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November 10, 2006

Monetary Aggregates and Monetary Policy at the Federal Reserve:
A Historical Perspective

Remarks
by
Ben S. Bernanke
Chairman
Board of Governors of the Federal Reserve System
before the
Fourth ECB Central Banking Conference
Frankfurt, Germany
November 10, 2006

My topic today is the role of monetary aggregates in economic analysis and
monetary policymaking at the Federal Reserve. I will take a historical perspective, which
will set the stage for a brief discussion of recent practice.
The Federal Reserve's responsibility for managing the money supply was
established at its founding in 1913, as the first sentence of the Federal Reserve Act
directed the nation's new central bank "to furnish an elastic currency."! However, the
Federal Reserve met this mandate principally by issuing currency as needed to damp
seasonal fluctuations in interest rates, and during its early years the Federal Reserve did
not monitor the money stock or even collect monetary data in a systematic way.2, 3
The Federal Reserve's first fifteen years were a period of relative prosperity, but
the crash of 1929 ushered in a decade of global financial instability and economic
depression. Subsequent scholarship, notably the classic monetary history by Milton
Friedman and Anna J. Schwartz (1963), argued that the Federal Reserve's failure to
stabilize the money supply was an important cause of the Great Depression. That view
today commands considerable support among economists, although I note that the
sources ofthe Federal Reserve's policy errors during the Depression went much deeper
than a failure to understand the role of money in the economy or the lack of reliable
monetary statistics. Policymakers of the 1930s observed the correlates of the monetary
contraction, such as deflation and bank failures. However, they questioned not only their
own capacity to reverse those developments but also the desirability of doing so. Their
hesitancy to act reflected the prevailing view that some purging of the excesses of the
1920s, painful though it might be, was both necessary and inevitable.

- 2-

In any case, the Federal Reserve began to pay more attention to money in the
latter part of the 1930s. Central to these efforts was the Harvard economist Lauchlin
Currie, whose 1934 treatise, The Supply and Control 0/Money in the United States, was
among the first to provide a practical empirical definition of money. His definition,
which included currency and demand deposits, corresponded closely to what we now call
Ml. Currie argued that collection of monetary data was necessary for the Federal
Reserve to control the money supply, which in turn would facilitate the stabilization of
the price level and of the economy more generally.4 In 1934, Marriner Eccles asked
Currie to join the Treasury Department, and later that year, when Eccles was appointed to
head the Federal Reserve, he took Currie with him. Currie's tenure at the Federal
Reserve helped to spark new interest in monetary statistics. In 1939, the Federal Reserve
began a project to bring together the available historical data on banking and money.
This effort culminated in 1943 with the publication of Banking and Monetary Statistics,
which included annual figures on demand and time deposits from 1892 and on currency
from 1860.
Academic interest in monetary aggregates increased after World War IT. Milton
Friedman's volume Studies in the Quantity Theory o/Money, which contained Phillip
Cagan's work on money and hyperinflation, appeared in 1956, followed in 1960 by
Friedman's A Program/or Monetary Stability, which advocated that monetary policy
engineer a constant growth rate for the money stock. Measurement efforts also
flourished. In 1960, William 1. Abbott of the Federal Reserve Bank ofSt. Louis led a
project that resulted in a revamping of the Fed's money supply statistics, which were

-3subsequently published semimonthly. 5 Even in those early years, however, financial
innovation posed problems for monetary measurement, as banks introduced new types of
accounts that blurred the distinction between transaction deposits and other types of
deposits. To accommodate these innovations, alternative definitions of money were
created; by 1971, the Federal Reserve published data for five definitions of money,
denoted M1 through M5. 6
During the early years of monetary measurement, policymakers groped for ways
to use the new data. 7 However, during the 1960s and 1970s, as researchers and
policymakers struggled to understand the sharp increase in inflation, the view that
nominal aggregates (including credit as well as monetary aggregates) are closely linked
to spending growth and inflation gained ground. In 1966, the Federal Open Market
Committee (FOMC) began to add a proviso to its policy directives that bank credit
growth should not deviate significantly from projections; a similar proviso about money
growth was added in 1970. In 1974, the FOMC began to specify "ranges of tolerance"
for the growth ofM1 and for the broader M2 monetary aggregate over the period that
extended to the next meeting of the Committee. 8
In response to House Concurrent Resolution 133 in 1975, the Federal Reserve

began to report annual target growth ranges, 2 to 3 percentage points wide, for M1, M2, a
still broader aggregate M3, and bank credit in semiannual testimony before the Congress.
In an amendment to the Federal Reserve Act in 1977, the Congress formalized the

