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Workina P a ~ e r8407
MONETARY POLICY REGIMES:
A SYNTHESIS OF THE MONETARY CONTROL
AND RATIONAL EXPECTATIONS LITERATURES
by James G. Hoehn

Working papers o f t h e Federal Reserve Bank o f
C l eve1and are p r e l i m i nary materi a1s, c i r c u l a t e d
t o stimulate discussion and c r i t i c a l comment.
The views expressed a r e those o f t h e author and
n o t necessarily those o f t h e Federal Reserve
Bank o f Cleveland o r t h e Board o f Governors
o f t h e Federal Reserve System.
The author g r a t e f u l l y acknowledges useful
comments on e a r l i e r d r a f t s by Matthew Canzoneri ,
W i l l iam Gavin, K i m Kowal ewski , and David Lindsey.
I t i s emphasized t h a t these persons do n o t
necessarily agree w i t h t h e opinions expressed
by t h e author. Kathy Begy and Laura Davis
assisted i n manuscript preparation.

December 1984
Federal Reserve Bank of Cleveland

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Abstract

The monetary control l i t e r a t u r e has attempted t o explore the e f f e c t s of
alternative policies without succeeding i n incorporating rational expectations
or i n integrating analysis of the money supply sector into a complete
macroeconomic framework. The rational expectations approach, while reserving
a place for the monetary control issues under the concepts of instrument
(Sargent and Wall ace 19751, automatic stabil izers (McCall um and Whi taker
19791, and structural reforms (Dotsey and King 19831, has not provided the
needed integration.

Extending earl i e r work by Hoehn (1979, 1983b) and

McCallum and Hoehn (1982, 19831, t h i s paper attempts t o provide a synthesis of
the concepts from the rational expectations and monetary control l i t e r a t u r e s ,
i n the context of a relatively complete, i f ad hoc, macroeconomic model

.

I t i s concluded t h a t , under the most plausible assumptions concerning the
availability and use of information of various types by private agents and the
monetary authorities, the monetary regime--defined a s the conjunction of the
open-market strategy and the institutional and regulatory framework--does
matter f o r the distribution of output, as well as of money, i n t e r e s t rates,
and prices.

On the other hand, the rational expectations approach raises a

number of problems and ambiguities regarding policy e f f e c t s t h a t require
further theoretical research.
c r i t i c a l ly eval uated.

Some recent e f f o r t s along these l i n e s are

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The l i t e r a t u r e on monetary control and rational expectations expanded rapidly
i n the 1970s and early 1980s, each spurred by the experience of stagflation

and the ineffectiveness of postwar monetary policies.

The term monetary

control 1i terature signifies the analyses of a1 ternati ve money supply
behaviors as influenced by the modus operandi of monetary policy and the
institutional and regulatory framework.

A basic premise of t h i s 1i terature

i s that these factors, which taken together shall be termed a regime, are
-i-...-.~ ~ t ~ ~ r determinants
-tant
of macroeconomic outcomes. T h i s 1i terature i s
seriously 1i m i ted by i t s narrow focus on monetary control per se and by i t s
1ack of f u l l integration w i t h macroeconomic theory.

The rational expectations

1i terature, which has rev01 u t i onized macroeconomic theory, has exerted 1i t t l e
influence on the monetary control 1i t e r a t u r e (though i t may be on the
threshold of doing so).

The reason f o r t h i s may 1i e i n the unreal i s t i c

concepts of policy i n the rational expectations l i t e r a t u r e , which seem
inadequate o r simply inapplicable to real world phenomena. These concepts
have been a continuing, a1 bei t rather unjustified, source of skepticism
regarding the policy implications of rational expectations--or, more
general l y , new classical --model s and may he1 p explain continued adherence t o
traditional policies and macroeconomic concepts.
The two 1i teratures have advanced independently, ref1 e c t i ng the fa1 1acious
dichotomy between the broad macro and money market sectors of analytical
models and previous l i t e r a t u r e and the infamous two-stage policy decision
sequence.

A reconciliation between these l i t e r a t u r e s will serve a number of

purposes.

F i r s t , where the two l i t e r a t u r e s d i f f e r i n t h e i r concept of policy,

an attempt a t reconciliation forces careful reassessment.

I t will be seen

that the monetary control l i t e r a t u r e has, i n some important ways, modeled

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pol icy more real i s t i c a l ly.

As the monetary control 1i terature' s val i d

contributions are incorporated into a rational expectations macromodel, some
important 1oophol e s in the pol icy ineffectiveness proposition w i 11 come t o
light.
The present paper can be regarded a s an extension of previous e f f o r t s t o
reconcile rational expectations macroeconomics and the monetary control
1i terature (by Hoehn 1979, 1983b).

McCal 1um and Hoehn (1982, 1983),

. (1983) a1so deal

Goodf riend (19831, and Goodf riend e t a1

w i t h the narrower

issues of monetary control per se using the rational expectations assumption
Related work includes Sargent and Wallace (19751, McCall urn

i n some way.

(1981, 1984), Dotsey and King ( 19831, Canzoneri , Henderson, and Rogoff (1983),
and Goodf riend ( 1984b). These 1a t t e r papers 1argely concern macroeconomic
issues beyond the normal scope of the monetary control l i t e r a t u r e .
I

I.

The Monetary Pol icy Sector i n Macroeconomic Model s

Monetary pol icy plays an important role i n macroeconomic theories,
particularly theories of the business cycle.

A monetary policy sector i s

necessary t o complete a macroeconomic model.

One of the most important

advances i n macroeconomics has been t h a t policy behavior has been modeled more
and more real i stical ly.
In the simple Keynesian models the monetary policy sector s e t s the
i n t e r e s t rate, which i s treated as e i t h e r fixed o r a s a choice parameter.
IS-LM models, which include monetarist models as a special case, assign the
monetary policy sector the role of setting the money stock.

In these models,

the money stock i s e i t h e r fixed o r a choice parameter, invariant w i t h respect
to the s t a t e of the economy.

Monetarists gave special attention t o the role

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of monetary policy, emphasizing the comparison of constant growth rules--which
they advocated--versus randomized or state-dependent money supply behavior.
Even though the monetarists warned of the dangers of fixing i n t e r e s t rates,
they d i d not incorporate such pol icy behavior into t h e i r model s.
The rational expectations t h e o r i s t s offered a significant advance by
formally treating monetary pol icy as the choice of a feedback rule.'

In

t h e i r model s , pol icy i s typically characterized by the instrument and a rule
f o r i t s behavior, stated a s a function of s t a t e variables.

Sargent and

Wall ace (1975) showed t h a t , under rational expectations and certain
assumptions regarding aggregate supply and demand behavior, the time path of
output i s invariant w i t h respect t o the feedback rule.2

However, a t the

same time, the choice of the instrument does have implications for the
distribution of output.

Rational expectations theorists generally continued

t o assign monetary policy the role of setting the money stock, because the use
of the i n t e r e s t r a t e a s an instrument was believed t o r e s u l t i n the
indeterminacy of nominal variables.

Like the monetarists, rational

expectations theorists generally emphasized the dangers of fixing i n t e r e s t
rates, and may therefore have preferred t o construct models employing money
supply behavior, the adoption of which they considered beneficial

.

In

applying t h e i r models t o the explanation of actual events, the rational
expectations theorists, l i k e the monetarists, may often have confused
normative and positive economics.

Another reason for specifying monetary

policy as a rule for the money stock was analytical convenience.
So a1 though the rational expectations theorists offered a significant
advance over e a r l i e r modelbuilders i n t h e i r treatment of the monetary policy
sector, t h e i r earl i e s t model s were unequipped t o expl ai n o r predict economic

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events i n the case i n which the Federal Reserve d i d not use the money stock a s
the instrument.

This was a serious limitation.

Not only has the Federal

Reserve employed the federal funds r a t e as the instrument d u r i n g most of the
period i n which the rational expectations l i t e r a t u r e has expanded, b u t i t i s
also infeasible f o r the Federal Reserve t o adopt what can be regarded
mathematically as a money stock rule unless radical institutional and
regulatory changes take place.

Indeed, even a t o t a l reserve o r monetary base

instrument i s infeasible under current arrangements.
The major remaining barrier t o incorporating both rational expectations
and an adequate policy sector into macromodels i s analytical and econometric
intractability.

A r e a l i s t i c rule f o r the federal funds r a t e or nonborrowed

reserves as a function of e i t h e r future expectations of goal variables o r past
observations on s t a t e variables raises the order of the system of difference
equations t h a t represent the structure of the economy beyond an order t h a t
permits derivation of analytical reduced forms corresponding t o the observable
reduced forms.

Perhaps more research will overcome the analytical

d i f f i c u l t i e s , b u t early success cannot be anticipated.
T h i s discussion does not directly concern the identification and

estimation of a structural probability model of the macroeconomy.

However, an

appropriate research strategy f o r b u i l d i n g such a model must include the
construction of a tractable and simp1e, y e t adequate, monetary pol icy sector.
There i s obviously a need f o r great improvement i n t h i s area.

Development of

such a model i s essential i f the macroeconomic 1i t e r a t u r e and the l i t e r a t u r e
on monetary control are to be integrated.

Without such an integration, the

conclusions of the l i t e r a t u r e on monetary control are not secure.

Benjamin

Friedman (1975 and 1977) has shown that a f a i l u r e t o integrate the broad

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macroeconomic analysis and the money market analysi s can 1ead t o potential l y
serious e r r o r (even i n a conventional Keynesian model

i n policy analysis.

11. A Reconsideration of the Instrument Concept
The problem of monetary pol icy i s t h a t of designing a rule--that is', a
procedure f o r adjusting policy instruments--that responds t o incoming
information t o minimize deviations of objective variables from t h e i r targets.
The only rational approach to t h i s design i s t o construct a complete
structural probabi 1i ty model that 1inks pol icy instruments t o the u l timate
objectives.

In practice, the objectives have included stabilization of

output, prices, money, and i n t e r e s t rates.
A pol icy instrument i s a variable t h a t the Federal Reserve can control

directly and precisely.
controlled precisely.

I t must be immediately observable, o r i t cannot be
In the traditional use of the term, and i n an ultimate

sense, monetary policy instruments include open-market operations, a l l aspects
of d i scount-wi ndow admi n i stration, reserve requi rements, and various other
regulations such as deposit-rate ceilings.

