The Role of Money and Monetary Policy in Economic Stabilization: A Debate, Schemes and Mind Maps of Business

Download The Role of Money and Monetary Policy in Economic Stabilization: A Debate and more Schemes and Mind Maps Business in PDF only on Docsity! y,.:_.:_~... ..~Ma,aaaeaa.aaAgi.,ava-., . - -. “n.IM~,4 ~th~x g~a..ahi¼nAMW k.a-.._.&fr.,A.e..~,. Editor’s Note to “The Role of Money and Monetary Policy” The following is a guest article prepared by Dr. Karl Brunner. Since July 1966, Dr. Brunner has been the Everett D. Reese Professor of Economics at The Ohio State Univer- sity. For the previous fifteen years he was Professor of Economics at the University of California at Los Angeles. in this article Dr. Brunner examines the current status of the debate regarding the role of money and monetary policy in economic stabilization actions. It is presented in this Review with the anticipation that his examination of the issues involved in this debate will bring forth further discussion by proponents of the various views. Such discussions are essential for development of the framework required for rational stabilization policy. Dr. Brunner and several other well-known economists have been leading proponents of the monetary view of economic stabilization. On the basis of a great amount of theo- retical and empirical research, they contend that the Federal Reserve can control the money stock and that the money stock is a good indicator of the thrust of Federal Reserve actions on output, employment, and prices. These economists have been critical of the role played by the Federal Reserve System in monetary management because they have found little evidence that the System has recognized the importance of money in carrying out its responsibility for economic stabilization. A countercritique to the criticisms of these monetary economists has been presented in several publications of the Federal Reserve System. This countercritique derives its eco- nomic foundations from a so-called “New View” of monetary economics. This “New View” stresses the role of assets, both real and financial, and the relative price mechanism in mone- tary analysis. The countercritique contends that the Federal Reserve has little control over the money stock and that the money stock plays only a minor role in the transmission mechanism linking Federal Reserve actions to the real sectors of the economy. Dr. Brunner, in this article, analyzes and evaluates various issues raised by the counter- critique. He points out that the main economists who stress the role of money and monetary policy also utilize the asset and relative price approach to monetary analyis; hence, in this regard there is little difference between them and the “New View.” The main point of conten- tion between the two groups, according to Dr. Brunner, lies in the extent of the development of testable hypotheses bearing on the issues raised by each group. He maintains that the monetary point of view has developed such hypotheses and has subjected them to rigor- ous empirical examination. On the other hand, the “New View” and the countercritique, according to Dr. Brunner, have kept their analyses of the monetary mechanism in the realm of abstract economics. He characterizes their analyses as “an empty form with little empirical content.” Recent discussions of various points of view on these issues appear in “Standards For Guiding Monetary Actions,” hearings before the Joint Economic Committee, May 1968. Positions of academic economists, business economists, and members of the Board of Gov- ernors of the Federal Reserve System are contained in these hearings. The “Report of the Committee,” June 1968, recommends to the Federal Reserve System that the yearly growth of the money stock be held within a range of 2 to 6 per cent. Numerous works are cited in this article, and the interested reader should refer to them for elaboration of the many summary arguments advanced by the author. Several statistical tests are reported in tables; the author should be contacted directly for further information on these tests and in regard to the data used. Page 8 4-. -. --— ... -. .2—. ~ The Rote of Money and Monetary Policy KARL BRUNNER° The Ohio State University HE DEVELOPMENT of monetary analysis in the past decade has intensified the debate concerning the role of money and monetary policy. Extensive research fostered critical examinations of the Fed- eral Reserve’s traditional descriptions of policy and of the arrangements governing policymaking. Some academic economists and others attribute the cyclical fluctuations of monetary growth and the persistent problem concerning the proper interpretation of monetary policy to the established procedures of monetary policy and the conceptions traditionally