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^Review
March 1980
Vol. 62, No. 3

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2 The F O M C in 1979: Introducing Reserve Targeting
26 The Dynamics and Estimation of Short-Run
Money Demand

The FOMC in 1979: Introducing
Reserve Targeting
RICHARD W. LANG

M
a j o r changes in the implementation of mone
tary policy occurred in 1979. In accordance with the
Full-Employment and Balanced Growth Act of 1978,
the Federal Open Market Committee (FO M C ) was
required to announce long-run ranges for monetary
growth in 1979 in a new format. In addition, the
FOM C had to adjust its one-year range for M l growth
to take into account the introduction of two financial
innovations in late 1978 — the automatic transfer
service (A TS) between savings and checking ac
counts at banks nationwide and negotiable orders of
withdrawal (N O W ) accounts in New York State.
The most important change in the implementation
of monetary policy, however, occurred in the FOM C’s
short-run operating procedures. On October 6, 1979,
the Federal Reserve announced a series of actions to
“assure better control over the expansion of money
and bank credit, help curb speculative excesses in
financial, foreign exchange, and commodity markets,
and thereby serve to dampen inflationary forces.”1 The
most significant of these actions was the FOM C’s ap
proval of a change in the day-to-day procedures used
to conduct monetary policy.
This action involves placing greater emphasis in
day-to-day operations on the supply of bank re
serves and less emphasis on confining short-term
fluctuations in the federal funds rate.2

This announcement introduced a different strategy for
the conduct of open market operations — a strategy of
targeting on bank reserves rather than the federal
funds rate.
Note: Unless specified otherwise, citations throughout this
paper are from either the “Record of Policy Actions of the
Federal Open Market Committee” or “Statements to Congress,”
Federal Reserve Bulletin (February 1979 through March 1980).
^‘Announcements: Monetary Policy Actions,” Federal Reserve
Bulletin (October 1979), p. 830.
2Ibid.

This article discusses these modifications to the
implementation of monetary policy and summarizes
the decisions of the FOMC in 1979. The Committee’s
domestic policy directives are summarized in table 1.
Excerpts from the monthly “Record of Policy Actions
of the FOM C,” which provide a more detailed meet
ing-by-meeting summary of FOMC discussions, ap
pear in a supplement to this article.

LONG-RUN RANGES OF
MONETARY GROWTH
Since 1975 the FOMC has publicly announced oneyear growth ranges for the monetary aggregates (M l,
M2, and M 3). At that time, Congress requested in
House Concurrent Resolution 133 that the Board of
Governors consult with congressional committees on
a quarterly basis about the Federal Reserve System’s
objectives and plans for the ranges of growth of mone
tary and credit aggregates over the next 12 months.
Such consultations became a requirement with the
Federal Reserve Reform Act of 1977. The format of
these one-year ranges was altered in 1979, however,
under the requirements of the Full Employment and
Balanced Growth Act of 1978 (also called the Humphrey-Hawkins A ct). At the same time, the FOMC
had to formulate monetary growth ranges that took
into account the introduction of nationwide ATS ac
counts and New York NOW accounts.

The Humphrey-Hawkins Act
Before 1979 the FOM C reviewed and adopted oneyear growth ranges for several monetary and credit
aggregates each quarter and presented them to Con
gress. The period to which these growth ranges ap
plied began with the previous quarter and ended in
the same quarter of the following year. For instance,

MARCH

F E D E R A L R E S E R V E B A N K O F ST. LO U IS

1980

Organization of the Committee in 1979
The Federal Open Market Committee (FO M C ) con
sists of the seven members of the Federal Reserve
Board of Governors and five of the twelve Federal Re
serve Bank presidents. The Chairman of the Board of
Governors is also, by tradition, chairman of the Com
mittee. The president of the New York Federal Re
serve Bank is a permanent member of the Committee
and, also by tradition, its vice chairman. All Federal
Reserve Bank presidents attend the meetings and
present their views, but only those presidents who are
members of the Committee may cast votes. Four mem
berships rotate among the Bank presidents and are
held for one-year terms beginning March 1 of each
year.
Members of the Board of Governors at the begin
ning of 1979 included Chairman G. William Miller,
Philip E. Coldwell, J. Charles Partee, Nancy H.
Teeters, and Henry C. Wallich. There were two
vacancies on the Board as a result of the death of
Vice Chairman Stephen S. Gardner and the resigna
tion of Governor Phillip C. Jackson in November 1978.
In addition to Paul A. Volcker, president of the Fed
eral Reserve Bank of New York, the following presi
dents served on the Committee during January and
February 1979: Ernest T. Baughman (D allas), David
P. Eastbum (Philadelphia), Mark H. Willes (M in
neapolis), and Willis J. Winn (Cleveland). The Com
mittee was reorganized in March and the four rotating
positions were filled by: John J. Balles (San Francisco),
Robert P. Black (Richmond), Monroe Kimbrel (Atlan
ta ), and Robert P. Mayo (Chicago). In July, Emmet
J. Rice was appointed to the Board, filling one of the
two vacancies, and Frederick H. Schultz was ap
pointed to the Board as vice chairman, filling the
other vacant position. During August, Chairman Miller
resigned and was replaced by Mr. Volcker.
The Committee met nine times during 1979 to
discuss, among other things, economic trends and to
decide upon the future course of open market opera
tions.1 As in previous years, however, telephone or
telegram consultations were held occasionally between
scheduled meetings.2 During each regularly scheduled
meeting, a directive was issued to the Federal Reserve
Bank of New York. Each directive contained a short
review of economic developments, the general
economic goals sought by the Committee, and in
structions to the Manager of the System Open Market
Account at the New York Bank for the conduct of
open market operations. These instructions were stated
in terms of money market conditions and short-term
rates of growth of M l and M2 which were considered
to be consistent with desired longer-run growth rates
iNo formal meetings were held in January, June, and
December 1979.
2Consultations were held on January 12, March 2, April
27, June 15, July 27, August 30, and October 22.

of the monetary aggregates. Special factors, such as
conditions in domestic financial markets and foreign
exchange markets, were also taken into account.
The Manager makes all decisions regarding the
timing, types, and amount of daily buying and selling
of securities in fulfilling the Committee’s directive.
Each morning the Manager and his staff plan the
open market operations for that day. This plan is
developed on the basis of the Committee’s directive
and the latest developments affecting money and credit
market conditions, monetary aggregate growth, and
bank reserve conditions. The Account Manager, in a
conference call, then informs staff members of the Board
of Governors and one voting president about present
market conditions and open market operations that he
proposes to execute that day. Other members of the
FOMC are informed of the daily plan by wire.
The directives issued by the FOMC and a summary
of the reasons for FOM C actions are presented to the
public in the “Record of Policy Actions of the Federal
Open Market Committee.” The “Record” is released a
few days after the following FOM C meeting. Soon after
its release, the “Record” appears in the F ed eral R eserve
Bulletin and, in addition, “Records” for the entire year
are published in the Annual R eport o f th e B oard o f
Governors. The “Record” for each meeting during 1979
generally included:
1 ) A staff summary of recent economic develop
ments — such as changes in prices, employ
ment, industrial production, and components of
the national income accounts — and projections
of general price, output, and employment devel
opments for the year ahead;
2 ) A summary of recent international financial de
velopments and the U.S. foreign trade balance;
3 ) A summaiy of recent credit market conditions
and recent interest rate movements;
4 ) A summary of open market operations, growth
of monetary aggregates and bank reserves, and
money market conditions since the previous
meeting;
5 ) A summary of the Committee’s discussion of
current and prospective economic and financial
conditions and of current policy considerations,
including money market conditions and the move
ment of monetary aggregates;
6 ) Conclusions of the FOM C;
7 ) A policy directive issued by the Committee to
the Federal Reserve Bank of New York;
8 ) A list of the members’ voting positions and any
dissenting comments;
9 ) A description of any actions and consultations
that may have occurred between the regularly
scheduled meetings.

F E D E R A L R E S E R V E B A N K O F ST. LO U IS

MARCH

1980

Table 1

FOMC Operating Ranges — 19791
Short-Run Tolerance Ranges
Date of
meeting
December 19,1978
December 29’
January 1 2 ,19792
February 6*

Federal funds
rate range
9%-10 1/2%

(or slightly
higher)
(no change)
9% -10V2

Initial
federal funds
rate target

Ranges specified

Period to which
M1 & M2 apply

Dec.-Jan.

2- 6%

5-9%

Feb.-Mar.

3-7

5-9

Mar.-April

4-8

April-May

10 %
(or slightly
higher)

Actual growth rates3
M1
-0.8%

M2
2.3%

(or slightly
higher)
(no change)

0.4

3.3

3y2-7i/2

10.1

9.2

4-8

4-81/2

9.5

9.8

May-June

0-5

4-8V2

7.9

9.8

July-Aug.

21/ 2 - 61/2

6 V2 -IO 1/2

8.6

11.9

Aug.-Sept.

4-8

7-11

9.1

11.6

Sept.-Oct.
Oct.-Dec.

3-8

41/2

61/ 2-1 01/2
71/2

7.0
3.1

10.4
6.8

3.3
N.A.

6.0
N.A.

(or slightly
higher)
March 22
March 20b

(or slightly
higher)
9% -10V2

(or slightly
higher)
(or slightly
higher)

April 17°

April 272
May 22d
June 152
July 11
July 272
August 14'
August 302
September 18f
October 6
October 222
November 20
January 8-9, 1980

9%-10i/2

(no change)
9 % - 101/2
101/4
9% - 101/2
10V2-103/4
10 % - 1 1 1/4
10 % - 111/2
111/4-11%
111/ 2- 151/2
(no change)
111/2-151/2
111/2-15V2

(or slightly
higher)
(no change)
101/4
101/4
101/4
101/2-10%

11
111/4
111/2
NONE
(no change)
NONE
NONE

Nov.-Dee.
Jan.-Mar.

(no change) (no change)
81/2
5
4-5
7

Longer-Run Ranges
Date of meeting
February 6s
July 11h
October 6

Target period
IV/78-IV/79

11/ 2 -41/ 2 %
11/ 2 -41/2
3-6

5-8%
5-8
5-8

6-9%
6-9
6-9

Bank credit

71/ 2- 101/ 2 %
71/ 2 - 101/2
71/ 2 -IO 1/2

‘Short-run ranges were adopted at each of the FOMC’s regularly scheduled meetings. The ranges for the monetary aggregates
were specified in terms of two-month or three-month simple annual rates of change from the month prior to each meeting
at which ranges were established to the month following the meeting. The ranges for the federal funds rate were specified
to cover the period from each meeting at which ranges were adopted to the following regularly scheduled meeting,
telephone or telegram consultations were held between scheduled meetings to modify intermeeting ranges for the federal
funds rate.
3Data used are revised data as of January 9, 1980. They include benchmark adjustments based on December 1978 and March
1979 Call Reports.

the FOM C adopted ranges of monetary growth at its
April 1978 meeting that applied to the period from
the first quarter of 1978 to the first quarter of 1979.3
3For an example, see Richard W. Lang, “The FOMC in 1978:
Clarifying the Role of the Aggregates,” this Review (March
1979), pp. 2-24, especially table 1 and charts 1 and 2.

At the July 1978 meeting, it adopted one-year ranges
that then applied to the period from the second
quarter of 1978 to the second quarter of 1979. Thus,
the base period — the quarter from which growth of
the monetary aggregates was to be measured —
changed each quarter when the FOMC announced

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

1980

Table 1 (continued)

Supplementary Footnotes — Dissents to FOMC Actions
“Mr. Coldwell dissented from this action because he preferred to direct open market operations early in the coming period
toward a slight firming in money market conditions. He felt that the greatest current danger was an intensification of
inflationary pressures and that the longer-range prospects for inflation were unacceptable.
bMessrs. Volcker, Coldwell, Kimbrel, and Wallich dissented from this action because they favored a somewhat more restric
tive policy posture in view of inflationary forces reinforced by pressure on capacity in some industries and in view of the
near-term potential for excessive inventory demands. They believed that, despite uncertainty about prospects for economic
activity later this year, some additional firming in money market conditions at this time was appropriate to help contain
inflationary pressures and maintain renewed confidence in the dollar in foreign exchange markets.
'Messrs. Volcker, Coldwell, and Wallich dissented from this action because they continued to favor a somewhat more restric
tive policy posture in view of strong inflationary forces reinforced by pressure on capacity in some industries. They believed
that, despite uncertainty about prospects for economic activity later this year, some additional firming in money market con
ditions at this time would help in limiting inflationary pressures by curbing inflationary expectations quickly.
dMessrs. Balles and Partee dissented from this action in view of indications that a cyclical peak might be near at hand. Thus,
they favored a less restrictive policy posture, especially in view of the delayed impact on the economy. In the present un
certain environment, they believed that some prompt easing in money market conditions, along with a greater emphasis on
the behavior of the monetary aggregates in guiding the conduct of operations, would reduce the risk of a continuing shortfall
in monetary growth and would tend to provide needed support to the economy later in the year.
Mr. Wallich dissented from this action because, in view of the strong inflationary pressures in the economy, he continued
to favor a more restrictive policy posture. Believing that inflationary expectations had increased in recent months while inter
est rates had changed little, he thought that additional firming in money market conditions would have a favorable effect on
such expectations and would have little effect on the course of real output.
eMr. Black dissented from this action because, in view of the rapid monetary growth in recent months, he preferred to specify
lower ranges for growth of Ml and M2 over the August-September period in order to increase the probability of holding
growth within the Committee’s longer-run ranges. Wl3le he agreed that open market operations should be directed toward
attaining a slight increase in the federal funds rate initially in the coming intermeeting period, he believed that the direc
tive adopted by the Committee allowed for too rapid monetary growth before a further increase in the funds rate would be
triggered.
Mr. Rice dissented from this action because he believed that an additional firming in money market conditions at this time
to restrict growth of money and credit, in the face of the evidence of weakening in economic activity, would risk deepening
the recession. In his view, the effort to balance the goal of reducing the rate of inflation with the objective of minimizing the
impact of the recession called for a policy directed toward the maintenance of prevailing money market conditions unless
growth of the monetary aggregates over the August-September period appeared to be substantially faster or slower than the
rates currently expected.
'Messrs. Balles, Black, and Coldwell agreed with the majority that open market operations should be directed toward attaining
a slight increase in the federal funds rate initially in the coming intermeeting period, but they dissented because they be
lieved that, given the excessive monetary growth in recent months relative to the Committee’s longer-run ranges, the direc
tive adopted by the Committee would allow for too rapid monetary growth before an additional increase in the objective for
the funds rate would be triggered. To enhance the prospects for achieving the Committee’s objective of restraining monetary
growth, they preferred, moreover, to provide leeway for a rise in the funds rate to an upper limit of 12 percent.
Mr. Rice dissented from this action because he believed that an additional firming in money market conditions would inten
sify the developing weakness in economic activity and was unlikely to affect the rate of inflation favorably within six to nine
months. In his judgment, monetary growth most likely would slow in the months immediately ahead even if current money
market conditions were maintained, and growth of the monetary aggregates over the year ending in the fourth quarter of
1979 probably would fall within the Committee’s longer-run ranges.
^Messrs. Wallich and Willes dissented from this action because, with the Committee’s objective of slowing the rate of infla
tion in mind, they preferred to specify lower ranges for growth of the monetary aggregates. Mr. Willes believed that the
range adopted for Ml, after allowance for the effects of ATS and a possible further downward shift in the public’s demand
for money, represented an increase from the ranges that had been adopted during 1978. Mr. Wallich thought that, after allow
ance for the expansion in repurchase agreements and Eurodollars in addition to the other forces affecting growth of Ml, the
range adopted represented too much of an increase from the ranges set earlier.
“Mr. Wallich dissented from this action because, with the Committee’s objective of slowing the rate of inflation in mind, he
believed that the range adopted for M l, after allowance for the effects of ATS and NOW accounts, was too high. In his
opinion, growth of the money stock, after allowance for the expansion in repurchase agreements and Eurodollars as well as
for the effects of ATS and NOW accounts, had been considerably more rapid than indicated by the behavior of Ml.

these one-year ranges.
This method of establishing one-year monetary
growth ranges resulted in “base drift” and allega
tions that the FOMC implicitly employed a
“forgiveness principle” in adopting these ranges. To
illustrate this, suppose that at the beginning of the
second quarter the FOMC adopted a one-year range
for M l growth of 4 to 6 percent for the period from

the first quarter of one year to the first quarter of
the next, but that in the second quarter M l actually
increased at an 8 percent annual rate. The FOMC
would establish a new M l growth range at the be
ginning of the third quarter which would be meas
ured from the second quarter of the year to the
second quarter of the following year. By using the
second quarter’s average level of M l as the base
from which the new one-year growth rates of M l

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

MARCH

1980

would be calculated, the level of M l in the base pe
riod would “drift” from quarter to quarter. Further
more, since the FOM C frequently kept the same
numerical one-year ranges (e.g., keeping a 4 to 6
percent range from second quarter to second quarter)
despite deviations of M l growth from that range in
the previous quarter, deviations of monetary growth
from their original ranges were essentially ignored
or “forgiven.”

centive to earn interest on checkable bank balances,
the Federal Beserve expected that many individuals
would use ATS savings accounts as a substitute for
holding balances in their checking accounts. Thus,
during a transition period in which demand deposits
were being transferred into ATS accounts, the growth
of ATS balances (which were not included in M l)
was expected to reduce the growth of M l (demand
deposits plus currency).8

The Humphrey-Hawkins Act requires the FOMC
to establish calendar-year growth ranges for monetary
and credit aggregates in February of each year. The
FOM C has chosen to establish these ranges from the
fourth quarter of the previous year to the fourth quar
ter of the current year. The FOM C must review these
ranges in mid-year, although it may reconsider the
one-year ranges at any time.4 The Committee, how
ever, may not change the period to which the oneyear ranges apply. Thus, the base period (the fourth
quarter) remains the same.

A similar but smaller effect was expected to result
from the introduction of NOW accounts in New York
State. NOWs can be used by individuals in the same
manner as checks to make transactions, but balances
in NOW accounts earn interest as do savings accounts
and were not included in M l.6 Upon congressional
approval, NOW accounts were extended to New York
State in November 1978; they had been introduced
much earlier in the New England states. The growth
of these accounts in New York also was expected to
reduce M l growth during a transition period.

