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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


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.


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.

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.


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

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


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

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.


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

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

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


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.


determination of specific strategies is a problem in optimal control


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.


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.


structure of a recent version of the FRB-MIT model was used for the
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
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.


satisfy the demand for money after some point.

Limiting interest

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.


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.


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

maximum absolute changes in the bill rate of 30 and 10 basis points


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







1 9 64






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

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

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.



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


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









( ) 3.5-4.5%












___ i
___ i


___ I










- 1 2 -


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.



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
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

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


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

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

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.


Ideally, we would like to generate new long-term forecasts
each quarter and to map out new alternative policy strategies each

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.

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,


however, relaxation of the constraints should be a rare event.


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.


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.