4 Thefollowing article is reprinted from the July 1968 issue of the Federal Reserve Bank of St Louis Review. Karl Brunner The Role of Money and Monetary Policy HE DEVELOPMENT of monetary analysis in A response to the criticisms of existing mone- the past decade has intensified the debate con- tary policy methods was naturally to be ex- cerning the role of money and monetary policy. pected and is welcomed. Four articles which de- Extensive research fostered critical examinations fend present policy procedures have appeared of the Federal Reserve’s traditional descriptions during the past few years in various Federal of policy and of the arrangements governing Reserve publications.1 ‘I’hese articles comprise a policymaking. Some academic economists and countercritique which argues that monetary im- others attribute the cyclical fluctuations of pulses are neither properly measured nor ac- monetary growth and the persistent problem tually transmitted by the money stock. The concerning the proper interpretation of authors reject the Monetarist thesis that mone- monetary policy to the established procedures tary impulses are a chief factor determining of monetary policy and the conceptions tradi- variations in economic activity, and they con- tionally guiding policymakers. tend that cyclical fluctuations of monetary growth cannot be attributed to the behavior of The critique of established policy procedures, the Federal Reserve authorities. These fluctua- which evolved from this research into questions tion are claimed to result primarily from the concerning the monetary mechanism, is de- behavior of commercial banks and the public. rived from a body of monetary theory referred to in this paper as the Monetarist position. ‘I’he ideas and arguments put forth in these Three major conclusions have emerged from articles deserve close attention. The controversy the hypotheses put forth. First, monetary im- defined by the critique of policy in professional pulses are a major factor accounting for varia- studies and the countercritique appearing in tions in output, employment and prices. Second, Federal Reserve publications bears on issues of movements in the money stock are the most fundamental importance to public policy. Under- reliable measure of the thrust of monetary im- lying all the fashionable words and phrases is pulses. Third, the behavior of the monetary the fundamental question: What is the role of authorities dominates movements in the money monetary policy and what are the requirements stock over business cycles. of rational policymaking? ‘Lyle Gramley and Samuel Chase, “Time Deposits in Alternative Approaches to the Analysis of the Financial Monetary Analysis,” Federal Reserve Bulletin, October Structure,” Monthly Review, Federal Reserve Bank of Kan- 1965. John H. Kareken, ‘Commercial Banks and the sas City, March 1968. Richard 0. Davis, “The Role of the Supply of Money: A Market Determined Demand Deposit Money Supply in Business Cycles,” Monthly Review, Rate,” Federal Reserve Bulletin, October 1967. J. A. Cacy. Federal Reserve Bank of New York, April 1968. FEDERAL RESERVE BANK OF ST. LOWS 5 The following sections discuss the major as- role of the public’s and the banks’ behavior in pects of the countercritique. These rejoinders the determination of the money stock, bank may contribute to a better understanding of the credit and interest rates. issues, and the resulting clarification may re- Kareken’s paper supplements the Gramley- move some unnecessary disputes- Even though Chase arguments. He finds “the received money the central contentions of the controversy will supply theory” quite inadequate. His paper is remain, the continuous articulation of opposing designed to improve monetary analysis by con- points of view plays a vital role in the search structing a theory of an individual bank as a for greater understanding of the monetary firm. This theory is offered as an explanation of process. a bank’s desired balance sheet position. It also appears to form the basis of a model describing A SUMMARY OF THE the interaction of the public’s and the banks’ COUNTERCRITIO,UE behavior in the joint determination of the money stock, bank credit and interest rates. The four articles relied on two radically dif- The whole development emphasizes somewhat ferent groups of arguments- Gramley-Chase, suggestively the importance of the public’s and Kareken and Cacy exploit the juxtaposition banks’ behavior in explanations of monetary “New View versus Traditional View” as the cen- growth. It is also designed to undermine the tral idea guiding their countercritique. The ana- empirical hypotheses advanced by the Monetar- lytical framework developed by the critique is ist position. This is achieved by means of ex- naturally subsumed for this purpose under the plicit references to specific and “obviously “Traditional View” label. On the other hand, desirable” features of the model presented. Davis uses the analytical framework developed Cacy’s article develops neither an explicit by the critique in order to organize his framework nor a direct critique of the basic