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Paper presented a t the 19o9 Money and Banking
Workshop, Federal Reserve Bank of M i n n e a p o l i s , May 9 , 1 9 6 9 .

Sherman J . M a i s e l , Governor
Federal Reserve System
Washington, D. C .

^ want today to comment informally on two issues of m o n e t a r y and Federal
Reserve policy which seem to me to be mistreated in much of the economic

I don't think that the traditional view is necessarily

Wrong, but it does I believe lead to a misinterpretation of both what
Federal Reserve does and secondly of the time period within which we
should expect to measure the results of alteration in monetary policy.


y first point is'that I believe that most p e o p l e , including, unfortunately,


n y in the Federal Reserve S y s t e m , have an incorrect idea of how m o n e t a r y

Policy w o r k s , and of how the Federal Reserve controls monetary policy.
all know the elementary textbook case in which the Federal Reserve

e a t e s reserves and thereby bank d e p o s i t s .

l s

In the one-bank case, money

created based upon the amount of new reserves and the reserve ratio.
the next more complicated textbook case, we show five or six banks


d show that it takes a little while for the new reserves to be multi-

Plied into a given amount of m o n e y .
0 u t

When we are sophisticated, we point

in modern terminology that banks are profit making organizations and

therefore don't create m o n e y a u t o m a t i c a l l y .

Banks m u s t want assets


e f o r e they create liabilities.


a n k s don't automatically create liabilities, but sometimes


h e i r excess reserves.

Since these are not always available,

(Although in the last ten y e a r s , this complication

^°esn't add m u c h because the amount of change in excess reserves has not
been great.)


you teach according to these cases you might conclude, as do m a n y

People, that last month the Federal Reserve by creating y reserves


*creased the m o n e y supply by x % .

O r , you might point out that in April

he Federal Reserve increased the m o n e y supply by 117 and then decreased



l n

by 2% in M a y .

These figures trigger lots of articles stating how

n the Federal Reserve be so foolish.

W h y do they create so much money

one month and then decrease it the next?

Wouldn't it be much better

they would just create reserves at a given rate and call it quits?
^•he a n s w e r , I b e l i e v e , is that the textbooks do not paint an accurate
Picture of how the Federal Reserve influences the m o n e y supply even though
l t

is suggested in the more advanced literature such as in articles by

Tiegan or G u t e n t o g .

The point that I want to stress is this--under present p o l i c i e s , reserves
and the m o n e y supply are endogenous not exogenous v a r i a b l e s .

The Fed

influences them, but Federal Reserve policy variables are only some among
many forces impinging on their g r o w t h .

What the Federal Reserve does

is to influence the m a r g i n a l cost of m o n e y to b a n k s .

o s t s change, banks alter their a s s e t s .

When their m a r g i n a l

It becomes more or less worth-

while for a bank to sell or purchase investments.

Depending upon changes

in market conditions, the bank w i l l change their asset h o l d i n g s .

As a

result, banks w i l l also change their liabilities to the same e x t e n t .
Depending upon what form their liabilities take, the narrowly defined
money supply or time deposits or demand deposits or government deposits
Will a l t e r .

As a result, the bank's required reserves two weeks from

now w i l l change.

The F e d e r a l Reserve under its present operating

Will furnish most of those required reserves.


Reserves are furnished

after the fact, after the m o n e y supply has increased or the amount of
hank liabilities and assets have increased.

Reserves are furnished as


i r t u a l l y an automatic p r o c e s s .


o when you teach about the Federal Reserve, you should say that the

Federal Reserve changes its policies in order to change the m a r g i n a l

o s t of m o n e y to the b a n k s .

As a result of altered cost-price

ships, the growth of monetary aggregates or, in the assets and
banks is a l t e r e d .


Under this strategy, the operational directives

° the open market committee to the manager of the open market account
say, "Change the rate at which you are purchasing bills in the open
market in order to influence those short-term rates upon which you have
^ e greatest impact."

These rates are those for Federal Funds and

dealer borrowing rates.

Such rates plus m a n y other factors


the treasury bill rate.

For e x a m p l e ^ ^ u r r e n t l y , because the Treasury

has gotten to the point where it is paying off debt on a seasonal basis
instead of b o r r o w i n g , it probably has m o r e impact on the three month
hill rate than the Federal -Reserve does in any given w e e k .




There are

other important influences such as state funds, corporation


Assume that you are at a given level of short-term rates, the

e d open market operations may move the Fed Fund rate by 10, 15, or 20

basis points and their pressure on the bill rate in the same w a y .


the same time, h o w e v e r , other market pressures m a y have a greater
impact in the opposite d i r e c t i o n .

All of these conflicting movements

take place with some relationship to the discount rate.

So that if

the discount rate, is m o v e d , there is a new peg around which these other

ates are a l i g n e d .

