York City asked for help.
Governor PARTEE. I dare say there would be if we do not get the
money back.
Mr. NEAL. I would imagine there would be. I think then the
American public would be wondering why Congress was not on its
toes, do you not think, at that time?
Governor PARTEE. I was not directly involved, in any way with
this, Mr. Chairman.
Mr. NEAL. I was not either.
[General laughter.]
Mr. NEAL. Let me ask you one other question. I have never understood why the Fed concentrates on the Federal funds rate instead of
on reserves or some other element. Could you help me understand
that better?
Governor PARTEE. Well, Mr. Chairman—are you talking about an
interest rate as against an aggregate?
Mr. NEAL. Exactly.
Governor PARTEE. I would not say that we concentrate on the funds
rate as against the reserves. The members of the Federal Open Market
Committee have objectives in terms of rates of growth in the various
monetary aggregates. There are, for operational reasons, month
objectives as well as the year-long objectives which are given to the
Congress, and we try to see, within our ability, that the reserves that
are provided are appropriate to those objectives.
There are times, though, when there can be a change in the demand
for money—perhaps quite temporary—where, in order to hold to the
reserve target, there would have to be tremendous upward or downward pressure on interest rates, reflected in the first instance in the
Federal funds rate. And because we feel that sharp gyrations in interest
rates would not be constructive to the performance of the economy,
in the short run we constrain our efforts to achieve the monetary
aggregates by having limits on how far the Federal funds rate can move
in a short period of time. It is not true that we are looking only at the
funds rate. But the rate is, operationally speaking, a constraint on how
far, without looking again at the whole situation at the committee
level, how far the manger of the System Open Market Account can
move in terms of rate effect to get the aggregates that we are after.
It is an old, long-established system in the management of reserve
provision, and there are a lot of reasons behind it. But, I would say the
main one is that we are concerned that sharp gyrations in interest
rates would be upsetting to financial decisionmaking, and thus,
counterproductive from the economy's point of view.
Mr. NEAL. But you are making a judgment, are you not, that those
sharp turns in interest rates would be more upsetting than sharp turns
in the money supply, and we might try to look into that.
73-959—76




10

142
Governor PARTEE. We have.
Mr. NEAL. IS that a demonstrable fact?
Governor PARTEE. We think it is. We have done elaborate econometric and analytic studies of the economy, and we have concluded
that the short run variations in money supply growth, or of growth in
any of the aggregates, have very little impact on the performance of
the economy so long as they are offset later on. Technically speaking,
what we have found is that a two-quarter variance in money supply
growth from a normalized rate does not affect the economy if it is
offset in the subsequent two quarters. That is pretty well researched.
We feel, as I say, that interest rate gyrations are unfavorable. Now,
I want to be absolutely clear about this. These are simply instructions
to the system account manager. Every 4 or 5 weeks the Federal Open
Market Committee meets and it considers what has gone on in the
interval between meetings. And if, in fact, we are not getting the
monetary aggregates that have been specified, even though the funds
rate has been run all the way to the limit that was given to the manager, then it is open season for the committee to say, "Well, we are
going to have to raise that funds rate range for the manager in the
period ahead/' or perhaps, "We think it would be so unfavorable in
the present circumstance for that to be done that we are going to
tolerate, for a period, the somewhat higher growth in the aggregates."
I am describing a decisionmaking process in which all of the people
are brought together, physically, to discuss this all day long every
4 or 5 weeks, during which the instruction for the manager is framed;
and any or all of these specifications may be changed.
I think it is a reasonable way of running the system. Monetarists
often say that we should simply supply the reserves to the banking
system and let the interest rates go where they will. But our view is
that it is a short-run day-to-day operating matter; that there are a lot
of difficulties with the monetarist approach operationally; and that
it would cause variations in interest rates that would be so large that
it would be very difficult for people to adjust to them.
That is the explanation, sir.
Mr. NEAL. YOU would anticipate a wide fluctuation in interest
rates during a year's period?
Governor PARTEE. It should not be all that much different during
a year. But I am really talking about day-to-day and week-to-week
movements, because we are presently speaking of operations.
Just as a hypothetical example, if the Federal Open Market Committee wanted a narrow money supply increase in a range between 4.5
and 7 percent, which is the one that is currently stated, and if nothing
happened to make them change their mind on that—such as a change
in the money demand function or a change in the definitions or a
change in the behavior of the economy—there is no reason, using the
operational technique that I have described, why we would not get
an increase in the narrow money supply within that range by permitting, over a time, interest rates to change consistent with that money
growth objective.
Tolerating some variation in money supply simply smoothes the
change in interest rates. But in fact, if there is no change in the view
of the committee, I would guess that the interest rates at the end of the
year would be about the same under either circumstance
Mr. NEAL. One further question. Do you operate substantially
differently than do other central banks throughout the world?




143
First of all I would like some source on information on how other
central banks operate.
Governor PARTEE. I will have to talk to Dr. Weintraub about a
source. It is a pretty complicated question.
I have some knowledge of this although I have not been active in
the international field. I would say that we have a closer control,
market-oriented control, over the system than any other country that
I know of in terms of our open-market operations. We also have a
system of reserve requirements against member banks—unfortunately
not all banks, but only those banks that are members of the Federal
Reserve System—that many countries do not have.
I would say that in recent years we have paid comparatively more
attention to growth rates in the various monetary measures as an
intermediate aim of policy. Of course, in the end, the aim of policy is
always a good economic performance. But we have paid more attention
to the aggregate than has been generally true around the world.
In general, central banks can be divided into two groups: Those
who operate by providing reserves and taking out reserves or liquidity
through open market operations; and those who do it by making
loans to the banks or by taking out the loans. We are in that former
group. Many other countries are in the latter group.
I think we can probably get you some reference on foreign central
bank operations so you could read about the subject.
Mr. NEAL. I really appreciate that very much.
[The information referred to by Governor Partee follows:]
BOARD OF GOVERNORS,
OF THE FEDERAL RESERVE SYSTEM,

Washington, D.C., June 22, 1976.
Hon. STEPHEN L. NEAL, Chairman,

Subcommittee on Domestic Monetary Policy of the Committee on Banking, Currency
and Housing, House of Representatives, Washington, D.C.
DEAR M R . CHAIRMAN: At the recent hearings on Federal Reserve policy and
the economy, j^ou requested that I supply some reading references on central
bank operations and the conduct of monetary policy in other countries. I asked
the staff to look into the matter, and they recommend the following:
(1) Federal Reserve Bank of Boston. Monetary Policy in Twelve Industrial
Countries. Boston: Federal Reserve Bank of Boston, 1973.
(2) U.S. Congress. Joint Economic Committee. Comparative Features of Central
Banks in Selected Foreign Countries, prepared for the Joint Economic Committee
by the staff of the Board of Governors of the Federal Reserve System. Joint
Committee Print, Paper No. 1. Washington, D . C : Government Printing Office,
1963.
The first reference, a copy of which I am enclosing, provides a relatively nontechnical discussion of the institutions and instruments of monetary policy in
Austria, Belgium, Canada, France, Germany, Italy, Japan, the Netherlands,
Norway, Sweden, Switzerland, and the United Kingdom. It also provides a short
bibliography on each country. The second reference is admittedly dated but, we
believe, still largely accurate. The publication contains information on ownership
selection of boards, disposition of profits, relation to Finance Ministries, and roles
in Government finance of the central banks of Belgium, Canada, France, Germany,
Italy, Japan, the Netherlands, Sweden, Switzerland, and the United Kingdom.
In addition, you asked that we supply figures on the high employment Federal
Budget surplus or deficit. Quarterly data for the period 1952 through 1975 are
enclosed. I have taken the liberty of providing data from the Council of Economic
Advisors instead of our own Federal Reserve figures because our quarterly data
does not begin until 1964 and therefore would not be suitable to the requirements
of the Committee's staff. In any event, the CEA series is not very different from
our own.
I would be happy to respond to any questions about the material.
Yours truly,
J. CHARLES PARTEE.

[NOTE.—The 587-page document Monetary Policy in Twelve Industrial Countries
(Reference (1)), is not included in the hearing record.]




144
COUNCIL OF ECONOMIC ADVISERS
High employment budgetl

3

(Surplus (+), Deficit (-),$ billions, S.A.A.R.)
1952:
I
_
_
II
III
__
IV
1953:
I
II __
_
III
IV
1954:
I
II
__
III
IV
1955:
I
II
III
IV
1956:
I
II
III
IV
__
1957:
I
II
III
IV
1958:
I
II
III
IV
1959:
I
II
III
IV_
_
1960:
I
II
III
IV
1961:
I
II
III
IV
1962:
I
II
III
IV
See footnotes at end of table.




1963:
-1.0
I
_ -3. 8
II
___ - 7 . 6
III
5. 6
IV
1964:
-7.5
I
-9.1
II
-7.4
III
-8.3
IV
1965:
-6.9
I
___ -2.6
II
-1.4
III
. 1
IV
1966:
1.7
I
4.3
II
8. 6
III
4. 5
IV
1967:
___
6.2
I
5.4
II
7. 1
III
7. 1
IV
1968:
6.0
I
5. 5
II
7.2
III
__
6.7
IV
1969:
5. 7
I
2. 3
II
-.4
III
-1. 8
IV
1970:
3.7
I
5. 9
II
6. 3
III
__
7.2
IV
1971:
14.9
I
13. 6
II
13. 2
III
13. 4
IV
1972:
12. 1
I
9. 8
II
9 4
.
III
8.2
IV
1973:
4.2
I
5. 6
II
6 9
.
III
7.0
IV

10.6
11.9
10.4
9. 1
4.4
-.2
3.7
5.7
8. 7
7.2
-.6
-3. 5
-.6
.7
-3. 5
-4.7
-9.4
-9.3
-9. 9
-10.0
-7. 1
-9. 9
-. 1
3.7
10. 1
12. 6
10.7
11. 0
11.2
3. 5
3. 6
5.9
3.4
-1. 6
-. 7
. 4
2

-2. 2
-9. 4
-1. 7
-20.0
.4
6 3
.
10. 6
12. 5

145
COUNCIL OF ECONOMIC ADVISERS

High employment budget l

3

(Surplus (+), Deficit (-), $ billions, S.A.A.R.)

1974:
I
II
III
IV

1975:
17. 9
I
23.8
II
32. 0
III
27. 9
IV

4
14. 0
-34.9
-7. 8
-6. 8

1
Information on the assumed rates of growth of potential GNP and other factors involved in the calculation of the fullyemployment budget can be obtained from past issues of the Economic Report of the President.
2
The $9.1 billion estimated increase in overwithholding of personal income taxes is not included in the
1972 estimates of full employment receipts, cf., Economic Report of the President, 1976, p. 55.
3
Latest C.E.A. estimates which may be different from the data presented in earlier issues of the Economic
Report of the President.
4
In estimating full-employment expenditures, adjustments were made only for those outlays made pursuant to those provisions in the unemployment insurance laws which are regarded as permanent. Policy
initiatives such as federal supplemental benefits and the special unemployment assistance programs are
treated as discretionary by the C.E.A., even though these programs might be made permanent at a later
date. For more information, see the Economic Report of the President, 1976, pp. 55-56.

Mr. NEAL. DO you concentrate more on interest rates than do other
central banks?
Governor Partee. Less so, I think.
Mr. NEAL. Less so?
Governor PARTEE. It certainly is true, historically, and I think it is
still true for the last few years. Eveiyone is moving toward more
emphasis on aggregates. But, I think we have been ahead of most
foreign countries in the attention we have given to that.
Mr. NEAL. Thank you very much for coming today. Your testimony
has been very helpful to us.
Governor PARTEE. Thank you very much, Mr. Chairman.
Mr. NEAL. We will recess now, subject to the call of the Chair.
[Whereupon, at 12:27 p.m., the subcommittee recessed, subject to
the call of the Chair.l




THE IMPACT OF THE FEDERAL RESERVE'S MONEY
POLICIES ON THE ECONOMY
THURSDAY, JUNE 24, 1976
HOUSE OF REPRESENTATIVES,
SUBCOMMITTEE ON DOMESTIC MONETARY POLICY
OF THE COMMITTEE ON BANKING, CURRENCY AND HOUSING,

Washington, D.C.
The subcommittee met, pursuant to notice, at 10 a.m., in room
2128, Rayburn House Office Building, Hon. Stephen L. Neal [chairman
of the subcommittee], presiding.
Present: Representatives Neal, Hannaford, Allen, and Hansen.
Also present: Dr. Robert Weintraub, staff director.
Mr. NEAL. Gentlemen, I am going to go ahead and start if it is
all right with you. I will have to leave shortly and then return—however, our extremely able colleague from California will chair the
subcommittee for me in my absence.
The subcommittee held hearings on the impact of the Fed's money
policies on June 8, 9, and 10 and this morning we are continuing those
hearings. Primarily, we are interested in learning whether increases
and decreases in the money supply, which are decided by the Open
Market Committee of the Federal Reserve, significantly affect the rate
of inflation and production and employment. I have asked the staff
to conduct indepth research into these questions. Preliminary results
from several econometric experiments indicate that about 60 percent
of our inflation is attributable to changes in money supply. For convenience, we have prepared an exhibit which illustrates the effects of
fluctuations in money supply on inflation. The effects are mapped
23 months after actual changes in money supply growth occur. This
23-month lag was selected b}^ computer studies, which show that the
impact of changes in money supply on the rate of inflation are greatest
at that time. Other more complicated experiments, involving money
growth and the Federal deficit at several lags and changes in industrial production as well, reinforce the findings mapped in the exhibit—
for instance, inflation rises and falls in the wake of increases and
decreases in money growth.
Our exhibit also shows that recessions follow after sharp declines in
money supply growth. Preliminary results from our other experiments
lend support to the relationship depicted here between money growth
and production and unemployment.
[An exhibit mapping M-l money growth, the rate of inflation 23
months later and the recession periods experienced from 1954 to 1976
follows:]
(147)




148

YEARLY'MONEY SUPPLY CHANGES
Percentage Changes From Ono Month in One Year to the Same Month !n the \'ext Year
YEARLY CHANGES IN THE COST OF LIVING OCCURRING U MOft
LATER
RECESSION PERIODS
Percent Chance

-2

,! I..I..I-I..I

1951 '55

I.I I..I..I: '.•l'.l..l..l,,l..'..1-.l.,1.-l..l,.l..l..l..l..l..l..l..l..|.

'56 '57 '58 '69 . ' 6 0

'$1 'fit '83 '64 '65 '66 '57 '68 '69 • '70

'71 '72 '73 '74 '7$

'7$

As I noted, other factors that affect inflation, production and unemployment, such as the Federal deficit and interactions between
inflation and production are also being researched. Our results to date
indicate that the Federal deficit exerts some independent influence on
our economy's performance. But it is a relatively weak influence
compared to money growth. This finding does not condone excessive
Government spending. Federal deficits are an important factor in our
rate of inflation. It should be noted, however, that in the past, the
Fed responded to the pressures of large deficits by creating more
money to finance these debts. But by no means was the Fed required
to do so; and in the past year, the Fed has proved that it can withstand
pressures to monetize the deficit.
In our work, it is important not only to study the effects of changes
in money supply, but to hear what outside experts have to say.
Certainly, we hope that these hearings will provide increased knowledge in the area of monetary policy and guide us into more effective
means of carrying out congressional oversight responsibilities in this
area.
This morning we are pleased to welcome two very distinguished
witnesses: Dr. James L. Pierce, who is a consultant with the Banking
Committee, and Dr. Allan Meltzer of the Graduate School of Industrial Administration at Carnegie-Mellon University.
Let me make one additional comment if I may, gentlemen. We
really are trying to be as objective as we can and we welcome comments which can help us better understand the economic consequences
of increases or decreases in money supply.
We are very grateful for your coming this morning. Our hearings
will continue and will be conducted as a forum for various points of
view. So as we go along, if you have additional ideas that will help us,
please never hesitate to let us know about them.




149
Dr. Pierce, we would like to bear from you firstl Please proceed as
you wish.
STATEMENT OF DR. JAMES I . PIERCE, ECONOMIC CONSULTANT
AND PROFESSOR OF ECONOMICS, UNIVERSITY OF CALIFORNIA,
BERKELEY

Dr. PIERCE. Thank you, Mr. Chairman.
Let me apologize in advance for having a relatively lengthy statement. I didn't have enough time to boil it down. So let me proceed
with trying to go through it.
Fiscal and monetary policies are the two tools the Government has
available to stabilize the Nation's economic activity. While the
spending and taxing programs of fiscal policy are highly visible to the
public, a mystique surrounds monetary policy. Nevertheless, there is
a growing awareness by the public that monetary policy somehow has
an important effect on the economic well-being of the Nation.
Virtually all economists agree that monetary polic}^ is extremety
important; they disagree on the relative strengths of monetary and
fiscal policy. Some economists argue that monetary policy is of paramount importance and that fiscal policy has, at best, only a transient
impact on economic activity. I, and many other economists, believe
that fiscal policy has an important and more lasting impact on income,
employment, and inflation. The extent of this impact, however, will
be conditioned by the monetary policy that the Federal Reserve pursues. The effects of Government taxing and expenditure policies can
be offset by monetary policy or they can be reinforced by it.
No matter what relative strengths various economists assign to fiscal
policy, there is also general agreement in the profession concerning
the importance of monetary policy in influencing inflation. The
economy cannot experience sustained inflation without a monetary
policy that underwrites it. The economy could not have enjoyed the
low inflation rates of the 1950's and early 1960's had monetary
policy created the rapid money growth of the past decade. Conversely,
the high inflation rates of the past decade could not have occurred had
the Federal Reserve pursued a growth in the money supply as low as
that experienced in the 1950's and early 1960's.
Mr. HANNAFORD. Doctor, I don't like to interrupt you this early.
Dr. PIERCE. NO, go ahead.
Mr. HANNAFORD. But we are almost as well off to just go on over
now before you really get steamed up into this, and get back. I kind of
enjoy this all-California team we have here, and of course, we have
Mr. Allen from Tennessee.
[A brief recess was taken.]
Mr. HANNAFORD. The subcommittee will resume with the testimony
of Dr. James L. Pierce of one of the great universities of the world.
Dr. Pierce, please proceed.
Dr. PIERCE. Thank you, Mr. Chairman.
Let me try to pick up where I left off, which was talking about the
importance of monetary policy for determining inflation rates, and relating it to the growth in money over a period.
But I would like to hasten to add, there is more to monetary policy
than the quantity of money. Such factors as bank reserves and




150
interest rates also play important roles. The importance that economists
have come to attach to the money supply results, in part, from the
difficulties that have been encountered in attempting to assess the
implications of interest rates. The significance of interest rates in
the economy; that is, whether a particular level of interest rates
encourages expansion or contraction, depends at least in part upon
the inflationary expectations that exist in the economy as well as the
state of the economy as such. For example, interest rates normally
should decline in a recession and rise during a boom, but the question
remains, by how much? This is often very difficult to determine.
Furthermore, it is perfectly possible that interest rates should remain
high or even rise during recession if financial markets anticipate an
acceleration in inflation rates.
This is not to say that the behavior of the money stock is a completely reliable guide either, particularly in the short run. There are
times when the behavior of the money stock is extremely difficult to
interpret. One need only look at the behavior of money growth relative to output and inflation in late 1975 and early 1976 to confirm
this point. There was a near consensus that higher money growth than
was actually achieved was required to obtain the rapid expansion in
economic activity that we have recently experienced. But somehow a
less than 3-percent growth in money has accompanied a more than
12-percent growth in nominal GNP and a nearly 7-percent growth in
real output. Needless to say, this is not a normal pattern.
The behavior of money growth in 1974 is also an important example.
The growth of money during that year was relatively high by historical
standards, around 6 percent, but in light of the tremendous inflationary
shocks the economy experienced, shocks from OPEC, lagged effects of
decontrolling prices, the commodity boom and so on, this money
growth was, in an economic sense, really quite low. Money grew at
about half the rate that prices rose so that the same quantity of money
had to finance a much larger volume of nominal transactions. As a
result, the monetary policy during 1974 was highly contractionary
and the economy responded by producing the most severe recession in
the postwar era.
Historically, the Federal Reserve, like other central banks, has
exhibited a strong tendency to stabilize fluctuations in interest rates,
particularly short-run fluctuations. The Fed's penchant for stabilizing
interest rates has among other things helped produce a procyclical
behavior in the growth of the mone}^ stock; that is, money grows
rapidly during economic expansion and slowly during recessions.
The reason for this is clear enough: when the economy is expanding
rapidly credit demands also expand, tending to put upward pressure
on interest rates. The Federal Reserve attempts to constrain these
interest rate increases by providing more bank reserves through open
market operations. The increase in bank reserves in turn leads to
expansion in the money stock and underwrites an expansion in
economic activity.
During recessions, credit demands decline and interest rates begin
to fall; the Fed attempts to constrain the decline in interest rates by
selling securities on the open market, therein reducing bank reserves
and retarding growth in the money stock. The retardation of money
growth and constraint on interest-rate declines tend to exacerbate the




151
decline in economic activity. It seems clear that attempts to stabilize
interest rates can and have produced greater cyclical fluctuations
in income, production, employment, and inflation than would have
been the case had the Fed not been so concerned about interest rate
fluctuations.
If the Federal Reserve adhered more closely to a target growth for
the money stock, interest rates would tend to move more quickly;
that is, fall more rapidly in recession and rise more rapidly in expansion
than has heretofore been the case. These sharper interest-rate movements would serve to moderate the fluctuations in economic activity.
If interest rates were allowed to react more quickly, aggregate demand
would be affected more rapidly and hence would not probably fluctuate
so widely. As a result, it is likely that interest rates would themselves
actually fluctuate less widely.
It is precisely because interest rates have important implications
for economic activity that many observers believe that the Fed
should adhere more closely to a money path and adhere less strictly
to constraining interest-rate fluctuations. This might produce sharper
cyclical fluctuations in interest rates, but smaller fluctuations in the
money stock and more importantly, economic activity. Thus, it is
perfectly possible to subscribe to an apparent nonmonetarist position,
that is, to stress the importance of interest rates, and at the same time
argue for a more steady growth in the money supply. It is because of
this consideration that the battle in the profession between monetarist
and nonmonetarist economists is more a flight of fancy by the press
than a.matter of substance.
It is instructive to observe in this context how the Fed has responded
to changes in the fiscal policy. Historically, the Federal Reserve has
been highly accommodative of shifts in fiscal policy—it is expansionary
when fiscal policy is expansionary and restrictive when fiscal policy is
restrictive. While it is difficult, if not impossible for an outsider to
determine why the Fed has behaved in this way, two reasons come to
mind. First, the Fed has attempted to go along with the fiscal policy
of the country. Second, swings in fiscal policy can have an important
impact on aggregate demand in the economy and on interest rates.
The Fed attempts to circumscribe the movement of interest rates
by speeding up money growth when aggregate demand is rising
rapidly in response to fiscal policy and slow down money growth
when interest rates are declining or not rising as rapidly when fiscal
policy becomes less expansionary.
Whatever the cause, the record seems clear. There is only one
important counter-example I am aware of and that occurred in 1975
when the Fed reacted strongly to the bulge in the money stock created
by the tax cuts and rebates that occurred. In that situation interest
rates rose sharply for a short period of time before they returned to a
more sustainable level. That performance appears to be quite unusual.
Now, Mr. Chairman, I gave a fairly lengthy analysis of the relationship between money growth and Federal deficits in an effort to try to
document my case that monetary policy has been accommodative,
and rather than go through that, I will just submit it for the record
and try to answer questions if there are any.
Mr. HANNAFORD. Proceed in whatever manner you would like.
Dr. PIERCE. Well, let's do it that way, then.




152
Let me just conclude by making just one point, and that has to do
with the accountability of the Federal Eeserve, which is on the last
page of the testimony.
I would like to make the point that there are really two steps in
assessing monetary policy, the first, to determine what the Fed is
attempting to achieve by its actions in terms of employment, production, and inflation, and second, to determine whether its policies,
for example, money growth, will achieve those ends. If these two steps
are combined, one never knows whether a policy is technically wrong,
that is, will not achieve the chosen ends, or whether it only appears
to be wrong because perhaps you and I disagree with what the Federal
Reserve is trying to do. Until one can unravel these two steps, it will
be extremely difficult for any outsider including the Congress to assess
and oversee the execution of monetary policy.
I would like to conclude by saying that I understand this subcommittee is interested in knowing how monetary policy is actually
formulated. This is a large topic which I have only touched upon in
my statement. I would like to submit two papers for the record, that
describe in some detail how monetary policy is formulated, and I
would be happy to answer any questions on this topic as well as any
others that you care to ask.
[The prepared statement of Dr. Pierce and the above-mentioned
papers follow:]
PREPARED STATEMENT OF D R . JAMES L. PIERCE, ECONOMIC CONSULTANT AND
PROFESSOR OF ECONOMICS, UNIVERSITY OF CALIFORNIA, BERKELEY

Fiscal and monetary policies are the two tools the government has available to
stabilize the nation's economic activity. While the spending and taxing programs
of fiscal policy are highly visible to the public, a mystique surrounds monetary
policy. Nevertheless, there is a growing awareness by the public that monetary
policy somehow has an important effect on the economic wellbeing of the nation.
Virtually all economists agree that monetary policy is extremely important;
they disagree on the relative strengths of monetary and fiscal policy. Some economists argue that monetary policy is of paramount importance and that fiscal
policy has, at best, only a transient impact on economic activity. I, and many other
economists, believe that fiscal policy has an important and more lasting impact
on income, employment and inflation. The extent of this impact, however, will
be conditioned by the monetary policy that the Federal Reserve pursues. The
effects of government taxing and expenditure policies can be offset by monetary
policy or they can be reinforced by it.
No matter what relative strengths various economists assign to fiscal policy,
there is also general agreement in the profession concerning the importance of
monetary policy in influencing inflation. The economy cannot experience sustained inflation without a monetary policy that underwrites it. The economy
could not have enjoyed the low inflation rates of the 1950s and early '60s had monetary policy created the rapid money growth of the past decade. Conversely, the
high inflation rates of the past decade could not have occurred had the Federal
Reserve pursued a growth in the money supply as low as that experienced in the
1950s and early '60s.
But there is more to monetary policy than the quantity of money. Such factors
as bank reserves and interest rates also play important roles. The importance that
economists have come to attach to the money supply results, in part, from the
difficulties that have been encountered in attempting to assess the implications of
interest rates. The significance of interest rates in the economy—that is, whether
a particular level of interest rates encourages expansion or contraction—depends
at least in part upon the inflationary expectations that exist in the economy as
well as the state of the economy as such. For example, interest rates normally
should decline in a recession and rise during a boom, but the question is, by
how much* This is often difficult to determine. Furthermore, it is perfectly possible




153
that interest rates should remain high or even rise during a recession if financial
markets anticipate an acceleration in inflation rates.
This is not to say that the behavior of the money stock is a completely reliable
guide either, particularly in the short run. There are times when the behavior
of the money stock is extremely difficult to interpret. One need only look at the
behavior of money growth relative to output and inflation in late 1975 and early
1976 to confirm this point. There was a near consensus that higher money growth
than was actually achieved was required to obtain the rapid expansion in economic
activity that we have recently experienced. Somehow a less than 3 percent growth
in money has accompanied a more than 12 percent growth in nominal GNP and
a nearly 7 percent growth in real output. This is not a normal pattern.
The behavior of money growth in 1974 is also an example. The growth in money
during that year was relatively high by historical standards—around 6 percent—
but in light of the tremendous inflationary shocks the economy experienced—
from OPEC, lagged effects of decontrolling prices, the commodity boom, etc.—
this money growth was, in an economic sense, quite slow. Money grew at about half
the rate that prices rose so that the same quantity of money had to finance a
much larger volume of nominal transactions. As a result, the monetary policy
during 1974 was highly contractionary and the economy responded by producing
the most severe recession in the post-war era.
Historically, the Federal Reserve, like other central banks, has exhibited a
strong tendency to stabilize fluctuations in interest rates, particularly short-run
fluctuations.
The Fed's penchant for stabilizing interest rates has among other things helped
produce a pro-cyclical behavior in growth of the money stock—that is, money
grows rapidly during economic expansion and slowly during recessions. The reason
for this is clear enough: when the economy is expanding rapidly credit demands
also expand, tending to put upward pressure on interest rates. The Federal Reserve
attempts to constrain these interest rate increases by providing more bank reserves
through open market operations. The increase in bank reserves in turn leads to
expansion in the money stock and underwrites an expansion in economic activity.
During recessions credit demands decline and interest rates begin to fall; the Fed
attempts to constrain the decline in interest rates by selling securities on the open
market, therein reducing bank reserves and retarding growth in the money stock.
The retardation of money growth and constraint on interest rate declines tend to
exacerbate the decline in economic activity. It seems clear that attempts to
stabilize interest rates can, and have, produced greater cyclical fluctuations in
income, production, employment and inflation than would have been the case had
the Fed not been so concerned about interest rate fluctuations.
If the Federal Reserve adhered more closely to a target growth rate for the
money stock, interest rates would tend to move more quickly, that is, fall more
rapidly in recession and rise more rapidly in expansion than has heretofore been
the case. These wider interest rate movements would serve to moderate the
fluctuations in economic activity. If interest were allowed to react more quickly,
aggregate demand would be affected more rapidly and, hence, probably would not
fluctuate so widely. As a result, it is likely that interest rates would themselves
actually fluctuate less widely.
It is precisely because interest rates have important implications for economic
activity that many observers believe that the Fed should adhere more closely to a
money path and adhere less strictly to constraining interest rate fluctuations. This
might produce sharper cyclical fluctuations in interest rates but smaller fluctuations in the money stock and economic activity. Thus, it is perfectly possible to
subscribe to an apparent "non-monetarist" position, that is, to stress the importance of interest rates, and at the same time argue for a more steady growth in the
money supply. It is because of this consideration that the battle in the profession
between monetarist and non-monetarist economists is more a flight of fancy by the
press than a matter of substance.
It is instructive to observe in this context how the Fed has responded to changes
in fiscal policy. Historically the Federal Reserve has been highly accommodative
ofshifts in fiscal policy—it is expansionary whenfiscalpolicy is expansionary and
restrictive whenfiscalpolicy is restrictive. While it is difficult, if not impossible, for
an outsider to determine why the Fed has behaved in this way, two reasons come to
mind. First, the Fed has attempted to go along with thefiscalpolicy of the country.
Second, swings infiscalpolicy can have an important impact on aggregate demand
in the economy and on interest rates.




154
The Fed attempts to circumscribe the movement in interest rates by speeding
up money growth when aggregate demand is rising rapidly in response to fiscal
policy and slow down money growth when interest rates are declining or not rising
as rapidly when fiscal policy becomes less expansionary. Whatever the cause, the
record seems clear. There is only one important counter-example I am aware of
and that occurred in 1975 when the Fed reacted strongly to the bulge, in the
money stock created by the tax cuts and rebates. In that situation interest rates
rose sharply for a short period of time before they returned to a more sustainable
level. That performance appears to be quite unusual.
The more normal behavior of the Fed with respect to fiscal policy can be seen
in Chart I. The top panel shows the high-employment surplus or deficit. These
surpluses or deficits are an imperfect, but useful, measure employed by economists
to assess the contribution to aggregate demand of fiscal policy. The high-employment deficit, rather than the actual deficit, is used because tax revenues vary
with economic activity. During recessions, an actual deficit will be incurred
simply because revenues have fallen even though expenditure levels and tax
rates have remained unchanged. Such a deficit is not expansionary. The highemployment deficit adjusts for this effect by using not actual revenue figures
but rather an estimate of the revenues that would have been generated if the
economy had been producing at high levels of employment. The relationship of
the high-employment measure to actual deficits or surpluses is shown in Chart II.
The bottom panel of Chart I shows the actual growth in the money stock.
When one compares the two panels it is clear that when fiscal policy is highly
expansionary, i.e., large high-employment deficits, money growth tends to be
high. When fiscal policy is restrictive, i.e., large high-employment surpluses,
money growth is low. Thus, the Federal Reserve underwrites fiscal policy. One
can see this effect very strikingly in the second half of the 1960s. During that
period, the Government was running large high-employment deficits at the same
time that the economy was, in fact, highly employed. These policies contributed
to the inflationary pressures that began to be felt by the end of the decade, and
which we are still living with today. The fiscal policies of the late 1960s have been
widely discussed and criticized but what has been mentioned much less frequently
is that the Federal Reserve was underwriting these policies and was in essence
monetizing the actual deficits, by purchasing the debt that the Treasury was
issuing to finance the deficits. The result was rapid money growth and a further,
and probably substantial, contribution to the inflationary pressures that were
being put into place during that period.
The relationship between money growth and actual deficits or surpluses would
have told the same story as illustrated in Chart I, except that it would have been
a little more difficult to discern. No matter what measure of deficits is used, the
moral of the story is the same. Monetary policy has been highly accommodative
of fiscal policy. This behavior of monetary policy makes one wonder just how
independent the Federal Reserve really is.
In my opinion it is up to the Congress and ultimately the electorate to determine whether or not the Federal Reserve should accommodate fiscal policy. No
matter what the answer is to that question, however, it is fair to say that one cannot judge the impact of fiscal actions without knowing how the Fed will react to
them. History suggests that it will accommodate fiscal policy, although the degree
is unknown. The experience of 1975 suggests that at times monetary policy will
attempt to offset fiscal policy. In either case, the effects of fiscal policy will be
profoundly affected by what monetary policy does. I know of no way that the
Congress and the Administration can go about determining appropriate fiscal
policy without knowing the Fed's intent and how the Fed will react to various
fiscal policies. If one knew what objectives the Fed sought to achieve in the economy
one would have some basis for deducing how it might respond to changes in tax
and expenditure policies. More generally, if one knew the Fed's objectives, one
could deduce how it might respond to any change in the economic situation. Without such knowledge it is virtually impossible to evaluate general economic policy,
including monetary policy.
It seems important to make an additional crucial point. There are really two
steps in assessing monetary policy: first, to determine what the Fed is attempting
to achieve by its actions in terms of employment, production and inflation and
second, to determine whether its policies, e.g., Mi growth, will achieve those
ends. If these two steps are combined, one never knows whether a policy is
technically wrong, i.e., will not achieve the chosen ends or whether it only appears
to be wrong because it seeks to accomplish something that you or I disagree with.




