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Open Market Policies and Operating Procedures-Staff Studies




BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM




Library of Congress Catalog Card Number 72-611769
C o p ie s o f th is p a m p h le t m a y b e o b ta in e d fr o m P u b lic a tio n s
S e r v ic e s , D iv is io n o f A d m in istr a tiv e S e r v ic e s , B o a r d o f G o v ­
ern ors o f th e F e d e r a l R e s e r v e S y s te m , W a s h in g to n , D .C .
20 5 5 1 . T h e p r ice is $ 2 .0 0 p e r c o p y ; in q u a n titie s o f 10 o r
m o re s e n t to o n e a d d r e ss, $ 1 .7 5 e a c h . R e m itta n c e s h o u ld
b e m a d e p a y a b le to th e o r d e r o f t h e B o a r d o f G o v e r n o r s o f
th e F e d e r a l R e s e r v e S y ste m in a fo rm c o lle c tib le a t p a r in
U .S . c u r r en cy . (S ta m p s a n d c o u p o n s n o t a c c e p te d .)

P U B L I S H E D I N J U L Y 1971

The staff studies included in this book
were prepared as part of a study of the
policies and operating procedures im ­
plicit in the policy directives of the Fed­
eral Open Market Committee. These stu­
dies represent the views of the individ­
ual authors and should not be attributed
to either the Federal Open Market Com­
mittee or individual members of that
Committee.
The role of monetary aggregates and
of money market conditions in the decision-making process of the FOMC and
in the day-to-day conduct of open market
operations is described in an article,
“Monetary Aggregates and Money Market
Conditions in Open Market Policy,” which
appeared in the Federal Reserve B u lletin
for February 1971. This article is reprinted
here as an appendix.







THE FOMC DIRECTIVE AS
STRUCTURED IN THE LATE 1960’s:
THEORY AND APPRAISAL
Stephen H. Axilrod
SHORT-RUN TARGETS FOR OPEN
MARKET OPERATIONS
Richard G. Davis
SELECTION OF A MONETARY
AGGREGATE FOR USE IN THE FOMC
DIRECTIVE
Leonall C. Andersen
DETERMINING THE OPTIMUM
MONETARY INSTRUMENT VARIABLE
John Kareken, Thomas Muench,
Thomas Supel, and Neil Wallace
THE TRADE-OFF BETWEEN SHORTAND LONG-TERM POLICY GOALS
James L. Pierce
TACTICS AND STRATEGY IN
MONETARY POLICY
Benjamin M. Friedman
RULES-OF-THUMB FOR GUIDING
MONETARY POLICY
William Poole
APPENDIX:
MONETARY AGGREGATES AND
MONEY MARKET CONDITIONS IN
OPEN MARKET POLICY
Stephen H. Axilrod







by Stephen H. Axilrod




THE FOMC DIRECTIVE AS
STRUCTURED IN THE
LATE 1960’s: THEORY AND
APPRAISAL

CONTENTS




3

INTRODUCTION

3
3
5
8

STRUCTURE OF THE DIRECTIVE
Nature of first paragraph
Operational elements in the second paragraph
Role for Manager’s judgment

9

FUNCTION OF MONEY MARKET
CONDITIONS AS AN OPERATING GUIDE
Day-to-day role of free reserves and the Fed­
eral funds rate
Money market conditions in relation to
bank deposits
Money market conditions in relation to
over-all interest rates
Evaluation of the need for a money market
conditions guide

10
11
12
14
17

17
19
21
23

POSSIBLE RELATIONSHIP BETWEEN
THE STRUCTURE OF THE
DIRECTIVE AND A THEORY OF
MONETARY POLICY FORMULATION
Formulation of longer-run projections
Role of money market conditions and proviso
in relation to longer-run projections
Errors and uncertainties considered
Money market conditions: policy target aspects

24

RECAPITULATION AND CONCLUDING
REMARKS

28

APPENDIX:
An Empirical View of “Even Keel”

FOMC DIRECTIVE IN LATE 1960‘s

INTRODUCTION
This paper attempts to lay out and appraise
the workings of, and a possible theory for, the
structure in the latter part of the 1960’s of the
Federal Open Market Committee’s directive to
the Manager of the Open Market Account. An
effort is made to indicate and evaluate the
practice of open market policy as it flowed
from the structure of the directive. The paper
also attempts to outline one theoretical ration­
ale for the directive’s structure and to indicate
the nature of the flow of economic information,
including projections, that appears to be re­
quired to satisfy such a theoretical under­
pinning for the directive.

STRUCTURE OF THE DIRECTIVE
For many years the FOMC directive has con­
tained two paragraphs. The first paragraph is a
statement about the economy and the general
goals of monetary policy, while the second
contains operating guides for the Account
Manager covering the interval between Open
Market Committee meetings. In the recent past
this interval has generally been 3 or 4 weeks.
The nature of the information and instructions
in these two paragraphs has changed over the
years. In this section, the paragraphs as they
were formulated in the late 1960’s will be de­
scribed and evaluated.1
NATURE OF FIRST PARAGRAPH. The
first paragraph of the directive typically con­
tained statements about over-all economic ac­
tivity, prices, various financial flows—particu­
N o t e . —The author is Associate Director, Division
of Research and Statistics, Board of Governors of
the Federal Reserve System.

1 The wording of the directive issued on Aug. 12,
1969, is as follows:
The information reviewed at this meeting
indicates that expansion in real economic activ­
ity slowed somewhat in the first half of 1969
and some further moderation is projected. Sub­
stantial upward pressures on prices and costs are
persisting. Most market interest rates recently
have receded slightly from their earlier highs. In
July the money supply expanded as U.S. Govern­
ment deposits decreased further; bank credit



larly bank credit and money—and interest
rates. Generally, only the statement about
over-all economic activity had a future cast to
it. But the time horizon for this future was
often rather indefinite. Sometimes the wording
has been such that the reader would think it
referred to no more than a quarter ahead, or
to the quarter in process. An example of such
wording would be “economic activity appears
to be slowing.” On the other hand, at times
statements simply noted that economic activity
is projected to slow. In such cases the time ho­
rizon appears more indefinite.
To understand the magnitude and timing of
the future projections of economic activity that
provide a basis for FOMC decisions and for
the instructions given to the Account Manager,
it is necessary to look outside the directive it­
self. For the public, the policy record that is
published at the same time as the directive
(both with about a 3-month lag) contains a
general indication as to the direction and mag­
nitude of the gross national product, but the
references are qualitative and not necessarily
consistent as to time periods mentioned. The
declined on average, after adjusting for an in­
crease in assets sold to affiliates and to customers
with bank guarantees. The run-off of large-denomination CD’s which began in mid-December
continued without abatement in July, and there
apparently were net outflows from consumer-type
time and savings accounts at banks and nonbank
thrift institutions combined. The over-all balance
of payments deficit on the liquidity basis re­
mained very large in July; the balance on the
official settlements basis was still in surplus in the
first half of the month but subsequently shifted
toward deficit as U.S. banks’ borrowings of
Euro-dollars leveled off. Foreign exchange
markets appear initially to be adjusting in an
orderly fashion to the announced devaluation of
the French franc. In light of the foregoing de­
velopments, it is the policy of the Federal Open
Market Committee to foster financial conditions
conducive to the reduction of inflationary pres­
sures, with a view to encouraging sustainable
economic growth and attaining reasonable equili­
brium in the country’s balance of payments.
To implement this policy, System open market
operations until the next meeting of the Com­
mittee shall be conducted with a view to main­
taining the prevailing firm conditions in money
and short-term credit markets; provided, how­
ever, that operations shall be modified if bank
credit appears to be deviating significantly from
current projections or if pressures arise in con­
nection with foreign exchange developments or
with bank regulatory changes.

FOMC itself has available to it specific, dated
projections presented by the staff at each meet­
ing. The staff projections are in considerable
detail with specific numbers and generally with
a time horizon of about a year.
Thus, the economic analysis behind FOMC
instructions to the Account Manager in the
directive cannot be understood by reference
only to the first paragraph of the directive; it
requires other documentation. Some might
argue that there is no reason for the first para­
graph to express the full scope of the eco­
nomic and financial analysis that lies behind
the specific operating instruction of the second
paragraph. However that may be, the main
point here is that the structure and meaning of
the directive that is issued cannot be under­
stood in itself but must be considered in rela­
tion to the information gathering, economic
analysis, and policy discussion that are integral
to the FOMC meeting. In that respect, it
should, of course, be pointed out that the staff
material and projections may not give a cor­
rect impression of the views of the members of
the FOMC. Their outlook for the future has
often been different from the staff’s, and a
thorough understanding of their views and the
relation of these views to the directive requires
access to the minutes of the meeting, although
a brief summary of the policy discussion is
contained in the policy record that is published
along with the directive.
The final sentence of the first paragraph of
the directive states the goals of monetary pol­
icy as they relate to the balance of payments,
economic growth, and inflation. From time to
time the structure of this sentence is rearranged
so as to give particular emphasis to the bal­
ance of payments, or to price stability, or to
the need to encourage economic growth, as
may be appropriate. This rearrangement can
then be taken to represent a general statement
of the Committee’s over-all priorities with re­
spect to the ultimate goals of policy.
There is no explicit mention of potential
trade-offs among various competing goals,
however, in the final sentence of the first para­




graph. The order in which the goals are pre­
sented may give some indication of priorities
attached to particular goals by the Committee,
but there is nothing to indicate that the Com­
mittee is considering the sacrifice of a degree
of attainment of one goal in order to obtain a
greater degree of attainment for another goal.
In fact, it may be an overstatement to suggest
that rearrangements of the wording of this sen­
tence indicate explicit consideration by the
Committee of the trade-off problem. It is more
likely that rearrangement should be interpreted
as indicating that the Committee is moving, for
example, toward an emphasis on combating in­
flation rather than encouraging growth. But
whether the Committee believes it can have
both some desired level of economic growth
and a desired degree of price stability over
some given time period is certainly not made
clear in the general statement of goals.
The indefinite nature of the time horizon of
the first paragraph and its very general state­
ment of goals make its connection with the op­
eration elements of the second paragraph
rather tenuous. The second paragraph refers
explicitly to how the Account Manager should
operate in the market over the interval be­
tween Committee meetings. Presumably, these
operations would be consistent with the desires
of the Committee with respect to the economy
and the balance of payments as expressed in
the last sentence of the first paragraph. But
how these two paragraphs relate to each other
is not made clear in the directive itself, or in
the policy record accompanying the directive.
In order to relate them it would seem neces­
sary to analyze the relationship of: (1) the op­
erating variables that the Manager works with,
(2) the financial flows and over-all interest rates
that result from these operations, and (3) re­
lated effects over time on economic activity,
prices, and the balance of payments. Thus,
while clear for the first paragraph of the direc­
tive, it is even clearer for the whole structure of
the directive as constructed in the late 1960’s—
not to mention other periods— that the directive
cannot be analyzed independently of the total

FOMC DIRECTIVE IN LATE 1960’s

flow of material and projections given to the
FOMC, and of the nature of the discussion
undertaken by the FOMC in relation to this
material. In brief, the procedures of the
FOMC and the directive are inseparable.2
Before discussing the relationships among
the day-to-day operational variables in the sec­
ond paragraph of the directive, aggregate mon­
etary flows, over-all interest rates, and longerrun projections of the economy, it is desirable
to describe the constituent elements of the sec­
ond paragraph that affect the Manager’s opera­
tions. These are by no means clear, of course,
as expressed in the second paragraph of the
directive, but they are fairly clear to those
present at FOMC meetings and with access to
the full FOMC documentation.
OPERATIONAL ELEMENTS IN THE
SECOND PARAGRAPH. The second para­
graph of the FOMC directive generally has
asked the Manager to maintain— or ease, or
seek tauter, as the case may be—money market
conditions. Sometimes the term “money market
conditions” has been expanded to “money and
short-term credit market conditions.” In addi­
tion, in the last 4 years of the 1960’s the sec­
ond paragraph included a proviso clause, which
noted that the money market conditions should
be attained provided bank credit was not
deviating significantly from projections. More­
over, the second paragraph contains, when
appropriate, references to “even keel” around
periods of Treasury financings. And finally, this
paragraph has made references to possible
modifications of operations in cases of liquidity
crises or similar emergencies, such as excep­
tionally large outflows of funds from banks or
thrift institutions at interest-crediting periods or
potential domestic market reactions to foreign
exchange market developments. The Manager
also appears to have a continuing authority to
2 This paper will not, however, discuss the content
of FOMC discussions and the nature of the go-around among FOMC members, but will rather con­
centrate on the economic issues germane to the theo­
retical basis of the directive— thereby implicitly
discussing the types of decisions that would appear
to require FOMC discussion.




avert disorderly market conditions; just how
such conditions are defined is unclear, but they
are generally taken to mean a drying-up of
trading in securities and large and cumulative
downward price movements for which no end
seems in sight.
Money and other short-term market condi­
tions. The money and other short-term market
conditions referred to in the second paragraph
include principally the Federal funds rate, bor­
rowings by member banks, and net free or net
borrowed reserves. At times, the rate on 3month Treasury bills has been included in this
constellation. The words “other short-term
market conditions” have generally been taken
to indicate inclusion of the 3-month bill rate,
although that rate has also at times been
something of a factor in operations even with­
out such specific wording. The emphasis
placed on the bill rate has varied considerably
with monetary and economic conditions. For
instance, in the early 1960’s when it was
thought that international flows of funds were
responsive to relations between short-term
market rates here and abroad, much attention
was paid to the 3-month bill rate in opera­
tions. Also, the 3-month bill rate was a partic­
ularly important operating variable when it
and the whole bill rate structure were hovering
around Regulation Q ceilings, and the Com­
mittee did not wish to encourage either a large
expansion in bank credit that might be associ­
ated with a decline in the bill rate or a large
contraction that might be associated with a
rise in the bill rate.
A constellation of money market conditions,
rather than a single indicator, has been relied
on for operating purposes because changes in
reserve distribution and other temporary mar­
ket factors may result in divergent tendencies in
any one of the money market conditions, and
such a divergent tendency might be offset
through manipulation of other conditions in
order to maintain an over-all degree of ease or
tightness in the money market. For example,
when reserves are distributed in favor of lead­

time went on, and nondeposit funds became
relatively important sources of bank credit, the
bank credit referred to became the total of
member bank deposits plus the average for the
month of weekly data on liabilities to branches
abroad, and then finally plus the average of
borrowings through commercial paper issued
by bank-related affiliates. A theory behind the
proviso clause will be discussed in an ensuing
section of the paper, including some discussion
of what particular aggregates might best be
included in such a clause.
The proviso was generally a two-way pro­
viso. That is, the Manager was directed to ease
money market conditions a little if bank credit
were falling short of expectations and was di­
rected to tighten them a little if bank credit
were rising above expectations. Sometimes,
however, the proviso was expressed so that its
effect was only one way. For example, if the
Committee were particularly anxious to avoid
a sharp rise in bank credit, it might have di­
rected the Manager to alter money market
conditions only if bank credit were rising
above projections.
For the most part, projections of bank
credit provided by the staff were for only 1
month ahead, although on occasion figures for
a slightly longer time period were presented.
The monthly projections were based on recent
trends in deposit data, knowledge as to likely
Treasury financing activity, expectations as to
the effects of market interest rates on time de­
posits given Regulation Q ceilings at banks,
and a view as to the intensity of loan demands
in light of the outlook for GNP. Either the
projections have assumed no change in money
market conditions, or if a change in the sec­
ond paragraph was to be considered by the
FOMC, then they have been based on some­
what tighter or easier money market conditions,
as the case might be. The Committee generally,
but not always, accepted the staff projections
as the appropriate quantities for the proviso
clause.
3 Loans and investments of the large weekly re­
porting banks are available weekly in fairly detailed
There was nothing in the directive to indi­
categories, while estimates for loans and investments
cate when the proviso would be put into effect
at all commercial banks are available only for the
last Wednesday of the month.
—whether it would be after 1 week of devia­

ing money center banks the Federal funds rate
will often decline, and this would appear to be
an indication of easing in the market unless
member bank borrowings are permitted to rise
and net borrowed reserves deepen. On the other
hand, when reserves and funds move away
from money center banks, the Federal funds
rate will tend to rise because these major money
center banks appear to be more willing than
other banks to borrow and to pay higher rates
for day-to-day money in the market. In such a
case, if member bank borrowings are not per­
mitted to decline somewhat, the over-all money
market will appear to tighten. There are limits
within which these trade-offs can take place,
and the range of trade-offs represents the over­
all constellation of money market conditions
that have been the day-to-day operating guide
for the Account Manager.
The operating emphasis on money market
conditions has meant that the directive was es­
sentially accommodative, in the sense that
market demands for credit and money would
be accommodated at a given Federal funds rate
or level of net borrowed or net free reserves.
Some constraint on the degree of accommoda­
tion was instituted by the proviso clause, but
in practice this represented a rather minor ele­
ment of constraint, in part because the Com­
mittee was willing to tolerate wide swings in
bank credit and in part because the proviso
clause was not in application taken as a strong
target of policy.
Bank credit proviso. The proviso clause in
the directive during the latter part of the 1960’s
was for the most part related to bank credit,
although in its early days required reserves
were used (and on one or two occasions
money supply was noted along with bank
credit). The bank credit referred to was origi­
nally a proxy for daily-average bank credit as
measured by total member bank deposits, a se­
ries for which daily figures are available.3 As




FOMC DIRECTIVE IN LATE 1960’s

tion from projections or 2 or 3. Nor was there
anything in the directive to indicate how much
of a change in money market conditions the
Manager should seek in light of a deviation of
bank credit from projections. Much of the
time the word “significantly” appeared in the
proviso in relation to deviations from projec­
tions, and this would appear to indicate that
the deviation would have to be relatively large,
with the dimension having to be gleaned by
the Account Manager from Committee discus­
sion.
No large change in money market condi­
tions was ever undertaken by using the proviso
clause. Only small shadings were undertaken,
no matter how large the deviation of bank
credit from projections, with the FOMC recon­
sidering its whole stance at the next Commit­
tee meeting. When it was used, the proviso
clause was generally not taken as a target, or
at least not as a strong target, because the Ac­
count Manager was not directed to alter mar­
ginal reserves and money market conditions as
need be to attain the specified bank credit
range.
Even keel. The words “even keel” have re­
ferred to the operations of the Federal Reserve
Open Market Account around periods of Treas­
ury financings. As the appendix notes, “in
practical terms ‘even keel* has meant that, for
a period encompassing the announcement and
settlement dates of a large new security offer­
ing or refunding by the Treasury, the Federal
Reserve has not made new monetary policy
decisions that would impede the orderly mar­
keting of Treasury securities and significantly
increase risks of market disruption from sharp
changes in market attitudes in the course of a
financing.”
The past timing of even keel and its effect
on interest rates and monetary aggregates are
discussed in some detail in the appendix and
will not be repeated here. However, two points
should be highlighted. One is that there have
been rather marked fluctuations in both dayto-day interest rates and longer-term interest
rates during even-keel periods, as well as fluc­
tuations in member bank borrowings and net



reserves; but in spite of such fluctuations, the
trend of the narrow money market measures
has not generally changed during even-keel pe­
riods. As a second point, it should be noted
that during even-keel periods the money sup­
ply and bank credit have often risen relative to
their trend and that they have not always com­
pletely dropped back after even keel. If any
general conclusion about even keel can be
drawn, it may be that in such periods the Fed­
eral Reserve has permitted somewhat more ex­
pansion in monetary aggregates than it might
otherwise have done in order to keep interest
rate fluctuations more damped than they other­
wise would be.
But whether such a conclusion should be at­
tributed to even keel, as such, is a question.
Since the FOMC directive has been essentially
an accommodative directive, and regardless of
whether the System maintained even keel, very
lumpy credit demands, such as the Treasury’s,
would have been associated with an enlarged
expansion in bank credit and money. The
major impact of even keel has been that the
System refrained from changing its constella­
tion of money market conditions in a period of
Treasury financings, whereas it would not re­
frain from doing so in periods of particular
corporate or State and local government financ­
ings. The reasons for refraining with respect to
Treasury financings are the very large size of
such financings and the extreme sensitivity of
the markets as a whole to the receptions given
these financings. Moreover, should such financ­
ings fail, the System would be under extreme
pressure to take up the slack since the Treas­
ury generally requires the money either to roll
over maturing debt or to finance committed
expenditures.
Liquidity, emergency, and other provisions.
As noted above, one use of liquidity and emer­
gency provisions in the second paragraph of
the directive has been to guard against market
disruption in case of very large and unex­
pected net outflows of funds from banks and
savings or other types of financial institutions.
While these net outflows would often make
funds available to the securities markets, they

could raise the threat that the institutions
would not be able to meet commitments and,
therefore, that confidence in the institutions,
and perhaps in financial markets generally,
might be dissipated—with undesirable reper­
cussions on the economy itself. Certain kinds
of liquidity and emergency provisions have
also been used at times when foreign exchange
markets have been in flux, and large outflows
of funds from the dollar were in prospect that
would have exerted strong and undesired up­
ward pressure on the interest rate structure in
this country.
Finally, it might be noted that the second
paragraph of the directive has at times given
the Manager authority with respect to adjust­
ing operations to take account of changes in
the discount rate or reserve requirements when
it seemed relatively certain that such changes
were about to take place. Exactly how he
should adjust operations is, of course, not
spelled out in the directive. But some guidance
has been given through Committee discussion
or through staff analysis. Nevertheless, in this
respect as in others, there is a role, although
circumscribed, for the Manager’s judgment.
ROLE FOR MANAGER’S JUDGMENT.
The Manager’s judgment as to what money
market conditions to seek has been circum­
scribed in recent years through greater statisti­
cal specification by the Committee. The staff
has presented projections of bank credit, as
noted earlier, and also detailed projections of
member bank deposits, the money supply, time
deposits, nondeposit sources of funds, and in­
terest rates generally, on the assumption of un­
changed money market conditions or, as an al­
ternative, either tightened or eased conditions.
Ranges have been given both for money mar­
ket conditions and for the projected monetary
aggregates. Needless to say, not all members
of the FOMC would accept staff specifications
as their own. Thus some members might pre­
scribe a slightly different range for the Federal
funds rate, even for a directive for unchanged
money market conditions. And some members
might be more willing than others to see bank



credit expand above, or move below, projec­
tions.
Given the multiplicity of variables and the
sometimes conflicting desires of various Com­
mittee members, the Manager has had consid­
erable scope to play off one variable against
another as consistent with his sense of the de­
sires of the majority of the FOMC so long as
at least some key variables remain within spec­
ified ranges. The problem of compromising
among objectives, is made more difficult be­
cause not all Committee members necessarily
discuss the same variables, so the Manager
cannot be sure of the wishes of those members
who have not expressed themselves with re­
spect to, say, the Federal funds rate or the 3month bill rate. Finally, it might be noted that
the Manager seems to have had some capacity
marginally to alter money market conditions if
credit markets more generally were being buf­
feted by unusual conditions or if the public’s
view of System monetary policy seemed to be
changing undesirably—with market expecta­
tions developing that policy was either tighter
or easier than the FOMC desired— as a result
of a published series of money market statistics
or operations deviating significantly from pre­
vious trends or actions.
While a good deal of specification is pre­
sented by the staff and while the various Com­
mittee members themselves often specify
numerically what they hope to see happen, de­
velopments often turn out differently from
projections. This, of course, has been less
likely to happen with the narrow money mar­
ket conditions— such as the Federal funds rate
and net borrowed reserves—since these have
been the principal operating variables the
Manager sought to attain; and it has been
much more likely to happen with bill rates,
longer-term interest rates, bank credit, and
money supply. In large part, of course, unex­
pected developments are the result of errors in
specifying the relationship between money
market conditions and monetary aggregates, or
it may be that the levels of economic activity
and credit demands are stronger or weaker

FOMC DIRECTIVE IN LATE 1960’s

than assumed for purposes of making the
projection.
But whatever the reason for the difference
between the projected and the actual outcome
with respect to interest rates and monetary ag­
gregates, or even with respect to narrow
money market conditions, some outcomes are
acceptable to the FOMC even though un­
specified as a possibility. For example, a greater
than expected rise in interest rates, as com­
pared with projections, may turn out to be
acceptable to the FOMC if this occurs at a
time when demands in the economy are turn­
ing out to be larger than anticipated. In fact,
the FOMC may often have told the Manager
not to offset a market-generated tendency for
interest rates to rise, or to fall.
Whether the multiplicity of short-run tar­
gets means that the Manager has had more
scope for judgment than if he had only a sin­
gle target is an open question. If the single
target were net borrowed reserves, it would be
clear that the Manager would have almost no
scope for judgment, because net borrowed re­
serves are one of the more certainly attainable
objectives within the constellation of short-run
targets. However, if the single target were a
rate of increase in the money supply, the Man­
ager might have to exercise a very considerable
degree of judgment because he would likely be
faced with sharp day-to-day variations in de­
posits and hence would have to make almost
continuous judgments as to whether he should
tighten money market conditions or ease them
in the particular statement week in order to
make sure that over the month, the quarter, or
whatever the relevant period, he would attain
the desired money supply target.
While the degree of judgment required of
the Manager need not be a principal factor in
determining FOMC operating targets, the at­
tainability of targets with a reasonable degree
of accuracy should probably be a criterion.
What types of targets are so attainable, and
over what time periods, are not within the pur­
view of this paper. The only point that might
be added here is that emphasis on money mar­



ket conditions in the second paragraph of the
directive has reflected in part a sense by the
FOMC that such conditions represented an
attainable target, one to which the Manager
could be held accountable, and one that might
minimize his scope for judgment in day-to-day
operations. Other targets too might be feasible
—and perhaps more desirable for economic
reasons—but they would require more day-today judgmental decisions by the Manager since
the target (for example, money supply or bank
credit) might be one or two steps removed in
terms of availability of statistics from the dayto-day flow of bank reserve adjustment data
and money market information. Such targets
might be attainable, but they would require
that the FOMC provide the Manager with
more day-to-day— or more importantly more
week-to-week—freedom in operations and
might also require greater tolerance for errors,
given existing institutional arrangements (such
as the structure of reserve requirements).

FUNCTION OF MONEY MARKET
CONDITIONS AS AN OPERATING
GUIDE
As an operating guide, money market condi­
tions have given the Manager a rather specific
means by which he could determine whether
or not to inject or absorb reserves. The net
borrowed reserve position of member banks is
relatively easy to meet within a week, particu­
larly since required reserves are given as a
result of lagged reserve accounting, and the
Federal funds rate is available every day. In
addition to providing the Manager with a tar­
get that he can achieve and thus one to which
he can be held accountable, the money market
conditions target permits market demands to
influence money, bank credit, and reserves, as
has been earlier noted. In that sense it permits,
among other things, the market to make its
own seasonal adjustment of the money supply
and related items.
At the same time, of course, nonseasonal

changes in demand would also be accommo­
dated. Whether such accommodation is desira­
ble has been one of the critical issues over the
years in the FOMC’s method of operation,
since it raises the danger of providing or ab­
sorbing bank reserves, credit, and money in a
procyclical fashion.
DAY-TO-DAY ROLE OF FREE RE­
SERVES AND THE FEDERAL FUNDS
RATE. This section will analyze in detail the
day-to-day operating function of free reserves
and other money market conditions, principally
the Federal funds rate. The net reserve position
and the Federal funds rate are basic elements
of money market conditions influencing the
Manager’s day-to-day decisions as to whether
to buy or sell securities. In the framework of
the directive of the late 1960’s, it is his task to
supply or absorb reserves in response to market
demands under given money market conditions.
The Federal funds rate—the rate banks charge
for selling excess reserves to other banks, usu­
ally on an overnight basis—is one of the most
sensitive measures of the demand for or the
supply of reserves. While shifts in the distribu­
tion of reserves among major banks, or between
major money market and country banks, affect
this rate, a persisting tendency for the rate to
rise from previous levels indicates a greater
desire for reserves relative to supply than in
earlier periods, and vice versa.
The Federal funds rate generally bears a
consistent, and relatively stable, relationship to
the net free or net borrowed reserves position
of member banks, although there can be
week-to-week fluctuations between the two
measures as a result of reserve distribution
problems or unusual Treasury and other short­
term financing demands in the market. There
can also be a longer-run shift in the relation­
ship—for example, the Federal funds rate may
rise relative to net borrowed reserves if bank
deposit drains cumulate and bank liquidity be­
comes increasingly strained, thereby increasing
banks’ demands for Federal funds borrowings
(and assuming their effective demand for bor­
rowing at the discount window is restricted by



Federal Reserve rationing). In day-to-day op­
erations the Federal funds rate and net re­
serves have been considered jointly, while rec­
ognizing the necessity of some give-and-take in
maintaining an over-all unchanged state of
ease or tightness for the money market (as­
suming the FOMC voted for an unchanged
state of money market conditions).
The net reserve position of member banks is
measured by the difference between their ex­
cess reserves and their borrowings. For pur­
poses of understanding the relation of free re­
serves to System operations, however, it is
better to look at such reserves as the difference
between nonborrowed reserves (the reserves
that can be supplied through open market op­
erations) and required reserves (the result of
joint decisions by banks and the public affect­
ing the level and distribution of deposits, at
given interest rates).
If the FOMC voted to keep money market
conditions unchanged, the Account Manager
would assume that the net reserve position of
banks should remain about where it was in
previous weeks. In his operations the amount
of reserves he supplied or absorbed through
the market would depend on other sources of
nonborrowed reserves and on required reserves
during the statement week. Thus, the Desk has
to have at hand projections of float, the Treas­
ury balance at the Federal Reserve, currency
in circulation outside the banking system, gold
flows, and foreign drawings or repayments on
Federal Reserve swap lines, all of which are
factors other than his own operations that
affect nonborrowed reserves and that are for
the most part outside his control.
In addition, the Desk would need to have
for the current statement week estimates of the
amount and distribution of deposits by type
of deposit and class of bank in order to obtain
a measure of required reserves. Under the
lagged reserve scheme put into effect in Sep­
tember 1968, required reserves in a current
statement week are based on deposits 2 weeks
earlier, and thus the Desk knows with cer­
tainty what required reserves will be in the

FOMC DIRECTIVE IN LATE 1960’s

current week. But the System had operated
with a money market conditions target (with
or without a proviso) for a great many years
before adopting the lagged reserve provision,
and the theory of using money market condi­
tions as an operating guide is little different
with or without lags—although the timing of
the effects of operations on key financial
variables might be affected by the presence of
lags.
MONEY MARKET CONDITIONS IN
RELATION TO BANK DEPOSITS. Over
the very short-run period of a bank reserve
statement week, bank deposits are probably
determined mainly by credit demands on
banks and by bank investment policies, given
money market conditions and, more generally,
the level and structure of interest rates. As in­
dividual banks enter a new statement week,
they are confronted with particular supply and
demand conditions. On the supply side, they
are faced with a set of fund availabilities given
to them and about which they can do little
(U.S. Government and private demand depos­
its, which in large part are beyond their influ­
ence in the short run)4 and costs (reserve
requirements; rates on Federal funds on Euro­
dollars, and on CD’s and other time depos­
its if available under Regulation Q; and so
forth) that influence their willingness to obtain
additional funds and affect their loan terms
4 There are obvious exceptions to the statement
that pertain to both private and Government demand
deposits, but some of these in reality apply to banks’
lending or borrowing policy rather than demand de­
posit flows as such. For example, banks can obtain
U.S. Government deposits at times by bidding for
Treasury bills offered with payment through credit to
tax and loan accounts. But to an individual bank this
is a temporary source of funds, which it considers on
the same basis as Federal funds. The Federal funds
rate represents the opportunity cost to the bank that
influences the price at which it bids for the tax and
loan balance. Such U.S. Government deposits are
probably more appropriately considered as Federal
funds in contrast to, say, normal seasonal deposit
flows. Similarly, policy with respect to compensating
balances may be changed by banks in the short run,
but this is probably better considered as a factor in
loan terms and conditions.




and portfolio policies. On the demand side,
banks have formulated portfolio policies and
they are faced with demands for loans, reflect­
ing the underlying demand for goods and serv­
ices and given the costs to borrowers of var­
ious alternative methods of financing, including
banks’ own loan rates and terms. Through in­
teraction of these supply and demand forces, a
certain volume of credit will be extended by
banks and a volume of deposits will be gener­
ated.
A similar short-run process takes place re­
gardless of whether reserves are lagged. A
bank’s willingness to extend loans or to com­
pete for time deposits, even under a lagged
scheme, will be limited by its seasonal pattern
of demand deposit flows and by the cost to it
of obtaining reserves in the Federal funds mar­
ket, including particularly expected deposit
flows and costs of Federal funds 2 weeks hence
when reserve requirements on the current
week’s deposits have to be met. It must be as­
sumed under existing procedures that the dis­
count window is not a permanent source of re­
serve supply and that it can provide funds to
individual banks only for short and infrequent
periods when their reserve calculations go as­
tray.
While the general theory of operating with a
money market conditions guide is the same
when reserves are lagged as when they are
not, there may be some difference in timing of
bank response to System operations. For ex­
ample, if the System is tightening under an un­
lagged scheme, it is possible for the banking
system to adjust to a smaller increase in non­
borrowed reserves by selling assets to the
public and reducing required reserves in the
current week. Under a lagged scheme, the
banking system cannot reduce required reserves
in the current week, but that does not mean
that banks need necessarily avoid preparing for
the tightening of conditions in the current week.
Clearly, they may still sell assets to the public
in the current week—thereby reducing deposits
currently and required reserves 2 weeks from
now. However that may be— and the charac­

teristic of bank reactions to changes in reserve
availability within short-run periods is an area
where further empirical research is much
needed—in this paper it is assumed that bank
deposits in the very short run, such as a state­
ment week, are not much affected in practice
by System operations within that period, and
that the operating option for the System is
whether to supply the necessary required re­
serves through the discount window or by
providing nonborrowed reserves.
If money market conditions are kept un­
changed, the System through open market op­
erations will supply or absorb enough
nonborrowed reserves—given the other factors
affecting nonborrowed reserves—to keep the
net reserve position of banks and member
bank borrowings (the most volatile element in
the net reserve position under current circum­
stances, with excess reserves generally at mini­
mal levels) at around their previous levels.
And apart from reserve distribution problems,
the Federal funds rate would generally also
show little net change.
Because projections of non-System factors
affecting nonborrowed reserves are uncertain
(and in the days before the lag, projections of
required reserves too were uncertain), the be­
havior of the Federal funds rate in the course
of a statement week helps provide a clue as to
whether the staff projections of net borrowed
reserves and factors affecting such reserves are
correct. For instance, if staff projections show
that net borrowed reserves early in the state­
ment week are deeper than those prevailing in
earlier weeks (and thus would require System
reserve-supplying operations under an un­
changed policy), while at the same time the
Federal funds rate is opening lower than in
previous weeks, the Manager might consider
holding off on any reserve-supplying opera­
tions in the expectation that there were in fact
more reserves available than the projection for
net borrowed reserves indicated. This might
then turn out to be the case when the next
day’s figures became available because, say,
float was running higher than was allowed for



or than was normal for that particular time of
the year. The interplay between statistical
projections and the Federal funds rate is a val­
uable source of information to the Account
Manager.
If the FOMC voted to tighten money mar­
ket conditions, the Account Manager would
conduct his operations so as to force banks to
borrow more at the discount window than they
had in earlier weeks, assuming excess reserves
are at minimal levels. As banks find that they
are forced more into the discount window,
they also find fewer reserves available relative
to demand in the Federal funds market (both
being aspects of a reduced supply of nonbor­
rowed reserves by the System) and the Fed­
eral funds rate tends to rise. Banks will also
begin to undertake portfolio adjustments, such
as selling Treasury bills, particularly if they
think the tighter conditions are likely to per­
sist; they will begin to alter offering rates on
CD’s and Euro-dollars; and they will begin to
change loan terms and conditions. These
changes soon begin to show up in the rate of
growth of bank deposits and credit. For exam­
ple, slower growth than otherwise in deposits
may develop over a period of weeks as indi­
vidual banks begin selling securities to the
nonbank public as part of the adaptation to
tighter money market conditions.
MONEY MARKET CONDITIONS IN
RELATION TO OVER-ALL INTEREST
RATES. While following a money market
conditions target essentially has meant that the
System would accommodate whatever market
demands for money and deposits developed at
a given Federal funds rate and bank net re­
serve position, this did not necessarily mean
that the System could be construed as stabiliz­
ing interest rates other than the overnight
money rate. Interest rates broadly conceived
will probably tend to fluctuate less in the short
run under an accommodative monetary policy
than they might otherwise. But still there are
likely to be rather wide swings, and also trend
movements, in interest rates on obligations
maturing in 2 or 3 months and longer as

FOMC DIRECTIVE IN LATE 1960’s

a result of shifts in credit demand or market
expectations, if money market conditions re­
main unchanged. Experience in the latter half
of 1969 is evidence in this respect, although
the markedly slower rate of growth in the
money supply that developed simultaneously
would also be consistent with the hypothesis
that an unwillingness on the part of the Sys­
tem to accommodate completely demands for
money—however that unwillingness came
about—was an important causative factor in
the increase in interest rates.
A number of factors can account for the
over-all variability in interest rates under an
unchanged money market conditions target.
One, of course, is expectations. An increase in
inflationary anticipations, for example, will
increase the interest rate premium demanded
by investors and will make borrowers more
willing to pay it. Similarly, an abatement of
inflationary expectations will have the reverse
effect.
Expectational effects on interest rates can
also develop out of shifting attitudes with re­
spect to fiscal and monetary policies. Anticipa­
tions of a fiscal surplus, and of course the ac­
tual development of one, may lead to declines
in interest rates on both short- and long-term
Treasury securities as dealers become more
willing to position securities currently in antici­
pation of a relative scarcity of securities later
or in recognition of a shortage in the process
of developing.
Similarly, a pervasive attitude that the
monetary authority may at some time in the fu­
ture begin to ease money market conditions is
likely to bring interest rates down currently as
investors attempt to acquire large amounts of
high-yielding securities. In the bill market,
such a phenomenon may be associated with
declines in both 3- and 6-month bill rates, but
often a relatively greater decline develops in
the 6-month bill rate—reflecting the greater
likelihood that short-term rates will be lower
in the longer-term future than over the very
near term. Expectations of a tightening in
money market conditions will have the reverse




effect. But if expectations of a shift in money
market conditions prove unfounded, interest
rates are likely to revert to previous levels.
A more permanent effect on interest rates,
however, can develop as money market condi­
tions remain unchanged over a sustained pe­
riod because of a cumulating tightness that de­
velops on banks. For instance, if member bank
borrowings from the Federal Reserve remain
at, say, around $1 billion for a number of
months, many banks will have sought funds at
the discount window a number of times. Given
the attitude of the Federal Reserve that such
borrowing should be only occasional and pri­
marily for unforeseen reserve adjustment con­
tingencies, the reluctance of banks to borrow
will tend to increase with the number of times
they have previously borrowed. Thus, as a
given degree of pressure on bank reserve posi­
tions is sustained, banks will increasingly sell
Treasury bills, reduce purchases of municipal
securities, and make other adjustments that re­
duce the likelihood of their having to come to
the discount window. These adjustments will
add to upward pressures on interest rates.
Such a process tends to be intensified in pe­
riods when Regulation Q ceilings are at unrealistically low levels and banks are forced to
adjust portfolio policies and loan terms because
of large losses of time deposits. Interest rates
tend to rise under such circumstances partly
because the banks appear to be more efficient
investors than are the large number of individ­
uals and corporations. But in addition, it is
likely that the structure of interest rates may
be affected—with long-term interest rates rising
relative to short-term rates—as those with­
drawing funds from banks, such as corpora­
tions, invest largely in short-term market in­
struments, while banks react not only by
selling Treasury bills but also by reducing ac­
quisitions of long-term State and local govern­
ment securities and by stiffening lending terms,
which may force some business borrowers into
the open market, including the capital market,
for funds.
Finally, over-all interest rates may vary,

given money market conditions, along with
changes in basic credit demands, which may re­
flect changes in the trend of GNP. A weaken­
ing of demands for bank credit will reduce the
need for banks to undertake liquidity and
portfolio adjustments and will contribute to a
lowering of market interest rates in general.
Changes in demands on bond markets—pre­
dicted in part on, say, changing needs to fi­
nance business capital outlays—will also affect
long-term interest rates while money market
conditions remain unchanged. However, in
these, as in other instances of changing credit
demands, the extent of the change in interest
rates will be influenced by expectations and will
also be limited by the accommodative posture
of the Federal Reserve—that is, by the ex­
tent to which the Federal Reserves does or
does not permit money market conditions to
change.
In general, as credit demands weaken, the
accommodative monetary policy at given
money market conditions will be consistent
with interest rate declines, but the extent of
decline in the short run will be limited by Sys­
tem actions leading to unchanged, rather than to
easing, day-to-day financing rates and member
bank indebtedness at the Federal Reserve.
Similarly, as credit demands strengthen, inter­
est rates generally will rise, but the degree of
rise in the short run will be limited by System
actions maintaining day-to-day financing costs
at previous levels rather than letting them rise
and making it more expensive for dealers to
underwrite the securities that are issued and
more expensive for individual banks to accom­
modate loan demands through marginal bor­
rowing in the Federal funds market.
EVALUATION OF THE NEED FOR A
MONEY MARKET CONDITIONS GUIDE.
One of the chief advantages of operating with
money market conditions as a guide would ap­
pear to be the automatic seasonal adjustment
that is provided for bank reserves and money.
For instance, the drain on bank reserves from
outflows of currency to the public around the
Thanksgiving and Christmas holiday periods



and the greater transactions need for demand
deposits are not permitted to tighten the
money markets, since the System provides
offsetting reserves to the banks through open
market operations. The resulting increase in
the money supply, as it recurs regularly, would
be represented as no more than seasonal in the
money supply statistics. In addition, other tem­
porary demands are provided for, even though
they may not recur year after year and thereby
qualify as seasonal demands. An example
would be a one-time speed-up in corporate tax
payments.
The desirability of stabilizing money market
conditions in order to provide an automatic
short-run accommodation to banks’ changing
demands for reserves may, of course, be open
to question. One reason for operating in that
way is that banks have not had automatic ac­
cess to the discount window. If there were
such access, and assuming that the discount
rate were continuously in touch with market
rates, member bank borrowings—rather than
nonborrowed reserves—might be permitted to
fluctuate for seasonal reasons. But apart from
that possibility, the theory behind the directive
has appeared to imply the desirability of pro­
viding seasonal and other temporary accom­
modation to the market on the grounds that
the market cannot be completely relied on to
arbitrage out, through the interest rate mecha­
nism, the shifting seasonal demands for credit
and money. It seems unlikely, for instance,
that the market would fully anticipate tax-pe­
riod needs for credit at times of seasonal slack
and thereby avoid severe crunches in credit
markets at tax dates. Of course, one might
argue that the market’s learning process is
rapid and that it would not take more than
one or two tax dates before the market did
learn to borrow in advance, when short-term
interest rates would be tending to be lower.
While there is something to be said for ac­
commodating seasonal and temporary market
demands in the System’s day-to-day opera­
tions, there are also dangers. The chief danger
is that if economic activity is advancing faster

FOMC DIRECTIVE IN LATE 1960’s

than expected, there is likely to develop over
the short run a larger expansion of bank credit
and money than is desired for seasonal, tem­
porary, or longer-run growth reasons. On the
other hand, if the economy is weakening, the
System is likely to find itself in a position of
absorbing more reserves over the short run
than it may wish to when taking into account
the sustainable growth needs of the economy.
This condition might be corrected, of
course, either by strict adherence to the pro­
viso (that is, by making it more of a target) or
by adjusting the money market conditions tar­
get when the FOMC again meets. But in very
weak or very strong economic situations, small
adjustments in money market conditions— and
experience shows that in the past the FOMC
has moved in small steps with respect to
money market conditions—may not be suffi­
cient to achieve over-all financial conditions
consistent with desired economic activity. A
focus on money market conditions, therefore,
and a concern with stability of money market
conditions tend to limit the System’s ability to
control monetary aggregates and to effect the
desired associated changes in over-all credit
conditions and interest rates.
While money market conditions have gener­
ally been considered to be an operating and
merely instrumental target, they have been
moved infrequently enough and slowly enough
that, for all practical purposes, they as­
sumed the aspects of a goal of policy. The sta­
bility of the money market has clearly been a
short-run goal, but often the desire not to have
sharp shifts in money market conditions has
appeared to be a longer-run goal, in that the
System in the past has appeared reluctant to
change money market conditions by more than
small, gradual amounts. Such short-run and
longer-run goals for the money market can
often interfere with the attainment of the long­
er-run interest rate, bank credit, and money
objectives of policy— all of which appear to be
more closely related to economic activity than
are money market conditions themselves.
It is not without reason that the System



pays such close attention to the money market
and its operations. Many of the reasons have
been discussed earlier in this paper. In particu­
lar, the use of such a target for enabling the
System to provide for the seasonal and tempo­
rary reserve needs of the economy has been
noted. In addition, at least the theoretical con­
sistency between money market conditions and
longer-run policy goals will be sketched out in
a subsequent discussion of how the System
might attain credit conditions and monetary
flows consistent with a desired GNP, while op­
erating day to day on money market condi­
tions, through an interlocking set of short- and
long-run projections of financial and real
flows.
But perhaps the chief reason why the
FOMC has focused on the money market in
its operations has been the feeling that such a
focus would lead to less interest rate fluctua­
tion and less danger of liquidity crises than
would a focus on a monetary aggregate. The
history of central banking, and particularly the
genesis of the Federal Reserve System, has
had as one of its main themes the need to
have an institution that will be able to avert
old-fashioned financial panics by providing a
source of ultimate liquidity to the economy.
Thus, the state of the central money market—
where liquidity pressures focus—has histori­
cally been a main concern of the Federal Re­
serve. Perhaps partly explainable as an
outgrowth of such a tradition, it would appear
that the structure of the directive in the late
1960’s, not to mention earlier years, was con­
sistent with a belief by the FOMC that wide
fluctuations in interest rates over the short run
are more likely than short-run swings in the
money supply or bank credit to cause destabil­
izing disturbances in the behavior of borrowers
and lenders, who rely to a great extent on the
interest rate structure as a source of informa­
tion about current and prospective credit and
possibly economic conditions.
The sharp rise in both short- and long-term
interest rates over the latter half of 1969 cer­
tainly raised questions, however, as to how

much stability in interest rates is produced by
a focus on narrow money market conditions.
Setting aside the question of whether one
should stabilize interest rates at all in the short
run, it might be pointed out that more stability
could be introduced into the interest rate
structure, if that were desirable, by encourag­
ing offsetting fluctuations in the Federal funds
rate. That is, a tendency for bill or other inter­
est rates to rise could be offset by forcing the
Federal funds rate down, and vice versa. This
might be desirable, depending on economic
prospects, but there is the danger that such a
policy would simply increase the likelihood of
providing reserves procyclically. For example,
if people expected interest rates to rise, an ef­
fort by the System to lower the Federal funds
rate and to provide more nonborrowed re­
serves in order to prevent such a rise would
result in an even larger short-run rise in the
money supply than would otherwise be the
case. And this might over the longer run fore­
stall a rise in market interest rates if the
greater expansion in money should lead to in­
flationary expectations.
While changes in money market conditions
to offset fluctuations in over-all interest rates
are not desirable in a period when the econ­
omy is either strengthening undesirably or
weakening undesirably, it may be desirable to
permit money market conditions to move in
such a way as to reinforce over-all interest rate
movements. That is, the money market itself
might be permitted to tighten as other interest
rates rise, or to ease off as other interest rates
decline. But if the money market is permitted
to tighten sharply, there is a danger that the
tightening might affect the solvency of dealers
in securities who may have exposed positions
and may rely on the money market for financ­
ing. Thus, an excessive tightening of the
money market over the short run could lead to
some failures of underwriters and to an associ­
ated weakening of confidence generally.
While there is reason for the System to as­
sure a degree of stability in the money market,




more fluctuation in money market conditions
than has been permitted seems to have desira­
ble aspects. An emphasis on money market
conditions apparently leads many market par­
ticipants to view a change in money market
conditions as signaling a change in policy. If
the money market were permitted to fluctuate
more, this view might be eroded. To the extent
that that happened, the System’s flexibility in
attaining targets for interest rates more gener­
ally, reserves, or other monetary aggregates
would be enhanced.
A greater fluctuation in money market vari­
ables, once the market had become accus­
tomed to such fluctuation, would not appear in
and of itself to affect credit conditions that af­
fect spending. As the Federal funds rate
fluctuates up and down, banks are unlikely to
change loan and investment policies, and deal­
ers in securities are unlikely to become signifi­
cantly more or less aggressive in bidding for a
position in securities. But a clear trend in
money market conditions toward either the
tight or easy side would, as it has in the past,
have an effect on over-all credit conditions.
If the money market were permitted to fluc­
tuate more, this might make it possible for the
System to carry out an open market policy with
less short-run variability in the money supply,
bank reserves, bank deposits, and possibly even
interest rates generally. But whether it is better
policy to minimize short-run variability in the
money supply or short-run variability in
money market conditions is a much debated
question.
If the System were to move to a monetary
aggregate target for the short run, the effect on
money markets would depend on how the
value of the aggregate was chosen. The System
could choose, for example, to expand bank
credit in accommodation of Treasury financing
demands in a current month just as it would
under a fixed money market conditions target.
If the staff projected that bank credit would
expand at a 15 per cent annual rate in a
month with fixed money market conditions,

FOMC DIRECTIVE IN LATE 1960’s

given the Treasury financing and past seasonals, and the Committee accepted the 15 per
cent as a suitable target for the month, then it
is likely that money market conditions, assum­
ing the staff is correct, would remain relatively
stable within the month and would show little
change from the previous month.
In practice, however, if an aggregate were
taken as a primary target, the money market
would be likely to fluctuate more than in the
past because the Manager would have to move
rapidly to attain the aggregate target if the
projections appeared to be wrong. But an ag­
gregate target over a 1-month period is not
likely to be considered except as a part of a
desired longer-term trend. And as it became
clear to the market what the longer-term trend
appeared to be, some of the short-run varia­
tion in money market conditions might tend to
moderate as borrowers and lenders became
more efficient in discounting the future.

POSSIBLE RELATIONSHIP BETWEEN
THE STRUCTURE OF THE
DIRECTIVE AND A THEORY OF
MONETARY POLICY FORMULATION
The second paragraph of the directive is es­
sentially an instruction to the Manager on how
to operate in the open market during the inter­
val between Committee meetings. In that sense
the second paragraph need not be interpreted
as representing monetary policy, if monetary
policy as it influences financial markets is to
be judged by such key variables as over-all
credit conditions, interest rates, the availability
of funds to the mortgage market, the money
supply, and the liquidity positions of banks,
other financial institutions, corporations, and
individuals. All of these key financial variables
can change while the operating phrases in the
second paragraph of the directive remain un­
changed, at least as the directive was struc­
tured in the latter part of the 1960’s. It takes




only a cursory reading of history to point out
such periods, but the one that comes to mind
most quickly is the period from the spring to
the end of 1969, when there was a sharp tight­
ening in what almost anyone would call mone­
tary policy—whether judged by interest rates,
money supply, or liquidity—without any ac­
companying change in the second paragraph of
the directive.
Since money market conditions themselves
are not a key variable affecting spending, the
theory of using money market conditions, with
a proviso clause, as day-to-day operating vari­
ables in the directive can be explained by not­
ing one possibility of how the second para­
graph of the directive of the late 1960’s might
relate to projections for key financial variables
that affect the economy and to projections of
economic activity itself. It should first be
pointed out that the view of these interrelation­
ships to be presented here represents a theory
that it is not clear that all, or even most, mem­
bers of the FOMC held, particularly as the
theory pertains to the role of the proviso. Nev­
ertheless, it is a theory that is generally con­
sistent with the type of information presented
by the staff to the FOMC, although as will be
brought out in the concluding section of the
paper, there are gaps between theory and
practice. Some of these gaps may reflect the
fact that the FOMC itself did not accept or
did not follow the theory, and some may be
because the detailed information and interrela­
tionships required by the theory simply were
not ascertainable with a reasonably small mar­
gin of uncertainty, given the state of economic
knowledge.
FORMULATION
OF LONGER-RUN
PROJECTIONS. The staff ordinarily presents
to the FOMC longer-term projections of devel­
opments in the economy, with certain assump­
tions as to monetary policy. These assumptions
have been expressed in various ways at various
times; for example, at times they have been
expressed in terms of a particular bill rate, at
other times in terms of a growth in bank

credit, and at times in terms of growth in total
reserves. Most frequently, perhaps, the policy
assumptions are stated as a collection of finan­
cial flow and interest rate variables that are
believed to be mutually consistent.5
Basic to the formulation and operations of
monetary policy is a long-run forecast of how
the economy is likely to develop over a period
of, say, 1 year. For the purposes of this analy­
sis, the techniques of such forecasts—the alter­
natives and problems of which have been under
intensive debate among economists for some
time now—will not be discussed. Within the
structure of a long-run forecast of economic
activity—meaning GNP in both real and nomi­
nal terms—there would be contained a time
path of economic activity. The units of time
could be as small as one would like, but the
state of economic data and the art of forecast­
ing suggest one quarter as a reasonably short
division of time for projections of real eco­
nomic activity and associated financial flows.
While the quarterly pattern of projections
within the context of a longer-run projection
may be satisfactory for policy formulation by
the FOMC, it seems clear that even shorterrun projections, at least of certain key financial
variables, are needed for the operations of pol­
icy in the open market in order to verify that
policy is on the track of the longer-run projec­
tion, assuming that attainment of the latter
projection represents a goal of policy.
But before discussing the projections needed
for day-to-day open market operations, it is
necessary, first, to consider in a little detail the
assumptions behind the longer-run forecast of
real activity and financial flows, since this fore­
cast is presumed to provide the ultimate guide­
line for operations. One basis for a longer-run
forecast would be an assumption of no change
in over-all credit conditions as currently pre­

5 The following few paragraphs on the formulation
of longer-run projections and their relation to operat­
ing guides are based for the most part on a paper,
“Notes on Monetary Policy Formulation and Opera­
tions,” written by the author for another occasion.




vailing, or changes in credit conditions could
be posited if required to lead to a desired
GNP. One reason for using an assumption
about credit conditions is that most of the
links thus far found between financial condi­
tions and categories of spending appear to be
from the credit side—interest rates and credit
availability—rather than from the asset side—
money supply and so forth. A forecast could
also be constructed on the assumption of no
change in the rate of money supply growth
from, say, a growth of the previous several
months on average. And, of course, assump­
tions about credit conditions imply a particular
money supply growth, and vice versa. But for
purposes of presenting a theory consistent with
the directive of the late 1960’s, it will be as­
sumed that projections of GNP are based on
credit market assumptions.
An assumption of unchanged credit condi­
tions from those prevailing in the recent past
might not be inconsistent with some fluctuation
or movement of nominal interest rates, but it
would not be consistent with such large varia­
tions as to change the willingness of borrowers
to undertake credit-financed spending from
what had been anticipated at the time of the
forecast. Real economic activity also depends,
of course, on past financial market conditions
as they have come to influence spending in the
quarters ahead. Finally, fiscal policy, wage and
price pressures, and exogenous shocks to the
system—such as technological changes, unfore­
seen defense emergencies, and sudden surges
of consumer optimism or pessimism—all influ­
ence the forecast of economic activity.
For the forecast level of GNP to be real­
ized, a certain pattern of financial flows would
be required, given current and past credit con­
ditions. This pattern would reflect the credit
demands of businesses, individuals, the U.S.
Treasury, and State and local governments.
The financing of these demands, given a level
and structure of interest rates, would imply a
distribution of financial assets held by consum­
ers and others that would in effect serve as a
source of funds for the borrowers. Thus, the

FOMC DIRECTIVE IN LATE 1960’s

money supply, time deposits, savings and loan
shares, and so forth fall out of the projection;
and so does the need for aggregate bank re­
serves.
If the pattern of real economic activity in
the projection is satisfactory to the monetary
authority, then in view of how the projections
were made, there will be no need for monetary
policy to be changed—in the sense that there
is no need for open market operations to be
directed toward achieving firmer or easier
over-all credit conditions. But that does not
mean that there would be no short-run varia­
tions in rates of growth in bank reserves and
the money supply, given the lumpiness of var­
ious types of demands from both the U.S.
Government and businesses, as required to be
consistent with the longer-run financial and
credit flows necessary to achieve the desired
level of growth of economic activity.
If some other pattern of change in real eco­
nomic activity were desired by the FOMC, a
consistent projection of real economic activity
and financial flows could, of course, also be
worked out, with the effects of past monetary
policies imposing a restraint on how soon a
more desired economic goal might be achieved
or on how large a wrench might be required in
the financial system to attain it.
ROLE OF MONEY MARKET CONDI­
TIONS AND PROVISO IN RELATION TO
LONGER-RUN PROJECTIONS. A structure
of interest rates and pattern of financial flows
consistent with the credit and money demands
generated by the desired level of economic ac­
tivity can be attained by using money market
conditions as a day-to-day guide for open mar­
ket operations as described in the earlier sec­
tion of the paper, provided the relationship
among money market conditions, financial and
monetary flows, over-all credit conditions, and
desired GNP can be reasonably well predicted.
In this context, day-to-day open market opera­
tions conducted in terms of money market con­
ditions can be said to be free of the sin of
money market myopia. But they can only be
said to be so if there is no hesitancy in reset­




ting the money market conditions guide when
it appears that over-all credit conditions are
becoming tighter, or easier, than desired. What
all this amounts to is that money market con­
ditions have little meaning for policy in and
of themselves and that they acquire meaning
only as they lead to changes in financial vari­
ables that affect spending.
Needless to say, however, there can be
many slippages between the specification of the
set of money market conditions and the ensu­
ing financial developments that more directly
affect GNP (as well as reflect GNP), just as
there can be large miscalculations as to the
basic state of aggregate demands in the econ­
omy or of the degree of fiscal stimulus and re­
straint. Because of these slippages and because
money market conditions in themselves do not
include variables that directly affect spending,
it would appear that such conditions would
have to be varied frequently as errors in speci­
fication between money market conditions and
variables that affect spending become apparent
or as errors in projections of aggregate demand
become apparent. In practice, therefore, one
would on theoretical grounds expect rather fre­
quent changes in both the directive and in
projections.
One way of hedging against the possibility
that given money market conditions are lead­
ing to a policy that condones undesirable eco­
nomic developments is to make short-run fore­
casts for time units of less than one
quarter—such as for the months within the
quarter—for certain key banking and mone­
tary variables, such as total reserves, nonbor­
rowed reserves, money supply, and time de­
posits, that are immediately responsive to open
market operations. In other words, money
market condition targets can be set in the ex­
pectation that they will lead to a certain
growth of bank credit, money, and reserves
over a particular 1-month period, which repre­
sents an interval roughly reflective of the time
between FOMC meetings. And the growth
rate in such variables over that month—as
well as the successive monthly projections

—would be consistent with the quarterly
growth rates that are implicit in the credit con­
ditions leading to the GNP forecast—provided
all the elements were put together consistently,
that is, with correct analysis of the relation­
ships between real economic activity and credit
conditions (taking due account of the distinc­
tion between nominal and real interest rates in
judging the appropriateness of credit condi­
tions), between credit conditions and the pub­
lic’s preferences for assets, and between finan­
cial flows this month and next month. That
such relationships can be predicted with accu­
racy represents, of course, a very heroic as­
sumption, but this paper is discussing theory
as much as reality.
The proviso clause in the directives of the
late 1960’s can be interpreted as using total
member bank deposits subject to reserves—
called the bank credit proxy—as a variable for
testing the consistency between money market
conditions and projected developments in the
real economy. If the successive weekly and
monthly observations of this variable were ris­
ing faster than projected, the assumption
would be that GNP was stronger than ex­
pected. If this variable were weaker than pro­
jected, the assumption would be that GNP was
weaker.
On this theory that the proviso clause is the
link between the day-to-day money market
conditions target and the ultimate GNP goal,
two principal criteria for the variable to be in­
cluded in the proviso clause could be reasona­
bly posited: one would be its responsiveness to
GNP, and the other would be the ready availa­
bility of data on a daily basis so that they
could be taken into account in the course of
operations. Still another criterion might be the
controllability of the variable through open
market operations; but this criterion becomes
more important to the degree that the proviso
is considered more as a target to be attained
rather than as an indicator of GNP trends.
And the proviso may have certain target as­
pects because under particular conditions—
such as inflation—the FOMC might wish to




put more stress on attaining the specified ag­
gregates if it felt relatively more uncertain
about appropriate credit conditions because of
inability to evaluate the impact of inflationary
expectations on interest rates. The ambiguities
in the concept of the proviso—whether it is a
target or an indicator of whether GNP and as­
sociated credit demands are behaving as ex­
pected—are discussed in somewhat more detail
later in this section.
Whether total member bank deposits meet
the first criterion of being related to aggregate
economic demands in a consistent manner is a
testable proposition. On a priori grounds, one
might think that the money supply would be a
better variable in this respect, since the income
elasticity of money probably dominates the in­
terest rate elasticity of money. Total member
bank deposits, on the other hand, include a
time deposit component that is highly elastic
with respect to interest rates and probably less
elastic with respect to income.
In its short-run forecasts of total member
bank deposits, the staff does attempt to esti­
mate the extent to which time and savings de­
posits, as well as demand deposits, will be af­
fected by the level of market interest rates
expected to accompany a given level of money
market conditions. Thus, an expected amount
of so-called intermediation or disintermediation
is included in the forecast. For purposes of the
proviso clause, the assumption could then be
made that if the projection of total member
bank deposits is wrong, it is wrong not be­
cause of errors in forecasting intermediation or
disintermediation, but because the assumption
about aggregate demands is wrong. It is ob­
vious, however, that the staff may also miscal­
culate the income elasticity of total member
bank deposits, even if its forecast of GNP is
correct.
The monthly projections of monetary aggre­
gates provided to the FOMC may be thought
of as the link between day-to-day money mar­
ket conditions and real economic activity. This
link depends on a degree of detailed knowl­
edge about the functioning of the economy and

FOMC DIRECTIVE IN LATE 1960’s

about interrelationships between real and finan­
cial variables and among financial variables
that is barely attainable by the human mind,
and is certainly not at hand at the moment.
Thus, at best, the directive may be said to
have been working with a very imperfect
mechanism, but a mechanism—that is, a pro­
viso clause—which was probably better than no
such mechanism at all, for it may give correct
signals in periods when there are large devia­
tions in GNP as compared with projections.
Before the problems of errors and uncer­
tainties implicit in such a theory and practice
of the directive are discussed in somewhat
more detail, the ambiguities in the role of the
proviso clause in practice need to be brought
out. Many apparently have considered that the
proviso clause represented a target for policy,
not an indicator of whether money conditions
were set in such a way as to achieve a desired
GNP. Those who have considered the proviso
as a target, therefore, have been concerned
about whether it measures bank credit prop­
erly, if that is taken as a goal of policy. It may
have been concern with the target aspect of
the proviso that led the FOMC to add to total
member bank deposits the funds obtained
abroad through Euro-dollars and obtained do­
mestically through nondeposit sources when
specifying the ranges for the proviso. But if the
proviso is taken purely in its indicator role—
that is, its role as reflecting transactions or
credit demands in the economy—it is not clear
that it needs to be a comprehensive measure of
bank credit. In this sense, the use of the term
“bank credit proxy” may have led to consider­
ably more conceptual confusion than is
necessary.
The theoretical bases for considering the
proviso clause as a target as compared with
considering it as an indicator of whether the
relationship between money market conditions
and evolving GNP is about as expected would
appear to be quite different. Taking it as a tar­
get, one would have to argue that the proviso
clause should contain a flow variable readily
controllable by the Federal Reserve and most




likely to lead to desired GNP in the future,
given the lags in monetary policy. Moreover,
one would probably also have to argue that
the proviso clause should be the principal op­
erating instruction. However, taking the pro­
viso clause as an indicator of GNP (not as an
indicator of monetary policy in this context, it
should be stressed), one might argue that it
need only contain a flow variable that is
highly income-sensitive and that is readily
available. It is not immediately apparent that,
insofar as monetary aggregates are concerned,
a target variable and indicator-of-currentGNP variable need be one and the same,
though this is an empirical question basically.
But there does seem to be some uncertainty in
the FOMC directive as to which type of vari­
able has been sought.
ERRORS AND UNCERTAINTIES CON­
SIDERED. As the previous section has at­
tempted to make clear, there is considerable
scope for error in the relationship between the
operating targets in the second paragraph of
the directive and the ultimate goal of policy—
a satisfactory performance of the economy in
terms of activity, prices, and the balance of
payments. Errors in projections of GNP and in
prices, since they are given in framing monthly
and quarterly financial projections, can ob­
viously lead to errors in the directive variables
given to the Manager. In addition, GNP
might be correctly projected, but the staff
might err in its evaluation of the relationship
between current financial flows and the given
GNP. Finally, there may simply be random
variations, or noise, affecting monthly esti­
mates of monetary flows. One result of ran­
dom events or noise as a source of misestimation would be that, if money market conditions
were given in the directive, bank credit might
turn out to be stronger or weaker than pro­
jected, but still not be inconsistent with the de­
sired GNP. Nevertheless, the deviation of bank
credit from projections might trigger the pro­
viso clause and set up a chain of events that
would lead to an undesired GNP. The possibil­
ity of this sort of error is one of the reasons

why the proviso clause was generally not trig­
gered except in cases of large deviations from
projections, and that when triggered, it led to
only very minor changes in money market
conditions.
There are potential sources of error that
would affect operations, of course, regardless
of whether the directive was couched in terms
of some monetary aggregate rather than money
market conditions, or whether the clauses in
the directive were reversed—that is, with an
aggregate in the principal clause and money
market conditions in the proviso. But the
sources of error might differ somewhat. With
some sort of monetary aggregate target—such
as the money supply—there would be some
built-in protection against underevaluating the
effect of inflationary expectations on nominal
interest rates and thereby choosing a wrong in­
terest rate target when using a market condi­
tions guide. On the other hand, a money sup­
ply target might very well be set wrongly—say,
too low—in relation to liquidity demands, with
the result that credit conditions become too
tight to achieve desired GNP.
In general, linkages between financial varia­
bles and economic activity, as well as among
financial variables, including money market
conditions, are—despite two decades of empir­
ical research—still subject to considerable un­
certainty. As a result, any form of directive by
the FOMC is likely to involve the risk of error
and thus of poor policy after the fact, though
presumably economic research will lead us to
a point where it will be possible to specify op­
erating variables that at least minimize the po­
tential deleterious effect on the economy of
mistakes in projecting relationships among
economic and financial variables. Whether
such operating variables would encompass
monetary aggregates, interest rates, or some
combination of the two is not within the pur­
view of this paper.
The potential sources of errors are the result
of uncertainties as to linkages between and
among financial and economic variables, as
well as the unpredictability of exogenous




shocks to the economy, such as wars, techno­
logical breakthroughs, and erratic changes in
consumer buying sentiment. There is uncer­
tainty as to which financial variables affect
economic activity—for example, it is not clear
whether or what type of rationing occurs in
the economy when there is a shortage of credit
relative to demand, or whether the balancing
of demand and supply is accomplished com­
pletely through interest rates. It is not clear
what the lags are between changes in financial
variables and changes in economic activity.
And it is not clear how strong a change in fi­
nancial variables is required to obtain a given
effect on economic activity—that is, whether
the money supply should rise or fall 2 or 4 per
cent, or whether interest rates should fall or
rise 2 or 4 percentage points.
In addition to these uncertainties as to link­
ages, there are uncertainties as to how much
variability should be permitted in key financial
variables over the short run. One of the prem­
ises underlying the form of the FOMC direc­
tive in the latter part of the 1960’s was that it
is better to keep money market conditions
stable over the short run, while permitting
more short-run variability in such items as the
money supply, longer-term interest rates, and
even Treasury bill rates.
A decision to stabilize money market condi­
tions would appear to assume that this will
lead to fewer mistakes with respect to other fi­
nancial variables that more directly affect the
desired volume of economic activity than
would a decision to stabilize a longer-run in­
terest rate or a money supply variable itself. In
other words, the directive of the late 1960’s
seemed to assume that the greater variability
in member bank borrowings and the Federal
funds rate that might result from specification
of a money supply or total reserve target
would be more harmful to the economy—
given the prevailing state of uncertainty as to
what should be the level, rate of change, and
value of key financial variables—than would
stability of money market conditions. The rea­
son would have to be that a money market

FOMC DIRECTIVE IN LATE 1960’s

conditions target gives maximum scope for per­
mitting market demands to determine financial
flows and for permitting expectations to deter­
mine movements in interest rates away from
the basic relationship to the Federal funds
rate. These may be determinations that the
FOMC felt it could not make directly, at least
in the short run, because in the current state
of knowledge it could not know the linkages;
or because it believed that the demand for
money is inherently unstable; or because, out
of concern with the potential for liquidity
crises, it placed higher value on money market
stability in the short run than on predeter­
mined levels or rates of change in other varia­
bles.
Perhaps at the risk of reading more into the
framing of the directive than was in the minds
of the framers, it would appear that uncertain­
ties as to linkages between financial variables
and economic activity, and uncertainties as to
the ability to determine the short-run demand
for money and bank reserves, were important
factors behind the choice of money market
conditions as the principal operating target. In
addition, it is likely that money market condi­
tions can be thought of as bearing a closer and
more predictable relationship to over-all credit
conditions and liquidity positions of banks and
other key lending institutions. This may be a
reason why those who adhere to a view that
credit conditions—rather than changes in the
public’s holdings of financial assets, particu­
larly money—determine spending may feel
more comfortable with the money market con­
ditions target. But for those who hold such a
theory, it is difficult to understand why it
would not be better to specify some particular
interest rate, constellation of interest rates, or
desired reduction or enhancement of liquidity
for banks, as a target instead.
However that may be, the uncertainties
faced by the policy-makers, together with the
need to provide the Manager with an attaina­
ble target, provided them with a reason for ad­
hering to money market conditions as a shortrun operating guide for the System Account