Let me write this strategy as a set of relationships.

How does the Fed

influence what I call the intermediate m o n e t a r y variable?


(intermediate m o n e t a r y variable) can be a m o n e t a r y aggregate.
People m i g h t define it as interest rates.


Many would probably think of

it as either bank assets or liabilities, or they might think of it as
°ne type of bank asset or bank


^his picture of operations can be expressed
Whe re:






Free reserves


Q ceiling


Treasury bill rate
Federal funds rate


Call money rate to dealers


Economic activity
L i q u i d i t y preference of corporations, b a n k s ,
financial institutions, e t c .
Treasury cash management


Discount rate








Intermediate moruTtra^y variable






Open market operations







= M (R^



Rp, Q , r b , r f , r c > G N P , L , T)









T )


( 2


The change in the intermediate m o n e t a r y v a r i a b l e , however d e f i n e d , is
determined by the interaction of the Federal Reserve controlled varia

b l e s ; certain m o n e y market rates strongly influenced by the Federal

Reserve; changes in output and prices; m o v e m e n t s in the financial sector
liquidity functions; and the Treasury as in (1.0).

The Federal Reserve action m a y influence directly the I M V .

It also w i l l

influence m o n e y m a r k e t rates as in (2.0).
Rb; Rf





R ( RR, S)


T^e change in the intermediate m o n e t a r y variable approximately determines

he change in required reserves two weeks later (3.0).

Given the change

required reserves, the manager of the Open M a r k e t Account can (within
limits of his operating m i s s e s ) determine exactly the level of net
free reserves (4.0).

The banking system, given a level of net free

e s e r v e s , determines its own level of borrowings and excess reserves


other w o r d s , this IMV then is a function of such things as:


mount of net borrowed reserves in the System; regulations such as Q .
the past three months the relationship of market rates to Q has had



major impact upon bank assets and bank liabilities.)

It also depends

Pon short-term rates--say the short-term rate on the Treasury b i l l ,

^ e short-term rate on Federal F u n d s , the short-term rate on dealer

It also obviously depends on what is happening to the e c o n o m y .

W i l l depend upon the liquidity preference function of the e c o n o m y ,
in the short run will depend very greatly on treasury operations-If the treasury borrows and how the treasury handles its cash b a l a n c e s .
* you look at banks you'll note that the treasury balances in banks
fluctuate from three to eight billion or w i l l fluctuate by five
^^llion over rather short-term p e r i o d s .

The amount of change in bank

s e t s and bank liabilities results from an interplay of all these


It does not result from the fact that the Federal Reserve says


to a

next month we're going to create $22,000.00 of reserves in order

lter bank assets and liabilities by $ 1 0 0 , 0 0 0 . 0 0 .

That is m y first


As a

related item to this first p o i n t , let me call attention to the need


°r more careful definition and use of the concept of the m o n e y supply.


you look at the rates of growth in the monetary a g g r e g a t e s , everybody


be impressed by the tremendous differences in period-to-period

d e m e n t s of the different definitions of the m o n e y supply.


you would expect to happen would vary greatly depending which
^ e t a r y aggregates you believe in.



We now are at a period when the

e r e n c e s among the rates of change in these variables have been very



y Q U

believe that short-run m o v e m e n t s are important you would

*Pect the economy to react in a very different m a n n e r , depending on
definition you trusted.


For e x a m p l e , I have here a breakdown

8 back approximately 16 m o n t h s .

It is divided into three periods.

first period the bank credit proxy (roughly equivalent to the

° Friedman M 0 ) rose at an annual rate of 3 1/27. at the same time


narrowly defined m o n e y supply grew at a rate of 87.


In the next

°d they changed at annual rates of 14.1 and 3 . 4 , respectively.
in the last period M 2 declined at a rate of - 3 . 2 7 while M x w a s


*g at 37.



As you can s e e , these are rather large differences.


means that we need some w a y of deciding which among these m o n e t a r y

&gregates to use.

It also m a y mean that we need some way of deciding

are logical periods when we talk about the monetary aggregates.

know that over five years differences aren't great'.

But in a year

^ o y e a r s , particularly with the sorts of policies we have been
/ S V i n

8 , their movements vary a good d e a l .

. second point is to call attention to a problem in relating monetary

° l i c y and monetary theory.


Currently^w^jreally have two or three

types of m o n e t a r y theories.

T h e s e , h o w e v e r , have to be broadened

Set explanations as to how and when monetary policy w i l l alter price,


and e m p l o y m e n t .

' ,





As e c o n o m i s t s , we normally list five ways in w h i c h m o n e t a r y policy
influences the level of spending.