B u t , of these, only open-market

operations are flexible enough t o employ on an essentially continual basis.
In recent l i t e r a t u r e , the term instrument has been used t o signify a1 ternative
c r i t e r i a of open-market operations.

The alternative instruments are

essentially quantity-setting or interest- rate- setting rules of behavior.
While i n principle a relation between a quantity and a rate, similar t o
Poole's combination pol icy, can serve as the operational c r i t e r i o n of
open-market operations, and i n general shoul d , analytical i nsi ghts are often
faci 1i tated by contrasting pol a r cases of quantity versus rate- setti ng pol icy
behavior (see Poole 1970).

An additional reason for considering these polar

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- 7 -

*

cases i s that they have sometimes described actual policy.
The value of the instrument i s kept constant only so long as i t remains
consistent w i t h the ultimate objectives.

When new information about

deviations of target variables i s received, the instrument should be reset, an
action termed feedback.

Information i s , i n principle, conveyed by observed

a l l of the observable variables, both exogenous and endogenous,
movements i n that enter into the complete structural probability model.

The model t e l l s us

how the instrument must be r e s e t t o be consistent w i t h the objectives,
conditional on the s e t of observed realizations.

Feedback cannot be

continuous o r immediate, because most information i s conveyed only a t discrete
intervals:

there i s an information lag.

In addition, because some time i s

required t o f i 1t e r information and execute the appropriate instrument
resetting, there i s also a decision lag.

In practice, the decision lag i s

lengthened by bureaucratic o r committee behavior.

Instrument resettings are

often made only a f t e r a broad-based consensus develops among non-analytical
policymakers t h a t such a resetting i s needed.

The instrument issue e x i s t s

precisely because feedback cannot be instantaneous and continuous.

The

Federal Reserve must have some c r i t e r i o n f o r actions between points of time a t
which new information becomes available, can be processed, and used t o make a
new decision.

Policy cannot be asked to do nothing i n the interval, unless

doing nothing i s defined.
The instrument problem and the feedback problem are complementary; i n t h a t
together they make up the complete problem of policy design.

Consequently, a

correct conception of the instrument problem requires an understanding of
feedback--in particular, we must have an accurate understanding of which
information i s available t o the pol icymaker, w i t h which 1ags.

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This view of the policy problem suggests t h a t the instrument issue has
been widely misconceived i n several respects.

Most important, many economists

have confounded the feedback and instrument problems.

Many influential

studies of the "instrument issue 1' implicitly o r e x p l i c i t l y have sought a
variable, which, i f pegged without feedback, would more closely achieve the
goal s than i f a1 t e r n a t i ve variables were pegged permanently.

This natural l y

1ed t o an unwarranted bias against i nterest- rate- setti ng rules, because they
require more feedback i n a cyclical context.

Instead, the instrument should

be chosen s t r i c t l y on i t s a b i l i t y t o insulate the goals from unknown
disturbances.

Past disturbances can be imputed from available data i n

conjunction w i t h the model, and i t i s the proper role of feedback t o o f f s e t
the impact of known disturbances.
An associated misconception i s of the time horizon relevant t o the

i nstrument choice problem.
lag.

That horizon i s the information (and decision)

Unfortunately, a practical separation between instrument and feedback

issues i s complicated by the different frequencies with which information
becomes available.

The instrument concept of recent 1i t e r a t u r e i s simply

'

inapplicable without information o r decision lags, f o r otherwise feedback can
and should be continuous.

The nature of the instrument choice problem depends

as c r i t i c a l l y on the assumptions about information availability as i t does on
the other structural characteristics of the model.
Given the conception of the pol icy problem a s t h a t of responding t o
information, the reserve accounting period i s a useful means of separating for
information that i s currently avail able and information that i s available only
w i t h a lag.

(The reserve accounting period also corresponds t o the period of

the traditional adjustment mechanism inherent i n reserve requirements. )

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Informati on avai 1able w i t h a 1ag i ncl udes observations on money, output,
prices, and the family of reserve aggregates.

I t will be assumed here t h a t

the information lag on these variables i s one o r more reserve accounting
periods.

On the other hand, the Federal Reserve i s assumed t o have perfect

current information on the securities i n i t s portfol io ( t h e open-market
position) and on the federal funds rate.

In addition, the pol icymaker has

partial know1edge of the so-call ed uncontroll able factors affecting reserve
supply ( f l o a t , Treasury cash, currency, and so on), excess reserve demand, and
borrowed reserve demand. The way the Federal Reserve uses immediately
available information will be thought of here as an operating procedure, a
concept related to the instrument b u t more descriptive.
The particular information structure assumed i s a central feature of the
analysis.

Besides the obvious advantage of being expl i c i t, the specific

assumptions made will f a c i l i t a t e analysis of the e f f e c t s of alternative
operating procedures and regulatory factors on the control of money
especially, b u t i n a broader macro context i n which the objectives involve the
stabil i t y of i n t e r e s t rates, prices, and output.

I 11. An Analytical Framework
T h i s section develops a model of the instrument issue t h a t is dynamic and

incorporates rational expectations of prices.

I t s dynamics are rather simp1e ,

exploiting the idea t h a t 1agged behavioral responses are more important f o r
the feedback issue than f o r the instrument issue.

While t h i s notion

f a c i l i t a t e s analysis of instrument issues, i t will be necessary t o consider
ways i n which the instrument and feedback issues cannot be entirely separated
i n a rational expectations model.

A1 1 variables are measured as deviations

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from deterministic components, which has the e f f e c t of eliminating constants
and polynomials i n the time index.
A serious limitation of the model i s t h a t i t does not account explicitly

f o r changes in the "structural " parameters and d i sturbance variances t h a t
would occur as the policy regime i s altered.

In other words, the model i s ,

1i ke virtual ly every other analytically tractable model , subject t o the
we1 1-known Lucas (1976) critique.

Consequently, the s e n s i t i v i t y of resul t s to

l i k e l y changes i n parameters should be assessed.

In many relevant practical

situations, t h i s can probably be done, and i l l u s t r a t i o n s will be given below.
Quantitative simul ations using existing money market model s , while interesting
and suggestive, do not lead t o secure conclusions without t h i s k i n d of
s e n s i t i v i t y analysis.
Aggregate commodity demand i s taken t o be a negative function of the ex
ante real r a t e of i n t e r e s t and i s subject t o a white-noise disturbance:

where
y = natural log of output,

r = federal funds rate,
p = natural log of the price level,

and t i s a reserve accounting period time index.
Expectations of inflation are taken t o be equal t o the objective expectation
of the next period's price 1evel , conditioned on a1 1 1agged ( t-1)
real i zations, m i nus the current (actual ) price 1evel

.

Later, the imp1 ications

of a1 1owing the pub1 i c t o form future price expectations based on current
observations wi 11 be examined.

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The aggregate supply function i s t h a t of Sargent and Wallace (1975):

(2) Yt

=

s (pt

-

Et-l

pt)

+

Upt,

s>o.

O u t p u t supply responds positively t o price level surprises and i s subject t o a

whi te-noi se disturbance.

There are a t 1e a s t three j u s t i f i c a t i o n s f o r t h i s

aggregate supply function (see McCallum 1980, pp. 720-1).

F i r s t , the

accel erationi s t or expectations-augmented P h i 11ips curve of Friedman, Phel ps,
and others; second, Lucas' island parable, i f agents only know the current
local price plus any lagged information; and t h i r d , a s a single-equation
representation of Keynesian econometric wage-markup price equations. 3
The key contention here i s t h a t , f o r the issues addressed by the monetary
control 1 i terature, the Sargent-Wall ace supply function is more appropriate
than available a1 ternatives, such as those that begin w i t h the Lucas island
parable b u t a1 low agents t o respond t o information contained i n the i n t e r e s t
rate.

The assumption t h a t private agents e i t h e r do not observe or do not

respond t o elements of the information s e t available t o the Federal Reserve
results i n a preservation of the relevance of the monetary regime for output
stabil ization.

Some rational expectations theorists, such a s Barro (1976) and

Dotsey and King (19831, have e x p l i c i t l y noted t h a t superior information by the
Federal Reserve can form a basis f o r output stabilization policy.

These

theorists, however, have been deliberately reluctant t o make such an allowance
of superior information i n t h e i r analyses.

This reluctance a r i s e s from the

contentions t h a t ( a ) the policy of releasing the superior information t o the
pub1 i c i s essenti a1 l y equivalent t o feedback i n terms of stabi 1ization
effects, and that ( b ) i n any case, such information hardly forms the basis f o r
stabilization of the countercyclical type advocated by Keynesians or t h a t

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observed i n postwar experience.

Contention ( b ) , while surely correct, seems

irrelevant i n the context of monetary control issues.

B u t contention ( a ) must

be careful l y considered.
I t m i g h t seem t h a t prompt release of the Federal Reserve's fragmentary

observations on reserve and deposit data would, by el imi nating the Federal
Reserve information advantage, render the monetary policy regime irrelevant.
B u t t h a t surely cannot be the case:

the policy regime also influences what

k i n d of information i s generated and how i t i s processed.

For example, the

recent switch of reserve requirement accounting altered the k i n d of
information flowing t o the Federal Reserve from the banking system and sped i t
up.

Regulatory issues such as this f a l l into the category of structural

reform as conceived by Dotsey and King (1983). B u t the other aspects of the
regime, the instrument and feedback rules, can r e f l e c t a more e f f i c i e n t
processing of information than can be accomplished by private agents alone.
I t i s probably not economic for private agents t o index contracts fully t o
r e f l e c t a l l variations i n , for example, f l o a t , Treasury cash balances, and
currency flows.

Yet each of these reserve supply factors can d i s t o r t the

information conveyed by the i n t e r e s t rate and other prices.

There would

appear t o be economies of scale i n processing information that can be
exploited by the Federal Reserve.

The benefits derived can be distributed

widely by appropriate manipulation of i n t e r e s t rates.

An interesting question

not y e t adequately addressed i s whether such information processing i s a
pub1 i c good.

If not, there may be no justification on grounds of economic

efficiency f o r a public monopoly.
The aggregate supply function, i n conjunction w i t h rational expectations
and the aggregate demand equation, ensures t h a t the familiar "policy

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ineffectiveness" r e s u l t o f Sargent and Wallace (1975) w i l l p r e v a i l :

the

behavior of output w i l l be i n v a r i a n t w i t h respect t o p o l i c y feedback.
However, operating procedures and r e g u l a t o r y f a c t o r s can, by a f f e c t i n g t h e
d i s t r i b u t i o n o f p r i c e 1eve1 surprises, have imp1i c a t i ons f o r t h e behavior o f
output.