Manager, while at the same time keeping an
eye on other financial variables that bear more
direct relations to spending and to GNP in the
formulation of policy.
MONEY MARKET CONDITIONS: POL­
ICY TARGET ASPECTS. While the staff s
presentations and projections of GNP and
financial variables in both the short run and the
long run do give members of the FOMC
an idea of what is likely to happen to key
variables under given money market condi­
tions, there is still the danger that a directive
couched primarily in terms of money market
conditions will lead to unexpected and unde­
sired changes in variables that are more di­
rectly reflective of the impact of monetary pol­
icy on GNP. This can happen not only
because of errors in staff projections but also
because money market conditions themselves
can come to be taken as an objective of pol­
icy. Money market conditions can become an
objective of policy partly because the need for
a stable money market in the short run is over­
stressed. But it can happen in part because a
continued stable money market comes to be
viewed by the market as an objective of pol­
icy. When this occurs, the System often tends
to get locked in, because it feels that any
change in money market conditions will be in­
terpreted as a change in policy and, therefore,
lead to overreactions by market participants
and others. This is particularly true in periods,
such as 1969, when abatement of inflationary
psychology appeared to be the ultimate aim of
monetary policy. With that aim, there seemed
to be the fear that any change in money mar­
ket conditions would be interpreted itself as
signaling a change in policy and thus would
fuel inflationary psychology.
Whatever the relation in particular periods
among money market conditions, over-all
credit conditions, and the money supply, it
does seem clear that concentration on money
market conditions in the operating paragraph
of the directive has led both the Committee
and the market at times to interpret these con­
ditions as policy itself. If an operating directive

or so large an easing (or tightening) of credit
were phrased in terms of some monetary ag­
conditions as might be necessary to achieve its
gregate, or even in terms of over-all credit
economic goals. Thus, there may have been a
conditions, the Manager might have more dif­
conflict between the attitude toward money
ficulty in operating but there would tend to be
market conditions and what is necessary to
less confusion between operating variables and
achieve changes in financial variables that
the financial conditions that are the goals of
more directly affect changes in the public’s
policy. Such a directive might also lead to
spending
propensities.
more fluctuation in money market conditions
—but that would come to be considered nor­
mal. However, it is difficult to predict how
money market conditions would react over the
longer run to such a recasting of the directive,
RECAPITULATION AND
since the market itself might find ways of sta­
CONCLUDING REMARKS
bilizing itself as borrowers and lenders come to
discount the future more accurately.
This paper has attempted to indicate how
In sum, the second paragraph of the direc­
the construction of the second paragraph of
tive would appear to have had only a tenuous
the FOMC directive, as it was in the late
relationship to monetary policy as most econo­
1960’s, related to the flow of money and depos­
mists perceive such policy. That relationship
its and of interest rates broadly conceived in
has depended on staff projections of the rela­
the practice of open market operations. It also
tionship between money market conditions and
attempted to present one theory—though ad­
other financial variables. These projections are
mittedly one that might not be generally held
generally made known in summary form to the
or acted upon by the FOMC—as to how the
public when the policy records are released
money market conditions operating guide in
after a 3-month lag. Unless money market
the second paragraph, in conjunction with the
conditions themselves change, many in the
proviso clause, could be fitted into a nexus of
market do not consider that monetary policy
financial and nonfinancial projections of the
has changed, and it is not completely clear
economy and related to financial variables that
that this view has not also been held by many
more directly affect spending decisions. It was
members of the FOMC.
not the task of the paper to determine if an­
The focus on money market conditions has
other theory—for example, one that put more
in practice tended to prevent the Committee
stress on monetary aggregates both in opera­
from adjusting these conditions rapidly.
tions and in their role in economic forecasting
Changes in money market conditions, when
—would improve the functioning and posture
they have been undertaken, have been under­
of monetary policy. But the paper has pointed
taken gradually. Another reason for gradual
out the great uncertainties present in the eco­
changes, apart from concern with the money
nomic and financial relationships that would
market as such, has been the uncertainty of the
have to be projected both over short and over
System as to effects of its actions or as to their
longer periods of time to satisfy the theoretical
desirability. This resulted in a directive that
basis presented here for the FOMC directive
specified attainment of slight, modest, or mod­
of the late 1960’s. Uncertainties, though per­
erate changes in money market conditions. But
haps of not exactly the same sort, would also
because of this unwillingness to move money
plague other conceivable forms of a directive.
market conditions rapidly at times, the System
While the general problem would appear to
may also have been put in the posture of not J be one of finding a form for the directive that
being able to encourage so rapid an accelera­
would minimize the potential for errors in pol­
tion (or decelaration) in money supply growth
icy, it does not appear that the directive of the



FOMC DIRECTIVE IN LATE 1960’s

late 1960’s, even on its own terms, quite lived
tions will, perforce, be appropriate. Such a
up to the theory that has been constructed for
theory does not imply that monetary policy
it here. There were, in other words, gaps be- y ' would stabilize either interest rates broadly
tween theory and practice. Some of these gaps
conceived or a rate of change in some monemay have occurred because the theory re­
tary aggregate. It does imply, however, that
quired more knowledge or explanation than
over the short run money demands would be
was, or conceivably could have been, pro­
accommodated at any given Federal funds
duced; some, because the FOMC simply oper­
rate, and to that extent policy operations
ated on another theory or theories; and some
would tend to moderate fluctuations in other
because money market conditions in practice
interest rates, although such rates would still
took on aspects of a target role instead of
be affected by changes in expectations and
shifts in credit demand.
playing only an instrumental role in policy.
(3 i Under such a theory, economic and as­
The following points recapitulate the high­
sociated financial projections are required for
lights of the paper and offer some conclusions:
1.
Neither the first nor the second para­ several quarters ahead, as are short-run projec­
tions—for, say, a month—of key monetary
graph of the FOMC’s directive to the Ac­
flows, such as bank credit and the money sup­
count Manager, nor the relation between the
ply. The short-run projections can be used to
two paragraphs, has been completely under­
indicate whether the money market conditions
standable when the directive is considered by
fixed
for the interval between FOMC meetings
itself, or perhaps even when it is taken in con­
are
leading
to the flows of bank credit and
junction with the simultaneously published
money
that
were
projected over the longer run
policy record. It can be best understood as an
to
be
consistent
with
desired GNP, given credit
aspect of the whole procedure at FOMC meet­
conditions, and interest rates. To the degree
ings, including the economic information and
that the short-run flows are showing changes
projections presented and the discussion of
greater or less than projected, the presumption
policy by the members of the FOMC as ulti­
is that GNP, or aggregate demand, is stronger
mately revealed in the minutes published for the
or weaker than projected. In this view, the
meeting. Within this context a theory for the
proviso clause in the second paragraph serves
directive might be constructed, particularly a
as an indicator of aggregate demand, which
theory that relates the operating instructions
would suggest that the variable included in the
of the second paragraph to the economic fore­
clause should be one that is dominated more
cast and objectives that are noted, however
by income elasticity than by interest rate elas­
vaguely, in the first paragraph.
ticity. This may be an argument for using
C£*)One theory for using money market
money supply rather than bank credit, al­
conditions—essentially the net free or net bor­
though the staff projection of bank credit
rowed reserve position of member banks and
would have already allowed for the interest
the Federal funds rate—as a day-to-day oper­
elasticity of bank deposits, particularly time
ating guide for the Account Manager would be
deposits.
that such conditions bear a predictable relation
4.
There are many gaps between theory
to over-all credit conditions, that over-all
and practice. The most obvious is that even if
credit conditions (including interest rate struc­
such a theory provided a proper basis for pol­
ture, bank liquidity, and so forth) can be set
icy, the requisite economic knowledge of inter­
so as to influence economic activity in a de­
relationships among financial variables and be­
sired direction or toward a desired level, and
tween financial variables and real economic
that the flow of bank reserves, bank credit,
activity might not exist to permit the attach­
and money expected to result from the money
ment of a high degree of probability to the nec­
market conditions and desired credit condi-




essary projections. It is probably recognition of
the uncertainties about the state of economic
knowledge—not to mention the sharp and
unexplained swings noticeable in daily and
week-to-week deposit and reserve data—that
led the FOMC to require implementation of
the proviso clause for the most part only when
deviations from projections were “significant”
and that led to only very minor variations in
money market conditions when the proviso
clause was implemented.
5. Another gap between theory, at least as
presented here, and practice is that the proviso
may have been considered to serve partially as
a target for monetary policy rather than as an
indicator of the relationship between money
market conditions and GNP. Viewing the pro­
viso clause as a target may help to explain
why it focused on bank credit (which those
who start from credit conditions may believe to
be a reasonable short-run target related to
spending)—without here discussing whether the
change in bank credit was really a desirable
flow target (as compared with other possibilities
such as the change in aggregate reserves or
money supply). But if the proviso were taken
as a target, it does not appear to have been a
very high-priority one, since experience shows
that money market conditions were not varied
rapidly enough or to the extent necessary to
keep bank credit within proviso limitations
when it tended to move significantly outside
those limitations.
6. The desire of the FOMC to minimize
short-term variability in money market condi­
tions, as well as the relatively small changes in
such conditions that were undertaken when the
money market target was shifted, suggests that
in themselves money market conditions were to
some degree a target of policy, rather than
being merely instrumental variables through
which the interest rate and financial flow, and
ultimately economic, objectives of policy are
attained. While the relation between free re­
serves and over-all credit conditions might be
predictable— at least judgmentally if not econ-




ometrically—experience, especially in 1969,
appears to indicate that the relation is not con­
sistent—that is, with fixed free reserves, credit
conditions can and will change. Thus, mini­
mizing fluctuations in money market condi­
tions and changing such conditions only grad­
ually over the longer run would represent yet
another gap between theory as presented here
and practice— unless, of course, the FOMC
willingly accepts the changes in over-all credit
conditions (not to mention inflows of mone­
tary aggregates) that accompany an un­
changed, or only gradually changing, level of
free reserves.
7.
As a short-run target, money market
conditions have the advantage of permitting the
market to make decisions about the appropri­
ate short-run flows of bank credit and money.
But as is well known, so accommodative a
monetary policy might lead the System also to
provide larger or smaller amounts of reserves,
credit, and money than are consistent with de­
sired economic objectives if credit demands
turn out to be stronger or weaker than pro­
jected, or, expressed in another way, if bank’s
demand for free reserves turn out to be weaker
or stronger than expected. The proviso, of
course, has represented something of a hedge
against such undesired short-run developments.
But if the economy weakens or strengthens
considerably more than expected, the proviso
is a weak hedge unless the FOMC is willing,
either when it meets or in the interval between
meetings, to move money market conditions,
or permit them to be moved, rapidly enough
to offset the changing impact on reserves of
demand forces. For example, both the money
supply and interest rates may be declining be­
cause demand is weakening; to turn the econ­
omy around under such circumstances may re­
quire a sharp easing of money market
conditions (for example, a sharp short-run de­
cline in member bank borrowings, assuming
they are already high) if the Federal Reserve
is to do more than merely permit a built-in
flexibility of over-all interest rates to brake the

FOMC DIRECTIVE IN LATE 1960’s

decline in economic activity and is to encour­
age an expansion of economic activity, credit,
and money.
8. The target aspect of money market
conditions inhibits the flexibility of monetary
policy when these aspects become so ingrained
in market thinking that the System is reluc­
tant to move for fear that any move will be
overinterpreted. When combatting inflationary
psychology is taken as a primary goal of pol­
icy, for instance, it becomes difficult to permit
an easing in money market conditions because
this might be taken as signaling an unwilling­
ness of the System to persist in its efforts to
reduce inflationary expectations.
9. The short-run stability of money mar­
ket conditions and the gradualness of any
longer-run change in money market conditions
tempt one to the conclusion—be theory what
it may—that a basic reason for couching the
second paragraph in such terms was prag­
matic. Given uncertainties as to the proper
levels or changes in money supply, bank credit,
or interest rates, money market conditions
represented objectives that were readily attain­
able, that kept the scope for the Account Man­
ager’s judgment within reasonable bounds, and
to which the Account Manager could be
readily held accountable*
10. Within the context of the theory pre­
sented in this paper, or almost any other
theory of how monetary policy works, it would
appear desirable to permit more short-run vari­
ability in money market conditions and to move
such conditions more rapidly or frequently over
the longer run in carrying out open market op­
erations. This would, at a minimum, reduce the
market’s focus on these conditions and thus in­
crease the flexibility of the FOMC in attaining
targets for reserve or monetary aggregates, if it
so wished, or even in attaining credit condition
objectives in relation to shifting demands and
GNP by reinforcing, or offsetting, a tightening
or an easing of trends in credit terms and con­
ditions when it appeared desirable to do so.
11. There are probably some limits to the




flexibility that could be permitted in money
market conditions, although the degree of limi­
tation is both a conjectural proposition and an
empirical question on which precious little evi­
dence is available. Such limitations would ap­
pear to apply more to the tightening side than
to the easing side. When interest rates are ris­
ing, a considerable tightening of the money
market might have undesirable repercussions
on such sensitive market participants as secu­
rities dealers, who might be faced with the pros­
pect of failures if carrying costs rose sharply
relative to the return on their pre-existing se­
curity holdings, and might thereby lead to fi­
nancial crises that would affect confidence gen­
erally. Even on the easing side, a sharp easing
of money market conditions could lead to an
overly large build-up in speculative positions
in securities, which might force the System to
provide more reserves and money than it
would otherwise want to, or be faced with
considerable market confusion and churning if
the market were forced to liquidate these posi­
tions over the short run.
But in the absence of much recent experi­
ence with a monetary system in which rela­
tively wide fluctuations in money market
conditions were permitted,0 it is obviously hard
to tell how the market would react in such a
different environment. If human nature is any
guide, there will be periods of market prob­
lems, including undue speculation, no matter
what the system by which monetary policy
works. Some concern with money market con­
ditions might reduce this problem, but the con­
tribution of money market stability might not
be commensurate with the key role of such
conditions in the directives of the late 1960’s
and of earlier years, and with the System’s ap­
parent unwillingness to change such conditions
except by small degrees.
12.
Perhaps the chief general conclusion
to be drawn from the rather lengthy analysis
6 Very wide fluctuations may not develop if the
market discounts the future properly.

of this paper is that a workable theory for the
directive of the late 1960’s might be con­
structed, but that in practice there are gaps—
some of which may have been unavoidable
given the state of economic knowledge—be­
tween theory and practice. Among the require­
ments for bridging theory and practice are a
more certain knowledge of relations among fi­

nancial variables and between these and eco­
nomic activity, a sophisticated and consistent
meshing of short- and long-run projections,
and a willingness to reduce the target aspects
of money market conditions and regard them
solely as instrumental variables capable of
short-run fluctuation and more rapid trend
movement.

APPENDIX:
An Empirical View of “Even Keel”
whole are highly sensitive to the reception of
Treasury financings because o f the sheer size of
offerings, the involvem ent of the U .S. Govern­
ment’s credit, and the key role o f the Govern­
ment securities market in liquidity and portfolio
adjustments o f investors.
Even keel should be sharply distinguished from
the old pre-1951 policy o f pegging interest rates
on U.S. Government securities. The even-keel
policy does not provide any assurance that partic­
ular interest rates on new or outstanding Treas­
ury issues will be maintained. Rather, the evenkeel approach only helps to sm ooth the process
of marketing several billion dollars o f Treasury
issues (even more in the case o f advance or pre­
refundings). It provides those who help under­
write Treasury issues (such as banks and non­
N o t e — The views expressed in this appendix do
bank U .S. Governm ent securities dealers) with a
not necessarily represent those of the Federal Re­
short period of time in w hich market forces
serve System. Parts of this paper are drawn from a
rather than new m onetary policy decisions are
previously unpublished paper on the subject prepared
the main factors affecting interest rates. Those
by the author and Joseph E. Bums.
1 Discussion of the even-keel policy has usually who make markets in U .S. G overnm ent securities
been focused on its relation to tightening actions. But
are by no means assured o f stable interest rates
in practice the policy also influences the timing of
on the new issues, but they do have som e time to
easing actions. For instance, a discount rate reduc­
contact customers with n o more than a normal
tion in the middle of a Treasury financing period
market risk on their temporary holdings o f secu­
may be avoided because it might encourage undue
speculative activity.
rities.

The words “even keel” refer to the policy pur­
sued by the Federal Reserve in relation to Treas­
ury financings. In practical terms even keel has
meant that, for a period encompassing the an­
nouncement and settlement dates of a large new
security offering or refunding by the Treasury,
the Federal Reserve has not made new monetary
policy decisions (as contained in announcements
from the Board of Governors or as specified in
the second paragraph of the policy directives of
the Federal Open Market Committee) that would
impede the orderly marketing of Treasury securi­
ties and significantly increase risks o f market dis­
ruption from sharp changes in market attitudes in
the course o f a financing.1 Financial markets as a




FOMC DIRECTIVE IN LATE 1960’s

Because o f the relatively limited nature o f the
Federal R eserve’s even-keel commitment, the def­
inition of the comm itm ent in terms o f financial
variables is to a degree equivocal. The timing of
even keel, the behavior o f interest rates and other
monetary variables, and the extent o f Federal R e­
serve open market operations depend in large
part on the type o f market and market psychol­
ogy that develops in anticipation or in the wake
o f the Treasury financing involved. The purpose
o f this paper is to review the behavior of key fi­
nancial variables during the 3 years 1966-68 in
an effort to determine how much variation or
stability they show during even-keel periods in
comparison w ith other periods.
This empirical approach is designed to shed
some light on the variations in financial variables
that have been tolerated under the constraint of
even keel. But the results are necessarily limited
by inability to quantify market attitudes, changes
in which w ill influence the tolerance with which
the market views differing degrees o f variations
in interest rates, reserves, and related measures.
The results are also limited in part by the
“crude” nature o f the empirical analysis o f the
paper, w hich consists o f charting time series for
the relevant variables and o f scanning these series
for differences in behavior. W hile such an ap­
proach has obvious limitations, its advantage is
that even-keel periods can be easily viewed in re­
lation to longer-term trends and turning points in
such trends. M oreover, fluctuations o f a variable
within an even-keel period are also discernible.
And questions as to the exact dating o f even-keel
periods can be m inimized since the charts would
indicate the direction o f change if 1 or 2 weeks
were added to, or subtracted from, the beginning
or end o f even-keel periods.
the

t im in g

of

even

keel

and

O F T R E A SU R Y ISSU E. The policy
directives o f the Federal Open Market Committee
provide a basis for dating even-keel periods and
for relating them to the type o f Treasury security
offering. Such directives during even-keel periods
would refer to Treasury financings as a factor to
be taken into account in the conduct o f open
market operations. Generally the directive would
also stipulate that operations should be directed
to maintenance o f prevailing m oney market con­
ditions. But it is also possible that the operations
could be directed toward tightening or easing.
type




This could occur, for example, if the directive
were written for a policy period that begins
fairly well in advance of the anticipated Treasury
financing announcement, thereby permitting some
adjustment in policy prior to the financing period.
Or this could occur to permit some shading to­
ward restraint or ease depending on the develop­
ing market attitude toward the financing, includ­
ing the speed with which the financing is
distributed in the secondary market and the ex­
tent to which the market is tending to discount
potential Federal Reserve action in advance.
The time span of, and money market stability
during, even keel has varied in the past with the
nature o f the Treasury financing, with the market
environment, and with the urgency behind the
need for a monetary policy change. For purposes
of this study, the interval from a week before the
announcement of terms to a week after settle­
ment date has been taken as the basic unit of
time for an even-keel period, but shortened
when necessary to be consistent with the dating
of FOMC directives referring to Treasury financ­
ings. The various relevant dates that bear on even
keel are shown in Table 1.
In practice, even keel might extend somewhat
beyond 1 week after settlement date if an espe­
cially large volume o f new securities were left over­
hanging the market, whereas if the new offering
were small or well distributed even keel might
end at settlement date. And the period might not
begin until 2 or 3 days before announcement
date, depending on market conditions as they af­
fect the Treasury’s ability to appraise pricing of
the new issues. On balance, the basic unit o f time
for even keel in this study probably tends to err
on the generous side.
Even keel has been applied quite consistently
to coupon issue financings, which are generally
large in size. A period o f 2 to 3 weeks normally
elapses between announcement o f the offering
and payment. The Treasury sets the price and
coupon rate when the offering is announced; a
few days later books are open and the public
places its orders; and a week and a half or more
passes before payment or settlement date on the
new issue.
In contrast to offerings of coupon issues, the
even-keel constraint has not been regularly a fea­
ture o f FOMC directives around Treasury bill
financing periods. When it has been, the period

ings varied between $3 Vi billion and %AVi billion
in size.
There are a number o f reasons for keeping the
even-keel period short in relation to bill financ­
ings and for applying it less rigorously, if at all.
First, the bill is auctioned, so there is less
need to hold markets stable between announce­
ment date and auction date; in a coupon financ­
ing, on the other hand, the new issue is priced by
the Treasury at announcement in the expectation
that market attitudes will not shift significantly in
the interval (typically 5 days in recent financ­
ings) until the books are open. Second, the risk
of price fluctuation to holders o f bills, which ma-

has generally been shorter than for coupon issues,
although it has also overlapped a coupon issue
period and thereby lengthened the time when
even keel has been applied in consecutive weeks.
Even keel has been noted in directives at times
when bill issues for cash have been large and/or
when short-term markets have been likely to be
under particular strain. During the 3 years
1966-68, there were three instances in which the
even-keel constraint was noted in the directive in
relation to Treasury bill financings raising net
new cash, out of 12 such financings in the period
(other than simply additions to the regular
weekly or monthly bill actions). The three financ­
TABLE 1: Treasury Financings During Even-Keel Periods

D escription o f offering

D a tes related to even keel
B ooks
opened

Settlem ent
date

A ttrition or
a llo tm e n t ratio

D irective
date

A n nouncem ent
date

1 2 /1 4 /6 5
1/11

1 /5

1 /1 0

1/19

Cash

1/11
2 /8

1 /2 6

1 / 3 1 - 2 /2

2 /1 5

1 3 .7

4 /1 2
5 /1 0

4 /2 7

51 2 -5 /A

5 /1 5

Rights
(incl. pre­
refunding)
Rights

2 .5

18 m o

7 /2 6

7 /2 7

8 /1 -8 /3

8 /1 5

8 .1

1 yr
4 yr 9 m o

1 0 /4
11/1

1 0 /5

10/11

1 0 /1 8

Rights
(incl. pre­
refunding)
TA

3 .5

185 d a y
247 day

11/1

1 0 /2 7

H /1

1 1 /1 5

Cash

3 .2

1 yr 3 m o
5 yr

. 30(A L )
. 10(A L )

1 /1 0
2 /7

1 /2 5

1 /3 0

2 /1 5

Cash

3 .9

1 yr 3 m o
5 yr

. 10(A L )
.07CAL)

5 /2

4 /2 6

5 /1 -5 /3

5 /1 5

9 .1

1 yr 3 m o
5 yr

.1 9 (AT)

4 .0

Type

A m o u n t1
(billions o f
dollars)

M aturity

1966
1 .5

. 14(A L )

10 m o
18 m o
4 yr 9 m o

1 7 . 4 / . 17(A T)
,4 6 (A T )
* 4 .3 /.2 0 ( A T )

1967

6 /2 0

6 /2 8

7 /5

7 /1 1

R ights
(incl. pre­
refunding)
TA

7 /1 8

7 /2 6

7 /3 1

8 /1 5

Cash

3 .8

255 day
286 day
1 yr 3 m o

.3 5 (A L )

8 /1 5

8 /1 7

8 /2 2

8 /3 0

Cash

2 .6

3 yr 5

. 38(A L )

10 /3

9 /2 2

1 0 /3

1 0 /9

TA

4 .4

1 0 /2 4

1 0 /2 5

1 0 /3 0

1 1 /1 5

Cash

4 .8

196 day
259 day
1 yr 3 m o
7yr

2 /6

1/31
2 /8
5/1
5/1
7/3 1

2 /5
2 /1 3
5 /6
5 /8
8 /5

2 /1 5
2/2 1
5 /1 5
5 /1 5
8 /1 5

R ights
Cash
R ights
Cash
Cash

1 2 .0
4 .1
3 .9
3 .2
5 .1

7 yr
15 m o
7 yr
15 m o
6 yr

.2 8 (A T )
.3 9 (A L )
.3 0 (A T )
.2 8 (A L )
. 18(A L)

1 0 /2 3

1 0 /2 8

1 1 /1 5

Rights

5 .5

18 m o
6 yr

,3 3 (A T )

rno

_
.3 6 (A L )

1968

4 /3 0
7 /1 6
1 0 /8
1 0 /2 9

1 O ffered to the public.
2 A m o u n t exchanged in pre-refundings in b illio n s o f dollars.
A L allo tm e n t ratio; A T attrition ratio; T A ta x anticipation bill.




FOMC DIRECTIVE IN LATE 1960’s

ture in a year or less, is smaller than to holders
o f intermediate-term or long-term coupon issues.
And third, the time span between auction and
payment for bills is generally about 1 week, while
for coupon issues 10 to 14 days usually elapse be­
tween subscription and payment dates; this is a
technical matter, but presumably it reflects the
shorter period normally required to distribute a
new bill issue as compared with a longer-term
obligation.
E V E N KEEL A N D IN TER EST RATES.
Interest rates have shown a relatively large
amount o f movement during even-keel periods.
M ovements o f interest rates are shown in Chart
1, with even-keel time spans represented by the
shaded areas. It is not without interest that the
even-keel periods defined as noted above take up
roughly 40 per cent of the 36 months shown.
Norm al quarterly refundings themselves would
lead to even keel for about one-quarter o f the
year, with the actual result being a little more or
a little less depending on market conditions and
also the requirements of monetary policy. W hen
the Treasury raises cash, or undertakes advance
refundings outside the regular quarterly refunding
period, monetary policy is affected at rather more
frequent intervals.

Day-to-day m oney rates. Short- and long-term
interest rates show different patterns of move­
ment during even-keel periods and also differ in
relation to their behavior outside such periods.
Day-to-day rates, such as the Federal funds and
dealer loan rates, sometimes fluctuate rather
sharply within an even-keel period, just as they
do in other periods. For instance, the Federal
funds rate fluctuates in response to week-to-week
shifts in the distribution o f reserves between
country and city banks. However, these rates gen­
erally do not show either an upward or down­
ward trend in even-keel periods. Trend move­
ments in such rates— that is, a clear upward or
downward tendency persisting for some weeks—
generally occur in the periods between even keel.
W hile an absence of trend movements in dayto-day m oney rates is a characteristic of evenkeel periods, there have been a few exceptions
during the period under review. In even-keel peri­
ods during the winter and spring of 1966, direc­
tives sought some reduction in reserve availabil­
ity, while taking into account forthcoming or
current Treasury financings. These directives cov­
ered the mid-February and mid-M ay refundings.
Federal funds and dealer loan rates did not in
any event show a rising trend in the first o f these

FIGURE 1

INTEREST RATES
in c i. t . a .

in c i. t . a .

Per cent

t.a .

6.5

5.5

4.5

3.5

6.5

5.5

4.5

MAR.

JUNE

1966

SEPT.

DEC.

MAR.

JUNE

SEPT.

1967

Shaded areas indicate periods of even keel. T.A. tax anticipation bill.




DEC.

MAR.

JUNE

1968

SEPT.

DEC.

periods, but in the even-keel period covering
from about the third week in April to the third
week in May, an upward trend in Federal funds
and dealer loan rates was in practice permitted to
develop.
Because the A pril-M ay period illustrates a
modest tightening o f policy during even keel, it is
worthwhile to note the results o f the financing
and market factors bearing on it. The financing
involved was a $2.5 billion rights exchange (in
terms o f public holdings) involving an offering of
a single 18-month note. The attrition rate for this
offering was very large— 46 per cent— the highest
attrition rate by far in the period covered. Of
course, A pril-M ay 1966 was a period of sharply
rising loan demands in credit markets, so the
unfavorable reception might be partly attributed
to cash needs o f commercial banks and other
holders o f the maturing issue. In addition, the
market was disappointed at that time by a fading
of hopes for a program for fiscal restraint. Fi­
nally, the offering was priced to have a yield ad­
vantage o f 10 to 12 basis points over the out­
standing market, which represents only a normal
yield spread between new offerings and outstand­
ing issues of a comparable maturity. All in all,
there appear to be a variety of market factors ac­
counting for the poor reception o f the issue, but
tightening of monetary policy, as expressed by
money market conditions, and expectations of
further tightening certainly contributed.
Bill rates. Treasury bill rates, as indicated by
the yield on the 3-month bill, tend to display
roughly the same kind of behavior— both in
terms o f fluctuation and trend— during an evenkeel period as is characteristic of the span of sur­
rounding weeks and months. In 1965, a year not
shown on the chart, bill rates— not to mention
other rates— showed little movement in or outside
even-keel periods. In the 1966-68 period, how­
ever, bill rates moved relatively widely both in
and outside even-keel periods.
As examples of cyclical-trend movements in
bill rates in even-keel periods during the 1966-68
period, there were upward movements in the rate
during the late July-late August 1966 period and
in the M ay 1968 period; there were downward
m ovem ents in the late January-late February
1967 period and in the late A pril-M ay 1967 pe­
riod. It is likely that the more evident trend
movem ent in the 3-month bill rate, as compared




with day-to-day m oney rates, in even-keel periods
reflects the role o f expectations in determining in­
terest rates. With a 3-month horizon, investors in
3-month bills are more likely to be influenced by
what monetary policy— and also other factors
such as debt management and business credit de­
mands— may be expected to do in the period
ahead. Consequently, even-keel policies w ould be­
come correspondingly less important in influenc­
ing these interest rates during the weeks in which
even keel is in effect.
Longer-term rates. Longer-term rates, as typi­
fied by the yields on 3- to 5-year Governm ent
securities and on such securities maturing in over
10 years, would also tend to be less influenced
than day-to-day m oney rates by current monetary
policy, and longer-term rates do show trend
movements both in and outside even-keel periods.
They have both risen and fallen in even-keel pe­
riods, the direction being generally consistent
with the over-all tendency o f surrounding peri­
ods. Rate movements appear to have generally
been larger in magnitude outside even-keel pe­
riods, but this is by no means always the case.
For instance, there was a very sharp rise in the
yield on intermediate-term Governm ents in the
mid-July-late August period o f 1966. T his was a
relatively large refunding, including a pre-refund­
ing, that zeroed in on the intermediate-term cou­
pon area. Moreover, the financing took place in a
period when financial market pressures were
building to a peak; and certain tightening m one­
tary policy measures, including increases in re­
serve requirements announced in late June and
mid-August, were put into effect quite close to
the refunding period. With respect to open mar­
ket operations, the FOMC directive on July 26
indicated an even-keel stance and no change in
money market conditions.
While even keel was technically in effect in
this financing, the sharp rise of interest rates in
the maturity area containing one o f the new is­
sues offered in the refunding reflects the general
expectation o f the time that financial markets
were facing a credit crunch. This expectation, in
turn, was partly a reflection o f the monetary pol­
icy actions that appeared to be in train before the
even-keel period, and in prospect afterwards.
Thus, a technical even-keel condition did not
forestall a tightening of financial markets; nor
was it accompanied, at that time, by any expan­

FOMC DIRECTIVE IN LATE 1960’s

show less cyclical or trend m ovem ent than the 3month bill rate and longer-term market rates in
even-keel periods, but they do fluctuate widely
and occasionally do m ove persistently in one
direction.
Free reserves showed downward movements in
the February and May 1966 periods, for example,
when the FOM C was tightening in terms of re­
serve availability, while taking account o f Treas­
ury financing. On the other hand, free reserves
rose, and member bank borrowings declined, in
the even-keel period of O ctober-N ovem ber 1966,
beginning the trend m ovem ent in those variables
that lasted until the spring o f 1967.
In 1968, net borrowed reserves deepened,
and member bank borrowings rose, during the
even-keel period in February. The FOM C direc­
tive o f February 6, 1968, sought to maintain firm
conditions in the m oney market, but permitted
operations to be modified to the extent permitted
by the Treasury financing if bank credit appeared
to be expanding as rapidly as projected. The ex­
pansion o f bank credit in that period apparently
was sufficiently large to lead to some diminution
in the extent to which reserves were supplied by
open market operations (that is, through nonbor­
rowed reserves) relative to demand.

sion in the monetary base (member bank reserve
balances plus currency held by banks and the
public), bank credit, or the money supply.
Sharp downward movements in longer-term in­
terest rates began in the middle o f the M ay 1968
even-keel period and continued until the August
period. Brightening prospects for fiscal restraint
legislation contributed to the turnaround. And the
decline was sustained by an accomm odative open
market policy, as indicated by the mid-June and
mid-July directives. These directives stipulated
that open market operations should accom m odate
tendencies for short-term rates to decline (in
mid-June) and for less firm m oney market condi­
tions to develop (in m id-July). The mid-July
directive took cognizance o f the forthcom ing A u­
gust refunding in the operating paragraph. But
the mid-June directive did not take note o f an
early July $4 billion tax bill financing, as the
market atmosphere o f the time clearly posed no
marketing problem for even a very large bill
financing for cash.
M A R G IN A L RESERVE M E A SU R E S. Free
reserves and member bank borrowings, shown in
Chart 2, behave somewhat the same in even-keel
periods as does the cost of 1-day m oney— that is,
Federal funds and dealer loan rates. T hey tend to
FIG UR E 2

MARGINAL RESERVE MEASURES
Incl. T.A.

1966
S h ad ed

1967

areas in d ic a te p e r io d s o f e v e n k e e l. T .A . t a x a n tic ip a tio n b ill.




Billions of dollars

T.A.

1968

M O N ETA R Y A G G R EG A TES. The relation
between even keel and monetary aggregates
(monetary base, bank credit proxy, and money
supply) is both highly complex and erratic. As
shown in Chart 3, it is difficult to perceive signif­
icant differences in behavior o f the monetary base
in even-keel periods as compared with surround­
ing periods. In the summer and fall of 1966, the
monetary base showed virtually no growth in or
outside even-keel periods. Beginning in late 1966,
the monetary base began to expand, and a more
or less steady expansion persisted for the ensuing
2 years, with the rise in even-keel periods seem­
ingly little different from the rise outside such
periods.
It is true that in October of 1967 there was a
relatively sharp increase in the monetary base
during an even-keel period, as was also the case
in N ovem ber 1968. The October 1967 period
comprises a $4Vi billion tax offering. The re­
lationship to even keel was less direct than
with an ordinary even-keel constraint. The sec­
ond paragraph o f the directive o f October 3,
1967, noted that operations should be directed to
maintaining prevailing conditions in the money
market with a proviso that operations should be

modified to the extent permitted by Treasury
financing to moderate any apparent tendency for
bank credit to expand significantly more than
currently expected. Apparently bank credit (as
measured on a proxy basis weekly by total mem ­
ber bank deposits) did not rise significantly more
than expected, although the increase in the period
was quite sharp as shown in Chart 4. Growth o f
bank credit did slow in subsequent weeks.
While the monetary base appears to show rela­
tively little difference in behavior in even-keel as
compared with other periods, there are somewhat
more frequent occurrences o f differential behav­
ior for bank credit and m oney supply measures
(weekly figures on a daily-average basis).2 The
February 1968 coupon financing was an instance
of accelerated bank credit growth in an even-keel
period. This financing was a combination “rights”
exchange and cash financing, with the cash part
settled a week later than the exchange. A bout $4
2 Technically, differences in behavior among bank
credit, money supply, and the monetary base may be
explained by changes in deposit mix or in deposit
distribution between country and city banks. But the
monetary base series comes from a source different
from that for the credit and money supply series, and
the seasonal factors could Also be inconsistent.

FIGURE 3

MONETARY BASE
Billions o f dollars, seasonally adjusted

In c l, T.A ,

1966

1967

1968

M o n e ta r y b a se:
m em b e r ban k d e p o sits a t R eserv e B a n k s an d cu rren cy h eld b y b a n k s and th e n o n b a n k p u b lic .
S h a d ed a reas in d ic a te p e r io d s o f ev en k e e l. T .A . ta x a n tic ip a tio n b ill.




FOMC DIRECTIVE IN LATE 1960’s

the Treasury ($4 billion in tax bills and the re­
mainder in coupon issues). On the other hand,
through the summer and early fall o f 1966, bank
credit showed no tendency to expand— even keel
or not— despite about $8 billion of net new cash
raised by the Treasury, practically all through
new bill issues. In this period, banks were unable
to compete effectively for time deposits.
The money supply, too, showed more rapid
growth at times in even-keel periods than in
surrounding periods. A number of periods where
this seems the case may be cited— February
1967; May 1967; May 1968; and October
-N ovem ber 1968. It is not simple to develop an
explanation for this phenomenon. One might hy­
pothesize that the process of exchanging securi­
ties, or issuing new securities, at times leads to
enlarged holdings of cash balances as investors
prepare for and consummate payments— either
cash payments directly to the Treasury, or pay­
ments to other investors and underwriters for
buying “rights” or in secondary market distribu­
tion of the new issues. Some confirmation o f that
explanation might come from noting that money
supply growth slowed or contracted following
each of the even-keel periods noted above.
CONCLUSIONS. 1. Even keel has been ap­
plied consistently to coupon issue financings.

billion of new money was raised in the financing.
The large net new cash demand made the financ­
ing similar in effect on bank credit to the tax bill
financing noted above. There was, however, a
contraction in outstanding bank credit for some
weeks subsequent to the Treasury financing.
Bank credit also appeared to show an acceler­
ated expansion in the^O ctober-Novem ber 1968
even-keel period. The mid-November financing
did raise about $2 billion of new money. The ac­
celerated rate of credit expansion continued into
December, sustained by issuance o f a $2 billion
tax bill by the Treasury for payment in early D e­
cember— a financing that was not even keeled in
the sense o f recognition in FOM C directives.
It would appear that even keel is often associ­
ated with accelerated bank credit expansion in
periods when even keel is applied to financings
that raise large amounts o f net new cash and
when at the same time market interest rates are
low enough relative to Regulation Q ceilings that
individual banks do not feel constrained in their
ability to obtain time deposits and thus in their
capacity to invest in U.S. Government securities
as well as to make loans. In the long even-keel
period in the summer of 1967, there was an ac­
celerated bank credit expansion, w hich help ed
finance about $6Vi billion o f new cash raised by
FIGURE 4

BANK CREDIT AND MONEY STOCK

JW £

1966

SEPT.

DEC.

MAR.

JUNE

1967

Shaded areas indicate periods of even keel. T.A. tax anticipation bill.




SEPT.

DEC.

MAR.

JUKE

1968

With respect to bill financings, even keel has
been applied in large financings, but only in cer­
tain market situations, and has been generally ig­
nored in small financings.
2. There is nothing in the material analyzed
to suggest that even keel is necessarily a fixed pe­
riod or that it excludes some shading of policy
toward restraint or ease.
3. Even keel has been consistent with vary­
ing movements of bank credit, money supply,
and interest rates. If any variable were to be
taken as an objective indicator of even keel, at
least as it has unfolded in recent experience, one
would select the cost of 1-day money, and assign
marginal reserves to a secondary, but important,
role. These are the variables most in the minds of
market participants and also the ones that show
the least trend movement during even-keel periods
(after allowing for normal day-to-day or weekto-week fluctuations)—although even here market
participants would tend to recognize that financ­
ing demands related to the distribution of newly
offered Treasury securities would themselves tend
to exert upward pressure on day-to-day money
rates.
4. There have been fairly wide day-to-day
fluctuations in money market variables during
even-keel periods, and there have also even been
some trend movements reflecting efforts by the
FOMC to tighten or ease while taking account of
Treasury financings. At times, this has been ac­
complished while not changing the attitudes of
market participants because trend movements
have been disguised for a few weeks by the large
fluctuations that market participants are used to
or because they have encompassed only a small
portion of an even-keel period as defined for pur­
poses of this analysis.
5. While the wide variations in behavior of
the variables examined suggests that the even-keel
commitment is flexible not only in terms of tim­
ing but also in terms of credit conditions, any
sharp movements permitted in day-to-day money
market conditions, or even under some circum­
stances in interest rates, are likely over the short
run to risk an unsuccessful Treasury refunding
in the sense of an unexpectedly large attrition or
high allotment ratio.
6. Bill rates and intermediate- and long-term




rates are influenced by changes in the supply of
securities and by expectations as well as by mon­
etary policy. Thus, it is not surprising that bill
rates and other yields show movements independ­
ent of even keel. However, it may be that their
movements during financings would be more ex­
aggerated without the even-keel constraint. But
whether the trend of interest rates over a rela­
tively long period would be any different without
even keel is quite another, and an unresolved,
issue.
7. The behavior of monetary aggregates in
even-keel periods has not been consistent. But
when they have diverged from their behavior out­
side even-keel periods, it has been in the direc­
tion of relatively greater expansion, though often
offset by slower growth or contraction in subse­
quent weeks. The relatively greater expansion,
when it occurs, may not be a function of even
keel, however. It may more basically be a func­
tion of the way monetary policy is conducted—
with or without even keel. In general, monetary
policy attempts to encourage credit conditions in
the economy consistent with sustainable economic
growth. The credit conditions sought by the Fed­
eral Reserve influence the interest rates the Treas­
ury has to offer on its securities and the type of
buyer—for example, bank or nonbank—attracted
to these securities. Treasury credit demands, like
such demands from businesses or consumers,
tend to fall in part on banks, who may either buy
Treasury securities or help finance those who do.
And money supply may also expand as an as­
pect of the financing and distribution process.
Thus, credit demands or refinancings by the U.S.
Government at times have led to an accelerated
expansion in bank credit or money. But the ex­
tent to which this occurs will be affected by the
existing tautness or ease of credit markets as in­
fluenced by monetary policy; in 1966, for in­
stance, net cash borrowing by the Treasury did
not lead to expansion in bank credit or money.
In any event, the significance of any accelerated
expansion of monetary variables in even-keel pe­
riods—as in other periods—cannot be assessed
without evaluating the credit conditions with
which they are associated and the appropriateness
of these conditions to the economic goals being
sought.

by Richard G. Davis




SHORT-RUN TARGETS FOR
OPEN MARKET
OPERATIONS

CONTENTS




39

INTRODUCTION

41

OFFSETTING ACTIONS NEEDED
TO HIT TARGET VARIABLES AT THE
DESIRED LEVELS
A classification scheme for targets in terms of
needed offsetting actions
Targets in Group “A”
Targets in Group “B”
Targets in Groups “C” and “D”
Summary

41
41
42
44
44
45
46
46
46
48
48
54
56
56
58
61

MULTIWEEK STRATEGIES
FOR HITTING PARTLY ENDOGENOUS
TARGETS
Choice of variables to be used as a
weekly target
Translating the monthly target into appropriate
values of the weekly target
Error-response mechanisms
TRANSLATING MONTHLY TARGETS
INTO AVERAGE MONTHLY
VALUES OF WEEKLY TARGETS
Regression techniques
Implications of the regression results
THE EFFECTS OF QUANTITY TARGETS
ON MONEY MARKET STABILITY
The nature of the problem
An experiment
Evaluation

66
67

SOME MIXED STRATEGIES—
BLENDING MONEY MARKET AND
QUANTITY CONSIDERATIONS
IN FRAMING TARGETS
Pure money market strategies
Pure quantity strategies
The credit proxy proviso clause
Using money market targets as a tactical device
in a quantities-oriented strategy
Quantity targets with money market modifiers
A money market proviso

68

SOME GENERAL CONCLUSIONS

62

62
63
64
65

SHORT-RUN TARGETS

INTRODUCTION
This paper examines several types of targets
that could be used by the Federal Open Mar­
ket Committee to guide the actions of the
Manager during the interval between meetings.
The paper considers a number of different
monetary, banking, and money market meas­
ures that might be used as target variables, as
well as strategies that could be used to aim the
variable chosen at the target value selected by
the Committee.
The paper starts from the premise that
whatever may be the ultimate goals of the
FOMC and whatever criteria (or indicators) it
may use to judge the impact of its decisions,
the Committee must give instructions to the
Manager to determine his actions between
meetings. For various reasons, these instruc­
tions will not be couched in terms of goal vari­
ables such as the gross national product or the
rate of change of the price deflator. These in­
structions may or may not be couched in terms
of the same variables the Committee uses to
measure the impact of its actions. For example,
the Manager may be instructed to hold free
reserves within a given range, making free
reserves the target variable, and at the same
time the Committee may use levels of free
reserves to define degrees of policy tightness
and ease. Thus the same variable, free reserves
in this case, may serve both as “target” and as
“indicator”—to use the Brunner-Meltzer termi­
nology.1 Alternatively, the instructions to the
Manager might be couched in terms of free
reserves, but the Committee might judge tight­
ness and ease in terms of some other variable
such as the monetary growth rate—that is,
target and indicator may be distinct.
N o t e .—The author, who is Adviser to the Federal
Reserve Bank of New York, is indebted to Paul Meek
for many useful conversations on the subjects dis­
cussed in this paper. He would also like to thank
Susan K. Skinner for excellent research assist­
ance. The author assumes sole responsibility for the
views expressed.
1 See, for example, Karl Brunner and Allan
Meltzer, “The Meaning of Monetary Indicators,” in
G. Horwich, ed., Monetary Process and Policy
(Homewood, 111.: R. D. Irwin, 1967), pp. 187-217.




In any case, the target variable or variables
will almost certainly come out of a familiar, if
rather long, list of banking and money market
measures—free reserves, nonborrowed re­
serves, the money supply, and so forth. A tar­
get may take many forms. Thus, for example,
it might be stated in terms of a single value, or
in terms of a range of values. The target might
be a single variable or it might be several vari­
ables—provided, of course, that the values or
ranges chosen for these variables were compa­
tible during the period in question. The pri­
mary target variable might be made subject to
a side condition stated in terms of some other
variable—as in the case of the so-called proviso
clause.2 The target might be stated in terms of
an explicit or implicit weighted average of
several variables. For example, the famous
notion of money market “tone” as a target may
be thought of as a weighted average of several
measures of marginal reserves and money mar­
ket rates—with the weights left unquantified,
though hopefully reasonably well understood in
any given historical situation.
Much of the attention of this paper is de­
voted to ways in which the so-called “aggrega­
tive” or “quantity” variables (such as money
supply and bank credit) could be used as tar­
gets, the accuracy with which such targets
could be hit, the cost of aiming at such targets
in terms of money market stability, and the
ways in which the use of such targets could be
reconciled with an acceptable minimum of
market stability. These subjects have been cho­
sen for the major share of attention because
they seem to be the ones of greatest interest at
the moment.
On the other hand, relatively little is said
about money market targets as such. Experi­
ence has already taught us much about such
targets and there seems little new to be
added in a general way. Another subject that
is treated only tangentially is the relative mer­
its as between different quantity (or aggrega­
2 For a discussion of the proviso clause see pp.
64-65.

tive) targets: Is M t a better target than M 2? Is
M 2 a better target than bank credit? Most of
the interesting problems that arise in trying to
answer such questions turn out really to be
questions as to which variable is the more eco­
nomically meaningful, which variable is the
better measure of the impact of the System on
the economy, and which variable better char­
acterizes the tightness or ease of policy. Since
the paper is concerned only with the “target”
properties of these variables as such, questions
of this kind are considered off limits.
While the paper makes no attempt to come
up with a specific recommendation from
among the various possible targets, the writer
should perhaps admit to a feeling that for var­
ious reasons, the System is likely in the future
to judge its performance more on the behavior
of quantities—monetary and bank credit
growth rates—than it has in the past and less
on the basis of money market conditions. By
the same token, the degree of control provided
over some of these quantitative growth rates
seems likely to become a more weighty consid­
eration in the choice of FOMC procedures in
the future than it has been in the past— even if
this means some reduction in the ability to sta­
bilize money market conditions.
The format of the paper is as follows: The
first section looks at the various possible tar­
gets from the point of view of the noncon­
trolled variables that must be offset to hit these
targets. Out of this analysis it picks the varia­
bles that appear to be operationally feasible as
week-to-week objectives. The second section
considers the main elements of multiweek
strategies, strategies through which targets not
feasible as week-to-week objectives may never­
theless be hit over the longer period between
FOMC meetings. The third section considers
ways in which targeted values of such multi­
week targets (for example, the monetary
growth rate) might be translated into appro­
priate average weekly values of the variables
used as week-by-week targets (such as non­
borrowed or free reserves). In addition, this
section attempts to provide some assessment of




the accuracy with which variables such as the
monetary or bank credit growth rates could be
manipulated over periods as short as a month
or a quarter if such manipulation became the
deliberate and sole objective of open market
operations.
The fourth section tries to determine how
much buffeting the money market might suffer
if the use of money market targets were re­
placed by procedures that aimed directly at the
monetary aggregates without special regard for
their market consequences. The fifth section
offers some “mixed” strategies through which
control over monetary aggregates might be
blended with concern for a reasonable degree
of money market stability. The final section of­
fers some brief general comments on the re­
sults of the paper.
For convenience, a list of the variables con­
sidered singly or in combination as possible
targets, and the symbols used to represent
them, follows ;
Ru

Rt
Re
Rb
Rf
Rr

Bu
Bt
C
Dp
Dt
Mx
m2

BC
FR

rd
n

Member bank nonborrowed re­
serves
Member bank total reserves
Member bank excess reserves
Member bank borrowed reserves
Member bank free reserves
Member bank required reserves
Nonborrowed monetary base
Total monetary base
Currency in hands of nonbank
public
Private demand deposits adjusted
Treasury deposits
Private demand deposits adjusted
plus currency
Private deposits adjusted plus
currency
Total bank credit
Bank credit proxy (variously de­
fined)
Federal funds rate
Discount rate
Treasury bill rate

SHORT-RUN TARGETS

A CLASSIFICATION SCHEME FOR
TARGETS IN TERMS OF NEEDED OFF­
SETTING ACTIONS. Table 1 summarizes the
noncontrolled items that must be offset to fix
the target variable listed in the left-hand col­
umn at whatever level or range has been speci­
fied by the Committee. The targets listed have
been divided into four groups, A, B, C, and D,
according to the different sorts of problems in­
volved in hitting specific values of each target
within a given reserve-averaging period—that
is, one week.
TARGETS IN GROUP “A.” The first
group of items, the A group, is the easiest to
hit. The noncontrolled factors that must be
offset to hit targets in this group are entirely
exogenous with respect to open market opera­
tions. Hence there will be no feedbacks, no
“simultaneity problem” involved. The first two
items, nonborrowed reserves and the nonbor­
rowed monetary base, can be hit on a weekly
basis with as much (but no more) accuracy as
the noncontrolled operating transactions, such
as float, can be forecast. The second two tar­
gets, nonborrowed reserves less reserves re­
quired behind Treasury deposits and the non­
borrowed base less such required reserves,
obviously require, in addition to the operating
transactions, correct forecasting of the behav­
ior of Treasury deposits at commercial banks.

OFFSETTING ACTIONS NEEDED TO
HIT TARGET VARIABLES AT THE
DESIRED LEVELS
The only variable under the complete and di­
rect control of the Open Market Account
Manager is the size and composition of the
Account’s portfolio. Nevertheless, for obvious
reasons, the portfolio has in recent times sel­
dom if ever been suggested as a target varia­
ble. Thus every variable that has been sug­
gested is determined in part by actions not
under the direct control of the Manager. Some
of these actions are taken by the Treasury,
some by the banks, some by the public, and
some, even, are Acts of God! Thus the first
question in determining the feasibility of hit­
ting any particular target variable is: “What
noncontrolled items are involved?” Since hit­
ting the target means adjusting the portfolio to
offset the effects of these noncontrolled items
on the target variable, the next consideration
may well prove to be: “How well can the
movements in the noncontrolled items be pre­
dicted?” or alternatively, “Can the movements
of the noncontrolled items be known soon
enough so that the appropriate offsetting ac­
tions can be carried out during the time period
—day, week, or month—during which the tar­
get variable is to be hit?”

TABLE 1: Target Variables and Noncontrolled Items to be Offset

T arget

A - Rn-Rr T reas,.
Bm-RT T r e a s ...

B

............

B*
R*-Rr T r e a s ...
JB*-Rr T r e a s ...
f A fi.............. ..

c j[ M t ...........
D i

O perating
transaction s

Excess
reserves

B orrow ed
reserves

X
X
X
X
X

irff.......................




M em ber bank
reserves required against—
T im e

Treasury

Private
dem and

N et
interbank

X
X

X
X
X

D em a n d
dep o sits
at n o n ­
m em ber
ba n k s

T im e
M arket
d e p o sits
dem ands
a t n o n - fo r variou s
m em ber
instrubank s
m en ts

X
X
X
X

X
X
X
X
X
X
X
X

T o ta l
required
reserves

X
X
X
X
X
X
X

X
X
X

X
X
X
X
X

X
X
X

X
X
X
X

41

Free reserves, the final item in the A group,
require the offsetting of both operating trans­
actions and changes in required reserves. Since
the advent of lagged reserve accounting, how­
ever, required reserves are known at the begin­
ning of each week and hence present no
additional forecasting problem.
Prior to lagged reserve accounting, of
course, required reserves were not strictly pre­
determined. However, the working assumption
of the System seems to have been that re­
quired reserves were, in fact, largely independ­
ent of the level of nonborrowed reserves in the
same week. Put differently, the banking sys­
tem’s purchase of assets was assumed to be
rather unresponsive to the state of money mar­
ket conditions within the same week. Under
the circumstances, required reserves would
have been determined largely by conditions in
previous weeks and therefore would have been
essentially exogenous insofar as the current
week was concerned. Hence, to the extent that
this is true, the introduction of lagged reserve
accounting has not changed the situation in
any fundamental way, although it has reduced
the number of exogenous variables that the
System must forecast in any given week.
TARGETS IN GROUP “B ” Success in
hitting targeted values of variables in the B
group involves offsetting items whose move­
ments are themselves functionally related to
the volume of open market operations under­
taken within any given week. As a result, at­
tempts to aim directly at variables in the B
group require not only projections of exogen­
ous movements in operating transactions but
also some attempt to estimate the feedback ef­
fects of open market transactions on other var­
iables entering into the target. For the varia­
bles included in the B group, the crux of the
feedback problem lies in the long-observed in­
terdependence between the volume of nonbor­
rowed reserves supplied through open market
operations and the volume of borrowed re­
serves supplied through the discount window.
To analyze the problem and the possibilities
for hitting targets in the B group, it is useful



to analyze the market for reserves as that mar­
ket exists within a given reserve-averaging pe­
riod. In the general case, it can be assumed
that bank demands for both borrowed and ex­
cess reserves are interest rate sensitive—per­
haps the Federal funds rate is especially rele­
vant. Required reserves are predetermined by
lagged reserve accounting as noted. Nonbor­
rowed reserves are an exogenous variable, be­
ing determined by market factors and System
operations. In the linear case, the system of
equations describing the reserve market is
therefore simply as follows (ignoring constant
terms):
( 1)

Rb =

(2)

Re = b(r/f) + et

(3)

Rt ^ Rb + Ru

(4)

R t s Re + Rr

where eh and ee are random variables repre­
senting the random components of the de­
mands for borrowed and excess reserves, re­
spectively.
If the System supplies reserves, its actions
will tend to raise nonborrowed reserves and
lower interest rates. Excess reserves will tend
to rise and borrowed reserves will tend to fall.
The Trading Desk can predict the effects of its
actions on these magnitudes and on total re­
serves only if it has some notions about the
elasticities of demand for borrowed and excess
reserves—in addition, of course, to predictions
about the behavior of operating factors.
Some features of the situation are brought
out more clearly by solving equations 1 to 4
for the reduced form equation for total re­
serves.

r^se*-r ^ w ’

+
As the equation indicates, errors in predicting
operating factors and stochastic elements in
the demands for excess and borrowed reserves
would remain as sources of error even if the

SHORT-RUN TARGETS

Desk knew the elasticities of demand for ex­
cess and borrowed reserves. Since a, the inter­
est rate coefficient of the demand for borrowed
reserves, is equal to or greater than zero, and
since bf the interest rate coefficient of the de­
mand for excess reserves, is equal to or less
than zero, b/(b — a), the response of total re­
serves to an increase in nonborrowed reserves,
will be nonnegative.
However, the response of total reserves in a
given statement week to an injection of nonbor­
rowed reserves in the same statement week
may approach zero under two circumstances.
First, it will approach zero for very large val­
ues of a—that is, when demands for borrowed
reserves are very sensitive to the interest rate
effects induced by increases or decreases in
nonborrowed reserves. In the limit, an increase
in nonborrowed reserves will be exactly offset
by the repayment of borrowings without any
perceptible fall in interest rates. Thus in this
case, an increase in nonborrowed reserves has
no effect on total reserves until the point is
reached where borrowings are reduced to zero.
Further increases in nonborrowed reserves be­
yond this point, however, increase total re­
serves by the same amount, with the interest
rate falling enough to absorb the entire in­
crease into excess reserves.
Second, b/(b — a) will approach zero as b
approaches zero—that is, when demands for
excess reserves are very msensitive to interest
rates. In the limit, the demand for excess re­
serves reduces to a random variable (presuma­
bly with positive mean), and the reduced form
equation 5 for total reserves becomes
(5a)

Rt = Rr + ee

In this case, as in the first case, an increase in
nonborrowed reserves will, in general, have no
effect on total reserves within the same state­
ment week. An increase in nonborrowed re­
serves tends to push down interest rates. But
since, by assumption, this fall in rates pro­
duces no rise in the demand for excess re­
serves, the fall in rates must proceed far
enough to induce banks to repay borrowed re­




serves by the full amount of the increase in
nonborrowed reserves. (As in the first case,
this process is obviously limited by the fact
that borrowings cannot fall below zero.)
How likely is it that one or the other of
these two extreme cases will prevail and that,
as a result, the Desk will have little or no in­
fluence on total reserves within a given state­
ment week by its actions within that week?
The first possibility, in which the elasticity of
demand for borrowed reserves approaches in­
finity, can be ruled out. Indeed, all of the ar­
gument has been over whether borrowings
show any substantial responsiveness to interest
rates. The second case, however, in which the
interest elasticity of the demand for excess re­
serves approaches zero, seems to have some
real significance. Market experts apparently
believe, for example, that when excess reserves
are down to virtually frictional levels, as at
present (fall 1969), demands for excess re­
serves may be quite insensitive to rate fluctua­
tions within the normal range, so that weekto-week fluctuations in excess reserves have to
be treated as essentially random.
The following example (summarized in
Table 2) was suggested by one market ob­
server. Suppose, as at the present writing, that
net borrowed reserves are around $1.0 billion
in a given week. Suppose that in the following
week required reserves rise by $200 million. If
the System supplies $200 million in nonbor­
rowed reserves, free reserves will obviously re­
main unchanged. Abstracting from random
shifts in the demand for excess and borrowed
reserves, the Federal funds rate would also be
unchanged, as would both excess and bor­
rowed reserves. Total reserves would rise by
the $200 million increase in nonborrowed
TABLE 2: Example of Change in Reserves—Tabular
Summary (where bf(b — a) — 0.2)
t?..
tA -

1
2,

R esu ltin g change

A ssum ed change

am ple
num ber R equired
reserves
+200
+200

N on­
borrow ed
reserves
+200
+ 100

T otal
Free
E xcess B orrow ed
reserves reserves reserves reserves
0
-2 0

0
+80

0
-1 0 0

+200
+ 180

(and required) reserves. Now if, on the other
hand, the System were to supply only $100
million in nonborrowed reserves, this market
observer felt that borrowed reserves might rise
by about $80 million instead of remaining un­
changed, and that excess reserves might fall by
about $20 million instead of remaining un­
changed. In effect, this observer is estimating
that b /(b — a) is only about 0.2, owing to a
very low elasticity of demand for excess re­
serves. If this estimate is correct, a $100 mil­
lion reduction in the rate at which the System
supplies nonborrowed reserves produces only a
$20 million reduction in the rate at which total
reserves grow.
Certainly a value of 0.2 for b / (b — a) is by
no means the same as a zero value, and it by
no means implies a complete inability to influ­
ence total reserves within the statement week.
It may be low enough, however, to reduce
greatly the practical ability of the Desk to con­
trol total reserves on a week-by-week basis.
Thus a $100 million cutback in the rate at
which nonborrowed reserves are supplied
might have a significant influence on the Fed­
eral funds rate while reducing excess (and
total) reserves by only $20 million, a very
small effect relative to the random component
of week-to-week fluctuations in excess re­
serves. The implication of these estimates, if
correct, is that the Desk might be able to exert
a clear and substantial influence over total re­
serves within the statement week only, if at all,
by inducing rather violent fluctuations in bor­
rowings and in the Federal funds rate. More­
over, attempts to hold the growth of total
reserves below the predetermined rate of
growth in required reserves very quickly run
into the absolute limitation that excess reserves
cannot be negative.
TARGETS IN GROUPS “C” AND “D ”
The variables in group C present problems
similar to those in B. In principle, however,
the problems are more severe because a larger
number of functional interdependencies are in­
volved. For example, direct aim at the narrow
money supply on a week-by-week basis would



require not only predictions of operating fac­
tors and knowledge of the demand schedules
of excess and borrowed reserves, but also
knowledge of the demand schedules for all the
major deposit liabilities as well—obviously an
impractical requirement. From this point of
view Mi, M2, the proxy, and bank credit are
on a par since they all require knowledge of the
same relationships—though arranged in differ­
ent ways.
Finally, the group D variables—the money
market rates—present a different kind of prob­
lem considered as week-by-week target varia­
bles. In principle, their successful use as tar­
gets would require a complete model of the
money market. In practice, however, a tolera­
ble accuracy can be achieved by taking advan­
tage of the reasonably close relationship be­
tween money market rates and free reserves
and borrowings. Thus the general strategy for
a given week could be laid out by the level of
free reserves thought to be compatible with the
targeted level of, say, the Federal funds rate.
Specific daily adjustments in this general strat­
egy could then be made in response to the
emergence of rates in the market that deviates
from targeted values.
SUMMARY. The results of this survey of
targets can be summarized as follows: The
variables in the A group— nonborrowed re­
serves, the nonborrowed base, these two varia­
bles less reserves required behind Treasury de­
posits, and free reserves—can all be used as
weekly targets subject only to errors in pre­
dicting operating transactions and, where rele­
vant, required reserves behind Treasury depos­
its. Variables in the B group—borrowings,
total reserves, the total base, and these last
two items less required reserves behind Treas­
ury deposits— can theoretically be used as
weekly targets provided the Desk has at least
some crude knowledge of the interest rate elas­
ticities of demand for excess and borrowed re­
serves (that is, b /(b - a ) ) . As with the A
group, errors in hitting targets in the B group
will be subject to errors in hitting operating
transactions and also to errors in estimating

SHORT-RUN TARGETS

the demand elasticities of excess and borrowed
reserves and/or stochastic shifts in the demand
schedules for these quantities. Since it is diffi­
cult to imagine why errors in hitting operating
factors should be systematically offset by er­
rors in judging the demands for excess and
borrowed reserves, variables in the B group
will be significantly harder to hit on a weekby-week basis than variables in the A group.
Moreover, under certain assumptions about the
demand elasticities of excess and borrowed re­
serves, targets in the B group, such as total re­
serves, may not be feasible at all as weekly
targets. Thus it is often argued that the interest
elasticity of demand for excess reserves is so
low under present conditions that the Desk’s
operations within a week have only a marginal
influence on total reserves within that week—
at least within tolerable limits of interest rate
fluctuations—and that actual control would
not be possible. Variables in the C group, such
as the money supply and bank credit, could be
aimed at directly on a week-by-week basis
only with presently unavailable knowledge of
numerous demand and supply schedules. The
D group variables, including money market
rate targets, present much greater problems in
theory, as noted, than they do in practice when
considered as weekly targets.
The difficulty, and perhaps the impossibility,
under present conditions of aiming directly at
total reserves, the total base, and the various
money and credit variables on a weekly basis
does not mean that these variables cannot be
used as targets to be approached indirectly
over somewhat longer periods. It does, how­
ever, mean that week-by-week targets must be
chosen from among those variables that can be
used for this purpose, with the weekly setting
of these targets picked according to some
strategy designed to hit the basic target varia­
ble on the average over some longer period.
Since, as indicated in the introduction, the
“target problem” is the problem of the instruc­
tions to be given to the Manager by the Com­
mittee, the logical period in this context appears
to be the period between FOMC meetings,




presumably about a month. The next section
considers the rough outlines of a multiweek
control strategy for hitting target variables not
suitable for use on a week-by-week basis.

MULTIWEEK STRATEGIES FOR
HITTING PARTLY ENDOGENOUS
TARGETS
If System actions to fix nonborrowed or free
reserves within a given week have only a small
influence on the behavior of variables such as
the money supply or bank credit within that
week relative to random or otherwise hard-topredict influences, these variables cannot be
used as operationally meaningful targets gov­
erning Desk decisions on a week-by-week
basis. To put it more concretely, the decision
to increase nonborrowed reserves by $50 mil­
lion in a particular week, given a forecast of
operating factors, implies a concrete decision
about open market operations. The injunction
to increase the money supply by $50 million
in a particular week, by contrast, is probably
almost empty of concrete implications for open
market operations given the state of our
knowledge at present and for the foreseeable
future. Nevertheless, while variables in the C
group such as the money supply (and proba­
bly variables in the B group such as total re­
serves) are not controllable on a week-byweek basis and are therefore not suitable as
week-by-week targets, it is clear that the
weekly settings of targets in the A group, such
as nonborrowed and free reserves, do influence
the behavior of the broader variables over the
somewhat longer run.
The question arises as to what kinds of
strategies are available for using this influence
to hit targets that are not under the direct con­
trol of the Desk over the longer period of
about a month between FOMC meetings by
setting week-by-week targets for variables that
can be directly hit—subject only to errors in
offsetting operating transactions and other

purely stochastic matters. Any strategy would
appear to consist of three basic elements: (1)
the choice of a weekly target; (2) a procedure
for translating the value of the monthly target
into week-by-week values of the weekly target;
and (3) a set of rules for responding to
"misses” within the period between FOMC
meetings. (Presumably responses in subsequent
periods to misses over the entire period are a
matter for the FOMC to decide at its meeting
and therefore beyond the scope of this paper.)
Assume that the FOMC issues its instructions
in terms of a desired seasonally adjusted
growth rate over the month for one of the
broader magnitudes such as the money supply.
This of course can immediately be translated
into a seasonally wnadjusted level of the
monthly target for the month in question.
CHOICE OF VARIABLES TO BE
USED AS A WEEKLY TARGET. As sug­
gested earlier, the first question in carrying out
the Committee’s instructions is the choice of
variables to be used as a weekly target. The
previous analysis has argued that in practice,
the choices probably narrow down to nonbor­
rowed reserves, free reserves, borrowings, and
money market rates. It should be noted, how­
ever, that in any given week, the choice be­
tween free reserves and nonborrowed reserves
is not really a choice at all. Given required re­
serves, a decision about a target level of
nonborrowed reserves is simultaneously a deci­
sion about free reserves—and vice versa.
There may be a tactical difference, though.
For example, it might prove better to make
decisions based on known past relationships
between rates of growth of nonborrowed re­
serves and the monthly target variable rather
than on known past relationships between lev­
els of free reserves and the rate of growth of
the monthly target variable.
TRANSLATING THE MONTHLY TAR­
GET INTO APPROPRIATE VALUES OF
THE WEEKLY TARGET. Once a decision
has been made as to which of the possible
weekly target variables will be used, the next




step is to translate the monthly target deter­
mined by the FOMC into appropriate values
of the weekly target. For example, the pre­
liminary judgment might be reached that a 4
per cent targeted annual rate of growth in
Mx for the month of October could be
achieved by about a 5 per cent annual rate
of growth in nonborrowed reserves. Such a
judgment might be reached by means of a re­
gression equation or a “hand” method based
on the projectionist’s “feel” for the probable
behavior of the money supply under various
assumed rates of growth in nonborrowed re­
serves. (The next section of this paper pre­
sents the results of a number of regression
equations relating monthly values of directly
controllable variables such as nonborrowed re­
serves to monthly values of targets from
groups B and C—such as total reserves, the
money supply, and bank credit.) Whatever
method is used, the resulting monthly rate of
growth in nonborrowed reserves could be
translated into preliminary weekly targets for
nonborrowed reserves simply by making the
appropriate extrapolation from the level of
such reserves in the last week of the previous
month. The situation is illustrated in Figure 1.
The top panel shows a weekly pattern of M x
consistent with the targeted growth rate for the
month designated “October.” The line AB in
the bottom panel of the diagram shows the pre­
liminary weekly targets for nonborrowed re­
serves given the targeted behavior of M
ERROR-RESPONSE MECHANISMS. The
third and final broad element in a strategy
consists of error-response mechanisms. Errors,
or “misses,” are of course inevitable. They are
of two basic types. First, weekly targets may
be missed—in the case of free and nonbor­
rowed reserves because of misses in predicting
operating factors; and in the case of borrowed
reserves and money market rate targets, for
other reasons as well. Second, even if the ac­
tual values of the week-by-week control varia­
bles are right on target, the expected path of
the broader monthly target may not result.

SHORT-RUN TARGETS

The Manager might decide to respond only
to the first type of error, errors in hitting the
weekly target. In that case, successful hitting
of the targeted path for nonborrowed reserves
would imply that he would continue to move
along the given path (AB in the diagram) even
though M x was not responding as expected.
This would be a plausible approach if slip­
pages between the money supply and nonbor­
rowed reserves could be assumed to be random
FIGUR E 1

over time so that they could be expected to
cancel out when averaged over a period of
weeks. Even if the Manager does respond only
to errors of the first kind—in this case errors
in hitting the weekly targets for nonborrowed
reserves—there are still a number of possible
types of error-response open to him. Some of
the possibilities are illustrated in Figure 1,
where point H is assumed to be the tar­




geted level of nonborrowed reserves in the first
week of October. Suppose the actual level falls
short of this, say to point K. This might call
for a new and steeper path of targeted values
for the remaining 3 weeks such as KFD. Al­
ternatively, the Manager might try to offset all
the effect on the monthly average of the first
week’s miss in the second week. In that case
he would aim for point I in the second week.
If it were successfully hit, he would revert to
his original path in the final 2 weeks—that is,
points J and B. Presumably there are many
other possibilities.
Instead of responding only to errors in the
weekly target, the Manager could also respond
to errors in the monthly target. Thus, for ex­
ample, if all were going well, the level of M x
reached in the first week would be point C in
the upper panel of the diagram. Whether be­
cause of errors in hitting the weekly target or
slippages between the weekly target and the
value of the monthly target expected to be as­
sociated with it, Mi might fall short of this
level in the first week of October, say to point
G. Such an error might then call for resetting
the target path of growth for nonborrowed re­
serves for the remaining 3 weeks of the month
in an attempt to compensate for this “miss” of
total reserves in the first week.
In summary, if the FOMC wishes to aim for
some target that cannot be aimed for directly
on a week-to-week basis, a target that must in­
stead be approached indirectly over a period of
weeks, decisions concerning the following must
be made: (1) A week-by-week target variable
must be chosen. (2) Some rule must be found
for translating the FOMCs monthly target into
weekly values for the week-by-week target.
(3) Rules for responding to inevitable misses,
whether in the weekly targets themselves or in
the expected relationship between weekly tar­
get values and the monthly target, must be de­
vised. These three elements must be faced
whether the monthly target be M u as assumed
here, bank credit, total reserves, or what have
you.