By requiring the FOMC to establish calendar-year
monetary growth ranges measured from an unchang
ing base, the Humphrey-Hawkins Act eliminates “base
drift” and the “forgiveness principle” within each
calendar year. Nevertheless, these problems still can
occur from one year to the next because the
Humphrey-Hawkins Act requires the FOMC to
establish new one-year ranges each calendar year.
Thus, the FOM C would use the most recent fourth
quarter average level of the monetary aggregate as
the base.

Chairman G. William Miller outlined the effect
of ATS accounts on the growth of M l and the broader
monetary aggregates on July 28, 1978 when he an
nounced to Congress the one-year ranges established
at the July 1978 FOMC meeting. He noted that, dur
ing the transition period in which bank customers
adjust to ATS, M l growth would be lowered while
M2 and M3 growth would be little affected.7

ATS and New York NOW Accounts
Financial innovations in 1978 presented the FOMC
in 1979 with the difficult problem of assessing their
impact on the growth of various measures of money.
Starting November 1, 1978, commercial banks and
mutual savings banks were permitted to offer indi
vidual customers an automatic transfer service ( ATS)
between savings and checking accounts. This seivice
provides for the transfer of funds from a savings ac
count to cover checks written against an individual’s
checking account. Consequently, the new ATS savings
accounts enable individuals to earn interest on funds
that previously might have been held in their check
ing (demand deposit) accounts. Because of the in4At the time of the mid-year review of the one-year ranges,
the FOMC also establishes tentative ranges for the monetary
aggregates for the next year — measured from the fourth
quarter of the current year to the fourth quarter of the follow
ing year.

Although discussed at the July meeting, the
scheduled introduction of ATS accounts in Novem
ber 1978 first affected the FOM C’s decision about the
one-year monetary growth ranges at the October 17,
1978 meeting. A majority of the Committee voted to
retain the existing ranges for M2 and M3 for the pe
riod from third quarter 1978 to third quarter 1979
(III/7 8 to 111/79). The Committee also indicated
that it expected M l growth to be within a range of 2
to 6 percent during that period, “depending in part
on the speed and extent of transfers from demand to
savings deposits resulting from the introduction of
ATS.”8 This expected range of M l growth was both
lower and wider than the one adopted in July. The
“For a more detailed analysis of the effect of ATS on the
money supply process, see John A. Tatom and Richard W.
Lang, “Automatic Transfers and the Money Supply Process,”
this Review (February 1979), pp. 2-10.
6NOW balances at commercial banks were included in old
M2, while NOW balances at thrift institutions were included
in old M3.
7Chairman G. William Miller, “Statements” (August 1978),
p. 646.
8“Record” (December 1978), p. 953.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

FOMC, however, placed less emphasis on M l than
on M2 and M3.9
When the one-year ranges were established at the
February 6, 1979 meeting under the requirements
of the Humphrey-Hawkins Act, the FOMC felt more
confident about the magnitude of the effects of both
ATS and New York NOW accounts on M l growth
and again gave equal emphasis to M l growth. A staff
analysis indicated that the growth of ATS and New
York NOW accounts would lower M l growth over
1979 by about 3 percentage points.10 The FOMC used
this estimate in formulating its range for M l growth
over the period from IV /78 to IV /79.
The FOMC’s discussion at the February meeting
stressed that monetary growth ranges be chosen that
were consistent with a reduction in the rate of
inflation.11 The Committee decided at this meeting
to lower the monetary growth ranges. The ranges also
were widened to 3 percentage points, compared with
their previous width of 2.5 percentage points.12 This
widening reflected, in part, “the special factors [ATS
and New York NOW accounts] expected to influence
monetary growth and the uncertainties with respect to
the magnitude of their impact.”13 The M2 and M3
ranges were lowered to 5 to 8 percent and 6 to 9 per
cent for the period IV /78 to IV /79, respectively, from
previous ranges of 6.5 to 9 and 7.5 to 10 percent for
the period 111/78 to 111/79 (table 1 ). The FOMC
adopted an M l range of 1.5 to 4.5 percent from IV /78
to IV /79 and noted that this “range allowed for the
possibility of a significant deceleration of growth from
the pace of recent years” even after allowance for the
estimated 3 percentage-point slowing in M l growth
due to the effects of ATS and New York NOW
accounts.14
Two Committee members, however, felt that the
1.5 to 4.5 percent M l range allowed for too rapid
M l growth. In fact, they felt that this range repre
sented a higher, not a lower, range than the previously
adopted M l ranges.
Messrs. Wallich and Willes dissented from this
action because, with the Committee’s objective of
9Chairman G. William Miller, “Statements” (November 1978),
p. 846; and Lang, “The FOMC in 1978,” p. 14.
^ “Record” (April 1979), p. 330.
u Ibid.
12In the case of M l, recall that the 2 to 6 percent range from
111/78 to 111/79 was not typical of ranges in earlier periods.
The M l range in eifect for most of 1978 was 4 to 6%
percent.
13“Record” (April 1979), p. 331.
14Ibid.

MARCH

1980

slowing the rate of inflation in mind, they pre
ferred to specify lower ranges for growth of the
monetary aggregates. Mr. Willes believed that the
range adopted for M l, after allowance for the effects
of ATS and a possible further downward shift in the
public’s demand for money, represented an increase
from the ranges that had been adopted during 1978.
Mr. Wallich thought that, after allowance for the
expansion in repurchase agreements and Eurodollars
in addition to the other forces affecting growth of
M l, the range adopted represented too much of an
increase from the ranges set earlier.15

To understand why the 1979 M l range could be
viewed as higher than previous ranges of growth, one
must consider what it would have been without the
effect of ATS and New York NOW accounts. The
FOMC used an estimate that growth of these accounts
would lower M l growth by 3 percentage points. This
means that 3 percentage points were subtracted from
the lower and upper ends of an initial M l range to
obtain a lower limit of 1.5 percent and an upper limit
of 4.5 percent. The initial range implicit in this calcu
lation is 4.5 to 7.5 percent. One can view this 4.5 to
7.5 percent range as the M l range that would have
prevailed if ATS and New York NOW accounts had
no effect at all on M l growth. The upper end of this
range represented almost the same rate of M l growth
as actually occurred in the previous two years — M l
increased 7.9 percent from IV /76 to IV /77 and 7.2
percent from IV /77 to IV /78.
Furthermore, this 4.5 to 7.5 percent range repre
sented an increase in the upper limit of the M l range
compared with those adopted in 1977 and 1978, when
the upper limits were no higher than 6.5 percent. If
the FOMC had adjusted the M l range that had
been in effect during most of 1978 — 4 to 6.5 percent16
— for the estimated 3-percentage-point effect of ATS
and New York NOW account growth, the resulting
M l range would have been 1 to 3.5 percent from
IV /78 to IV /79 instead of the 1.5 to 4.5 percent M l
range actually adopted.

Mid-Year Review
The Humphrey-Hawkins Act required the FOMC
to transmit to Congress in July a review of its 1979
monetary growth ranges as well as a preliminary in
dication of its ranges for 1980. At the July 11,
1979 meeting, a staff analysis indicated that “shifts
in funds from demand deposits to savings accounts
with automatic transfer services and to NOW ac15Ibid., pp. 331-32.
16See footnote 12 and the earlier discussion of the M l range
adopted at the October 17, 1978 meeting.

F E D E R A L R E S E R V E B A N K O F ST. LO U IS

counts had retarded the annual rate of growth of M l
by the assumed amount of about 3 percentage points
in the first quarter of 1979 but by only about 1.5 per
centage points in the second quarter. . . .”17 Uncer
tainty about the further growth of ATS accounts was
compounded by an April federal court ruling that
barred these accounts as of January 1, 1980, unless
Congress enacted legislation authorizing them.18
At the July meeting, most Committee members
favored ranges that reflected a continuation of the
policy stance adopted in February.19 The Committee
decided to retain the same ranges for 1979 that it had
adopted in February and tentatively indicated that
these ranges also would be appropriate for 1980
(table 1 ). Although the FOMC continued to use the
estimate that the growth of ATS and New York
NOW accounts would reduce M l growth by about
3 percentage points in 1979, it “also agreed that actual
growth in M l might vary in relation to its range to
the extent of any deviation from that [3 percentagepoint] estimate.”20 In this regard the Committee noted
that monetary growth in 1980 “might be within the
same ranges” as in 1979, but that this was especially
tentative in light of the uncertain legislative and
judicial position of ATS and other interest-earning
transactions accounts.21
The M l range for 1979 was indeed modified later
in the year. At the special meeting held on October
6, 1979, the “Record of Policy Actions” noted that
the recent growth of ATS and New York NOW ac
counts implied that their effect on M l growth was
smaller than the original 3 percentage-point estimate.
It now appeared that expansion of such accounts
would reduce measured growth of Ml over the year
by about 1.5 percentage points. After allowance for
the deviation from the earlier estimate, the equiv
alent range for M l was 3 to 6 percent.22
The revised 3 to 6 percent range for M l growth
from IV /78 to IV /79 (table 1) again translates into
an initial range of M l growth of 4.5 to 7.5 percent
(obtained by adding 1.5 percentage points to the
17“Record” (September 1979), p. 752.
18Congress temporarily extended authorization of ATS ac
counts through March 1980 in order to allow more time to
consider permanent legislation.
19“Record” (September 1979), p. 753.
2°Ibid., p. 754.
21The retention of the 1.5 to 4.5 percent range for M l growth
again was cause for dissent by Governor Wallich. He still
felt that this range was too high given the Committee’s
objective of slowing inflation. ( Mr. Willes was not a voting
member at this meeting.) Ibid.
22“Record” (December 1979), p. 973.

MARCH

1980

FOM C’s revised M l range). In effect, the FOMC in
October 1979 continued to use an estimate of the re
duction of M l growth due to the growth of ATS and
New York NOW accounts to mark down the 1979 M l
range from an initial range of 4.5 to 7.5 percent. This
latter range was higher and wider than the M l ranges
adopted in 1978, and can be interpreted as the range
that would have prevailed if the growth of ATS and
New York NOW accounts had no effect at all on M l

Actual Money Growth and the
One-Year Ranges
Growth rates of the monetary aggregates were be
low their one-year ranges in the first quarter of the
year, but were above tbese ranges in the second and
third quarters. Thus, after falling below their ranges
in the first quarter, the levels of the monetary aggre
gates were within their ranges by the end of the sec
ond quarter and were above or near the tops of
their ranges by the end of the third quarter (charts
1 and 2 ).
Rapid growth of M l in the third quarter brought
the level of M l above the original 1.5 to 4.5 percent
range. After readjusting the M l range for the lower
estimate of the effect of ATS and New York NOW
accounts, however, the level of M l was near the top
of the revised 3 to 6 percent range at the end of the
third quarter (chart 1 ). Nevertheless, it was clear to
the FOM C in early October that a continuation of
monetary growth at third-quarter rates would result in
growth rates for the year that would exceed the
1979 ranges.23
The Committee’s desire to hold growth of the
monetary aggregates within their 1979 ranges was the
principal reason for the October 6 changes in shortrun operating procedures.24 This shift in procedures,
discussed below in detail, apparently succeeded in
slowing growth of all the monetary aggregates in the
fourth quarter. As a result, both M l and M3 in 1979
were kept within the FOM C’s adopted ranges of
growth, while M2 was slightly above the upper limit
of its range. From IV /78 to IV /79, M l increased
about 5.5 percent, M2 about 8.3 percent, and M3
about 8 percent.
It must be emphasized, however, that the 5.5 per
cent M l growth in 1979 is not comparable to M l
23lbid., p. 974.
2*Ibid.

F E D E R A L R E S E R V E B A N K O F ST. LO U IS

MARCH

1980

Chart 1

M l R ange for Period I V / 7 8 to I V / 7 9

R a tio Sc a le
B illio n s of D o lla rs

R a tio Scale

M l Range as Revised October 6, 1979

B illio n s of D o lla rs

R a tio Scale
B illio n s of D o lla rs

1978

N o te :

1979

D a ta used a re s e a s o n a lly a d ju s te d a nd in c o rp o ra te th e b e n c h m a rk adjustm ents released by th e B o a rd o f G o ve rn o rs on Ja n u a ry 10, 1980.

growth in previous years. For example, to compare M l
growth rates for 1979 and 1978, one must adjust the
1979 growth rate by the estimated effect of ATS and
New York NOW accounts. Assuming that M l growth
in 1979 was reduced by 1.5 percentage points — the
figure used by the FOMC in October to adjust the
M l range — one must add this amount to the 5.5
percent rate of growth in 1979. This results in a 7
percent growth rate, about the same as the 7.2 percent
rate in 1978.

SHORT-RUN OPERATING PROCEDURES
Prior to October 6, 1979, FOMC short-run operat
ing procedures were carried out as in the previous
several years.25 At each meeting, the FOMC set an
intermeeting range for the federal funds rate along
with two-month tolerance ranges for M l and M2
25Lang, “The FOMC in 1978,” pp. 2-10. For an historical per
spective on the FOMC’s short-run operating procedures, see
Henry C. Wallich and Peter M. Keir, “The Role of Operating
Guides in U.S. Monetary Policy: A Historical Review,” Fed
eral Reserve Bulletin (September 1979), pp. 679-91.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

MARCH

1980

Chart 2

R anges for M 2 , M 3 , a n d Bank Credit for
Period I V / 7 8 to I V / 7 9
R a t io S c a lo

R a t i o S c a lo

B il l i o a s of D o lla r s

l i l l i o i s o f D o lla r s

130
lit lo

R a t i o S c a lo

S e a l*

l i l l i e i s o f D o lla r s

B il l i o a s o f D o lla r s

l i l l i o a s o f D o lla r s

B il l i o a s o f D o lla r s

1971

197*

1980

N ote: D a ta us a d a r e s e a s o n a lly a d ju s te d a n d in c o rp o ra te th e b e n c h m a rk ad justm e nts relea sed b y the B o ard o f G o verno rs J a n u a ry 10, 1980.

growth (table 1 and charts 3 and 4 ) . Within the fed
eral funds rate range, the Committee specified an
initial level of the funds rate that was thought to be
consistent with the short-run ranges set for M l and
M2. The two-month ranges for M l and M2, in turn,
were intended to provide an indicator to determine
when changes in the federal funds rate should be
made (subject to its own range). These short-run
ranges were specified over moving two-month periods.

meeting specified ranges for M l and M2 growth over
the February-March period. At the March 20 meet
ing it then set new ranges for the March-April pe
riod (table 1 ). If the two-month growth rates of M l
and M2 appeared to deviate from their respective
ranges — either from the midpoints of their ranges
or from their upper or lower limits — the level of the
federal funds rate could be changed within its range,
or the Committee could reconsider the range.26

For example, the FOMC at its February 6, 1979

26For more details, see Lang, “The FOMC in 1978,” pp. 2-10.

http://fraser.stlouisfed.org/
10
Federal Reserve Bank of St. Louis

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

Prior to October 6, the domestic policy directives
followed the same general format as in 1978 with
regard to short-run operating procedures. Less than
three weeks after adopting such a directive at
its September 18 meeting,27 this format was aban
doned when the FOMC instituted its new short-run
operating procedures. The new procedures were
adopted at a special FOMC meeting called by Chair
man Volcker, “to consider actions that might be
taken, in conjunction with actions being contemplated
by the Board of Governors, to improve control over
the expansion of money and bank credit in the light
of developing speculative excesses in financial and
commodity markets and additional evidence of strong
inflationary forces in the economy.”28
After the September 18, 1979 meeting, incoming
data indicated that the economy was stronger
than had been expected, while both consumer
and producer price indexes continued to record
double-digit increases. In the foreign exchange mar
kets, the dollar declined substantially despite large
purchases of dollars by the United States and by for
eign central banks. This decline was attributed to the
continuing rapid U.S. inflation rate.29 Furthermore,
speculation in gold markets had increased between
August and October 1979 and had apparently spread
to other metal and commodity markets, as evidenced
by a more than 50 percent increase in September in an
industrial commodity price index. This was attributed
to “a general rise in inflationary expectations that
tended to feed on themselves.”30 Against this back
ground ( see Supplement, meeting of October 6, 1979),
the Federal Reserve announced several policy actions
— a 1 percentage-point increase in the discount rate,
a new marginal reserve requirement on certain
managed liabilities of member banks, and a change in
the FOM C’s short-run operating procedures.31

MARCH

1980

C k irl 3

F O M C S h o rt-R u n R a n g e s for M o n e t a r y A g g r e g a t e s
1*79
H I Tolerance Ranges

DEC./JAN. JAN/FEB. FEB./MAR MAR./APR. APR /MAY MAY/JUNE JUNE/JUIY JUIY/AUG. AUG./SBT. SEPT./OCT.
Note-. After the October 6, 1979 FOMC meeting, the FOMC no longer specified tolerance ranges tor Mi and M2 ir
the tame manner. See table I.
U. During the January-February and June-July periods, ranges for Ml and M2 wer not specified by the FOMC.
\2 Actual growth rate data are revised os of January 10, 1980.
\3_The shaded areas represent two-month ranges adopted by the Committee at each regularly scheduled meeting.

gates within their 1979 ranges was the catalyst for
the change in the FOM C’s short-run operating
procedures.
The principal reason advanced for shifting to an
operating procedure aimed at controlling the supply
of bank reserves more directly was that it would
provide greater assurance that the Committee’s ob
jectives for monetary growth could be achieved.32

30Ibid.

The Committee recognized that the relationship be
tween bank reserve and monetary growth was
not precise; there was no guarantee that the shift in
emphasis would be successful in reducing monetary
growth over the last few months of 1979. The Com
mittee also recognized that this change in short-run
procedures could be accompanied initially by sub
stantial increases in interest rates and that movements
in interest rates would be more uncertain.33 After
some debate between members who favored the
change in short-run operating procedures and
those who preferred continuing to direct open mar
ket operations toward controlling the level of the
federal funds rate, the Committee unanimously ap
proved a modification of the domestic policy direc
tive. Greater emphasis was placed on controlling the

31For a more detailed description of the new marginal reserve
requirements on managed liabilities, see “Announcements:
Monetary Policy Actions,” Federal Reserve Bulletin (October
1979), pp. 830-32.

:i2“Record” (December 1979), p. 974.
33Ibid., p. 976.