Thus, Sargent and Wallace suggested, t h e instrument choice i s

generally consequential f o r output even i f feedback i s not.

I t w i l l be shown

l a t e r t h a t t h e importance o f t h e instrument, or, more broadly, o f t h e p o l i c y
regime, i s robust w i t h respect t o a number o f r e - s p e c i f i c a t i o n s o f t h e
aggregate supply equation.
The money demand equation i s q u i t e conventional , except t h a t i t i s
expressed as a f i r s t - o r d e r Taylor expansion o r l i n e a r approximation:
( 3 ) mt = alpt

+ a2yt + a3pt + et,

al<O,

a?,

a3X,

where

m = money (reservabl e deposits) ,
and e i s

a white- noise disturbance.

The 1ineari t y permits consi s t e n t use o f t h e (1 inear) bal ance sheet i d e n t i t i e s
i n t h e money supply sector o f t h e model.
The money supply sector provides a r e l a t i o n between t h e money stock and
t h e i n t e r e s t r a t e t h a t i s needed t o complete t h e model and determine output,
p r i c e l e v e l , money stock, and i n t e r e s t rate.
money supply function.

This r e l a t i o n can be termed a

I n general i t has t h e form:

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where the s l ope, B, i s a nonl inear function of the parameters i n the money
supply sector, and vt i s a 1inear function of the disturbances i n the money
supply sector.
The s l ope of the money supply function he1 p s determine the way commodity
market and money market disturbances a f f e c t output, the price level, the money
stock, and the i n t e r e s t rate.

All of Poole's (1970) q u a l i t a t i v e r e s u l t s can

be dupl icated w i t h i n this model , i f an exact money supply rul e replaces the
money supply sector of the model.

The use of ( a ) the real r a t e of i n t e r e s t i n

the aggregate demand function, ( b ) an aggregate supply function of the
Sargent-Wall ace type, and ( c ) rational expectations does not destroy Pool e ' s
qua1 i t a t i v e results, a t 1e a s t i n t h i s model , as 1ong a s Pool e ' s 1eve1 s of
variabl es are converted t o one-peri od innovations.

(The imp1 i c a t i ons of

aggregate supply disturbances, which Poole d i d n ' t examine, a r e essentially the
same as aggregate demand disturbances, i f output s t a b i l i z a t i o n i s the
objective. )
In addition t o making these improvements, the model here adopted
f a c i l i t a t e s analysis of the effects of a1 ternative operating procedures,
reserve requirement systems, and discount policies.

These alternatives

influence the slope and variability of the money supply function and the
variances of y, p , m, and r.

Hence, the framework of analysis allows an

integration of the monetary control and macroeconomic aspects of analysis.
The money supply sector comprises four equations:

two reserve demand

equations, a rule f o r open-market operations, and a reserve identity.

The

demand for total reserves i s the sum of required reserves, the fraction kl
(reserve requirement r a t i o ) of the money stock, plus a random term

*

W

1 , representing excess reserves:

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- 15 (5) T R t = klmt

+

wtt,

0

< k1<'

In the case of contemporaneous reserve requirements (CRR), i t i s assumed that
kl i s a positive fraction.

In the case of lagged reserve requirements

( L R R ) , i t i s assumed t h a t the demand for total reserves i s a function of the
1agged money stock, as in:

( 6 ) T R t = klmt-1 + wft.

Because the term in mt

-

will n o t appear i n expressions f o r innovations i n

the endogenous variabl es, formal analysis of innovations can proceed most
conveniently by setting kl

= 0

under LRR.

As emphasized elsewhere, the

presence of lagged terms anywhere i n the model merely affects the optimal
feedback and i s not relevant to the instrument issue.
Total reserve supply i s defined as the sum of the open-market position,
St, borrowed reserves, BRt,

affecting reserve supply

and the so-called uncontrollable factors

*

(lt + ht).

The Federal Reserve i s assumed t o have some direct information on the
uncontrol 1able factors, b u t not compl ete information.

In particul ar, when the

open-market program for the reserve accounting period i s determined, the
Federal Reserve knows the portion

lt

b u t does not know

*

lt.

The borrowed reserve demand equation:

makes borrowing a positive function of the funds rate, w i t h random disturbance
terms w

2t

*

and w

2t'

l

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The former i s directly observable t o the Federal Reserve before open-market
operations are carried out, while the l a t t e r i s not.

The coefficient k p

represents the response of borrowings t o a change in the funds rate.
The Federal Reserve's information s e t includes St, rt,

A+,,

wZt,

and past real i zations of a1 1 observable variables, i ncl udi ng money, output,
prices, and the family of reserve measures.

The relevant general form of the

pol icy rule i s then:

ignoring the feedback terms on lagged observations.

Policy can (only) choose

a relation among the observable variables and can achieve t h a t relation
precisely by manipulating the open-market position.

Different operating

procedures can be represented by different values of the ci Is.

A value of

zero for c3 characterizes the essentially quanti ty-setti ng pol i c i e s , w h i 1e
an i n f i n i t e value for c3 characterizes the pure rate- setting case.

These

special cases are represented by:

and

respectively.

These expressions w i 11 facil i t a t e the analysis of a1 ternative

operating targets, which imply different values for the c i ' s or bi 's.

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A policy regime can generally be defined as a s e t of values for k l ,
k p , and cl, c2, and c3, because policymakers ultimately exercise

control over a l l of them.

The values of the ci characterize the operating

procedure, while the values of ki represent the reserve requirement system
and discount policies.
Solving the four equations of the money supply sector (using the general
form of the policy r u l e ) , we find the following a1 ternative expressions f o r
the money supply function:

(12) mt

-1 ( C

= kl

-1[ ( ~ ~ + l ) ~ ~ + ( c ~* + l*) w *~ ~ - w ~ ~ + w ~ ~ + ~ ~ ]
+k
)
r
+k
3 2 t l
f o r kl#O, c3<w ,

or
(13) rt

=

kl(c3+k2)-lmt
-1 * * *
+(c3+k2) [ w ~ ~ - w ~ ~ - A ~ - ( c ~ + ~ ) A ~ - ( c ~ + ~ ) w ~ ~ J ,
f o r (c3+k2)&0.

The f i r s t expression makes e x p l i c i t that the pol icy regime uniquely determines the
slope of the money supply function

(4):

In addition, k l , cl, and cp help determine the variance of the disturbance,

"t' i n the money supply function. One immediate r e s u l t i s t h a t the optimal
value of both cl and cp i s -1. T h i s i s seen by observing t h a t such a value
for cl and c2 ellminates ,xt and wpt from the money supply function.
Another obvious r e s u l t i s that k2 and c3 appear addi tively.

Open-market

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operations (c3) and discount-window administration
as policy tools, b u t one of them i s redundant.

(k2)

can b o t h be employed

An implication i s t h a t "reforms"

of the discount window--for example, those t h a t would result i n a zero value for

k2--need n o t influence the determination of money, the interest rate, o u t p u t , or
prices, i f the rule of open-market operations i s changed in an offsetting manner.
Reserve requirements (given by the ratio k l ) and open-market operations (imp1ied
by c3) are distinct policy tools, however.

The semi -reduced-form sol utions for the endogenous variables in the model are
given be1ow -for the general case of the pol icy rule.

A wide variety of regime

changes or reforms can be analyzed using these equations:

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and

where
J = [(

S-d) ( alkl-k2-~3)+dk1(a2s+a3]-

.

1

Determinacy of Nominal Magnitudes
Perhaps one reason t h a t an a n a l y s i s o f o p e r a t i n g procedures was n o t performed
i n the c o n t e x t of a r a t i o n a l e x p e c t a t i o n s model was t h a t most economists
accepted the Sargent and Wall ace (1975) argument:

within such a model ,

nominal magnitudes a r e i ndetermi n a t e under an i n t e r e s t - r a t e r u l e , regard1 ess
of feedback.

Economists of d i f f e r e n t views toward r a t i o n a l e x p e c t a t i o n s

responded d i f f e r e n t l y t o the Sargent and Wall a c e argument.

Some of t h o s e

opposed regarded i t a s a cause f o r skepticism about either r a t i o n a l
e x p e c t a t i o n s o r the Sargent and Wallace model, s i n c e i t was well known t h a t
the Federal Reserve i n p r a c t i c e operated by f i x i n g the funds r a t e .

The notion

seemed t o be t h a t i f the price l e v e l were indeterminate, i t should have
behaved more wildly than i t did.

On the o t h e r hand, proponents o f r a t i o n a l

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expectations, as well as many monetarists, regarded the Sargent and Wallace
indeterminancy r e s u l t as a strong argument i n favor of quantity-setting policy
behavior.

Some of these proponents e i t h e r dismissed a s impossible t h a t the

Federal Reserve used the funds r a t e as the instrument, or concluded t h a t the
Federal Reserve pol icy was responsible for observed price instabil i ty.
Nevertheless, the Sargent and Wallace argument should never have been
understood t o imply t h a t a pure quanti ty- setting rule i s optimal.

I t merely

suggests that the Federal Reserve should adopt a policy regime t h a t results i n
some slope t o the money supply function.
negative slope brings determinacy.
Wallace,

B

Even a very s l i g h t positive or

In terms of the analysis of Sargent and

of equation ( 4 ) must be f i n i t e , or the money supply function i s a

pure rate- setting equation t h a t i s not sufficient t o determine money or prices
i n a rational expectations model.

The coefficient

B

does not have to equal

zero.
McCallum (1981) upset the Sargent and Wallace r e s u l t by showing t h a t i f
the feedback rule reflected some degree of concern over the money stock i n
some future period--a case t h a t seems relevant--then nominal magnitudes are

.

determinate a f t e r a1 1

McCal 1um' s resul t can be general i zed, so that feedback

t h a t r e f l e c t s any degree of concern for any nominal variable-- prices i n
particul ar--yiel ds determinacy

.

Hence, the view t h a t the Federal Reserve must

be concerned about money per se, or any other nominal intermediate target, t o
achieve determinacy i s not correct.