Federal Reserve's reporting of monetary targets by directing the Board to "maintain long
run growth of monetary and credit aggregates ... so as to promote effectively the goals of

-4maximum employment, stable prices, and moderate long-term interest rates.,,9 In
practice, however, the adoption oftargets for money and credit growth was evidently not
effective in constraining policy or in reducing inflation, in part because the target was not
routinely achieved. 10
The closest the Federal Reserve came to a "monetarist experiment" began in
October 1979, when the FOMC under Chairman Paul Volcker adopted an operating
procedure based on the management of non-borrowed reserves. I I The intent was to focus
policy on controlling the growth ofM! and M2 and thereby to reduce inflation, which
had been running at double-digit rates. As you know, the disinflation effort was
successful and ushered in the low-inflation regime that the United States has enjoyed
since. However, the Federal Reserve discontinued the procedure based on non-borrowed
reserves in 1982. It would be fair to say that monetary and credit aggregates have not
played a central role in the formulation of U.S. monetary policy since that time, although
policymakers continue to use monetary data as a source of information about the state of
the economy.
Why have monetary aggregates not been more influential in U.S. monetary
policymaking, despite the strong theoretical presumption that money growth should be
linked to growth in nominal aggregates and to inflation? In practice, the difficulty has
been that, in the United States, deregulation, financial innovation, and other factors have
led to recurrent instability in the relationships between various monetary aggregates and
other nominal variables. For example, in the mid-1970s, just when the FOMC began to
specify money growth targets, econometric estimates ofMl money demand relationships

-5-

began to break down, predicting faster money growth than was actually observed. This
breakdown--dubbed "the case ofthe missing money" by Princeton economist Stephen
Goldfeld (1976)--significantly complicated the selection of appropriate targets for money
growth. Similar problems arose in the early 1980s--the period of the Volcker
experiment--when the introduction of new types of bank accounts again made Ml money
demand difficult to predict. 12 Attempts to find stable relationships between Ml growth
and growth in other nominal quantities were unsuccessful, and formal growth rate targets
for Ml were discontinued in 1987.
Problems with the narrow monetary aggregate Ml in the 1970s and 1980s led to
increased interest at the Federal Reserve in the 1980s in broader aggregates such as M2.
Econometric methods were also refined to improve estimation and to accommodate
more-complex dynamics in money demand equations. For example, at a 1988 conference
at the Federal Reserve Board, George Moore, Richard Porter, and David Small presented
a new set ofM2 money demand models based on an "error-correction" specification,
which allowed for transitory deviations from stable long-run relationships (Moore, Porter,
and Small, 1990). One of these models, known as the "conference aggregate" model,
remains in use at the Board today. About the same time, Board staff developed the socalled p* (P-star) model, based on M2, which used the quantity theory of money and
estimates of long-run potential output and velocity (the ratio of nominal income to
money) to predict long-run inflation trends. The p* model received considerable
attention both within and outside the System; indeed, a description of the model was
featured in a front-page article in the New York Times.

13

- 6-

Unfortunately, over the years the stability of the economic relationships based on
the M2 monetary aggregate has also come into question. One such episode occurred in
the early 1990s, when M2 grew much more slowly than the models predicted. Indeed,
the discrepancy between actual and predicted money growth was sufficiently large that
the p* model, ifnot subjected to judgmental adjustments, would have predicted deflation
for 1991 and 1992. Experiences like this one led the FOMe to discontinue setting target
ranges for M2 and other aggregates after the statutory requirement for reporting such
ranges lapsed in 2000.
As I have already suggested, the rapid pace of financial innovation in the United
States has been an important reason for the instability of the relationships between
monetary aggregates and other macroeconomic variables. 14 In response to regulatory
changes and technological progress, U.S. banks have created new kinds of accounts and
added features to existing accounts. More broadly, payments technologies and practices
have changed substantially over the past few decades, and innovations (such as Internet
banking) continue. As a result, patterns of usage of different types of transactions
accounts have at times shifted rapidly and unpredictably.
Various special factors have also contributed to the observed instability. For
example, between one-half and two-thirds ofD.S. currency is held abroad. As a
consequence, cross-border currency flows, which can be estimated only imprecisely, may
lead to sharp changes in currency outstanding and in the monetary base that are largely
unrelated to domestic conditions. 1s, 16

-7The Board staff continues to devote considerable effort to modeling and
forecasting velocity and money demand. The standard model of money demand, which
relates money held to measures of income and opportunity cost, has been extended to
include alternative measures of money and its detenninants, to accommodate special
factors and structural breaks, and to allow for complex dynamic behavior of the money
stoCk. 17 Forecasts of money growth are based on expert judgment with input from
various estimated models and with knowledge of special factors that are expected to be
relevant. Unfortunately, forecast errors for money growth are often significant, and the
empirical relationship between money growth and variables such as inflation and nominal
output growth has continued to be unstable at times. IS
Despite these difficulties, the Federal Reserve will continue to monitor and
analyze the behavior of money. Although a heavy reliance on monetary aggregates as a
guide to policy would seem to be unwise in the U.s. context, money growth may still
contain important information about future economic developments. Attention to money
growth is thus sensible as part ofthe eclectic modeling and forecasting framework used
by the U.s. central bank.

