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What Remains of Milton Friedman's
Monetarism?

WP 17-09

Robert L. Hetzel
Federal Reserve Bank of Richmond

What Remains of Milton Friedman’s Monetarism?

Robert L. Hetzel
Senior Economist
Federal Reserve Bank of Richmond
Research Department
P. O. Box 27622
Richmond VA 23261
804-697-8213
robert.hetzel@rich.frb.org
July 13, 2017

Working Paper No. 17-09

Abstract: From the early 1960s until the early 1970s with the emergence of rational expectations,
under the rubric of monetarism, Milton Friedman defined macroeconomic debate. Although the
Keynesian consensus that he challenged has disappeared, the current academic literature makes little
reference to monetarist ideas. What happened to them? The argument here is that those ideas remain
relevant but require translation into terms expressible in modern macroeconomic models and in the
monetary policies of central banks, neither of which contain any obvious references to money.
Moreover, the Friedman and Schwartz methodology for identifying shocks retains relevance.

JEL: B22

The author is senior economist and research advisor at the Federal Reserve Bank of Richmond. He
thanks Edward Nelson for helpful comments. The views in this paper are the author’s, not those of
the Federal Reserve Bank of Richmond or of the Federal Reserve System.
DOI: https://doi.org/10.21144/wp17-09

1

As exposited by Milton Friedman, monetarism incorporated two hypotheses. One is that the
price level is a monetary phenomenon in that its behavior depends upon the institutions for
controlling money creation. The second is that the price system works well in order to attenuate
cyclical fluctuations provided the central bank follows a rule that creates a stable nominal anchor and
that allows market forces to determine real variables. Professional consensus seems assured over
Friedman’s view that the severity of the Great Depression owed to contractionary monetary policy
while the inflation of the 1970s owed to inflationary monetary policy. Following Friedman’s
challenge to Keynesianism, economists no longer attribute failure of the price system to the
replacement of competitive markets by monopolies and inflation to the exercise of monopoly power.
Nevertheless, monetarism today appears to be just a name for ideas consigned to the history
of thought. The monetarist/Keynesian debate appears dated. In a PBS (2006) obituary, a newspaper
columnist characterized Milton Friedman as “a bookend to John Maynard Keynes.” Macroeconomic
research has moved away from empirical estimation of money demand functions. No one proposes
that central banks target money growth through the adoption of reserves-money multiplier
procedures. Much of the monetarist literature appears as event studies with little obvious relevance
to current central bank practices. Because of the absence of an explicit model, Friedman’s work in
monetary economics is difficult to read for the new generation of economists.
In addition, with the Great Recession, there has been a change in the intellectual environment
hostile to monetarist hypotheses. Some have argued that inflation targeting contributed to the Great
Recession by ignoring financial stability (Curdia and Woodford 2009; Woodford 2012). Market
commentators have argued that the appearance of the zero lower bound on interest rates has limited
the ability of central banks to achieve their inflation targets.
The argument here is that Friedman’s ideas can still stimulate debate. However, they need to
be translated into a language that is accessible to the new generation of economists. Specifically, one
can use the New Keynesian (NK) model as a Rosetta stone for translating his ideas. Ultimately,
monetarist hypotheses will survive or decline based on the acceptance of the NK model. Moreover,
in choosing among models in monetary economics, it is essential to keep in mind the poor
experimental design that generates the data. It remains important to understand how Friedman’s
methodology for the identification of shocks dealt with that fact.
Section 1 offers reasons why economists today find Friedman hard to read. Section 2
discusses his methodology in the context of the Cowles Commission debate. Section 3 reviews his
critique of the stop-go monetary policy. Section 4 summarizes the data that monetarists drew upon in
this critique. Section 5 relates monetarist ideas to the NK model. Section 6 provides a monetarist
overview of the Great Recession. Section 7 concludes.
1.

Why is Friedman hard to read?

In the 1960s through the early 1970s with the advent of rational expectations, Milton
Friedman was the dominant voice challenging the Keynesian consensus (Nelson, forthcoming). The
debate addressed the fundamental issues of macroeconomics. When left to operate without
“management” by the fiscal and monetary authorities, can the price system stabilize macroeconomic
fluctuations? Alternatively, is that management itself destabilizing? What is the nature of inflation?
What is the nature of the interaction between inflation and unemployment? Despite the continued
relevance of these issues, economists today no longer read Friedman’s work. Why is that?

2

Most obviously, his work includes no explicit model. The expositions in Friedman (1969
[1969]; 1989) start with the conceptual experiment of a doubling of the money stock that leads to a
doubling of the price level. In itself, the conceptual experiment offers no guidance on how to test the
hypothesis of the neutrality of money. The exposition then jumps to a summary of NBER style
cyclical timing relationships involving money. The empirical relationships between money and
cyclical peaks in the business cycle and between money and inflation, however, no longer offer
guidance on how to test hypotheses about the role of money in the transmission of monetary policy.
Friedman’s comparative advantage was as an applied statistician not as a model builder.
Moreover, Friedman developed his ideas over time in the context of contemporaneous debate.
Today, the disappearance of that context can render opaque the underlying issues. Consider two
examples. First, Friedman challenged the prevailing view of the Great Depression as evidence of
failure of the price system. According to the real bills views then prevalent among policymakers, the
role of the Fed was to proportion the supply of credit to the demand for credit arising from legitimate
(nonspeculative) uses. Given the view that it should only accommodate the demand for credit, the
Fed allowed the money stock to collapse. In their turn, Keynesians employed the idea of a liquidity
trap in order to dismiss the relevance of monetary policy to the Depression. In opposition, Friedman
used a reserves-money multiplier framework with reserves as an exogenous variable to argue that
money was a causal factor. Second, given his methodology for testing hypotheses based on their
predictive power, using OLS regressions, Friedman and Meiselman (1963) compared the power of
money versus exogenous expenditures (investment) for predicting consumption. The organization of
Friedman’s ideas around the exogeneity of money makes his work seem dated now.
2.

Identification: Friedman versus Cowles

In order to understand Friedman’s methodology for identification of the forces causing
macroeconomic instability, it is helpful to place it in the context of the debate that took place around
1950 at the University of Chicago between Friedman and members of the Cowles Commission. This
debate in turn arose in the context of the movement away from the institutionalism that emphasized
descriptive reality and how the structure of the economy would change as institutions changed.
Economics became a discipline that tested hypotheses based on the predictions of a model. The need
for a model in order to disentangle causation from correlation now constitutes a bedrock principle of
the discipline of economics. In this respect, the Cowles Commission set the research agenda for
modern macroeconomics (Christ 1952). The holy grail of macroeconomics has become construction
of a structural model of the economy grounded in microeconomic theory.
One motivating force behind the Cowles agenda was the creation of a structural model that
could be used to implement a policy of aggregate-demand management. Lawrence Klein (1964, 2)
wrote: “At an early stage, it was recognized that this policy implementation would require accurate
predictions of the macro-economy, and econometric model building has this goal precisely in mind.”
He led the profession in the estimation of large-scale econometric models of the economy subject to
identification restrictions such as the exclusion restrictions in individual equations. 1

1

Friedman (1953, 8) criticized this method of identification by pointing out that in dynamic models
in which the future is important expectations affect both supply and demand. “[T]he simple and even

