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Economic Commentary Federal Reserve Bank of Cleveland October 1, 1986 money 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 economic growth [SSN 0428-1276 choosing Ml. The targeting of Ml is money and economic activity is not is to provide a stable price 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- Monetarism and retical and empirical considerations. conduct of monetary policy. ciated with accelerating inflation. Ml is defined to include assets 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 demand for money 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 price level COMMENTARY value 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 currency 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 interest 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 business cycle 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 economists, 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- prices (or stable inflation) and deregu- 6 lation of deposit interest rate 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 Quantity Theory of Money. 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 Milton Friedman (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 Market 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 gold standard 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.
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