Nevertheless, the determinacy issue gives

us an interesting example of how the instrument and feedback issues cannot
a1ways be analyzed independently i n a rational expectations model

.

In the interpretation made here, a proviso i s required t h a t in cases where
the policy regime results i n a perfectly e l a s t i c money supply function, the

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-

21 -

policy r u l e ' s feedback reflects a degree of concern--no matter how small--for
some current value of a t l e a s t one of the nominal variables:
prices.

e i t h e r money o r

Interestingly, a funds rate- setting regime i s only one of several i n

which indeterminacy a r i s e s i n the absence of t h i s proviso.

As will be shown

be1 ow, regimes w i t h LRR or a borrowed reserve target will a1so yield a
perfectly e l a s t i c money supply function.
Before discussing some implications of the model, i t i s useful to look a t
some generalizations t h a t can be made without affecting results, as we1 1 as
some of the model ' s 1imitations.

Behavioral Lags
All of the r e s u l t s derived w i t h this mode1 f o r the innovations i n y, p, m, and
r would be unaffected i f any terms involving lagged realizations of variables
were added to the equations.

In the innovation form of the model--sometimes

referred to as a mapping into expectations space--which recasts the variables
as deviations from prior expectations, a l l of these lagged terms drop out.
Hence, the LRR case can be handled by simply s e t t i n g kl equal t o zero.

That

lagged terms can be ignored greatly f a c i l i t a t e s analysis of the instrument
question i n contexts where the feedback problem i s very complicated.

It is

the role of feedback t o deal w i t h lagged terms o r disturbance
autocorrel ations.

A simi 1a r result i s derived i f the disturbances are

replaced w i t h moving average processes.

A1 t e r n a t i ve Aggregate Supply and Aggregate Demand Specifications
Because the appropriate specifications f o r aggregate supply and aggregate
demand are the subject of considerable controversy, i t i s useful t o assess how

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sensitive are r e s u l t s t o be derived w i t h respect t o a number of possible
changes i n specification.
The innovation form of the aggregate supply function i s :

The aggregate supply equation can handle a fixed-output assumption, by
setting s

=

upt

=

0.

I t can also handle supply behavior t h a t s e t s the price

level inflexibly one period i n advance by taking the limit of reduced form
solutions as the e l a s t i c i t y of aggregate supply, s , approaches i n f i n i t y .

Most

re1 evant imp1 ications of different pol icy regimes are qua1 i tatively simi 1a r i n
these cases, although solution expressions f o r the endogenous variables a r e
considerably simpl ified.

A so-call ed Keynesian supply function, i n which the

prior expectation of pt i s eliminated from the expression, results i n
exactly the same innovation form for aggregate supply.

The Sargent and

Wall ace supply function i s not c r i t i c a l i n analyzing the instrument question
i n t h i s model.

Any

supply behavior t h a t makes output innovations a function

of innovations i n the price level yields the same qualitative results--in
particular, i t does not matter whether the so-called long-run Phillips curve
i s vertical o r not, or even whether the more r e s t r i c t i v e rational expectations

or natural r a t e hypotheses are accepted.

Of course, these l a t t e r hypotheses

have powerful implications regarding the e f f e c t s of feedback.
The aggregate demand equation's innovation form is:
(23) yt

= d(rt

+

pt)

+

ult.

A simp1 e r innovation form obtains i f the operator Et -

i s placed i n front of

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pt, representing a case i n which current information i s not available about
the current price level when inflation expectations (which go into the
In this case, pt i s

calculation of the ex ante real r a t e ) are formed.

eliminated from the innovation form of the aggregate demand equation.

The

zero- inflation case t h a t Poole studied, or one i n which prices are
predetermined one period i n advance, results i n the same exclusion of pt
from the innovation form.

Solutions then become considerably simpler, b u t

r e s u l t s for the innovations of y, m, and r under a1 ternative instruments o r
operating procedures are, i n many important ways, qua1i t a t i vely simi 1ar.
The r e s u l t s derived from the model are sensitive t o the specification of
the aggregate demand equation i n one respect:

i f expectations of the future

price level are formed with any current information on p, y, m, o r r , the
innovation form of the aggregate demand equation involves the innovation i n
the expectation of future prices ( Etpt+l-Et-lpt+l

1, which i s not

general l y zero (McCallum and Hoehn 1982, 1983).

This expression generally

depends on the feedback rule and other lagged terms throughout the structural
equations, and the neat analytical separation between the instrument problem
and the feedback problem cannot generally be made.

A wide variety of special

cases and curious r e s u l t s then becomes possible--and has appeared i n the
1i terature- - but none has much general i t y

.

The bothersome expression can be eliminated i f the expectation of the
future price level i s invariant w i t h respect t o current observations.
Goodfriend (1984b) characterizes t h i s restriction as trend- stationari ty , and,
i n formal analysis , 1i n k s it t o the absence of base d r i f t i n money.

However,

trend- stationarity, as defined by Nelson and Pl osser (19821, requires merely

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t h a t a variable eventually return t o a predetermined trend.

This definition

i s l e s s r e s t r i c t i v e than the condition t h a t the future expectation be a fixed
target-- t h a t i s , t h a t the price level tends to return immediately t o a
predetermined trend.

If the r e s t r i c t i v e condition i s met, the expectation of

the price level a t time t+l, formed a t time t-1, will not be revised a t time
t.

Thus, the bothersome term i s identically zero and does not appear i n the

innovation form as before.
There are other ways t o get rid of the bothersome term.

If the only

current information going into future price level expectations i s the i n t e r e s t
rate ( a reasonably plausible case, and one of those examined by Canzoneri,
Henderson, and Rogoff (19831, the term will then vanish i f the i n t e r e s t r a t e
does not actually convey any information about the future price level.

That

will occur i f the money supply function i s horizontal and nonstochastic:

if

the r a t e i s fixed by a pol icy rule, then i t s innovation i s zero, and i t cannot
relay any information.

I f the policy regime results in a stochastic,

horizontal money supply curve (such as under LRR or a borrowed reserve
operating target, as currently employed), then i nterest- rate innovations
r e f l e c t self-reversing disturbances to the reserve market.

One m i g h t be

tempted to conclude t h a t , once again, the current i n t e r e s t r a t e conveys no
useful information about the future price level.
not warranted.

However, t h i s conclusion i s

Funds r a t e innovations due t o reserve market shocks

destabilize p, y, and m and therefore relay information about current values
of those variables.

Unless the feedback i n the policy rule implies fixed

future expectations of prices, that information will, i n general, affect
future expectations of the price level.
In cases other than these, a feedback rule t h a t permits the price level t o

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be non-trend-stationary will, under the modification of the way expectations
and the real r a t e are determined, lead t o a rather intractable analytical
probl em i f there are 1agged terms i n the model.

The resul t s of the Federal

Reserve adopting feedback t h a t permits non-trend-stationary behavior f o r
nominal magnitudes i s an important topic of current research, and i t i s
possible t h a t some r e s u l t s derived from the model will be upset f o r the case
i n which private agents use current information sets.

I t i s quite possible

that the d i r e c t results and intuitions we have from Poole's analysis will not
prove re1 evant i n a dynamic rational expectations framework.
Recent theoretical and empirical r e s u l t s suggest t h a t t h i s
trend- stationarity r e s t r i c t i o n of the model i s a potentially serious one i f
private agents use current information sets.

Goodfriend (1984b) argues t h a t

tension between objectives of price-level and interest- rate stabilization can
create a strong motive for non-trend-stationary policy rules.
a non-trend-stationary model requires great simp1 i c i ty.

The analysis of

Goodfriend manages i t

by reducing the number of disturbances t o two and the number of structural
parameters to four, two of which characterize pol icy.
analysi s has some unsati sfyi ng aspects.

However, Goodfriend's

A sufficiently high degree of

interest- rate smoothing will always require a negative k i n d of base d r i f t i n
money and prices; t h a t i s , t o keep nominal i n t e r e s t rates stable, this
period's accommodative increases i n money w i 11 have to be foll owed by 1arger
decreases i n money i n the next period.
well a s counterintuitive.

T h i s seems empirically implausible a s

B u t i t may be a r e s u l t of the assumption t h a t the

real r a t e i s exogenous, or, equivalently, t h a t output i s fixed despite
aggregate demand fluctuations.

McCall um (1984) notes, i n a discussion of

Goodfriend, t h a t the i n a b i l i t y of contemporaneous accommodation t o achieve

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smoothing under a pure base d r i f t policy depends c r i t i c a l l y on this output
exogeneity assumption.

Despite these limitations and troubling implications

of the model, Goodfriend i l l u s t r a t e s the point t h a t i n t u i t i v e and seemingly
sensible results can be overturned i n rational expectations models i f ( a ) the
pub1 i c exploits current information s e t s , and ( b ) the Federal Reserve a1 lows
d r i f t i n the price level from a predetermined trend path.

Empirical results

of Nelson and Plosser (1982) suggest t h a t the price level has not been
trend-stationary, a t l e a s t i n the sense of a straight- 1 ine trend.
In principle, one can escape t h i s problem by adopting a trend-stationary
money-supply rule.

In practice, however, t h i s will not achieve the necessary

trend- stationarity of prices unless money velocity i s also trend-stationary.
Financial innovation appears t o render velocity non-trend-stationary, and
Nelson and Plosser find velocity cannot be regarded as having a l i n e a r trend.
Given the theoretical ambiguities, i t i s tempting t o suggest running
experiments on the economy t o answer seemingly intractable analytical
questions.

Yet, opinions vary about whether meaningful experiments (such as

the one beginning i n October 1979) have actually been run, and about how t o
i n t e r p r e t the results.

The varying views spring from theoretical

disagreements and ambiguities.

Hence, i t seems unlikely t h a t experimentation

alone will solve the analytical problems.

As further support f o r this

contention, consider the skepticism among many--the refusal t o face the
fact- - that the Federal Reserve was really using a funds rate instrument i n the
1970s, given the (mistaken) theoretical belief that such a pol icy was e i t h e r
impossible or extremely i 11-advi sed!

Only McCall um' s modification of the

Sargent and Wallace indeterminacy argument cleared the disbelief among some.

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IV.

Some Implications f o r Recent Policy Regimes and Reform Proposals

The remainder of t h i s paper considers particular issues of the monetary
control 1i terature w i t h i n the context of the complete rational expectations
macroeconomic framework.
A f i r s t result i s t h a t , i n the case of a pure rate- setting rule, the

i s the money supply function.
pol icy rule -

None of the other money supply

sector equations i s needed t o determine the money supply function, and hence
play no part i n determining p , y , m, or r.