3

In A Theory of the Consumption Function, Friedman (1957a) contributed to the Cowles
agenda of constructing micro-founded structural models. However, as reflected in his critique of
aggregate-demand management and his advocacy of rules that relied upon unfettered operation of the
price system to assure macroeconomic stability, Friedman was skeptical of economists’ ability to
construct adequate large-scale econometric models. Accordingly, as an alternative to identification
through estimation of such models, Friedman looked for episodes in which the Fed interfered with
the operation of the price system as flags for predicting cyclical turning points in the economy.
In this spirit, Friedman investigated how the practice of controlled experiments in the hard
sciences could be applied to economics. 2 In “The Methodology of Positive Economics,” Friedman
(1953) argued that the validity of a hypothesis lies not in its descriptive realism but rather in whether
its predictions can be refuted. Only with the abstractions of a model rather than with a complicated
description of reality is it possible to make predictions that can be refuted rather than rationalized ex
post (Hetzel 2016a). Friedman also stressed that the test of a model was not how well it fit the data
but rather how well it predicted when applied to data not available to the economist at the time of
formulating the model (Friedman and Schwartz 1991; Hammond 1996).
In testing monetarist hypotheses, Friedman organized the historical record in a way that
isolated episodes in which the Fed interfered with the price system. The challenge is that the forces
generating the phenomena of concern—inflation and cyclical fluctuations—are obscured by the poor
experimental design that gives rise to them. As evidenced by the historical narrative in Friedman and
Schwartz (1963a), Friedman therefore pursued an identification strategy characterized here as the
concatenation of semicontrolled policy experiments. During the monetarist heyday, Friedman
flagged them from monetary accelerations and decelerations (Friedman and Schwartz 1963b). The
use of historical narrative in order to concatenate episodes of monetary disorder would hopefully
wash out other forces that could not be held constant (Hammond 1996, 103). 3

obvious step of filing the relevant factors under the headings of ‘supply’ and ‘demand’ effects a great
simplification…. But the generalization is not always valid. For example, it is not valid in a …
speculative market.”
2

One can see the different approaches to identification in Koopmans’ (1947, 166-7) criticism of
Burns and Mitchell’s NBER approach to the study of the business cycle:
[E]conomic theories are based on … knowledge of the motives and habits of consumers and
of the profit-making objectives of business…. The mere observation of regularities in the
interrelations of variables then does not permit us to recognize or to identify behavior
equations among such regularities. In the absence of experimentation, such identification is
possible, if at all, only if the form of each structural equation is specified.

Friedman (1960, 23) chose to push the idea of “experimentation” in his narrative exploration of the
hypothesis that “Governmental intervention in monetary matters, far from providing the stable
monetary framework for a free market economy that is its ultimate justification, has proved a potent
source of instability.” See Hetzel (2016a).
3

The earliest example of Friedman’s concatenation methodology was “Price, Income, and Monetary
Changes in Three Wartime Periods” (Friedman 1952 [1969]). Friedman argued for inflation as a

4

Certain phenomena do not wash out, however. The alternations of phases of growth and
decline that characterize the business cycle entail the alternation of market psychology from
optimism about the future and debt accumulation to pessimism about the future and debt
deleveraging. Endowing these alternations of market psychology with causal influence motivates
real bills and Keynesian animal-spirits explanations of the business cycle as self-generating cycles of
instability in a capitalist system. Human nature produces periodic bouts of excessive speculation
followed inevitably by a period of purging required in order to eliminate the imbalances created by
prior speculation. Friedman therefore used historical information specific to place and time in order
to argue that the actions of the central bank often arose in response to adventitious events rather than
within a framework of a consistent response to the behavior of the economy. 4
Recognition that the estimation of micro-founded DSGE models defines the research agenda
in macroeconomics is consistent with admission that the models remain misspecified and thus
problematic for identifying the shocks that cause cyclical fluctuations (Chari et al. 2009). For
example, Andrle (2014, 5-6) wrote:
The assumption of uncorrelated structural shocks is always a point of departure when the
models are formulated…. However … it is a rule rather than exception that the uncovered
shocks are strongly correlated…. The issue is extremely common with DSGE models, where
the positive co-movement of output, consumption, investment, and hours is hard to
achieve…. Economists must work with misspecified models, because there are no other
models.
The historical narrative approach of Friedman and Schwartz to identification probably makes many
uncomfortable because it involves judgment and is not quantitatively replicable. In a world in which
poor experimental design renders purely econometric techniques inconclusive, however, economists

monetary phenomenon using the Civil War, World War I, and World War II. He pointed to the
consistency of money per unit of output as a predictor of the price level while fiscal policy and union
power varied greatly in each wartime instance. One can find another example in a letter that
Friedman (1957b) wrote Arthur Burns criticizing Burns’ manuscript for the book Prosperity without
Inflation. Friedman argued that one should consider the effect of the money stock on nominal
expenditure and prices independently of the operation of the credit market. “[I]t is striking that
changes in the stock of money have had very similar effects under widely different institutional
arrangements for bringing about changes in it, some under which the credit market was of minor
importance....”
4

Friedman (1960, 22-23) wrote:
This sketch of our monetary experience has concentrated on the major economic
fluctuations—those substantial inflations and severe contractions that have from time to time
produced widespread distress…. Every such episode has been accompanied by a significant
monetary disturbance…. The monetary disturbances have had a largely independent origin in
enough cases to establish a strong presumption that they are contributory causes rather than
simply incidental effects of the economic fluctuations….

For more recent examples, see Romer and Romer (1989) and for the United Kingdom, Cloyne and
Hürtgen (2016).

5

should continue to consider as one tool for identification Friedman’s methodology, which treats
recessions as a series of concatenated event studies in which the central bank interferes with the
operation of the price system.
3.

Friedman’s critique of activist policy

Friedman advanced three criticisms of the Fed’s activist policy in the 1970s. The intention
was to achieve low, stable unemployment at an acceptable cost in terms of inflation as measured by
the Phillips curve. First, he associated a policy of aggregate-demand management with a simple
feedback rule running from the economy to the Fed’s instrument—money. Using the price level as
an example, Friedman (1960, 87) argued
that the link between price changes and monetary changes over short periods is too loose and
too imperfectly known to make price level stability an objective…. While the stock of money
is systematically related to the price level on the average…. there is much evidence that
monetary changes have their effect only after a considerable lag and over a long period and
that the lag is rather variable. [Italics in original] 5
Stimulative policy in recession might be appropriate, but attempts to implement such a policy
contemporaneously can destabilize the economy as its effects might emerge only after recovery had
begun. Friedman and Friedman (1984, 100) highlighted the lag in the effect of monetary
accelerations on real output of nine months and on inflation of two years and argued that “using
today’s prices to determine today’s monetary growth is like fighting the last war.” (See Figures 1
and 2.) In the figures, the lag in money starts in 1956 when the lean-against-the-wind (LAW)
procedures of the William McChesney Martin Fed came fully into effect (Hetzel 2008, Ch. 4). Note
that in the stop-go era when inflation did emerge, the Fed responded strongly to it (Figure 3).
Friedman (1980, 270) wrote:
The United States has embarked on rising monetary growth four times during the past twenty
years. Each time the higher monetary growth has been followed first by economic
expansion, later by inflation. Each time the authorities have slowed monetary growth in
order to stem inflation. Lower monetary growth has been followed by an inflationary
recession.... [W]e have overreacted to the recession by accelerating monetary growth, setting
off on another round of inflation, and condemning ourselves to higher inflation plus higher
unemployment.
Friedman (1968 [1969], 109) explained stop-go as follows:
The reason for the propensity to overreact seems clear: the failure of monetary authorities to
allow for the delay between their actions and the subsequent effects on the economy. They
tend to determine their actions by today’s conditions—but their actions will affect the

5

In the context of discussion of the NK model, a later section will return to the Friedman criticism in
the quotation of making “the price level an objective” and the Friedman (1975 [1983]) criticism,
reproduced below, of using the funds rate as an instrument.

