Benjamin M. Friedman

English

Research Papers in Economics

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2  2005 323
What Remains from the Volcker Experiment?
Benjamin M. Friedman
ever, because the central bank is free to specify
its provision of reserves in terms of either the
quantity of reserves or their price (in other words,
the relevant interest rate).2 Yet a further complex-
ity arises in that the central bank’s provision of
reserves (or setting of the interest rate) affects the
aspects of economic activity policymakers are
seeking to influence only over time. As a result,
under some circumstances it may be helpful to
formalize ways of exploiting information about
what is happening in the meanwhile by focusing
policy on still other observable aspects of eco-
nomic activity—in this instance, the most obvious
example is the money stock—that of course differ
from the genuine objectives being pursued but
that may provide some indication of the extent
to which those objectives are being achieved.
Thinking about monetary policy in this famil-
iar way provides a structured framework for asking
what was, or is, new about any specific innova-
tion: (i) Is it a change in the objectives that policy-
makers are seeking to achieve? (ii) Is it a change
in the choice of policy instrument—in the case
of monetary policy, the quantity versus the price
dimension in the provision of reserves? (iii) Is it
a change in the way auxiliary aspects of economic
activity are being used to steer policy in the con-
text of time lags in the effect of central bank
actions on the ultimate objectives of monetary
policy?
A
ssessing the lasting impact of any
experiment in economic policymaking
requires, first of all, understanding
in what key respects that experiment
represented a departure from prior established
practice. The new policymaking framework that
the Federal Reserve System began to employ in
October 1979 is no exception. Specific quantita-
tive targets for growth of the money stock, or for
either borrowed or nonborrowed reserves in the
banking system, have long since disappeared from
the Federal Reserve’s approach to formulating
and implementing monetary policy. Yet there
remains a widespread sense that the world of
monetary policymaking in the United States has
been somehow different since 1979. What exactly
is different, and in what respects those differ-
ences stem from the innovations introduced in
1979, are questions well worth addressing.
The conventional representation of economic
policymaking, applicable to monetary policy no
less (and maybe far more readily) than to other
familiar contexts, posits a policymaker deploying
whatever instruments may be available to best
achieve a finite set of typically conflicting objec-
tives, subject to the constraints presented by exist-
ing institutional arrangements and technology
and by the behavior of the relevant actors in the
economy’s private sector. In the specific case of
monetary policy, the policy problem is simplified
because the central bank normally has only one
genuine instrument at its disposal—namely, its
provision of reserves to the economy’s banking
system.1 The problem is also more complex, how-
1 As a technical matter, the central bank can also typically adjust
the amount of reserves (if any) that banks are required to maintain 
in relation to their outstanding deposits. But under most circum-
stances, changes in reserve requirements and changes in the pro-
vision of reserves are equivalent for purposes relating to the broad
macroeconomic objectives of monetary policy.
2 It is also possible to specify the central bank’s provision of
reserves in terms of some combination of quantity and price (that
is, a reserve-supply function with positive but finite elasticity).
Benjamin M. Friedman is the William Joseph Maier Professor of Economics at Harvard University.
Federal Reserve Bank of St. Louis Review, March/April 2005, 87(2, Part 2), pp. 323-27.
© 2005, The Federal Reserve Bank of St. Louis.
 Most public discussion of the Volcker experi-
ment at the time emphasized (ii) and (iii)—in
particular, the joint implication that under the
new policymaking framework market interest
rates (the facet of monetary policy of which most
citizens are most acutely aware) were now free
to fluctuate far more freely than in the past. The
subsequent academic literature has likewise
mostly focused on either (ii) or (iii). With time,
however, what was new with regard to neither
(ii) nor (iii) has survived. If there has been any-
thing lasting from the apparent sea change of
October 1979, therefore, it lies in (i). 
To be specific, the broad public discussion
of the Federal Reserve’s new approach in 1979
primarily emphasized the elevation of quantita-
tive money growth targets—element (iii)—from
the irregular and mostly peripheral role they had
played, beginning in the early 1970s, to center
stage: The Federal Open Market Committee
(FOMC) decided what money growth it sought
going forward and articulated its policy in terms