155
Until one can unravel these two steps it will be extremely difficult for any outsider
including the Congress to assess and oversee the execution of monetary policy.
I would like to conclude by saying that I understand this Subcommittee is
interested in knowing how monetary policy is actually formulated. This is a large
topic which I have only touched upon in my statement. I would like to submit
two articles for the record that describe in some detail how monetary policy is
formulated, and I would be happy to answer any questions on this topic as well
as any others that you care to ask.
in
CM

i-l




o

in

o

r-l

CM

—•

O




Chart II - - Federal Government Surplus (or Deficit)

billions of dollars
+30

billions of dollars

FULL EMPLOYMENT SURPLUS (OR DEFICIT)

-

b3

*b4

'55

'56

'57

'53 '59

'60

'61 ^62

'63 ^ 6 4

*65

'66 »67

*68*69

70

71

72

73

74;

'75

76

-70

157
QUANTITATIVE ANALYSIS FOR DECISIONS AT THE FEDERAL RESERVE

(By Dr. James L. Pierce)*
[The purpose of this paper is to describe how policy analysis and advice is made at the Federal Reserve Board as
well as to discuss the implications of the process for optimal control applications. An attempt is made to highlight
those areas where control applications might make the greatest contribution to improving the policy-making process.
Some of the problems that have been encountered in using control techniques at the Fed—problems with structural
models and specification of objective functions—are pointed out along with some of the insights that these applications
have provided.]

The way in which our work at the Fed bears on control theory applications can
probably best be illustrated by discussing how policy analysis and advice is
actually made at the Federal Reserve. To begin, it might be instructive to provide
a description of the policy-making process itself.
Every month in Washington, there is a meeting of the Federal Open Market
Committee (FOMC), which is the basic policymaking body of the Federal Reserve.
This Committee is composed of the seven members of the Board of Governors
plus five Federal Reserve Bank presidents. The presidents of the remaining seven
Federal Reserve Banks also attend these meetings and freely enter into the discussion, but do not vote. Thus, there are twelve voting members on the Committee.
Immediately, the severe problems involved in specifying an objective function for
monetary policy can be seen: there are twelve individuals with twelve separate
sets of preferences trying to reach a single decision. Somehow, however, decisions
do get made. The FOMC decides upon open market operations—the purchases
and sales of Government securities, which are made daily in New York—that affect
directly commercial bank reserves in the economy. This is the primary vehicle
through which monetary policy operates.
In addition to the FOMC, the seven members of the Federal Reserve Board
formally meet together several times a week and—among their other duties—
decide upon reserve requirements and approve discount rate changes, two additional monetary policy instruments. But because these actions are carefully
coordinated with the activities of the Committee, for purposes of this discussion,
the FOMC will be considered to be the ongoing policymaking body.
The staff periodically makes several kinds of presentation to the FOMC.
They will all be discussed in some detail here because each of them may provide
some insights for control applications.
Three or four times a year, depending on the behavior of the economy, a major
effort is made to prepare quarterly forecasts of the economy for the FOMC. These
usually run 4 to 6 quarters into the future. The forecasts are not extended any
further because generally not much credence is put in longer-run forecasting. I
must admit, as someone who has tried to do forecasting, I share these sentiments.
This basic forecast is conditional on explicit assumptions concerning monetary
policy.
To begin its analysis, the staff makes a conditional forecast that contains some
kind of simple policy assumption. For instance, it may be assumed that a particular
growth path for the money stock will obtain during the period, or maybe a simple
pattern in interest rates is taken as the policy. Given this basic assumption, we run
our econometric model—which is our own version of the FMP (FRB-MIT-Penn)
model—and obtain a set of results after judiciously adjusting the constant terms
in equations that have not been tracking well. These adjustments can be justified
as a means of building in prior information to make a conditional forecast for a
specific future time period.
At the same time, another forecast is being made by judgmental means—i.e.
without aid of a formal model. Judgmental forecasters at the Fed usually have a
very good feel for what is going on in the economy, and they often make better
short-term forecasts than the models do. The judgmental forecast is compared to
the model forecast. The differences between the two forecasts often lead to insights
and revisions in each forecast. A consensus forecast is then arrived at that is a
blend of the forecasts obtained from the two methods.
The consensus forecast provides figures for such target variables as GNP
and its major components, the unemployment rate, and the rate of inflation. At
this point, the quarterly model is adjusted in terms of intercept shifts in individual
equations so as to force its sectors and totals to agree quarter by quarter with the
consensus forecast. Once these adjustments are made, we run policy alternatives
off of the adjusted form of the model.
•Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve
System. The opinions expressed here are my own and do not necessarily reflect those of the Federal Reserve
Board or its staff. I wish to thank Mary Ann Graves for her valuable help and advice in converting the original taped version of this talk into an intelligible form for publications.

73-959—76




11

158
Because we normally do not have to adjust the model very far in order to make
it agree with the consensus forecast, these adjustments have virtually no effect on
the multipliers in the model, even though the model is nonlinear. Thus, the policy
alternatives applied to the adjusted form of the model give us, for all intents and
purposes, the same marginal effects as would occur if we had not adjusted the
model to begin with. Its multipliers are left intact, but the adjustments allow
us to talk about a common level of the target variables.
The policy alternatives may be for different growth paths of a monetary
aggregate, such as the money stock, or for different patterns of an interest rate.
In the interests of clarity, this discussion will focus on the money stock. Alternative
growth paths of the money stock can be handled very conveniently with our neoKeynesian model. We usually run several alternatives—an easier alternative, a
tighter alternative, and then different time paths in between. This gives the
FOMC some feel for what the tradeoffs are among important target variables
such as employment, output, and the inflation rate.
We also do alternative simulations for those sectors about which we feel
particularly uncomfortable or uncertain. One of our biggest problems is predicting
fiscal policy over the policy horizon. As you know, in the United States, monetary
and fiscal policy are determined separately. The Fed has to predict fiscal policy
just as anybody else does (including the President and Congress), and we sometimes make large errors in the predictions. Currently, for example, we have to guess
whether the President's impounding scheme will or will not work, how Congress
will react, and whether more or less money ultimately will be spent. When uncertainty about fiscal policy is particularly pressing, we work out various assumptions about the fiscal sector to examine the implications for some given monetary
policy. In addition to the bothersome fiscal sector, there are times when we feel
uneasy about a particular co-determined variable, like inventory investment. At
that time, we may try different patterns of inventory investment, again, to see
what the implications of variability in that sector are for the selection of a particular policy.
By the end of this process, the staff has compiled a large number of alternatives.
However, there is a real limit to the number of alternatives that can be presented to
any audience. A welter of detail seems to cause more confusion than assistance.
While the entire exercise is "quite useful to the staff, the presentation to the FOMC
must be more limited. Thus the staff determines what are the crucial issues at the
time, and presents the results relevant to those issues.
On the basis of the staff's presentation and its own evaluation of events, the
FOMC sets a policy for the next six months or more in terms of say, the growth
path of the money stock. In principle, the FOMC's longer-run strategy can be
updated each month: in practice, however, it does not change that often—for no
other reason than new and useful information does not arrive on a monthly basis.
While we do not go through a full-scale forecasting and policy alternative analysis
each month, we do update our forecast for each meeting based on the policy
trajectory previously chosen by the Committee and on any new data. As events
warrant, the FOMC does change its basic policy trajectory.
I would like to point out that while we have never formally presented an
optimal control solution to the FOMC, we have produced such solutions for a
certainty version of our model. The outcome has been very useful in designing
policy alternatives and as background for policy advice. In the cases studied so far
it has been possible to come very close to the optimal solution with some very
simple policy moves. One of our big fears had been that in the optimal solution, the
money stock or interest rates might explode right off the charts. Of course the
policymakers would not believe this sort of result, and probably rightfully so. In
fact, however, we have been able to come very close to an optimal trajectory with
quite a gradual and smooth movement in the path of both interest rates and the
money stock. Thus, even in a rudimentary form, we have found these exercises to
be very helpful.
While the FOMC meets once a month, its open market operations go on daily.
Thus, every month, the Committee must decide upon its "operating strategy/'
that is, it has to give instructions to the trading desk in New York, where securities
are actually bought and sold, as to what to do during the month that will lapse
before the next Committee meeting. These instructions are composed of two parts.
First, the Committee states its decision regarding its longer-run strategy, say, some
growth path in the money stock. Then it must decide about how to return the
targeted variable—whether the money stock or an interest rate—to the desired
path when it strays off course. For instance, the money stock is very rarely exactly
on course because it cannot be determined with complete accuracy. The FOMC's
decision on how quickly to bring the money stock back towards the desired longerrun path is not independent of its decision concerning the variability in short-term




159
interest rates that it will tolerate—or vice versa. Thus, there is a tradeoff between
control of the money stock, or any other monetary aggregate, and variability of
short-term interest rates.
Each month the staff presents short-run operating strategy alternatives to the
FOMC in very much the same manner that it presents longer-run GNP projections.
Namely, we have a model, a form of which was described by Pindyck and Roberts
at this conference, that is used to generate monthly forecasts of the money market.
The forecasts are conditional on income estimates derived from the quarterly
forecast and on a specific pattern of bank reserve growth. The forecasts from the
monthly model are blended with independent judgments (along with the results
of other models) to arrive at a set of alternatives to present to the FOMC. For
instance, if the money stock is off track, then the alternatives are in the form of
various growth paths of bank reserves required to move the money stock from its
current value back to the desired long-run path over different time horizons.
Predictions of the implication for short-term interest rates of the various alternatives are also presented. The more quickly that the money stock is brought back to
the long-run path, the greater will be the movement in interest rates, other things
equal. Since there is some concern about interest movements in their own right, the
estimated tradeoff between hitting the money stock target and movements in
interest rates are also presented. On the basis of this presentation and its own
evaluation of the money market, the FOMC decides on its short-run operating
strategy.
In general, the longer-run movements in the money stock, or some other
monetary aggregate, are viewed as stabilizing the economy (income, employment,
and inflation), and the shorter-run movements, in part, are viewed as stabilizing
the money market (e.g., short-term interest rates). One can think of the situation
in terms of spectral analysis: the high frequency movements in the money stock are
really those used to stabilize the money market and the low frequency ones are
used to stabilize the economy. There is a conflict between these movements in the
money stock, but the conflict need not be very great so long as the money stock
tends to fluctuate evenly around the long-run trajectory. Sometimes this is not so,
and the money stock gets too far off the trajectory to allow it to be returned in any
short period of time without unacceptable movements in interest rates. As a result,
longer-run stabilization policy itself may be affected. Unfortunately for our
purposes, the money stock is not solely set by the Federal Reserve but rather is
co-determined in the economy; it is the path of bank reserves that is under policy
control. While the stock of money is highly influenced by Federal Reserve policy,
it is still difficult both to predict and control. Furthermore, the money stock is not
the only intermediate target for monetary policy; interest rates, credit conditions,
etc. also compete for the FOMC's consideration. When these other factors are
given heavier weight, the money stock can stray even farther from its predetermined growth path—perhaps, with no cost to the objectives of policy.
I would like to suggest some implications of these procedures for optimal
control applications. The first concerns the use of an intermediate target variable
as a means for obtaining the ultimate ends of monetary policy. The FOMC really
makes two decisions: it makes the decision as to what is the preferred time path of
the economy, and then makes the decision as to what intermediate target, say, the
growth path in the money stock, will be consistent with this goal. In other words, it
aims at the money stock—or at other times interest rates—as a vehicle for accomplishing its ends with respect to the real sectors of the economy.
It is not obvious that this is the appropriate thing to do. One is certainly
entitled to ask: why not go directly from the true instruments of policy (open market operations, the discount rate, and reserve requirements) to the real economic
targets? Why go through this intermediate vehicle at all? Clearly, this sort of procedure would not make any sense in a world of certainty, where we knew the exact
relationships between the instruments and the ultimate targets. To the contrary,
however, we operate in a world with a high degree of uncertainty. The rationale for
using an intermediate target lies in the fact that its data are more frequently available than are data on the real sectors; movements in the intermediate target can
provide early information on how the real sectors are responding to policy. In
addition, it must be under some degree of policy control and it must be causally
related to the ultimate objectives of policy. Thus, the difficulty or ease with which
a target for the money stock can be hit in a particular situation, presumably,
indicates what is happening in the real sectors. While this idea of using an intermediate target has appeal, no one has proved that it is appropriate.
One very useful application of optimal control procedures would be to analyze
the conditions under which it is desirable to use an intermediate target for monetary policy. Furthermore, if these conditions are likely to exist, what is the best
intermediate target to use? If the conclusion were to be that it is never or hardly




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ever appropriate to use an intermediate target variable, then it is important to
know the costs incurred by pursuing one.
The next issue I want to discuss is uncertainty in general. It is difficult to
overemphasize the degree of uncertainty with which policy decisions must be made.
A high degree of uncertainty concerning future values of exogenous variables is
one of the reasons why it is difficult to make reliable forecasts very far into the
future. The forecasting errors in the exogenous variables become so large, or at
least the variance around some expected value becomes so large, that the worth of
our GNP projections diminishes greatly as the forecast horizon is extended.
Another area of uncertainty has to do with our models. I want to stress this
because users of control theory often tend to take models as given and work out
solutions without seriously questioning the reasonableness of the models. This
tendency is not very harmful when one is working on technique. However, there is
a real danger of giving more credence to model results than they deserve, especially
if a particular policy trajectory is highly influenced by the choice of a model.
The problem lies not only with uncertainty concerning the true value of model
parameters, but also with the structure of models themselves. I cannot state
with much certainty that we have a good approximation to the economy with our
models at the Federal Reserve Board. I have even more doubt about other models
that are used for policy analysis. My particular concern involves whether or not
we have correctly approximated the impact of monetary policy in the models. For
example, we have found that with some relatively minor changes in the specification of our quarterly model—changing just three or four equations—we can
importantly alter its policy multipliers; I believe this is true of other models as
well. A couple of examples should make the point.
We have a wide variety of money demand functions from which we can choose,
& 1 estimated with about the same R2, with about the same standard error of esti1
mate, and all about as intuitively sensible or unsensible as the other. However, the
results from the full model are quite different just because of the different interest
elasticities of money demand implied by these functions. The way that this and
other structural models work is to impose clearing in the money market; shortterm interest rates must move sufficiently to equate money demand with money
supply. Other things equal, the smaller the short-run interest elasticity of money
demand, the greater the movement in interest rates required to induce the public to
change its holdings of money balances by a given amount. For a given change in the
growth in the money stock, different money demand functions with their different
elasticities will imply different changes in short-term interest rates. The changes in
short rates then feed to longer-term rates, to wealth, and to spending. Thus, the
short-run impact of a change in the money stock predicted by the model will depend rather crucially on the money demand function selected. At this time, we
simply have no reliable guidelines to help us choose among the functions available.
Another example is provided by the model's consumption function. Theoretically, consumption should depend upon wealth and it does in our model. Unfortunately, as soon as we have consumption dependent upon wealth, we have to
predict the impact of monetary policy on the stock market, because the major
component of the variance in wealth is the variance in stock prices. Given a choice,
I think any of us would far prefer to just go ahead and forecast consumption than
to forecast the stock market. However, because we would be losing a major
channel through which monetary policy works b3^ leaving wealth out, we leave it in.
We then have all kinds of ad hoc procedures for explaining the stock market. The
way that the stock market is specified to adjust to monetary policy variables is
crucial to estimating the impact of these variables on consumption and hence,
GNP. Again we have no reliable means of selecting the "correct" specification.
Another question I want to raise is: what is an acceptable way of evaluating a
model? How do we know when it is right? There are many models that explain
their sample period well and also do pretty well outside the sample period, but
which differ drastically in their specifications and also in their implied policy
multipliers. Unfortunately, there is no very reliable method of choosing among
alternative models. In a related vein, we have learned that individual structural
equations might look sensible, but when they are put together in a full model,
they can give some very strange results. Thus, it becomes very difficult to know
when an equation is good nor not. Should it be judged as an individual equation
or in terms of how it contributed to the full model?
An excellent case in point has to do with stability of models. Should one impose
stability on a model or not? By stability, I mean if the model is shocked with, say,
a permanent change in the growth rate of the money stock, does the model go
through explosive cycles? The real world might be like that, but then again it may
not. It is not possible to know because the real world never gets shocked in the
way that models are shocked. Instability per se does not bother control theorists




161
because they point out that the system can be stabilized even though it is structurally unstable. Perhaps that may be what happens in the economy. Perhaps the
economy is inherently unstable but policy at least has been good enough on average
to keep it from exploding. It is difficult to determine where the truth lies. The
problem is clearly an important one because the kind of stability conditions
imposed will have implications for a models dynamic policy multipliers. It seems
fair to say that there is no firm basis for knowing what kind of stability conditions
to impose on our models, if any.
There is an additional problem that plagues any user of models for forecasting
and policy analysis. There is no solid basis for establishing a practical method of
incorporating prior information into models. This information comes from such
sources as recent performance of the model, judgmental assessments of the
economy, and special survey information. Adjustments of a model's constant
terms is a rough and ready way to deal with this problem, but the method is clearly
deficient. Slope coefficients as well as intercepts should be adjusted when appropriate. The development of better procedures for incorporating prior information
would provide a major contribution to policy analysis.
At this point I would like to offer a few comments about the objective function
used in the formulation of monetary policy. As mentioned earlier, it is particularly
difficult to talk about "the" objective function because there are really twelve
objective functions on the FOMC, and there has to be a majority of people on the
Committee to agree on policy. The different ways that the Committee members
grapple with uncertainty often condition disagreements more than their basic
underlying objectives. For instance, if someone places a high weight on avoiding
high inflation rates, he will be very worried that somehow future inflation rates
have been underestimated. He will be willing to pay a relatively high penalty, in
terms of higher expected unemployment rates, in order to avoid a bad draw in the
sense of getting inflation rates greater than anticipated. The same sort of argument
applies to a member who is worried about unemployment. Being central bankers
and being in a position where decisions have to be made, the Committee members;
are risk averse—they are willing to trade off expected value for decrease in variance*
Their aversion to risk often takes the form of restricting movements in policy
instruments. This occurs not because instrument stability is necessarily valued per
se, but rather stems from a fear of going outside the range of experience. Theseparticular restrictions, then, do not belong in the objective function. By restricting,
movements in its instruments, the FOMC has in a sense solved its own control
problem. I think there is too much tendency on the part of researchers doing
control applications simply to assume that there should be a penalty cost on
movements in the instruments, and then justify this assumption by observing that
the instruments, in fact, have not moved very much in the real world. This
procedure precludes us from ever being able to demonstrate whether or not the
movements have been too restrictive.
For monetary policy, there really is no cost (in an economic resource sense) of
large movements in the reserve instrument. It is no more costly to buy a billion
dollars of Government securities per unit that to buy a thousand dollars worth,
and there are probably great scale economies. Thus, movements in bank reserves
do not belong in the objective function. It is true that policymakers worry about
short-term variability of interest rates and, at times, about the level of rates.
These interest rate considerations should appear in the objective function, or at
least as side conditions in a control problem.
Three additional observations concerning objective functions may be in order
at this point. First, it is very difficult to convince a policymaker to move an instrument in what he views to be the wrong direction. That is to say, if income is expanding very rapidly and the models are predicting that it is going to fall in the future
unless he eases up, it is very difficult to get him to ease up because that sort of
policy recommendation is contrary to what is going on currently. I must say that
until our models do a lot better, his wariness may be justified. Again, the problem
is one of how to handle risk: what if the model were wrong? What if the economy
were expanding very rapidly, the policymaker eases up, but economic expansion becomes more rapid? The cost of the error to the policymaker would be very large.
Second, I have observed over time that risk aversion on the part of the policymakers leads to risk aversion on the part of those giving advice. The reason is
very simple: if advice is followed and it turns out to be wrong, the policymakers
probably will not listen next time. Thus, the people giving advice also have a loss
function that further compounds the risk aversion. As a result, policy advice
often goes only part way, trying to point policy in what appears to be the right
direction. Contrary to the opinion of some observers, policy advisers are not in
the habit of recommending "fine tuning" of the economy.




162
Third, for optimal control studies, we need to know how crucial the weights
are in the loss function. We have done a few optimal control experiments in this
area using our quarterly model; they indicate that at least for some initial conditions, the choice of weights is not very important. In these experiments, wide
variations in the relative weights assigned to the unemployment rate and the rate
-of inflation resulted in surprisingly similar optimal policy trajectories. The reason
that this result occurs is that the inflation rate responds much less rapidly to
changes in policy variables than does the unemployment rate. In the longer run,
however, the effect of monetary policy is much more powerful on the rate of
inflation. Thus, even if the unemployment rate receives a relatively large weight
in the objective function, an attempt to bring it quickly back to target will set in
train forces leading ultimately to a relatively large rise in inflation above its target.
Thus, so long as the inflation rate receives a weight in the objective function, it
will reduce the incentive to move the unemployment rate quickly to its desired
value, although some movement is desirable. In the longer run, small changes in
the unemployment rate are associated with relatively large changes in the rate of
inflation, so again the inflation rate must enter importantly in computing the loss.
This would be a very powerful result if it held for a large number of initial
conditions. It would indicate that researchers would not have to worry so much
about getting the correct weights in the objective function. The result would also
be a demonstration of the robustness of the technique of optimal control. If it
turned out that the technique depended crucially on these weights, however, then
i t becomes much weaker because we really have no way of knowing what the
weights are.
I would like to conclude my remarks with some observations on the complexity
of models used for control applications. There seems to be a great desire among
economists to work with the newest and biggest models. It is particularly difficult
to work with new models, especially if they are large, because their properties
are not well known and because their sheer size leads to severe technical problems.
The Federal Reserve only has about two or three instruments, so we are not
terribly interested in looking at results where sixty different instruments can
be varied. It would be extremely productive if we could talk in a more meaningful
way about movements in real output, employment, and inflation in response to
variations in one instrument. There probably is a very substantial payoff to
working with smaller models that describe the behavior of those two or three
target variables and their relation to a policy instrument. The use of small models
would clear away a great deal of the pure technical problems, particularly in
stochastic control problems. It is not at all clear to me that larger models are
needed in order to carry out this kind of experiment. In fact, we are currently
engaged in efforts to come up with a scaled down version of our own quarterly
model. Hopefully, we will then be able to do control problems more efficiently
than we have been able to do in the past.
I would like to conclude by saying that I think the work on optimal control is
very promising, and our applied work at the Fed indicates that control techniques
can and will provide important contributions toward solving stabilization
problems.
Board of Governors of the Federal Reserve System.
{From Open Market Policies and Operating Procedures—Staff Studies, Board of Governors of the Federal
Keserve System, July, 1971.]
M O N E T A R Y A G G R E G A T E S AND M O N E Y M A R K E T C O N D I T I O N S I N O P E N
POLICY

MARKET

(By Stephen H. Axilrod)
There has been widespread discussion over the past year or so about the emphasis given to monetary and credit aggregates, as compared with traditional operating variables such as money market conditions, in the formulation and
conduct of the Federal Reserve System's open market policy. This article discusses the role—in the decisionmaking process of the Federal Open Market
Committee (FOMC) * and in the day-to-day conduct of Federal Reserve open
1
The Federal Open Market Committee is the statutory body responsible for open market operations
(purchase and sale of U.S. Government securities in the open market), the mostflexibleand frequently used
instrument by which monetary policy affects bank reserves, bank credit, money supply, and ultimately
over-all credit conditions. The FOMC consists of the seven members of the Board of Governors of the Federal
Keserve Bank of New York, and four of the remaining 11 Reserve Bank presidents serving in rotation. The
Chairman of the Board of Governors has traditionally been elected by the Committee to serve as Chairman
of the Open Market Committee, and the President of the Federal Reserve Bank of New York has traditionally been elected Vice-Chairman.




163
market operations—of aggregates such as the money supply and bank credit in
comparison with other financial variables. Such aggregates, of course, represent
only a few of the many financial variables, including interest rates and credit
flows through nonbank institutions and the market directly, that are evaluated
in monetary policy decisions and their implementation. And financial conditions
as a whole are evaluated against the underlying purpose of monetary policy—the
Encouragement of a healthily functioning economy, both domestically and in
relation to the rest of the world.
The policy decisions of the FOMC are based on a full-scale evaluation by Committee members of likely tendencies in critical measures of economic performance
such as output, employment prices, and the balance of payments. In deciding on
the stance of monetary policy, the Committee considers whether these tendencies
in domestic economic activity and the balance of payments appear desirable, and
if not, how they might be influenced by changes in financial conditions—including
the pace of monetary expansion, credit availability, interest rates—and by expectational factors. Once a general policy stance is adopted guidelines are set for
the day-to-day conduct of operations in the open market. During 1970 somewhat
more emphasis was placed on the behavior of monetary aggregates—such as the
money supply and bank credit—in providing guidance for the day-to-day conduct
of open market operations.
Since it has always been recognized that the effect of monetary policy stems
from its influence on bank credit, money, interest rates, and financial flows
generally, the greater emphasis placed on monetary aggregates basically represented a modification of operating procedures rather than a change in the fundamental objective of policy. Under conditions of uncertainty—for example, uncertainty about the impact on interest rates of expectational factors or about the
strength of future demands for goods and services—some emphasis on the aggregates helps to guard against the risk that open market operations might in the
end supply either too large or too small amounts of bank reserves, credit, and
money as a result of unexpected and undesired shifts in demands for goods and
services and for credit.
At the same time, however, an approach that utilizes aggregates as one operating guide must take account cf shifts in the demand for money and liquidity
at given levels of income. Such shifts would have to be accommodated through
open market operations in order to help provide the money and liquidity demanded if interest rates and credit conditions generally were not to become unduly tight or easy. Thus, the longer-run path for monetary aggregates needs
to be evaluated in relation to emerging credit conditions and tendencies in economic activity, to help determine if demands for liquidity have been properly
assessed. And whatever longer-run path for the aggregates may be included as
guidance for open market operations, short-run, self-correcting variations in
money and credit demands need to be accommodated in order to avoid inducing
unnecessary, and possibly destabilizing, fluctuations in money market conditions.
In practice, allowance has to be made—in the formulation of monetary policy
and in the guides to the conduct of policy—for uncertainties with respect to both
the demand for goods and the demand for money and liquidity. And trends in
monetary aggregates, interest rates, and other financial variables have to be evaluated in relation to the continuing flow of evidence as to the likely course of
economic activity.
DIRECTIVES OP THE FOMC

The monetary policy decision of the FOMC—which in recent years has generally
met about every 4 weeks—are embodied in the Committee's current economic
policy directive, voted on near the end of each meeting. This directive is issued
to the Federal Reserve Bank of New York, which, because it is located in the
Nation's central money and credit market, undertakes open market operations
for the Federal Reserve System. The directive is carried out by a senior officer
of the Bank, who is designated by the FOMC as Manager of the System Open
Market Account.
Both the form and the content of the FOMC directive have changed over the
years. Since 1961 the directive has contained two paragraphs. The first paragraph
has contained statements about recent key economic and financial developments,




164
and also a general statement of current goals of the FOMC with respect to economic growth, price stability, and the balance of payments.2 The second paragraph
contains the FOMC's instructions to the Account Manager for guiding open
market operations in the interval between FOMC meetings. The second paragraph
is, in essence, a highly condensed summary of the Committee's discussion and
conclusions as to the sort of operations that will be required to reach its longer-run
policy goals. These directives are made public after a 3-month lag in a "record of
policy actions," which also includes a resume of prevailing economic and financial
conditions and of the Committee's discussion of policy implications at the meeting.
The nature of the operating instructions in the second paragraph of the directive
has changed from time to time. Money market conditions have remained as
important guides in determining day-to-day open market activity. Though
emphasis on various money market indicators has varied over the years in light
of changing economic and financial circumstances, money market conditions have
generally been construed to include member bank borrowings at the Federal
Reserve discount window, the net reserve position of member banks (excess
reserves of banks less^borrowings from the Federal Reserve), the interest rate on
Federal funds (essentially reserve balances of banks that are made available to
other banks, usually on an overnight basis), and at time the 3-month Treasury
bill rate.
At times when it was framing the operating instructions contained in the second
paragraph of its directive solely in terms of money market conditions, the FOMC
was nevertheless concerned with developments in monetary aggregates and
financial conditions generally as they affect the broad objectives of policy. Beginning in 1966, the Committee supplemented the reference to money market conditions in the second paragraph with a reference to certain monetary aggregates,
such as bank credit, and later the money suppty.3 The desired behavior of aggregates has been given increased emphasis since early 1970.
From mid-1966 through 1969 the reference to aggregates was generally to bank
credit and was contained in a so-called proviso clause. The second paragraph of
the directive issued on December 16, 1969, is illustrative:
"To implement this policy, System open market operations until the next
meeting of the Committee shall be conducted with a view to maintaining the
prevailing firm conditions in the money market; provided, however, that operations shall be modified if bank credit appears to be deviating significantly from
current projections or if unusual liquidity pressures should develop."
In 1970 monetary aggregates came to play a more prominent role in the phrasing
of the second paragraph, and references were made to the money supply as well as
to bank credit. In the directive issued on March 10, 1970, the Committee stated
more directly its desires with respect to the aggregates rather than referring to
them in the form of a proviso clause. The second paragraph of the directive of that
date read as follows:
"To implement this policy, the Committee desires to see moderate growth in
money and bank credit over the months ahead. System open market operations
until the next meeting of the Committee shall be conducted with a view to maintaining money market conditions consistent with that objective."
The operating instructions in the second paragraphs of FOMC directives are not
confined to money market conditions and a desired pattern of behavior in the
monetary aggregates. The System Account Manager has also been directed, when
appropriate, to take account of Treasury financings, liquidity pressures, and the
2 For illustrative purposes the first paragraph of the directive issued on Dec. 16, 1969, is quoted below:
"The information reviewed at this meeting indicates that real economic activity has expanded only
moderately in recent quarters and that a further slowing of growth appears to be in process. Prices and costs,
however, are continuing to rise at a rapid pace. Most market interest rates have advanced further in recent
weeks partly as a result of expectational factors, including concern about the outlook forfiscalpolicy. Bank
credit rose rapidly in November after declining on average in October, while the money supply increased
moderately over the 2-month period; in the third quarter, bank credit had declined on balance and the
money supply was about unchanged. The net contraction of outstanding large-denomination CD's has
slowed markedly since late summer, apparently reflecting mainly an increase in foreign official time deposits.
However, flows of consumer-type time and savings funds at banks and nonbank thrift institutions have
remained weak, and there is considerable market concern about the potential size of net outflows expected
around the year-end. In November the balance of payments deficit on the liquidity basis diminished further
and the official settlements balance reverted to surplus, mainly as a result of returnflowsout of the German
mark and renewed borrowing by U.S. banks from their foreign branches. In light of the foregoing developments, it is the policy of the Federal Open Market Committee to foster financial conditions conducive
to the reduction of inflationary pressures, with a view to encouraging sustainable economic growth and
attaining reasonable equilibrium in the country's balance of payments."
3
There was also occasional reference to such aggregates in directives during the first half of the 1960's.