-8References
Anderson, Richard G. and Kenneth A. Kavajecz (1994). "A Historical Perspective on the
Federal Reserve's Monetary Aggregates: Definition, Construction and Targeting,"
Federal Reserve Bank ofSt. Louis Review, MarchiApril, pp. 1-31.
Board of Governors of the Federal Reserve System (1943). Banking and Monetary
Statistics, 1914-1941. Washington: Board of Governors of the Federal Reserve System.
---------- (1960). "A New Measure of the Money Supply," Federal Reserve Bulletin, vol.
46 (October), pp .. 102-23.
---------- (1976). Banking and Monetary Statistics, 1941-1970. Washington: Board of
Governors of the Federal Reserve System.
----- (1998). Federal Reserve Act and Other Statutory Provisions Affecting the Federal
Reserve System. Washington: Board of Govemors of the Federal Reserve System.
Bremner, Robert P. (2004). Chairman of the Fed: William McChesney Martin Jr. and
the Creation ofthe American Financial System. New Haven: Yale University Press.
Carpenter, Seth and Joe Lange (2003). "Money Demand and Equity Markets." Federal
Reserve Board Finance and Economics Discussion Series, 2003-3. Washington: Board
of Governors of the Federal Reserve System, February.
Currie, Lauchlin (1935). The Supply and Control ofMoney in the United States, red.
Cambridge: Harvard University Press.
-----------, ed. (1956). Studies in the Quantity Theory ofMoney. Chicago: University of
Chicago Press.
Friedman, Milton (1960). A Program/or Monetary Stability. New York: Fordham
University Press.
Friedman, Milton and Anna J. Schwartz. (1963). A Monetary History of the United
States, 1867-1960. Princeton: Princeton University Press.
Goldfeld, Stephen M. (1976). ''The Case of the Missing Money." Brookings Papers on
Economic Activity, 3:1976, pp. 683-739.
Hallman, Jeffrey J., Richard D. Porter and David H. Small (1991). "Is the Price Level
Tied to the M2 Monetary Aggregate in the Long Run?" American Economic Review,
81(September), pp. 841-858.

..
- 9Humphrey, Thomas M. (1986). "The Real Bills Doctrine," in Thomas M. Humphrey,
Essays on Inflation. Richmond: Federal Reserve Bank of Richmond.
Judson, Ruth and Seth Carpenter (2006). "Modeling Demand for M2: A Practical
Approach," unpublished manuscript, Board of Governors of the Federal Reserve System,
Division of Monetary Affairs, October.
Kilborn, Peter T. (1989). "Can Inflation Be Predicted? Federal Reserve Sees a Way,"
New York Times, June 13.
Mankiw, N. Gregory and Jeffrey A. Miron (1986). "The Changing Behavior ofthe Tenn
Structure of Interest Rates," Quarterly Journal of Economics, 101(2), pp. 211-228.
Meltzer, Allan H. (2003). A History of the Federal Reserve. Volume 1: 1913-1951.
Chicago: University of Chicago Press.
Moore, George R., Richard D. Porter, and David H. Small (1990). "Modeling the
Disaggregated Demands for M2 and Ml: The U.S. Experience in the 1980s," in Peter
Hooper et. aI., eds., Financial Sectors in Open Economies: Empirical Analysis and Policy
Issues. Washington: Board of Governors of the Federal Reserve System, pp. 21-105.
O'Brien, Yueh-Yun C. (2005). "The Effects of Mortgage Prepayments on M2." Federal
Reserve Board Finance and Economics Discussion Series, 2005-43.
U.S. Department of the Treasury (2006). The Use and Counterfeiting of United States
Currency Abroad, Part 3. Washington: Department of the Treasury.