6

economy only six or nine months later. Hence they feel impelled to step on the brake, or the
accelerator, as the case may be, too hard.
The monetarist narrative identified stop-go policy with cyclical inertia in the adjustment of
the Fed’s funds rate target (see, for example, Poole 1978, 105). 6 Friedman (1984, 27) wrote:
Rising concern about inflation, and growing recognition of the role played by monetary
growth in producing inflation, led Congress in 1975 to require the Federal Reserve to specify
targets for monetary growth…. In practice, it continued to target interest rates, specifically
the federal funds rate, rather than monetary aggregates, and continued to adjust its interest
rate targets only slowly and belatedly to changing market pressure. The result was that the
monetary aggregates tended on average to rise excessively, contributing to inflation.
However, from time to time, the Fed was too slow in lowering rather than raising the federal
funds rate. The results were a sharp deceleration in the monetary aggregates and an
economic recession. [italics added]
In his second critique, Friedman (1981 [1983], 244-247) criticized the Fed’s practice of
“pegging the federal-funds rate” with the result that “mistakes are cumulative and self-reinforcing.”
[I]f the Fed picks too high a funds rate, it must drain an excessive amount from the
[monetary] base, discouraging spending, decreasing demand for loans, and ultimately adding
to downward pressure on interest rates…. [I]n using the federal-funds rate as its operating
target, the Fed is always balancing on a knife-edge…. [C]ontrolling the base directly and
letting the market determine interest rates could produce steady and predictable monetary
growth…. The belief that the Fed can or does control interest rates is a myth….
Friedman (1975 [1983], 230) wrote earlier, “So long as the Fed tries to control monetary growth
through the federal-funds rate, it will fail.”
In his third critique of activist policy, Friedman (1968 [1969]) criticized the idea of assuming
predictable trade-offs between inflation and unemployment represented by the Samuelson-Solow
(1960 [1966]) Phillips curve. As part of the hypothesis that a market economy does not assure full
employment, Keynesians assumed the pervasiveness of institutionally determined nominal prices
including wages. The resulting taxonomic classification of inflation included demand-pull, costpush, and wage-price spiral. As a result of demand-pull inflation, fluctuations in aggregate demand,
real or nominal, would cause inverse movements in inflation and unemployment while cost-push
inflation would shift inflation upward for a given level of unemployment (Hetzel 2013a).
Friedman criticized the implication of the above reasoning that real variables lack welldefined values but rather fluctuate in response to variation in aggregate demand. In doing so, he
reintroduced the idea of natural values. The price system works well to determine unique, marketclearing values of real variables. The Phillips-curve correlations between prices and output result

6

Fève et al. (2009, 13) repeat for Europe this monetarist critique: “[T]he form of monetary policy,
namely monetary policy inertia, has played an important role in the large and persistent increase of
the real interest rate and the sizeable output losses that have followed from disinflation policies of the
eighties.” See also Fève et al. (2010).

7

from central bank behavior that causes the price level to evolve in an unpredictable manner. Over a
period long enough to identify changes in aggregate nominal demand due to monetary policy, firms
undo the effects of monetary policy on output and employment.
The pre-1981 period constituted an extraordinary period for testing monetarist hypotheses.
Because the real demand for the monetary aggregate M1 was interest insensitive, nominal money
bore a fairly stable relationship to nominal output. Money then served as a reliable indicator of the
stance of monetary policy. 7 The ability of money to predict nominal GDP and inflation is consistent
with variations in money arising from discrepancies between the real value of the Fed’s funds rate
target and the natural rate of interest. (See Figures 1 and 2.)
4.

Identification of episodes of contractionary monetary policy as event studies

Friedman’s methodology for identifying fluctuations in money as arising independently of
nominal income and prices used the intuition of price fixing in an individual market applied to Fed
interference with the market determination of the real interest rate (Friedman 1968 [1969], Sec. I. A;
1981 [1983], 244-247 cited above). In the absence of a structural model of the economy capable of
measuring a divergence between the real rate of interest implied by the central bank’s interest rate
target and the natural rate of interest, Friedman and Schwartz (1963b) highlighted the associated
monetary accelerations and decelerations. Following them, Figures 4 and 5 show annualized M1
growth rates using step functions fitted to the monthly observations as a visual aid to seeing the
alternations in money growth rates. As shown, monetary contractions predict cyclical peaks.
As noted in footnote 7, this method of identification lost relevance in the early 1980s. In
order to give continued empirical content to the monetarist view that the price system works well to
attenuate cyclical fluctuations in the absence of monetary disturbances, it is useful to note that
recessions are infrequent events. It follows that the central bank must possess a baseline rule that
allows the price system to work. That rule was never one of explicit monetary control but rather, in
the words of William McChesney Martin, was one of “lean-against-the-wind” (LAW). In a
measured, persistent way, the Fed raises the funds rate above its prevailing value when output grows
at a sustained rate in excess of potential (rates of resource utilization are increasing and the
unemployment rate is falling) and conversely in the case of sustained economic weakness.
The lag in lowering rates after cyclical peaks resulted in monetary deceleration while the lag
in raising rates after cyclical troughs resulted in monetary acceleration (Friedman 1984, 27, cited
above). That cyclical inertia originated in the Fed’s periodic attempt to manipulate an output gap.
As reflected in the appellation “stop-go” monetary policy and as criticized by Friedman (1968
[1969]), the Fed wanted to create a negative output gap in order to lower inflation after cyclical peaks
and wanted to speed reduction in the magnitude of the negative output gap after cyclical troughs
(Hetzel 2008, Chs. 23-25).

7

With the deregulation of interest rates legislated in the Monetary Control Act of 1980, real money
demand became interest sensitive and the behavior of M1 became countercyclical. For example, in
recession, which calls for cyclically low interest rates, M1 growth rises.

8

Figures 6 and 7 show the weakening of real GDP growth prior to cyclical peaks. Figures 8
and 9 fit a trend line to real personal consumption expenditures from peak to peak for a given cycle
and extend it through the subsequent recession (monthly data become available in 1959). (A single
trend line is fitted to the short 1980 recession and the 1981-82 recession.) As shown, consumption
weakened relative to trend prior to cyclical peaks. Figures 10 and 11 show the cyclical lag at peaks
in the decline in the real rate of interest. 8 Figure 12 shows the real rate series from Figure 11 and the
output gap measured by the Congressional Budget Office.
Standard Fed rhetoric is that because interest rates are at cyclical lows during recessions,
monetary policy is easy. However, the relevant characteristic of policy is the inertia the Fed imparts
to the funds rate prior to cyclical peaks while the economy weakens. Although Fed policymakers
never talk in terms of trade-offs, effectively at these times they were trying to create a negative
output gap in order to lower inflation.
Figures 13 and 14 organize a narrative account of Fed behavior. 9 Going into recessions,
inflation (the solid line) is at a cyclical high. Examination of FOMC transcripts shows that the
priority of the Fed at these times was to reduce inflation (Hetzel 2008, 2012, 2013a, 2013b; Romer
and Romer 1989). As a consequence, the Fed raised the funds rate until the economy weakened, as
illustrated by the way in which consumption fell below trend (dashed line). It then maintained a
cyclically high real rate (diamonds) in order to create a negative output gap. Over the course of the
recession, the real rate declined. With the exception of the recovery from the July 1981 to November
1982 cyclical contraction, during the economic recovery short-term real interest rates fell to zero.
However, by then it was too late to undo the effects of contractionary monetary policy.
The criteria used above in order to associate contractionary monetary policy with the onset of
recession provide causal substance to the common practice of using the yield curve as a predictor of
recession. As illustrated by Estrella and Trubin (2006), forecasters associate a flattening of the yield
curve with an increased probability of recession. While the Fed is raising short-term rates out of
concern for inflation, in response to a weakening economy, markets are lowering long-term rates.
Wright (2006) shows that a better predictor of recession is the combination of a flattening of the yield
curve and a cyclically high short-term interest rate, as is evident in Figures 10 and 11.
The validity of monetarist hypotheses depends upon the interpretation of the experiment in
the Volcker-Greenspan era of abandoning stop-go. In the Volcker-Greenspan era, the Fed

8

Figure 10 uses inflation forecasts from the Livingston survey, which is biannual and available after
1945. Figure 11 uses inflation forecasts contained in the Board of Governors staff document called
the Greenbook prepared for FOMC meetings. See “Appendix: Real Rate of Interest.”