TRANSLATING MONTHLY TARGETS
INTO AVERAGE MONTHLY VALUES
OF WEEKLY TARGETS
As noted in the previous section, a complete
strategy for hitting monthly deposit and bank
credit targets involves translating monthly tar­
get values into appropriate values for one of the
operational weekly targets. The translation
procedure might itself be part of the instruc­
tions given by the FOMC to the Manager.
However, it is more likely that the determina­
tion of such a procedure would be regarded as
a technical problem—one that required weekby-week or even day-by-day flexibility and one
that would best be solved by the operating per­
sonnel on the spot.
REGRESSION TECHNIQUES, One way
in which monthly deposit or credit targets
could be translated into average monthly val­
ues of a weekly target such as nonborrowed
reserves is by use of a regression equation re­
lating the FOMC’s monthly target to monthlyaverage values of the weekly target together
with whatever lagged variables and seasonal
dummies seem useful. Given such an equation,
the average monthly value of the weekly target
variable needed to achieve the FOMC’s de­
posit or credit objective could be calculated
from its coefficient in the equation. Moreover,
the pattern of forecast errors observed from
applying the equation to data both within and
without the equation’s sample period could be
used as an indication of the accuracy with
which monthly deposit and credit variables
could be controlled by manipulating the aver­
age monthly value of the week-by-week target.
There are, to be sure, a number of dangers
involved in interpreting such equations. First,
the historical tendency of the System to ac­
commodate demands for reserves in the proc­
ess of stabilizing money market conditions
may introduce a simultaneous equations bias
into the estimation of such equations. They
may not be true reduced forms, and the coeffi­
cient of nonborrowed reserves may not give an
unbiased estimate of the impact on deposits



and credit of a given deliberate change in non­
borrowed reserves. Second, use of the error
terms from such equations to evaluate the ac­
curacy with which the dependent variable
could be controlled assumes perfect control of
the independent variable. The current exogen­
ous variables included in the various equations
presented below are, alternatively, nonbor­
rowed reserves, total reserves, and these two
measures less required reserves behind Trea­
sury deposits. For reasons already discussed
in detail, none of these variables can be set by
the actions of the Desk without error, and it
may be virtually impossible to set total re­
serves on a week-by-week basis under a wide
range of circumstances. A third problem with
these equations is that they make no allowance
for the time distribution within a period of
changes in reserve measures. Thus, for exam­
ple, they tacitly assume that the expected effect
of raising the daily-average level of nonbor­
rowed reserves in a month by $100 million is
the same whether the change is spread out
evenly over the period or concentrated entirely
in the final day.
Despite these difficulties, as well as some
other limitations to be mentioned later, such
regression equations still seem to have a clear
relevance to the problem at hand, and a large
number of such equations are presented in the
accompanying tables. In Tables 3 and 4, Parts
A and B, it is assumed that nonborrowed re­
serves are to be the week-by-week target varia­
ble. Consequently the tables show a number of
equations in which percentage changes in var­
ious potential monthly targets from groups B
and C are regressed on current monthly per­
centage changes in nonborrowed reserves and
in some lagged nonborrowed and total reserve
changes. Part A of Table 3 shows equations for
nonseasonally adjusted data, both with and
without seasonal dummies. Table 4, Part A,
repeats Table 3, Part A, with required reserves
behind Treasury deposits subtracted from the
various reserve measures. Again the results are
reported with and without seasonal dummies.
Part B of Tables 3 and 4 repeats Part A, this

SHORT-RUN TARGETS

time with seasonally adjusted data. All equa­
tions were estimated over the 1965-68 period.
The standard errors are reported as percentage
changes arithmetically blown up to annual
rates. (The justification for annualization is
simply that annual rates of change are the com­
mon measure in terms of which these growth
rates are usually expressed.)
In a large number of cases, the R 2’s of the
equations are impressively high, but the stand­
ard errors are discouragingly large. For exam­
ple, by using seasonal dummies, the R 2’s of
percentage changes in the deposit components
of M 1 and M 2 are 0.95 and 0.88, respectively,
but the standard errors amount to annual rates

of 6.4 and 4.4 per cent (Table 3, Part A). If
current movements in Treasury deposits are
correctly allowed for, these standard errors
drop somewhat, to 5.9 and 3.9 per cent, re­
spectively (Table 4, Part A ). As Part B of
these tables shows, somewhat better results in
terms of standard errors are obtained when
seasonally adjusted data are used. However, it
is clear that none of these standard errors are
small in terms of the ranges of growth rates
normally thought of as spanning the gap be­
tween “tight” and “easy” monetary policy. For
example, the smallest standard error in the de­
mand deposit component of the money supply,
4.5 per cent, may be compared with the 2 to 6

TABLE 3: Current-Period “ Exogenous” Variable: N on borrow ed Reserves
Regressions of Monetary Aggregates on Reserve Aggregates
D e p e n d en t variable

C on stant

%A
NBR

% A
N B R -l

N B R -2

% A
T R -1

% A
T R -2

D .W .

SE E

Sim ple
R 3 of
% ANBR

A. B ased on m onthly data without seasonal adjustm ent, 19 6 5 -6 8
W ithou t season al dum m ies:
% A T R .......... .............................................

.3 5 8 2

% A D D .......................................................,

.2 4 4 8

% A T D & D D ...........................................

.5 9 9 8
.4 3 2 0

W ith season al dum m ies:
% A T R ..........................................................

.7 7 7 4

% A D D .........................................................

2 .5 5 2 7

% A T D & D D ...........................................

1 .1 5 3 2
1 .0 8 7 0

.553
(5 .9 )
.9 7 7
( 6 .1 )
.429
(5 .8 )
.525
(1 0 .2 )

.4 9 0
( 3 .8 )
- .0 8 1
(-0 .4 )
.1 0 8
( 1 .1 )
.0 4 2
( 0 .6 )

.091
(0 .6 )
- .0 6 2
( -0 .3 )
- .0 1 6
( -0 .1 )
- .0 3 5
( -0 .4 )

- .6 3 5
( -4 .0 )
- .2 3 4
( -0 .9 )
- .1 6 8
(-1 .3 )
.0 0 0
(0 .0 )

- .2 4 9
(-1 .6 )
- .1 0 4
( -0 .4 )
- .0 2 2
(-0 .2 )
.0 4 3
( 0 .5 )

.68 1 9
.6 4 4 0
.5 8 8 2
.5391
.56 1 3
.5091
.7553
.7 2 6 2

.2 0 8
(1 .2 )
.1 2 8
(1 .1 )
.1 5 5
( 1 .9 )
.3 1 6
(3 .8 )

.5 4 3
( 2 .7 )
- .0 9 3
(-0 .7 )
.1 2 6
(1 -4 )
.2 0 2
( 2 .2 )

.2 7 5
( 1 .2 )
.2 7 9
( 1 .9 )
.1 6 4
( 1 .6 )
.0 5 3
( 0 .5 )

- .5 9 7
(-3 .4 )
- .1 8 3
(-1 .5 )
- .0 9 9
( -1 .2 )
.0 2 6
( 0 .3 )

- .2 4 7
( -1 .4 )
- .0 8 1
(-0 .7 )
.0 1 3
( 0 .2 )
.0 6 4
( 0 .8 )

.7 5 6 2
.6 3 0 3
.9 5 1 7
.9 2 6 8
.8 8 3 5
.8 2 3 4
.8 6 4 5
.7 9 4 5

1 .8 2

9 .3 5

.5 3 5

2 .1 8

1 5 .9 5

.547

2 .1 0

7 .3 5

.5 3 5

1 .3 4

5 .1 4

.7 5 0

1 .7 8

9 .5 3

1 .5 0

6 .3 6

1 .1 8

4 .4 1

1 .2 7

4 .4 5

1 .8 7

3 .1 8

B . B ased on m onthly data seasonally adjusted, 1 9 6 5 -6 8
% A T R ..........................................................

.0 6 6 4

% A D D .........................................................

.2 3 8 6

% A T D & D D ............................................

.5 4 6 8
.3 2 8 4

.7 5 8
(1 0 .2 )
.2 9 7
(2 .4 )
.2 3 5
( 2 .9 )
.4 6 5
( 5 .8 )

- .1 2 7
( -1 .0 )
- .1 9 8
( -0 .9 )
.1 1 9
( 0 .8 )
.091
( 0 .6 )

- .1 6 7
(-1 .2 )
- .0 2 8
(-0 .1 )
.1 3 7
( 0 .9 )
.0 3 0
( 0 .2 )

.2 2 7
( 1 .5 )
.1 3 4
( 0 .6 )
- .0 7 6
( -0 .5 )
.1 0 8
(0 .7 )

.2 2 6
( 1 .5 )
.1 3 6
( 0 .5 )
- .0 1 3
( -0 .1 )
.0 4 0
( 0 .2 )

.7721
.7 4 5 0
.1 4 6 3
.0 4 4 7
.3 8 2 6
.3 9 1 0
.6 4 0 8
.5 9 8 0

1 .7 4

5 .2 0

1 .4 0

3 .5 0

1 .5 8

3 .4 3

C. Based on quarterly data seasonally adjusted, 1 9 6 0 -6 7
% A T R .......................................................... , - . 4 8 2 3
% A D D .........................................................

- .4 4 1 2

% A T D & D D ............................................

.4 5 2 8
.1 8 2 5

.899
(1 0 .7 )
.4 3 2
( 2 .7 )
.5 4 6
( 3 .6 )
.7 7 0
( 5 .6 )

- .2 4 2
( -1 .9 )
.0 3 6
( 0 .1 )
- .1 1 7
( -0 .5 )
- .2 8 1
( -1 .3 )

- .1 0 5
( -1 .1 )
- .0 3 9
( -0 .2 )
— .2 4 5
(-1 .5 )
- .2 3 8
( -1 .6 )

,5 1 6
( 3 .1 )
.2 7 0
( 0 .9 )
.6 0 6
( 2 .0 )
.6 9 6
( 2 .6 )

N o t e .— Standard errors o f estim ates (SEE) are a t an n u al rates, "t” valu es are in parentheses.




.3 9 2
( 3 .2 )
.4 1 3
( 1 .8 )
.617
( 2 .8 )
.5 8 5
( 2 .9 )

.8 9 2 8
.8 7 2 2
.5 6 2 3
.4781
.6 5 7 4
.5 9 1 5
.7 2 4 6
.6 7 1 6

1 .6 3

1 .2 2

1 .4 5

2 .3 0

1 .2 5

2 .2 1

1 .1 6

2 .0 1

per cent range of growth rates for Mx some­
times cited as the prudent limits of tight and
easy money. A more graphic impression of the
size of the errors can be obtained from Figures
2-5 showing the time series of residuals from
certain of the equations presented in Tables 3
and 4, Parts A and B. The equations have
been used to “predict” developments in the
first half of 1969. As the figures indicate, the
results were quite poor in most cases. Perhaps
part of the difficulty could stem from struc­
tural changes produced by the inauguration of
lagged reserve accounting in the fall of 1968.

For the sake of completeness, a second set
of tables, Tables 5 and 6, paralleling Tables 3
and 4, Parts A and B, has been prepared that
assume, in effect, that total reserves rather
than nonborrowed reserves are the variable to
be used as the week-by-week target. Again,
the control problem with regard to total re­
serves should be kept clearly in mind in evalu­
ating these equations. In any event, the lesson
of Tables 5 and 6 is essentially the same as
the lesson of Tables 3 and 4. The standard er­
rors of estimate (expressed, as before, in terms
of annual rates) are still quite large relative to

TABLE 4: Current-Period “ Exogenous” Variable: N onborrow ed Reserves A d ju ste d f o r R eserves R eq u ired
A gainst U .S . G overn m en t D eposits
Regressions of Monetary Aggregates on Reserve Aggregates Adjusted for Reserves Required Against U.S. Government
Deposits
D epend en t variable

C onstant

% A
NBR*

% A
N B R -1 *

% A
N B R -2 *

% A
T R -1 *

%A
T R -2 *

R

2

SEE

Sim p le
R* o f
% anbr

1 .8 5

9 .7 1

.621

1 .4 6

9 .8 9

.8 2 8

1 .4 2

4 .9 4

.7 9 7

1 .7 3

6 .3 7

.5 9 7

1 .8 0

9 .8 5

1 .2 9

5 .9 3

D .W .

A. B ased on m onthly data without seasonal adjustm ent, 19 6 5 -6 8
W ithout season al dum m ies:
% A T R * ................................................

.38 5 0

% A D D ..................................................

.0 1 4 6

% A T D & D D ....................................

.5 1 9 2

% A P rox y .............................................

.4 5 9 4

W ith season al dum m ies:
% AT R * ................................................

.9441

% A D D ..................................................

2 .2 4 1 4

% A T D & D D ....................................

.8 9 5 6

% A P roxy.............................................

1 .0 9 9 3

.601
(6 .8 )
1 .1 4 5
(1 2 .7 )
.4 9 5
( 1 1 .0 )
.411
(7 .1 )

.495
(3 .8 )
“-.1 7 7
( -1 .3 )
.0 6 0
(0 .9 )
.0 6 5
(0 .8 )

.099
(0 .7 )
- .0 3 7
( -0 .3 )
.0 0 0
(0 .0 )
- .0 6 6
(-0 .7 )

- .6 8 0
(-4 .2 )
.048
(0 .3 )
— .0 6 5
( -0 .8 )
.0 2 3
( 0 .2 )

- .2 8 2
(-1 .8 )
.0 0 4
(0 .0 )
.0 0 2
( 0 .0 )
.0 4 6
( 0 .4 )

.7449
.71 4 5
.8 4 1 6
.8228
.8 0 1 5
.7 779
.6241
.5 7 9 3

.2 2 4
(1 .2 )
.348
(3 .0 )
.2 7 0
( 3 .6 )
.223
(2 .5 )

.5 1 0
(2 .4 )
- .0 8 1
( —0 .6 )
.1 6 3
(1 .9 )
.3 1 3
(3 .1 )

.1 2 5
(0 .5 )
.1 3 8
(1 .0 )
.0 8 8
( 1 .0 )
.0 6 4
(0 .6 )

— .6 2 4
( -3 .5 )
- .0 6 0
(-0 .6 )
- .0 3 0
( -0 .4 )
.0 3 8
(0 .5 )

- .2 8 5
(-1 .6 )
- .0 4 4
(-0 .4 )
.0 3 4
( 0 .5 )
.0 7 2
(0 .9 )

.80 6 3
.70 6 3
.95 7 9
.9 3 6 2
.9 0 9 3
.8 6 2 4
.8 4 9 0
.7 7 1 0

1 .1 0

3 .8 9

1 .4 0

4 .7 0

.7 1 7 8
.6 8 4 2
.3 629
.2 8 7 0
.5 1 6 9
.4 5 9 4
.5 1 9 6
.4 6 2 4

1 .7 9

3 .1 1

1 .8 7

4 .5 0

1 .3 6

3 .0 9

1 .5 6

3 .9 7

.9103
.8 9 3 0
.6 9 7 8
.6 397
.7 3 6 4
.6 8 5 7
.6 6 3 7
.5 9 9 0

1 .5 7

1 .0 5

1 .7 4

1 .9 1

1 .0 9

1 .9 3

1 .6 1

2 .2 2

B. Based on monthly data seasonally adjusted, 1965-68
% AT R * ................... ........................................... 1123
% A D D ..................... ........................................... 0771
% AT D & D D .

........................................... 4592

% A P roxy................ ........................................... 3088

.6 9 6
(9 .1 )
.4 8 6
(4 .4 )
.329
( 4 .3 )
.288
(3 .0 )

- .1 0 0
( -0 .8 )
- .2 8 6
( -1 .6 )
.071
(0 .6 )
.2 2 0
(1 .4 )

- .1 8 4
(-1 .4 )
- .1 5 2
( -0 .8 )
.0 8 2
( 0 .6 )
.1 0 8
(0 .7 )

.2 2 8
(1 .5 )
.351
(1 .6 )
.0 4 7
(0 .3 )
.148
(0 .8 )

.1 8 9
(1 .2 )
.2 5 6
( 1 .2 )
.0 3 6
( 0 .2 )
- .0 2 3
( - 0 .1 )

C. Based on quarterly data seasonally adjusted, 1960-67
% AT R * ................... ..................................

- .4 0 6 7

% A D D ..................... ..................................

- .7 1 2 4

% AT D & D D

........................................... 2781

% A P roxy................ ............................................2319

.8 1 6
(9 .9 )
.6 5 5
( 4 .4 )
.7 3 9
( 4 .9 )
.7 3 4
( 4 .2 )

- .1 5 7
( -1 .4 )
- .1 5 6
( -0 .8 )
- .3 2 9
( -1 .6 )
- .2 1 2
( -0 .9 )

- .0 7 3
(-0 .9 )
- .0 9 4
( “ 0 .7 )
- .2 8 2
( -2 .0 )
- .2 5 9
( -1 .6 )

.4 2 4
(2 .8 )
.3 9 6
(1 .4 )
.7 8 9
(2 .8 )
.5 6 5
( 1 .7 )

.363
( 3 .1 )
.5 3 0
( 2 .5 )
.5 9 8
( 2 .8 )
.6 1 2
( 2 .5 )

N o t e . — * sh ow s where reserve requirem ents against U .S . G o v t, dem and d ep osits have been subtracted from the reserve m easures. Standard
errors o f estim ates (SEE) are a t annu al rates, “ t ” values are in parentheses.




SHORT-RUN TARGETS

FIGURE 2

Residuals from equations for percentage changes in DEMAND DEPOSITS
D a ta not s e a s o n a l ly ad j u s te d

Per c e nt

' 15

i is

M o n th ly d a ta show n at annual rates. E q u a tio n s em ploy seasonal dum m ies.

FIGURE 3

Residuals from equations for percentage changes in DEMAND PLUS TIME DEPOSITS
Pe r ce n t

.....'■'] 15

...i

M o n th ly d ata show n at an n u a l rates. E q u a tio n s em ploy seasonal dum m ies.




20

FIGURE 4

Residuals from equations fo r percentage changes in the PROXY
52

Dat a not s e a s o n a lly a d ju s te d

Per ce nt

; 15

FIG U R E 5

Residuals from equations for percentage changes in DEMAND DEPOSITS
Data s e a s o n a l ly ad ju ste d




Per c e n t

j 15

J

15

SHORT-RUN TARGETS

TABLE 5: Current-Period “ Exogenous” Variable: T ota l Reserves
Regressions of Monetary Aggregates on Total Reserves
D ep en d en t variable

C on stant

% A
TR

%A
TR -1

%A
T R -2

/?2

D .W .

SE E

Sim ple
R 2 of
% ATR

A. B ased on monthly data without seasonal adjustm ent, 1965-68
W ithou t season al dum m ies:
% A D D ...............................................

.2919

% A T D & D D ..................................

. 5895

% A P roxy...........................................

.4321

W ith season al dum m ies:
% A D D ................................................

2 .8 1 0 2

% A T D & D D ..................................

1.3 7 0 5

% A P roxy...........................................

1.4 1 2 8

%A D D .................................................

.2339

.811
(4 .3 )
.4 1 2
(4 .9 )
.479
(6 .8 )

-.3 2 3
( ~ 1 .7 )
- .0 6 8
( —0 .8 )
.0 3 6
(0 .5 )

“ .1 7 8
( -1 .0 )
- .0 2 7
( —0 .3 )
.0 1 6
( 0 .2 )

.4 3 9 5
.4 0 1 3
.4381
.3 9 9 8
.5 5 1 8
.5 2 1 2

2 .3 3

1 8 .1 8

.4 0 2

2 .2 6

8 .1 3

.4 3 0

2 .2 6

6 .8 0

.5 4 9

.1 3 3
( 1 .3 )
.158
(2 .1 )
.281
(3 .5 )

- .0 7 0
(-0 .7 )
.0 5 4
(0 .7 )
.205
(2 .5 )

.0 3 6
( 0 .4 )
.1 1 2
( 1 .5 )
.1 4 2
(1 .8 )

.9 4 5 2
.9 2 2 0
.8549
.7933
.8089
.7 2 7 8

1 .8 0

6 .5 6

1 .1 9

4 .7 7

1 .3 6

5 .1 2

B. Based on monthly data seasonally adjusted, 1965-68

% A T D & D D ..................................

.4 8 3 4

% A P roxy...........................................

.2 5 4 8

.325
(2 .6 )
.3 7 5
( 4 .5 )
.6 6 4
(9 .4 )

- .0 7 5
( -0 .6 )
.0 4 4
( 0 .5 )
.1 5 8
(2 .2 )

.083
( 0 .7 )
.0 9 5
( 1 .2 )
.0 2 6
( 0 .4 )

.1 4 9 4
.0 9 1 4
.3 9 1 0
.3 4 9 5
.7311
.7 1 2 8

1 .7 8

5 .0 7

1 .3 7

1 .5 0

3 .3 9

.3 6 2

1 .8 5

2 .9 0

.6 9 7

N o t e . — Standard errors o f estim ate (SEE) are a t annual rates, “ t" values in parentheses.

TABLE 6: Current-Period “Exogenous” Variable: T otal R eserves A d ju ste d f o r R eserves R equ ired A gain st
U.St G o vern m en t D eposits
Regressions of Monetary Aggregates on Total Reserves Adjusted for Reserves Required Against U.S. Government Deposits
C on stant

D ep en d en t variable

% A
TR*

%A
T R -1 *

% A
T R -2 *

R*
Ri

D .W .

SE E

Sim ple
R 2 of
% ATR

A. Based on monthly data without seasonal adjustm ent, 19 6 5 -6 8
W ith ou t season al dum m ies:
% A D D ..................................................

.02 4 3

% A T D & D D ....................................

.4 8 8 9

% A P roxy .............................................

.4 6 6 5

W ith season al dum m ies:
% A D D ..................................................

2 .5 2 4 5

% A T D & D D .....................................

1 .1 8 2 4
1 .3 5 9 2

.9 9 8
(7 .4 )
.4 8 0
( 8 .2 )
.3 7 3
(5 .3 )

- .0 9 3
(-0 .7 )
.0 1 6
( 0 .3 )
.0 7 0
(1 .0 )

- .0 4 3
(-0 .3 )
.0 2 0
( 0 .3 )
- .0 1 2
( -0 .2 )

.6513
.6 2 7 6
.6 6 4 0
.6411
.4 4 0 7
.4 0 2 6

.2 9 5
(3 .1 )
.2 4 4
(3 .5 )
.233
(2 .7 )

.0 6 8
(0 .7 )
.1 3 5
( 1 .8 )
.2 3 7
( 2 .6 )

.079
(0 .8 )
.1 3 7
( 2 .0 )
.1 7 0
( 2 .0 )

.9 5 4 2
.9 3 4 8
.8 7 8 0
.82 6 3
.7841
.6925

2 .3 9

1 4 .3 4

.648

2 .2 7

6 .2 9

.6 6 3

2 .1 9

7 .6 0

.4 2 3

2 .0 4

6 .0 0

1 .3 8

4 .3 7

1 .3 8

5 .4 5

B. Based on m onthly data seasonally adjusted, 1965-68
% A D D ...................................... ...........................0428
% A T D & D D ......................... ...........................3564
...........................1912

.5 9 7
( 5 .2 )
.5 3 6
(7 .3 )
.521
( 5 .0 )

- .0 1 8
( -0 .1 )
.0 9 6
( 1 .3 )
.3 5 4
( 3 .3 )

.1 1 3
( 1 .0 )
.1 1 0
( 1 .5 )
.0 7 2
( 0 .7 )

.42 0 7
.3 8 1 2
.6 2 8 7
.6 0 3 4
.5 4 7 6
.5168

1 .9 6

4 .1 9

.4 0 8

1 .5 8

2 .6 5

.588

1 .6 4

3 .7 7

.4 1 4

* W here reserve requirem ents against U .S . G overn m en t d em and d ep osits have been subtracted from the reserve m easures.
o t e . — Standard errors o f estim ates (SEE) are a t annu al rates, "t" values in parentheses.

N




what is often considered the range between
prudent extremes of “tight” and “easy” mone­
tary policy.
IMPLICATIONS OF THE REGRESSION
RESULTS. First of all, the results provide no
support whatever for the view expressed, for
example, by Allan Meltzer that “month-tomonth changes in money .. . can be kept within
a very narrow range” .3 His conclusion is ap­
parently based on an examination of equations
relating monthly dollar changes in M 1 and M 2
to current and one-period lagged changes in the
monetary base and Treasury deposits at com­
mercial banks. The R 2’s of Meltzer’s equations
range from 0.70 to 0.86, thereby leading to his
optimistic view of the prospects for control. As
the results for similar equations presented above
show, however, R 2's may indeed be high,
especially when unadjusted data are used and
seasonal dummies are included. Nevertheless,
the standard errors remain quite large. Even
if the standard errors had been substantially
smaller, moreover, Meltzer’s conclusion would
still remain subject to the reservations regard­
ing this type of regression equation noted on
page 48.
While the equations do suggest that the
Desk would be likely to miss rather badly any
given deposit or credit target in any given
month if it simply used one of these equations
to guide its actions, the results do not neces­
sarily mean that there is no way of hitting such
targets with tolerable accuracy on a monthly
basis. First, better equations could probably be
devised with further experimentation. More
variables exogenous to the banking sector
could be included. More complex lag struc­
tures could be investigated. Systematic allow­
ance for autocorrelation could be made, and
so forth. Second, informed judgment by the
Desk might yield better ways of determining
appropriate growth rates for nonborrowed re­
serves than any equation could provide. Third,
even if such equations were relied on fairly
3 “Controlling Money,” Federal Reserve Bank of
St. Louis Review (May 1969), pp. 18 and 19.




mechanically, there can be little doubt that re­
sults would be improved by making midmonth
adjustments in the targeted behavior of non­
borrowed reserves for the balance of the
month in light of any misses in the deposit or
credit target occurring earlier in the month.
Finally, even if there proved to be no way
of hitting such targets as the monetary growth
rate with tolerable accuracy on a monthly
basis, this does not mean that such targets
could not be hit with acceptable accuracy on
the average over a span of months. The opera­
tion of a strategy with a multimonth horizon
might well require the FOMC to review de­
viations of actual results over the preceding
period from targeted values presented to the
Account Manager at the previous meeting.
While the operation of a multimonth strategy
is beyond the scope of this paper, some equa­
tions using quarterly data but otherwise similar
to the ones discussed above are presented in
Part C of Tables 3 and 4 (pp. 49 and 50).
Here the equations were estimated on percent­
age changes in seasonally adjusted quarterlyaverage values of the variables for the period
1960-67. The standard errors in the deposit
and credit proxy equations are all about 2 per
cent (annual rate), much lower than for the
monthly equations, as expected.4 For the seven
quarters beyond the sample period (that is, all
of 1968 and the first three quarters of 1969),
the average absolute prediction error for de­
mand deposits was a 2 . 1 per cent annual rate
if no allowance were made for Treasury de­
posits. Adjusting for behavior of reserves re­
quired behind Treasury deposits actually wors­
4 If quarterly percentage changes in total reserves
are used, there is only a negligible reduction in the
standard error for the two deposit measures. If total
reserves are used with adjustments for reserves re­
quired behind Treasury deposits, the standard errors
for the two deposit totals drop moderately to about
a 1.6 per cent annual rate. Again warning is made of
the implicit assumption that total reserves less re­
serves required behind Treasury deposits can be per­
fectly controlled. Indeed, as Part C of Table 3
shows, nonborrowed reserves can only be used to
control total reserves on a quarterly basis up to a
standard error of 1.2 per cent (annual rate).

SHORT-RUN TARGETS

F IG U R E 6

Percentage changes in DEMAND DEPOSITS
Per c e n t

Da ta sea s o n a lly a d j u s t e d

15

* B ased on d ata in T a b le 3, P a rt C. Q u arterly d ata show n at an n u a l rates.

ened the results slightly, giving an average
prediction error of 2.3 per cent (annual rate)
in the seven-quarter period.
Results beyond the sample period for equa­
tions for time and private demand deposits
combined were less satisfactory, with the equa­
tion consistently and substantially overstating
the growth rate of the deposit total. The aver­
age absolute prediction error for these equa­
tions amounted to a 4.5 per cent annual rate.
Predicted and actual figures for the sample pe­
riod and for the seven-quarter extrapolation
period for demand deposits and for demand
deposits plus time deposits are shown in Fig­
ures 6 and 7
It is possible to take either an optimistic or
a pessimistic view of the results using quarterly
data. One could say that the standard errors of
around 2 per cent per annum for the sample
period and of about that size in the case of de­
mand deposits in the seven-quarter extrapola­
tion period are not large and could be substan­

5 Prediction errors beyond the sam ple period for
equations using current changes in total reserves
were about the same as for the equations using cu r­
rent changes in nonborrow ed reserves.




tially reduced in practice by means of
midcourse corrections. The poor results for de­
mand plus time deposits in the 1968-69 pe­
riod could be dismissed as simply failing to
allow for the profound effects of Regulation Q.
Such a deficiency, it might be argued, could
easily have been overcome in practice. The
pessimistic view, however, would be that all
the equations show a number of quarters both
within and without the sample period where
errors amount to a 2 per cent annual rate or
more and that, for percentage changes in quar­
terly average levels, this is simply not a very
good performance in a world where an annual
rate of 2 to 6 per cent is accepted by many as
defining the limits of prudent policy.
Probably a sensible conclusion would be
somewhat as follows: (1) There is no existing
evidence to demonstrate the possibility of tight
control over monetary and credit growth rates
— even over quarterly-average periods and
even if such control is sought relentlessly to
the exclusion of other possible considerations.
(2) Nevertheless, existing evidence does give
reasonable grounds for hope that such control
would in fact be possible over quarterly peri­
ods if midquarter corrections and the use of

FIGURE 7

Percentage changes in TIME plus DEMAND DEPOSITS

1 B ased on d a ta in T a b le 3, P art C. Q uarterly d a ta show n at an n u al rates.

judgment can be brought in to substantial ad­
vantage.
The proposition that the Federal Reserve
could control monetary growth rates or the
credit proxy with tolerable accuracy on a
quarterly-average basis if it sought to do so
without regard to any other possible constraints
on its behavior should perhaps not seem terri­
bly controversial. The problem of just what
sacrifices might in fact have to be made as
regards the money market effects of such a pur­
suit is discussed in the next section.

THE EFFECTS OF QUANTITY
TARGETS ON MONEY MARKET
STABILITY
THE NATURE OF THE PROBLEM.
Every sort of evidence suggests that the
FOMC has relied largely on money market
targets in the period from the TreasuryFederal Reserve accord through the late
1960’s. These targets included free reserves,
borrowed reserves, the Federal funds rate, the



rate on 3-month Treasury bills, and other rates.
The emphasis on these various measures has
no doubt fluctuated over time. In most cases,
the actual target has probably represented
essentially a weighted average of these varia­
bles, with the weights never quantified or
spelled out— though defined to some extent in
the discussion at the Committee’s meetings.
These variables tend to be reasonably collinear
in any given period. Thus it is possible, for
example, to spell out levels of free reserves
that would be compatible with certain levels of
borrowed reserves, the Federal funds rate, and
the bill rate. Stabilizing one or more of these
measures in effect fixes the “tone” of the
money market— since that elusive concept ap­
pears to be essentially coterminous with a
weighted average of these variables. The single
major exception to the complete dominance of
money market targets has apparently been the
use of the proviso clause.'1 In obedience to this
clause, money market targets have been al­
tered between FOMC meetings on several
occasions when the bank credit proxy has
6 See pages 64 and 65.

SHORT-RUN TARGETS

deviated substantially from its projected growth
rate.
A basic feature of money market targets is
that their use requires accommodation of fluc­
tuations in levels of required reserves during
the period within which the target variable is
to be stabilized at a given value. Since fluctua­
tions in required reserves ultimately reflect fluc­
tuations in the demand for bank credit and de­
posits at the level of money market rates
associated with the given money market target,
a money market target basically means accom­
modating fluctuations in the demand for credit
and deposits. This is true whether the fluctua­
tions are seasonal or trivial random move­
ments or whether they are related to changes in
business conditions or to shifts in the underlying
structural demand equations for bank credit
and deposits.
To argue that the use of money market tar­
gets necessarily involves accommodation of de­
mand shifts is not to argue that the System is
wholly passive with respect to quantities when­
ever it employs money market targets. The
level at which the target is set, ceteris paribus,
does influence the rate of growth of the aggre­
gates for reasons developed by many writers
both before, but especially after, James Meigs’
well-known treatment of the problem. 7 Despite
this influence, however, the essential points are
( 1 ) that once a money market target has been
set, the System reacts essentially passively to
shifts in demands as long as the target is un­
changed, and ( 2 ) that the ex-post statistical
relationship between levels of money market
targets and rates of growth of reserves, money,
bank credit, and so forth have tended to be
extremely weak. This point has also been
rather well established by many writers from
Meigs on. As a result of these considerations,
many have argued that the use of money mar­
ket targets has in practice deprived the System

7 See references to the literature cited in Thomas
Mayer, "Monetary Policy in the United States**
(New York: Random House, 1968) Chapter 3, pp.
79-109.




of any effective means of controlling aggre­
gates. Defenders of money market targets have
argued that the System should accommodate,
at least in the short run, most shifts in the
demand for bank credit and deposits since
such shifts are predominantly seasonal and
temporary in nature. Failure to accommodate
them, according to this view, would simply
produce economically undesirable fluctuations
in money market conditions.
Whatever the merits of these arguments, it
remains true that just as stabilizing money
market conditions involves the accommodation
of fluctuations in demand, so would the use of
quantity targets involve fluctuations in money
market conditions. If you wish to stabilize the
price of any good, the amount you supply will
reflect fluctuations in the demand schedule for
the good; conversely, if you wish to stabilize
the amount you supply, you must allow fluctu­
ations in demand to be reflected in price fluc­
tuations. A major question therefore is how
much money market instability would be pro­
duced by attempting to follow quantity targets
and how serious a problem would such in­
stability turn out to be.
Unfortunately, there appears to be no way
of providing confident answers to these ques­
tions in advance. Experience would have to
tell the story. In principle, a correctly specified
money market model could be used to simulate
the interest rate effects of any given rate of
growth of nonborrowed reserves. Unfortunately,
no suitable model exists and the construction of
such a model would undoubtedly be a major
task. Even if a suitable model did exist, more­
over, the answers it would grind out might
have relevance only for a short time. It seems
reasonably likely that money market institu­
tions themselves would evolve under the pres­
sure of changed conditions, and that the ulti­
mate impact on money market rates of ceas­
ing to accommodate demand shifts would be
different from the initial impact.
Suppose, for example, that the System re­
placed money market targets with a target
stated in terms of week-by-week stability in

the rate of growth of nonborrowed reserves,
not seasonally adjusted. All our experience
suggests that sharp week-to-week fluctuations
in demand for bank credit and deposits as well
as marked seasonal patterns in these de­
mands would lead to erratic and large move­
ments in the Federal funds rate and related
rates and would substantially magnify any sea­
sonal patterns that may exist in money market
rates. How far out on the maturity spectrum
the rate fluctuations introduced by such a
change in the System’s modus operandi would
extend is a question. At the very short end of
the market, there is every reason to believe
that conditions would be substantially different
from what they are today. After banks and
other financial institutions began to acquire
some experience with the new environment,
however, they might well discover ways of
adapting to it that would themselves tend to
dampen rate instability in the market. For ex­
ample, by borrowing ahead, borrowers could
avoid having to pay very high rates at periods
of seasonal tension. This would tend to diffuse
rate pressures over time. Similarly, lenders
could take advantage of seasonal rate pres­
sures by building up adequate loanable funds
in advance, and this too would tend to diffuse
rate pressures.
In general, institutions could be expected to
learn to respond more flexibly to take advan­
tage of rate fluctuations—thus increasing the
supply elasticity of funds and thereby dampen­
ing the fluctuations themselves. Banks would
probably want to keep stronger average basic
reserve positions, with an increased willingness
to buy or sell Federal funds depending upon
rate conditions. While the precise nature of
these institutional adaptations cannot be fore­
seen, it seems clear that some developments
along these general lines would occur, tending
to dampen random and seasonal fluctuations in
money market rates.
AN EXPERIMENT. While, as noted
above, only the simulation of a complete money
market model could, even in principle, give an
accurate indication of the kind of money mar­




ket instability that would be created in the
short run by quantity targets, the following
cruder procedure may give some rough insight
into the dimensions of the problem. In general,
the method used here consists of computing
the weekly levels of free reserves as they
would have been in a particular historical pe­
riod if the System had provided a constant
week-by-week growth in nonborrowed reserves
in that period, given the historical pattern of
actual changes in required reserves. An equa­
tion relating the Federal funds rate to free re­
serves and the discount rate is then used to es­
timate what the funds rate would have been
had the System followed the quantity target.
The computed rate is then compared with the
actual pattern of the rate for the period.
The period for the initial test covered July,
August, and September 1967, a period in
which policy was unchanged and in which the
summary money market measures remained
quite stable. For example, the average Federal
funds rate in those 3 months was 3.79, 3.90,
and 4.00 per cent, respectively; borrowings av­
eraged $87 million, $89 million, and $90 mil­
lion, respectively; and free reserves averaged
$272 million, $298 million, and $268 million,
respectively. Between the week of June 28 and
the week of September 27, nonborrowed re­
serves rose by a total of $732 million, not sea­
sonally adjusted. This increase occurred in an
irregular fashion, however, since week-to-week
fluctuations in such reserves roughly matched
week-to-week fluctuations in required reserves
as the Desk went about the business of
stabilizing money market conditions.
Let us suppose, contrary to fact, that the
System had produced the $732 million in­
crease in nonborrowed reserves that occurred
in this period through steady, equal weekly in­
crements of about $56 million. Let us also
suppose, however, that week-to-week changes
in required reserves under this hypothetical sit­
uation would have been the same as they in
fact were during the period. In Table 7 the re­
sulting hypothetical weekly levels of free re­
serves are compared with the levels that ac-

SHORT-RUN TARGETS

TABLE 7: Actual and Hypothetical Reserve Measures
N on b orrow ed
reserves
W eek
A ctual

1967— June 28

H ypo­
thetical 1

Free reserves
R equired
■ reserves H y p o ­
(actual) thetical
(2 -3 )

A ctual

(1)

(2)

(3)

(4)

(5)

2 3 ,4 0 6

2 3 ,4 0 6

2 3 ,1 1 6

290

290

July

5
1 2 . .. . .
19
26

23,531
2 3 ,9 9 7
2 3 ,8 3 8
2 3 ,9 6 7

2 3 ,4 6 2
2 3 ,5 1 9
2 3 ,5 7 5
2 3 ,631

2 3 ,4 2 2
2 3 ,4 2 3
2 3 ,6 5 3
2 3 ,5 8 9

40
96
-7 8
42

109
574
185
378

A u g.

2 ...
9
16
23
30

2 3 ,8 5 8
2 3 ,8 6 9
2 3 ,6 3 4
2 3 ,7 2 6
2 3 ,4 2 9

2 3 ,6 8 7
2 3 ,7 4 3
2 3 .8 0 0
2 3 ,8 5 5
2 3 ,9 1 2

2 3 ,6 7 9
2 3 ,5 8 9
2 3 ,3 8 1
2 3 ,3 0 0
2 3 ,2 1 5

8
154
418
555
697

179
280
253
426
214

Sept.

6
13
20
2 7 ,

2 3 .8 4 6
2 3 ,9 6 9
2 4 ,2 1 0
2 4 ,1 3 8

2 3 ,9 6 9
2 4 ,0 2 5
24,081
2 4 ,1 3 8

2 3 ,5 9 3
2 3 ,6 5 3
2 3 ,9 0 8
24 ,0 0 1

376
372
173
137

253
316
302
137

1 C om puted by dividing actu al change in nonborrow ed reserves
between w eeks o f June 28 and Sept. 27 into 13 equal weekly increm ents.

tually prevailed. The actual level of free
reserves fluctuated, for the most part, reasona­
bly narrowly around the average for the pe­
riod. Actual week-to-week fluctuations presuma­
bly reflected not only misses by the Desk due
to misallowance for operating factors, but also
deliberate changes reflecting allowances by the
Desk for shifts in the distribution of reserves
within the banking system and other familiar
considerations.
Compared with the actual course of free re­
serves, the hypothetical level shows a distinct
time path (Figure 8 ). Thus the hypothetical
level (based on constant increments in unad­
justed nonborrowed reserves) rises strongly
during August, reflecting the seasonal weak­
ness in required reserves, and thereafter de­
clines as the September tax date puts upward
pressure on required reserves, and, in this hy­
pothetical world where such seasonal pressures
are not accommodated, on money market con­
ditions as well.
It can be validly argued, of course, that the
assumption on which this exercise rests—
namely, that weekly movements in required re­
serves would be the same in the hypothetical
situation as in the actual situation—is false, at
least to some degree. Presumably the growing
money market ease through late August pic­
tured in the hypothetical situation would bring




forth greater credit and deposit demands and
hence larger required reserves than actually
occurred, with the reverse process occurring as
stringencies developed in September. Since
such developments would no doubt have oc­
curred to some extent, the seasonal movement
in free reserves generated by the hypothetical
example has to be regarded as defining the
outer limits of the possible effects on the
money market of a policy of rigid weekly in­
crements in nonborrowed reserves during the
period. The true pattern of free reserves under
such a policy would no doubt show a some­
what milder seasonal pattern. Furthermore, the
experiment was conducted assuming constant
weekly increments in nonborrowed reserves
FIGURE 8

FREE RESERVES, JUNE 28-S EP T. 27, 1 9 6 7
Millions of dollars

*........................................*.......................
H yp oth etical, based on constant increm ents in:

28

JUNE

5

12

19

JULY

26

2

9

16

AUGUST

23

30

6

13

20

-i

iooo

27

SEPTEMBER

* C o m p u ta tio n s are the sam e as th o se d escrib ed in th e tex t,
e x c e p t that the D e s k is a ssu m ed to su p p ly a c o n sta n t in cre­
m ent in se a so n a lly a d ju s te d n o n b o rr o w ed reserv es o v er the
p erio d (a s d eterm in ed fro m w eek ly s e a so n a l f a c t o r s ) .
D a ta are w e e k ly a v e r a g es o f d a ily figures.

without seasonal adjustment. Simple transla­
tion to a rule of constant increments in season­
ally adjusted nonborrowed reserves would
tend to smooth the fluctuations in free reserves
generated by the use of a strict quantity target. 8
In any case, the effects on money market
rates of the hypothetical policy of nonaccom­
modation can be estimated with the aid of an
equation relating the Federal funds rate to the
level of free reserves and the discount rate.
One such equation, estimated on biweekly re­
8 Some experiments along these lines suggest that
the smoothing effects would be quite substantial. See
Figures 8-11.

serve averaging periods from mid-1966 to
mid-1968 is shown below (“t” values in par­
entheses).
rff = 2.30 *- m 2 R f + M 9rd
(12.0)
(5.2)

TABLE 8: Derivation of Hypothetical Federal Funds Rate

1967— June 2 8 . . .




H ypoth etical
com p uted
Federal
fu n d s
rate

A ctual
Federal
fu n d s
rate

0

4 .0 7

4 .0 7

July

5 ...
1 2 . ..
1 9 . ..
2 6 ...

+
+
+
+

.1 3 8
.9 5 6
. 526
.6 7 2

3 .7 3
3 .9 8
3 .5 4
3 .9 3

3 .8 7
4 .9 4
4 .0 7
4 .6 0

A u g.

2 ...
9 ...
1 6 . ..
2 3 ...
3 0 . ..

+ .3 4 2
+ .2 5 2
- .3 3 0
- .2 5 8
-.9 6 6

3 .7 5
4 .0 2
4 .0 5
3 .9 8
3 .5 9

4 .0 9
4 .2 7
3 .7 2
3 .7 2
2 .6 2

Sept.

6 ___
1 3 . ..
2 0 ...
2 7 ...,

- .2 4 2
- .1 1 2
+ .2 5 8
0

4 .0 2
3 .9 8
4 .0 0
4 .0 0

3 .7 8
3 .8 7
4 .2 6
4 .0 0

R 2 = .915, R 2 = .912,
SEE = .22 percentage point
This equation can be regarded as a reduced
form, derivable from the simple model pre­
sented on page 42 if the discount rate is in­
cluded, as it should be, in the demand equa­
tions for excess and borrowed reserves. The
free reserves variable is of course nonborrowed
reserves minus the predetermined level of re­
quired reserves and may itself be determined
as an exogenous policy variable, deliberately
fixed (subject to random errors) by the Desk.
If this equation were used directly to com­
pute the hypothetical Federal funds rate, the
results would differ from the actual rate not
only because of differences between hypotheti­
cal and actual levels of free reserves, but also
because of the error term in the equation. To
avoid this muddying of the waters, the hypo­
thetical funds rate was computed, instead, by
obtaining the difference between hypothetical
and actual free reserves in each week from
Table 7, multiplying this difference by the free
reserves coefficient in the equation ( — .0 0 2 ),
and adding the result to the actual level of the
funds rate. The resulting hypothetical time
path of the Federal funds rate is shown in
Table 8 . Both the actual and hypothetical
funds rates are shown in Figure 10.
The range of the funds rate under the hypo­
thetical program of steady increments in non­
borrowed reserves is, of course, much larger
than the range under a regime of accommodat­
ing fluctuations in required reserves. Thus in
the hypothetical case, the funds rate ranges
from a high of 4.94 per cent in the week of
July 1 2 to a low of 2.62 per cent in the week
of August 30. In fact, the rate ranged from a
high of only 4.07 per cent in the week of June
28 to a low of only 3.54 per cent in the week

H yp oth etical
free reserves
less
actu al free
reserves
tim es ( —.002)

W eek

of July 19. Thus the hypothetical spread was
232 basis points, as compared with an actual
spread of only 53 basis points.
Computed week-to-week fluctuations in the
funds rate were also substantially larger under
a policy of constant weekly increments in non­
borrowed reserves than they were in fact dur­
ing the period. Thus the average absolute
weekly change in the level of the funds rate
was 0 . 2 2 percentage point. The computed av­
erage weekly change was almost 2 Vi times as
large, or 0.53 percentage point.
Roughly similar results, as to effects on both
the range of the funds rate and the average
size of its week-to-week fluctuations were ob­
tained for each of the three subsequent 3 FIGURE 9

FREE RESERVES, SEPT. 27-D EC . 27, 1 9 6 7
^

Millions of dollars

I H yp oth etical, based on co n sta n t increm ents in:
••
^

Seasonally adjusted nonborrowed reserves*
Unadjusted nottborrowed reserves '

r-

SV

i
a

\y \

/

Actual

;

800

;

BOO

i

400

200

+
0
27

SEPT.

4

11

18

OCTOBER

25 '

200
8

15

22

NOVEMBER

29

6

13

20

27

DECEMBER

C o m p u ta tio n s are th e sa m e a s th o se d e sc rib e d in th e te x t.
e x c e p t th a t th e D e s k is a ssu m e d to su p p ly a c o n s ta n t in c re ­
m en t in s e a s o n a lly a d ju s te d n o n b o rr o w ed r eserv es o v e r the
p e r io d ( a s d e ter m in ed fr o m w e e k ly s e a so n a l f a c to r s )
D a ta a re w e e k ly a v e r a g es o f d a ily figures.

SHORT-RUN TARGETS

month periods. The technique for computing
the funds rate was exactly the same as was
used for the period June-September just de­
scribed. In each period, the assumed week-toweek increase in nonborrowed reserves was the
average actual weekly increase from the first
week of the period to the last week of the
period. The results are summarized below in
Table 9.
EVALUATION. The experiment reported
above is hardly a sufficient basis for judging
the amount of money market instability that
might be associated with rigid adherence to a
quantity target. In two respects at least, it
seems to overstate the likely degree of instabil­
ity. First, as noted earlier, it assumes that re­
quired reserves would not respond at all to the
effects on free reserves and the funds rate of
pumping in a constant increment of nonbor­
rowed reserves week by week. Actually, there
would certainly be at least some response, and
it would be in a stabilizing direction. Required
reserves would tend to weaken under the pres­
sure of tight money market conditions and to
strengthen under the encouragement of easy
money market conditions, thereby themselves
tending to modify the extremes of tightness
and ease in the money market.
Secondly, and also as noted earlier, the pro­
vision of a constant increment of seasonally
adjusted nonborrowed reserves would certainly
produce substantially milder seasonal move­
ments in money market conditions than would
the provision of constant increments of zmseasonally adjusted reserves. A comparison of
hypothetical paths for free reserves and for
the Federal funds rate using equal seasonally
adjusted increments with hypothetical paths
using equal unadjusted increments for two

FIGURE 10

FEDERAL FUNDS RATE, JUNE 28-SEPT. 27, 1967
Per cent

I

.

:

:■

H yp oth etical, based on co nstant increm ents m: ;
S e a s o n a l ly a d j u t U d n o n b o r r o w e d

28

5

JUNE

12

19

26

JULY

2

9

16

AUGUST

23

re»«rv«s *

30

6

5.0

13

20

27

SEPTEMBER

* C o m p u ta tio n s are the sa m e a s th o se d escrib ed in th e text,
e x c e p t that the D e s k is a ssu m ed to su p p ly a c o n sta n t in cre­
m ent in s e a so n a lly a d ju s te d n o n b o rr o w ed reserves ov er the
p erio d ( a s determ in ed fro m w e e k ly se a so n a l f a c t o r s ).
D a ta are w eek ly a v e r a g es o f d a ily figures.

different 3-month periods is shown in Figures
8-11. Of course, the implementation of a sea­
sonally adjusted nonborrowed reserve target
would raise the thorny technical problem of
developing satisfactory weekly seasonal adjust­
ment factors.
Having said that certain features of the ex­
periment tend to overstate the degree of poten­
tial money market instability, however, the
writer is inclined to the view that the degree of
instability indicated is nevertheless rather sur­
prisingly mild. As Table 9 shows, the com­
puted average absolute weekly change in the
Federal funds rate tends to be only around 50
basis points, certainly substantially larger than
the average changes that actually occurred
(around 17 basis points), but not more than
the market would seem able to handle without
undue stress. Similarly, the computed ranges of

TABLE 9: Federal Funds Rate, Selected Periods
A ctual values
Period

June 28 to Sept.
Sept. 27 to D ec.
D ec. 27 to M ar.
M ar. 27 to June

2 7 ...............................
2 7 ...............................
2 7 ...............................
2 6 ...............................




H igh

L ow

R ange

4 .0 7
4 .6 3
5 .4 0
6 .3 4

3 .5 4
3 .5 0
4 .5 5
5 .4 0

.5 3
1 .1 3
.8 5
.9 4

C om puted values
Average
absolute
w eekly
change
0 .2 2
0 .1 5
0 .1 3
0 .1 6

H igh

Low

R ange

4 .9 4
4 .8 3
5 .9 2
6 .5 7

2 .6 2
3 .2 5
4 .4 9
4 .5 6

2 .3 2
1 .5 8
1 .4 3
2 .0 1

Average
a bsolute
weekly
change
0 .5 3
0 .5 1
0 .6 9
0 .4 3

61




FIGURE 11

FEDERAL FUNDS RATE, SEPT. 27-DEC. 27, 1967
Per c e n t

" ..... '■ " "
..........
H y p o th e tic a l, b a s e d on c o n s ta n t increments in :

as one goes further back in time, because of
the lesser importance of the funds market.

5.5

S e a s o n a lf y a d j u s t e d n o n b o r r o w e d r e s e r v e * *

SOME M IXED STRATEGIES—
BLENDING MONEY M ARKET AND
QUANTITY CONSIDERATIONS IN
FRAM ING TARGETS

. . .
27

SEPT.

4

II

. . ,
18

OCTOBER

25

1

8

15

22

NOVEMBER

29

0
6

13

20

27

DECEMBER

* C om p u tatio n s are the sam e as those described in the text,
except that the D esk is assum ed to supply a co n stan t in c re­
m ent in seasonally adjusted nonborrow ed reserves over the
period (as determ ined fro m weekly seasonal fa c to rs).
D ata are weekly averages of daily figures.

the funds rate over the periods tested, about
150 to 225 basis points, were substantially
larger than the ranges that actually occurred,
about 50 to 115 basis points, but again, seem­
ingly not beyond the limits of manageability
considering that the funds rate is a 1-day
rate. Moreover, as Figures 8-11 suggest, these
ranges could well be narrowed considerably by
even a crude allowance for seasonal fluctua­
tions in reserve demands associated with sea­
sonal fluctuations in required reserves.
Perhaps the apparent mildness of the money
market's reaction to a quantity target as indi­
cated in this experiment ought to be regarded
with some degree of skepticism. One factor
upon which the reasonableness of the calcula­
tions depends is, of course, the estimate of the
coefficient of free reserves in the equation for
the funds rate, —.002 in this case. How stable
is this coefficient? How indicative is the
—.002 estimate of what might be expected in
the future? A similar equation covering a pe­
riod 18 months earlier, the beginning of 1965
to the end of 1966, gives a very similar result
(the coefficient of free reserves is — .0018). For
pre-1965 periods, the computed coefficient
tends to be much smaller, but the relevance of
results before 1965 is questionable because of
the market convention that the funds rate
would never go above the discount rate and,

Having examined some features of monetary
aggregates as FOMC targets, it now seems use­
ful to sketch some procedures through which
improved control over these aggregates might
be reconciled with the desire to moderate fluc­
tuations in the tone of the money market.
These procedures involve “mixed strategies” in
which both the monetary aggregates and meas­
ures of money market conditions have a spe­
cific role to play. Before looking at these mixed
strategies, however, some salient features of
pure money market and pure quantity strate­
gies are reviewed.

PURE MONEY MARKET STRATEGIES.
In a pure money market strategy, the Manager
can be instructed to maintain marginal reserve
measures at a certain level or within a certain
range, or he can be instructed to hold money
market rates, in recent years especially the
Federal funds rate, at a certain level or range.
The normal practice, as noted earlier, has been
to use a somewhat vaguely defined blend of
these two approaches. If the banking system’s
aggregate demand schedules for excess and
borrowed reserves remain stable,9 rates such
as the funds rate and the marginal reserve
measures will move fairly closely in step with
each other. Hence it will make little difference
whether the Committee’s instructions em­
phasize the marginal reserve measures or short­
term interest rates. Stabilizing free or borrowed
reserves at some target level will effectively
stabilize ihe funds rate, and vice versa.
In fact, the aggregate demand schedules of
the banking system for excess and borrowed

9
T hat is, the dem and schedu le defined w ith respect
to the level o f m oney m arket interest rates.

SHORT-RUN TARGETS

reserves evidently show a fair degree of shiftability. This is due in large measure to shifts in
the distribution of reserves between groups of
banks with very different individual demand
schedules. The country-city bank shift is the
one most often cited. However, not all causes
of shifts in the banking system’s aggregate
demand schedules need be as shortlived as
those related to shifts in the distribution of
reserves generally are. For example, shifts in
bankers’ expectations about future reserve needs
may shift their demand schedules for excess
and borrowed reserves at crucial junctures.
Thus it has been argued that the demand for
free reserves shifted to the right in the sum­
mer of 1966 as the risk of a huge September
run-off in CD’s began to seem more real to
bankers. According to this argument, banks
sought both to build up excess reserves and to
reduce borrowings so as to strengthen their
claim to future discount-window accommo­
dation when the period of peak strain actually
arrived. Whatever the causes of shifts in the
demand schedules for excess and borrowed re­
serves, such shifts drive a wedge between
short-term rates, such as the funds rate, and
aggregate levels of free and borrowed reserves.
As a result, it does make some difference
whether a pure money market strategy fo­
cuses primarily on stabilizing marginal reserve
measures or primarily on the Federal funds
and related rates.
If attention is focused on interest rates, the
Desk will find itself accommodating not only
shifts in the demand for deposits and bank
credit, a feature of all pure money market
strategies, but also shifts in the banking sys­
tem’s aggregate demand for free reserves. If
the Desk is instructed to hold the Federal
funds rate at around x per cent, it must re­
spond equally to both types of shifts. A surge
in the demand for deposits (bank credit) at
current interest rates will expand the amount
of required reserves, and in order to keep the
funds rate from rising the Desk will have to
supply nonborrowed reserves. Similarly, an at­
tempt on the part of banks to build up excess




reserves or to repay borrowings and thus clear
the books for subsequent borrowings will also
tend to push up the funds rate. Again the
Desk will have to supply enough nonborrowed
reserves to keep the funds rate from rising.
On the other hand, if the money market
strategy is framed exclusively in terms of the
marginal reserve measures, only shifts in the
public’s demand for deposits and credit will be
accommodated. A rise in the level of free re­
serves desired by the banking system at given
interest rates will not be met by the Desk with
a corresponding increase in nonborrowed re­
serves. As a result, actual free reserves remain
unchanged, consistent with their targeted be­
havior, while interest rates rise, and, ceteris
paribus, rates of growth of the deposit and bank
credit aggregates tend to decline. Since it is
difficult to see what policy purpose is served by
the interest rate and deposit/credit effects of
unexpected shifts in the aggregate demand
schedule for free reserves, the interest rate
variant of the money market strategy seems to
have advantages over versions relying on mar­
ginal reserve measures. Clearly, the use of such
reserve measures can produce wholly unin­
tended tightening or easing both of money mar­
ket rates and of the aggregates when demand
schedules for these reserves shift. 10
PURE QUANTITY STRATEGIES. At the
opposite extreme of the pure money market
strategy, whether in its free reserves or Federal
10 A formal elaboration of the implications of in­
terest rate targets for the behavior of marginal re­
serve measures and the growth of aggregates and of
the implications of marginal reserve targets for the
behavior of interest rates and the growth of aggre­
gates is given in Richard G. Davis, “Open Market
Operations, Interest Rates, and Deposit Growth,”
Quarterly Journal of Economics, (Aug. 1965), pp.
433-42. Occasions in which shifts out in the demand
schedule for free reserves may have resulted in inad­
vertent tightening are examined in two articles by
Jack M. Guttentag. “The Strategy of Open Market
Operations,’* Quarterly Journal of Economics, (Feb.
1966), pp. 1-30, discusses such shifts the first half
of 1960, while “Defensive and Dynamic Open
Market Operations, Discounting, and the Federal
Reserve System’s Crisis-Prevention Responsibilities,”
Journal of Finance, (May 1969), pp. 249-63, dis­
cusses the summer of 1966.

funds rate variant, is the pure quantity strat­
egy. This strategy involves exclusive use of
rates of growth in some monetary aggregates as
targets to be pursued without any regard for
the resulting effects on money market condi­
tions. The main features of this approach have
been discussed in earlier sections and need
only be recapitulated very briefly here. A de­
sired growth rate in bank credit, M u M s, or
some other aggregate would be picked by the
FOMC for the month ahead. Conceivably the
Committee itself, or more likely the staff,
would translate this target into a monthly rate
of growth in nonborrowed reserves and, ulti­
mately, into week-by-week targets for such re­
serves. The pure quantity target need not, of
course, involve anything so crude as a constant
week-by-week increment in nonseasonally ad­
justed nonborrowed reserves during the period
between FOMC meetings. Indeed it almost
certainly would not. Seasonally adjusted data
might be used, for example, and, given the in­
evitable “misses” and the existence of some
kind of “error response” mechanism as de­
scribed in an earlier section, the pure quantity
target would in fact probably involve week-toweek changes in the nonborrowed reserve in­
crements sought by the Manager. By defini­
tion, however, these changes would never be
chosen in light of their impact on money mar­
ket conditions, but solely in terms of their ap­
propriateness for hitting a monthly target for
M u bank credit, or whatever variable the
Committee has in mind. Clearly the result
would be larger fluctuations of a short-term
and perhaps medium-term nature than pres­
ently exist in free reserves, the Federal funds
rate, and other measures of money market
conditions.
While something very akin to the pure
money market target was used over a period
of many years, it came under increasingly
heavy criticism. The pure quantity target, on the
other hand, has never been tried. In view of the
possible risks posed by the pure quantity
target to the money and capital markets—most
of them risks of essentially unknown and per­



haps unknowable magnitude—many would no
doubt argue that a pure quantity target should
not be tried. In these circumstances, the mid­
dle ground between pure money market and
pure quantity targets is of considerable inter­
est. Such a middle ground would hopefully
contain approaches that would retain some so­
licitude for money market conditions while
providing a real measure of control over the
monetary aggregates.
THE CREDIT PROXY PROVISO
CLAUSE. The first operational result, insofar
as open market strategies are concerned, of the
increased concern within the System over the
behavior of monetary aggregates was apparently
the “proviso” clause. The inclusion of such a
clause in the Committee’s regular directive to
the Account Manager represents, however, only
the most cautious of steps outside the familiar
world of the pure money market target. As it
has been used, the proviso clause requires the
Manager to shift the money market targets in
the appropriate offsetting direction if growth in
the bank credit proxy is deviating significantly
from the figures projected at the time of the
FOMC meeting.
There have, of course, been many doubts
and criticisms raised in connection with the
proviso clause. Some would prefer to substitute
other variables for the credit proxy as being
more economically meaningful. Others feel
that the proviso clause has in practice proved
too vague to give the Manager sufficient guid­
ance. Thus there are always uncertainties as to
just when deviations in the proxy from projec­
tions become substantial enough to require
modification of the money market targets and
uncertainties as to how large any such modifi­
cations should be. From the point of view of
the present discussion, however, the chief
problem with the proviso is that it does rela­
tively little to augment the System’s control
over quantities. Indeed, in the minds of some
within the System, it has not even been in­
tended or expected to have such an effect.
In the first place, the wording of the proviso
in terms of deviations from “currently pro­

SHORT-RUN TARGETS

jected” growth rates stops far short of indicaing a desired growth rate, that is, a genuine
target growth rate. Secondly, the proviso
clause falls far short of providing a program
for hitting such a target. The proviso clause
does provide for a shift in the money market
target in a somewhat easier or tighter direction
if the proxy falls substantially short of, or rises
substantially higher than, its projected growth
rate. All the existing literature, as noted
earlier, indicates that, ceteris paribus, the ef­
fects of these changes in the money market
target should, in fact, tend to move the proxy
in the desired direction. But there is no way
of knowing how great the influence will be or
what rate of change in the proxy will, in fact,
be associated with the revised money market
target. Moreover, the proxy and other quantity
targets will continue to fluctuate in response to
shifting demands under the new money market
target, just as they did under the old one—
although presumably the fluctuations will be
around a higher (or lower) average than would
have obtained under the old target.
Without denying the very real usefulness of
the proviso clause in protecting the System
against large, unforeseen, and undesired move­
ments in the rate of growth of the proxy, it is
evident that the proviso clause moved the Sys­
tem only a little closer to real control over
quantities than it had been in the days of the
pure money market target. In view of this situa­
tion, it seems worthwhile to consider some
other ways of trying to blend quantity targets
with a reasonable degree of money market
orderliness.
USING MONEY MARKET TARGETS
AS A TACTICAL DEVICE IN A QUANTITIES-ORIENTED STRATEGY. One way of
using money market targets as a tactical device
in a quantities-oriented strategy really involves
no departure at all from the pure money mar­
ket target. It does, however, require a more
flexible use of such targets. Over much of the
period since the accord, and even at present,
the FOMC has apparently tended to identify
its money market targets with the “tightness”




or “ease” of policy. In the Brunner-Meltzer
terminology, it has tended to treat its “target”
as, simultaneously, its “indicator.” A change in
the money market targets that the Manager is
instructed to maintain is identified as a
change in “policy.” In one sense, the identifica­
tion of changes in the money market target
with changes in “policy” is a merely semantic
matter. Nevertheless, the consequences of this
identification have been far from trivial. Thus
it becomes a major act for the Committee to
change its money market target since, by defi­
nition, this is a change in “policy.” As a result,
the target may go essentially unchanged or
may be modified only slightly and gradually
over fairly long periods. Often, events may
have to become rather radically out of joint
with the Committee’s intentions before enough
momentum is generated to produce a clear and
decisive change in the money market target.
This sort of “inertia” can lead to long periods
in which fluctuations in the rates of change of
monetary aggregates remain almost wholly at
the mercy of fluctuations in demand condi­
tions. Periods in which there have been only
minor, if any, modifications in the money mar­
ket objectives but in which rather major, and
often unwanted, accelerations or decelerations
in the monetary aggregates have nevertheless
developed have not been rare.
If the Committee were to drop its tendency
to identify changes in money market targets
with changes in policy, a very different sort of
situation could well develop. In the first place,
a change in the money market target instruc­
tions given the Manager would very likely
come to be thought of as involving only a rou­
tine technical adjustment—a change in tactics,
rather than a fairly weighty decision to be
made only after substantial evidence of unac­
ceptable developments has accumulated. Con­
sider, for example, a situation in which the
Committee identifies “policy” with the rate of
growth of the bank credit proxy. In that case
the first paragraph of the directive might de­
scribe current economic conditions and the
current objectives of policy, as it does now.

The second paragraph might then go on to say
that in these circumstances, a growth rate in
the proxy of approximately x per cent per
annum seems appropriate. In a final sentence,
it might then state that for the period ahead,
such a growth rate could best be fostered by
such and such money market conditions.
These conditions could be stated either as
ranges for specific money market measures or
simply described by some qualitative phrase,
with numerical values understood from the dis­
cussion at the Committee meeting.
The actual content of this final sentence
with its reference to the money market target
would have to be determined on the basis of
staff projections. As long as policy were to re­
main “unchanged,” the rate of monetary
growth referred to in the second paragraph as
appropriate in view of the objectives stated in
the first paragraph would remain unchanged.
The money market conditions target, however,
might be expected to change routinely at every
meeting, even with “unchanged policy.” This
being the case, monthly-average levels of free
reserves and the Federal funds rate might be
expected to fluctuate more frequently and
more widely than they do at present. The gen­
eral procedure of sticking to money market
targets, but modifying them more or less rou­
tinely in the service of some more basic quan­
tity objective has the advantage of requiring
only a fairly modest departure, operationally,
from a pure money market target. While
money market targets would be changed sub­
stantially more often and perhaps by substan­
tially larger amounts than under a pure money
market target, the state of the money market
would still be the Desk’s primary week-byweek concern. The money market would not
be left to its own devices; there would be no
more risk of the daily-average rate for Federal
funds jumping from 2 per cent one week to 1 2
per cent the next than there is at present. It is
very difficult to see how the health of the finan­
cial markets could in any way be risked by
following such a procedure.
The main objection to the proposal is that



while it certainly promises closer control over
aggregates than exists under the regime of rel­
atively inflexible money market targets, it may
not go far enough. One reason is that, as long
as the money market targets remain rigid in
the period between meetings, the System’s re­
sponse to shifts in bank credit and deposit de­
mands within that period remains essentially
accommodative and passive. Second, there is
still the problem of the very loose relationship
between money market variables and monetary
and credit growth rates. It may be very hard
to find the right money market targets given
the desired monetary growth rate. Once the
money market target is fixed, moreover, the
resulting behavior of the growth rate may show
unacceptably wide deviations from its expected
response.
QUANTITY TARGETS WITH MONEY
MARKET MODIFIERS. The next step along
the road that leads from pure money market
targets to pure quantity targets would be a
procedure in which the FOMC instructs the
Desk to hit a quantity target over the month,
but to hit this target in a way that takes ac­
count of the impact on money market condi­
tions. Presumably the general format of the
operational part of the directive under such a
regime would be something like this: “Open
market operations shall be conducted in such a
way as to encourage the bank credit proxy to
grow at an annual rate of about x per cent,
while smoothing fluctuations in money market
conditions to the extent possible consistent
with this objective.”
There are any number of ways by which
such a directive might be carried out in prac­
tice. It may be useful to give one rather con­
crete but also rather mechanical procedure as
an illustrative example. Suppose the Commit­
tee wants to see the proxy grow at an 8 per
cent annual rate over the month ahead. As
discussed in earlier sections, this desired 8 per
cent rate of growth must then, by one tech­
nique or another, be converted into an appro­
priate monthly percentage change in nonbor­
rowed reserves. Given the average level of

SHORT-RUN TARGETS

such reserves in the previous month, this
change can, in turn, be translated into an aver­
age level for the month ahead. Now there are
any number of possible weekly patterns of
changes (or levels) of nonborrowed reserves
compatible with the desired monthly average
level. Thus there is considerable leeway in
making decisions about individual weekly
changes (levels) in nonborrowed reserves for
the 4 or 5 weeks covered by the period in
question. The aim of the Desk in carrying out
the Committee’s directive should then be to
choose levels (or changes in) nonborrowed re­
serves week by week that ( 1 ) average out to
the desired level over the month, and at the
same time (2 ) minimize week-to-week fluctua­
tions in the tone of the money market.
One very reasonable way of interpreting
( 2 ), the money market “modifier,” would be
to pick weekly levels of nonborrowed reserves
(consistent with the desired monthly average)
that seem likely to minimize week-to-week fluc­
tuations in free reserves. If it is assumed that
the bulk of week-to-week fluctuations in re­
quired reserves are seasonal, and if weekly
seasonal factors are computed, a rough pattern
for week-to-week fluctuations in required re­
serves for the month can be projected. Given
these projected week-to-week fluctuations in
required reserves, the familiar reserve identity
associates with every possible weekly change
in nonborrowed reserves a corresponding
weekly change in free reserves. Thus, given the
required reserve projections and the reserve
identity, we can solve for that set of week-toweek changes in nonborrowed reserves consist­
ent with the targeted monthly-average level
that (a) minimizes the average absolute
weekly change in free reserves, or (b) mini­
mizes the sum of the squares of the weekly
changes, or (c) equalizes weekly changes, or
(d) satisfies some other criterion that seems to
capture the idea of smoothing out changes in
the tone of the money market.
The possibilities outlined above may seem to
suggest that the problem could be solved with
mathematical rigor. While this is true in prin­




ciple for any well-defined notion of “smooth­
ing” free reserves, there would obviously have
to be much fudging in practice. First, not
all weekly changes in required reserves would
be precisely seasonal. Indeed, if they were,
there would hardly be any point to the exer­
cise. Second, weekly seasonal factors always
involve heavy doses of judgment. Third, there
would be misses in hitting nonborrowed re­
serves. Fourth, midmonth corrections would
probably have to be made on the monthly
nonborrowed reserves objective whenever it
became apparent that the primary objective,
the monthly growth rate in the bank credit
proxy, was not turning out as targeted. Yet de­
spite these problems, and others that could be
mentioned, it still seems reasonable to hope
that any given desired monthly change in non­
borrowed reserves could be distributed over
the month in a way that takes advantage of
prior knowledge about seasonal changes in re­
serve needs and thereby minimizes money
market instability. This is really all the pro­
posal amounts to.
A MONEY MARKET PROVISO. A final
possible version of the “mixed strategy” idea
would be to use a quantity target with a
money market conditions proviso, exactly the
reverse of the procedure currently in use. In
spirit, this suggestion is very similar to the one
just discussed. That proposal involves aiming
directly for some monthly-average value of a
quantity variable, but adjusting the week-byweek path of developments in a way most
likely to minimize money market instability. In
the present proposal, a monthly value of some
quantity variable would again be the objective,
but there would be no specific attempt to
make week-by-week changes in nonborrowed
reserves such as to minimize fluctuations in
free reserves. Instead, the concern for reasona­
ble money market stability would be imple­
mented by absolute constraints on the permit­
ted range in the level (or weekly change) in
some money market variable such as free re­
serves or the funds rate. Thus the operational
part of the directive might read something like

can be better served by seeking direct control
over the tone of the money market, and
thereby exerting an important conscious influ­
ence on related financial markets. It would be
grossly simple-minded to interpret this issue as
a question of “Keynesianism” versus “mone­
tarism.” Nevertheless, it is true that some
major questions currently agitating monetary
economics are involved.
While the relative values to be attached to
control over aggregates versus control over the
money market are beyond the scope of this
paper, considerable attention has been given to
the trade-offs between these two objectives. Ex­
perience seems to indicate that the System can
exert a very high degree of control over money
market conditions if it chooses to disregard
quantity considerations. By contrast, there is
no experience to show what degree of control
over monetary aggregates might be possible if
such control were to be pursued exclusively
and without regard to the effects on the money
market. Similarly, there is no experience to
show what the cost in terms of money market
instability might be. The evidence adduced in
this paper has not been able to provide firm
answers to these questions. In the nature of
the case, a high degree of uncertainty is bound
to remain, unless and until the FOMC actually
experiments with procedures that depart from
current and past practices.
Despite the lack of adequate evidence on
the controllability of quantities and on the
costs of such control in terms of money mar­
ket instability, some tentative judgments on
these matters can be made. Thus, the pros­
SOME GENERAL CONCLUSIONS
pects for close control of aggregates over
In the last analysis, a decision about targets
monthly periods do not look terribly bright.
for open market operations has to be made on
The slippage between current monthly changes
the basis of considerations that go beyond the
in nonborrowed, or even total, reserves and
relatively narrow focus of this paper. Conse­ " current changes in the major monetary aggre­
quently any attempt to make recommendations
gates appears to be rather large. An advance
here would be misplaced. A basic question, for
allowance—even one that is perfectly correct—
example, is whether it is better for the Federal
for the reserves that will be needed to back
Reserve to attempt to exercise reasonably close
movements in Treasury deposits helps, but ap­
control over monetary and bank credit growth
parently not enough. Further allowance for
rates, or alternatively whether its basic aims
other types of deposit movements that are simi­
this: “Open market operations shall be con­
ducted in such a way as to encourage the bank
credit proxy to grow at an annual rate of
about x per cent, except that operations shall
be modified when needed to prevent undue
stringency or ease in the money market.”
Again, the last clause could be quantified in
the directive itself, or the acceptable limits of
fluctuations in free reserves or the funds rate
could be more informally communicated. As in
previous examples of quantity targets, more­
over, the targeted x per cent growth in the
credit proxy would of course have to be trans­
lated into an appropriate rate of growth for
the month in nonborrowed reserves.
In one sense, the money market proviso ap­
proach is somewhat more conservative than
the approach presented in the previous section
since it puts absolute limits on the amount of
money market instability that would be permit­
ted in pursuit of the basic quantity target.
Thus, for example, if the permissible limits of
fluctuations in net borrowed reserves were
placed at $800 million to $ 1 , 2 0 0 million, this
pursuit would simply have to be abandoned in
any week when the quantity objective ap­
peared to call for a change in nonborrowed re­
serves that would, in turn, imply a level of free
reserves outside the permitted range. Ob­
viously the significance of the money market
proviso would depend, in practice, on how
wide a range in free reserves (or the funds
rate) were to be allowed.