165
possible impacts of bank regulatory changes in the process of achieving satisfactoryconditions in the money market and satisfactory performance of monetary
aggregates.
As the nature of economic andfinancialproblems has altered, so has the phrasing
of the second paragraph of the directive. For instance, the second paragraph of the
directive issued on May 26, 1970, emphasized the need to moderate pressures on
financial markets; it read as follows:
"To implement this policy, in view of current market uncertainties and liquidity
strains, open market operations until the next meeting of the Committee shall be
conducted with a view to moderating pressures onfinancialmarkets, while, to the
extent compatible therewith, maintaining bank reserves and money market conditions consistent with the Committee's longer-run objectives of moderate growth
in money and bank credit."
The short-run bulge in bank credit expansion expected to result from the Board's
action around midyear in suspending ceilings on maximum interest rates payable
by banks on large certificates of deposit in the 30- to 89-day maturity range was
taken into consideration in the phrasing of the second paragraph of the directive
issued by the FOMC on July 21, 1970:
"To implement this policy, while taking account of persisting market uncertainties, liquidity strains, and the forthcoming Treasuryfinancing,the Committee
seeks to promote moderate growth in money and bank credit over the months
ahead, allowing for a possible continued shift of creditflowsfrom market to banking channels. System open market operations until the next meeting of the Committee shall be conducted with a view to maintaining bank reserves and money
market conditions consistent with that objective; provided, however, that operations shall be modified as needed to counter excessive pressures infinancialmarkets
should they develop."
And in the directive issued on August 18, 1970, an easing of conditions in credit
markets was taken as an objective of open market operations parallel with desires
with respect to monetary aggregates, as follows:
"To implement this policy, the Committee seeks to promote some easing of
€onditions in credit markets and somewhat greater growth in money over the
months ahead than occurred in the second quarter, while taking account of possible
liquidity problems and allowing bank credit growth to reflect any continued shift
of credit flows from market to banking channels. System open market operations
until the next meeting of the Committee shall be conducted with a view to maintaining bank reserves and money market conditions consistent with that objective,
taking account of the effects of other monetary policy actions."
The first and second paragraphs of all directives issued from December 16, 1969,
through December 15, 1970, are shown in the appendix to indicate the variety of
considerations that the FOMC takes into account in formulating its policy and
framing its operating instructions.
POLICY FORMATION

The FOMC's basic concern is with the real economy—production, employment,
prices, and the balance of payments. But the Committee must translate its
broader economic goals into the monetary and credit variables over which the
Federal Reserve has a direct influence. Thus, whatever emphasis is given to the
financial variables that influence day-to-day open market operations, it is recognized that the immediate targets of day-to-day operations are not the goals of
monetary policy, but rather that those targets are set with a view to facilitating
the achievement of the broader financial and economic objectives of the FOMC.
In setting its immediate operating targets, the FOMC necessarily reviews
past and prospective relationships between financial conditions and economic
•objectives. A benchmark in this review is provided several times a year in a
presentation by the staff to the Committee of an interrelated set of longer-run
economic and financial projections. These exercises review in detail recent economic and financial developments, assess the outlook for and impact of fiscal
policy, and trace the likely patterns of change in such measures as income, output,
employment, prices, and the balance of payments for a period of about a year
ahead. Provisional estimates are also presented of the flow of funds—including
various monetary aggregates—and interest rates expected to be consistent with
these patterns of economic development. A reappraisal of current tendencies in
and prospects for economic activity, financial flows and credit market conditions
and the balance of payments is presented to the FOMC by the staff on the occasion




166
of each meeting. Included in the regular documentation is an analysis of relationships among money market variables, paths for monetary aggregates, and interest
rates broadly considered for a period several months ahead.
At each FOMC meeting, most of the time is given over to a free interchange
of views by Committee members of their assessment of the current economic
situation and outlook and of the related appropriate monetary policies. As the
discussion proceeds, each Committee member indicates his assessment of the basic
tendencies in economic activity, prices, employment and so forth; his appraisal of
recent financial developments in relation to desired economic goals; and what
steps might be taken through open market operations (or other policy instruments that interact with open market operations) to help achieve financial conditions suitable to economic goals.
It may develop, for instance, that most of all Committee members believe
that economic prospects are deviating from those that had previously been
expected and desired. If so, the Committee may wish to modify its objectives
concerning money market conditions and desired rates of expansion in monetary
and credit aggregates, so as to promote over-all financial and credit conditions
that are more conducive to desired economic conditions. Or it may turn out that
economic activity is developing about in line with expectations but seems to be
entailing a pattern of financial flows different from that originally expected. Still
another possibility is that the relationship that is developing between the variables
specified for the System Account Manager for purposes of guiding day-to-day
open market operations and broaderfinancialflowsand interest rates is not what
was expected. Under any of such circumstances, the FOMC could react by changing its operating instructions.
The operating instructions in the second paragraph of the directive are expressed
qualitatively. But the specific variables involved—money market conditions and
monetary and credit aggregates—are typically indicated in terms of ranges in the
discussion.
Over the past year the operating instructions embodying the Committee's
policy thrust have changed in two general ways. First, as has been noted, somewhat more emphasis has been placed on monetary aggregates as a target for open
market operations rather than as an outgrowth of such operations. Second, the
time horizon for a path of monetary and credit aggregates (in relation to money
market conditions and other financial variables) has been viewed as encompassing
several months or, expressed in calendar quarters, at least one or two quarters
ahead. Longer-run paths provide the Committee with a means for focusing on the
emerging trend of growth in the money supply or in bank credit, while recognizing
that, over very short-run periods of a week or a month or so, there may be irregular
movements in rates of change in monetary aggregates because of erratic shifts
in the public's demand for deposits and such factors as Treasury financings, a
large change in U.S. Government deposits, or movements of funds between the
U.S. and foreign countries.
BOLE OP MONETARY AGGREGATES

The somewhat greater use of monetary aggregates in the formulation and
conduct of open market policy during the past year represents for the most part an
extension of the trend of policy over the previous several years. It has always been
recognized that monetary policy achieves its effects through its influence on bank
credit, money supply, interest rates, andfinancialflowsgenerally. But the benefits
that might be expected from an increased degree of emphasis on monetary aggregates in the conduct of open market operations relate to the question of monetary control under conditions of uncertainty.
Greater emphasis on aggregates is consistent with a variety of economic theories,
and it does not necessarily imply any particular judgment as to the importance for
the economy of monetary flows relative to interest rates and credit conditions or
relative to other influences such as fiscal policy and technological innovation.
Operationally, however, by placing more emphasis on monetary aggregates in the
instructions to the Account Manager, the FOMC has a greater assurance that
unexpected and undesired shortfalls or excesses in the demands for goods and
services in the economy, and hence in the demands for credit and money, will not
lead more or less automatically to too little or too much expansion in bank reserves,
bank credit, and money.
Giving more weight to monetary aggregates means, for example, that if there
were an unexpected and undesired short-fall in business and consumer demand for
goods and services, the Federal Reserve would continue to provide reserves to




167
try to keep growth in money and bank credit from weakening unduly at a time
when the public, with transactions demand for cash reduced, was seeking to invest
excess funds in various financial assets. In the process, there would be a greater
short-run decline in interest rates than would otherwise be the case. The drop in
interest rates and the easing of credit conditions would help to provide financial
incentives that would encourage a strengthening of demands for goods and
services.
While increasing the emphasis on monetary and credit aggregates tends to
increase the protection against undesired shifts in demands for goods and services,
it at the same time runs the risk of reducing protection against unexpected shifts
in the public's demand for cash and liquidity. Thus, for example, if the public
decides to hold more liquidity relative to income than had been earlier assumed,
failure to permit a faster rise in the money supply to accommodate this desire
would lead to higher interest rates and tighter credit conditions as the public
seeks to sell other assets to acquire cash. The tightening of credit conditions
would tend to lead to a weaker GNP than desired. In contrast, the tendency toward
tighter conditions could be averted if the Federal Reserve helped to meet the
desire for greater liquidity by increasing its purchases of financial assets (through
open market acquisitions of U.S. Government securities)—thereby providing
more bank reserves to support an increase in bank deposits and in the money
supply and to keep interest rates from rising.
In practice, allowance has to be made for uncertainties about both the demand
for goods and services and the demand for money and liquidity. Opinions differ
among professional economists as to the relative degrees of stability of these
types of demand, and practical experience over the past several years suggests
that there is a good deal of variation in both. There have been periods when large
increases in Federal Government purchases of goods and services and/or in
private sector demands for capital goods and inventories have caused marked
shifts in over-all demands for goods and services at given interest rates. But there
have also been periods when liquidity strains, greatly increased financial transactions, and various international uncertainties have resulted in a sizable upward
shift in the demand for cash and closely related assets at given interest rates.
Furthermore, open market policy not only needs to distinguish between, and take
account of, shifts in both the demand for goods and services and the demand for
money and liquidity at given interest rates, but also must evaluate the extent to
which such shifts are transitory or more permanent.
The late spring and the summer of 1970 are an example of a period when liquidity
strains in the economy—typified b}r rising long-term interest rates at a time when
economic activity was sluggish, by the bankruptcy of a major railroad, and
by a generally cautionary attitude on the part of investors toward securities,
particularly commercial paper—were giving rise to considerable uncertamt}^ and
were threatening a marked erosion in confidence. Under those circumstances
Federal Reserve policy stressed the need to moderate pressures on financial markets
and to accommodate liquidity needs.
In late June the Board of Governors suspended maximum ceiling rates on large
CD's maturing in 30- to 89-days as part of the effort to reliquify the economy.
This action made it possible for banks to compete for funds and to accommodate
borrowers who were not able, in the conditions of the time, to refinance their
borrowings in the commercial paper market, or were not able to do so without a
bank loan commitment as back-up. And open market operations during the period
were conducted in such a way as to provide the reserves to sustain the very large
increase in bank credit resulting from renewed ability of banks to obtain funds
through issuance of certain large CD's. The FOMC's policy directives in that period
(see directives in May 26 and July 21, 1970, on pp. 99 and 100) tended to subordinate, temporarily, longer-run objectives for monetary aggregates to the
shorter-run liquidity needs of the economy.
In general, in evaluating the appropriateness of particular operating guidelines
at a particular time, the FOMC has to make judgments about the nature of the
fundamental influences that are affecting the domestic economy and the international position of the dollar. If, for example, it developed that interest rates
were higher, and over-all credit conditions tighter, than expected for a given rate
of increase in bank credit or money, the FOMC would have to make a judgment
as to whether GNP was stronger than anticipated, whether inflationary expectations were affecting interest rates, or whether the demands for money and closely ,
related assets had shifted at given levels of income and interest rates. Or, as another
example, interest rate movements might be undesirably affecting capital flows
between the United States and foreign countries; in this case judgments might




168
have to be made as to how the various policy instruments could be adapted to
such a development.
Judgments made with respect to interrelationships among policy objectives
would affect not only the open market policy instrument but also other monetary
policy instruments. With respect to open market policy, types of adjustments called
for in operating instructions would include, for instance, whether to change the
targets for aggregates and/or whether to put more stress on money or credit market conditions. Or adjustments might be called for in other policy instruments—
such as the discount rate or reserve requirements, including provisions such as
those recently made affecting Euro-dollar borrowings of U.S. banks—in order to
achieve a variety of policy objectives more effectively.
In looking toward a desired longer-run growth rate in monetary aggregates, the
FOMC has focused on money and bank credit in its operating instructions. The
concept of money used for these purposes has generally been the so-called narrowly denned money supply—currency in circulation outside the banking system
plus demand deposits other than U.S. Government and domestic interbank
deposits—but broader definitions have also been taken into account. The determination of what rates of growth may be desired for money takes into account not
only what is happening in credit markets but also the rates of growth in certain
types of assets held by the public that are closely related to narrowly defined
money and that the public holds as a store of value and as a source of immediate
liquidity.
A number of broader concepts of the money supply and of liquidity have been
utilized by economic analysts in relating money supply to economic activity.
These include, in addition to the narrowly defined money supply, a concept—
here termed M2—that adds time and savings deposits other than large CD's at
commercial banks to narrowly defined money; and a concept, termed M3, thnt
adds deposits at both mutual savings banks and savings and loan associations.
And even these concepts can be broadened by adding other money-like assets,
such as large marketable negotiable CD's issued by banks and other short-term
marketable securities. Annual, quarterly, and monthly rates of change over the
past year in the three concepts of money noted above are shown in the table
below.
VARIOUS MEASURES OF MONEY: RATES OF CHANGE
[Seasonally adjusted annual rates, in percent]

Mi
(Currency
plus demand
deposits*)

Period

1969
1970

.

1970—Ql

M8
( M i plus coml.
bank time deposits
other than
large CD's)

M3
(M2 plus deposits
at S & L's and
mutual savings
banks)

3.1
5.4
5.9
5.8
6.1
3.4
9.4
-4.1
12.3
9.9
5.2
2.3
5.7
6.8
5.7
1.1
2.8
6.2

2.4
8.2
3.4
8.4
11.0
9.2
2.2
-1.5
9.6
10.8
7.6
6.7
9.9
12.5
10.3
7.3
7.0
13.0

2.8
7.9
2.6
7.9
10.5
9.7
1.2
-1.2
7.8
9.7
7.2
6.6
9.9
11.4
10.0
8.1
8.1
12.6

...

I.III I"_~I_II~I"I_IIIIIII I

Q2
1970—January
February
March
April.
May
June
July
August
September
October
November
December

.

.

_

_

_

_

•Demand deposits other than interbank and U.S. Government.
Note: P/lonthly rates of change based on the daily-average levels outstanding. Quarterly and annual rates of changes
measured from daily-average levels outstanding in end-of-period months.

As may be seen, the rates of change for the various measures may diverge
noticeably, and they may show a high degree of fluctuation over the short run.
Differential tendencies in the various measures of money and liquidity have been
the result in large part of sharp shifts of funds by the public between deposits and
market securities when market interest rates moved above and then back below




169
ceiling rates on deposits at banks and thrift institutions. But divergent movements,
particularly in the short run, may develop even when ceiling rates are not a
disturbing element. This highlights the need to evaluate a variety of money and
liquidity measures, among other things in gauging the impact of monetary policy
on the economy. Moreover, the relatively large month-to-month variations in
growth for any particular money measure—and variations are even larger from
week to week—emphasize the need to evaluate data over some long period of
time in judging the underlying tendency of the series.
As noted earlier, in addition to the money supply, the second paragraph of the
directive has emphasized bank credit. A current measure of bank credit for the
guidance of the Account Manager was provided by measuring bank credit from
the liability side, since liability data are available more quickly and can be used
to construct a series on a daily-average basis. This daily-average measure does
not encompass all bank liabilities (it excludes non-member bank deposits and
bank capital, for example) but it includes the most volatile ones. It encompasses
not only the member bank component of deposits included in M2 above, but also
funds obtained by banks through large time CD's, U.S. Government deposits,
and interbank deposits and through nondeposit sources such as Euro-dollars
and commercial paper issued by bank-related affiliates. The sum of these deposits
and nondeposit sources is called the adjusted credit proxy.

CREDIT PROXY ADJUSTED;
TOTAL RESERVES
BILLIONS OF DOLLARS
350
CREDIT PROXY ADJUSTED

300

250
0

30

TOTAL RESERVES

25

1967

1S68

1969

1970

Bank "credit proxy adjusted" is total member bank deposits plus funds provided
by Euro-dollar borrowings and bank-related commercial paper. Through the
first half of 1969, no data on bank-related commercial paper were available,
but amounts outstanding were not thought to be growing significantly in those
periods.




170
Inclusion of bank credit in tiie directive might be considered as recognition of
a broader concept of money, since time and savings deposits at commercial banks
are a key source of bank credit. In addition, however, the inclusion recognizes
that bank credit is a key component of total credit availability and one that is
immediately sensitive to open market operations.
The amount of bank credit that the FOMC is willing to encourage or to countenance depends, like the money supply, on over-all economic and financial conditions. When, for example, banks have been unable for an extended period to
increase time and savings deposits because interest rate ceilings on time deposits
were unrealistically low relative to market rates, it was to be expected that outstanding bank credit would grow rapidly for a time after ceiling rates again became
competitive. This growth would represent mainly a shifting of credit flows from
market to banking channels as banks sought to restore their previous competitive
position and as the public restructed its financial asset portfolios to reflect the
changed yield relationships. Federal Reserve open market operations could
provide the reserves necessary to sustain the shift in the public's ability and
willingness to hold time deposits relative to other assets. The accompanying chart
shows monthly changes in bank credit, as measured by the adjusted credit proxy,
^along with total bank reserves.
DAY-TO-DAY OPEN MARKET OPERATIONS

"The day-to-day operations in the market by the System Account Manager
have continued to be guided mainly by money market conditions, in part because
the information that is available daily and continuously as to the state of the
money market—for example, the Federal funds rate and dealer loan rates—reflects
the interaction of the demand for and existing supply of bank reserves and hence
provides a basis for making daily decisions as to whether the System should be in
the market providing additional or absorbing existing reserves; and if so, by how
much and through what means. But the degree to which the Manager seeks to
influence money market conditions has been affected by the relationship that is
presumed to exist at any given time among money market conditions, reserves,
and the monetary aggregates and by the Committee's desires with respect to
monetary aggregates and over-all conditions in the credit market.
Changes in money market conditions, of course, may reflect factors other than
efforts to influence reserve flows in accordance with longer-run targets for monetary
aggregates. Some changes in money market conditions reflect no more than shifts
in the distribution of reserves among banks. Others represent the short-run effects
of bulges in demand for day-to-day credit at times of Treasury financings or in
tax payment periods. Yet others represent unanticipated, virtually random
changes in technical factors—such as float or currency in circulation—that supply
to or absorb from the market more reserves than was either expected or seemed
likely to be sustained. And as in the summer of 1970, open market operations in
relation to money market conditions may sometimes reflect primarily a concern
with liquidity pressures in the economy.
Although recognizing that money market conditions are subjeet to a number of
influences, the System Account Manager takes into consideration the relationship
between money market conditions and the trends in bank credit and money that
has prevailed in the recent past and the relationship that is expected to develop
in the future in making decisions concerning reserve provision or absorption
through open market operations. At the beginning of a statement week, for
example, his operations may be aimed at a condition of tightness or ease in the
money market roughly similar to that of previous weeks. This would mean that
such variables as the Federal funds rate, dealer loan rates, the net reserve position
of member banks, and borrowings by member banks from the Federal Reserve
would generally tend to fluctuate within the range of recent experience—although
there might be special, sometimes unforeseen developments (such as a mail strike)
that could cause marked short-run changes in money market conditions.
If and as it becomes evident that monetary aggregates are running above or
below the desired path, however, the Account Manager may aim at correspondingly tighter or easier money market conditions. Also, if it should turn out that
the apparent new relationship was not long-lasting, the Account Manager would
•subsequently have to reverse the direction of his operations. Thus, to the
extent that monetary aggregates are given more emphasis in the operating paragraph of the directive, money market conditions may be subject to a somewhat
greater degree of fluctuation.




171
While the counterpart of greater sensitivity to monetary aggregates would be
a somewhat greater tendency for actual money market conditions to change
more frequently than otherwise, sharp short-run shifts in money market conditions
are not likely to develop, in part because the FOMC is concerned with the state
of money and credit markets as well as with tendencies in monetary aggregates.
There are a number of reasons for the continuing role of money market conditions
as a day-to-day guide for open market operations.
First, the money market reflects the pressure of demand for liquidity, and the
nation's central bank has a unique responsibility for maintenance of orderly
conditions in such a market.
Second, there are large and often unpredictable week-to-week and month-tomonth swings in the economy's demand for money and bank credit. These demands are often self-correcting, and as a result there is little purpose in permitting
the sharp fluctuations in money market conditions, and perhaps in credit markets
generally, that would be likely to develop should the flow and ebb of these demands
not be accommodated in Federal Reserve operations affecting bank reserves.
Third, because of the key role of the money market in quickly reflecting shifts
in the need for and availability of liquid funds, presumably in large part as a result
of the interaction of the public's spending decisions and monetary policy, sharp
shifts in money market conditions may be interpreted by market participants
as a harbinger of relatively permanent changes in credit demand or monetary
policy. Investors, businessmen, and consumer may vary their credit outlook,
and perhaps their economic outlook too, in response to the money market to the
extent that they regard changes in the market as a signal of events to come. This
prospect itself counsels caution in undertaking open market operations that lead
to large short-run changes in money market conditions until it becomes fairly
certain that longer-run tendencies in money supply, bank credit, and over-all
credit conditions require such changes.
While there are reasons for emphasis on money market conditions, it should be
stressed that money market conditions are only instrumental to the attainment
of the main financial objectives of policy—flows of monetary aggregates and overall credit conditions-—that are appropriate to achievement of over-all economic
goals. For the Account Manager, the day-to-day operations of the Account and
the effect of these operations on the money market are made even more complex
because he is aware that the FOMC generally has in mind not only some view
concerning the desired longer-run trend in various monetary aggregates but also
a view concerning what should be sought in the way of associated credit conditions.
These desires may sometimes turn out to be in conflict; for example, monetary
aggregates as a group may be rising more rapidly than desirable while credit conditions may be tightening more than desirable. Meeting one desire by holding
back on the provision of reserves in order to restrain growth in bank credit and
money would tend, at least temporarily, to thwart the other desire by leading to
even more tightening of credit conditions. Under such circumstances, the Account
Manager would have to adjust his operations—thereby affecting day-to-day
money market conditions—in line with the sense of priority among operating
objectives given by the FOMC.
While the whole set of objectives would be reconsidered at the next FOMC
meeting, the Account Manager's operations are monitored daily through a morning
telephone conference call. This call involves the Trading Desk in New York,
senior officials on the staff of the Board of Governors in Washington, and one of
the Reserve Bank Presidents (serving in rotation) who is a voting member of the
FOMC (other than the President of the Federal Reserve Bank of New York).
Individual Board members may also participate in the call from time to time, as
may the President of the New York Reserve Bank. In this call the Manager
explains his program for the day, and that program, or possible alternative approaches are discussed. As part of this process, not only are current figures on bank
reserve positions, money market conditions, and broader credit conditions reported, but also information on the latest deposit and bank credit figures and
how these compare with FOMC desires is appraised.
In general, as the FOMC's objectives with respect to monetary aggregates, and
also over-all credit conditions, have been given increased stress in the directive to
the Account Manager, the timing and extent of the System's day-to-day open
market operations have, of course, been altered, with consequent effects on day-today money market conditions. At the same time, the Manager still takes account
of the emerging tightness or ease in the money market as a factor affecting the
timing and extent of day-to-day open market operations. But this emerging
tightness or ease is evaluated against trends in money, bank credit, and over-all




172
credit conditions, which are, and always have been, among the basic financial
objectives of monetary policy.
APPENDIX: CURRENT ECONOMIC POLICY DIRECTIVES ISSUED BY THE

FOMC

MEETING HELD ON DECEMBER 16, 1969

The information reviewed at this meeting indicates that real economic activity
has expanded only moderately in recent quarters and that a further slowing of
growth appears to be in process. Prices and costs, however, are continuing to
rise at a rapid pace. Most market interest rates have advanced further in recent
weeks partly as a result of expectational factors, including concern about the
outlook for fiscal policy. Bank credit rose rapidly in November after declining
on average in October, while the money supply increased moderately over the
2-month period; in the third quarter, bank credit had declined on balance and
the money supply was about unchanged. The net contraction of outstanding
large-denomination CD's has slowed markedly since late summer, apparently
reflecting mainly an increase in foreign official time deposits. However, flows of
consumer-type time and savings funds at banks and nonbank thrift institutions
have remained weak, and there is considerable market concern about the potential
size of net outflows expected around the year-end. In November the balance of
payments deficit on the liquidity basis diminished further and the official settlements balance reverted to surplus, mainly as a result of return flows out of theGerman mark and renewed borrowing by U.S. banks from their foreign branches.
In light of the foregoing developments, it is the policy of the Federal Open Market
Committee to fosterfinancialconditions conducive to the reduction of inflationary
pressures, with a view to encouraging sustainable economic growth and attaining
reasonable equilibrium in the country's balance of payments.
To implement this policy, System open market operations until the next meeting
of the Committee shall be conducted with a view to maintaining the prevailing
firm conditions in the money market; provided, however, that operations shall be
modified if bank credit appears to be deviating significantly from current projections or if unusual liquidity pressures should develop.
MEETING HELD ON JANUARY 15, 1970

The information reviewed at this meeting suggests that real economic activity
leveled off in the fourth quarter of 1969 and that little change is in prospect for
the early part of 1970. Prices and costs, however, are continuing to rise at a rapid
pace. Most market interest rates have receded from highs reached during December. Bank credit and the money supply increased slightly on average in
December and also over the fourth quarter as a whole. Outstanding largedenomination CD's held by domestic depositors have continued to contract in
recent months while foreign official time deposits have expanded considerably.
Flows of consumer-type and savings funds at banks and nonbank thrift institutions,
have remained weak, and there apparently were sizable net outflows after year-end
interest crediting. U.S. imports and exports have both grown further in recent
months but through November the trade balance showed little or no further
improvement from the third-quarter level. At the year-end the over-all balance
of payments statistics were buoyed by large temporary inflows of U.S. corporate
funds. In light of the foregoing developments, it is the policy of the Federal
Open Market Committee to foster financial conditions conducive to the orderly
reduction of inflationary pressures, with a view to encouraging substainable economic growth and attaining reasonable equilibrium in the country's balance of
payments.
To implement this policy, while taking account of the forthcoming Treasury
refunding, possible bank regulatory changes and the Committee's desire to see a
modest growth in money and bank credit, System open market operations until
the next meeting of the Committee shall be conducted with a view to maintaining
firm conditions in the money market; provided, however, that operations shall!
be modified if money and bank credit appear to be deviating significantly from
current projections.
MEETING HELD ON FEBRUARY 10, 1970

The information reviewed at this meeting suggests that real economic activity^
which leveled off in the fourth quarter of 1969, may be weakening further in
early 1970. Prices and costs, however, are continuing to rise at a rapid pace.




173
Long-term market interest rates recently have fluctuated under the competing;
influences of heavy demands for funds and shifts in investor attitudes regarding
the outlook for monetary policy. Bank credit declined in Januaiy but the money
supply increased substantially on average; both had risen slightly in the fourth
quarter. Flows of time and savings funds at banks and nonbank thrift institutions
have remained generally weak since year-end, and they apparently have been
affected little thus far by the recent increases in maximum rates payable for such
funds. The U.S. foreign trade balance improved somewhat in December, as
imports fell off. The over-all balance of payments has been in substantial deficit
in recent weeks. In light of the foregoing developments, it is the policy of the
Federal Open Market Committee to foster financial conditions conducive to the
orderly reduction of inflationary pressures, with a view to encouraging sustainable
economic growth and attaining reasonable equilibrium in the country's balance
of payments.
To implement this policy, while taking account of the current Treasury refunding, possible bank regulatory changes and the Committee's desire to see
moderate growth in money and bank credit over the months ahead, System open
market operations until the next meeting of the Committee shall be conducted
with a view to moving gradually toward somewhat less firm conditions in the
money market; provided, however, that operations shall be modified promptly
to resist any tendency for money and bank credit to deviate significantly from a
moderate growth pattern.
MEETING HELD ON MARCH 10, 1970

The information reviewed at this meeting suggests that real economic activity,
which leveled off in the fourth quarter of 1969, is weakening further in early 1970.
Prices and costs, however, are continuing to rise at a rapid pace. Market interest
rates have declined considerably in recent weeks, partly as a result of changing
investor attitudes regarding the outlook for economic activity and monetary
policy. Both bank credit and the money supply declined on average in February,
but both were tending upward in the latter part of the month. Outflows of time
and savings funds at banks and nonbank thrift institutions, which had been sizable
in January, apparently ceased in February, reflecting advances in rates offered
on such funds following the recent increases in regulatory ceilings, together with
declines in short-term market interest rates. The U.S. foreign trade surplus
narrowed in January and the over-all balance of payments deficit has remained
large in recent weeks. In light of the foregoing developments, it is the policy of
the Federal Open Market Committee to foster financial conditions conducive to
orderly reduction in the rate of inflation, while encouraging the resumption of
sustainable economic growth and the attainment of reasonable equilibrium in
the country's balance of payments.
To implement this policy the Committee desires to see moderate growth in
money and bank credit over the months ahead. System open market operations
until the next meeting of the Committee shall be conducted with a view to maintaining money market conditions consistent with that objective.
MEETING HELD ON APRIL 7, 1970

The information reviewed at this meeting suggests that real economic activity
weakened further in early 1970, while prices and costs continued to rise at a
rapid pace. Fiscal stimulus, of dimensions that are still uncertain, will strengthen
income expansion in the near term. Most long-term interest rates backed up
during much of March under the pressure of heavy demands for funds, but then
turned down in response to indications of some relaxation of monetary policy
and to the reduction in the prime lending rate of banks. Short-term rates declined
further on balance in recent weeks, contributing to the ability of banks and other
thrift institutions to attract time and savings funds. Both bank credit and the
money supply rose on average in March; over the first quarter as a whole bank
credit was about unchanged on balance and the money supply increased somewhat.
The U.S. foreign trade surplus increased in February, but the over-all balance of
payments appears to have been in considerable deficit during the first quarter.
In light of the foregoing developments, it is the policy of the Federal Open Market
Committee to foster financial conditions conducive to orderly reduction in the
rate of inflation, while encouraging the resumption of sustainable economic growth
and the attainment of reasonable equilibrium in the country's balance of payments.
73-959—76




12

174
To implement this policy, the Committee desires to see moderate growth in
money and bank credit over the months ahead. System open market operations
until the next meeting of the Committee shall be conducted with a view to maintaining money market conditions consistent with that objective, taking account
of the forthcoming Treasury financing.
MEETING HELD ON MAY 5, 1970

The information reviewed at this meeting indicates that real economic activity
weakened further in the first quarter of 1970. Growth in personal income, however,
is being stimulated in the second quarter by the enlargement of social security
benefit payments and the Federal pay raise. Prices and costs generally are continuing to rise at a rapid pace, although some components of major price indexes
recently have shown moderating tendencies. Most market interest rates have risen
sharply in recent weeks as a result of heavy demands for funds, possible shifts in
liquidity preferences, and the disappointment of earlier expectations regarding
easing of credit market conditions. Prices of common stocks have declined markedly since early April. Attitudes in financial markets generally are being affected
by the expansion of military operations in Southeast Asia and by concern about
the success of the Government's anti-inflationary program. Both bank credit
and the money supply rose substantially from March to April on average, although during the course of April bank credit leveled off and the money supply
receded sharply from the end-of-March bulge. The over-all balance of payments
was in considerable deficit during the first quarter. In light of the foregoing develments, it is the policy of the Federal Open Market Committee to foster financial
conditions conducive to orderly reduction the rate of inflation, while encouraging
the resumption of sustainable economic growth and the attainment of reasonable
equilibrium in the country's balance of payments.
To implement this policy, the Committee desires to see moderate growth
in money and bank credit over the months ahead. System open market operations until the next meeting of the Committee shall be conducted with a view
to maintaining bank reserves and money market conditions consistent with that
objective, taking account of the current Treasury financing; provided, however,
that operations shall be modified as needed to moderate excessive pressures in
financial markets, should they develop.
MEETING HELD ON MAY 26, 1970

The information reviewed at this meeting indicates that real economic activity
declined more than previously estimated in the first quarter of 1970, but little
further change is projected in the second quarter. Prices and costs generally are
continuing to rise at a rapid pace, although some components of major price indexes recently have shown moderating tendencies. Since early May most longterm interest rates have remained under upward pressure, partly as a result of
continued heavy demands for funds and possible shifts in liquidity preferences,
and prices of common stocks have declined further. Attitudes in financial markets
generally are being affected by the widespread uncertainties arising from recent
international and domestic events, including doubts about the success of the
Government's anti-inflationary program. Both bank credit and the money supply
rose substantially from March to April on average; in May bank credit appears
to be changing little while the money supply appears to be expanding rapidly.
The over-all balance of payments continued in considerable deficit in April and
early May. In light of the foregoing developments, it is the policy of the Federal
Open Market Committee to foster financial conditions conducive to orderly
reduction in the rate of inflation, while encouraging the resumption of sustainable
economic growth and the attainment of reasonable equilibrium in the country's
balance of payments.
To implement this policy, in view of current market uncertainties and liquidity
strains, open market operations until the next meeting of the Committee shall be
conducted with a view to moderating pressures on financial markets, while, to the
extent compatible therewith, maintaining bank reserves and money market conditions consistent with the Committee's longer-run objectives of moderate growth
in money and bank credit.