9

An empirical Taylor-rule literature characterizes Fed behavior. In these regressions, the constant
term plus the output gap capture the cyclical behavior of short-term interest rates over the cycle while
the inflation term captures the relationship between trend inflation and short-term interest rates.
Because these regressions are reduced forms, two caveats arise. First, they only partially capture the
relevant structural reaction function used by the Fed. Second, to the extent that they do capture the
latter, there is no reason to believe they express optimal policy around cyclical peaks when the Fed
responds directly to inflation it considers too high (Hetzel, forthcoming).

9

accompanied its LAW procedures with communication to financial markets that changes in the funds
rate would cumulate to whatever extent required in order to maintain low, stable inflation. The
marker for the credibility of this commitment was the absence of inflation premia in bond rates. 10
The most dramatic tests of the Fed’s credibility in the Volcker-Greenspan era occurred as “inflation
scares” (Goodfriend 1993; Hetzel 2008, Ch. 14). The need to establish credibility with the “bond
market vigilantes” required rejection of the earlier stop-go policy of attempting to manipulate Phillips
curve relationships through trading off between an output gap and inflation (Goodfriend and King
2005).
Hetzel (2008) termed these latter procedures “LAW with credibility.” The evidence for
credibility became the condition that in response to “news” about the economy, say, that it was
growing more strongly than previously anticipated, the yield curve would move in a stabilizing way
with all of the movement in real forward rates and none in inflation premia (Hetzel, forthcoming).
When the Fed follows a rule such that it consistently sets its funds rate target based on a forecasted
path that will keep real output growing at potential, markets will forecast the pattern of forward rates
that will cause the yield curve to keep output growing at potential. In this way, the Fed constrains
itself to set the funds rate to track the natural rate of interest. Although LAW with credibility was not
a money growth rule, it was monetarist in spirit. The price system works in that financial markets
use information efficiently. The Friedman long-and-variable-lags critique applied to LAW
procedures implemented as stop-go. With LAW with credibility, the Fed was tracking the real rate
and thus giving free rein to market forces to determine real variables, not attempting to control the
real rate in order to manipulate an output gap. 11
5.

The NK model as a monetarist model

The monetarist stylized facts of Section 4 do not substitute for a model. With the NK model,
monetarists got a model. The benchmark for judging optimality became the real business cycle
(RBC) core of the NK model (Kydland-Prescott 1982). That core summarizes a competitive market
economy predicated on the assumption that the price system works well to assure full employment of
resources. Forward-looking households and firms with rational expectations process information
about the future efficiently (Kydland and Prescott 1977; Lucas 1980 [1981]). The monetarist
argument for a rule gained a theoretical foundation built on the way in which a rule conditions
expectations about future monetary policy to respond in a stabilizing way in response to “news”
about the economy. Those characteristics of the NK model challenged the Keynesian recourse to
animal spirits and periodic bouts of pessimism that presumably overwhelm the stabilizing properties
of the price system and the intertemporal consumption-smoothing property of the real interest rate.

10

After the Treasury-Fed Accord in 1951, these procedures began to evolve under William
McChesney Martin and Winfield Riefler. The Fed abandoned them initially in response to pressure
from the Johnson administration and later in the 1970s Burns-Miller era but returned to them in the
Volcker-Greenspan era (Hetzel 2008, Chs. 5-7 and 14-15).
11

In the Greenspan era, the minor recessions of 1990-91 and 2001 continue to exhibit the
combination of a weakening of the economy prior to cyclical peaks and persistent, cyclically high
real rates of interest. In the former, policy aimed at moving from 4 percent inflation to price stability.
The latter reflected a minor go-stop policy set off by the Asia crisis (Hetzel, Chs. 15 and 17).

10

Goodfriend and King (1997) highlighted the monetarist character of the NK model by
pointing out that a policy of price stability eliminates the nominal friction that prevents the economy
from behaving as a competitive market economy. Blanchard and Gali (2007) referred to the
simultaneous occurrence of price stability and full employment as “divine coincidence.” The
practical implication of an objective of price stability is that the Fed follows a rule that turns the
determination of real variables over to market forces. In the monetarist literature, the nominal anchor
entailed a real balance effect based on the assumption of an exogenously given monetary aggregate
(Patinkin 1965). In the NK model, the nominal anchor is a monetary policy that causes “stickyprice” firms, which set dollar prices for multiple periods, to coordinate on the central bank’s inflation
target. The counterpart of the objective of price stability is the objective of maintaining expected
inflation equal to the inflation target. With that nominal anchor, the central bank can control trend
inflation while allowing firms to separate the determination of relative from absolute prices. The NK
model thus embodies the spirit of monetarism that the central bank can follow a rule that provides for
economic stability by separating the determination of relative prices from the price level.
To counter this version, which does not allow for Phillips curve trade-offs as part of optimal
policy, Blanchard and Gali (2007) introduced markup shocks, which reflect the exercise of monopoly
power in pushing up prices and make such trade-offs optimal. However, in the stop-go period, the
Fed was not successful in using Phillips-curve trade-offs in order to achieve a socially acceptable
combination of inflation and unemployment. In this period, the Fed interpreted inflation as arising
from cost-push shocks, that is, from markup shocks reflecting the exercise of monopoly power by
large corporations and unions. It misjudged the character of inflation and introduced instability
through attempts to exploit inflation-unemployment trade-offs (Hetzel 2008; Orphanides 2001).
In the spirit of the Cowles/Klein agenda of estimating large-scale econometric models,
economists have estimated structural versions of the NK model in order to identify the shocks that
drive the business cycle, for example, Smets-Wouters (2007). Motivated by the disruption to
financial intermediation that followed the Lehman bankruptcy on September 15, 2008, economists
have worked on models that allow for financial intermediation and financial frictions, for example,
Christiano et al. (2013). As in Bernanke et al. (1999), an external finance premium that moves
negatively with the net worth of firms creates a financial-accelerator mechanism that amplifies the
effect of macroeconomic shocks. A “credit-risk” shock in the form of a positive exogenous shock to
the external finance premium captures the idea of a financial crisis.
Nevertheless, in the NK model, monetary policy still possesses strong stabilizing powers.
The reason is that the output gap equals the cumulated sum of the current and future values of the
differences between the real rate of interest and the natural rate of interest (multiplied by the negative
of the intertemporal rate of substitution in consumption). Even with the zero lower bound, policy
retains its stabilizing powers because the central bank can commit to keeping the real rate below the
natural rate after the latter turns positive (Eggertsson and Woodford 2003). 12 Stated negatively, in
order to explain a recession with the NK model, one must assume contractionary monetary policy.

12

Kaplan et al. (2016) limit the power of monetary power by assuming liquidity-constrained
households, which cannot borrow in order to redistribute consumption to the present. The issue then
is empirical: what fraction of households is liquidity constrained? At the same time, the existence of

11

The stabilizing power of monetary policy also appears in the NK model in that the central
bank can neutralize the impact on consumption of a demand shock (a shock to the intertemporal
consumption Euler equation) by following the change in the natural rate with its policy rate. In the
basic NK large-scale DSGE model without financial frictions, a demand shock (a positive savings
shock) would by itself raise investment by lowering consumption. 13 Similarly, in a model with
financial frictions, a credit-risk shock that depresses investment increases consumption (see for
example, Kollmann et al. 2016, Fig. 3e). Models that include financial frictions then also include
demand shocks. As just noted, however, with demand shocks, the central bank can neutralize the
impact on the real economy by keeping the real rate equal to the natural rate. At the same time,
adding a financial friction in addition to sticky prices creates one more objective in the central bank’s
objective function. The central bank should go beyond the divine coincidence that entails tracking
the natural rate and trade off among objectives (Carlstrom et al. 2010). Optimal policy in a financial
crisis would then require missing the inflation and output objectives on the upside, not on the
downside as occurred in the Great Recession. 14
6.

