Recent experience does not include a "monetarist experiment," as some have argued, but may slightly reinforce preexisting reasons for doubting that the best way of formulating monetarist policy prescriptions is in the form of a constant growth rule for the money stock.A more desirable rule would pertain to the monetary base, which is much more directly under Fed control. While a constant base growth rule might provide good macroeconomic performance, better results should be obtainable from a rule that at regular intervals adjusts the base growth rate upward or downward depending on whether nominal GNP is below or above a target path that specifies constant, non-inflationary growth for that variable. This type of rule is activist, to an extent, but is non-discretionary.The implied absence of policy-making flexibility is desirable for reasons explained in the literature on dynamic inconsistency.

Bennett T. McCallum

English

Research Papers in Economics

NBER WORKING PAPER SERIES
MONETARIST RULES IN THE LIGHT OF
RECENT EXPERIENCE
Bennett T. McCallum
Working Paper No. 1271
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
February 19814
Prepared for AEA Session "Monetarism: Lessons From the Post—1919
Experiment," December 28, 1983. The research reported here is part
of the NBER's research program in Financial Markets and Monetary-
Economics. Any opinions expressed are those of the author and not
those of the National Bureau of Economic Research.NBER Working Paper #1277
February 1984
Monetarist Rules in the Light of
Recent Experience
ABSTRACT
Recent experience does not include a "monetarist experiment,"
as some have argued, but may slightly reinforce preexisting
reasons for doubting that the best way of formulating monetarist
policy prescriptions is in the form of a constant growth rule for
the money stock.A more desirable rule would pertain to the
monetary base, which is much more directly under Fed control.
While a constant base growth rule might provide good macroeconomic
performance, better results should be obtainable from a rule that
at regular intervals adjusts the base growth rate upward or
downward depending on whether nominal GNP is below or above a
target path that specifies constant, non—inflationary growth for
that variable. This type of rule is activist, to an extent, but
is non—discretionary.The implied absence of policy—making
flexibility is desirable for reasons explained in the literature
on dynamic inconsistency.
Bennett T. McCallum
Graduate School of
Industrial Administration
Carnegie—Mellon University
Pittsburgh, PA 15213
(1412)578—23147MONETARIST RULES IN THE LIGHT OF
RECENT EXPERIENCE
Bennett T. McCallum*
The title of this session, like a host of recent writings by
critics of monetarism, suggests that the period from late 1979 to
mid 1982 witnessed a significant "rnonetarist experiment," i.e.,
that U.S. monetary policy during that period conformed to
monetarist prescriptions. For a number of reasons, however, that
suggestion is clearly untenable.Among these are the following:
growth rates of monetary aggregates fluctuated widely on a
month—to—month or quarter—to—quarter basis; the Fed's operating
procedures were more poorly designed for money stock control than
those in place prior to October, 1979;1 and discretionary
responses to current cyclical conditions were never foresworn. In
addition, the growth rate of the (Ml) money stock was only
slightlylower than that of the previous decade and was higher
than that of the previous 20 years.2It is true that the Fed
demonstratedconsiderable resolve in reducing Ml growth rates from
the values of 1977—78 even though this required a spell of
unusually high interest rates, and the operating procedures
announced in October 1979 were politically helpTul in disclaiming
responsibility for these unpopular rates.But such steps hardly
constitute an embrace of monetarism——an opinion shared, it might
be added, by officials of the Fed as well as leading proponents of
monetarism.3
Consequently, any argument of the form "wetriedmonetarism
andit produced undesirable results" seems to me unworthy of
discussion.But that conclusion does not eliminate the2
possibility that the time period since 1979 has produced new
evidence relevant to a reasoned consideration of the desirability
of monetarist prescriptions.It is, in other words, conceivable
that the new data points generated during that period were so
highly informative about the nature of the economy that opinions
concerning the merits of monetarist prescriptions could reasonably
have been altered. Let us then continue the discussion from that
perspective.
I.NEW EVIDENCE
Contemplating the developments of 1979—82, one is led to the
conclusion that the main new information relevant to monetarism
does not pertain to the behavior of macroeconomic variables or
their inter—relationships. Much of the discussion has,
admittedly, emphasized the unusually high interest rates (nominal
and ex post real) of 1980—81, the severe unemployment of 1982, the
rapid decline in inflation between 1981 and 1982, and the sharp
fall in Ml velocity during 1982.But none of these facts is
incompatible with the basic hypotheses about the economy that are
essential to a monetarist position, namely, that money stock
movements have strong effects on nominal GNP and that there is no
permanent tradeoff between unemployment and inflation, Nor do
these facts serve to discredit——indeed, quite the contrary!——t.he
monetarist presumption that no one possesses a reliable structural
model of the economy, Instead, the new developments that deserve
attention are those pertaining to technological innovation and
regulatory change in the payments industry, prominent examples of3
which include the introduction of NOW and sweep accounts, the
growth of money market mutual funds, and the widespread use of
repurchase agreements. These developments have, as is well—known,
led to redefinitions of traditional monetary aggregates such as Ml
and M2 and have weakened the correspondence of the former to the
concept of the medium of exchange. As a consequence, the
developmentshave engendered a widespread belief that the
economy's demand function for any operationally—defined monetary
aggregate has beensubject to significant shifts and will continue
to shift in an unpredictable fashion in the future.
In saying this, I do not mean todeny that these developments
