Federal Reserve Bank of Cleveland October 1, 1986 growth rule for one or another GNP growth. However, this emphasis that the way to provide the best envi- of the monetary aggregates, with most on the short-run relationship between ronment for long-run [SSN 0428-1276 choosing Ml. The targeting of Ml is money and economic activity is not is to provide a stable level. based on the constraint imposed by fundamental to the basic monetarist In retrospect, attempts to use active current regulations, as well as on theo- principles that bear on the efficient stabilization policy have been asso- and retical and empirical considerations. conduct of . ciated with accelerating . Ml is defined to include that are While monetarism means different Chart 4 shows the wholesale price in- ECONOMIC the Ml Target mainly held for transaction purposes. things to different people, most mone- dex from 1895 to the present. The per- The theory of the transactions demand tarists agree that the framework for iod from 1895 (actually, the same holds by William T. Gavin for money is more highly developed monetary policy should be structured true from the end of the eighteenth than theories of the so as to create the optimal environment century) to World War II was one of in its other uses, such as a store of for economic growth and efficient allo- relative price stability. The COMMENTARY or a unit of account. Further- cation of resources." Further, moneta- rose and fell about at an average that more, empirical studies done both rists agree that, in such a framework, was last seen approximately in 1940. inside and outside the Federal Reserve policy actions should be predictable and prior to the 1980s showed that the should be expected to produce a stable The Federal Reserve has once again cover" linking issue to the demand for Ml was more predictably price environment. Monetarists think decreased emphasis on the Ml target as government's gold stock. Conclusion Chart 1 Velocity of Ml and related to movements in rates that attempts to use discretionary a guide for short-run policy actions. In The problem for the Federal Reserve, The recent instability of Ml velocity is the Commercial Paper Rate, and economic activity than were the changes in the money growth rates in the first half of 1986,Ml growth aver- both then and now, is how to maintain broader aggregates. As shown above, order to smooth the or to due to forces that were set in motion by 1950-1985 economic policies of the past. Attempts aged 11.8 percent, while nominal gross price stability in a monetary system these "predictable" relationships have promote higher employment will either national product (GNP) growth aver- Percent with unbacked paper money; no society not survived in the 1980s. destabilize the economy or lead to infla- to change important monetary or bank regulatory policy are likely to lead to a aged only 4.6 percent and inflation con- 16r------, has ever succeeded in doing so. Con- The monetarist policy prescription be- tion or both. tinued to be lower than expected. Policy- 14 trary to the suggestions offered in text- came more and more popular as inflation In the Full Employment Act of 1946, temporary period of instability in veloc- ity. Even when this period of transition makers and , including 12 books and treatises by monetary re- accelerated and as more experience sug- Congress gave the federal government leading monetarists, argue that Ml is formers, experience shows that it is no gested that Ml velocity was stable and (and indirectly, the Federal Reserve) is over, we should expect Ml velocity to 10 be more variable in a regime of stable no longer an appropriate short-run easy matter to stabilize the price level predictable. Monetarism became associ- the responsibility to "... use' all practi- guide for monetary policy.' 8 with a paper money system. ated with the notion that short-run cable means ... to promote maximum em- (or stable inflation) and deregu- 6 lation of ceilings This Economic Commentary discusses The monetarist solution to this prob- changes in money were closely and sys- ployment, production, and purchasing the apparent breakdown in the relation- lem is to protect the value of money by tematically related to short-run changes power." While much of the willingness than it was during the period of accel- 4L_~rr'v' ship between Ml and economic activ- 2 limiting its quantity. The intellectual in GNP and that velocity would con- to tolerate accelerating inflation can be erating inflation. To conduct policy efficiently in such an environment, it is ity. The first part of this essay makes a foundation for this solution is the tinue to grow 3 percent a year, no mat- traced to legitimate concerns about pro- claim that is quite simple, although 1950 1955 1960 1965 1970 1975 1980 1985 important to develop institutions that . As refor- ter what the Federal Reserve did. duction and employment, new advances perhaps controversial; namely, that the allow the Federal Reserve to commit to mulated by (Studies When that short-run relationship in macroeconomic theory support the breakdown of the relationship between SOURCE: Board of Governors of the Federal in the Quantity Theory of Money, 1956), long-run price stability. At the same Reserve System. disappeared, monetarism naturally lost monetarist contention that there is no Ml and nominal GNP is only apparent. it is essentially a theory of money popularity among economists and policy- long-run tradeoff between inflation and time it must retain the short-run flexi- bility to respond to technological The illusion of stability between Ml demand, that is, a theory about why makers, who