The FOMC was especially concerned with the ex
pansion of both the monetary aggregates and bank
credit, which had been increasing at rapid rates after
the first quarter of 1979 (charts 1 and 2 ). The issue
of how to slow monetary growth to keep the aggre27“Record” (November 1979), pp. 912-13.
28“Record” (December 1979), p. 972.
29Govemor Henry C. Wallich, “Statements” (November 1979),
p. 899.

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

volume of bank reserves and less on
controlling fluctuations in the federal
funds rate.34

1980

Chart 4

F O M C R a n g e s for the F e d e ra l F u n d s R a te

Effect on the Domestic
Policy Directive
The wording of the domestic policy
directive was altered substantially by the
FOM C’s new operating procedures. The
directive adopted at the October 6 meet
ing stated:
In the short run, the Committee
seeks to restrain expansion of reserve
aggregates to a pace consistent with
deceleration in growth of Ml, M2, and
M3 in the fourth quarter of 1979 to
rates that would hold growth of these
monetary aggregates over the whole
period from the fourth quarter of 1978
to the fourth quarter of 1979 within
the Committee’s longer-run ranges, pro
vided that in the period before the
next regular meeting the weekly aver
age federal funds rate remains within
197f
a range of 11% to 15% percent. The
j y Weekly overages of effective daily rales.
7j At each meeting during 1979. the FOMC established a range for the federal funds rate. These ranges are indicated for the firi
Committee will consider the need for
full week during whicti they were in effect.
supplementary instructions if it appears
that operations to restrain expansion
of reserve aggregates would maintain the federal
November 20, 1979 meeting.37 Again, more specific
funds rate near the upper limit of its range.35
short-run objectives for M l and M2 growth were
This section of the directive — which deals with the
FOM C’s short-run objectives — was not specific about
the short-run growth rates of M l and M2 that the
FOM C desired to achieve. The “Record of Policy Ac
tions” of the October 6 meeting, however, was more
precise.
Specifically, the Committee instructed the Manager
to restrain expansion of bank reserves to a pace
consistent with growth from September to December
at an annual rate on the order of 4.5 percent in Ml
and about 7.5 percent in M2 and M3, provided that
in the period before the next regular meeting the
federal funds rate remained generally within a range
of 11% to 15% percent. Because such rates of
expansion would result in growth of the monetary
aggregates in the upper part of their ranges for
the year, the Committee also agreed that over
the three-month period somewhat slower growth
would be acceptable.36

stated in the “Record” of that meeting (table l ) . 38
At the January 8-9, 1980 meeting, however, specific
short-run objectives for M l and M2 growth were ex
plicitly incorporated into the domestic policy directive.
In the short run, the Committee seeks expansion
of reserve aggregates consistent with growth over
the first quarter of 1980 at an annual rate between
4 and 5 percent for Ml and on the order of 7 per
cent for M2, provided that in the period before
the next regular meeting the weekly average federal
funds rate remains within a range of 11% to 15%
percent.39

Wording almost identical to that in the October 6
directive appeared in the directive adopted at the

Although only three new domestic policy directives
had been released by the time this article was writ
ten, a few observations can be made about the
FOM C’s new operating procedures. First, the
FOMC no longer targets on a specific level
of the federal funds rate as its short-run operating
objective. Second, the 4 percentage-point range of
the federal funds rate that has been maintained in
the directive since October 6 is substantially larger

3<Ibid., pp. 974-76.
ssibid, p. 977.
3«Ibid., pp. 975-76.

37“Record” (January 1980), p. 46.
38Ibid., p. 45.
39“Record” (March 1980), p. 236.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

than the one-half to three-quarter percentage-point
ranges established previously (table 1 ). The absence
of a specific federal funds rate objective and the
wider range have been evident in both inter-day and
intra-day fluctuations of the federal funds rate, which
changed radically after October 6.
In the FOM C’s new directives, desired growth rates
of M l and M2 over two- or three-month periods are
established in terms of specific rates of change, or, in
the case of the January 1980 directive, a 1 percentagepoint range. In contrast, short-run ranges of M l and
M2 growth typically were specified in terms of 3
percentage-point ranges prior to October 6. Further
more, the short-run M l and M2 ranges previously
were specified as “tolerance ranges” to be used by the
Manager of the System Open Market Account only
as an indicator “for determining when changes in the
funds rate were appropriate. . . .”40 Under current
short-run operating procedures, however, the Manager
is directed to achieve growth rates of bank reserves
consistent with specified growth rates of M l and M2,
provided that the federal funds rate remains within a
broad range.
The Manager of the System Open Market Account,
who is responsible for achieving the FOM C’s objec
tives, has had to change the focus of domestic open
market operations from attaining specific levels of the
funds rate to maintaining growth of “reserve aggre
gates” consistent with specified rates of M l and M2
growth. These reserve aggregates, however, are not
specified in either the directive or the “Records of
Policy Actions.” The FOMC votes on growth rates of
the monetary aggregates, not the reserve aggregates.
Consequently, it is left to the staffs of the Board of
Governors and the New York Federal Reserve’s Open
Market Desk to establish guidelines for the growth
of these reserve aggregates.

Domestic Open Market Operations
and Reserve Targeting
Until recently, information was sketchy about the
Federal Reserve’s new procedures for implementing
monetary policy. Although various Federal Reserve
officials had mentioned that the Open Market Desk
was tracking a “family” of reserve aggregates rather
than a single aggregate, it was not clear which meas
ures were included in this “family” nor how the Desk
related growth of these aggregates to the FOM C’s
monetary growth objectives. A staff paper released by
the Board of Governors on January 31, 1980 clarified
40“Record” (August 1978), p. 663.

MARCH

1980

these matters substantially.41 The staff paper outlined
the new operating procedure in eight principal steps,
highlights of which are presented in exhibit 1.
The process of translating the FOMC’s desired
rates of short-run monetary growth into weekly tar
get levels of total reserves, monetary base, and non
borrowed reserves are described in steps 1 through
4 of exhibit 1. Although the staff paper makes it
clear that the “overall” objective of the Open Mar
ket Desk is to control the growth of total reserves
(step 5, exhibit 1 ), it also makes clear that the im
mediate short-run operating objective is to control the
growth of nonborrowed reserves (step 6, exhibit 1 ).
Thus, the Manager of the Desk directs the purchase
and sale of government securities in order to attain
some pattern of changes in (or path of) the level of
nonborrowed reserves between FOMC meetings. At
taining the desired path for nonborrowed reserves
will not necessarily yield the desired path for total
reserves, however, since the actual path of total re
serves also depends on the behavior of member bank
borrowing at the discount window. For example, if
borrowings are larger than the level assumed in con
structing the path for nonborrowed reserves, then
total reserves will be above the desired path even
though nonborrowed reserves are on their desired
path.
In the event that total reserves are above the
Desk’s desired path, the staff paper indicates that cer
tain adjustments could be made to bring the growth
of total reserves back to the desired path — either a
lowering of the nonborrowed reserve path or an in
crease in the discount rate (step 7, exhibit 1 ). The
first adjustment may be made by the staff of the
Board of Governors in conjunction with the Manager
of the System Open Market Account. The second
adjustment, however, must be initiated by the Boards
of Directors of the district Federal Reserve Banks,
subject to the approval of the Board of Governors.
According to the staff paper, neither adjustment
would be made until the growth of total reserves
had been overshooting the desired path for some
time.
The staff paper’s analysis of the effects of open
market operations on reserve and money growth un
der the new operating procedures is essentially the
same as such analyses under the old procedures.
According to this staff paper, control of nonborrowed
reserves and the discount rate affect the growth of
41“The New Federal Reserve Technical Procedures for Con
trolling Money,” Board of Governors of the Federal Reserve
System, January 31, 1980.

MARCH

FED ER A L. R E S E R V E B A N K O F ST. L O U IS

1980

Exhibit 1

Excerpts from “The New Federal Reserve Technical Procedures
for Controlling Money”
( 1 ) The policy process first involves a decision by the
FOM C on the rate of increase in money it wishes to
achieve . . . .
( 2 ) After the objective for money supply growth
is set, reserve paths expected to achieve such growth
are established for a family of reserve measures. These
measures consist of total reserves, the monetary base
(essentially total reserves of member banks plus cur
rency in circulation), and nonborrowed reserves. Estab
lishment of the paths involves projecting how much
of the targeted money growth is likely to take the
form of currency, of deposits at nonmember institu
tions, and of deposits at member institutions (taking
account of differential reserve requirements by size of
demand deposits and between the demand and time
and savings deposit components of M 2). Moreover,
estimates are made of reserves likely to be absorbed
by expansion in other bank liabilities subject to reserve
requirements, such as large CDs, at a pace that appears
consistent with money supply objectives and also takes
account of tolerable changes in bank credit. . . .
[E stim ates are also made of the amount of excess
reserves banks are likely to hold.
(3 ) The projected mix of currency and demand
deposits, given the reserve requirements for deposits
and banks’ excess reserves, yields an estimate of the
increase in total reserves and the monetary base con
sistent with FOM C monetary targets. The amount of
nonborrowed reserves — that is total reserves less
member bank borrowing — is obtained by initially
assuming a level of borrowing near that prevailing
in the most recent period. . . .
(4 ) Initial paths established for the family of re
serve measures over, say, a 3-month period are then
translated into reserve levels covering shorter periods
between meetings. . . .
(5 ) Total reserves provide the basis for deposits
and thereby are more closely related to the aggregates
than nonborrowed reserves. Thus total reserves rep re
sent the principal overall reserve objective. However,
only nonborrowed reserves are directly under control
through open market operations, though they can be
adjusted in response to changes in bank demand for
reserves obtained through borrowing at the discount
window. [E m phasis added.]
(6 ) Because nonborrowed reserves are more closely
under control of the System Account Manager for open
market operations (though subject to a small range of
error because of the behavior of non-controlled factors
affecting reserves, such as float), he would initially
aim at a nonborrowed reserve target (seasonally un
adjusted for operating puiposes) established for the

Digitized for14
FRASER

operating period between meetings. To understand
how this would lead to control of total reserves and
money supply, suppose that the demand for money
ran stronger than was being targeted — as it did in
early October of last year. The increased demand for
money and also for bank reserves to support the money
would in the first instance be accompanied by more
intensive efforts on the part of banks to obtain
reserves in the federal funds market, thereby tending
to bid up the federal funds rate, and by increased
borrowing at the Federal Reserve discount window.
As a result of the latter, total reserves and the mone
tary base would for a while run stronger than targeted.
Whether total reserves tend to remain above target
for any sustained period depends in part on the
nature of the bulge in reserve demand — whether or
not it was transitory, for example — and in part on
the degree to which emerging market conditions
reflect or induce adjustments on the part of banks
and the public. These responses on the part of banks,
for example, could include sales of securities to the
public (thereby extinguishing deposits) and changes
in lending policies.
( 7 ) Should total reserves be showing sustained
strength, closer control over them could be obtained
by lowering the nonborrowed reserve path (to at
tempt to offset the expansion in member bank bor
rowing) and/or by raising the discount rate. A rise
in the discount rate would, for any given supply of
nonborrowed reserves, initially tend to raise market
interest rates, thereby working to speed up the adjust
ment process of the public and banks and encouraging
a more prompt move back to the path for total
reserves and the monetary base. Thus, whether adjust
ments are made in the nonborrowed path — the only
path that can be controlled directly through open
market operations — and/or in the discount rate de
pends in part on emerging behavior by banks and the
public. Under present circumstances, however, both
the timing of market response to a rise in money and
reserve demand, and the ability to control total reserves
in the short run within close tolerance limits, are
influenced by the two-week lag between bank de
posits and required reserves behind these deposits.
(8 ) Other intermeeting adjustments can be made to
the reserve paths as a family. These may be needed
when it becomes clear that the multiplier relationship
between reserves and money has varied from expecta
tions. . . . Given the naturally large week-to-week
fluctuations in factors affecting the reserve multiplier,
deviation from expectations in one direction over a
period of several weeks would be needed before it
would be clear that a change in trend has taken place.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

total reserves and money by influencing the demand
for bank reserves and the demand for money (steps
6 and 7, exhibit 1 ). Open market operations that re
duce nonborrowed reserves tend to increase inter
est rates, which (after a lag) reduce the demand for
money, thereby reducing the demand for bank re
serves used to support money. A rise in the discount
rate tends to increase other market interest rates,
which (after a lag) again reduce the demand for
money and the demand for bank reserves. Deviations
in the growth of total reserves or money from desired
rates are controlled, then, by inducing changes in
interest rates which affect the demands for money
and bank reserves. This analysis of controlling money
growth is comparable to Board staff analyses of the
FOM C’s pre-October 6 procedures for controlling
money growth.
An example of this comparability appears in an
article by Governor Wallich and Peter Keir which
appeared in the September 1979 Federal Reserve Bul
letin.42 Written before the introduction of reserve tar
geting, this article discussed control of the monetary
aggregates via interest rate changes under the old
operating procedures. In particular, the authors ex
plain the problems of correcting deviations of money
growth from desired rates in terms of the pre-October
6 procedures.
When incoming data show a sudden marked ac
celeration or slowing in money growth rates, the
Committee must decide whether the change is a
temporary aberration likely soon to be reversed,
or a more fundamental change in money demands
that stems from a basic adjustment in the perform
ance of the economy. If the Committee acted im
mediately to counter an observed change in money
growth, and the change then proved to be temporary,
the action could be destabilizing and require a sub
sequent offsetting adjustment. Since C om m ittee
actions affect the pu blic’s willingness to h old m oney
w ith a lag through their influence on interest rates,
such attempts at fine tuning could produce perverse
results. [Em phasis added.]
To minimize this risk, the FOM C typically has
adopted an intermediate position.43

Thus, the overall framework for analyzing the effects
of open market operations on reserve and money
growth — that open market operations change inter
est rates, which affect the demand for money, thereby
influencing the demand for bank reserves used to
support money — has not changed. W hat has changed
under the new operating procedures is the FOM C’s
42Wallich and Keir, “The Role of Operating Guides in U.S.
Monetary Policy,” pp. 679-91.
43Ibid., p. 688.

MARCH

1980

emphasis on restricting interest rate fluctuations and,
consequently, the Desk’s ability to respond to devia
tions of money growth from its desired path.
The interest rate constraints placed on the Desk
under the old procedures are described by Wallich
and Keir:
When the performance of the money supply ap
pears to be deviating from the Committee’s stated
two-month ranges, the Manager of the System Ac
count is still constrained in his efforts to offset these
deviations by a federal funds rate proviso. He can
initiate countering open market purchases or sales
only so long as these operations, or other market
factors, do not push the weekly average federal funds
rate outside its specified range, generally 50 to 100
basis points wide. If growth rates for M l and M2
. . . appear to be remaining outside the Committee’s
desired ranges, and the Manager’s actions to counter
this deviation have moved the funds rate to the
upper or lower limit of its range, he must request
new instructions from the Committee.44

Prior to October 6, the Committee generally was un
willing to allow large movements of the federal funds
rate that would have been sufficient to achieve de
sired rates of monetary growth within relatively short
periods of time. (Recall that the FOM C’s two-month
ranges of M l and M2 growth were not themselves
treated as short-run targets, but as indicators for de
termining when to change the federal funds rate.)
Confronted with an unexpected overshoot or under
shoot of its money growth targets, the Committee
has taken action that neither fully ignores nor fully
responds to the miss, until the underlying growth
tendency can be differentiated from the “noise” of
aberrations in the data. This approach poses some
risk that needed countercyclical policy actions will
be less timely than desired. But the Committee be
lieves that the accentuated volatility in short-term in
terest rates likely to result from efforts at instanta
neous fine tuning of the aggregates poses a greater
risk.46

Like the old procedures, the new procedures also
do not attempt to “fine time” the short-run growth of
the monetary aggregates. As pointed out in the staff
paper (exhibit 1 ), neither deviations of reserve growth
nor deviations of money growth from their desired
paths will necessarily be responded to immediately.
Adjustments of the nonborrowed reserve path or the
discount rate would occur only after overshooting or
undershooting of the desired paths persisted. W hat
is different about the new procedures is that the Desk
no longer operates under as restrictive a federal funds
rate constraint. The range for the federal funds rate
44Ibid., p. 686.
45Ibid., p. 688.

F E D E R A L R E S E R V E B A N K O F ST. LO U IS

MARCH

1980

has been widened to 400 basis points— compared
with the typical pre-October 6 range of 50 to 100 basis
points — and the FOMC no longer specifies a target
level of the funds rate (table l ) . 46 Consequently, the
Desk has greater flexibility in offsetting deviations of
reserve and money growth from their desired paths.

quired by the Humphrey-Hawkins Act, announced
new one-year ranges for monetary growth on Febru
ary 20, 1980, for the period from IV /79 to IV /80.
These new ranges were formulated in terms of the
recently redefined monetary aggregates — MIA, M1B,
new M2, and new M3.48

In effect, these new procedures allow the Manager
of the System Open Market Account to stabilize
growth of nonborrowed reserves within narrower
limits. The old procedures, in contrast, forced the
Manager to keep the federal funds rate within nar
row limits, which resulted in wider fluctuations in
the growth of non-borrowed reserves.

The MIA definition of the money stock is the same
as old M l except that it excludes demand deposits
held by foreign commercial banks and official institu
tions. The M1B definition includes MIA plus other
checkable deposits.49 These deposits include NOW
and ATS accounts, credit union share drafts, and de
mand deposits at thrift institutions.

The Desk’s implementation of the FOM C’s policy
directives prior to October 6 were described in 1977
by the Manager of the System Open Market Account
as short-run accommodation of the public’s demand
for money.