Monetarism and the Great Recession

The Great Recession has posed a challenge to acceptance of the NK model. Economists have
criticized the objective of price stability or “inflation targeting” as preventing central banks from
intervening in order to prevent the financial excess presumed responsible for the Great Recession
(Curdia and Woodford 2009). Such explanations often assume that the low interest rates in the early
2000s initiated a boom-bust cycle in housing whose fallout led to the Great Recession (Taylor 2009).
With the Great Recession, one confronts the difficulties of identification caused by the poor
experimental design that generates the data given to economists. It is plausible that the uncertainty
surrounding the Lehman bankruptcy in September 2008 produced a sharp decline in the natural rate
of interest. 15 If the central bank puts inertia into declines in the policy rate relative to the natural rate,

liquidity-constrained households offers the central bank additional avenues to stimulate demand. The
issue is empirical. The monetarist hypothesis is that as long as the central bank does not disturb the
operation of the economy by interfering with the price system, households will remain optimistic
about the future. Friedman’s permanent income hypothesis will then be a valid characterization of
household behavior.
13

In order to generate the simultaneous decline in consumption and investment characteristic of
recession, modelers include a marginal efficiency of investment (MEI) shock that increases the
relative price of investment in terms of the consumption good.
14

Del Negro et al. (2016) simulate a model in which a liquidity shock can explain a decline in output
and the nominal interest rate. However, they do not perform a simulation with optimal credit policy
in which the central bank replaces risky assets in the public’s portfolio on a massive scale with safe
assets or a simulation with optimal monetary policy in which the central bank commits to keeping the
real rate below the natural rate after the natural rate again becomes positive.
15

Using a DSGE model for the United States, for the period 2008Q1 through 2009Q1, Gali et al.
(2012) estimated a decline of about 6 percentage points for the output gap and 12.5 percentage points
for the natural rate of interest. Numbers kindly supplied by Rafael Wouters.

12

nominal rigidities require that real income decline in order to offset the incipient increased demand
for the risk-free asset. There is, however, no clear way to disentangle the effect on output of a
disruption to financial intermediation from a decline in the natural rate of interest not tracked by a
reduction in the funds rate. 16
With a single episode, economists will never agree on the relative importance of monetary
contraction and financial frictions in making the Great Recession so severe. However, an implication
of the NK model is that a decline in both the output gap and in inflation is inconsistent with optimal
monetary policy. Also, the persistent decline in inflation below the FOMC’s 2 percent target must
reflect monetary policy (Figure 15). In the monetarist spirit of identification, does the NK model flag
central bank interference with the operation of the price system in the Great Recession?
One characteristic of the Great Recession is the close correspondence of cycle peaks in
developed countries (Hetzel 2016b). An explanation for this commonality is the similar response of
central banks to a prolonged inflation shock. Analogously to the stop phases of past recessions, the
central banks of the developed countries kept interest rates at cycle highs while their economies
weakened in order to create a negative output gap that would restrain high headline inflation. The
unacceptably high inflation in 2008 emerged not from prior monetary expansion but rather from a
worldwide increase in commodity prices. Illustrative of the increase in commodity prices, Figure 16
shows the sustained rise in the real price of oil that began in summer 2004 and peaked in summer
2008. Figure 15 shows how the inflation shock pushed headline inflation above core inflation.
Earlier, using the NK model, Kosuki Aoki had applied monetarist arguments relevant to the
Great Recession. In order to allow the price system to determine relative prices, central banks should
have allowed high headline inflation, which originated in the flexible-price sector, to pass through to
the price level. Aoki (2001, 57 and 75) pointed out that a policy designed to achieve divine
coincidence stabilizes the aggregate output gap by pursuing price stability in the sticky-price sector.
[T]here is a trade-off between stabilizing the aggregate output gap and aggregate inflation,
but … there is no trade-off between stabilizing [the] aggregate output gap and stabilizing core
inflation…. [S]uppose there is an increase in the price of food and energy … putting an
upward pressure on aggregate inflation…. The central bank could respond with a sharp
contractionary policy and reduce aggregate demand by a large amount so as to decrease
prices in the sticky-price sector…. However, our model shows that such a policy is not
optimal. The optimal policy is to stabilize core inflation.
The remainder of the section provides the narrative that fills out this monetarist identification.
The increase in energy and commodity prices produced the decline in consumption below trend
shown in Figure 17 by depressing real personal disposable income (PDI). Average annualized
monthly changes in real personal consumption expenditures (PCE) went from 3.2 percent from

16

The panic of fall 2008 when Ben Bernanke, Tim Geithner (New York Fed president), and Henry
Paulson (Treasury secretary) warned that the economy was teetering on the brink of another Great
Depression likely lowered the natural rate of interest while the FOMC was trying to keep the funds
rate up using IOER (interest on excess reserves) out of a concern for inflation (Hetzel 2012, Ch. 12).

13
January 2005 through December 2006 to 1.3% from January 2007 through November 2007. 17
Residential investment, which began to fall in 2005Q3, provided an additional shock.
As the economy weakened, following its LAW procedures, the FOMC lowered the funds rate
from its cyclical peak of 5.25 percent at its September 18, 2007, meeting to 2 percent at its April 2930, 2008 meeting. The peak of the business cycle occurred in December 2007. In the March 13,
2008 Greenbook, the Board (2008a, March 13, I-1 and I-7) staff projected that for 2008 real final
sales to private domestic purchasers would decline 1.6 percent and wrote that “[P]rivate payrolls are
estimated to have contracted about 100,000 per month since the turn of the year…. We are
anticipating a further retrenchment in consumer spending in the next few months; Consumer
confidence has plummeted; soaring energy prices are biting into household purchasing power; the
labor market is weakening; and real estate values are dropping.”
The April Greenbook remained pessimistic about the economy. “With mounting job losses
and outsized increases in energy prices holding down real income, falling home values cutting into
household net worth, and consumer sentiment deteriorating further, we would, all else equal, expect a
noticeable decline in PCE in the second quarter” (Board 2008a, April 23, I-6). Nevertheless, the
Minutes (Board 2008b, April 29-30, 9) for the April 29-30 FOMC meetings put financial markets on
notice that that the easing cycle had likely ended:
[A]lthough downside risks to growth remained, members were also concerned about the
upside risks to the inflation outlook, given the continued increases in oil and commodity
prices and the fact that some indicators suggested that inflation expectations had risen in
recent months.… [R]isks to growth were now thought to be more closely balanced by the
risks to inflation. Accordingly, the Committee felt that it was no longer appropriate for the
statement to emphasize the downside risks to growth…. In that regard, several members
noted that it was unlikely to be appropriate to ease policy in response to information
suggesting that the economy was slowing further or even contracting slightly in the near
term, unless economic and financial developments indicated a significant weakening of the
economic outlook.

17

The three spikes in real PDI in the years 2008 and 2009 shown in Figure 17 derived from the Bush
tax rebate, augmented social security payments, and the Obama stimulus program. The following
figures are for annualized growth rates of monthly real PCE:
12/2007 – 2/2008:
3/2008 – 5/2008:
6/2008 – 9/2008:
10/2008 – 12/2008:

-1.9 percent
1.7 percent
-3.8 percent
-4.5 percent

The interruption of negative growth in March, April, and May 2008 came from the boost to income
from the Bush tax cut signed into law February 12, 2008. Although the rebates arrived in the month
of May, households anticipated them. Real PDI rose at an average monthly rate of $12.1 billion from
January 2007 through September 2007; at the average rate of $6.6 billion from October 2007 through
April 2008; and then soared to $562.1 billion in May 2008.