viewed monetarism as a these real variables." In this regard, and nominal GNP that prevailed after people want to hold money balances." justification for fine-tuning nominal the monetarists have an important mes- advances and other shocks to the struc- ture of financial markets. World War II resulted from the acceler- the 1900s, monetary systems were based The most important factor determin- sage for policymakers when they argue ating inflation and interest rate regula- on commodity standards, usually met- ing the demand for Ml is the level of tions that uniquely characterized that als. There h'ave been paper money sys- transactions. It is common practice to New England Economic Review, Marchi April Reserve Settlement Periods of Member Banks," The Structure 0/ Monetarism, W. W. Norton & period. Such stability should not be tems in the past (the first recorded use nominal GNP as an approximate 1975, pp. 21·30, and the proposal to stagger Journal 0/ Finance, vo1.19 (March 1964), pp.76-93. Co., 1978, pp. 1-46. considered to be the norm. instance of state-issued paper money oc- measure of transactions because aggre- reserve maintenance periods among groups of In fact, as the first part of this essay curred in China in the ninth century), gate transactions data are not available. banks in Albert H. Cox, Jr. and Ralph F. Leach, 8. For a discussion of what is meant by the term 9. For a discussion of these issues see James G. shows, the recent variability of Ml ve- but they always degenerated with high Over a relatively short period (say three "Defensive Open Operations and the monetarism, see William Poole, Money and the Hoehn, "Monetary Policy Debates Reflect Theo- Economy: A Monetarist View, Addison-Wesley retical Issues," Economic Commentary, Federal locity, while large in comparison to our inflation and consequently disappeared.s months to a year), quantity theorists Publishing Co., 1978, pp. 1-4, or Thomas Mayer, Reserve Bank of Cleveland, May 1, 1986. experience after World War II, is still While metallic standards were often expect the demand for money to rise or small relative to our experience before suspended during wars and national fall in a predictable fashion with a rise that war. The monetarist call for a con- emergencies, they were usually rein- or fall in GNP. The ratio of nominal Federal Reserve Bank of Cleveland BULK RATE stant money growth rule followed an ex- stated soon after the emergency ended. GNP to the amount of money is termed Research Department U.S. Postage Paid tensive study of this prewar experience, The United States adopted a modi- the velocity of money, in reference to P.O. Box 6387 Cleveland, OH and was not based on the postwar sta- fied in the Bretton Woods the turnover per year, or the velocity of Cleveland, OH 44101 Permit No. 385 bility of Ml velocity. The second part of Agreement after World War II. The dol- circulation, of money. this essay presents a monetarist cri- lar remained tied to gold until the late Of course, velocity is not a constant. tique of recent experience. 1960s or early 1970s. Officially, the dol- There are seasonal and other variable lar was freed from gold when President factors affecting money demand and Nixon suspended convertibility for there is error in measuring income and Historical Perspective other central banks on August 15, 1971. money. Of the nonseasonal factors, the To understand the challenge for mone- But, effectively, the dollar had already most important are probably interest tary policy, it helps to take a long histor- been freed from a gold constraint in rates and technological innovations affect- ical perspective. We live in a unique 1968 when Congress removed the "gold ing the efficiency of the payments system. time. For the four thousand years before

William T. Gavin is an economic advisor at the 1. One notable exception was the late Michael]. procedure based on a constant growth rule for Federal Reserve Bank 0/ Cleveland. Hamburger (Wall Street Journal, July 8, 1986, p. nominal GNP, not a constant growth rule for M1. Material may be reprinted provided that the The views stated herein are those 0/ the author 30) who argued that his money-demand equation, Address Correction Requested: Please send 2. See Elgin Groseclose, Money and Man, Freder- source is credited. Please send copies of reprinted and not necessarily those 0/ the Federal Reserve specified two decades ago, continued to explain corrected mailing label to the Federal Reserve ick Ungar Publishing Co., 1961, p. 118, or Rupert materials to the editor. Bank 0/ Cleveland or 0/ the Board 0/ Governors 0/ the relationship between Ml and nominal GNP. Bank of Cleveland, Research Department, ]. Ederer, The Evolution 0/ Money, Public Affairs the Federal Reserve System. Note, however, that he implicitly recommended a P.O. Box 6387, Cleveland, OH 44101. Press, 1964, p. 91. When interest rates rise, people econ- in Ml velocity was flat. When interest socia ted with discretionary monetary omize on non-interest-bearing currency Chart 2 Velocity of M1 and Chart 3 M1 Velocity Growth, rates fell, velocity fell. After World War policy. While one cannot prove or dis- and on checking balances, and then ve- Chart 4 Wholesale Price , the Commercial Paper Rate, 1895-1985 II, rates began to rise - approximately prove the proposition that money de- locity rises. When interest rates fall, 1895-1985 doubling every decade to 1980 - and ve mand would be stable if 1895-1985 people are more willing to leave funds Percent Percent Percent change. annual rate locity also rose. If the decline in interest were stable, the proposition is a fun- idle as balances, and velocity falls. 