The construction of M1B as an alternative to MIA
was an attempt to avoid the problem of interpreting
old M l growth when financial innovations such as
ATS and New York NOW accounts occurred. The
difference in growth between M1B and MIA is in
dicative of the problems the FOMC faced in evaluat
ing old M l growth in 1979 relative to previous years.
From IV /78 to IV /79, MIA increased 5.5 percent —
the same as old M l — which represented a reduction
in growth from its 7.4 percent increase in the previous
year.50 In contrast, M1B increased in 1979 at about
the same rate as in the previous year — 8 percent
from IV /78 to IV /79 compared with 8.2 percent
from IV /77 to IV /78. The difference in growth be
tween MIA and M1B reflected the growth of New
York NOW accounts and nationwide ATS accounts,
for which the FOMC in 1979 attempted to adjust
when adopting a one-year range of growth for old
M l.51 As this article went to press, Congress approved
proposed legislation to allow nationwide use of NOW
accounts. This could cause MIA and M1B again to
grow at substantially different rates over a transition
period. The possibility of nationwide NOW accounts
was the primary reason that the Board of Governors
adopted these two measures of M l.62

The FOMC’s instructions to the Manager of the
System Open Market Account regarding the manage
ment of bank reserves provide — to a considerable
extent — for the accommodation of the public’s de
mand for money in the short run, while at the same
time prescribing a response when growth of money
appears inconsistent with the Committee’s long-term
objectives.47
For example, upward pressure on the federal funds
rate was viewed as reflecting an increase in the de
mand for money. The Desk “accommodated” this in
creased demand by supplying bank reserves to keep
the funds rate constant. If the old short-run operat
ing procedures could be described as “accommoda
tive,” the current procedures — under which the Desk
attempts to stay on some growth path of bank re
serves — can be described as “less accommodative” of
changes in the demand for money.

THE YEAR AHEAD
The major changes in the implementation of mone
tary policy in 1979 will continue to influence mone
tary policy actions in 1980. Chairman Volcker, as re46In fact, on March 7, 1980, the FOMC widened the funds
rate range to 650 basis points — HVi to 18 percent. See,
“Record of Policy Actions,” Federal Reserve Press Release
(March 21, 1980), p. 16; forthcoming in the Federal Re
serve Bulletin ( April 1980).
47“The Implementation of Monetary Policy in 1976,” Federal
Reserve Bulletin (April 1977), p. 326. This article was
adapted from a report submitted to the FOMC by Alan R.
Holmes and Peter D. Stemlight, Manager and Deputy Man
ager of the System Open Market Account, respectively. John
S. Hill and Christopher J. McCurdy were primarily respon
sible for its preparation.

16FRASER
Digitized for

The redefinition of the monetary aggregates also
alters the FOM C’s choice of short-run operating tar
48“Monetary Policy Report to Congress,” Federal Reserve Bul
letin (March 1980), pp. 177-78; and “The Redefined Mone
tary Aggregates,” Federal Reserve Bulletin (February 1980),
pp. 97-114.
49For a detailed description of all the new monetary aggregates
and their relationship to the old measures, see “The Rede
fined Monetary Aggregates;” or R. W. Hafer, “The New
Monetary Aggregates,” this Review (February 1980), pp.
25-32.
50Old M l growth in 1978 was also about the same as MIA
growth—-7.2 percent from IV/77 to IV/78.
51“The Redefined Monetary Aggregates,” p. 102.
62Ibid., p. 100.

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

gets in 1980. Because data on MIA and M1B are
available weekly, while data on new M2 and M3 are
available only monthly, the FOM C’s short-run ranges
of monetary growth are being specified in terms of
M IA and M1B.53 Consequently, the Desk must now
formulate intermeeting paths of total and nonbor
rowed reserves consistent with the FOM C’s short-run
ranges of MIA and M1B growth.
The introduction of reserve targeting in 1979 marks
53“Record of Policy Actions of the FOMC: Meeting Held on
February 5, 1980,’’ Federal Reserve Press Release (March
21, 1980), p. 14, forthcoming in the Federal Reserve Bulle
tin (April 1980).

1980

the beginning of a different approach to the imple
mentation of monetary policy. The effectiveness of the
new short-run operating procedures in controlling
monetary growth, and these procedures’ effects (or
side-effects) on the economy, can be evaluated ade
quately only over a longer period of time. Growth of
the monetary aggregates decelerated between October
and January of this year, in fine with the FOM C’s ob
jectives. Nevertheless, analysts undoubtedly will give
greater weight to monetary growth in 1980 — relative
to the FOM C’s new one-year ranges — in evaluating
the effectiveness of the new operating procedures.

Supplement: FOMC Discussions in 1979
This supplement consists of selected excerpts from
the “Record of Policy Actions” for each of the FOMC
meetings in 1979. Each “Record” includes analyses of
current and projected economic developments, discus
sions of current policy actions, and long- and shortrun operating instructions issued by the FOM C to the
Trading Desk. The complete text of each “Record of
Policy Actions” appears in issues of the Federal Re
serve Bulletin and “Records” for the entire year are
published in the Annual Report of the Board of
Governors.

Meeting Held on February 6, 1979
By late December, staff projections suggested that
growth in M2 over the December-January period
would be at an annual rate well below the lower limit
of the range of tolerance specified for that aggregate
and growth in M l would be in the lower portion of its
range of tolerance.
These developments pointed to a reduction in the ob
jective for the federal funds rate toward the 9% percent
lower limit of the specified range. However, on December
29 the Committee voted to modify its directive by calling
for open market operations directed at maintaining the
weekly average federal funds rate at about 10 percent or
slightly above. This action was taken in view of uncer
tainties surrounding the interpretation of the behavior of
the monetary aggregates and in light of domestic economic
conditions and developments in domestic and interna
tional financial markets. On January 12 the Committee
held a telephone conference to review the situation and

to consider whether supplementary instructions were
needed, but no change was made in the instruction to
the Manager.
Most market interest rates declined on balance during
the intermeeting period. Factors apparendy contributing
to this development included a market sentiment that
further tightening in monetary policy had become less
likely in light of the behavior of the monetary aggregates
and the better performance of the dollar in foreign ex
change markets. Another influence appeared to be the re
cent modest growth of total business credit demands.
W ith respect to the economic situation and outlook,
most members of the committee expressed little or no dis
agreement with the staff projection of a marked slowing
in the expansion by the second quarter of 1979 and of a
sustained slow rate of growth over the rest of the year
accompanied by some increase in the rate of unemploy
ment. However, a few members questioned whether a
very slow pace of growth was sustainable and suggested
that the onset of a recession before the end of the year,
with a larger increase in the unemployment rate, was the
more likely development. Other members thought that
over the past few months the probabilities of the develop
ment of a recession before the end of this year had de
clined somewhat. It was also observed that expansion
might prove to be stronger than projected by the staff,
especially if businessmen believed that effective steps were
being taken to moderate the rate of inflation.
The members continued to anticipate a relatively rapid
rise in average prices. Inflation was viewed as a distortion
that could contribute to the development of a recession,
and it was noted that forecasters typically had underesti
mated the strength of inflationary forces. In this connec

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

MARCH

1980

tion, it was observed that the economy was operating at
a higher rate in relation to its potential than had been
thought earlier.

At the same time, it was noted, developments since the
turn of the year were apparently mixed, contributing to
increased uncertainty.

In the Committee’s discussion, stress was placed on
the importance of adopting [one-year] ranges for mone
tary growth over the year ahead that would be consistent
with a reduction in the rate of inflation, thereby reinforc
ing the governmental actions over recent months in pur
suit of that objective.

Many members of the Committee thought that the staff
was overly optimistic in projecting continued, if sluggish,
growth in real GNP throughout the second half of 1979;
they believed that the chances of a recession beginning
before the end of the year or in early 1980 were fairly
high. The recent increase in the price of oil, the accelera
tion of the overall rise in prices, and the sluggish growth
of the monetary aggregates over the latest five months
were cited among the factors that increased the probabil
ity of a recession. The observation also was made that if
a recession developed, it was likely to be moderate and
short-lived.

In the discussion of policy for the period immediately
ahead, most members of the Committee favored directing
operations initially toward maintaining the money market
conditions currently prevailing, as indicated by a federal
funds rate of 10 percent or slightly higher, but some senti
ment was expressed for a slight additional finning in
money market conditions. The views of the members dif
fered primarily with respect to the influence that the
incoming evidence concerning growth of the monetary
aggregates should have on the objective for the funds rate
later in the period before the next meeting.

Meeting Held on March 20, 1979
In January and February growth of total credit at U.S.
commercial banks accelerated considerably from its re
duced pace during late 1978. Expansion in business loans
was unusually strong, and banks also added substantially
to their holdings of securities.
M l declined in both January and February, M2
changed little, and M3 grew at a relatively slow rate. With
interest rates remaining high, the behavior of all three
monetary aggregates was affected by unusually large shifts
of funds from deposits to money market mutual funds and
other liquid assets. The weakness in M l also reflected the
effects of continuing movements of funds from demand
deposits to savings deposits associated with the recently
authorized automatic transfer service (A TS) and negoti
able orders of withdrawal (N O W ) accounts in New York
State.
At the beginning of March, projections suggested that
over the February-March period M l would grow at a rate
moderately below the lower limit of the range established
by the Committee and M2 would grow at a rate just
below the lower limit of its range. In a special telephone
meeting on March 2, the Committee instructed the Man
ager to continue aiming for a weekly average federal funds
rate of 10 percent or slightly higher.
Most market interest rates rose moderately on balance
during the intermeeting period, after having declined in
January.
In the Committee’s discussion of the current economic
situation, attention was drawn to the more rapid expan
sion in output of goods and services in the fourth quarter
of 1978 than had been anticipated. The Commerce D e
partment had just released a second upward revision in
its estimate of growth in real gross national product in
that quarter, and it was observed that the rate of resource
utilization therefore was higher than had been thought
earlier, accounting in part for the recent intensification of
upward pressures on prices.
Digitized for18
FRASER

The members expressed some differences of opinion con
cerning prospects for prices. A significant easing from
the rapid rise of recent months was suggested, to the ex
tent that recent increases in prices represented temporary
factors or were made in anticipation of possible price
and wage controls. Moreover, slackening of economic ac
tivity later in the year could be expected to slow the rise
in prices generally. The view was also expressed, how
ever, that inflation would remain rapid even during a
recession. In any case, it was observed, a long lag could
be expected in the response of prices to the additional
measures of restraint imposed toward the end of 1978.
In contemplating policy for the period immediately
ahead, the Committee continued to face unusual uncer
tainties concerning the forces affecting monetary growth.
A staff analysis had suggested that M l was likely to ex
pand in March, contributing to a pickup in growth of
M2. Nevertheless, M l was expected to register a decline
in the first quarter, on a quarterly average basis. It was
estimated that shifts of funds from demand deposits to
savings accounts with automatic transfer services and to
the NOW accounts in New York had depressed growth of
M l by about 3 percentage points in the quarter. Moreover,
it appeared that growth of both M l and M2 had been
affected by a downward shift in the public’s demand for
money in relation to income, although the magnitude of
that effect was uncertain.
In the Committee’s discussion, several members stressed
their concern about the shortfall in monetary growth rela
tive to the longer-run ranges that the Committee had
adopted at its meeting on February 6, 1979, especially
in view of the risks that a recession might develop in the
period ahead. Supporting the goal of bringing growth of
the monetary aggregates up into those ranges over a num
ber of months, particularly because of the uncertainty
about the outlook for economic activity, they favored di
recting operations in the period just after the meeting
toward maintaining the money market conditions currentiy
prevailing — as indicated by a federal funds rate of 10
percent or slightly higher — or toward a little less firm
ness in those conditions. The objective of operations later
in the period before the next regular meeting of the
Committee would be determined on the basis of the in
coming evidence on the behavior of the monetary aggre
gates, although it was suggested that the Committee con
sult again before any change was made in the operational
objective for the funds rate.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

Other members of the Committee emphasized the re
cent acceleration of the rise in prices, and they believed
that action should be taken to demonstrate that inflation
represented the greatest risk to economic stability over a
period of time. Accordingly, they advocated directing ini
tial operations in the period ahead toward a slight firming
in money market conditions, represented by an increase
in the objective for the federal funds rate to about 10%
percent. Their prescription for operations later in the pe
riod called for holding the objective for the funds rate
within a relatively narrow range.
The Manager was instructed to direct open market opera
tions initially toward maintaining the federal funds rate
at about the current level, represented by a rate of about
10 percent or slightly higher.

Meeting Held on April 17, 1979
Total credit at U.S. commercial banks expanded at a
much slower pace in March than in January and February,
as growth in real estate and business loans moderated
considerably and banks reduced their holdings of securi
ties. However, commercial paper issued by nonfinancial
firms increased sharply, and the overall rate of short-term
business borrowing was maintained. For the first quarter
as a whole, nonfinancial businesses substantially increased
their borrowing in short- and intermediate-term markets.
At the same time, they reduced their public offerings of
bonds to the smallest quarterly total since 1973.
The narrowly defined money supply, M l, grew some
what in March after having declined in both January and
February. The broader monetary aggregates, M2 and M3,
expanded at relatively slow rates during the month, al
though growth in both measures picked up somewhat from
the pace earlier in the year.
In late March and early April staff projections suggested
that over the March-April period M l would grow at a
rate close to the lower limit of the range established by
the Committee and M2 at a rate just below the midpoint
of its range. These projections were not viewed as suffi
ciently weak in relation to the Committee’s ranges to call
for a change in the federal funds rate objective of 10
percent or slightly higher.
Short-term interest rates fluctuated over a fairly wide
range during the intermeeting period and generally rose
a little on balance.
In the Committee’s discussion of the current economic
situation and outlook, attention was drawn to the indica
tions of considerably slower growth in real output of goods
and services in the first quarter of 1979 than had appeared
likely earlier. It was noted that residential construction
and consumer spending for goods had weakened more
than had been anticipated, and that such expansion as
had occurred in the first quarter apparently reflected
a substantial acceleration in the growth of business
inventories.
The members in general anticipated relatively slow
growth in economic activity for the near term, and some
believed that growth could remain at a sluggish pace for
many quarters. Many continued to believe that the proba
bilities of a downturn in activity before the end of 1979

MARCH

1980

were fairly high, especially in view of the unusually long
duration of the current business expansion. It was also sug
gested by some that a pickup in activity, based in part on
a surge in business demands for equipment and for inven
tories, might occur and persist for a time before an even
tual downturn.
As at other recent meetings, great concern was expressed
about inflation. It was observed that the rate of increase in
prices had tended to accelerate from year to year recently
and that there were few if any indications of a near-term
reversal in that momentum.
In contemplating policy for the period immediately
ahead, the Committee continued to face uncertainties con
cerning the forces affecting monetary growth. A staff
analysis had suggested that M l, after having registered
a decline in the first quarter, would expand over the
April-May period, reflecting in part rapid growth in nom
inal GNP. It was anticipated that shifts of funds from
demand deposits to savings accounts with automatic trans
fer services and to NOW accounts in New York State
. . . would have a somewhat less dampening effect
on growth of M l in the period immediately ahead
than in the first quarter. Moreover, it was assumed
that the public’s demand for money in relation
to income would continue to shift downward, but at
a sharply slower pace than in recent months. Thus, the
rise in the income velocity of M l was expected to be
relatively rapid, but less than the unusually rapid rate of
the two most recent calendar quarters.
In the Committee’s discussion at this meeting, as at the
meeting on March 20, 1979, several members stressed
their concern about the degree of the shortfall in mone
tary growth relative to the longer-run ranges that the Com
mittee had adopted at its meeting on February 6. It was
observed that restrictive policy actions taken in late 1978
had contributed to the recent slowing of monetary growth
(after allowance for the impact of special factors) and
apparently also to a moderation of the expansion in eco
nomic activity. Now, some easing in money market condi
tions might be appropriate, with the objective of raising
growth of the monetary aggregates over a number of
months into the longer-run ranges and of helping to sup
port economic activity later in the year.
However, an easing in money market conditions was
generally regarded as premature in the current environ
ment of rapidly rising prices, although it was felt that
monetary policy could have little if any immediate effect
on prices of food, energy, and housing items, which had
been largely responsible for the recent acceleration of the
overall rise. Given the staff expectation of a near-term
strengthening of monetary growth, most members advo
cated or found acceptable a policy of directing operations
early in the period immediately ahead toward maintaining
the money market conditions currently prevailing . . .
and of having the objective for operations later
in the period before the next regular meeting determined
on the basis of incoming evidence on rates of growth of the
monetary aggregates over the April-May period in relation
to the growth rates currently anticipated.
A few members advocated an immediate increase in the

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

MARCH

1980

objective for the federal funds rate to IOV4 percent or
IOV2 percent and a range for subsequent operations provid
ing for a further increase in the funds rate if incoming
evidence suggested relative strength in growth of the mon
etary aggregates. They stressed the recent acceleration in
the rise in prices and high rates of resource use, and they
continued to believe that action should be taken to dem
onstrate that inflation represented the greatest risk to eco
nomic stability over a period of time. In their view, in
flationary expectations had increased over recent months
while interest rates on balance had changed little. In the
current circumstances, moreover, they attached little sig
nificance to the behavior of the monetary aggregates.

view of the inflationary pressures that had been accumu
lating. It was noted that some reduction in growth of
nominal GNP had been an objective of the restrictive pol
icy actions taken last autumn, although the reduction had
so far been reflected in growth of real GNP rather than in
the rate of inflation.

Meeting Held on May 22, 1979

In contemplating policy for the period immediately
ahead, the Committee took note of a staff analysis sug
gesting that over the May-June period growth of M l
would be quite slow, in part because of the unwinding of
the transitory effects of federal income tax payments and
refunds that had contributed to its exceptionally rapid
growth in April. It was expected that growth of M2 over
the two-month period would be retarded by the slow
growth of M l but that growth of the interest-bearing com
ponent would remain relatively strong.

Total credit outstanding at U.S. commercial banks grew
rapidly in April, as it had on balance during the first
quarter of the year. The April growth was lead by a re
bound in expansion of business loans, which had slack
ened in March from rapid rates in January and February.
Commercial paper issued by nonfinancial firms increased
sharply in April for the second consecutive month.
The narrowly defined money supply, M l, expanded
sharply in April, after having declined on the average in
the first quarter. A substantial part of the April increase
was attributable to delays in the Treasury’s processing of
checks in payment of federal income taxes and to bunch
ing of tax refunds. Reflecting in part the behavior of M l,
growth of M2 and M3 accelerated to rapid rates in April
from relatively slow rates in the first quarter.
In late April projections suggested that over the AprilMay period M l and M 2 would grow at rates that were
close to or above the upper limits of their respective
ranges. In accordance with the directive issued at the
meeting on April 17, operations were directed toward an
increase in the federal funds rate to a level of about IOV4
percent. Subsequently, in early May, the two-month rates
of growth projected for M l and M2 were somewhat
stronger. However, financial markets appeared to be in a
sensitive state, and recent developments affecting supplies
and distribution of energy were adding to uncertainties
about economic prospects. Moreover, it appeared that the
rapid pace of monetary growth was attributable in part to
transitory forces. In the circumstances, and in view of the
directive’s instruction to give due regard to developing
conditions in domestic financial markets, the objective for
the federal funds rate was maintained at lOVi percent.
Short-term interest rates in general changed little on
balance during the intermeeting period.
In the Committee’s discussion of the economic situa
tion and outlook, the members in general agreed that the
pace of expansion in economic activity had slowed signifi
cantly, apart from the effects of severe weather in the first
quarter and of the work stoppage in the trucking industry
early in the current quarter. . . . A number of members
now thought that a cyclical peak in activity might well be
registered in the current quarter.
Despite the current risks of recession in activity, the
slowing of the expansion from the excessively rapid pace
in late 1978 was regarded as a desirable development, in
Digitized for20
FRASER

Members continued to express great concern about in
flation. . . . According to a number of economic projec
tions, moreover, deceleration of inflation would be a slow
and lengthy process. The observation was made that if
the rate of inflation was not sharply reduced in the months
immediately ahead, renewed expansion in business activ
ity would begin with prices rising at a relatively fast pace.