175
MEETING HELD ON JUNE 23, 1970

The information reviewed at this meeting suggests that real economic activity
is changing little in the current quarter after declining appreciably earlier in the
year. Prices and costs generally are continuing to rise at a rapid pace, although
some components of major price indexes recently have shown moderating tendencies. Since late May market interest rates have shown mixed changes following
earlier sharp advances, and prices of common stocks have recovered part of the
large decline of preceding weeks. Attitudes in financial markets continue to be
affected by uncertainties and conditions remain sensitive, particularly in light of
the insolvency of a major railroad. In May bank credit changed little and the
money supply rose moderately on average, following substantial increases in
both measures in March and April. Inflows of consumer-type time and savings
funds at banks and nonbank thrift institutions have been sizable in recent months,
but the brief spring upturn in large-denomination CD's outstanding at banks has
ceased. The over-all balance of payments was in heavy deficit in April and May.
In light of the foregoing developments, it is the policy of the Federal Open Market
Committee to foster financial conditions conducive to orderly reduction in the
rate of inflation, while encouraging the resumption of sustainable economic growth
and the attainment of reasonable equilibrium in the country's balance of payments.
To implement this policy, in view of persisting market uncertainties and liquidity strains, open market operations until the next meeting of the Committee
shall continue to be conducted with a view to moderating pressures on financial
markets. To the extent compatible therewith, the bank reserves and money
market conditions maintained shall be consistent with the Committee's longer-run
objective of moderate growth in money and bank credit, taking account of the
Board's regulatory action effective June 24 and some possible consequent shifting
of credit flows from market to banking channels.
MEETING HELD ON JULY 21, 1970

The information reviewed at this meeting indicates that real economic activity
changed little in the second quarter after declining appreciably earlier in the
year. Prices and wage rates generally are continuing to rise at a rapid pace.
However, improvements in productivity appear to be slowing the rise in costs,
and some major price measures are showing moderating tendencies. Since midJune long-term interest rates have declined considerably, and prices of common
stocks have fluctuated above their recent lows. Although conditions in financial
markets have improved in recent weeks uncertainties, persist, particularly in the
commercial paper market where the volume of outstanding paper has contracted
sharply. A large proportion of the funds so freed apparently was rechanneled
through the banking system, as suggested by sharp increases in bank loans and
in large-denomination CD's of short maturity—for which rate ceilings were
suspended in late June. Consequently, in early July bank credit grew rapidly;
there was also a sharp increase in the money supply. Over the second quarter as
a whole both bank credit and money supply rose moderately. The over-all balance
of payments remained in heavy deficit in the second quarter. In light of the
foregoing developments, it is the policy of the Federal Open Market Committee
to foster financial conditions conducive to orderly reduction in the rate of inflation, while encouraging the resumption of sustainable economic growth and the
attainment of reasonable equilibrium in the country's balance of payments.
To implement this policy, while taking account of persisting market uncertainties, liquidity strains, and the forthcoming Treasury financing, the Committee seeks to promote moderate growth in money and bank credit over the
months ahead, allowing for a possible continued shift of creditflowsfrom market
to banking channels. System open market operations until the next meeting of
the Committee shall be conducted with a view to maintaining bank reserves
and money market conditions consistent with that objective; provided, however,
that operations shall be modified as needed to counter excessive pressures in
financial markets should they develop.
MEETING HELD ON AUGUST 18, 1970

The information reviewed at this meeting suggests that real economic activity,
which edged up slightly in the second quarter after declining appreciably earlier
in the year, may be expanding somewhat further. Prices and wage rates generally
are continuing to rise at a rapid pace. However, improvements in productivity
appear to be slowing the rise in costs, and some major price measures are showing




176
moderating tendencies. Credit demands in securities markets have continued?
heavy, and interest rates have shown mixed changes since mid-July after declining
considerably in preceding weeks. Some uncertainties persist in financial markets,
particularly in connection with market instruments of less than prime grade. In
July the money supply rose moderately on average and bank credit expanded
substantially. Banks increased holdings of securities and loans to finance companies, some of which were experiencing difficulty in refinancing maturing commercial paper. Banks sharply expanded their outstanding large-denomination
CD's of short maturity, for which rate ceilings had been suspended in late June,
and both banks and nonbank thrift institutions experienced large net inflows of
consumer-type time and savings funds. The over-all balance of payments remained
in heavy deficit in the second quarter, despite a sizable increase in the export
surplus. In July the official settlements deficit continued large, but there apparently was a marked shrinkage in the liquidity deficit. In light of the foregoing
developments, it is the policy of the Federal Open Market Committee to foster
financial conditions conducive to orderly reduction in the rate of inflation, while
encouraging the resumption of sustainable economic growth and the attainment
of reasonable equilibrium in the country's balance of payments.
To implement this policy, the Committee seeks to promote some easing of
conditions in credit markets and somewhat greater growth in money over the
months ahead than occurred in the second quarter, while taking account of
possible liquidity problems and allowing bank credit growth to reflect any continued shift of creditflowsfrom market to banking channels. System open market
operations until the next meeting of the Committee shall be conducted with a
view to maintaining bank reserves and money market conditions consistent with.
that objective, taking account of the effects of other monetary policy actions.
MEETING HELD ON SEPTEMBER 15, 1970

The information reviewed at this meeting suggests that real economic activity
which edged up slightly in the second quarter, is expanding somewhat further in
the third quarter, led by an upturn in residential construction. Wage rates
generally are continuing to rise at a rapid pace, but improvements in productivity
appear to be slowing the rise in costs, and some major price measures are rising less
rapidly than before. Interest rates declined in the last half of August, but most
yields turned up in early September, as credit demands in securities markets have
continued heavy; existing yield spreads continue to suggest concern with credit
quality. The money supply rose rapidly in the first half of August but moved
back down through early September. Bank credit expanded sharply further in
August as banks continued to issue large-denomination CD's at a relatively rapid
rate, while reducing their reliance on the commercial paper market after the Board
of Governors acted to impose reserve requirements on bank funds obtained from
that source. The balance of payments deficit on the liquidity basis diminished
somewhat in July and August from the very large second-quarter rate, but the
deficit on the official settlements basis remained high as banks repaid Euro-dollar
liabilities. In light of the foregoing developments, it is the policy of the Federal
Open Market Committee to foster financial conditions conducive to orderly
reduction in the rate of inflation, while encouraging the resumption of sustainable
economic growth and the attainment of reasonable equilibrium in the country's,
balance of payments.
To implement this policy, the Committee seeks to promote some easing of
conditions in credit markets and moderate growth in money and attendant bank
credit expansion over the months ahead. System open market operations until;
the next meeting of the Committee shall be conducted with a view to maintaining
bank reserves and money market conditions consistent with that objective.
MEETING HELD ON OCTOBER 20, 1970

The information reviewed at this meeting suggests that real output of goods
and services increased slightly further in the third quarter but that employment
declined and unemployment continued to rise; activity in the current quarter
is being adversely affected by a major strike in the automobile industry. Wage
rates generally are continuing to rise at a rapid pace, but improvements in productivity appear to be slowing the increase in costs, and some major price measures
are rising less rapidly than before. Most interest rates have declined since midSeptember, although yields on corporate and municipal bonds have been sustained,
by the continuing heavy demands for funds in capital markets. The money supply -




177
Tose slightly on average in September and increased moderately over the third
quarter as a whole. Bank credit expanded further in September but at a rate
considerably less than the fast pace of the two preceding months. Banks continued
to issue large-denomination CD's at a relatively rapid rate and experienced
heavy inflows of consumer-type time and savings funds, while making substantial
further reductions in their use of nondeposit sources of funds. The balance of payments deficit on the liquidity basis diminished in the third quarter from the very
large second-quarter rate, but the deficit on the official settlements basis remained
high as banks repaid Euro-dollar liabilities. In light of the foregoing developments,
it is the policy of the Federal Open Market Committee to foster financial conditions conducive to orderly reduction in the rate of inflation, while encouraging the
resumption of sustainable economic growth and the attainment of reasonable
equilibrium in the country's balance of payments.
To implement this policy, the Committee seeks to promote some easing of
conditions in credit markets and moderate growth in money and attendant bank
credit expansion over the months ahead. System open market operations until
the next meeting of the Committee shall be conducted with a view to maintaining
bank reserves and money market conditions consistent with those objectives,
taking account of the forthcoming Treasury financings.
MEETING HELD ON NOVEMBER 17, 1970

The information reviewed at this meeting suggests that real output of goods
and services is changing little in the current quarter and that unemployment
has increased. Part but not all of the weakness in over-all activity is attributable
to the strike in the automobile industry which apparently is now coming to an
end. Wage rates generally are continuing to rise at a rapid pace, but gains in
productivity appear to be slowing the increase in unit labor costs. Recent movements in major price measures have been erratic but the general pace of advance
in these measures has tended to slow. Most interest rates declined considerably
in the past few weeks, and Federal discount rates were reduced by one-quarter
of a percentage point in the week of November 9. Demands for funds in capital
markets have continued heavy, but business loan demands at banks have weakened. The money supply changed little on average in October for the second
consecutive month; bank credit also was about unchanged, following a slowing
of growth in September. The balance of payments deficit on the liquidity basis
was at a lower rate in the third quarter and in October than the very high secondquarter rate, but the deficit on the official settlements basis remained high as
banks repaid Euro-dollar liabilities. In light of the foregoing developments, it is
the policy of the Federal Open Market Committee to foster financial conditions
conducive to orderly reduction in the rate of inflation, while encouraging the
resumption of sustainable economic growth and the attainment of reasonable
equilibrium in the country's balance of payments.
To implement this policy, the Committee seeks to promote some easing of
conditions in credit markets and moderate growth in money and attendant bank
credit expansion over the months ahead with allowance for temporary shifts
in money and credit demands related to the auto strike. System open market
operations until the next meeting of the Committee shall be conducted with
a view to maintaining bank reserves and money market conditions consistent
with those objectives.
MEETING HELD ON DECEMBER 15, 1970

The information reviewed at this meeting suggests that real output of goods
and services has declined since the third quarter, largely as a consequence of the
recent strike in the automobile industry, and that unemployment has increased.
Resumption of higher automobile production is expected to result in a bulge in
activity in early 1971. Wage rates generally are continuing to rise at a rapid pace,
but gains in productivity appear to be slowing the increase In unit labor costs.
Movements in major price measures have been diverse; most recently, wholesale
prices have shown little change while consumer prices have advanced substantially.
Market interest rates declined considerably further in the past few weeks, and
Federal Reserve discount rates were reduced by an additional one-quarter of a
percentage point. Demands for funds in capital markets have continued heavy,
but business loan demands at banks have been weak. Growth in the money
supply was somewhat more rapid on average in November than in October,
although it remained below the rate prevailing in the first three quarters of the
year. Banks acquired a substantial volume of securities in November, and bank




178
credit increased moderately after changing little in October. The foreign trade
balance in September and October was smaller than in any other 2-month period
this year. The over-all balance of payments deficit on the liquidity basis remained in October and November at about its third-quarter rate. The deficit
on the official settlements basis was very large as banks continued to repay
Euro-dollar liabilities. In light of the foregoing developments, it is the policy of
the Federal Open Market Committee to foster financial conditions conducive
to orderly reduction in the rate of inflation, while encouraging the resumption of
sustainable economic growth and the attainment of reasonable equilibrium in
the country's balance of payments.
To implement this policy, System open market operations shall be conducted
with a view to maintaining the recently attained money market conditions until
the next meeting of the Committee, provided that the expected rates of growth
in money and bank credit will at least be achieved.

Mr. HANNAFORD. Thank you, Dr. Pierce.
Fortunately, and in the nick of time the chairman has arrived
before I had to make any decisions about how to proceed.
Would it be best to proceed by questioning Dr. Pierce, or would
you—all right, let's proceed then with Dr. Meltzer's testimony, and
you can proceed in whatever manner you would like, Dr Meltzer.
STATEMENT OF DR. ALLAN H. MELTZER, GRADUATE SCHOOL OF
INDUSTRIAL ADMINISTRATION, CARNEGIE-MELLON UNIVERSITY
Dr. MELTZER. Thank you, Mr. Chairman and Mr. Hannaford.
The subcommittee's interest in the problem of maintaining appropriate monetary policy, as evidenced by regular hearings under
House Concurrent Resolution 133, is, I believe, one of the most
important developments in recent years. It will have an important
influence on the way in which we conduct our economic policy.
The rate of increase of consumer prices in the United States has
fallen, gradually, from nearly 14 percent in mid-1974 to an average
rate of about 6 percent for the past 6 months. Some further reduction
in the average rate of inflation is likely to occur in 1976.
Experience in the rest of the world covers a wide range. Some
countries substantially reduced the rate of price increase; in others
the rate of increase remained high. During the year 1975, consumer
prices rose by more than 20 percent in Britain, by approximately 10
percent in France, Italy and Canada, and by 5 percent or less in
Germany and Switzerland.
Why are the rates of price increase in these countries so different?
Why is inflation no longer proceeding at high or rising rates everywhere? Why have some countries succeeded in reducing inflation where
others have failed?
The answer to these questions is surprisingly simple. Government
policies toward inflation have differed. Some countries recognized
inflation as mainly a monetary phenomenon, the result of too much
money in circulation and too high a growth rate of money and took
effective action to control inflation. The countries that now have the
lowest rates of inflation, Switzerland, Germany, and the United
States, are the same countries that changed their approach to monetary
control. Each of the countries has, in its own way, chosen a target
rate of increase in money. Each has managed to keep the growth rate
of money close to the announced target.




179
Where the rate of growth of money has been reduced, the rate of
inflation has been reduced. Where monetary growth has been kept
at a high rate, the rate of inflation has remained high or has increased.
Britain is an outstanding example. During the past year most
countries experienced less inflation, but Britain experienced more.
British consumer prices rose by 16 percent in 1974 and by more than
20 percent in 1975. Even Italy, with its severe political, social and
economic problems, was able to slow inflation, to reduce the rate of
increase in consumer prices from 1974 to 1975. But Britain did not.
Economists differ about why inflation starts and about how inflation
can be reduced and ended. For decades influential British economists
argued that it was unnecessary to control the rate of monetary expansion. Some argued that the way to end inflation was to stimulate
the economy by Government policies that create jobs and output. By
increasing output they hoped to lower prices or the rate of inflation.
Contrary to experience everywhere they sought to end inflation by
stimulating the economy.
The result was predictable, and both the predictions and the results
are part of British history. Inflation increased. An economically weak
Britain became weaker as measured by emplo^nnent and inflation.
Programs similar to those that failed in Britain are advocated and
at times adopted here. We followed the British into stop and go
policies—policies to stimulate the economy today and take care of
the inflation tomorrow. We achieved more inflation and currently
have more unemployment. We followed the British and other Europeans in attempting to control inflation by using government intervention in wage and price setting. Inflation did not stop, iti ncreased.
The policies of the past year and the results they achieved are a
means of discriminating between the differing opinions about the causes
of inflation and the means of ending inflation. Some prominent economists both here as well as in Britain urged rates of monetary expansion
in 1975 as high as 16 percent, and a rate of monetary growth of 10
percent in 1976. They argued that with unemployment high, strong
stimulus would reduce unemployment and reduce inflation.
If we had adopted very expansive policies, we, like the British, would
have experienced rising inflation in 1975 and 1976. Instead of a falling
rate of inflation we would now have a rising rate of inflation.
The marked difference in countries' experience with inflation during
1975 and 1976 is not a unique event. Recent experience is only a
repeat of the experience of the late forties with a change in the roles
chosen by the governments of particular countries. Then, and now the
countries that promptly reduced the rate of monetary growth ended
inflation promptly. Countries that experimented with controls on
prices and wages, with restrictions on credit or that engaged in fine
tuning of taxes and government spending continued to experience
inflation.
No sustained inflation has ever been ended until the growth rate
of money has been reduced. Inflations at the end of World War II,
after the Korean war, and in other times and places were ended b}^
controlling money. The experiences of the past 2 years are in this respect consistent with the past.
What of the future? Barring some new shock like the oil price
increase, a crop failure, or a war, we can expect the economy to approach full employment in about 2 years if Government policies are




180
less erratic in the future than in the past. We cannot expect, however,
to reach full employment without inflation. In this respect, as in many
others, Government promises and performance differ.
Ending inflation means bringing the average rate of price change,
properly measured, to zero. We are fighting inflation. Inflation has
1>een reduced, but we will not end inflation unless we change some
Government policies and continue others.
I believe we can end inflation in the next few years. To do so, we
must adhere to four principles of economic policy.
First, we must continue the present international monetar}^ arrangement known as the fluctuating exchange rate system. The chairman
of this subcommittee has been very important in getting that system
of fluctuating exchange rates adopted as U.S. policy. Under the
fluctuating rate system, we rely on the market and not on governments to determine the current exchange value of our currency. The
exchange value of the dollar fluctuates, rising with increases in the
demand for dollars and falling when we speed up the printing press
and increase the supply of dollars. The fluctuating exchange rate
protects us against inflationary or deflationary economic policies
abroad. If foreign governments adopt policies more inflationary
than ours, and many governments have, the fluctuating dollar helps
us to avoid inflation. We are freer to pursue stable prices.
Second, we must reduce the growth rate of Government. A high
growth rate of Government transfers spending from private to public
hands, and reduces efficiency. Growth of public employment transfers
skilled labor from more productive to less productive activities and
slows the growth of the economy. Government regulation absorbs
skilled personnel in countless wrangles with the bureaucracy, increases
uncertainty and deters investment. But the principal effect of a growing
public sector on inflation is not from the loss of efficiency and growth.
A rising government budget creates strong pressure to finance the
Government by printing money. Our current inflation began when
we tried to finance war and social programs in the midsixties without
raising taxes. Despite a 400 percent increase in the Federal budget, in
little more than a decade, costs of social programs continue to increase
and the problem of financing the budget without increasing taxes
remains a force for inflation.
Third, we must continue to reduce the growth rate of money
gradually. Between 1973 and 1976, the rate of monetary growth has
been lowered from 9 percent to about 5 percent. This reduction is the
most important force working to reduce present and future inflation.
During the next 2 or 3 years, the rate of monetary expansion must be
brought, gradually, to about 3 percent. Once we fully adjust to the
lower rate of growth on money, the economy will be at full employment
without inflation.
Fourth, we must avoid price and wage controls and Government
interference in price and wage decisions.
If we do these things, we will achieve economic stability with high
employment and low inflation that we currently do not have.
Thank you.
Mr. HANNAFORD. Thank you, Dr. Meltzer.
One general question I would like answered would apply to both of
you. In your statements you ascribe a cause-effect relationship with




181
the money supply and various other forces, but primarily with the
money supply that does not seem to take into account the 23-month
lag that we have discussed in our charts here, and as you describe
what we have done in money supply just very recently, Dr. Meltzer, in your last sentence or so, could you comment on that?
It seems to me that lacking precision as to how long an action
takes place, puts us all in the dark feeling around and not knowing
the cause and effect relationship.
Dr. MELTZER. First, the 23 months, or roughly 2 }^ears, is an.
average. It does not hold in any particular instant, but it is well
researched and I believe has been supported in a general way b}^ the
work of many different people. Therefore I think we can use it as a
reasonable rule of thumb in trjdng to think about the effects of monetary policy. We can think about a 2-year average lag between the
time we slow down the money growth rate and the time that the rate
of inflation slows down.
That means that the lower rate of inflation that we are currently
experiencing is mainly the result of slower monetary growth that
began sometime in 1974. We are now getting the benefits of the
slowing in policy, the very rapid slowing in policy in 1974 that
Dr. Pierce talked about in his statement. I believe that slower monetary growth, maintained for the past 2 years, has contributed to the
lower rate of inflation. Of course, it also contributed to the recession.
We experienced a recession, a severe recession in between.
We are now getting the benefits of the slow growth, having paid
most of the costs in the past. It is important to understand that
because we have paid those costs, and are now reaping the benefits,
that we must continue this policy so as to receive the benefits for
which we have already paid.
Mr. HANNAFORD. Your answer then is that your cause-effect relationship does indeed take into account the 2-year lag.
Dr. MELTZER. Indeed.
Mr. HANNAFORD. YOU know what happened to the Breton Woods
amendment last week under suspension. You made comments about
the importance of the floating rates of foreign trade and our committee got quite a shock last week on that bill.
Dr. MELTZER. It is quite important, I think, that we continue the
floating rate system and that we do not try to substitute the judgment
of governmental agencies for the market process determining exchange
rates. The main reason is that I don't believe that governments are
able to pick exchange rates that will be stable exchange rates. Most
of the experience that we have had in the past leads us to believe that
if countries pursue different monetary policies and have different
rates of inflation, there is no way that they can maintain fixed exchange
rates. The only choice that they are going to have will be a choice
between whether they want rates to change in large jumps, with
great dislocations, or in small, steady movements as they have been
doing since the floating exchange rate system has been in effect.
Mr. HANNAFORD. YOU expressed concern, some disagreement about
the various Government full employment programs as a contributor
toward inflation. If such programs created production for the marketplace instead of leaf-raking, you wouldn't be concerned about that,,
would you, if you used the recently experienced program in Germany




182
to pay a small subsidy for employing people in the private sector, or
what have you?
Could you comment on that sort of program?
Dr. MELTZER. I believe that there are important and useful
things that Government can do to stimulate employment, but I don't
believe that they include either employing people in the public sector
in makework jobs or subsidizing the employment in the private
sector in the way in which you just described. I believe that there are
useful things that can be done, and one of the most useful is to try
to get people employed in meaningful jobs within the private sector.
In order to do that, it seems to me that there are some useful
things to be done. One of them is that instead of paying a subsidy for
training that minimum wage legislation be removed for selected classes
of employment, particularly for people who would be trained to do
useful work. With training, they would have the prospect of earning
higher wages at some time in the future. I think that kind of program—
I will be glad to expand on some other—that kind of program is more
meaningful and more helpful than either the kind of program envisaged, say, under the Humphrey-Hawkins bill or the kind of
program that would require some subsidy for private employment.
It is very difficult to administer the subsidies to private employment that would be required by many bills, and it is particularly
difficult to assure that the employees who are being subsidized, the
employment that is being subsidized directly by the Government
is in fact new creation of employment rather than just simply the
moving of people from one job, unsubsidized, to a job that is subsidized, with little net increase in employment.
Mr. HANNAFORD. Early in your statement you said that you
thought House Concurrent Resolution 133 was one of the most
important acts of recent years. I was pleased to hear that because
I didn't have that much faith in it when we did it. If a little bit is
good, is more better?
Dr. MELTZER. Well, that depends on what more.
Mr. HANNAFORD. I mean in terms of House Concurrent Resolution
133.
Do you think more exacting demands, congressional demands might
be made in terms of monetary policy and perhaps coordination of the
two, or do you think we are about where we should be in terms of
congressional interference with Fed policy?
Dr. MELTZER. I believe that we should not make exacting demands
that set up anticipations that we can deliver things that we, that is,
we economists are unable to deliver. If we set very precise targets for
what we want to achieve, I don't think that we have the ability now
or in the near term future to deliver.
On the other hand, I think the Congress could be more exacting in
its demands on the Federal Reserve. Among the things that it could
do would be to get greater precision in statements describing what the
Federal Reserve is trying to achieve. I agree with the general thrust of
Dr. Pierce's statement. It would be useful if the Federal Reserve
announced what it was trying to achieve and over what horizon it was
trying to achieve its goals, without being committed, necessarily,
to those goals. An announcement of what it is that the Government
is aiming at, what its policy seeks to achieve, and what kinds of




183
programs it had adopted in order to achieve those ends, those would
be steps in the right direction. It would give information to people
without giving the impression that targets have been chosen that
necessarily must be achieved for the survival of the agency.
Mr. HANNAFORD. Mr. Neal, do you have some questions?
Mr. NEAL. I would like to pursue the point you made a moment
ago about other programs that you might have in mind for reducing
unemployment in noninflationary ways. How, in fact, can this be done?
It is certainly highly unlikely that the minimum wage laws would be
rescinded.
Dr. MELTZER. I would like to relax them to exclude some people,
particularly—we have an enormous problem of young unemployment.
When we look at the unemployment statistics, they are not an undifferentiated mass. There is a large group of people who are being
kept from gainful employment, in my opinion, because they have no
skill and there is no mechanism presently available to get them trained
in the kind of skills that would permit them to lead useful lives and do
productive labor.
Mr. NEAL. Well, if employers would substitute unskilled young
workers to whom they could pay reduced wages, wouldn't many
older, skilled workers—breadwinners, heads of households—be out of
work?
Dr. MELTZER. There is, of course, some tendency for that to occur.
I don't believe that the offset would be one to one. There would be
some incentive on the part of companies to take advantage of the
opportunity to hire people at lower wages and train them to do skilled
jobs that need to be done, and that are not now being done.
One observes in foreign countries when imported labor enters they
do jobs that local citizens often do not do. The same kind of situation
exists here. The choice is either to hire a foreign worker or not have the
job done. Labor in the domestic economy is not available at wage
rates that would permit the job to be done profitably.
Mr. NEAL. Would that be your No. 1 priority?
Dr. MELTZER. That would be one of my—I don't know that I
want to assign a priority. I would like to see considerably more done
to try to stimulate employment in the private sector than is currently
being done, but in a noninflationary way.
Mr. NEAL. Like what?
Dr. MELTZER. The second step—I'm sorry.
Mr. NEAL. What do you have in mind?
Dr. MELTZER. Well, I would believe that it would be salutary to
reduce the size of the public sector and reduce taxes, to reduce the
total size of the budget and taxes, and that I believe that would have a
stimulating effect on employment in the private sector.
Mr. NEAL. What programs would you do away with? Where would
you make this cut?
Dr. MELTZER. Specific programs I would do away with in the public
sector?
Mr. NEAL. Right.
Dr. MELTZER. I believe that there are two ways in which we can
reduce total costs of Government. One is that many of the programs
that we have are programs that employ large numbers of people
without accomplishing any specific end. I will begin to detail some of
the programs and some of the areas.




184
Mr. NEAL. Well, I would be very interested in that.
Dr. MELTZER. All right.
I think that in the regulation of housing and in the regulation of construction there are a number of laws that require enforcement, that
are enforced, and that are supervised, that in fact have deleterious
effects on employment in this country. For example, Davis-Bacon is an
important law. Now, you may say it is politically impossible to remove
Davis-Bacon. Neverthless, Davis-Bacon has a negative effect on
construction in the private sector. So if we would remove that law
and remove the people who are responsible for enforcing that law, we
would reduce public employment and at the same time we would
remove a regulation that prevents people from building more buildings
at lower prices. That would be a step in the right direction.
There are a whole series of such laws, for example, the Jones Act,
which restricts interstate commerce to carrying cargo in American
bottoms. It raises the cost of carrying cargo.
There are a series of such laws.
Mr. NEAL. Well, excuse me. Even though I personally don't think
Davis-Bacon is a very good idea, it is not the kind of program employing large numbers of Federal workers, which I thought you had in
mind.
Dr. MELTZER. Well, we could take OSHA, where there is a large
number of public employees. One of the main reasons for that large
number of public employees is because the Congress has been unwilling
to make clear and definite rules regulating the practices that it seeks
to regulate. Consequently OSHA has put into the field a large number
of employees who are subject to very little direct control by the Congress and who are making rules and enforcing rules differently in
different districts and without very much control.
That has three effects. One, it creates employment in the Federal
sector; two, it deters private activity by diverting attention within
the private sector toward the administration of a series of rules;
and three, it creates uncertainty about what the consequences of
particular kinds of activities are. There are large numbers of programs,
particularly in recent years, that have passed in recent years, that
have similar effects on employment.
Now, I am trying very carefully to separate the public purpose'
that Congress may wish to achieve from the way in which that
purpose is achieved.
Mr. NEAL. HOW could the Congress attempt to achieve the statutory
objectives in the area of occupational safety and health, for instance,
without having regulators in the field?
Dr. MELTZER. It could outlaw certain kinds of practices. That
would be one way. It could require insurance type arrangements.
Certain kinds of activities that contributed, that were known to contribute, a considerable amount to lack of safety would be insured,,
perhaps at high cost, by those people who engage in the practices..
That would diversify the responsibility for those activities and
reduce the cost of administration and reduce the arbitrariness of the
ways in which those decisions are made. We could try to base the
costs of insurance on the historic frequencies with which the accidents
have occurred, and charge insurance premiums. Those insurance
premiums would be a deterrent to the type of activity that people




185
may now engage in and that Congress may wish to prevent. I believe
that would be a cheaper way of doing it; it would leave much more
to private decisionmaking, and it would tend to reduce uncertainty.
Mr. NEAL. YOU would have private insurers increase the rates for
certain types of businesses; is that what you are saying?
Dr. MELTZER. Congress would require that people who produce
certain kinds of high risk where safety was involved, must carry
insurance; that's right.
Mr. NEAL. Must cany health insurance?
Dr. MELTZER. Either insure or not engage in activities.
Mr. NEAL. Or life insurance, in some cases, of some type, and then
naturally you would say the Government shouldn't set the rate
because it should be set by private industry.
Dr. MELTZER. It should be done in the private market.
Mr. NEAL. I will move briefly to another subject. Public debate
centers around fiscal policy as the main culprit in creating inflation,
but our preliminary findings indicate that monetary policy is probably
more to blame for inflation than fiscal policy. I did not hear everyone's
comments on this issue except for Dr. Meltzer's comment that the
Fed increases the money supply because of the pressures exerted on
it by the actions of Congress, but
Dr. MELTZER. Congress and the administration.
Mr. NEAL. Or of Government, right.
But you wouldn't say that the Fed necessarily had to respond
as it did.
Dr. MELTZER. N O ; it did not.
Mr. NEAL. However, officials

of the Fed and members of the business community back home who write me about the subject say that
the Fed had to respond to what the Congress and the administration
want.
Dr. MELTZER. The Fed has a choice.
Mr. NEAL. Dr. Pierce?
Dr. PIERCE. I think the record is clear enough that the Fed on
average has behaved in that way. It seems to me the importan t
point is that because the Fed makes no pronouncement to the effect
that it will accommodate fiscal policy, and often makes pronouncements to the contrary—that it is the institution that will fight inflation
and work against the profligate spending of either the administration
or Congress or both—but in fact ends up financing the deficits, that
there is a tendency to underestimate the inflationary impact of the
fiscal programs because in fact you are having two policies working
in locked step. You are having both a fiscal and a monetary effect
and I think that was part of the problem in the 1960's. There was
a lot of debate about fiscal policy, a lot of talk on the part of the
Federal Reserve about fighting the possible inflation that would come
from it, but in fact it was not, with a couple of spasms, such as 1966.
There was, therefore, a tendency to understate the inflationary impact
that the Government was having on the economy.
That was particularly important in light of the fact that there are
long lags between inflationary policies, either fiscal or monetary,
and the inflation itself. So it looked like this was a free thing to do
at the time. Prices weren't rising very rapidly. We could finance the
war and the social programs and not raise taxes and not even have




186
interest rates rising very much. It looked like the best of all possible
worlds, and then we pay the price for it later.
And it seems to me the important thing is to be aware of the lags,
and second, to be aware of the importance of policing both monetary
and fiscal policy.
Mr. HANNAFORD. Would you yield?
Mr. NEAL. Yes.
Mr. HANNAFORD.

