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Research Papers in Economics

October 6, 1979 may represent one of the
key dates in the nation's monetary history,
along with December 23, 1913 (the passage of
the Federal Reserve Act) and March 4, 1951
(the signing of the "Accord" which removed
Treasury domination of central-bank policy).
On that October day, the Federal Reserve
began to improve its monetary control by
changing its operating techniques - that is, by
controlling the quantity of bank reserves
rather than by tightly pegging the cost ofthose
reserves (the Federal-funds rate). The Fed
subsequently has been broadly successful in
meeting its monetary-control objectives, but
its operational shift also has been accompanied
by increased volatility in both interest rates
and the monetary aggregates. This issue ofthe
Economic Review examines these several
aspects ofpost-1979 monetary policy, and also
analyzes the response of major economic
variables to policy changes.
Paul Evans investigates how much of the
recent increase in interest-rate volatility stem-
med from the October 1979 change in mone-
tary policy. He finds that this policy change
produced only about 30 percent of the
increased volatility in long-term interest rates,
and that the rest came from sources not
directly under Federal Reserve control.
"Almost all of this 30 percent resulted from
the Fed'sadherence to its monetary targets; by
itself, the freeing ofthe funds rate had little to
do with the increased rate volatility."
Evans' findings thus indicate that the
Federal Reserve has been responsible for only
a small part of the increase in interest-rate
volatility. Citing a number of national and
international political events ofthe period, he
argues, "Clearly, none of these events was a
direct consequence of the monetary-policy
change. Furthermore, future years may see a
5
return to normalcy, with a sharp reduction in
interest-rate volatility."
Continuing, he argues that the Federal
Reserve's decision to move the Fed-funds rate
more in response to monetary surprises entails
more volatility of both long- and short-term
interest rates. "It probably also helps the
Federal Reserve to hit its targets for money
growth and hence for inflation. For this
reason, the increased volatility - and the
resultant reduction in capital formation and
redirection of capital towards shorter-lived
assets - may be the price that must be paid to
hit these targets."
Turning to the surprisingly high variability
of the monetary aggregates in the post-1979
environment, John Judd and John Scadding
have developed a monthly money-market
model which explains this phenomenon. The
model shows how certain types of financial-
market disturbances, such as sharp changes in
bank loans, can affect the money supply and
thus cause problems ofmonetary control. The
evidence indicates that large swings in bank
loans; induced primarily by the Special Credit
Restraint Program, were the major source of
money's variability in 1980.
Conventional money-market models reflect
the view that the monetary aggregates are
determined primarily by the public's demand
for money. The Judd-Scadding model reflects
an alternative view - that the monetary
aggregates are determined in the short-run pri-
marily by the supply ofmoney, which rises out
of the behavior of banks and the public in
credit markets On the markets for bank loans
and banks' liabilities like large certificates of
deposit}. As evidence, they note that banks'
demand for reserves responds to its financial-
market determinants with very short lags, con-
sistent with the typical speed ofadjustment incredit markets, but not with the typical slug-
gishness of money demand. Also, bank loans
had a potent influence on the monetary
aggregates in 1980, as their model predicts.
Finally, they note that the market for money is
often characterized by disequilibrium in the
short-run: money-supply shocks temporarily
push the public off its short-run money-
demand curve, which allows the money supply
to exert a large short-run influence on the
stock of money observed in the economy.
The Judd-Scadding results imply that policy
makers should pay close attention to financial-
market developments, especially when signs
appear of a shift in the conventional money-
demand function. They cite in particular the
second quarter of 1980, when conventional
models severely overpredicted the money
stock. "Evidence of a downward shift in the
money-demand relationship would imply that
the money supply should be allowed to fall
commensurately to avoid anoverly expansion-
ary monetary policy. On the other hand, our
model explains the decline in money as supply
shock, induced by the decline in bank loans
that followed from the Special Credit Control
Program of 1980. Such a conclusion implies
that monetary-control efforts should be
directed toward more rapid money-supply
growth to avoid an overly contractionary
policy."
Next, Rose McElhattan presents a small
model ofthe U.S. economy for estimating the
response of inflation and real output to a
change in monetary policy. Measures obtained
from the model's reduced-form equations pro-
vide estimates of the complete adjustment
paths ofinflation and real output to a monetary
disturbance. In her model, prices continue to
change until both the inflation rate and the
6
level of real money balances reach their
respective long-run values, while real output
continues to adjust until it equals the level of
potential output and is growing at the rate of
potential output. Most other reduced-form
models focus only upon the adjustment of
rates ofchange in prices and output to a mone-
tary disturbance. In contrast with these,
McElhattan's model provides results which are
consistent with the neutrality ofmoney, which
is one of the most generally accepted proper-
ties regarding economic behavior. Itholdg:that
changes in the money supply ultimatelyaff~.ct
only nominal variables, such as prices a~d
wages, leaving all real quantities, such as
goods and services, unchanged.
In McElhattan's model, both inflation and
real GNP respond quickly to a change in
monetary policy, with the major stimulative or
deflationary phase occurring within two years
ofthe initial change. Her findings thus conflict
with most of the published literature, which
suggests that output and prices require about
five years to respond to a change in money
growth.
McElhattan thus provides an alternative to
the viewpoint that it will take a long time to
bring down the inflation rate, and that we risk
an economic recession in the process.
"Changes in monetary growth, at least since
the mid-1960's, !lPparently have acted fairly
rapidly upon inflation - and hence upon
aggregate demand as well. Thus, since a mone-
tary contraction is likely to bring inflation
down faster than previously anticipated, less of
the brunt ofthat contraction need be borne by
real GNP, so that a major decline or loss ofreal
income need not result when we adopt a policy
which gradually reduces monetary growth."

Monetary policy and interest rates

http://www.frbsf.org/publications/economics/review/1981/81-3_5-6.pdf

Monetary policy and interest rates

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Research Papers in Economics