Monetary

Economics
Theory and Policy
WIT W r I
-

Bennett T. McCallum
Carnegie-Mellon University

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Macmillan Publishing Company
New York

Collier Macmillan Publishers

London
 PREFACE

Copyright © 1989, Macmillan Publishing Company, a division of Macmillan, Inc,

The object of this book is to present a systematic treatment of mone-
Printed in the United States of America
tary economics in a manner that is clear and nontechnical, yet accu-
All r~ghts reserved. No pa~t of this book ma~ be reproduced or transmitted in any form rately reflective of important research developments of the past 20
or b~ any means, electrome or mechamcal, .IncludIng photocopying, recording. or any
l!1formatton storage and retneval system, wJlhout permission in writing from the pub- years. Such a task is not an easy one, since recent research has empha-
hsher. sized dynamic and stochastic aspects of economic behavior-aspects
Macmillan Publishing Company that involve analytical difficulties. My strategy for accomplishing the
866 Third Avenue, New York, New York 10022 task has been to begin with simple models, to introduce complexities only
Collier Macmillan Canada, Inc. as needed, to focus selectively on matters of fundamental importance,
Library of Congress Cataloging in Publication Data
and to relate the discussion at each point with what has gone before.
By proceeding in this fashion, I have found it possible to handle in a
McCallum. Bennett T. satisfying manner numerous topics not usually included in textbook
Moneiary economics: theory and policy/Bennett T. McCallum. discussions. In particular, the book is novel in its emphasis on severe
p. em.
Includes index. inflation, on monetary standards (including commodity-money arrange-
ISBN 0-02-378471-7 ments), and on realistic descriptions of central-bank operating proce-
1. Money. 2. Monetary policv. l. Title. dures. Also, there is a discussion of United States monetary history
HG221.M423 1989 .
332.4--dc19 that is unusual in its coverage, as three-quarters of its length is de-
voted to periods before the creation (in 1914) of the Federal Reserve
Printing: 7 8 Year: 5 6 7 8 System. In terms of technique, moreover, the book includes extensive
expositions of inflationary steady-state analysis, dynamic analysis with
adaptive and rational expectations, and a systematic procedure for
solving linear stochastic models with rational expectations.
The book does not, on the other hand, include much institutional
detail or any substantial amount of material on the subject of finance.
These omissions do not in my opinion constitute a weakness; an impor-
tant ingredient of effective instruction is selectivity in terms of cover-
age.
Because the book emphasizes recent research topics but strives for
analytical simplicity, it should be appropriate for textbook use in a
variety of settings. Preliminary versions have been used successfully in
advanced undergraduate and MBA courses, yet much of the material
could be helpful to beginning graduate students in economics. The
book is primarily designed for courses in monetary economics, but
could alternatively serve as a textbook in macroeconomics or money
and banking with analytical emphasis. It would need to be augmented
v
vi Preface 2

with additional material on consumption, investment, and fiscal policy

(in the former case) or on financial markets and institutions (in the
latter). A synopsis of the material in each chapter is provided in Sec-
CONr!'ENTS
tion 1.4 on pp. 12-15.
In expressing thanks to those who have been helpful to me in writing
the book, I will begin with two organizations. First, the Graduate
School of Industrial Administration (GSIA) at Carnegie-Mellon Uni-
versity has provided an excellent intellectual atmosphere plus the pos-
sibility of combining research and teaching activities. Second, the
Research Department of the Federal Reserve Bank of Richmond,
with which I have been associated for several years, has provided the
opportunity of learning from its members about monetary issues in Preface v
general and the Federal Reserve System in particular. Needless to say,
none of the views expressed in the book should be attributed to either
of these institutions. ____________________ PARTI--------------------
Many individuals have contributed in a variety of ways. Excellent
typing was provided by GSIA's word-processing department and by
Rudiments of Monetary Analysis
my secretaries, Sue Sholar and Gerri Carrozzi. At Macmillan, Ken
MacLeod and Elaine Wetterau were helpful in their roles as Editor and
Production Supervisor, while special thanks go to Jack Repcheck for 1 An Introduction to Monetary Economics 3
crucial support and encouragement in the initial and intermediate
1.1 Preliminary Remarks 3
stages of the project.
1.2 A Few Historical Facts 5
Helpful comments on various chapters have been provided by a 1.3 The U.S. Monetary Experience of 1979-1982 9
number of economists. My thanks go particularly to those who read
1.4 A Look Ahead 12
large portions of the manuscript, including David Aschauer, Michael Problems 15 References 15
Bordo, Martin Eichenbaum, Richard Froyen, Marvin Goodfriend,
John Huizinga, and Dean Taylor. I regret that time pressures have kept
me from incorporating more of their thoughtful suggestions.
2 Basic Concepts 16
Final thanks go to my wife, Sally, whose support has been extra-
ordinary. She deserves substantial credit for anything that I manage to 2.1 The Functions of Money 16
accomplish. 2.2 Empirical Measures 19 .
2.3 Monetary Standards: Fiat Versus Commodity
B.T.M. Money 22
2.4 Legal Tender 24 . .
2.5 Money, Credit, and Financial IntermedlatlOn 25
Problems 30 References 32