They merely determine various

reserve quantities given the equilibrium values of those variables.

The

values of k l and k2 (and t h e i r real -world variabil i t y ) and variances of
money supply sector disturbances are inconsequential.

Issues related to LRR

versus CRR, the Depository Institutions Deregul ation and Monetary Control Act
of 1980, discount-window administration, and f l o a t a r e irrelevant to the
behavior of the variables of real concern.

The switch i n 1979 t o a

quanti ty-setti ng pol icy ru1 e made these issues re1 evant.
A second r e s u l t of generality, noted e a r l i e r , i s t h a t the optimal value of

both cl and c2 i s -1.

Obviously, open-market operations should a c t t o

o f f s e t known disturbances to the reserve market arising from fluctuations i n
borrowed reserve demand and the uncontrol 1abl es.

The optimal combination

pol icy will establ ish as the criterion for open-market operations the
condition:

where c3 i s the optimal response of the open-market position to r.

As

intuitions derived from Poole's analysis suggest, the optimal value of c3
depends on the objective function and a l l of the structural parameters and

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disturbance variances.

28

-

(For example, i f output stabil ization i s the

objective, c3 should be larger, the larger money demand and reserve market
disturbances are relative to aggregate demand and aggregate supply
disturbances, and so forth.

Such results are too familiar to repeat here.)

One can, i n principle, find the optimal value of cg for any objective
function defined on the variance of innovations in p, y, m, and r.
The re1evant comparison between pure quantity- and rate-setting rul es i s
between:

and

A 1imitation--not so much of the model i t s e l f , b u t rather of the analysis

conducted here w i t h i t - - i s that the opportunity the Federal Reserve has i n
pursuing a reserve operating target of extracting information about unobserved
reserve market shocks from the observed federal funds rate will not be
considered.

In practice, the Federal Reserve should, and apparently does, use

such information (see Wallich 1984, p. 27).

To i l l u s t r a t e with a simple case,

suppose the reserve measure serving as an operating target i s Rt, and i t s
demand is:

where f>O and e i s an unobserved disturbance term.
t

Let the supply be the

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sum of the open-market position, St, and an unobserved disturbance, vt,
representing uncontroll abl e factors affecting supply:

The Federal Reserve observes St and rt, b u t not Rt, whose control i t
seeks.

Consider f i r s t the pure quanti ty- setting rul e:

In this case:

(30) R t = v t ,

w i t h variance

2

0,.

On the other hand, w i t h a reserve supply rule of form:

then

w i t h variance

(33)

VARIR) = f 2 ( f - 9 ) - 2u2 ,

2
92 ( f - 9 ) -2 oe,

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assuming et and vt are uncorrelated.

The optimal value of g is:

Hence, the policy rule t h a t achieves closest control of the reserve operating
t a r g e t i s actually a combination policy.
In the context of the complete model, the reserve market cannot be
is01ated as i n the above i l l u s t r a t i o n .

The reduced form reserve demand

equation represents the simultaneous interaction of a l l the parameters and
disturbances i n the model.

The choice of g t o s t a b i l i z e R becomes

analytically intractable i n the general case.

More importantly, incorporating

t h i s into the analysis of operating targets blurs the useful distinction

between essentially rate- setting versus essentially quanti ty- setting pol icy
behavior.

In any case, an application of Occam's razor i s needed somewhere.

I t would be desirable to trace the analysis to i t s most elementary nuts and
bolts; the Federal Reserve ought t o do so.

However, the structure of

information flows t o the Federal Reserve cannot be adequately known to an
"outsider" such as t h i s writer.

I t must be conceded t h a t t h i s can become a

serious problem i n the analysis of a1 ternati ve pol icy regimes, particularly t o
the extent that regime changes a r e associated with changes i n the structure of
information flows avai 1able t o the Federal Reserve.
In descriptions of decisionmaking a t the Federal Reserve, i t i s often said
t h a t the Federal Reserve takes part of the adjustment t o information, seeming
t o imply t h a t cl and cp are something l e s s than unity i n absolute
magnitude.

A1 ternatively, t h i s could be interpreted as a different use of the

term information than used here.

The Federal Reserve may have noisy data

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- 31 (which i t c a l l s " information" ) t h a t i t f i l t e r s t o g e t i n f o r m a t i o n (which
c o n s t i t u t e s the "adjustment" t o the reserve path).
Now we consider some a1t e r n a t i ve operating procedures t h a t have r e c e n t l y
been i n e f f e c t o r proposed.

As w i l l become clear, none o f the popular

proposals considered f o r p a r t i c u l a r operating procedures i s optimal ; each
involves discarding information.

This r e s u l t imp1i e s t h a t an optimal pol i c y

system w i l l n o t permit a simple d e s c r i p t i o n and p a r t l y explains why confusion
over the open-market p o l i c i e s a c t u a l l y employed has been widespread.

Total reserve operating t a r g e t .

I f t h e Federal Reserve attempts t o

c o n t r o l t o t a l reserves, i t sets:

where
Itincludes St,

rt,

kt,

wZt.

This i s achieved by s e t t i n g :

c1 = c2 = -1, and
c3 =

-

k2, o r

This r u l e has the term i n rt only because changes i n the funds r a t e r a i s e
(observed) borrowed reserves t o prevent known f l u c t u a t i o n s i n borrowings from
a f f e c t i n g t o t a l reserves; the open-market p o s i t i o n must be adjusted by an
o f f s e t t i n g amount.
The r e s u l t , assuming kl f 0 (CRR), i s a s t r i c t l y supply-determined money

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stock.

Innovations i n money a r i s e s t r i c t l y from reserve market disturbances:

This p o l i c y has t h e d e s i r a b l e property t h a t known f l u c t u a t i o n s i n t h e
uncontrol l a b l e s (ht) and i n borrowed reserve demand (k2rt

I

+

w

~ are
~ )

offset.

But t h e p o l i c y i s n o t optimal, unless by chance t h e optima1 c3 =

-k2 '0.

T h i s i s a p o s s i b i l i t y , b u t i s n o t very l i k e l y , even if monetary

c o n t r o l i s t h e s o l e o b j e c t i v e , because i t gives f u l l f o r c e t o t h e reserve
market disturbances
If k

*

*

*

wit, w ~ and
~ , ht.

- 0 (LRR), then a t o t a l reserve o p e r a t i n g t a r g e t r e s u l t s i n an

1 -

undefined money supply function.

Yet many monetarists were c a l l i n g f o r such a

t a r g e t , even w i t h o u t c o n d i t i o n i n g i t on a r e t u r n t o CRR!
been taken, p, y, m, and r would have been indeterminate.

I f t h e i r advice had
This i s a d i f f e r e n t

k i n d o f indetermi nacy than nominal indeterminacy, because r e a l v a r i a b l e s woul d
a l s o be indeterminate, and because i t does n o t depend on the nature o f
feedback.

It must be admitted, however, t h a t such an extreme p o l i c y would

make some loopholes i n t h e argument important.

These loopholes r e l a t e t o

reserve c a r r y o v e r provisions, as of adjustments, and t h e t i m i n g of borrowing.

i

These 1oophol es invol ve pal 1i a t i ve a c t i o n s by bank reserve management t h a t
I

" lean a g a i n s t " i n t e r e s t - r a t e movements.

I t seems c l e a r t h a t they can o n l y

m i t i g a t e and n o t e l i m i n a t e t h e magnified i n t e r e s t r a t e and o t h e r i n s t a b i 1it i e s
a r i s i n g from a p o o r l y designed pol i c y regime.

As proof of t h i s p r o p o s i t i o n ,

i t s u f f i c e s t o consider t h a t if t h e i n s t a b i l i t i e s were completely e l i m i n a t e d

by bank behavior, there would be no i n c e n t i v e s f o r such a c t i o n s by t h e banks.
Nonborrowed,reserve operating t a r g e t .

A nonborrowed reserve o p e r a t i n g

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t a r g e t would set:

which r e q u i r e s cl

= -1 and c 2 = c3 = 0, o r

T h i s i s i n e f f i c i e n t because i t ignores known s h i f t s i n borrowed reserve demand
( ~ ~ ~The1 r e. s u l t i n g money supply f u n c t i o n i s an upward-sloping (assuming
kl#O)

and s t o c h a s t i c r e l a t i o n between mt and rt:

f o r k2 # 0.

But i f kl = 0 (LRR), t h e money supply f u n c t i o n becomes a h o r i z o n t a l , y e t
s t i l l stochastic, r e l a t i o n :

f o r k2 f 0.

Hence, under LRR, a nonborrowed reserve operating t a r g e t i s e q u i v a l e n t t o a
s t o c h a s t i c funds r a t e peg.

On t h e o t h e r hand, if CRR were i n effect, and t h e discount r a t e were t i e d

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to rt, k 2 would equal zero, and the money supply function would be:

for kl # 0.
This money supply function i s vertical, b u t subject t o greater stochastic
influences than under the total reserve operating target, because known
borrowed reserve demand s h i f t s (wet) are ignored.

If both k 2 and k l are

zero ( L R R and a tied, or penalty, discount r a t e ) , then prices, output, money,

.

and the i n t e r e s t r a t e are indeterminate (thei r variance i s indefinitely 1arge)
Another feature of the nonborrowed reserve operating t a r g e t i s t h a t i t
inefficiently ignores any information about excess reserve demand.

Although

the model assumes, f o r simplicity, t h a t the Federal Reserve has no such
information, i n practice i t often has.
Borrowed reserve target.

A borrowed reserve target i.s equivalent t o the

condi ti on :

By renormal i zi ng this condition, we arrive a t the money supply function:

(44) rt

-1wZt,

= -k2

for k2t0.
T h i s i s equivalent t o the special case of the "pure" funds r a t e rule w i t h
bp = -kil.

T h i s target i s obviously inefficient, because i t permits

the funds r a t e t o fluctuate i n response t o known disturbances i n borrowed
reserve demand.

I t also obviously does not "lean against" commodity market o r

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money demand disturbances t o stabilize prices, output, or money.

The

borrowing target del i vers a money supply function that i s horizontal and
stochastic--a "dirty" funds rate pol icy.
Under LRR, the borrowed reserve target i s less inefficient than a
nonborrowed reserve target.