Most members of the Committee believed that, despite
increasing signs of weakening in economic activity and
the risks of recession, a general easing in monetary re
straint at this time would be premature in view of the
continuance of strong inflationary pressures. Given the staff
expectations of slow growth in M l and M2 over the MayJune period, they favored a policy of directing open mar
ket operations early in the period immediately ahead to
ward maintaining the money market conditions currently
prevailing . . . and of having the objective for operations
later in the period before the next meeting determined on
the basis of incoming evidence on the behavior of the
monetary aggregates in relation to that currently antici
pated. In view of uncertainties concerning interpretation
of credit conditions and monetary growth in the current
environment, they also favored specifying unusually wide
ranges for growth of M l and M2 over the May-June
period and giving greater weight than usual to money
market conditions in the conduct of operations until the
next meeting.
Subsequent to the meeting, on June 15, incoming data
indicated that M l and M2 were growing at exceptionally
rapid rates in early June, and projections suggested that
for the May-June period both monetary aggregates would
grow at annual rates above the upper limits of the ranges
that had been specified by the Committee. . . . However,
in view of many indications of weakening in economic
activity, the difficulties of interpreting the behavior of the
aggregates in the light of these circumstances, the condi
tion of financial markets, and the general uncertainty about
the economic outlook, Chairman Miller recommended that
the Manager be instructed to continue to aim for a federal
funds rate of about 10 *4 percent.

Meeting Held on July 11, 1979
Total credit outstanding at U.S. commercial banks con
tinued to expand rapidly in May and June, but the rate

F E D E R A L R E S E R V E B A N K O F ST. LO U IS

of growth for the two months combined was down some
what from the average pace in earlier months of the
year. Increases in bank loans during May and June were
concentrated in the business and real estate categories.
Commercial paper issued by nonfinancial firms rose con
siderably further over the two months.
The narrowly defined money supply, Ml, increased
sharply in June and the broader measures of money, M2
and M3, also grew rapidly.. . .
Federal funds traded somewhat above the Committee’s
objective in late June and early July, in response to pres
sures associated with unusual churning in the money mar
ket around the midyear bank statement date and the
July 4 holiday.
Most interest rates other than the federal funds rate
fell substantially on balance during the intermeeting pe
riod. The declines appeared to be in response to the grow
ing evidence that economic activity had been weakening.
With respect to the economic situation and outlook, no
member of the Committee expressed disagreement with
the staff appraisal that real gross national product had de
clined somewhat in the second quarter and that further
declines were likely for the remaining two quarters of the
year. The suggestion was made that the recession was
most likely to be mild and short-lived. However, it could
prove to be more severe than currently expected because
the recent increases in prices of energy items and inflation
generally were reducing disposable income and eroding
the financial position of the household sector.
Another reason advanced for thinking that the recession
could be more severe was the possibility that the down
turn in economic activity would become widespread
among industrial countries.
Members continued to express great concern about in
flation. It was suggested that the unexpectedly large in
creases in OPEC oil prices in late June had seriously
harmed the government’s anti-inflation efforts. Thus, wind
ing down the rate of increase in prices might well take
considerably longer than had been thought earlier and
would be more costly in terms of its impact on output,
employment, and real income.
In the discussion of policy for the period immediately
ahead, members of the Committee in general favored di
recting open market operations initially toward maintain
ing the money market conditions currently prevailing . . .
on the expectation that over the July-August period growth
of Ml and M2 would be both moderate and consistent
with their longer-run ranges. Some sentiment was ex
pressed for a near-term reduction in the federal funds
rate because of the downturn in economic activity, but it
was agreed that current conditions in foreign exchange
markets militated against a prompt reduction.
About a week after the meeting, on July 19, projections
suggested that over the July-August period Ml would
grow at an annual rate moderately above the upper limit
of the range of 2% to 6% percent that had been specified
by the Committee and that M2 would grow at a rate about
equal to the upper limit of its range of 6 V2 to 10% per

MARCH

1980

cent; in those circumstances, the Manager began to aim
for a weekly average federal funds rate at about the 10%
percent upper limit of its range. On July 27, with the pro
jections suggesting that growth of both Ml and M2 over
the July-August period would exceed the upper limits of
their ranges and with the objective for the federal funds
rate at the upper limit of its range, the Committee voted
to modify the directive adopted at the meeting on July
11. Specifically, the Committee raised the upper limit of
the intermeeting range for the federal funds rate to 10%
percent and instructed the Manager to aim for a rate
within a range of 10% to 10% percent, depending on sub
sequent behavior of the monetary aggregates, on conditions
in foreign exchange markets, and on the current Treasury
financing.

Meeting Held on August 14, 1979
Expansion of total credit outstanding at U.S. commercial
banks, which had picked up in June, moderated in July
to about the April-May pace. Growth in loans also mod
erated in July after an acceleration in June. Banks con
tinued to add sizable amounts to their holdings of securi
ties, especially U.S. government obligations. Growth in
commercial paper issued by nonfinancial firms exceeded
the strong second-quarter pace, owing in part to large sales
by foreign issuers.
The monetary aggregates — Ml, M2, and M3 — con
tinued to expand rapidly in July.
In the Committee’s discussion of the economic situation
and oudook, none of the members expressed disagreement
with the staff appraisal that real gross national product
was continuing to decline in the current quarter. How
ever, members expressed considerable uncertainty about
the duration and extent of the decline in activity.
Members continued to express great concern about in
flation. It was observed that for a long period elements
in the economic situation had seemed to justify expecta
tions of a reduction in the rise in prices. Such expectations
had been disappointed. Moreover, little reduction could
be expected in the short run because recent increases in
energy prices had not yet fully worked through the price
structure. It was noted that the decline in the rate of
inflation projected for the quarters immediately ahead was
small, and much smaller than that associated with the pre
vious recession. Thus, inflation might still be at a high rate
when economic activity turned up again. Inflationary ex
pectations appeared to have worsened in the sense that,
more than ever before, consumers and businessmen seemed
to take the inflationary environment into account in mak
ing spending and investing decisions.
In considering policy for the period immediately ahead,
Committee members focused on the problems posed by
emerging recession and its potential for substantial in
creases in unemployment, concurrent with strong mone
tary growth, high actual and expected rates of inflation,
and an exposed position of the dollar in foreign exchange
markets pending anticipated improvement in the U.S. for
eign trade and current accounts.
There was little disagreement with the proposition that

F E D E R A L R E S E R V E B A N K O F ST. LO U IS

for the near term modest measures should be taken to
direct policy toward slowing growth of the monetary ag
gregates. Control of monetary growth was regarded as
essential to restore expectations of a decline in the rate
of inflation over a period of time.
In support of modest measures directed toward restraint,
it was suggested that monetary policy recently had not
been so restrictive as it might have appeared. Monetary
growth since the beginning of the year had been con
siderably greater than that indicated by M l, owing to
rapid expansion in close substitutes for demand deposits
and currency. In addition, the increase in interest rates
had been less than that in expected rates of inflation.
On the other hand, it was noted that interest rates were
close to historic highs. Some doubt was expressed, more
over, that further restraint could have a significant effect
on inflation, particularly in view of the role of energy in
the rapid rate of increase in prices recently. In the face
of clear evidence of weakening in economic activity, it
was observed, the need to balance the objective of con
taining the recession with the goal of moderating infla
tion called for a steady policy for the time being.
In considering policy specifications for the period im
mediately ahead, the Committee took note of a staff analy
sis suggesting that the current growth rate of nominal
GNP and other influences, including possibly a temporary
accumulation of precautionary balances by the public in
response to unusual uncertainties, were tending to sup
port the demand for money. On the assumption of con
tinuance of prevailing money market conditions, therefore,
growth of both M l and M2 over the August-September
period most likely would be high relative to the Com
mittee’s longer-run ranges, although growth could be ex
pected to slow substantially from the rapid rates of recent
months.
At the conclusion of its discussion of policy, the Com
mittee decided to instruct the Manager for Domestic Op
erations to direct open market operations initially toward
an increase in the weekly average federal funds rate to
about 11 percent.
Subsequent to the meeting, in late August, incoming
data indicated that M l and M2 were growing at rapid
rates in August. On August 30, projections for the AugustSeptember period suggested that growth of M l would be
at an annual rate well above the upper limit of the range
that had been specified by the Committee and that growth
of M2 would be at about the upper limit of its range.
Over the preceding week, the Manager for Domestic Op
erations had been aiming for a weekly average federal
funds rate approaching the 1 IVi percent upper limit of its
specified range, and in the statement week ending August
29, the rate averaged 11.16 percent. In these circum
stances, Chairman Volcker recommended that the upper
limit of the range for the funds rate be raised to 11%
percent, but with the understanding that not all of the
additional leeway would be used immediately; use of the
leeway would depend on subsequent behavior of the
monetary aggregates and on developments in foreign ex
change markets. The Committee voted to amend the
domestic policy directive in accordance with the Chair
man’s recommendation.

MARCH

1980

Meeting Held on September 18, 1979
Total credit outstanding at U.S. commercial banks grew
more slowly in August than in most earlier months of the
year. Banks’ holdings of Treasury obligations declined
and growth in their total loans moderated. However, busi
ness loans continued to expand rapidly in August and
commercial paper issued by nonfinancial firms again in
creased sharply.
The monetary aggregates — M l, M2, and M3 — con
tinued to expand at relatively rapid rates in August and
early September, although somewhat less rapidly than in
June and July.
Short-term interest rates rose substantially during the
intermeeting period, in response to strong business de
mands for credit as well as to the System’s actions firming
money market conditions and to expectations of further
monetary restraint. Bond yields also increased somewhat.
In the Committee’s discussion of the economic situation
and outlook, none of the members expressed disagreement
with the staff appraisal of some further contraction in
real gross national product after the current quarter’s in
terruption of the decline. However, members continued
to express uncertainty about the duration and extent of
the contraction in activity.
Members continued to express great concern about the
rapid rise in prices. It was observed that inflation was
more persistent now than it had been in earlier periods of
some weakening in demands and that there was still a
tendency to underestimate its strength. Furthermore, the
current and foreseeable rate of inflation could itself lead
to additional shocks to the economy.
In contemplating policy for the period immediately
ahead, Committee members took note of a staff analysis
suggesting that growth of M l was likely to taper off dur
ing the September-October period in response to the
lagged effects of the substantial increase in interest rates
during the summer and the prospective weakening of ex
pansion in nominal GNP. However, growth over the two
months would still be relatively high.
Members who favored policy measures directed toward
some additional firming in money market conditions
stressed the importance of achieving a significant reduc
tion in the pace of monetary expansion over the months
ahead. Such a reduction was necessary if growth over the
year ending in the fourth quarter of 1979 was to be held
well within the longer-run ranges that had been reaffirmed
by the Committee in July. Additional measures to restrain
monetary growth, moreover, would tend to lower expected
rates of inflation and, consequently, would have a con
structive influence on a range of decisions affecting prices
and wages as well as the value of the dollar in foreign
exchange markets.
It was suggested, in addition, that monetary policy had
not been as restrictive as it might have appeared. Despite
the level of interest rates, credit demands and credit ex
pansion remained strong. Interest rates after allowance for
expected rates of inflation were not high. Furthermore,
monetary growth this year had been greater than indicated

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

by M l alone, owing to rapid expansion in close substi
tutes for demand deposits and currency.
In support of a policy directed toward maintenance for
the time being of prevailing money market conditions,
members emphasized the substantial rise in interest rates
over the past two months and the tendency of changes in
rates to affect monetary growth and economic activity only
after a considerable lag. In this connection, it was ob
served that growth of demand deposits had slowed mark
edly in July and August, while expansion of M l had been
supported by an unexplained pickup in growth of cur
rency in circulation. Growth of the monetary aggregates
was likely to taper off in coming months, and additional
firming in money market conditions might slow growth to
an unwanted degree. In the current circumstances, the
Committee should avoid policy actions that might inten
sify the developing weakness in economic activity.
At the conclusion of its discussion of policy, the Com
mittee decided to instruct the Manager for Domestic Op
erations to direct open market operations initially toward
a slight increase in the weekly average federal funds rate
to about 11 Vi percent.

Meeting Held on October 6, 1979
This meeting of the Committee was called by the Chair
man to consider actions that might be taken, in conjunc
tion with actions being contemplated by the Board of
Governors, to improve control over the expansion of money
and bank credit in the light of developing speculative ex
cesses in financial and commodity markets and additional
evidence of strong inflationary forces in the economy.
Special attention was given to the conduct of open mar
ket operations in order to contain growth in the monetary
aggregates within the ranges previously adopted by the
Committee for the year ending in the fourth quarter of
1979.
The information available at the time of the meeting
suggested somewhat stronger economic activity in the third
quarter than had been indicated at the time of the Com
mittee’s meeting on September 18, and real output of
goods and services was estimated to have recovered a sig
nificant part of the second-quarter decline. According to
staff projections, however, a decline in activity in the
fourth quarter still appeared probable. Prices on the aver
age were continuing to rise somewhat more rapidly than
anticipated earlier, in part because of additional large in
creases in energy items and renewed upward pressures on
foods. Moreover, developments in spot and futures mar
kets for a number of commodities were indicative of an
intensification of speculative activity and of the possibility
of a further singe in prices.
In foreign exchange markets the weighted average value
of the dollar against major foreign currencies had de
clined substantially since the Committee’s meeting in midSeptember, and monetary authorities had purchased, net,
a large amount of dollars.
Interest rates had remained under considerable upward
pressure since mid-September, and most yields had risen
to new highs for the year.
The monetary aggregates — M l and M2 — continued

MARCH

1980

to expand at rapid rates in September, and growth in bank
credit appeared to have accelerated appreciably from its
pace in the prior two months.
In the Committee’s discussion of policy for the period
immediately ahead, the members agreed that the current
situation called for additional measures to restrain growth
of the monetary aggregates over the months ahead. The
members felt that growth of the aggregates at rates within
the ranges previously established for 1979 remained a
reasonable and feasible objective in the light of the avail
able information and the business outlook. Given that ob
jective, most members strongly supported a shift in the
conduct of open market operations to an approach placing
emphasis on supplying the volume of bank reserves esti
mated to be consistent with the desired rates of growth
in monetary aggregates, while permitting much greater
fluctuations in the federal funds rate than heretofore. A
few members, while urging strong action to restrain mon
etary growth, expressed some preference for continuing
to direct daily open market operations toward maintenance
of levels of the federal funds rate and other short-term in
terest rates that appeared to be consistent with the Com
mittee’s objectives for growth in the monetary aggregates.
The advantages and disadvantages of the different ap
proaches were discussed.
The principal reason advanced for shifting to an operat
ing procedure aimed at controlling the supply of bank
reserves more directly was that it would provide greater
assurance that the Committee’s objectives for monetary
growth could be achieved. In the present environment of
rapid inflation, estimates of the relationship among interest
rates, monetary growth, and economic activity had become
less reliable than before, and monetary growth since the
first quarter of 1979 had exceeded the rates expected de
spite substantial increases in short-term interest rates.
Committee members recognized that for a number of rea
sons the relationship between growth of various reserve
measures and growth of the monetary aggregates was not
precise; thus the shift in emphasis to controlling reserves
improved prospects for achievement of the Committee’s
objectives for monetary growth over the next few months
but did not assure it.
Committee members suggested that the shift in operat
ing techniques, along with the other actions being con
templated by the Board of Governors, would tend to
increase confidence at home and abroad in the System’s de
termination to achieve its objectives for monetary growth
and to avoid further deterioration in the inflationary out
look. Partly because it would increase uncertainty about
the near-term course of interest rates, the new operating
technique should induce banks to exercise greater caution
in extending credit and might dampen speculative beha
vior by increasing its risks and costs. Altogether, the
System’s action would tend to moderate inflationary ex
pectations, thereby exerting a constructive influence over
time on decisions affecting wages and prices in domestic
markets and on the value of the dollar in foreign ex
change markets.
The observation was made that the new emphasis in
open market operations might be accompanied by larger
increases in interest rates in the immediate future than

F E D E R A L R E S E R V E B A N K O F ST. LO U IS

would otherwise occur. On the other hand, the emphasis
on reserves also could be expected to produce a shift
toward easier conditions in money markets more promptly
whenever the demand for money and credit abated sig
nificantly in response to a weakening in economic activity.
The point was made that an easing in money market con
ditions under circumstances in which growth of monetary
aggregates was restrained, economic activity was weak
ening, and the rise in prices was moderating should not
adversely affect inflationary expectations and the value of
the dollar in foreign exchange markets.
At the conclusion of the discussion and after full consid
eration of the advantages and disadvantages of alternative
courses of action, the Committee agreed that in the con
duct of open market operations over the remainder of
1979 the Manager for Domestic Operations should place
primary emphasis on restraining expansion of bank re
serves in pursuit of the Committee’s objective of decel
erating growth of M l, M2, and M3 to rates that would
hold growth of these monetary aggregates over the year
from the fourth quarter of 1978 to the fourth quarter of
1979 within the Committee’s ranges for that period.
Subsequently, on October 22, 1979, the Committee held
a telephone conference to review the situation and to con
sider whether supplementary instructions to the Manager
were needed. Since October 6, expansion of total reserves
had exceeded the pace consistent with the Committee’s
objective for growth of the monetary aggregates during
the fourth quarter. At the same time, the federal funds
rate had begun fluctuating close to the upper limit of the
11% to 15% percent range established by the Committee.
It was recognized that the desired restraint in the expan
sion of total reserves might involve continued pressure on
money market conditions, including higher levels of mem
ber bank borrowings from the Federal Reserve than had
been anticipated, as banks made orderly adjustments that
would in time slow monetary growth. It was not clear,
however, that retention of the 15% percent upper limit of
the range for the federal funds rate would be inconsistent
with the desired restraint on monetary growth. Moreover,
unsettled conditions in financial markets also suggested no
change in the upper limit of the range for the federal
funds rate. Consequently, no change was proposed in
the domestic policy directive issued at the meeting on
October 6.

