Table Of ContentMonetary Policy on the 75th Anniversary
of the Federal Reserve System
Monetary Policy on the 75th Anniversary
of the Federal Reserve System
Proceedings of the Fourteenth Annual Economic Policy
Conference of the Federal Reserve Bank of 8t. Louis
edited by
Michael T. Belongia
Federal Reserve Bank 01 S1. Louis
~.
"
Springer Science+Business Media, LLC
Library of Congress Cataloging-in-Publication Data
Economic Policy Conference of the Federal Reserve Bank of SI. Louis
(14th: 1989: Federal Reserve Bank of SI. Louis)
Monetary policy on the 75th anniversary of the Federal Reserve
System: proceedings of the Fourteenth Annual Economic POlicy
Conference of the Federal Rese rve Bank of SI. Louis/edited by
Michael T. Belongia.
p. cm.
Conference held 10/19/89.
Includes bibliographical references.
ISBN 978-94-010-5731-8 ISBN 978-94-011-3888-8 (eBook)
DOI 10.1007/978-94-011-3888-8
1. Monetary policy-United States-History-Congresses.
2. United States-Economic policy-History-Congresses.
3. Federal Reserve banks-History-Congresses. 1. Belongia,
Michael T. II. Title.
HG501.E26 1990
332.4'973-dc20 90-38802
CIP
Copyright © 1991 by Springer Science+Business Media New York
Originally published by Kluwer Academic Publishers in 1991
AII rights reserved. No pari of this publication may be reproduced, stored
in a retrieval system or transmitted in any form or by any means,
mechanical, photocopying, recording, or otherwise, without the prior
written permission of the publisher, Springer Science+Business Media, LLC.
Printed on acid-free paper
Set in 10 /12pt Times Roman
by Graphicraft Typesetters Ud., Hong Kong
Contents
Contributing Authors vii
Preface ix
SESSION I
1
The Fed at Seventy-Five 3
Allan H. Meltzer
Commentary: Has the Fed Made a Difference? A Comparison of
Pre-and Post-1914 Conditions by Jeffrey A. Miron 66
Commentary: The Behavior of Foreign Central Banks: Comparisons and
Contrasts with Fed Performance by K. Alec Chrystal 84
Commentary: The Federal Reserve Policy Process by Donald L. Kohn 96
Reply by Allan H. Meltzer 104
SESSION II
2
Why Does the Fed Smooth Interest Rates? 111
Alex Cukierman
Commentary by Michelle R. Garfinkel 148
3
Precommitment to Rules in Monetary Policy 159
Edmund S. Phelps
v
vi CONTENTS
Commentary by Manfred J. M. Neumann 179
SESSION III
4
Monitoring Monetary Aggregates Under Risk Aversion 189
William A. Barnett, Melvin Hinich, and Piyu Vue
Commentary: Monetary Aggregates and Their Uses
by Julio J. Rotemberg 223
Reply by William A. Barnett 232
5
Money and Business Cycles: A Real Business Cycle Interpretation 245
Charles I. Plosser
Commentary by N. Gregory Mankiw 275
Contributing Authors
William A. Barnett N. Gregory Mankiw
Department of Economics Department of Economics
Washington University Harvard University
S1. Louis, Missouri 63130 Cambridge, Massachusetts 02138
K. Alec Chrystal Allan H. Meltzer
Centre of Banking Graduate School of
The City University of London Industrial Administration
Frobisher Crescent Carnegie-Mellon University
220 Schenley Park
Barbican Centre
Pittsburgh, Pennsylvania 15213
England
Jeffrey A. Miron
Alex Cukierman
Department of Economics
Tel Aviv University Boston University
Tel Aviv 69978 Boston, Massachusetts 02215
Israel
Manfred J. M. Neumann
Michelle R. Garfinkel Institut fur Internationale
Research Department Wirtschaftspolitik
Federal Reserve Bank of S1. Louis University of Bonn
P.O. Box 442 Lennestrasse 37
St. Louis, Missouri 63166 5300 Bonn
West Germany
Melvin Hinich
Edmund 5. Phelps
Department of Government
Department of Economics
University of Texas at Austin
Columbia University
Austin, Texas 78712
New York, New York 10027
Donald l. Kohn Charles I. Plosser
Board of Governors of the Department of Economics
Federal Reserve System University of Rochester
Washington, D.C. 20551 Rochester, New York 14627
vii
Julio J. Rotemberg Piyu Vue
Sloan School of Management Research Department
Massachusetts Institute of Technology Federal Reserve Bank of St. Louis
E52-434 P.O. Box 442
Cambridge, Massachusetts 02139 St. Louis, Missouri 63166
Preface
When the 12 District Banks of the Federal Reserve System opened their
doors for business on November 16, 1914, few observers could have
foreseen the Fed's present role as a major, if not dominant, player in U.S.
and world economic policymaking. After all, two previous attempts to
create a central bank in this country had ended in failure. Moreover, much
of the economic theory and institutional structure that have given rise to
monetary policy's influence in recent years were not yet in place. Indeed, it
would take the Fed more than 20 years to learn (by accident!) the power of
open market operations. Clearly, the modern Federal Reserve System has
found itself with powers and responsibilities that were not envisioned by its
founders.