14

Monetary policy actions comprise the information the FOMC conveys to markets about the
future path of the funds rate that it anticipates. With the April 2008 meeting, the focus changed from
a deteriorating economy to inflation (Hetzel 2012, 217-219). For observations the day following an
FOMC meeting, Figure 18 plots the difference between the 3-month (6-month) Treasury bill rate and
the funds rate target. The difference is positive when markets expect the FOMC to raise the funds
rate. The series declined after the May 9, 2007, FOMC meeting and declined significantly after the
September 18, 2007, FOMC meeting. At the April 29-30, 2008, meeting, the FOMC lowered the
funds rate from 2.25 percent to 2 percent. However, in line with the message sent by the FOMC
about the likely direction of the next move in the funds rate, as shown in Figure 18, the yield curve
jumped. (The decline after September 2008 reflected the flight to safety offered by Treasury’s.)
In June 2008, Chairman Bernanke (2008) expressed the dual concerns that continued high
headline inflation would erode the FOMC’s credibility and that the dollar would depreciate:
Another significant upside risk to inflation is that high headline inflation, if sustained, might
lead the public to expect higher long-term inflation rates, an expectation that could ultimately
become self-confirming…. We are attentive to the implications of changes in the value of the
dollar for inflation and inflation expectations and will continue to formulate policy to guard
against risks to both parts of our dual mandate, including the risk of an erosion in longer-term
inflation expectations.
For the September 2008 FOMC meeting, the Board (2008a, September 10, 2008, I-1) staff
based its forecast for the economy on the assumption that the funds rate would remain at 2% and then
rise toward the end of 2009. As indicated by the sharp rise in the inventory/sales ratio and sharp
decline in the ISM manufacturing index in July 2008, however, the economy had already entered into
a deep recession earlier in the summer (Hetzel 2012, 207). The Board (2008a, October 22, I-1) staff
later made this point. “[I]ncoming data on consumer and business spending, industrial production,
and employment suggest that aggregate output had already decelerated sharply during the summer—
before the recent intensification of financial turmoil….” The reference to financial turmoil was to
the flight of the cash investors from financial institutions with illiquid, opaque portfolios following
the Lehman bankruptcy on September 15, 2008. The FOMC did not lower the funds rate until
October 6, 2008, however, and did not reduce its range to 0-25 basis points until December 15, 2008.
Once the cyclical peak had occurred, the December 2007 to June 2009 contraction displayed
relatively low real interest rates. At the time, FOMC Chairman Bernanke (2009) interpreted the low
level of short-term interest as evidence of expansionary monetary policy. 18 Based on this
assessment, he discounted the efficacy of monetary policy and advocated credit policy based on
programs intended to revive the flow of credit to specific sectors of the economy. The underlying
assumption was that dysfunction in credit markets was preventing funds from flowing from savers to
investors with viable investment projects. The FOMC then was slow in aggressively adopting
forward guidance in order to bend down the yield curve.

18

That assumption conflicts with the fact that the real rate of interest stayed somewhat below zero for
years during the recovery without the reemergence of inflation (Figure 11).

15

The prescient comments of Aoki (2001) highlight the continuing relevance of the
Keynesian/monetarist debate over the role of the Phillips curve in monetary policy. Following the
basic NK model exposited by Goodfriend and King (1997), the Fed should implement a rule that
provides for the separation of the determination of the price level from relative prices and real
quantities—the classical dichotomy. In the design of such a rule, it is important to decompose
inflation into the parts that arise in the sticky-price sector and in the flexible-price sector. The
unfettered movement of relative prices requires controlling inflation in the sticky-price sector while
allowing inflation in the flexible price sector to pass through completely into headline inflation. The
FOMC then follows a rule that moves the funds rate in a way that tracks movements in the natural
rate of interest. A monetarist critique of policy in the Great Recession is that the Fed reverted to
manipulating an output gap in order to control inflation.
7.

A summary of the issues

The issues raised in the monetarist/Keynesian debate remain relevant. If the price system
does not work well to attenuate cyclical fluctuations, then the Fed is forced into trading off between
price and output stability. In a Keynesian world in which cost-push pressures cause increases in
relative prices to pass through to the price level, a goal of price stability would exacerbate real
instability. Similarly, in a Minsky world in which investor euphoria lowers the external finance
premium (the wedge between intertemporal rates of substitution for households and firms), the Fed
should create a negative output gap and below-target inflation in order to prevent the emergence of
asset bubbles. An exclusive goal of price stability would again exacerbate real instability.
If the price system does work well in the absence of central bank interference that imparts
unpredictability to the evolution of prices, then the basic NK model is an apt representation of
monetarist principles. Monetarists were wrong in their normative prescriptions about the central role
that money should play in the formulation of policy and about the nature of a stable nominal anchor.
Nevertheless, money remains central. Although in the Volcker-Greenspan era, the Fed did not move
to a stable nominal anchor using a money target: money remained central as the “stick in the closet.”
The power to discipline inflationary expectations originates in the ability of the central bank to create
a difference between the real rate of interest and the natural rate through money creation and
destruction. That power allows it to enforce a rule that creates a stable nominal anchor in the form of
nominal expectational stability. As exposited in the NK model, that rule not only causes firms to set
dollar prices in a way that aggregates to a price level conformable with the central bank’s inflation
target but also separates the determination of relative prices from the determination of the price level.
In order to maintain price stability, the central bank must have procedures that cause nominal
money to grow in line with real money demand. Those conditions hold regardless of whether the
central bank exercises explicit control over money. If the NK model is relevant, then the central
bank should follow the monetarist golden rule of providing a stable nominal anchor and allowing the
price system to determine the real interest rate and, by extension, other real variables. With an
interest-rate target, nominal money will then follow the real money demand consistent with growth in
potential output and with price stability.
Finally, there is no self-evident experimental design to the forces that cause recessions. As a
result, economists will never form a consensus over the cause of a particular recession. Various
approaches toward the identification of the shocks that cause recessions exist. All offer some insight
but there is no econometric technique that does not incorporate significant judgment. The Friedman-

16

Schwartz methodology of concatenating episodes of monetary and real instability in the hope of
“washing out” extraneous third factors remains essential. Their approach entails judgment about the
adventitious factors that cause the central bank to set its policy rate in a way that interferes with the
operation of the price system. Economists must resign themselves to the incessant, trained
intellectual combat of economics. It would, however, help if central banks communicated in terms of
a strategy, made explicit forecasts based on that strategy, and after the fact evaluated the
appropriateness of the strategy. That is, as urged by Friedman, they should follow an explicit rule.

Appendix: Real Rate of Interest
The real interest rates shown are the difference between either the Treasury bill rate or the
commercial paper rate and Greenbook (now Tealbook) inflation forecasts. The Greenbook contains
forecasts of the National Income and Product Accounts prepared by the staff of the Board of
Governors before FOMC meetings. Because FOMC meetings fall unevenly within quarters, the
maturity of the real rate varies from somewhat more than one quarter to somewhat less than two
quarters. The commercial paper rate is for prime nonfinancial paper placed through dealers
(A1/P1). The dates for the interest rates match the publication dates of the Greenbooks. From 1965
through 1969, interest rate data are from the New York Fed release “Commercial Paper.”
Subsequently, they are from the Board of Governor’s database or from Bloomberg. From 1965
through April 1971, the paper rate is for 4-6 month paper. Thereafter, if there are fewer than 135
days from the Greenbook date to the end of the subsequent quarter, the 3-month paper rate is used;
otherwise, the 6-month paper rate is used.
From 1966 through 1970, the forecasted inflation series is for the implicit GNP deflator.
From 1971 through March 1976, it is for the GNP fixed-weight index. Thereafter, until January
1980, the series used is the gross business product fixed-weight index. The Board staff forecasts for
“core” inflation become available in January 1980. From January 1980 until February 1986, the
gross domestic business product fixed-weight index excluding food and energy is used. Thereafter,
until January 2000, the CPI excluding food and energy is used. From January 2000 onward, the
personal consumption expenditures chain-weighted index excluding food and energy is used.
A weighted-average inflation rate for the period from the Greenbook date to the end of the
succeeding quarter is calculated from the Greenbook’s inflation forecasts for the current and
succeeding quarter. The weight given to the current quarter’s inflation rate is the ratio of the number
of days left in the current quarter to the number of days from the Greenbook date until the end of the
succeeding quarter. The weight given to the succeeding quarter’s inflation rate is the ratio of the
number of days in that quarter to the number of days from the Greenbook date until the end of the
succeeding quarter. This weighted-average forecasted-inflation rate is subtracted from the market
rate of interest in order to construct the series for the real rate of interest.
In the 1960s, the FOMC usually met more than 12 times per year. For example, it met 15
times in 1965. In order to make the real rate series monthly through 1978, if there was more than one
meeting per month, an observation was recorded only for the first meeting of the month. The FOMC
met only nine times in 1979. (Because the October 6, 1979, meeting was unscheduled, there was no
Greenbook and no real rate is calculated for this date.) It met 11 times in 1980. Starting in 1981, it