We have talked about the lags and we have
talked in general terms about a 2-year lag in monetar}^ policy and its
effect.
What kind of a lag are we talking about in fiscal policy? It is
somewhat short, isn't it, it is much shorter, isn't it, almost immediate?
Dr. PIERCE. N O ; the way I tend to view these things is I look at
inflation being generated by the effect that say a policy has on the
behavior of demand in the economy relative to the available supply.
Fiscal policy would only have a shorter lag than monetary policy
if somehow its effects on demand and the economy are more rapidly
than for monetary policy. There is a little bit of evidence on that,
but not a great deal.
Fiscal policy may be a little bit more rapid, but I don't really think
that is an important issue. I think the important thing is it takes time
to get going and that the effects are distributed over time. One place
where I would be at issue with some of the work that is being done is
that the effect of policy depends on where you are and how long the
policy is sustained. But I don't think that anyone has demonstrated
to any believable degree that if one puts money in today, out plops
prices 27 months from now. The relationship that is being looked at
is an average. It depends on the circumstances in the economy and how
long that policy is pursued.
The crucial issue, it seems to me, for basic policymaking is whether
these policies are pursued for sustained periods of time. If they are,
then their effects will be felt, I believe, on the rate of inflation in the
economy.
Mr. HANNAFORD. The Congress enacted a tax stimulus last year,
earlier in the year, which the President signed with one hand while
he held his nose with the other.
Dr. PIERCE. Right.
Mr. HANNAFORD. Subsequently we had an improvement in the
employment, in the general economic climate, and that was a very
shortrun situation, thereafter both Congress and the President
claiming credit for it.
Dr. PIERCE. Right.
Mr. HANNAFORD. What you are saying is that we have a 2-year
lag in both monetary and fiscal policy, more or less.
Dr. PIERCE. With respect to prices, not demand for output and
employment. That lag is much shorter. That is why the reading of
the situation can be deceptive. It looks like you can get a lot of employment with no inflation in the short run. The inflation will come later.
Mr. HANNAFORD. All right, I see.
I was afraid that any good work that I did would accrue to the
benefit of my successor.
Dr. PIERCE. That almost always is the case, but that is life.




187
Mr. NEAL. Dr. Meltzer, you said in your comnients that you think
that the Federal Government has been too stimulative recently,
did you not say that?
Dr. MELTZER. N O ; I did not. I would like to see the Federal Government gradually reduce the rate of growth in the money stock and
of course, the size of the budget deficit, and I would add, the level
of expenditure and tax rates, or at least the growth rate of the budget.
To talk to the monetary policy first, I said that I thought that the
policy has, on average, been stabilizing. The growth of the money
stock has come down from 9 percent to approximately 5 percent. I
think that over the next few years we have to bring it down even
more if we are going to be rid of inflation. That is a goal that I think
we want to achieve. We would have to bring the rate of the growth of
money down from approximately 5 percent at present to about 2 to
3 percent over the next several years, but I would like to see that done
gradually.
While I refer to the current reduction as gradual, we ought to
mention the fact that it is highly erratic as well. I would like to see
it much less erratic than it has been, but the average movement has
been one that seems to me to be appropriate.
Mr. NEAL. DO you think that fiscal policy hasfbeen conducted
appropriately, and that if we stay on the course thatfwe are on, that
that is responsible?
Dr. MELTZER. I favor the stimulus that the economy received from
the tax reductions in early 1975, and the continuation of those reductions. I would like to see larger tax reductions accompanied by reductions in the growth rate of Government expenditure.
Dr. PIERCE. May I respond to that?
Dr. Meltzer and I may agree that the Government should be
smaller, or we may disagree, but it seems to me that has nothing to
do particularly with controlling inflation. Inflation has to do with the
economic policies in general that the Government is pursuing, and
we could half the size of the Federal sector and still have monetary
policy generate tremendous inflation today.
I think it is productive to try to separate those two issues. I don't
think the cause of inflation in this country is Davis-Bacon or the
minimum wage. Those factors may introduce inefficiencies into the
economy and lead to a lower standard of living than we might otherwise have, assuming we can agree on how to measure standard of
living. If we always measure the standard of living by the output of
the private sector, which so many people are inclined to do, mistakenly, I believe, then those factors affect the standard of living,
not the inflation rate.
Imposing restrictions on private firms restricting competition on
the economy affect the potential for output of the economy. They
don't have any obvious effect on the rate of inflation in the economy.
And I think one would be misguided to say well, the way to really
solve the inflation in this country is to get rid of the minimum wage,
throw out the labor unions and stop all Federal regulations.
I think there is a tendency on some people's part—and I am not
accusing Dr. Meltzer of this, but one sees it elsewhere—these measures
would get inflation under control, and I think that is wrong. I think
the way to get it under control is with joint economic policies,, and if




188
one doesn't like the mix between the public and private sectors of
the economy, fine, change those. But those should be separate decisions that are viewed in the context of their effects on the society.
Dr. MELTZER. We entirely agree. In fact, I have been careful to
keep the issues separate. I don't think that one wants to forget them
for that reason. There are questions of efficiency. Whether we add 0.1
of 1 percent to the growth rate, or one-quarter of 1 percent per year,
makes a substantial difference to the lives of individuals. The effect
accumulates over time. We can live in a society with zero inflation
and very low, slowly increasing standards of living, or we can live
in a society with zero inflation and rapidly increasing standards of
living. It is that question we have to address at some point.
The question is how efficiently and for what purposes we use resources? That is a very important question, and it is very much involved with the subject matter that this subcommittee either is or
should be interested in, and I believe that the members are interested
in.
Dr. PIERCE. Let me finish this little bit.
I agree with Dr. Meltzer, except I don't draw any necessary relationship between the output of goods and services in the economy
as measured by the GNP and the standard of living. If a society wants
to spend more of its time in leisure, if it wants to spend more of its time
on education, that is its business, and that is a social decision, and I
don't think that one wants to draw the inference because an economy
is growing in terms of the GNP accounts, that somehow it is inefficient
and wrong.
Dr. MELTZER. NO, no, we are not talking about that question. We
are talking about the inefficiencies built in by regulation. I am trying
to be careful to say that if Congress wants regulations, that is a
separate issue that we ought to discuss separately. A separate issue
is whether we provide the regulations or rules in such a way as to
permit the maximum efficiency under that set of rules. I am arguing
that the way that we go about regulating encourages inefficiencies.
We can separately decide whether we have good rules or bad rules.
Those are judgments that I believe Congress has to make.
Mr. NEAL. The subcommittee staff has conducted research on the
growth of money supply and preliminary results show that money
supply changes are responsible for 60 percent of inflation. What do
you say?
Dr. MELTZER. I would say more than 60 percent.
Mr. NEAL. But something in that neighborhood is right, and you
can account for the other 40 percent, say, with things like Federal
deficits, the aftermath of wage and price controls, the dollar devaluation, oil prices, and food prices, administered prices and the power of
labor unions and all of these other things that you can talk about.
Is that an accurate or essentially accurate description of the
situation?
Dr. PIERCE. That is a hard question to answer. Because monetary
and fiscal policies in this country move together, we really have no
way of separating with any degree of accuracy who the culprit is. If
every time that the administration or the Congress goes on a spending
spree the Fed prints money to finance that, then it is really a matter of
taste as to whether you lay the blame on Congress or the Fed. If the




189
initiating influence is the Congress and the administration, then I
should think that we would have to blame most of the inflation on
them because all the Fed has done has been the good stepchild and
gone along.
And so much of the arguments are in terms of economists' controlled experiments. They say, well, what if money hadn't grown so
rapidly, yet fiscal policy had continued.
Now, to the best that we can estimate, that would truly influence
the rate of inflation, but if it never happens, the question is moot.
Mr. NEAL. Well, excuse me. It seems to me we do have the opportunity now, if Dr. Meltzer is correct, to move in the right direction
because we have suffered the consequences, or a majority of the
consequences of our previous mistakes.
Dr. PIERCE. Oh, I agree, indeed, and I would put a higher number
on the role of the Government policy than the 60 percent that you do.
I think there were some shortrun shocks, particularly OPEC, that
were unavoidable, but the basic inflation rate in this country has been
determined by the policies of the U.S. Government. They have not
been caused by shocks. A lot of them are hard to read: the effect of the
commodity boom. I think a reasonable person could argue that the
United States was not exactly blame-free in causing that commodity
boom as an exporter of inflation.
I put the rate very high. I don't know if I would put all the blame on
monetary policy, but on Government policies in general.
Dr. MELTZER. I would like to go back to that question, Mr. Neal,
because first I would put the percentage higher than 60 percent on
monetary policy. I would like to say a few words about the kinds of
evidence that will help us to find an answer. We don't have to look
solely at our own experience. We have a country like Brazil that has
gone from 80-percent inflation down to something like 10 or 15 percent
and back up to 60 or 70 percent. During the period that it went from 10
or 15 up to 60 percent, the government budget has been balanced
almost all the time. The inflation has been entirely produced by giving
credit to the private sector.
We can look back at our own experience. We have experience with
inflation when the public sector was extremely small. Central banks
are able to produce high inflation without a budget deficit.
Take the great German inflation of the 1920's. The public sector
in Germany was larger than the public sector in the United States at
the time, but by no means large by any of the standards we would
use today. Much of that inflation was produced by giving credit to
the private sector.
I can cite other examples. We have inflation where the Government
budget is financed by printing money. We have inflation where the
private sector is financed by printing money, and we have the experience repeated over and over again for as long as we have had
experience with money.
So it seems to me that we have a preponderant weight of evidence
which says that it doesn't really make very much difference—and I
want to emphasize, it doesn't make very much difference who is being
financed in the first round of spending. What is important is the
rate at which that financing occurs.
73-959 0—76




13

190
Dr. PIERCE. The difference is more apparent, I think, than real.
I think that in the postwar period in the United States that there has
been a very close coincidence between monetary and fiscal policies.
That is not to say they had to be the same, they could have been
quite different. Had they been different, the results in the economy
would have been different. It is perfectly possible for monetary policy
to offset fiscal policy. It is perfectly possible for the two policies to
go their own way or to move together.
Mr. NEAL. Well, let me interrupt you gentlemen.
It has always troubled me, and it seems to me this has occurred,
I think it happened in 1974—the Fed said that the reason for the
inflation we are experiencing is the level of deficits, and their answer
was to cut off the supply of money, slow it sharply enough to promote
recession.
Now, that was not a reasonable response, it doesn't seem to me.
Nor is it reasonable to finance deficits by excessive money growth.
There is a middle ground I believe.
Dr. PIERCE. There is a human tendency I think to say that you
are to blame for the mistakes and we are going to correct them. The
deficits which they were talking about, which were important deficits
in my opinion, were the ones that occurred in the late 1960's, when
policy in this country was extremely expansionary, and there were
some later effects in 1972 for example, both fiscal and monetary
policies. Those deficits, particularly in the 1960's, were inflationary.
Now, the current deficit
Mr. NEAL. Well, excuse me. If monetary policy had been different
at that time
Dr. PIERCE. Then the effects would have been different, indeed.
Mr. NEAL. The effects would have been
Dr. PIERCE. In Dr. Meltzer's terms, if the Fed had not allowed
the money supply to grow more than 3 percent a year during the
late 1960's, the effect on the economy would have been far, far
different.
Dr. MELTZER. We can say what that effect would have been.
There would have been far less inflation.
Mr. NEAL. But to return to the 1970's, would we have had a recession with 3 percent money growth?
Dr. PIERCE. I think we would have had some recession from OPEC.
That is unavoidable. The degree of it was exacerbated by the policy
reaction to the shocks that occurred from the outside, and from the
distortions that we had built into the economy, wage-price controls,
higher demand, and so on and so forth. The recession was probably
unavoidable given the background, but the background was influenced so strongly by governmental policies.
So I basically believe that the economy is really a very stable animal
except for the Government, and it is the Government that imparts a
great deal of instability to it. And that is why I would put less emphasis
on the Fed underwriting a private boom in the economy than a
Government-induced boom. The private booms are hard to find, except maybe railroads. The booms seemed to come from the Government itself, and then feeding on it.
Dr. MELTZER. We entirely agree on that. We agree that in U.S.
history, the Government is the main source of instability. We have
a lot of evidence from other countries as well that shows that the




191
Government can produce inflation by financing a private boom, and
of course, they have. There are examples from the past and in the case
of Brazil at present, where the budget is in balance yet the inflation
rate has gone up to 60 or 70 percent.
Dr. PIERCE. But with the current deficit, while very large, the
great bulk of that deficit is caused from the still depressed economy
and depressed tax revenues, not from any positive Government
action on the part of expenditures or taxes. There was a tax cut, but
it was a pretty small tax cut, given the size of the economy. It had an
effect, but it certainly couldn't turn things around when you are having a $20 billion tax cut and a $1 trillion economy. It was in the right
direction, but small. The bulk of the current deficit is simply depressed
revenues. There is some fiscal stimulus right now, but not very large.
Dr. MELTZER. May I take a slightly different tact on that question
and see if it is responsive to your question?
Recently, on average, the Fed has taken about 17 to 20 percent of
the deficit and financed it. If it did that this past year, we would
have a much more rapid rate of growth in the money stock, and
Dr. Pierce and I would both agree that we would currently experience
both, more stimulus in the economy than we currently enjoy, and we
would be running into the problem of rising prices.
Now, we may differ about whether the rising prices would have occurred 2 months ago or 6 months ago or whether they will occur
6 months from now. The precise timing around the 24-month, 2-year
average, we might differ about that in the particular instance. But we
would not differ, as far as I can tell, about what the effect would be.
We would run into a problem of inflation.
We would then have to face the probleln of how we get out of that
period of rising prices, or try to prevent its full effect. We would have
to slow down the growth rate of the money stock. Slowing down the
growth rate of the money stock would almost certainly mean that we
would reduce the stimulus in the economy. That would produce a
contractionary effect 6 months or 8 months later for the same reason
that we forced a contraction in 1974 when we slowed the money growth
rate suddenly.
Dr. PIERCE. Well, perhaps Dr. Meltzer is inferring more agreement
to me than he should.
I don't think that if we had a somewhat more expansive monetary
policy that the effect on inflation would have been very large, provided that policy were cut back as we came closer to fully employed
resources. But we do have some general information that if you have
sustained, rapid money growth, you can expect some inflation eventually, and probably it doesn't take all that long. It could be a matter
of a couple of years.
That, I think, is sufficient to keep the performance of monetary
policy within relatively narrow bounds, and I would hope would lead,
for both monetary and fiscal policy, to much more stable policies.
If we could give stability to economic policies in this country, a lot of
our problems would go away. The Government is continually reacting
to the mistakes of the past and overreacting to them, and I thought
for a while we were running the danger of having explosive policies.
The errors get bigger and bigger and the responses get bigger and
bigger, and that can go on until God knows what happens.




192
Mr. HANNAFORD. YOU have both indicated that Government
policy is a major, overwhelmingly the major cause of the cycles, particularly inflation.
Dr. MELTZER. Yes, sir.
Mr. HANNAFORD. YOU are

not suggesting that we should not pursue,
consciously pursue fiscal policy and consciously engage in monetary
policy by a central banking system.
Before the advent of the Federal Reserve and Keynes, going back
into the 19th century, it seems to me I remember an old Cleveland
Trust chart that was around for many years in which the peaks and
valleys looked like sharks' teeth and a much worse world than we
have had since that time; is that right?
Dr. MELTZER. That's correct. We have managed to take some of the
worst fluctuations out of the economy. Despite many claims 2 years
ago to the contrary, we have managed to avoid a really severe recession in the postwar period. We've had a big recession but by no means
the kind of recessions that people experienced during the 19th century or during the earlier part of the 20th century.
Mr. HANNAFORD. And when we say Government policy is the
cause, we say that now that we can second-guess Government policy
and there is such a thing, that we can sit back and——
Dr. PIERCE. Well, I think it depends on the kind of Government
policy. There are some basic policies, deposit insurance, a central
bank as lender of last resort, a taxation system that acts as a built-in
stabilizer of the economy, and a whole host of factors that serve as a
sort of basic background for the economy. These have imparted
greater economic stability. But at the same time, the Government
has often pursued active policies which have increased instability.
And maybe the standards are wrong. Maybe the Government
should follow the tack of saying, well, we only want to pursue those
policies which won't make the situation worse, and we will guard
ourselves against making the situation worse. We might have better
policies than ones that are based on the belief we know enough in
order to fine tune, to be able to second-guess what the economy is
going to be doing 18 months from now, but without a sufficient realization of what lags. Perhaps there should be a basic background of the
Government in its expenditures and taxation in the same sense that
there is a background in terms of deposit insurance, that it doesn't
change very rapidly.
And my guess is with the tremendous stability we have in the
economy now, that it will probably perform better. We have to
avoid excesses.
Mr. NEAL. Can you all stay with us for a while? We have a vote.
Mr. HANNAFORD. Well, I do not expect to return. I will not be
back, gentlemen. Thank you very much.
Mr. NEAL. I would like to return. If you can stay with us for a
while, we will be back.
[A brief recess was taken.]
Mr. NEAL. Have you had a chance to look at our exhibit?
Dr. MELTZER. Yes; I have looked at the chart.
Mr. NEAL. DO you see any problems?
Dr. MELTZER. I think in general the relationship is correct. It is a
careful reproduction and extension of earlier work. What the chart




193
shows is there is about a 2-year lag with no absolute precision or
uniformity about the timing. Each time there is a ripple in money, as
Dr. Pierce has said, it doesn't show up in price changes. However, it
is certainly true that the main movements are shown on the chart.
When the rate of monetary growth expands, on average 2 years later
we have an increase in the rate of price change, and when the rate of
monetary growth slows down, about 2 years later we have a slowdown in the rate of inflation. We are now experiencing the results of
that process. We should be careful to avoid saying, and I think the
paper accompanying the chart does, that the only thing that has
any effect on the rate of price change is the rate in the growth of the
money stock. A very large fraction of the rate of inflation is explained
by past changes in the growth of the money stock.
Mr. NEAL. One thing that would be very helpful to me would be
some brief information on the relationships between money and
deficits and inflation in foreign countries. You mentioned Brazil, and
I imagine you could talk about Argentina and maybe Chile and
Germany. It is a fascinating story and one we just don't have.
Dr. MELTZER. I will submit two recent papers—neither of them
my own—one by Michael Hamburger and Rutbert D. Reisch and
the other by Robert Lucas looking at some of the relationships between rates of inflation in other countries. There has been no systematic study of what's happened in each and every country, but I
think there is some information about foreign countries that is consistent. I will be glad to make available what I have.
Mr. NEAL. Very well. Absent any objection, I would like to have
inserted in the record at this point both papers and other related
information.
Dr. MELTZER. Fine.
[The papers submitted by Dr. Meltzer on studies of inflation abroad
by Michael J. Hamburger and Rutbert D. Reisch entitled "An
Empirical Analysis of Inflation, Unemployment and Macroeconomic
Policy in Open Economies" and by Robert E. Lucas, Jr., entitled
"Some International Evidence on Output-Inflation Tradeoffs,"
follow :1




194
AN EMPIRICAL ANALYSIS OF INFLATION, UNEMPLOYMENT
AND MACROECONOMIC POLICY IN OPEN ECONOMIES
Michael J. Hamburger and Rutbert D. Reisch*
Federal Reserve Bank of New York
During 1974, there was a sharp and unanticipated upward surge in the
United States' price level. The most common reaction to this development
among popular commentators and, to some extent, professional economists was
that something was seriously wrong with traditional economic analysis, in general, and its explanation of inflation, in particular. Although the force of this
argument was substantially weakened by the economy's apparently rapid
response to the restrictive monetary policy pursued during the second half of
1974 and the early part of 1975, it seems reasonable to consider this a temporary phenomenon. Future spurts of inflation or other unexpected events are
likely to renew the call for alternative approaches to analysis and policy which
promise greater control over the economy.
This study has two principal objectives. First, we seek to determine
the extent to which existing theory can explain fluctuations in prices and output
(employment). Within the limits of this knowledge, we then attempt to evaluate
the role that traditional economic policy can play in moderating these fluctuations. Consequently, the analysis is not restricted to the American experience in 1974. Instead, we examine the explanatory power of a set of relatively
standard macroeconomic models across a number of countries and time intervals. The work drawn upon is that of Lucas (1973), Stein (1976) and Korteweg
(1975). Lucas' model treats aggregate demand as an exogenous variable and
seeks to explain the trade-off between real output and inflation, under the
assumption that suppliers possess rational price expectations. The model is
tested using data for nearly twenty open economies, but no allowance is made
for any special effects which the international sector may have on the domestic
economy.
The Stein model, which was developed to help resolve some outstanding issues in the monetarist controversy as it pertains to the U.S. economy, is
more traditional. Aggregate demand is taken to depend on domestic policy
variables and little attention is devoted either to the foreign sector or to supply
behavior. Reduced-form equations are explicitly derived to explain the rate of
price change and the unemployment rate. Korteweg's work, which is specifically
* We are grateful to M. Arak and K. Brunner for helpful comments and suggestions, and are indebted to
H. Ferster and N. Marks for excellent research assistance. The views expressed are ours alone and should
not be attributed to the Federal Reserve Bank.




195
oriented to the Dutch economy, relies heavily on the Brunner-Meltzer (1974,)
(1976) analyses of open and closed economies. The reduced-form equations
he develops for aggregate production and the inflation rate are similar in spirit
to Stein's. One important difference is that Korteweg includes two variables
to measure the influence of the foreign sector.
In the analysis which follows, we first update the Lucas equations for
the United States, the United Kingdom, Germany, France, and the Netherlands.
Second, we modify the Stein model in the manner suggested by Korteweg and
estimate the resulting equations for the U.S., the U.K., Germany, and the
Netherlands. Finally, we assess these alternative approaches to the inflation/real
output trade-off and draw implications for the efficacy of macroeconomic
stabilization policy.

I. INFLATION, OUTPUT AND AGGREGATE SUPPLY
In the final analysis, real output and inflation should result from a
two-equation system describing aggregate demand and aggregate supply. We
concentrate first on the supply side only and treat aggregate demand as an exogenous variable. To describe suppliers' behavior and to explain real output, we
adopt Lucas' (1973) approach. Lucas assumes that aggregate supply depends on
the discrepancy between actual and expected prices, and on the cyclical component of last period's real output. Aggregate demand - - determined exogenously and hence a proxy for all policy variables - - is assumed to be of unitprice elasticity, which implies that the breakdown of nominal aggregate demand
into prices and real output is entirely supply-determined.
More specifically, Lucas assumes rational suppliers distributed over a
large number of competitive markets with unevenly distributed demand in which
suppliers know the price Pt(z) in market z at time t and the history of the
system, but not the current general price level P^. In each market z, supply
consists of a long-run trend component y n t common to all markets, and a
cyclical component y ^ :
(1)

yt(z) = y n t + yct(z)

(log of real output in z at t),

with
(2)

y n t = a + 0t




(log of trend component of real
output);

196
and the cyclical component determined by Pt(z) relative to the general price
level P t expected on the basis of information It(z) available in z at time t, and
by its own lagged value:
y c t = 7 [P t (z) - E(Pt/It(z)] + Xy CjM (z),

(3)

where all symbols denote the logarithms of the variables.
Assuming the unknown general price level P t is normally distributed
with mean P t and variance a , and that Pt(z) = P t + z where z is distributed
normally with mean 0 and variance r 2 and independently of P t , the joint
density function is:
-l/2L< p t-P t ) 2
f(Pt, Pt(z)) = _ J _ e
2iror

= f(P t ,P t ) = f(P t |P t ) . h (Pt),
OO

with h (Pt) = / f (Pt, Pt) dPt.
-oo

Collecting terms in P t , substituting

P*- c

and using

= P.

oo -p 2 / 2
/ e
dp - y/2it.,
-oo

the marginal density function can be written as:

h(Pt) =




197
Dividing this into f (P t , P t ):

(4)

f(p t |p t ) = *

+7

—
Hence_E(Pt{ Pt» p t( z »

and

j¥f

+ %+

=

^

Introducing 6 =
=

, the mean and the variance can be expressed:

V2
E ^ P ^ U ) ) = (1-a) Pt(z) + 0P t ,
and
V (P t |P t , Pt(z)) = Bo2 .
Combining E (Pti P t , Pt(z)), (1), and (3), and averaging over all markets z yields
the aggregate supply function:

with k = yd
Lucas' aggregate supply function, which we will use for our empirical
analysis, is only one form to describe suppliers' behavior. For instance, the
aggregate supply function could depend only on the discrepancy between actual
and expected prices (Sargent, 1973):
(6)

y t = y n t + k(Pt - E(P t ));




198
or include several lagged values of the cyclical component:
(7)

T
y t = y n t + k(P t -E(P t )) + 2 Xi(y t 4 - y
il

M

or incorporate adjustments in expected future price movements:

(8)

yt = ynt + k [ p t- E ( p t)-(Tr2EP t + i 42 E p t+
i=l t

i=l t - 1

which could be further modified by introducing a more sophisticated weighting
pattern instead of-i-. Finally, E(Pt) has to be specified. A simple formulation is
the well-known adaptive expectations model:
oo

(9)

E(Pt) = 1
i=l

WiPt4>

which will not be pursued further here. Rather, following Lucas, we assume
rational price expectations:
(10)

E(Pt) = E(Pt|history of the system, policy variables, other exogenous variables).

In this framework, suppliers know past movements of nominal aggregate demand, past shifts of real output, the trend component of real output; and assess
current nominal aggregate demand x t on the basis of:
(H)

x

t

= X

M

+

Ax

t'

where Ax t is the proxy for a current policy shift which by assumption follows
(12)

[Ax t ] -




dn(5,ax2).

199
Postulating the solution,
(13)

P t = 7T0

we obtain:
(14)

E(P t ) = TT0 + *i(xtml

+ 5) + n2xt-\

To complete his model, Lucas assumes an exogenously determined
demand function with unit-price elasticity:
(15)

xt = yt + Pt,

where x t = log of nominal aggregate demand.
Questions may be raised regarding the applicability of this function
to an open economy. At the very least, it seems appropriate to distinguish
between domestic and foreign prices, both of which, are included in P t . Moreover, with foreign sources of supply available, we would expect the price elasticity of the demand for domestic output to rise and, at least with respect to
domestic prices, it could exceed unity. *
Returning to the standard Lucas model, we solve the system (5),
(15), for fluctuations in real output and the inflation rate to obtain:
(16)

y c t = -TrS + TrAx^Xy^.j, with T = - J i T
1 + k;

(17)

APt = -0 + (1 - TT) Ax t + *AxtA - A A y c M ,
with APt = P t - P M .

Lucas fitted these two equations to annual observations for 18 countries for the
period 1953-1967, to test the natural unemployment rate hypothesis by comparing the results for countries with different time patterns of nominal income.
Some support for the latter contention is provided by Arak (1975), who reestimated the Lucas model
for the U.S., and found the elasticity of aggregate demand with respect to P. (the general price level) to be
greater than one.




200

This was not our objective. Instead, we sought to determine whether
the model would continue to adequately explain the real output/inflation tradeoff when high and fluctuating inflation rates became more the rule than the exception, as they were during Lucas' time period. In particular, we were interested in comparing the performance of the model with the more traditional analyses which focus on the explanation of aggregate demand. Moreover, there are
the questions of what effects, if any, the general increase in inflationary tendencies had on the real output/inflation trade-off in different countries, and the
extent to which the 1974 experience can be explained from the supply side.
The regressions performed for the period 1953-1973 (Table 1) indicate that the measures of goodness of fit are generally similar to Lucas1 except
that, whereas his equations explain real output better than prices, we find
the same explanatory power to prevail for both output and price equations.
(Following Lucas, the unadjusted R2 is used as the measure of goodness of fit
in these equations. The equations are estimated without constraints. Comparing
the coefficients of the output and price equations shows that the model performs reasonably well. While it is interesting to note that the U.S. shows the
most favorable trade-off in the concurrent period, no conclusions can be drawn
from the price equations as to how the inflationary impact is distributed over
time, since the full effect on prices must be transmitted in the concurrent and
subsequent periods on the basis of the model's specification.
To test for structural shifts, we also ran our regressions for two subperiods '-"-1953-1962 and 1963-1973 - - in order to investigate whether the
trade-off terms have changed significantly during the period 1953-1973. The
Chow test reveals that eight of the 10 equations (five" for output, five for prices)
show no significant shift between the two sub-periods. This suggests that overall
the trade-off terms have neither improved nor deteriorated during 1953-1973.
The Chow test rejects the hypothesis of no shift only for the output equations
of Germany and the Netherlands. Since such a shift in the output equations
should be accompanied by a shift in the corresponding price equation - - which is
not the case here - - this result is probably of little relevance. However, the
deterioration in the trade-off terms observed for Germany and the Netherlands
is of some interest. The reason for any given stimulatory policy to be reflected in
a significantly smaller increase in real output in the later period may be the
changing labor supply conditions between the two periods; until 1961, there was
a continuous labor inflow from East Germany as some 3 million people were
absorbed by the German economy after 1945. On the other hand, labor migration from other E.E.C. countries into Germany did not take place on any substantial scale until the late sixties. Thus, the highly elastic labor supply in the
earlier period may account for the more favorable trade-off terms during that




201
period. For the Netherlands (where the Chow test is far less significant), it is
conceivable that the results simply reflect the change in Germany's labor market
conditions, since the Dutch economy is closely linked to Germany's through its
export sector.
Finally, we tested the model's ability to predict. Using the results
presented in Table 1 to predict 1974 real GNP and the inflation rates for the
U.S. and Germany shows that real GNP is overpredicted and the inflation rate
underpredicted for both countries. For the U.S., the predicted GNP was $871.3
billion (1958 prices) versus the actual $821.6 billion; for Germany, it was DM
625.8 billion (1962 prices) versus the actual DM 596.4 billion. The annual inflation rates, on the other hand, are forecast at 6.2 percent for the U.S. versus the
actual 9.7 percent, and at 4.0 percent for Germany versus the actual 6.4 percent.
The difference between the actual and predicted GNP deflators - - 3.5 percentage
points for the U.S. and 2.4 percentage points for Germany - - may be accounted
for by the foreign sector, which is not explicitly included in Lucas' model.
Specifically, the sharp boost in import prices beginning in late 1973 - - largely
because of escalating oil prices - - must have caught suppliers by surprise, and
should help to explain the divergence of predicted from actual values. Therefore, it seems more appropriate to test the models' predictive ability for 1973.
Running the regressions for the period 1953-1972, and then predicting the 1973
values, reveals that real GNP is overpredicted for the U.S., Germany, and the
Netherlands; and underpredicted for the U.K. and France (Table 2). Conversely, inflation rates are underpredicted for the U.S. and the Netherlands,
overpredicted for the U.K. and France, and forecast correctly for Germany.
The absence of significant shifts over time suggests that the underlying structure is stable and that the model reflects basic trends. Short-run
predictions, however, remain problematic since various exogenous factors not
incorporated in the model can exert a sizable impact on output and prices. For
the 1974 predictions, the oil crisis is one such factor. For 1973, the forecast
errors are smaller for countries with stable import prices (Table 2). Price controls are another exogenous factor not incorporated in the model; they also help
to explain the comparatively large 1973 forecast errors in inflation rates for the
U.S. and the U.K. Presumably, the reported U.S. inflation rate was "catching
up" in 1973 after the 1971 and 1973 price controls, thereby overstating the
"true" inflation rate. On the other hand, the U.K. imposed a total price freeze
from November, 1972, to April 1973, which was followed by somewhat relaxed
controls, hence suppressing "true" inflationary pressures. Thus, the forecast
errors in the inflation rates are consistent with the impact of price controls on
the 1973 inflation rates in both countries.




202
II. AGGREGATE DEMAND
We turn next to the more traditional approach to macroeconomic
analysis, i.e., models that focus on the determination of aggregate demand.
Stein's (1976) study is used as the basis for this analysis because of its simplicity,
its completeness, and the impressive empirical results that he reports. The purpose here is to evaluate the applicability of such models to countries with different economic structures, and to compare their explanatory power to that of the
supply-oriented approach discussed above.
Included in the Stein model are: a labor market characterized by
wage and price flexibility and an endogenously determined unemployment rate;
asset markets for capital and bonds; an excess demand equation for goods; two
price-change equations; and a government budget constraint.
In summary form, the model may be expressed by the following
equations:
(18)

real wage change, ^L = a + TT* - TT + h(U),
w

where ir is the rate of price change, 7r* is the currently expected
rate of price change, and h(U) is a function of the unemployment
rate,h < 0;
w

(19)

unemployment rate, U = F(

Gp,
A(tj,
where A(t) is the level of productivity which grows at rate a and
Gj is the government demand for labor (per unit of capital);

(20)

bond market, p = g (U, TT*, m, 0),
where p, the nominal rate of interest depends on m, real money
balances (per unit of capital), 0, the ratio of government interestbearing debt to the money supply, U and TT*;

(21)

government budget constraint,G -T = [A0 + (1 + 0)/i]m,
where G - T denotes real government purchases of goods and
services minus real taxes (both per unit of capital), and /i is the
rate of monetary expansion;




203

(22)

Change in real money balances/capital,—

M -n -T ,
T

where the only new variable, n, is the growth rate of capital;
(23)

price change, ir = P(U, 7r*, m, G, 0);

(24)

adaptive price expectations, TT* = b(;r - 7r*).

