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For Release on Delivery M o n d a y , A p r i l 2 4 , 1972 5 p . m . G . M . T . (12 n o o n , E . S . T . ) M O N E T A R I S T C R I T I C I S M A N D THE C O N D U C T O F F L E X I B L E M O N E T A R Y P O L I C Y IN THE U N I T E D S T A T E S Lecture By Andrew F. Brimmer Member B o a r d of G o v e r n o r s of the Federal Reserve System P r e s e n t e d a t the I n s t i t u t e of E c o n o m i c s and S t a t i s t i c s Oxford University Oxford, England A p r i l 2 4 , 1972 T A B L E OF C O N T E N T S Page I. II. Introduction 1 A n a l y t i c a l L i m i t a t i o n s of the M o n e t a r i s t A r g u m e n t s 5 A. Monetarist v s . Keynesian Doctrine 6 B. D i f f e r e n c e s in the P e r c e p t i o n of the M o n e t a r y Process S t a b i l i t y of D e m a n d for M o n e y N a t u r e a n d S p e e d of R e s p o n s e to M o n e t a r y A c t i o n R o l e of P r i c e E x p e c t a t i o n s C. D. E. III. IV. Assessment of Federal Reserve Performance Concluding Observations: in M o n e t a r y M a n a g e m e n t Appendix Table N e e d to M a i n t a i n 9 10 13 14 20 Flexibility 25 M O N E T A R I S T C R I T I C I S M A N D THE C O N D U C T OF F L E X I B L E M O N E T A R Y P O L I C Y IN THE U N I T E D S T A T E S By Andrew F . Brimmer I. a Introduction T h e d e b a t e o v e r the b e s t w a y to c o n d u c t m o n e t a r y p o l i c y in the U n i t e d S t a t e s has b e e n in f u l l f l o w e r for a g e n e r a t i o n . Yet, the c o n t r o v e r s y seems to p r o d u c e a s m u c h h e a t t o d a y a s it d i d a decade ago. T h e r e a s o n s w h y this is so a r e e a s i l y u n d e r s t o o d : l e a d i n g c r i t i c s of m o n e t a r y p o l i c y the (who in v a r y i n g d e g r e e s c a n be g r o u p e d u n d e r the b a n n e r o f the m o n e t a r i s t s c h o o l o f t h o u g h t ) h a v e a t t r a c t e d n u m e r o u s s u p p o r t e r s n o t o n l y in the e c o n o m i c s profession b u t a l s o in the f i n a n c i a l c o m m u n i t y a s w e l l as in s o m e G o v e r n m e n t A s s i g n i n g c o n s i d e r a b l e w e i g h t to the r o l e o f m o n e y in e c o n o m i c circles. activity, the m o n e t a r i s t s h a v e b e c o m e i n c r e a s i n g l y v o c a l p a r t i c i p a n t s in the a r g u m e n t o v e r the b e s t w a y to c o n d u c t n a t i o n a l e c o n o m i c * M e m b e r , B o a r d of G o v e r n o r s o f the F e d e r a l R e s e r v e policy. System. I a m g r a t e f u l to s e v e r a l m e m b e r s o f the B o a r d ' s s t a f f for a s s i s t a n c e in t h e p r e p a r a t i o n of this p a p e r . M r . J a m e s L . P i e r c e w a s p a r t i c u l a r l y h e l p f u l in t r a c i n g the d i f f e r e n c e s in the m o n e t a r i s t a n d K e y n e s i a n a p p r o a c h e s to m o n e t a r y m a n a g e m e n t . A s s i s t e d b y M r . J a r e d E n z l e r , he p e r f o r m e d the c o m p u t e r - b a s e d s i m u l a t i o n s of the n a t i o n a l e c o n o m y to e s t i m a t e the e f f e c t s o n G N P o f a r e d u c t i o n in i n f l a t i o n a r y e x p e c t a t i o n s . I w a s a b l e to draw o n w o r k d o n e b y M r . P e t e r M . K e i r to a s s e s s the p e r f o r m a n c e of the F e d e r a l R e s e r v e in its c o n d u c t o f a f l e x i b l e m o n e t a r y p o l i c y in the l a s t two d e c a d e s . H a v i n g e x p r e s s e d m y a p p r e c i a t i o n for the s t a f f ' s a s s i s t a n c e , I m u s t a l s o s t r e s s t h a t the v i e w s e x p r e s s e d h e r e a r e m y o w n and s h o u l d n o t b e a t t r i b u t e d to the B o a r d ' s s t a f f — n o r to m y c o l l e a g u e s o n the Board. T h e n a t u r e o f the m o n e t a r i s t c r i t i c i s m o f m o n e t a r y b y the F e d e r a l R e s e r v e is w i d e l y u n d e r s t o o d : monetarists management generally a r g u e t h a t w e k n o w v e r y l i t t l e a b o u t the l i n k a g e s b e t w e e n m o n e t a r y v a r i a b l e s a n d the r e a l e c o n o m y a n d t h a t w e a r e q u i t e i g n o r a n t o f the time lags b e t w e e n m o n e t a r y actions and their impact on economic activity. G i v e n t h e s e l i m i t a t i o n s , t h e y a s s e r t t h a t the b e s t w a y to c o n d u c t e c o n o m i c s t a b i l i z a t i o n p o l i c y is t h r o u g h r e l a t i v e l y small variations leader, in the r a t e o f g r o w t h o f the m o n e y s t o c k . Their P r o f e s s o r M i l t o n F r i e d m a n , g o e s so far a s to a r g u e t h a t a t t e m p t s conduct monetary policy on a contra-cyclical basis are likely i n c r e a s e i n s t a b i l i t y in the e c o n o m y a n d p r o d u c e d i s t o r t i o n s long-lasting. C o n s e q u e n t l y , h e s u g g e s t s that the F e d e r a l to to that are Reserve s h o u l d a i m for a s t e a d y a n d m o d e r a t e r a t e o f g r o w t h in the q u a n t i t y of m o n e y M o n e t a r i s t s a stabilization d o w n g r a d e the e f f i c a c y of f i s c a l p o l i c y a s device. O n the o p p o s i t e s i d e o f the d e b a t e a r e the K e y n e s i a n a n d post-Keynesian economists. F o r the m o s t p a r t , t h e y e m p h a s i z e tax a n d s p e n d i n g p o l i c i e s a s u s e f u l i n s t r u m e n t s of e c o n o m i c W h i l e a c c e p t i n g the i m p o r t a n c e o f m o n e t a r y p o l i c y , t h e s e Government stabilization. economists s t r e s s the r o l e o f i n t e r e s t r a t e s a s the p r o p e r f o c u s for t h a t p o l i c y . F o r m o s t o f the l a s t t w e n t y f i v e y e a r s , the K e y n e s i a n s h a v e b e e n 1/ 21 See M i l t o n Friedman and David M e i s e l m a n , "The Relative Stability o f M o n e t a r y V e l o c i t y a n d the I n v e s t m e n t M u l t i p l i e r in the U n i t e d S t a t e s , 1 8 9 7 - 1 9 5 8 , " in S t a b i l i z a t i o n P o l i c i e s , C o m m i s s i o n o n Money and Credit, Englewood Cliffs, 1963. S e e A l b e r t A n d o a n d F r a n c o M o d i g l i a n i , " E c o n o m e t r i c A n a l y s i s of Stabilization Policy," American Economic Review, Vol. 59, No. 2, M a y , 1968, pp. 296-314. - 3 trend-setters in c o n t e m p o r a r y e c o n o m i c t h o u g h t , a n d they h a v e a l s o o c c u p i e d m o s t of the e c o n o m i c a d v i s o r y p o s i t i o n s in G o v e r n m e n t . To a c o n s i d e r a b l e e x t e n t , they h a v e d o m i n a t e d t h i n k i n g in the F e d e r a l R e s e r v e for s e v e r a l decades. In r e c e n t y e a r s , h o w e v e r , the m o n e t a r i s t s h a v e a l s o had s o m e i n f l u e n c e o n the w a y in w h i c h the F e d e r a l R e s e r v e c o n c e i v e s its r o l e . System P a r t l y in r e s p o n s e to m o n e t a r i s t c r i t i c i s m , the S y s t e m h a s m o d i f i e d b o t h its c o n c e p t i o n of the m o n e t a r y p r o c e s s and the o p e r a t i n g t e c h n i q u e s u s e d to i m p l e m e n t its p o l i c y decisions. B u t for a v a r i e t y o f r e a s o n s , the S y s t e m h a s s t o p p e d far s h o r t of 3/ f o c u s i n g s i m p l y on the m o n e y s t o c k a s p r e s c r i b e d b y the m o n e t a r i s t s . — ' In m y j u d g m e n t , the F e d e r a l R e s e r v e h a s d i s p l a y e d m u c h w i s d o m in r e f u s i n g to p u r s u e the c o u r s e a d v o c a t e d b y the m o n e t a r i s t s . T o d o so w o u l d m e a n t h a t the n a t i o n w o u l d b e d e n i e d w h a t e v e r contribution t h a t a m o r e e c l e c t i c m o n e t a r y p o l i c y can m a k e toward a c h i e v i n g a b e t t e r r e c o r d of e c o n o m i c performance. T h e r e a r e a n u m b e r o f r e a s o n s w h y I b e l i e v e it is p r e f e r a b l e for the F e d e r a l R e s e r v e to m a i n t a i n a f l e x i b l e p o s t u r e in the of m o n e t a r y p o l i c y r a t h e r than f o c u s i n g o n a s i n g l e e c o n o m i c conduct variable: - - T h e m o n e t a r i s t s h a v e n o t s h o w n c o n v i n c i n g l y t h a t the r e l a t i o n s h i p b e t w e e n the m o n e y s u p p l y a n d e c o n o m i c a c t i v i t y is p a r t i c u l a r l y c l o s e . M o r e o v e r , t h e i r p e r c e p t i o n of the m o n e t a r y p r o c e s s in the U n i t e d S t a t e s o f f e r s l i t t l e i n s i g h t into the w a y s in w h i c h c h a n g e s in m o n e y affect real output. 