guiding policymakers. The critique of established policy procedures, which evolved from this research into questions con- cerning the monetary mechanism, is derived from a body of monetary theory referred to in this paper as the Monetarist position. Three major conclusions have emerged from the hypotheses put forth. First, mone- tary impulses are a major factor accounting for vari- ations in output, employment and prices. Second, movements in the money stock are the most reliable measure of the thrust of monetary impulses. Third, the behavior of the monetary authorities dominates movements in the money stock over business cycles. A response to the criticisms of existing monetary °This paper owes a heavy debt to my long and stimulating association with Allan H. Melizer. I also wish to acknowledge the editorial assistance of Leonall C. Andersen, Keith M. Carlson, and Jerry L. Jordan of the Federal Reserve Bank of St. Louis. policy methods was naturally to be expected and is welcomed. Four articles which defend present policy procedures have appeared during the past few years in various Federal Reserve publications.1 These articles comprise a countercritique which argues that monetary impulses are neither properly measured nor actually transmitted by the money stock. The authors reject the Monetarist thesis that monetary impulses are a chief factor determining variations in economic activity, and they contend that cyclical fluctuations of monetary growth cannot be attributed to the behavior of the Federal Reserve authorities. These fluctuations are claimed to result primarily from the behavior of commercial banks and the public. The ideas and arguments put forth in these articles deserve close attention, The controversy defined by the critique of policy in professional studies and the countercritique appearing in Federal Reserve pub- lications bears on issues of fundamental importance to public policy. Underlying all the fashionable words and phrases is the fundamental question: What is the 1Lyle Cramley and Samuel Chase, “Time Deposits in Mone- tary Analysis,” Federal Reserve Bulletin, October 1965. John H. Kareken, “Commercial Banks and the Sup~lyof Money: A Market Determined Demand Deposit Rate,’ Federal Re- serve Bulletin, October 1967. J. A. Cacy, “Alternative A~- proaches to the Analysis of the Financial Structure, Monthly Review, Federal Reserve Bank of Kansas City, March 1968. Richard C. Davis, “The Role of the Money Supply in Business Cycles,” Monthly Review, Federal Reserve Bank of New York, April 1968. Page 9 Wh.~ .. . ~ ., ~~z.atq~ ‘~ ‘~a~ cal pieces inherited from past efforts in order to develop some specific hypotheses which do explain portions of our observable environment. The New Viewers’ obvious failure to recognize the limited con- tent of theft programmatic statements only contrib- utes to maintenance of the conflict. A subtle difference appears, however, in the re- search strategy. The New View was introduced essen- tially as a generalized approach, including a quite formal exposition, but with little attempt at specific structuring and empirical content. The most impres- sive statements propagated by the New View were crucially influenced by the sheer formalism of its exposition. In the context of the New View’s almost empty form, little remains to differentiate one object from another, For instance, in case one only admits the occurrence of marginal costs and marginal yields associated with the actions of every household, firm, and financial intermediary, one will necessarily con- clude that banks and non-bank financial intermedi- aries are restricted in size by the same economic forces and circumstances, In such a context there is truly no essential difference between the deter- mination of bank and non-bank intermediary liabili- ties, or between banks and non-bank intermediaries, or between money and other financial assets. The strong impressions conveyed by the New View thus result from the relative emptiness of the formu- lation which has been used to elaborate their position. In the context of the formal world of the New View, “almost everything is almost like everything else”. This undifferentiated state of affairs is not, how- ever, a property of our observable world. It is only a property of the highly formal discussion designed by the New View to overcome the unsatisfactory state of monetary analysis still prevailing in the late 1950’s or early 1960’s.8 8Adcquate analysis of the medium of exchange function of money, or of the conditions under which inside money be- comes a component of wealth, was obstmcted by the pro- grammatic state of the New View. The useful analysis of the medium-of-exchange function depends on a decisive rejec- tion of the assertion that “everything is almost like