These proceedings from a conference held at the Federal Reserve Bank
of St. Louis on October 19-20, 1989, examine U.S. monetary policy from
a variety of perspectives: a historical review of how it has affected
aggregate economic performance; a positive analysis of why the Federal
Reserve has chosen particular policy strategies; a review of normative
arguments about what the Fed should pursue as its policy objective; a
critique of how the Fed's "output"-the flow of monetary services in the
U.S. economy-is measured; and, finally, a debate over the Fed's ability
to influence real economic activity by changing the nominal quantity
of money in circulation. Throughout, the authors blend historical data,
institutional detail, economic theory, and empirical testing to identify
the strengths and weaknesses of monetary policy as it has been imple
mented in the United States. As a collection, these articles are perhaps
best seen not as the end-product of a recent research agenda but as a
roadmap for future research on unresolved issues in monetary theory and
policy.
ix
x PREFACE
Session I
As a preliminary to the conference's discussion of the historical record of
V.S. economic performance, Allan H. Meltzer undertakes the difficult
task of reviewing the Federal Reserve's role in economic policymaking.
Recognizing both that 75 years of history were too much for a single
conference paper and that Friedman and Schwartz (1963) and Brunner and
Meltzer (1964) had thoroughly examined the Fed's first 50 years, Meltzer
focuses primarily on the conduct and performance of V.S. monetary policy
since the early 1960s. Finally, rather than yield to the temptation to
second-guess the Fed's actions on an episodic basis, Meltzer instead takes
the constructive route of trying to identify systematic components of the
policy process that have caused problems for monetary policy in the past
and, unless changed, can be expected to cause problems in the future.
Meltzer's review of the policy process embodies the arguments that have
become known as the "monetarist critique." Briefly, he argues that the
Federal Reserve has looked at the wrong variables to evaluate the in
fluence of its policy actions. As a consequence, the Fed, in his view,
generally has misinterpreted both how the economy is performing at the
moment and which policy actions will be consistent with the desired path of
future economic activity. To many, his arguments are familiar: using free
reserves to guide policy and interest rates as a gauge of its policy stance,
the Fed would consistently view monetary policy to be restrictive (or
expansive) and undertake actions to ease (or tighten) when, in fact, the
truth was just the opposite. Thus, one should expect that an activist
approach to monetary policy in the context of this policy process would
exacerbate both the inflation at cycle peaks and the output and employ
ment losses at cycle troughs.
Meltzer also argues that the Federal Open Market Committee's
(FOMC's) reliance on staff forecasts to chart the course of future economic
performance has given policymakers a false sense that policy mistakes now
can be offset by timely policy changes in the future. But an examination of
the staff's forecasting record shows that even its short-term errors are large
enough to cover a variety of disparate outcomes so that basing policy
decisions on forecasts may contribute still more volatility to the business
cycle.
Of all the evidence Meltzer presents to support his policy critique,
perhaps the most damning is his finding that the average growth rate of
money has been higher in each recent business cycle expansion than in the
one previous to it. Specifically, we have gone from 4 % average M1 growth in
the expansion of the 1960s to rates in excess of 6% and then 7% during the
1970s to nearly 9% during the expansion of the 1980s. In Meltzer's mind,
PREFACE xi
these data indicate that fundamental problems with the policy process lead
to procyclical patterns in money growth that have produced a higher
underlying inflation rate without the benefit of greater economic stability.
Meltzer's analysis of the historical record naturally leads him to recom
mend that the Fed be held accountable for achieving announced money
stock targets. His specific method of accomplishing this has shown promis
ing results in simulation experiments for reducing both the average rate of
inflation and the variability of output.
A presentation of Meltzer's scope called for several discussants to
address the variety of issues that were raised. In his comments, Jeffrey A.
Miron investigated whether the Federal Reserve has had a demonstrable
effect on U.S. economic performance. By examining consistent data series
since 1870 and dividing the data both into lO-year and longer periods
(1870-1913; 1919-1940; 1947-1987), Miron first finds that real economic
growth has been nearly a full percentage point lower in the postwar period
relative to 1870-1913. He also finds, consistent with Meltzer's arguments,
a slight decline in the price level between 1870-1913 contrasted with a
4.4% average inflation rate since 1947. Finally, he reports that the Fed's
emphasis on smoothing interest rates has been associated with little change
in the variability of output over time.
To assess whether the Federal Reserve's approach to monetary policy
and the U.S. record of economic performance have deviated from that in
other countries, K. Alec Chrystal reviews Meltzer's arguments relative to
the experience abroad. He argues that Switzerland, Germany, and Japan
largely have achieved price stability by pursuing money stock targets in
their conduct of monetary policy. Moreover, when these foreign central
banks abandoned their money stock targets to pursue other objectives,
such as the exchange rate, a higher inflation rate later ensued. Finally, he
directs attention to the tradeoff between the benefits of deregulation in the
banking industry, which will increase the stability of the financial system,
and the impact these changes will likely have on the macroeconomic
relationships of monetary policy.
Donald L. Kohn discusses U.S. monetary policy from the viewpoint
of someone involved in its day-to-day implementation. Although Kohn
acknowledges that drawing distinctions between changes in real and
nominal interest rates, among other factors, contributed to some undesir
able monetary policy results in the 1960s and 1970s, he is quick to point out
that the brief "monetarist experiment" of 1979-1982 also was fraught with
problems. More important, the continuing instability in velocity leads
Kohn to argue that none of the monetary aggregates is likely to be a useful
guide to policy. In a direct criticism of Meltzer's proposal to target the
Description:When the 12 District Banks of the Federal Reserve System opened their doors for business on November 16, 1914, few observers could have foreseen the Fed's present role as a major, if not dominant, player in U. S. and world economic policymaking. After all, two previous attempts to create a central b