3/ In a n o t h e r p a p e r , I h a v e d i s c u s s e d t h e s e d e v e l o p m e n t s in c o n s i d e r a b l e d e t a i l . See " T h e P o l i t i c a l E c o n o m y of M o n e y 1:1 E v o l u t i o n and Impact o f M o n e t a r i s m in the F e d e r a l R e s e r v e S y s t e m , p r e s e n t e d a t the E i g h y - f o u r t h A n n u a l M e e t i n g of the A m e r i c a n E c o n o m i c A s s o c i a t i o n , New Orleans, Louisiana, December 27, 1971. - 4 — T h e m o n e t a r i s t s t a k e l i t t l e o r n o a c c o u n t o f the i m p a c t o f u n p r e d i c t a b l e c h a n g e s in the d e m a n d for m o n e y o n the behavior of financial markets. Since such shifts o b v i o u s l y o c c u r , the m o n e t a r y a u t h o r i t i e s m u s t a t t e m p t to c o p e w i t h t h e m — i f the p a c e o f r e a l e c o n o m i c a c t i v i t y is n o t to b e d i s t o r t e d . - - T h e m o n e t a r i s t s i g n o r e the i n f o r m a t i o n t h a t i n t e r e s t r a t e m o v e m e n t s c a n p r o v i d e . T h e y a l s o r e f u s e to r e c o g n i z e the p o s s i b i l i t y t h a t the r e l a t i o n s h i p s between m o n e y , income,and prices also depend upon s u c h f a c t o r s a s the d e g r e e of c a p a c i t y u t i l i z a t i o n , the e x t e n t o f u n e m p l o y m e n t , a n d the s t a n c e o f f i s c a l policy. T h e s e d e f i c i e n c i e s ( a m o n g o t h e r s ) i n the m o n e t a r i s t approach to m o n e t a r y m a n a g e m e n t s u g g e s t to m e t h a t it w o u l d b e u n w i s e for t h e F e d e r a l R e s e r v e to r e c a s t the c o n d u c t o f m o n e t a r y p o l i c y a l o n g the l i n e s u r g e d b y P r o f e s s o r M i l t o n F r i e d m a n a n d h i s followers. M o r e o v e r , w h i l e the m o n e t a r i s t s a c c u s e the F e d e r a l R e s e r v e o f b e i n g a m a j o r s o u r c e o f e c o n o m i c i n s t a b i l i t y , it a p p e a r s t h a t in r e c e n t y e a r s the S y s t e m h a s g r e a t l y i m p r o v e d its a b i l i t y to u s e m o n e t a r y p o l i c y to h e l p s t a b i l i z e e c o n o m i c a c t i v i t y . this p e r f o r m a n c e c a n b e a p p r a i s e d The nature of fully o n the b a s i s o f the statistical record. The rest of these remarks is organized as follows: a n a l y t i c a l l i m i t a t i o n s o f the m o n e t a r i s t s Section II. 1 several arguments are discussed T h e v a r y i n g p e r f o r m a n c e o f the F e d e r a l R e s e r v e System f in the c o n d u c t o f a f l e x i b l e m o n e t a r y p o l i c y s i n c e the e a r l y 1 9 5 0 s in is - 5 assessed in S e c t i o n I I I . F i n a l l y , in S e c t i o n I V , I c o n c l u d e w i t h a s t a t e m e n t o f w h y I b e l i e v e p e r s o n a l l y the F e d e r a l R e s e r v e should c o n t i n u e to m a i n t a i n a f l e x i b l e p o s t u r e r a t h e r than a d o p t a fixed r u l e for m o n e t a r y m a n a g e m e n t . II. A n a l y t i c a l L i m i t a t i o n s o f the M o n e t a r i s t Arguments A s I m e n t i o n e d a b o v e , the s h a r p e s t c r i t i c i s m o f m o n e t a r y m a n a g e m e n t in the U n i t e d S t a t e s o r i g i n a t e s w i t h t h o s e e c o n o m i s t s w h o classify themselves (or a r e c l a s s i f i e d b y o t h e r s ) a s m o n e t a r i s t s . To a considerable extent,the monetarist criticism has been b y e c o n o m i s t s w h o a p p r o a c h the issues from a K e y n e s i a n countered perspective. T h e g e n e r a l c o n t e n t o f m o n e t a r y t h e o r y e s p o u s e d Dy the two s c h o o l s is w i d e l y u n d e r s t o o d a n d n e e d n o t b e d i s c u s s e d h e r e in a n y d e t a i l . H o w e v e r , s e v e r a l a r g u m e n t s a d v a n c e d in the d e b a t e c a r r y c r u c i a l i m p l i c a t i o n s for the c o n d u c t o f m o n e t a r y p o l i c y , a n d t h e s e s h o u l d be explored carefully. T h e s e a r g u m e n t s c o n c e r n (1) d i f f e r e n c e s in the p e r c e p t i o n o f the m o n e t a r y p r o c e s s , (2) the s t a b i l i t y and predictability of the d e m a n d for m o n e y , (3) the s p e e d a t w h i c h the e c o n o m y r e s p o n d s to m o n e t a r y a c t i o n s , a n d of output and prices. (4) the r o l e o f e x p e c t a t i o n s in the d e t e r m i n a t i o n E a c h o f these a r g u m e n t s is e x a m i n e d below. F i r s t , h o w e v e r , it m i g h t b e h e l p f u l to s k e t c h the m a i n o u t l i n e s of t h e g e n e r a l p o s i t i o n s o c c u p i e d b y the m o n e t a r i s t s a n d the K e y n e s i a n s . - 6 Monetarist vs. Keynesian Doctrine W h i l e o n e c a n i d e n t i f y n u m e r o u s d i f f e r e n c e s in d e t a i l b e t w e e n the m o n e t a r i s t a n d K e y n e s i a n p o s i t i o n s , s e v e r a l f a i r l y u n i f o r m e l e m e n t s can also be traced. Expressed most simply, Keynesians argue m o n e t a r y p o l i c y i n f l u e n c e s the r e a l s e c t o r o f the e c o n o m y that through i n t e r e s t r a t e s , a m o n g w h i c h a few s t r a t e g i c r a t e s a r e o f m a j o r importance. T h e p r o c e s s w o r k s as f o l l o w s : the c e n t r a l b a n k t h e q u a n t i t y o f m o n e y , a n d i n t e r e s t r a t e s r e s p o n d in the direction. changes opposite T h i s c h a n g e in i n t e r e s t r a t e s i n f l u e n c e s i n v e s t m e n t w h i c h in t u r n h a s a n i m p a c t o n c o n s u m p t i o n a n d o t h e r forms o f s p e n d i n g . K e y n e s i a n s a l s o a r g u e t h a t c h a n g e s in the q u a n t i t y o f m o n e y a r e o f f s e t b y s h i f t s in t h e d e m a n d for m o n e y the d e m a n d for m o n e y is h i g h l y u n s t a b l e ) . (implicitly arguing Strict often that F u r t h e r m o r e , they a r g u e the d e m a n d for m o n e y is h i g h l y i n t e r e s t e l a s t i c so t h a t a g i v e n in the q u a n t i t y o f m o n e y p r o d u c e s s m a l l c h a n g e s in the r a t e o f that change interest. O n the o t h e r h a n d , the m o n e t a r i s t s a r g u e t h a t the d e m a n d for m o n e y is h i g h l y s t a b l e a n d n o t v e r y i n t e r e s t e l a s t i c . They also a r g u e t h a t t h e r e is n o s i n g l e r a t e o f i n t e r e s t in the e c o n o m y — b u t rather a large number of rates w h i c h have differing effects on aggregate demand. T h u s , t h e y h o l d t h a t there is n o s i n g l e i n t e r e s t r a t e to follow or w h i c h s h o u l d b e a t a r g e t for c o n t r o l , a n d a n y a t t e m p t to s e t a single interest rate w i l l not have any predictable impact on aggregate demand. M o n e t a r i s t s - a l s o a s s e r t t h a t the c e n t r a l b a n k c a n n o t e v e n s e t single interest rate for v e r y long because a l l interest rates are a essentially - 7 e n d o g e n o u s to the e c o n o m y - - t h a t i s , they d e p e n d o n the b e h a v i o r of the e c o n o m y i t s e l f . T h e r e a s o n for this is t h a t a c h a n g e in the g r o w t h o f the m o n e y s t o c k i n f l u e n c e s n o t o n l y s h o r t - t e r m r a t e s of i n t e r e s t b u t a l s o the a c t u a l a n d e x p e c t e d r a t e of i n f l a t i o n . the m o n e t a r i s t v i e w , a t t e m p t s to r e d u c e i n t e r e s t r a t e s e x p a n d i n g the m o n e y s t o c k c a n b e f r u s t r a t e d b y a So in through r i s e in p r i c e s w h i c h , in t u r n , lead to e x p e c t a t i o n s of f u r t h e r i n c r e a s e s in p r i c e s a n d to a r i s e in the n o m i n a l r a t e o f i n t e r e s t . possible T h e y a r g u e that it is p e r f e c t l y (and they b e l i e v e q u i t e l i k e l y ) that i n c r e a s e s in the q u a n t i t y of m o n e y w i l l lead to i n c r e a s e s in the n o m i n a l r a t e of interests. In r e c e n t y e a r s , e c o n o m i s t s of b o t h the K e y n e s i a n a n d m o n e t a r i s t p e r s u a s i o n s h a v e d e v e l o p e d t h e i r t h e o r i e s to the p o i n t t h a t it is v e r y d i f f i c u l t to t e l l them a p a r t . Both groups of economists a c t u a l l y c a s t t h e i r a r g u m e n t s in terms of the s a m e g e n e r a l equilibrium t h e o r y , b u t they c o m e to t h e i r t h e o r e t i c a l framexvork from d i f f e r e n t e n d s of the p o l i t i c a l s p e c t r u m . o r i e n t a t i o n of m a n y While divergencies in the p o l i t i c a l o f t h e s e d i f f e r e n t e c o n o m i s t s lead them to r e c o m m e n d d i f f e r e n t m o n e t a r y p o l i c i e s f r o m time to t i m e , a c t u a l l y is n o t h i n g in their t h e o r i e s w h i c h r e q u i r e s t h i s . In f a c t , w h e n there the b e s t e x p o s i t i o n s of the g e n e r a l m o n e t a r i s t t h e o r y a r e v i e w e d a p a r t f r o m t h e i r s p e c i f i c p o l i c y p r e s c r i p t i o n s , it is v i r t u a l l y impossible to d i s t i n g u i s h t h e i r t h e o r y f r o m that p r e s e n t e d b y the K e y n e s i a n s 4/ 4/ Fo>r e x a m p l e , see M i l t o n F r i e d m a n , " T h e R o l e o f M o n e t a r y P o l i c y , " American Economic Review, Vol. LVIII, No. 1, March, 1968, pp. 1-17, a n d J a m e s T o b i n , " A G e n e r a l E q u i l i b r i u m A p p r o a c h to M o n e t a r y T h e o r y , " J o u r n a l of M o n e y , C r e d i t , a n d B a n k i n g , F e b r u a r y , 1 9 6 9 , p p . 