of what open market operations the System
Account needed to conduct to keep the money
stock as close as possible to the targeted trajectory.
The subsequent history of money growth tar-
gets for monetary policy, in the United States as
well as elsewhere, is thoroughly well-known and
need not be reviewed in any detail. Almost imme-
diately after October 1979, actual events belied the
conventional presumption among most advocates
of money growth targets that the major monetary
aggregates would move roughly in synchrony so
that choosing just which among them was the right
one to target was at best a secondary consideration.
Prominent monetarist economists publicly argued
that policy was too easy, or too tight, depending
on which measure they chose to emphasize. The
FOMC had chosen to place primary emphasis on
the narrow M1 aggregate, but by 1982 that measure
displayed so little tie to either income growth or
price inflation that the Committee formally moved
away from it. Evidence since then shows that by
the mid-1980s M1 had disappeared altogether as
an observable influence on policymaking, and
the same happened to the broader M2 measure
by the early 1990s.3 In 1987 the FOMC stopped
setting a target for M1 growth, and in 1993 the
Federal Reserve publicly acknowledged the
“downgrading” of its M2 target—a change that
most observers of U.S. monetary policy had
already noticed well before then. 
The reasons for the breakdown of what had
seemed to be longstanding relationships (though
in fact even then they were probably less reliable
than they appeared) between money and income,
or money and prices, have also been thoroughly
studied. The standard list includes financial
innovation, deregulation, and globalization of
markets for deposits and other closely substi-
tutable financial assets. But the main point here
is simply that the reliance on money growth targets
that was key to at least the public presentation of
the new monetary policy regime in 1979 has now
entirely disappeared.
The same is true for element (ii), the use of,
in turn, several variants of an open market operat-
ing procedure based on the quantity of either
nonborrowed or borrowed reserves. In part, the
1979 change in (ii) was a consequence of the
change in (iii): Once the proximate objective of
policy was to control money growth, doing so by
fixing a measure of reserves month-to-month
seemed likely to deliver better results than fixing
the overnight interest rate. In time this presump-
tion too came to appear doubtful. But the issue
became moot because the FOMC abandoned
money growth targets anyway. 
The only way some version of a reserves-based
operating procedure could have survived, once
the money growth targets were gone, would have
been if policymakers thought the relationship
between reserves growth and economic activity
was more reliable than the relationship between
interest rate growth and economic activity. Few
economists have been prepared to make that case.4
Friedman
324 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW
3 See Friedman (1997) for a review of this evidence, but the associated
empirical literature is vast.
4 Following the enormous body of work by Brunner and Meltzer, and
in more recent times by McCallum, many economists have argued
for a reliable relationship between economic activity and the mone-
tary base. The key difference is that the monetary base includes—
indeed, mostly consists of—currency in circulation. Hence, the base
may or may not be a plausible replacement for money stock as an
intermediate target of monetary policy, but it is not a plausible
short-run operating instrument.
 As a result, the Federal Reserve has gone back to
carrying out monetary policy by fixing a short-
term interest rate—in the modern context, the
overnight federal funds rate—just as it did for
decades prior to 1979.5
That leaves (i). Did the Volcker experiment
represent a new, presumably greater weighting
attached to achieving “price stability” vis-a-vis
the other objectives of monetary policy? And, if
so, has that greater weighting survived?
The post-1979 record of price inflation in the
United States surely creates some prima facie
presumption to this effect. After reaching either
near double-digit levels (the gross domestic
product deflator) or low double-digit levels (the
consumer price index) in the late 1970s, inflation
dropped to roughly 4 percent per annum in the
1980s, then 3 percent and eventually 2 percent
in the 1990s. Cyclical considerations perhaps
obscure the underlying trend in the current
decade, but to date there is certainly no clear indi-
cation of resurgent inflation beyond the 2 to 3
percent per annum range. More to the point, the
impression is both widespread and confident
that, were such a resurgence to begin to develop,
the Federal Reserve would act vigorously to resist
and reverse it.
Does this, however, represent a genuine
change in the weighting placed on inflation among
policymakers’ sometimes competing objectives,