3 The Demand for Money 33

3.1 Informal Discussion 33
3.2 A Formal Model 35
3.3 Uncertainty 41
3.4 Empirical Money Demand Functions 42
vII
viii Contents Contents Ix
3.5 Velocity 47 7 Inflationary Dynamics 133
3.6 The Baumol-Tobin Model 48
3.7 Conclusions 52 7.1 The Cagan Model 133
Problems 53 References 54 7.2 Hyperinflation Episodes 135
7.3 Cagan's Estimates 136
7.4 Stability Analysis 139
4 The Supply of Money 55 7.5 Weakness of Adaptive Expectations 142
Problems 144 References 144
4.1 Introduction 55
4.2 Basic Relationships 56
4.3 Monetary Control 60
4.4 Alternative Control Procedures 63 8 Rational Expectations 145
4.5 Algebraic Analysis 67 8.1 Basic Properties 145
4.6 Conclusions 71 8.2 Application to the Cagan Model 148
Problems 72 References 73 8.3 Solution Procedure 151
8.4 Properties of the Solution 153
PARTII ____________________
8.5 Examples of Rational Expectation Solutions 155
8.6 Models with Lagged Variables 157
Monetary Macroeconomics 8.7 Multiple Solutions 158
Appendix: Mathematical Expectation: A Review 160
Problems 172 References 173
5 The Static Classical and Keynesian Models 77
5.1 Introduction 77
5.2 The IS Function 78 9 Inflation and Unemployment: Alternative Theories 174
5.3 The LM Function 83
9.1 Dynamics and the Keynesian Model 174
5.4 The Aggregate Demand Function 85 9.2 The Original Phillips Curve 177
5.5 The Classical Aggregate Supply Function 89 9.3 The Augmented Phillips Curve 181
5.6 The Classical Model 93 9.4 Lucas's Monetary Misperceptions Theory 185
5.7 The Keynesian Aggregate Supply Function 96 9.5 Taylor's Relative-Prices Theory 188
5.8 The Keynesian Model 100 9.6 Fischer's Sticky-Wage Theory 189
Appendix: IS-LM and Maximizing Analysis 102 9.7 Real Business Cycle Theory 192
Problems 107 References 108 9.8 Conclusions 196
Problems 197 References 199
6 Steady Inflation 109
6.1 Introduction 109
10 Money and Output: An Analytical Framework 201
6.2 Real Versus Nominal Interest Rates 112
6.3 Inflation in the Classical Model 113 10.1 Introduction 201
6.4 Comparative Steady States 117 10.2 Aggregate Supply: Basic Model 203
6.5 Analysis with Real-Balance Effects 120 10.3 Normal Output 208
6.6 Analysis with Output Growth 122 10.4 Multiperiod Pricing 211
6.7 The Welfare Cost of Inflation 124 10.5 Rationale for Price Stickiness 214
6.8 Concluding Comments 130 10.6 Conclusions 215
Problems 131 References 131 Problems 217 References 217
x Contents Contents xi

PART III 15 Episodes in U.S. Monetary History 298

Monetary Policy 15.1 Introduction 298
15.2 Money in Colonial America 299
15.3 From the Revolution to the Civil War 309
11 Analysis of Alternative Policy Rules 221 15.4 From the Civil War to World War I 317
15.5 From 1914 to 1944 324
11.1 Introduction 221 15.6 Conclusion 331
11.2 Monetary Policy Ineffectiveness? 221 Problems 333 References 334
11.3 The Lucas Critique 228
11.4 Money Stock Control 230
11.5 Conclusions 235
16 A Strategy for Monetary Policy 336
Problems 236 References 236
16.1 Basic Considerations 336
16.2 A Specific Rule 339
12 Rules Versus Discretion in Monetary Policy 237 16.3 Performance of Proposed Rule 343
16.4 Conclusions 348
12.1 Fundamental Distinctions 237 Problems 350 References 350
12.2 Rules Versus Discretion: An Example 239
12.3 Effects of Rules Versus Discretion 241
12.4 Extensions of the Basic Model 244 Index 352
12.5 Evidence 245
Problems 248 References 248