1 5 - 2 9 . - 8 T h e r e a s o n f o r the s i m i l a r i t y o f t h e o r y is r e a d i l y nearly all economists are convinced that neo-classical e q u i l i b r i u m t h e o r y h o l d s in the l o n g - r u n . understood: general For this r e a s o n , there r e a l l y is n o d i f f e r e n c e b e t w e e n m o d e r n m o n e t a r i s t s a n d m o d e r n K e y n e s i a n s w i t h r e s p e c t to the l o n g - r u n i m p l i c a t i o n s o f t h e i r The main implications are: (1) R e a l o u t p u t is d e t e r m i n e d b y theory. available c a p i t a l a n d l a b o r , a n d o u t p u t g r o w t h is d e t e r m i n e d b y g r o w t h in these two sectors a l o n g with technological p r o g r e s s . the l o n g - r u n , the s u p p l y o f labor is d e t e r m i n e d economy; (2) In p r i m a r i l y b y r e a l w a g e s in the a s a r e s u l t t h e r e is l i t t l e e f f e c t i v e t r a d e - o f f b e t w e e n a n d i n f l a t i o n in the l o n g - r u n . employment P u t a n o t h e r w a y , the l a b o r m a r k e t c l e a r e d in t h e l o n g - r u n , a n d t h e r e is a n a t u r a l u n e m p l o y m e n t determined essentially by frictional factors. is rate (3) C h a n g e s in t h e m o n e y s t o c k p r o d u c e p r o p o r t i o n a t e c h a n g e s in the p r i c e l e v e l in the longr u n a n d h a v e n o p e r m a n e n t i m p a c t o n the r e a l s e c t o r s o f the economy. (4) H o w e v e r , in the l o n g r u n , a n i n c r e a s e in the r a t e o f g r o w t h o f m o n e y c a n l e a d to a n i n c r e a s e in i n t e r e s t r a t e s b e c a u s e o f the i m p a c t of the m o n e y s t o c k o n p r i c e s . G i v e n this similarity of theoretical a p p r o a c h , one m i g h t a s k , w h y is the a r g u m e n t c o n t i n u i n g to g e n e r a t e so m u c h h e a t ? It a p p e a r s t h a t the d e b a t e b e t w e e n the m o n e t a r i s t s a n d the K e y n e s i a n s h i n g e s o n the s e v e r a l c e n t r a l i s s u e s o u t l i n e d a b o v e . to a n a s s e s s m e n t o f t h o s e arguments. We can now proceed - 9 B. D i f f e r e n c e s in the P e r c e p t i o n of the M o n e t a r y Process T h e s i g n i f i c a n t d i f f e r e n c e s in the w a y in w h i c h the m o n e t a r i s t s a n d the K e y n e s i a n s p e r c e i v e the m o n e t a r y p r o c e s s a r i s e m a i n l y philosphical rather than from analytical considerations. from T h e r e is n o t h i n g in the t h e o r e t i c a l a p p r o a c h e s p e r se that l e a d them to d e s c r i b e the m o n e t a r y p r o c e s s a s t h e y d o . M o n e t a r i s t s a r g u e t h a t the m o n e y s t o c k i n f l u e n c e s the e c o n o m y t h r o u g h c h a n g e s in r e l a t i v e i n t e r e s t r a t e s a n d in w e a l t h . H o w e v e r , t h e y a r g u e f u r t h e r t h a t the p r o c e s s is s i m p l y too complicated to s p e c i f y in d e t a i l . T h e y e m p h a s i z e the p o i n t that c h a n g e s in the m o n e y s t o c k i n f l u e n c e n o t o n l y i n t e r e s t r a t e s o n financial instruments b u t also implicit rates of return on a l l commodities. B e c a u s e t h e r e is n o w a y to o b s e r v e a l l of the r e l e v a n t r a t e s o f r e t u r n , t h e y b e l i e v e t h a t a n y a t t e m p t to s p e c i f y e x p l i c i t l y the m e c h a n i s m b y w h i c h the e f f e c t s of c h a n g e s in m o n e y a r e t r a n s m i t t e d a n d i n t o c h a n g e s in i n c o m e is d o o m e d to translated failure. W h i l e m o n e t a r i s t s l a m e n t i n t e l l e c t u a l l y the i n a b i l i t y to s p e c i f y the m o n e t a r y p r o c e s s , t h e y a r g u e o n a p r a c t i c a l level t h a t it is n o t n e c e s s a r y to s p e c i f y it a t a l l . I n s t e a d , they a s s e r t t h a t it is p o s s i b l e to r e l a t e the m o n e y s t o c k d i r e c t l y to a g g r e g a t e d e m a n d . They b e l i e v e that a stable relationship between m o n e y and a number of key economic variables (such a s G N P a n d p r i c e s ) d o e s e x i s t . This analytical t e c h n i q u e o f p r o c e e d i n g d i r e c t l y f r o m m o n e y t o , s a y , G N P has b e e n c o m p a r e d to a ff b l a c k box 11 in w h i c h m o n e y is p o u r e d i n t o o n e e n d a n d G N P f l o w s o u t of the o t h e r . This rather uncomplimentary analogy - 10 a p p a r e n t l y d o e s n o t t r o u b l e the m o n e t a r i s t s v e r y m u c h . Rather, b e l i e v e t h a t t h e y c a n p r e d i c t the i m p a c t o f m o n e t a r y p o l i c y o n they the economy m o r e a c c u r a t e l y using this technique than can be done w i t h the e l a b o r a t e m o d e l s u s e d b y the Keynesians. I n c o n t r a s t , the K e y n e s i a n s b e l i e v e that it is p o s s i b l e to s p e c i f y t h e t r a n s m i s s i o n m e c h a n i s m for m o n e t a r y p o l i c y . o n t h i s b e l i e f , in t h e i r r e s e a r c h t h e y i n s i s t u p o n u s i n g Working empirical m o d e l s in w h i c h t h i s m e c h a n i s m is i m b e d d e d in a l a r g e n u m b e r o f simultaneous equations.—^ Using these large-scale structural K e y n e s i a n s h a v e s o u g h t to i d e n t i f y a n d a n a l y z e the c h a n n e l s models, through which monetary variables, fiscal variables, interest rates, etc., affect economic behavior. In t h e i r v i e w , o n e o f the m a i n w e a k n e s s e s in the m o n e t a r i s t s ' a p p r o a c h is t h e i r f a i l u r e to e x p l o r e f u l l y s t r u c t u r e a n d p e r f o r m a n c e of f i n a n c i a l m a r k e t s a n d to e x a m i n e l i n k s b e t w e e n t h o s e m a r k e t s a n d the m a r k e t s c # for g o o d s a n d the the services. S t a b i l i t y o f D e m a n d for M o n e y A n o t h e r b a s i c i s s u e d i v i d i n g the m o n e t a r i s t s a n d the K e y n e s i a n s c o n c e r n s the s t a b i l i t y o f t h e d e m a n d for m o n e y , o n t h e o n e h a n d , a n d t h e s t a b i l i t y of s p e n d i n g r e l a t i o n s h i p s , o n t h e o t h e r . r e a s o n t h a t s t a b i l i t y is a t i s s u e is t h a t in a d e t e r m i n i s t i c 5/ The world For a good discussion of w h e t h e r large-scale econometric m o d e l s h a v e a n i n h e r e n t l y K e y n e s i a n b i a s , see J a m e s L . P i e r c e , "Do Large-Scale Macro-Econometric Models Have a Keynesian Bias," p a p e r p r e s e n t e d a t the S e c o n d W o r l d C o n g r e s s of the E c o n o m e t r i c Society, Cambridge, England, September, 1970. (that i s , a w o r l d w i t h o u t s h o c k s or u n e x p e c t e d a u t o n o m o u s c h a n g e s ) , it m a k e s a b s o l u t e l y no d i f f e r e n c e , t h e o r e t i c a l l y , w h e t h e r one f o c u s e s on i n t e r e s t r a t e s in K e y n e s i a n f a s h i o n or on the m o n e y s t o c k in m o n e t a r i s t fashion. In s u c h a w o r l d , the a m o u n t of m o n e y d e m a n d e d a t d i f f e r e n t i n t e r e s t r a t e s is k n o w n . H e n c e a n y s t a t e m e n t a b o u t the interest r a t e c a n b e e a s i l y t r a n s l a t e d into a s t a t e m e n t a b o u t the m o n e y and c o n v e r s e l y . stock-- G i v e n the d e m a n d for m o n e y , it m a k e s no d i f f e r e n c e w h e t h e r o n e d e s c r i b e s r e s p o n s e s to m o n e t a r y a c t i o n s in terras of the i n t e r e s t r a t e (price) o r the m o n e y s t o c k (quantity). As s o o n as one d r o p s the a s s u m p t i o n of a d e t e r m i n i s t i c w o r l d , the q u e s t i o n of the s t a b i l i t y of the v a r i o u s d e m a n d relationships in the e c o n o m y b e c o m e s c e n t r a l to the d e b a t e b e t w e e n the m o n e t a r i s t s f\ / a n d the K e y n e s i a n s . — A s o b s e r v e d a b o v e , m a n y K e y n e s i a n s a s s e r t the d e m a n d for m o n e y is h i g h l y u n s t a b l e . that If this d e m a n d is b o t h u n s t a b l e and u n p r e d i c t a b l e , a t t e m p t s to run m o n e t a r y p o l i c y by s e t t i n g the q u a n t i t y of m o n e y w o u l d lead to i n s t a b i l i t y a n d unpredictability o f i n t e r e s t r a t e s - - a n d h e n c e m a k e the r e l a t i o n s h i p b e t w e e n the m o n e y stock and aggregate demand a very loose o n e . In this sort of w o r l d , it w o u l d b e p r e f e r a b l e s i m p l y to set the i n t e r e s t rate a n d to a c c o m m o d a t e the s h i f t s in the d e m a n d for m o n e y . Monetarists willingly concede the i n t e l l e c t u a l i s s u e t h a t such i n s t a b i l i t y in m o n e y d e m a n d w o u l d m a k e the m o n e y s t o c k a n u n a p p e a l i n g c a n d i d a t e for p o l i c y control. T h e y a r g u e , h o w e v e r , that this i n s t a b i l i t y s i m p l y d o e s n o t "67 ~~ exist. F o r a n i n t e r e s t i n g d i s c u s s i o n o f the i s s u e s i n v o l v e d see W i l l i a m P o o l e , " O p t i m a l C h o1i1 c e of M o n e t a r y P o l i c y I n s t r u m e n t s in a S i m p l e S t o c h a s t i c Macro-Model, Q u a r t e r l y J o u r n a l of E c o n o m i c s , M a y , 1 9 7 0 , p p . 