SHORT-RUN TARGETS

larly insensitive to System operations within a
given month and that can therefore be projected
more or less independently of the assumed sup­
ply of reserves would provide additional help.
Time deposits other than large certificates of
deposit appear relevant in this connection. Mid­
month adjustments in the planned supply of
reserves to compensate for unsatisfactory per­
formance in the first part of the month would
probably also help significantly in improving
control over the month-by-month movements
in the aggregates. Nevertheless, despite the im­
provements obtainable from these various de­
vices, it is still likely to turn out that the sys­
tematic response of the banking system to
given changes in the rate at which reserves are
supplied within a given month would be only
moderate relative to other, largely unpredicta­
ble determinants of deposit and bank credit
behavior within that same month.
On balance, it appears likely that even a
policy designed to zero in on the growth rate
of some aggregate would still leave the
month-to-month behavior of that aggregate im­
portantly conditioned by these random, hardto-predict developments. Hence the short-term
behavior of the aggregates would continue to
display a substantial amount of statistical
“noise.” It does not at all follow from this,
however, that the influence of the System
might not be dominant in the longer run. A
policy of aiming at the growth rate of, say, the
money supply might be able to fix the actual
growth rate of that target averaged over a mul­
timonth period with a satisfactory degree of
precision. The results obtained for quarterlyaverage figures can be interpreted as reasona­
bly encouraging—again assuming the regres­
sion results can be materially improved upon
by midcourse corrections, the use of judg­
ment, and so forth. No doubt the results could
be improved further if still longer periods were
used. Unfortunately, of course, the need to av­
erage the behavior of a quantity target over
relatively long periods to obtain an acceptable
degree of control means that a change in the




setting of the target might have a reliable and
clearly visible effect on the actual behavior of
the target variable only after a similarly long
period of time.
The results of this study suggest that the
Committee could adopt the use of explicit
quantity targets without producing an unac­
ceptable degree of short-term instability in the
money market. In part, this conclusion rests
on the evidence presented in the section begin­
ning on page 56. That section suggests that
movements in the Federal funds rate induced
by supplying nonborrowed reserves (not sea­
sonally adjusted) at a constant rate would not
be intolerably large. Everyone will recognize
the insufficiency of this evidence taken by itself,
however. More fundamentally, therefore, the
conclusion rests on the belief that allowance
for seasonal changes in required reserves—or,
better yet, adoption of one of the “mixed
strategies” presented in the previous section—
would permit fluctuations in money market
conditions to be held within tolerable bounds.
Probably the worst that could result from
the adoption of one of these mixed strategies
would be that neither the aggregate nor the
money market would turn out to be regulated
with much precision. It could be that given the
difficulty of precise control of the aggregates in
the short run under even the best of circum­
stances, and given the compromises that might
be needed to hold money market fluctuations
within acceptable limits, the behavior of the
aggregate target might continue to be domi­
nated by random, or at least uncontrolled, fac­
tors. At the same time, both the marginal re­
serve measures and the Federal funds rate
would surely show a less steady, “rational”
pattern than is presently the case. As long as
laboratory experiments on these matters are
impossible, however, such risks are inevitable.
Whether they should be taken depends heavily
on how much importance is attached to
achieving meaningful control over monetary
aggregates—as opposed merely to exerting a
rather loose “influence” over these magnitudes.




by Leonall C. Andersen




SELECTION OF A MONETARY
AGGREGATE FOR USE IN
THE FOMC DIRECTIVE




CONTENTS

73

INTRODUCTION

73

A GENERAL FRAMEWORK OF THE
INFLUENCE OF MONETARY ACTIONS
ON THE ECONOMY

74
74
75

MONETARY AGGREGATES AND
MOVEMENTS IN GNP
Response of GNP to each monetary aggregate
Basis for selecting a monetary aggregate

79

RECOMMENDATION

80

APPENDIX:
Estimation Aspects of the “Simultaneous
Equations Bias” Issue by H. Albert Margolis

SELECTION OF A MONETARY AGGREGATE

INTRODUCTION
One suggestion for change in the Federal
Open Market Committee directive is to place
main emphasis on a stipulated movement in a
monetary aggregate. Presumably this would be
the best aggregate available for assisting the
FOMC in achieving its ultimate economic
goals.
There are two general ways in which a
monetary aggregate could be incorporated into
the directive. First, the desired rate of change
in the aggregate could be specified directly in
the second paragraph of the directive. This
paragraph contains the specific instructions
of the FOMC to the New York Federal Re­
serve Bank for the conduct of open market
operations between Committee meetings. The
Manager of the open market desk at the New
York Federal Reserve Bank is assigned the re­
sponsibility for carrying out the directive. Sec­
ond, a desired rate of change in the chosen ag­
gregate could be specified in the first paragraph
of the directive, with instructions given to the
Manager in the second paragraph in terms of
changes in some other variable that could be
more readily observable by the Manager and
might be subject to his more direct control.
Achievement of the specified movement in this
latter variable by the Manager would be ex­
pected to produce the FOMC’s desired rate of
change in the monetary aggregate. In either
case, the explicit goal of the FOMC is desired
movements in one monetary aggregate. The
two procedures just outlined differ only in the
short-term operating instruction given to the
Manager.
In this paper six monetary aggregates are
considered for inclusion in the directive—non­
borrowed reserves (Nb), total member bank
reserves (TR), the monetary base (B ), the
narrowly defined money stock (M J , the
money stock plus time deposits at commercial
banks (M2), and bank credit (BC). This
paper is concerned primarily with properties of
each aggregate as they relate to the ability of
the Federal Reserve System to achieve its ulti­
mate goals of desired real product growth and




price level stability. Although other papers dis­
cuss in detail the ability of the Manager to
control various aggregates, this paper merely
takes a brief look at this problem.

A GENERAL FRAMEWORK OF THE
INFLUENCE OF MONETARY
ACTIONS ON THE ECONOMY
The general framework used in this paper
for relating the influence of monetary actions
to movements in real output and the price
level differs greatly from that incorporated in
most large-scale econometric models. Mone­
tary actions, summarized by changes in some
monetary aggregates, and changes in Federal
Government expenditures are viewed as the
main determinants of total spending measured
in current-dollar gross national product (nomi­
nal GNP). A given change in nominal GNP is
then divided between a change in real output
and a change in the GNP deflator. An impor­
tant factor in explaining this division is the dif­
ference between potential real output in the
quarter and actual real output in the preceding
quarter. Another factor is past price move­
ments. The specific model relating a particular
summary measure of monetary influence (Mx)
to output and the price level is presented
elsewhere. 1
In contrast, most econometric models use a
building-block approach, which considers that
the major influence of monetary actions on
both output and the price level is primarily in­
direct—for example that it operates through
interest rates. One building block consists of
the major components of GNP and their deter­
minants, which include fiscal actions and other
exogenous variables. A second building block,
the financial sector, determines a market rate
of interest. Finally, the price level is deter­
N o t e .— The author is Vice President, Federal Re­
serve Bank of St. Louis.
1 Leonall C. Andersen and Keith M. Carlson, “A
Monetarist Model for Economic Stabilization.” Re­
view, Federal Reserve Bank of St. Louis (Apr.
1970).

mined by a Phillips curve equation or a wage/
price mark-up equation. Joint simulations of the
three blocks are used to allow interactions
among the three blocks. Frequently, the com­
ponents of GNP in real terms are summed, and
this sum is multiplied by the price level to pro­
duce an estimate of nominal GNP.

MONETARY AGGREGATES AND
MOVEMENTS IN GNP
This section presents empirical evidence that
is used to select the best monetary aggregate
from those under consideration for inclusion in
the FOMC directive. First, the relation be­
tween changes in GNP and changes in each
aggregate is measured by regression analysis.
Second, three criteria are presented for the
selection of the “best” aggregate, and relevant
data are developed for application of the crite­
ria to each aggregate.
RESPONSE OF GNP TO EACH MONE­
TARY AGGREGATE. As mentioned earlier,
monetary actions and changes in Government
expenditures are viewed as the major determi­
nants of movements in GNP. Six individual re­
gression equations are run in which quarterly
changes in GNP are regressed on current and
lagged changes in each of the six monetary ag­
gregates along with, in each regression, current
and lagged changes in Government expendi­
tures on goods and services plus transfer pay­
ments (AE). Ordinary least-squares estimates
of parameters are made, by using Almon lags
with a fourth degree polynomial and coefficients
for t + 1 and t — n — 1 constrained to zero.
The length of the lag period (n ) is determined
by the minimum standard error of estimate.
The regression results are presented in
Table 1. The fits of the equations seem to be
very good, considering that first differences are
used. The smallest R 2 is 0.52 for nonbor­
rowed reserves, and the largest is 0.67 for bank
credit. The Durbin-Watson statistic indicates
small likelihood of serial correlation in any of
the residuals. Most of the regression coeffi­




cients are statistically significant from zero at
the 5 per cent level.
Some may be surprised by the positive coef­
ficients for Government expenditures for a few
quarters followed by negative coefficients. In
every regression, the sum of the coefficients for
AE is not statistically significant from zero at
the 5 per cent level. Each regression may be
viewed as measuring the response of GNP to
changes in a monetary aggregate with Govern­
ment expenditures held constant and its re­
sponse to changes in Government spending
with the monetary aggregate held constant. In
the latter case, Government expenditures are
financed by taxing or borrowing from the pub­
lic. In such an instance, Government expendi­
tures may, over time, crowd out an equivalent
amount of private expenditures, thereby ac­
counting for the observed pattern of regression
coefficients.
In most econometric work, the question of
simultaneous-equation bias is always present.
The appendix discusses this question in some
detail and highlights the unsettled nature of
this problem. In summary, formal discussions
of bias are based on the asymptotic properties
of large-size samples, and little is known about
bias in the limited, finite samples available in
economic research, and even these discussions
do not apply to the case in which lagged endo­
genous variables appear. Moreover, one of the
papers cited in the appendix shows that, in
small samples with no lagged endogenous vari­
ables in a regression, if ordinary least squares
(OLS) are biased, then two-stage least squares
(TSLS) estimates are also biased, although
under certain circumstances the degree of bias
is smaller. TSLS estimates are commonly used
to handle the bias problem.
Bias, however, is not the only undesirable
property of an estimation procedure; a large
variance of parameter estimates is also unde­
sirable. It is well known in statistics that par­
ameters estimated by OLS have smaller vari­
ances than those estimated by TSLS. Thus, in
selecting estimation procedures, one may have

SELECTION OF A MONETARY AGGREGATE

sample period. Third, the aggregate should
perform best with regard to the ability of the
Federal Reserve to control its movements.
In the sample period 1953-1 to 1969-III,
there is virtually no difference in the fit of the
regressions for the equations involving M lf A/2,
B, and BC (Table 1 ). The R 2's range from
0.65 for the monetary base to 0.67 for bank
credit and, similarly, the standard errors of esti­
mates (SEE) range from 3.79 to 3.93. The fit
of the regressions involving TR and Nb are
not so close—with R 2's of 0.52 and 0.59 and
SEE’s of 4.26 and 4.63. For these last two re­
gressions the Durbin-Watson statistics are also
lower. On the basis of sample-period statistics,
M lt M2, B, and BC all seem to perform
equally well, and they all perform better than
Nb and TR.
The ex ante forecasting ability of each equa­
tion was tested for successive eight-quarter pe­
riods beginning with 1965-1. For example, each
regression equation was estimated for 1953-1
to 1964-1V; then quarterly forecasts of
changes in GNP for 1965 and 1966 were
made by using the parameters estimated for
the sample period. This procedure assumes

to trade off bias against larger variance of pa­
rameter estimates. The appendix cites both a
demonstration and experimental results to
show that the mean-squared error statistic—
which combines bias and variance of parame­
ter estimates into one number—can, in certain
circumstances, be considerably greater for
TSLS than for OLS. In view of the unsettled
nature of these issues in economic research,
there is no clear-cut case for asserting that
there is obviously a large bias in the OLS pa­
rameter estimates presented in Table 1, or that
the bias is of such a magnitude as to more
than offset the gain from a smaller variance of
parameter estimates.
BASIS FOR SELECTING A MONETARY
AGGREGATE. Three criteria are used in this
study for selection of a monetary aggregate for
monetary management. First, it should per­
form best in terms of goodness of fit relative
to the five other aggregates in the sample pe­
riod used to relate changes in GNP to changes
in each monetary aggregate. Second, and more
importantly, the aggregate selected should pro­
duce the smallest forecasting errors in ex ante
forecasts of changes in GNP made beyond the
TABLE 1: Minimum Standard Error Regressions
(1953-I-1969-III)
(1)
Item
Q uarters
t
t-1
t-2
t-3
t-4
t-5
t-6
t-7
t-8
t*9
t -io
t-11
t-12
t-13
t-14
t-15
t-16

AMi

1 .2 3 1 *
1 .7 8 7 *
1 .6 0 0 *
.8 7 5 *
.091

(2)
AE

.5 8 9 *
.4 4 2 *
- .0 2 1
- .4 4 0 *
- .5 1 3 *

AA /i

- .0 7 4
.5 4 8 *
.9 3 5 *
.7 3 2 *
.1 5 6

(3)
AE

.2 7 7
.3 7 0 *
.0 8 4
- .4 4 4 *
- .7 4 0 *

AB

3 .3 1 0 *
6 .2 4 8 *
7 .0 5 8 *
5 .1 5 9 *
1 .1 4 5
- 3 .2 1 3 *
- 4 .9 6 9 *

(4)
AE

.4 1 5 *
.1 6 4
- .2 3 5 *
- .4 5 9 *
-.3 8 2 *
- .0 7 1
.2 1 0

1 .2 6 4
.7 5 0
.057

2 .2 9 7 *

- .4 5 3

A TR

2 .1 9 2
7 .3 4 9 *
1 1 .0 2 1 *
1 0 .8 5 0 *
6 .5 6 8 *

(5)
AE

.3 8 6
.3 4 2 *
.081
- .1 9 2
- .2 8 1

ANb

(6)
AE

ABC

2 .3 1 5 *
3 .8 4 2 *
4 .7 4 1 *
5 .1 5 3 *
5 .2 0 5 *
5 .0 0 4 *
4 .6 4 3 *
4 .1 9 8 *
3 .7 2 9 *
3 .2 7 7 *
2 .8 7 1 *
2 .5 1 8 *
2 .2 1 3
1 .931
1 .6 3 4

.1 9 2 *
.2 6 5 *
.2 5 4 *
.1 9 0
.0 9 8
.0 0 2
- .0 8 3
- .1 4 3 *
- .1 7 2 *
- .1 6 6 *
- .1 2 6
- .0 5 8
.0 2 6
.1 1 2
.179
.2 0 3

.0 7 2
.6 3 1 *
.8 9 3 *
.6 0 6 *
.0 4 2

.2 5 5
.3 3 5 *
.0 7 4
- .3 9 9 *
- .6 6 2 *

5 5 .2 8 7 *

.9 2 7

2 .2 4 3 *

- .3 9 6

.1 5 4

Sum

5 .5 8 3 *

C on stant

2 .6 6 9 *
.6 6

.6 6

.6 5

.5 9

.5 2

.6 7

D .W ,

1 .7 5

1 .7 0

1 .7 3

1 .5 0

1 .3 0

1 .7 3

SE E

3 .8 8

3 .8 6

3 .9 3

4 .2 6

4 .6 3

3 .7 9

1 .5 3 2

* V alues are significant a t the 5 per cen t level.




1 4 .7 3 8 *
2 .5 0 6 *

- .3 5 8

AE

3 7 .9 7 9 *
.8 4 6

.3 3 6

- 2 .6 6 4

.9 7 2

that the values of the independent variables for
the forecast period were known in 1964-IV.
Next, the regressions were rerun to include an
additional year, and quarterly forecasts were
made for the next 2 years. This procedure was
repeated until the sample period ending with
1968-IV was reached.
Two statistics are developed for each suc­
cessive 2 -year forecast period to compare the
forecasting abilities of the six equations. The
average-squared residual between the actual and
the forecasted quarterly changes in GNP are
calculated for each year of a forecast period
and for each whole 2-year period. The second
statistic is the standard error of forecast for
each quarter of a 2-year forecast period. The
standard error of forecast takes into considera­
tion the stochastic element in each equation,
the variance of the parameters estimated for
the sample period, and the variability of the
independent variables in the forecast period.
Table 2 presents the average squared residu­
als for each equation. For every 2-year forecast
period as a whole, the equation for M t has the
lowest average squared residual. Although in a
few cases some of the other five equations for
an individual year have smaller average

squared residuals than the M t equation, their
average squared residuals vary considerably
more from year to year than in the case of the
M 1 equation. For example, forecasts of
changes in GNP based on a 1953-65 regres­
sion for BC have average squared residuals
of 2.7 for 1966 followed by 60.1 for 1967.
The comparable averages for M x are 10.7 and
12.1.
The average standard error of forecast and
its variance over each 2 -year forecast period
are presented in Table 3. In most forecast pe­
riods there is little difference between the aver­
age standard error of forecasts for each regres­
sion, except for Nb, which consistently has the
largest average standard error of forecast.
However, there is considerable difference in
the variability of the standard errors of fore­
cast. In almost every case, its variance for
forecasts of changes in GNP based on Mi re­
gressions is relatively small and for three fore­
cast periods is the smallest.
This paper covers only two aspects of the
System’s ability to control monetary aggre­
gates. These are the magnitude of the control
problem and the present flow of information
on which control would be based. The prob-

TABLE 2: Average Squared Residuals of GNP Forecasts Based on Monetary Aggregates
Sam ple period

Forecast
period

AM i

AMi

AB

AT R

ANB

ABC

1965
1966

2 0 .9
7*1

2 2 .4
1 3 .9

3 5 .2
6 3 .5

3 1 .2
1 9 .2

3 8 .5
1 0 .3

2 5 .7
6 .1

A verage

1 4 .0

1 8 .2

4 9 .4

2 5 .2

2 4 .4

1 5 .9

1966
1967

1 0 .7
1 2 .1

9 .3
4 7 .5

2 8 .3
6 9 .7

1 6 .2
5 3 .1

1 7 .1
1 0 5 .0

2 .7
6 0 .1

A verage

1 1 .4

2 8 .4

4 9 .0

3 4 .7

6 1 .1

3 1 .4

1967
1968

1 6 .1
1 1 .8

4 4 .8
1 3 .4

5 2 .0
1 .3

4 5 .8
1 .1

6 5 .5
1 6 .6

6 2 .0
3 .8

A verage

1 4 .0

2 9 .1

2 6 .7

2 3 .5

4 0 .6

3 2 .9

1968
1969*

1 1 .2
7 .0

8 .9
3 8 .2

2 .2
1 9 .4

1 .1
2 8 .7

3 6 .7
3 4 .2

0 .8
2 4 .6

A verage

~9A

2 3 .6

1 0 .8

1 4 .9

3575

1 2 .7

1969*

_9_.1

2 8 .0
----

2 0 .6
_---

3 0 .3
----

2 0 .2

----- -

---

9 .1

2 8 .0

2 0 .6

3 0 .3

2 0 .2

2 6 .5

1953 -I-1 9 6 4 -IV

1 9 53 -I-1 9 6 5 -IV

1953-1-1966-IV

1 9 5 3 -I-1 9 6 7 -IV

1 953 -I-1 9 6 8 -IV
A verage

* F o reca st period co n sists o f o n ly three quarters.




2 6 .5

SELECTION OF A MONETARY AGGREGATE

TABLE 3: Comparison of Standard Error of Forecast
Forecast period 1
Sam ple period

A Mi

AM t

1 953-I-1964-IV
M ean
V ariance

5 .2 6
.2 5

5 .2 5
.6 2

1 953-I-1965-IV
M ean
V ariance

5 .6 7
.1 7

1953-I-1966-IV
M ean
V ariance

ATR

A NB

ABC

5 .1 6
*27

5 .0 5

7 .0 9

.86

4 .6 7

.10

6 .2 6
.4 8

5 .7 1
.1 5

5 .6 1
.1 5

8 .3 9
1 .5 8

5 .2 8
.2 3

5 .4 1
.0 6

5 .7 1
.4 9

5 .4 2
.1 9

5 .2 4

8 .7 5
.5 3

S . 16

1953-I-1967-IV
M ean
Variance

4 .9 0
.0 3

5 .0 1
.3 2

5 .0 1
.1 7

4 .9 9
.0 4

8 .6 9

5 .1 3

.11

.12

1 953-I-1968-V
M ean
V ariance

5 .7 0

5 .2 5
.1 7

4 .6 5
.0 7

4 .7 5
.0 3

7 .7 4
.0 6

5 .0 6

(*>

.12

.10

.12

.02

1 The forecast period fo r each o f the sam ple periods ending 1964, 1965, and 1966 is eight quarters; for the sam ple ending 1967, seven quarters;
and fo r the sam ple ending 1968, three quarters.
* L ess than .005.

lem of control is investigated by partitioning
the six monetary aggregates into two classes.
The first class consists of those considered to
be more closely related to GNP—M u M 2, and
BC; the second set consists of those considered
to be subject to closer Federal Reserve control
—B, TR, and Nb.
The Brunner-Meltzer framework provides an
approach for investigating the ability of the
Federal Reserve to control M u M2, and BC.
This approach views each of these aggregates
as the product of the appropriate multiplier
(mi) and the monetary base. The values of the
mi’s reflect actions of the public, commercial
banks, and the Government as they influence
movements in each of the three aggregates. The
monetary base reflects actions of the Federal
Reserve. To reach a desired level of one of
these aggregates, the monetary base would be
changed to compensate for movements in the
appropriate multiplier.
Within the multiplier-base framework, there
is a smaller problem of controlling M t due to
actions of the public, commercial banks, and
the Government (variations in the M t multi-

2 Monthly averages for BC were approximated by
averaging end-of-month data for the current and pre­
vious month. This procedure may tend to overstate
the variability in BC.




plier) than for M 2 and BC. Multipliers were
developed for M u M2, and BC (monthly aver­
ages of unadjusted data 2 for January 1960 to
November 1969), and the standard deviations
and ranges of monthly changes in each multi­
plier were calculated. The standard deviations
are: 0.008 for AM u 0.017 for AM2, and 0.018
for A BC. Given the monetary base and the
level of each aggregate for November 1969,
these standard deviations in annual rate of
change in each aggregate are: 3.6 per cent for
Mj, 4.0 per cent for M 2, and 4.3 per cent for
BC. Similar rates of change for the range of
variation in these multipliers are: 23 per cent
for M u 26 per cent for M 2, and 46 per cent for
BC. Thus, there is smaller variability in
due
to variations in its multiplier, thereby creating
a lesser control problem than in the cases of
M 2 and BC.
The question remains of the ability of the
Federal Reserve to control the monetary base
relative to its ability to control member bank
reserves and nonborrowed reserves. Table 4
lists the factors determining each of these ag­
gregates. If the Federal Reserve were to meet
a desired level of one of these aggregates, its
holdings of U.S. Government securities would
be adjusted so as to offset movements in the
sum of all other factors. Changes in monthlyaverage levels (unadjusted data, January 1960

to November 1969) of factors other than Sys­
tem holdings of U.S. Government securities
were calculated for B, TR, and Nb. The stand­
ard deviations of these changes are little dif­
ferent for each aggregate— 0.412 for total re­
serves, 0.437 for nonborrowed reserves, and
0.443 for the monetary base. These standard
deviations in terms of annual rates of change
from November 1969 levels are substantially
different—7 per cent for the monetary base,
18 per cent for total reserves, and 2 0 per cent
for nonborrowed reserves. It appears that the
control problem, as measured above, is less for
the monetary base than for the two reserve ag­
gregates.
The preceding analyses of controlling each
of the six monetary aggregates considered only
the comparative magnitudes of variations in
each aggregate from sources not under direct
System control. The ability to forecast such

variations was not examined on a comparative
basis.
Finally, let us consider the data require­
ments for controlling B, TR, and N b. Table 4
demonstrates the difference among these three
aggregates regarding the data required to con­
trol each. All of the data required to control
the monetary base are required to control the
other two. In addition, both TR and Nb re­
quire information on currency in circulation
and its distribution beween member banks,
nonmember banks, and the nonbank public.
Currency movements can cause wide seasonal
movements in TR and Nb, thereby adding to
the control problems for these two aggregates
beyond those caused by similar movements in
factors common to all three of these aggre­
gates. From a data standpoint, the monetary
base appears easier to control than total re­
serves or nonborrowed reserves.

T A B L E 4 : F a c t o r s A f f e c t in g M o n e ta r y B a s e , T o t a l R e s e r v e s , a n d N o n b o r r o w e d R e s e r v e s o f t h e B a n k in g S y s t e m ,
J u ly 1 9 6 9 1
M o n th ly averages o f d a ily figures in m illio n s o f d ollars
Item

Federal R eserve c r e d it.....................................................................................................
H o ld in g s o f se c u r itie s .............................................................................................
M em ber bank borrow ings fro m F .R ...............................................................
O th er b o rro w in g s......................................................................................................
F .R . flo a t.......................................................................................................................
O ther F .R . a s s e t s .......................................................................................................
G o ld s to c k ..............................................................................................................................
T reasury currency o u tsta n d in g .....................................................................................
T reasury cash h o ld in g s.....................................................................................................
D e p o s its a t the F .R . (other than m em ber bank d e p o sits)..............................
T rea su ry .........................................................................................................................
F o r e ig n ...........................................................................................................................
O th e r ...............................................................................................................................
O ther F .R . lia b ilities an d c a p ita l.................................................................................
C u rrency in c ir c u la tio n ....................................................................................................

S ources o f b ase

T otal reserves a n d n o n b o rro w ed
reserves o f ban k in g system

s 6 0 ,8 8 8
5 4 ,2 9 8
1 ,1 9 0

* 6 0 ,8 8 8
5 4 ,2 9 8
1 ,1 9 0

2 ,6 8 4
2 ,6 7 0

2 ,6 8 4
2 ,6 7 0
1 0 ,3 6 7
6 ,7 3 7
—
657
— 1 ,7 3 2

— 1 ,1 1 7
—
142
—
473

10 ,3 6 7
6 ,7 3 7
—
657
— 1 ,7 3 2
— 1 ,1 1 7
—
142
473

— 2 ,0 3 8

Source b a s e ............................................................................................................................
R eserve adjustm ents *.......................................................................................................

7 3 ,5 6 5
3 ,8 7 6

M on eta ry b a s e ......................................................................................................................

7 7 ,4 4 1

— 2 ,0 3 8
— 5 1 ,2 5 6

M em b er bank reserves w ith the F .R ..............................................................................................................................................................................................
C u rrency held by m em b er banks (a llo w ed a s required reserv es).....................................................................................................................................

2 2 ,3 0 9
4 ,6 7 1

T o ta l reserves o f m em ber b a n k s......................................................................................................................................................................................................
C urrency held by no n m em b er b a n k s .............................................................................................................................................................................................
R eserve adjustm ents *............................................................................................................................................................................................................................

2 6 ,9 8 0
«1, 432
3 ,8 7 6

A ggregate reserves o f the banking sy s te m ...................................................................................................................................................................................
M em b er bank borrow ings from the F .R ......................................................................................................................................................................................

3 2 ,2 8 8
— 1 ,1 9 0

N o n b o rro w ed reserv es..........................................................................................................................................................................................................................

3 1 ,0 9 8

1 N o t adjusted fo r season al variation.
* In clu d es $46 m illion a ccep tan ces n o t sh ow n separately.
* A d justm ents for ch an ges in reserve requirem ents, sh ifts in d ep osits betw een tim e d ep o sits and d em and dep osits, an d sh ifts a m o n g classes o f
bank s.
* E stim ated .
S o u r c e .— F ederal R eserv e Bulletin.




SELECTION OF A MONETARY AGGREGATE

RECOMMENDATION

The results of this study, in my opinion,
suggest that among the six monetary aggre­
gates investigated, M 1 would be the best to in­
clude in the FOMC directive. The regressions
for the sample period of changes in GNP on
the six aggregates indicate that total reserves
and nonborrowed reserves would be inferior to
the other four. The ex ante forecasting experi­
ment indicates that Afa performs the best. With
regard to our ability to control movements in
M u Mo, and (Bank Credit), evidence was pre­
sented that Mx would be subject to closer con­
trol.
These results lead me to recommend that




M t be incorporated in the Committee’s direc­
tive, preferably in the instructions to the Man­
ager. If it is believed that there exists a major
problem of controlling M x and that it would be
desirable to give operating instructions in
terms of some other aggregate, I recommend
the monetary base. Among the aggregates in­
fluenced more closely by the Federal Reserve
(Nb, TR, and B ), control of the monetary
base appears to have fewer problems. In such
a case, however, I also recommend that de­
sired movements in Mx be specified in the first
paragraph of the directive. Implicit in this
study is the assumption that the Manager’s in­
structions be in terms of annual rates of change
in quarterly averages of M x and/or B.

APPENDIX:
Estimation Aspects of the “Simultaneous
Equations Bias” Issue

This appendix surveys the general state of
knowledge regarding the problem o f “simultane­
ous equations bias.” Such bias is said to arise
when one applies ordinary least squares (OLS)
estimation procedures to an equation in which a
critic feels at least one o f the independent varia­
bles is not predetermined, that is, all of the inde­
pendent variable’s current and past values are not
independent o f the current random disturbance
term ([2], p. 353).
In statistical terms, if all but one o f the varia­
bles in an estimated equation are exogenous, then
OLS yields estimators with desirable properties.
In particular, the bias is zero, that is, the differ­
ence between the expected value o f the estimator
and the true parameter is zero.1 If there is more
than one endogenous variable in the estimated
equation, “classical least-squares applied to the
individual structural equations yield biased esti­
mates o f their parameters” ([6], p. 385). This is
the standard textbook assessment o f the situation.
Oi’s ([11], p. 36) statement is that when “two or
more variables in an equation are simultaneously
determined by som e larger system o f equations,”
then OLS “will produce asymptotically biased pa­
rameter estimates.” 2
N o t e .— The author is an Economist at the Federal
Reserve Bank of St. Louis.
1 The definitions of technical terms used in this ap­
pendix can be found in most econometric texts (for
example 2, 6, 7). For the convenience of the reader,
a few basic definitions are given here in a relatively
informal phrasing. An estimator is consistent if its
probability distribution tends to become stacked com­
pletely above the true parameter as the sample size
increases beyond a certain value. An estimator is
asymptotically unbiased if the mean of the estimator
approaches the true parameter as the sample size in­
creases. The former is a stronger property than the
latter. They are both “large sample” properties.
2 Sawa ([13], p. 932) shows that under very special




by H*Albert Margolis

For purposes of specific discussion, let us take
an equation that has been estimated by ordinary
least squares in which changes in G N P are con­
sidered to be a function o f present and lagged
values o f changes in indicators o f monetary influ­
ence— for example, the m oney supply— and pres­
ent and lagged values o f changes in Government
expenditures. The question is raised as to how
much reliance can be placed on the estimated
coefficient o f the money supply in the current
time period. The critics w ho raise this question
assert that the m oney supply is an endogenous
variable. In such a case, a statistically complete
system would require at least one additional
equation accounting for the behavioral m ode by
which G N P reacts back on the m oney supply.
M ost textbooks point out that, “In recursive
models 3 o f the type advocated by W old . . . single-equations least-squares estimators are consist­
ent ([5], p. 14).” But this is simply begging the
question in the equation under discussion. Critics
o f the equation are asserting that the system is
not causal— that is, that there is indeed reverse
causation from G N P to m oney. It seems natural
to ask these critics to indicate the form o f the re­
verse causation.
The question might be stated informally,
“When should one o f the explanatory variables
be considered endogenous and an additional struc­
ture equation added to the model?” Christ ([2],
p. 157) elaborates on this point as follows:
circumstances the small sample bias of both OLS
and TSLS (two stage least squares) disappears.
3 A system is recursive if the equations in it can
be ordered so that in the first equation only one en­
dogenous variable appears and in each succeeding
equation only one new endogenous variable appears
in addition to previously included endogenous varia­
bles. In addition, the covariance matrix of the dis­
turbance terms is diagonal.

SELECTION OF A MONETARY AGGREGATE

For there is no point in the enlargement of
most models at which a <?Onvincing stand can be
made against such arguments for the addition of
another equation—unless it is the point where
all possible variables have already been in­
cluded, and of course the model would then be
utterly unmanageable. What the economist
should do in practice, therefore, in my opinion,
is to stop adding equations and variables when
he believes that the variables he chooses to call
exogenous meet the definition closely enough so
that the errors incurred through the discrepancy
are small in comparison with the degree of ac­
curacy that he thinks is desirable for his pur­
pose (or is attainable). This is necessarily a
somewhat arbitrary decision, for, .unlike the
other variables, the random disturbances by
their nature can never be observed either. These
decisions, like other decisions about what the
form of each equation is to be and what varia­
bles are to be excluded from each, must be
made on the basis of whatever presumptions
seem plausible in the light of economic theory
and experience. The model itself can be defini­
tively tested only after it is confronted with new
data. If it proves reasonably accurate all may be
well, and if not, it is likely that at least one
wrong assumption was made somewhere.
This seems to say that there is no statistical way
to test whether an assumption that a variable is
exogenous is correct.4
A survey of basic econometric texts shows two
discussions in which techniques are mentioned by
which the single-equation format is retained.5
Christ ([2], pp. 4 5 7 -6 3 ) follow s Bronfenbrenner
[1] and suggests that attempts be made to deter­
mine the range o f possible error in the estimate
by making assumptions about the unobservable
error term in the equation. This seems extremely
arbitrary. Kane ([8], pp. 3 1 3 -1 8 ) gives an ex­
ample in which Ferber avoids an overestimate of
the marginal propensity to consum e by estimating
the marginal propensity to save. In other words,
Hi as in favor o f a particular hypothesis is re­
versed (but not eliminated). This strategem is

4 To emphasize this, we should point out that a
necessary condition for zero bias under OLS estima­
tion is that the independent variables not be corre­
lated with the error term ([4], p. 591). But the error
term is unobservable. We have the residual as only
an approximation, and the estimates are constructed
so that the expected value of the product of the re­
sidual and the independent variable is zero.
5 Reference should be made to T. Haavelmo, who
is usually credited with the discovery of the bias
(cf.[10]).




more easily adopted because in the example— as
in most discussions o f simultaneous equation bias
— the second equation is an identity. On the
whole, these suggestions do not seem useful in
the present circumstances.
We proceed now to the question as to what the
situation involves if we feel there should be a
second endogenous variable in the estimated
equation. In other words, let us examine the situ­
ation as envisioned by the critics. A s soon as the
money supply is considered to be endogenous,
conceptually we have a larger system in which
one equation is the G N P equation; now lagged
values o f an endogenous variable— m oney supply
— occur in the G N P equation. W e are then faced
with a choice among various estimation proce­
dures— OLS, TSLS, other forms o f limited infor­
mation methods, and full information methods.
The latter two procedures have not been widely
used in practice. The choice seems to narrow to
one between OLS and TSLS.
Fisher ([4], p. 602) points out that TSLS esti­
mators share with other limited information
methods certain practical difficulties when used in
economy-wide econometric models with lagged
endogenous variables. The first stage o f estima­
tion (the reduced form) may be difficult. The in­
clusion o f lagged endogenous variables “raises
considerable difficulties in the likely presence of
serial correlation o f the disturbances.”
A ccording to Walters ([9], p. 189), a choice
between OLS and TSLS can be made on the
basis o f the purpose o f the estimation. If our
purpose is to predict an endogenous variable,
OLS will yield unbiased and best estimators while
those o f TSLS are biased and inefficient. On the
other hand, if our purpose is to estimate struc­
tural parameters, then OLS gives biased and in­
consistent estimators while those o f TSLS are
consistent “although biased in small samples.”6
This reference to the small sample properties
o f TSLS estimators seems very relevant, and we
pursue it by quoting first from several textbooks
and finally by referring to a recent paper that ad­
dresses itself directly to this question.
Fisk ([5], p. 6) comments:

6 The results indicated in this paragraph apply
only if there are no lagged endogenous variables in­
cluded; otherwise there are no known finite sample
results.

It is not obvious that this lack of consistency
(of single-equation least-squares) should always
cause concern, particularly when dealing with
small samples for which the alternative consist­
ent estimator may have grossly inflated variances
compared with the biased estimator given by
(least-squares). We must always balance the de­
sirability of consistent estimators against the
other criteria by which we judge estimators—
principally: degree of precision of the estimator
and ease of calculation.
Goldberger ([6], p. 360) points out:
. . . for small samples the second moments of
the classical least-squares estimators (about the
true parameter values) may be less than those
of the TSLS estimators— their variances may be
sufficiently small to compensate for their bias. It
should be emphasized, however, that as the sam­
ple size increases, the variance of both classical
least-squares and TSLS tend to zero, but the
bias of classical least-squares persists.
Christ ([2], p. 466) gives a table o f properties
o f various types o f estimators in a m odel that ad­
mits lagged endogenous variables. It shows that
OLS yields inconsistent estimators in general, al­
though with a small variance. The various other
estimation procedures are shown to yield consist­
ent estimators. It should be remembered, how­
ever, that consistency is an asymptotic property
and is frequently used as a criterion only because
there are very few results dealing with small sam­
ple properties.
Am ong the first steps toward the latter goal—
that is, working with the exact distribution func­
tions of OLS and TSLS estimators— is an
important paper by Richardson and W u [12].
This paper shows that in a case similar to the
G N P equation, with the important and vital dif­
ferences that the Richardson and Wu case does
not admit lagged endogenous variables, TSLS es­
timators are unbiased if, and only if, OLS estima­
tors are unbiased. It is not possible to derive the
size o f the bias from these results, but the rela­
tive bias o f TSLS and OLS as a function o f var­
ious parameters is tabulated. The values vary
from almost one to almost zero as the sample
size ranges from approximately 10 to approxi­
mately 100.
In another paper Sawa [13] derives the exact
sampling distributions o f OLS and TSLS estima­
tors of a structural parameter in a structural
equation with two endogenous variables. The
exact distributions are “essentially similar,” and




in a numerical example he finds that the plotted
distributions are “surprisingly similar,” with the
bias o f each always in the same direction.
These results do not apply in a rigorous sense
to the case discussed in this study, because, thus
far, they have not been extended to include
lagged endogenous variables. On the other hand,
in a very similar sense, the criterion o f consist­
ency is not relevant to models with a finite sam­
ple size but it is used for lack o f a better crite­
rion.
The Richardson and Wu and the Sawa papers
are among the few dealing with the exact distri­
bution o f the various estimators. M ost works
dealing with small sample properties have used
M onte Carlo experiments. Fisher ([4], pp. 6 0 4 05) points out that even these results do not
apply to the case in which lagged endogenous
variables appear.
The quotes from Fisk and Goldberger suggest
that the small variance o f OLS may compensate
for any bias. The mean-square-error criterion dis­
cussed in Johnston ([7], pp. 2 7 6 -7 7 ) combines
the effects o f these two pathologies, variance and
bias. The author (p. 294) rejects OLS on the
basis of the bias even though he cites some stud­
ies that show OLS performing well on the meansquare-error criterion. Goldberger ([6], pp. 3 6 2 63) also opts for TSLS even though in the
principal study he indicates that “the variance o f
OLS was sufficiently small to give it generally the
smallest second m o m e n t. .
Sawa ([13], p. 933) suggests that TSLS is pre­
ferable but with som e qualifications:
Indeed the TSLS estimator seems to dominate
the OLS estimator in every case, but, in certain
cases, this dominance is not readily observable.
Furthermore, the bias of the TSLS estimator is
not negligible. Consequently, it may be said that
the TSLS estimator is not such a good estimator
as expected in finite samples.
The Richardson and Wu paper ([12], pp. 1 1 13) gives more perspective on this issue by
presenting a table that derives the exact ratio o f
expected mean-square errors o f TSLS and OLS
estimators as a function of several parameters.
The values in the table range from 9.5 to 0.04 as
the sample size ranges from approximately 10 to
approximately 100. This means that it is possible
for either TSLS or OLS to enjoy a considerable
advantage over the other according to the mean-

SELECTION OF A MONETARY AGGREGATE

square-error criterion. The caveat is repeated that
the formulas used in this study do not include the
lagged endogenous case. But then, as we have
seen, neither the theoretical large sample proper­
ties nor the Monte Carlo small sample results
apply in a firm fashion to the present case.
For a last note o f nihilism in the simultaneous-equation bias controversy we quote Fisher
([4], p. 590), who points out that “very few re­
sults are available on the relevant robustness— the
relative degree to which they (various estimators)
stand up to such things as multicollinearity, speci­
fication error, and serial correlation in the dis­
turbance of the m odel.” Evans ([3], p. 5) refers
to results obtained by Klein, w hich suggest that,
when multicollinearity is present, it is the more
complex methods o f estimation other than OLS
that are more susceptible to bias.
Christ ([2], pp. 4 8 0 -8 1 ) summarizes by say­
ing “it is not yet clear that the least-squares
method for structural estimation is dead and
should be discarded. . . . For structural parame­
ters, least-squares sometimes are preferable to simultaneous-equations methods (probably espe­
cially where samples are small and specification
error is present). . .
Oi ([11], p. 45) quotes Theil approvingly:




Therefore, after reviewing all arguments we
should conclude that although the method of
least-squares can no longer claim to have the
brilliant properties which earlier econometricians
thought it had, it can be regarded as one of the
few one-eyed men who are eligible for king in
the country of the blind— at least as far as ex­
perimental small-sample estimation unaided by
significant a priori information is concerned.
Estimates o f regression coefficients and the de­
termination of lag structures cannot be accom­
plished with certainty. The fact that we have
lagged variables and that we have only small
samples, while our statistical techniques refer
chiefly to large sample properties with current
values, only highlights the unsettled nature of
measuring econom ic relationships. The contro­
versy over the choice o f estimation procedures is
far from being settled when skeptics have a larger
arsenal o f weapons to use in critizicing research
results than constructive researchers have for
their purposes. “These problems must be faced,
however, if an attempt is to be made to estimate
the structure o f the econom y by empirical meth­
ods. Rejecting all empirical results out o f hand
because o f visible disagreement among different
studies will not help bring about a solution to
these problems.” ([3], p. 2)

REFERENCES
Books

Periodicals and Other




1. Bronfenbrenner, Jean. “Sources and Size of
Least-Squares Bias in a Two-Equation
M odel.” H ood, William C., and Koopmans,
Tjalling C. (eds.). Studies in E conom etric
M eth o d. N ew York: John W iley & Sons,
Inc., 1953.
2. Christ, Carl F. Econom ic M odels and M eth ­
ods. N ew Y ork : John W iley & Sons,
Inc., 1966.
3. Evans, M ichael K. M acroeconom ic A ctivity:
Theory, Forecasting, and C on trol. N ew
York: Harper & Row, 1969.
4. Fisher, Franklin M. “D ynam ic Structure and
Estimation in Economy-W ide Econometric
M odels.” Duesenberry, James S. et aL The
Brookings Q uarterly E conom etric M odel
o f the U nited States. Chicago: Rand
M cN ally and Co., 1965.
5. Fisk, P. R. Stochastically D epen den t Equa­
tions: A n Introductory T ext fo r E conom e­
tricians. N ew York: Hafner Publishing
Company, 1967.
6. Goldberger, Arthur S. E conom etric T h eory.
N ew York: John W iley & Sons, Inc.,
1964.
7. Johnston, J. E conom etric M o d els. N ew
York: M cGraw-Hill Book Company, 1963.
8. Kane, Edward J. E conom ic Statistics and
E conom etrics. N ew York: Harper & Row,
1968.
9. Walters, A . A. A n Introduction to E conom e­
trics. London: M acmillan and Co., 1968.
10. Haavelmo, T. “M ethods o f Measuring the
Marginal Propensity to Consum e,” Jour­
nal o f The A m erican Statistical A ssocia­
tion, Vol. 42 (Mar. 1947), pp. 1 0 5-22.
11. Oi, Walter Y. “On the Relationship A m ong
Different Members o f the K-Class,” Inter­
national E conom ic R eview , V ol. 10 (Feb.
1 9 6 9 ).
12. Richardson, D avid H ., and Wu, De-M in. “A
N ote on the Comparison o f Ordinary and
Two-State Least-Squares Estimators.” U n ­
published research paper, University of
Kansas, 1969.
13. Sawa, T. “The Exact Sampling Distribution
o f Ordinary Least Squares and Two-Stage
Least Squares Estimators,” Journal o f The
A m erican Statistical A ssociation, V ol. 64
(Sept. 1969), pp. 9 2 3 -3 7 .

by John Kareken, Thomas Muench,
Thomas Supel, and Neil Wallace




DETERMINING THE
OPTIMUM MONETARY
INSTRUMENT VARIABLE

CONTENTS




87

INTRODUCTION

88

I. QUADRATIC UTILITY AND A SIMPLE
ECONOMIC STRUCTURE

89

II. QUADRATIC UTILITY AND A
COMPLEX ECONOMIC STRUCTURE
Distributions of parameters, disturbances, and
exogenous variables
Results

90
91
92

III. THE REAL INCOME-VARIANCE OF
PRICE UTILITY FUNCTION

93

IV. CONCLUSION

94

APPENDIX:
Holbrook and Shapiro on the Optimum
Monetary Instrument Variable

OPTIMUM MONETARY INSTRUMENT VARIABLE

INTRODUCTION
For some time monetary economists and
officials have been debating how central banks
ought to operate. Should the Federal Reserve,
for example, seek to control one or another of
the monetary aggregates? And if so, which
one? Or should it control some interest rate or
rates?
We do not know how the Federal Reserve,
or for that matter any other central bank,
ought to operate. We do, though, know what
seems to us a not unreasonable way of decid­
ing; a way, that is, of determining the opti­
mum monetary instrument variable. And in
this paper we explain or, better, illustrate our
way.
The central bank that is certain about the
economic structure constraining it or does not
care about the variance of policy outcomes
can, with complete indifference, use any possi­
ble instrument variable. It is difficult, however,
to imagine any central bank being certain or
not caring about the variance of policy out­
comes. The presumption must therefore be
that most if not all central banks have a true
choice to make: namely, which of all possible
instrument variables to use. 1 And what we
would have central banks do is decide by max­
imizing their respective expected utilities; or in
other words, by comparing the maximum ex­
pected utilities associated with all the various
possible instrument variables. What in effect
we would have the Federal Reserve do is cal­
culate alternative opportunity loci, there being
one such for each possible instrument variable,
and then, having specified values for its target
variables, determine which of these loci or
constraints allows it to achieve the greatest ex­
N o t e .— Messrs. Kareken, Muench, and Wallace, all
of the Economics Department, University of Minne­
sota, are Consultants to the Federal Reserve Bank of
Minneapolis; Mr. Supel is Senior Economist at that
Bank. They would like to thank Arthur Rolnick for
his very considerable help, and the Minneapolis Bank
for its financial support.
1 See W. Poole, “Optimal Choice of Monetary Pol­
icy Instruments in a Simple Stochastic Macro
Model,” Quarterly Journal of Economics, (May 1970),
and J. Kareken, “The Optimal Monetary Instrument




pected utility. We would have the Federal Re­
serve do this not once but, since the cost is not
much, at the beginning of every policy period.
Nor is it impractical to suggest this. How­
ever complex the underlying economic
structure, opportunity loci can be calculated.
In Section I, we use a very simple economic
structure. But we do so only because our pur­
pose there is to explain our way of determin­
ing the optimum monetary instrument variable;
and it is convenient in explaining to use a sim­
ple structure. In Sections II and III, wherein
we derive actual Treasury bill rate and demand
deposit loci, we use the Federal Reserve-MITUniversity of Pennsylvania economic structure,
which is very complex. 2
We do then provide some numbers or ex­
perimental findings. We would caution, how­
ever, against paying much attention to them.
They are not, we think, even suggestive of
how the Federal Reserve ought to operate. We
decided to include them in the paper only be­
cause they show that our way of determining
the optimum monetary instrument variable is
practical.
But our way is practical or feasible only for
myopic central banks, for those concerned
only about current-period developments or, by
way of approximation, willing to pretend that
they are. It is no accident that in Sections I
and II we take utility as depending simply on
current-period nominal gross national product
and in Section III as depending on currentperiod real GNP and the current-period change
in the price level. Had we taken utility as de­
pending on future-period values as well, we
would not have been able to go further; we
would not have been able to show the practic­
ability or feasibility of calculating and compar­
ing the maximum expected utilities associated
with the various possible instrument variables.
Variable,” Journal of Money, Credit, and Banking,
(Aug. 1970).
2 Hereinafter, we shall refer to the FR structure.
There is, we understand, a new version. If so, we
used an old version, the one described in part by F.
de Leeuw and E. Gramlich in “The Federal ReserveMIT Econometric Model,” Federal Reserve Bulletin,
(Jan. 1968).

It is not known what policies are optimal for
a central bank that is uncertain about the true
values of structural parameters and whose con­
cern extends into the future.
We might have proposed comparing the ex­
pected utilities of arbitrary rather than optimal
policies. But which ones? Or we might have
proposed that variances of structural parame­
ters be ignored. It seemed to us, however, that
uncertainty about parameters is an important
fact of life and that we ought therefore to take
utility as depending only on current-period val­
ues of target variables.
Some readers might want to object that the
Treasury bill rate and the stock of demand
deposits are not possible Federal Reserve in­
strument variables. We believe, though, that
the Federal Reserve if it wanted to could de­
termine the bill rate exactly. It would only
have to announce a price for bills. And is
coming quite close to some preassigned value
for, say, the 3-month average of demand de­
posits impossible? We think not. But it does
not really matter if we have been inept in se­
lecting possible Federal Reserve instrument
variables. Our way might be used for choosing
between (or among) other possible instrument
variables.

Let the economic structure be
(1)

Y = so +

+ ex

and
(2)

m — S2 + s$Y + Sat + e%

Equation 1 describes nominal aggregate de­
mand as a function of the interest rate, r, and
equation 2 the condition for equality between
the actual stock of demand deposits, m, and
the desired stock. The monetary authority is
uncertain about the values of the parameters,
s0, su . . . , s4 and about the values of the dis­
turbances ex and e2.
If r is used as the instrument variable, the
reduced-form equation for Y is equation 1. If
m is used as the instrument variable, it is
(3)

Y = sh + s&n + e 3

where
SiSo S2Si
s& = ----- 1------S4 + ^ 3
*6

= ----:----£4 + S\Sz

and
I. QUADRATIC UTILITY AND A
SIMPLE ECONOMIC STRUCTURE
Let the monetary authority’s utility function
be
U = - C T - Y) 2
where Y is nominal current-quarter GNP and
Y is the desired or target value of Y . Then
EU = - V Y - (EY - Y) 2
where E stands for expected value and V for
variance. Iso-expected utility contours are
parabolas, symmetric about E Y = Y, in the
positive quadrant of the (E Y , V Y ) plane. The
relevant opportunity loci, or constraints subject
to which EU is maximized, are therefore all at­
tainable combinations of E Y and V Y .




£3 =

s^ei
— S\ € 2
-----------------------$4 + SiS3

From these reduced forms, the two loci can
be obtained. To illustrate, from equation 1,
(4)
and

EY(r) = Es 0 + rEsi + Ee 1

(5) VY(r) = V(So + *0
+ r2Vsi + 2rC(s0 + ei, Si)
where C stands for covariance. Solving equa­
tion 4 for r and substituting the result into
equation 5 gives the r-locus
(6 )

VY(r) = Co + cxEY{r) + c&EY{r)Y

OPTIMUM MONETARY INSTRUMENT VARIABLE

where
VsJE(s0 + e1)Y
Co = K(so + ei) +
(ESly
2E(sq + ei)C(sQ+ ^1? $i)
Esi
Ci =

2C(s0 + eu ^i)
Es i

2VsiE(s0 + ei)
(^ i) 2

c2 = Vsi/(Esi) 2
Equation 6 gives all combinations of E Y and
V Y attainable when r is used as the instrument
variable.
The opportunity locus for m, the m-locus,
is obtained in the same way as the r-locus was,
but from equation 3.
As we show in Section II, traditional or
classical estimation of equations 1 and 2 pro­
vides the basic information needed to determine
numerical values for the coefficients of the rlocus (that is, for c0, cu and c2) and for the
coefficients of the m-locus. And with numerical
opportunity loci, the monetary authority can
determine its optimum instrument variable. All
it has to do is specify a target value for Y .
It is worth pausing briefly here to consider
what it means to determine numerical opportu­
nity loci by traditional estimation of the
economic structure. Each variance of possible
outcomes of Y , for example VY(r), combines
true randomness in the economy and uncer­
tainty about the values of structural parameters.
Indeed, VY(r), like VY(m), is a forecast vari­
ance; that is to say, a variance of forecast Y
around “true” or actual Y. To be sure, the
randomness of “true” Y is entirely attributable
to ex and e2. But the monetary authority, in
making its instrument variable choice, must
also be influenced by how certain it is about
parameter values. Suppose that when m is used
as the instrument variable, Y is partly deter­
mined by some parameter the value of which
is extremely uncertain; and when r is used as
the instrument value, Y is not determined even
in part by this parameter. If at all averse to
risk, the monetary authority should then, ceteris
paribus, use r as its instrument variable.




II. QUADRATIC UTILITY AND A
COMPLEX ECONOMIC
STRUCTURE
The FR economic structure is, as we have
said, very complex. There are many behavioral
equations, some of which are nonlinear. It can
be written
Fi(x, z, r, au et) = 0

(z = 1, 2, . . . , K )

where x is a vector of the current values of
endogenous variables, K in number; z is a vec­
tor of contemporaneous, nonpolicy exogenous
variables; r is the rate on 3-month Treasury
bills; ai is a vector of parameters; and e » is a
disturbance. If all nonlinear terms in x and r
are approximated by first-order Taylor expan­
sions, then the structure can be written
(7)

Ax = Br + C

where A is a KxK matrix with elements a»y;
B is a Kx 1 matrix with elements bn\ and C is a
Kx 1 matrix with elements Cf. Also,
a<j =

2

, r°, a,-, et)

bn =

z, r°, at, et)

and
Ci = hi(xQ, z, r°, au e{)
where jc° and r° are the values of x and r used
in making the model linear. It follows that
( 8)

Xi = Y — dur + dio

and
(9)

x 2 = m = d2\r + d‘>[

where dn = A j 1 B, A'l being the/th row of
A~l, and dj 0 — A f 1 C. Then
Y(r) = dnr + rfio
and

= Dnm + Dio

So what is required are estimates of the first
two moments of the vectors (dlu d10) and
(Dn , Z)10). But since the d's and D’s are com­
plicated functions of the underlying random
variables—the parameters an, the disturbances
eif and the contemporaneous values of noninstrument exogenous variables Zi—their distri­
butions cannot be derived analytically from the
distributions of the underlying random vari­
ables. 3 It is possible, though, to sample from the
distributions of the underlying random vari­
ables, insert the sampled values into equation
7, and solve for values of the reduced-form
coefficients, the d’s and the D’s. By repeated
sampling, a set of values of the d’s and
the D’s is built up, from which moments can
be estimated and numerical opportunity loci
derived.4
It is also possible to proceed differently.
Relevant opportunity loci can be determined
point by point from a nonlinear structure. For
each of a set of values of r and each of a set
of values of m, a sample of values of Y is gen­
erated and estimates of the first two moments
are calculated. We decided against proceeding
this way in part because of the cost. A great
many simulations would have been required:
2 (nxp) simulations, in fact, in order get p
points on each locus, using n observations on
Y for each point.

3 Even for very simple economic structures, such
as that of Section II, it is difficult if not impossible
to derive the distributions of the reduced-form coeffi­
cients as functions of the moments of the structural
parameters. To determine the numerical loci implied
by the structure of Section II, it would therefore also
be necessary to sample from the joint distributions of
the structural parameters that are consistent with
statistical estimation.
4 Why derive numerical opportunity loci rather
than calculate expected utilities? It is just that to cal­
culate expected utilities, Y, the desired or target
value of Y, must be known or assumed. But having
derived numerical loci, one may find dominance in a
neighborhood of some reasonable value for Y — that
one variance is smaller than the other at every value
of E Y in the neighborhood. Clearly, deriving numeri­
cal loci is for outsiders.




DISTRIBUTIONS OF PARAMETERS,
DISTURBANCES,
AND
EXOGENOUS
VARIABLES. We assumed that the mean of
each parameter in Fi is equal to the corre­
sponding estimate, that the variance-covariance
matrix of a set of parameters is equal to a con­
stant times the variance-covariance matrix of
the corresponding estimators, and that the
variance of the disturbance in Fi is equal to
a constant times the corresponding residual
variance. 5
Sample values of «i, the vector of parameters
in the ith equation, not the original structure,
were generated jointly according to the matrix
equation
<*i —

+ R{V

where a* is the vector of point estimates of
aif Ri is a matrix such that RiR'i equals the es­
timated variance-covariance matrix of at, and
v is a vector of random variables chosen inde­
pendently of one another from a normal distri­
bution with mean zero and variance one trun­
cated at plus and minus two. The disturbance
for the zth equation was generated according to
ei = <iiV
where ^ is the estimated residual standard
error for the zth equation and v is a single in­
dependent drawing from the same truncated
normal. It follows that the expected value of
is
that the variance-covariance matrix
o f i s 0.77 times the variance-covariance ma­
trix for
that the mean of ex is zero, and that
its variance is 0.77 v f. (The constant is 0.77
because we inadvertently failed to recognize
that the variance of the truncated normal is
0.77 and not unity.)
We chose a truncated distribution for v be­
cause many of the equations of the FR struc­
ture are in a form inconsistent with an un5 Thus, the data requirements for each estimated
equation are the point estimates of the coefficients,
the point estimates of the residual variance, and the
inverse of the relevant cross-product matrix of the
independent variables. The coefficient and residual
variance estimates were available, but the cross-prod­
uct matrices had to be re-estimated.

OPTIMUM MONETARY INSTRUMENT VARIABLE

limited range for the disturbance. For example,
several of the estimated equations for interest
rates are linear, so that disturbances from a
distribution with unlimited range could produce
negative interest rates. Also, we did a certain
amount of linearization and thereby changed
some estimated equations which originally had
forms that constrained the dependent variables
to proper ranges.
There are quite a few noninstrument exoge­
nous variables in the FR structure that can be
treated as random. These include population,
Federal Government expenditures, and exports.
We assumed that these variables are generated
by second-order autoregressive schemes,
Z t ,% — P o t +

P u Z t-i,i +

P u Z t-2 ,i +

U t, i

The /?’s were taken as fixed and equal to the
estimated coefficients from an ordinary least
squares regression of z% on two lagged values of
itself over the period 1952-Q1 to 1968-Q4.
(It was an oversight that we did not also take
the fi's as random.) The disturbance, ut)i, was
treated as random with mean zero and variance
equal to 0.77 times the estimated residual
variance from that regression.
The distributions of the exogenous variables
can play an important role in determining the
better instrument variable. In a simple model,
the less variance in the aggregate demand
schedule the more likely is it that the interest
rate is the better instrument variable. Inability
to forecast exogenous variables like govern­
ment expenditures and exports contributes di­
rectly to variance of aggregate demand. Thus,
if there are schemes that forecast those vari­
ables with smaller error variance than do our
autoregressive schemes, our failure to use them
would seem, on the whole, to favor demand
deposits as the optimum monetary instrument
variable.
RESULTS. We derived opportunity loci for
the first quarter of 1969 using 100 random
drawings. 6 With r as the instrument variable
6 Deriving loci for 1969-Q1, we linearized the FR
structure around values for 1968-Q4.




E(Y) = 884.9 - .819r
and
V(Y) = 361.0 - 2(.671)r + ,088r2
where r is measured as a per cent per annum
and Y is measured in billions of dollars at an
annual rate. Therefore, the r-locus is
V(Y) = 102,012 - 231.4 £(7) +.13166 [E(Y)¥
The highest value of E(Y) for which the locus
has any meaning is E(Y) — 884.9, since there
r = 0. At r = 10, E(Y) = 876.7. The locus is
drawn in Figure 1 for approximately that range
of values. We would expect our estimated locus
to most closely approximate the locus obtained
from the original nonlinear model in the vicinity
of r = r°, the value around which we linear­
ized, or in the vicinity of E(Y) — 880.3.
With m as instrument,
E(Y) = 805.8 + .495m
and
V(Y) = 1067.0 - 2(5.178)w + .0365m2
where m is in billions of dollars. Therefore, the
m-locus (also shown in Figure 1) is
V(Y) = 114,713.7 - 26\2E(Y) + .14909[£(7)]2
Note that in Figure 1 m dominates r as an
instrument variable. For any expected value of
y, the variance of Y is smaller with m as the
instrument variable than with r as the instru­
ment variable. But the difference between the
FIGURE 1

MEAN-VARIANCE LOCI
E|Y]

V|Y)

92

variances at, say, E(Y) = 880 is 20, and 20 is
not a significant difference. For a sample of
100 drawings, a 90 per cent confidence interval
around the variance of the w-locus at E(Y) —
880 ranges from 269 to 432, whereas the cor­
responding interval for the r-locus ranges from
285 to 457. There is, therefore, considerable
overlap of the confidence intervals.

given value of the variance of the deflator, fair
gambles on X are always rejected. The relevant
opportunity loci consist of all attainable com­
binations of E log X and 104E[(P — P°)/P0]2.
These were obtained for r and for m as follows.
Whether r or m is used as the instrument
variable, there are reduced-form equations for
both real income and the deflator. Let
X — b\r +

&2

P — b ^ -f- b\
III. THE REAL INCOME-VARIANCE
OF PRICE UTILITY FUNCTION
We also derived the first-quarter 1969 opportu­
nity loci relevant for maximization of expected
utility, where
U = \ogX - 6[100(P - P°)/i >0] 2
X is real GNP in 1958 prices, P is the GNP
deflator, and P° is the deflator for the fourth
quarter of 1968. Iso-expected utility contours
for this function are straight lines with slope
b in the [E log X , 104E(P - P°/P°)2] plane.
The log function implies risk aversion; at a

FIGURE 2

THE MEAN INCOME-PRICE VARIANCE LOCI
E log X




be those for r. Thus,
E(log X) = E log (ihr + b2)
so E log X cannot be written as a function of
r and of the moments of bx and b2. It is pos­
sible, however, to compute E log X for each
value of r in a reasonable range. We let r range
from 1 per cent to 10 per cent. For each value
of r, we computed and averaged log ( b j + b2)
over the sample of values of bx and b 2 and took
the resulting average as our estimate of E log
X . From the reduced form for P, we have

OPTIMUM MONETARY INSTRUMENT VARIABLE

ings, 90 per cent confidence intervals around
those estimates are almost coincident.

= V W b 'E Q x * ) + £(&,*)
+ (P0) 2 - 2P°(rEbs + Ebt) + 2rE(b,bi)]

IV. CONCLUSION
Selected values of E log X and 104E
are given in Table 1. Some values for the m~
locus, which were obtained in the same way
using the reduced-form equations for my are
also given in Table 1. Both loci are shown in
Figure 2.
TABLE 1: Selected Values For Real Income—Price
Variance Loci
/71-loCUS

r-locus
r

S lo g *

1

6 .5 6 9
6 .5 6 8
6 .5 6 7
6 .5 6 6
6 .5 6 5
6 .5 6 4
6 .5 6 3
6 .5 6 3
6 .5 6 2
6.561

2
3
4

5
6
7
8
9
10

io < £ |
.2 5 2
.2 5 0
.247
.2 4 4
.241
.239
.2 3 6
.2 3 3
.231
.2 2 8

m

E lo g X

140.1
142.1
144.1
146.1
148.1
150.1
152.1
154.1
1 5 6.1
158.1

6 .5 5 9
6 .5 6 0
6 .5 6 1
6 .5 6 2
6 .5 6 3
6 .5 6 4
6 .5 6 6
6 .5 6 7
6 .5 6 8
6 .5 6 9

10«E

( t

)'

.2 2 2
.2 2 6
.2 2 9
.2 3 2
.2 3 5
.2 3 9
.2 4 2
.2 4 5
.2 4 9
.2 5 2

Once again m dominates r; at each value of
E log X the variance of the deflator is smaller
for the /rz-locus than it is for the r-locus. The
difference, however, is miniscule. At E log X
= 6.5647, which corresponds to r = r° for the
r-locus, the percentage variance of the deflator
for the w-locus is 0.2393, while that for the
r-locus is 0.2397. For a sample of 100 draw­




As indicated in the introduction, we think
that little attention should be paid to our ex­
perimental findings. It is not only because our
samples were too small, but also because, to
calculate numerical loci, it is necessary to as­
sume a utility function and, what is more, an
economic structure. And to accept calculated
loci, or a comparison thereof, is to accept the
assumed utility function and the assumed struc­
ture. Even if our samples had been larger, we
would not then have cared to press our findings.
Before doing that, we would want to average
over time 7 and several economic structures.
But more fundamentally, we feel that no
monetary authority should decide once and for
all, by statistical inference, which of its possible
instrument variables to use. Unless faced with
prohibitive costs, it should decide which vari­
able to use at the beginning of every policy
period or possibly every quarter. This ulti­
mately is why we could in good conscience
content ourselves only with offering a way of
determining the optimum instrument variable
(and with a sample of only 1 0 0 drawings).
7 See the appendix, wherein we appraise the at­
tempt of Holbrook and Shapiro to determine empiri­
cally the optimum monetary instrument variable.

APPENDIX:
Holbrook and Shapiro on the Optimum
Monetary Instrument Variable

There has been one attempt that we know of,
by Holbrook and Shapiro (H&S), to determine
empirically the Federal Reserve’s optimum in­
strument variable. 1 What H&S did was to cal­
culate and then to compare certain variances of
real GNP, variances associated with three pos­
sible monetary instrument variables: the nar­
rowly defined stock of money, the monetary
base, and, what would seem a rather surprising
choice, the average rate on long-term Treasury
bonds. 2 What they found was, for every calen­
dar quarter in a long stretch of years, a smaller
variance for the narrowly defined money stock
than for both the monetary base and, by a
much wider margin apparently, the average
Treasury bond rate. Thus, their tentative con­
clusion was that, in setting its policy, the Fed­
eral Reserve ought to use the narrowly defined
money stock.
But H&S calculated and so compared the
wrong variances. They went astray, we suspect,
because they forgot that there must be dis­
turbance terms in their structural equations.
Whatever the explanation, though, they cannot
be regarded as having made a case, even a
highly provisional case, for the narrowly de­
fined money stock as the Federal Reserve’s
optimum monetary instrument variable.
H&S distinguished between actual GNP, de­
noted here by 7, and predicted GNP, denoted
here by yp. Suppose that
1 See Robert Holbrook and Harold Shapiro, “The
Choice of Optimal Intermediate Economic Targets,”
American Economic Review, May 1970, pp. 40-46.
2 Holbrook and Shapiro referred to the narrowly
defined stock of money, the money base, and the av­
erage rate on Treasury bonds as possible intermedi­
ate target variables. But they assumed that the Fed­
eral Reserve is able to determine exactly any one of
these three variables, so it is quite proper for us to
refer to them here as possible instrument variables.




(1)

C = axY + Ux

(2 )
(3)

/ =
v=

#2

+

03

r + U%

cisY H- Qtfti -f- C/3

#4

(4)

Y = C+ I

where C and / are, respectively, consumption
and investment, r and m are the two possible
monetary instrument variables, respectively, the
rate of interest and the stock of money and
Ulf U2, and U3 are random disturbances. 3 Then
(5) Y(r) =

1
1

(i02 + a3r + Ui + U2)

- ai

and
(6 ) Y(m) =

1

1 — 01 — 0305

(0 2

+ 0304

+ azdtfn + Ui + U2 + 0»t/*)
where Y (r) is actual GNP with r as the instru­
ment variable and Y (m ) is actual GNP with
m as the instrument variable. Also
(5a)

1

y»(r) =

5 " (0 2 +
- ai

1

0

*r)

and
(6 a) yp(m) =

1
-

-x -s - (# 2 +

1 — d i — <3305

0304

+ 030em)
where yp(r) is predicted GNP with r as the
instrument variable, yp(m) is predicted GNP
with m as the instrument variable, and 0 * is
the estimator of a
3 This economic structure is far simpler than the
one specified by H&S. But since we want only to illus­
trate wherein they went wrong, we do not need even
a faintly realistic structure or more than two possible
monetary instrument variables. H&S failed to include
disturbances in describing their model, but they must
surely belong there, for otherwise the model must be
rejected unless the data fit it exactly.

OPTIMUM MONETARY INSTRUMENT VARIABLE

The loss function explicitly assumed by H&S
is
(7)

L(x) = [yp(x) - Y(x)Y

(x = r, m)

where Y p(r) and Y p{m) are the first-order
Taylor expansions of, respectively, >>p(r) and
yp(m) around the point a = (a*, a2> . . . , o6).
Since
(8 ) Yp(r) = y ~ ~ t« 2 + fl> + (fli - ai)^]
I —Qi
and
(9) W

= !