have in large part been a response to prevailing regulations and
policy.Nor do I mean to express agreement with antimonetarist
observers who justify each departure from announced monetary
targets with a claim that money demand has shifted, or those who
believe that all tangible media of exchange will soon disappear as
modern economies adopt accounting systems of exchange. Nor do I
wish to suggest that technical progress in the payments industry
is something new, which it surely is not.But I nevertheless
believe that •recent experiences have served to reinforce pre-
existing reasons for doubting that the best way of expressing
monetarist prescriptions is in the form of a constant growth rate
rule for the money stock. While the latter——whether measured as
Ml or M2——could certainly be made more controllable by the Fed,
wide—ranging institutional changes such as those recommended in
Milton Friedman's Program for MonetarLStability (1960) would be
required for truly tightcontrol.5 Consequently, it will probably14
continueto be the case that the money stock, which is not an
ultimate goal variable, is also not a directly—manipulable
monetary instrument.
II. A REVISED MONETARIST RULE
Because of this intermediate status of themoney
stock——identifiable as neither instrument nor goal variable——its
role is undesirably ambiguous.It is thus not surprising that
money stock "targeting" as practiced by the Fed has been
characterized by ambiguity, with departures from target values
sometimes treated as something to be eliminated but often as mere
bits of information requiring rio response. It would be better, it
would appear, to have a rule that specifies behavior of the
monetary base, or stock of high—powered money, which is directly
enough under Fed control to be treated as a bona fide instrument.6
With observations on the base obtainable from Fed and Treasury
balance sheets, its magnitudes could be monitored almost
continuously and no significant departures from specified target
paths would ever need to occur.
It will be objected that the velocity of the base relative to
GNP will again be changing irregularly in the future so that a
constant growth rate for the base would be undesirable. But there
is nothing in the concept of a rule that requires the growth rate
to be constant. Personally, I suspect that constant base growth
at 1% per year over the next decade would yield satisfactory
macroeconomic performance. But still better performance should be
provided by a rule that periodically adjusts the base growth rate5
in response to past movements in some nominal target variable,
with nominal GNP an attractive candidate.Thus in my opinion a
desirable rnonetarist rule would adjust the base growth rate each
month or quarter, increasing the rate if nominal GNP is below its
target path and vice versa.This target path, in turn, should
specify nominal GNP growth of about 3% per year, a figure
consistent with near—zero inflation.
There are three distinct ways, deserving of explicit mention,
in which macroeconomic performance could benefit from an
adjustable growth rate rule as compared with one of the constant—
growth rate (CGR) type. First, the adjustable scheme could
correct for any tendency of base velocity growth to change
secularly as the pace of technological innovation increases or
decreases.Second, there would be stronger countercyclical
effects on aggregate demand and these would be of an automatic
type.7Third, the adjustments would counteract the tendency
——discussed in McCallum (1981)—— of' CGR rules plus fixed tax
schedules to generate dynamic instability in the stock of
government debt.
I am confident that both monetarists and anti—monetarists
will object to this proposal, partly for substantive reasons and
partly because I have termed it "monetarist."Taking the last
objection first, the label is warranted because the proposed rule
is entirely non—discretionary and is expressed exclusively in
terms of nominal magnitudes.Substantively, the only apparent
drawback -from a rnonetarist perspective is that the adjustable base
growth rate lacks the popular appeal of an absolutely constant6
value.nhieanadjustable path would be slightly harder to
monitor than a constant path if everything else were the same,
having a path expressed in terms of an instrument variable should
provide greater operational content and improved monitoring
possibilities in comparison with a constant growth path for a
variable that can only be controlled indirectly.
The substantive objections from non—monetarists will be
different, of course, and will presumably focus on the
non—discretionary aspect of the proposal.In this regard, it is
important to recognize that while the rule is non—discretionary,
it is not non—activist.That is, the rule specifies instrument
settings for the base growth rate that are contingent on the state
of the economy——nominal GNP relative to its target path.It is
less activist than a rule that (for example). prescribes higher—
than—average nominal GNP growth when unemployment is above
average, but it is activist nonetheless, An important reasonfor
not attempting the more ambitious type of rule is the absence of a
reliable model of the economy. If such a model were available, it
would make no sense to use an intermediate target variable like
nominal GNP, rather than focussing directly on ultimate goals (B.
Friedman, 1975).
III. RULES vs. DISCRETION
There remains to be discussed why the Fed should adopt any
rule at all, rather than proceeding in a discretionary manner, as
the latter would permit the same month—to—month base growth values
as the rule would dictate but would also provide the virtueof7
flexibility.The answer is that, given the nature of the U.S.
economy, flexibility is not a virtue; the absence of flexibility
couldlead to superior performance in terms of unemployment-
inflation combinations.To make this argument as simply as
possible, I will utilize an analogy.8 Imagine parentsconfronted
withan instanceof misbehavior by their child, whose welfare is
uppermostin their minds.Shall they punishthe child forthe
misbehavior,thereby inflicting disutility on themselves as well
asthe child?Or shall they refrain from punishment in this
particular case, while promising punishment for all future
instances of misbehavior?From the viewpoint of the moment in
time when this decision is being faced, it is clearly optimal to
