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K-J'D in r e c o r d s s e c t i o n 3 1970 Thfe Trade-Off Between Short-and Long-Term Polic^ Goals James L. Pierce i ---- The existence of long lags in the response of the real sectors of the economy to changes in monetary policy instruments is well documented. These lags may require an horizon for monetary policy strategies which spans many calendar quarters. Even if long planning horizons are desirable, specific operating strategies still must be adopted for the actual short-run conduct of monetary policy. however, should be consistent with the long-term goals. \ These, If short-run considerations such as stabilization of money market interest rate movements cause modification of the operating strategy, the long-run goals in terms of income, employment and the price level may suffer. The purpose of this paper is to discuss some of the areas in which short and long-term goals may conflict and to attempt to evaluate the costs to the long-term targets of imposing short-run side conditions on policy actions. I. Short-Run vs Long-Run Goals Available econometric evidence indicates that variations in monetary policy instruments can exert little influence on the non financial sectors of the economy in the short run. For example, experiments with a recent version of the FRB-MIT econometric model indicate that, other things equal, a $1 billion increase in the money stock in a given quarter will produce only a $.3 billion increase in * I should like to thank William Poole for his constructive comments on an earlier version of this paper. -2- nominal GNP in that quarter. Further, inspection of the coefficients for the relevant equations in the model suggest that even this small response is probably overstated. It is interesting to note that the long-run multiplier relation between money and nominal GNP is substantial. Other things equal a $1 billion permanent rise in the money stock leads to a permanent increase in nominal OTP of approximately $3.2 billion. Given the short-run multiplier, attempts to establish shortrun (quarter by quarter) control over the economy may require varia tions in policy instruments which are unacceptably large. may clarify the issue. An example Assume that during a generally inflationary period, the decision is made to attempt to stop the inflation within a single quarter. To accomplish this end, a sharp rise in interest rates, and probably a substantial reduction in the levels of the monetary aggregates, would be required during the quarter. Even if this strategy were successful, a new problem would immediately develop. With the passage of time beyond the quarter, the economy would continue its deflationary adjustment--probably at an increased rate--in response to the monetary restriction. If an over-response of the economy to the original policy restriction is to be avoided, policy must reverse itself immediately by sharply reducing interest rates and expanding the mone tary aggregates. This easing of policy would require in turn a restrictive policy the next quarter. Thus, by never looking more than one quarter ahead, large short-term reversals of policy would be required -3- to stabilize the economy. Whether or not this mgropic strategy of trying to hit targets in the real sector on a quarter by quarter basis can be successful over the long run depends among other things upon the existing parameters of the system. — ^It is quite possible that pursuit of such a strategy would have no long run future because ever larger changes in monetary policy instruments would be required to achieve stability in the real sector. Even if the strategy would produce permanent economic stability it could create extreme fluctuations in financial markets. It is quite possible, however, that large fluctuations in financial variables would alter interest rate expectations sufficiently to greatly weaken the efficacy of the myopic policy strategy. Rapid reversals of monetary policy may encourage investors to expect wide fluctuations in the path of short-term interest rates. In this situation, efforts to reduce long-term rates would be thwarted by investor expectations of a rise in rates in the near future. Thus, the pursuit of the myopic policy strategy could be self-defeating. There are two obvious ways to approach the problem posed by the small amount of short-term control over the economy. First, monetary policy could pursue the myopic rule of attempting to hit a target quarter by quarter but subject the strategy to constraints imposed by financial conditions. Thus, a specific target value for employment or the price 1/ For a simple treatment of this problem see E. Gramlich, "The Usefulness of Monetary and Fiscal Policy as Discretionary Stabilization Tools", a paper presented at the A.B.A. Conference of University Professors, Sept. 1969. lavel would be pursued provided that the act of attempting to hit the target did not cause "excessive" fluctuations in interest rates. If the movement of interest rates were deemed undesirable, policy instruments would be changed sufficiently to bring the interest rate fluctuations within the allowable range. The imposition of such constraints could- greatly reduce the ability of monetary policy to achieve short-term goals. The second