13 The Gold Standard: A Commodity-Money System 249

13.1 Introduction 249
13.2 Basic Model 250
13.3 Analysis with Basic Model 255
13.4 Dynamic Analysis with Rational Expectations 258
13.5 Bimetallism 263
13.6 Conclusions 267
Problems 267 References 268

14 Open-Economy Monetary Analysis 269

14.1 Introduction 269
14.2 Basic Open-Economy Model 271
14.3 Properties of the Model 275
14.4 Extensions 280
14.5 Fixed Exchange Rates 285
14.6 The Balance of Payments 288
14.7 Fixed Versus Floating Exchange Rates 293
Problems 296 References 297
Rudiments of
Monetary
Analysis
 JiIJ
1
An Introduction to
Monetary Economics
1.1 Preliminary Remarks

Monetary economics is concerned with the effects of monetary institu-

tions and policy actions on economic variables that are of importance
to individuals and organizations. Among these variables are com-
modity prices, wages, interest rates, and quantities of employment,
consumption, and production-all considered at various levels of
disaggregation but especially on an economy-wide or aggregate basis.
Given the foregoing definition, it would be natural to ask why this
topic warrants designation as a special field or area of study within
economics. "Money is just one of many commodities," some persons
would say, "so why emphasize it rather than bicycles or suitcases or
five-year government bonds?" Part of the answer to this question is
that money is quite special in its role as a crucial intermediary object
that is involved on one side of most transactions that take place in
today's market economies. A second part of the answer, moreover,
stems from the fact that a majority of analysts-including professional
economists, journalists. policymakers, and financial market partici-
pants-believe that monetary policies have an overwhelmingly impor-
tant impact on the economic life of a nation. Indeed. for this reason
Paul Volcker was frequently described during the years 1979-1987 as
the "second most powerful man in the United States" (Le., second only
to the President). I Such statements were, of course, made about him not

I See The Economist. September 22, 1984, p. 5.

3
4 1 An Introduction to Monetary Economics 1.2 A Few Historical Facts 5

because of his height-although it is 6 feet 7 inches!-but because 1.2 A Few Historical Facts
Vo1cker occupied the dominant executive position in the Federal
Reserve System, which is the central institution in the country's current
"The price level" is a term used to refer to some average of the money
monetary system. (In August 1987, Alan Greenspan replaced Vo1cker
as Chairman of the Board of Governers of the Federal Reserve prices of a broadly defined group of commodities-in other words, the
System.) price (in monetary units) of some "representative" bundle of commod-
Mention of the Federal Reserve System, typically referred to as "the ities. The inverse of the price level, then, is a measure of the commod-
Fed," is a useful reminder that recent U.S. monetary experience has ity value of a unit of money. Probably the most striking fact about U.S.
been both eventful and contentious. A brief overview of some aspects monetary experience of the past 40 years is that the price level has risen
of that recent experience will be provided momentarily, in Section 1.3. since the end of World War II by a factor of about 5.8. Equivalently,
Before turning to the recent period, however, it will be useful to take a the value of a U.S. dollar in 1987 is only 17 percent of what it was in
look at certain features of U.S. monetary experience over a longer 1946. 2 Now, to some readers this fact may not at first seem striking, as
historical span of time. it reflects an average inflation rate of only a few percentage points a
year. 3 But in that regard it is important to realize that the U.S. price
level at the start of World War II was only a little higher than it had
Table 1-1. U.S. Price-Index Numbers
been at the nation's inception (i.e., at the outbreak of the War of
Independence). More specifically, the price level in 1940 was approx-
WPI WPI WPI CPI imately 1.3 times its level in 1776. 4 Never in the nation's history, until
Date W&p a BLSb W&P C BLSd the last 40 years, had major movements in the price level occurred
without being substantially reversed within one or two decades. Some
1749 68 24.0
1776 86 pertinent statistics concerning U.S. price-level history are reported in
30.3
1800 129 45.5 51 Table 1-1.
1820 106 37.4 42 Mulling upon these facts, one tends naturally to ask: What is the
1840 95 33.5 30 explanation for this vastly different inflationary experience of the post-
1860 93 32.8 27 war period as compared with previous historical eras?5 There are
1865 185 65.2 46 various levels at which an answer could be attempted, but one possibly
1890 82 28.9 28.9 27 significant difference is provided by the complete abandonment since
1900 28.9 25 World War II of any attachment to a commodity-money standard.
1915 35.8 30.4 There is no single point in time at which this abandonment took place;
1920 79.6 60.0 nevertheless, the following facts are clear. First, before 1933 the nation
1929 49.1 51.3
1933 34.0 40.9
1940 40.5 42.0 2 This calculation is based on one well-known measure of the general price level, the U.S.