+ ^

+ a3ma6 + (Si — ai)7 + (dz — a3)r
+ ^ 3(^ 5 ~

05

)^

it follows that 4
(10) EL{r) = E[Yp(r) - 7(r) ] 2
_ ™

+ „(]* ± £ )

and
(11) EL{m) = E[Yp(m) ~ i'M P
PW

\

1

— fll — G3^5 /

£L (r) is the expected loss with r as the instru­
ment variable and EL{m) is the expected loss
with m as the instrument variable.
The straightforward procedure would seem
to be to minimize E L (r) by the choice of r
and to minimize EL(m) by the choice of m
and then to compare the respective minima.
But doing so would amount to assuming that
the monetary authority does not care about the
expected value of Y. H&S therefore assumed
that “the policy maker . . . select(s) the value
of each intermediate target variable such that
the expected value of income is equal to desired
income, and then . . . choose(s) among (in­
strument) variables that one which minimizes
the expected squared deviation of actual from
desired income.” So H&S would have the
4
This formula for forecast error holds exactly
only in the post-sample period, for in the sample pe­
riod there is also a covariance term.




monetary authority minimize E L (x ), but sub­
ject to the constraint
(12)

EYp(x) = Y

where Y is the target value of Y . But they
themselves did not compute their constrained
minima of E L (x ), that is, EL(x).
They forgot to calculate the second terms
on the right-hand sides of equations 1 0 and
l l . 5 This is hardly a minor oversight. Those
terms would remain even if the sample size
were indefinitely large. And we suspect that
for their estimated model the omitted terms are
relatively large. A ranking of instruments by
V Y p(x) in no way implies a ranking by EL(x).
Even if H&S had not forgotten the second
terms on the right-hand sides in equations 1 0
and 1 1 , they would have ended up calculating
the wrong variances. For in calculating vari­
ances, they used actual values of both r and m
(that is, ra and ma). And as is easily shown,
E Y p(ma) is not in general equal to E Y p(ra).
The expectation of Yp at r = ra is, by equation
8,

(13)

EYp(ra) =

7
1

~ ~ [a2 + W a]
— a\

assuming unbiased estimators of the a^s. From
equation 3, it follows that
(14)

mtt = — [ra — at — a 5y(ra) — t/3]

and from (5) that
(15) ma = +

(X\Q\

- [(1 - ai - aza5)ra
—

“b

O 5U2)

~b

U3

—

O 1 C /3 ]

But the expectation of Y p(m) at m = ma is,
by equations 9 and 15,
(16) EYp(ma) -

- j [a2 + aarj
Q z ia ^ U i
(1

+

CI5U2

— ai - aza5)

(1

- ax)

5 In footnote 7, p. 45, they recognize but do not
deal with this omission.

So at any point in time E Y p(ma) ^ E Y p(ra)
unless, by some chance, all Ui$ happen to be
zero.
Thus, if actual or observed values of both
(all) possible instrument variables are used in




calculating variances, the resulting variances
will correspond to different mean values of Y p,
and a comparison of variances corresponding to
the same value of E Y P, which is what H&S
proposed, is not achieved.

by James L. Pierce




THE TRADE-OFF BETWEEN
SHORT- AND LONG-TERM
POLICY GOALS

CONTENTS




99

INTRODUCTION

99

SHORT-RUN VS. LONG-RUN GOALS

101

SOME SIMULATION EXPERIMENTS

103

CONCLUSIONS

TRADE-OFF BETWEEN POLICY GOALS

INTRODUCTION
The existence of long lags in the response of
the real sectors of the economy to changes in
monetary policy is well documented. These
lags may require an horizon for monetary pol­
icy strategies that spans many calendar quar­
ters. Even if long planning horizons are desira­
ble, specific operating strategies still must be
adopted for the actual short-run conduct of
monetary policy. These, however, should be
consistent with the long-term goals. If shortrun considerations—such as stabilization of
money market interest rate movements—cause
modification of the operating strategy, the
long-run goals in terms of income, employ­
ment, and the price level may suffer. This
paper discusses some of the areas in which
short- and long-term goals may conflict and at­
tempts to evaluate the costs to the long-term
targets of imposing short-run side conditions
on policy actions.

SHORT-RUN VS. LONG-RUN GOALS
Available econometric evidence indicates that
variations in monetary policy instruments
can exert little influence on the nonfinancial
sectors of the economy in the short run. Ex­
periments with a recent version of the Federal
Reserve-MIT model indicate that, other
things equal, a $ 1 billion increase in the
money stock in a given quarter will produce
only a $0.3 billion increase in nominal gross
national product in that quarter. Further,
inspection of the coefficients for the relevant
equations in the model suggests that even this
small response is probably overstated. It is in­
teresting to note that the long-run multiplier
relation between money and nominal GNP is
substantial. Other things equal, a $ 1 billion
permanent rise in the money stock leads to a
permanent increase in nominal GNP of ap­
proximately $3.2 billion.
N o t e . —The author, who is Associate Adviser, Di­
vision of Research and Statistics, would like to thank
William Poole for his constructive comments on an
earlier version of this paper.




Given the short-run multiplier, attempts to
establish short-run (quarter by quarter) con­
trol over the economy may require variations
in policy instruments that are unacceptably
large. An example may clarify the issue. As­
sume that during a generally inflationary pe­
riod, the decision is made to attempt to stop
the inflation within a single quarter. To ac­
complish this end, a sharp rise in interest
rates, and probably a substantial reduction in
the levels of the monetary aggregates, would
be required during the quarter. Even if this
strategy were successful, a new problem would
immediately develop. With the passage of time
beyond the quarter, the economy would con­
tinue its deflationary adjustment—probably at
an increased rate—in response to the mone­
tary restriction. If an overresponse of the
economy to the original policy restriction is to
be avoided, policy must reverse itself immedi­
ately by sharply reducing interest rates and ex­
panding the monetary aggregates. This easing
of policy would require in turn a restrictive
policy the next quarter. Thus, by never looking
more than one quarter ahead, large short-term
reversals of policy would be required to stabi­
lize the economy.
Whether this myopic strategy of trying to hit
targets in the real sector on a quarter-by-quarter basis can be successful over the long run
depends, among other things, upon the existing
parameters of the system. 1 It is quite possible
that pursuit of such a strategy would have no
long-run future because ever larger changes in
monetary policy instruments would be required
to achieve stability in the real sector. Even if
the strategy produced permanent economic sta­
bility, it could create extreme fluctuations in
financial markets.
It is quite possible, however, that large fluc­
tuations in financial variables would alter in­

1 For a simple treatment of this problem see E.
Gramlich, “The Usefulness of Monetary and Fiscal
Policy as Discretionary Stabilization Tools,” pre­
sented at the Conference of University Professors
sponsored by the American Bankers Association,
Sept. 1969.

terest rate expectations enough to weaken
greatly the efficacy of the myopic policy strat­
egy. Rapid reversals of monetary policy may
encourage investors to expect wide fluctuations
in short-term interest rates. In this situation,
efforts to reduce long-term rates would be
thwarted by investor expectations of a rise in
rates in the near future. Thus, the pursuit of
the myopic policy strategy could be self-defeat­
ing.
There are two obvious ways to approach the
problem posed by the small amount of short­
term control over the economy. First, mone­
tary policy could pursue the myopic rule of
attempting to hit a target quarter by quarter
but could subject the strategy to constraints
imposed by financial conditions. Thus, a spe­
cific target value for employment or for the
price level would be pursued provided the act
of attempting to hit the target did not cause
excessive fluctuations in interest rates. If inter­
est rates moved more than was deemed desira­
ble, policy instruments would be changed suffi­
ciently to bring interest rates within the
allowable range. The imposition of such con­
straints could greatly reduce the ability of
monetary policy to achieve short-term goals.
The second approach would involve a
lengthening of the policy-planning horizon. In
this situation, policy would take a view longer
than one quarter into the future. The aim
would be to achieve the best path of, say, em­
ployment over some interval of time consistent
with acceptable performance of financial mar­
kets. Extension of the horizon would allow
problems of the real sector and of the financial
sector to coexist on a more equal basis. No
immutable constraints would be placed on the
system by money market conditions if the
planning horizon could be extended. However,
by giving up some short-term control over var­
iables in the real sector, it should be possible
to reduce fluctuations in financial variables to
more manageable proportions.
Conceptually, it should be possible to deter­
mine the trade-off between ( 1 ) short-term
control over employment and prices and ( 2 )
stability of the financial sector. In general, a




lengthening of the policy-planning horizon to
promote short-run stability in financial markets
will come at the cost of reduced control over
nonfinancial variables. Alternatively, a shorten­
ing of the planning horizon will come at the
cost of increased short-run fluctuations in fi­
nancial variables.
Lengthening the horizon for major policy
goals raises some obvious problems. Because
the long-term goals of employment and prices
are relatively far in the future, it is easy to
give them a back seat to the short-run stabili­
zation problems often encountered in financial
markets. The problem with this approach is
that overattention to short-run problems may
have important implications for the paths re­
quired to hit desired long-run targets. Further,
if short-run constraints are continually im­
posed, it may be impossible to hit the long-run
goals in the time specified. Under those cir­
cumstances it may be necessary to lengthen the
horizon and to accept the ensuing costs of less
desirable performance of the real sector.
The previous paragraph suggests that over
the longer run the goals of price and output
stability may not conflict with the goal of
money market stability. Overzealous attempts
to stabilize the money market in the short run
may distort output and prices to the point that
large changes in interest rates are required in
the longer run to bring the economy under
control. By allowing wider short-run fluctua­
tions in money market conditions, it might be
possible to avoid large swings in interest rates
over the longer run.
The discussion suggests that, given a set of
initial conditions in the economy, there is an
optimal policy strategy available. The strategy
determines simultaneously the length of the
planning horizon, the paths of target variables
such as employment and prices over the pe­
riod, and the expected stability of financial
markets. The determination of specific strate­
gies is a problem in optimal control theory and
is beyond the scope of this paper. Instead, the
paper attempts to assess the trade-offs involved
and illustrates problems that may arise from
pursuing particular policy strategies.

TRADE-OFF BETWEEN POLICY GOALS

SOME SIMULATION EXPERIMENTS
This section describes some simulation ex­
periments that were conducted to illustrate the
problems encountered when short-term and
long-term goals conflict. The structure of a re­
cent version of the FR-MIT model was used
for the simulation exercises. 2
The first experiment assumes a monetary
policy that focuses on the rate of growth of
the money stock provided the change in the
Treasury bill rate over any quarter does not
exceed some arbitrary value. An unconstrained
growth in money is assumed to promote de­
sired long-run behavior of the real sector.
However, if the policy-determined money
stock for a quarter led to a projected change
in the bill rate over that quarter that exceeded
the constraint value, then the money supply
was changed sufficiently to bring the change in
the bill rate back to its allowable range. In
those situations in which monetary policy is at­
tempting to offset either boom or recession,
this constrained policy would lead to a per­
formance of the economy that is inferior to
one which is unconstrained.
If shifts in the demand for money are the
source of wide interest rate fluctuations when
policy is attempting to hit a money stock tar­
get, the situation is changed. Here, it would be
appropriate to introduce interest rate con­
straints. Such constraints would automatically
satisfy the demand for money after some
point. Limiting interest rate movements in this
case would promote long-run stability. 3 The re­
sults of the simulation experiments suggest,
however, that one should have strong reasons
for believing that shifts in money demand are
2 Some of the simulation results reported here are
drawn from an earlier paper on a related topic. See
J. Pierce, “Some Rules for the Conduct of Monetary
Policy," in Controlling Monetary Aggregates (Fed­
eral Reserve Bank of Boston, 1969).
3 For a theoretical discussion of the desirability of
interest rate versus money stock stabilization in a
stochastic world, see W. Poole, “Optimal Choice of
Monetary Policy Instruments in a Simple Stochastic
Macro Model,” Quarterly Journal of Economics,
Vol. 84 (May 1970), pp. 197-216.




causing wide quarter-to-quarter fluctuations in
interest rates. If unexpected shifts in aggregate
demand are the cause, long-run goals may suf­
fer greatly.
To illustrate the problems that arise during
periods of excess aggregate demand, various
simulations of the FR-M IT model were run
for the 1963-68 period. First, a control simu­
lation was run that took all exogenous varia­
bles at their historical values but assumed that
the money stock grew at a constant annual
rate of 4.25 per cent. This was the constant
rate at which the initial money stock in 1962IV had to grow to achieve its actual value in
1968-IV. Then additional simulation experi­
ments were conducted by applying the same
exogenous variables and the same 4.25 per
cent money growth rate to the model provided
that the Treasury bill rate did not change dur­
ing the quarter by more than a specified abso­
lute amount. If the bill rate fell outside the al­
lowable range, bank reserves and the money
supply were changed sufficiently to bring the
bill rate back to the nearest boundary of the
range. All other exogenous variables were as­
sumed to remain unchanged. Several absolute
change values were attempted; results for ab­
solute changes of 30 basis points and 10 basis
points are reported.
The results indicate that the placement of
sufficiently narrow bounds on the change in
the bill rate can have a large impact on the
simulated value of GNP. Figure 1 shows the
differences between the simulated values of
GNP for the steady rate of growth of money
and those subject to maximum absolute
changes in the bill rate of 30 and 10 basis
points, respectively. In both cases, because in­
terest rates could not rise in the later periods,
there was a tendency to add to the existing
excess demand conditions.
As indicated earlier, if interest rate fluctua­
tions are caused by erratic shifts in the de­
mand for money, then stabilization of interest
rates may be a reasonable course of action. The
simulation results suggest, however, that inter­
est rate stabilization can be costly during peri­
ods of strong excess demand.

1 0 2

FIG U RE 1

Effect on GNP of 4 .2 5 % GROWTH IN MONEY
SUBJECT TO MAXIMUM ABSOLUTE CHANGE
IN BILL RATE
Deviations from STRAIGHT 4 .2 5 % MONEY-GROW TH SIM ULATION
Bill ion s o f dol lars

It is interesting to note that if stabilization
of financial markets takes the form of con­
straining the rate of growth of the money
stock, the problems encountered during periods
of shifting aggregate demand are diminished.
Assume that monetary policy attempts to hit
an employment target by setting market inter­
est rates at appropriate levels. Introducing a
constraint on the allowable range of growth
rates of the money stock in this situation can
under some circumstances lead to improved
performance of the economy. If it happens
that the interest rate selected is not the cor­
rect one because aggregate demand is either
stronger or weaker than expected, variations in
the rate of growth of the money stock can pro­
vide important evidence of this condition. For
example, if aggregate demand is stronger than
expected, given the interest rate and the de­
mand for money, the growth in the money
stock will be greater than expected. If the ac­
celeration in the growth rate of money is taken
as a signal to raise the interest rate, the growth
rate of money will fall and the excessive
growth in aggregate demand will be reduced.
If the unexpected growth in the money
stock is the result of a shift in the demand for
money, then the monetary expansion should be



accommodated. In this situation, interest rates
should not rise. There is really no way to
avoid making judgments concerning the
causes of fluctuations in the money stock and
in interest rates. If the source is unexpected
strength or weakness in aggregate demand, one
course of action is called for. If the source is
erratic shifts in the demand for money, quite a
different policy reaction is required. The pur­
pose of the simulation experiments was not to
“prove” that aggregate demand is always the
cause of money market fluctuations. Rather,
the purpose of the exercises was to illustrate
the potential costs of pursuing a policy strat­
egy that implicitly assumes that money market
fluctuations are caused primarily by an erratic,
unpredictable demand for money.
Simulation experiments with the model were
conducted to measure the impact of con­
straints on the growth rate of money. The con­
trol simulation was one in which the interest
rate was made to rise at a constant annual rate
from a base period of 1963-1 to achieve its ac­
tual value in 1968-1. In this simulation, the
money stock is endogenous. Additional policy
simulations were then conducted in which con­
straints on the growth rate of money were im­
posed on this interest rate policy. If the rate of
growth of the endogenous money stock fell
outside the allowable range, the interest rate
was changed sufficiently to bring the growth in
money back to the nearest boundary of its al­
lowable range.
Figure 2 shows the difference between the
values of GNP from the control simulations
and those for maximum ranges of 3 to 5 per
cent and of 3.5 to 4.5 per cent in the annual
growth rate of money. The results indicate that
this combination of interest rate and money
supply policies would have been beneficial
over the period of simulation.
Further simulation experiments were con­
ducted taking the conditions of the 1960-61
recession as the starting point for the policy
exercises. The results were similar to those de­
scribed above for periods of excess demand.
Control simulations were conducted for the pe­

TRADE-OFF BETWEEN POLICY GOALS

riod 1960-III to 1968-1 under the assumption
of a constant rate of growth of the money
stock. Given the actual history of the exoge­
nous variables in the system and given the ini­
tial conditions, the time required to get ini­
tially to full employment was a decreasing
function of the money growth rate. Particularly
rapid growth rates, however, lead to substan­
tial overshooting and can create chronic excess
demand. Quite predictably, imposition of a
constraint on policy in the form of maximum
allowable quarterly changes in the Treasury
bill rate made it more difficult to hit the full
employment target. The interest rate constraint
produced a slowing of the rate of expansion of
output and employment from the recession
base and lengthened the time necessary to hit
a full employment target. The results also indi­
cate that the degree of the slowdown of eco­
nomic expansion resulting from the constraint
depends upon how quickly the target level of
employment is to be reached and how narrow
is the allowable range of the quarterly change
in interest rates.
FIGURE 2

Effect on GNP of CONSTANT BILL-RATE
GROWTH SUBJECT TO MAXIMUM
MONEY-GROWTH RATES
D eviations from STRAIGHT BILL-RATE-GROWTH SIMULATION
B i ll i o n s o f d o l l a r s

; 3-5%
|r—--------------- —

''

' "■' ''

'

' '- ' •

I-

+
0

-i 15

-

''63

'64

’■
'65

■L*
*66

‘67

*
'68

It should be emphasized that a restriction
on changes in interest rates is potentially less
disruptive to the economy than is a restriction
on the level of rates. Constraints on the maxi­




mum short-term change in interest rates can
retard but not arrest desired adjustments of the
economy. The existence of ceilings or floors on
the level of interest rates may prevent the ad­
justments from ever occurring. Pegging the
level of interest rates can lead to a total loss of
control by policy over output, employment,
and prices.
The recession results for a money supply
constraint are also similar to those obtained
for the excess demand case. A monetary policy
that attempts to achieve its objectives through
influencing money market conditions— interest
rates— can be enhanced in the recession case
by imposing a constraint on the rate of growth
of money. If the course of aggregate demand
proves to be other than expected, variations in
the interest rate promoted by the constraint
imposed by an allowable range of growth in
money rates will serve to push the rate of ex­
pansion in the desired direction.

CONCLUSIONS
The brief discussion in the preceding section
suggests that high priority should be placed on
coordinating short-run operating procedures
with the longer-run goals of monetary policy.
Failure to achieve such coordination can lead
to a serious reduction in the ultimate effective­
ness of monetary policy. Stabilizing short-term
interest rate fluctuations can lead to destabiliz­
ing shocks to the real sectors of the economy.
Better information on the stability of the de­
mand functions in the economy is sorely
needed. The focus of policy on money market
conditions may be badly misplaced if the
money demand function is relatively stable and
predictable through time. Certainly the hypoth­
esis that the demand for money is erratic and
unpredictable is not well documented. It is cu­
rious, therefore, that policy decisions should
depend so strongly on money market condi­
tions.
It might be argued that the central bank is
obligated to stabilize the markets for debt in-

104

strumpnts. An unfortunate paradox can result
here. An overly zealous attempt to stabilize in­
terest rates can so disturb the real sectors of
the economy as to lead ultimately to extreme
variations in market interest rates. The experi­
ence of the last few years appears to bear out
this contention. It would appear that a mone­
tary policy based almost exclusively on stabiliz­
ing short-run money market conditions is a
luxury we can ill afford.
On a conceptual basis the appropriate
course of action for policymaking appears to
be clear. Given staff projections of the course
of the economy over the coming year or so,
the instruments of monetary policy should be
set to promote the desired time paths of
variables such as employment and prices over
the period. In order to make such decisions
meaningful, several policy alternatives should
be presented showing alternative time paths for
the target values in the real sector.
The policy alternatives should be compared
both in terms of the expected values of such
variables as output, employment, and prices,
and in terms of the dispersion of these projec­
tions around their expected values. In assess­
ing the variability of the projections, it is nec­
essary to provide evidence as to the possible
impacts on the projections of various shocks to
the system. How sensitive are the projections
to shifts in the demand for money or in the
demand for investment goods? An analysis of
the impact on the projections of alternative as­
sumptions concerning the values of certain key
exogenous variables such as Government
spending is also crucial. Furthermore, it is
quite likely that the sensitivity of the projec­
tions to shocks and alternative values of
exogenous variables is not independent of the
existing state of the economy. At times
projections are quite insensitive to fairly large
changes in the underlying specifications of the
system, but at other times they are extremely
sensitive to these specifications. It is essential,
therefore, that evidence be provided concern­
ing the likely dispersion of relevant variables
around their projected values.




The fluctuations in interest rates and mone­
tary aggregates implied by the various policy
alternatives should also be projected. On the
basis of all of this information, trade-offs be­
tween expected money market stability and the
behavior of variables in the real sector can be
assessed. The need for reliable econometric
models and for seasoned judgment in these ex­
ercises is obvious. At this point, our ability to
generate the required set of projections is
quite limited. These limitations suggest that
policy strategies should be fairly simple and
straightforward. Elaborate policy strategies do
not seem consistent with our ability to assess
and trace through time the impact of policy
acts on the economy.
Given a policy strategy over the coming
year or so, how can the strategy be reduced to
day-by-day operating procedures? Here, there
is need for a document that presents projec­
tions of financial conditions to be expected
over the near term. A blending of projections
obtained from quarterly and monthly econo­
metric models is sorely needed. Conceptually,
such blends are difficult but possible. On the
basis of these short-term projections and the
basic policy strategy mentioned above, specific
operating instructions can be formulated. Here,
limitations on the ability to make short-term
projections suggest that the operating proce­
dures adopted should be fairly simple.
We now come to the central problem. How
can we continue to link the basic policy strategy with operating procedures as the economic
forecasts are modified and as monetary policy
strays off course? As policy is currently con­
ducted, there is no effective means of varying
the basic strategy as new information comes
in, and there is no way to relate changing con­
ditions to actual operating procedures.
Ideally, we would like to generate new
long-term forecasts each quarter and to map
out new alternative policy strategies each quar­
ter. Often, however, the new information that
comes in leads to conflicting conclusions about
changes in the future course of the economy.
Further, econometric models and other proce-

TRADE-OFF BETWEEN POLICY GOALS

dures often do not predict with sufficient ac­
curacy to allow useful quarter-by-quarter
changes in implied operating strategy. The dis­
cussion of the original projections also suggests
that the initial strategies may at times be very
much in doubt.
A possible strategy under these conditions is
to set quarterly operating instructions in terms
of some combination of interest rates and
money stock. A policy that sets an interest
rate subject to constraints on the rate of
growth of money is a very appealing candi­
date. By setting a range to the allowable
growth of money, shifts in the money demand
function are automatically accommodated up
to the extreme points of the range. The width
of the range should depend in part on esti­
mates of likely quarterly fluctuations in the de­
mand for money. In setting the range, how­
ever, it must be recalled that the wider the
allowable range, the greater the potential loss
in output and employment when variations in
aggregate demand are the cause of money
growth fluctuations. For this reason, a rela­
tively narrow band, for example, 4 to 6 per
cent, seems desirable as a working principle.
Certainly, if there are persuasive arguments
explaining why an unusual shift in money de­
mand occurred in a particular quarter, then a
growth rate of the money stock outside the
range should be allowed. The point is, how­
ever, that relaxation of the constraints should
be a rare event. In every case when such an
action is being considered, the burden of proof




should rest squarely on those who believe that
an unexpected movement of money outside the
range is caused by money demand and not by
aggregate demand. Further, the longer the con­
dition of unusually high or low money growth
persists at existing interest rates the greater
should be the presumption that the interest
rate is inappropriate and should be changed.
These recommendations do not call for a
drastic departure from current procedures;
they call primarily for greater attention to be
paid to the long-run objectives of economic
stabilization policy. Such objectives are de­
signed to put short-run stabilization of money
market conditions in the context of possible
costs to the economy in terms of income, em­
ployment, and prices.
Truly effective implementation of policy re­
quires that operating strategies intended to
achieve desired long-term goals be set forth
explicitly. Such strategies must be followed
under conditions of great uncertainty about the
course of the exogenous variables in the sys­
tem and about the performance of our models.
In such a situation it would appear to be a
mistake to focus attention primarily on the un­
certainties of the money market. Monetary
policy decisions must come to grips with the
uncertainties we face with respect to aggregate
demand. A policy strategy that relies as much
as possible on projections but that also com­
bines a setting of interest rates with allowable
ranges on the money growth rate appears to
be most appropriate for the near future.




by Benjamin M. Friedman




TACTICS AND STRATEGY
IN MONETARY POLICY

CONTENTS




109

INTRODUCTION

109

I. STRATEGY, TACTICS, AND THE
DECISION PROCESS
Frequency of Committee decisions
Strategy and the sequential decision
process
Tactics

109
110
111
112

118

II. ECONOMIC SPECIFICATION AND
APPROPRIATE TACTICAL RESPONSE
Economic content of tactical decisions
Role of economic specification: four
different cases
Conclusions

119
119
120
121
125

III. QUESTIONS OF STABILITY
A two-equation stock-flow model
Extensions of the model
Stability conditions in context of the model
Conclusions

125

IV. OPTIMAL FILTERING OF
OPERATIONS DATA
Available Federal Reserve data
Conceptual use of probability distribution
parameters
Example of a data filtering scheme
Alternative schemes
Conclusion

112
114

125
128
129
131
132
132

V. SUMMARY OF CONCLUSIONS
FOR MONETARY POLICY

134

REFERENCES

TACTICS AND STRATEGY

INTRODUCTION
In this paper monetary policy is viewed
from the standpoint of operational policy deci­
sion-making.
Section I divides the monetary policy deci­
sion process into two separate phases—strat­
egy and tactics—applying heuristic arguments
of largely intuitive appeal. The strategy phase
involves quarterly decisions outlining a plan
for monetary policy over the next several
quarters. The tactics phase involves shorterrun technical decisions concerning implementa­
tion of the first quarter of the strategy and
deals with the question of how best to adjust
for apparent deviations of the monetary policy
instruments from their planned targets.
Sections II, III, and IV, applying more for­
mal analysis, take up several problems that are
especially relevant at the tactics stage. Section
II examines the influence of economic specifi­
cation in making tactical decisions, showing
that different specifications may imply no re­
sponse at all to past operating misses of the
monetary policy instruments or may imply
compensating responses of a number of forms.
Section III considers questions of stability in­
volved in choosing the appropriate speed of
tactical action. Section IV, which includes ap­
plications based on Federal Reserve data,
shows the implications for monetary policy
tactics of using data that are imperfect and
subject to subsequent revision.
Section V briefly restates the major conclu­
sions of Sections I through IV for monetary
policy.

I. STRATEGY, TACTICS, AND THE
DECISION PROCESS
As now constituted, the decision process of
the Federal Open Market Committee seems to
involve an independent monetary policy deci­
sion at each meeting of the Committee, held
once every 3 or 4 weeks. Although Committee
members may apply to these decisions as short
or as long a time horizon as they see fit, the



decision in fact commits the Federal Reserve
System only for the time interval until the
Committee’s next meeting. Some three times
per year, major staff reassessments of the eco­
nomic outlook occur in the form of audiovisual
chart shows presented to the Committee, but
chart show meetings do not necessarily involve
a different form either of discussion or of de­
cision on the Committee’s part.
Most currently available estimates suggest
that monetary policy affects real spending only
after substantial time lags. The Federal ReserveMassachusetts Institute of Technology econo­
metric model, for example, suggests that mone­
tary policy actions have little effect for the first
two to four subsequent quarters and that twothirds of the effect of such action has occurred
only after some 2 years. 1 The loosely anchored
relationships between monetary policy and real
spending decisions suggest that frequent and
abrupt policy shifts will have little effect, or
in any case an unpredictable effect, on real
spending.
FREQUENCY OF COMMITTEE DECI­
SIONS. The Committee in fact does not shift
policy at every meeting or every other meeting.
It has followed a more slowly moving proce­
dure of establishing a monetary policy stance
and then maintaining it for some months.
Various shadings of this stance may occur,
but a fundamental revision is likely to happen
only at larger intervals. It therefore seems un­
necessary to preserve an operating machinery
under which the Committee may shift policy at
each meeting, when in practice this potential
flexibility remains virtually unused.
Maintaining this unused flexibility would not
necessarily be detrimental to efficient decision
making, were it not for limited resources on
the part of both staff and principals. Taking

N o t e .— The author, who is lunior Fellow of the
Society of Fellows, Harvard University, and Consult­
ant, Board of Governors, Federal Reserve System, is
grateful to Mrs. Irene Welch of the research staff of
the Reserve Bank of Boston for carrying out the sta­
tistical computations involved in preparing the tables
presented in the text.
1 de Leeuw and Gramlich (1968).

decisions hurriedly at frequent intervals may
well be inefficient if it precludes less frequent
but more intensive discussions and examina­
tions of the relevant financial and general eco­
nomic developments, both observed and antici­
pated.
Hence, a primary reason for taking major
monetary policy decisions less frequently is to
permit more thorough exploration of the out­
look and the available alternatives,- accompa­
nied by more meaningful Committee discus­
sions in terms of the goals of monetary policy.
Useful staff support to such Committee
decisions may involve presentations along the
lines of the present chart shows, expanded to
include projections of the most likely conse­
quences of several different patterns of mone­
tary policy, as well as an analysis of the cur­
rently attainable trade-offs among different
policy goals.
A further, related reason for reducing the
frequency of major Committee decisions con­
cerns the dangers and safeguards built into a
decision-making process by the design of its
machinery. Incremental decision-making, with
each decision considered independently, may
in any organization lead at times to faulty ac­
tions and missed opportunities that a more
unified decision process can help to avoid. The
problem is that past Committee decisions sim­
ply become part of the data, while future ones
remain unconsidered; hence the true unity and
interdependence of the series of decisions is
not evident.
Consider, for example, a Committee deci­
sion of whether or not to move to a tightmoney policy: A Committee member may well
ask, under the current decision machinery,
what is the cost of delaying the move until the
next Committee meeting, if the move is in fact
advisable at all. Given the currently available
state of knowledge about economic relation­
ships, the answer must be that the cost of this
several weeks’ delay is so small and uncertain
as to be virtually unidentifiable. The problem
arises in that the same question, asked at six
successive Committee meetings, may elicit the




same answer of nearly negligible cost to the in­
cremental delay each time; yet the true cost of
delaying the move for 6 months may be not
only identifiable but in fact quite substantial.
Two conclusions emerge from this discus­
sion: First, decision-making opportunities
should occur with quantum time intervals great
enough to render individual decisions meaning­
ful; and, second, the relation among interde­
pendent decisions should be explicitly evident,
even when those decisions follow one another
in time.
If the Committee’s major policy decisions
should occur less frequently than every 3 or 4
weeks, what time interval is then appropriate?
Although a number of possibilities are perhaps
workable, for several reasons 3 months seems
to be the best. Much of the relevant economic
data to be used in considering monetary policy
decisions are available only on a quarterly
basis; real expenditures information in the na­
tional income accounts is perhaps the leading
example. Further, our knowledge of economic
relationships is based largely on a quarterly
discrete time conception of the economic
system; judgmental analysts seem to think
primarily by quarters, and the available
econometric work is mostly in quarterly form.
In addition, referring again to the observable
impact of monetary phenomena on real spend­
ing, the quarter is probably the smallest time
unit for which meaningful information is now
identifiable.
STRATEGY AND THE SEQUENTIAL
DECISION PROCESS. Collecting the several
conclusions derived above gives a brief outline
of the strategy stage of the decision-making
process for monetary policy: The Open Mar­
ket Committee may meet quarterly to analyze
recent and prospective economic develop­
ments; to study the outlook for the foreseeable
future in the light of the possible patterns of
monetary policy and the projected conse­
quences of each; to consider the attainable trade­
offs among different monetary policy goals;
and to take a decision on the course of mone­
tary policy. In sum, the strategy decision con­

TACTICS AND STRATEGY

siders the entire relevant economic picture and
derives the best monetary policy decision to
meet it. The committee may well continue to
meet on its current more frequent schedule, but
it would take major monetary policy decisions
only quarterly.
A further question is whether the Commit­
tee should decide the course of policy only
until the time of the next major decision meet­
ing, or should instead attempt actively to in­
clude a longer time horizon in its plans. If five
or six quarters into the future is the furthest
ahead that analysts can reasonably look, using
currently available methods, and if the lag
required for monetary policy to take effect is
approximately two quarters, then the furthest
horizon for which the Committee can viably
plan policy actions is three to four quarters
into the future. Is there any advantage to the
Committee’s formulating a hypothetical policy
for this three- or four-quarter period, which
would extend considerably past the time of the
next Committee meeting?
The decision systems elaborated by Holt,
Theil, and Simon2 suggest that formulating
long-range plans and revising them at shorter
intervals may well be more efficient than
merely planning for the shorter interval be­
tween decisions. Even though in practice one
may choose to plan only from January to
April, for example, and wait to examine the
situation in April before finalizing further
plans, tracing through the anticipated course of
events after April and considering April’s deci­
sion in advance is a useful exercise for im­
proving January’s decision. This principle is
especially valid in light of the lags associated
with monetary policy, which imply that Janu­
ary’s decision may have little or no effect on the
goals of the policy before July. In addition, this
system of coordinated hypothetical planning
for the future helps bring into focus the unity
and interdependence of the entire series of
Committee decisions.
Hence at its quarterly meetings the Commit­
2 Holt (1962), Theil (1964), and Simon (1956).




tee may formulate a strategy for several
quarters, of which the immediate quarter be­
comes actual policy to be followed until the
Committee’s next major decision meeting. At
each such meeting the Committee updates its
strategy by one quarter; it revises the previous
decision’s hypothetical second-quarter plan to
become an immediate-quarter plan, which is
then the Committee’s actual policy for opera­
tional purposes. In this way a sequential de­
cision process enables the Committee to take
as long a view as is possible in formulating its
strategy, while preserving as much flexibility as
is probably necessary.
TACTICS. Once the Committee has speci­
fied its strategy for the quarter immediately
ahead, several operational problems are likely
to arise which require decisions of a subor­
dinate nature. For example, suppose that the
Committee has expressed its strategy as achiev­
ing over the quarter a movement of X in M,
where X is an appropriately chosen number
and M is some selected financial variable (or
X may be a vector of numbers and M a list
of variables). In effect the Committee has
specified a target path for variable M. If M
were directly within Federal Reserve control,
or if the operational levers available to in­
fluence M had no uncertainties attached to
their use, then following the Committee’s
strategy would be a straightforward and un­
ambiguous process.
In practice, however, market activity, as
well as Federal Reserve operations, works to
determine most of the interesting candidates
for M; and a multitude of uncertainties and
shifting structures characterize the entire finan­
cial system. Hence a series of subordinate de­
cisions— a set of tactics— are necessary to
adjust operating procedures in the light of un­
foreseen situations as they arise. Such tactics
govern Federal Reserve response to sudden
surprise movements of financial variables and
resulting deviations of M from the target path
specified in the quarter’s strategy.
Since further decisions are still necessary
once the Committee has formulated its strat­

egy, one may perhaps question the efficacy of
the two-stage decision process developed here.
One rationale for it is that the Open Market
Committee may reserve strategy decisions to
itself, while delegating tactical matters to a
subordinate group subject to its review, much
as it currently delegates many operating de­
cisions to the Manager of the Open Market Ac­
count. Alternatively, if the Committee wishes
to reserve both strategy and tactics for its own
decisions, allocating some meetings to strategy
and others to tactics is probably a more effi­
cient use of time than the system currently in
practice.
Finally, since strategy and tactics are differ­
ent decisions on two distinct sets of questions,
separating the two— even if only in discussion
—should enhance clarity and thereby help de­
cision-makers to operate more efficiently. A
strategy is the result of an examination of the
entire relevant economic outlook; it expresses
the best monetary policy response to that situa­
tion. Tactics embrace the more technical oper­
ational difficulties involved in meeting the
monetary policy targets specified in the strat­
egy.

II. ECONOMIC SPECIFICATION AND
APPROPRIATE TACTICAL
RESPONSE
Retaining the division of monetary policy
decisions into the two levels of strategy and
tactics, the discussion of this and the following
two sections examines several issues especially
relevant for the tactics stage. An assumption
which therefore underlies this discussion is that
the basic elements of the prevailing monetary
policy strategy are fixed inputs in evaluating a
tactical problem. More specifically, assume
throughout these three chapters that the Open
Market Committee has identified the financial
target variable (or list of variables) M and
has specified a desired movement of X (where
X is a vector if M is more than one variable)
for the immediate quarter.



The value of M at the beginning of the
quarter and the desired movement X together
suffice to define a target path for M. A typical
tactical problem arises if, after one month of
the quarter, incoming reports indicate that M
has strayed away from this target path. The
basic decisions in the tactical stage of the
monetary policy process involve confronting
this problem and formulating appropriate Fed­
eral Reserve responses.
The following discussion explores three sets
of issues related to this central tactical prob­
lem of observed deviations of M from its tar­
get path:
In this section, how does the specification of
the economic transmission of the effects of
monetary policy influence the appropriate tac­
tical response?
In Section III, what precautions are neces­
sary to prevent these responses from destabil­
izing, rather than stabilizing, the economy?
In Section IV, what are the implications of
using data subject to revision, in evaluating the
situations to which monetary policy tactics are
to respond?
ECONOMIC CONTENT OF TACTICAL
DECISIONS. Although tactical decisions in the
sense used here may be technical and opera­
tional in nature, they do have substantial eco­
nomic content. Perhaps the clearest example of
this fact is the influence upon tactical decisions
of one’s specification of the effects of monetary
policy on the economy.
Consider the following simplified illustration:
The Open Market Committee has identified one
financial variable M as its target variable and
has set down its strategy for the quarter as a
movement of X in M. For the purpose of this
example, let M be some monetary aggregate
and let X be equivalent to a given increase in
M. (X < 0 implies a desired decrease in M.)
Then,
M x* = Mo + Ai *M
M 2* = M x* + A2*M
Mz* = M2* + A 3*M = Mo + X

Ai* M + A2*M + A3*M = X

TACTICS AND STRATEGY

where M 0 = actual value of M at the begin­
ning of the quarter, Mi* = desired value of M
at the end of the zth month, and A{*M = de­
sired change in M during the /th month.
For further simplicity assume that the initial
intention is to spread the total movement X
evenly over the quarter. 3 Then
Ai *M = Ai* M = A3*M = \^X

The Manager of the Open Market Account
will then conduct open market operations over
the first month in the manner that he thinks
is most likely to achieve the desired movement
At*M. A large number of factors beyond the
Manager’s immediate control, however, also in­
fluence movements in M .4 As a result, his abil­
ity to achieve an exact total of M x* at the end
of the month is limited. In more general terms,
the Manager may miss A |* M and M i * and in­
stead achieve A\M and Mi, where AiM =
actual change in M during the /th month, and
Mi = actual value of M at the end of the /th
month.
A number of responses to this situation are
possible: For example, the Manager may at­
tempt to rectify the entire error during the
next month, so as to return M to its target path
by the end of that month. This plan leads to a
revised desired change in M in month / + 1:
A

= Ai+x*M + Ai*M - A,-Af M i+i* - M {

where Ai**M = revised desired change in M
during the /th month. M i+1* remains un­
changed.
Alternatively, the Manager may attempt to
spread the correction process so as to return
M to its target path only at the end of the
quarter. This plan involves revising both the
desired change in M in month / 4- 1 and the

desired level of M at the end of the month
i + l:
Ai+1**M = Ai+l*M +

(Ai*M - AtM)

= M i+1* - ^ (Ai*M - AiM)
where N = 3 — i — number of months remain­
ing in the quarter, and Mi** = revised desired
value of M at the end of the /th month. In the
special case of equal desired monthly incre­
ments, mentioned above, when, with 2 months
remaining,
Ai+x*M = Ai+i*M = ± X
these relationships simplify to
A<+1**M = \ (X - A,M)
M i+1** = Mi + 1 (X - AiM)
In the special case that i ~ 2, that is, when
the Manager has kept M to its target path for
the first month of the quarter but could not
prevent a deviation in the second, this plan of
achieving the full correction only by the end of
the quarter coincides with the earlier plan of
achieving the full correction in the first pos­
sible month.
Neither of these alternatives includes any
scheme for “compensation” for past devia­
tions. If, for example, M has strayed below its
target path during the first month of the quar­
ter, one tactical response could be to force it
above its target path by an equivalent amount
and for an equivalent period of time. Assum­
ing that the first month’s deviation has been
accumulating gradually, the revised program
becomes
M 2** = M 2*+ M i * - M x
A2**M = A2*M + 2 (Ai*M - AiM)

3 Note that making each movement Ai*M the same
differs from pursuing a constant rate of growth in
each period.
4 Among these factors are float, currency in circu­
lation, Treasury deposits at Federal Reserve Banks,
gold and foreign accounts, Federal Reserve foreign
currency holdings, and so forth. See Maisel (1969).



A3**M = A3*M - (Ai*M - AXM)

M3* remains unchanged.
These three limited programs by no means
exhaust the possible tactical responses to a de-

viation of M from its target path, nor is the
Manager restricted to revising his operations
monthly. Weekly data reports for some finan­
cial variables and daily reports for others
should help him to recognize incipient devia­
tions quickly. Nevertheless, some deviations
will almost certainly occur, and the simplified
illustrations above suggest at least two ques­
tions relevant to deciding upon appropriate re­
sponses: Should the Manager correct devia­
tions in M as rapidly as possible, or should he
spread the correction process so that M re­
turns to its target path only by the end of the
quarter? Further, should he compensate for
unintended deviations of M in one direction by
deliberately inducing controlled deviations in
the other direction, or should he simply restore
M to its target path with no compensation
for past errors?
ROLE OF ECONOMIC SPECIFICA­
TION: FOUR DIFFERENT CASES. One
factor determining the answers to these ques­
tions, particularly that of compensation, is the
specification of the relationship between M
and the economic variables that are the ulti­
mate goals of monetary policy. In the strategy
stage of the policy-decision process, the Open
Market Committee has determined variable(s)
M and the desired movement(s) X by refer­
ring to some relationships, however vaguely
conceived, of the form

Y = y(M )
where Y — the ultimate policy goal variable
(or vector of variables) and y is some func­
tional relation (or set of relations).
In general, four separate possibilities are
available for this relationship; only two of
these have similar implications for purposes of
tactical decisions. Although the reality of the
economy is perhaps closer to a continuous
time mathematical representation, preservation
of the discrete system with a time interval of
1 month is preferable here for ease in ex­
position.
The following discussion retains the frame­
work used above, in which the set strategy for




the quarter calls for a movement X in M, and
the Manager sets out to achieve X in three
equal monthly movements, each equal to ^X.
The object of working through the logic and
algebra of these straightforward exercises is to
illustrate the significant influence upon tactical
decisions of one’s specification of the relation

Y = y(M ).
Case A: One unlikely specification is that

Y depends on M with these properties: First,
the proper argument in the relation is the
movement in M, that is, AM, not the value of
M itself. Second, there are no continuing lags
in the system’s response to this movement in
M. This second restriction means that a AM in
one month influences Y in one month only (not
necessarily the same m onth); similarly, it
means that Y in any month is influenced by AM
in only one month (again not necessarily the
same m onth). Hence, while the restriction per*
mits Y to depend upon one lagged value of
AM, it precludes the dependence of Y on
lagged values of itself, since such a lagged re­
sponse relation would enable AM in any given
month to influence Y in a series of months
through a Koyck-type distributed lag.5
In this case, there need be no compensation
for past errors of any form. Assume, for ex­
ample, that AM in any month influences Y as
described above, with a 6-month lag. Then
AiM influences Yi+6. If a fM deviates from its
specification in the Committee’s strategy deci­
sion, it is of no benefit to adjust At+1M to com­
pensate. Doing so merely causes Y i+J to de­
viate from its desired value. Under the specifi­
cations of Case A, when the /th month ends,
all Y through Ki+6 are beyond the control of
monetary policy. Monetary policy can still in­
fluence Y beginning with Y Ul\ but these 7 ’s
are in no way affected by the error in A{M, and
so compensation for that error is pointless and
even harmful. Hence the Manager should con­
tinue to try to achieve AM equal to j X
5 Koyck (1954).

in

TACTICS AND STRATEGY

each subsequent month, and the target path for
M over the quarter shifts vertically to reflect
Mi as its new starting point.
The restrictive specification of Case A ren­
ders it highly unrealistic, and only methodo­
logical completeness justifies its inclusion here.
Case B: A slightly less restrictive specifica­
tion is that Y depends on M with these prop­
erties: First, the proper argument in this relation
is the value of M itself. Second, as in Case A,
there are no continuing lags in the system’s re­
sponse to the value of M. Again, this second
restriction means that a value M in one month
influences Y in one concurrent or succeeding
month only; similarly, it means that Y in any
month is influenced by the value M in only one
concurrent or preceding month. Again, as in
Case A, this restriction precludes the depend­
ence of Y on lagged values of itself.
In this case, however, one form of compensa­
tion is in order. If M deviates from its target
path in the zth month, retaining the 6-month lag
assumption used above, Yi+6 takes on an un­
desired movement that is beyond the influence
of monetary policy once the ith month has
ended. Nevertheless, permitting M to persist in
this deviation past the ith month perpetuates the
undesired movements in Y past Yi+6. Hence it
is essential to restore M to the appropriate
initial target path.
The Case B answer to the compensation
question, then, is as follows: When AiM has
deviated from At*M, so that M i deviates from
Mi*, Aj+/**M replaces Ai+;*M according to
some scheme to compensate for the original
error, where } extends to as many months as
are necessary to return M to its original target
path. If this correction process is to take more
than 1 month, M i+/** replaces M i+j*, where j
extends to one less than the number of months
necessary to return M to its initial target path.
Hence in Case B there is compensation in
the sense of responding to A*M different from
Ai*M by letting Ai+;**M differ from Ai+/*M in
the opposite direction. There is no compensa­
tion in the sense of responding to a level M i




different from M i* by letting M*+/** differ
from M i+;* in the opposite direction.
The speed of adjustment conclusion for Case
B, arguing narrowly from the causal effects of
M on Y, is to return M to its target path as
rapidly as possible, since continuing the devia­
tion through Mi+j** perpetuates the undesired
effects on Y through Yi+J+e.
The more interesting Cases C and D repeat
the argument specifications for Cases A and B,
only without the extremely restrictive assump­
tion of no continuing lags in the response of
Y to the movement AM (Case C) or the value
M (Case D ). Relaxing this restriction admits
more realistic and believable specifications in
which Y depends on lagged values of itself.
The tactical conclusions for Case C emerge to
be similar to those for Case B, while Case D
introduces a new form of compensation. The
formal analysis is as follows:
Case C: Here the proper argument in the
relation between Y and M is the movement in
M, that is, AM. Since Y i may depend on a
series of lagged Aj-yM (or, equivalently, on
some one Ai_/M and also on Y*_i), a AM in
one month influences Y in a number of suc­
ceeding months.
In this case, as in Case B, it is necessary to
provide compensating movements in AM, in
order to return M to the original target path
(or near it, as in Example 2 below). If A{M
has differed from Ai*M, recasting the 6-month
lag assumed above into a 6-month no-response
period, Yi+6 takes on an undesired movement
that is beyond the influence of monetary
policy once the zth month has ended. The
specification in Case C, however, indicates that
the error in A*M itself, if not offset by compen­
sating revisions of Ai+y*M to Ai+j**M, will lead
to undesired movements in Y i+j+6.
Example 1 (rectangular lag): Suppose that
Y| depends equally on A,_6M through A^nM,
that is, the lag is rectangular and persists for
two quarters after an initial no-response period
of two quarters. Then, if AiM has differed from
Ai*M, setting

116

At-+i**M = Ai+i* M + Ai*M - A{M =
M i+ i*

— Af,-

returns M to its target path after only 1 month’s
deviation. Y i +6 will have an undesired com­
ponent which no further monetary policy can
correct; assuming no further errors in M , how­
ever, y i+7 through Yuii will be on target. A
problem emerges only for Yi+12, which still de­
pends on A i+1M but not on A iM. If no further
corrective adjustment occurs, Yi+12 will have an
undesired element equal in size and opposite
in direction to that which occurred in Y i+e.
Here arises one of the few differences in
compensation action conclusions between Case
B and Case C: Under the former specification,
the compensation in A
which returns M
to its target path, limits the undesired move­
ments in Y to Yj+6 only. With the perpetuating
lags of Case C, however, the error compensa­
tion adjustment in A i+1**M , which also returns
M to its target path, causes Yi+as to differ from
its desired value.
If the speed of adjustment is such that the
compensation occurs not just in Aj+i**M but in
A w h e r e j extends to as many months as
are necessary to return M to its target path,
then the situation is somewhat more complex.
Y takes on diminishing deviations through all
Yi+j+5, instead of just in Yi+6; similarly, Y takes
on diminishing deviations through all Yi+/+u,
instead of just in Y i+12. As in Case B, however,
it seems desirable, in light of the arguments
considered here, for the speed of adjustment to
be as rapid as possible, thus minimizing the
deviations of Y in the two periods beginning
with Y i+G and Y*+12.
The existence of the second deviation period
for Y, beginning with Y i+12, leads to a further
complexity. While this second deviation period
is due to the compensating tactics of monetary
policy, further monetary policy tactics can off­
set at least part of it. Whether or not to do so
depends on the specific loss attached to devia­
tions of Y from its desired values through time.
If, for example, the relevant loss function is a
sum of absolute values of deviations of Y from
its desired values, then, within the context of



the rectangular lag on AM, it is a matter of
indifference whether or not to offset the second
deviation period. Alternatively, if the loss func­
tion is a sum of squared deviations of Y , then
it is preferable to replace one large deviation
with several small ones, and so this second off­
setting action can potentially reduce the total
loss sustained.
More formally, suppose, in line with the
above discussion, that the y function includes
this component:
Yi = . . . + fi £

j =6

A,WM + . . .

Suppose further that AiM has contained an
error of e, that is,
e = AiM - A?M
and that A
has fully offset this error, re­
turning M to its original target path by the end
of month i + 1 :
Af+1M = Ai+1**M = A{+i*M - e

Then the only difference between Y and its
desired value in the first deviation period is
Yu g

Y i+d* = /3e

where Yi* — the desired value of Y in period i.
Hence the loss associated with the first devia­
tion period, by using a simple quadratic penalty
function, is
Li - (Yi+ 6 -

Yi+s * y = (0e)2 = /32e2

This loss is unavoidable once AiM has
differed from A f*M and occurs whether or not
monetary policy attempts to offset the second
deviation period in Y. If monetary policy fore­
goes such secondary offsetting action, the loss
from the secondary deviation is
U = (Yi+12 - Y £ l2)* = ( - 0 e) 2 = 0 V
One possibility for offsetting action is simply to
set
Ai+7**M = A,+v*M + ~ (

and
Ai+s**M = A<+g*M - i e

TACTICS AND STRATEGY

The resulting secondary loss is
u = (Yi+i2 - r i+12* y + (Yi+n -

- W

+

f r y

Yi+li* y

- l ' "

Hence the result of this secondary offsetting
action is to reduce the loss associated with the
secondary deviation by 50 per cent and the
loss associated with the entire episode by 25
per cent, with the losses measured by a simple
quadratic function.
Example 2 (Koyck lag): Suppose that Y {
depends on A*.5M and all preceding AM, that
is, Ai-jsM for all j > 0 , with geometrically
declining weights. Then
Yi = . . . j8 £

(1 - X )'A ,_ 6M + . . .

j= l

0 < X< 1
This geometric lag pattern is probably more
realistic than the rectangular pattern assumed
above in Example 1. An error in the zth month
of
AiM - Ai*M = e
then leads to a primary deviation in Yi+6 and
an associated
Lx = (Y{+ 6 - 1^6 * ) 2 = 08(1 - X)e) 2
= (1 - \ ) 2j3V
A compensatory tactic setting
At*+i**M = Ai+1*M - (1 - X)e
permits Y to sustain no deviation from its de­
sired value through time, beginning with Yi+7.
Furthermore, revising Ai+1*M to A
i n
this manner eliminates the secondary deviation
problems inherent in the rectangular lag of Ex­
ample 1. Hence the only deviation of Y from
Y* for the entire episode is that contained in
Yi*.
This result highlights a second difference be­
tween the Case B and Case C compensation
conclusions. Under the former specification,
revised level
replaces M i+j* only for
one less month than necessary to return M to
its target path, after allowing for speed of ad­




justment considerations. Under the Case C
specification with a geometric lag pattern, level
differs from Mi+;* by
Mi+j** = M i+j* + Xe

for all j > 0. This change implies a vertical
shift in the entire target path for M, similar to
that required in Case A, making
the
new starting point and proceeding with move­
ments of Ai+;-+1*M as previously planned.
Hence, while Case B always involves returning
M to its original target path, Case C may or
may not involve such a return, depending upon
the specific lag pattern involved.
The clear implication for monetary policy is
that tactics become much simpler if a geo­
metrically declining lag pattern maintains in the
Y — y ( M ) relation. Even if different lag pat­
terns maintain, however, a corresponding sim­
plicity in tactics may result from the introduc­
tion of uncertainty discounting into the loss
function. In other words, the economy may be
sufficiently stochastic that random events render
planning for the more distant future increas­
ingly futile after some point. In terms of the
discussion of primary and secondary deviations
of Y from Y*, unforeseen circumstances un­
associated with monetary policy may arise,
causing movements in Y and at times calling
for revisions in A* M and M*, thereby elimi­
nating the rationale behind intricate plans cal­
culated to minimize secondary deviations.
Case D: The final category of specification
requires that the proper argument in the
Y = y ( M ) relation is the value M itself, as
in Case B; while the Yi may depend on a series
of lagged M i- jt Hence M in one month influ­
ences Y in a number of succeeding months.
A relation of this sort introduces a new
dimension of compensation for previous opera­
tional errors in keeping M to its designated
target path. If A\M has differed from Aj*M,
causing Mi to differ from Mj*, an adjustment
is necessary not merely to return M to its target
path but also to cause an offsetting deviation
of equivalent magnitude and duration in the
opposite direction. Analogously to Case C, only

substituting levels of M for movements AM, a
deviation of even one
from the correspond­
ing Mi* will cause undesired movements in a
series of subsequent Yi if not compensated.
Consider again the rectangular and geometric
lag examples:
Example 1 {rectangular lag): The direct
analog to Case C is to compensate for a devia­
tion of Mi from Mi* by setting
M i+1 ** = Mi+i* + Mi* - Mi
and retaining M i+j+1* unchanged for all j > 0 ,
assuming that speed of response considera­
tions call for correcting the error entirely in the
first month. This step to minimize the primary
deviation in Y implies revisions in monthly
movements
A*i**M = At+i*M + 2(Ai*M - A{M)
and
Af+a**M = Ai+2 *M - (Ai*M - A{M)
and retention of Ai+;-+2*M unchanged for all
j > 0. Hence M returns to its target path only
in the second month following the initial error
in M,.
This response accomplishes full compensa­
tion on M in the first month after the initial
error, returning M to its original target path
at the end of that month. Preserving the
assumption of a rectangular lag of 6 months,
this scheme restricts the primary deviation in
Y to Y i+e only. The argument concerning sub­
sequent tactics to prevent secondary deviations
of ^i+i+12 from Yi+j+i 2 * is directly analogous
to that presented for Case C, Example 1 .
One assumption underlying Case D is that
the value M\ represents a mean value over the
/th month. 6 If Mi instead represents the level
at the close of the /th month, it is important to
estimate during how much of the month that
level maintained, before formulating tactics.
The duration and magnitude of the compensa­
tory portion of M's actual path both must
match the corresponding features of the error
6 This usage represents a change from that intro­
duced on p. 113 in which
is the actual value of M
at the end of the /th month.



portion of the path. The argument works in the
other direction as well; an end-of-month Mi
equal to Mi* does not indicate success of mon­
etary policy operations if the actual level pre­
vailing through most of the month differs sub­
stantially from that implied by the M * path.
Example 2 (Koyck lag): Again in analogy
to the Case C treatment of the geometric lag,
suppose that the Y = y(M) relation contains
the following term:
Yi = . .. + fi £

(1 -

+ ...

j=l
If M i has deviated from M i* , adjusting M i+1*
by
= Mi+i* - (1 - X) (Mi - Mi*)

leaving M i+j+1* unchanged for all / > 0, con­
fines the undesired movement in Y to Y i+Q*
This step implies revisions in the monthly
movements of
Ai+i**M = Ai+i*M - (2 - X) (Mi - Mi*)
Ai+2**M = A,-+a*Af — (1 — X) (Mi - Mi*)

and leaves Auj+z*M unchanged for all / > 0 .
Like Case B, Case D requires ultimately return­
ing M to its originally specified target path.
CONCLUSIONS. To summarize the conclu­
sions of this section, optimal monetary policy
tactics depend fundamentally on the specifica­
tion of the relationship between the financial
variables chosen as monetary policy targets
and the variables that represent the goals of
the policy. Tactics may require no response at
all to operating errors or very complex re­
sponses; may call for redefining a new target
path for M or for retaining the original target
path; or may imply the adequacy of a onceand-for-all response to operating errors or the
necessity of acting to prevent future policyinduced instabilities. The one seemingly
consistent conclusion in all four possible cases
is that compensatory responses, if warranted at
all, should take place as rapidly as possible;
Section III examines this tentative conclusion
more closely and exposes it to additional con­
siderations.
Before proceeding, however, one further

TACTICS AND STRATEGY

issue deserves explicit treatment. The above
discussion, for all cases, has used a time pe­
riod of 1 month and has often considered up
to 1 2 periods into the future; a fixed strategy
decision, under the program formulated in Sec­
tion I, covers only 3 months.
There are two justifications for this apparent
contradiction. First, these illustrations are
more general in their application than the dis­
cussion—couched in more specific terms for
expository purposes—may indicate. Second,
considering immediate actions in terms of their
implied effects on future actions—even when
those future plans will be revised—is an aid to
proper policy formulation. This principle holds
for sketching tactical decisions beyond the
point at which a new strategy will supplant the
current one, as well as for formulating stra­
tegic decisions for quarters beyond the imme­
diate one.

III. QUESTIONS OF STABILITY

The discussion in Section II reviews different
possible specifications of the relationship be­
tween the instruments and the goals of
monetary policy, drawing the implications of
each specification for appropriate policy tactics
in response to an unintended deviation of an
instrument from its designated path. In those
cases of specification that warrant compensa­
tory movements in monetary policy instru­
ments, the analysis tentatively suggests that the
best tactics would always be to accomplish the
full compensation as rapidly as possible. Doing
so would avoid further undesired movements
in the policy goal variables beyond that caused
by the initial error in the instruments. The cor­
responding analysis for strategic shifts in policy,
to offset exogenous shifts in demands and sup­
plies in the economy, appears to be similar,
also calling for as rapid a policy response as
possible.
This analysis, while perhaps adequate to in­
dicate the importance of specification of the




Y = y(M ) relation, is too restrictive to deal
effectively with the speed-of-response question.
In particular, it omits considerations of stabil­
ity which arise from feedback effects of Y
upon M in the private economy, independent
of Federal Reserve action.
A
TWO-EQUATION
STOCK-FLOW
MODEL. To be more specific, consider a
two-variable illustration of monetary policy
control: Let Y be some measure of output
(equal to income) of the economy, and let M
represent the existing stock of some set of fi­
nancial assets. Analysis that has previously
treated growth models with capital stock accu­
mulation has a monetary analog. The follow­
ing model uses these familiar tools to deal with
a growth model that has an accumulating
stock of financial assets and to draw implica­
tions for desired speeds of response in mone­
tary policy tactics. 7
Suppose that the Y = y(M ) relationship is
homogeneous of degree one; the linear forms
of the four specifications of Section II may all
meet this condition under certain assumptions.
It then follows that growth in either of Y or M
must imply an equiproportional growth in the
other. For any period of time, the growth rate
of Y is
Yt - Yp
Yq
while that for M is
M t - Mo
Mo
Suppressing the time unit and dealing in a con­
tinuous time framework, the corresponding
rates of growth are
(3.1)

= D log Y and ~ D M = D \ o g M

respectively, where D is the differential opera­
tor with respect to time. The condition of
equiproportional growth, implied by the homo7 This discussion follows closely the format pre­
sented in Chapter 10 of Allen (1967).

120

geneous degree one condition on
Y — y(M ) relation, is that over time

the

Yt - Y 0
Mt - M Q
Yo
~~
Mo
In particular, if the economy satisfies this con­
dition at every point in time,
D log Y — D log M
Let g indicate this common growth rate for Y
and M. Then integration over time of the
growth-rate equation

where

log Y = constant + gt
or

(3.6)
v
7

By the same steps,
(3.3)
M = Moe“
where M — M 0 at time t — 0.
These results depend only on the homoge­
neous degree one properties of the Y — y(M )
relation. Since the model theoretically repre­
sents a real economy with a stock of finan­
cial assets, however, it is possible to impose
stock and flow conditions upon the system. In
equilibrium, the economy must satisfy both
sets of conditions.
For a stock condition, posit a simple fixed
velocity relation for Y — y ( M ) :

0

for all t

.

For a flow condition, assume that income
earners desire to add a fixed fraction of cur­
rent income to their stock of asset M; further
assume that the Federal Reserve System con­
ducts monetary policy so as to accommodate
this desire. Then




.

sY=-DY
V

I D Y = D log Y = sv

(3.7)

D M = s(vM)

Hence this model gives an attainable steadystate growth only for
(3.8)

Y = Yoeot

where v >

1

j-j D M = D log M — sv

where A is an arbitrary constant of integra­
tion. Replacing arbitrary A with an initial con­
dition Y 0 at time t = 0 gives

Y = vM, or M = ^ Y ,

< s <

These two conditions together yield a solu­
tion for the common growth rate attainable si­
multaneously for Y and M f from elimination
of M from equations 3.4 and 3.5:

Y = Ae**

(3.4)

0

and so g = sv. The same solution results from
elimination of Y from equations 3.4 and 3.5:

D log Y = g
yields

(3.2)

D M = s Y for all t

(3.5)

D log Y = D log M = g = sv

EXTENSIONS OF THE MODEL. So far
the model does not allow for exogenous shifts
in the asset-creating propensities of the private
sector. Suppose that the Federal Reserve has
provided sufficient reserves to enable the stock
of asset M to grow at rate g = sv, while in­
come Y has also grown at g = sv. Further
suppose that at time t = 0 a new asset be­
comes available, leading income earners to al­
locate to this new asset some fixed amount of
the income that previously they would have al­
located to accumulation of asset M. Mean­
while, suppose that the initial velocity relation
Y — y ( M ) continues to hold. This change
means a shift in the flow condition from equa­
tion 3.5 to

(3.9)

sY = D M + A for alU > 0

where A is the fixed accumulation of the new
asset. The stock condition, equation 3.4, re­
mains unchanged.
The solution of the system now changes, to
reflect the change in the flow condition. The
differential equation 3.6, formed by eliminating

TACTICS AND STRATEGY

M from both stock and flow conditions, be­
comes
(3.10)

sY - A = -D Y
V

Y now follows the path through time which is
consistent with the solution of differential
equation 3.10. That solution is
(3.11)

+ ( r ° - j ) egt

where Y = Y 0 at time t — 0 (initial condition)
and g — sv as before.
Equation 3.11 is a generalization of the
simpler path of equation 3.2, which is consist­
ent with the model with no alternative asset,
as solved in equation 3.6. g — sv remains in
equation 3.11 the only possible rate of steadystate growth consistent with the homogeneous
degree one properties of the stock condition,
but here there are more possible results. A — 0
leads, as expected, to the same path as before.
A — sY0 indicates, using the new flow condi­
tion 3.10, that the economy directs all asset
creation to asset A , leaving no growth in asset
M; hence, by stock condition 3.4,
7 = -s for all / ~
>

0

indicating the establishment of a stationary
state. 0 < A =£ sY0 leads to a steady growth
(if A < sYo) or decline (if A > sY 0) in Y
and in M . The path of M, analogous to equa­
tion 3.11, is
(3.12)

time. If A varies over time in a pattern indi­
cated by some function A ( t ), then differential
equation 3.10 becomes

M =^ +

where M 0^ ~ — Y0, and g = sv. Equation 3.12
v
is itself a generalization of the simpler path for
M of equation 3.3, which is consistent with
the model with no alternative asset, as solved
in equation 3.7.
A further extension of the model is to re­
duce the restrictions on the exogenous finan­
cial asset accumulation A . Specifically, it is un­
realistic to assume that A is constant through




(3.13)

sY - ^D Y - A(i) = 0

The solution of this equation is
(3.14)

Y = f(t) + B e ° *

where the particular integral /(/) depends on
the function A (t), and B is an arbitrary form
determined by the initial condition Y0.
STABILITY CONDITIONS IN CON­
TEXT OF THE MODEL. This machinery,
developed at some length, is now available to
explore problems of stability of the economy
and its susceptibility to monetary policy con­
trol. Here stability bears the traditional sense
of Harrod’s usage, especially with reference to
the “knife-edge” problem. 3
So far the analysis has assumed fulfillment of
the stock condition 3.4 both initially, giving
Yo = vM 0
and through all time, giving
Yt - vMt
for all t. Following Allen’s treatment, 9 the
basic stability questions arise if output Y and
stock of the asset M are out of line, that is,
deviate from this stock condition. Such devia­
tions, or disequilibria, may stem from errors on
the part of policy-makers or from unforeseen
exogenous disturbances in the economy. The
analysis here may treat the discrepancy either
as existing initially, making M 0 out of line with
Y0f or as arising in the paths of M and Y
through time.
Any resulting response on the part of the
Federal Reserve to try to adjust M introduces
a servo-mechanism control device into the
system. 10 The disequilibrium situation invali8 Harrod (1948).
s»Allen (1967).
10 A servo-mechanism is a controller which sets
the magnitude and/or direction of the controlling im­
pulse as a function of the state of the system to be
controlled.

122

dates the stock condition 3.4; if the policy re­
sponses follow a set pattern, dictated by prede­
termined strategic or tactical principles, they
then replace stock condition 3.4 by a new
stock condition. The new condition represents
both the reliance on and the accumulation of
asset M in the private sector, as well as the
discretionary influence of the Federal Reserve.
If the Federal Reserve responses follow a
sufficiently regular pattern to permit their
being expressed as a new stock condition, it is
possible to analyze the resulting system to de­
termine just what effects such Federal Reserve
actions will produce, in terms of their stabiliz­
ing or destabilizing influence on the economy
in its disequilibrium state. Conversely, examin­
ing different response systems in the abstract
yields conditions that any actual policy scheme
must meet to ensure that it stabilizes, rather
than destabilizes, the economy.
This approach to stability is relevant both to
the longer-term strategy decisions of the Open
Market Committee and to nearer-term exer­
cises in monetary policy tactics. As in the dis­
cussion of Section II about different forms of
compensating movements, the specification of
the particular relationships in the system is
crucial to the conclusions derived. Further, for
at least one important conclusion, the actual
values of the coefficients in the relations as­
sume a new significance.
Before illustrating these results with an ex­
ample, it is best to determine the definition of
stability that best fits the intent of monetary
policy. Suppose that the Open Market Com­
mittee has specified a desired path of M
through time, denoted M*, and that associated
with M* is a path for Y, denoted Y*. Suppose,
further, that M* and Y* call for M and Y to
meet the stock and flow conditions 3.4 and
3.5 at all times. Then these paths call for ex­
ponential growth of both M and Y at rate
g = sv,7 and M = —
y Y at all times.

deviate from M*, for example, M > M*,
which implies M > — Y*. Call this point in
time t — 0 , and consider the problem of gen­
erating growth paths of Y and M from the
initial condition M 0 > — Y 0,
v
Two alternative definitions of stability of the
system are possible: The first requires these
generated growth paths to converge back onto
the original desired paths Y * and M*. This
requirement is very severe and is not well
suited to the current stock-flow model in which
Y represents income and M the stock of a set
of financial assets. It is more appropriate to a
model in which Y represents the goals of policy
in a more stationary form, for example, the
unemployment rate and the rate of price in­
crease, and in which M has similar character­
istics and stands itself for rates of asset growth
or for interest rates.
A second definition of stability, identified
by Jorgenson as “stability in the sense of
Harrod, ” 12 requires only that the growth rates
of Y and M converge over time to the rate
g = sv. Y and M find new paths, then, which
do not necessarily regress to the initially de­
sired paths Y* and A/*, but which do meet the
conditions of the original system in that both
Y and M come to grow at rate g. If the Federal
Reserve can stabilize the economy in this
sense, it will be offsetting the initial exogenous
disturbance in the stock condition just suffi­
ciently to allow the economy to proceed as
before, only consistently with the new, shifted
stock condition. In the context of the stockflow model as developed here, with the cur­
rent definitions of Y and M, this definition of
stability seems appropriate.
Adopting the second, or Jorgenson-Harrod,
definition of stability, consider again the model
with a unique steady-state growth solution
given by

O

Now suppose that some exogenous shift in
the financial determinants11 of M causes M to
11 See footnote 4, p. 113.



(3.2, 3.3)

Y = Y 0eot

and

M = M 0eot

where g = sv, provided that the initial values
12 Jorgenson (1960).