approach would involve a lengthening of the policy planning horizon. In this situation, policy would take a longer view than one quarter into the future. The aim would be to achieve the best path of, say, employment over some time interval consistent with acceptable performance of financial markets. Extension of the horizon would allow problems of the real sector and of the financial sector to coexist on a more equal basis. There would be no immutable constraints placed on the system by money market conditions if the planning horizon can be extended. However, by giving up some short-term control over variables in the real sector, it should be possible to reduce fluctua“ons in financial variables to more manageable proportions. Conceptually, it should be possible to determine the trade off between short-term control over employment and prices and stability of the financial sector. In general, a lengthening of the policy planning horizon to promote short-run stability in financial markets will come at the cost of reduced control over nonfinancial variables. Alternately a shortening of the planning horizon will come at the cost - 5 - of increased short-run fluctuations in financial variables. Lengthening the horizon for major policy goals raises some obvious problems. Because the long-term goals of employment and prices are relatively far in the future, it is easy to give them a backseat to the short-run stabilization problems often encountered in financial markets. The problem with this approach is that over-attention to short-run problems can have important implications for the paths required to hit desired long-run targets. Further, if short-run con straints are continually imposed, it may be impossible to hit the longrun goals in the time specified. This may require a lengthening of the horizon and the realization of the ensuing costs of less desirable performance of the real sector. The discussion in the previous paragraph suggests that over the longer run the goals of price and output stability may not conflict with the goal of money market stability. Over-zealous attempts to stabilize the money market in the short run may distort output and prices 1 sufficiently that large changes in interest rates are required in the longer run to bring the economy under control. By allowing wider short- run fluctuations in money market conditions it might be possible to avoid large swings in interest rates over the longer run. The discussion suggests that, given a set of initial condi tions in the economy, there is an optimal policy strategy available. The strategy simultaneously determines the length of the planning horizon, the paths of target variables such as employment and prices over the period, and the expected stability of financial markets. The determination of specific strategies is a problem in optimal control -6- theory and is beyond the scope of this paper. Instead, the paper attempts to assess the trade-offs involved and illustrates problems which may arise from pursuing particular policy strategies. II. Some Simulation Experiments The purpose of this section is to describe some simulation experiments which were conducted in order to illustrate the problems encountered when short-term and long-term goals conflict. The structure of a recent version of the FRB-MIT model was used for the 2/ simulation exercises. — The first simulation experiment assumes a monetary policy which focuses on the rate of growth of the money stock provided that the change in the Treasury bill rate over any quarter does not exceed some arbitrary value. The unconstrained growth in money is assumed to promote desired long run behavior of the real sector. If the policy determined money stock for a quarter would lead to a projected change in the bill rate over that quarter which exceeds the constraint value, the money supply was changed sufficiently to bring the change in the bill rate back to its allowable range. In situations in which policy is attempting to offset either boom or recession, this policy would lead to a performance of the economy which is inferior to one which is unconstrained. If shifts in the demand for money are the source of wide interest rate fluctuations when policy is attempting to hit a money stock target, the situation is changed. Here, it would be appropriate to introduce interest rate constraints. Such constraints would automatically 2/ Some of the simulation results reported here are drawn from an earlier paper on a related topic. See J. Pierce, "Some Rules for the Conduct of Monetary Policy," in Controlling Monetary Aggregates. Federal Reserve Bank of Boston. -8- satisfy the demand for money after some point. Limiting interest 3/ rate movements in this case would promote long-run stability.