1946 62.3 Bureau of Labor Statistics's Consumer Price Index (CPI) for all items. Its value was 340.4 in
58.5 1987, on a scale that makes the 1967 value equal to 100, as compared with 58.5 for the year
1960 94.9 88.7 1946. The ratio 340.4/58.5 is 5.82; its inverse is 0.172.
1970 110.4 116.3 3 Solving (1 + 7T)41 = 5.82 gives 7T = 0.0439, or an average inflation rate of about 4.4
1980 268.8 246.8 percent per year.
1987 307.6 4 This calculation is based on a Wholesale Price Index (WPI) comparison, rather than one
340.4
involving consumer prices, because the CPI is available only hack to 1800. Actually, the
a Base year 1910-1914. See Historical Statistics of the United States, Bureau of Labor Statistics's WPI measure only goes back to 1890, but there is also an index of
pp. 201-202. wholesale prices created by the economists Warren and Pearson [see p. 186, vol. 1, of U.S.
b Base year 1967. Historical Statistics of the United States, p. 199, and
Department of Commerce, Bureau of the Census, Historical Statistics of the United States
(WaShington: U.S. Government Printing Office, 1975)]. The Warren and Pearson index is 86
Survey of Current Business.
for 1776 and 82 for 1890; the Bureau of Labor Statistics WPI figures are 28.9 for 1890 and 40.5
'Base year 1967. The first column multiplied by 28.9/82. for 1940. The calculation in the text in effect "splices" the series as of 1890, using the two
dBase year 1967. Historical Statistics of the United States, pp. 210- values for that year. A qualification to this comparison is mentioned in Chapter 15.
11, and Survey of Current Business. , A similar contrast is present in the data for other nations; see Chapter 12.
6 An Introduction to Monetary Economics 1.2 A Few Historical Facts 7

was officially on the gold standard in the sense that a dollar was a legal pose of creating and maintaining ... conditions under which there will be
claim to 0.0484 ounce of gold. In particular, Federal Reserve Notes, afforded useful employment opportunities ... and to promote maximum
which were the main circulating currency, were convertible into gold: employment, production, and purchasing power. 9
the Fed was obligated to exchange its Notes, if presented at certain
specified locations, for gold in the quantity mentioned above. 6 Sec- It seems almost certainly the case that the existence of this expansion in
ond, since 1971 there has been no link whatsoever between dollars and the macroeconomic policy role of the federal government has affected
gold or any other commodity. The Fed now makes no promises about the Fed's conduct of monetary policy, and it is at least conceivable that
what its Notes are worth in real terms; they are not legal claims on the effect would be of a type that is conducive to inflation. Indeed,
anything (except other dollars!). some formal analysis presented in Chapter 12 suggests that such is the
The implicit suggestion of the preceding paragraph is that the ab- case-that discretionary policy has had an inflationary bias.
sence of a commodity-money standard has permitted the Fed to expand In other words, a plausible suggestion is that increased emphasis on
the nation's money stock excessively, thereby inducing the fall in the real objectives such as output and employment has contributed to the
value of a dollar that has in fact taken place. As a partial test of this inflationary character of the postwar period. A natural question to ask,
suggestion, one might examine the data pertaining to the U.S. money then, is whether there has been any compensating improvement in the
stock to see if in fact it has grown rapidly in the postwar period. Doing behavior of output and employment, relative to earlier eras. In that
so, it is found that the stock of money was approximately $40 billion in regard, a mere glance at the unemployment data reported in Table 1-2
1940 and about $750 billion at the end of 1987, a ratio of 18.7 to 1. 7 So, suggests that cyclical fluctuations may have been less severe in the
at least in this rather rough way, the facts are indeed consistent with postwar period than before. To examine the data in a slightly more
our supposition. 8 informative way, let us consider the behavior of the difference between
A second important difference in postwar U.S. monetary arrange- UNt (the measured unemployment rate in year t) and UN,* (the "natu-
ments, as compared with previous periods, is the extent to which ral" or "normal" unemployment rate for that year). If real employ-
responsibility for real macroeconomic conditions has been accepted by ment fluctuations have been less severe in the recent period, the abso-
the Fed and by the federal government more generally. In this regard, lute value of UNt - UN: should on average be smaller than before. In
too, the change did not occur entirely at a single point in time. But it is fact, if we use estimates of UNt* developed by Gordon (1984), the
certainly true that before World War II the use of activist monetary average of annual values of I UNt - UNr* lover three major periods is as
policy to smooth out fluctuations in aggregate output and employment follows:
was not generally regarded as an important part of the Fed's duties. For
Time Period Average Value of IUN, -uNtl
the past 40 years, by contrast, monetary policy has been conducted in
an environment significantly affected by the Employment Act of 1946, 1890-1915 3.9
which declares that 1920-1940 8.0
1946-1985 1.2
It is the continuing policy and responsibility of the Federal Government to Thus this measure, in agreement with a simple glance at Table 1-2,
use all practical means consistent with its needs and obligations ... to
suggests that fluctuations in output and employment have been con-
coordinate and utilize all its plans, functions, and resources for the pur-
siderably less severe in the postwar period than before. Thus it might
be possible to argue that the change in monetary policy arrangements
has on balance been desirable, even if it induced more inflation. But
6 Actually, this statement is accurate only for the period 1900-1933. Before 1900, the
that position is debatable; whether the improvement in unemployment
country was officially on a bimetallic-gold and silver-standard. That type of arrangement
will be discussed in Chapter 13.
7 The two figures pertain to slightly different variants of Ml, the basic money stock
measure. The earlier is taken from Gordon (1984), the latter from the Federal Reserve 9 The three omitted phrases are as follows; (I) "and other essential considerations of
Bulletin. national policy, with the assistance and cooperation of industry, agriculture, labor, and
8 The main reason why the price-level increase was proportionately less than that of the state and local government"; (2) "in a manner calculated !O foster and promote free
money stock is that real income has grown and led to a growth in the real value of competitive enterprise and the general welfare"; and (3) "including self-employment for
transactions. This type of effect is discussed in Chapter 3. those able, willing, and seeking to work. "
8 An Introduction to Monetary Economics 1.3 The U.S. Monetary Experience of 1979-1982 9