select the second of these options. But of course the same choice
will turn out to be optimal after the next instance of
misbehavior, and so on, so the resulting steady state is one in
which the parents never punish the child, whose behavior
accordingly conforms to a regime in which there is no need ever to
fearpunishment.
Inan economy with widespread nominal contracting, the
problem faced each "year" is similar to that of parents confronted
with an instance of misbehavior.The options are to impose
monetary stringency, with resulting disutility for most parties,
orto refrain from stringency this year while promising stringency
in all future years.But with decision—makingflexibility, the
same choice will be made in future years when the intervening
year's misbehavior becomes a thing of the past. Thus stringency
tends to be imposedrarely, yet——since there is no permanentstimulus to employment from monetary leniency——there is no
additional employment to compensate for the additional inflation
that results from monetary leniency.
Some parents, however, obtain superior outcomes by
sacrificing flexibility——by not making their choices after each
instance of misbehavior, but instead adopting a rule that results
in automatic punishment after each case of misbehavior.9 The Fed
could similarly obtain superior outcomes by surrendering
flexibility in favor of a rule of the type described above, To do
sowould not only result in improvedeconomic performance, but
would also represent genuine policy behavior——as opposed to
case—by—caseattempts to optimize——of the type that central bank
independence is intendedto produce. Thus, despite the political
pressuresdescribed by Kane (1982) and others, the Fed should have
a powerful motive to adopt a policy rule: if choicesaretobe
madeon a case—by—case basis, there is noreason why they should
be made by an independent agency instead of the current
administration.9
REFERENCES
Barro, Robert J., and Gordon, David B., "A Positive Theory of
Monetary Policy in a Natural—Rate Model," Journal of
Political Economy, August 1983, 91, 589—610.
Brunner, Karl, and Meltzer, Allan H., "Strategies and Tactics for
Monetary Control," Carnegie—Rochester Conference Series on
Public Policy, Vol. 18, ed. by K. Brunner and A. H. Meltzer.
Amsterdam: North Holland, 1983.
Friedman, Benjamin M., "Targets, Instruments, and Indicators of
Monetary Policy," Journal of Monetary Economics, October
1975, 1, LL3....i473.
Friedman, Milton, A Program for Monetary Stability. New York:
Fordham University Press, 1960.
Kane, Edward J., "Selecting Monetary Targets in a Changing
Financial Environment," Monetary Policy Issues in the 1980s,
Federal Reserve Bank of Kansas City, 1982.
Kydland, Finn E., and Prescott, Edward C., "Rules Rather than
Discretion: The Inconsistency of Optimal Plans," Journal of
Political Economy, June 1977, 85, 473—91.
McCallum, Bennett T., "Monetarist Principles and the Money Stock
Growth Rule," American Economic Review Papers and
Proceedings," May 1981, 71, 134—138.
McCallum, Bennett T., and Hoehn, James G., "Instrument Choice for
Money Stock Control with Contemporaneous and Lagged Reserve
Requirements,"urna1ofMoneyCredjtLafldBaflkjfl,
February 1983, 15, 9—101.
U.S. Congress, Joint Economic Committee, Monetarism and the
Federal Reserve's Conduct of Monetary Policy. Washington:
U.S. Government Printing Office, 1982.10
FOOTNOTES
*Professorof Economics, Carnegie—Mellon University; Research
Associate, National Bureau of Economic Research; and Adviser,
Federal Reserve Bank of Richmond.I am indebted to Marvin
Goodfriend and Allan Meltzer for helpful suggestions and to
the National Science Foundation (SES 82—08151) for financial
support.
1.This is suggested by the analytical results in McCallum and
Hoehn (1983) as well as the discussion in Brunner and Meltzer
(1983) and elsewhere.
2.From December, 179, through June 1982, the average Ml growth
rate was 6.1%.During 1970—79 the figure was 6.6%; for
1960—79 it was 5.2%. (Data from Economic Report of the
President, February 1983).
3. See, for example, contributions by Voicker, M. Friedman, arid
Meltzer in the Joint Economic Committee'sMonetarism and the
Federal Reserve's Conduct of Monetary Policy (1982).
'4.These hypotheses are discussed in McCallum (1981). That
neither the second or third of the four cited facts is
inconsistent with monetarist principles should not need to be
argued. The first fact would be inconsistent with the
"Ricardian" brand of monetarism if it were established that
the high interest rates of 1980—81 resulted from unmonetized
deficits, but such is only one hypothesis.Also, less
extreme forms of monetarism are more typical. And as for the11
fourth fact, a change in velocity does notimply a shift in
money demand behavior——a sharp drop in interest rates (asin
1982) should induce a velocity declineaccording to most
theories.Furthermore, evidence of behavioral shifts taken
from studies of conventionalmoney demand functions is
unsatisfactory because estimates of the usual (Goldfeld)
specification are implausible, implying as they do thatmany
quarters are needed for portfolio adjustments that can be
effected almost instantaneously with negligible cost.
5. Furthermore, it would appear that extremely good substitutes
for bank deposits can be developed by intermediariesnot
subjectto any given set of regulations.
6. The importance of conrollability and the absence ofambiguity
playcrucial roles in Milton Friedman's argument for a rule
expressed in terms of the money stock, rather than the price
level (1960, pp. 86—89).Emphasis on themonetary base has
longbeen recommendedby Brunner and Meltzer. Another
possibleinstrument is total reserves.
7. If the economy is infact Keynesian in nature, these counter—
cyclicaleffects would be likely to be helpful. If it isin
factpurely classical, they should be neither helpful nor
harmful.
8.This analogy was suggested to me by Stanley Fischer.The
argumentthat is is supposed to elucidatewas originally
developedby Kydland and Prescott (1977)and was usefully
elaboratedby Barro and Gordon (1983). The reader is
referred to these papers for a more formalanalysis,12
including a more precise specification of the assumed nature
of the economy.The argument abstracts from cyclical
fluctuations only for simplicity.
9.This is only a hypothetical possibility, of course; I do not
claim to know of'anyactual cases.