1 9 7 - 2 1 6 . - 12 I n s t e a d , t h e y p o i n t to a w e l t e r o f e m p i r i c a l s t u d i e s t h a t to i n d i c a t e t h a t m o n e y d e m a n d is h i g h l y purport predictable. M o n e t a r i s t s a l s o a r g u e t h a t the b a s i c s o u r c e o f economic i n s t a b i l i t y lies in the e c o n o m y ' s d e m a n d for r e a l o u t p u t . I n this s i t u a t i o n , a t t e m p t s to c o n d u c t m o n e t a r y p o l i c y t h r o u g h interest r a t e s w o u l d lead to w i d e v a r i a t i o n s in a g g r e g a t e d e m a n d . can be seen readily: if t h e r e s h o u l d b e a n u n e x p e c t e d The reason increase a g g r e g a t e d e m a n d , the m a i n t e n a n c e of a n i n t e r e s t r a t e w o u l d essentially a c c o m m o d a t e this d e m a n d a n d p u s h the e c o n o m y off of its d e s i r e d If t h e m o n e y s t o c k r a t h e r t h a n i n t e r e s t r a t e s w e r e s e t b y the b a n k , t h e i n c r e a s e in a g g r e g a t e d e m a n d w o u l d tend to b i d u p T h u s , the i s s u e of the p r i m a c y of the m o n e y s t o c k u p o n the s t a b i l i t y of the d e m a n d for m o n e y r e l a t i v e to the path. central interest r a t e s w h i c h , in t u r n , w o u l d r e t a r d the e x p a n s i o n in a g g r e g a t e itself. in demand depends stability of the r e l a t i o n s h i p s b e t w e e n i n c o m e a n d c o n s u m e r s p e n d i n g o r b e t w e e n income and business investment. In p a s s i n g , it m i g h t b e w o r t h w h i l e to m e n t i o n a r e l a t e d issue. M o n e t a r i s t s b e l i e v e t h a t f o c u s i n g on the m o n e y s t o c k p r o v i d e s a fail-safe system: in the l o n g r u n , e r r o r s in s e t t i n g the m o n e y stock w i l l not affect real variables in the e c o n o m y . On the o t h e r h a n d , a n i n t e r e s t r a t e p o l i c y , they s a y , lacks this f a i l - s a f e quality. If the c e n t r a l b a n k p i c k s a n i n t e r e s t r a t e and it p r o v e s to b e the w r o n g o n e , t h e r e w i l l e n s u e c h a n g e s in the m o n e y s t o c k a n d i n the p r i c e l e v e l w h i c h w i l l force the e c o n o m y e v e n f a r t h e r f r o m its d e s i r e d path. T h u s , if the m o n e t a r y a u t h o r i t i e s m u s t p i c k a p o l i c y a n d if they m u s t s t i c k w i t h it for some o v e r r i d i n g r e a s o n , it is b e t t e r to s t i c k w i t h the m o n e y s t o c k than it is to s t i c k w i t h i n t e r e s t D # N a t u r e a n d S p e e d o f R e s p o n s e to M o n e t a r y rates. Action T h e s p e e d w i t h w h i c h the r e a l e c o n o m y r e s p o n d s to m o n e t a r y a c t i o n is a l s o a m a t t e r o f c o n s i d e r a b l e controversy. i m p o r t a n c e — a s well as M o n e t a r i s t s a p p e a r to a r g u e that the r e a c t i o n s in the l o n g - r u n c a n a l s o b e e x p e c t e d to hold e v e n in the expected short-run. T h u s , t h e y a r g u e t h a t c h a n g e s in G o v e r n m e n t e x p e n d i t u r e s h a v e o n l y a t r a n s i t o r y i m p a c t o n G N P - - w i t h v i r t u a l l y a l l of the e f f e c t s e x h a u s t e d in two or three c a l e n d a r q u a r t e r s . be greatly concerned over unemployment. being T h e y a l s o s e e m n o t to I n s t e a d , they a r g u e that a t t e m p t s to e l i m i n a t e u n e m p l o y m e n t t h r o u g h c h a n g e s in the m o n e y stock w i l l lead to c h a n g e s in p r i c e s w i t h l i t t l e i m p a c t o n the u n e m p l o y m e n t rate itself. M o n e t a r i s t s a l s o a s s e r t t h a t the lags b e t w e e n c h a n g e s in the m o n e y s t o c k a n d c h a n g e s in G N P a r e q u i t e s h o r t . As e v i d e n c e of this, t h e y p o i n t to r e s u l t s r e p o r t e d b y the F e d e r a l R e s e r v e B a n k of S t . L o u i s w h i c h i n d i c a t e t h a t the total i m p a c t of c h a n g e s in m o n e y on G N P a r e realized within a year. In a d d i t i o n , t h e y s e e m to a r g u e that the lags b e t w e e n m o n e y and p r i c e s a r e a l s o q u i t e s h o r t — a l t h o u g h e m p i r i c a l r e s u l t s d o n o t b e a r this o u t . their own A n e x a m i n a t i o n of the p r i c e e q u a t i o n e s t i m a t e d b y the F e d e r a l R e s e r v e B a n k of S t . L o u i s indicates that the lag b e t w e e n c h a n g e s in m o n e y a n d the r e s p o n s e of p r i c e s is quite l o n g — i n the n e i g h b o r h o o d of 10 q u a r t e r s . In f a c t , the lag is q u i t e s i m i l a r in l e n g t h to the lag e s t i m a t e d b y K e y n e s i a n economists. - 14 Working with large-scale econometric models, Keynesians have also obtained evidence of m u c h longer lags between changes m o n e y a n d c h a n g e s in G N P . T h e s e m o d e l s i n d i c a t e that the in impact is s p r e a d o v e r a t l e a s t 8 c a l e n d a r q u a r t e r s , a n d s e v e r a l m o d e l s t h a t the lag is v e r y l o n g indicate indeed. The Keynesians also obtain evidence of a trade-off u n e m p l o y m e n t and i n f l a t i o n in the s h o r t - r u n . between T h u s , there are times w h e n u n e m p l o y m e n t c a n be r e d u c e d by e x p a n s i o n a r y m o n e t a r y a n d fiscal p o l i c i e s a n d , f u r t h e r m o r e , a t a v e r y low c o s t in t e r m s o f a c c e l e r a t i n g the r a t e of i n f l a t i o n . T h e K e y n e s i a n a p p r o a c h a l s o l e a d s to the c o n c l u s i o n that the i m p a c t of m o n e t a r y p o l i c y o n the e c o n o m y depends c r u c i a l l y u p o n the c u r r e n t s t a t u s of the e c o n o m y - - i . e . , u p o n factors s u c h a s the d e g r e e o f c a p a c i t y u t i l i z a t i o n a n d the e x t e n t o f e x i s t i n g inflationary pressures. T h i s , in t u r n , leads to the c o n c l u s i o n t h e r e is n o s i m p l e r e l a t i o n s h i p b e t w e e n c h a n g e s in the m o n e y a n d c h a n g e s in the r e a l e c o n o m y . have seriously underestimated stock T h u s , t h e y a s s e r t t h a t the m o n e t a r i s t s the c o m p l e x i t y o f the e c o n o m y b y c o n c e n t r a t i n g o n a s i m p l e l i n e a r r e l a t i o n s h i p b e t w e e n m o n e y and E. R o l e of P r i c e that GNP. Expectations It m i g h t b e u s e f u l to end this s e c t i o n w i t h a d i s c u s s i o n o f the r o l e of p r i c e e x p e c t a t i o n s . A g a i n , t h e r e is l i t t l e in t h e o r y b e t w e e n the m o n e t a r i s t s a n d the K e y n e s i a n s . assert that spending decisions Both groups in the e c o n o m y a r e i n f l u e n c e d b y r e a l i n t e r e s t r a t e s and n o t b y t h e i r n o m i n a l c o u n t e r p a r t s . r a t e s a r e i n f l u e n c e d b y the e x p e c t e d r a t e of i n f l a t i o n . difference Nominal interest Thus, a rise - 15 in the n o m i n a l r a t e s t h a t is c a u s e d b y a n a c c e l e r a t i o n in the e x p e c t e d r a t e o f i n f l a t i o n w i l l n o t r e t a r d s p e n d i n g b e c a u s e the r e a l rate has been left interest unaffected. A g a i n , there are significant empirical differences a p p e a r in the two a p p r o a c h e s . To i l l u s t r a t e this p o i n t , w i t h a s s i s t a n c e o f s e v e r a l m e m b e r s o f the B o a r d ' s s t a f f a n d u s i n g l a r g e - s c a l e e c o n o m e t r i c m o d e l a v a i l a b l e to us (the model)^ the SSRC-MIT-PENN r e d u c t i o n in the r a t e of i n f l a t i o n . interesting example the T h e t a s k w a s to e s t i m a t e the d i f f e r e n t i a l e f f e c t s o n the e c o n o m y of a c h i e v i n g a significant The issue studied provides an o f h o w the s t r u c t u r a l e q u a t i o n s s p e c i f i e d b y the K e y n e s i a n s c a n b e u s e d to s t u d y a n i m p o r t a n t p r o b l e m . 11 the s e v e r a l s i m u l a t i o n e x p e r i m e n t s w e r e c o n d u c t e d in w h i c h e x p e c t e d r a t e of i n f l a t i o n w a s r e d u c e d . box that The lf black a p p r o a c h u s e d b y the m o n e t a r i s t s p r o v i d e s us w i t h n o i n s i g h t s into the s a m e p r o b l e m . In the S S R C - M I T - P E N N m o d e l , s p e n d i n g d e c i s i o n s a r e b a s e d , in l a r g e p a r t , u p o n the b e h a v i o r of the r e a l r a t e of interest—i.e., t h e n o m i n a l r a t e less the e x p e c t e d r a t e of i n f l a t i o n . If the n o m i n a l r a t e o f i n t e r e s t r e m a i n s u n c h a n g e d w h i l e i n f l a t i o n is e x p e c t e d to b e r e d u c e d , the r e a l r a t e o f i n t e r e s t h a s r i s e n . equal, O t h e r things a r i s e in the r e a l i n t e r e s t r a t e w i l l r e t a r d s p e n d i n g since it is n o w m o r e e x p e n s i v e in r e a l t e r m s to invest. W h e r e a s the n o m i n a l i n t e r e s t r a t e is a n o b s e r v e d v a l u e , the v a l u e a s s i g n e d to e x p e c t e d p r i c e c h a n g e s h a s to b e c o n s t r u c t e d . the m o d e l u s e d , the v a l u e of p r i c e e x p e c t a t i o n s is c o n s t r u c t e d r e l a t i v e l y l o n g s e r i e s o f o b s e r v e d p a s t c h a n g e s in p r i c e s . 