Table 1·2. U.S. Unemployment Rates, 1890-1985 behavior has been attributable to improved monetary policy is a lead-
ing unsettled issue in macroeconomics. Indeed, a major objective of
Year VN, (%)8 Year VN, (%)8 Year UN, (%)8
this book is to develop the tools necessary for the reader to reach an
1890 4.0 1930 8.9 1960 5.5 informed conclusion of his or her own on that question.
1 5.4 1 16.3 1 6.7
2 3.0 2 24.1 2 5.6
3 11.7 3 25.2 3 5.6
4 18.4 4 22.0 4 5.2 1.3 The U.S. Monetary Experience of 1979-1982
5 13.7 5 20.3 5 4.5
6 14.4 6 17.0 6 3.8
7 14.5 7 14.3 7 3.8
Having briefly highlighted some contrasts between the pre- and post-
8 12.4 8 19.1 8 3.6 World War II record, let us now consider a recent episode that has
9 6.5 9 17.2 9 3.5 received considerable attention. As a result of the relatively severe
1900 5.0 1940 14.6 1970 5.0 inflation of the late 1970s, Volcker and other officers of the Fed became
1 4.0 1 9.9 1 6.0 convinced during 1979 that to prevent an extremely unhealthy situation
2 3.7 2 4.7 2 5.6 they would need to exercise tighter control over growth of the money
3 3.9 3 1.9 3 4.9 stock than in previous years. To facilitate such control,10 they publicly
4 5.4 4 1.2 4 5.6 adopted on October 6, 1979, a new set of operating procedures, proce-
5 4.3 5 1.9 5 8.5 dures that featured increased emphasis on a particular measure of bank
6 1.7 6 3.9 6 7.7
7
reserves (i.e., non borrowed reserves) and reduced emphasis on short-
2.8 7 3.9 7 7.0
8 8.0 8 3.8
term interest rates. Their new procedures were supposed to be helpful
8 6.0
9 5.1 9 6.1 9 5.8
to the Fed in achieving its targets for money supply growth-targets
1910 5.9 1950 5.2 1980 7.2 that it had been announcing since 1975 but failing to achieve in most
1 6.7 1 3.3 1 7.6 years.
2 4.6 2 3.0 2 9.7 The practice of announcing these money supply targets, it should be
3 4.3 3 2.9 3 9.6 explained, had been reluctantly adopted by the Fed at the insistence of
4 7.9 4 5.6 4 7.5 the U.S. Congress. I! As can be seen from Table 1-3, the targets were
5 8.5 5 4.4 5 7.2 not highly precise. For the year ending with the fourth quarter of 1978,
6 5.1 6 4.1 6 7.0 for example, the target consisted of a range of values for the money
7 4.6 7 4.3 7 6.2 growth rate that extended from 4.0 to 6.5 percent. (The actual value
8 1.4 8 6.8
9 1.4
turned out to be 7.2 percent in this year, as can also be seen from Ta-
9 5.5
1920 5.2 ble 1-3.) Given the modest degree of precision sought for, it appeared
1 11.7 that the failure to achieve the official targets should in principle be
2 6.7 correctible.
3 2.4 The new operating procedures begun in October 1979 were kept in
4 5.0 place by the Fed until late 1982, with September 1982 usually regarded
5 3.2 as the last month of the episode. Because so-called "monetarist" eco-
6 1.8 nomists had for many years been recommending tighter money stock
7 3.3 control as the best way of fighting inflation, and had often recom-
8 4.2 mended operating procedures with a measure of bank reserves 12 as the
9 3.2
• UN, denotes the unemployment rate for all U.S. workers, during year t. Data 10 According, at least, to the Fed's public statements on the subject.
for 1900-1982 come from Gordon (1984. Table B-1); earlier values appear in His- lIOn this topic, see Weintraub (1978).
torical Statistics of the United States and more recent ones are reported in numerous 12 Total reserves, however. not the nonborrowed reserves measure actually emphasized by
publications. the Fed.
10 An Introduction to Monetary Economics 1.3 The US. Monetary Experience of 1979-1982 11