Meeting Held on November 20, 1979
Over the first half of October, measures of bank reserves
in general grew faster than had been anticipated at the
time of the meeting on October 6, both because demands
for reserves were unexpectedly strong and because System
operations provided more reserves than had been expected.
Subsequently, System operations were directed more firmly
at restraining growth of reserves. As such operations lim
ited growth of nonborrowed reserves while demands for
reserves remained strong, member bank borrowings rose
to a daily average of about $3 billion in the last two
statement weeks of October and the federal funds rate
rose to an average a little above 15V2 percent in the final
week. In the first half of November, demands for reserves
eased, and member bank borrowings subsided to a daily

MARCH

1980

average of about $2 billion and the federal funds rate
declined to an average of about 13% percent.
Growth of M l, which had accelerated in September
and had been exceptionally rapid in the third quarter as
a whole, slowed to an annual rate of 2% percent in Oc
tober. Growth of M2 slowed less than that of M l, to a
rate of about 8% percent in October, as overall expan
sion in the interest-bearing components remained strong.
A marked rise of net flows into money market certificates
and other time deposits at commercial banks, fostered by
substantially higher deposit yields, offset a sharp reduction
in savings deposits.
Growth in loans and investments at commercial banks
moderated appreciably in October.
Since early October interest rates had risen sharply in
both short- and long-term markets and had been unusually
volatile.
In foreign exchange markets the downward pressure on
the dollar that had developed in September was reversed
in early October, and by the end of the month, the tradeweighted value of the dollar against major foreign cur
rencies had risen about 3% percent. Around mid-Novem
ber, however, the dollar came under renewed downward
pressure and lost a portion of its October gain, in part
reflecting developments relating to Iran.
In the Committee’s discussion of the economic situation
and outlook, the members in general agreed with the staff
appraisal that the unexpectedly strong rebound in real
gross national product in the third quarter would be fol
lowed by some contraction in activity and by a rise in
unemployment, although uncertainty was expressed about
the depth and duration of the anticipated downturn as
well as about its precise timing. Some members cited the
onset of the heating season with energy prices so much
higher than a year earlier, the overall rate of inflation,
the recent sharp rise in interest rates, and the developing
stringency in some financial markets as influences that
might cause the contraction to be relatively severe.
Continuation of the rapid rise in prices of goods and
services remained a major concern of Committee mem
bers, some of whom thought that the risks were on the
side of a rise greater than that currently anticipated. The
prospects for supplies and prices of oil, which would have
a substantial effect on the economy, were regarded as es
pecially uncertain, in view of the political situation in Iran
and of the meeting of petroleum-exporting countries sched
uled to begin on December 17.
In contemplating policy for the period immediately
ahead, the Committee took note of a staff analysis indi
cating that the behavior of the monetary aggregates since
September had been reasonably consistent with the policy
adopted on October 6 . . . .
In the Committee’s discussion of policy for the period
immediately ahead, the members indicated that in the
present circumstances pursuit of the goal of restraining
growth of the monetary aggregates from the fourth quar
ter of 1978 to the fourth quarter of 1979 within the
ranges previously established for that period remained
feasible and desirable; they agreed that in pursuit of that

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

underlying goal, the broad objectives for monetary growth
during the current quarter adopted at the meeting on Oc
tober 6 were still appropriate. In contemplating objectives
for rates of monetary growth over the weeks through the
end of 1979 and into January 1980, the members differed
somewhat in their views concerning the extent to which
operations should be directed toward promoting accelera
tion in growth of M l from the recently reduced rates. A
few members favored operations consistent with the Oc
tober 6 decision to seek a 4% percent annual rate of
growth in M l over the September-December period. A
few members favored acceptance of a significantly slower
rate of growth for the quarter. Most members, however,
advocated a compromise between those two prescriptions.
It was recognized that, while the decision affecting such a
short period would have quite minor implications for mon
etary growth over the year ending in the fourth quarter of
1979, it would affect credit and money market conditions
in the weeks ahead and the path of monetary growth en
tering the new year.
Views with respect to an acceptable range of fluctua
tion for the federal funds rate did not vary greatly. It was
agreed that the range should continue to be relatively
wide, and most members indicated a preference for re
taining the range of 11 ¥ 2 to 15% percent adopted at the
October 6 meeting.

Meeting Held on January 8-9, 1980
Over the first four weeks after the November meeting,
both total and nonborrowed reserves grew at about the
rates projected at the time of the meeting. Member bank
borrowings averaged about $1% billion, compared with
an average of slightly less than $2 billion in the preced
ing three weeks, and the federal funds rate continued to
average around 13% percent. Toward the end of the fourweek period, however, the demand for reserves appeared
to be easing relative to the path consistent with desired
monetary growth. In the three weeks remaining before this
meeting, member bank borrowings declined to a daily
average of about $1.1 billion. Despite the decline in bor
rowings, the federal funds rate edged up to an average of
about 14 percent in late December and early January, at
least in part because of exceptionally large demands for
excess reserves around the year-end holidays.
Expansion in the major monetary aggregates remained
at a reduced pace in November and December, after hav
ing slowed markedly in October.
Growth in total loans and investments at commercial
banks slowed sharply in the fourth quarter. Slower expan
sion was especially pronounced in business loans. Growth
in real estate loans remained close to the pace in the first
three quarters of the year.
Since the November meeting of the Committee, interest
rates had fluctuated over a relatively wide range, although

MARCH

1980

they had been somewhat less volatile than in the previous
intermeeting period. On balance, most interest rates had
declined.
Staff projections suggested that growth of nominal gross
national product would slow considerably in the current
quarter and then pick up gradually over the remainder
of 1980. The projections suggested, however, that a con
traction in real GNP would develop in the current quarter
and would continue later in the year, although at a di
minishing pace in the second half, and that the rate of
unemployment would increase substantially. The rise in
average prices was projected to accelerate slightly during
the early part of 1980, mainly because of increases in
energy costs, but to subside later.
In the Committee’s consideration of the economic out
look, several members stressed the elements of uncertainty
in the current situation. The observation was made that the
relationships of the past appeared to provide less guidance
than usual in appraising the current situation and outlook.
In the later part of 1979, for example, overall activity had
been unexpectedly strong and the widely anticipated re
cession had not developed, although automobile produc
tion and housing starts had declined. In the judgment of
a number of members, a downturn now seemed to be
getting under way, but there was also recognition that it
could be delayed for another quarter or two.
Inflation remained a major concern. In part because of
earlier increases in oil prices and in mortgage interest
rates, the consumer price indexes to be published in the
next few months probably would continue to show excep
tionally large advances.
In the discussion of policy for the near term, the mem
bers in general considered rates of monetary growth for
the three months from December to March within the
framework of some reduction in ranges for growth over
the whole of 1980 from those for 1979 in pursuit of the
Committee’s objective of reducing the rate of inflation.
The Committee also took note of a staff analysis indi
cating that the demand for money could be relatively
weak in the first quarter of 1980, if growth of nominal
GNP did in fact slow sharply, and could strengthen as
the year progressed.
Differences in views concerning the particular rates of
monetary growth to be specified for the period from D e
cember to March were not great. Preferences were ex
pressed for growth indexed by expansion in M l at an an
nual rate of 4 percent, a rate of 5 percent, and something
between the two.
With respect to the acceptable range of fluctuation for
the federal funds rate, almost all members preferred to
retain the range of 11% to 15% percent, originally adopted
at the meeting on October 6, 1979, and continued at the
meeting on November 20. One member suggested raising
the range slightly, to 12 to 16 percent.

The Dynamics and Estimation of
Short-Run Money Demand
R. W. HAFER and SCOTT E. HEIN

i \ STABLE money demand function is crucial to
the formation and implementation of effective mone
tary policy. Consequently, recent findings of temporal
instability in this relationship have concerned both
policymakers and economists. Previous studies have
examined the stability issue by focusing on the
“proper” specification of the money demand equation.
For the most part, these studies were directed toward
discovering which scale variable and interest rates are
appropriate. Unfortunately, such attempts to explain
the apparent breakdown in the money demand rela
tionship in the early 1970s have not been successful.

demand function relate the demand for real money
balances (m ") to “the” interest rate ( r ) (measured
in nominal terms and therefore incorporating inflation
ary expectations) on assets that are thought to be
relatively close substitutes for money and to some
measure of economic activity, such as real GNP (y ),
to capture the volume of transactions undertaken in
the economy. Real money balances are conventionally
measured by M l divided by the price level (GNP
deflator).

Within this literature there is surprisingly little at
tention devoted to the process by which money bal
ances are assumed to adjust to the desired level. This
paper investigates the importance of the moneydemand adjustment process as well as the technique
used to estimate this relationship. Both the specifica
tion of the adjustment process and the estimation
technique employed are shown to be significant fac
tors in determining whether the short-run money de
mand function has been temporally stable during
recent years.

( 1)

BACKGROUND
In the transactions view of the demand for real
money balances, money is held primarily for two
reasons: the lack of synchronization between receipts
and expenditures and the existence of positive trans
actions costs.1 Formulations of the transactions money
'In contrast to other analyses which place greater emphasis
on money’s role as a store-of-value, the transactions approach
focuses on the medium of exchange function played by money
in the economy. For an introduction to the transactions ap
proach, see Thomas M. Havrilesky and John T. Boorman,
Monetary Macro-Economics (Culington Heights: AHM Pub
lishing Corp., 1978), pp. 96-113. The standard references
on this topic are: John Maynard Keynes, The General Theory
of Employment, Interest, and Money (London: Harcourt,
Brace and World, 1936); William J. Baumol “The Transac
tions Demand for Cash: An Inventory Theoretic Approach,”
Quarterly Journal of Economics (November 1952), pp. 545

This relationship may be written as:
md = f( r, y).

This relationship is typically estimated in the loglinear form,
(2 )

In m? = a» + aj In rt +

a. In yt +

£t,

where £ is a random error term. Furthermore, the
transactions demand for money framework suggests
that the following restrictions should hold for the esti
mated regression coefficients:
0 > a, > -0.5, and 1 > a= > 0.5.2

Equation 2 often has been estimated directly using
annual data.3 Because equation 2 represents a long56; and James Tobin, “The Interest Elasticity of the Trans
actions Demand for Cash,” The Review o f Economics and
Statistics (August 1956), pp. 241-47. For an example of
money viewed as a store-of-value, see Milton Friedman, “The
Quantity Theory of Money: A Restatement,” in Milton Fried
man, ed., Studies in the Quantity Theory of Money (Chicago:
University of Chicago Press, 1956).
2The Baumol-Tobin framework suggests that ai = -0.5 and
a= = 0.5. For a generalization, see Robert J. Barro, “Integral
Constraints and Aggregation in Inventory Models of Money
Demand,” Journal of Finance (March 1976), pp. 77-88.
3See, for example, Allan H. Meltzer, “The Demand for Money:
The Evidence from the Time Series,” Journal of Political
Economy (June 1963), pp. 219-46; T. J. Courchene and H. T.
Shapiro, “The Demand for Money: A Note from the Time
Series,” Journal of Political Economy (November 1964), pp.
1205-19; and David E. W. Laidler, “Some Evidence on the
Demand for Monev,” Journal of Political Economy (April
1966), pp. 111-31. '

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

run equilibrium in which full adjustment between
actual and desired real money balances is completed
within one year, no adjustment process is specified.
When equation 2 is estimated with quarterly data,
however, a more flexible specification is needed to
characterize the short-term money market disequilibria that may exist. To do this, “desired” money bal
ances are posited to depend upon the same variables
found in equation 2. Thus,
(3 )

In m® = a„ + a> In rt + ai In yt .+ Et>

MARCH

1980

mechanism.5 One important implication of this speci
fication is that a decline in the real value of last pe
riod’s nominal money stock due to rising prices will
be fully and immediately offset by an increase in the
amount of nominal money balances currently held.
In other words, it is implicitly assumed that an in
crease in the price level will induce an im m e d ia te
increase in nominal money holdings to equate the
real value of last period’s nominal money holdings to
the currently desired level.

where m? represents desired (or long-run) real money
balances for period t.4 However, since actual real
money balances (m t ) and desired holdings (m?) may
not be equal in the contemporaneous period — be
cause transaction costs prevent immediate adjustment
of actual balances to their desired levels — a specific
stock-adjustment process is specified.

The real-adjustment mechanism has been criticized
on the grounds that the change in money balances
due to a price level change will not occur instan
taneously because such adjustments are costly — just
as they are when interest rates and income change.
Goldfeld and White have suggested an alternative
adjustment mechanism, commonly referred to as the
nominaZ-adjustment mechanism.6

The most commonly used adjustment mechanism
can be formalized as,

The nominal-adjustment hypothesis can be written
as,

(4 ) In mt - In mt-i — X (In m? - In m, i); (0 < X < 1),

(7 ) In M, - In M,-, = X' (In Mf - to M ,-,); (0 < X' < 1),

where X represents the coefficient of adjustment —
the speed at which actual money holdings adjust to
the gap between last period’s stock and the currently
desired level. Substituting equation 3 into equation
4 yields,

where M is nominal money balances, that is, Mt =
mt(P t ). Transforming equation 3 so that the left-hand
side is equal to In Mt and substituting that equation
into equation 7 yields,

(5 ) In mt - In m,-i = X [(a» + ai In r, + a2 In yt + £t) In m, ,],

(8 )

In Mt - to Mi-i = Xf [(a„ + ai In rt + a2 to yt +
to P t + Et) - to Mt-i].

Solving equation 8 for In Mt gives,

which, upon simplification, gives the following solu
tion for In mt:

(9 ) In Mt = X^o + X’ai to rt + X'a» to y, + \f to Pt +

(6 )

The dependent variable in equation 9 is specified
in nominal terms. Equation 9 usually has been esti
mated, however, with real money balances as the de
pendent variable. To transform the nominal-adjust
ment specification so that real money balances are on

In mi = Xa„ + Xai In rt + Xa» In yt +
(1 - X) In mt-i + Xe i .

Equation 6, then, represents a commonly estimated
quarterly money demand function. The adjustment
coefficient (X ) is derived from the estimated coeffi
cient on the lagged dependent variable (In mt_,). If,
for example, the estimated coefficient on In m,-, is 0.7,
this indicates a 30 percent (1 - 0.7) per quarter adjust
ment of actual money balances to the desired level.
Also, whereas the estimated coefficients on In r, and
In yt represent the short-run elasticities of real money
balances with respect to these variables, dividing these
coefficients by the adjustment coefficient (X ) yields
estimates of these variables’ long-run elasticities.
Equation 4 has been labeled the reaZ-adjustment
4Writing equation (3 ) in nominal form yields,
In M? = ao + ai In rt + a2 In yt + In Pt + Et,
where In Pt is the natural logarithm of the price level in
period t, and In M? is the natural logarithm of the desired
level of nominal money balances.

(1 - X') to Mt-t + X'fit.

5This nomenclature follows that used by Stephen M. Goldfeld,
“The Case of the Missing Money,” Brookings Papers on Eco
nomic Activity (3:1976), pp. 683-730.
A specification very similar to equation (6 ) can be gen
erated if one assumes that the appropriate levels of the de
pendent variables are formed adaptively. Thus, the dynamics
of the adjustment process could be due to expectation forma
tion, rather than transactions costs. See David E. W. Laidler,
The Demand for Money, 2nd. ed., (New York: Dunn-Donnelley, 1977), pp. 142-43.
®See Stephen M. Goldfeld, “The Demand for Money Revisited,”
Brookings Papers on Economic Activity (3: 1973), pp.
577-638, and “The Case of the Missing Money,” Brookings
Papers on Economic Activity (3 : 1973), pp. 683-730; William
H. White, “Improving the Demand-for-Money Function In
Moderate Inflation,” International Monetary Fund Staff Papers
(September 1978), pp. 564-607. The nominal-adjustment
mechanism discussed here is used in the MPS (MIT-PennSocial Science Research Council) demand deposits equation.
See Jared Enzler, Lewis Johnson, and John Paulus, “Some
Problems of Money Demand,” Brookings Papers on Economic
Activity (1 : 1976), pp. 261-79.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

the left-hand side, In Pt must be subtracted from both
sides of equation 9:
(10)

In Mt - In Pt — X'ilo + X'ai In rt + X’a- In yt (1 - X') In P, + (1 - X ' ) In Mt-, + X'e ,.

Equation 10 can then be rewritten in the form,
(11)

In mt = X’ao + X'ai In rt + X’a2 In yt +
( 1 - X ' ) In (M.-./P.) + X'e,.