A key element of the model is the price-change relationship (23),
which is assumed to represent the sum of two elements: a demand-pull effect
and a cost-push effect. The cost-push effect is ^
- a, the growth of the
nominal wage in excess of the rate of labor augmenting technical change. The
demand-pull effect is a function of real excess demand for goods per unit of
capital, E. Letting Xp denote a finite speed of response, this hypothesis may be
expressed:
(25)

; =( ^

- a) + XpE(-),

where the real excess demand for goods per unit of capital is the
sum of real planned investment (I) plus real planned consumption (C) plus real government purchases (G) less output (y)
all per unit of capital; i.e. :
(26)

E = C + I + G - y.

Noting that AW/W = Aw/w + TT, substituting(18) into (25), and writing E as
a function of TT*, m, G, 0, and U yields the price-change equation (23).
Solving this system, Stein obtains estimation equations for the rate of
price change (IT) and the unemployment rate (U) in terms of three independent control variables: the rate of monetary growth Qu); real government purchases of goods and services per unit of capital (G); and the ratio of government
interest-bearing debt to the money supply.
(27)

5
U(t) = const. + a j U(t - 5) + a27r(t - 5) + a 3 2/x (t - 0
1




5
5
+ a 4 2G(t - i) + a 5 20(t - i) + j j (t).

204

(28)

6
(t) = const. + b 1 U(t-5) + b 2 7r(t-5) + b 3 Z/i(t-i)
5
5
+ b 4 2G(t - i) + b 5 20(t - i) + j 2 (t),

where jj and j 2 are error terms; 8 is an arbitrary constant; and t - 5 represents
some earlier time period. Thus, conditions at time t are assumed to depend on
the state of the world at t - 8 and on the pattern of control inputs applied from
that date to the present.
The Stein model is appealing but contains a number of deficiencies.
Among the more important ones, from our point of view, are the treatment of
price expectations, and the failure to make any explicit allowance for the influence of the foreign sector on the domestic economy. There is now considerable
evidence to suggest that an autoregression on past price movements may not be
the most appropriate model of inflationary expectations. ^ A prominent alternative is to assume that economic units form their expectations rationally, i.e.,
they make some effort to learn the structural model that describes the economy
and form their expectations accordingly. Given the current level of abstraction,
it is not clear how the model's solution would be altered by the replacement of
equation (24) with a rational expectations scheme. Hence, we have assumed that
7T* may be treated as an endogenous variable, and that this is why Stein failed to
obtain significant coefficients for the variable when it was included in equations
(27) and (28) Consequently, like Stein, but for different reasons, we do not
include an explicit measure of inflationary expectations in the estimation
equations.
On the other hand, it does seem important to modify the model to
incorporate the influences on the domestic economy emanating from the foreign
sector. Here we follow Korteweg (1975), who identifies two kinds of foreign
trade impulses: those relating to variations in the foreign sector's demand for
private domestic output; and those relating to changes in the prices the home
country has to pay for its imports of goods and services (the effects of international capital flows other than those which occur as a result of changes in the
domestic monetary base on the money supply, are not considered).
The foreign sector's demand for domestic output is measured by
Korteweg's weighted volume of world trade, e - - a measure of predetermined
exports:
e = 2w f i f ,
2

See, for example, Fama (1975), Rutledge (1974), Sargent (1973), and Lucas (1973).




205
where if denotes the total import demand of each of the home country's trading
partners; and Wf, a weighting factor, is measured as:

wf =

H

-1

the share of trading partner f s imports in the preceding period which came
from the home country. In other words, e indicates the volume of a country's
exports, assuming that the distribution of all its trading partners' imports remain
unchanged from the previous period. ^
As a measure of the influence of foreign prices on the domestic
economy, we use the index of home country import prices denominated in the
local currency. The effect of changes in import prices, arising either from variations in foreign prices per se or from changes in exchange rates, depends on the
degree of substitutability between domestic and foreign goods, and whether the
effects are transmitted through the supply or the demand side of the domestic
economy. Thus, to the extent that there are no_domestic substitutes for imported goods, a rise in the price of the latter could be contractive with respect
to domestic employment (output) and prices.
To incorporate the above discussion in the Stein model, we rewrite
the price-change equation (25):
(25)

7 = [(AW . a ) - + 7 ( p )] + ApE(U,7r*,m,G,0,e,p m ),
T

w

where p m , the percentage change in the index of import prices, is added to both
the cost-push and demand-pull components of (25); and e, the measure of predetermined export demand, is included as an additional determinant of excess
demand. As a result of this substitution equation (23) may be replaced by
(231)

ir = P(U, 7T*, m, G, 0, p m , e).

An alternative measure of the foreign sector's demand for domestic output is the volume of the home
country's exports. The problem with this measure is that, to the extent a country's exports depend on the
current value of the domestic price level relative to foreign prices, it will be at least partially endogenous.

73-959 O - 76 - 14




206
Solving this extended version of the model yields the estimation equations
relevant for an economy that is open to international trade:
5
(271)

U(t) = const. +

1

2

3

5
5
5
+ a 4 2G(t - 0 + a 5 20(t - i) + a 6 2 p
1
°\
1

(t - i)

5
+ a 7 le(t-i) + jjCt);
(28)

5
7r(t) = const. + bjU( t - 5) + b27r(t - 5) + b^nit
1
5
5
+ b 4 2G(t - i) + b 5 20(t - i

- i)

5

5
-h b 7 2 e ( t - i ) + j 2 ( t ) .

To test the proposition that the extended version of the Stein model
provides a general explanation of price and employment movements, our intention was to estimate equations (271) and (28f) for the five countries under consideration. Unfortunately, data limitations restricted this portion of the analysis
to four countries: Germany; the Netherlands, the United Kingdom and the
United States. Furthermore, the data for Germany and the Netherlands are
measured on annual average bases and hence do not permit a reproduction of
Stein's lag structure. 4
One modification that was introduced into the estimation procedure,
even for the U.S. where data is plentiful, is to take observations on the dependent variables spaced four quarters apart rather than every quarter. This is done
to eliminate any problems that might result from seasonal variation in the data,
and to reduce the serial correlation which might be introduced into equation

In estimating his equations, Stein assumed that 5 = 3 . This implies that each dependent variable is a
linear function of all the dependent variables three quarters ago and a simple unweighted average of each of
the control variables over the three previous quarters. While no justification is provided for this structure
and it seems doubtful that it represents a crucial element in the specification, the model did fit the U.S.
data more closely when we approximated Stein's lag structure, as opposed to incorporating the restrictions
imposed by annual average data.




207
(28') because of the way ir is measured, i.e., as the rate of price change over the
past three quarters. ^ Finally, because 6 was the least significant policy variable
in Stein's tests and because of the well-known conceptual problems associated
with measuring the public debt, d is excluded as a control variable from all tests.
With these modifications, Stein's closed-economy equations, (27) and
(28) were fitted to U.S. data for the period 1954:IV to 1970:IV. Our purpose
was to determine the combined effects of: (1) the changes in the estimation
procedure; and (2) the lengthening of the sample period (the most common
period used by Stein was 1960:IV to 1970:IV). The results shown in the center
of Tables 3 and 4 are quite similar to Stein's, reproduced in the left-hand columns of the tables. The main differences in the results are a substantial drop in
the serial correlations of the residuals and a decline in the significance of money,
(ju) in the price-change equation. However, given the similarity in the parameter
estimates, and the much smaller number of degrees of freedom in our sample as
compared to Stein's (12 versus 36), this finding may be neither very surprising
nor disturbing. (To facilitate comparison of our results with Stein's, the unadjusted R2 is used as the measure of goodness of fit in these tables; hereafter, we
use R2.)
We next test for the influence of exports and import prices on employment and the inflation rate. The right-hand columns of Tables 3 and 4
present the parameter estimates and other results for equations (27') and (28f),
when all insignificant variables are eliminated, and the lagged value of /u is substituted for the current value. Assuming that p m and e are at least approximately exogenous, the evidence provides strong support for the proposition that
the U.S. is an open economy. Exports are highly significant with the appropriate sign in both equations. Moreover, during the sample period, 1954-1970.
increases in import prices tended to reduce aggregate output (employment), but
apparently had little impact on the domestic price level. The latter result is a
bit puzzling, but it makes it somewhat difficult to attribute the open economy
results for the U.S. to the endogeneity of the index of import prices.
The effects of changes in the domestic policy variables are also interesting. According to the right-hand columns of Tables 3 and 4, a change in the
growth rate of the money supply first affects real output and employment, and
then, prices. Such a result is consistent with the generally accepted view of how
monetary policy influences the economy, and with our earlier findings for the
Lucas model. The estimates of the effects of fiscal policy are similar to most
Another adjustment incorporated in the estimation procedure - - as much for convenience as any other
reason - - was to. allow the control variables to begin to influence the state variables in the current period.
As a result, the summations associated with each of the control variables in equations (XT) and "H')now
begin at zero instead of one. With the dependent variables measured in the fourth quarter of the year, this
permits the use of annual averages for the control variables, which may be an important simplification for
countries other than the U.S.




208
other analyses of this type. They suggest that such policy operations have no
significant effect on either employment or prices.
A final test of the applicability of the Stein model to the U.S. is provided by extrapolating the price and unemployment equations through 1974.
The results shown in Tables 5 and 6 are not very impressive, but the patterns of
the errors are informative. The open-economy equation, (28*), does a good, but
not outstanding, job of tracking the inflation rate during the post-sample period.
Considering the insignificance of the import-price-coefficient during the sample
period, this may not be very surprising. As far as the unemployment rate is concerned, the closed-economy model, equation (27), provides the superior predictions. There is a sense, though, in which the open-economy results are the more
reasonable of the two. Indeed,'the major problem with the 10.3 percent unemployment rate prediction for 1974:IV could be that it occurred one quarter too
soon.
Let us now turn briefly to the results for other countries. Those for
the U.K. do not support the open-economy version of the Stein model. Although the estimates of goodness of fit for the U.K. inflation and unemployment equations are similar to those for other countries, all efforts to obtain
statistically significant parameter estimates consistent with standard macroeconomic theory proved unsuccessful. The only variable whose parameter even
approached statistical significance was AG, and it invariably had the wrong sign,
both currently and with a one-year lag, i.e., increases in government expenditures were associated with increases in the unemployment rate and a fall in
inflation. Such results cast some doubt on the general applicability of the Stein
model. However, in the case of the U.K., the problem may simply be due to
multicolinearity among the variables included in equations (27') and (28').
Turning to the Netherlands, we again draw on the work of Korteweg
(1975). In explaining Dutch inflation during the 1953-1973 period, he finds the
most important determinants to be: the lagged rate of change in the narrowmoney supply; the rate of unused industrial capacity lagged one year, Q(t - 5),
which serves the same function as the lagged unemployment rate in our specification; and a summary measure of the effects of changes in government policy
variables, such as indirect taxes, subsidies, rents, and E.E.C. and Kennedy-round
adjustment measures, p au (t - 5).
The parameter estimates for Korteweg's price-change equation (fitted
to annual averages of the variables) are shown on the left side of Table 7. The
results on the right side are those for a similar equation estimated for the period
1953-1971. This shorter time interval was used in an attempt to obtain a consistent series for the unemployment rate. Although such a series is obtainable for
this period, it appears less appropriate than the rate of unused industrial capacity




209
as an indicator of the slack in the Dutch economy. Consequently, we follow
Korteweg and use Q(t - 5), rather than U(t - 5), as a lagged state variable, and
do not report the parameter estimates for the unemployment rate equation.
Two aspects of the results warrant particular attention. First, regardless of the sample period, the most important determinant of year-to-year
variations in the Dutch price level (as measured by the t-statistics) is p a u , a
policy variable specific to the Netherlands. Its omission from the 1953-1971
regression causes the coefficients of most other variables to lose statistical significance. Second, when the sample period is extended to include 1972 and 1973,
the effects of import prices and fiscal policy (AG), become difficult to assess,
i.e., the t-statistics drop below 1.20. Since these were years in which the money
supply and the price level both rose very rapidly, the problem may be that the
parameter estimates are sensitive to the movements in the variables. Even if
the apparent instability in the Dutch price-change equation can be explained in
this way, the present results, like those for the U.K., raise questions regarding
the general usefulness of the Stein model. For example, the sensitivity of the
estimates of the parameters in the Dutch price level equation to the inclusion of
p a u suggest that unless all important policy variables are included in the specification, it may be difficult to measure the effects of those that are.
German data accord the Stein model a more favorable reception. The
inflation-rate equation (fitted to annual averages of the variables for the period
1960-1973) is quite similar to its U.S. counterpart (see Table 8). According to
both equations, the principal determinants of year-to-year movements in the
price level are: the lagged unemployment rate; the growth rate of the money
supply; and the foreign sectors' demand for domestic output. Moreover, unlike
the Netherlands, the results for Germany and the U.S. reveal no significant
instability in the parameters when the sample periods are extended beyond
1971. However, there are two interesting differences in the way the price level
responds to changes in its determinants in the latter countries. First, as might
be expected, increases in foreign demand appear to be more inflationary in
Germany than in the U.S. Second, the insignificance of the lagged price-change
term in Table 8 suggests that, regardless of the stimulus, the domestic price
level responds more quickly to changes in its determinants in Germany than in
the U.S. This may also be a consequence of the greater openness of the German
economy. Whatever the reason, the similarity between this result and the
corresponding one for the Lucas model would seem to increase our confidence
in both formulations.

However, these estimates were generally consistent with the implications of the Stein model.




210
III. ASSESSMENT, INTEGRATION AND POLICY IMPLICATIONS
The empirical evidence presented in the previous sections does not
lend itself to an unambiguous interpretation of the ability of existing theory - as represented by the Lucas and Stein models - - to explain fluctuations in prices
and output. • Tests of the Lucas model suggest considerable stability on the
supply side of the Dutch, French, German, U.K., and U.S. economies. Moreover,
with the exception of the U.K., the constraints the model imposes on the parameters are generally fulfilled. On the other hand, the model fails to explain
the extent of the 1974 price increases in all the countries included in the sample.
Considering the focus of the Lucas model - - the supply side of the domestic
economy - - and one of the important causes of the 1974 disturbance - - a sharp,
unanticipated increase in the import prices - - it is difficult to assess the seriousness of this deficiency.
The results for the Stein model, which focuses on the sources of
variation in aggregate demand, differ in some respects from those for the Lucas
formulation. Nevertheless, the overall performance of the two approaches is
similar. For Germany, the Netherlands, and the U.S., Stem-type price equations
fit the data quite closely, and the specific determinants of the price movements
are readily identifiable.
The difficulties with this formulation are: (a) the
equations do not fit the U.K. data very well; and (b) for other countries, there
is considerable variation in the parameter estimates both over time and across
countries. One noteworthy element of constancy, though, is that the growth
rate of the money supply always appears as a significant determinant of the
inflation rate. Finally, the errors involved in explaining the 1974 price movements are of the same order of magnitude as those for the Lucas model.
Three properties of the results are of particular interest. First, the
overall comparability in the explanatory power of supply-and demand-oriented
models suggests that the overriding attention macroeconomics devotes to the
latter may be misplaced. The qualitative similarity in results for the various
countries examined is also an important finding, implying that the underlying
structures of these economies may have more elements in common than not.
However, the variability of the parameters in Stein's aggregate demand model is
a matter of concern. It suggests that such a model, and the theory upon which
it rests, does not provide a general explanation of year-to-year fluctuations in
prices and output. __--•• "" '
A number of hypotheses could be put forward to account for this
deficiency. The one we wish to explore holds that although simple aggregate
demand models of the Stein type can identify longer term economic trends, a
year is too short a period in which to observe such movements. Such a view




211
stands in sharp contrast to current econometric practice which seeks to explain
not only annual fluctuations in economic data but quarterly movements as well.
The specific formulation we use to test our hypothesis posits that, over five-year
periods, the growth rate of the money supply is a reliable predictor of the
growth of nominal income and, for all practical purposes, this is independent of
a country's institutional structure:
(29)

Y it = a + bMit + e it ,

where

Y- is the five-year growth in nominal income of country, i, measured
from the average annual level of Y;
Mj is the five-year growth in the narrow-money supply of country, i,
measured from end-of-year to end-of-year, so that each observation leads the corresponding one for Y by approximately one-half
year;
a and b are constant both over time and across countries ;
€| is an error term.
Data for four countries (Germany, the Netherlands, the U.K., and the U.S.) are
used to estimate a and b, with five non-overlapping observations spanning the
sample period, 1951-1975, for each country. °
The parameter estimates and other results presented in the left-hand
column of Table 9 indicate that equation (29) fits the data rather closely. However, the key results - - the t-statistics for a and b - - do not provide a powerful
test of the hypothesis that these coefficients are the same for all countries. The
other results in Table 9 address this question directly. Those in the middle
column report the estimates for equation
(29a)

Y it = a + bMit + a us D us + b us D us M t .

This equation is similar to (29), except that it includes the dummy variable D u s
which equals 1, when U.S. data are used in the equation, and zero otherwise.

The choice of a five-year time period is somewhat arbitrary. For the U.S., though, such a period corresponds roughly to a complete business cycle. One problem in using such a long observation period is that
it substantially reduces the sample size and hence restricts the number of independent variables that can be
considered. We focus on the money supply because it is the one variable that was consistently found to be
significant in the Stein equations.
All observations are five-year growth rates, except those for the last period, 1971-74, which are threeyear rates extrapolated to five years. It is important that the observations be non-overlapping because
otherwise we run the risk of introducing complicated serial correlation patterns among the residuals. The
data are from the International Financial Statistics (IFSH972 Supplement. The most recent figures are
drawn from later IFS issues and/or national sources.




212
It is easily shown that the estimated values of a us and t>us represent the differences in the parameters for the U.S. and the average of the other countries. ^
Since the t-statistics for both of these coefficients are less than 2, we may reject
the hypothesis that the U.S. parameters taken individually are significantly
different from the average of the others. The F-statistic presented at the bottom
of the column is substantially less than its critical value at the 5 percent confidence level. This implies that we may also reject the hypothesis that the two
U.S. parameters taken together are different from their counterparts in the other
countries.
The numbers in the right-hand column of Table 9 may be used to
assess the hypothesis that the parameters for each of the other three countries
(the U.K., Germany, and the Netherlands), taken separately, are different from
those for the U.S. Once again, both the F- and the t-statistics lead us to reject
this view. Numerous other combinations of parameters could be considered and
some of them were, in fact, evaluated. In every case, though, we were unable to
reject the hypothesis that the data for all countries were drawn from the same
population.
Given the difficulties encountered with the Stein model, it is also
relevant to test our simple quantity theory model for temporal stability. Here,
equation (29) was reestimated, dropping the last observation for each country.
The parameter estimates are essentially identical to those shown in Table 9,
while the standard error of the equation increases slightly to 8 percent (1.6
percent at an annual rate).
(29')

Y = 27.38 + .61M.
(7.17) (6.21),
R 2 = .72; S.E. = 1.96; DW = 1.44
(sample period, 1951-1970).

When equation (29') is extrapolated through the last observation, 1971-74, the
following error statistics are obtained.

Put another way, the regression coefficients for the other countries are given by a and b, while those for
the U.S. equal a + a u s and b + b ^ .




213

United 'States
United Kingdom
Germany
Netherlands

Predicted
Income Growth
46.9
68.0
62.1
67.2

Actual
Growth
54.1
72.1
51.1
71.9

Difference
-7.2
-4.1
11.0
-4.7

Relative to the standard error of the equation the predictive errors are small
and offsetting. Thus, the same stable long-run relationship appears to exist
between money and income in all the countries, explaining the events of the
early 1970s as well as it does those of the 1950s and 1960s. Considering the
differences in the money-supply processes in these economies and their evolution over time, the results are impressive. I 0 They suggest that, over five-year
periods, variations in the growth of money have a significant and well determined effect on the growth of income, essentially independent of the process
that determines the money stock. * *
Over periods as long asfiveyears, we would expect, and the data tend
to confirm, that most of the effects of changes in the money supply are on
prices. It would be desirable to go further and make more precise statements
regarding the effects of monetary policy and the determinants of inflation. At
the moment, we are unable to do so. Although all the economies we considered
exhibited considerable structural stability in both the short- and the long-run, in
the course of a year (or less), numerous exogenous factors can exert a sizable
impact on output and prices, and overshadow the effects of money. Over longer
periods, though, it is clear that increases in the money supply, which exceed the
growth in real output, will result in a predictable amount of inflation. Thus, we
find that, to the extent governments (or their central banks) are able to control
the domestic money stock, they will be able, within narrow limits, to determine
a country's long-run inflation rate. Whether they choose to exercise such control is, of course, another question.

Among the reasons for these differences and the variation over time are: the position of the dollar as a
reserve currency; the development of the international payments mechanism; and the emphasis each central
bank has given to the control of interest rates and the money supply.
11
The close fit of our general model, equation (29), to the U.K. data (R 2 = .88) suggests that, despite the
fact that the Bank of England has not sought to actively manage the growth rate of the narrow money supply, variations in this variable have had the same important impact on economic activity in Britain as they
have in other countries. Hence, the present results are in strong opposition to the views expressed by Kaldor
(1970).




214
Table 1
Lucas Output Equation
n Ax

yct

t

U.S.

1953-73

- .050
(-7.566)

0.782
(7.993)

0.756
(9.363)

0.8824

U.K.

1953-73

- .012
(-1.311)

0.184
(1.483)

0.550
(2.804)

0.3258

Germany

1953-73

- .052
(-3.521)

0.614
(3.842)

0.862
(8.714)

0.8169

France

1953-73

- .011
(-1.074)

0.103
(1.026)

0.741
(4.520)

0.5351

Netherlands

1953-73

- .037
(-3.415)

0.408
(3.726)

0.655
(4.848)

0.6571

Lucas Price Equation
APt = -0 + (1-1
R2
0.7894

U.S.

1953-73

- .038
(-4.533)

0.090
(1.460)

0.971
(7.296)

- .746
(-5.798)

U.K.

1953-73

- .025
(-2.110)

0.513
(2.823)

0.440
(1.900)

- .046
(- .228)

0.6921

Germany

1953-73

- .061
(-3.282)

0.402
(3.200)

0.662
(4.053)

- .666
C-3.706)

0.6051

France

1953-73

- .054
(-4.152)

0.886
(8.229)

0.132
(1.483)

- .165
(- .799)

0.8236

Netherlands

1953-73

- .037
(-2.359)

0.470
(4.021)

0.403
(2.710)

- .284
(-1.380)

0.6707




215
Table 2
1973 - Forecasts of Real GNP and Inflation Rates on
Basis of Lucas 1953-1972 Regressions
Real GNP
(billions of units)
Forecast
Actual
854.9
56.1
611.6
942.9
91.2

U.S. (1958-$)
U.K.(1970-t)
Germany (1962-DM)
France (1970-FF)
Netherlands (1963-NG)

Import Prices

Inflation Rate
(percent;
Forecast
Actual
4.04
9.89
5.73
7.11
7.32

839.2
57.0
594.0
953.6
90.1

5.45
7.28
5.70
6.95
7.60

1970= 100

1968
U.S.
U.K.
Germany
France
Netherlands

1969

1970

1971

1972

1973

1974

90.6
92.7
98.1
84.8
91.

93.4

100.0
100.0
100.0
100.0
100.

105.2

113.0
109.1
96.5
104.4
103.

134.3

105.2
99.0
103.5
104.

198.8
210.3
128.7
165.5
154.




95.5
100.0
90.2
93.

138.1
102.7
112.1
111.




Table 3
United States Unemployment Rate Equation
(t-statistic in parentheses)
Stein 's Results
Quarterly'Observations
1960:IV - 1970:IV
constant

3.9

(5.3)

Fourth Quarter Observations, 1954: IV - 1970:1V
Open Economy Equation (27 )
Modified Equation (27)
2.4

(1.9)

1.74

(1.7)

U(t-5)

.41

(3.9)

.59

(2.8)

.75

(4.2)

ir(t - 5)

.12

(1.3)

.30

(1.9)

.27

(2.3)

AG(t - 8)

-.005

(1.3)

-.002

Hit-8)

-.33

(8.8)

-.28

(1.1)
(3.0)

-.312

(4.3)

.145

(2.2)

-.022

Pm
e

(3.4)

S.E.

.36

.69

.52

R2

.9

.65

.82

D-W

.5

1.67

2.63

to




Table 4
United States Price Change Equation
(t-statistic in parentheses)

constant
U(t - 5)
7T(t - 5 )

AG(t-5)
M(t - 5)

Steins Results
Quarterly Observations
1960:1[V - 1970:IV
2.4
(4.0)
-.37
(-4.4)
.72
(10.0)

Fourth Quarter Observations, 1954:IV - 1970:IV
Open Economy Equation (28')
Modified Equation (28)
(3.7)
3.6
4.7
(4.0)
(3.7)
-.56
- .72
(-3.8)
.49

(3.4)

-0.000

(-0.6)

-.001

(3.3)

.105

(1.2)

(4.9)

.19*

(2.5)
(2.7)

(-0.6)

.097

.46

Pm
e
S.E.

.29

.62

.014
.43

2

.96

.86

.93

.9

2.30

2.32

R

D-W

• In equation (281) ju(t - 5) is lagged one year.

to

218
Table 5
U.S. Unemployment Rate Predictions

1971:IV
1972:IV
1973:1V

Actual
Unemployment
60
.
53
.
48
.

1974:1V

Predicted Unemployment
Modified Eqn.(27)
Simplified Eqn. (27')
53
.
5.6
5.0
6.0
4.4
4.9
58
.

66
.

10.3

Table 6
U.S. Price Change Predictions
Actual
Inflation Rate

Predicted Inflation
Modified Eqn. (28)

Simplified Eqn.(28')
4.0

1971:IV

35
.

38
.

1972:IV

37
.

2.7

33
.

1973:IV

74
.

3.4

4.8

1974: IV

12.0

55
.

72
.




219
Table 7
Netherlands Price Change Equations
(t-statistics in parentheses)
Korteweg Results
1953-1973
2.79

(3.34)

-.43
1.29
.14

(2.80)
(3.73)
(1.14)

.21
.10
-.02
1.21
2.12
.81

constant

(2.81)
(0.95)
(0.23)

7T(t-5)

Q(t-5)
5

Pau^ )
AG(t-5)
M(t-5)
M(t-l-5)
Pm
e
S.E.
D-W

New]Results
1953-1971
3.46
-.30
-.37
1.44
.24
.11

(4.96)
(2.63)
(3.04)
(5.75)
(2.82)
(1.94)

.25 (3.33)
.77
2.00
.87

Table 8
German Price Change Equation, 1953-1973
(t-statistics in parentheses)
constant
U(t-5)
M(t-5)
e(t-5)
S.E.
R2
D-W




4.31
-403
.32
.21
1.08
.70
2.18

(3.66)
(5.43)
(3.45)
(4.06)

220
Table 9
Pooled Nominal Income Equations, 1951-1974
(United States, United Kingdom, Germany, Netherlands)
Observations are Five-Year Growth Rates*
(t-statistics in parentheses)

All
Ponied
constant

u
C

U.S.

U

27.37
(7.85)
.62
(7.62)

U.S.

C

United States
versus
Others Pooled

Others Individually

31.03
(7.07)
.55
(6.01)
-14.46
(1.50)

16.57
(2.11)
1.00
(2.98)

.44
(1.18)

7.53
2.09
.76

14.17
(1.54)
-.37
(1.02)
11.57
(0.61)
-.49
(1.09)
5.67
(0.46)
-.17
(0.43)
6.89
2.79
.80

1.19
3.63

1.65
3.00

U.K.

U

U.K.

C

G

"G
C

N

U

N

S.E.

D-W
R2
F-stat.
Crit. Value (5%)

United States
versus

7.61
1.96
.75

•Except for the last periods (1971-74) which are three-year rates extrapolated to
five years.




221
REFERENCES
1.

Arak, M., "The Trade-Off Between Inflation and Output: A Comment on
the Lucas Model," Research Paper 7515, Federal Reserve Bank of
New York, 1975.
——

' "Monetary and Fiscal Policy in Open Interdependent
Economies with Fixed Exchange Rates," mimeo, March 1974.)

3

Brunner, K., and Meltzer, A.H., "An Aggregative Theory for a Closed Economy," in Monetarism,, (ed. J. Stein), Amsterdam: North Holland
1976.

4.

Fama, E.F., "Short-Term Interest Rates as Predictors of Inflation," American Economic Review. LXV, No. 3, (June 1975), 269-282.

5.

Kaldor, N., "The New Monetarism," Llovds Bank Review. No. 97, (July
1970), 1-18.

6.

Korteweg, P., "Inflation, Economic Activity and the Operation of Fiscal,
Foreign and Monetary Impulses in the Netherlands - - A Preliminary

7.

Lucas, R.E. Jr., "Some International Evidence on the Output-Inflation
Tradeoffs," American Economic Review. LXIIL No. 3. (June 1973),
326-334.

8.

Rutledge J. A Monetarist Model of Inflationary Expectations. Lexington,
Mass.: Lexington Books, 1974.

9.

Sargent, T.J., "Rational Expectations, the Real Rate of Interest, and the
Natural Rate of Unemployment," Brookings Papers on Economic
Activity, No. 2 ,Washington, D.C.: The Brookings Institution, (1973),
429-480.

10.

Stein,J.L., "Inside the Monetarist Black Box" in Monetarism, (ed. J.L.
Stein), Amsterdam: North Holland, 1976.

11.

Statistics Bureau of the International Monetary Fund. International Financial Statistics, Supplement, Washington, D.C., 1972.

73-959 O - 76 - 15




222

Some International Evidence on
Output-Inflation Tradeoffs
By ROBERT E. LUCAS, JR.*

This paper reports the results of an
empirical study of real output-inflation
tradeoffs, based on annual time-series from
eighteen countries over the years 1951-67.
These data are examined from the point
of view of the hypothesis that average
real output levels are invariant under
changes in the time pattern of the rate of
inflation, or that there exists a "natural
rate" of real output. That is, we are concerned with the questions (i) does the
natural rate theory lead to expressions of
the output-inflation relationship which
perform satisfactorily in an econometric
sense for all, or most, of the countries in
the sample, (ii) what testable restrictions
does the theory impose on this relationship, and (iii) are these restrictions consistent with recent experience?
Since the term "natural rate theory",
refers to varied aggregation of models and
verbal developments,1 it may be helpful
to sketch the key elements of the particular
version used in this paper. The first
essential presumption is that nominal output is determined on the aggregate demand
side of the economy, with the division
into real output and the price level largely
dependent on the behavior of suppliers of
labor and goods. The second is that the
partial "rigidities" which dominate shortrun supply behavior result from suppliers'
lack of information on some of the prices
relevant to their decisions. The third
* Graduate School of Industrial Administration, Carnegie-Mellon University.
1
The most useful, general statements are those of
Milton Friedman (1968) and Edmund Phelps. Specific
illustrative examples are provided by Donald Gordon
and Allan Hynes and Lucas (April 1972).




presumption is that inferences on these
relevant, unobserved prices are made
optimally (or "rationally") in light of the
stochastic character of the economy.
As I have argued elsewhere (1972),
theories developed along these lines will
not place testable restrictions on the coefficients of estimated Phillips curves or
other single equation expressions of the
tradeoff. They will not, for example, imply
that money wage changes are linked to
price level changes with a unit coefficient,
or that "long-run" (in the usual distributed lag sense) Phillips curves must be
vertical. They will (as we shall see below)
link supply parameters to parameters
governing the stochastic nature of demand
shifts. The fact that the implications of the
natural rate theory come in this form suggests an attempt to test it using a sample,
such as the one employed in this study, in
which a wide variety of aggregate demand
behavior is exhibited.
In the following section, a simple aggregative model will be constructed using
the elements sketched above. Results
based on this model are reported in Section II, followed by a discussion and conclusions.
I. An Economic Model
The general structure of the model developed in this section may be described
very simply. First, the aggregate pricequantity observations are viewed as intersection points of an aggregate demand and
an aggregate supply schedule. The former
is drawn up under the assumption of a
cleared money market and represents the
output-price level relationship implicit in

223
the standard IS-LM diagram. It is viewed
as being shifted by the usual set of
demand-shift variables: monetary and
fiscal policies and variation in export demands. The supply schedule is drawn under the assumption of a cleared labor
market; its slope therefore reflects labor
and product market "rigidities."
The structure of this model, which is
essentially that suggested in Lucas and
Leonard Rapping (1969), will be greatly
simplified by an additional special assumption: that the aggregate demand curve is
unit elastic.2 In this case, the level of
nominal output can be treated as an
"exogenous" variable with respect to the
goods market, and the entire burden of accounting for the breakdown of nominal
income into real output and price is placed
on the aggregate supply side. In the next
subsection, A, a supply model designed to
serve this purpose is developed. In subsection B, solutions to the full (demand and
supply) model are obtained.

is distributed unevenly over markets,
leading to relative as well as general price
movements. As a consequence, the situation as perceived by individual suppliers
will be quite different from the aggregate
situation as seen by an outside observer.
Accordingly, we shall attempt to keep these
two points of view separate, turning first
to the situation faced by individual suppliers.
Quantity supplied in each market will be
viewed as the product of a normal (or
secular) component common to all markets
and a cyclical component which varies
from market to market. Letting z index
markets, and using ynt and yrt to denote
the logs of these components, supply in
market z is:

A. Aggregate Supply

The cyclical component varies with perceived, relative prices and with its own
lagged value:

All formulations of the natural rate
theory postulate rational agents, whose
decisions depend on relative prices only,
placed in an economic setting in which
they cannot distinguish relative from general price movements. Obviously, there is
no limit to the number of models one can
construct where agents are placed in this
situation of imperfect information; the
trick is to find tractable schemes with this
feature. One such model is developed
below.
We imagine suppliers as located in a
large number of scattered, competitive
markets. Demand for goods in each period
2
An explicit derivation of the price-output relationship from the IS-LM framework is given by Frederic
Raines. Of course, this framework does not imply an
elasticity of unity, though it is consistent with it. Since
the unit elasticity hypothesis is primarily a matter of
convenience in the present study, I shall comment below
on the probable consequences of relaxing it.