TACTICS AND STRATEGY

Y0 and M 0 satisfy Y 0 = vM0. Assume now,
without loss of generality, that Y 0 < vM0. Re­
taining M * as the desired path of M, the initial
condition is M 0 > M 0*. For M to have achieved
a level greater than its target, it must have
grown at greater than the desired rate. Let

Combining the two, the new planned rate of
growth for M is
8

1 M — Af**
~ T '
M
~

8

1/
~ T\

1 Y**\
~ v M )

by using
7** = VM**

* = \-.DM
M

Hence the Federal Reserve, in this disequilib­
rium situation, imposes in place of the unsatis­
fied stock condition 3.4 a growth rate for M
over time of

Then

Now assume that the Federal Reserve adopts
a policy to reduce M to a new path M** which
will satisfy the stock condition Y = vM (equa­
tion 3.4). Further suppose that the intended
tactics of policy are to have the stock condition
satisfied by the end of T time periods. The
specific mechanics of the tactics may be as fol­
lows: A new desired path Y** replaces the
original path Y*. This new path, together with
the stock condition 3.4, implies some new path
M** for M.
Since M 0 > — Y0, clearly M ** < M 0, since
v

0

the paths Y** and M** proceed from Y0 and
— Y0, respectively. Then the tactics call for
v
moving M onto M** by the end of T time
periods. During these T time periods, there­
fore, there is yet a different planned target path
M*** that the tactics indicate for M to follow;
originates at the point M 0 and converges
to M** at the end of the Tth time period.
Such a policy 13 involves reducing M in each
period up to the Tth by an amount equal to
— (M — M /* ). The corresponding proporT
f
tional rate of reduction, analogous to the pro­
portional rate of growth g, is

( i
m

\ ***
dm )

k
r _ u
D + k [_8
T\

_ i
M

where

is the speed of response of the tactical response
process, and the differential form is standard
for simple exponential lags. 14
Equation 3.15 and flow condition 3.5 to­
gether form a system that contains enough in­
formation to solve for x***, defined now as the
rate of growth of M that monetary policy tac­
tics should achieve.
Use
/ i
**** =

\***
= D log M***

to substitute in condition 3.5 to obtain
Y = - Mx***
s
Hence
1 Y _ x***
vM
g

(3.16)

Substitute 3.16 into equation 3.15 to obtain

1 M - M**
T '
M

‘• • - s T i t ' - f O - r ) ]
which is a first-order differential equation in

13 The policy described returns M to M** only
asymptotically; it does not accomplish the full
correction in T periods.




jc*

* *

*

14 For reference, see Allen (1967), pp. 88 ff.

124

(3.17) Dx*** + k ( l

x***

The solution of this differential equation is
(3.18) x*** = g + (x 0 - g)e~kll~(,Fr)]1
where x*** = x 0 at i = 0 is the initial condi­
tion of the system.
Hence if x 0 = £, there is no problem and
x*** = g for all f, thus giving the familiar
steady-state growth solution of equation 3.3.
In the initial disturbance, or disequilibrium,
case, however, x 0 =^=g> and so the full gen­
eralized equation 3.18 is necessary to determine
x***. In particular, the coefficient on t in the
exponential term of the equation determines the
system’s behavior over time. Let

represent this coefficient. The speed of response
factor k, constrained by k > 0 , merely deter­
mines how fast or slow x*** is to follow any
given pattern; it does not itself influence
whether that pattern will be stable or unstable.
The part of c within the brackets, in particular
the relation between parameters g and T, de­
termines the stability for x*** over time. Three
cases arise:
Case 1: If T = — , then c vanishes, and so
g
the exponential term in equation 3.18 for x***
remains constant at unity for all time. Hence
x*** = x0 > g for all t. While x*** does not
diverge further from g, it does not converge to
g either, and so this case does not meet the
Harrod definition of stability.
Case 2; If T < ~

then k > 0 implies that

c > 0. Since c is the coefficient on time itself,
the exponential term in equation 3.18 increases
through time, and the growth rate x*** steadily
diverges from g. In policy terms, this means
that the Federal Reserve response to x 0 > g
would have to make M grow at an ever-faster



rate for all time, just to aim at returning M to
M ** by the end of the ever-receding Tth pe­
riod. This case clearly is unstable.
Case 3: If T > —, then k > 0 implies
c < 0. Hence the exponential term in equation
3.18 decreases through time, vanishing in the
limit to yield x*** = g. In policy terms, the
Federal Reserve response to x 0 > g would be
to make M grow at x*** > g for some time,
eventually returning to the original steady-state
growth rate g. This case is clearly stable, and
so the policy-oriented definition of stability be­
comes clear:
A policy-response system is stable if a finite
initial disturbance leads to a finite amount of
compensation to be effected in some period of
time, thereby permitting the system to return
to equilibrium and to the rates of growth which
maintained before the disturbance. Hence
T > — is necessary for the stability of the sys­
tem.
Proceeding to derive the actual pattern of
monetary policy, it is a straightforward exercise
to use equations 3.15, 3.5, and 3.18 to obtain
the target paths M *** and Y **, and the cor­
responding path A/**. Using x*** = D log
M*** and integrating 3.18 will yield
(3.19) log

Mo

= gt + I ( x o - g)

[1 -

']

Using 5.5 yields
(3.20)

Y **
Af*

-k[l
~(rr) It

The target path M**, representing not the path
which monetary policy forces M to follow but
rather that which it always seeks to make M
approach by — of the discrepancy per period,
is simply M** = -i- y**.
v

TACTICS AND STRATEGY

In the limit of the stable case, M*** returns
to M **, and x*** returns to g. M never re­
turns to the original target path M*; in the
limit
(3.21)

Af*** = M * * = zM oeot

where
(3.22)

log z = ^ (x 0 - g) J ? T
_ t

Similarly, Y** never returns to its original
path Y* but rather follows the path of equa­
tion 3.20. Since M *** = M ** in the limit,
for the stability case, the system returns to
equilibrium with the original stock condition
satisfied.
CONCLUSIONS. The object of this some­
what tortuous exercise has been to illustrate
the danger that the Federal Reserve System
may itself destabilize the economy by causing
movements in monetary policy instruments
that attempt to do too much too soon. This
point is relevant for decisions at both the
strategic and the tactical levels. The specifica­
tions and parametric values of the economic
relationships involved determine the conditions
for actual stabilization.
The important result in the model used here
is that T > y is necessary for stability of the
system. This conclusion contradicts the pre­
sumption of Section II that, in planning move­
ments of monetary policy instruments to cor­
rect for past exogenous disturbances or errors,
proper tactics call for effecting the entire com­
pensation as quickly as possible. The analysis
of this section, which includes not only the
Y = y ( M) relation but also the feedback
effects of Y on the accumulation of M t shows
that this presumption is incorrect. Considera­
tions of stability force the compensation speed
of response to be less than a certain rate, as
determined by both the specification of the re­
lations involved and the values of the system’s
individual parameters.



IV. OPTIM AL FILTER IN G OF
OPERATIONS DATA
The discussion of Sections II and III, while
explicitly acknowledging random events in the
form of disturbances to the process of mone­
tary operations, has assumed complete cer­
tainty in the knowledge of past events. In the
notation used in these sections, the actual
value of the financial variable Mi? as well as
its movement AiM, is an available datum as
of the close of the /th time period.
In reality, however, the available data are
merely estimates that are based on sampling
and reporting machineries and are subject to
revision. This information-generating process is
familiar in Bayesian analysis of decisions and
in control theory. 15 Using certain advance in­
formation, the estimator formulates a subjec­
tive prior probability distribution for the varia­
ble in question. He then uses the newly
available sampling and reporting data to up­
date this prior distribution into a posterior
probability distribution on the same variable.
When he receives yet another set of sample in­
formation, he treats this posterior distribution
as a prior distribution (prior in the sense of its
being prior to the second sample) and repeats
the updating process to produce a new poster­
ior probability distribution. He may repeat this
process as often as new information continues
to arrive, producing as many posterior distri­
butions as there are distinct samples of data.
AVAILABLE
FEDERAL
RESERVE
DATA* Actual practice differs from this ideal­
ized conception only by being less complete.
Each Friday the Federal Reserve Board staff
produces a “Perspective on Bank Reserve
Utilization.” This report presents, among other
information, point estimates for the monthly
movements in a number of monetary aggre­
gates. These point estimates are the means of
the probability distributions considered in the
Bayesian formulation of the information proc­
15 Standard references are Pratt, Raiffa,
Schlaiffer (1965) and Bryson and Ho (1969).

and

ess. The last Perspective of any month gives,
for that month’s movements in a given mone­
tary variable M, a projection which for pur­
poses of this discussion is equivalent to the
mean of a prior probability distribution. As
the month ends and more complete sample
data arrive, the staff uses the newly available
information to update this estimate, producing
a new estimate which is then the mean of a
posterior probability distribution. This new esti­
mate appears in the first Perspective following
the month’s end.
As another week passes and still more sam­
ple data arrive, the staff treats the previous
week’s posterior distribution as the current
week’s prior distribution and updates it to pro­
duce a new posterior distribution for its expec­
tation of the movement in M in the month re­
cently ended. The mean of this second
posterior distribution enters the second
Perspective after the end of this month as a
new, revised point estimate for the movement
in M for this month.
Current practice is to repeat this process not
less than eight nor more than 15 times, and so
the staff estimate of a month’s movement in M
appears in the first eight and perhaps up to the
next seven weekly Perspectives.
Although the staff may not directly concep­
tualize its data-revision activities within a
Bayesian framework, the updating process nev­
ertheless follows this general pattern. Similarly,
while the staff may not explicitly view its point
estimates as means of posterior probability dis­
tributions, the numbers generated are in each
case the expected posterior values of M (pos­
terior in the sense of following upon all infor­
mation received through that time).
Since the available monetary data represent
the means of probability distributions, it is
likely that other parameters of these distribu­
tions also yield information of potential useful­
ness for monetary policy and particularly for
monetary policy tactics. The problem again is
that the staff does not explicitly derive these
probability distributions as such and hence
cannot directly quote their various parameters.



One approach—not a very good one for this
application—would be to have the staff indi­
cate its confidence in each reported estimate,
perhaps by bracketing its point estimate within
an interval wide enough to reduce the subjec­
tive probability of the true number’s lying out­
side this band to one-third. Then assuming, for
example, normal properties for the distribution
itself, this band would be two standard devia­
tions wide. While formulating confidence
intervals in this subjective manner may be a
useful procedure in developing judgmental
projections of future events, it is not well
suited to the problem of developing levels of
confidence in reported data subject to revision.
A more direct approach is to analyze, ex
post, the record of the staff’s data estimation
machinery, testing the relation between data
estimates for successive weeks and the num­
bers later accepted as the true numbers. Tables
1 through 4 show the results of such an exam­
ination applied to Perspective reports during
1968 and the first half of 1969.16
In Table 1, for example, the lines corre­
spond to different financial variables, all mone­
tary aggregates. The first column gives, for
each variable, the variance of the first reported
estimate of a month’s movement about the
“true” value. 17 The next seven columns give,
for each variable, the analogous variances for
the second through the eighth estimates. For
monthly changes in total reserves, for example,
Table 1 shows that the first reported estimate
has variance of 6,630 about the true value. By
the fourth reported estimate, that is, allowing a
reporting lag of 4 weeks, this variance falls to
814; by the eighth reported estimate, the vari­
ance falls to 328.
Tables 2 and 3 repeat the same format, giv­
ing, respectively, the standard deviations and
average absolute errors corresponding to Table

16 Specifically, the Perspective reports used span
the period from January 1968 through July 1969.
17 For purposes of this analysis the “true” value is
the last one reported in a Perspective table, before
the month is dropped from the listings.

TACTICS AND STRATEGY

TABLE 1: Variances of Reporting Errors
Weekly Estimates of Monthly Changes in Monetary Aggregates
W eeks after m onth -end
V ariable

1

2

3

5

4

7

8

740
1 ,1 4 0
886

641
980
872

328
668
628

.0 3 6
.065
.0 0 0
.0 6 6
.0 0 4
.0 1 3
.049

.0 3 5
.0 5 4
.001
.061
.0 0 3
.0 0 7
.0 4 7

.001
.0 1 7
.001
.0 1 6
.0 0 2
.007
.0 1 6

6

7

8

27
34
30

25
31
30

18
26
25

.1 9 0
.2 5 5

.2 5 7
.0 6 3
.1 1 4
.221

.1 8 7
.2 3 2
.0 3 2
.2 4 7
.0 5 5
.0 8 4
.2 1 7

.0 3 2
.1 3 0
.0 3 2
.1 2 6
.0 4 5
.0 8 4
.1 2 6

6

7

8

6

M illio n s o f d ollars, squared
T otal reserves................................................................................
N on borrow ed reserves..............................................................
T otal required reserves..............................................................

6 ,6 3 0
3 ,7 8 0
2 ,8 6 0

2 ,5 7 0
2 ,0 3 0
2 ,3 0 0

1 ,5 1 0
1 ,7 2 0
1 ,5 5 0

T otal m em ber bank d e p o sits..................................................
T otal m on ey su p p ly ....................................................................
C u rrency..........................................................................................
D em an d d ep o sits.........................................................................
U .S . G overnm ent dem and deposits (m em ber b a n k s).
T im e deposits (com m ercial b an k s)......................................
M on ey supply an d tim e d e p o sits..........................................

.0 5 9
.0 9 8
.0 0 3
.0 8 8
.0 2 4
.0 1 6
.1 3 5

.057
.0 5 0
.0 0 6
.0 3 9
.0 0 9
.0 1 8
.0 6 8

.031
.0 5 2
.0 0 2
.0 4 5
.003
.0 1 3
.0 4 6

814
1 ,3 9 0
885

810
1 ,2 4 0
884

B illions o f dollars, squared
.0 3 7
.0 5 5
.0 0 2
.053
.0 0 3
.0 1 3
.051

.028
.055
.001
.0 5 5
.0 0 2
.011
.0 4 6

TABLE 2: Standard Deviations of Reporting Errors
Weekly Estimates of Monthly Changes in Monetary Aggregates
W eeks after m onth -end
V ariable
1

2

3

4

5

M illio n s o f dollars
T otal reserves.................................................................................
N on b orrow ed reserves..............................................................
T otal required reserves..............................................................

81
62
53

51
45
48

39
42
39

T otal m em ber bank d e p o sits..................................................
T otal m on ey su p p ly....................................................................

.2 4 3
.3 1 3
.0 5 5
.2 9 7
.1 5 5
.1 2 6
.3 6 7

.239
.2 2 4
.0 7 7
.1 9 7
.0 9 5
.1 3 4
.261

.1 7 6
.2 2 8
.0 4 5
.2 1 2
.0 5 5
.1 1 4
.2 1 4

29
37
30

28
35
30

B illion s o f dollars

D em an d d e p o sits.........................................................................
U .S . G overnm ent dem and d ep osits (m em ber b a n k s).
T im e d ep osits (com m ercial b a n k s)......................................
M on ey supply and tim e d e p o sits.........................................

.1 9 2
.2 3 5
.0 4 5
.2 3 0
.0 5 5
.1 1 4
.2 2 6

.1 6 7
.2 3 5
.0 3 2
.235
.0 4 5
.1 0 5
.2 1 4

—_

TABLE 3: Average Absolute Reporting Errors
Weekly Estimates of Monthly Changes in Monetary Aggregates
W eeks after m onth -end
Variable
1

2

3

4

5

M illio n s o f dollars
T otal reserves.................................................................................
T otal required reserves..............................................................

57
46
35

32
30
27

25
25
21

.1 8 4
.2 7 9
.0 2 6
.2 5 3
.111
.111
.321

.1 4 7
.1 8 4
.0 4 7
.1 4 7
.0 5 3
.0 8 4
.2 2 6

.111
.1 8 4
.021
.1 3 7
.0 2 6
.0 6 3
.1 7 4

16
22
13

15
19
13

13
17
12

9
11
11

5
7
9

.0 6 3
.1 5 3

.0 5 3
.1 1 6
.0 0 5
.111
.0 1 6
.0 3 2
.1 1 6

.0 0 5
.0 5 8
.0 0 5
.0 4 7
.011
.0 3 2
.0 6 8

B illion s o f dollars
T otal m em ber bank d e p o sits..................................................
T otal m on ey su p p ly ....................................................................
U .S . G overnm ent dem and dep o sits (m em ber b a n k s).
T im e d ep osits (com m ercial b a n k s)......................................
M on ey supply and tim e d e p o s its .........................................




.1 0 5
.1 7 4
.0 1 6
.1 5 3
.0 3 2
.0 6 8
.1 6 8

.0 6 3
.1 4 2
.0 0 5
.1 3 7
.021
.0 5 3
.1 4 2

---

.1 4 7
.0 2 6
.0 4 7
.1 3 7

TABLE 4: Average Reporting Errors
Weekly Estimates of Monthly Changes in Monetary Aggregates
W eeks a fter m onth -end
Variable
1

2

3

4

5

8

6

7

-1 2
-1 6
-7

-9
-1 1
-8

-5
-7
-6

- .0 2 1
.0 5 8
.0 0 0
.053
— .0 0 5
- .0 2 6
.0 3 2

- .0 3 2
.021
- .0 0 5
.0 1 6
- .0 1 6
- .0 1 1
.011

.0 0 5
.0 3 7
- .0 0 5
.037
- .0 0 1
- .0 1 1
.0 3 7

M illio n s o f d ollars
T otal reserv es................................................................................
N on borrow ed reserves..............................................................
T otal required reserves.............................................................

-4 3
-2 8
-2 1

-2 6
-2 5
-2 1

-1 9
-2 0
-1 6

T otal m em ber bank d e p o sits.................................................
T otal m on ey su p p ly ....................................................................
C urrency..........................................................................................
D em and d e p o sits.........................................................................
U .S . G overnm ent dem and deposits (m em ber b an k s).
T im e dep osits (com m ercial b a n k s)......................................
T im e supply and time d ep o sits....... .....................................

.0 0 5
.0 5 8
- .0 0 5
.0 3 2
.047
.0 0 5
.111

- .0 1 1
.068
.005
.0 4 2
.011
- .0 3 2
.0 3 7

.0 1 6
.0 5 8
.0 0 0
.0 5 3
- .0 0 5
- .0 1 1
.0 4 7

-1 3
-1 5
-8

-1 3
-1 8
-8

B illions o f dollars

1. Table 4 gives the corresponding mean er­
rors; nonzero mean errors indicate bias in the
reporting process and are probably due to the
effect on the computations of data series
revisions. 18
As an illustration of the significance of these
data, compare the standard deviations for two
monetary aggregates that the Open Market
Committee may wish to control, for example,
the money supply and total reserves of mem­
ber banks. In the first report after the end of
the month, the money supply estimate is ac­
curate to within a standard deviation of $313
million, or approximately yG of a per cent on
a base of some $ 2 0 0 billion; the total reserves
estimate is accurate to within a standard devia­
tion of $81 million, or approximately 16 of a
per cent on a base of some $27 billion. 19
These errors correspond to a 2 and a 4 per
cent annual rate of change, respectively.
By the fourth report after the end of the
month, the money supply estimate is accurate
to within a standard deviation of $235 million,
or approximately y1 0 of a per cent, and the
total reserves estimate is accurate to within a
standard deviation of $29 million, or approxi­

18 The calculations reported in the tables have al­
ready made some adjustments for series revisions.
19 The magnitude of reporting error in member
bank total reserves may seem surprisingly large.
These errors in fact reflect the “as-of adjustments”
made within the Federal Reserve Banks to correct
for accounting errors in debiting and crediting mem­
ber bank accounts.




.011
.0 5 8
- .0 0 5
.0 5 8
- .0 1 1
- .0 0 5
.0 5 3

- .0 1 1
.047
.005
.053
.0 0 0
- .0 1 1
.0 3 7

mately y1 0 of a per cent. These errors both
correspond to a VA per cent annual rate of
change. By the eighth report after the end of
the month, the money supply estimate is ac­
curate to within a standard deviation of $130
million, or approximately 7/100 of a per cent;
the total reserves estimate is accurate to within
a standard deviation of $18 million, or ap­
proximately 7/100 of a per cent. Both of these
errors correspond to a 1 per cent annual rate
of change.
Hence, under current reporting and estima­
tion systems, money supply information is in
the first instance more accurate than total re­
serves information; but this difference effec­
tively vanishes with an allowed reporting lag of
one month or longer.
CONCEPTUAL USE OF PROBABILITY
DISTRIBUTION PARAMETERS. The object
of the above exercise has been to obtain pa­
rameters of the successive probability distribu­
tions corresponding to successive data reports,
while circumventing the tedious and somewhat
inapplicable procedure of having the staff esti­
mate these parameters subjectively. The re­
ported data in the Perspectives are the means
of these distributions. By assuming that the
sampling, reporting, and updating machineries
have not changed radically in the past 2 years,
it is possible to accept the data in Table 1 as
approximations to the variances of these prob­
ability distributions.
That such variances, or any corresponding
parameters, are useful inputs in formulating

TACTICS AND STRATEGY

monetary policy tactics remains to be shown.
Heuristically, the argument is as follows:
As elaborated earlier, there is usually an ad­
vantage to discovering operational errors in
the monetary policy instrument variables and
to undertaking the proper responses as quickly
as possible. Even in circumstances in which
considerations of stability lead to spreading
compensatory reactions over some substantial
period, it is usually advantageous to begin these
reactions at the earliest possible time.
Simultaneously, however, basing tactical de­
cisions on incorrect data leads to incorrect de­
cisions. It is possible to undertake compensa­
tory responses to errors that have not
occurred, as well as to over- or underestimate
the amount of correction necessary. It is possi­
ble, though less probable, to undertake a com­
pensatory response in the wrong direction, if
the data report is such as to change the signs of
the true differences that have arisen between
the actual and the desired values of the mone­
tary policy instruments. Hence, from the stand­
point of avoiding mistakes due to faulty data,
it is best to postpone taking action until the
data are more secure.
Two influences therefore oppose each other
—one tending to accelerate and one to delay
tactical action. The solution to the dilemma
must in most cases be some compromise. Just
what this answer means in operational terms,
however, is not obvious. The following more
formal analysis should clarify the role of the
data probability distribution parameters in de­
termining the best tactics in any given situa­
tion.
EXAMPLE OF A DATA FILTERING
SCHEME. Consider, for example, a simple
Y = y(M) model of the form
(4.1)

Yi = . . . + p E

i —K

M i- i + • • •

where none of the omitted terms is a lagged
value of Y. This model is the rectangular lag
model of Example 1, Case D, in Section II. To
recall, Case D is interesting in that operational
errors in this specification call for subsequent
compensatory responses in both the levels M



and the changes AM. Here K is the number of
time periods in the no-response section of the
lag in the effect of M on Y , while N time pe­
riods is the total length of the lag.
More specifically, consider the case in which
K — 0 and N = 2. While this lag pattern is
unrealistic, it has two advantages: First, the
mathematical manipulations of the problem in­
crease in number as (N — K + 1 ) 2 increases,
and a simple example should suffice to illustrate
the main points of the analysis without intro­
ducing unnecessary complexities. Second, if
p = Vs, then this expression is simply an
averaging term; replace Yi on the left-hand side
by some term in M, and the equation expresses
the average value of M in a quarter as onethird times the sum of M in each month of the
quarter. Hence the K = 0, N = 2 model is ap­
plicable both to tactical decisions as discussed
above and to the somewhat narrower, more
specific problem of achieving a predetermined
average M over any given quarter.
Suppose, then, that month i — 2 has ended,
and that the tactical problem is to select the
proper plan for month / — 3. Suppose also that
the circumstances are the following:
1. Y 3* is fixed, from the currently operative
strategy.
2. Mt*, M2*, and M3* are also fixed from the
currently operative strategy.
3. M x and M 2 are known; further, M x
and M 2 ^=M2*.
4. The loss associated with Y3 is the simple
quadratic L 3 = (Y3* — Y3) a.
In the deterministic cases considered in Sec­
tions II and III, achieving
(4.2) M 3** = M3* - (Mt - M2*)
- (Mi - Mi*)
will determine Y3 = Y3* and L 3 = 0.
Suppose, however, that assumption 3 above
does not hold. M x and M 2 are not known with
certainty. Instead, define M*J = value of M at
the end of the zth month, as reported at the end
of the jth month. Then the most recent avail­

able estimates of M x and M 2 are M x2 and M 22>
namely, the current report on both values as of
the close of month j = 2 .
The tactical decision of equation 4.2 may
now become

timates available k months after the fact, and
0 < yk < 1, all k > 0.
Using the rule of equation 4.5 yields the
relation between M3** and the actual previous
experience of

(4.3) M 3** = M 3* - (M 22 - M 2*)

(4.6) M3** = M3* -

- (M i 2 - Mi*)

but acting in this fashion ignores the possibility
of reporting errors, that is, the possibility that
M 22 ^ M2 and M x2 ^ M2.
One recourse is to apply some uncertainty
discounting factor to the second and third
terms in equation 4.3, in line with the classical
formulations of optimal filtering. Define the
variables
a s Mi - Mi *
€ik — Mij

Mi*,

Rik ss Mij - Mi,

k = j

i

(4.4)

€» = 6 ik

Rik

Equation 4.2, the rule with certain knowledge,
is then
M 3** = M 3* - 6 2 - 6 1
Equation 4.3, the equivalent using reported
data estimates, is
M 3** = M 3* “ €20 — €11

By using equation 4.4 and substituting,
M 3** = M 3* -

(62

+ * 20) - (ei + Ru)

The idea of applying a filtering process to
the available data is to make the operating rule
(4.5)

M 3** =

M z*

— 70*20

—

yien

where y* = discount factor applied to data es­



+ * 20)

— 7i(*i + * 11)
Assuming that the Manager in fact achieves
this goal, so that M3 = M3**, a series of ma­
nipulations yields
(4.7) Lz = 02[e2(l -

70

) + «i(l - 7i)

+ 70*20 + 7i*n]2
The optimal filtering problem is to choose
y0 and yx so as to minimize the expected value
of L3,
(4.8)

E (L z) =

PWV ~

270 + 7o2)

+ €i2( 1 — 2 7 1 — 7i3)

k =j - i

Here
= the true operating miss on M in the
/th month; eu- = the estimated operating miss
on M in the /th month, as reported k months
after the end of the /th month; and Rin = the
reporting error in the estimate of M in the /th
month, reported k months after the end of the
/th month.
Then

7 0 (6 2

+

26162 (l

—

70

—

71

+ 7071)

+ 2e2/?2o(7o — 7 o 2)

+
+

261

/^1 1 (7 1 — 7 12) +

261

262

* 2 0 ( 7 0 — 7o7i) +

* 1 1 (7 1 — 7o7i)
2

* 20* 11(7 0 7 1 )

+ 7 o2* 202 + 7 i 2* i i 2]

At this stage, several specific assumptions are
necessary that are crucial to the specific results
achieved, though not to the development of the
argument. In other words, changing this set of
assumptions would change the results of the
computation without invalidating the process
of deriving these results:
First, assume, as suggested above, that the
probability distribution of R a reflects the re­
cent history of A-month lagged observations on
the variable M. Assume that the reporting
record in the recent past for such estimates Rik
is unbiased (mean zero) and has variance
0%
-“. Hence
(4.9) E(Rik) = 0, E(Rik*) =

all /

Second, assume that there is no relation be­
tween an error in the reported estimate of one
month’s value of M and any errors in simul­

TACTICS AND STRATEGY

taneously reported estimates of values of M for
other months. Hence

(4.18) (en2 + 2<7-i2) ti — *n2 + cr\ 2

(4.10) E(RikRjh) = 0, all / ^ j,

These equations are analogous to 4.13 and
4.14, but are operational in the sense of con­
taining only the unknowns to be found ( 7 0 and
yi), the reported operating misses, and vari­
ances drawn from analysis of the recent his­
tory of data-reporting errors. Again, this is a
simultaneous system; the operational solution
analogous to equations 4.15 and 4.16 is

(/ - j ) = - ( k - h)
Third, assume that there is no relation be­
tween errors in reported data estimates and the
difference between actual M and target M* for
any month or for any report. Hence
(4.11)

E(uR*) = 0,

all /, k

Applying these three assumptions to equa­
tion 4.8 yields
(4.12) E{U) = /32[e22(l - 27o - To2)
+ Ci2(l — 2yi — 7 12)
+ 2e2ei(l — To — 7i + ToTi)
+ ToVo2 + T i 2^ i 2]

The first-order minimum conditions are

Applying these conditions yields
(4.13)

(e22 + <ro 2) t o = e22 + *2ei(l - 7 i)

(4.14)

(ei2 + <ti2) t i = *i2 + €26i ( 1 — To)

Solving this pair of simultaneous equations for
the discount parameters yields
x

*2Vi2 + €ie2<ri2

(4.15)

70 - £ iW + ^ 2 + ^2 ^2

(4.16)

7i -

e iW

+

tif2<ro 2

+ ej2<ro2 +

The principal remaining difficulty with this
pair of equations is that the true operating
misses, the e* are unknown. The solution,
therefore, is to return to equations 4 .13 and
4 .1 4 and substitute the appropriate eik and
R ik expressions from 4.4 , and then to take ex­
pected values as before, using assumptions 4.9,
4 .10, and 4.11. The result of these operations
is the pair of equations
(4.17)

(e2o2 + 2(7o2) to = *202 + cro2




+ €20*11(1 — Ti)

+ €20*11(1 “ To)

(4.19)
_ eii2q~o2 + 2e20 V i 2 + e20en<7i2 + 2<70 V i 2
To_
2e„W + 2a20Vi5 + 4<r0W
(4.20)
_

^1

6202<rl 2 +

2 €liV 0 2 + €20*110'Q
2 + 2 q-qVi2
e o ci 2 + 2 €h20 -o2 + 4<ro2(ri2

2 2 2

These two equations express the optimal
weights to be attached to the reported errors
e20 and en in making a tactical decision about
Af3** according to equation 4.5. Based on the
relative magnitudes of e20, *u, oo2, anc* °i 2
discount parameters may vary substantially; in
particular, their values are very sensitive to
whether the reported errors e20 and etl are in
the same or opposite directions. In some cases
one of the two discount parameters may be
greater than 1.0. The sum of the two, however,
is always less than 2 . 0 when the reporting error
variances are nonzero. (If these variances do
go to zero, there is no uncertainty factor in the
reported data, and there exists no true solution
for y0 and y1? as seen from equations 4.13
and 4.14.)
ALTERNATIVE SCHEMES. Equations
4.19 and 4.20 express the optimal uncertainty
discount factors, consistent with the specifica­
tion of the model itself in 4.1, a quadratic loss
function, and an operating rule as in 4.3 and
4.5. This solution is probably the best and most
workable method, but others are possible. Al­
ternative solutions for choosing these uncer­
tainty discount factors could take two different
paths from here, one simpler and one more
complex.

The simpler solution is to return to equa­
tions 4.13 and 4.14 and to make the same re­
cent historical observations about the operating
misses e* as the analysis above has done for the
data-reporting variances a*2. Specifically, data
study may show that over some recent period
the root mean-square operating miss has been
some value e. Further study may show that the
operating miss in one month is not necessarily
correlated with a miss in the next. Then apply­
ing expected values of the form
E(ei) = e and E(uej) = 0, / ^ j
reduces equations 4.13 and 4.14 to
(4.21)

e2
70 '
*

(4.22)
^

e2
€2

+

<T\

2

This nonsimultaneous form may in fact be
preferable because of its simplicity. It implies
setting the yfc on the basis of the relevant datareporting variances in relation to the operatingmiss variances of the recent past. It requires no
specific calculation of new y a t each tactical
decision, but only a periodic updating of the
crft and e values to keep them consistent with
current experience.
The more complex solution than equations
4.19 and 4.20 involves reconsidering assump­
tions 4.10 and 4.11 in the light of further data
study. First, it is possible that data-reporting
errors in successive months are correlated. Sec­
ond, if the staff personnel evaluating the in­
coming reports are aware of the targets that
monetary policy operations are trying to
achieve, it is possible that a given month’s
operating miss and that month’s data-reporting
error are correlated. Relaxing these assump­
tions would involve substituting for some terms
of equation 4.8 their estimated recent values,
rather than dropping them altogether as is the
case in equation 4.12. Hence the resulting
rules analogous to equations 4.19 and 4.20
would be more complex, though perhaps more
realistic, determinants of y0 and yt.



Although the analysis above has presented
only a simple example, for one particular
specification of the Y = y( M) relation and for
one loss function, the methods developed are
applicable to more general circumstances, and
the changes necessary to incorporate modifica­
tions follow directly from this procedure.
Similarly, as in previous sections, the monthly
time period used here is merely an expositional
device. The Perspective tables and their implied
probability distributions are available weekly,
and Tables 1 to 4 summarize some parameters
of these distributions. If, for example, tactics
use rules of the form of equations 4.21 and
4.22 to set the uncertainty discount factors
yic, then the relevant y&to use may change with
each week; this procedure would reflect the
greater confidence in data reports after the
extra week’s time lag.
CONCLUSION, The main point of this sec­
tion is that monetary policy tactics should take
account of the possibility of errors in the avail­
able current data by applying some filtering
process to these data. In actual practice the
filter should take the form of a set of uncer­
tainty discount parameters to apply to data
reports and estimates of particular vintages. A
number of schemes, some simple and some
complex, are available to compute these param­
eters, and there is room for choice among
them; but failing to discount for data errors at
all and ignoring the possibility of data revisions
may lead to undesired results in monetary
policy operations.

V. SUMMARY OF CONCLUSIONS
FOR MONETARY POLICY
The major conclusions of Sections I through
IV for monetary policy can be briefly restated
as follows:
1.
The monetary policy decision process
should contain two phases— strategy and tac­
tics. Strategy involves quarterly decisions out­
lining a plan for monetary policy over the sev­
eral following quarters. Tactics involve

TACTICS AND STRATEGY

shorter-run technical decisions concerning im­
plementing the first quarter of the strategy and
deal with the question of how best to adjust
for apparent deviations of the monetary policy
instruments from their planned targets.
2. The formulation of monetary policy
strategy should follow a sequential decision­
making procedure, revising multiquarter strate­
gies once per quarter. At each decision, the
immediate quarter of such a strategy becomes
the currently effective operating policy.
3. Tactical decisions are not purely techni­
cal. An illustration of their real economic sub­
stance is the dependence of proper tactics
upon the specification of the relation between
the instruments and the ultimate goals of mone­
tary policy. Different specifications may imply
no response at all to past operating misses of
the monetary policy instruments or may imply
compensating responses of a number of differ­
ent forms.




4. In planning monetary policy tactics, as
well as strategy, it is important to take account
of the implications for stability of the simulta­
neous structure of the financial and nonfinancial system. Because of feedback relationships
between instrument variables and the rest of the
economy, movements in the instruments from
one level to another, should they be too rapid,
may in fact destabilize the economy rather than
stabilize it.
5. Because the data available to monetary
policy decisions contain reporting errors and
are subject to revision, it is necessary to apply
a set of uncertainty discount factors to the
data when devising appropriate responses to
apparent operating misses in the monetary pol­
icy instruments. These uncertainty discount
factors should effect a compromise between
the desire to react quickly so as to prevent un­
wanted situations from persisting and the de­
sire to delay so as to have better data.

REFERENCES
134

Books

Allen, R. G. D . M acro-E conom ic T heory. Lon­
don: Macmillan, 1967.
Bryson, Arthur E., and H o, Yu-Chi. A p p lied O p­
tim al Control: O ptim ization , Estim ation and
C ontrol. Waltham: Blaisdell Publishing Com ­
pany, 1969.
Harrod, R. F. Tow ards a D yn am ic E conom ics.
London: Macmillan, 1948.
Koyck, L. M. D istribu ted Lags and Investm ent
A nalysis. Amsterdam: N orth-H olland Publish­
ing Company, 1954.
Maisel, Sherman J. “Controlling Monetary Aggre­
gates,” Controlling M onetary A ggregates. Bos­
ton: Federal Reserve Bank o f Boston, 1969.
Pratt, John, Raiffa, Howard, and Schlailfer, R ob­
ert. Introduction to Statistical D ecision T h eory.
N ew York: M cGraw-Hill, 1965.
Theil, Henri. O ptim al D ecision R ules fo r G overn ­
m ent and Industry. Amsterdam: North-Holland
Publishing Company, 1964.

Periodicals and Other

de Leeuw, Frank, and Gramlich, Edward. “The
Federal R eserve-M IT Econometric M odel,”
Federal Reserve Bulletin, V ol. 54 (Jan. 1 9 6 8 ),
pp. 11 -4 0 .
Holt, Charles C. “Linear D ecision Rules for E co­
nomic Stabilization and Growth,” Q uarterly
Journal o f Econom ics, V ol. 76 (Feb. 1962),
pp. 2 0 -4 5 .
Jorgenson, Dale W. “On Stability in the Sense of
Harrod,” E conom ica, V ol. 27 (Aug. 1960),
pp. 2 4 3 -4 8 .
Simon, Herbert A . “D ynam ic Programming
under Uncertainty with a Quadratic Criterion
Function,” E conom etrica, V ol. 24 (Jan. 1956),
pp. 7 4 -8 1 .




CONTENTS




137

INTRODUCTION

138

I. THE THEORY OF MONETARY
POLICY UNDER UNCERTAINTY
Basic concepts
Monetary policy under uncertainty in a
Keynesian model

138
139
145
145
145
148
149
151
151
153
158
161
167
167
167
172

II. EVIDENCE ON THE RELATIVE
MAGNITUDES OF REAL AND
MONETARY DISTURBANCES
Nature of available evidence
Impact of an expenditure disturbance
Evidence from reduced-form equations
Evidence on stability of demand for money
function
III. A MONETARY RULE FOR
GUIDING POLICY
Rationale for a rule-of-thumb
Post-accord monetary policy
A monetary rule
Tests of the proposed rule
IV. SELECTION AND CONTROL
OF A MONETARY AGGREGATE
Basic issues
Selection of a monetary aggregate
Technical problems of controlling money stock

182
184
186

V. SUMMARY
Purposes of the study
The theory of monetary policy under
uncertainty
Evidence on relative magnitudes of real and
monetary disturbances
A monetary rule for guiding policy
Selection and control of a monetary aggregate
Concluding remarks

187-

REFERENCES

179
179
179
181

by William Poole




RULES-OF-THUMB FOR
GUIDING MONETARY
POLICY

RULES-OF-THUMB FOR POLICY

INTRODUCTION
This study has been motivated by the recogni­
tion that the key to understanding policy prob­
lems is the analysis of uncertainty. Indeed, in
the absence of uncertainty it might be said that
there can be no policy problems, only adminis­
trative problems. It is surprising, therefore,
that there has been so little systematic atten­
tion paid to uncertainty in the policy literature
in spite of the fact that policy-makers have re­
peatedly emphasized the importance of the un­
known.
In the past, the formal models used in the
analysis of monetary policy problems have al­
most invariably assumed complete knowledge
of the economic relationships in the model.
Uncertainty is introduced into the analysis, if
at all, only through informal consideration of
how much difference it makes if the true rela­
tionships differ from those assumed by the pol­
icy-makers. In this study, on the other hand,
uncertainty plays a key role in the formal
model.
Since this study is so long, a few comments
at the outset may assist the reader in finding
his way through it. The remainder of this in­
troductory section outlines the structure of the
study so that the reader can see how the var­
ious parts fit together. The reader interested
only in a summary of the analysis and empiri­
cal findings should read this introductory sec­
tion and then turn directly to the summary in
Section V. This summary concentrates on the
theoretical analysis while only briefly stating
the most important empirical findings. It omits
completely the technical details of both the
theoretical and empirical work. The reader in­
terested in the technical details should, of
N o t e .—The author is Senior Economist* Special
Studies Section, Division of Research and Statistics,
Board of Governors of the Federal Reserve System.
Special thanks are due Miss Joan Walton for her as­
sistance in programming and other matters, Mrs.
Lillian Humphrey for assistance with the figures, and
Miss Debra Bellows for typing a long and messy
manuscript through several drafts. The author, of
course, is wholly responsible for any remaining er­
rors.




course, turn to the appropriate parts of Sec­
tions I through IV. Insofar as possible these
sections have been written so that the reader
can understand any one section without having
to wade through all of the other sections.
Section I contains the theoretical argument
comparing interest rates and the money stock
as policy-control variables under conditions of
uncertainty. The analysis is verbal and graphi­
cal, using the simple Hicksian IS-LM model
with random terms added. This model is gen­
eral enough to include both Keynesian and
monetarist outlooks, depending on the specific
assumptions as to the shapes of the functions.
Since the theoretical analysis emphasizes the
importance of the relative stability of the ex­
penditures and money demand functions, an
examination of the evidence on relative stabil­
ity appears in Section II.
Given the conclusion of Section II on the
superiority of a policy operating through ad­
justments in the money stock, the next ques­
tion is how the money stock should be
adjusted to achieve the best results. While pol­
icy-makers generally look askance at sugges­
tions for policy rules, the only way that econo­
mists can give long-run advice is in terms of
rules* That is to say, the economist is not being
helpful at all if he in effect says, “Look at the
rate of inflation, at the rate of unemployment, at
the forecasts of the Government budget deficit,
and at other relevant factors, and then act ap­
propriately.” Advice requires the specification
of exactly how policy should be adjusted, and
for this advice to be more than an ad hoc rec­
ommendation for the current situation, it must
involve specification of how the money stock
or some other control variable should be ad­
justed under hypothetical future conditions of
inflation, unemployment, and so forth. The
purpose of Section III is to develop such a
rule-of-thumb, or policy guideline, based on
the theoretical and empirical analyses of Sec­
tions I and II.
A number of technical problems of mone­
tary control are examined in Section IV. After
a short introduction to the issues, the first part

of this section discusses the relative merits of a
number of monetary aggregates including var­
ious reserve measures, the narrowly and
broadly defined money stocks, and bank
credit. The second part examines whether pol­
icy should specify desired rates of change of
an aggregate in terms of weekly, monthly, or
quarterly averages, or in some other manner.
The third part examines in a very incomplete
fashion a few of the problems of adjusting
open market operations so as to reach the de­
sired level of an aggregate.
Finally, Section V consists of a summary of
Sections I through IV. To avoid undue repeti­
tion, woven into this summary section are a
number of general observations not examined
in the other sections.

I. THE THEORY OF M ONETARY
POLICY UNDER UNCERTAINTY
BASIC CONCEPTS, The theory of optimal
policy under uncertainty has provided many in­
sights into actual policy problems [8, 12, 21,
25]. While much of this theory is not accessible
to the nonmathematical economist, it is pos­
sible to explain the basic ideas without resort
to mathematics.
The obvious starting point is the observation
that with our incomplete understanding of the
economy and our inability to predict accu­
rately the occurrence of disturbing factors such
as strikes, wars, and foreign exchange crises,
we cannot expect to hit policy goals exactly.
Some periods of inflation or unemployment are
unavoidable. The inevitable lack of precision
in reaching policy goals is sometimes recog­
nized by saying that the goals are “reasonably”
stable prices and “reasonably” full employ­
ment.
While the observation above is trite, its im­
plications are not. Two points are especially
important. First, policy should aim at minimiz­
ing the average size of errors. Second, policy
can be judged only by the average size of er­
rors over a period of time and not by individ­



ual episodes. Because this second point is par­
ticularly subject to misunderstanding, it needs
further amplification.
Since policy-makers operate in a world that
is inherently uncertain, they must be judged by
criteria appropriate to such a world. Consider
the analogy of betting on the draw of a ball
from an urn with nine black balls and one red
ball. Anyone offered a $2 payoff for a $1 bet
would surely bet on a black ball being drawn.
If the draw produced the red ball, no one
would accuse the bettor of a stupid bet. Simi­
larly, the policy-maker must play the eco­
nomic odds. The policy-maker should not be
accused of failure if an inflation occurs as the
result of an improbable and unforeseeable
event.
Now consider the reverse situation from
that considered in the previous paragraph.
Suppose the bettor with the same odds as
above bets on the red ball and wins. Some
would claim that the bet was brilliant, but as­
suming that the draw was not rigged in any
way, the bet, even though a winning one, must
be judged foolish. It is foolish because, on the
average, such a betting strategy will lead to sub­
stantially worse results than the opposite strat­
egy. Betting on red will prove brilliant only
one time out of 10, on the average. Similarly,
a particular policy action may be a bad bet
even though it works in a particular episode.
There is a well-known tendency for gam­
blers to try systems that according to the laws
of probability cannot be successful over any
length of time. Frequently, a gambler will
adopt a foolish system as the result of an ini­
tial chance success such as betting on red in
the above example. The same danger exists in
economic policy. In fact, the danger is more
acute because there appears to be a greater
chance to “beat the system” by applying eco­
nomic knowledge and intuition. There can be
no doubt that it will become increasingly pos­
sible to improve on simple, naive policies
through sophisticated analysis and forecasting
and so in a sense “beat the system.” But even
with improved knowledge some uncertainty

RULES-OF-THUMB FOR POLICY

will always exist, and therefore so will the
tendency to attempt to perform better than the
state of knowledge really permits.
Whatever the state of knowledge, there must
be a clear understanding of how to cope with
uncertainty, even though the degree of uncer­
tainty may have been drastically reduced
through the use of modern methods of analy­
sis. The principal purpose of this section is to
improve understanding of the importance of
uncertainty for policy by examining a simple
model in which the policy problem is treated
as one of minimizing errors on the average.
Particular emphasis is placed on whether con­
trolling policy by adjusting the interest rate or
by adjusting the money stock will lead to
smaller errors on the average. The basic argu­
ment is designed to show that the answer to
which policy variable—the interest rate or the
money stock—minimizes average errors de­
pends on the relative stability of the expendi­
tures and money demand functions and not
on the values of parameters that determine
whether monetary policy is in some sense more
or less “powerful” than fiscal policy.
MONETARY POLICY UNDER UNCER­
TAINTY IN A KEYNESIAN MODEL.1 The
basic issues concerning the importance of
uncertainty for monetary policy may be ex­
amined within the Hicksian IS-LM version of
the Keynesian system. This elementary model
has two sectors, an expenditure sector and a
monetary sector, and it assumes that the price
level is fixed in the short run.2 Consumption,
investment, and government expenditures func­
tions are combined to produce the IS function
in Figure 1, while the demand and supply of
money functions are combined to produce the
LM function. If monetary policy fixes the stock
of money, then the resulting LM function is
LAfi, while if policy fixes the interest rate at r0

1 For the most part this section represents a verbal
and graphical version of the mathematical argument
in [25].
2 Simple presentations of this model may be found
in [6, pp. 275-82] and [7, pp. 327-32].




FIGURE 1

the resulting LM function is LM 2. It is assumed
that incomes above “full employment income”
are undesirable due to inflationary pressures
while incomes below full employment income
are undesirable due to unemployment.
If the positions of all the functions could be
predicted with no errors, then to reach full em­
ployment income, Yh it would make no differ­
ence whether policy fixed the money stock or
the interest rate. All that is necessary in either
case is to set the money stock or the interest
rate so that the resulting LM function will cut
the IS function at the full employment level of
income.
Significance of disturbances. The positions
of the functions are, unfortunately, never pre­
cisely known. Consider first uncertainty over
the position of the IS function—which, of
course, results from instability in the under­
lying consumption and investment functions—
while retaining the unrealistic assumption that
the position of the LM function is known. What
is known about the IS function is that it will
lie between the extremes of /Si and IS 2 in Fig­
ure 2. If the money stock is set at some fixed
level, then it is known that the LM function
will be L Mlf and accordingly income will be
somewhere between the extremes of
and Y*>.
On the other hand, suppose policy-makers fol­
low an interest rate policy and set the interest
rate at r0. In this case income will be some­
where between Y /, and Y 2', a wider range than

140

FIGURE 2

FIGURE 3

Y x to r*, and so the money stock policy is
superior to the interest rate policy.3 The money
stock policy is superior because an unpredicta­
ble disturbance in the IS function will affect the
interest rate, which in turn will produce spend­
ing changes that partly offset the initial disturb­
ance.
The opposite polar case is illustrated in Fig­
ure 3. Here it is assumed that the position of
the IS function is known with certainty, while
unpredictable shifts in the demand for money
cause unpredictable shifts in the LM function
if a money stock policy is followed. With a
money stock policy, income may end up any­
where between Y x and Y But an interest rate
policy can fix the LM function at LM 3 so that
it cuts the IS function at the full employment
level of income, Y ft With an interest rate
policy, unpredictable shifts in the demand for
money are not permitted to affect the interest
rate; instead, in the process of fixing the inter­
est rate the policy-makers adjust the stock of
money in response to the unpredictable shifts
in the demand for money.
In practice, of course, it is necessary to cope
with uncertainty in both the expenditure and

monetary sectors. This situation is depicted in
Figure 4, where the unpredictable disturbances
are larger in the expenditure sector, and in
Figure 5 where the unpredictable disturbances
are larger in the monetary sector.
The situation is even more complicated than
shown in Figures 4 and 5 by virtue of the fact
that the disturbances in the two sectors may not
be independent. To illustrate this case, consider
Figure 5 in which the interest rate policy is
superior to the money stock policy if the dis­
turbances are independent. Suppose that the
disturbances were connected in such a way that
disturbances on the LM2 side of the average
LM function were always accompanied by dis­
turbances on the IS 2 side of the average IS
function. This would mean that income would
never go as low as Y u but rather only as low as
the intersection of LM t and IS2, an income not
as low as Y x under the interest rate policy.
Similarly, the highest income would be given
by the intersection of LM Z and ISU an income
not so high as Y2'.4

4 The diagram could obviously have been drawn so
that an interest rate policy would be superior to a
money stock policy even though there were an inverse
relationship between the shifts in the IS and LM func­
tions. However, inverse shifts always reduce the mar­
3 In Figure 2 and the following diagrams, the out­ gin of superiority of an interest rate policy, possibly
comes from a money stock policy will be represented
to the point of making a money stock policy supe­
by unprimed Y*s, while the outcomes from an inter­
rior. Conversely, positively related shifts favor an in­
terest rate policy.
est rate policy will be represented by primed Y's.



RULES-OF-THUMB FOR POLICY

FIGURE 4
FIGURE 5

Importance of interest elasticities and other
parameters. So far the argument has concen­
trated entirely on the importance of the relative
sizes of expenditure and monetary disturbances.
But is it also important to consider the slopes
of the functions as determined by the interest
elasticities of investment and of the demand
for money, and by other parameters? Consider
the pair of IS functions, ISXand IS2, as opposed
to the pair, IS 3 and IS4, in Figure 6. Each pair
FIGURE 6




represents the maximum and minimum posi­
tions of the IS function as a result of disturb­
ances, but the pairs have different slopes. Each
pair assumes the same maximum and minimum
disturbances, as shown by the fact that the
horizontal distance between
and IS 2 is the
same as between IS 3 and IS4. For convenience,
but without loss of generality, the functions
have been drawn so that under an interest rate
policy represented by LAf2 both pairs of IS

functions produce the same range of incomes.
To keep the diagram from becoming too messy,
only one LM function, LM U under a money
stock policy has been drawn. Now consider
disturbances that would shift LM X back and
forth. From Figure 6 it is easy to see that if
shifts in LM Xwould lead to income fluctuations
greater than from 5V to 5V—which fluctua­
tions would occur under an interest rate policy
— then an interest policy would be preferred
regardless of whether we have the pair ISX and
IS2>or the pair IS 3 and /S4.
The importance of the slope of the LM function is investigated in Figure 7 for the two LM
pairs, LM Y and LM 2, and LM S and LM 4. The
functions have been drawn so that each pair
represents different slopes but an identical
range of disturbances. It is clear that if shifts
in ISX are small enough, then an interest rate
policy will be preferred regardless of which pair
of LM functions prevails. Conversely, if a
money stock policy is preferred under one pair
of LM functions because of the shifts in the IS
function, then a money stock policy will also be
preferred under the other pair of LM functions.
The upshot of this analysis is that the cru­
cial issue for deciding upon whether an inter­
est rate or a money stock policy should be
followed is the relative size of the disturbances
in the expenditure and monetary sectors. Con­
trary to much recent discussion, the issue is
not whether the interest elasticity of the de­
mand for money is relatively low or whether
fiscal policy is more or less “powerful” than
monetary policy.
To avoid possible confusion, it should be
emphasized that the above conclusion is in
terms of the choice between a money stock
policy and an interest rate policy. However, if
a money stock policy is superior, then the
steeper the LM function is, the lower the
range of income fluctuation, as can be seen
from Figure 7. It is also clear from Figure 6
that under an interest rate policy an error in
setting the interest rate will lead to a larger
error in hitting the income target if the IS func­
tion is relatively flat than if it is relatively steep.



But these facts do not affect the choice between
interest rate and money stock policies.
The “combination” monetary policy. Up to
this point the analysis has concentrated on the
choice of either the interest rate or the money
stock as the policy variable. But it is also pos­
sible to consider a “combination” policy that
works through the money stock and the inter­
est rate simultaneously. An understanding of
the combination policy may be obtained by
further consideration of the cases depicted in
Figures 2 and 7.
In Figure 8 the disturbances, as in Figure 2,
are entirely in the expenditure sector. As was
seen in Figure 2, the result obtained by fixing
the money stock so that LM Xprevailed was su­
perior to that obtained by fixing the interest
rate so that LM 2 prevailed. But now suppose
that instead of fixing the money stock, the
money stock were reduced every time the in­
terest rate went up and increased every time
the interest rate went down. This procedure
would, of course, increase the amplitude of
interest rate fluctuations.5 But if the proper re­
lationship between the money stock and the
interest rate could be discovered, then the LM
function could be made to look like LM 0 in
Figure 8. The result would be that income
would be pegged at Y ft Disturbances in the IS
function would produce changes in the interest
rate, which in turn would produce spending
changes sufficient to completely offset the effect
on income of the initial disturbance.
The most complicated case of all to explain
graphically is that in which it is desirable to
increase the money stock as the interest rate
rises and decrease it as the interest rate falls.
5 The increased fluctuations in interest rates must
be carefully interpreted. In this model the IS func­
tion is assumed to fluctuate around a fixed-average
position. However, in more complicated models in­
volving changes in the average position of the IS
function, perhaps through the operation of the in­
vestment accelerator, interest rate fluctuations may
not be increased by the policy being discussed in the
text. By increasing the stability of income over a pe­
riod of time, the policy would increase the stability
of the IS function in Figure 8 and thereby reduce in­
terest rate fluctuations.

RULES-OF-THUMB FOR POLICY

FIGURE 8

143
FIGURE 9

In Figure 9 the leftmost position of the LM
function as a result of disturbances is LM t
when the money stock is fixed and is LM 2 when
the combination policy of introducing a positive
money-interest relationship is followed. The
rightmost positions of the LM functions under
these conditions are not shown in the diagram.
When the interest rate is pegged, the LM func­
tion is LM 3. If either LM r or LM 2 prevails, the
intersection with IS 1 produces the lowest in­
come, which is below the Y / level obtained
with LM3. But in the case of LM 2, income at
Y x is only a little lower than at Y /, whereas
when IS 2 prevails, LM 2 is better than LM 3 by
the difference between Y2 and Y 2 . Since the
gap between Y 2 and Y 2 is larger than that be­
tween Ya and Y /, it is on the average better to
adopt LM 2 than LM Z even though the ex­
tremes under LM 2 are a bit larger than under
LM3.
Extensions of model. At this point a natural
question is that of the extent to which the
above analysis would hold in more complex
models. Until more complicated models are
constructed and analyzed mathematically, there
is no way of being certain. But it is possible to
make educated guesses on the effects of adding



more goals and more policy instruments, and
of relaxing the rigid price assumption.
Additional goals may be added to the model
if they are specified in terms of “closer is bet­
ter” rather than in terms of a fixed target that
must be met. For example, it would not be
mathematically difficult to add an interest rate
goal to the model analyzed above, if deviations
from a target interest rate were permitted but
were treated as being increasingly harmful. On
the other hand, it is clear that if there were a
fixed-interest target, then the only possible pol­
icy would be to peg the interest rate, and in­
come stabilization would not be possible with
monetary policy alone.
The addition of fiscal policy instruments af­
fects the results in two major ways. First, the
existence of income taxes and of government
expenditures inversely related to income (for
example, unemployment benefits) provides au­
tomatic stabilization. In terms of the model,
automatic stabilizers make the IS function
steeper than it otherwise would be, thus reduc­
ing the impact of monetary disturbances, and
reduce the variance of expenditures disturb­
ances in the reduced-form equation for income.
This effect would be shown in Figure 6 by

drawing ISt so that it cuts LM 2 to the right of
y / and drawing IS 2 so that it cuts LM %to the
left of y 2'.
The second major impact of adding fiscal
policy instruments occurs if both income and
the interest rate are goals. Horizontal shifts in
the IS function that are induced by fiscal pol­
icy adjustments, when accompanied by a coor­
dinated monetary policy, make it possible to
come closer to a desired interest rate without
any sacrifice in income stability. An obvious illustration is provided by the case in which the
optimal monetary policy from the point of
view of stabilizing income is to set the interest
rate as in Figure 5. Fiscal policy can then shift
the pair of IS functions, ISt and IS2, to the
right or left so that the expected value of in­
come is at the full employment level.
If the interest rate is not a goal variable,
then fiscal policy actions that shift the IS func­
tion without changing its slope do not improve
income stabilization over what can be accom­
plished with monetary policy alone, provided
the lags in the effects of monetary policy are
no longer than those in the effects of fiscal
policy. An exception would be a situation in
which reaching full employment with monetary
policy alone would require an unattainable in­
terest rate, such as a negative one.
These comments on fiscal policy have been
presented in order to clarify the relationship
between fiscal and monetary policy. While
monetary policy-makers may urge fiscal action,
for the most part monetary policy must take
the fiscal setting as given and adapt monetary
policy to this setting. It must then be recog­
nized that an interest rate goal can be pursued
only at the cost of sacrificing somewhat the in­
come goal.6
6 An interest rate goal must be sharply distin­
guished from the use of the interest rate as a mone­
tary policy instrument. By a goal variable is meant a
variable that enters the policy utility function.
Income and interest rate goals might be simultane­
ously pursued by setting the money stock as the pol­
icy instrument or by setting the interest rate as the
policy instrument.




All of the analysis so far has taken place
within a model in which the price level is fixed
in the short run. This assumption may be re­
laxed by recognizing that increases in money
income above the full employment level in­
volve a mixture of real income gains and price
inflation. Similarly, reductions in money in­
come below the full employment level involve
real income reductions and price deflation (or
a slower rate of price inflation). The model
used above can be reinterpreted entirely in
terms of money income so that departures
from what was called above the “full employ­
ment” level of income involve a mixture of
real income and price changes. Stabilizing
money income, then, involves a mixture of the
two goals of stabilizing real output and of sta­
bilizing the price level.
However, interpreted in this way the struc­
ture of the model is deficient because it fails to
distinguish between real and nominal interest
rates. Price level increases generate inflation­
ary expectations, which in turn generate an
outward shift in the IS function. The model
may be patched up to some extent by assum­
ing that price changes make up a constant
fraction of the deviation of income from its
full employment level and assuming further
that the expected rate of inflation is a con­
stant multiplied by the actual rate of inflation.
Expenditures are then made to depend on the
real rate of interest, the difference between the
nominal rate of interest and the expected rate
of inflation. The result is to make the IS func­
tion, when drawn against the nominal interest
rate, flatter and to increase the variance of dis­
turbances to the IS function. These effects are
more pronounced: (a) the larger is the inter­
est sensitivity of expenditures; (b) the larger is
the fraction of price changes in money income
changes; and (c) the larger is the effect of
price changes on price expectations. The con­
clusion is that since price flexibility in effect
increases the variance of disturbances in the
IS function, a money stock policy tends to be
favored over an interest rate policy.

RULES-OF-THUMB FOR POLICY

II. EVIDENCE ON THE
RELATIVE MAGNITUDES OF
REAL AND MONETARY
DISTURBANCES
NATURE OF AVAILABLE EVIDENCE.
Little evidence is available that directly tests
the relative stability of the expenditure and
money demand functions. It is necessary,
therefore, to proceed somewhat indirectly.
First, simulation of the FR-MIT m odel7
is used to show the probable size of the
effect on gross national product (GNP),
the GNP deflator, and the unemployment rate
of an assumed expenditure disturbance. This
evidence provides some indication of the ex­
tent to which the impact of an expenditure dis­
turbance depends on the choice between the
money stock and the Treasury bill rate as
monetary policy control variables. This evi­
dence bears only on the question of what hap­
pens if an expenditure disturbance occurs, not
on the relative stability of the expenditure and
money demand functions. However, this ap­
proach is useful when combined with intuitive
feelings about relative stability.
The second type of evidence, derived from
reduced-form studies, is more direcdy related
to the question of relative stability; neverthe­
less, it is not entirely satisfactory because the
studies examined were not designed to answer
the question at hand. To supplement these
studies by other investigators, there follows a
simple test of the stability of the demand for
money function.
IMPACT OF AN EXPENDITURE DIS­
TURBANCE. Simulation of the FR-M IT
model provides some insight as to how the size
of the impact of an expenditure disturbance
depends on the choice of the monetary policy
instrument. The simulation technique is neces­
sary because the FR-M IT model is nonlinear,
making it impossible to obtain an explicit ex­
pression for the reduced form.8 However, com­
7 For a general description of the model, see [14].
8 See opposite column.




parison of two sets of simulations provides
some interesting results. Except as indicated
below, the simulations all used the actual his­
torical values of the model’s exogenous varia­
bles and all simulations started with 1962-1, a
starting date selected arbitrarily.
The first set of five simulations assumes an
exogenous money stock that grows by 1 per
cent per quarter, starting with the actual
money stock in 1961-IV as the base. To inves­
tigate the impact of a disturbance in an exog­
enous expenditures variable, the exogenous
variable “Federal expenditures on defense
goods” was set in one simulation at its actual
level minus $10 billion; in another at actual
minus $5 billion; and in three further simula­
tions at actual, actual plus $5 billion, and ac­
tual plus $10 billion. This procedure produces
four hypothetical observations on “disturb­
ances” in defense expenditures, of —10, “ 5,
+ 5, and + 10, and the simulation provides
four corresponding observations for the change
in income (and other endogenous variables).
By using income as an example, the change in
an endogenous variable in response to a dis­
turbance in defense expenditures is the differ­
ence between income simulated by the model
when defense expenditures were set at actual
historical values and when set at actual plus
10, plus 5, and so forth. The income obtained
in the simulations, even when defense expendi­
tures are set at actual levels, is not the same as
the actual historical level of income both be­
cause the assumed monetary policy differs from
the policy actually followed and because of
errors in the model itself.
By calculating the ratio of the change in an
endogenous variable to the disturbance in de­
fense expenditures for the four observations,
four estimates of the linear approximation to
the reduced-form parameter, or multiplier, of
8 In a reduced-form equation, an endogenous (that
is, simultaneously determined) variable is expressed
as depending only on exogenous and predetermined
variables (variables taken as given for the current
period).

defense expenditures are obtained, and these
four estimates have been averaged to produce
a single estimate. Since the effects of a disturb­
ance accumulate over time, the reduced-form
parameter estimate has been calculated for the
12 quarters from 1962-1 through 1964-IV.
Exactly the same procedure has been used for
the simulations with a fixed rate for 3-month
Treasury bills. Finally, the ratio of the param­
eter estimates for the reduced forms under the
money stock and interest rate policies has been
calculated with the parameter estimates from
the simulations with the exogenous money
stock in the numerator of the ratio.
The reduced-form parameter estimates under
the two monetary policies, and the ratios of
these estimates, have been plotted in Figure 10
for 12 quarters for the reduced forms for nom­
inal GNP, for the unemployment rate, and for
the GNP deflator. The results are striking. A
substantial difference appears in the parame­
ters of reduced forms for the fourth quarter
following the initial disturbance, and the dif­
ferences in the parameters become steady
thereafter. By the 12th quarter the reducedform parameters for the money stock policy are
only about 40 per cent of those for the interest
rate policy.
The interpretation of these results is that
employment, output, and the price level are far
more sensitive to disturbances in defense ex­
penditures under an interest rate policy than
under a money stock policy. This conclusion
presumably generalizes to expenditures varia­
bles other than defense expenditures, but the
results would differ in detail because each ex­
penditures variable enters the F R -M IT model
in a somewhat different way.
It might be argued that these results suggest
that there is no significant difference between
interest rate and money stock policies because
the reduced-form parameters are essentially
identical up to about four quarters. Surely, so
this argument goes, mistakes could be discov­
ered and offset within four quarters. There are
two difficulties with this argument. The first is
that the F R -M IT model may overstate the




FIGURE 10

REDUCED-FORM PARAMETER ESTIMATES FOR
FEDERAL DEFENSE EXPENDITURES FROM
FR-MIT MODEL
Per c e n t

P er c e n t

Q U ARTE RS FO LLO W IN G 1961 Q4

length of the lags and therefore understate the
differences in reduced-form parameters for the
two policies for the quarters immediately fol­
lowing a disturbance. But the second and more
important reason is that it may not be easy to
reverse the effects of the disturbance after the
disturbance has been discovered. With an in­
terest rate policy, a very large change in the
rate might be required to offset the effects ap­
pearing after the fourth quarter, and such a
change might not be feasible, or at least not
desirable in terms of its effects on security
markets and on income in the more distant fu­
ture.
The numerical results reported above de­
pend, of course, on the F R -M IT model, and
this model is deficient in a number of respects.
But any model in which, other things being
equal, investment and other interest-sensitive
expenditures decline when interest rates rise
will show results in the same direction.

RULES-OF-THUMB FOR POLICY

These results may be extended to analyze the
significance of errors in forecasting exogenous
variables. Consider an explicit expression for
the reduced form for income. Let the exoge­
nous variables such as government expendi­
tures, perhaps certain categories of investment,
strikes, weather, population growth, and so
forth, be X l9 X 2, . . . , X n, and let the coeffi­
cients of these variables be ora,
when
the interest rate is the policy instrument, and
Ai, A2, . . . , An when the money stock is the
instrument. Then the reduced form for income
when the interest rate is the instrument is
(1) y = <*0 + OL\Xi + <22^2
+ . . . + anXn + ocrr + u
where <xr is the coefficient of the interest rate
and u is the random disturbance. On the other
hand, when the money stock is the instrument,
the reduced form is
(2) Y = Xo + XiA’i + \ 2X 2
+ . . . + \ nXn + AjvfM + v
As discussed in Section II, the disturbance
vt may have either a larger or a smaller vari­
ance than the disturbance ut. One factor tend­
ing to make v* smaller than ut is that a money
stock policy reduces the impact of expenditures
disturbances, but another factor, the introduc­
tion into the reduced form of money demand
disturbances, tends to make vf larger. The net
result of these two factors cannot be deter­
mined a priori.
But in formulating policy it is not possible to
reason directly from equations 1 and 2 because
many of the X { cannot be predicted in advance
with perfect accuracy. For scientific purposes
ex post it may be possible to say that a change
in income was caused by a change in some
X u for policy purposes ex ante this scientific
knowledge is useless unless the change in X {
can be predicted. It is necessary to think of
each X i as being composed of a predictable
part, X if and an unpredictable part, E
Xi = Xi + Ei




For policy purposes the error term in the
reduced form includes both the disturbances to
the equation and the errors in forecasting ex­
ogenous variables. The two types of errors
ought to be treated exactly alike in formulating
policy. Equations 1 and 2 can then be rewrit­
ten as follows:
(3)

Y = Oto + Ctjtl + CX2X 2 + . . . + QtnXn
+ aTr + aiEi + a 2E 2 + . . . + anEn + u

(4)

Y — Xo + \\X i + X2Z 2 + . . . + \nXN
+

\m M

+

XlEl + \ 2E 2 +

. . . +

Xn£n +

V

For policy purposes the error term in the reduced-form equation 3 is the sum of the terms
from atE lt through ut and in the reduced-form
equation 4 the sum of the term E lt through
v(.
A systematic study of the importance of the
Ei terms cannot be made because no formal
record of errors in forecasting exogenous vari­
ables exists insofar as the author knows. How­
ever, some insight into the problem may be
obtained by listing the variables that must be
forecast. Which variables have to be forecast
depends, of course, on the model being used.
The larger econometric models generally have
relatively few exogenous variables that raise
forecasting problems because so many varia­
bles are explained endogeneously by the model
itself. The FR-M IT model has 63 exogenous
variables; some of these are relatively easy to
forecast, but others are subject to considerable
forecasting error. The latter include such vari­
ables as exports, number of mandays idle due
to strikes, Armed Forces, and Federal expend­
itures. Furthermore, this model involves lagged
endogenous variables in many equations; hence
an inaccurate forecast of GNP next quarter
will increase the error in forecasting GNP two
quarters into the future, which in turn will
lead to errors in forecasting GNP three quar­
ters into the future, and so forth. Errors in
forecasting exogenous variables, therefore, pro­
duce cumulative errors in forecasting GNP in
future quarters.
In simpler models the forecasting problem is

148

more severe. Consider, for example, the oppo­
site extreme from the large econometric model,
the single-equation model. Convenient repre­
sentatives of such models are those spawned in
the controversy over the Friedman-Meiselman
paper [2] on the stability of the money/income
relationship. The various definitions of exoge­
nous, or “autonomous,” spending utilized by
the various authors in this controversy are as
follows:
a) Friedman-Meiselman definition: Au­
tonomous expenditures consist of the
“net private domestic investment plus
the government deficit on income and
product account plus the net foreign
balance” [2, p. 184].
b) Ando-Modigliani definition: Autono­
mous expenditures consist of two var­
iables which enter the reduced form
with different coefficients. One varia­
ble is “property tax portion of indi­
rect business taxes” plus “net interest
paid by government” plus “govern­
ment transfer payment” minus “un­
employment insurance benefits” plus
“subsidies less current surplus of gov­
ernment enterprises” minus “statistical
discrepancy” minus “excess of wage
accruals over disbursement.” The sec­
ond variable is “net investment in
plant and equipment, and in residen­
tial houses” plus “exports” [10, pp.
695, 696, and 702].
c) DePrano-Mayer definition: The basic
definition is “investment in producers’
durable equipment, nonresidential
construction, residential construction,
federal government expenditures on
income and product account, and ex­
ports. One variant of this hypothesis
subtracts capital consumption esti­
mates, and the other does not” [15,
p. 739]. DePrano and Mayer also
tested 18 other definitions of autono­
mous expenditures [15, pp. 739 and
740].
d) Hester definition: Autonomous ex­
penditures consist of the “sum of gov­
ernment expenditure, net private do­
mestic investment, and the trade
balance” [19, p. 366]. Hester also ex­
perimented with three other defini­
tions involving alternative treatments




of imports, capital consumption al­
lowances, and inventory investment
[19, pp. 366, 367].
To a considerable extent the diversity in
these definitions is misleading because except
for the Friedman-Meiselman definition all the
definitions are in fact rather similar. But
whichever definition is used, it is impossible to
escape the feeling that inaccurate forecasting
of exogenous variables is likely to be a major
source of uncertainty. And while this discus­
sion has taken place within the context of for­
mal models, exactly the same problem plagues
judgmental forecasting. Every forecasting
method can be viewed as starting from fore­
casts of “input,” or exogenous, variables and
then proceeding to judge the implications of
these inputs for GNP and other dependent, or
endogenous, variables.
Regardless of what type of model is used, it
appears that for the foreseeable future it will
be necessary to forecast exogenous variables
that simply cannot be forecast accurately by
using present methods. As a result, it seems
very likely that the error term including fore­
cast errors has a far smaller variance in equa­
tion 4 than in equation 3. Indeed, it might be
argued that as a source of uncertainty the E {
terms are far more important than the u or v
terms, and therefore that the smaller size of
the Xi parameters as compared to the «i pa­
rameters is of great importance. If the parame­
ter estimates from the FR-M IT model are ac­
cepted, the standard deviation of the total
random term relevant for policy (that is, in­
cluding errors in forecasting exogenous varia­
bles) would be over twice as large under an
interest rate policy as under a money stock
policy. If this argument is correct, shifting
from the current policy of emphasizing interest
rates to one of controlling the money stock
might cut average errors in half, where errors
are measured in terms of the deviations of em­
ployment, output, and price level from target
levels for these variables.
EVIDENCE FROM REDUCED-FORM
EQUATIONS. Additional insight into the

RULES-OF-THUMB FOR POLICY

relative sizes of disturbances under interest
rate and money stock policies may be obtained
by examining the controversy generated by the
Friedman-Meiselman paper on the stability of
the money/income relationship [2]. In this
paper equations almost the same as equations
1 and 2 above were estimated. The equation
corresponding to equation 1 differs in that the
exogenous variables were assumed to consist
only of a single autonomous spending variable,
as defined above. The equation corresponding
to equation 2 has the same disability for our
purposes, but it also did not include an interest
rate as a variable.
Before examining the implications of the
Friedman-Meiselman findings for this study, it
should be noted that their approach was
sharply criticized in papers by Donald D. Hes­
ter [19], Albert Ando and Franco Modigliani
[10], and Michael DePrano and Thomas
Mayer [15], These critics particularly attacked
the Friedman-Meiselman definition of autono­
mous expenditures, and proposed and tested
the alternative definitions listed above. How­
ever, they also attacked the single-equation ap­
proach and recommended the use of large
models instead.
The tests of alternative equations must be
regarded as inconclusive in terms of which
variable—the money stock or autonomous
spending—is more closely related to the level
of income*9 Both approaches achieve values
for R 2 of 0.98 or 0.99 so that the unexplained
variance is very small in both cases. It seems
very unlikely that the addition of an interest
rate variable to the equations by using autono­
mous expenditures as the explanatory variable,
which addition would make the equations cor­
respond to equation 1 above, would make any
substantial difference.
9 For reasons that need not be explained here,
most of this controversy was conducted in terms of
equations with consumption rather than GNP as the
dependent variable. In the Friedman-Meiselman
study* however, results are reported for equations
with GNP [2, p. 227]. Such results are also reported
in [9, p. 17].