Table 1-3 Money Stock Growth Rates (percent) 30 - - - - - - - - - - - - - - - , - - - - , . - - - - , - - - - - - . , . - - - - - ,

(Monthly changes at annual rales,
as currently adJus(ed
Ml Growth Rates' [or seasonality)
20
Year Ending
4th Quarter of: Target Range Actual Value
10
1976 4.5-7.5 5.8
1977 4.5-6.5 7.9 or-------¥------f-+---~--~rl-_+~L-~~~~
1978 4.0-6.5 7.2
1979 4.5-7.5 6.8 -10
1980 4.0-6.5 6.9
1981 3.5-6.0 2.4 -wL-----____ ~_ ___-L____ -L~ ______ ~ ______L -____ ~

1982 2.5-5.5 9.0 1976 1977 1978 1979 1980 1981 1982
1983" 4.0-8.0 10.3 (a)
1984 4.0-8.0 5.2 24r-----------------------~----------------------~
1985" 4.0-7.0 12.2 (Monthly average)
1986d 3.0-8.0 15.3
"Some adjustments to raw values have been made to reflect E
anticipated shifts into or out of NOW accounts. For the reason for
E 16
;
these adjustments, and more detail concerning the figures, see
Broaddus and Goodfriend (1984).
bIn the second quarter of 1983 a new target range of 5.0-9.0
percent was set for the remaining half-year; the actual rate was 7.4
percent.
c During 1985 the target range was changed to 3.0-8.0 percent.
d During 1986 the Ml target was suspended.
O~~------~------L----~i-----~------~----~
1976 1977 1978 1979 1980 1981 1982

(b)

key variable, this experience has frequently been termed a "monetarist Figure 1-1. (a) Growth rate of M1 money measure before and after
experiment." Actually, for various reasons, that label is highly in- October 1979. Source of primary data: Board of Governors, Federal
appropriate. 13 But the episode did nevertheless constitute a policy ex- Reserve System. (b) Federal funds rate before and after October 1979.
periment of a sort, and is therefore of considerable interest. SOURCE: Board of Governors, Federal Reserve System.
What, then, were the results of this experiment? In one respect the
Fed's attempts were successful: by September 1982 the U.S. inflation
rate had been reduced from around 11 or 12 percent (per year) to a
magnitude in the vicinity of 4 or 5 percent. Other aspects of the the extent of month-to-month variability of interest rates was greater
outcome were not as planned, however, and were highly unpopular than ever before. Third, in 1981 a recession began that was the most
with the public and with most commentators. Of these undesirable side severe since the Great Depression of the 1930s; the nation's overall
effects, four will be mentioned. First, short-term interest rates rose to unemployment rate climbed over 10 percent in the second half of 1982.
levels unprecedented in U.S. history. Over the month of May 1981, for So while the economy was relieved-at least temporarily-of the
example, the 90-day Treasury bill rate averaged 16.3 percent. Second, inflationary pressures that it had been experiencing for about a decade,
this relief was apparently14 obtained at the cost of an unwelcome
recession and the associated loss in output.
13 In particular, monetarist prescriptions have typically stressed the importance of nearly
constant money growth rates and the absence of activist attempts to vary these rates counter-
cyclically. In fact, the Fed did not abstain from activism during 1979-1982 and - as we will see 14 The word apparently is inserted because a few economists would argue that the recession
Shortly-money growth rates were far from constant. For an elaboration on this argument of 1982-1983 was not brought about by the monetary policy actions under discussion. The
see Friedman (1983). . viewpoint of such economists is discussed in Section 9.7.
12 An Introduction to Monetary Economies 1.4 A look Ahead 13