every- thing else.” This analysis requires proper recognition that the marginal cost of information concerning qualities and prop- erties of assets differs substantially between assets, and that the marginal cost of readjusting asset positions depends on the assets involved. The analysis of the wealth position of inside money requires recognition of the marginal produc- tivity of inside money to the holder. Adequate attention to the relevant differences between various cost or yield functions associated with different assets or positions is required by both problems. The blandness of the New View’s standard program cannot cope with these issues. The reader may consult a preliminary approach to the analysis of the medium of exchange function in the paper by Karl Brunner and Allan H. Meltzer, in the Journal of Finance, 1964, listed in footnote 9. He should also consult for both issues the important Two sources of the conflict have been recognized thus far. The Monetarists’ research strategy was con- cerned quite directly with the construction of em- pirical theories about the monetary system, whereas the New View indulged, for a lengthy interval, in very general programmatic excursions. Moreover, the New Viewers apparently misconstrued their program as being a meaningful theory about our observable environment. This logical error contributed to a third source of the persistent conflict. The latter source arises from the criticism ad- dressed by the New Viewers to the Monetarists’ the- ories of money supply processes. Three of the papers exploit the logically dubious but psychologically ef- fective juxtaposition between a “New View” and a “Traditional View.” In doing this they fail to dis- tinguish between the inherited state of monetary system analysis typically reflected by the money and banking textbook syndrome and the research output of economists advocating the Monctarist thesis. This distinction is quite fundamental, Some formal analogies misled the New Viewers and they did not recognize the logical difference between detailed formulations of empirical theories on the one side and haphazard pieces of unfinished analysis on the other side.° A related failure accompanies this logical error. There is not the slightest attempt to assess alter- native hypotheses or theories by systematic exposure to observations from the real world. It follows, there- fore, that the countercritique scarcely analyzed the empirical theories advanced by the Monetarist critique book by Boris Pesek and Thomas Saving, Money, Wealth and Economic Theory, The Macmillan Company, New York, 1967, or the paper by Harry Johnson, “Inside Money, Outside Money, Income, Wealth and Welfare in Monetary Theory, to be published in The Journal of Money, Credit and Rank- ing, December 1968. 9 As examples of the empirical work performed by the Mone- tarists, the reader should consult the following works: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867-1960, (Princeton: Princeton Uni- versity Press, 1963). Philip Cagan, Determinants and Effects of Changes in the Stock of Money, (Columbia: Columbia University Press, 1965). Karl Brunner and Allan H. Meltzer, “Sonic Further Investigations of Demand and Supply Func- tions for Money,” Journal of Finance, Volume XIX, May 1964. Karl l3runncr and Allan H. Meltzer, ‘A Credit-Market Theory of the Money Supply and an Explanation of Two Puzzles in U.S. Monetary Pohcy,” Essays in Honor of Marco Eanno, 1966, Padova, Italy. Karl Brunner and Robert Crouch, “Money Supply Theory and British Monetary Experience, Methods of Operations Research III — Essays in Honor of Wilhelm Krelle, ed. Rudolf Henn (Published in Meisenheim, Germany, by Anton Ham, 1966). Karl Brunner, “A Schema for the Supply Theory of Money,” International Economic Review, 1961. Karl Brunner and Allan H. Meltzer, “An Al- ternative Approach to the Monetary Mechanism,” Subcom- mittee on Domestic Finance, Committee on Banking and Currency, House of Representatives, August 17, 1964. Page 12 and consequently failed to understand the major im- plications of these theories. For instance, they failed to recognize the role as- signed by the Monetarist view to banks’ behavior and the public’s preferences in the monetary process. The objection raised by the New View that “the formula [expressing a basic framework used to form- ulate the hypothesis] obscures the important role played by the public” has neither analytical basis nor meaning. In fact, the place of the public’s be- havior was discussed in the Monetarist hypotheses in some detail. Moreover, the same analysis discussed the conditions under which the public’s behavior dominates movements of the money stock and bank credit.b0 It also yielded information about the re- sponse of bank credit, money stock and time