7_/ In from a I n this T h e s i m u l a t i o n s w e r e p e r f o r m e d w i t h a m o d i f i e d v e r s i o n of the Social Science Research Council-MIT-PENN quarterly econometric model. - 16 s p e c i f i c a t i o n , t h e c h a n g e s in p r i c e s in p e r i o d s in the i m m e d i a t e have little effect on current price expectations; it t a k e s a n h i s t o r y o f p r i c e c h a n g e s b e f o r e t h e r e is a n a p p r e c i a b l e in p r i c e e x p e c t a t i o n s . as permanent--thus extended alternation T h e r e f o r e , it o r d i n a r i l y t a k e s a l o n g before a given change in prices past time (such a s a s u d d e n f a l l ) is p e r c e i v e d changing price e x p e c t a t i o n s — w h i c h causes a c h a n g e in the r e a l i n t e r e s t r a t e — w h i c h in t u r n , c a u s e s s p e n d i n g to change. In the simulation e x p e r i m e n t s , consideration was focused on the d i f f e r e n t i a l i m p a c t o f two s h a r p l y v a r y i n g c h a n g e s in p r i c e expectation. I n C a s e I , a n a b r u p t f a l l in p r i c e s is o n l y perceived as p e r m a n e n t . gradually In C a s e I I , a r e d u c t i o n in i n f l a t i o n immediately perceived as permanent. I n c a r r y i n g o u t the is simulations, in C a s e I a n a d j u s t m e n t is m a d e to the m o d e l w h i c h c a u s e s t h e r a t e o f c h a n g e in p r i c e s to b e r e d u c e d s u d d e n l y , b u t s p e n d i n g u n i t s o n l y g r a d u a l l y to the n e w c i r c u m s t a n c e s . adapt I n C a s e I I , the p r i c e a n t i c i p a t i o n t e r m s a r e a l t e r e d so t h a t s p e n d i n g u n i t s immediately i n c o r p o r a t e the c h a n g e d i n f l a t i o n s i t u a t i o n into t h e i r b e h a v i o r . T o i s o l a t e the d i f f e r e n c e s b e t w e e n the two s i t u a t i o n s , a n i n i t i a l s i m u l a t i o n , C a s e I , w a s r u n b y a p p l y i n g the G N P a n d a s s u m p t i o n s c o n t a i n e d in the C o u n c i l o f E c o n o m i c A d v i s e r s for 1 9 7 2 . These projections related (CEA) Report i n c o r p o r a t e a d e c l i n e in the i n f l a t i o n rate of 1.0 p e r c e n t a g e p o i n t a t t r i b u t e d to the N e w E c o n o m i c P o l i c y . This a Base P r o j e c t i o n w h i c h could be taken as a n indication of the course yielded the e c o n o m y m i g h t f o l l o w in the a b s e n c e o f m a j o r c h a n g e s in p r i c e anticipations. T h e n e x t s t e p w a s to c o n d u c t the e x p e r i m e n t s for C a s e It W a s a s s u m e d t h a t the a n t i c i p a t e d r a t e o f i n f l a t i o n w a s r e d u c e d b y II. 1.0 p e r c e n t a g e p o i n t , a n d the p r o c e s s o f a d j u s t m e n t w a s t r a c e d o v e r two y e a r s , b e g i n n i n g in the f i r s t q u a r t e r o f 1972. - 17 T h e d i f f e r e n c e s in the two sets of r e s u l t s for k e y variables can be summarized economic here. C a s e II less C a s e I ($ B i l l i o n s ) $ GNP Real GNP _ Unemployment 1972 I II III IV --2.9 - 6.4 - 9.0 -10.8 -2.3 -4.8 -6.4 -7.2 .1 .2 .3 .3 1973 I II III IV -11.3 -10.9 - 9.8 - 8.4 -7.0 -6.1 -4.7 -3.2 .4 .3 .3 .2 T h e s e r e s u l t s s u g g e s t that it d o e s m a k e a g r e a t d e a l o f d i f f e r e n c e w h e t h e r the p u b l i c reacts s l o w l y o r r a p i d l y to c h a n g e s the actual rate of inflation. Under circumstances where u n i t s d o r e a c t q u i c k l y to a d e c l i n e in the rate of in spending inflation (Case I I ) , the e f f e c t w o u l d be to d e p r e s s n o m i n a l G N P by a p p r o x i m a t e l y $ 1 1 b i l l i o n m o r e a f t e r four c a l e n d a r q u a r t e r s t h a n w o u l d o c c u r the r e a c t i o n t a k e s p l a c e g r a d u a l l y (Case I ) . if O v e r the s a m e p e r i o d , r e a l G N P w o u l d b e a b o u t $7 b i l l i o n l o w e r , and the u n e m p l o y m e n t w o u l d b e a b o u t .3 p e r c e n t h i g h e r u n d e r C a s e II t h a n u n d e r C a s e rate I. As the a d j u s t m e n t p r o c e e d s o v e r t i m e , the gap b e t w e e n the two sets of results narrows s t e a d i l y . The r e a s o n for this is r e l a t e d to the e f f e c t s of r e d u c e d e x p e c t a t i o n s of i n f l a t i o n in C a s e I . i n f l a t i o n r a t e g r a d u a l l y has a n i m p a c t on a n t i c i p a t e d The actual inflation—which, - 18 in t u r n , t e n d s to d e p r e s s a g g r e g a t e d e m a n d E v e n t u a l l y the a n t i c i p a t e d in t h a t simulation. i n f l a t i o n r a t e w i l l e q u a l the a c t u a l r a t e , a n d the two s i m u l a t i o n s w i l l g i v e the s a m e results. It w a s n o t p o s s i b l e to p e r f o r m a c o m p a r a b l e e x p e r i m e n t w i t h m o n e t a r i s t e c o n o m e t r i c m o d e l s — f o r e x a m p l e , w i t h the m o d e l d e v e l o p e d the F e d e r a l R e s e r v e B a n k of S t . L o u i s . T h e s t r u c t u r e o f the e c o n o m y r e p r e s e n t e d b y t h a t m o d e l is n o t s p e l l e d o u t in s t r u c t u r a l I n s t e a d , a s e t o f r e d u c e d - f o r m e x p r e s s i o n s is u s e d w h i c h the e f f e c t s o f p r i c e e x p e c t a t i o n s other effects. equations. prevents from b e i n g s e p a r a t e d o u t T h e c h a n g e in n o m i n a l G N P is d e t e r m i n e d b y from changes in the m o n e y s t o c k c o u p l e d w i t h a t r a n s i t o r y e f f e c t o f c h a n g e s Federal expenditures. by in T h e c h a n g e in t h e p r i c e l e v e l is d e t e r m i n e d by a demand pressure variable ( n o m i n a l G N P r e l a t i v e to f u l l e m p l o y m e n t G N P ) a n d b y the a n t i c i p a t e d r a t e o f i n f l a t i o n — w h i c h , in t u r n , d e p e n d s s o l e l y u p o n p r e v i o u s c h a n g e s in p r i c e s . T h e e x p r e s s i o n s for c h a n g e s in n o m i n a l G N P a n d c h a n g e s in the p r i c e l e v e l i m p l y a n e x p r e s s i o n for c h a n g e s in r e a l G N P . G i v e n this set o f e x p r e s s i o n s , t h e r e s i m p l y is n o w a y to p e r f o r m a n e x p e r i m e n t c o m p a r a b l e to t h a t c o n d u c t e d w i t h the q u a r t e r l y model. structural It w o u l d b e p o s s i b l e to r e v i s e d o w n w a r d the e x p r e s s i o n for the a c t u a l c h a n g e in the p r i c e l e v e l , b u t t h i s w o u l d o n l y y i e l d a c o m p a r a b l e to the C a s e I s i m u l a t i o n d i s c u s s e d a b o v e . simulation W i t h the S t . L o u i s Bank's m o d e l , nominal output would remain unchanged and real output w o u l d r i s e in p r o p o r t i o n to the c o n s t r u c t e d d e c l i n e in p r i c e s . Once - 19 this w e r e d o n e , h o w e v e r , t h e r e w o u l d be no role for the p r i c e a n t i c i p a t i o n s v a r i a b l e b e c a u s e this v a r i a b l e only i n f l u e n c e s a c t u a l c h a n g e in p r i c e s w h i c h has a l r e a d y b e e n m o d i f i e d . t h e r e is no s i m u l a t i o n p o s s i b l e for C a s e in m o s t c i r c u m s t a n c e s Thus, II. One m i g h t take the v i e w that m o n e t a r i s t s r e g a r d anticipation effects as unimportant. the price A p p a r e n t l y , they b e l i e v e that the s t r u c t u r e of the e c o n o m y d o e s n o t c h a n g e e n o u g h to u p s e t the r e d u c e d - f o r m d e s c r i p t i o n . If this is t r u e , then a s u d d e n r e d u c t i o n in i n f l a t i o n can lead o n l y to a corresponding i n c r e a s e in r e a l o u t p u t l e a v i n g n o m i n a l o u t p u t u n c h a n g e d . More likely the m o n e t a r i s t s do feel the s t r u c t u r e is changed e n o u g h to u p s e t the r e l a t i o n s h i p s i m p l i e d b y their e q u a t i o n s . P r e s u m a b l y the implied r i s e in r e a l i n t e r e s t r a t e s w o u l d lower n o m i n a l G N P - - g i v e n the m o n e y stock. H o w e v e r , w e do n o t k n o w the m a g n i t u d e s of the e f f e c t b e c a u s e they h a v e not s p e c i f i e d the s t r u c t u r e from w h i c h t h e i r r e d u c e d form stems. F r o m the f o r e g o i n g d i s c u s s i o n , I c o n c l u d e that the a n a l y t i c a l f r a m e w o r k d e v e l o p e d b y the m o n e t a r i s t s is n o t c a p a b l e of y i e l d i n g m u c h i n s i g h t into some of the m o s t p r e s s i n g issues faced b y the m o n e t a r y authorities. A n u m b e r of i n h e r e n t d e f i c i e n c i e s ( r e l a t i n g to m a t t e r s such as the n a t u r e of the m o n e t a r y p r o c e s s , time l a g s , the d e m a n d for m o n e y , and p r i c e e x p e c t a t i o n s ) m u s t be r e m e d i e d b e f o r e c e n t r a l b a n k e r s can e x p e c t to find m u c h g u i d a n c e in the m o n e t a r i s t p r e s c r i p t i o n for m o n e t a r y m a n a g e m e n t . W h i l e the K e y n e s i a n s have n o t p r o v i d e d a l l the s o l u t i o n s to these i m p o r t a n t p r o b l e m s , they h a v e s u p p l i e d us w i t h a s t r u c t u r e w h i c h p r o v i d e s i m p o r t a n t i n s i g h t s into the w o r k i n g s of m o n e t a r y policy. O n e i m p o r t a n t i n s i g h t is that the w o r l d is too c o m p l i c a t e d us the l u x u r y of f o c u s i n g o n l y on the m o n e y s t o c k in s e t t i n g policy. to a l l o w - 20 III. A s s e s s m e n t of F e d e r a l R e s e r v e Performance T o g a i n a s u m m a r y i m p r e s s i o n of the p e r f o r m a n c e of the F e d e r a l R e s e r v e in its c o n d u c t of a f l e x i b l e m o n e t a r y p o l i c y , a n a n a l y s i s was made (with a s s i s t a n c e f r o m the B o a r d ' s s t a f f ) of the b e h a v i o r of i n t e r e s t r a t e s , n e t r e s e r v e s , and m o n e t a r y and c r e d i t a g g r e g a t e s in the f a c e of c h a n g i n g e c o n o m i c c o n d i t i o n s in the l a s t t w o d e c a d e s . T h e a n a l y s i s p r o c e e d e d on the a s s u m p t i o n t h a t a f l e x i b l e m o n e t a r y p o l i c y w o u l d r e q u i r e the m o n e t a r y m a n a g e r s to a n t i c i p a t e prospective c h a n g e s in e c o n o m i c a c t i v i t y w i t h s u f f i c i e n t l e a d time to a l l o w c h a n g e s in p o l i c y to c o u n t e r e m e r g i n g i n f l a t i o n a r y o r d e f l a t i o n a r y tendencies. A s e v i d e n