16 8 15r-----,------, rates since 1982 is regarded as a perrna damental assumption leading to the 1967=100 Of course, interest rates change every nent decline, then it should be associated call for a constant money growth rule. 350r------~ 14 11.90 day, but firms and do not 10 with a decline in the velocity trend. 12 300 adjust their money balances to every From this perspective, what seems 5 250 short-run change in interest rates. It 10 unusual is not the experience of the takes time and resources to rearrange 8 0 1980s, but rather the apparent stability A Monetarist Critique 200 our monetary affairs. Therefore, the 6 .5 of velocity from 1950 to 1980. It is of Recent Experience 150 adjustments will be made when it is 4 likely that this relative stability was When we take the longer perspective, 100 convenient, or when there is a signifi- ·10 made possible by a combination of two we see that it was a mistake to expect 2 cant change in the level of interest atypical circumstances. The first was so much of Ml in the first place. The 50 rates that people expect to bepermanent. ·15 ~# ~ the accelerating inflation and rising monetarist philosophy, which forms o We have also seen a rise in velocity ~ " ~ interest rates of the period. The other the intellectual basis for monetary tar- ~-"'<-;,~iP@~*_~r..<-;,rj;:> (decline in the demand for money) with was the prohibition against paying geting, was developed with this longer ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ the advance of technology and innova- SOURCE: Federal Reserve Bank of Cleveland. SOURCE: Federal Reserve Bank of Cleveland. interest on deposits. These two circum- perspective in mind. The most basic tions in the banking industry. For stances, which combined to produce the tenet of the monetarist philosophy is SOURCE: Federal Reserve Bank of Cleveland. example, households use credit cards steady rise in velocity, were both elimi- that the economy will function most for transactions, reducing average bal- nated in the early 1980s. efficiently if government institutions ances that are kept in checking ac- 1980 seems to confirm the monetarist allowed to pay interest on checking Not only was there a change in the and policies are structured to permit counts. Firms have developed a wide position (See chart 1). until 1981. The effective deregulation growth trend of Ml velocity in the market forces to operate with as little that banks adjust their portfolios to array of cash management techniques.' Velocity rose in a smooth fashion of interest-rate ceilings on demand de- 1980s, but there was also an increase in day-to-day interference from govern- meet average reserve requirements The technological innovations were from 2.52 in 1950 to 7.11 in 1981. The posits by regulatory approval of nation- the variability as measured by changes ment as possible. every two weeks. This only makes sense partly spurred by rising interest rates; interest rate shown in chart 1 is the wide NOW and Super-NOW accounts in the level. This measure of the varia- Monetarists think that if monetary if one wants to force the economy to when interest rates fall, some of these short term (4-6 month) commercial was therefore an important factor in bility in Ml velocity is shown in chart institutions are properly structured the adjust to a fixed path for Ml, no matter cash management methods will become paper rate. This interest rate rose from changing the velocity trend. The 3, which illustrates annual percent economy is inherently stable, and will what the . Such an arrangement is uneconomical, but others, with lower 1.45 in 1950 to 14.76 in 1981; however, deregulation effect has worked to lower changes in Ml velocity from 1895 to tend toward full employment even not likely to be optimal, however, if we marginal , will remain. its rise was not smooth. While the velocity, as has the perceived perman- 1985. Once again, we see that the dif- when buffeted by outside shocks such view the money stock as a buffer to trends in both velocity and interest ent decline in interest rates. Deregula- ferent pattern for Ml velocity in the as weather and changes in population, help lower transactions and other mar- rates were rising, there does not appear tion also has confounded attempts to 1980s is not so different if we take a technology, or tastes. Consequently, keting costs associated with mis- quantify the effect that falling interest longer historical perspective. The vari- monetarists tend to attribute long peri- matched income and commodity flows. The Velocity Breakdown to be much quarter-to-quarter or year- rates are having on the velocity trend. ability in recent years pales in compar- ods of slow growth and periods of large Setting a constant growth rule for in the 1980s to-year co-movement between these variables. Consequently, there did not This departure from the 3 percent ison to the variability in the period economic fluctuations to inefficient the monetary base under current regu- During the 1970s, many came to be- seem to be much reason to make the growth trend, illustrated in chart 1, before World War II. government institutions or to inap- lations could lead to highly volatile lieve that these other factors (interest monetary targets conditional on the represents the apparent breakdown in It is likely that the data for this early propriate policy actions. interest rates. To avoid sharp swings rates and innovations in cash manage- outcome for interest rates. Further- Ml velocity that is the source of the period are of low quality. But these are Given efficient and stabilizing institu- in interest rates, the Federal Reserve ment) didn't matter