The borrowed reserve target, unlike the

nonborrowed reserve target, insulates the money supply function from
unobserved fluctuations i n excess reserves, uncontrollable factors affecting
reserve supply, and borrowed reserve demand.

Under CRR, these advantages of a

borrowing target must be weighed against the "1eani ng against" properties of
the nonborrowed reserve target.
Free reserve operating target.

A free reserve operating target i s

identical t o a borrowed reserve target, in the (assumed) absence of any
information about fluctuations i n excess reserves.

Hence, like a borrowing

target, i t i s less inefficient t h a n a nonborrowed reserve target under LRR,
and may be more or less inefficient t h a n a nonborrowed reserve target under

CRR.

The October 1979 Regime Change
The regime change t h a t occurred i n October 1979 involved two major elements.
First, the operating procedure shifted from a federal funds rate rule t o a
quanti ty-setting ruq e.
altered.

Second, the nature of the feedback was fundamentally

Our model i s best suited t o analyze the former.

In terms of the instrument issue, the 1979 s h i f t was highly

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inappropriate.

As shown above, t h e pure funds r a t e r u l e i s optimal under

lagged reserve requirements.
(45)

The regime change a l t e r e d t h e p o l i c y r u l e from:

rt = 0,

where t h e l a t t e r r e f l e c t s t h e attempt by t h e Federal Reserve t o o f f s e t known
changes i n u n c o n t r o l l abl es and borrowed reserve demand (Levi n and Meek 1981 1.
The money supply f u n c t i o n then became:

A comparison o f equation (47) w i t h equation (45) y i e l d s an immediate

conclusion.

The adoption o f a q u a n t i t y r u l e under LRR ushered i n a regime

t h a t o f f e r e d i n f e r i o r p o t e n t i a l c o n t r o l o f money, r e l a t i v e t o t h e funds r a t e
regime and, i n a d d i t i o n , increased t h e variance o f innovations i n i n t e r e s t
rates.

E m p i r i c a l l y , t h e change i n o p e r a t i n g procedures was associated w i t h a t

l e a s t a doubling of t h e c o e f f i c i e n t of v a r i a t i o n i n t h e e n t i r e m a t u r i t y
spectrum o f i n t e r e s t r a t e s (Hoehn 1982).

The standard d e v i a t i o n o f monthly

percentage growth r a t e s i n M I , adjusted f o r s h i f t s t o negotiable order o f
withdrawal (NOW) accounts, rose by about o n e - t h i r d (Hoehn 1983b1, as shown i n
t a b l e 1.
A s i m i l a r conclusion holds f o r t h e variances o f innovations i n o u t p u t and
t h e p r i c e 1eve1:

they shoul d have increased, regard1 ess o f t h e o b j e c t i v e t h e

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pol i c y r u l e was intended t o s a t i s f y .

That i s because under LRR, t h e optimal

value o f c g i s i n f i n i t y f o r any o b j e c t i v e f u n c t i o n defined on t h e variances
of y, p, m, and r.

The reason can be explained q u i t e simply:

money supply f u n c t i o n i s h o r i z o n t a l .

under LRR, t h e

Macroeconomic events cannot a f f e c t t h e

i n t e r e s t r a t e w i t h o u t delay, as they would under CRR.

They do so under CRR

( g i v e n a f i x e d open-market p o s i t i o n ) by, f o r example, r a i s i n g t h e q u a n t i t y o f
money, i n t u r n r a i s i n g t h e demand f o r reserves, and thus r a i s i n g t h e funds
rate.

This 1i n k was delayed under LRR f o r two weeks, by which time

a p p r o p r i a t e feedback c o u l d be administered i n any case.

On t h e o t h e r hand,

reserve market disturbances c r e a t e f l u c t u a t i o n s i n t h e i n t e r e s t r a t e .

The

r e s u l t i s a money supply curve t h a t i s h o r i z o n t a l and t h e r e f o r e cannot " l e a n
a g a i n s t " macro disturbances, y e t t h e p o s i t i o n o f t h a t curve i s d i s t u r b e d by
t h e reserve market shocks.

I t would be unambiguously b e t t e r , given t h a t t h e

money supply curve is h o r i z o n t a l , t o f i x t h e r a t e t o prevent i t from
f l u c t u a t i n g u n h e l p f u l l y i n response t o reserve market disturbances.

This

e x p l a i n s why the optimal combination pol i c y has cg equal t o i n f i n i t y - - a

.

pure r a t e - s e t t i n g r u l e a f t e r a1 1

T h i s r e s u l t o b t a i n s regard1 ess o f t h e

o b j e c t i v e function.
Some went so f a r as t o argue t h a t , under LRR, t h e r e was no money supply
f u n c t i o n a t a1 1.

According t o Porter, Lindsey, and Laufenberg (1975) :

...
under lagged reserve accounting, t h e textbook supply o f
demand deposits f u n c t i o n does n o t e x i s t : t h e r e i s no
independent avenue f o r reserve i n j e c t i o n s t o a f f e c t t h e
e q u i l i b r i u m l e v e l of d e p o s i t s i n t h e same week o t h e r than by
operating through i n t e r e s t r a t e s and deposit demand.
Marshall's s c i s s o r s has l o s t one o f i t s blades (p. 4).

.demand
.. no rdeposits,
e l a t i o n . . .exists.. . t o r e l a t e t h e c u r r e n t week's
nonborrowed reserves, and i n t e r e s t r a t e s
t h a t i s n o t dependent on t h e demand deposit function (p. 40).

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Certainly i t i s true t h a t , under LRR, the textbook money supply function does
not e x i s t , essentially because one cannot renormalize the reserve demand
equation to express the current quantity of money as a function of the current
level of

reserve^.^

B u t the apparent suggestion i s t h a t under LRR, the

money stock i s s t r i c t l y demand-determi ned.

Thi s i s incorrect.

The money

demand function gives us a relation between the money stock and the i n t e r e s t
r a t e , b u t i s not sufficient t o determine the quantity of money.

If the

i n t e r e s t r a t e i s given by the horizontal money supply function of LRR, then
money demand and supply jointly can determine the quantity.

If the horizontal

money supply function i s affected by reserve market shocks, then the supply
curve i s doing as much cutting as the demand curve.

In the model, the only

case i n which the money stock i s s t r i c t l y determined by e i t h e r demand o r
supply occurs when the money supply curve i s vertical, a s i n the case of CRR
and a total reserve operating target.

Then the money stock would be s t r i c t l y

supply-determined, and the r a t e would be determined by both supply and demand.
Laurent (1984) suggests t h a t one need not suppose the existence of a money
demand function a t a l l t o understand how the quantity of money i s determined.
Laurent's model has not been formalized, b u t appears t o lack an adequate
number of equations t o determine equilibrium in the money market and the
quantity of money.
model

.

Inclusion of a money demand equation would complete the

On the other hand, Kopecky (1984), i n an exchange w i t h Laurent, seems

t o propound the notion t h a t the concept of money supply i s not a useful
analytical concept.

His model i s quite explicit, b u t his use of

the concept of money demand seems confined to the determination of the
currency-to-demand deposit and time deposi t-to-demand deposit r a t i o s i n

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-

39

-

familiar models such as t h a t of Burger (1971), who considers his a "money
supply" model!

Indeed, there does not appear t o be any fundamental difference

between Kopecky' s and Burger's model s.
I t must be confessed that, i n a model i n which the pub1 i c can hold money
in the form of currency and different deposits w i t h different reserve
requirement r a t i o s , the di s t i n c t i on between demand and supply becomes
probl emati c.

I f the model were expanded t o incorporate t h i s heterogeneity i n

money, the distinction drawn between demand and supply sectors would be
bl urred.

However, qua1i tatively similar r e s u l t s could be derived.

The

incl usi on of currency, coup1 ed w i t h 1agged vault cash accounting, creates
somewhat more troubl ing analytical probl ems.

Neither of these issues seems

c r i t i c a l t o consider t o understand the essential nature of equi 1i bri um.
A source of confusion i n the 1i terature and financial press was the

supposition t h a t increased i nterest- rate vol a t i 1i ty per s e woul d be associated
with more precise monetary control.

Greater interest- rate vol a t i l i t y may be

associated w i t h t i g h t e r money control , y e t simply increasing the vol a t i l i t y of
the funds r a t e does not necessarily improve the control of money.
r e s u l t depends on the nature of the interest- rate v o l a t i l i t y .

Such a

The increased

range of movement i n i n t e r e s t rates improves money control i f i t represents
greater responses t o deviations of money from i t s target path.

B u t i f the

increased variabil i ty of i n t e r e s t r a t e s i s unrelated t o money demand s h i f t s ,
as i n the case of a reserve market disturbance affecting the funds r a t e , then
the increased variabil i ty worsens money control.

A similar k i n d of argument

against interest- rate v o l a t i l i t y per se can be made i f the objective i s price

or output stabilization.

What the 1979 policy d i d , from the standpoint of the

instrument issue, was simply t o randomize funds r a t e innovations, rather than
s e t up a mechanism f o r "1eaning against" money demand or commodity market

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disturbances.
I t was possible t o predict t h a t the 1979 pol icy would be accompanied by a
reduction in the elasticity of borrowed reserve demand, k2, under given
administrative guidelines for the discount window.

As the variance of the

funds rate increased, banks spread their limited borrowing privileges over a
wider range of funds rates.

A given rise i n the funds rate (relative t o the

discount rate) led t o less of an increase in borrowings.

While this

suggestion represents only an informal motivation for expecting a lower
elasticity, a more rigorous analysis has been offered by Goodfriend (1983)
t h a t seems t o imply the same result.

Furthermore, empirical observation seems

t o suggest that the elasticity d i d decline (see charts 1, 2, and 3 ) .
This kind of structural change worsened monetary control beyond w h a t would
have been expected from a fixed-parameter model.

Given LRR, the only way

excess supplies or demands for reserves due t o reserve market disturbances
coul d be el imi nated (barring any el astici ty in excess reserves) was by changes
i n borrowing induced by fluctuations i n the funds rate.

Just how far the

funds rate must move t o clear the market depended on the magnitude of k2.
As borrowed reserve demand becomes less el astic, the funds rate moves
further.

What a1so apparently happened was t h a t the borrowed reserve demand's

disturbance term increased in variance.