Perhaps the most_interesting aspect of the episode, however, per- and the supply of money, respectively, with the latter also including a
tains to the fourth item on our list: the Fed did not succeed in improv- preliminary analysis of the way in which the Fed attempts to control the
ing its record of money stock control. Instead, the realized growth U.S. money stock. Together, Chapters 1 through 4 constitute Part I of
rates for the years ending in the fourth quarter of 1980, 1981, and 1982 the book, a part that might be viewed as comprising the rudiments of
were again outside the specified target range, as indicated in Table 1-3. monetary economics.
And monthly values of the growth rate were highly variable, as can Part II of the book, which includes Chapters 5 through 10, concerns
readily be seen from Figure 1-1. This is especially striking, of course, monetary macroeconomics-that is, macroeconomic analysis with a
because the special operating procedures of 1979-1982 were designed strong emphasis on monetary aspects. In Chapter 5 we review two
precisely for the purpose of improving money stock control so as better models that have been extremely important in macroeconomic analysis
to achieve the monetary growth targets! and teaching over the last 40 years: the "classical" and "Keynesian"
The facts that we have just reported are not a matter of dispute- models. These two models can be used to provide various insights into
students of the episode agree that inflation came down, unemployment the operation of actual economies, but they share the drawback of
rose, interest rates became high and variable, and money stock targets being essentially static (i.e., timeless) in nature. In Chapter 6, then, we
were not met. What interpretation to place on the facts is, however, begin the task of developing a framework for dynamic analysis. The
another matter. To some economists they suggest that it is unwise to first step is to consider situations in which some of the economy's
pursue money stock targets, in part because of the putative unreliabil- variables are changing over time but at a constant rate. In particular,
ity of money demand behavior in an economy in which new payments Chapter 6 is concerned primarily with steady, ongoing inflation-a
practices and financial assets are constantly being developed. 15 To process of steadily increasing prices. In Chapter 7 we turn to an analysis
other economists, however, the experience illustrates how poorly the of inflation when its magnitude is not constant but is changing from
Fed's procedures were designed for money stock control and how period to period. As it happens, this generalization can be effected
dangerous it is to allow excessive money growth-and the inflation that most easily for cases in which inflation is very severe, so part of Chap-
it engenders- to become established in an economy. 16 ter 7 is devoted to a discussion of actual hyperinflation episodes that
have occurred in Europe during this century. Some of the main con-
cepts of dynamic analysis are introduced in this context.
Whenever variables are changing over time, the expectations held by
1.4 A Look Ahead individuals and firms about values in the future are important determi-
nants of current demand and supply decisions. In the analysis of Chap-
In the chapters that follow, we shall develop the theoretical and factual ter 7, a particular model of expectation formation is utilized. As it
knowledge necessary to draw reasoned conclusions regarding issues- happens, however, that model-known as the model of adaptive ex-
including, for example, the just-mentioned disagreement-relating to pectations-is open to severe criticism. In Chapter 8, accordingly, we
the conduct of monetary policy and the design of monetary institutions. explain that criticism and then introduce a second hypothesis about
The object will be more to enhance the reader's analytical skills than to expectations that is not open to the same criticism. The second hypoth-
reach specific conclusions, but the author's opinions will undoubtedly esis, known as the hypothesis of rational expectations, has been very
be apparent in several places. important in recent macroeconomic discussions and is widely used
The material begins in Chapter 2 with a discussion of the nature and today. Consequently, Chapter 8 provides a rather lengthy discussion of
role of money in a market economy, together with an introduction to the concept and an introduction to the techniques of conducting formal
the most important empirical measures of the money stock used in the analysis under conditions of rational expectations.
United States. Also included is a section contrasting fiat-money and The analysis in Chapters 6-8 proceeds within a version of the classi-
commodity-money standards and one on the significance of legal tender cal model, a framework which implies that real output and employment
requirements. Chapters 3 and 4 are devoted to the demand for money are virtually independent of monetary policy actions. That assumption
can be useful in developing an understanding of the basic nature of
For an expression of this view, see Blinder (1981) or Bryant (1983).
15
inflation, but must be reconsidered in the context of business cvcle
These views are expressed by Brunner and Meltzer (1983) and Friedman (1983). among
16 analysis for there are reasons to believe that, in reality, monetary
others. policy actions have important effects on the cyclical behavior of real
14 An Introduction to Monetary Economics References 15