too much for the more, given the relation between veloc- current disaffection with the Ml data that Milton Friedman collected tions, monetarists conclude that the would have to monitor constantly the purpose of choosing the Ml target. ity and interest rates from 1950 to target. As stated earlier, this appear- and studied as he developed the mone- best that the monetary authority can do demand for reserves and attempt to While velocity growth was quite varia- 1981, one would not have predicted an ance of breakdown results from a tarist rule of constant money growth.t is to supply the monetary base at a con- counter shifts in this demand with ble from quarter to quarter, these fluc- abrupt decline in velocity, even know- myopic view of history that includes Using these data, Friedman concluded stant growth rate. The monetary base offsetting changes in the supply of tuations were largely offsetting. Over ing the actual outcome for interest only the period after World War II. that the short-run (quarter-to-quarter is government-supplied money. This reserves. The discount window pro- periods of a year or two, Ml velocity rates in the early 1980s. However, when we take a longer or year-to-year) relationship between would be expected to lead to fairly sta- vides another safety valve that supplies usually seemed to grow at its trend rate The smooth rise in velocity occurred view, we see that this latest decline in money and the economy was so unpre- ble and predictable growth rates for dif- reserves whenever there is an unex- of 3 percent, regardless of what hap- during a period with steadily rising velocity is not atypical; rather, it is dictable that monetary policy could not ferent types of bank deposits, for nom- pected increase in demand. Current pened in the short run to interest rates trends in inflation and interest rates. Fed- consistent with a long-standing rela- be used to fine-tune the path for nomi- inal GNP, and for the overall price level. reserve requirement regulations would and advances in cash management. eral Reserve System Regulation Q pro- tionship between Ml, GNP, and inter- nal GNP. He also went to some lengths As a practical matter, our monetary have to be changed before the Federal Indeed, one of the debates among econ- hibited banks from paying interest rates est rates (See chart 2). While transitory to argue that the major episodes of control institutions are not well-suited Reserve could make operational a rule omists was whether the Federal on checking deposits, and the rising in- changes in interest rates did not seem tc instability in velocity were due to a for setting a constant growth rule for for the monetary base.? Reserve's monetary targets should take terest rates on alternative assets reflected be closely related to Ml velocity, it failure to maintain stable growth in the the supply of base money. For example, When asked to make monetary policy account of changes in interest rates rising opportunity costs to depositors. appears that changes in the trend of money supply." money demand is quite unpredictable in recommendations based on our current and other factors affecting money Had banks been allowed from the be- interest rates have been associated Friedman argued that the social costs the very short run, say within the period regulations, monetarists have demand. Monetarists said no, claiming ginning to pay interest on checking with changes in the trend of velocity. of having the economy adjust to money of one month. Yet current rules require responded by recommending that the that while interest rates mattered in deposits, we might not have seen such When the trend in the interest rate demand disturbances would be less than Federal Reserve adopt a constant theory, they did not seem to matter a runoff of deposits and such a rapid was flat, from 1895 to 1929, the trend the social costs of having the economy much in practice. A look at velocity and rise in velocity. But banks were not adjust to the uncertain environment as- interest rates in the period from 1950 to

3. See Milton Friedman, "The Quantity Theory use the term money to refer to balances held 4. For a detailed description, see John B. Carlson, man, A Program for Monetary Stability, Fordham Chapter 7, Friedman and Schwartz attribute the 7. There have been proposals for reserve of Money - A Restatement," in Studies in the primarily to conduct transactions. This corres- "Methods of Cash Management," Economic University Press, 1959. steep decline in velocity to the severity of the requirement reforms that would make a mone- Quantity Theory of Money, University of Chicago ponds to the definition of money known as Ml. Commentary, Federal Reserve Bank of Cleveland, depression which, they contend, was due to the tary base target operational. For two examples, 6. See Milton Friedman and Anna J Schwartz, A Press, 1956, pp. 3-21. While Friedman advocated M1 includes currency, travelers' checks, demand April 5, 1982. 35 percent decline in the stock of money between see the proposal for an expanded reserve carry- Monetary History of the United States: 1867·1960, alternative measures of money (M2 in his early deposits, and other checkable deposits such as August 1929 and April 1933. forward system in William Poole, "The Making 5. Friedman recommends a 4 percent constant Princeton University Press, 1963. For example, in work and, n:ore recently, the monetary base), we NOW accounts and credit-union share drafts. For of Monetary Policy: Description and Analysis," money growth rule in Chapter 4 of Milton Fried- a more precise definition, see any recent issue of the Federal Reserve Bulletin, page A3.