de- posits to changes in ceiling rates, or to changes in the speed with which banks adjust their deposit- supply conditions to evolving market situations. Every single aspect of the banks’ or the public’s behavior emphasized by the countercritique has been analyzed by the Monetarist’s hypotheses in terms which render the results empirically assessable. Little remains, consequently, of the suggestive countercritique as- sembled in the papers by Gramley-Chase, Kareken and Cacy.” 10 The reader will find this analysis in the following papers: Karl Brunner and Allan H, Meltzer, “Liquidity Traps for Money, Bank Credit, and Interest Rates,” Journal of Political Economy, April 1968. Karl Brunner and Allan H. Meltzer, “A Credit-Market Theory of the Money Supply and an Explanation of Two Puzzles in U.S. Monetary Policy, Essays in Honor of Marco Fanno, Padova, Italy, 1966. B. A Monetarist Examination of the New View’s Money Supply Theory Three sources of the conflict have been discussed thus far. Two sources were revealed as logical mis- construals, involving inadequate construction and as- sessment of empirical theories. A third source pertains to legitimate differences in research strategy. These three sources do not explain all major aspects of the conflict. Beyond the differences in research strategy and logical misconceptions, genuinely substantive issues remain. Some comments of protagonists advo- cating the Ne\v View should probably be interpreted as conjectures about hypotheses to be expected from their research strategy. It should be clearly under- stood that such conjectures are not logical implications of the guiding framework. Instead, they are pragmatic responses to the general emphasis associated with this approach. A first conjecture suggests that the money stock and bank credit are dominated by the public’s and the banks’ behavior. It is suggested, therefore, that cy- clical fluctuations of monetary growth result primarily from the responses of banks and the public to chang- ing business conditions. A second conjecture naturally supplements the above assertions, It is contended that the money stock is a thoroughly “untrustworthy guide to monetary policy”. Articles by Gramley-Chase and Kareken attempt to support these conjectures with the aid of more explicit analytical formulations allegedly expressing the general program of the New View. The paper contributed by Gramley-Chase has been critically ex- amined in detail on another occasion,’2 and only some crucial aspects relevant for our present purposes will be considered at this point. Various aspects of the first conjecture are examined in this and the next section. The second conjecture is examined in sec- tions D and E. liThe reader is, of course, aware that these assertions require analytic substantiation. Such substantiation cannot be sup- plied within the confines of this article. But the reader could check for himself. If he finds, in the context of the countercritique, an analysis of the Monetarists’ major hypotheses, an examination of implication, and exposure to observations, I would have to withdraw my statements. A detailed analysis of the banks’ and the public’s role ia the money supply, based on two different hypotheses previously reported in our papers will be developed in our forthcoming books. This analysis, by its very existence, falsifies some major objections made by Cacy or Gramley-Chase. Much of their criticism is either innocuous or fatuous. Gramley- Chase indulge, for instance, in modality statements, i.e. statements obtained from other statements by prefixing a modality qualifier like “maybe” or “possibly.” The result of qualifying an empirical statement always yields a statement which is necessarily true but also quite uninformative. The modality game thus yields logically pointless but psycho- logically effective sentences. Cacy manages, on the other hand, some astonishing assertions. The New View is credited with the discovery that excess reserves vary over time. He totally disregards the major contributions to the analysis of excess reserves emanating from the Monetarists’ research. A detailed analysis of excess reserves was developed by Milton Friedman and Anna Schwartz in the book men- tioned in footnote 9. The reader should also note the work by Ceorge Morrison, Liquidity Preferences of Com- mercial Banks, (Chicago: University of Chicago Press, 1966), and the study by Peter Frost, “Banks’ Demand for Excess Reserves,” an unpublished dissertation submitted to the University of California at Los Angeles, 1966. The classic example of an innocuous achievement wns supplied by Cacy with the assertion: the actual volume of money balances determined by competitive market forces may or may not be equal to the upper limit established by the