plausibly one that can be dated to October 1979?
Or is there some other explanation, independent
of the Volcker experiment?
One point worth making explicitly is that, to
the extent that one standard objective of monetary
policy is smoothness in short-term interest rates,
there is no evidence that the increased tolerance
for interest rate fluctuations that the Federal
Reserve exhibited during the Volcker period has
survived. One of the most frequent criticisms of
monetary policy operating procedures based on
fixing short-term nominal interest rates is that
central banks have traditionally proved too hesi-
tant to adjust the interest rates they set, and when
they do move interest rates they have tended to
do so too slowly. The usual explanation is that,
in addition to their objectives for such macro-
economic variables as price inflation and the
growth of output and employment, central banks
also take seriously their responsibility to maintain
stable and well-functioning financial markets,
together with the (more questionable) assumption
that sudden or wide fluctuations in short-term
interest rates are inimical to achieving that goal.
For this reason, now-conventional expressions of
operating rules for monetary policy, such as the
Taylor rule, normally include a lagged interest rate
along with measures of inflation and output (or
employment) relative to the desired benchmark.6
Part of what distinguished the Volcker experi-
ment was the unusually wide (albeit not totally
unconstrained) fluctuations of short-term interest
rates that occurred under the Federal Reserve’s
quantity-based operating procedures. (Indeed, one
element of the folklore surrounding the entire
episode is the claim that the adoption of money
growth targets, and the reserves-based operating
procedure that went with them, was in part simply
a diversion that enabled the Federal Reserve to
put in place far higher interest rates than would
otherwise have been politically possible.) Merely
glancing at a chart showing the time path of
interest rates in recent years immediately shows
that no such fluctuations have been allowed to
occur. Might the Federal Reserve again permit
them if doing so seemed necessary to rein in incip-
ient inflation? Perhaps so, but on the evidence
there is no ground for claiming that this aspect
of the 1979 experiment has survived either.
What remains, then, is the question of
whether 1979 brought a new, greater weight on
the Federal Reserve’s objective of price stability
vis-a-vis its objective of output growth and high
employment. To be sure, that is one interpretation
of the historical experience both before 1979 and
after. But there are other interpretations as well,
especially in light of the record not just in the few
years immediately preceding 1979 but substan-
Friedman
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2 2005 325
5 During some periods before 1979, the FOMC specified its policy
in terms of the net free-reserves position of the banking system,
but most Federal Reserve economists (and most market participants)
understood that net free reserves was a close proxy to short-term
interest rates.
6 See also Barro (1989) for a theoretical analysis of the implications
of interest rate smoothing as a part of monetary policy.
 tially before as well. The United States experi-
enced little inflation in the 1950s and not much
in the 1960s either.7 Hence, the historical evidence
is also consistent with the view that the 1970s
were exceptional rather than that the experience
since 1979 has differed from what went before as
a whole.
Even the idea that the Volcker experiment
represented a return to the greater policy weight
on price stability vis-a-vis real outcomes that had
motivated the Federal Reserve before the 1970s,
and that this renewed commitment to price sta-
bility has lasted ever since, would make the events
of 1979 a major and lasting contribution to U.S.
monetary policymaking. But here, as well, other
explanations are also possible. For example, per-
haps policymakers in the 1970s were just as com-
mitted to the objective of price stability as they
were before and have been since, but required
some significant experience in an inflationary
environment in order to understand, and begin
to respond appropriately to, the newly relevant
distinction between nominal and real interest
rates. Perhaps policymakers in the 1970s were no
less committed to the objective of price stability
but were operating under a different (in retrospect,
some have argued, a flawed) understanding of
the broader economic behavior constraining the
relationship between their actions and the result-
ing policy outcomes.8 Perhaps policymakers were
no less committed to price stability but simply
faced an extraordinary sequence of macroeco-
nomic shocks (OPEC, anchovies, etc.) that were,
temporarily, adverse from the perspective of
achieving either price stability or desired rates
of real growth and levels of unemployment.9
Resolving the merits of these and other poten-