These two structural changes are

strongly suggested by the observed relation between borrowings and the spread
between the funds rate and the discount rate.

These changes i n the structure

of the model, brought a b o u t by the change in operating procedures, suggest

that simulations based on fixed-parameter models t h a t try t o assess the impact

of a1 ternati ve instruments may 1ead t o quantitatively quite inaccurate
results.

Work on the microfoundations of reserve demand behavior i s another

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f i e l d f o r research t h a t would enable us t o predict more accurately the e f f e c t s
of alternative operating procedures.

However, i t will be exceedingly'

d i f f i c u l t t o integrate f u l l y such analysis into a complete structural
probability model.

We may have t o resort t o ad hoc "patchups," accounting as

best we can for likely changes i n parameters and variances.
One d i r e c t imp1 ication of t h i s discussion i s that, under LRR, any
so-called reform of the discount window t h a t reduced the magnitude of k2
would not only destabilize p, y , and i n t e r e s t rates, b u t would a1 so reduce
monetary control.

In f a c t , a regime i n which k 2 were zero would lead t o

indeterminacy of p , y, m, and r.

T h i s i s a different k i n d of indeterminacy

than occurs under a funds r a t e peg without feedback, for not only are nominal
The indeterminacy now

magni tudes indeterminate, b u t so a r e real variables.

r e s u l t s from the i n a b i l i t y of any funds rate t o clear the reserve market.
Consequently, the money supply function i s undefined.

The discount window i s

the only safety valve for reserve market disturbances under LRR w i t h a
quantity-setting rule.

A discount r a t e t i e d t o the funds r a t e o r closure of

the window a1 together would each constitute such a regime i n which K2
equaled zero.

The monetarists should not have advocated such so-called

reforms without predicating them on a return t o CRR.
Wal sh (1984) suggested t h a t the increase i n i nterest- rate vol a t i l i ty would
a1 so be associated w i t h a decrease i n the e l a s t i c i t y of money demand.

Such a

change would, i t seems, reduce the control errors arising from reserve market
disturbances and associated interest- rate changes.

On the other hand, i t

would, given 1arge sel f-reversi ng money demand function s h i f t s , create further
i n s t a b i l i t y i n i n t e r e s t rates, prices, and output.

Hence, such a decline i n

the e l a s t i c i t y of money demand woul d probably be unhelpful , unless monetary

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c o n t r o l were desired f o r i t s own sake.
Wal sh' s r e s u l t s , however, appear t o depend c r i t i c a l l y on t h e absence i n
h i s model o f a nonmoney a s s e t w i t h a p o s i t i v e and c e r t a i n r a t e of r e t u r n .
Thi s f e a t u r e i s c r u c i a l , because, i n h i s model, money is e s s e n t i a l l y he1d f o r
p o r t f o l i o r a t h e r than t r a n s a c t i o n s reasons.

Furthermore, a d e c l i n e i n money

demand e l a s t i c i t y was n o t e m p i r i c a l l y observed a f t e r 1979.

While i t would be

s u r p r i s i n g i f t h e money demand f u n c t i o n were e n t i r e l y i n v a r i a n t w i t h respect
t o pol i c y , i t i s very d i f f i c u l t t o model t h e demand f o r t r a n s a c t i o n s media i n
a completely adequate a n a l y t i c a l fashion, from f i r s t p r i n c i p l e s r a t h e r than
s t a r t i ng from curves.
A1 though t h e October 1979 p o l i c y was n o t promising i n terms o f t h e
instrument issue, i t s feedback p r o p e r t i e s were more promising.

By using t h e

l e v e l o f nonborrowed reserves r a t h e r than t h e funds r a t e as t h e benchmark f o r
feedback decisions from one reserve p e r i o d t o t h e next, feedback apparently
allowed f a r l e s s scope f o r base d r i f t i n t h e money stock.

Hoehn (1983a) found

evidence t h a t t h e Federal Reserve's feedback i m p l i e d a f a s t e r response o f t h e
funds r a t e t o f l u c t u a t i o n s i n money growth.

This r e s u l t was a n t i c i p a t e d i n a

t i m e l y and p r e s c i e n t a r t i c l e by Judd and Scadding (1979).

Borrowed o r f r e e

reserves a1 so became more c l o s e l y r e l a t e d t o changes i n money growth.
The o v e r a l l assessment of t h e 1979 procedure, then, i s t h a t t h e Federal
Reserve t r i e d harder through stronger feedback t o keep t h e money stock on i t s
annual t a r g e t path a f t e r i n i t i a l money d e v i a t i o n s took place, b u t t h e
procedure p e r m i t t e d 1a r g e r i n i t i a l d e v i a t i o n s t o occur.

It i s hard t o judge

whether t h e new procedure was a n e t improvement, d e s p i t e improved feedback.
(Money and o t h e r v a r i a b l e s became more unstable, b u t one can argue t h a t o t h e r
causes were a t work.)

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In any case, i t i s the role of economists t o suggest better means of
accomplishing given objectives, and there was much i n the 1979 modus operandi
to c r i t i c i z e on technical grounds.

An important unanswered question about the

1979 procedure i s whether appropriate feedback could have been delivered
without adopting a regime t h a t had extremely poor operating characteristics.
To the extent t h a t the Federal Open Market Committee (FOMC) tends to confuse
instruments and targets i n the way suggested by Judd and Scadding (1979),
appropriate feedback depends on choosing an instrument t h a t proxies f o r the
target as closely as possible over cyclical and secular timeframes.

B u t to

the extent t h a t the FOMC ' s continuing confusion merely ref1 ects the continuing
confusion among economists of the feedback and instrument issues, i t will
become possible t o design and adopt pol icy regimes w i t h appropriate feedback
without the problems associated w i t h the 1979 procedure, as economists come t o
make clearer distinctions.
Another c r i t i c a l issue i s whether some types of feedback are really more
appropriate than others, or i n what sense they are more appropriate.

In the

formal model, the k i n d of (lagged) feedback i s of consequence to neither
output

nor innovations i n any endogenous variables.

In more Keynesian

model s--for example, w i t h mu1 t i period contracts as i n F i scher (1977) or Tayl or
(1979)--the type of feedback will be important f o r output stabilization.

V.

More Recent Operating Procedures and the Imposition of Partially
Contemporaneous Reserve Requirements

The procedure i n e f f e c t from the f a l l of 1982 until the institution of
parti a1 l y contemporaneous reserve requirements i n February 1984 apparently

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adopted borrowed reserves as the benchmark for feedback, b u t used nonborrowed
reserves as the operating target.

The nonborrowed reserve target implied t h a t

the criterion of open-market operations was:

Under LRR, this resulted in money supply behavior t h a t determined the rate
accordi ng t o:

which allows the funds rate t o vary w i t h reserve market shocks, b u t not i n
response t o commodity market or money market shocks.

This i s another variant

of the "dirty" funds rate peg.
When CRR was adopted, the Federal Reserve announced i t s intention t o
maintain unchanged operating procedures.

B u t the anticipated uncertainty

among banks regarding their reserve positions during the f i r s t few reserve

periods was expected t o increase b o t h the level and the variance of excess
reserves.

I t was appropriate t o adopt a procedure for offsetting expected

fluctuations i n excess reserves.

As shown i n equations (43) and (441, a

borrowed reserve operating target, as opposed t o a nonborrowed reserve
operating target, has this property.

In addition, i t automatically offsets

any unexpected b u t observed or known current fluctuations i n excess reserves.
Hence, the anticipated problems of the transition t o CRR may have prompted
reconsideration of the nonborrowed reserve operating target.

Apparently the

Federal Reserve in fact moved t o a borrowed reserve operating target after the

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reimposition of CRR, even beyond the initial transition period.
properties of such a regime have been analyzed above:

The

i t i s equivalent t o a

"dirty" funds rate rule, w i t h the funds rate target dependent upon known
disturbances i n borrowed reserve demand. Obviously, since such a dependence
i s unhelpful, a pure funds rate rule woul d constitute a better operating
procedure.

B u t a comparison of equations ( 4 4 ) and ( 4 9 ) makes clear t h a t the

borrowed reserve target (under either LRR or C R R ) i s an improvement over the
nonborrowed reserve target under LRR.

And furthermore, the switch from a

nonborrowed reserve t o a borrowed reserve operating target as CRR was
instituted may have been an improvement over maintenance of the nonborrowed
reserve operating procedure.

This contention will appear paradoxical, since

i t has been contended above t h a t the October 1979 regime, which incorporated a
nonborrowed reserve operating target, would have been improved upon by a
reimposition of CRR.
To explore this paradox, i t i s useful t o suppose the nonborrowed reserve

operating target had been maintained as CRR was imposed.

With CRR

reinstituted, the same operating procedure would have implied an upward slope
to the one-period money supply curve:

A clear imp1 ication i s t h a t the character or distribution of sources of

interest-rate fluctuations would have been quite different than under LRR,
despite continued employment of the nonborrowed reserve operating target.
With this money supply sector, r i s exposed to all the disturbances i n the

model, whereas i t was exposed only t o reserve market shocks before.

The

response of r t o reserve market shocks will be muted, however, because in

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addition t o the safety valve of the window, the familiar textbook adjustment
mechani sm invol v i ng changes i n requi red reserves a1 so comes into p l ay

.

Nevertheless, i t seems likely t h a t the overall e f f e c t on the variance of r
would have been an increase.

A t l e a s t t h i s would have been true i f the only

change had been t o unlag reserve requirements.
One implication of the new upward slope i n the money supply function would
have been that the variance of one-period innovations i n the money stock would
have been reduced i n t h i s model , given a preponderance of money demand shocks
relative to money supply shocks.

And i t might appear t h a t , by g i v i n g money

supply an upward slope, reintroduction of CRR would have brought an
improvement, whether our objective were t o s t a b i l i z e p, y, o r m, because r
would lean against commodity market and money demand s h i f t s .

B u t there are a t

l e a s t three reasons f o r doubting t h i s , as follows:
F i r s t , assuming borrowed reserves continued t o serve as the benchmark f o r
feedback from one period t o the next, any response of r t o macroeconomic
disturbances would have been reversed i n the subsequent reserve period.

So

reinstitution of CRR under the same operating procedures would essentially
have j u s t increased the range of self-reversing fluctuations i n the funds
rate.