(If w e are pure quantity

don't have to be concerned with the level of spending.
^ a t monetary policy is going to affect prices directly.)
U s


We can say
But m o s t of

are probably not pure quantity theorists and we're not willing to

g r e e that in M V = P O , "V" and "0" are constants, and that therefore
is a direct function of "M".

assume that all four of these factors are v a r i a b l e s .

We must explain

how m o n e t a r y policy influences spending rather than velocity a l o n e .
W a

y is through the stock of m o n e y - - t h i s is the simplest and most direct


Changes in the amount of m o n e y are directly transmitted

changes in spending.


Questions do arise as to what constitutes m o n e y .

They have been very important in recent p e r i o d s .
a s


There are also questions

to w h e t h e r changes in m o n e y and^spending are or are not p r o p o r t i o n a l .
other w o r d s , what is the degree to which "V" varies and the degree


o which you can predict changes in "V"?

^hat time lags exist?
1 3

What variables influence "V"? •

Are these long or short?

Are they regular or -

But the general point of those who stress the stock of m o n e y

a belief that people w i l l spend less when they hold less m o n e y .


decrease in the rate of m o n e y creation will be followed by a fall in the
rate of new spending.

second path from changes in monetary policy to changes in spending
is through the cost of c a p i t a l .

This is a good Keynesian approach.

The level of interest rates is an important factor determining the
amount purchasers w i l l spend on real estate and other long-lived a s s e t s .
If interest rates rise ceteris p a r i b u s , less should be spent on plant

n d e q u i p m e n t , on h o u s i n g , probably also on consumer durables and on



Third we have the wealth e f f e c t .

n c e d by their net w o r t h .


o r t h falls.

This says consumer spending is influ-

Consumers w i l l demand less when their net

T h e r e f o r e , m o n e t a r y policy has a deflationary impact inso-




far as it tends to lover the prices of stocks and b o n d s .
lovers the assets of h o u s e h o l d s , they spend


The fourth path is through the availability of credit.
monetary p o l i c y , you make credit less a v a i l a b l e .
rationing in particular a r e a s .
make credit more a v a i l a b l e .

W h e n it

If you tighten

This leads to credit

On the other hand when you e x p a n d , you

Banks can increase their intermediation or

banks create credit which goes into the hands of spenders.

The spenders

then p u r c h a s e , and you get a m u l t i p l i e r effect as a result of the new

Finally, spending might be influenced by psychology or expectations.
This raises the question of how much people do or do not change their
spending policy as a result of psychology or e x p e c t a t i o n s .

These are the five channels between m o n e t a r y policy and spending.


concerns me is that when I look at most monetary theory, whether it
stresses portfolio adjustment or the wealth impact, or the cost of

a p i t a l - - a n d to a certain e x t e n t , the m o n e y stock--all are theories

under which we would expect v e r y long lags between policy changes and
movements in prices and e m p l o y m e n t .

In fact, if you look at the

Brookings or the FRB-MIT econometric m o d e l s , or similar o n e s , you find
only a little monetary impact on p r i c e s , for three years or so.


Probably don't get even half your price impact until w e l l after the
third y e a r .

The price impact of any change in monetary policy this

year in fact w i l l still be felt four or more years from n o w .

In contrast, some have taken the m o n e y stock theory and have run regressions which seem to say, w e ' l l get a spending impact in an average
of about nine m o n t h s .

If you put your trust in those m o d e l s , you

Probably get about 50% of your spending impact between the 8th and 13th

You still, h o w e v e r , have to move from that spending impact and

ask when w i l l prices be changed.
into the future.

Again this puts you out a long time

I won't argue about the validity of those regressions

or the v a l i d i t y of those theories.

In any c a s e , I think one m i g h t agree

^ a t w h i c h e v e r basic theory we teach t h e m , they don't give you much
short-run impact for m o n e t a r y p o l i c y .


would g u e s s , h o w e v e r , that if we go beyond the simplified


can find a basis for believing in a shorter run impact.

What m u s t

he done is to add to the theories as they now stand a credit availability
and expectations factor.

W h i l e I don't give m u c h weight to e x p e c t a t i o n s ,

would note that some of m y colleagues put a great deal of weight on


I personally would put m o s t of m y stress on availability and the

impact on spending of the creation of c r e d i t .

I think these do explain

o w m o n e t a r y policy has a shorter run impact by limiting or increasing

the amount of credit banks and financial institutions can create and
thereby shifting directly spending functions.

But it seems to me that

if you stick with the m o r e traditional m o n e t a r y theories, you really

°n't find m u c h reason for using monetary policy--certainly not for


ountercyclical purposes.

You would have to conclude from these


that m o n e t a r y policy ought just to do its thing by remaining almost
constant along some line and sticking close to it.

H o w e v e r , if you

look at availability and e x p e c t a t i o n s , then I believe you can find some
reason for shifts in p o l i c y .