c e of e x c e s s a g g r e g a t e d e m a n d b e g a n to m a t e r i a l i z e , t h e a u t h o r i t i e s w o u l d b e e x p e c t e d to a d o p t a p o l i c y to r e s t r i c t the g r o w t h o f m o n e y and c r e d i t . The authorities would also b e e x p e c t e d to a n t i c i p a t e the end o f the e x p a n s i o n p h a s e of the b u s i n e s s c y c l e a n d to m o v e in a t i m e l y f a s h i o n to o f f s e t toward tendencies recession. F o r p u r p o s e of a n a l y s i s , s e v e n e p i s o d e s w e r e i d e n t i f i e d . of t h e s e c e n t e r e d o n b u s i n e s s cycle p e a k s , a n d two were points at w h i c h the e c o n o m y w a s j u d g e d to h a v e r e a c h e d f u l l e m p l o y m e n t . as reference the m o n t h in w h i c h the c y c l i c a l p e a k or f u l l Using employment p o i n t o c c u r r e d , s i x - m o n t h p e r i o d s b e f o r e a n d a f t e r the r e f e r e n c e were delineated. The m o n e t a r y p o l i c y a p p r o p r i a t e u n d e r the circumstances was indicated. Five C h a n g e s in i n t e r e s t r a t e s , n e t point prevailing reserves, - 21 arid m o n e t a r y a n d c r e d i t a g g r e g a t e s w e r e then c a l c u l a t e d . F i n a l l y , the a c t u a l c h a n g e s in the m o n e t a r y v a r i a b l e s w e r e c o m p a r e d w i t h the objectives required by a flexible, contra-cyclical monetary policy. T h e d e t a i l s of the a n a l y s i s a r e shown in the A p p e n d i x Table (attached). 1. The g e n e r a l c o n c l u s i o n s can be s u m m a r i z e d J u l y , 1953: briefly: Cyclical Peak M o s t of the i n d i c a t o r s s u g g e s t s t r o n g l y that the p e r f o r m a n c e o f m o n e t a r y p o l i c y fell s h o r t of w h a t w a s r e q u i r e d in the c o n t e x t of a d e v e l o p i n g r e c e s s i o n . The d i s c o u n t r a t e w a s n o t reduced d u r i n g the f i r s t six m o n t h s f o l l o w i n g the p e a k in e c o n o m i c a c t i v i t y . W h i l e b o t h short- a n d l o n g - t e r m i n t e r e s t rates d r o p p e d a p p r e c i a b l y a f t e r the p e a k , this w a s m a i n l y a r e f l e c t i o n o f r e d u c e d c r e d i t d e m a n d s . E a c h of the m o n e t a r y a n d c r e d i t a g g r e g a t e s (M-^, M 2 , a n d b a n k c r e d i t ) increased less in the s i x m o n t h s a f t e r the c y c l i c a l p e a k than in the like p e r i o d p r i o r to the d o w n t u r n . (The v e r y rapid rate of g r o w t h in free r e s e r v e s p r i o r to the c y c l i c a l p e a k r e f l e c t e d in p a r t a large d r o p in the l e v e l of m e m b e r b a n k b o r r o w i n g c o i n c i d e n t w i t h the s u b s e q u e n t e x p i r a t i o n of the K o r e a n W a r excess profits tax.) 2. J u n e , 1955: P e r i o d of E x c e s s D e m a n d G i v e n the p r i n c i p a l n a t i o n a l goal of c u r b i n g e x c e s s a g g r e g a t e d e m a n d , the record of m o n e t a r y p o l i c y w a s r e a s o n a b l y g o o d . T h e F e d e r a l R e s e r v e d i s c o u n t rate w a s a d v a n c e d b y 1/4 p e r c e n t a g e p o i n t as t h e e c o n o m y a p p r o a c h e d f u l l e m p l o y m e n t and by 3/4 p e r c e n t a g e p o i n t in the six m o n t h s a f t e r a g g r e g a t e d e m a n d had b e g u n to p r e s s a g a i n s t c a p a c i t y . O n b a l a n c e , m a r k e t i n t e r e s t r a t e s c l i m b e d higher b o t h b e f o r e a n d a f t e r J u n e , 1 9 5 5 . A n e s p e c i a l l y sharp spurt in s h o r t - t e r m r a t e s o c c u r r e d o v e r the half y e a r f o l l o w i n g that d a t e . The l e v e l of free r e s e r v e s s h r a n k s i g n i f i c a n t l y . Bank c r e d i t , M-^ a n d M 2 i n c r e a s e d a f t e r J u n e a t r a t e s b e l o w t h o s e r e g i s t e r e d in the p r e c e d i n g h a l f y e a r . - 22 3. J u l y , 1957: Upper Turning Point A t this j u n c t u r e , w h e n the m a i n s p r i n g s of e c o n o m i c e x p a n s i o n w e r e w e a k e n i n g p r o g r e s s i v e l y , the p e r f o r m a n c e o f m o n e t a r y p o l i c y w a s p r o b a b l y the w o r s t in the p e r i o d u n d e r r e v i e w . N e a r l y a l l of the i n d i c a t o r s of monetary policy behaved o p p o s i t e l y — o r responded sluggishly--to what was required. The discount rate was r a i s e d a f t e r the t u r n i n g p o i n t - - a l t h o u g h it w a s r e d u c e d s u b s e q u e n t l y . Free reserves expanded substantially in the six m o n t h s f o l l o w i n g the d o w n t u r n - - w h i c h g a v e the i m p r e s s i o n to some t h a t m o n e t a r y p o l i c y had s h i f t e d from a p o s t u r e of r e s t r a i n t to c o n s i d e r a b l e e a s e . W h i l e i n t e r e s t r a t e s d e c l i n e d , the d r o p in y i e l d s on l o n g - t e r m U . S . Government securities was not much greater than t h e r i s e w h i c h had o c c u r r e d in the p r e c e d i n g h a l f y e a r . T h e n a r r o w m o n e y s t o c k (Mi) a c t u a l l y c o n t r a c t e d a t a s i z a b l e rate in the p e r i o d f o l l o w i n g the c y c l i c a l p e a k a f t e r r e g i s t e r i n g no i n c r e a s e in the six m o n t h s b e f o r e . B a n k c r e d i t and M 2 a l s o e x p a n d e d a t s l o w e r r a t e s a f t e r the c r e s t in e c o n o m i c a c t i v i t y had p a s s e d . 4. M a y , 1960: Upper Turning Point The m o n e t a r y a u t h o r i t i e s w e r e f a i r l y s u c c e s s f u l i n p u r s u i t o f a f l e x i b l e p o l i c y d e s i g n e d to c u s h i o n t h e i m p a c t of the e m e r g i n g r e c e s s i o n . T h e d i s c o u n t r a t e w a s r e d u c e d twice (by a t o t a l of 1.0 p e r c e n t a g e p o i n t ) in the six m o n t h s f o l l o w i n g the c y c l i c a l p e a k . Free reserves expanded substantially both before and a f t e r the t u r n . I n t e r e s t r a t e s d e c l i n e d t h r o u g h o u t the p e r i o d . T h e two m e a s u r e s o f the m o n e y s t o c k (M^ a n d M 2 ) had r e c o r d e d d e c l i n e s p r i o r to the t u r n i n g p o i n t , a n d the s u b s e q u e n t s w i n g to n e t e x p a n s i o n w a s n o t i c e a b l e . B a n k c r e d i t had g r o w n o n l y m o d e r a t e l y in the six m o n t h s l e a d i n g u p to the p e a k , b u t a large r i s e o c c u r r e d in the following period. 5. J a n u a r y , 1966: P e r i o d of E x c e s s Demand T h e t a s k in this e p i s o d e w a s to u s e m o n e t a r y p o l i c y to d a m p e n e x c e s s d e m a n d p r e s s u r e s g e n e r a t e d in s u b s t a n t i a l p a r t b y the m i l i t a r y b u i l d u p a s s o c i a t e d w i t h the V i e t n a m W a r . A l t h o u g h the F e d e r a l R e s e r v e w a i t e d too l o n g in m o v i n g to r e s t r a i n t in the face of this b u i l d u p , once t h e m o v e h a d b e e n i n i t i a t e d , the p e r f o r m a n c e w a s q u i t e g o o d . T h e d i s c o u n t r a t e w a s i n c r e a s e d b y 1/2 p e r c e n t a g e p o i n t in D e c e m b e r , 1 9 6 5 — o v e r the o p p o s i t i o n o f the - 23 A d m i n i s t r a t i o n . N e t free r e s e r v e s d e c l i n e d a p p r e c i a b l y in the J a n u a r y - J u l y m o n t h s o f 1 9 6 6 . L o n g - t e r m i n t e r e s t rates r o s e t h r o u g h o u t the p e r i o d - although some short-term yields dropped slightly from J a n u a r y to J u l y — f o l l o w i n g a s h a r p i n c r e a s e in the last h a l f of the p r e c e d i n g y e a r . A l l of the m o n e t a r y a n d c r e d i t a g g r e g a t e s e x p a n d e d a t a g r e a t l y r e d u c e d p a c e in the six m o n t h s a f t e r J a n u a r y , 1 9 6 6 , c o m p a r e d w i t h t h a t r e c o r d e d six m o n t h s e a r l i e r . J a n u a r y , 1967: Informal Cyclical Peak T h e r e c o r d o f m o n e t a r y p o l i c y d u r i n g this e p i s o d e w a s p a r t i c u l a r l y e n c o u r a g i n g . As s i g n a l s o f s l a c k e n i n g e c o n o m i c a c t i v i t y b e g a n to a p p e a r , the F e d e r a l R e s e r v e shifted promptly and substantially toward ease. The s t r o n g r e s p o n s e o f the f i n a n c i a l s y s t e m w a s p r o b a b l y t r a c e a b l e in p a r t to the s e v e r i t y o f the m o n e t a r y r e s t r a i n t i m p o s e d in the p r e c e d i n g y e a r . In e a r l y 1 9 6 7 , the d i s c o u n t r a t e w a s r e d u c e d b y 1/2 p e r c e n t a g e p o i n t . N e t free r e s e r v e s w e r e e x p a n d e d b o t h b e f o r e a n d a f t e r the t u r n i n g point. Short-term interest rates decreased substantially after January, but long-term yields rose following a n e a r l i e r d r o p . A l l o f the m o n e t a r y a n d c r e d i t a g g r e g a t e s ( M ^ , M 2 , a n d b a n k c r e d i t ) r o s e m u c h m o r e r a p i d l y in the h a l f y e a r f o l l o w i n g J a n u a r y , 1 9 6 7 , t h a n t h e y d i d in the p r e c e d i n g p e r i o d . In f a c t , a l l o f t h e m e x p a n d e d a t h i s t o r i c a l l y high r a t e s . S o m e o b s e r v e r s m a y feel t h a t m o n e t a r y p o l i c y b e c a m e too e a s y in e a r l y 1 9 6 7 - - g i v e n the m i l d n e s s a n d s h o r t d u r a t i o n o f the r e c e s s i o n . This c r i t i c i s m d o e s n o t a p p e a r to be j u s t i f i e d , a l t h o u g h it is true t h a t m o n e t a r y e a s e w a s c a r r i e d too far into the y e a r — r e s u l t i n g in s i z a b l e i n c r e a s e s in the m o n e t a r y a g g r e g a t e s (M-., 6 . 