arguments. propositions advanced by the Monetarist thesis. Gramley-Chase describe their general argu- However, he provides a useful summary of the ment in the following words: general position of the countercritique. The Monetarist analysis is conveniently subsumed by “(New) developments have reaffirmed the bankers’ Cacy under a “Traditional View” which is jux- point of view that deposits are attracted, not taposed to a “New View” of monetary mecha- created, as textbooks suggest. In this new environ- nisms: “The new approach argues... that there ment, growth rates of deposits have become more suspect than ever as indicators of the conduct of is no essential difference between the manner monetary policy A framework of analysis [is in which the liabilities of banks and nonbank required] from which the significance of time financial institutions are determined. Both types deposits and of changing time deposits can be of institutions are subject in the same way to deduced. Traditional methods of monetary analysis the portfolio decisions of the public.” The new are not well suited to this task. The ‘New View’ in approach is contrasted with the Traditional monetary economics provides a nlote useful View, which “obscures the important role analytical framework. In the new view, banks— played by the public and overstates the role like other financial institutions—are considered as played by the central bank in the determination suppliers of financial claims for the public to hold, of the volume of money balances.”~The general and the public is given a significant role in deter- comparison developed by Cacy suggests quite mining the total amount of bank liabilities. -- clearly to the reader that the Traditional View Traditional analysis. --fails to recognize that substitution between time deposits and securities allegedly espoused by the Monetarist position may be an important source of pro-cyclical varia- cannot match the “realistic sense” of the New tions in the stock of money even in the face of View advocated by the countercritique. countercyclical central bank policy.” In the context of the framework developed by This general argument guided the construction the critique, Davis questions some basic proposi- of an explicit model designed to emphasize the tions of the Monetarist position: 2 Gramley-Chase, pp. 1380, 1381, 1393. ~lbid.,p- 7. ‘Cacy, pp. 5 & 7. SEPTEMBER/OCTOBER 1989 6 “In the past five to ten years, however, there pirical conjectures are logical implications of the has come into increasing prominence a group of general program. The explicit separation of the economists who would like to go considerably three aspects is crucial for a proper assessment beyond the simple assertion that the behavior of of the New View. money is a significant factor influencing the behavior of the economy. ---In order to bring a Section A examines some general character- few of the issues into sharper focus, this article istics of the countercritique’s reliance on the will take a look at some evidence for the ‘money New View. It shows the New View to consist of supply’ view. - a program acceptable to all economists, a re- It confines itself to examining the historical rela- search strategy rejected by the Monetarist posi- tionship between monetary cycles and cycles in tion, and an array of specific conjectures ad- general business. The article concludes that the vanced without analytical or empirical substanti- relationship between these two kinds of cycles ation. Also, not a single paper of the counter- does not, in fact, provide any real support for the critique developed a relevant assessment of the view that the behavior of money is the predomi- Monetarist’s empirical theories or central prop- nant determinant of fluctuations in business activi- ositions. ty. Moreover, the historical relationship between cycles in money and in business cannot be used to In sections B and C detailed examinations of demonstrate that monetary policy is, in its effects, specific conjectures centered on rival explana- so long delayed and so uncertain as to be an un- tions of cyclical fluctuations of monetary satisfactory countercyclical weapon.” growth are presented. The direct assault on the Monetarist position by Davis is discussed in AN EXAMINATION OF THE ISSUES some detail in section D. This section also states the crucial propositions of the Monetarist thesis A careful survey of the countercritique yield- in order to clarify some aspects of this position. ed the following results. The Gramley-Chase, This reformulation reveals that the reservations Kareken, and Cacy papers parade the New View assembled by Davis are quite innocuous. They in order to question the status of empirical provide no analytical or empirical case against theories used by the Monetarist critique in its the Monetarist thesis. Conjectures associated examination of monetary policy. The Davis with the interpretation of monetary policy (the paper questions quite directly, on the other “indicator problem”) are presented in section E. hand, the existence and relevance of the evi- dence in support of the Monetarist position, and A.