From this evidence it appears that ex post
explanations of the level of income are about
as accurate by using autonomous expenditures
alone as are those by using money stock alone.
But given the inaccuracies in forecasting au­
tonomous expenditures, it must be concluded
that ex ante explanations by using the money
stock are substantially more accurate than
those with forecasts of autonomous expendi-'
tures. From this evidence, the total random
term in equation 4 appears to have a substan­
tially smaller variance than the total random
term in equation 3.
For the reasons mentioned by the Fried­
man-Meiselman critics, evidence from single­
equation studies cannot be considered definitive.
But neither can the evidence be ignored, espe­
cially in light of the difficulties encountered
in the construction and the use of large
econometric models such as the FR-M IT
model.
EVIDENCE ON STABILITY OF DE­
MAND FOR MONEY FUNCTION. One of
the shortcomings of the single-equation studies
discussed above is that their authors paid too
little attention to the stability of regression
coefficients over time. Consider the following
statement by Friedman and Meiselman:
The income velocity of circulation of
money is consistently and decidedly sta­
bler than the investment multiplier except
only during the early years of the Great
Depression after 1929. There is through­
out, including those years, a close and
consistent relation between the stock of
money and consumption or income, and
between year-to-year changes in the stock
of money and in consumption or income
[2, p. 186].
This conclusion is based on correlation coeffi­
cients between money and income (or con­
sumption), but what is relevant for policy is
the regression coefficient, which determines
how much income will change for a given
change in the money stock. In the FriedmanMeiselman study, a table [2, p. 227] reports
the regression coefficient for income on money
as being 1.469 for annual data 1897-1958.

150

However, the same table reports regression
coefficients for 12 subperiods, some of which
are overlapping, ranging from 1.092 to 2.399.
With a few exceptions, most economists
agree that velocity changes can be explained in
part by interest rate changes.10 Thus, variabil­
ity in the regression coefficients when income
is regressed on money is not evidence of the
instability of the demand for money function.
To obtain some evidence on the stability of
this function, the following simple procedure
was used. Quarterly data were collected on the
money stock, GNP, and Aaa corporate bond
yields for 1947 through 1968. A demand for
money function was fitted by regressing the log
of the interest rate on the log of velocity, and
vice versa. The regressions were run for the
four periods, 1947 through 1960, 1947
through 1962, 1947 through 1964, and 1947
through 1966. The results inside each estima­
tion period were then compared with the re­
sults outside the estimation period.
The results of this process for the 1947-60
estimation period are shown in Figure 11. The
observations for 1947 through 1960 are repre­
sented by dots, and the observations for 1961
through 1968 by X ’s. The two least-squares
regressions— log interest rate on log velocity
and vice versa— fitted for the 1947-60 period
have been drawn. From Figure 11 it appears
that the relationship since 1960 has been quite
similar to the one prior to 1960.
Table 1 presents the results of applying a
standard statistical test to the regression and
postregression periods to determine whether
the demand for money function was stable. To
understand this table, refer first to section A of
the table, and to the 1947-60 estimation pe­
riod. Section A reports results from regressing
the log of velocity on the log of the Aaa cor­
porate bond rate, and the first row refers to
the regression for 1947 through 1960. The
square of the regression’s standard error of es­
timate is 0.00517 with 54 degrees of freedom.
There were 32 quarters in the postregression
10 F o r a convenient review of evidence on this sub­
ject, see [4],




FIG U RE 11

VELOCITY AND INTEREST RATE REGRESSIONS
Regressions Fitted to Quarterly Data, 1 9 4 7 -6 0
Log R R
6.69 1.9
! A. 1
6.05

1.8

B- 1
* =i

5.47

1.7

4.95

1.6 .

4.48

1.5 *

4.06

1.4 i

3.67

1.3 r

3.32

1.2 5

3.03

1.1

2.72

1.0 t

Observation in 1961 -6 8 period

/ / ,
. * *v/ / ,
/
* 9*

2.46
.7
2.01 2.23

.9

1.0

1.1
1.2
Log V

1.3

1.4

1.5

2.46

2.72

3.03

3.67

4.06

4.48 4.95

3.32

1.6

V

period 1961 through 1968, and for this period
the mean-square error of velocity from the ve­
locity predicted by the regression is 0.00836.
The ratio of the mean-square errors from re­
gression outside to those inside the estimation
period is given in the column labeled “F.” Since
the ratio of two mean squares has the F distri­
bution under the hypothesis that both mean
squares were produced by the same process,
an F test may be used to test whether the deTABLE 1: Tests of the Stability of the Demand for M oney
Function by Using Quarterly Data
A. Log velocity regressed on log Aaa corporate bond yield
Estim ation
period

Regression
(SEE)*

1 9 4 7 - 6 0 ..........00517
1 9 4 7 - 6 2 .......... 0 0 48 4
1 9 4 7 -6 4 ..........00509
1 9 4 7 -6 6 ..........00 50 2

Postregression

d.f.

M SE

d.f.

54
62
70
78

.0 0 8 3 6
.0 0 7 4 6
.00 587
.0 0 9 8 6

32
24
16

8

Significance
level
1 .6 2
1 .5 4
1 .1 5
1 .9 6

.10
. 10
> .2 5
. 10

B. Log Aaa corporate bond yield regressed on log velocity
Estim ation
period

Regression
(SEE)2

1 9 4 7 -6 0 .......... 00 6 8 4
1 9 4 7 - 6 2 .......... 0 0 61 4
1 9 4 7 - 6 4 .......... 0 0 57 0
1 9 4 7 - 6 6 ..........0053 7

‘ M SE < (SEE)1.

Postregression

d.f.

M SE

54
62
70
78

.0 0 5 S9
.00 723
.0 1 162
.0 2 1 9 2

32
24
16

Significance
level
1 .1 6 *
1 .1 8
2.0 4
4.0 8

> .2 5
> .2 5
.02 5
.00 5

RULES-OF-THUMB FOR POLICY

mand for money function has been stable. If
the function has been stable, then errors from
regression outside the period of estimation
should be, on the average, the same size as the
errors inside the period of estimation. For the
1947-60 regression being discussed, F = 1.62
and is significant at the 10 per cent level but
not at the 5 per cent level.
Looking at Table 1 as a whole it can be seen
that, for three of the regressions, the errors out­
side the period of estimation are not statistically
significantly larger than those inside the period
of estimation. Indeed, for the bond rate regres­
sion for the 1947-60 period, the errors outside
the period of estimation were actually smaller,
on the average, than those inside the period of
estimation. Over-all, however, these results
taken at face value cast some doubt on the
stability of the demand for money function.
However, there is reason to believe that
there are problems in applying the F test in
this situation. The reason is that the residuals
from regression exhibit a very high positive se­
rial correlation as indicated by Durbin-Watson
test statistics of around 0.15 for all of the re­
gressions. What this means is that the effective
number of degrees of freedom is actually less
than indicated in the table, and with fewer de­
grees of freedom the F ratios computed have
less statistical significance than the significance
levels reported in the table. The only way
around this problem is to run a more complex
regression that removes the serial correlation
of the residuals, but there is no general agree­
ment among economists as to exactly what
variables belong in such a regression. The vir­
tue of the simple regressions of velocity on an
interest rate and vice versa is that this form
has been used successfully by many investiga­
tors starting in 1954 [22].
The appropriate conclusion to be drawn
from this evidence would seem to be that the
relationship between velocity and the Aaa cor­
porate bond rate is too close and too stable to
be ignored, but not close enough and stable
enough to eliminate all doubts. However, the
question is not whether an ironclad case for a




money stock policy exists but rather whether
the evidence taken as a whole argues for the
adoption of such a policy. While there is cer­
tainly room for differing interpretations of Fig­
ure 11 and Table 1, and of the other evidence
examined above, on the whole all of these re­
sults seem to point in the same direction. It
appears that the money stock rather than in­
terest rates should be used as the monetary
policy control variable.

III. A M ONETARY RU LE FO R
GUIDING POLICY
RATIONALE FOR A RULE-OF-THUMB.
The purpose of this section is to develop a
rule-of-thumb to guide policy. Such a rule—
not meant to be followed slavishly—would
incorporate advice in as systematic a way as
possible. The rule proposed here is based upon
the theory and evidence in Sections II and III
and upon a close examination of post-accord
experience.
Individual policy-makers inevitably use in­
formal rules-of-thumb in making decisions.
Like everyone else, policy-makers develop cer­
tain standard ways of reacting to standard situ­
ations. These standard reactions are not, of
course, unchanging over time, but are adjusted
and developed according to experience and
new theoretical ideas. If there were no stand­
ard reactions to standard situations, behavior
would have to be regarded as completely ran­
dom and unpredictable. The word “capricious”
is often, and not unfairly, used to describe
such unpredictable behavior.
There are several difficulties with relying on
unspecified rules-of-thumb. For one thing, the
rules may simply be wrong. But an even more
important factor, because formally specified
rules may also be wrong, is that the use of un­
specified rules allows little opportunity for
cumulative improvements over time. A policy­
maker may have an extremely good operating
rule in his head and excellent intuition as to the
application of the rule but unless this rule can

be written down there is little chance that it
can be passed on to subsequent generations of
policy-makers.
An explicit operating rule provides a way of
incorporating the lessons of the past into cur­
rent policy. For example, it is generally felt
that monetary policy was too expansive follow­
ing the imposition of the tax surcharge in
1968. Unless the lesson of this experience is
incorporated into an operating rule, it may not
be remembered in 1975 or 1980. How many
people now remember the overly tight policy
in late 1959 and early 1960 that was a result
of miscalculating the effects of the long steel
strike in 1959? Since the FOMC membership
changes over time, many of the current mem­
bers will not have learned firsthand the lesson
from a policy mistake or a policy success 10
years ago. If the FOMC member is not an
economist, he may not even be aware of the
10-year-old lesson.
It is for these reasons that an attempt is
made in this section to develop a practical pol­
icy rule that incorporates the lessons from past
experience. The rule is not offered as one to
be followed to the last decimal place or as one
that is good for all time. Rather, it is offered
as a guide—or as a benchmark— against which
current policy may be judged.
A rule may take the form of a formal model
that specifies what actions should be taken to
achieve the goals decided upon by the policy­
makers. Such a model would provide forecasts
of goal variables, such as GNP, conditional on
the policy actions taken. The structure of the
model and the estimates of its parameters
would, of course, be derived from past data
and in that sense the model would incorporate
the lessons of the past.
But in spite of advances in modelbuilding
and forecasting, it is clear that forecasts are
still quite inaccurate on the average. In a study
of the accuracy of forecasts by several hundred
forecasters between 1953 and 1963, Zarnowitz
concluded that the mean absolute forecast
error was about 40 per cent of the average




year-to-year change in GNP [26, p. 4]. He
also reported, “there is no evidence that fore­
casters’ performance improved steadily over
the period covered by the data” [26, p. 5],
Not only are forecasts several quarters
ahead inaccurate but also there is considerable
uncertainty at, and after, the occurrence of
business-cycle turning points as to whether a
turning point has actually occurred. In a study
of FOMC recognition of turning points for
the period 1947-60, Hinshaw concluded that
[1, p. 122]:
The beginning data of the Committee’s
recognition pattern varied from one to
nine months before the cyclical turn. . . .
On the other hand, the ending of the rec­
ognition pattern varied from one to seven
months after the turn. . . . With the ex­
ception of the 1948 peak, the Committee
was certain of a turning point within six
months after the NBER date of the turn.
At the date of the turn, the estimated
probability was generally below 50; it
reached the vicinity of 50 about two
months after the turn.
This recognition record, which is as good as
that in 10 widely circulated publications whose
forecasts were also studied in [2], casts further
doubt on the value of placing great reliance on
the forecasts.11
Given the accuracy of forecasts at the cur­
rent state of knowledge,12 it seems likely that
for some time to come forecasts will be used
primarily to supplement a policy-decision-making process that consists largely of reactions to
current developments. Only gradually will poli­
cy-makers place greater reliance on formal

^ 0r further analysis of forecasting accuracy, see
12 The accuracy of forecasts may now be better
than in the periods examined in the studies cited
above. But without a number of years of data there
would be no way of knowing whether forecasts have
improved, and so forecasts must in any case be as­
sumed to be subject to a wide margin of error at the
present time.

RULES-OF-THUMB FOR POLICY

forecasting models.13 While a considerable
amount of work is being done on such models,
essentially no attention is being paid to careful
specification of how policy should react to cur­
rent developments. While sophisticated models
will no doubt in time be developed into highly
useful policy tools, it appears that in the
meantime relatively simple approaches may
yield substantial improvements in policy.
Given that knowledge accumulates rather
slowly, it can be expected that carefully speci­
fied but simple methods will be successful be­
fore large-scale models will be. Careful specifi­
cation of policy responses to current develop­
ments is but a small step beyond intuitive
policy responses to current developments. This
step surely represents a logical evolution of the
policy-formation process.
POST-ACCORD MONETARY POLICY.
That an operating guideline is needed
can be seen from the experience since the
Treasury-Federal Reserve accord. In order
that this experience may be understood better,
subperiods were defined in terms of “stable,”
“easing,” or “firming” policy as determined
from the minutes of the Federal Open Market
Committee. The minutes used are those pub­
lished in the Annual Reports of the Board of
Governors of the Federal Reserve System for
1950 to 1968. The definitions of “stable,”
“easing,” and “firming” periods are necessarily
subjective as are the determinations of dates
when policy changed.14 The dating of policy
13 It may be objected that great reliance is already
placed on forecasts, at least on judgmental forecasts.
However, these forecasts typically involve a large ele­
ment of extrapolation of current developments. It
seems fair to say that in most cases in which condi­
tions forecast a number of quarters ahead differ
markedly from current conditions, policy has fol­
lowed the dictates of current conditions rather than
of the forecasts.
14 The author was greatly assisted in these judg­
ments by Joan Walton of the Special Studies Section
of the Board’s Division of Research and Statistics.
Miss Walton, who is not an economist, carefully
read the minutes of the entire period and in a large
table recorded the principal items that seemed impor­
tant at each FOMC meeting. Having a noneconomist




changes was based primarily on the FOMC
minutes, although the dates of changes in the
discount rate and in reserve requirements were
used to supplement the minutes. “Stable” peri­
ods are those in which the policy directive was
unchanged except for relatively minor wording
changes. In some cases the directive was es­
sentially unchanged although the minutes re­
flected the belief that policy might have to be
changed in the near future. While the Manager
of the System Open Market Account might
change policy somewhat as a result of such
discussions, the unchanged directive was taken
at face value in defining policy turning points.
More difficult problems of interpretation
were raised by such directives as “unchanged
policy, but err on the side of ease,” or “resolve
doubts on the side of ease.” Such statements
were used to help in defining several periods
during which policy was progressively eased
(or tightened). For example, in one meeting
the directive might call for easier policy, the
next meeting might call for unchanged policy
but with doubts to be resolved on the side of
ease, and a third meeting might call for further
ease. These three meetings would then be
taken together as defining an “easing” period.
However, unless accompanied by other FOMC
meetings clearly calling for a policy change,
statements such as those calling for an “un­
changed policy with doubts resolved on the
side of ease” were interpreted as not calling
for a policy change.
Some important monthly economic time se­
ries for the post-accord period are plotted in
Figure 12. The heavy vertical lines represent
periods of “stable,” “easing,” and “firming”
policy as indicated by “S,” “E,” and “F” at the
bottom of the figure. Except for the unemploy­
ment rate, the average of each series for each
policy period has been plotted as a horizontal
line.
read the minutes tempered the inevitable tendency
for an economist to read either too much or too lit­
tle into the minutes. However, the final interpretation
of the minutes rested with the author.

154

Two features of the post-accord experience
are especially noteworthy. First, decisions to
change policy have been taken about as close
to the time when, in retrospect, policy changes
were needed as could be expected in the light
of existing knowledge.15 There have been mis15 F or additional views on the tim ing of Federal
Reserve decisions, see [13] and [1].

takes in timing, but the over-all record is im­
pressive. The second major feature of this pe­
riod is that policy actions, as opposed to
policy decisions, have been in the correct
direction if policy actions are defined by either
free reserves or interest rates, but not if policy
actions are defined in terms of either the
money stock or bank credit.

FIGURE 12

POST-ACCORD MONETARY POLICY




B illion s o f d ollars

RULES-OF-THUMB FOR POLICY

To examine the timing question in more de­
tail, a useful comparison is that between busi­
ness cycle turning points (as defined by the
National Bureau of Economic Research) and
decisions to change policy. The post-accord
period begins at a time when the U.S. econ­
omy was beset by inflation stemming from the
war in Korea. The dates of the principal

changes in policy and of the business cycle
peaks and troughs are listed in Table 2. The
policy dates are those that define the beginning
of the “stable,” “easing,” and “firming” peri­
ods indicated in Figure 12.
The decision to ease policy was made prior
to the business cycle peaks of July 1953 and
May 1960. The decision in 1957 was made in

155

FIGURE 12 (CONCLUDED)

POST-ACCORD MONETARY POLICY
B illio n s o f d o llars

10

0

TREASURY BILL RATE

3 -m o n th

; 2
1

.




.

o
Per cent

‘ 6
4

0

156

the fourth month following the cycle peak in
July, but as can be seen from Figure 12, the
unemployment rate had not risen very much
through October. Given the amount of uncer­
tainty always present in interpreting business
conditions, this lag must be considered to be
well within the margin of error to be expected
for stabilization policy. However, the easing
policy decision in 1968 was clearly a mistake
in retrospect but not in prospect given the ex­
pectations held by the majority of economists
that the tax increase would significantly temper
the economic boom.
TABLE 2: Dates of Principal Monetary Policy Decisions
and of Business Cycle Peaks and Troughs
B u siness cycle
Turning
p oin t

D ate

Peak

1953, July

Trough

1954, A ugust

Peak

1957, July

Trough

1958, April

Peak

1960, M ay

Trough

1961* February

F O M C p olicy decisions
P olicy

Starting date

A ccord
Firm ing
Stable
E asing
Stable
Firm ing
Stable
Easing
Stable
F irm ing
S table
Easing
Stable
Firm ing
Stable
Firm ing
Stable
Firm ing
Stable
Firm ing
Stable
Firm ing
Stable
Firm ing
Stable
Easing
Stable
Firm ing
Stable
Easing
Stable
Firm ing
Stable

1951— M ar. 1 -2
1952— Sept. 25
D ec. 8
1953— June II
D ec. 15
1954— D e c . 11
1955— O ct. 4
1957— N o v . 12
1958— A pr. 15
July 29
1959— June 16
1960— M ar. 1
A ug. 16
1961— O ct. 24
N o v . 14
1962— June 19
July 10
D ec. 18
1963— Jan. 8
M ay 7
A u g. 20
1964— A u g. 18
1965— M ar. 2
D e c . 14
1966— Sept. 13
N ov. 1
1967— M ay 2
N o v . 27
1968— Apr. 30
July 16
A ug. 13
D ec. 17
1969— Apr. 29

Firming policy decisions were also generally
well timed. Following the 1953-54 recession,
decisions to firm policy in small steps were
taken from December 1954 to September
1955, as unemployment declined to about 4
per cent of the labor force. During the recov­
ery period after the 1957-58 recession, firming
decisions were taken from July 1958 to May
1959. There was also a series of firming deci­
sions taken from the end of 1961 to 1966. Es­
pecially noteworthy are those taken from De­



cember 1965 to August 1966, in response to
the beginning of inflation associated with the
escalation of military activity in Vietnam. The
easing policy decisions taken in late 1966 and
early 1967 were fully appropriate in light of
the economic slack that developed in 1967.
Even from the point of view of those who
doubt the importance of fiscal policy, this rec­
ord of the timing of policy decisions in the
post-accord period is remarkably good. The
timing record does not suggest that much at­
tention was paid to forecasts, but this lack of
attention was perhaps not unfortunate given
the accuracy of forecasts during the period.
From this point of view, the only real mistake
was the easing decision taken in 1968. Of
course, those who believe that a steady rate of
growth of the money stock is better than any
discretionary policy likely to be achieved in
practice may read this record as supporting
their thesis. But the post-accord record of the
timing of policy decisions is certainly encour­
aging to those who believe that the lags in the
effects of policy are short enough, and the ef­
fects predictable enough, to make discretionary
monetary policy a powerful stabilization tool if
only decisions can be made promptly.
While the System’s performance in the tim­
ing of policy decisions has been commendable,
the same cannot be said for the actions taken
in response to the decisions. In the earlier dis­
cussion the purposely vague terms “easing,”
“firming,” and “stable” were used to describe
policy decisions. These terms were meant to
convey the notions that policy-makers wanted,
respectively, to accelerate, decelerate, or main­
tain the pace of economic advance. The ques­
tion that must now be examined is whether
policy actions did in fact tend to accelerate,
decelerate, or maintain the level of economic
activity.
Policy actions were in accord with policy
decisions if these actions are measured by ei­
ther the 3-month Treasury bill rate or free re­
serves. The bill rate rose in “firming” periods,
fell in “easing” periods, and tended to remain
unchanged in “stable” periods. However, there

RULES-OF-THUMB FOR POLICY

was some tendency for the bill rate to rise in
“stable” periods following “firming” periods,
and to fall in “stable” periods following “eas­
ing” periods, a pattern not inconsistent with
the interpretation of policy being offered in
this study. Similar comments apply to free re­
serves.
But the picture is quite different if policy
actions are measured by the rate of growth of
the money stock. Careful study of Figure 12
will make this point clear. The growth rate de­
clined in response to the “firming” policy deci­
sion in late 1952, and again in the “stable” pe­
riod in early 1953. This behavior was, of
course, consistent with the “firming” decision.
But the rate of growth declined further follow­
ing the “easing” decision in June 1953 and re­
mained low until the middle of 1954. The un­
employment rate rose rapidly from its low of
2.6 per cent at the cycle peak in July 1953 to
6.0 per cent in August 1954, the cycle trough;
the money stock was at the same level in April
1954, 9 months following the cycle peak and
10 months following the decision to adopt an
“easing” policy, as it had been at the peak.
The same pattern that had appeared during
the 1953-54 recession appeared again at the
time of the 1957-58 recession. The rate of
growth of the money stock declined in 1957
prior to the cycle peak. (The Treasury bill
rate also rose substantially.) But after the de­
cision to adopt an “easing” policy in Novem­
ber 1957, the growth rate of the money stock
declined further. From October 1957 to Janu­
ary 1958, the money stock fell at a 2.9 per
cent annual rate; from the cycle peak in July
to October it had fallen at a 1.5 per cent an­
nual rate.
The rate of growth of the money stock in­
creased substantially in February 1958, and it
remained at the higher level during the “sta­
ble” policy period April to July. There fol­
lowed a period of “firming” policy decisions
from the end of July 1958 to May 1959; how­
ever, the average growth rate of the money
stock during this period was virtually identical
to the average in the preceding “stable” pe­




riod. But in the “stable” period from June
1959 to February 1960, the rate of growth of
money, at —2.2 per cent, was much lower
than in the preceding “firming” period. This
rate of growth of money can hardly be consid­
ered appropriate in the light of the fact that
except for one month the unemployment rate
was continuously above 5 per cent. However,
the picture was confused by a long steel strike.
The decision to ease policy was taken on
March 1, 1960, but the rate of growth of the
money stock remained negative until July. The
rate of growth of money fell following the
“firming” policy decisions of October 1961
and June 1962. In spite of another firming de­
cision in December 1962 the rate of growth
then increased, and it continued to rise during
the “firming” period in 1963, maintaining the
same rate in the following “stable” period. In
August 1964, another “firming” decision was
taken, and the growth rate trended down dur­
ing the “firming” period from August 1964 to
February 1965.
During the “stable” period from March to
November 1965, the Vietnam war heated up.
In the second half of 1965 the growth rate of
money was 6.1 per cent compared with 3.0
per cent during the first half. The “firming”
policy decision came in December, but the rate
of growth of money averaged over 6 per cent
for the months December through April 1966.
At this point monetary growth ceased. In Jan­
uary 1967 the money stock was actually less
than in May 1966—there having been no in­
crease in the growth rate in the months imme­
diately following the “easing” decision of
November 1, 1966.
The growth rate of money then accelerated
during the “stable” period from May through
October 1967; for the period as a whole
growth averaged 8.7 per cent. In the following
“firming” period November 1967 through
April 1968, the rate of growth of the money
stock was lower but it was still relatively high
at 5.1 per cent. The growth rate then rose to
9.6 per cent in the “stable” period May
through July 1968 and thereafter fell to a little

less than 6 per cent in the July-November
1968 period following the “easing” decision of
July 16, 1968.
There ensued a “firming” period from De­
cember 1968 through April 1969. Although
original figures indicated that monetary growth
was relatively little during this period, a revi­
sion in the money stock series showed that the
rate averaged 5.5 per cent for the period as a
whole. The rate following April was lower, es­
pecially in the June-December 1969 period,
which saw no net growth in the money stock.
A broadly similar view of the timing of pol­
icy actions is obtained from a careful examina­
tion of the rate of growth of total bank credit.
However, as shown in Figure 12, this series is
quite erratic and much more difficult to inter­
pret than the series on the rate of growth of
the money stock.
The proper way to interpret these results
would seem to be as follows. When interest
rates fell in a recession, policy was easier than
it would have been if interest rates had not
been permitted to fall. But if the money stock
was also falling, or growing at a below-average
rate, policy was tighter than it would have
been had money been growing at its long-run
average rate. Similar statements apply to rising
interest rates and above-average monetary
growth in a boom.
A MONETARY RULE. Given the argu­
ments of Sections I and II on the advan­
tages of controlling the money stock as op­
posed to interest rates, a logical first step in
developing a policy guideline is to examine
cases clearly calling for ease or restraint. Con­
sider first a recession. To insure that monetary
policy is expansionary, the rule might be that
interest rates should fall and the money stock
should rise at an above-average rate. This pol­
icy avoids two possible errors.
The first is illustrated in Figure 13. If the IS
function shifts down from ISX to IS 2 while the
LM function shifts from LM X to LM2, the in­
terest rate will fall from rx to r2. The shift from
LMi to LMn could be caused by a shift in the




demand for money with the stock of money
unchanged. But this shift could also be caused
by a decline in the stock of money, perhaps
because of an attempt by policy-makers to
keep the interest rate from falling too rapidly.
However, in terms of income it is clearly bet­
ter to permit the interest rate to fall to r3 by
maintaining the stock of money fixed, and bet­
ter yet to shift the LM function to the right of
LM! by increasing the stock of money.
The point is the simple one that monetary
policy should not rely simply on a declining
interest rate in recession but should also insure
that the money stock is growing at an ade­
quate rate. The LM function may still shift to
LMo in spite of monetaiy growth because of an
increased demand for money; without the
monetary growth, however, this shift in the de­
mand for money would push the LM function
to the left of LM 2 and income would be even
lower.
The second type of error avoided by the
proposed policy rule is illustrated in Figure 14.
Again, it is assumed that the situation is one
of recession. With a fixed money stock, an in­
crease in the demand for money will shift the
LM function from LM t to LM2, tending to re­
duce income. However, if the interest rate is
prevented from rising above rl9 the increased
demand for money is met by an increased sup­
ply of money.
Maintaining monetary growth and a declin­
ing interest rate in recession insures that the
contribution of monetary policy is expansive.
Increases in the demand for money, unless ac­
companied by a falling IS function, are fully
offset by preventing increases in the interest
rate. The greater the fall in the IS function the
smaller the offset to an increased demand for
money. However, in no case should a fall in
the IS function be permitted to cause a fall in
the money stock.
The policy proposed does not, of course,
guarantee an expansion of income. No such
guarantee is possible because downward shifts
in the IS function may exceed any specified

RULES-OF-THUMB FOR POLICY

shift in the LM function. But more important
than theoretical possibilities are empirical
probabilities. For all practical purposes the
problem is not how to insure expansion in a
recession but how to trade off the risks of too
much expansion against too little. The discus­
sion of Figures 13 and 14 was entirely in
terms of encouraging income expansion, or
limiting further declines, in the face of de­
pressing disturbances. But disturbances may be
expansionary in a recession, and such disturb­
ances may combine with expansionary policy
to create overly rapid recovery from the reces­
sion.
Consider again Figure 13, but suppose the
initial position is as shown by IS 2 and LM2. If
the interest rate is not permitted to rise, a shift
to /Si will lead to a large increase in income to
the level given by the intersection of ISX with a
horizontal LM function drawn at r2. This situ­
ation can be avoided only if the interest rate is
permitted to rise. The natural question is how
the interest rate can be permitted to rise within
a recession policy of pushing the interest rate
down and maintaining above-average monetary
growth. The answer is that the recession policy
FIGURE 13




should be followed only if the interest rate can
be kept from rising with a monetary growth
rate below some upper bound.
Exactly the same analysis running in reverse
applies to a policy for checking an inflationary
boom. In a boom interest rates should rise and
monetary growth should be below average.
However, there must be a lower limit on mon­
etary growth to avoid an unduly contraction­
ary policy. Having presented the basic ideas
behind the formulation of a monetary rule, it
is now necessary to become more specific
about the rule. After specifying the rule in de­
tail, it will be possible to discuss the considera­
tions behind the specific numbers chosen.
The proposed monetary policy rule-ofthumb is given in Table 3. The rule assumes
that full employment exists when unemploy­
ment is in the 4.0 to 4.4 per cent range and
that monetary growth in the 3 to 5 per cent
range is consistent with price stability. At full
employment the Treasury bill rate may rise or
fall, either because of market pressures or be­
cause of small adjustments in monetary policy;
however, monetary growth should remain in
the 3 to 5 per cent range.

159

TABLE 3: Proposed Monetary Policy Rule-of-Thumb
In per cent
R u le fo r m o n th 1
U n em p loym en t rate
previous m onth

0 - 3 . 4 .......................................
3 . 5 - 3 . 9 .......................................
4 . 0 - 4 . 4 ........................................
4 . 5 - 4 . 9 ........................................
5 . 0 - 5 . 4 ........................................
5 . 5 - 5 . 9 ........................................
6 . 0 - 1 0 0 . 0 ...................................

D irection o f
Treasury bill
rate (3-m onth)

G row th o f m oney
stock (annual rate)

R isin g
R isin g
R isin g or falling
F alling
Falling
F alling
Falling

2 1 -3
1 2 -4
3 -5
* 4 -6
* 5 -7
afr-8
6 -8

1 T he 3-m onth bill rate is to be adjusted in the indicated direction
provided that m onetary grow th is in the indicated range. I f the bill
rate change ca n n o t be achieved within the m onetary grow th rate
guideline, then the bill rate guideline should be aband oned.
s I f the bill rate the previous m on th w as b elow the bill rate 3 m on th s
prior to that, then the upper and low er lim its on m onetary grow th are
b oth increased by I per cent.
* I f the bill rate the previous m onth was a b o v e the bill rate 3 m o n th s
prior to that, then the upper and low er lim its on m onetary grow th are
b oth reduced by 1 per cent.

When unemployment drops below 4 per
cent, the rule calls for a restrictive monetary
policy. The bill rate should rise and monetary
growth should be reduced. If the bill rate and
monetary growth guidelines are not compati­
ble, then the monetary guideline should be
binding. For example, suppose that unemploy­
ment is in the 3.5 to 3.9 per cent range. If mon­
etary growth below 2 per cent would be re­
quired to obtain a rising bill rate, then
monetary growth should be 2 per cent and the
bill rate be permitted to fall. If this situation
persists so that the bill rate falls for several
months in spite of the low monetary growth,
then the limits on monetary growth should be
increased as indicated in footnote 2 to Table
3. The reason for this prescription is that the
bill rate on the average turns down 1 month
before the peak of the business cycle [21, p.
111]. Unemployment, on the other hand, may
increase relatively little in the early months
following a cycle peak. Tying monetary growth
to the bill rate in the way indicated in footnote
2 of Table 3 produces a more timely adjust­
ment of policy than relying on the unemploy­
ment rate alone.
The proposed rule calls for a falling bill rate
and a relatively higher rate of monetary
growth as unemployment rises above the
4.0 to 4.4 per cent range. The rule for high un­




employment situations calls for adjusting the
monetary growth rate downward when the bill
rate is consistently rising as indicated by foot­
note 3 to Table 3. The reasoning behind this
adjustment is exactly parallel to the reasoning
above for low unemployment situations.
The proposed monetary rule has the virtues
of simplicity and dependence on relatively
well-established economic doctrine. Because of
its simplicity, the basic ideas behind the rule
can be explained to the noneconomist. The
simplicity of the rule also will make possible
relatively easy evaluations of the rule’s per­
formance in the future if the rule is followed.
With more complicated rules it would be much
more difficult to know how to improve the rule
in the future because it would be difficult to
judge what part of the rule was unsatisfactory.
Since, as has been repeatedly emphasized
above, the rule is not proposed as being good
for all time, it is best to start with a simple
rule and then gradually to introduce more var­
iables into the rule as experience accumulates.
In designing the rule, the attempt was made
to base the rule on fairly well-established eco­
nomic knowledge. There is, of course, a great
deal of debate as to just what is and what is
not well established. What can be done, and
must be done, is to explain as carefully as pos­
sible the assumptions upon which the rule is
based, with full recognition that other econo­
mists may not accept these assumptions.
First, the evidence for the importance of
money is impressive. It seems fair to say that
very few economists believe today that changes
in the stock of money have nothing to do with
business fluctuations. Rather, the argument is
over the extent to which monetary factors are
important. Some no doubt will feel that the 2percentage-point ranges on monetary growth
specified by the rule are excessively narrow;
however, it should be noted that a 4 per cent
growth rate is double a 2 per cent growth rate.
Also important is the fact that the rule is
meant to serve as a guideline rather than be
absolutely binding. Since policy should deviate

RULES-OF-THUMB FOR POLICY

from the rule if there is good and sufficient
reason—such as wartime panic buying—a fur­
ther element of flexibility exists within the
framework of the rule.
The rule is specified in terms of changes in
the bill rate and the monetary growth rate,
with the monetary growth rate being tied to
the unemployment rate and to changes in the
bill rate in the recent past. This formulation
has been designed to avoid what seem to be
the most obvious errors of the past. Over the
years the monetary growth rate has been low­
est at business cycle peaks and in the early
stages of business contractions, and highest at
cycle troughs and in the middle stages of busi­
ness expansions. The highest rate of monetary
growth since the Treasury-Federal Reserve
accord has been during the inflation associated
with escalation of military operations in Viet­
nam. For purposes of smoothing the business
cycle, so far as this author knows, there is no
theory propounded by any economist that
would call for high monetary growth during
inflationary booms and low monetary growth
during recessions. Such behavior of the money
stock could only be optimal within a theory in
which money had little or no effect on business
fluctuations and in which other goals such as
interest rate stability were important.
Being based on the unemployment rate and
bill rate changes in the recent past, the pro­
posed monetary rule does not rely on forecast­
ing. Nor does the rule depend on the current
and projected stance of fiscal policy. Both of
these factors ought to be included in applying
the rule by adjusting the rate of growth of the
money stock within the rule limits, or even by
going outside the limits. But given the accu­
racy of economic forecasts under present
methods, and given the current uncertainty
over the size of the impact of fiscal policy (not
to mention the hazards in forecasting Federal
receipts and expenditures), it does not appear
that these variables can be systematically in­
corporated into a rule at the current state of
knowledge.




TESTS OF THE PROPOSED RULE.
Three types of evidence on the value of the
rule are examined below. The first approach
involves a simple comparison of the rule with
the historical record to show that the rule
would generally have been more expansionary
(contractionary) than actual policy when ac­
tual policy—in the light of subsequent eco­
nomic developments—might be judged to have
been too contractionary (expansionary). The
second approach examines the cyclical behav­
ior of the estimated residuals from a simple
demand for money function to show that it is
unlikely that the proposed rule would interact
with the disturbances to produce an exces­
sively inflationary or deflationary impact. Both
these approaches are deficient because they
rely heavily on the historical record, a record
that would have been quite different had the
rule been followed in the past. To avoid this
difficulty, a third approach uses simulation of
the FR-M IT model, but the results do not ap­
pear very useful because of shortcomings in
this model.
An impressionistic examination of the rule.
Broadly speaking, the results of comparing the
rule with the historical record since the Treas­
ury-Federal Reserve accord in March 1951
are these. The rule would have provided a
substantially tighter monetary policy than the
actual during the inflationary period from the
accord until about September 1952. At that
point, actual policy as measured both by the
rate of growth of the money stock and by the
3-month bill rate became considerably tighter.
In the last quarter of 1952, actual policy was
in accord with the rule, but thereafter it tight­
ened even further. In the 9 months following
the cyclical peak in July 1953, the money
stock had a zero rate of growth while the un­
employment rate rose from 2.6 per cent to 5.9
per cent. Under the rule the rate of growth of
the money stock would never have gone below
1 per cent and would have steadily increased as
unemployment rose.
Actual policy became more expansive in the

second quarter of 1954, and the cycle trough
was reached in August. However, the rule
would have been considerably more expansive,
and it would have remained more expansive
than the actual all through the 1955-56 boom.
Inasmuch as the unemployment rate remained
near 4.0 per cent from May 1955 through Au­
gust 1957, the rule would have been too infla­
tionary during this period. However, it can be
argued that monetary policy was overly restric­
tive before the cycle peak in July 1957, since
in the year prior to the peak the money stock
grew only by 0.7 per cent. Less subject to dis­
pute is the fact that policy was far too restric­
tive after the peak; in the 6 months following
the peak the money stock fell at an annual
rate of 2.2 per cent, and at the same time the
unemployment rate rose from 4.2 per cent to
5.8 per cent.
The rule would have been considerably
more expansive all during the high unemploy­
ment period of 1958-59, and it would have
prevented the declines in the money stock in
late 1959 and early 1960. At the peak in May
1960 the unemployment rate was 5.1 per cent,
and the money stock had fallen by 2.1 per
cent in the previous 12 months. Unlike the pe­
riods following peaks in 1954 and 1957, pol­
icy became more expansive immediately after
the May 1960 peak, although not so expansive
as called for by the proposed rule.
From the trough in February 1961 through
June 1964, the unemployment rate never de­
clined below 5 per cent. Under the rule, policy
would have been more expansive than the ac­
tual policy followed throughout this period,
especially as compared with the MarchSeptember 1962 period, during which the
money stock fell slightly. Unemployment fell
rapidly in 1965 with the Vietnam build-up; the
rule would have been more expansive than ac­
tual through July 1965 and then less expansive
than actual through April 1966. Indeed, in the
9-month period prior to April 1966, with the
unemployment rate falling from 4.4 per cent to
3.8 per cent, monetary growth accelerated to a




6.6 per cent annual rate; the proposed rule
would have first called for monetary growth in
the 3 to 5 per cent range, and then in the 2 to 4
per cent range starting in February 1966, fol­
lowing the drop in the unemployment rate
below 4.0 per cent in January. Finally, the
negative growth rates of money in the 1966
credit crunch would have been avoided under
the rule, as would the high rates of growth in
1967 and 1968.
This impressionistic look at the proposed
rule may be supplemented by a simple scoring
system for judging when the rule would have
been in error. For each month during the sam­
ple period it was determined whether the rule
would have been more or less expansive than
the actual policy, or about the same as the ac­
tual policy. The unemployment rate 12 months
from the month in question was used to indi­
cate whether or not the policy was correct,
with a desired range of unemployment of 4.0
to 4.4 per cent. The rule was deemed to have
made an error if: (1) the actual policy was in
accord with the rule, but unemployment 12
months later was not in the desired range; (2)
the rule called for a more expansive policy
than the actual, and unemployment 12 months
later was below the desired range; and (3) the
rule called for a less expansive policy than the
actual, and unemployment 12 months later
was above the desired range.
Since the latest data used in this analysis
were for July 1969, comparison of the rule with
actual policy ends July 1968. Starting the sam­
ple with 1952, the first full year after the accord,
provides a total of 199 months. Based on the
criterion described above, the rule would have
been in error in 63 months. If the criterion is
changed by substituting the unemployment rate
9 months ahead instead of 12 months ahead,
the rule has 62 errors; using the unemployment
rate 6 months ahead yields 59 errors.
Some of these errors are of negligible im­
port. For example, in March 1953 the rule
calls for a money growth rate of 2 to 4 per
cent, but the actual was 1.9 per cent. Thus,

RULES-OF-THUMB FOR POLICY

the rule would have been more expansive than
the actual this particular month, a mistake
since unemployment was too low and inflation
too high during this period. However, the rule
would have been less expansive than actual in
every one of the preceding 6 months and in
all but one of the 6 months following this
“mistake.” Except for scattered errors such as
the one just discussed, most of the rule errors
occurred in two separate periods. The first is
the 2-year period following the cycle trough in
August 1954, during which time the rule
would have been too expansive. The second is
the last half of 1964 and the first half of 1965,
when the rule would have been too expansive
in light of the subsequent sharp decline in un­
employment.
Unless one has completed a careful exami­
nation of the data, there is a tendency to un­
derestimate how rapidly the economy can
change. For example, from the cycle peak in
July 1953 to the cycle trough 13 months later,
the unemployment rate rose by 3.4 percentage
points; and from the peak in July 1957 to the
trough 9 months later in April 1958, it rose by
3.2 percentage points. Changes in the other
direction have tended to be somewhat less
rapid, but significant nonetheless. In the year
following the trough in August 1954, the un­
employment rate declined 2.0 percentage
points, and it declined 2.2 percentage points in
the year following the trough in April 1958. In
January 1965 unemployment was 4.8 per cent
and the problem was still one of how to reach
full employment. A year later the rate was 3.9
per cent and the problem was inflation.
Thus, it appears that for the most part the
rule would have been superior to policy actu­
ally followed. Of course, the rule is not in­
fallible and would have erred on a number of
occasions. But in spite of these errors— and it
should be recognized that some errors are
inevitable no matter what rule or which discre­
tionary policy-makers are in charge—the pro­
posed rule has the great virtue of turning policy
around promptly as imbalances develop.




Relationship of the rule to monetary dis­
turbances. Since the rule was developed on
the basis of the theoretical and empirical anal­
ysis of Sections I and II, which emphasized
the relative stability of the demand for money,
it is appropriate to conduct a systematic exam­
ination of the disturbances in the demand for
money. It will be recalled that the rule was
formulated in such a way as to insure expan­
sionary policy action in a recession and con­
tractionary policy action in a boom. However,
it was recognized that disturbances in the ex­
penditure sector and/or in the monetary sector
might reinforce policy actions leading to an ex­
cessively expansionary or contractionary effect
on income. If there were a significant chance
of these excessive effects occurring, then the
rule proposed would be overly “aggressive”
and a rule involving a smaller range of mone­
tary growth rates would be in order.
To provide some evidence of the effect of
disturbances in the money demand function,
the residuals from the simple velocity function
tested in Section II were examined carefully.
The technique involved regressing velocity on
the Aaa corporate bond rate, and vice versa,
for the 1947-68 period and then comparing
the residuals with turning points in the busi­
ness cycle. The reader may make these com­
parisons visually from Figure 15. At the bot­
tom of this figure cycle peaks and troughs are
identified bv “P” and “T,” respectively.
The residuals from the estimated equations
suggest that the demand for money has con­
tractionary disturbances near business cycle
peaks and expansionary disturbances near
cycle troughs. The residuals have the same
turning points for the regression of velocity on
the interest rate as for the regression of the
interest rate on velocity. The residual peaks
occur at or before the cycle peaks, while the
residual troughs occur at or after the cycle
troughs.
To assess the significance of these findings,
consider the following simple view as to the
dynamics of monetary effects. In the short run,

be littie danger that the rule would be overly
expansionary because after the cycle trough,
while policy is still expansionary, contractive
shifts in the demand for money occur.
Simulations of the FR -M IT model. The
final technique used to test the proposed mon­
etary rule was to simulate the FR -M IT model
under the rule. As explained below, the results
are of questionable value but are presented
anyway for the sake of completeness and in
order not to suppress results unfavorable to
the proposed rule.
To simplify the computer programming, the
rule used in the simulations is not exactly the
same as the one proposed in Table 3 above.
The proposed rule, it will be recalled, involved
a bill rate guideline and a money stock guide­
line. If, for example, the bill rate cannot be
pushed up without pushing monetary growth

income is a predetermined variable in the de­
mand for money function. An increase in the
money stock makes the interest rate lower
than it would be otherwise, and this eventually
leads to expansion in investment and income.
A downward disturbance in the demand for
money function has the same effect.
Given this view of monetary dynamics, Fig­
ure 15 suggests the following conclusions.
Shifts in the demand for money tend to be
contractive in their effect on income in the late
stages of a business cycle expansion, implying
that a restrictive monetary policy must not be
pushed too hard. Then, shortly before the
cycle peak, the shifts apparently tend to be­
come expansive. This effect is fortunate since
it is only after the cycle peak that rising unem­
ployment would trigger a policy change under
the proposed rule. However, there appears to

RESIDUALS FROM VELOCITY REGRESSION COMPARED WITH BUSINESS-CYCLE TURNING POINTS
Per cent

rj

LOG

■
VELO CITY

\




RESIDUAL

<
Period

r

Regression: log V=.0 5 4 + .8 5 4 log R
of e stim a tio n : 1 9 47 -6 8

■
2
:i
R =.901 ;
J

RULES-OF-THUMB FOR POLICY

FIG U R E 16

SIMULATIONS OF UNEMPLOYMENT IN FR-MIT MODEL
Per c e n t

'

’58

'60

'62

’64

’66

4

’68

1958

’60

’64

’62

Per c e n t

’66

’68
Per c e n t

Pe r c e n t

4

Is
0
1960
A

’62

’64

’66

’68

1962

'64

’66

’68

1964

’66

’68

A c tu a l

S Rule sim ulation
• Control sim ulation

below the lower limit in the money guideline,
the proposed rule calls for setting monetary
growth at its lower limit. The simulation rule,
on the other hand, ignores the bill rate guide­
line and simply sets the monetary growth rate
at the midpoint of the range specified by the
proposed rule.
Another difference, and no doubt a more
important one, between the proposed rule and
the simulation rule is that the simulation rule
had to be specified in terms of quarterly data
since the F R -M IT model uses quarterly data.
In the simulation rule, the growth of the



money stock depends on the level of unem­
ployment determined by the model in the pre­
vious quarter. The growth rate of the money
stock was modified by past changes in the bill
rate, as in footnotes 2 and 3 to Table 3, ex­
cept that the relevant bill rate change was in
terms of the previous quarter compared with
the quarter before that. The simulation rule,
then, reacts somewhat more slowly to unem­
ployment trends than does the proposed rule.
In order to investigate the importance of the
starting point, simulations were run with start­
ing dates in the first quarters of 1956, 1958,

1960, 1962, and 1964. The simulated unem­
ployment rate for the five simulations is shown
in the five panels of Figure 16 by the curves
marked “S.” The actual unemployment rate is
shown by the curves marked “A,” and control
simulations, to be explained below, by the un­
connected points.
It is clear from Figure 16 that the simula­
tion rule for money growth produces an unsta­
ble unemployment rate. However, because of
deficiencies in the model this result is probably
not very meaningful. That the model is defec­
tive can be seen by comparing unemployment
in the control simulations with the actual un­
employment. In the control simulations all of
the model’s exogenous variables, including the
money stock, were set at their actual levels.16
Even with the exogenous variables set at their
actual levels, the simulated level of unemploy­
ment at times differs from the actual level.
Because of the role of the stochastic disturb­
ances in the model, especially as they feed
through lagged endogenous variables, it cannot
be expected that control simulations will ex­
actly duplicate the actual results. But the fact
that the control simulations differ from the ac­
tual by considerable margins over long periods
of time strongly suggests that the money rule
simulations do not provide much useful infor­
mation on the properties of the proposed rule.
The simulations are valuable in one respect,
however. An examination of Figure 16
strongly suggests that the money rule is inter­
acting with the rest of the model to produce a
16 The FR-M IT model was estimated with the
money stock as an endogenous variable. There are
separate equations for currency and demand deposits,
both of which are endogenous, while unborrowed re­
serves are exogenous. In the simulations the money
stock was made exogenous by suppressing the equa­
tion that makes demand deposits depend on unborrowed reserves. To simulate the effects of a particu­
lar rate of growth of money, the currency equation
was retained, but demand deposits were set at what­
ever level was required to obtain the desired rate of
growth of demand deposits plus currency. In the
control simulations demand deposits were set at their
actual levels, but currency remained an endogenous
variable and differed somewhat from actual since
simulated GNP differed somewhat from actual GNP.



cycle of 5 to 6 years. Such a cycle is particu­
larly evident in the simulations starting in
1956 and 1958. That the monetary rule has
very powerful effects in the model is shown by
the simulations beginning in 1960 and 1962.
In both simulations unemployment reaches a
trough in 1964 and then rises in spite of the
1964-65 tax cuts and the stimulus of spending
for military operations in Vietnam starting at
the end of 1965.
There is no doubt that the monetary rule is
too aggressive within the context of the
FR-M IT model. A simulation of a perfectly
steady rate of growth of money is shown in
Figure 17. The rate of growth in this simula­
tion is 2.76 per cent per year, the same as the
actual rate of growth over the period 1955-IV
through 1969-L In Figure 17, the curve la­
beled S2 is the simulated unemployment rate
with the steady rate of growth of money. The
simulated unemployment rate under the mone­
tary rule is shown by Sly which is the same as
S in panel A of Figure 16. The unconnected
points show the same control simulation as
shown in panel A of Figure 16.
It appears impossible to draw any firm con­
clusions from the simulations. However, the
simulations clearly raise the possibility that the
proposed monetary rule may produce ecoFIGURE 17

SIMULATIONS OF FR-MIT MODEL
Per cent

• Control simulation
S2 Constant growth rate simulation
Sj Rule simulation

RULES-OF-THUMB FOR POLICY

nomic instability. If anything, the proposed
rule is too aggressive, and so policy should
probably err on the side of producing growth
rates in money closer to a steady 3 to 5 per
cent rather than farther from the extremes in
the proposed rule.

IV. SELECTION AND CONTROL
OF A MONETARY AGGREGATE
BASIC ISSUES. Up to this point, the
analysis has been entirely in terms of optimal
control of the money stock. The theoretical
analysis has been general enough that no pre­
cise definition of the money stock has been re­
quired. The empirical work, however, has used
the narrow definition of demand deposits ad­
justed plus currency, for the simple reason that
this definition seems to be the most
appropriate one.
In principle there is no reason not to look
simultaneously at all of the aggregates and, of
course, at all other information as well. But in
practice, at the present state of knowledge,
there simply is no way of knowing how all of
these various measures ought to be combined.17
Furthermore, the selection of a single aggre­
gate for operating purposes would permit the
FOMC to be far more precise in its policy de­
liberations and in its instructions to the Man­
ager of the Open Market Account. Thus, the
best procedure would seem to be to select one
aggregate as the policy control variable, and
insofar as the state of knowledge permits, to in­
corporate other information into policy by
making appropriate adjustments in the rate of
growth of the aggregate selected.
17 This point is an especially important one since
those favoring simple approaches are frequently cas­
tigated for ignoring relevant information, and for
applying “simplistic solutions to inherently complex
problems.” For this charge to be upheld, it must be
shown explicitly and in detail how this other infor­
mation is to be used, and evidence must be produced
to support the proposed complex approach. As far as
this author knows, there is essentially no evidence
sorting out the separate effects of various compo­
nents of monetary aggregates.




In principle the aggregate singled out as the
control variable should be subject to exact de­
termination by the Federal Reserve. The rea­
son is that errors in reaching an aggregate that
cannot be precisely controlled may interact
with disturbances in the relationships between
the aggregate and goal variables such as GNP
to produce a suboptimal policy. However, as
argued later in this section, this consideration
is likely to be quite unimportant in practice for
any of the aggregates commonly considered.
Therefore, the analysis of which aggregate
should be singled out will be conducted under
the assumption that all of the various aggre­
gates can be precisely controlled by the Fed­
eral Reserve.
SELECTION OF A MONETARY AG­
GREGATE. At the outset it must be em­
phasized that the various aggregates frequently
discussed are all highly correlated with one
another in the postwar period. This is true for
total bank credit, the narrow money stock, the
broad money stock (narrow money stock plus
time deposits), the bank credit proxy (total
member bank deposits), the monetary base
(member bank reserves plus currency held by
the public and nonmember banks), and several
other figures that can be computed.
While these various aggregates are highly
correlated over substantial periods of time,
they showr significantly different trends for
short periods. In selecting an aggregate, the
most important considerations are the theoreti­
cal relevance of the aggregate and the extent
to which the theoretical notions have been
given empirical support. Both of these consid­
erations point to the selection of the narrowly
defined money stock.
The most important theoretical dispute is
between those who emphasize the importance
of bank deposit liabilities—the “monetary”
view—and those who emphasize the impor­
tance of banks’ earning assets—the “credit”
view. This controversy, which dates back well
into the 19 th century, is difficult to resolve be­
cause historically banks have operated on a
fractional reserve basis and so have had both

earning assets and deposit liabilities. Since bal­
ance sheets must balance, bank credit and
bank deposits are perfectly correlated except
insofar as there are changes in nonearning as­
sets—such as reserves—or nondeposit liabil­
ities—such as borrowing from the Federal
Reserve System. If these factors never changed,
the perfect correlation between bank deposits
and bank credit would make it impossible ever
to obtain evidence to distinguish between the
monetary and the credit views. Since the corre­
lation, while not perfect, has historically been
very high, it has been very difficult to obtain
evidence. Hence, it is still necessary to place
major reliance on theoretical reasoning.
There would be little reason to examine the
issue closely if we could be confident that the
very high correlation between deposits and
bank credit would continue into the indefinite
future. But there are already substantial differ­
ences in the short-run movements of bank
credit and bank deposits, and these differences
are likely to become greater and of a longerterm character in the future. Banks are raising
increasingly large amounts of funds through
nondeposit sources such as sales of commercial
paper and of capital certificates and through
borrowing from the Euro-dollar market and
the Federal Reserve System. (Borrowings from
the System would probably expand signifi­
cantly if proposed changes in discount-window
administration were implemented.)
The easiest way to examine the theoretical
issues is to consider some hypothetical experi­
ments. Consider first the experiment in which
the Federal Reserve raises reserve require­
ments by $10 billion at the initial level of
deposits but simultaneously buys $10 billion in
U.S. Government securities in the open mar­
ket. Deposits need not change, but banks must
hold more reserves and fewer earning assets.
Under the monetary view the effects would be
nil (except for very minor effects examined
below) because deposits would be unchanged,
but under the credit view the effect would be a
tendency for income to contract because bank
credit would be lower.



The monetary view is easily explained. Sup­
pose first that the banks initially hold U.S.
Government securities in excess of $10 billion.
When reserve requirements are raised, the banks
simply sell $10 billion of these securities, and
this is exactly the amount being purchased by
the Federal Reserve. Thus, since deposits are
unchanged and bank loans to the nonbank pri­
vate sector—hereinafter called simply the
“private sector”—are also unchanged, there
should be no effects on that sector.
Now suppose that the banks do not have
$10 billion in Government securities. In this
case they must sell private securities, say cor­
porate bonds, to the private sector. The pri­
vate sector obtains the funds to buy these bonds
from the sale of $10 billion of Government se­
curities to the Federal Reserve. The amount of
credit in the private sector is again unchanged.
The banks own fewer private securities, while
the public owns more private securities and
fewer Government securities.
Thus, the amount of credit extended to the
private sector need not change at all even
though bank credit falls. However, two minor
effects are possible: First, the Federal Reserve
purchase of Government securities changes the
composition of portfolios. Thus, even if banks
have over $10 billion of Government securi­
ties, they may be expected to adjust their port­
folios by selling some Government securities
and some private securities. For ease of expo­
sition, run-offs of loans may be included in the
sale of private securities. The net result, then,
is that the banks have more reserves, fewer
Government securities, and fewer private se­
curities; the private sector has fewer Govern­
ment securities and fewer liabilities to the
banks. The private sector may have—but it
will not necessarily have—fewer claims within
the sector. It is quite possible that private units
may substitute claims on other private units
for the Government securities sold to the Fed­
eral Reserve.
Looked at from the liability side, those units
initially with liabilities outstanding to banks
may have those liabilities shifted to other pri­

RULES-OF-THUMB FOR POLICY

vate sector units. This occurs, of course, when
banks sell securities to the private sector or
allow loans to run off that are then replaced
by firms selling commercial paper to other
firms, drawing on sources of trade credit,
and/or borrowing from nonbank financial insti­
tutions. A net effect can occur only when the
combined portfolios of banks and the private
sector contain fewer Government securities,
though more reserves, than before; such a
change may be looked upon as a reduction in
liquidity and thereby lead to a greater demand
for money and a reduced willingness to under­
take additional expenditures on goods and
services.
The second effect of the hypothetical experi­
ment being discussed is that bank earnings will
be reduced by the increase in reserve require­
ments. Banks will eventually adjust by raising
service charges on demand deposits and/or re­
ducing interest paid on time deposits. For sim­
plicity, assume that the change in reserve re­
quirements applies only to demand deposits so
that there is no reason for banks to change the
interest paid on time deposits. With higher
service charges on demand deposits, lower in­
terest rates on securities are required if people
are to hold the same stock of money as before.
Since the hypothetical experiment assumed
that deposits did not change, interest rates
must fall by the same amount as the increase
in service charges, an effect that will tend to
expand investment and national income.
The portfolio effect tends to contract income
while the service charge effect tends to expand
income. These effects individually seem likely
to be small, and the net effect may well be nil.
In this regard, it is interesting to note that the
relationship of velocity to the Aaa corporate
bond rate is about the same for observations
in the 1950’s as in the 1920’s [22, 23] in
spite of the enormous changes in financial
structure and in Government bonds outstand­
ing.
Consider another hypothetical experiment
—one that is in fact not so hypothetical at the
current time. Suppose that banks suddenly




start issuing large amounts of commercial
paper and investing the proceeds in business
loans. It is possible that the loans simply go to
corporations that have stopped issuing their
own commercial paper. In this case the bank
would be purely a middleman with no effect
on the aggregate amount of commercial paper
outstanding. The increase in bank credit would
not represent an increase in total credit.
But, of course, banks issuing commercial
paper must perform some function. This func­
tion is clearly that of increasing the efficiency
of the financial sector in transferring funds
from the ultimate savers to the ultimate bor­
rowers. The efficiencies arise in several ways.
First, under fractional reserve banking, banks
have naturally developed expertise in lending.
It is efficient to make use of this expertise by
permitting banks to have more lendable funds
than they would have if restricted to demand
deposits alone. The efficiency takes the form
of fewer administrative resources being re­
quired to transfer funds from savers to bor­
rowers.
The second form of efficiency results from
the fact that financial markets function best
when there is a large amount of trading in a
standardized instrument. For example, the
shares of large corporations are much more
easily marketed than those of small corpora­
tions. Many investors want, and require, read­
ily marketable securities, and they can be per­
suaded to buy securities in small firms only if
the yields are high. As a result funds may go
to large corporations to finance relatively lowyielding investment projects while high-yielding
projects available to small firms cannot be
financed. Commercial banks, and other finan­
cial intermediaries, improve the allocation of
capital by issuing relatively standardized secu­
rities with good markets and lending the pro­
ceeds to small firms.
The question is whether there is any effect
on economic activity from an increase in bank
credit financed by commercial paper—assum­
ing that the money stock is not affected. To
begin with, it must be emphasized that an in­

crease in the efficiency of investment does not
necessarily affect the total of investment. The
same resources may be absorbed either in
building a factory that will produce a product
that cannot be sold or in building a factory to
produce a highly profitable product in great
demand.
Banks, and financial intermediaries in gen­
eral, have the effect of reducing somewhat the
cost of capital for small firms. Because inter­
mediaries bid funds away from large corpora­
tions, the cost of capital for large corporations
tends to be somewhat higher than it would be
if there were no intermediaries. At this stage
in the analysis the net effect on investment is
impossible to predict since it depends on
whether the reduction in investment by large
corportions is larger or smaller than the in­
crease in investment by small corporations.
In examining the effects of intermediation,
however, another factor must be considered.
Suppose it is assumed that the interest rates
relevant for the demand for money are rates
on high-quality securities. It was argued above
that intermediation tends unambiguously to
raise the yields on high-quality securities above
what they otherwise would be. Since the as­
sumption throughout has been that the stock
of money is unchanged, the level of income
must increase if the quantity of money de­
manded is to be unchanged with the higher in­
terest rate of high-quality securities. The con­
clusion, therefore, is that the increase in bank
credit is expansionary in the hypothetical ex­
periment being discussed.
This conclusion, however, does not warrant
the further conclusion that bank credit is the
appropriate monetary aggregate for policy pur­
poses. The effect examined above occurs when
any financial intermediary expands. Not only is
there the problem that data for all intermedi­
aries are simply not available on a current
basis but also there are serious problems in
even defining an intermediary. A particularly
good example of this difficulty is afforded by
trade credit. A large nonfinancial corporation
may advance trade credit to customers, many




of whom may be small, and may also advance
funds to suppliers through prepayments. The
large corporation finances these forms of credit
through the sale of securities, or through re­
tained earnings diverted from its own invest­
ment opportunities and/or from dividends. In
this case the large corporation is serving ex­
actly the same function as the financial inter­
mediaries are. But tracing these credit flows is
obviously impossible at the present time.
Another problem with bank credit as a
guide to policy is that changes in bank credit
depend both on changes in bank deposits and
on changes in nondeposit sources of funds. As
demonstrated by the hypothetical experiments
examined above, the effect of a change in
bank credit depends heavily on whether or
not deposits change.
One final hypothetical experiment will be
considered. Suppose the U.S. Treasury sells
additional Government securities to the public
to finance an increase in cash balances at com­
mercial banks. Since banks have received no
additional reserves, total deposits cannot
change. Deposits owned by the public are
transferred to the Treasury. Bank credit is un­
changed, but the impact on the private sector
is clearly contractionary. The private sector
holds more Government bonds and fewer de­
posits. Equilibrium can be restored only
through some combination of a rise in interest
rates and a decline in income.
The conclusion is that it appears to be fun­
damentally wrong for policy-makers to place
primary reliance on bank credit. This is not to
say that there is no information to be gained
from analysis of bank and other credit flows.
However, selection of bank credit as the mon­
etary aggregate would be a mistake. Instead, in­
formation on credit flows may be used to ad­
just the desired rate of growth of the money
stock, however it is defined, although it is not
clear that the knowledge presently exists as to
how to interpret credit flows.
From this analysis it appears that neither
bank credit nor any deposit total that includes
Treasury deposits is an appropriate monetary

RULES-OF-THUMB FOR POLICY

aggregate for monetary policy purposes. Before
considering the narrow and broad definitions
of the money stock, let us examine the mone­
tary base, total reserves, and unborrowed re­
serves.
It is clear that different levels of the money
stock may be supported by the same level of
the monetary base. Given the monetary base,
different levels of the money stock result from
changes in reserve requirement ratios; from
shifts of deposits between demand and time,
which of course are subject to different reserve
requirement ratios; from shifts of deposits
among classes of banks with different reserve
ratios; and from shifts between currency and
deposits. These effects are widely understood,
and they have led to the construction of mone­
tary base figures adjusted for changes in re­
serve requirements. Similar adjustments are
applied to total and nonborrowed reserves. If
enough adjustments are made, the adjusted
monetary base is simply some constant frac­
tion of the money stock, while adjusted re­
serves are some constant fraction of deposits.
It is obviously much less confusing to adopt
some definition of the money stock as the ap­
propriate aggregate rather than to use the ad­
justed monetary base or an adjusted reserve
figure.
There can be no doubt that FOMC instruc­
tions to the Manager in terms of nonborrowed
reserves would be more precise and more eas­
ily followed than instructions in terms of the
money stock. But the simplicity of reserve in­
structions would disappear if adjusted reserves
were used, for then the Manager would have
to predict such factors as shifts between de­
mand and time deposits, the same factors that
must be predicted in controlling the money
stock. No one would argue that such factors
—and others such as changes in bank borrow­
ings and shifts in Treasury deposits—should
be ignored. If the FOMC met daily, instruc­
tions could go out in unadjusted form with the
FOMC making the adjustments. But surely
this technical matter should be handled not by
the FOMC but by the Manager and his staff in




order to permit the FOMC to concentrate on
basic policy issues.
The only aggregates left to consider are the
narrowly and broadly defined money stocks.
There is a weak theoretical case favoring the
narrow definition because time deposits must
be transferred into demand deposits or cur­
rency before they can be spent. The case is
weak because the cost of this transfer is rela­
tively low. If the cost were zero, then there
would be no effective distinction between de­
mand and time deposits. Indeed, since time de­
posits earn interest, all funds would presuma­
bly be transferred to time deposits.
No strong empirical case exists favoring one
definition over the other. The broad and
narrow money stocks are so highly correlated
over time that it is impossible to distinguish
separate effects. It appears, however, that there
is a practical case favoring the adoption of the
narrow money stock. Time deposits include
both passbook accounts, which can be readily
transferred into demand deposits, and certifi­
cates of deposit, which cannot. Since CD’s ap­
pear to be economically much more like com­
mercial paper than like passbook time
accounts, they ought to be excluded from the
broadly defined money stock.
There is, of course, no reason why CD’s
cannot be excluded from the definition of
money. The problem is that banks may in the
future invent new instruments that will be
classified as time deposits for regulatory pur­
poses but that are not really like passbook ac­
counts. In retrospect it may be clear how the
new instrument should be treated, but the situa­
tion may be confused for a time. The same sort
of problem exists with demand deposits—con­
sider the compensating balance requirements
imposed by many banks—but it seems likely
that the problem will remain more serious for
time deposits.
In summary, there is a strong case favoring
the selection of some definition of the money
stock as the monetary aggregate, and there ap­
pears to be a marginal case for preferring the
narrowly defined money stock.

172

TECHNICAL PROBLEMS OF CON­
TROLLING MONEY STOCK. In the pre­
ceding sections it has been argued that the
monetary policy control instrument should be
the money stock. The purpose of this section
is to investigate some of the technical prob­
lems in controlling the money stock. The first
topic examined is that of the form of instruc­
tions to the Manager of the System Open Mar­
ket Account. Following this discussion is an
examination of the feedback method of control.
Finally, there is an examination of the signifi­
cance of data revisions. All of this discussion
is in terms of the narrowly defined money
stock, but much of it also applies to other ag­
gregates.
Specification of the desired money stock.
There are two major issues connected with the
form of FOMC instructions to the Manager.
The first is whether the desired money stock
should be expressed in seasonally adjusted or
unadjusted form, while the second is whether
the desired money stock should be expressed
in terms of a complete path week by week
over time or of an average over some period of
time. The first issue turns out to be closely re­
lated to the question of data revisions, and so
its discussion will be deferred for the moment.
It is to the second issue that we now turn.
Since required reserves are specified in
terms of a statement-week average, the state­
ment week is the natural basic time unit for
which to measure the money stock, and the
measure takes the form of the average of daily
money stock figures over the statement week.
The fact that daily data may not be available
on all components of the money stock does
not affect the argument; however estimated,
the weekly-average figure is the most appropri­
ate starting point in the analysis.
The weekly money stock is clearly not sub­
ject to precise control because of data lags and
uncontrollable random fluctuations. Further­
more, no one believes that these weekly
fluctuations have any significant impact. The
natural conclusion to be drawn is that there is
no point in specifying instructions in terms of




weekly data but rather that some average level
over a period of weeks should be used. Upon
closer examination, however, this conclusion
can be shown to be unjustified.
The difficulty in expressing the instructions
in terms of averages can be explained very
simply by two examples. To keep the exam­
ples from becoming too complicated, it will be
assumed that instructions take the form of
simple rates of growth on a base money stock
of $200 billion. The neglect of compounding
makes no essential difference to the argument.
For the first example, assume that the policy
instruction is for a growth rate of 4 per cent
per annum, which is $8 billion per year or
about $154 million per week. If the money
stock grew by $154 million per week for 8
weeks, then the figure for the eighth week
would be above the base week figure by an
amount representing a 4 per cent annual growth
rate. The average of weeks 5 through 8 would
be above the average of weeks 1 through 4 by
$616 million, an amount also representing a 4
per cent annual growth rate. So far, there is no
reason to favor the path specification over a
specification in terms of 4-week averages.
Now suppose that the increase in weeks 1
through 4 was on schedule, but that a large
uncontrollable increase of $500 million oc­
curred in the fifth week. Starting from a baseweek figure of $200 billion, the average money
stock for weeks 1 through 4 would be
$200,385 billion, and if the instruction were in
terms of 4-week averages it would specify an
average money stock of $201,001 billion for
weeks 5 through 8.
Since by hypothesis the money stock grew
by $154 million in each of the first 4 weeks, in
the fourth week the level was $200,616 billion.
The jump of $500 million in the fifth week
would take the level to $201,116 billion, a
figure already above the desired average of
$201,001 billion for weeks 5 through 8. To
reach this desired average given the jump in
week 5, the money stock in weeks 6 through 8
would have to average less than $201,001 bil­
lion, and so the money stock would have to be

RULES-OF-THUMB FOR POLICY

forced below the level of the fifth week for
weeks 6 through 8. Furthermore, as the reader
may calculate, it would be necessary to have
higher than normal weekly growth in weeks 9
through 12 if the average of these weeks were
to be above the average of weeks 5 through 8
by $616 million. On the other hand, if the in­
struction were in terms of the desired weekly
path, the instruction would read that the de­
sired money stock in the eighth week was
$201,232 billion, and therefore the Manager
would not have to force the money stock down
in weeks 6 through 8. Instead, he could aim
for a growth of about $39 million in each of
the weeks 6 through 8 to bring the level in
week 8 to the desired figure of $201,232 bil­
lion.
From this example it can be seen that speci­
fication in terms of averages of levels of the
money stock forces the Manager to respond to
random fluctuations in a whipsawing fashion.
Since week-by-week fluctuations have essen­
tially no significance, there is no point in
wrenching the financial markets in order to
undo a random fluctuation. If averaging is to
be used, the average should be specified in
terms of the desired average weekly change
over, say, the next 4 weeks rather than in
terms of the average level of the next 4 weeks.
Specification in terms of the average weekly
change is equivalent to a specification stating
that the Manager should aim for a particular
target level in the fourth week.
The second example illustrating the hazards
of specification in terms of the average level
will show what happens when policy changes.
As before, assume that the money stock in the
base week is $200 billion and that the desired
growth is at a 4 per cent rate in weeks 1
through 4. In this example it is assumed that
there are no errors in hitting the desired
money stock. Thus, the money stock is as­
sumed to grow by $154 million per week,
reaching a level of $200,616 billion in the
fourth week and an average level of $200,385
billion for weeks 1 through 4.
Now suppose that in week 4 the FOMC de­



cides on a policy change and specifies a 1 per
cent growth rate for the money stock for
weeks 5 through 8. If the specification were in
terms of the average level, then it would re­
quire an increase in the average level of $154
million, which would bring the average level to
$200,539 billion for weeks 5 through 8. But
the figure for week 4 is already $200,616 bil­
lion, and so the money stock in weeks 5
through 8 would have to average less than the
figure already achieved in week 4.
Thus, after a steady 4 per cent growth week
by week, an average-level policy specification
would actually require a negative week-byweek growth before the new 1 per cent growth
rate could be achieved. On the other hand, a
policy specification in terms of the weekly path
would require a weekly growth of $38.5 mil­
lion each week for weeks 5 through 8.
To make the point clear, this example was
constructed so that the policy shift from a 4 to
a 1 per cent growth rate would actually re­
quire a negative growth rate for a time on a
week-by-week basis when the instructions are
in terms of average levels. In general, when
average levels are used, a policy shift to a
lower growth rate will require in the short
term a growth rate lower than the new policy
rate set, and a policy shift to a higher growth
rate will require a short-term growth rate
above the new policy rate. Since policy-makers
will typically want to shift policy gradually, the
levels specification is especially damaging be­
cause it in fact instructs the Manager to shift
policy more rapidly than the policy-makers
had desired. It should be noted that the larger
the number of weeks included in the averagelevel specification, the more severe this prob­
lem becomes.
Because the money stock cannot be con­
trolled exactly, there is a natural tendency to
feel that instructions stated in terms of aver­
ages are more attainable. In actuality, of
course, this effect is illusory; averaging pro­
duces a smaller number to measure the errors,
but does not improve control. Nevertheless, if
averages are to be used in the instructions, the

above examples demonstrate that the averages
should be calculated in terms of weekly (or
perhaps monthly) changes but not in terms of
averages of levels.
Use of average changes does have one ad­
vantage, however. An instruction in this form
permits the Manager to correct an error in
week 1 over the next few weeks rather than
instructing him to correct the error entirely in
week 2. As explained above, an instruction in
terms of the average weekly change over the
next 4 weeks is equivalent to an instruction in
terms of the desired level in week 4, leaving
unspecified the desired levels in weeks 1
through 3.
Control through the feedback principle. It is
useful to begin by comparing the problems of
controlling the money stock with the problems
of controlling interest rates. In controlling in­
terest rates, the availability of continuous read­
ings on rates makes it possible for the Man­
ager to exercise very accurate control without
understanding the causes of rate changes.
Being in continuous contact with the market,
the Manager can intervene with open market
purchases or sales as soon as the Federal
funds rate, the Treasury bill rate, or any other
rate starts to change in an undesirable fashion.
This feedback control is not exact since inter­
est rate information arrives with some lag, and
there are other lags such as the time required
to decide upon and execute an open market
transaction and the time it takes for the mar­
ket to react to the transaction.
More precise control over interest rates
could be achieved if the Manager were willing
to announce Federal Reserve buying and sell­
ing prices for, say, 3-month Treasury bills
available to all comers. This is essentially the
way in which Government securities were
pegged during World War II. In principle,
there is no reason why such a peg could not be
operated in peacetime, although it would cer­
tainly be desirable to change the peg fre­
quently, perhaps as often as every day or even
every hour. However, in terms of actual be­
havior of interest rates there is no significant



difference between a frequently adjusted peg
and continuous intervention by the Manager
as described in the previous paragraph.
The main point of this discussion of interest
rate control is to emphasize that with frequent
interest rate readings it is not necessary to
know exactly what causes interest rate
changes. In time the Manager develops a feel
for the market that enables him to guess ac­
curately which interest rate changes are tempo­
rary and which are likely to be “permanent”
and so require offsetting open market opera­
tions. Furthermore, his feel for the market will
enable him to know how large the operations
should be. Finally, when he guesses wrongly
on these matters, his continuous contact with
the market enables him to correct mistakes
rapidly.
The same arguments apply to controlling
the money stock. The difference between inter­
est rate control and money stock control is a
matter of degree rather than kind. Data on the
money stock become available with a greater
lag, and the data are more subject to revision.
But since it is not necessary to control the
money stock down to the last dollar, the ques­
tion is whether it is technically possible to
have control that is accurate enough for policy
purposes. The answer to this question would
certainly appear to be in the affirmative.
The weekly-average figure for the money
stock is released to the public 8 days following
the end of the week to which the average re­
fers. Of course, data are available internally
with a shorter lag. Since the policy rule in the
previous section is based on controlling the
monthly-average money stock, it would appear
that the data are at the present time available
with a short enough lag that feedback methods
of control are feasible.
To see how feedback control would work,
suppose that the Manager were instructed to
come as close as possible to a target money
stock of M 4* in week 4 of a 4-week operating
horizon. The Manager knows that the weekly
change in the money stock depends on open
market purchases, P, which he controls, and

RULES-OF-THUMB FOR POLICY

many other factors as well, which for simplic­
ity of exposition will be denoted by one factor,
z. These factors cannot be predicted exactly,
and so the Manager will think of z as consist­
ing of a predictable part, z, and an unpredicta­
ble part, u. These relationships may be ex­
pressed as

At the end of the first week the Manager
has the estimate, M ly for the money stock for
that week, and again it is assumed that he
wants to spread the desired change M* — Mt
equally over the next 3 weeks. Thus, the Man­
ager sets P2 according to

(5)

(7)

AM =

aP

+ z =

aP

+ z + u

where a is the coefficient giving the change in
money per dollar of open market purchases.
If there were no errors in measuring the
money stock, the analysis could be completed
on the basis of equation 5. But of course there
are errors in measuring the money stock. To
analyze the significance of measurement errors,
let Mi be the money stock for week / as meas­
ured at the end of week Z.18 Also, let M tf be the
final “true” money stock figure for week i, and
let ei = Mi — M i.
The Manager starts out the 4-week period
with an estimated money stock of M0 for week
zero. Of course, the figure for M0 is a pre­
liminary one, but revisions in this figure as
more data accumulate will affect the estimates
for the money stock in later weeks and so affect
the Manager’s actions in later weeks. It will be
assumed that he wants to increase the money
stock by equal amounts in each week to reach
the desired figure of M4* in week 4. In week 1,
therefore, he wants to produce a change in the
money stock Va (M4* — M0). Substituting
this figure into equation 5 we obtain
1/4 (M4* - M 0) - aPi +
Thus, the Manager sets
(6)

Pi =

I

Px

+ m

according to

[ J (M 4* - Mo) - z j

18 If a money stock estimate is not directly avail­
able at the end of week i, one can be constructed by
taking the estimate from actual deposit data for
week i —l and adding to it a projection for the
effects of open market operations and other factors
for week /. This projection would, of course, come
from equation 5.