— The results of the simulation experiments suggest, however, that one should have strong reasons for believing that shifts in money demand are causing wide quarter to quarter interest rate fluctuations. If unexpected shifts in aggregate demand are the cause, long-run goals may suffer greatly. To illustrate the problems which arise during periods of excess aggregate demand, various simulations of the FRB-MIT model were run for the 1963-1968 period. A control simulation was first run which took all exogenous variables at their historical values but assumed that the money stock grew at a constant 4.25% annual rate. This was the constant rate at which the initial money stock in 1962-IV had to grow to achieve its actual value in 1968-IV. Additional simula tion experiments were conducted applying the same exogenous variables and the same 4.25% money growth rate to the model provided that the Treasury bill rate did not change during the quarter by more than a specified absolute amount. If the bill rate fell outside the allowable range, bank reserves and the money supply were changed sufficiently to bring the bill rate back to the nearest boundary of the range. All 2/ For a theoretical discussion of the desirability of interest vs money stock stabilization in a stochastic world see: W. Poole, "Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model" Q.J.E. forthcoming. -9other exogenous variables were assumed to remain unchanged. Several absolute change values were attempted; results for absolute changes of 30 basis points and 10 basis points are reported. The results indicate that placing sufficiently narrow bounds on the change in the bill rate can have a large impact on the simulated value of GNP. Figure I shows the differences between the simulated values of GNP for the steady rate of growth of money and those subject o maximum absolute changes in the bill rate of 30 and 10 basis points esp'^tively. In both cases because interest rates could not rise in -he 3ater periods, there was a tendency to add to the existing excess demand conditions. As indicated above, if the source of interest rate fluctuations is erratic shifts in the demand for money, interest rate stabilization may be a reasonable course of action. The simulation results suggest, however, that interest rate stabilization can be costly during periods of strong excess demand. It is interesting to note that if stabilization of financial markets takes the form of bracketing the rate of growth of the money stock, the problems encountered during periods of shifting aggregate demand are diminished. Assume monetary policy attempts to hit an employment target by setting market interest rates at appropriate levels. Introducing a constraint on the allowable range of growth rates of the money stock in this situation can under some circumstances lead to improved policy performance. If the value of the interest rate is not the correct one because aggregate demand is either stronger or weaker FIGURE X EFFECTS ON_GNP_OF 4 .2 5% GROWTH IN MONEY SUBJECT TO A M A X I M U M ABSOLUTE CHANGE IN THE BILL RATE: DEVIATIONS FROM THE STRAIGHT 4~25% GROWTH RULE SIMULATION (a) 30 BASIS POINTS BILLIONS (b) 10 BASIS POINTS 1963 1 9 64 1965 1966 1967 1968 -10- chan expected, variations in the rate of growth of the money stock can provide important evidence of this condition. For example, if aggregate demand is stronger than expected, given the interest rate and the demand for money, the growth in the money stock will be greater than expected. If the acceleration in the money growth rate is taken as a signal to raise the interest rate, the money growth rate will fall nd the excessive growth in aggregate demand will be reduced. If the unexpected growth in the money stock is the result of i sh T in the demand for money then the monetary expansion should be t accommodated. In this situation, interest rates should not rise. There is really no way to avoid making judgements concerning the causes of money and interest rate fluctuations. If the source is unexpected strength or weakness in aggregate demand, one course of action is called for. If the source is erratic shifts in the demand for money, quite a different policy reaction is required. The purpose of the simulation experiments is not to "prove" that aggregate demand is always the cause of money market fluctuations. Rather, the purpose of the exercises is to illustrate the potential costs of pursuing a policy strategy which implicitly assumes that money market fluctuations primarily are caused by an erratic, unpredictable demand for money. Simulation experiments with the model were conducted to measure the impact of the money growth rate constraints. The control simulation was one in which the interest rate was made to rise at a constant annual rate from a base period of 1963-1 to achieve its actual value in 1968-1. In this simulation, the money stock is endogenous. Additional -11- policy simulations were then conducted imposing money growth rate constraints on this interest rate policy. If the rate of growth of the endogenous money stock fell outside the allowable range, the interest rate was changed sufficiently to bring the growth in money back to the nearest boundary of its allowable range. Figure II shows the difference between the values of GNP from the control simulations and those for maximum ranges of 3-5% and 3.5-4.5% in the annual money growth rate. The results indicate that this combination of interest rate and money supply policies would have been beneficial over the period of simulation. Further simulation experiments were conducted taking the conditions of the 1960-1961 recession as the starting point for the policy exercises. The results were similar to those described above for periods of excess demand. Control simulations were conducted which, beginning with