Thus, the only difference between the estimation of
the real-adjustment specification (equation 6 ) and
the nominal-adjustment specification (equation 11) is
the form of the lagged dependent variable. In the
real-adjustment version, lagged nominal money bal
ances are deflated by lagged prices. In the nominaladjustment version, they are deflated by current
prices.7

EMPIRICAL EVIDENCE

Cochrane-Orcutt Results
Goldfeld found little empirical difference between
the coefficient estimates of the real- and nominaladjustment specifications. Based on a superior fit, both
in- and out-of-sample, however, he favored the nomi
nal adjustment version. Friedman, on the other hand,
provides contrasting evidence which suggests that the
real-adjustment version provides more stable regres
sion coefficients over different sample periods.8
Tables 1 and 2 summarize the empirical evidence
on the real- and nominal-adjustment specifications of
7Heller and Khan recently have questioned the applicability of
the nominal-adjustment specification. See H. Robert Heller
and Mohsin S. Khan, “The Demand for Money and the Term
Structure of Interest Rates,” Journal of Political Economy
(Februaiy 1979), pp. 109-29. The issue raised by Heller and
Khan is essentially an econometric one. Specifically, estima
tion of the nominal-adjustment version within a single-equa
tion framework will avoid econometric problems associated
with simultaneous equations bias only when the dependent
variable is viewed as being determined by the exogenous var
iables specified on the right-hand side of the equation.
Although Heller and Khan suggest that a simultaneous equa
tions bias is present when the nominal-adjustment version is
estimated, this same criticism applies equally to the real-adjustment specification. Two points should be recognized with
respect to the Heller-Khan criticism. First, empirical estimates
of the nominal-adjustment specification traditionally define the
dependent variable to be real money balances, not nominal
money balances as given by equation 7. In a very important
sense this variable can be viewed as demand determined —
that is, determined by the price level, interest rates, and real
income. Second, and perhaps more importantly, the simul
taneous equation bias which results from estimating money
demand relationships in a single equation framework is quite
small. For a recent example of studies addressing the possi
bility of simultaneous equation bias, see Goldfeld, “The De
mand for Money Revisited” and “The Case of the Missing
Money.”
8Benjamin Friedman, “Crowding Out or Crowding In?: Eco
nomic Consequences of Financing Government Deficits,”
Brookings Papers on Economic Activity (3: 1978), pp. 593641. This evidence is found in his tables, but never discussed.

http://fraser.stlouisfed.org/
28
Federal Reserve Bank of St. Louis

MARCH

1980

the money demand relationship.9 The estimated co
efficients for the sample period II/1955-IV /1962 are
reported first, followed by estimates obtained by
lengthening the sample period in increments of four
quarters. Relevant summary statistics as well as the
static root-mean-squared error (R M SE) for the four
quarters immediately following the end of the sample
period are also presented. Except for the sample pe
riod II/1955-IV /1978, all regressions are estimated
using the Cochrane-Orcutt ( C O R C ) serial correlation
correction technique — the technique most commonly
implemented to estimate money demand when quar
terly data are employed.10
The regression results for the real- and nominaladjustment specifications ( tables 1 and 2, respectively)
from various sample periods up to and including the
II/1955-IV /1973 period are consistent with the results
of previous investigations.11 In addition, the coeffi
cients on the real income and interest rate variables
are similar across adjustment specifications. The nom
inal-adjustment specification continually produces, as
Goldfeld noted, a slightly slower speed of adjustment.
'■•Following Goldfeld, “The Demand for Money Revisited,”
these specifications incorporate two interest rates. The com
mercial paper rate (CPR) is included as a proxy for market
rates of return. The commercial bank passbook rate (RTD) is
included also. Banking regulations prevent this latter rate from
totally moving with the market rate of return. Small investors,
who do not have sufficient funds to invest in market assets,
may be sensitive to the yield on passbook rates.
10The last row of table 1 presents the regression results when
an alternative serial correlation adjustment procedure is used.
This alternative — known as Hildreth-Lu ( HILU) — was
employed because of the drastic change in the rho estimate
found when adding the observations for 1978 using the CORC
procedure. As seen in the table, CORC estimates of rho in
crease in value as the sample period is extended. When 1978
observations are added, however, the CORC estimate of rho
dropped dramatically to 0.466. The HILU results, however,
suggest that the “correct” rho value for the II/1955-IV/1978
sample estimation is 0.980.
This finding indicates that the Cochrane-Orcutt technique,
when applied to the II/1955-IV/1978 sample, had iterated
to a local rather than a global minimum of the sum-ofsquared residuals. This type of problem, although recognized
in the econometrics literature, has received little attention in
regard to estimating money demand functions. Interestingly
enough, while the Cochrane-Orcutt estimates revealed a
significant change in the coefficients once the observations for
1978 were added, this deterioration is not evident when the
Hildreth-Lu estimation technique is used: The estimated co
efficients on the passbook rate and income variables continue
to have the anticipated sign and are statistically different
from zero. In addition, the coefficient on the lagged depend
ent variable is comparable to that found for earlier sample
periods. None of these findings were obtained when the
Cochrane-Orcutt estimation procedure was employed for the
II/1955-IV/1978 sample period.
For a discussion of the problems associated with the
Cochrane-Orcutt technique, see J. Johnston, Econometric
Methods, 2nd ed., (New York: McGraw-Hill, 1972), pp.
262-63.
11See Goldfeld, “The Case of the Missing Money;” Enzler,
Johnson, and Paulus, “Some Problems;” and Friedman,
“Crowding Out or Crowding In?”

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

MARCH

1980

Table 1
Real-Adjustment Version (log-level equation)

Estimation
technique

Sample
period

Coefficients (absolute value of t-statistics in
parentheses)
-------------------------------------------------------------------In (M t-i/
C
In CPRt In RTDt
In yt
Pt-,)

Durbin-h

SEE
x 10“2

Rho

Static
4Q
RMSE
x102

CORC

11/1955-IV/1962

-0.644
(2.30)

0.140
(2.75)

-0.017
(4.11)

-0.034
(2.39)

0.698
(7.51)

0.9494

-0.029

0.3808

0.256

0.60

CORC

11/1955-IV/1963

-0.838
(3.13)

0.169
(3.39)

-0.018
(4.07)

-0.038
(2.61)

0.710
(7.64)

0.9494

0.034

0.3762

0.331

0.55

CORC

11/1955-IV/1964

-0.962
(3.93)

0.184
(3.92)

-0.018
(4.08)

-0.040
(2.81)

0.742
(8.17)

0.9651

0.181

0.3741

0.371

0.52

CORC

11/1955-IV/1965

-0.954
(4.37)

0.186
(4.28)

-0.019
(4.29)

-0.041
(3.08)

0.716
(8.25)

0.9774

0.365

0.3786

0.303

1.00

CORC

11/1955-IV/1966

-0.755
(3.40)

0.154
(3.44)

-0.021
(4.08)

-0.032
(2.32)

0.724
(7.59)

0.9818

0.614

0.4058

0.440

0.42

CORC

11/1955-IV/1967

-0.842
(4.43)

0.170
(4.34)

-0.021
(4.48)

-0.037
(2.95)

0.708
(8.07)

0.9866

0.569

0.3994

0.406

0.44

CORC

11/1955-IV/1968

-0.893
(4.90)

0.179
(4.72)

-0.021
(4.49)

-0.039
(3.27)

0.703
(8.27)

0.9905

0.748

0.3956

0.421

0.41

CORC

11/1955-IV/1969

-0.905
(5.04)

0.181
(4.88)

-0.023
(5.09)

-0.040
(3.36)

0.698
(8.53)

0.9925

0.811

0.3943

0.422

0.31

CORC

11/1955-IV/1970

-0.916
(5.23)

0.184
(5.09)

-0.022
(5.13)

-0.040
(3.53)

0.688
(8.71)

0.9933

0.932

0.3875

0.422

0.68

CORC

11/1955-IV/1971

-0.916
(4.89)

0.179
(4.84)

-0.017
(4.22)

-0.040
(3.38)

0.661
(8.12)

0.9933

1.381

0.4074

0.425

0.30

CORC

11/1955-IV/1972

-0.861
(5.18)

0.177
(5.04)

-0.016
(4.57)

-0.040
(3.51)

0.665
(8.36)

0.9945

1.321

0.4006

0.440

0.51

CORC

11/1955-IV/1973

-0.867
(5.24)

0.180
(5.16)

-0.016
(4.70)

-0.040
(3.57)

0.649
(8.28)

0.9952

1.460

0.4049

0.440

1.61

CORC

11/1955-IV/1974

-0.703
(3.90)

0.145
(3.87)

-0.022
(4.88)

-0.032
(2.48)

0.732
(8.54)

0.9940

1.125

0.4596

0.596

1.90

CORC

I1/1955-IV/1975

-0.716
(3.69)

0.155
(4.30)

-0.014
(3.01)

-0.048
(2.70)

0.678
(7.76)

0.9923

0.305

0.5051

0.871

0.65

CORC

II/ 1 9 5 5 - IV / 1 9 7 6

-0.702
(3.52)

0.156
(4.45)

-0.013
(2.95)

-0.050
(2.74)

0.652
(7.70)

0.9922

-0.278

0.4984

0.910

0.62

CORC

I I / 1955-IV/1977

-0.688
(3.41)

0.156
(4.50)

-0.013
(2.88)

-0.050
(2.72)

0.632
(7.51)

0.9912

-0.397

0.4970

0.925

1.17

HILU
(-.9, .9, .01)

11/1955-IV/1978

-0.919
(2.43)

0.190
(3.47)

-0.014
(3.15)

-0.045
(2.33)

0.583
(6.78)

0.9912

-0.386

0.5096

0.980

This specification also yields smaller standard errors
of the estimating equation (S E E ) and superior post
sample predictions in terms of the static RMSEs.
The regression results for sample periods with end
points beyond IV/1973, however, provide a different
picture. As the end point is advanced, all estimated
coefficients for the real-adjustment specification con
tinue to have their anticipated sign, are different from
zero at traditional levels of significance, and show rel
atively small changes in magnitude. There is, however,
a significant change in the estimated value of the

serial correlation coefficient (0.44 for the period end
ing IV /1973 to 0.98 for the period ending IV /1978).
While the change in the rho value has no economic
significance, it suggests a misspecification problem.
Moreover, the results indicate a marked deterioration
in both the in- and out-of-sample fit. Altogether, the
SEE increases 26 percent and, for the years 1974 and
1975, the RMSE is more than triple that observed for
1973.
The increase in the RMSE, however, does not tell
the whole story. A major problem with the post

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

1980

Table 2
Nominal-Adjustment Version (Cochrane-Orcutt estimation of log-level equation)
Coefficients (absolute value of t-statistics in parentheses)
Sample
period

In yt

In CPR,

In RTD, In (M .-./P ,)

D.W.

SEE
x 10 2

Rho

Static
4Q
RMSE
x 10-’

11/1955-IV/1962

-0.625
(2.20)

0.128
(2.54)

-0.017
(3.76)

-0.032
(2.35)

0.780
(7.11)

0.9584

1.81

0.3457

0.4922

0.50

11/1955-IV/1963

-0.777
(3.03)

0.148
(3.17)

-0.018
(3.98)

-0.033
(2.52)

0.811
(7.73)

0.9608

1.83

0.3314

0.5456

0.40

11/1955-IV/1964

-0.841
(3.62)

0.156
(3.53)

-0.018
(4.17)

-0.035
(2.69)

0.825
(8.14)

0.9723

1.85

0.3337

0.5231

0.38

11/1955-IV/1965

-0.836
(4.10)

0.157
(3.84)

-0.018
(4.30)

-0.035
(2.90)

0.816
(9.01)

0.9827

1.75

0.3316

0.4917

0.91

11/1955-IV/1966

-0.699
(3.43)

0.136
(3.29)

-0.020
(4.14)

-0.030
(2.35)

0.808
(8.22)

0.9852

1.65

0.3670

0.5559

0.56

11/1955-IV/1967

-0.810
(4.36)

0.156
(4.02)

-0.020
(4.35)

-0.035
(2.93)

0.787
(8.28)

0.9882

1.70

0.3746

0.5067

0.50

11/1955-IV/1968

-0.866
(4.87)

0.164
(4.38)

-0.021
(4.39)

-0.038
(3.24)

0.794
(8.54)

0.9917

1.70

0.3707

0.5307

0.33

11/1955-IV/1969

-0.861
(5.04)

0.164
(4.56)

-0.022
(5.00)

-0.038
(3.34)

0.792
(9.11)

0.9937

1.69

0.3625

0.5270

0.33

11/1955-IV/1970

-0.855
(5.14)

0.163
(4.65)

-0.021
(5.06)

-0.037
(3.36)

0.793
(9.42)

0.9944

1.67

0.3534

0.5285

0.72

11/1955-IV/1971

-0.839
(5.05)

0.166
(4.72)

-0.016
(4.05)

-0.038
(3.42)

0.737
(8.67)

0.9942

1.56

0.3769

0.5340

0.18

11/1955-IV/1972

-0.833
(5.42)

0.164
(4.98)

-0.016
(4.57)

-0.038
(3.57)

0.743
(9.17)

0.9954

1.69

0.3686

0.5321

0.22

11/1955-IV/1973

-0.809
(5.45)

0.160
(5.01)

-0.016
(4.71)

-0.037
(3.56)

0.748
(9.60)

0.9961

1.72

0.3644

0.5145

0.66

11/1955-IV/1974

-0.656
(5.15)

0.125
(4.64)

-0.017
(5.69)

-0.027
(2.97)

0.840
(13.22)

0.9961

1.78

0.3679

0.4967

1.56

11/1955-IV/1975

-0.327
(3.40)

0.054
(2.72)

-0.015
(4.68)

-0.008
(0.99)

1.003
(21.71)

0.9948

1.79

0.4161

0.4242

0.69

11/1955-IV/1976

-0.233
(3.32)

0.034
(2.40)

-0.014
(4.58)

-0.002
(0.26)

1.045
(29.39)

0.9945

1.88

0.4183

0.3990

0.16

11/1955-IV/1977

-0.227
(3.97)

0.033
(2.91)

-0.014
(4.67)

-0.001
(0.23)

1.047
(34.02)

0.9945

1.89

0.4102

0.3929

0.38

11/1955-IV/1978

-0.233
(4.55)

0.034
(3.49)

-0.014
(4.98)

-0.002
(0.29)

1.046
(38.93)

0.9943

1.88

0.4093

0.3886

sample performance of the real-adjustment equation
is that the specification consistently overpredicts
money demand. Table 3 provides the mean forecast
error for nominal money balances based on both the
real- and the nominal-adjustment specifications. The
real-adjustment specification, on average, overpredicts
money demand for each year following 1973. While
the apparent stability of the estimated coefficients pro
vides some ad hoc evidence for the belief that the
underlying economic relationship for the real-adjust
ment specification is stable, the changes in both the
rho estimate and the in- and out-of-sample fit question
such a conclusion.

In contrast, the results for the nominal-adjustment
version over the post-1973 era (table 2 ) indicate a
marked deterioration in the estimated regression co
efficients. This is somewhat surprising since the only
difference between these two specifications is whether
lagged money is deflated by lagged or contempora
neous prices. Interestingly enough, the most trouble
some result over this period is the increase in the size
of the coefficient on the lagged dependent variable.
The coefficient exceeds unity in the longer sample pe
riods, a finding that alone obviates any meaningful
interpretation of the estimates within the stock-adjustment framework. Based on the dramatic change in the

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

MARCH

1980

Table 3

Table 4

Mean Static Prediction Error*
(billions of nominal money balances)

F-statistics for Null Hypothesis that
Regression Coefficients Are Equal in
Two Sample Periods (CORC)

Prediction
interval

Real-adjustment
(Cochrane-Orcutt
estimation)

Nominal-adjustment
(Cochrane-Orcutt
estimation)

1/1974-IV/1974

-$2.85

-$1.00

11/1955-IV/1962 vs. 1/1963-IV/1978

5.72*

1.99

I/1975-IV/1975

- 3.33

- 3.01

II/1955-IW1967 vs. 1/1968-IV/1978

5.60*

3.00**

11/1955-IV/1973 vs. I/1974-IV/1978

8.33*

5.31*

1/1976-IV/1976

- 0.80

- 1.28

1/1977-IV/1977

- 0.55

- 0.11

1/1978-IV/1978

- 1.83

+ 0.11

“Error is calculated as actual nominal money stock less pre
dicted nominal money stock. A negative error thus indicates
overprediction.

estimated regression coefficients for the nominaladjustment specification, it appears that this economic
relationship has indeed broken down. Thus, even
though the nominal-adjustment specification continues
to have both a better in-sample and out-of-sample fit
(see table 3 ), it is difficult to attach any significance
to this in light of the coefficient estimates for the post1973 period.
Chow tests were employed to ascertain whether
either relationship is statistically stable over the full
sample period. Three alternative break points were
examined: (1 ) IV/1962, a point near which Slovin
and Sushka found evidence of a shift in the money de
mand relationship;12 (2 ) IV /1967, a point near the
middle of the sample period; and (3 ) IV/1973, a point
of recent concern and considerable testing. The calcu
lated F-statistics are reported in table 4 .13 With the
exception of the hypothesized IV /1962 break point
for the nominal-adjustment equation, the regression
coefficients are all statistically different for the oppos
ing sample periods. The finding that the real-adjustment specification is unstable over these sample pe
riods contrasts sharply with the apparent stability of
12Myron B. Slovin and Marie Elizabeth Sushka, “The Struc
tural Shift in the Demand For Money,” The Journal of
Finance (June 1975), pp. 721-31.
13The applicability of the Chow test is complicated in this
case by the existence of serial correlation in the disturbances.
The F-statistics in table 3 were calculated by estimating the
serial coefficient in each alternative sample period separately,
using the Cochrane-Orcutt technique. An alternative, “seem
ingly unrelated,” procedure was also used (see Franklin M.
Fisher, “Test of Equality Between Sets of Coefficients in Two
Linear Regressions: An Expository Note,” Econometrica
(March 1970), pp. 361-66). This latter procedure constrained
the serial correlation coefficient to be the same in each of the
respective sample periods. The results for this test did not
differ significantly from those reported.

Sample periods

RealNominaladjustment adjustment

* Significant at the 1% level. |
* i.u to, ,
, /Degrees of freedom — 5,84
Significant at the 5% level. )

the regression coefficients in table 1. These results indi
cate that cursory examinations of the stability of the
regression coefficients can be misleading.

First-Difference Results
As an alternative to the estimation performed
above, both money demand specifications were esti
mated in first-difference form using the ordinary leastsquares technique. In other words, instead of estimat
ing an equation of the form,
(12) In mt = b0 + bj In rt + b2 In yt + k In mt-i + £t;
(e, = pet-1 + n<)

with the Cochrane-Orcutt technique, the following
equation was estimated using ordinary least-squares:
(13) In mt - In mt-i = (bo - b0) + bi ( In rt - In rt-i) +
b2 (In yt - In yt_i) + h> (In mt-i - In mt-2) + T)t,

where the error terms, qt, are assumed to be indepen
dent and identically distributed N (0, a 2). The dif
ference between these alternative specifications lies in
the a priori assumption about the error structures.
These two specifications would be empirically equiva
lent if rho ( p) were restricted to unity in equation 12.
Although equation 12 is more general than equa
tion 13, estimation of the latter equation avoids an
important econometric problem associated with the
estimation of equation 12. Specifically, Theil has
shown that, in the presence of a lagged dependent
variable, estimation techniques, such as the CochraneOrcutt procedure, will underestimate (in absolute
value) the serial coefficient rho.14 This error will ren
der the estimated regression coefficients inconsistent
and inefficient. If the disturbances in equation 13 are
serially independent — a hypothesis that can be exam14Henri Theil, Principles of Econometrics (New York: John
Wiley and Sons, 1971), pp. 413-14.