tial interpretations of the historical record—
interpretations that, importantly, are in no way
mutually inconsistent—is surely a worthwhile
object of empirical research. It is also a necessary
underpinning of any judgment of whether what
happened in October 1979 actually represented
a change in the weight that policymakers attach
to the objective of price stability.
Finally, one further aspect of what 1979 may
or may not have been about bears attention. Per-
haps what was important about the changes rep-
resented by (iii), and in a subsidiary way, then, by
(ii), was not the specifics of money growth targets
and reserves-based operating procedures but
rather the concrete expression that they embodied
of the desire in many quarters to impose some
form of ongoing discipline on the monetary policy-
making process—in the traditional language of
this subject, to impose “rules” where there had
been “discretion.”
Whether the use of money growth targets,
with the FOMC free to choose and then change
the target as it saw fit, did or did not qualify as a
kind of “rule” in this context is a matter of debate,
in part substantive and in part semantic. But to the
extent that it was a form of rule for this purpose—
and the argument for money growth targets has
often been made on just those grounds—it, too,
clearly failed to survive. Federal Reserve policy-
making in recent years has epitomized what
“discretion” in monetary policy has always been
about.
Precisely for this reason, advocates of rules
over discretion today continue to seek some way
of moving Federal Reserve policymaking in that
direction. The proposal of this kind that has
attracted the most interest currently is “inflation
targeting.” Whether adopting inflation targeting
would be a good or bad step for U.S. monetary
policy is a separate issue.10 But one reason the
issue is even on the agenda today is that the
movement in this direction that the experiment
of October 1979 represented did not last either.
REFERENCES
Barro, Robert J. “Interest-Rate Targeting.” Journal of
Monetary Economics, January 1989, 23, pp. 3-30.
Friedman
326 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW
7 Before the Treasury–Federal Reserve Accord in 1951, monetary
policy was constrained by the wartime commitment to fix interest
rates. Before then, the Depression rendered the question moot.
Drawing inferences from the pre-Depression experience seems of
little relevance to this discussion.
8 Two examples of arguments along these lines are DeLong (1997)
and Sargent and Cogley (2005).
9 This too is a familiar argument. For a contemporary statement,
see Blinder (1979). See Orphanides (2004) for a particularly inter-
esting recent reincarnation.
10 For a compact statement of the views on either side, see Mishkin
(2004) and Friedman (2004).Blinder, Alan S. Economic Policy and the Great
Stagflation. New York: Academic Press, 1979.
DeLong, J. Bradford. “America’s Peactime Inflation:
The 1970s,” in Christina D. Romer and David H.
Romer, eds., Reducing Inflation: Motivation and
Strategy. Chicago: University of Chicago Press,
1997.
Friedman, Benjamin M. “The Rise and Fall of Money
Growth Targets as Guidelines for U.S. Monetary
Policy,” in Iwao Kuroda, ed., Towards More
Effective Monetary Policy. Houndmills: Macmillan
Press, 1997.
Friedman, Benjamin M. “Why the Federal Reserve
Should Not Adopt Inflation Targeting.” International
Finance, March 2004, 7, pp. 129-36.
Mishkin, Frederic S. “Why the Fed Should Adopt
Inflation Targeting.” International Finance, March
2004, 7, pp. 117-27.
Orphanides, Athanasios. “Monetary Policy Rules,
Macroeconomic Stability, and Inflation: A View
from the Trenches.” Journal of Money, Credit, and
Banking, April 2004, 36, pp. 151-75.
Sargent, Thomas J. and Timothy, Cogley. “The
Conquest of U.S. Inflation: Learning, Model
Uncertainty, and Robustness.” Review of Economic
Dynamics, 2005 (forthcoming).
Friedman
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2 2005 327328 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW

10 For a compact statement of the views on either side, see Mishkin

8 Two examples of arguments along these lines are DeLong

9 This too is a familiar argument. For a contemporary statement, see Blinder

America’s Peactime Inflation: The 1970s,” in

Interest-Rate Targeting.” Journal of Monetary Economics,

Monetary Policy Rules, Macroeconomic Stability, and Inflation: A View from the Trenches.”

Reducing Inflation: Motivation and Strategy.

The Conquest of U.S. Inflation: Learning, Model Uncertainty, and Robustness.” Review of Economic Dynamics,

The Rise and Fall of Money Growth Targets as Guidelines for U.S.

Why the Fed Should Adopt Inflation Targeting.” International Finance,

Why the Federal Reserve Should Not Adopt Inflation Targeting.” International Finance,

What remains from the Volcker experiment?

http://research.stlouisfed.org/publications/review/05/03/part2/Friedman.pdf

What remains from the Volcker experiment?

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