the third quarter of 1960 set a constant rate of growth of the money stock. Given the actual history of the exogenous variables in the system and given the initial conditions, the time required to get initially to growth rate. full employment was a decreasing function of the money Particularly rapid growth rates, however, lead to substan tial overshooting and can create chronic excess demand. Quite predictably, imposition of a constraint on policy in the form of maximum allowable quarterly changes in the Treasury bill rate made it more difficult to hit the full employment target. The interest rate constraint produced a slowing of the rate of expansion of output and employment from the recession base and lengthened the time necessary to hit a full employment F IG U R E H EFFECT ON GNP OF CONSTANT BILL RATE GROWTH SUBJECT TO MAXIMUM MONEY GROWTH RATES DEVIATIONS FROM THE STRAIGHT BILL RATE GROWTH SIMULATION (a) 3-5% BILLIONS + 0 5 10 ( ) 3.5-4.5% b j— i — 1963 i — 1 — i — ___i ___L. i 1964 i 1965 j— I ___ i ___ i 1966 i ___ I i i 1967 i 1 i i 1968 i - 1 2 - target. The results also indicate that the degree of the slowdown of economic expansion resulting from the constraint depends upon how quickly the target level of employment is to be reached and how narrow is the allowable range of the quarterly change in interest rates. It should be emphasized that a restriction on changes in interest rates is potentially less disruptive to the economy than is a restriction on the level of rates. Constraints on the maximum short term change in interest rates can retard but not arrest desired adjust ments of the economy. The existence of ceilings or floors on the level of interest rates may prevent the adjustments from ever occurring. Pegging the level of interest rates can lead to a total loss of control by policy over output, employment and prices. The recession results for a money supply constraint are also similar to those obtained for the excess demand case. A monetary policy which attempts to achieve its objectives through influencing money market conditions (interest rates) can be enhanced in the recession case by imposing a constraint on the rate of growth of money. If the course of aggregate demand proves to be other than expected, variations in the interest rate promoted by the constraint imposed by an allowable range of money growth rates will serve to push the rate of expansion in the desired direction. -13- III. C o n c lu s io n s The brief discussion in Section II suggests that high priority should be placed on coordinating short-run operating procedures with the longer run goals of monetary policy. Failure to achieve such coordination can lead to a serious reduction in the ultimate effective ness of monetary policy. Stabilizing short-term interest rate fluctua tions can lead to destabilizing shocks to the real sectors of the economy. Better information on the stability of the demand functions in the economy is sorely needed. The focus of policy on money market conditions may be badly misplaced if the money demand function is relatively stable and predictable through time. Certainly the hypothesis that the demand for money is erratic and unpredictable is not well documented. It is curious, therefore, that policy decisions should revolve so strongly on money market conditions. It might be argued that the Central Bank is obligated to stabilize the markets for debt instruments. result here. An unfortunate paradox can An overly zealous attempt to stabilize interest rates can so disturb the real sectors of the economy as to lead ultimately to extreme variations in market interest rates. The experience of the last few years appears to bear out this contention. It would appear that a monetary policy based almost exclusively on stabilizing short-run money market conditions is a luxury we can ill afford. On a conceptual basis the appropriate course of action for policy making appears to be clear. Given staff projections of the course -14of the economy over the coming year or so, the instruments of monetary policy should be set to promote the desired time paths of the variables such as employment and prices over the period. In order to make such decisions meaningful several policy alternatives should be illustrated showing alternative time paths for the target values in the real sector. The several policy alternatives should be compared both in terms of the expected values of such variables as output, employment and prices and in terms of the dispersion of these projections around their expected values. In assessing the variability of the projections it is necessary to provide evidence on the possible impacts on the projec tions of various shocks to the system. How sensitive are the projections to shifts in the demand for money or in the demand for investment goods? An analysis of the impact on the projections of alternative assumptions concerning the values of certain key exogenous variables such as govern ment spending is also crucial. Furthermore it is quite likely that the sensitivity of the projections to shocks and alternative values of exogenous variables is not independent of the existing state of the economy. At times projections are quite insensitive to fairly large changes in the underlying specification of the system. they