variables. The magnitude and nature of such effects are, however, Finally. in Chapter 16 we discuss a specific and operational strategy
matters that involve considerable disagreement among macro econom- for the conduct of monetary policy. This particular strategy has been
ists. Accordingly, in Chapter 9 we summarize today's leading alterna- promoted elsewhere by the present author, so there is no pretense that
tive theories regarding real cyclical effects of monetary policy. As it it represents the views of the profession in general. It is presented,
happens, each of the theories possesses some empirical or analytical rather, in the spirit of providing a response to the desire of many
weakness, so it is unclear which model would be most useful for students for some concrete and constructive position regarding policy,
analysis of cyclical phenomena. A compromise model is, consequently, rather than a mere string of criticisms. Whatever the reader's reaction
developed and exposited in Chapter 10. This model is designed to be may be to this proposal, its discussion provides an integrative review of
compatible with the basic principles of economic theory, reasonably several ideas developed elsewhere in the book.
consistent with recent cyclical experiences of the United States, and Each chapter is accompanied by a few problems. These are of
comparatively easy to work with. varying degrees of difficulty, but all are designed to illustrate significant
The last major portion of the book, Part III, stresses issues of points. In some cases the problems provide extensions or new applica-
monetary policy. In the setting of a dynamic model with rational tions of material covered in the text.
expectations, analysis of policy options is conducted in a manner that
differs from standard comparative static treatments. This difference is Problems
emphasized in Chapter 11, which takes up three specific policy issues
that have concerned researchers in recent years. That discussion pre- 1. From figures reported in the most recent issue of the Federal Re-
pares the way for Chapter 12, which involves a topic of long-standing serve Bulletin, determine the rate of growth of the M1 money stock
concern-the desirability of rules versus discretion in monetary over a six-month period ending (approximately) four months prior
policy-but in a new analytical form. Then Chapter 13 provides an ex- to the current date.
tensive analysis of one particular type of a monetary rule, namely, a 2. The Federal Reserve's annual reports to Congress are published in
commodity-money standard. Since the version that has been most the Federal Reserve Bulletin each year, usually in the March issue.
important historically featured gold as the monetary commodity, this From the most recent report, determine which monetary aggregates
chapter is entitled "The Gold Standard." are currently being targeted by the Fed.
Recently, considerations involving trade and financial relations 3. What was the ratio of the WPI in 1940 to its level in 1840')
among nations have become increasingly important, even for the com-
paratively self-sufficient economy of the United States. Accordingly,
References
Chapter 14 extends the macroeconomic analysis of Part II so as to be
applicable to an open economy, that is, one engaged in international Blinder, Alan S., "Monetarism Is Obsolete," Challenge 24 (September-
economic relationships. The analysis builds upon that of the preced- October 1981), 35-41.
ing pair of chapters, as an international monetary system with fixed Broaddus, Alfred, and Marvin Goodfriend, "Base Drift and the Longer Run
exchange rates entails adherence by each country to a particular mone- Growth of M1: Experienee from a Decade of Monetary Targeting," Federal
tary policy rule, while such a rule is in turn rather similar to a commod- Reserve Bank of Richmond, Economic Review 70 (November-December
ity-money standard. Our modeling of an open economy emphasizes, 1984), 3-14.
however, the currently relevant case of flexible (market determined) Brunner, Karl, and Allan H. Meltzer, "Strategies and Tactics for Monetary
exchange rates .. Control," Carnegie-Rochester Conference Series on Public Policy 18 (Spring
In Chapter 15 several of the book's analytical points are illustrated 1983),59-104.
by reference to actual occurrences in U.S. history, including some from Bryant, Ralph c., Controlling Money: The Federal Reserve and lIS Critics.
the pre-I776 colonial era. The object here is not to provide a well- (Washington, D.C.: The Brookings Institution, 1983).
Friedman, Milton, "Monetarism in Rhetoric and Practice," Bank of Japan.
rounded monetary history of the nation but rather to concentrate on Monetary and Economic Studies 1 (October 1983), 1-14.
selected episodes that bear upon analytical points in enlightening ways. Gordon, Robert 1., Macroeconomics. 3rd ed. (Boston: Little, Brown and
Enough of these episodes are considered, nevertheless, for the chapter Company, 1984).
to offer a coherent outline of the various monetary standards that have Weintraub, Robert E., "Congressional Supervision of Monetary Policy,"
prevailed during the nation's history. Journal of Monetary Economics 4 (April 1978), 34]-62.