7 p e r c e n t , and 10 p e r c e n t ) for the y e a r a s a w h o l e . W h a t e v e r w e i g h t o n e m i g h t w a n t to a s s i g n to this r e s e r v a t i o n a b o u t the r e s p o n s i v e n e s s of m o n e t a r y p o l i c y a t the l o w e r t u r n i n g p o i n t of the c y c l e , the t i m e l i n e s s a n d speed of r e a c t i o n to the e a r l i e r r e c e s s i o n cannot be overlooked and undoubtedly helped account for the r e l a t i v e m i l d n e s s of that d o w n t u r n . - 24 7. N o v e m b e r , 1969: Upper Turning Point H e r e a l s o the p e r f o r m a n c e o f the F e d e r a l R e s e r v e w a s f a i r l y g o o d — a l t h o u g h in r e t r o s p e c t it c o u l d b e a r g u e d t h a t r e s t r a i n t w a s p u r s u e d a b i t too f a r in 1 9 6 9 a n d the l i q u i d i t y o f the e c o n o m y w a s n o t r e b u i l t r a p i d l y e n o u g h in the e a r l y s t a g e o f t h e r e c e s s i o n . As excess demand faded, monetary policy shifted from c o n s i d e r a b l e r e s t r a i n t to a p o s t u r e d e s i g n e d t o f o s t e r lower interest rates and greater availability of money a n d c r e d i t . A l t h o u g h the d i s c o u n t r a t e w a s n o t r e d u c e d , n e t f r e e r e s e r v e s i n c r e a s e d b o t h b e f o r e a n d a f t e r the cyclical peak. Short-term yields declined appreciably, b u t l o n g - t e r m i n t e r e s t r a t e s — a g a i n r e f l e c t i n g the s t r a i n o n l i q u i d i t y — c o n t i n u e d to r i s e f o l l o w i n g the b e g i n n i n g o f the d o w n t u r n . T h e m a j o r d r o p in l o n g - t e r m r a t e s did n o t b e g i n u n t i l the s u m m e r o f 1 9 7 0 . E x p a n s i o n in the m o n e t a r y and credit aggregates quickened significantly i n the s i x m o n t h s f o l l o w i n g the c y c l i c a l p e a k . Yet, t h e g r o w t h rates r e m a i n e d r e l a t i v e l y m o d e r a t e — p e r h a p s b e l o w n o r m a l for M 0 a n d b a n k c r e d i t . O n the b a s i s of this s u r v e y , s e v e r a l c o n c l u s i o n s out: stand j u d g e d o n the b a s i s of t i m e l i n e s s in m o d i f y i n g the p o s t u r e o f m o n e t a r y p o l i c y , the F e d e r a l R e s e r v e p e r f o r m e d b e s t d u r i n g t h e t w o m o s t r e c e n t p e r i o d s of i n f l a t i o n ( f o l l o w i n g J u n e , 1955, a n d J a n u a r y , 1 9 6 6 ) a n d d u r i n g t h e two m o s t r e c e n t p e r i o d s of recession I n the (following January, 1967, and November, 1969). e a r l y s t a g e s o f the 1 9 6 0 r e c e s s i o n , the p e r f o r m a n c e w a s a l s o fair. H o w e v e r , i n e a r l i e r e p i s o d e s , m o n e t a r y m a n a g e m e n t b y the F e d e r a l R e s e r v e w a s n o t so g o o d . In the c a s e o f the 1 9 6 7 r e c e s s i o n , the m a g n i t u d e o f the s h i f t to m o n e t a r y e a s e w a s s o m e w h a t in e x c e s s w h a t was required, and policy remained easy longer than was of appropriate. - 25 F u r t h e r m o r e , w h i l e the r a t e of e x p a n s i o n in the m o n e t a r y aggregates (M^ a n d M 2 ) s l o w e d in the c l o s i n g m o n t h s of 1967 a n d in e a r l y 1968, a sharp acceleration occurred subsequently. two The results were consecutive years of relatively rapid monetary g r o w t h . The record o f t h e s e two y e a r s is f r e q u e n t l y c i t e d b y c r i t i c s o f the F e d e r a l R e s e r v e a s i l l u s t r a t i o n s o f the a l l e g e d d a n g e r s i n h e r e n t in the pursuit of a flexible monetary policy. IV. Need to M a i n t a i n F l e x i b i l i t y Concluding Observations: in Monetary Management I w a n t to c o n c l u d e these r e m a r k s w i t h a s u m m a r y o f the p r i n c i p a l r e a s o n s w h y I b e l i e v e the F e d e r a l R e s e r v e S y s t e m should m a i n t a i n a p o s t u r e o f f l e x i b i l i t y in m o n e t a r y m a n a g e m e n t r a t h e r than c o n f i n e its a c t i o n s to s m a l l c h a n g e s in the g r o w t h r a t e o f t h e money stock. In the f i r s t p l a c e , a d o p t i o n of s u c h a p o l i c y strategy w o u l d f o r c e the F e d e r a l R e s e r v e to i g n o r e the b e h a v i o r of a l l o t h e r factors affecting credit markets. In m y j u d g m e n t , the F e d e r a l R e s e r v e h a s a n u m b e r o f r e s p o n s i b i l i t i e s b e y o n d c o n c e r n for the money supply which must be m e t . It m u s t encourage credit a p p r o p r i a t e for the e c o n o m y as a w h o l e , and it a l s o h a s for T r e a s u r y f i n a n c e , the v i a b i l i t y of f i n a n c i a l conditions responsibilities institutions, and conditions influencing international capital flows. These c o n s i d e r a t i o n s s u g g e s t t h a t the c e n t r a l b a n k c a n n o t i g n o r e rate and credit developments. interest Indeed, at times such developments w i l l i m p o s e s e v e r e c o n s t r a i n t s o n the a b i l i t y o f the m o n e t a r y to f o l l o w a s t r i c t c o u r s e w i t h r e s p e c t to m o n e t a r y growth. authorities - 26 M o r e o v e r , it seems s e l f - e v i d e n t t h a t the c e n t r a l bank s h o u l d b e c a p a b l e o f p r o v i d i n g m o r e a s s i s t a n c e in the a t t a i n m e n t n a t i o n a l e c o n o m i c o b j e c t i v e s t h a n is i m p l i e d b y the policy of an unchanging monetary stance. neutralist In contra-cyclical p a r t i c u l a r l y , m o n e t a r y policy should be prepared to the e c o n o m y in r e c e s s i o n a n d less in b o o m . of terms, to g i v e m o r e support F u r t h e r m o r e , the F e d e r a l R e s e r v e s h o u l d b e a b l e to a n t i c i p a t e t h e s e developments w i t h s u f f i c i e n t a c c u r a c y to a l t e r p o l i c y in a d v a n c e of the n e e d s o f the e c o n o m y . The evidence presented here indicates t h a t the S y s t e m ' s a b i l i t y to d o this h a s i m p r o v e d o v e r the y e a r s . There will a l s o be circumstances under which national priorities with respect to t h e a l l o c a t i o n o f c r e d i t m i g h t w e l l r e q u i r e the m o n e t a r y a u t h o r i t i e s to d e p a r t for a t i m e for w h a t t h e y w o u l d c o n s i d e r b e the a p p r o p r i a t e r a t e of o v e r a l l m o n e t a r y g r o w t h . t h e m o n e t a r i s t s n o r the K e y n e s i a n s u n d e r s t a n d to While neither the m o n e t a r y process w e l l e n o u g h , the b e h a v i o r o f i n t e r e s t r a t e s a n d c r e d i t conditions d o p r o v i d e i n f o r m a t i o n w h i c h the F e d e r a l R e s e r v e s h o u l d n o t throw o u t in s l a v i s h p u r s u i t of a p o l i c y w i t h r e s p e c t to M ^ . U s e o f the m o n e y s t o c k a s the s o l e t a r g e t o f p o l i c y assumes t h a t t h e r e is a f a i r l y c o n s t a n t r e l a t i o n s h i p b e t w e e n m o n e t a r y g r o w t h a n d its i n f l u e n c e o n e c o n o m i c a c t i v i t y . This may be c o r r e c t in t h e l o n g - r u n , b u t it c a n n o t b e t r u e in the generally short-run. T h e p u b l i c ' s d e m a n d for l i q u i d i t y o b v i o u s l y s h i f t s f r o m t i m e to time, d e p e n d i n g o n t h e c o n f i d e n c e w i t h w h i c h t h e y v i e w the f u t u r e , c h a n g e s in i n f l a t i o n a r y e x p e c t a t i o n s , a n d s i m i l a r i n f l u e n c e s . If the - 27 F e d e r a l R e s e r v e d o e s n o t p r o v i d e the a d d i t i o n a l a s s o c i a t e d w i t h a n u p w a r d s h i f t in p r e f e r e n c e s liquidity (or a b s o r b the l i q u i d i t y r e l e a s e d b y d o w n w a r d shifts), a c o n s t a n t r a t e o f g r o w t h in m o n e y is l i k e l y to r e s u l t in v a r i a b l e r a t e s o f g r o w t h in the real economy. I n o t h e r w o r d s , a c o n s t a n t rate o f g r o w t h in m o n e y — i f p r e c a u t i o n a r y d e m a n d s for l i q u i d i t y a r e b e a s o u r c e of e c o n o m i c i n s t a b i l i t y . shifting—would F u r t h e r m o r e , the b e t w e e n s p e n d i n g , i n t e r e s t r a t e s , and m o n e y s h i f t relationships significantly— d e p e n d i n g u p o n the s t a t e of the e c o n o m y . A m o n e y s t o c k t a r g e t r e q u i r e s that the m o n e t a r y v a r i a b l e , o r the w e i g h t e d c o m b i n a t i o n of v a r i a b l e s , to b e c o n t r o l l e d s p e c i f i e d in a d v a n c e . be T h e m o n e t a r i s t s do n o t a l w a y s s p e c i f y w h i c h v a r i a b l e is to b e c o n t r o l l e d b y the c e n t r a l b a n k . However, they h a v e s o m e t i m e s f o c u s e d o n M]^ and s o m e t i m e s on M 2 . Yet, M ^ would b e a n e q u a l l y g o o d c a n d i d a t e , since d e p o s i t o r s in t h r i f t institutions s u r e l y r e g a r d t h e s e d e p o s i t s as the e q u i v a l e n t o f b a n k time d e p o s i t s in a l l r e s p e c t s . And M 4 (total liquid a s s e t s ) w o u l d a l s o b e a f likely candidate, since only by including C D s and other money m a r k e t instruments does one incorporate a m e a s u r e of corporate liquidity. O f c