For example, a s h i f t i n aggregate demand, aggregate supply, or money

demand, whether temporary o r permanent, would have affected the r a t e only f o r
the current reserve period (the rate would have had a memory of only one
period) unless the borrowed reserve benchmark were systematically a1 tered.

In

t h i s context, the favorabl e conclusion derived from our model seems especi a1 ly

dependent on the exclusion of the current i n t e r e s t r a t e from the public's
information s e t i n forming inflation expectations.

That exclusion i s once

again of no consequence i f the price level fluctuates randomly around a
stationary trend, b u t the assumption i s quite implausible when borrowed

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reserves a r e used as t h e benchmark f o r feedback adjustment t o t h e nonborrowed
reserve operating target.

The t r e n d - s t a t i onari t y assumpti on woul d be more

p l a u s i b l e i f nonborrowed reserves o r t o t a l reserves were used as t h e feedback
benchmark, as i n t h e 1979 procedure.
The consequences o f re1axing t h e t r e n d - s t a t i onari t y assumption a r e
A conjecture i s t h a t t h e increase i n

impossible t o e s t a b l i s h w i t h c e r t a i n t y .

sel f - r e s e r v ing f l uctuations would reduce t h e information content o f t h e
i n t e r e s t r a t e , and l e a d t o greater i n s t a b i l i t y i n prices, output, and money.
Second, t h e recent change i n reserve r e g u l a t i o n s d i d considerably more
than simply unlag reserve requirements.

I t a1so doubled t h e reserve period,

preserved a two-day lag, allowed expanded carryover p r i v i l e g e s , changed t h e
f l o w and t i m i n g o f deposit and other i n f o r m a t i o n a v a i l a b l e t o t h e pol icymaker,
and so on.

It i s harder t o assess t h e o v e r a l l impact o f a l l o f these changes

taken together.

Reserve requirements (kl)

were a l s o changed a t t h e same

time.
Goodfriend (1984a) notes t h a t t h e two-day l a g between computation and
maintenance periods under t h e c u r r e n t system o f so- called contemporaneous
reserve requirements can, under c e r t a i n open-market pol i c i es, compl e t e l y
e l i m i n a t e t h e p o t e n t i a l advantages o f CRR.

I f t h e Federal Reserve s t a b i l i z e s

the funds r a t e o r otherwise abandons i t s reserve t a r g e t i n g i n t h e l a s t two
days o f t h e maintenance periods, banks w i 11 engage i n intertemporal a r b i t r a g e
i n t h e reserve market so t h a t t h e funds r a t e w i l l be determined s t r i c t l y by
banks' expectations o f t h e Federal Reserve's funds r a t e t a r g e t i n these two
days.

An i n t e r e s t i n g i m p l i c a t i o n i s t h a t i f t h e Federal Reserve i n t e r p r e t e d

the funds r a t e ' s l e v e l i n t h e f i r s t 12 days as conveying information from t h e
market, and then s t a b i l i z e d t h e r a t e i n some degree i n t h e l a s t 2 days, t h e

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Federal Reserve would be engaging i n self-deception.

Rather than 1ooking a t

the r e s t of the world through a window, the Federal Reserve would be seeing
i t s e l f i n a mirror--albeit a "funny-house" mirror.

The reflection would be

distorted by the market's i n a b i l i t y t o comprehend f u l l y where the Federal
Reserve's funds r a t e target is.
T h i r d , the nonborrowed reserve operating target would probably have too

much current-period response of i n t e r e s t r a t e s t o money movements, given the
current economic environment.

I f income or price level s t a b i l i z a t i o n i s the

objective, and i f money demand i s v o l a t i l e and therefore serves a s a poor
proxy for the unobserved price and output level, exposing the i n t e r e s t r a t e t o
fluctuations caused by money demand s h i f t s i n the manner implied by current
operating procedures m i g h t increase i n s t a b i l i t y i n p and y.

Under LRR, funds

r a t e innovations were unaffected by disturbances t o aggregate demand and
supply or money demand.
such d i sturbances.

Under CRR, funds r a t e innovations will r e f l e c t a l l

The exposure t o money demand disturbances i s obviously

unhelpful, although i t cannot be avoided, i f responses t o aggregate demand and
supply shocks are t o be a l l owed.

T h i s wri t e r ' s intuition i s t h a t the degree

of responsiveness of the i n t e r e s t r a t e t o the three shocks taken together will
be too 1arge r e l a t i v e t o the optimal response.

In other words, because money

demand innovations a r e relatively large, the optimal combination policy will
be one i n which cg i s very high--a1 though f i n i t e , under CRR--so the i n t e r e s t
r a t e should respond very 1i t t l e.

The nonborrowed reserve operating target

will a l l ow too much one-period response.

The restoration of CRR has the e f f e c t of reducing the optimal value of c3
from i n f i n i t y t o some f i n i t e number.

Given the recent environment i n which

aggregate demand and supply shocks (essentially, inflation uncertainty) seemed
small , and money demand uncertainty was great, the optimal val ue of c3 was

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probably very high.

B u t in an environment of accelerating inflation, i n which

aggregate demand and supply d i sturbances a r e 1arger re1 a t i ve t o money demand
disturbances, c3 should be 1ower.

The restoration of C R R , together w i t h the

Monetary Control Act and reductions i n the variance of f l o a t , reduces the
optimal value of c3 and will render a pol icy 1ike t h a t of 1979 more
a t t r a c t i v e in an environment of inflation uncertainty.

Concluding Remarks on Recent Operating Procedures

VI.

T h i s discussion has emphasized how theoretical analysis of operating

procedures can be very m i sl eading i f i t ignores regul atory and i n s t i t u t i onal
factors.

Casual empiricism can also lead one t o the wrong conclusions, i f the

interactions of operating procedures, regul atory and institutional factors,
and the scope and nature of feedback (both "discretionary" and "automatic")
are over1 ooked.

For exampl e:

( 1 ) The 1979 policy procedure was not a f a i r t e s t of how well a
reserve-based procedure can control money without excessive interest- rate
vol a t i l i ty, because i t was conducted without benefit of reforms since
instituted.

Those who concluded from the experience t h a t a reserve-based

pol icy cannot improve monetary control are ignoring the interaction of
operating procedures and the regul atory and institutional factors.
( 2 ) The recent switch t o CRR under current operating procedures i s not

l i k e l y t o r e s u l t i n any improvement i n monetary control or s t a b i l i t y of the
macroeconomy.

Undoubtedly, some will conclude that the switch t o CRR i s

inconsequential

.

Once again, this conclusion would ignore the interaction

between operating procedures and regul atory and insti t u t i onal factors.

A

complete structural analysis of the type made here suggests that CRR can only

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improve matters--the potential minimum variance of p , y , or m i s s t r i c t l y
lower for the optimal combination policy under CRR than the m i n i m u m under
LRR--except i n the special case where the optimal policy i s a pure
rate- setting rule.

In short, CRR improves the operating characteristics of

optimally designed pol icy rules--perhaps not i n a dramatic way, b u t i n
re1 ation t o benefits t h a t are economy-wide--on a $3 t r i l l ion base--almost
certainly greater than the few mil 1ions i t costs.

Footnotes
1. Optimal control t h e o r i s t s of the Keynesian school had e a r l i e r employed the
concept of the feedback rule. Unfortunately, t h e i r work apparently received
limited attention i n the economic profession a t large, despite the h i g h
qua1 i ty of analysis. Much of t h i s work, a s appl ied t o monetary pol icy, took
place in the Special Studies section of the Board of Governors' Division of
Research and S t a t i s t i c s , under the mentoring of Peter Tins1 ey, John
Kalchbrenner, and others. These analyses are, of course, subject t o the
well-known "Lucas critique." Nevertheless, they can be seen as quite
prescient and provocative.
2.

I t was widely thought a t the time t h a t the invariance of the output path

w i t h respect t o the feedback rule arose s t r i c t l y from the particular k i n d of

supply behavior Sargent and Wallace posited. I t has more recently been
recognized t h a t this invariance r e s u l t i s sensitive t o demand behavior. For
the most lucid treatment of t h i s point, see Canzoneri , Henderson, and Rogoff
(1983).

3. The Sargent and Wallace supply function also generates essentially the
same results w i t h regard t o the instrument issue as does supply behavior under
Fischer (1977) or Tayl or (1979) wage-contract model s. This statement woul d
not necessarily hold true, however, i f private agents used current information
s e t s i n forming future p r i ce-1 eve1 expectations as discussed i n a subsequent
section. These wage-contract models also have different optimal feedback
characteristics and have been used t o upset the policy ineffectiveness
proposition.
Apparently, Hoehn (1979, 1983b) and McCall um and Hoehn (1982, 1983)
performed the f i r s t such analysis f o r operating procedures i n the context of a
rational expectations model.

4.

5.

See Burger (1971 ) for an example of the textbook money supply function.

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Table 1 Money Variability Under the 1979 Pol icy Procedure

1 -R variabil i t y using original seasonal adjustment
Intra- year M
factors, i n standard deviation of annualized percent growth r a t e s

F i scal year( s )

1971-79 average

.

Quarterly

Monthly

6.1

3.0

SOURCES: Lindsey e t a1 , "Monetary Control Experience Under the New Operating
Procedures, "New rlonetary Control Procedures Vol ume 11, Federal Reserve
Staff Study, Board of Governors of the Federal Reserve System, February 1981;
Federal Reserve System, February 1981; Federal Reserve S t a t i s t i c a l Re1 eases
H .6, dated November 30, 1981, Apri 1 23, 1982, October 29, 1982, and November
29. 1982: Board of Governors of the Federal Reserve System: and Annual
s t a t i s t i c a l Digest, 1980, Board of Governors of the federal Reserve System,
table 13. p. 31.

-

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- 52 Chart 1 Borrowed Reserve Demand:

October 1976 t o September 1979

Spread

Borrowed reserves, b i l l i o n s o f do1 1a r s

SOURCE:

Board o f Governors of t h e Federal Reserve System.

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- 53 Chart 2 Borroded Reserve Demand:

October 1979 t o September 1982

Spread

Borrowed reserves, billions of dollars

SOURCE:

Board of Governors o f the Federal Reserve System.

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Chart 3 Borrowed Reserve Demand October 1979 t o September 1982
Adjusted f o r Surcharge
Spread -

Borrowed r e s e r v e s , b i l l i o n s of d o l l a r s

SOURCE:

Board of Governors of the Federal Reserve System.

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