Pi = ^

M ») - * * ]

Similarly, he sets P3 and P4 according to equa­
tions 8 and 9.
(8)
(9)

{Mi*~ Mi) ~ *3]
Mt) - z 4]

Pt = -

a

From equations 9 and 5 it can be seen that
the actual money stock in week 4 is
(10) M 4 = W + AT* - M z - z4 + z
= M4*+ ez + Ui
This expression for the fourth week of a plan­
ning period generalizes to the /ith week of a
planning period of any length merely by re­
placing the subscript 4 by the subscript n. We
can, therefore, express the annual rate of
growth, g, over an n week period by

(U>

52 / M nf — M<>f\
)
_ 52 / « . » - M J
n

\

M o f

+

52 ,

~

(e « -l +

Wn)

From equation 11 it can be seen that the ac­
tual growth rate, g, equals the desired growth
rate plus an error term that becomes smaller
as n becomes larger.
This analysis shows that a feedback control
system that continuously adjusts open market
operations as data on the money stock in the
recent past become available can achieve a
target rate of growth with a margin of error
that is smaller the longer the period over
which the rate of growth is calculated. It also
provides a framework in which to examine the
relative importance of operating errors, the uit
and data errors, the e%.

To obtain an accurate estimate of the sizes
of these errors is beyond the scope of this
study. However, a very crude method may be
used to obtain an estimate of the maximum
size of the total error. Monthly money stock
changes at annual rates were computed for the
period January 1951 through September 1969
on the basis of seasonally adjusted data. This
time period yields a total of 225 monthly
changes. Then each monthly change was ex­
pressed in terms of its deviation from the aver­
age of the changes for the previous 3 months.
For example, the September deviation was cal­
culated by subtracting from the September
monthly change the average of the changes for
August, July, and June. The use of deviations
allows in part for longer-run trends in the
money stock, which trends are assumed to be
readily controllable. Since the deviations were
calculated over a period during which little or
no attention was paid to controlling the money
stock, they surely represent an upper limit to
the degree of volatility in the money stock to
be expected under a policy directed at control
of the money stock.
These monthly deviations have a standard
deviation of 3.12 per cent per annum. Apply­
ing equation 11, except for replacing 52 by 1
to reflect the fact that the rates of change were
expressed at annual rates in the first place, it is
found that the standard deviation over a 3month period would be 1.04 per cent per
annum. If it is assumed that these deviations
are normally distributed, the conclusion is that
over 3-month periods the actual growth rate
would be within plus or minus 1.04 per cent
of the desired growth rate about 68 per cent
of the time, and would be within plus or
minus 2.08 per cent about 95 per cent of the
time. Inasmuch as these limits would be cut in
half over 6-month periods, the actual growth
rate 95 per cent of the time would be in the
range of plus or minus 1.04 per cent of the
desired growth rate.19 When it is recalled that
19 If the calculations are based on the variability
of the monthly changes themselves rather than on the
deviations of the monthly changes, the results are not




these calculations are based on an estimate of
variability over a period in which very little at­
tention was paid to stabilizing money stock
growth rates, it is clear that fears as to the
ability of the Federal Reserve to control the
money stock accurately are completely
unfounded.20
This conclusion justifies the approach used
at the beginning of this section on the selection
of a monetary aggregate, at least for the nar­
rowly defined money stock and most probably
for other aggregates as well. That approach, it
will be recalled, analyzed the selection issue on
the assumption that every one of the aggre­
gates considered could be precisely controlled
for all practical purposes. There can be no
doubt that errors in reaching targets for goal
variables such as GNP, at the present state of
knowledge, are due almost entirely to incom­
plete knowledge of the relationships between
instrument variables (such as various aggre­
gates and interest rates) and the goal varia­
bles, and hardly at all to errors in setting in­
strument variables at desired levels.
Problems of data revisions and changing
seasonality. Another topic that needs examina­
tion is the effect of data revisions. While week­
ly-average data are released with an 8-day lag,
these figures are subject to revision. Not much
weight can be given to early availability of
data that are later revised substantially. To in­
vestigate this problem, two money stock series
were compared, one “preliminary” and one
greatly changed. The standard deviation of the
monthly changes over the same period used before is
3.53 per cent per annum, which yields a 95 per cent
chance of the growth rate being in a range around
the desired rate of plus or minus 2.36 (1.18) per cent
per annum for 3-month (6-month) periods.
20 Compare “First, however, it may be worthwhile
to touch on the extensively debated subject whether
the Federal Reserve, if it wanted to, could control
the rate of money supply growth. In my view, this
lies well within the power of the Federal Reserve to
accomplish provided one does not require hair-split­
ting precision and is thinking in terms of a time span
long enough to avoid the erratic, and largely mean­
ingless, movements of money supply over short peri­
ods.” [3, p. 75]

RULES-OF-THUMB FOR POLICY

“final.” Since the analysis below is based on
published monthly data, it obviously provides
little insight into the accuracy of weekly data.
However, since policy instructions may be
based on monthly data, the analysis is of some
value in assessing data accuracy. Furthermore,
the conclusions on the importance of revisions
in seasonal factors can be expected to hold for
the weekly data.
A “preliminary” series of monthly growth
rates of the money stock was constructed by
calculating the growth rate for each month
from data reported in the Federal Reserve
Bulletin for the following month. For example,
the Bulletin dated September reports money
stock data for 13 months through August; it is
the annual rate of change of August over July
that is called the “preliminary” August rate-ofchange observation. The “final” series is the
annual rate of growth calculated from the
monthly money stock series covering 1947
through September 1969, reported in the Fed­
eral Reserve Bulletin for October 1969, pp.
790-93. Data were gathered on both a season­
ally adjusted basis and an unadjusted basis for
January 1961 through August 1969.
The correlation between the preliminary and
final seasonally adjusted series is 0.767, while
for the unadjusted series the correlation is
0.997. Another way to compare the prelimi­
nary and final series is to examine the differ­
ences in the two series.21 For the seasonally
adjusted data, the differences have a mean of
0.122 and a standard deviation of 3.704, and
the mean absolute difference is 2.891. On the
other hand, for the seasonally unadjusted data
the differences have a mean of 0.150 and a
standard deviation of 1.366, and the mean ab­
solute difference is 0.955,22
21 The analysis of the differences inadvertently
runs from February 1961 through August 1969 while
the correlation analysis runs from January 1961
through August 1969.
22 To take account of the fact that the “final”
money stock series may be further revised for
months near the October 1969 publication date of
this series, the analysis of differences between the
preliminary and final series was also run on the pe-




These results make it abundantly clear that
the major reason why the preliminary and final
figures on the money stock differ is revision of
seasonal adjustment factors. While such revi­
sions may produce substantial differences be­
tween preliminary and final monthly growth
rates, the differences must be lower for the av­
erage of several months’ growth rates. The
reason, of course, is that revision of seasonal
factors must make the figures for some months
higher and those for other months lower, leav­
ing the annual average about unchanged.
The significance of revisions in seasonal fac­
tors can be understood only after a discussion
of the significance of seasonality for a money
stock rule. If the monetary rule were framed
in terms of the seasonally unadjusted money
stock, the result would be to introduce sub­
stantially more seasonality into short-term in­
terest rates than now exists. It can be argued
not only that greater seasonality in interest
rates would not be harmful but also that it
would be positively beneficial. Greater season­
ality in interest rates would presumably tend to
push production from busy, high-interest sea­
sons into slack, low-interest seasons.
Although the argument for seasonality in in­
terest rates could be pushed further, there is
an important practical reason for not initially
adopting a money rule stated in terms of the
seasonally unadjusted money stock. The rea­
son is that the rule ties the growth rate of the
money stock to the seasonally adjusted unem­
ployment rate and to the interest rate. The
rule has been developed through an examina­
tion of past experience. If the seasonal were
taken out of the money stock, a different sea­
sonal would be put into interest rates, and posriod February 1961 through December 1968. The
mean difference, the standard deviation of the differ­
ences, and the mean absolute difference, are, respec­
tively, for the seasonally adjusted data 0.026, 3.779,
and 2.922, while the figures for the seasonally unad­
justed data are 0.038, 1.280, and 0.890. In spite of
the fact that the “final” series is not really final for
1969 data, the average differences are generally larger
for the longer period due to the relatively large data
revisions in the middle of 1969.

178

sibly into the unemployment rate as well. Sea­
sonal factors for these variables, especially for
the unemployment rate, determined from past
data would no longer be correct if the money
stock seasonal were removed. Seasonally ad­
justing the unemployment index by the old
factors could produce considerable uncertainty
over the application of the monetary rule.
Thus, application of the rule through the sea­
sonally unadjusted money stock, if desirable at
all, should only come about through gradual
reduction rather than immediate elimination of
seasonality. A further reason for a gradual ap­
proach would be to permit the financial mar­
kets to adjust more easily to changed seasonal­
ity.
The point of this discussion is not to urge
acceptance of a rule framed in terms of the
unadjusted money stock, since this step would
not be initially desirable in any case. Rather,
the point is to emphasize that seasonality is in
the money stock only in order to reduce the
seasonality of other variables, primarily inter­
est rates. The seasonality of the money stock,
unlike variables such as agricultural produc­
tion, is not inherent in the workings of the
economy but rather exists because the Federal
Reserve wants it to exist. The money stock
can be made to assume any seasonal pattern
the Federal Reserve wants it to assume.
The monetary rule should be framed, at
least initially, in terms of the seasonally ad­
justed money stock—using the latest estimated
seasonal factors. In subsequent years changes
in these seasonal factors should not result from
mechanical application of seasonal adjustment
techniques to the money stock data but rather
should be the result of a deliberate policy
choice. The policy choice would be based on
the desire to change seasonality of other varia­
bles. For example, if it were thought desirable
to take the seasonality out of short-term inter­
est rates, the seasonal factors for the money
stock would then be changed to take account
of changes in tax dates and other factors.
Under a money stock policy, whether or not
guided by a monetary rule, revised seasonal




factors cannot properly be applied to past
data. If the changes are applied to past data
with the result that some monthly growth rates
of adjusted data become relatively high while
others become relatively low, the conclusion to
be drawn is not that policy was mistaken as a
result of using faulty seasonal factors. Instead,
the conclusion is merely that seasonal policy
differed in the past from current policy or
from the seasonal pattern assumed by the in­
vestigator who computed the seasonal factors.
Seasonal policy can be shown to be “wrong”
only by showing that undesirable seasonals
exist in other variables.
One final problem deserves discussion.
While it appears from the analysis of season­
ally unadjusted money stock data that revi­
sions of the data are relatively unimportant, at
least from the evidence for 1961-69, how
should the policy rule be adjusted when there
are major data revisions—as in the middle of
1969? For example, suppose that revisions in­
dicate that monetary growth has been much
higher than had been expected, and higher
than was desirable. On the one hand, pol­
icy could ignore the past high rate of growth
and simply maintain the current rate of growth
of the revised series in the desired range. On
the other hand, the policy could be to return
the money stock to the level implied by apply­
ing the desired growth rate to the money stock
in some past base period. The first alternative
involves ratifying an undesirably high past rate
of growth, while the second may involve a
wrenching change in the money stock to return
it to the desired growth path. The proper pol­
icy would no doubt have to be decided on a
case-by-case basis. However, a useful pre­
sumption might be to adopt the second alter­
native, but to set as the base the money stock
6 months in the past and to return to the de­
sired growth path over a period of several
months.
Improving control over the money stock.
The analysis above has shown that under pres­
ent conditions the money stock can be con­
trolled quite accurately. However, it should be

RULES-OF-THUMB FOR POLICY

emphasized that there are numerous possibili­
ties for improving control. Although detailed
treatment of this subject is beyond the scope
of this study, a few very brief comments ap­
pear appropriate.
There are three basic methods for improving
control. The first method is that of improving
the data. The more quickly the deposit data
are available, the more quickly undesirable
movements in the money stock can be recog­
nized and corrected. And the more accurate
the deposit data, the fewer the mistakes caused
by acting on erroneous information. It is clear
that expenditures of money on expanding the
number and coverage of deposit surveys and
on more rapid processing of the raw survey
data can improve deposit data.
The second method of improving control is
through research, which increases our under­
standing of the forces making for changes in
the money stock. For example, transfers be­
tween demand and time deposits might be
more accurately predicted through research
into the causes of such transfers.
The third method of improving control is
through institutional changes. To reduce fluc­
tuations in excess reserves and thereby achieve
a more dependable relationship between total
reserves and deposits, the Federal funds mar­
ket might be improved by making possible
transfers between the East and West Coasts
after east coast banks are closed. Also helpful
would be a change from lagged to contempor­
aneous reserve requirements. More radical re­
forms such as equalization of reserve require­
ments for city, country, and nonmember banks
and elimination of reserve requirements on
time deposits should also be considered.

V. SUMMARY
PURPOSES OF THE STUDY. The primary
purpose of this study has been to argue that
a major improvement in monetary policy would
result through a systematic policy approach
based on adjustments in the money stock.




Equal emphasis has been placed on the
“systematic” part and the “money stock” part
of this approach. The analysis has proceeded
first by showing why policy adjustments should
be made through money stock adjustments,
and second by showing how these policy ad­
justments might be systematically linked to the
current business situation through a policy
guideline or rule-of-thumb. A third, and sub­
sidiary, part of this study is an analysis of the
reasons for preferring the money stock over
other monetary aggregates, and of some of the
problems in reaching desired levels of the
money stock.
It has been emphasized throughout that this
policy approach is one that is justified for the
intermediate-term future on the basis of
knowledge now available. The specific recom­
mendations are not intended to be good for all
time. Indeed, the approach has been designed
to encourage evaluation of the results so that
the information obtained thereby can be incor­
porated into policy decisions in the future.
THE THEORY OF MONETARY POLICY
UNDER UNCERTAINTY. Since policy­
makers have repeatedly emphasized the im­
portance of uncertainty, it is necessary to
analyze policy problems within a model that
explicitly takes uncertainty into account. In
particular, only within such a model is it possi­
ble to examine the important current issue of
whether policy adjustments should proceed
through interest rate or money stock changes.
A monetary policy operating through inter­
est rate changes sets interest rates either
through explicit pegging as was used in World
War II or through open market operations di­
rected toward the maintenance of rates in
some desired range. Under such a policy the
money stock is permitted to fluctuate to what­
ever extent is necessary to keep interest rates
at the desired levels. On the other hand, a pol­
icy operating through money stock changes
uses open market operations to set the money
stock at its desired level while permitting inter­
est rates to fluctuate freely.
If there were perfect knowledge of the rela-

180

tionships between the money stock and interest
rates, the issue of money stock versus interest
rates would be nonexistent. With perfect
knowledge, changes in interest rates would be
perfectly predictable on the basis of policyinduced changes in the money stock, and vice
versa. It would, therefore, be a matter of pref­
erence or prejudice, but not of substance,
whether policy operated through interest rates
or the money stock.
To analyze the interest versus money issue,
then, it is necessary to assume that there is a
stochastic link between the two variables. And,
of course, this is in fact the case. There are
two fundamental reasons for the stochastic
link. First, the demand for money depends not
only on interest rates and the level of income
but also on other factors, which are not well
understood. As a result, the demand for
money fluctuates in a random fashion even if
income and interest are unchanged. If the
stock of money is fixed by policy, these ran­
dom demand fluctuations will force changes in
interest and/or income in order to equate the
amount demanded with the fixed supply.
The second source of disturbances between
money and interest stems from disturbances in
the relationship between expenditures—espe­
cially investment-type expenditures—and inter­
est rates. Given an interest rate fixed by pol­
icy, these disturbances produce changes in
income through the multiplier process, and
these income changes in turn change the
quantity of money demanded. With interest
fixed by policy, the stock of money must
change when the demand for money changes.
On the other hand, if the money stock were
fixed by policy, since the expenditure disturb­
ance changes the relationship between income
and interest, some change in the levels of in­
come and/or interest would be necessary for
the quantity of money demanded to equal the
fixed stock.
Money stock and interest rate policies are
clearly not equivalent in their effects, given
that disturbances in money demand and in ex­
penditures do occur. Since the effects of these




policies are different, which policy to prefer
depends on how the effects differ and on pol­
icy goals. At this level of abstraction, it is
clearly appropriate to concentrate on the goals
of full employment and price stability. Unfor­
tunately, the formal model that has been
worked out, which is examined carefully in
Section I above, applies only to the goal of
stabilizing income. If “income” is interpreted
to mean “money income,” then the goals of
employment and price level stability are in­
cluded but are combined in a crude fashion.
The basic differences in the effects of money
stock and interest rate policies can be seen
quite easily by examining extreme cases. Sup­
pose first that there are no expenditure dis­
turbances, so there is a perfecdy predictable
relationship between the interest rate and the
level of income. In that case, a policy that sets
the interest rate sets income, and policy-mak­
ers can choose the level of the interest rate to
obtain the level of income desired. When the
interest rate is set by policy, disturbances in
the demand for money change the stock of
money but not the level of income. On the
other hand, if policy sets the money stock,
then the money demand disturbances would
affect interest and income leading to less satis­
factory stabilization of income than would
occur under an interest rate policy.
The other extreme case is that in which
there are disturbances in expenditures but not
in money demand. If policy sets the interest
rate, expenditure disturbances will produce
fluctuations in income. But if the money stock
is fixed, these income fluctuations will be
smaller. This point can be seen by considering
a specific example such as a reduction in in­
vestment demand. This disturbance reduces in­
come. But given an unchanged money demand
function, with the fall in income, interest rates
must fall so that the amount of money de­
manded will equal the fixed stock of money.
The decline in the interest rate will stimulate
investment expenditures, thus offsetting in part
the impact on income of the initial decline in
the investment demand function. With expend-

RULES-OF-THUMB FOR POLICY

itures disturbances, then, to stabilize income, it
is clearly better to follow a money stock policy
than an interest rate policy.
The conclusion is that the money versus in­
terest issue depends crucially on the relative
importance of money demand and expendi­
tures disturbances. It is especially important to
note that nothing has been said about the size
of the interest elasticity of the demand for
money, or of the interest elasticity of invest­
ment demand. These coefficients, and others,
determine the relative impacts of changes in
money demand and in investment and govern­
ment expenditures when the changes occur.
The interest versus money issue does not
depend on these matters, however, but only
on the relative size and frequency of dis­
turbances in the money demand and expendi­
tures functions.23
The analysis above is modified in detail by
considering possible interconnections between
money demand and expenditures disturbances.
It is also true that in general the optimal pol­
icy is not a pure interest or pure money stock
policy, but a combination of the two. These
matters, and a number of others, are discussed
in Section I.
EVIDENCE ON RELATIVE MAGNI­
TUDES OF REAL AND MONETARY DIS­
TURBANCES. Resolution of the money ver­
sus interest issue depends on the relative size
of real and monetary disturbances. Unfortun­
ately, there is no completely satisfactory body
of evidence on this matter. Indeed, because of
the conceptual difficulties of designing empiri­
cal studies to investigate the issue, the evi­
dence is unlikely to be fully satisfactory for
some time to come. Nevertheless, by examin­
ing a number of different types of evidence, a
substantial case can be built favoring the use
of the money stock as the policy control varia­
ble.
Before discussing the evidence, it is neces­
sary to define in more detail what is meant by
“disturbance.” Consider first a money demand
23 For a full understanding of this important point,
the reader should refer to the analysis of Section I.




disturbance. The demand for money depends
on the levels of income and of interest rates,
and on other variables. The simplest form of
such a function uses GNP as the income varia­
ble, and one interest rate—say the Aaa corpo­
rate bond rate—and all other factors affecting
the demand for money are treated as disturb­
ances. To the extent possible, of course, these
other factors should be allowed for, but for
policy purposes these factors must be either
continuously observable or predictable in ad­
vance so that policy may be adjusted to offset
any undesirable effects on income of these
other factors. Factors not predictable in ad­
vance must be treated as random disturbances.
Similarly, expenditures disturbances are de­
fined as the deviations from a function linking
income to the interest rate and other factors.
These other factors would include items such
as tax rates, government expenditures, strikes,
and population changes. Again, for policy pur­
poses these factors must be forecast, and so
errors in the forecasts of these items must be
included in the disturbance term. It is impor­
tant to realize that the disturbances will be de­
fined differently for scientific purposes ex post
because the true values of government spend­
ing and so forth can be used in the functions
once data on these items are available.
In the discussion of the theoretical issues
above it was noted that an expenditure dis­
turbance would have a larger impact on in­
come under an interest rate policy than under
a money stock policy. Simulation of the
FR-M IT model provides the estimate that the
impact on income of an expenditures disturb­
ance, say in government spending, is over
twice as large under an interest rate policy as
under a money stock policy. An error in fore­
casting government spending, then, would lead
to twice as large an error in income under an
interest rate policy. Since there is no system­
atic record of forecasting errors for variables
such as government spending and strikes, there
is no way of producing evidence on the size of
such forecasting errors. However, after listing
the variables that must be forecast, as is done

in Section II, it is difficult to avoid feeling
that errors in forecasting are likely to be quite
significant.
These real disturbances, including forecast
errors in government expenditures, strikes, and
so forth, must be compared with the disturb­
ances in money demand. The reduced-form
studies conducted by a number of investigators
provide some evidence on this issue. These
studies compare the relative predictive power
of monetarist and Keynesian approaches in ex­
plaining fluctuations in income. From these
studies the predictive power of both ap­
proaches appears about equal. However, the
predictive power of the Keynesian approach
relies on ex post observation of “autonomous”
expenditures, and it is clear that these expendi­
tures are subject to forecasting errors ex ante
whereas the money stock can be controlled by
policy.
The evidence from the reduced-form studies
suggests that when forecast errors of autono­
mous expenditures are included in the disturb­
ance term, the disturbances are larger on the
real side than on the monetary side. There are
many difficulties with the reduced-form ap­
proach and so these results must be interpreted
cautiously. Nevertheless, the results cannot be
ignored.
The final piece of evidence offered in Sec­
tion II is a study by the author of the stability
of the demand for money function over time.
Using a very simple function relating the in­
come velocity of money to the Aaa corporate
bond rate, he found that a function fitted to
quarterly data for 1947-60 also fits data for
1961-68 rather well. The reader interested in
the precise meaning of “rather well” should
turn to the technical discussion in Section II.
Evidence on relative stability is difficult to
obtain and subject to varying interpretations.
No single piece of evidence is decisive, but all
the various scraps point in the same direction.
The evidence is not such that a reasonable
man can say that he has no doubts whatsoever. But since policy decisions cannot be
avoided, the reasonable decision based on the



available evidence is to adopt the money stock
as the monetary policy control variable.
A MONETARY RULE FOR GUIDING
POLICY. The conclusion from the theoretical
and empirical analysis is that the money
stock ought to be the policy control variable.
For this conclusion to be very useful, it must
be shown in detail how the money stock ought
to be used. It is not enough simply to urge
policy-makers to make the “appropriate” ad­
justments in the money stock in the light of all
“relevant” information.
There is no general agreement on exactly
what types of adjustments are appropriate.
However, it would probably be possible to ob­
tain agreement among most economists that
ordinarily the money stock should not grow
faster than its long-run average rate during a
period of inflation and should not grow slower
than its long-run average rate during recession.
But many economists would want to qualify
even this weak statement by saying that there
may at times be special circumstances requir­
ing departures from the implied guideline.
Others would say that there is no hope at
present of gauging correctly the impact of spe­
cial circumstances (or even of “standard” cir­
cumstances) so that policy should maintain an
absolutely steady rate of growth of the money
stock.
The basic issues are, first, whether policy­
makers can forecast disturbances well enough
to adjust policy to offset them, and second, the
extent to which money stock adjustments to
offset short-run disturbances will cause unde­
sirable longer-run changes in income and other
variables. The theoretical possibilities are
many, but the empirical knowledge does not
exist to determine which theoretical cases are
important in practice. It is for this reason that
a systematic policy approach is needed so that
policy can be easily evaluated and improved
with experience.
Policy could be linked in a systematic way
to a large-scale model of the economy. Target
values of GNP and other goal variables could
be selected by policy-makers, and then the

RULES-OF-THUMB FOR POLICY

model solved for the values of the money
stock and other control variables (for exam­
ple, discount rate) needed to achieve policy
goals. While this approach may be feasible in
the future, it is not feasible now because a suf­
ficiently accurate model does not exist. In­
stead, policy decisions are now made largely
on the basis of intuitive reactions to current
business developments.
Given this situation, the obvious approach is
to specify precisely how policy decisions ought
to depend on current developments, and this is
the approach taken in Section III. The specifi­
cation there takes the form of a policy guide­
line, or rule-of-thumb. The proposed rule is
purposely simple so that evaluation of its mer­
its would be relatively easy. Routine evaluation
of an operating guideline would over time pro­
duce a body of evidence that could be used to
modify and complicate the rule. But it is nec­
essary to begin with a simple rule because the
knowledge that would be necessary to con­
struct a sophisticated rule does not exist.
The proposed rule assumes that full employ­
ment exists when the unemployment rate is in
the 4.0 to 4.4 per cent range. The rule also as­
sumes that at full employment, a growth rate
of the money stock of 3 to 5 per cent per
annum is consistent with price stability. There­
fore, when unemployment is in the full em­
ployment range, the rule calls for monetary
growth at the 3 to 5 per cent rate.
The rule calls for higher monetary growth
when unemployment is higher, and lower mon­
etary growth when unemployment is lower.
Furthermore, when unemployment is relatively
high the rule calls for a policy of pushing the
Treasury bill rate down provided monetary
growth is maintained in the specified range;
similarly, when unemployment is relatively low
the rule calls for a policy of pushing the bill
rate up provided monetary growth is in the
specified range. Finally, the rule provides for
adjusting the rate of growth of money accord­
ing to movements in the Treasury bill rate in
the recent past. The exact rule proposed is in
Table 3 (p. 160) and the detailed rationale for




the various components of the rule is ex­
plained in the discussion accompanying that
table.
The rule is specified throughout in terms of
2 per cent ranges for the rate of growth of the
money stock on a month-by-month basis. By
expressing the rule in terms of a range, leeway
is provided for smoothing undesirable interest
rate fluctuations and for minor policy adjust­
ments in response to other information. Fur­
thermore, it is not proposed that this rule-ofthumb or guideline be followed if there is good
reason for a departure. But departures should
be justified by evidence and not be based on
vague intuitive feelings of what is needed since
the rule was carefully designed from the theo­
retical and empirical analysis of Sections I
and II, and from a careful review of post-ac­
cord policy.
There is no way of really testing the pro­
posed rule short of actually using it. However,
it is useful to compare the rule with post­
accord policy. A detailed comparison may be
found in Section III, pp. 153-57. A summary
comparison suggests, however, that for the
period January 1952 through July 1968 the
rule would have provided a less appropriate
policy than the actual policy in only 63 of the
199 months in the period. The rule was judged
to be less appropriate if it called for a higher—
lower—rate of monetary growth than actually
occurred and unemployment 12 months hence
was below—above—the desired range of 4.0
to 4.4 per cent. The rule was also judged less
appropriate than the actual policy if actual
policy was not within the rule but unemploy­
ment nevertheless was in the desired range 12
months hence. The rule actually has slightly
fewer errors if the criterion is unemployment
either 6 or 9 months following the months in
question.
The rule has the great virtue of turning pol­
icy around promptly as imbalances develop
and of avoiding cases such as the 2.2 per cent
rate of decline in the money stock from July
1957 through January 1958, during which
time the unemployment rate rose from 4.2 per

cent to 5.8 per cent. Furthermore, it seems
most unlikely that the rule would produce
greater instability than the policy actually fol­
lowed. Actual policy has, as measured by the
money stock, been most expansionary during
the early and middle stages of business cycle
expansions and most contractionary during the
last stages of business expansions and early
stages of business contractions. Unless a very
improbable lag structure exists, the rule would
surely be more stabilizing than the actual his­
torical pattern of monetary growth.
SELECTION AND CONTROL OF A
MONETARY AGGREGATE. The analysis in
this study is almost entirely in terms of the
narrowly defined money stock. The reasons for
using the narrowly defined money stock as op­
posed to other monetary aggregates may be
stated fairly simply.
Some economists favor the use of bank
credit as the monetary aggregate because they
view polic]' as operating through changes in
the cost and availability of credit. The major
difficulty with this view is that there is no un­
ambiguous way of defining the amount of
credit in the economy. And even if a satisfac­
tory definition could be worked out, there is
no current possibility of obtaining timely data
on the total amount of credit or of controlling
the total amount.
The definitional problem arises largely from
the activities of financial intermediaries. Sup­
pose, for example, that an individual sells
some corporate debentures and invests the
proceeds in a fixed-income type of investment
fund, which in turn uses the funds to buy the
very same debentures sold by the individual. If
both the debentures and the investment fund
shares are counted as part of total credit, then
in this example total credit has risen without
any additional funds being made available to
the corporation to finance new facilities and so
forth.
As another example, it is difficult to see that
it would make any substantial difference to ag­
gregate economic activity whether a corpora­
tion financed inventories through sales of com­




mercial paper to the public or through
borrowing from banks that raised funds
through sales of CD’s to the public. Since
there are numerous close substitutes for bank
credit, the amount of bank credit is most un­
likely to be an appropriate figure to empha­
size. Furthermore, since bank credit is only a
small part of total credit there is essentially no
possibility of controlling total credit, however
defined, through adjustments in bank credit.
Ultimately the issue again becomes that of
the stability of various functions. If the de­
mand and supply functions for all of the var­
ious credit instruments, including those of fin­
ancial intermediaries, were stable and were
known, then it would be possible to focus on
any aggregate that was convenient. For if all
the functions were known, then there would be
known relationships among various credit in­
struments, the money stock, and stocks and
flows of goods. But the demand and sup­
ply functions for the various credit instru­
ments are not known, and it is unlikely that
they ever will be known with any degree of
precision. There are two basic reasons for this
state of affairs. The first, and less important, is
that given the great degree of substitutability
among credit instruments, substitutions are
constantly taking place as a result of changes
in regulations, including tax regulations. But
second and more important, individual credit
instruments are greatly influenced by changes
in tastes and technology, factors that econo­
mists do not understand well.
As an example of the effects of regulations,
consider the substitution in recent years of de­
bentures for preferred stock as a result of the
tax laws permitting deduction of interest. As
examples of the effects of changes in tastes
and technology, consider the inventions of new
instruments such as CD’s and the shares in
dual-purpose investment funds. Furthermore,
the relationships among credit instruments will
change as attitudes toward risk change due to
numerous factors including perhaps fading
memories of the last recession or depression.
Money viewed as the medium of exchange

RULES-OF-THUMB FOR POLICY

seems to be substantially less subject to
changes in tastes and technology than do other
financial assets. Of course, money is not im­
mune to these problems, as shown by the un­
certainty presently existing over the impact of
credit cards. But a great deal of empirical
work on money has been completed and the
major findings have been substantiated by a
number of different investigators. And the in­
terpretation of the empirical findings is usually
clear because the empirical work has been
conducted within the framework of a welldeveloped theory of money. There is, on the
other hand, no satisfactory theory of bank
credit to guide empirical work and to permit
interpretation of the significance of empirical
findings.
For these reasons, and others, bank credit
does not appear to be an appropriate monetary
aggregate for policy to control. However, be­
cause bank credit and the money stock were
so highly correlated in the past, it must be ad­
mitted that it probably would not have made
much difference which one was used. From re­
cent experience, however, it appears that
changes in banks’ nondeposit sources of funds
are likely to become more, rather than less,
important, and so in the future the correlation
between money and bank credit is likely to be
lower than in the past. If this prediction is cor­
rect, then the issue is a significant one.
As a monetary aggregate, to be used for
policy adjustments, the money stock has clear
advantages over the monetary base and var­
ious reserve measures. These aggregates are al­
most always examined in adjusted form, where
the adjustments allow for such factors as
changes in the currency/deposit ratio, in re­
serve requirements, and in shifts between time
and demand deposits. The adjustments are
made because the effects of these various fac­
tors are understood and are thought to be
worth offsetting. The adjustments have the ef­
fect of making the base an almost constant
fraction of the money stock, or making total
reserves an almost constant fraction of demand
deposits. It obviously makes more sense to




look directly at the money stock, especially
since given the nature of the adjustments it is
no easier to control the adjusted base or ad­
justed total reserves than to control the money
stock.
The final aggregate to be considered is the
broadly defined money stock—the narrow
stock plus time deposits. No strong case can
be made against the broad money stock. From
existing empirical work both definitions of
money appear to work equally well. The theo­
retical distinction between demand deposits
and passbook savings deposits depends on the
costs of transferring between the two types of
deposits, and these costs appear to be quite
low. However, CD’s do appear to be theoreti­
cally different and probably should be ex­
cluded from the definition of money. The
major reason for excluding all time deposits
from the definition is that in the future banks
may invent new instruments that will be classi­
fied as time deposits for regulatory purposes
but for which the matter of definition as
money may not be at all clear.
The issue of controllability is a technical
one and need not be discussed carefully in this
summary. However, two conclusions may be
stated. First, instructions from the FOMC to
the Manager of the Open Market Account
should take the form of a specified average
weekly change in the money stock over the pe­
riod between FOMC meetings. Such an in­
struction must be distinguished from one in
terms of the average level of the money stock
over the period between FOMC meetings. The
average-level specification has several technical
difficulties and should be avoided.
The second conclusion is that it is possible
to control the rate of growth of the money
stock over a 3-month period in a range of 1
per cent on either side of a desired rate of
growth. This conclusion is based on an analy­
sis of monthly changes in the money stock
over the 1951-68 period, a period during
which little or no attention was paid to stabi­
lizing monetary growth, and it takes the histor­
ical record at face value. Assuming that efforts

to control the money stock would in fact suc­
ceed in part rather than make money growth
less stable than in the past, the estimate of
plus or minus 1 per cent is an upper limit to
the errors in controlling the growth rate of
money over 6-month periods.
CONCLUDING REMARKS. The orienta­
tion throughout this study has been the re­
direction of monetary policy on the basis of
currently available theory and evidence. The
recommendations are not utopian; in the au­
thor’s view they are supported by current
knowledge and are operationally feasible. The
approach has been in terms of what ought to
be done in the near future, rather than in terms
of what might be done eventually if enough in­
formation accumulates.
No effort has been made to slide over gaps
in our knowledge; rather, the emphasis has
been on how policy should be formed given
the huge gaps in our knowledge. Indeed, it is
precisely these gaps in our knowledge that lead
to the conclusion favoring policy adjustments
through the money stock.




It is the contention of this study that policy
can be improved if there is explicit recognition
of the importance of uncertainty. As much at­
tention should be given to the consequences of
errors in projections as to the projections
themselves. Policy may be improved more by
“don’t know” answers to questions than by
projections believed by no one.
This is the static view. If policy can be im­
proved now through greater attention to uncer­
tainty, in the long run it can be improved fur­
ther only through a reduction in uncertainty.
This longer view underlies the proposal for
a policy rule-of-thumb. Policy successes and
failures ought to be incorporated into a policy
design in a form that will repeat the successes
and prevent the recurrence of the failures.
Policy-making will always require judgment,
but the judgment will be applied to changing
problems at a moving frontier of knowledge. A
systematic formulation of policy will speed the
accumulation of knowledge so that the policy
problems of today will become the technical
staff problems of tomorrow.

RULES-OF-THUMB FOR POLICY

REFERENCES
Books

1. Fels, Rendigs, and Hinshaw, C. Elton,

Fore­
casting and Recognizing Business C ycle
Turning Points . New York: National

Bureau of Economic Research, 1968.
2. Friedman, Milton, and Meiselman, David.
“The Relative Stability of Monetary Ve­
locity and the Investment Multiplier in the
United States, 1897-1958.” Commission
on Money and Credit, Stabilization Poli­
cies. Englewood Cliffs, N.J.: PrenticeHall, Inc., 1963.
3. Holmes, Alan R. “Operational Constraints
on the Stabilization of Money Supply
Growth,” Controlling M onetary A ggre­
gates. Boston: Federal Reserve Bank of
Boston, 1969.
4. Laidler, David E. W. The D em and fo r
M oney: Theories and E vidence. Scranton,
Pa.: International Textbook Company,
1969.
5. Mincer, Jacob (ed.). Econom ic Forecasting
and E xpectations . New York: National
Bureau of Economic Research, 1969.
6. Reynolds, Lloyd G. E conom ics . 3rd ed.
Homewood, 111.: Richard D. Irwin, Inc.,
1969.
7. Samuelson, Paul A. E conom ics , 7th ed. New
York: McGraw-Hill, 1967.
8. Theil, Henri. O ptim al D ecision R ules for
G overnm ent and Industry . Amsterdam:
North-Holland Publishing Company, 1964.
Periodicals and Other




9. Andersen, Leonall C., and Jordan, Jerry L.
“Monetary and Fiscal Actions: A Test of
Their Relative Importance in Economic
Stabilization.” R eview , Federal Reserve
Bank of St. Louis (Nov. 1968), pp. 11-24.
10. Ando, Albert, and Modigiliani, Franco. “The
Relative Stability of Monetary Velocity
and the Investment Multiplier,” A m erican
E conom ic R eview , Vol. 55 (Sept. 1965),
pp. 693-728.
11.
. “Rejoinder,” A m erican E conom ic R e­
view, Vol. 55 (Sept. 1965), pp. 786-90.

188

12. Brainard, William. “Uncertainty and the
Effectiveness o f Policy,” A m erican E co­
nom ic R eview : Papers and Proceedings o f
the 79th Annual M eeting o f the A m erican
E conom ic A ssociation, Vol. 57 (M ay
1967), pp. 4 1 1 -2 5 .
13. Brunner, Karl, and Meltzer, Allan H. “The
Federal Reserve’s Attachment to the Free
Reserve Concept.” Prepared for the Sub­
comm ittee on D om estic Finance, Banking
and Currency Committee, H ouse of Rep­
resentatives, 88th Cong., 2d sess. Wash­
ington, D.C.: U .S. Government Printing
Office, 1964.
14. de Leeuw, Frank, and Gramlich, Edward.
“The Federal Reserve— M IT Econometric
M odel,” Federal Reserve B ulletin, Vol. 54
(Jan. 1968), pp. 1 1-40.
15. DePrano, M ichael, and Mayer, Thomas.
“Tests o f the Relative Importance o f A u­
tonom ous Expenditures and M oney,”
A m erican E conom ic R e vie w , Vol. 55
(Sept. 1965), pp. 7 2 9 -5 2 .
16.
. “Rejoinder,” A m erican E conom ic R e­
view , Vol. 55 (Sept. 1 9 6 5 ), pp. 7 9 1 -9 2 .
17. Friedman, Milton, and Meiselman, David.
“Reply to A ndo and M odigliani and to
DePrano and M ayer,” A m erican E co­
nom ic R eview , V ol. 55 (Sept. 1 9 6 5 ), pp.
7 5 3 -8 5 .
18.
. “Reply to D onald Hester,” R eview o f
E conom ics and Statistics, V ol. 46 (N ov.
19 6 4 ), pp. 3 6 9 -7 6 .
19. Hester, Donald D . “Keynes and the Quan­
tity Theory: A Com m ent on the Friedman-M eiselman CMC Paper,” R eview o f
E conom ics and Statistics, Vol. 46 (N ov.
1964), pp. 3 6 4 -6 8 .
20.
. “Rejoinder,” R eview o f E conom ics
and Statistics, V ol. 46 (N ov. 19 6 4 ), pp.
3 7 6 -7 7 .
21. Holt, Charles C. “Linear D ecision Rules for
Econom ic Stabilization and Growth,”
Quarterly Journal o f E conom ics, Vol. 76
(Feb. 1962), pp. 2 0 -4 5 .
22. Latane, Henry A . “Cash Balances and the
Interest Rate— A Pragmatic Approach,”
R eview o f E conom ics and Statistics, Vol.
36 (N ov. 1954), pp. 4 5 6 -6 0 .




Periodicals and other (Cont.)

RULES-OF-THUMB FOR POLICY

Periodicals and other (Cont«)




23. -------. “Income Velocity and Interest Rates—
A Pragmatic Approach,” R eview o f E co­
nomics and Statistics, Vol. 42 (N ov.
1 960), pp. 4 4 5 -4 9 .
24. Moore, Geoffrey H ., and Shiskin, Julius. In­
dicators o f Business Expansions and Con­
tractions, Occasional Paper 103. N ew
York: National Bureau of Econom ic Re*
search, 1967.
25. Poole, William. “Optimal Choice of M one­
tary Policy Instruments in a Simple Sto­
chastic Macro M odel,” Quarterly Journal
o f Economics, Vol. 84 (M ay 1 970), pp.
197-216.
26. Zarnowitz, Victor. A n A ppraisal o f ShortTerm E conom ic Forecasting, Occasional
Paper 104. N ew York: National Bureau
o f Econom ic Research, 1967.

189




By Stephen H. Axilrod




APPENDIX:
MONETARY AGGREGATES
AND MONEY MARKET
CONDITIONS IN OPEN
MARKET POLICY

CONTENTS




195

DIRECTIVES OF THE FOMC

198

POLICY FORMATION

200

ROLE OF MONETARY AGGREGATES

206

DAY-TO-DAY OPEN MARKET
OPERATIONS

210

APPENDIX:
Current Economic Policy Directives
Issued by the FOMC

This appendix is reprinted from the Federal
Reserve B ulletin, February 1971, pages
79-104.




Monetary Aggregates
and
Money Market Conditions
in Open Market Policy
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 Fed­
eral Reserve System’s open market policy. This article discusses
the role— in the decision-making process of the Federal Open
M arket Committee (F O M C )1 and in the day-to-day conduct
of Federal Reserve open 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 di­
rectly, that are evaluated in monetary policy decisions and their
implementation. And financial conditions as a whole are eval­
uated against the underlying purpose of monetary policy— the
encouragement of a healthily functioning economy, both do­
mestically 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
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 most flexible and frequently used instrument by which
monetary policy affects bank reserves, bank credit, money supply, and ulti­
mately over-all credit conditions. The FOMC consists of the seven members
of the Board of Governors of the Federal Reserve System, the President of
the Federal Reserve 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.




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 ten­
dencies in domestic economic activity and the balance of pay­
ments appear desirable, and if not, how they might be influ­
enced 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 mone­
tary policy stems from its influence on bank credit, money, in­
terest rates, and financial flows generally, the greater emphasis
placed on monetary aggregates basically represented a modifica­
tion of operating procedures rather than a change in the funda­
mental 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 un­
desired shifts in demands for goods and services and for credit.
At the same time, however, an approach that utilizes aggre­
gates as one operating guide must take account of shifts in the
demand for money and liquidity at given levels of income. Such
shifts would have to be accommodated through open m arket
operations in order to help provide the money and liquidity de­
manded 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 emerg­
ing 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 in­
cluded as guidance for open market operations, short-run, selfcorrecting variations in money and credit demands need to be ac­
commodated 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 AGGREGATES AND MARKET CONDITIONS

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 OF THE
FOMC




The monetary policy decisions of the FOM C— 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, under­
takes 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, and also
a general statement of current goals of the FOMC with respect
to economic growth, price stability, and the balance of pay­
ments.2 The second paragraph contains the FOM C’s instructions
to the Account Manager for guiding open market operations in
the interval between FOMC meetings. The second paragraph is,
- 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 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 con­
siderable 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 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 Commit­
tee to foster financial conditions conducive to the reduction of inflationary
pressures, with a view to encouraging sustainable economic growth and attain*
ing reasonable equilibrium in the country’s balance of payments/’

195




in essence, a highly condensed summary of the Committee s dis­
cussion 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 para­
graph of the directive has changed from time to time. Money
market conditions have remained as important guides in de­
termining 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 win­
dow, 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 times the 3-month Treasury bill rate.
At times when it was framing the operating instructions con­
tained in the second paragraph of its directive solely in terms of
money market conditions, the FOMC was nevertheless con­
cerned 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 supply.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.”
was also occasional reference to such aggregates in directives during
the first half of the 1960’s.




MONETARY AGGREGATES AND MARKET CONDITIONS

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 de­
sired pattern of behavior in the monetary aggregates. The Sys­
tem Account M anager has also been directed, when appropriate,
to take account of Treasury financings, liquidity pressures, and
the possible impacts of bank regulatory changes in the process
of achieving satisfactory conditions in the money market and
satisfactory performance of monetary aggregates.
As the nature of economic and financial problems 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 m arket uncer­
tainties 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 ex­
tent 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 re­
sult from the Board’s action around midyear in suspending ceil­
ings on maximum interest rates payable by banks on large cer­
tificates 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 FOM C on July 21,1970:
“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, allow­




ing for a possible continued shift of credit flows from m arket 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 consist­
ent with that objective; provided, however, that operations shall
be modified as needed to counter excessive pressures in financial
markets 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 m onetary
aggregates, as follows:
“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 prob­
lems 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.
FORMATION

The FOMC s basic concern is with the real economy— produc­
tion, 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 m arket opera­
tions, 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 achieve­
ment of the broader financial and economic objectives of the
FOMC.
In setting its immediate operating targets, the FO M C neces­
sarily reviews past and prospective relationships between finan­
cial conditions and economic objectives. A benchmark in this




MONETARY AGGREGATES AND MARKET CONDITIONS

review is provided several times a year in a presentation by the
staff to the Committee of an interrelated set of longer-run eco­
nomic 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 ex­
pected to be consistent with these patterns of economic develop­
ment. 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 FOM C by the
staff on the occasion 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 or all Committee mem­
bers believe that economic prospects are deviating from those
that had previously been expected and desired. If so, the Com­
mittee 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. O r it may turn out that economic activity is develop­
ing 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 M anager
for purposes of guiding day-to-day open m arket operations and

)0

broader financial flows and interest rates is not what was ex­
pected. 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 opera­
tions 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 move­
ments of funds between the U.S. and foreign countries.

ROLE OF
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, and financial flows
generally. But the benefits that might be expected from an in­
creased degree of emphasis on monetary aggregates in the con­
duct of open market operations relate to the question of mone­
tary control under conditions of uncertainty.
Greater emphasis on aggregates is consistent with a variety
of economic theories, and it does not necessarily imply any par­
ticular judgment as to the importance for the economy of mone­
tary 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







MONETARY AGGREGATES AND MARKET CONDITIONS

on monetary aggregates in the instructions to the Account Manager, the FOM C 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 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 strengthen­
ing of demands for goods and services.
While increasing the emphasis on monetary and credit aggre­
gates 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 pub­
lic’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 econo­
mists 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

201




purchases of goods and services and/or in private sector de­
mands for capital goods and inventories have caused marked
shifts in over-all demands for goods and services at given inter­
est 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 dis­
tinguish 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 by rising
long-term interest rates at a time when economic activity was
sluggish, by the bankruptcy of a major railroad, and by a gen­
erally cautionary attitude on the part of investors toward securi­
ties, particularly commercial paper— were giving rise to consider­
able uncertainty 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 FO M C’s
policy directives in that period (see directives of M ay 26 and
July 21, 1970, on pp. 99 and 100) tended to subordinate, tem­
porarily, 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 FO M C has to make
judgments about the nature of the fundamental influences that
are affecting the domestic economy and the international posi­
tion of the dollar. If, for example, it developed that interest rates




MONETARY AGGREGATES AND MARKET CONDITIONS

were higher, and over-all credit conditions tighter, than expected
for a given rate of increase in bank credit or money, the FOM C
would have to make a judgment as to whether GNP was stronger
than anticipated, whether inflationary expectations were affect­
ing 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 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 m arket 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 an d /o r whether to put more
stress on money or credit m arket 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 mone­
tary aggregates, the FOM C 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
defined money supply— currency in circulation outside the bank­
ing 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 analyst? in relating
money supply to economic activity. These include, in addition
to the narrowly defined money supply, a concept— here termed
M ,— that adds time and savings deposits other than large CD’s
at commercial banks to narrowly defined money; and a concept,

203




termed Ms, that 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 per cent

Period

Mi
(Currency
plus demand
deposits1)

m2
(M i plus coml.
bank time deposits
other than
large CD’s)

Mi
(M 2 plus deposits
at S&L’s and
mutual savings
banks)

1969.......................
1970.......................

3.1
5.4

2.4
8.2

2.8
7.9

1970—Q1...............
Q2...............
Q3...............
Q4...............

5.9
5.8
6.1
3.4

3.4
8.4

11.0
9.2

2.6
7.9
10.5
9.7

1970—January___
February. . .
March........
April...........
May............
June............
July.............
August........
September..
October___
November..
December. .

9.4
“ 4.1
12.3
9.9
5.2
2.3
5.7
6.8
5.7
1.1
2.8
6.2

2.2
- 1 .5
9.6
10.8
7.6
6.7
9.9
12.5
10.3
7.3
7.0
13.0

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 D em and deposits other than interbank and U .S . G ovt.
N o t e . — M onthly rates o f change based o n the daily-average levels o u tsta n d in g . Q uarterly and a n n u a l

rates o f changes m easured from daily*average levels outstand ing in en d -of-p eriod m o n th s.

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 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




MONETARY AGGREGATES AND MARKET CONDITIONS

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 M s above, but
also funds obtained by banks through large time CD’s, U.S.
Government deposits, and interbank deposits and through non­
deposit 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.
Inclusion of bank credit in the 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 m arket operations.
The amount of bank credit that the FO M C is willing to
encourage or to countenance depends, like the money supply,
on over-all economic and financial conditions. When, for exam­
ple, 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 restructured its
financial asset portfolios to reflect the changed yield relation­
ships. Federal Reserve open m arket 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

CREDIT PROXY ADJUSTED;
TOTAL RESERVES

206

BI L LI ONS OF DO LL AR S

1967______________ 1968_____________ 1969

1970

B ank "cred it proxy ad ju sted ” is to tal m em ber b an k deposits plus funds p ro v id e d by E u ro ­
dollar borrow ings and b an k -related com m ercial pap er. T h ro u g h th e first h a lf of 1969, n o
d ata on b ank-related com m ercial p aper w ere available, b u t am o u n ts o u tsta n d in g were n o t
thought to be grow ing significantly in those p eriods.

measured by the adjusted credit proxy, along with total bank
reserves.
DAY-TO -DAY OPEN
M A R K E T O PER A TIO N S




The day-to-day operations in the m arket by the System Account
M anager have continued to be guided m ainly by money m arket
conditions, in part because the inform ation that is available daily
and continuously as to the state of the money m arket— for ex­
ample, the Federal funds rate and dealer loan rates— reflects
the interaction of the dem and for and existing supply of bank
reserves and hence provides a basis for m aking daily decisions
as to whether the System should be in the m arket providing addi­
tional or absorbing existing reserves; and if so, by how m uch
and through what means. But the degree to which the M anager
seeks to influence money m arket conditions has been affected
by the relationship that is presum ed to exist at any given time
among money m arket conditions, reserves, and the m onetary
aggregates and by the Com m ittee’s desires with respect to m one­
tary aggregates and over-all conditions in the credit m arket.
Changes in money m arket conditions, of course, m ay reflect
factors other than efforts to influence reserve flows in accordance




MONETARY AGGREGATES AND MARKET CONDITIONS

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 shortrun effects of bulges in demand for day-to-day credit at times of
Treasury financings or in tax payment periods. Yet others repre­
sent 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 m arket operations in relation to money market conditions
may sometimes reflect primarily a concern with liquidity pres­
sures in the economy.
Although recognizing that money market conditions are sub­
ject 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 pre­
vailed 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 m arket conditions.
If and as it becomes evident that monetary aggregates are
running above or below the desired path, however, the Account
M anager 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 opera­
tions. 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.
While the counterpart of greater sensitivity to monetary aggre­
gates would be a somewhat greater tendency for actual money
market conditions to change more frequently than otherwise,

207

208




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 responsi­
bility for maintenance of orderly conditions in such a market.
Second, there are large and often unpredictable week-to-week
and month-to-month 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 gen­
erally, that would be likely to develop should the flow and ebb of
these demands not be accommodated in Federal Reserve opera­
tions affecting bank reserves.
Third, because of the key role of the money m arket 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 par­
ticipants as a harbinger of relatively permanent changes in credit
demand or monetary policy. Investors, businessmen, and con­
sumers 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 ten­
dencies in money supply, bank credit, and over-all credit conditions require such changes.
While there are reasons for emphasis on money m arket condi­
tions, it should be stressed that money market conditions are
only instrumental to the attainment of the main financial ob­
jectives of policy— flows of monetary aggregates and over-all
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 FOM C generally has in mind not only some view
concerning the desired longer-run trend in various monetary




MONETARY AGGREGATES AND MARKET CONDITIONS

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 M anager would have
to adjust his operations— thereby affecting day-to-day money
market conditions— in line with the sense of priority among op­
erating objectives given by the FOMC.
While the whole set of objectives would be reconsidered at
the next FOM C meeting, the Account M anager’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 FOM C (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 M anager 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 posi­
tions, money market conditions, and broader credit conditions
reported, but also information on the latest deposit and bank
credit figures and how these compare with FOM C desires is
appraised.
In general, as the FO M C’s objectives with respect to monetary
aggregates, and also over-all credit conditions, have been given
increased stress in the directive to the Account M anager, the
timing and extent of the System’s day-to-day open m arket opera­
tions have, of course, been altered, with consequent effects on
day-to-day money m arket conditions. At the same time, the
M anager still takes account of the emerging tightness or ease in
the money m arket as a factor affecting the timing and extent of
day-to-day open m arket operations. But this emerging tightness
or ease is evaluated against trends in money, bank credit, and
over-all credit conditions, which are, and always have been,
among the basic financial objectives of monetary policy.

209

210




APPENDIX: Current Economic Policy Directives Issued by
the FOMC
M eeting held on December 1 6 ,1 9 6 9
The information reviewed at this meeting indicates that real econom ic
activity has expanded only moderately in recent quarters and that a further
slowing o f 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 un­
changed. The net contraction of outstanding large-denomination C D ’s has
slowed markedly since late summer, apparently reflecting mainly an in­
crease in foreign official time deposits. However, flows o f consumer-type
time and savings funds at banks and nonbank thrift institutions have
remained weak, and there is considerable market concern about the poten­
tial size o f net outflows expected around the year-end. In N ovem ber the
balance of payments deficit on the liquidity basis diminished further and
the official settlements balance reverted to surplus, mainly as a result o f
return flows out of the German mark and renewed borrowing by U.S.
banks from their foreign branches. In light o f 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 equi­
librium 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.
M eeting held on January 1 5 ,1 9 7 0
The information reviewed at this meeting suggests that real econom ic
activity leveled off in the fourth quarter of 1969 and that little change is
in prospect for the early part o f 1970. Prices and costs, however, are con­
tinuing 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 large-denomination C D ’s held by domestic deposi­
tors have continued to contract in recent months while foreign official time
deposits have expanded considerably. Flows o f consumer-type time and
savings funds at banks and nonbank thrift institutions have remained weak,
and there apparently were sizable net outflows after year-end interest cred­
iting. U.S. imports and exports have both grown further in recent months
but through November the trade balance showed little or no further im ­
provement from the third-quarter level. At the year-end the over-all balance
o f payments statistics were buoyed by large temporary inflows o f U .S. cor­
porate funds. In light o f the foregoing developments, it is the policy o f the
Federal Open Market Committee to foster financial conditions conducive




MONETARY AGGREGATES AND MARKET CONDITIONS

to the orderly reduction of inflationary pressures, with a view to encourag­
ing sustainable econom ic growth and attaining reasonable equilibrium in
the country’s balance of payments.
To implement this policy, while taking account of the forthcoming Treas­
ury 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, how­
ever, that operations shall be modified if money and bank credit appear to
be deviating significantly from current projections.
Meeting held on February 1 0 ,1 9 7 0
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. 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 January but the money supply increased substantially on aver­
age; 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 o f 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 o f payments.
To implement this policy, while taking account o f 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 m oney and bank credit
to deviate significantly from a moderate growth pattern.
M eeting held on March 1 0 ,1 9 7 0
The information reviewed at this meeting suggests that real economic
activity, which leveled off in the fourth quarter of 1969, is weakening fur­
ther 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
econom ic activity and monetary policy. Both bank credit and the m oney
supply declined on average in February, but both were tending upward in
the latter part of the month. Outflows o f time and savings funds at banks
and nonbank thrift institutions, which had been sizable in January, appar­
ently 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

210




APPENDIX: Current Economic Policy Directives Issued by
the FOMC
M eeting held on December 1 6 ,1 9 6 9
The information reviewed at this meeting indicates that real econom ic
activity has expanded only moderately in recent quarters and that a further
slowing o f growth appears to be in process. Prices and costs, however, are
continuing to rise at a rapid pace. M ost 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 m oney supply
increased moderately over the 2-month period; in the third quarter, bank
credit had declined on balance and the money supply was about un­
changed. The net contraction o f outstanding large-denomination C D ’s has
slowed markedly since late summer, apparently reflecting mainly an in­
crease in foreign official time deposits. However, flows o f consumer-type
time and savings funds at banks and nonbank thrift institutions have
remained weak, and there is considerable market concern about the poten­
tial size of net outflows expected around the year-end. In N ovem ber the
balance o f payments deficit on the liquidity basis diminished further and
the official settlements balance reverted to surplus, mainly as a result o f
return flows out o f the German mark and renewed borrowing by U.S.
banks from their foreign branches. In light o f the foregoing developments,
it is the policy of the Federal Open Market Committee to foster financial
conditions conducive to the reduction o f inflationary pressures, with a view
to encouraging sustainable economic growth and attaining reasonable equi­
librium 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.
M eeting held on January 1 5 ,1 9 7 0
The information reviewed at this meeting suggests that real econom ic
activity leveled off in the fourth quarter o f 1969 and that little change is
in prospect for the early part of 1970. Prices and costs, however, are con­
tinuing to rise at a rapid pace. Most market interest rates have receded
from highs reached during December. Bank credit and the m oney supply
increased slightly on average in Decem ber and also over the fourth quarter
as a whole. Outstanding large-denomination C D ’s held by domestic deposi­
tors have continued to contract in recent months while foreign official time
deposits have expanded considerably. Flows o f consumer-type time and
savings funds at banks and nonbank thrift institutions have remained weak,
and there apparently were sizable net outflows after year-end interest cred­
iting. U.S. imports and exports have both grown further in recent months
but through November the trade balance showed little or no further im ­
provement from the third-quarter level. A t the year-end the over-all balance
o f payments statistics were buoyed by large temporary inflows o f U .S. cor­
porate funds. In light o f the foregoing developments, it is the policy o f the
Federal Open Market Committee to foster financial conditions conducive




MONETARY AGGREGATES AND MARKET CONDITIONS

to the orderly reduction o f inflationary pressures, with a view to encourag­
ing sustainable econom ic growth and attaining reasonable equilibrium in
the country’s balance o f payments.
To implement this policy, while taking account of the forthcoming Treas­
ury 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, how­
ever, 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. 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 January but the money supply increased substantially on aver­
age; both had risen slightly in the fourth quarter. Flows o f 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 o f 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 m oney 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 o f 1969, is weakening fur­
ther 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
econom ic 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, appar­
ently ceased in February, reflecting advances in rates offered on such funds
follow ing 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 condu­
cive to orderly reduction in the rate of inflation, while encouraging the
resumption of sustainable economic growth and the attainment of reason­
able 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 uncer­
tain, 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 o f 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 o f
payments appears to have been in considerable deficit during the first
quarter. In light of the foregoing developments, it is the policy of the Fed­
eral 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 o f reasonable equilib­
rium 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 objec­
tive, taking account o f 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 enlarge­
ment 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 ten­
dencies. M ost market interest rates have risen sharply in recent weeks as
a result o f heavy demands for funds, possible shifts in liquidity preferences,
and the disappointment o f earlier expectations regarding easing o f 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 A sia and by concern about
the success of the Government’s anti-inflationary program. Both bank credit




MONETARY AGGREGATES AND MARKET CONDITIONS

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 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 eco­
nomic growth and the attainment of reasonable equilibrium in the country’s
balance o f 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; pro­
vided, 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 long-term interest rates have remained under upward pres­
sure, partly as a result o f 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-infla­
tionary 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 m oney supply appears to be expanding rapidly. The over-all
balance of payments continued in considerable deficit in April and early
May. In light o f 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 sus­
tainable economic growth and the attainment of reasonable equilibrium in
the country’s balance of payments.
T o implement this policy, in view o f current market uncertainties and
liquidity strains, open market operations until the next meeting of the Com ­
mittee shall be conducted with a view to moderating pressures on financial
markets, while, to the extent compatible therewith, maintaining bank re­
serves and m oney market conditions consistent with the Committee’s longerrun objectives o f moderate growth in money and bank credit.

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 com ­

213




mon 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 o f a major
railroad. In May bank credit changed little and the money supply rose m od­
erately 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 C D ’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 pres­
sures 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 slow­
ing the rise in costs, and some major price measures are showing moderat­
ing tendencies. Since mid-June long-term interest rates have declined con­
siderably, 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 largedenomination C D ’s of short maturity— for which rate ceilings were sus­
pended in late June. Consequently, in early July bank credit grew rapidly;
there was also a sharp increase in the money supply. Over the second quar­
ter 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 reduc­
tion in the rate of inflation, while encouraging the resumption o f sustainable
economic growth and the attainment of reasonable equilibrium in the coun­
try’s balance of payments.
T o implement this policy, while taking account of persisting market un­
certainties, 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 o f credit
flows from market to banking channels. System open market operations




MONETARY AGGREGATES AND MARKET CONDITIONS

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 appre­
ciably earlier in the year, may be expanding somewhat further. Prices and
wage rates generally are continuing to rise at a rapid pace. However, im ­
provements in productivity appear to be slowing the rise in costs, and som e
major price measures are showing 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 con­
nection with market instruments o f less than prime grade. In July the money
supply rose moderately on average and bank credit expanded substantially.
Banks increased holdings o f securities and loans to finance companies, some
of which were experiencing difficulty in refinancing maturing commercial
paper. Banks sharply expanded their outstanding large-denomination C D ’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
o f 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 o f inflation, while encouraging the resumption o f sustainable eco­
nom ic 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
o f 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 credit flows from market to banking channels.
System open market operations until the next meeting o f the Committee
shall be conducted with a view to maintaining bank reserves and money
market conditions consistent with that objective, taking account o f the
effects o f other monetary policy actions.

Meeting held on September 15,1970
The information reviewed at this meeting suggests that real econom ic
activity, which edged up slightly in the second quarter, is expanding som e­
what further in the third quarter, led by an upturn in residential construc­
tion. W age rates generally are continuing to rise at a rapid pace, but im ­
provements in productivity appear to be slowing the rise in costs, and some
major price measures are rising less rapidly than before. Interest rates de­
clined in the last half o f August, but most yields turned up in early Septem­
ber, as credit demands in securities markets have continued heavy; existing
yield spreads continue to suggest concern with credit quality. The m oney




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 C D ’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 secondquarter rate, but the deficit on the official settlements basis remained high
as banks repaid Huro-dollar liabilities. In light of the foregoing develop­
ments, it is the policy of the Federal Open Market Committee to foster
financial conditions conducive to orderly reduction in the rate o f 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 attend­
ant 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 auto­
mobile 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 mid-September, although yields on
corporate and municipal bonds have been sustained by the continuing heavy
demands for funds in capital markets. The money supply rose 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 consider­
ably less than the fast pace of the two preceding months. Banks continued
to issue large-denomination C D ’s at a relatively rapid rate and experienced
heavy inflows of consumer-type time and savings funds, while making sub­
stantial further reductions in their use of nondeposit sources o f 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 liabili­
ties. In light of the foregoing developments, it is the policy o f the Federal
Open Market Committee to foster financial conditions conducive to orderly
reduction in the rate of inflation, while encouraging the resumption o f sus­
tainable economic growth and the attainment of reasonable equilibrium in
the country’s balance of payments.
To implement this policy, the Committee seeks to promote som e easing
of conditions in credit markets and moderate growth in money and attendant
bank credit expansion over the months ahead. System open market opera­
tions 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.




MONETARY AGGREGATES AND MARKET CONDITIONS

M eeting held on Novem ber 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 un­
employment has increased. Part but not all of the weakness in over-all
activity is attributable to the strike in the automobile industry which ap­
parently 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. M ost interest rates declined considerably in the past few
weeks, and Federal Reserve discount rates were reduced by one-quarter
of a percentage point in the week o f N ovem ber 9. Demands for funds in
capital markets have continued heavy, but business loan demands at banks
have weakened. The m oney 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 second-quarter rate, but the deficit on the
official settlements basis remained high as banks repaid Euro-dollar lia­
bilities. In light o f the foregoing developments, it is the policy o f the
Federal Open Market Committee to foster financial conditions conducive
to orderly reduction in the rate o f inflation, while encouraging the resump­
tion o f sustainable econom ic growth and the attainment o f reasonable
equilibrium in the country’s balance of payments.
To implement this policy, the Committee seeks to promote some easing
o f conditions in credit markets and moderate growth in money and attend­
ant bank credit expansion over the months ahead, with allowance for
temporary shifts in m oney 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.
M eeting held on D ecem ber 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 autom obile produc­
tion is expected to result in a bulge in activity in early 1971. W age rates
generally are continuing to rise at a rapid pace, but gains in productivity
appear to be slowing the increase in unit labor costs. M ovements in major
price measures have been diverse; most recently, wholesale prices have
shown little change while consumer prices have advanced substantially. Mar­
ket interest rates declined considerably further in the past few weeks, and
Federal Reserve discount rates were reduced by an additional one-quarter
o f a percentage point. Demands for funds in capital markets have contin­
ued heavy, but business loan demands at banks have been weak. Growth
in the money supply was somewhat more rapid on average in N ovem ber
than in October, although it remained below the rate prevailing in the
first three quarters o f the year. Banks acquired a substantial volum e of
securities in N ovem ber, and bank credit increased moderately after chang­
ing little in October. The foreign trade balance in September and October
was smaller than in any other 2-m onth period this year. The over-all

217

218




balance of payments deficit on the liquidity basis remained in October and
November at about its third-quarter rate. The deficit on the official settle­
ments basis was very large as banks continued to repay Euro-dollar lia­
bilities. 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 resump­
tion 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 ex­
pected rates of growth in money and bank credit will at least be achieved.




3 0313 00DH1 334=1