are extremely sensitive to these specifications. At other times It is essentially, therefore, that evidence be provided on the likely dispersion of relevant variables around their projected values. The fluctuations in interest rates and monetary aggregates implied by the various policy alternatives should also be projected. On the basis of all this information trade-offs between expected money -15- market stability and the behavior of variables in the real sector can be assessed. The need for reliable econometric models and for seasoned judgment in these exercises is obvious. At this point in time, our ability to generate the required set of projections is quite limited. These limitations suggest that policy strategies should be fairly simple and straight forward. Elaborate policy strategies do not seem consistent with our ability to assess and trace through time the impact of policy acts on the economy. Given the determination of a policy strategy over the coming year or so, how can the strategy be reduced to day by day operating procedures? Here there is need for a document like the Blue Book which presents projections of financial conditions to be expected over the near term. A blending of projections obtained from quarterly and monthly econometric models is sorely needed. are difficult but possible. Conceptually, such blends On the basis of these short-term projections and the basic policy strategy mentioned above specific operating instruc tions can be formulated. Here, limitations on the ability to make short-term projections suggest that fairly simple operating procedures be adopted. We now come to the central problem in this story. How can we continue to link the basic policy strategy with operating procedures as the economic forecasts are modified and as monetary policy strays off course? As policy is currently conducted there is no effective means of varying the basic strategy as new information comes in and there is no way to relate changing conditions to actual operating procedures. -16- Ideally, we would like to generate new long-term forecasts each quarter and to map out new alternative policy strategies each quarter. Often, however, new information as it comes in leads to con flicting conclusions about changes in the future course of the economy. Further, econometric models and other procedures often do not predict with sufficient accuracy to allow useful quarter by quarter changes in implied operating strategy. The discussion of the original projections also suggests that the initial strategies may at times be very much in doubt. A possible strategy under these conditions is to set quarterly operating instructions in terms of some combination of interest rates and money stock. A policy which sets an interest rate subject to constraints on the rate of growth of money is a very appealing candidate. i By setting a range to the allowable growth of money, shifts in the money demand function are automatically accomodated up to the extreme points of the range. The width of the range should depend in part on estimates of likely quarterly fluctuations in the demand for money. In setting the range, however, it must be recalled that the wider the allowable range the greater the potential loss in output and employment when variations in aggregate demand are the cause of money growth fluctuations. For this reason, a relatively narrow band, e.g. 4-6%, seems desirable as a working principle. Certainly, if there are persuasive arguments explaining why an unusual shift in money demand occurred in a particular quarter, then a money growth rate outside the range should be allowed. The point is, -17- however, relaxation of the constraints should be a rare event. In every case that such a course of action is being considered, the burden of proof should rest squarely on the shoulders of those who believe that an unexpected movement of money outside the range is caused by money demand and not by aggregate demand. Further, the longer the condition of unusually high or low money growth persists at existing interest rates the greater should be the presumption that the interest rate is inappropriate and should be changed. These recommendations do not call for a drastic departure from current procedures. They primarily call for greater attention to be paid to long-run objectives of economic stabilization policy. These are designed to put short-run stabilization of money market conditions in the context of possible costs to the economy in terms of income, » employment and prices. Truely effective policy implementation requires that operating strategies be explicitly set forth which are intended to achieve desired long-term goals. Such strategies must be followed under conditions of great uncertainty about the course of the exogenous variables in the system and about the performance of our models. In such a situation it would appear to be a mistake primarily to focus attention on the uncertainties of the money market. Monetary policy decisions must come to grips with the uncertainties we face with respect to aggregate demand. A policy strategy which relies as much as possible on projections but which also combines interest rates setting with allowable ranges on the money growth rate appears to be most appropriate for the near future.