o u r s e , a l l o f these q u a n t i t i e s d o n o t m o v e u p a n d d o w n a t a n y t h i n g l i k e the s a m e r a t e s in the s h o r t - r u n , so it is not enough to u s e o n e m e a s u r e of the m o n e y s t o c k a s a p r o x y for a l l o f the o t h e r s . N o r is e x p a n s i o n in a l l of the d i f f e r e n t c l o s e l y r e l a t e d to the p r o v i s i o n of b a n k reserves. measures - 28 T h e r e l a t i o n s h i p s b e t w e e n r a t e s o f c h a n g e in the v a r i o u s m e a s u r e s — a n d b e t w e e n t h e s e d e f i n i t i o n s of m o n e y a n d activity—are economic c l e a r l y s u b j e c t to a n u m b e r of i n f l u e n c e s , s t r u c t u r a l , competitive and technological c h a n g e . including T h u s , the emergence o f the s a v i n g s a n d l o a n a s s o c i a t i o n s in the p o s t - W o r l d W a r II y e a r s c l e a r l y i m p i n g e d o n the g r o w t h of b a n k t i m e d e p o s i t s . Similarly, the i n c r e a s i n g s o p h i s t i c a t i o n w i t h w h i c h m o n e y is m a n a g e d (partly a f u n c t i o n o f the u p w a r d trend in i n t e r e s t r a t e s ) h a s s e r v e d reduce idle non-interest bearing cash balances liquid assets (M4). Technological improvements to (Mj) r e l a t i v e to t o t a l (such a s j e t a i r c r a f t a n d b a n k a u t o m a t i o n ) m u s t h a v e r e d u c e d the f l o a t o f c h e c k s in t r a n s i t 0/ on which depositors formerly counted, and future advances wire transfer) clearly will reduce such float dramatically (such a s further. A l l o f this m a k e s it e x t r e m e l y d i f f i c u l t to m e a s u r e the r e a l of monetary policy over time. It a l s o s t r o n g l y s u g g e s t s t a r g e t e d g r o w t h r a t e s in m o n e y - - h o w e v e r d e f i n e d — n e e d impact that to b e m o d i f i e d in o r d e r to p r o d u c e a n u n c h a n g e d s e c u l a r s t i m u l u s to e c o n o m i c activity. T h i s n e e d a p p e a r s to b e m o s t p r o n o u n c e d in the c a s e of M ^ , s i n c e c a s h b a l a n c e s a r e m o s t s u b j e c t to t e c h n o l o g i c a l obsolescence. F o r t h e s e r e a s o n s , I b e l i e v e it is p r e f e r a b l e t h a t t h e F e d e r a l R e s e r v e c o n t i n u e to e x e r c i s e d i s c r e t i o n a n d j u d g m e n t in m o n e t a r y m a n a g e m e n t a n d n o t b e m i s l e d b y those w h o a d v o c a t e the p u r s u i t o f a few simple strategies 8? for m o n e t a r y policy. I n F e d e r a l R e s e r v e s t a t i s t i c s , m o n e y is m e a s u r e d in t e r m s o f b a l a n c e s o n t h e b a n k ' s b o o k s — n o t in c u s t o m e r r e c o r d s . 1. A p p e n d i x Table: Behavior of Interest Rates and M o n e t a r y Aggregates 1 Before and After Cyclical Peaks and Full Employment Points Since M i d - 1 9 5 0 s Objectives and Indicators of Monetary Policy Economic Date C h a n g e from 6 months before Situation (January, 1953) Federal Reserve Policy D e s i r aible b l e O b j ce c t i v e Policy Results 2 ' Money Market Reference Point Cyclical Peak!/ J u l y , 1953 (January, 1954) . Restraint Adequate Expansion Inadequate Level During Month Conditions I n t e r e s t R a t e s (per c e n t ) F.R. Discount Rate 3 month Treasury Bill U . S . Gov't. (Long-term) C o r p . A a a (New I s s u e ) + .08 +.24 +.42 2.04 3.04 3.58 Free Reserves +1,006 366 C h a n g e to 6 months after ($ m i l l i o n s ) 2.00 -.86 -.35 -.45 +469 2. Appendix Table Objectives and Indicators Monetary Policy of Change 6 months from before (continued) Reference C h a n g e to 6 months after Point Money and Credit Aggregates ( A n n u a l R a t e s of C h a n g e : P e r c e n t ) M2 Bank 2. Economic Date 2.0 0.6 3.3 2.7 0.4 6.0 Credit Situation (December, 1954) Federal Reserve Policy Desirable Objective Policy Results Money Market Full Employment Point J u n e , 1955 (December, 1955) Restraint Adequate Restraint Adequate Conditions U Level During Month I n t e r e s t R a t e s (Per c e n t ) F.R. Discount Rate 3 month Treasury Bill U . S . Gov't. (Long-term) C o r p . A a a (New I s s u e ) + .25 +.27 + .23 2.82 +.21 3.13 + .75 +1.13 + .09 + .11 Free Reserves -290 168 - 413 ($ m i l l i o n s ) Money and Credit Aggregates ( A n n u a l R a t e s of C h a n g e : P e r c e n t ) Mi M2 Bank Credit 3.2 3.3 3.3 1.75 1.41 1.2 1.7 2.6 3. Appendix Table Objectives and Indicators Monetary Policy 3. Economic Date Change from 6 months before of Situation (January, 1957) Federal Reserve Policy Desirable Objective Policy Results Money Market Reference Cyclical Peak J u l y , 1957 3.60 +.31 4.62 Free Reserves -500 ($ m i l l i o n s ) -383 -.72 -.36 -.97 +505 cent) 0.1 -2.2 3.0 3.8 1.9 ( N o v e m b e r , 1959) 0.8 Cyclical Peak M a y , 1960 Restraint Adequate (November, 1960) Expansion Barely Adequate Level During Month Conditions I n t e r e s t R a t e s (per c e n t ) F.R. Discount Rate 3 month Treasury Bill U.S. Gov't. (Long-term) C o r p . A a a (New I s s u e ) 3.00 8/ +.05 Situation Money Market (January, 1958) Level During Month +.26 Federal Reserve Policy Desirable Objective Policy Results C h a n g e to 6 months after Expansion Inadequate I n t e r e s t R a t e s (per c e n t ) F.R. Discount Rate 3 month Treasury Bill U . S . Gov't, (Long-term) C o r p . A a a (New I s s u e ) Economic Date Point Restraint Adequate Conditions Money and Credit Aggregates (Annual R a t e s of C h a n g e : Per Mi M2 Bank Credit 4. (continued) -.86 -.35 -.35 4.00 3.29 4.74 4.74 -1.00 - .92 - .11 - .11 4. Appendix Table Objecttives a n d I n d i c a t o r s Monetary Policy Free Reserves of ($ m i l l i o n s ) Money and Credit Aggregates ( A n n u a l R a t e s of C h a n g e : P e r Mj M2 Bank Credit 5. Economic Date Change from 6 months before +400 Money Market Reference Point -33 C h a n g e to 6 months after +647 cent) 0.9 5.1 6.4 -3.2 -2.1 1.7 Situation (July, Federal Reserve Policy Desirable Objective Policy Results (continued) 1965) Full Employment Point J a n u a r y , 1966 (July, 1966) Restraint Quite Adequate Restraint Barely Adequate Level During Month Conditions I n t e r e s t R a t e s (per c e n t ) F.R. Discount Rate 3 month Treasury Bill U . S . Gov't. (Long-term) C o r p . A a a (New I s s u e ) +.50 +.75 +.31 +.19 4.50 4.59 4.52 4.81 -.09 +.32 + .67 Free Reserves +130 -44 -318 ($ m i l l i o n s ) Money and Credit Aggregates ( A n n u a l R a t e s of C h a n g e : P e r c e n t ) Mt M2 Bank Credit 6.7 10.1 9.9 2.1 5.6 6.9 Appendix Table Objectives and Indicators Monetary Policy 6. Economic Date of Situation (July, 1966) Federal Reserve Policy Desirable Objective Policy Results Money Market Free Reserves ($ m i l l i o n s ) Money and Credit Aggregates ( A n n u a l R a t e s of C h a n g e : P e r c e n t ) MX M2 Bank Credit Money Market -.08 -.34 -.05 346 C y c l i c a l P e a k 9/ J a n u a r y , 1967 Change 6 months from after (July, 1967) Expansion Especially Adequate 4.50 4.72 4.50 5.43 -.50 -.51 +.51 + .35 -16 288 0.5 4.3 4.4 (May, 1969) Conditions Point Level During Month Situation Federal Reserve Policy Desirable Objective Policy Results Reference Restraint Adequate Conditions I n t e r e s t R a t e s (Per c e n t ) F.R. Discount Rate 3 month Treasury Bill U.S. Gov't. (Long-term) C o r p . A a a (New I s s u e ) Economic Date C h a n g e from 6 months before 5. (continued) 8.5 12.0 11.0 Cyclical Peak N o v e m b e r , 1969 Restraint Adequate (May, 1970) Expansion Adequate Level During Month 6. Appendix Table Objectives and Indicators Monetary Policy of Change 6 months I n t e r e s t R a t e s (Per c e n t ) F.R. Discount Rate 3 month Treasury Bill U . S . Gov't. (Long-term) C o r p . A a a (New I s s u e ) Free Reserves 1/ 2/ 3/ 4/ 5/ 6/ Tj 8/ j?/ Reference Point Change from 6 months after 6.00 +1.21 + ($ m i l l i o n s ) M o n e y and C r e d i t A g g r e g a t e s ( A n n u a l R a t e s of C h a n g e : Per M M2 Bank Credit from before (continued) .63 1.10 +114 7.24 6.74 8.32 -988 -.40 +.50 +.78 +223 cent) 2.1 0.4 2.9 5.4 5.0 4.3 C y c l i c a l t u r n i n g p o i n t s i d e n t i f i e d b y the N a t i o n a l B u r e a u o f E c o n o m i c R e s e a r c h . Objectives required by a flexible, contra-cyclical monetary policy. A s s e s s m e n t o f r e s u l t s is b a s e d on a c t u a l b e h a v i o r of i n t e r e s t r a t e s , r e s e r v e s , and m o n e t a r y a g g r e g a t e s during period indicated. C o n s i s t s of c u r r e n c y p l u s d e m a n d d e p o s i t s . C o n s i s t s of M ^ p l u s t i m e d e p o s i t s a t c o m m e r c i a l b a n k s o t h e r t h a n c e r t i f i c a t e s o f d e p o s i t in e x c e s s of $ 1 0 0 , 0 0 0 . L o a n s a n d i n v e s t m e n t s a t c o m m e r c i a l b a n k s (end of m o n t h s e r i e s ) . Point at which excess aggregate demand threatened generalized inflation. Periods (arbitrarily chosen) a n d r e l a t e d u n e m p l o y m e n t r a t e s w e r e : M a y , 1 9 5 1 , 3 p e r c e n t ; J u n e , 1 9 5 5 , 4 p e r c e n t ; J a n u a r y , 1 9 6 6 , 4 per c e n t . The F e d e r a l R e s e r v e D i s c o u n t r a t e w a s r a i s e d to 3 - 1 / 2 p e r c e n t in A u g u s t , 1 9 5 7 , a n d s u b s e q u e n t l y r e d u c e d to 3 p e r c e n t in m i d - N o v e m b e r of the s a m e y e a r . C y c l i c a l p e a k u s e d b y the U . S . B u r e a u o f the C e n s u s in e s t a b l i s h i n g the t u r n i n g p o i n t for the 1 9 6 6 - 6 7 mini-recession.
@FedFRASER