17

has met eight times a year. For this reason, starting in 1979, the observations of the Greenbook real
rate series are less frequent than monthly.
The real rate series begins in November 1965 because the Greenbook first began to report
predictions of inflation for the November 1965 meeting. Until November 1968, for FOMC meetings
in the first two months of a quarter, the Greenbook often reported a forecast of inflation only for the
contemporaneous quarter. For this reason, for the following FOMC meeting dates, the real rate
calculated is only for the period to the end of the contemporaneous quarter, not to the end of the
succeeding quarter: 11/23/65, 1/11/66, 2/8/66, 4/12/66, 5/10/66, 6/7/66, 7/26/66, 11/1/66, 12/13/66,
1/10/67, 7/18/67, 10/24/67, 11/14/67, 1/9/68, 2/6/68, 4/30/68, 5/28/68, 7/16/68, 10/8/68, 10/17/72,
and 11/20-21/72. For these dates, the maturity of the interest rate used to calculate the real rate
varies between one and three months. For other dates, the maturity varies between three and six
months. For this reason, some of the variation in real rates reflects term-structure considerations.
This variation is a consequence of the fact that the FOMC meets at different times within a quarter
and the Greenbook inflation forecasts are for quarters.
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Economic Review 91 (September 2001), 964-85.
Patinkin, Don. Money, Interest, and Prices, New York: Harper & Row, 1965.
PBS Newshour. “Nobel Prize-Winning Economist Milton Friedman Dies at Age 94,” November 16,
2006.
Poole, William. Money and the Economy: A Monetarist View. Reading, MA: Addison-Wesley
Publishing Company, 1978.
Romer, Christina D. and David H. Romer. “Does Monetary Policy Matter? A New Test in the Spirit
of Friedman and Schwartz.” in NBER Macroeconomics Annual 1989, vol. 4, pp. 121-170.
Samuelson, Paul and Robert Solow. “Analytical Aspects of Anti-Inflation Policy (1960),” in Joseph
Stiglitz, ed., The Collected Scientific Papers of Paul A. Samuelson. vol. 2, no. 102, 1966,
1336-53.
Smets, Frank and Rafael Wouters. “Shocks and Frictions in US Business Cycles: a Bayesian DSGE
Approach.” American Economic Review 97 (2007), 586-606.
Taylor, John B. Getting Off Track: How Government Actions and Interventions Caused, Prolonged,
and Worsened the Financial Crisis. Stanford, CA: Hoover Institution Press, 2009.

21

Woodford, Michael. “Inflation Targeting and Financial Stability.” NBER Working Paper 17967,
April 2012.
Wright, Jonathan H. “The Yield Curve and Predicting Recessions.” Finance and Economics
Discussion Series Working Paper 2006-7, Board of Governors of the Federal Reserve
System, February 2006.

22

20

Figure 1
Growth of Nominal Output and Lagged Money

Percent

Percent

20

Nominal GDP
M1+3.5%

15

15

10

10

5

5

0

0

-5

-5
48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81
Notes: Quarterly observations of 4-quarter moving averages of nominal GDP and M1. Beginning in 1956, M1 is lagged 2 quarters. The vertical line
separates lagged and unlagged M1 growth. In 1981, M1 is shift-adjusted M1 (Bennett 1982). The M1 series is augmented by 3.5 percentage points. Shaded
areas indicate recession. Heavy tick marks indicate fourth quarter of year.

15

Percent

Figure 2
Inflation and Lagged Money Growth

Percent

14

15
14

13

13

12

M1

12

11

Inflation

11

10

10

9

9

8

8

7

7

6

6

5

5

4

4

3

3

2

2

1

1

0

0

-1

-1
46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83

Notes: Inflation is the annualized percentage change in the fixed-weight GDP deflator over an 8-quarter period. The GNP deflator from Balke and Gordon
(1986) is used before 1947. Money growth is the annualized percentage change in M1 over an 8-quarter period. Beginning in 1956 M1 is lagged 7
quarters. The vertical line separates lagged and unlagged M1 growth. In 1981, M1 is "shift-adjusted" (Bennett 1982). Heavy tick marks indicate fourth
quarter of the year.

23
Figure 3
Fed Funds Rate and Core PCE Inflation
Percent

Percent

18

18

16

16

14

14

Fed funds rate
Core Inflation

12

12

10

10

8

8

6

6

4

4

2

2

0

0

-2

-2
65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Notes: Quarterly observations of annualized percentage changes in the core personal consumption expenditures deflator and the federal funds
rate. Shaded areas indicate NBER recessions. Tick marks indicate first quarter of year. Source: Data from Haver Analytics.

Figure 4
M1 Step Function and Recessions: 1906-1945
60 Percent

Percent

60

50

50

40

40

30

30

20

20

10

10

0

0

-10

-10

-20

-20

-30

-30

-40

-40
1906

1908

1910

1912

1914

1916

1918

1920

1922

1924

1926

1928

1930

1932

1934

1936

1938

1940

1942

1944

Notes: Series are a three-month moving average of the annualized monthly money growth rates and a step function fitted to monthly annualized
growth rates of money. Step function before May 1907 uses annual growth rates based on June observations of M2 from 1900-1907. Observations for
money from June 1900 to May 1914 are for M2; observations from June 1914 to December 1945 are for M1. Data are from Friedman and Schwartz
(1970). Shaded areas indicate NBER recessions. Heavy tick marks indicate December.

24

Figure 5
M1 Step Function and Recessions: 1946-1981
18

Percent

Percent

18

16

16

14

14

12

12

10

10

8

8

6

6

4

4

2

2

0

0

-2

-2

-4

-4

-6

-6
1946

1948

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

Notes: Series are a three-month moving average of the annualized monthly money growth rates and a step function fitted to monthly annualized growth
rates of money. Data on money (M1) from January 1946 to December 1958 from Friedman & Schwartz (1970). From January 1959 to December 1980
data from Board of Governors. January 1981 to December 1981 M1 is "shift-adjusted M1" (Bennett 1982). Shaded areas indicate NBER recessions.
Heavy tick marks indicate December.

Figure 6
Real Output Growth and M1 Step Function: 1963 to 1981
10

Percent

Percent

10

8

8

6

6

4

4

2

2

0

0

M1 Step

-2

-2

Real Output Growth
Quarterly annualized Real GDP

-4

-4

-6

-6
1963

1964

1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

Notes: The M1 steps are an average of the annualized quarterly M1 growth rates. In 1981, M1 is "shift adjusted" (Bennett 1982). Real output growth is 4-quarter
percentage changes in real GDP. Quarterly annualized real GDP is annualized quarterly growth rates. Shaded areas indicate NBER recessions. Heavy tick marks
indicate fourth quarter.

25

Figure 7
Real Output Growth: 1982 to 2014
10

Percent

Percent

10

8

8

6

6

4

4

2

2

0

0

-2

-2
Real Output Growth

-4

-4
Quarterly annualized Real GDP

-6

-6
1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

Notes: Real output growth is 4-quarter percentage changes in real GDP. Quarterly annualized real GDP is quarterly annualized growth rates. Shaded areas
indicate NBER recessions. Heavy tick marks indicate fourth quarter. Source: Haver Analytics.