F E D E R A L R E S E R V E B A N K O F ST. LO U IS

MARCH

1980

Table 5
Real-Adjustment Version: Log Differences (ordinary least squares)
Coefficients (absolute value of t-statistics in parentheses)

Static

------------------------------------------------------------------------------------------------------------

Iny,In yt-i

In CPRt In CPRj.!

In RTDt In RTD,-i

In M .V P t-iIn Mt-2/P t -2

Durbin-h

SEE
x 10-2

0.536
(3.21)

0.459

-2.94

0.4598

0.32

-0.047
(2.54)

0.571
(3.85)

0.524

-2.05

0.4421

0.35

-0.015
(2.75)

-0.050
(2.86)

0.639
(4.85)

0.581

-1.80

0.4295

0.60

0.146
(1.76)

-0.015
(2.66)

-0.051
(2.81)

0.592
(4.41)

0.539

-1.44

0.4493

0.53

0.0009
.(0.09)

0.151
(1.81)

-0.016
(2.85)

-0.044
(2.44)

0.590
(4.65)

0.523

-1.06

0.4547

0.55

11/1955-IV/1967

0.0004
(0.40)

0.160
(1.93)

-0.018
(3.17)

-0.048
(2.64)

0.576
(4.91)

0.530

-0.72

0.4623

0.38

11/1955-IV/1968

0.0004
(0.46)

0.175
(2.19)

-0.018
(3.30)

-0.050
(2.79)

0.574
(5.24)

0.540

-0.60

0.4557

0.48

11/1955-IV/1969

0.0001
(0.14)

0.194
(2.49)

-0.020
(3.72)

-0.047
(2.69)

0.571
(5.40)

0.545

-0.61

0.4567

0.31

11/1955-IV/1970

0.00002
(0.03)

0.206
(2.80)

-0.019
(3.75)

-0.045
(2.69)

0.544
(5.37)

0.541

-0.38

0.4478

0.75

11/1955-IV/1971

0.0003
(0.37)

0.157
(2.20)

-0.013
(2.80)

-0.049
(2.85)

0.529
(5.16)

0.492

0.60

0.4665

0.40

11/1955-IV/1972

0.0004
(0.53)

0.166
(2.43)

-0.013
(2.88)

-0.052
(3.10)

0.552
(5.61)

0.527

0.28

0.4614

0.53

11/1955-IV/1973

0.0002
(0.23)

0.171
(2.56)

-0.013
(2.90)

-0.051
(3.00)

0.548
(5.66)

0.528

0.30

0.4650

0.84

11/1955-IV/1974

-0.0005
(0.64)

0.208
(3.04)

-0.015
(3.46)

-0.045
(2.56)

0.609
(6.43)

0.587

-1.05

0.4872

0.78

11/1955-IV/1975

-0.001
(1.30)

0.252
(3.93)

-0.014
(3.14)

-0.044
(2.44)

0.567
(6.40)

0.583

-0.53

0.5041

0.28

11/1955-IV/1976

-0.001
(1.33)

0.253
(4.14)

-0.014
(3.21)

-0.044
(2.50)

0.564
(6.57)

0.571

-0.97

0.4955

0.46

11/1955-IV/1977

-0.001
(1.31)

0.253
(4.20)

-0.013
(3.11)

-0.045
(2.56)

0.555
(6.54)

0.571

-1.01

0.4938

0.71

11/1955-IV/1978

-0.001
(1.36)

0.237
(3.96)

-0.014
(3.31)

-0.042
(2.40)

0.562
(6.63)

0.542

-1.28

0.5048

----

Period

Constant

11/1955-IV/1962

-0.0001
(0.084)

0.147
(1.59)

-0.014
(2.31)

-0.042
(2.15)

II/1955-IW1963

0.0003
(0.22)

0.156
(1.76)

-0.014
(2.55)

11/1955-IV/1964

0.0007
(0.73)

0.138
(1.66)

11/1955-IV/1965

0.0001
(0.64)

11/1955-IV/1966

RMSE
X10-3

ined empirically — its estimation will avoid the prob
lem associated with the Cochrane-Orcutt technique.15
Thus, in this very important sense, estimation of equa
tion 13 is preferable.

Both the real- and nominal-adjustment versions of
the money demand relationship were estimated in
first-difference form. The respective findings are re
ported in tables 5 and 6.16

15First-di£Ferencing has been suggested as a means of avoiding
the econometric problems associated with nonstationary error
structures. See C. W. J. Granger and P. Newbold, “Spurious
Regressions in Econometrics,” Journal of Econometrics ( June
1974), pp. 111-20; and D. Williams, “Estimating in Levels or
First Differences: A Defense of the Method Used for Certain
Demand-for-Money Equations,” The Economic Journal ( Sep
tember 1978), pp. 564-68.
As an additional important matter, Charles I. Plosser and
G. William Schwert, “Money, Income, and Sunspots: Meas-

Consider first the results for the real-adjustment

uring Economic Relationships and the Effects of Differenc
ing,’ Journal of Monetary Economics (4: 1978), pp. 637-60,
show that the econometric problems of “overdifferencing” an
equation are not as severe as those of “underdifferencing.”
16A constant term was included in the specification to ascer
tain whether a time trend is evident in money demand. If
there is a trend in money demand, the trend rate of change

MARCH

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

1980

Table 6
Nominal-Adjustment Version: Log Differences (ordinary least squares)

D.W.

SEE
x 10'2

Static
4Q
RMSE
x10a

0.613

2.15

0.3896

0.21

0.736
(5.86)

0.669

2.15

0.3688

0.41

-0.031
(1.99)

0.730
(6.49)

0.683

2.13

0.3736

0.41

-0.019
(3.90)

-0.031
(1.97)

0.742
(6.60)

0.675

2.03

0.3772

0.61

0.184
(2.62)

-0.019
(3.80)

-0.027
(1.65)

0.701
(6.27)

0.627

1.95

0.4020

0.61

-0.0003
(0.28)

0.193
(2.64)

-0.020
(3.90)

-0.032
(1.87)

0.683
(6.15)

0.606

1.94

0.4230

0.30

11/1955-IV/1968

-0.0001
(0.17)

0.198
(2.80)

-0.020
(4.06)

-0.033
(1.99)

0.697
(6.62)

0.620

1.95

0.4141

0.32

11/1955-IV/1969

-0.0004
(0.46)

0.209
(3.10)

-0.022
(4.55)

-0.031
(1.94)

0.699
(7.11)

0.638

1.95

0.4072

0.17

11/1955-IV/1970

-0.0003
(0.46)

0.205
(3.23)

-0.021
(4.71)

-0.029
(1.88)

0.692
(7.31)

0.642

1.92

0.3953

0.73

11/1955-IV/1971

-0.0002
(0.22)

0.166
(2.65)

-0.016
(3.70)

-0.033
(2.06)

0.658
(6.94)

0.591

1.78

0.4185

0.38

11/1955-IV/1972

-0.0001
(0-14)

0.184
(3.10)

-0.017
(4.03)

-0.035
(2.24)

0.665
(7.38)

0.617

1.94

0.4151

0.38

11/1955-IV/1973

-0.0002
(0.29)

0.183
(3.16)

-0.016
(4.05)

-0.032
(2.11)

0.669
(7.71)

0.628

1.99

0.4127

0.48

11/1955-IV/1974

-0.001
(0.78)

0.194
(3.45)

-0.017
(4.69)

-0.027
(1.81)

0.728
(9.21)

0.702

2.12

0.4142

0.81

11/1955-IV/1975

-0.001
(1.67)

0.232
(4.20)

-0.015
(3.88)

-0.025
(1.59)

0.709
(8.87)

0.683

2.02

0.4394

0.43

11/1955-IV/1976

-0.001
(1.63)

0.230
(4.28)

-0.015
(3.88)

-0.026
(1.67)

0.700
(8.85)

0.672

2.10

0.4387

0.25

11/1955-IV/1977

-0.001
(1.62)

0.226
(4.33)

-0.014
(3.90)

-0.026
(1.68)

0.706
(9.10)

0.672

2.12

0.4317

0.45

11/1955-IV/1978

-0.001
(1.71)

0.221
(4.36)

-0.016
(4.24)

-0.024
(1.55)

0.717
(9.61)

0.665

2.10

0.4319

----

Coefficients (absolute value of t-statistics in parentheses)
In M t-i/P, In Mt-j/Pt-i

In CPR, In CPR,- !

In RTD,
In RTD,--i

0.170
(2.26)

-0.018
(3.44)

-0.027
(1.61)

0.702
(4.96)

-0.0002
(0.27)

0.175
(2.47)

-0.018
(3.78)

-0.029
(1.89)

11/1955-IV/1964

-0.0001
(0.09)

0.171
(2.46)

-0.018
(3.79)

11/1955-IV/1965

-0.0001
(-0.09)

0.169
(2.54)

11/1955-IV/1966

-0.0006
(0.64)

11/1955-IV/1967

Period

Constant

11/1955-IV/1962

-0.0005
(0.51)

11/1955-IV/1963

Iny, In y,-i

specification in table 5. The Durbin-h statistics indi
cate that, for sample periods ending beyond IV/1964,
there is no evidence to reject the hypothesis of serially
independent error terms: It is only in the earlier sam
ple periods that evidence of first-order autocorrelation
exists.
The regression coefficients found in table 5, like
should be equal to the constant term (see equation 13).
Lieberman suggests that such a variable is relevant for money
demand. See Charles Lieberman, “Structural and Technolog
ical Change in Money Demand,” American Economic Review,
Papers and Proceedings (May 1979), pp. 324-29.

those reported in table 1, indicate a remarkable de
gree of consistency as the sample period is extended.17
17In comparing the results in table 5 with those in table 1, one
should be cautioned against using the reported R2 as a basis
to judge the respective equations. Granger and Newbold,
“Spurious Regressions,” show that when the dependent and
independent variables follow a random walk, as they do in
our specification, a nonzero R2 will be expected, even if no
relationship between the variables actually exists. When the
equation is estimated in first-difference form, the variables
no longer follow a random walk and thus R! is expected to
be zero.
Furthermore, the reader is cautioned against solely using
the SEE as a basis of comparison. Recall the aforementioned
econometric problems associated with the Cochrane-Orcutt
estimation results.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

Table 7

Mean Static Prediction Error*
(billions of nominal money balances)
Prediction
interval

Real-adjustment
(First-difference
estimation)

Nominal-adjustment
(First-difference
estimation)

I/1974-IV/1974

-$1.65

-$0.82

1/1975-IV/1975

- 0.91

- 1.40

I/1976-IV/1976

+ 0.10

+ 0.14

1/1977-IV/1977

+ 0.17

+ 0.10

1/1978-IV/1978

- 1.24

- 0.74

"Error is calculated as actual nominal money stock less pre
dicted nominal money stock. A negative error thus indicates
overprediction.

With the single exception of the coefficient on the
passbook rate for the sample period ending in IV /
1971, the estimated coefficients all change by less
than one standard error.
The regression coefficients in table 5 are also simi
lar to those found in table 1 in other respects.18 The
coefficient on the lagged dependent variable indicates
a significant partial adjustment to the desired level
of real money balances. The relatively smaller coeffi
cient in table 5 indicates, however, a larger coefficient
of adjustment — ranging from 0.39 to 0.47. The find
ings in table 5 again support the notion of economies
to scale in money holdings, with the long-run income
elasticity estimated between 0.33 and 0.53. In addi
tion, the coefficients on the interest rate variables
continue to indicate a greater sensitivity to a propor
tional change in the passbook rate than the commer
cial paper rate.
An important improvement obtained from the firstdifference estimation procedure over the levels results
is the post-sample performance. Table 5 indicates a
deterioration in post-sample performance over the
1974-75 period, but the deterioration is slight relative
to that found in table 1. Not only are the RMSEs
consistently lower for the first-difference results, but
this specification does not consistently overpredict
money demand over the post-1974 period. In fact,
18As stated previously, the estimated constant term has no
counterpart in the levels form of the real-adjustment specifi
cation. This coefficient, while never significantly different
from zero in table 5, does change as the sample period is
extended to include the 1974 observation. When post-1974
observations are included in the sample, both the sign and
magnitude of this coefficient are in accord with Lieberman’s
findings. This suggests a slight, but statistically insignificant
negative drift in the relationship, which is unexplained by
other variables.

MARCH

1980

table 7 indicates that this specification slightly underpredicts money demand on average for 1976 and
1977.19
In contrast to the first-difference estimation of the
real-adjustment mechanism, table 6 shows that there
is no evidence in the nominal-adjustment specification
of any first-order serial correlation in the disturbances.
The Durbin-Watson statistics reveal no problems
associated with serial dependence in the errors.
Many of the previous comparisons between the
real- and nominal-adjustment levels estimations
(tables 1 and 2 ) continue to hold for the first-difference estimations. The coefficient of adjustment remains
smaller for the nominal-adjustment specification than
for the real-adjustment specification in table 5. The
other regression coefficients continue to be fairly simi
lar to those found for the real-adjustment equation.
The coefficient on the passbook rate for the nominaladjustment specification is not, however, significantly
different from zero over many of the sample periods.
Again the SEEs and the RMSEs are consistently
smaller for the nominal-adjustment specification, indi
cating a better in- and out-of-sample fit. Table 7 also
shows that using the first-difference of the nominaladjustment specification not only leads to a smaller
forecasting error on average, but more importantly,
alleviates the persistent problem of overprediction
which plagued the levels estimation.20
Unlike those observed in table 2, the regression
coefficients in table 6 do not change dramatically as
the sample period is extended beyond IV /1973.21 T h e
19It should also be noted that the mean overprediction that
takes place in 1978 is in large part due to overpredicting
money demand in the fourth quarter of that year, when ATS
accounts were legalized nationwide and NOW accounts were
legalized in New York.
20To determine if the inclusion of the constant term seriously
biases the post-sample performances of the equations, fore
casts based on equations that exclude the constant term were
made. For the real-adjustment equation, the most significant
effect is to change the sign on the mean static prediction for
the interval I/1976-IV/1976 from plus to minus. The mean
error, however, for the period is -$0.02 billion, quite small
relative to that reported in table 7. For the nominal-adjust
ment specification, the positive signs for I/1976-IV/1976 and
I/1977-IV/1977 are changed to negative when the constant
term is omitted from the forecasting equation. As with the
real-adjustment equation, however, the mean errors are very
small relative to those reported in table 7: -$0,002 billion
for I/1976-IV/1976 and -$0.07 billion for I/1977-IV/1977.
These results suggest that it is first-differencing, rather than
the inclusion of the trend variable in the specification, that
is most responsible for the improved forecasting accuracy of
these specifications.
21The possible exception to this is the behavior of the esti
mated constant term. This coefficient estimate increases (in
absolute value terms) five-fold as the 1974 observations are
added to the sample period. While the change in this coeffi
cient is noticeable, it is important to bear in mind that this
coefficient estimate is never significantly different from zero.

F E D E R A L R E S E R V E B A N K O F ST. LO U IS

changes that occur, instead, are relatively minor. This
is especially true of the coefficients on the real income
and lagged dependent variables. Thus, the use of firstdifferences apparently has resulted in a more stable
relationship.
Chow tests again were used to determine whether
either of these first-difference relationships is statis
tically stable over the full-sample period. The F-statistics for the same hypothesized break points con
sidered previously ( see table 4 ) are provided in table
8.22 These statistics indicate that neither of the specifi
cations is statistically different over any of the alter
native subperiods considered. This suggests that the
previous evidence of breakdowns in these relation
ships is the result of the estimation technique em
ployed. The first-difference estimation results, which
are econometrically preferable, show no evidence of
structural breakdown in either of the money-demand
specifications considered.

SUMMARY AND CONCLUSION
This paper has investigated two alternative stockadjustment mechanisms employed to empirically ex
plain money demand. In addition, two alternative
procedures have been used to estimate these rela
tionships. The results indicate that both stock-adjustment relationships are statistically stable when esti22Since the disturbances for the first-difference equation are
serially independent, the Chow test results reported in table
8 avoid the problem of serial dependence in the error terms
that plagued the previous tests.
In an alternative test, the first-difference equations were
estimated without a constant term and the Chow test was
used to test the stability of these equations. Using the same
hypothesized break-points as in table 8, the test results indi
cate that stability cannot be rejected at the 5 percent level
of significance (e.g., the largest calculated F-value is 0.69).
Thus, exclusion of the constant term does not adversely af
fect the stability finding.
In addition, the type of Chow test described in footnote
13 was specifically used to test if the constant term should
be allowed to vary across the various subperiods. For each
equation and the different subperiods, the calculated F-statistics were well below standard critical values. Thus, no
statistical advantage is gained by allowing the constant term
to take on different values in alternative subperiods.

MARCH

1980

Table 8

F-statistics for Null Hypothesis that
Regressions Are Equal in Two
Alternative Sample Periods
(first-difference)
Sample periods

RealNominaladjustment adjustment

11/1955-IV/1962 vs. 1/1963-IV/1978

0.47

11/1955-IV/1967 vs. 1/1968-IV/1978

1.11

1.02

11/1955-IV/1973 vs. I/1974-IV/1978

1.42

1.05

0.44

1% critical value, 3.21
5% critical value, 2.33

mated in first-difference form. This suggests that
much of the recent evidence of a breakdown in the
money-demand relationship is the result of the esti
mation technique employed. To the extent that the
nominal-adjustment specification consistently provided
a better fit (both in- and out-of-sample), the evidence
presented here further suggests that a relaxation of
the assumption that the money stock adjusts to a
price level shock within the quarter is worthwhile.
Furthermore, the results presented in this paper
deny the claim that monetary policy is impotent as
a result of a shifting money-demand relationship.
Those who argue this point recently have suggested
that attempts to control inflation through restrictive
monetary policy will be unsuccessful since the money
demand relationship is unstable. The findings of sta
bility presented here seriously question this assertion.
It does not appear that the relationship between
money demand, real-income, and interest rates has
changed significantly over recent periods. The sur
prisingly accurate predictions of money demand over
the post-1973 period using the first-difference approach
buttress the conclusion that the money-demand rela
tionship has not suffered from any drastic shifts that
would invalidate monetary policy.