1.This is suggested by the analytical results in McCallum and Hoehn

4.These hypotheses are discussed in McCallum

8.This analogy was suggested to me by Stanley Fischer.The argumentthat is is supposed to elucidatewas originally developedby Kydland and Prescott (1977)and was usefully elaboratedby Barro and Gordon

A Positive Theory of Monetary Policy in a Natural—Rate Model,&quot; Journal of Political Economy,

A Program for Monetary Stability.

for example, contributions by

Instrument Choice for Money Stock Control with Contemporaneous and Lagged Reserve Requirements,&quot;urna1ofMoneyCredjtLafldBaflkjfl,

Monetarist Principles and the Money Stock Growth Rule,&quot; American Economic Review Papers and Proceedings,&quot;

Rules Rather than Discretion: The Inconsistency of Optimal Plans,&quot;

Selecting Monetary Targets in a Changing Financial Environment,&quot; Monetary Policy Issues in the 1980s, Federal Reserve Bank of Kansas City,

Targets, Instruments, and Indicators of Monetary Policy,&quot;

the average Ml growth rate was 6.1%.During 1970—79 the figure was 6.6%; for 1960—79 it was 5.2%. (Data from Economic Report of the President,

The importance of conrollability and the absence ofambiguity playcrucial roles in Milton Friedman's argument for a rule expressed in terms of the money stock, rather than the price level

Monetarist Rules in the Light of Recent Experience

Monetarist Rules in the Light of Recent Experience

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