Figure 8
Real Personal Consumption Expenditures and Cycle Trend: 1960 to 1982
Percent

Percent

50

50

45

Cycle Trend

45

40

Real PCE

40

35

35

30

30

25

3.1%

20
15
10

25
20

4.8%

15
3.6%

10

5

5

0

0

-5

-5

-10

-10
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
Notes: Observations are the natural logarithm of monthly observations of real personal consumption expenditures normalized using the value at the
prior business cycle peak. Trend lines are fitted to these observations between peaks in the business cycle. The trend lines are extended through the
subsequent recession. Shaded areas indicate NBER recessions. Heavy tick marks indicate December. Source Haver Analytics.

26

Figure 9
Real Personal Consumption Expenditures and Cycle Trend: 1981 to 2014
Percent

Percent

45

45
Cycle Trend

40

Real PCE

40
4.2%

35

35

30

30

25

25

3.2%

3.8%
20

20

15

15

10

10
1.7%

5

5

0

0

-5

-5

-10

-10
1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

Notes: Observations are the natural logarithm of monthly observations of real personal consumption expenditures normalized using the value at the prior
business cycle peak. Trend lines are fitted to these observations between peaks in the business cycle. The trend lines are extended through the
subsequent recession. Shaded areas indicate NBER recessions. Heavy tick marks indicate December. Source: Haver Analytics.

Figure 10
The One-Year Market Interest Rate on Government Securities and
the Corresponding Real Rate of Interest: 1946 to 1969
10

Percent

Percent 10
Market Interest Rate

8

8

Real Interest Rate

6

6

4

4

2

2

0

0

-2

-2

-4

-4
46

47

48

49

50

51

52

53

54

55

56

57

58

59

60

61

62

63

64

65

66

67

68

69

Notes: The market rate of interest is monthly observations of the yield on U.S. government securities from "Short-Term Open Market Rates in New York
City" in Board of Governors (1976), Banking and Monetary Statistics, 1941-1970. Through July 1959 the series uses "9- to 12- month issues." Thereafter,
it uses "one-year Treasury bills." The series for the real rate of interest is the market rate minus predicted CPI inflation from the Livingston Survey.
Observations of predicted inflation are biannual and are for the months of May and November. See notes to Figure 4.4 (Hetzel 2008). Shaded areas
indicate NBER recessions. Heavy tick marks indicate the November observation of the market interest rate.

27

Figure 11
Real Treasury Bill and Commercial Paper Rates

Percent

Percent

12

12

10

10

Real TBR

8

8
Real CPR

6

6

4

4

2

2

0

0

-2

-2

-4

-4
1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981 1982

12

12

10

10

8

8

6

6

4

4

2

2

0

0

-2

-2

-4

-4
1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

12

12

10

10

8

8

6

6

4

4

2

2

0

0

-2

-2

-4

-4
2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Notes: The real interest rate series is either the Treasury bill rate or the commercial paper rate minus the inflation forecast made by the staff of the Board of Governors
in the Greenbook (later Tealbook). For a description of the series, see "Appendix: Real Rate of Interest." Shaded areas indicate NBER recessions. Heavy tick marks
indicate December FOMC meeting.

Figure 12
Output Gap and Real Rates of Interest
Percent

11
9
7

Output Gap
Treasury Bill Real Interest Rate

11
9
7

Commercial Paper Real Interest Rate

5

5

3

3

1

1

-1

-1

-3

-3

-5

-5

-7

-7

-9

-9
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
Notes: The output gap is the logarithm of real final sales to domestic purchasers minus the logarithm of potential output measured by the
Congressional Budget Office. The real interest rate series are the commercial paper rate or the Treasury bill rate minus core inflation forecasts
made by the staff of the Board of Governors before FOMC meetings. For a description of the series, see "Appendix: Real Rate of Interest."
Shaded areas indicate NBER recessions. Heavy tick marks indicate fourth quarter.

28

Figure 13
Deviation of Real PCE from Cycle Trend, Real Interest Rate, and Inflation: 1966-1982
16

Percent

Percent

16

Deviation of Real PCE
from Cycle Trend
Real Interest Rate

14
12

14
12

Inflation

10

10

8

8

6

6

4

4

2

2

0

0

-2

-2

-4

-4

-6

-6

-8

-8
1966

1968

1970

1972

1974

1976

1978

1980

1982

Notes: Deviation of Real PCE from Cycle Trend is the difference between the actual values and trend lines shown in Figure 8. Inflation is twelve-month
percentage changes in the personal consumption expenditures deflator. The Real Interest Rate is the commercial paper rate minus inflation forecasts
made by the staff of the Board of Governors shown in Figure 11. Shaded areas indicate NBER recessions. Heavy tick marks indicate December.
Source: Inflation data from Haver Analytics.

10

Figure 14
Deviation of Real PCE from Cycle Trend, Real Interest Rate, and Inflation: 1983-2009

Percent

Percent

10

8

8

6

6

4

4

2

2

0

0

-2

-2

-4

-4
Deviation of Real PCE from
Cycle Trend

-6
-8

Real Interest Rate
Inflation

-10

-6
-8
-10

1986
1988
1990
2000
2002
2004
2006
1984
1992
1994
1996
1998
2008
Notes: Deviation of Real PCE from Cycle Trend is the difference between the actual values and trend lines shown in Figure 9. Inflation is twelvemonth percentage changes in the personal consumption expenditures deflator. The Real Interest Rate is the commercial paper rate minus the inflation
forecasts made by the staff of the Board of Governors shown in Figure 11. Shaded areas indicate NBER recessions. Heavy tick marks indicate
December. Source: Inflation data from Haver Analytics.

29

Figure 15
Headline and Core PCE Inflation

YoY % Change

YoY % Change

5.5

5.5
Headline PCE

5

5

Core PCE
4.5

4.5

4

4

3.5

3.5

3

3

2.5

2.5

2

2

1.5

1.5

1

1

0.5

0.5

0

0

-0.5

-0.5

-1

-1

-1.5

-1.5

-2

-2
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17
Notes: Data are monthly observations of 12-month percentage changes for the personal consumption expenditures (PCE) deflator and the core PCE
deflator, which excludes food and energy. Shaded areas are NBER recessions. Tick marks indicate December. Data from Haver Analytics.

Figure 16
Real Price of Oil
140

2009 Dollars

2009 Dollars

140

130

130

120

120

110

110

100

100

90

90

80

80

70

70

60

60

50

50

40

40

30

30

20

20

10

10

0

0
1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Notes: Monthly observations of the West Texas intermediate crude oil spot price per barrel deflated by the personal consumption expenditures
price index. Data from the Wall Street Journal and Commerce Department via Haver Analytics. Shaded areas indicate NBER recessions. Heavy
tick marks indicate December.

30

Figure 17
Real Personal Disposable Income and Expenditures
8

Percent

Percent
Real PCE

7

8
7

Real DPI

6

6

5

5

4

4

3

3

2

2

1

1

0

0

-1

-1

-2

-2

-3

-3

-4

-4

-5

-5

-6

-6
2000

2002

2004

2005

2006

2007

2008

2009

2010

2011

Notes: Twelve-month percentage changes in real personal consumption expenditures (PCE) and real disposable personal income (DPI). Shaded areas
indicate NBER recessions. Heavy tick marks indicate December. Data from Haver Analytics.

Figure 18
Term Structure of Interest Rates: 3-month and 6-month
0.5

Percent

Percent

0

0.5

0

-0.5

-0.5

-1

-1

Difference between 3-month Treasury yield and funds rate target

-1.5

-1.5
Difference between 6-month Treasury yield and funds rate target

-2

-2
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Notes: The series are the difference between three-month and six-month Treasury yields and the funds rate target. Treasury yields are from Board
of Governors statistical release H.15 starting January 7, 2002 and from G.13 before. Starting October 2, 2001, yields are constant maturity. Before,
they are the three-month and six-month yields. Observations are for the day after an FOMC meeting. Heavy tick marks indicate December.