(1)

yt(z) =

The secular component, reflecting capital
accumulation and population change, follows the trend line:
(2)

0 )

ynt = a + 0t

v-t(2) = 7 [ A W -

E{Pt\ft(z))]

where Pt(z) is the actual price in z at t and
E(Pt\lt(z))
is the mean current, general
price level, conditioned on information
available in z at t, / t (z). 3 Since y tt is a
deviation from trend, | \ | < 1 .
3
A supply function for labor which varies with the
ratio of actual to expected prices is developed and verified empirically by Lucas and Rapping (1969). The
effect of lagged on actual employment is also shown.
In our 1972 paper, in response to Albert Rees's criticism, we found that this persistence in employment
cannot be fully explained by price expectations behavior. Both these effects—an expectations and a persistence effect—will be transmitted by firms to the goods
market. In addition, they are probably augmented by
speculative behavior on the part of firms (as analyzed
for example, by Paul Taubman and Maurice Wilkinson).
For a general equilibrium model in which suppliers
behave essentially as given by (3), see my 1972 papers.

224
The information available to suppliers
in z at t comes from two sources. First,
traders enter period t with knowledge of
the past course of demand shifts, of normal
supply ynt, and of past deviations yc,t-i,
yc,t-2, . . . . While this information does
not permit exact inference of the log of the
current general price level, Pt, it does determine a "prior" distribution on Pt, common to traders in all markets. We assume
that this distribution is known to be normal, with mean P t (depending in a known
way on the above history) and a constant
variance a2.,
Second, we suppose that the actual price
deviates from the (geometric) economywide average by an amount which is distributed independently of Pt. Specifically,
let the percentage deviation of the price in
z from the average Pt be denoted by z (so
that markets are indexed by their price
deviations from average) where z is normally distributed, independent of Pt, with
mean zero and variance r2. Then the observed price in z, Pt(z) (in logs) is the sum
of independent, normal variates

Averaging over markets (integrating with
respect to the distribution of z) gives the
aggregate supply function:
(7)

yx

»t + ey(Pt - Pt)

The slope of the aggregate supply function (7) thus varies with the fraction 6 of
total individual price variance, <T2-\-T2,
which is due to relative price variation. In
cases where r2 is relatively small, so that
individual price changes are virtually certain to reflect general price changes, the
supply curve is nearly vertical. At the
other extreme when general prices are
stable (a2 is relatively small) the slope of
the supply curve approaches the limiting
value of y.4
B. Completion and Solution of the Model

A central assumption in the development above is that supply behavior is
based on the correct distribution of the
unobserved current price level, Pt- To
proceed, then, it is necessary to determine
what this correct distribution is, a step
which requires the completion of the
(4)
Pt(z) = Pt + 2
model by inclusion of an aggregate deThe information It(z) relevant for estimamand side.
tion of the unobserved (by suppliers in z
As suggested earlier, this will be done by
at t) Pt, consists then of the observed
postulating a demand function for goods of
price Pt(z) and the history summarized
the form:
in Pt.

To utilize this information, suppliers use
(4) to calculate the distribution of Pt,
conditional on Pt(z) and Pt. This distribution is (by straightforward calculation)
normal with mean:
E{l\\h{z))
(5)

= (l - d)Pt(z) + opt

where 6 = T2/(<J2+ r 2 ), and variance 0(72.
Combining (1), (3), and (5) yields the
supply function for market z:

,A.
(6)

yM = y,a + ey[pt(z) - pt]




(8)

Pt = A-t

where xx is an exogenous shift variable—
equal to the observable log of nominal
GNP. Further, let {A#t} be a sequence of
independent, normal variates with mean 5
and variance <rx}
* This predicted relationship between a supply elasticity and the variance of a component of the price series
is analogous to the link between the income elasticity of
consumption demand and the variances of permanent
and transitory income components which Friedman
(1957) observes. As will be seen in Section II, it works
in empirical testing in much the same way as well.
5
This particular characterization of the "shocks" to
the economy is not central to the theory, but to discuss

225
The relevant history of the economy
then consists (at most) of ynt (which fixes
calendar time), the demand shifts xt,
xt-i, . . . , and past actual real outputs
3>t-i, ^t-2, . . . . Since the model is linear in
logs, it is reasonable to conjecture a price
solution of the form:6
(9)

^t = T0 + *1St + T2*t-l + T,at_2 +

07
H

075

1 +07

(10)

+

•••+ i
. . . 4-

To solve for the unknown parameters
T,, tij and £0 we first eliminate yt between
(7) and (8), or equate quantity demanded
and supplied. Then inserting the right
sides of (9) and (10) in place of Pt and P t ,
one obtains an identity in \xt}, {yt}, and
ynt, which is then used to obtain the
parameter values. The resulting solutions
for price and output are: 7
Byh

1

1+07

1+

rational expectations formation at all, some explicit
stochastic description is clearly required. Independence
is used here partly for simplicity, partly because it is
empirically roughly accurate for most countries in the
sample. The effect of autocorrelation in the shocks
would, as can be easily traced out, be to add higher order
lag terms to the solutions found below.
6
This solution method is adapted from Lucas (1972),
which is in turn based on the ideas of John Muth.
7
If a demand function of the form yt—ZPt-\-xt had
been used, these solutions would assume the same form,
with different expressions for the coefficients. If £y^l,
however, xt is an unobserved shock, unequal in general
to observed nominal income. In this case, the model still
predicts the time-series structure (moments and lagged
moments) of the series yct and APt and is thus, in principle, testable. I have found empirical experimenting
along these lines suggestive, but the series used are
simply too short to yield results of any reliability.




6y

1 +07

In terms of APt and yct, and letting
ir = 6y/(l-\-dy), the solutions are:
(11)

Then P t will be the expectation of P t ,
based on all information except xt (the
current demand level) or:

— #t-i —
1 +07

(12)

yei = - wb + irAxt +

Xyc,t^

APt = - |3 + (1 - 7r)Axt + irAxt-i
— XAj r , t _i

Let us review these solutions for internal
consistency. Evidently, Pt is normally distributed about P t . The conditional variance of P t will have the constant (as
assumed) variance 1/(1+0Y)V*. Thus
those features of the behavior of prices
which were assumed "known" by suppliers
in subsection A are, in fact, true in this
economy.
To review, equations (11) and (12) are
the equilibrium values of the inflation rate
and real output (as a percentage deviation
from trend). They give the intersection
points of an aggregate demand schedule,
shifted by changes in xt, and an aggregate
supply schedule shifted by variables
(lagged prices) which determine expectations. In order to avoid the introduction of
an additional, spurious "expectations parameter," one cannot solve for this intersection on a period-by-period basis; accordingly, we have adopted a method
which yields equilibrium "paths" of prices
and output. Otherwise, the interpretation
of (11) and (12) is entirely conventional.
Not surprisingly, the solution values of
inflation and the cyclical component of
real output are indicated by (11) and (12)
to be distributed lags of current and past
changes in nominal output. A change in the
nominal expansion rate, Axt, has an immediate effect on real output, and lagged
effects which decay geometrically. The

226
immediate effect on prices is one minus the
real output effect, with the remainder of
the impact coming in the succeeding period. We note in particular that this lag
pattern may well produce periods of simultaneous inflation and below average real
output. Though these periods arise because of supply shifts, the shifts result
from lagged perception of demand changes,
and not from autonomous changes in the
cost structure of suppliers.
In addition to these features, the model
does indeed assert the existence of a natural rate of output: the average rate of demand expansion, 5, appears in (11) with a
coefficient equal in magnitude to the coefficient of the current rate, and with the
opposite sign. Thus changes in the average
rate of nominal income growth will have no
effect on average real output. On the other
hand, unanticipated demand shifts do
have output effects, with magnitude given
by the parameter TT. Since this effect depends on "fooling" suppliers (in the sense
of subsection A), one expects that T will be
T
larger the smaller the variance of the
demand shifts. We next develop this implication explicitly.
From the definition of w in terms of 6
and 7, and the definition of 0 in terms of
<r2 and r2 we have
r'y

V2oT

7)

Combining with the expression for a2 obtained above, this gives
(13)
7)

For fixed r2 and y, then, -K takes the value
7/(1+7) at ax= 0 and tends monotonically
to zero as <J\ tends to infinity.
The prediction that the average deviation of output from trend, E(yrt), is invariant under demand policies is not, of
course, subject to test: the deviations from




a fitted trend line must average to zero.
Accordingly, we must base tests of the
natural rate hypothesis (in this context)
on (13): a relationship (between an observable variance and a slope parameter.
II. Test Results
Testing the hypothesis advanced above
involves two steps. First, within each
country (11) and (12) should perform
reasonably well. In particular, under the
presumption that demand fluctuations are
the major source of variation in APt and
Vet, the fits should be "good." The estimated values of T and X should be between
T
zero and one. Finally, since (11) and (12)
involve five slope parameters but only two
theoretical ones, the estimated w and X
values obtained from fitting (11) should
work reasonably well in explaining variations in APt.

The main object of this study, however,
is not to "explain" output and price level
movements within a given country, but
rather to see whether the terms of the
output-inflation "tradeoff" vary across
countries in the way predicted by the natural rate theory. For this purpose, we shall
utilize the theoretical relationship (13)
and the estimated values of IT and at.
Under the assumption that T2 and 7 are
relatively stable across countries, the estimated 7T values should decline as the sample variance of Axt increases.
Descriptive statistics for the eighteen
countries in the sample are given in Table
I.8 As is evident, there is no association
8
The raw data on real and nominal GNP are from
Yearbook of National Accounts Statistics, where series
from many countries are collected and put on a uniform
basis. The choice of countries is by no means random:
the eighteen used are all the countries from which continuous series are available. The sample could thus be
broadened considerably by use of sources from individual countries. To obtain the variables used in the
tests, the logs of real and nominal output, yt and xt, are
logs of the series in the source. The log of the price level,
Pt, is the difference xt — > > yr.t is the residual from the
v
trend line vt = a-\-bt,fitby least squares from the sample

227
TABLE 1—DESCRIPTIVE STATISTICS, 1952-67

Country

Mean
Ayt

Mean
A/\

Variance
yct

Variance
A/\

Variance
Axt

Argentina
Austria
Belgium
Canada
Denmark
West Germany
Guatemala
Honduras
Ireland
Italy
Netherlands
Norway
Paraguay
Puerto Rico
Sweden
United Kingdom
United States
Venezuela

.026
.048
.034
.043
.039
.056
.046
.044
.025
.053
.047
.038
.054
.058
.039
.028
.036
.060

.220
.038
.021
.024
.041
.026
.004
.012
.038
.032
.036
.034
.157
.024
.036
.034
.019
.016

.00096
.00104
.00075
.00109
.00082
.00147
.00111
.00042
.00139
.00022
.00055
.00092
.00488
.00205
.00030
.00022
.00105
.00175

.01998
.00113
.00033
.00018
.00038
.00026
.00079
.00084
.00060
.00044
.00043
.00033
.03192
.00021
.00043
.00037
.00007
.00068

.01555
.00124
.00072
.00139
.00084
.00073
.00096
.00109
.00111
.00040
.00101
.00098
.03450
.00077
.00041
.00014
.00064
.00127

between average real growth rates and
average rates of inflation: this fact seems
to be consistent with both the conventional
and natural rate views of the tradeoff.
Since our interest is in comparing real output and price behavior under different time
patterns of nominal income, these statistics
are somewhat disappointing. Essentially
two types of nominal income behavior are
observed: the highly volatile and expansive
policies of Argentina and Paraguay, and
the relatively smooth and' moderately expansive policies of the remaining sixteen
countries. But if the sample provides only
two ''points/' they are indeed widely
separated: the estimated variance of demand in the high inflation countries is on
the order of 10 times that in the stable
price countries.
The first three columns of Table 2 summarize the performance of equation (11)
in accounting for movements in vrt. The
estimated values for T all lie between zero
and one; with the exceptions of Argentina
period. The moments given in Table 1 are maximum
likelihood estimates based on these series. The estimates
reported in Table 2 are by ordinary least squares.




and Puerto Rico, so do the estimated X
values. The R2s indicate that for many, or
perhaps most countries, important output-determining variables have been omitted from the model. The R2s for the inflation rate equation, (12), are given in
column (4) of Table 2. In general, these
tend to be lower than for equation (11),
and not surprisingly the estimated coefficients from (12) (which are not shown)
tend to behave erratically. Column (5) of
Table 2 gives the fraction of the variance
of APt explained by (12) when the coefficient estimates from (11) are imposed.
(A " —" indicates a negative value.)9
With respect to its performance as an
intracountry model of income and price
determination, then, the system (11)-(12)
passes the formal tests of significance. On
the other hand, the goodness-of-fit statis9
The loss of explanatory power when these coefficients are imposed on (12) can be assessed formally by
an approximate Chi-square test. By this measure, the
loss is significant at the .05 level for Paraguay only. As
Table 2 shows, however, this test is somewhat deceptive: for several countries the least squares estimates of
(12) are so poor that there is little explanatory power to
lose, and the test is "passed" vacuously.

228
TABLE 2—SUMMARY STATISTICS BY COUNTRY, 1953-67

Country
Argentina
Austria
Belgium
Canada
Denmark
West Germany
Guatemala
Honduras
Ireland
Italy
Netherlands
Norway
Paraguay
Puerto Rico
Sweden
United Kingdom
United States
Venezuela

Rl
.011
(.070)
.319
(.179)
.502
(.100)
.759
(.064)
.571
(.118)
.820
(.136)
.674
(.301)
.287
(.152)
.430
(.121)
.622
(.134)
.531
(.111)
.530
(.088)
.022
(.079)
.689
(-121)
.287
(.166)
.665
(.290)
.910
(.086)
.514
(.183)

-.126
(.258)
.703
(.209)
.741
(.093)
.736
(.075)
.679
(.110)
.784
(.110)
.695
(-274)
.414
(.250)
.858
(.111)
.042
(.183)
.571
(.149)
.841
(.096)
.742
(.201)
1.029
(.072)
.584
(.186)
.178
(.209)
.887
(.070)
!937
(.148)

tics are generally considerably poorer than
we have come to expect from annual timeseries models.
In contrast to these somewhat mixed results, the behavior of the estimated IT
values across countries is in striking conformity with the natural rate hypothesis.
For the sixteen stable price countries, it
ranges from .287 to .910; for the two
volatile price countries, this estimate is
smaller by a factor of 10! To illustrate this
order-of-magnitude effect more sharply,
let us examine the complete results for two
countries: the United States and Argen-




.018

.929

.507

.518

.914
—

.875

.772

.661

.936

.418

—

.812

.498

.282

.881

.130

—

.356

.016

—

.274

.521

.358

.847

.499

.192

.746

.934

.914

.711

.627

.580

.893

.633

.427

.568

.941

.751

.939

.419

—

.525

.648

.405

.394

.266

.115

.945

.571

.464

.755

.425

—

tina. For the United States, the fitted versions of (11) and (12) are:
yct = _ .049 + (.910)A.vt + (.887)yflt_i
A/\ = - .028 + (.H9)Axt + (.758)A*t_i
The comparable results for Argentina are:
yet = - .006 + (.011)A*t - (.126)yf,t-i
APt = - .047 + (1.140)A*t - (.083)A*t-i
In a stable price country like the United
States, then, policies which increase nomi-

229
nal income tend to have a large initial
effect on real output, together with a small,
positive initial effect on the rate of inflation. Thus the apparent short-term tradeoff is favorable, as long as it remains unused. In contrast, in a volatile price
country like Argentina, nominal income
changes are associated with equal, contemporaneous price movements with no
discernible effect on real output. These
results are, of course, inconsistent with the
existence of even moderately stable Phillips
curves. On the other hand, they follow
directly from the view that inflation
stimulates real output if, and only if, it
succeeds in "fooling" suppliers of labor
and goods into thinking relative prices are
moving in their favor.
III. Concluding Remarks

The basic idea underlying the tests reported above is extremely simple, yet I am
afraid it may have become obscured by the
rather special model in which it is embodied. In this section, I shall try to restate this idea in a way which, though not
quite accurate enough to form the basis for
econometric work, conveys its essential
feature more directly.
The propositions to be compared empirically refer to the effects of aggregate demand policies which tend to move inflation rates and output (relative to trend) in
the same direction, or alternatively, unemployment and inflation in opposite
directions. The conventional Phillips curve
account of this observed co-movement says
that the terms of the tradeoff arise from
relatively stable structural features of the
economy, and are thus independent of the
nature of the aggregate demand policy
pursued. The alternative explanation of
the same observed tradeoff is that the
positive association of price changes and
output arises because suppliers misinterpret general price movements for relative
price changes. It follows from this view,




first, that changes in average inflation
rates will not increase average output, and
secondly, that the higher the variance in
average prices, the less "favorable" will be
the observed tradeoff.
The most natural cross-national comparison of these propositions would seem
to be a direct examination of the association of average inflation rates and average
output, relative to "normal" or "full employment." Unfortunately, there seems to
be no satisfactory way to measure normal
output. The deviation-from-fitted-trend
method I have used defines normal output
to be average output. The use of unemployment series suffers from the same difficulty, since one must somehow select the
(obviously positive) rate to be denoted full
employment.
Thus although the issue revolves around
the relation between means of inflation
and output rates, it cannot be resolved by
examination of sample averages. Fortunately, the existence of a stable tradeoff
also implies a relationship between variances of inflation and output rates, as
illustrated in Figure 1. With a stable
tradeoff, policies which lead to wide variation in prices must also induce comparable
variation in real output. If these sample
variances do not tend to move together
(and, as Table 1 shows, they do not) one

Var(y c ,) ~ a 2 Var(AP t )

a
O

Stable Price Country
Volatile Price Ccruntry

FIGURE 1

230
can only conclude that the tradeoff tends
to fade away the more frequently it is
used, or abused.
This simple argument leads to a formal
test if the output-inflation association is
entirely contemporaneous. In fact, however, it involves lagged effects which make
a direct comparison of variances, as just
suggested, difficult in short time-series.
Accordingly, it has been necessary to impose a specific, simple structure on the
data. As we have seen, this structure accounts for output and inflation rate movements only moderately well, but well
enough to capture the main phenomenon
predicted by the natural rate theory: the
higher the variance of demand, the more
unfavorable are the terms of the Phillips
tradeoff.
REFERENCES
M. Friedman, A Theory of the Consumption
Function, Princeton 1957.
, "The Role of Monetary Policy,"
Amer. Econ. Rev., Mar. 1968, 58, 1-17.
D. F. Gordon and A. Hynes, "On the Theory
of Price Dynamics," in E. S. Phelps et al.,
Micro-economics of Inflation and Employment Theory, New York 1969.
R. E. Lucas, Jr., "Expectations and the Neu-




trality of Money," J. Econ. Theor., Apr.
1972, 4, 103-24.
-, "Econometric Testing of the Natural
Rate Hypothesis," Conference on the Econometrics of Price Determination, Washington 1972, 50-59.
and L. A. Rapping, "Real Wages,
Employment and the Price Level," / . Polit.
Econ., Sept./Oct. 1969, 77, 721-54.
and
, "Unemployment in the
Great Depression: Is There a Full Explanation?", /. Polit. Econ., Jan./Feb. 1972, 80,
186-91.
J. F. Muth, "Rational Expectations and the
Theory of Price Movements," Econometrica, July 1961, 29, 315-35.
E. S. Phelps, introductory chapter in E. S.
Phelps et al., Micro-economics of Inflation
and Employment Theory, New York 1969.
F. Raines, "Macroeconomic Demand and Supply: an Integrative Approach," Washington Univ. working paper, Apr. 1971.
A. Rees, "On Equilibrium in Labor Markets,"
/. Polit. Econ., Mar./Apr. 1970, 78, 306-10.
P. Taubman and M. Wilkinson, "User Cost,
Capital
Utilization
and Investment
Theory," Int. Econ. Rev., June 1970, 11,
209-15.
United Nations, Department of Economic
and Social Affairs, United Nations Statistical Office, Yearbook of National Accounts
Statistics, 66 and 68, New York 1958.

231
Mr. NEAL. Dr. Pierce, I just asked Dr. Meltzer if he found any
problems with the chart. I know you've had the opportunity to see
it before. Do you have any comments?
Dr. PIERCE. Well, I guess not, really. Charts are simple things,
and they have to leave out a lot of complexity, but the relationship
is there. However, one thing that has always bothered me is that if
one shifts two charts around long enough, maybe he can make them
match up, and the question is has one really unearthed an underlying behaviorial relationship in the economy or has he simply fooled
around long enough until he has found the appropriate pairing.
I guess my instincts and experience say it is a combination of the
two. There is a great deal of empirical evidence that says that there's
a relationship between monetary policy and inflation, and that's
borne out by the chart. There's also a great deal of evidence in the
statistical literature which says that economic time series tend to
have steady patterns in their behavior, so-called serial correlation in
them, and that two series can appear to be related even though behaviorally they are not. I think there is some of that problem in
that chart.
But I would have to say that the chart dramatizes something that
is very important to dramatize. There is a relationship between
monetary policy and inflation.
All I would counsel you against doing is inferring that every time
there is an expansion in money growth, that as night follows day we
are going to have inflation 2 years from now. I don't know of any
empirical evidence that allows one to make that assertion, because
all we have is average relationships. On the average, the economy
tends to be fairly highly employed, and if the economy is fairly highly
employed and we have an expansion in monetary policy, then the
only place that that increase in demand in the economy can go is in
terms of bidding up prices. So, on average, there should be a relationship between accelerations in money growth and acceleration in
prices, with a lag, because the economy tends toward full employment.
When the economy is not fully employed, then it doesn't follow
that if we have a relatively rapid money growth for, say, two quarters,
if we wait 2 years, we will observe prices going up. I reject that proposition theoretically and I reject it empirically. The important
lesson is, though, don't keep it up.
Mr. NEAL. Well, let me ask this question. Why raise it to any
significant degree at all?
Dr. PIERCE. Well, because monetary policy has two effects. It
affects prices, indeed, but it also affects production and employment
in the economy. And if production and employment are depressed,
then monetary policy can have an effect of increasing production
and employment in the economy. And the point I would make is so
long as there is a substantial amount of idle resources, that those
resources can be brought back to work without a large impact on
inflation provided that that stimulus is not continued after the
economy becomes more fully employed.
But it is because you're trying to employ the economy. If the economy is always fully employed, then there's no reason. If we could
ever get to what economists call equilibrium, and the economy was
going along at a nice steady rate, then there's every reason to believe
that money ought to grow at a steady rate. There'd be no reason to
deviate.




232
Mr. NEAL. Well, let me askDr. MELTZER. We ought to pursue that a little more.
Mr. NEAL. I do want to pursue that.
Last year was probably a pretty good example. The economy was
very poorly employed, and your recommendation might have been to
expand the money supply.
Now, it's my understanding that money growth has been adequate
recently, say, since we passed H. Con. Res. 133. Now if you increase
the money supply;, you're going to add to the pool of money available.
Dr. PIERCE. Right.
Mr. NEAL. Why would you add to the pool of money supply at
this time?
Dr. PIERCE. Well, I'm not sure that right now I would counsel a
rapid money growth. The reason I and some other people were counseling it several months ago is that the economy was badly depressed.
We made the mistake of basing our recommendations on past relationships in which it looked as though if we were going to get a 7-percent
or greater growth in real output, we were going to need a relatively
rapid growth in the money stock. Now, for once, the fates were kind
to us—to the economy, not to the people making these recommendations—and it turned out that it was possible to finance a fairly rapid
expansion without a very rapid money growth.
My reaction to that, after the fact, is fine. What I wanted to see
occur was & brisk recovery and it was accomplished. Recommendations
were made concerning correct Government policy, they turned out to
be in error. But that's one of the reasons that one looks not just at
the money stock in the short run. The economy was throwing off
information in terms of declining interest rates during the recovery
that not so much money growth was required. So it was possible to
have the expansion in the economy, declining interest rates and not
very rapid money growth. As soon as that information came in, along
with some others, then some people were led to say, well, that initial
prescription was wrong, we don't need as much money growth as we
thought.
And in trying to interpret short-run behavior of the economy, I
think it is a mistake to just look at one variable. A short-run situation
is too hard to interpret. If we're trying to interpret the sweep of history, then one can do an awful lot of simplification. One can say that
in every case we know of, if there's rapid money growth over a decade,
you'll get inflation over that decade. And so you don't have to know
a lot of the complexities. But if you're trying to give a prescription for
the next 2 months or the next two calendar quarters, then you have
to know more.
Now, there are uncertainties and there are potential errors in
short-term policymaking. Some people would say it's not worth trying
to do somewhat better by having more rapid money growth for a
while. Just stick to a steady path. And that may imply that the economy won't expand quite as rapidly as you would want, but it will
prevent errors on the other side being made of keeping the expansionary policy going too long, and I think that argument has merit.
My reaction in 1975 was that the economy was so depressed that
it was worth having a somewhat more rapid money growth for two
or three calendar quarters than a constant rate. But I certainly was




233

never one of these people who said we ought to have a 15-percent
money growth for 2 years and let's see what happens. I think that
would not be good advice.
Dr. MELTZER. May I just take up some of that issue?
Mr. NEAL. Sure. But first, I want to ask one more question.
That is, at that time, wasn't there an ample pool of money in the
economy?
Dr. PIERCE. Well, I never know how to react to questions of that
sort. I don't know what "ample" means.
Mr. NEAL. Well, more money relative to the demand for it, I
would say.
Dr. PIERCE. We^> yes, it turned out that that was the case, based
in part on the evidence of declining interest rates. The only way that
the public could be made to hold increased money balances was with
declining interest rates. So it was ample in that sense.
The more general issue is, was money growth ample relative to
what one is trying to accomplish. If one is trying to accomplish deceleration in inflation rates as rapidly as possible, then it was probably
over ample. If one's trying to accomplish as rapid a recovery as possible, it wasn't ample enough. So you really can't put much meaning
on terms like "ample" until one says what he's trying to accomplish
with the given monetary policy. It appears after the fact that the
monetary policy was a fairly good one. Before the fact if someone had
said we're going to have a 3-percent growth of money during the early
stages of recovery, people would have screamed. But it turned out to
have worked. But it still wasn't the right policy to recommend ahead
of time. It just happened to work out that time.
Mr. NEAL. Yes,

sir.

Dr. MELTZER. I'd like to separate out several issues that have come
up in the last few minutes. One is the question of looking at one
variable. I don't think that any serious economist argues that you
should only look at the money stock or the growth rate of money
stock for all purposes; there is capital, there's labor, there's the rate
at which people come into the labor force, there are many variables
important for judging what the near term prospect of the economy is.
What seems to me to be much more important is to think about
the problem as it occurs. As we look at the economy, there's always
room, ample room for doubt about what is going to happen. When we
look back at those charts, things seem crystal clear. That's the nature
of the problem that we face. Things are much easier to see with
hindsight than they are with foresight. In many cases our problem
is that we economists are trying to offer advice, prescriptions, that
are beyond what we can reasonably expect to deliver. That is how we
get into many of our problems. We try to do more than we reasonably
can do or know how to do.
We can improve the performance of economy. Perhaps we have
improved the performance of the economy to some extent over
the post-war period. But most of what we can do is give advice
that is useful for the average of the year or for the average of the next
2 years. That's the kind of advice that we can reasonably be expected to give. Recommendations that say, try to keep the money
supply growing at a relatively constant rate don't mean that it should
grow at 3 percent per year, hour by hour, minute by minute, but that
it ought to stay between 2 and 4 percent, a little bit faster during




234

periods when the economy is slack and a little bit slower during the
period in which the economy is inflating. That is the kind of thing that
an economist can reasonably expect to do. To go back to an earlier
question of yours and I believe of Mr. Hannaford's, if we had done
that in 1965, we would not have experienced many of the problems
in the economy that we have experienced since that time. We would
not have had to devalue the dollar; we would not have had a great
many of the effects that we experienced because of the effects of
devaluation on domestic prices, particularly commodity prices and
farm prices. We might have avoided some of the worst features of the
OPEC cartel because the cartel, in part, was a response to the fact
that the real price paid for oil fell during the sixties.
Why did we not stabilize in 1964 or 1965 or 1966? The answer is
because we were too ambitious. We thought we could run the economy
and avoid the kinds of problems that we ultimately ran into. That was
a bad forecast. Many of the errors that we have made since that
time have been the result of similar bad forecasts. We are, I think,
a more chastened breed now. We ought not to make the kinds of
forecasts now that we made 10 years ago, and that some people
made last year, which called for very, very stimulative policies based
upon a model that is not capable of bearing the burden that is placed
upon it.
The best example I can offer, and I will close with that, is to look
at the error we would have made if we had followed the advice of
people who said let us have 16 percent growth rate in the money
stock in 1975 on the basis of extrapolating responses from previous
work that they had done. We would now be experiencing an inflation
rate substantially higher than the 5 to 6 percent that we are currently
experiencing and we would be faced with the problem that we were
faced with in 1973 and 1974.
Mr. NEAL. Excuse me, Dr. Meltzer, I have got to go catch this
vote. I am sorry I have to leave at this point. I really do want to thank
you both for appearing before the subcommittee.
We are going to continue these hearings, and any advice you have
for us as time goes along would certainly be appreciated.
Thank you again.
[Additional material supplied for the record by Chairman Neal
follows:]
[From U.S. News & World Report, May 17, 1976]
WHERE THE ECONOMY GOES FROM H E R E
INTERVIEW WITH ARTHUR F. BURNS, CHAIRMAN OF THE FEDERAL RESERVE BOARD

Question. Dr. Burns, where does the economy of this country go from here?
Answer. If we have learned our lessons, an era of lasting prosperity is in
prospect.
Loose financial practices prevailed in our country from about 1965 through
1973 and into 1974. We first had speculation in corporate take-overs; then speculation in the stock market; later still, heavy speculation in the real-estate market
and, finally, speculation in inventories. And these speculative waves were partly
overlapping.
During this period, inflation got out of control, and a deep recession inevitably
followed. We're all, I think, a little wiser now than before. We realize that the
basic source of our inflationary problem was the tendency of the Federal Government to run large deficits, year in and year out. And we know that as a result
of this lack of financial discipline, the strength of our economy was undermined
and that a severe recession occurred.