1 Board of Governors of the Federal Reserve System (1998), 1-001. In his recent history of the Federal
Reserve, Allan Meltzer (2003, p. 66) notes of some of the Act's proponents that: "[0]ne of their principal
aims was to increase the seasonal response, or elasticity, of the note issue by eliminating the provisions of
the National Banking Act that tied the amount of currency to the stock of government bonds."
2 See Mankiw and Miron (1986) for a discussion of the Fed's seasonal interest-rate smoothing. The
Federal Reserve did publish data on the issuance of Federal Reserve notes from its inception. Federal
Reserve notes were only part of total currency in circulation, however, the remainder being made up of
national bank notes, United States notes, Treasury notes, gold and silver certificates, and gold and silver
coin. Beginning in 1915, the Federal Reserve Bulletin included data on currency that had been collected by
the Treasury and data on total bank deposits that had been collected by the Office of the Comptroller of the
Currency as a byproduct of its regulatory role, but publication was irregular.
3 Indeed, the Federal Reserve's adherence to the real bills doctrine--which counseled against active
monetary management in favor of supplying money only as required to meet ''the needs oftrade"--gave the
new institution little reason to pay attention to changes in the money stock. See Humphrey (1986) for a
history of the real bills doctrine. The constraints of the gold standard also restricted (without entirely
precluding) active monetary management by the Federal Reserve.

..
- 10In the second edition of his book, Currie (1935) wrote: "The achievement of desirable objectives ... rests
entirely upon the effectiveness of control. The achievement, for example, of the objective of a price level
varying inversely with the productive efficiency of society demands a highly energetic central banking
policy and a high degree of effectiveness of monetary control. .. Even for the achievement of the more
modest obj ective of lessening business fluctuations by monetary means, the degree of control of the central
bank is of paramount importance." (pp. 3-4).
5 Board of Governors of the Federal Reserve System (1960).
6 In 1971, M1 was currency and demand deposits at commercial banks. M2 was M1 plus commercial bank
savings and small time deposits, and M3 was M2 plus deposits at mutual savings banks, savings and loans,
and credit unions; data from the latter type of institution were available only monthly. M4 was M2 plus
large time deposits, and M5 was M3 plus large time deposits. Changes in defInitions make it difficult to
track the historical development of the various monetary aggregates. Approximately, the 2006 defInition of
M1 is equivalent to this older defInition, the 2006 defInition ofM2 is equivalent to the older defmition of
M3, and the defmition ofM3 at its date oflast publication was equivalent to the older definition of MS.
M4 and M5 were dropped in a 1980 redefmition of the monetary aggregates. See Board of Governors of
the Federal Reserve System (1976), pp. 10-11 and Anderson and Kavajecz (1994).
7 For instance, in late 1959 and early 1960, money growth declined as other economic indicators rose. The
minutes of the December 1959 FOMC meeting report Chairman Martin as saying, "I am unable to make
heads or tails of the money supply," but those of the February 1960 meeting record his comment that "the
System ought to be looking at the growth of the money supply." For further discussion, see Bremner
(2004), pp. 141-142.
8 M2 now includes currency and demand deposits (the components ofMl) plus time deposits, savings
deposits, and non-institutional money market funds.
9 Board of Governors of the Federal Reserve System (1998),1-017
\0 Monetarists criticized the use of multiple targets, rather than a single objective. Another object of
criticism was "base drift," a set of practices that had the effect ofre-setting the base from which money
growth targets were calculated when the growth of one or more monetary aggregates exceeded the upper
end of the Federal Reserve's target range.
11 Whether the Federal Reserve's policies under Chairman Vo1cker were "truly" monetarist was a muchdebated question at the time.
12 The new accounts included negotiable-order-of-withdrawal (NOW) accounts and money market deposit
accounts.
13 Hallman, Porter, and Small (1991) and Kilborn (1989).
14 Another possible explanation for this instability is the Goodhart-Lucas law, which says that any empirical
relationship that is exploited for policy purposes will tend to break down. This law probably has less
applicability in the United States than in some other countries, as the Federal Reserve has not
systematically exploited the relationships of money to output or inflation, except perhaps to a degree in
1979-82.
IS For a recent summary, see U.S. Department of the Treasury (2006).
16 As another example, U.S. regulations require servicers of mortgage-backed securities to hold mortgage
prepayments in deposits counted as part of M2 before disbursing the funds to investors. A wave of
mortgage refInancing and the resulting prepayments can thus have signifIcant effects on M2 growth that are
only weakly related to overall economic activity. See O'Brien (2005) for more discussion.
17 See Judson and Carpenter (2006) for a summary. A special factor that helps to explain some episodes of
variable money demand is stock market volatility (Carpenter and Lange, 2003).
18 A recent example of instability occurred in the fourth quarter of2003, when M2 shrank at the most rapid
rate since the beginning of modem data collection in 1959 without any evident effects on prices or nominal
spending. Subsequent analysis has explained part of the decline in M2 (the transfer of liquid funds into a
recovering stock market was one possible cause), and data revisions have eliminated an additional portion
of the decline, but much of the drop remains unexplained even well after the fact.
4