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We now know that the business cycle is still very much with us; that fine tuning
of the economy is as yet an unattainable goal; that recessions are an ever-present
danger, and that a return to rapid inflation—if we allow that to happen—will
bring on new economic trouble, perhaps even greater trouble than we've gone
through recently. I see a mood spreading in our country to avoid this kind of
experience.
The Congress is now following new budgetary procedures. I think this is one of
the most promising developments that we've had in our country in a long while.
There also is a mood in the Congress at the present time to experiment with zerobase budgeting. That would be a very salutary step to take, and I believe it will
be taken before long.
We at the Federal Reserve are pursuing a moderate course of monetary policy.
We're firmly resolved not to permit money and credit to expand at a rate that
might release a new wave of inflation. Let there be no doubt about that.
A new mood is also spreading among private citizens. Our business people, our
bankers, even our trade-union leaders have learned a lesson. The recovery of our
economy is moving along in balanced fashion.
If we avoid the temptation to overstimulate the economy; if we realize—as
many people now do—that the current economic expansion has developed a momentum of its own; if we avoid any further governmental stimulation at this time
and prepare to apply some governmental restraint later on; if we keep all that in
mind, we may move into an era of lasting prosperity—an era that this country
deserves.
Question. How much danger is there that inflation will get out of hand again this
year or next?
Answer. I don't think there'*s much danger this year, but we'd better watch our
step next year.
Question. What do you mean?
Answer. Industrial raw-material prices have been advancing fairly briskly for
well over a year. And if you put aside erratic items such as foodstuffs and fuel,
wefindthat wholesale prices and consumer prices generally have been rising fairly
steadily at an annual rate of about 6 or 7 percent since the middle of last year.
Moreover, wage increases are still proceeding at a pace well above the rate of
increase in productivity. Some new collective-bargaining settlements are being
made with cost increases that average approximately 10 percent at an annual rate.
With wage costs rising and the economy continuing to advance, there is a fair
chance that price increases will multiply and we may have trouble on the inflation
front in 1977.
Question. Do federal deficits contribute to the danger of inflation?
Answer. With the economic advance gathering momentum, the Federal Government, unless it gets the budget deficit down sharply, will be adding to the inflationary danger.
What we have to do is to reduce the deficit, and we must also keep the growth
of money and credit at a moderate rate. That is the way to return to general
price stability. Unless we do that, inflationary expectations may worsen, and our
country would be headed for new and perhaps more serious trouble than we've
yet had.
Question. Do you mean another recession?
Answer. Yes. If we were to return to double-digit inflation, that recession
could be more severe than the one we've just gone through.
Question. Is there a chance that the recovery will be halted because the Federal
Reserve is restraining the availability of money and letting interest rates go up?
Answer. We're not restraining the availability of money. Pay no attention to
that kind of talk. The country is awash with liquidity.
You know, all this talk about the growth of money misses the point that what
is important about money, particularly in the short run, is the willingness to use
it—not the size of the stock of money or the rate at which the stock is growing.
Question. What's holding that back?
Answer. With confidence returning, nothing is holding back the willingness to
use money.
In fact, the turnover of existing money balances has been moving up at an
extraordinary pace. We've been able to finance a rapid economic expansion, along
with declining interest rates, with only a modest rate of growth of the money
supply. The basic reason is that confidence has returned. People are feeling better
about their future prospects and, therefore, are using their existing cash balances
more freely.




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Question. Is that true for corporations as well as individuals?
Answer. Sure. We all live in the same world.
Question. And you're afraid that a return to double-digit inflation would
destroy this confidence?
Answer. I don't think there is any doubt about that. Look at our own experience
in 1973 and 1974. Look at Great Britain and Italy today.
The three major countries that, by and large, have had the best economic
performance in the postwar period are the United States, Germany and Japan.
And the average inflation rate in these countries has been lower than in most of
the rest of the world.
Question. Many economists say the U.S. has a built-in inflation of around 5 or
6 percent a year. Do you agree with that?
Answer. I might set the figure a little higher than that—but, in any event,
the inflationary bias in our economy can and must be corrected.
Question. What should we be looking for in trying to figure out whether this
recovery will run beyond mid-1977?
Answer. We should be thinking of economic balance. The recovery thus far
has been well balanced except for a lag in business-capital investment, but there
are increasing signs that business-capital investment will experience a significant
expansion before this year is over.
We should be watching inventories. If inventories begin increasing rapidly
relative to sales, that could be a sign of trouble for the future.
We should certainly be watching the relation between costs of production and
prices. If we see the rate of inflation quickening, we should anticipate trouble a
year or two down the road.
If we see consumer credit expanding at a rate that is well above average, that
may be a sign that consumer spending particularly for durable goods, will turn
sluggish before long.
In short, we have to watch numerous indicators and try to judge whether reasonable balance is being maintained among the major economic factors.
Question. How do you as an economist decide whether any major segment of the
economy is getting out of balance?
Answer. Well, being a student of the business cycle, I've made a study of historical patterns: what the typical experience has been during previous businesscycle expansions. If the economy is deviating fairly significantly from those norms,
that gives me some clue to the future.
Question. Is there a minimum rate of inflation which is sustainable over a very
long period of time?
Answer. I doubt it. We should aim at price stability—that is, a zero rate of
inflation. If we set as our goal a rate of inflation of 2 per cent or 3 per cent a year,
as some have suggested, we will exceed that figure and get into trouble again.
Question. Is is politically possible tp put an end to inflation altogether?
Answer. I think we should strive for it.
Question. Would some form of guidelines or incomes policy be helpful in fighting
inflation?
Answer. I would not like to see a return to mandatory price and wage controls.
They rarely work well, even for a short period, and they never work well for a long
period.
I would, however, be inclined to breathe a little more life into the present
Council on Wage and Price Stability by giving it the authority to delay proposed
price and wage increases for a short period—perhaps 30 to 45 days.
I would hope that such a Council would limit its activity to price and wage
increases in key industries. It could hold public hearings, make recommendations
and follow them up to see if they're being observed. But it should not go beyond
that.
Question. Wouldn't mandatory wage-price controls be the next step?
Answer. I would consider that a very long step. We don't have to take it, I
wouldn't want to take it, and I hope we never take it.
Question. What's the real obstacle to getting rid of inflation?
Answer. I think it's mainly a political and psychological problem. The main
source of inflation is the tendency of modern governments to expand their outlays
at a rapid rate in response to incessant demands from the electorate.
Governments nowadays try to solve almost every economic and social ill by
spending money. With expenditures increasing faster than revenues, our own
Government has been persistenly paying out a great deal more to the public
than it takes in from the public by way of taxes.




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In the past 10 years, including the fiscal year that is just coming to a close, the
accumulated deficit under the unified budget comes to something like 220 billion
dollars. If you add in the off-budget outlays and the outlays of Governmentsponsored enterprises, as I think you should, the accumulated deficit comes to
about 300 billion dollars.
This has been the main cause of our inflation since the mid-60s.
Question. What happened to the idea that these massive deficits would soak up
all the available capital in the country and make it difficult for business to finance
needed investments in new plant and equipment?
Answer. That's an unfinished story.
The demand for bank credit by private enterprises diminished during the past
year. A lot of business corporations permitted their inventories to run down;
their profits, meanwhile, were improving.
Furthermore, they were able to borrow substantial sums in the capital market
and to float stock issues in large volume. So the pressure for bank loans that many
people expected did not develop.
With the economy continuing to expand and with the Federal Government
still running a huge deficit—having to borrow almost as much this calendar year
as it borrowed in 1975—there could be some "crowding out" before long. The
best way to avoid that, or to minimize this danger, is to reduce the budget deficit
sharply.
Question. Has the Federal Reserve taken steps to tighten credit?
Answer. We have modified our monetary-growth targets very slightly.
However, I have no way of knowing whether the money supply will increase
less rapidly in the months ahead than in the preceding months. What the Federal
Reserve has indicated is simply this: The recovery has now been running for a
full year. We're looking ahead to another full year of expansion, and a slight
reduction in the rate of growth of the money supply would thus be logical. Whether
that will actually occur or not is still uncertain. Our projections for the monetary
aggregates are specified as ranges. Over much of the past year, we've been well
below the lower limit of the range. It is hard to say where we will be three months
from now or a year from now.
Contrary to widespread opinion, our control over the money supply is quite
limited over short periods.
Question. We get the impression from bankers that there is plenty of money
for loans. Is that the way you see it?
Answer. I would agree with that. As I've said, this country is awash with
liquidity.
Question. When you announced a slightly lower money targets for the Federal
Reserve, you added that "further downward adjustments will be needed." Does
that mean we can look for slower monetary growth and higher interest rates later
this year?
Answer. What I had in mind is that if we're ever to regain general price stability
in our country, the rate of growth in currency and demand deposits, instead of
being in the 4*4 to 7 percent zone, will eventually have to come down to something
like 1 or 2 percent a year. That is something we should strive for, not this year
but gradually over the next few years.
Question. WTould you say the bond market found your policy statement reassuring?
Answer. Yes. They're sensible people.
They regard the Federal Reserve as a thoroughly responsible institution. They
know that we will act cautiously, and that nothing we have said or done threatens
the stability of the bond market.
Question. Does your policy imply that short-term interest rates have seen their
lows for the foreseeable future?
Answer. Not necessarily. We have merely signaled an intention to pursue a
monetary policy that will prevent any re-igniting of inflationary fires in this
country.
WHY INTEREST RATES COULD FALL

Question. Are higher interest rates to be expected as the recovery progresses?
Answer. All that I can tell you is that, historically, interest rates have moved
with the business cycle, tending to rise during periods of business-cycle expansion
and to decline during periods of business-cycle contraction.
Experience thus far in the present upswing of the economy has been unusual.
Interest rates, instead of rising, have actually come down during the past year.
73-959 0—76




16

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As for the future, I would not venture a prediction. But I would not lose sight
of the fact that history has something to teach us. Nor would I lose sight of the
fact that recent experience, which deviates from historical patterns, also has
something to teach us. Actually, I think that once people become fairly convinced
that the rate of inflation not only has come down but is going to stay down—once
this conviction spreads and grows among the people—very powerful forces making
for lower interest rates will come into being particularly in the long-term market.
Question. Are fiscal and monetary restraint all that is needed to curb inflation,
or are there other things that ought to be done?
Answer. There is also a range of structural policies that we need to follow. Far
too much attention is given to monetary andfiscalpolicies, while structural policies
are neglected.
Question. What kind of policies are you talking about?
Answer. The concept is very broad. Let me give you a few examples. First of all,
we need to improve productivity in our country. The trend of productivity has
flattened out, partly because people aren't working as hard as they used to.
Question. How can that be improved?
Answer. One way of improving the trend of productivity is to stimulate greater
investment in modern equipment. More modern facilities will help to enlarge the
output per man-hour.
As for getting people to work harder, there are habits that will have to be
changed. We still have featherbedding in many industries. Absenteeism has been
increasing. So have the number of holidays and the length of vacations, the
frequency of coffee breaks and their duration. These are habits that can be
changed.
"SLOW THE PACE" OF COSTLY PROGRAMS

Question. In addition to greater productivity, what other changes are needed?
Answer. Environmental and safety programs have been pushed very intensively
in the last few years, and they've been running up costs in numerous industries.
Without giving up our environmental and safety objectives, we can slow down
the pace at which we expect progress in those areas.
Next, we ought to try to increase employment and reduce unemployment by
changing some of our labor-market policies and not rely so heavily on expansionary
fiscal or monetary policies.
Question. What do you have in mind there?
Answer. One way would be to cut back on our unemployment-insurance programs.
They've become too liberal. Many people now are able to draw unemployment
insurance for a period of 65 weeks. Such a long duration tends to increase the
unemployment rate, as various studies have indicated.
Moreover the minimum wage ought to be reduced for teen-agers, many of
whom are being priced out of the labor market.
We didn't have a serious teen-age unemployment problem before the federal
minimum wage was enacted. Japan doesn't have any teen-age unemployment
problem now. In Japan, youngsters are underpaid relative to their productivity,
and therefore the demand for teen-age labor exceeds the supply. In our countrj^,
we have just the reverse.
We've also talked for years about establishing computerized job banks, so that
the labor market would be better organized and fractional unemployment could be
reduced. But we haven't done this on the scale that modern technology makes
possible.
Question. Should the Federal Government hire the unemployed?
Answer. Well, if it were to do it my way
Question. What's your plan?
Answer. You know, we've had debates for many years about what rate of
unemployment corresponds to full employment, and all kinds of numbers are
bandied about. To my mind, we as a nation should be aiming literally at a zero
rate of involuntary unemployment. To accomplish this, besides encouraging
private enterprise and investment, the Federal Government may need to serve as
the employer of last resort.
The wage paid by the Government, however, should not be so attractive as to
blunt incentives to find a job in private industry. The wage that would be appropriate for this purpose, I think, must be somewhat below the minimum wage.
I say that because we have something like 7 million people in our country who,
at the present time, are working in the private sector at a wage equal to or below
the minimum. If the Federal Government, acting as the employer of last resort,




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were to pay more than the minimum wage, there could be a large exodus of individuals from private employment into governmental work. That, I think, would
weaken private industry and burden the Government and taxpayers unduly.
Question. Does your concept envision taking many people off relief and forcing
them to take jobs?
Answer. Yes, it does. And it also calls for reducing drastically the length of
time that an individual could draw unemployment insurance. I've suggested a
period of 13 weeks.
Question. Is the country ready for that?
Answer. No, I don't think it is. Conservatives are afraid of it because they
fear that reliance upon Government would become even greater than it is at the
present time, and that budget expenditures would grow if such a responsibility
were assumed by the Federal Government. Liberals are opposed to my scheme
because they would like to have the Government pay prevailing wages, or something close to that.
However, I wouldn't be surprised if a plan such as mine received increasing
support 5 years from now or 10 years from now or 20 years from now.
The character of our society has changed. Ours is now an urban society. Very
few of us have folks back on the farm with whom we could stay and live for a
while. And family life is no longer as close, as intimate, as it once was. People
live preponderantly in cities, and many lead lonely lives.
When an economic society reaches a state such as that, the Government—in
the interest of the general welfare and in the interest also of economic and political
stability—should seriously consider undertaking the responsibility of becoming
an employer of last resort.
It should do so, however, in a manner that will respect free private enterprise
and in a manner that will not burden the federal budget.
I think if my scheme were applied, the added cost to the Government might
well be nil, because there would be large savings in welfare payments, unemployment-insurance payments and the like.
Question. Is it possible that your scheme would eventually run out of control
as Congress came under pressure to raise the wages for these Government jobs?
Answer. Yes, there is. The wage paid by the Federal Government might be
below the minimum at first, but then be increased year after year through congressional action. Congress has been known to do things like that. Conservatives
fear this, and rightly so.
To prevent such a "development," we might need a constitutional amendment
providing that, when the Government is acting as an employer of last resort,
this special wage would be linked irrevocably to the minimum wage.
ENERGY PLANS! BIG TALK, LITTLE RESULT

Question. Dr. Burns, do you think the U.S. still needs to worry about an
energy problem?
Answer. I think this country has a very serious long-range energy problem.
We've talked a great deal about energy independence, but we've done very
little about it.
As things stand now, this country is at the mercy of what a few foreign countries
may decide to do about the price of oil or about the amount of oil they are willing
to sell us. Our dependence on oil imports is growing, while our production of oil
and natural gas is declining. We are enjoying ourselves once again without
worrying about queues at the gasoline stations.
Question. Would you favor imposing quotas to hold down our imports of oil?
Answer. I wouldn't favor quotas, but I would favor building up our energy
resources. And I would favor businesslike negotiations at the financial, economic
and political level with the oil-producing countries in the Middle East and elsewhere.
I don't think we can count on being secure, militarily or economically, unless
we attend to the energy problem.
Question. How can we build up our energy resources?
Answer. I'm not an expert in this area. But we have enormous amounts of coal
available. Also, other countries in the world are making faster progress in utilizing
nuclear power than we are. And there are all kinds of sophisticated new energy
possibilities.
I think we've got to take our chances with new technology and be willing to
make some investment in it.




240
Question. Should the Federal Government subsidize such development along the
lines of Vice President Nelson Rockefeller's plan, which would establish a 100billion-dollar federal corporation?
Answer. I would be willing to subsidize it, yes, but not on the scale suggested by
Mr. Rockefeller.
And I certainly would want to finance any subsidy through the regular budget
and avoid off-budget financing, which, I believe, was a part of the scheme originally
advocated by the Administration.
Question. Are you concerned about the impact on our trade balance of the rising
oil imports.
Answer. Fortunately, the position of the dollar is very strong at present. I
think we can reasonably count on its remaining strong for some time, but not
indefinitely.
If our imports of oil should continue to rise rapidly, as will happen if we continue
to be careless in our use of oil, that could well leave its mark eventually on the
value of the dollar in exchange markets.
Question. What, if anything, should be done to make more funds available to
industry for capital investment?
Answer. I think that changes in tax policy could be very helpful. We tax our
corporations more heavily than many countries around the world.
I would like to see the corporate income-tax rate reduced, the capital-gains
tax reduced, and double taxation of dividends diminished. Measures of this sort,
I think, would be helpful in stimulating capital investment.
Question. Should oridinary individual income taxes be reduced?
Answer. I'd like to see all kinds of taxes reduced, but we can reduce taxes
responsibily only if we reduce Government spending.
Question. Dr. Burns, are the nation's banks stronger today than they were during
the recession?
Answer. It's undoubtedly true that during the early 1970s many of our banks,
particularly the large banks, shared in the euphoria that spread through the
business community. I went to Honolulu in October, 1974, and lectured the American Bankers Association on some of the carelessness that had crept into banking
practices.
I must say that within the past year and a half, I have found no need to lecture
the bankers. They have mended their ways. We have better management in our
banks now than we've had in some years. The bankers have learned their lesson.
Banks around the country have improved their liquidity position dramatically
within the past year. Their reliance on volatile funds has diminished. Their
capital position has improved. They've put aside huge sums in the form of reserves
to cover loan losses. And in spite of that, their profits in 1975 were somewhat larger
than during 1974.
So our banking system is sound, improvements are taking place within it, and
our banks are well prepared to finance economic expansion.
Question. When you lectured the bankers, did you fear there would be failures
among the big banks?
Answer. I had some fears that, unless bankers mended their ways, some very
troublesome situations could develop. But bear this in mind:
We've had only a small number of bank failures in our country in recent years,
although two or three of these failed banks were quite large. During the 1920s
and early 1930s, by way of contrast, some 12,000 banks failed. Moreover, the few
bank failures that we've had recently have not resulted in losses to depositors.
The banks continued to do business under a new arrangement, and bank-customer
relationship were maintained.
So our banking system has been tested very severely in the course of the recent
recession—the deepest since the 1930s—and the test has been well met.
ON LOANS ABROAD, "RECORD IS GOOD"

Question. Are you worried about the loans American banks have made to
underdeveloped countries?
Answer. Thus far, losses in connection with loans made to foreign enterprises
or foreign governments have been much smaller than losses on loans made to
domestic borrowers. Some of those foreign loans are made to American enterprises
operating abroad.
As for loans to foreigners, a foreign government that has borrowed abroad and
has permitted its business firms to borrow extensively abroad has a strong stake




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in maintaining its reputation. Even when interest payments are difficult to meet,
a serious effort is made to keep payments current so that the reputation of the
country for financial integrity will not suffer.
The record so far is good. That doesn't mean it will necessarily remain good.
This is an area where I feel that our banking firms should be very cautious, since
their loans abroad have grown to very large sums.
One of the secrets of good banking is balancing your portfolio. Too large a fraction of loans made to the less developed countries—or to any single category of
borrowers—could be an invitation to trouble. This is something that our bankers
are aware of, and I think they are pursuing more prudent policies now than they
did two or three years ago, or even a year ago.
[From the Washington Post, May 13, 1976]
T H E COMING PROBLEM OF INFLATION

(By Hobart Rowen)
Economic recovery has been moving along at a fast pace, and has now reached
a point where it can properly be called an expansion. Not a boom, mind you,
but a solid expansion.
No one takes greater satisfaction in the fast step-up in economic activity and
the sharp step-down in the rate of inflation than Federal Reserve Board Chairman
Arthur F. Burns.
Burns was not at all immodest in testimony before the House Banking Committee a few days ago in claiming that the Federal Reserve is entitled to a good
deal of credit. The Fed stubbornly resisted demands last year that a faster rate of
monetary growth was needed to stimulate recovery.
It is hard to argue with him. Burns and the Fed were right, and almost everybody else was wrong. Even Ford administration officials, who feared at the beginning of 1976 that money supply growth was too low, are ready to admit that
on this one Dr. Burns called the turn.
On the basis of past performance, Burns' forecast for what lies ahead deserves
close attention. He predicts, first of all, no letup "as yet" in the pace of expansion.
Financial market conditions remain favorable for a continuing upturn, he says.
Interest rates have been edging down, even for mortgage loans, which is a fillip
for the still depressed homebuilding industry.
Banks have been lowering the prime lending rate, with the First National City
Bank dropping its charge to best customers to 6.5 per cent. That's a far cry from
the peak of 12 per cent in mid-1974, and should encourage business borrowing.
Meanwhile, the Fed chairman notes, stock market prices have soared, which
not only makes everybody feel better, but makes it easier for companies to raise
funds, or build "equity cushions."
Even the banks that got overextended in the 1970's permitting "their financial
condition to deteriorate," are in better shape and have been giving "greater
attention to prudent management," Burns assures us.
Consumer confidence, evidenced by a faster pace in the sales of autos and other
goods, has improved. And there are signs of a "quickening tempo" of activity
in the sluggish capital goods industry.
It is not a perfect economic picture that the cautious Arthur Burns sketches.
The unemployment rate looks uncomfortably static at 7.5 per cent. But the general
condition of the economy is considerably better than it was just a few months
ago, and much perkier than anyone thought it would be at this stage.
Private economists agree with Burns. "So far," says economist Beryl Spinkel
of the Harris Bank and Turst Co. of Chicago, "it's a moderate recovery. The rise
is somewhat slower than the recovery from the 1957-58 downturn, and I'm glad
it is."
Otto Eckstein of Data Resources Inc., agrees with Burns that recovery is solid.
In fact, he predicts that the first quarter real GNP growth rate of 7.5 per cent
assures significant additional gains for the rest of the year, with 6.9 per cent for
1976 as a whole.
Jimmy Carter's chief economic adviser, Lawrence R. Klein of the Wharton
School, sticks to a 6.2 per cent real GNP forecast for this year, but sees a much
faster recovery in jobs, with consequent added pressure on prices.




242
Thus, the big imponderable ahead may be the course of prices. No one seems
to believe that the extremely low annual inflation rate of the first quarter (around
3 per cent) can last very long.
Sensitive raw materials prices have been creeping upward. In the absence of
any meaningful government policy on wages and prices, big increases in wholesale metals prices are now working their way through the system, and will be
reflected later in consumer goods prices.
Burns decided, as a matter of insurance, to try to nudge latent inflationary
pressures down by reducing monetary growth targets a fraction. This may or
may not make an actual difference, as experience both in this country and West
Germany shows.
The way the economy is acting suggests that one bread-and-butter issue
for the Democrats in the fall may be an inflationary bubble. True, it's not going
to be a double-digit nightmare. But as the administration has made clear about
unemployment, it's not the level but the trend that counts.
[From Newsweek magazine, June 2, 1975]
CONGRESS AND THE FEDERAL RESERVE

(By Milton Friedman)
Two recent events have produced a major change in the structure of monetary
policy—perhaps the most important change since the banking acts of the mid1980s. These are a joint Congressional resolution on monetary policy and the
testimony by Federal Reserve chairman Arthur Burns in response to the resolution.
House Concurrent Resolution 133, sparked by Senators William Proxmire,
Hubert Humphrey and James Buckley, has two provisions expressing "the sense
of Congress": one, which is of minor and passing importance, that the Fed "pursue
policies in the first half of 1975 . . . appropriate to facilitating prompt economic
recovery"; the second, which is of major and potentially permanent importance,
that the Fed "maintain long-run growth of the monetary and credit aggregates
commensurate with the economy's long-run potential to increase production."
CONCURRENT RESOLUTION

The resolution has no teeth. It simply provides that the Fed "consult" Congress semiannually about its "objectives and plans" for monetary growth and
"report to the Congress the reasons" for any subsequent departure from those
objectives.
Though superficially innocuous, the resolution represents the first time since
the Fed began operation in 1914 that Congress has (1) specified monetary and
credit aggregates as the Fed's immediate target, (2) enjoined it to produce steady
monetary growth in line with output growth, (3) required it to state its objectives
publicly in advance, and (4) required it to justify publicly any departure from
them. All four elements are major changes. The Fed has shifted among alternative targets—monetary aggregates, interest rates, exchange rates; it has produced widely varying rates of monetary growth; it has never specified long-range
numerical objectives and has decided its short-term objectives in camera, making
them public only long after the event; it has reported to Congress in vague terms
that have resisted strict accountability.
Even if the Fed chooses precisely the same objectives under the new procedure
as it would have chosen under the old, the requirement that it state them publicly
in advance and justify failure to achieve them makes it far more likely that they
will be achieved. In the past few years, the Fed has erred less in the monetary
objectives it has chosen than in its unwillingness to make the changes in its
methods of operation required to achieve them.
CHAIRMAN BURNS' TESTIMONY

Burns' testimony is noteworthy for both its spirit of wholehearted cooperation
with the Congressional initiative, and its content.
Burns specified the Fed's objective for the "twelve months from March 1975
to March 1 1976" as an increase of 5 to 7}i percent for Mx currency plus demand
deposits). As he said, "this is a rather high rate of expansion by historical stand*For other aggregates, he listed increases of 8% to 10% per cent for MQ, 10 to 12 per
cent for Ma, and 6% to 9% per cent for the credit proxy.




243
ards." I would prefer a lower rate. But it is more moderate than many critics
have been demanding, and, given both the abnormally low rates of monetary
growth in the prior six months and the severity of the recession, tolerable if not
long continued.
Chairman Burns recognized explicitly that these "rates of growth in monetary
and credit aggregates . . . could not be maintained indefinitely without running
a serious risk of releasing new inflationary pressures." In my opinion, these rates
would produce a long-run rate of inflation of some 6 or 7 percent a year and a
decidedly higher interim rate. I therefore applaud his statement that "as the
economy returns to higher rates of resource utilization, it will be necessary to
reduce the rate of monetary and credit expansion." This conclusion is entirely
consistent with the concurrent resolution's emphasis on "long-run growth . . .
commensurate with the economy's long-run potential to increase production"—
which implies roughly a 2 to 4 percent a year growth rate for M^
I have long feared that continuation of past patterns of monetary behavior
would produce an overreaction to the current recession, which would reignite
inflation by 1977 or so. On past performance, that is certainly the most likely
outcome. But these recent actions by Congress and the Fed give at least some
reason to hope that the lessons of the past have been learned and that a new
day has dawned for the Fed and for the country.
[From the Wall Street Journal, May 19, 1976]
A VOTE FOR TODAY'S SYSTEM

(By Allan H. Meltzer i)
The rate of increase of consumer prices in the United States has fallen, gradually,
from nearly 14% in mid-1974 to an average rate of about 6% for the past six
months. Some further reduction in the average rate of inflation is likely to occur
in 1976.
Experience in the rest of the world covers a wide range. Some countries substantially reduced the rate of price increase; in others the rate of increase remained high. During the year 1975, consumer prices rose by more than 20% in
Britain, by approximately 10% in France, Italy and Canada, and by 5% or less
in Germany and Switzerland.
Why are the rates of price increase in these countries so different? Why is inflation no longer proceeding at high or rising rates everywhere? Why have some
countries succeeded in reducing inflation where others have failed?
The answer to these questions is surprisingly simple. Government policies
toward inflation have differed. Some countries recognized inflation as mainly a
monetary phenomenon, the result of too much money in circulation, and took
effective action to control inflation. The countries that now have the lowest
rates of inflation—Switzerland, Germany and the United States—are the same
countries that changed their approach to monetary control. Each of the countries
has, in its own way, chosen a target rate of increase in money. Each has managed
to keep the growth rate of money close to the announced target.
Where the rate of growth of money has been reduced, the rate of inflation has
been reduced. Where monetary growth has been kept at a high rate, the rate of
inflation has remained high or has increased.
THE BRITISH EXAMPLE

Britain is an outstanding example. During the past year most countries experienced less inflation, but Britain experienced more. British consumer prices rose
by 16% in 1974 and by more than 20% in 1975. Even Italy, with its severe
political, social and economic problems, was able to slow inflation, to reduce
the rate of increase in consumer prices from 1974 to 1975. But Britain did not.
Economists differ about why inflation starts and about how inflation can be
reduced and ended. For decades influential British economists argued that it was
unnecessary to control the rate of monetary expansion. Some argued that the
way to end inflation was to stimulate the economy by government policies that
create jobs and output. By increasing output they hoped to lower prices or the
iMr. Meltzer is Maurice Falk Professor of Economics and Social Science, CarnegieMellon University. This article is adapted from a speech given before the American
Society of Newspaper Editors.




244
rate of inflation. Contrary to experience everywhere they sought to end inflation
by stimulating the economy.
The result was predictable, and both the predictions and the results are part of
British history. Inflation increased. An economically weak Britain became weaker.
Programs similar to those that failed in Britain are advocated and at times
adopted here. We followed the British into stop and go policies—policies to stimulate the economy today and take care of the inflation tomorrow. We achieved
more inflation and currently have more unemployment. We followed the British
and other Europeans in attempting to control inflation by using government
intervention in wage and price disputes. Inflation did not stop. It increased.
The policies of the past year and the results they achieved are a means of
discriminating between the differing opinions about the causes of inflation and the
means of ending inflation. Some prominent economists urged rates of monetary
expansion in 1975 as high as 16%, and a rate of monetary growth of 10% in 1976.
Thejr argued that with unemployment high, strong stimulus would reduce
unemployment and reduce inflation.
If we had adopted very expansive policies we, like the British, would have
experienced rising inflation in 1975 and 1976. Instead of a falling rate of inflation,
we would now have a rising rate of inflation.
The marked difference in countries' experience with inflation during 1975 and
1976 is not a unique event. Recent experience is only a repeat of the expereince
of the late forties with a change in the roles chosen by the governments of particular countries. Then, and now, the countries that promptly reduced the rate of
monetary growth ended inflation promptly. Countries that experimented with
controls on prices and wages, with restrictions on credit or that engaged in fine
tuning of taxes and government spending continued to experience inflation.
No sustained inflation has ever been ended until the growth rate of money has
been reduced. Inflations at the end of World War II, after the Korean war, and in
other times and places were ended by controlling money. The experiences of the
past two years are in this respect consistent with the past.
Why can't we fight inflation? I will answer not only that we can, but we have.
Barring some new shock like the oil price increase, a crop failure, or a war, we can
expect the economy to approach full employment in about two years if government policies are less erratic in the future than in the past. We cannot expect,
however, to reach full employment without inflation. In this respect, as in so
many others, government promises and performance differ.
Ending inflation means bringing the average rate of price change, properly
measured, to zero. We are fighting inflation. Inflation has been reduced, but we
will not end inflation unless we change some government policies and continue
others.
I believe we can end inflation in the next few years. To do so, we must adhere
to four principles of economic policy.
REDUCE GOVERNMENT GROWTH

First, we must continue the present international monetary arrangement
known as the fluctuating exchange rate system. Under the fluctuating rate system,
we rely on the market and not on governments to determine the current exchange
value of our currency. The exchange value of the dollar fluctuates, rising with
increases in the demand for dollars and falling when we speed up the printing
press and increase the supply of dollars. The fluctuating exchange rate protects
us against inflationary (or deflationary) economic policies abroad. If foreign
governments adopt policies more inflationary than ours, and many foreign
governments have, the fluctuating dollar helps us to avoid inflation. We are
freer to pursue stable prices.
Second, we must reduce the growth of government. A high growth rate of
government transfers spending from private to public hands, and reduces efficiency. Growth of public employment transfers skilled labor from more productive
to less productive activities and slows the growth of the economy. Government
regulation absorbs skilled personnel in countless wrangles with the bureaucracy,
increases uncertainty and deters investment. But the principal effect of a growing
public sector on inflation is not from the loss of efficiency and growth. A rising
government budget creates strong pressure to finance the government by printing
money. Our current inflation began when we tried to finance war and social
programs in the middle sixties without raising taxes. Despite a 400% increase
in the federal budget, in little more than a decade, costs of social programs continue to increase and the problem of financing the budget without increasing
taxes remains a force for inflation.




245
Third, we must continue to reduce the growth rate of money gradually. Between
1973 and 1976, the rate of monetary growth has been lowered from 9% to about
5%. This reduction is the most important force working to reduce present and
future inflation. During the next two or three years, the rate of monetary expansion must be brought, gradually, to about 3%. Once we fully adjust to the lower
rate of growth in money, the economy will be at full employment without inflation.
Fourth, we must avoid price and wage controls and government interference
in price and wage decisions.
Let me summarize the program. (1) Maintain fluctuating exchnage rates.
(2) Reduce the growth rate of government. (3) Gradually slow the rate of monetary growth. (4) Avoid controls.

[Whereupon, at 1:10 p.m., the subcommittee recessed subject to
the call of the Chair.]




o