central bank.” (p. 8). Indeed, we knew this before the New View or Any View, just as we always knew that “it may or may not rain tomorrow.” The reader should note that similar statements were produced by other authors with all the appearances of menningful elaborations. ‘ 2 The reader may consult my chapter “Federal Reserve Policy and Monetary Analysis” in Indicators and Targets of Mone- tary Policy, ed., by Karl Brunner, to be published by Chan- dler House Publishing Co., San Francisco. This book also contains the original article by Gramley-Chnse. Further contributions by Patric H. Hendershott and Robert Weintraub survey critically the issues raised by the Cramley.Chase paper. Page 13 A detailed analysis of the Graniley-Chase model demonstrates that it implies the following reduced form equations explaining the money stock (M) and bank credit (E) in terms of the extended monetary M=g(BC, Y, c) g1 >0 C g2, E =h(Be, Y, c) h1 > 0 > h2, and h1> g1 13 base (Be), the level of economic activity expressed by national income at current prices (Y), and the ceiling rate on time deposits (c).’4 The Gramley-Chase model implies that monetary policy does affect the money stock and bank credit. It also implies that the money stock responds posi- tively and bank credit negatively to economic activity. This model thus differs from the Monetarist hypothe- ses which imply that both bank credit and the money stock respond positively to economic activity. The Gramley-Chase model also implies that the responses of both the money stock and bank credit to mone- tary actions are independent of the general scale of the public’s and the banks’ interest elasticities. Uni- formly large or small interest elasticities yield the same response in the money stock or bank credit to a change in the monetary base. A detailed discussion of the implications derivable from a meaningfully supplemented Gramley-Chase model is not necessary at this point. We are foremost interested in the relation between this model and the propositions mentioned in the previous paragraph. The first proposition can be interpreted in two differ- ent ways. According to one interpretation, it could mean that the marginal multipliers g5 and h1 (i = 1, 2) are functions of the banks’ and the public’s response patterns expressing various types of substitution rela- tions between different assets. This interpretation is, however, quite innocuous and yields no differentia- tion relative to the questioned hypotheses of the Monetarist position. A second interpretation suggests that the growth rate of the money stock is dominated by the second component (changes in income) of the differential expression: AM = g1 ABC + g2 AY This result is not actually implied by the Gramley- Chase model, but it is certainly consistent with the model. However, in order to derive the desired result, theft model must be supplemented with special as- sumptions about the relative magnitude of g, and g2, and also about the comparative cyclical variability of 18 1n the Gramley-Chase model, g~and h 3 are indeterminant. t4 This implication was demonstrated in my paper listed in foot- note 12. The monetary base is adjusted for the accumulated sum of reserves liberated from or impounded into required reserves by changes in requirement ratios. ABC and AY. This information has not been provided by the authors. Most interesting is another aspect of the model which was not clarified by the authors. Theft model implies that policymakers could easily avoid pro- cyclical movements in AM. This model exemplifying the New View thus yields little justification for the conjectures of its proponents. A central property of the Gramley-Chase model must be considered in the light of the programmatic statements characterizing the New View. Gramley- Chase do not differentiate between the public’s asset supply to banks and the public’s demand for money. This procedure violates the basic program of the New View, namely, to apply economic analysis to an array of financial assets and financial institutions. Economic analysis implies that the public’s asset sup- ply and money demand are distinct, and not identical behavior patterns. This difference in behavior pat- terns is clearly revealed by different responses of desired money balances and desired asset supply to specific stimuli in the environment. For instance, an increase in the expected real yield on real capital raises the public’s asset supply but lowers the public’s money demand. It follows thus that a central analy- tical feature of the Gramley-Chase model violates the basic and quite relevant program of the New View. Kareken’s construction shares this fundamental analytical flaw with the Gramley-Chase model, but this is not the only problem faced by his analysis. The Kareken analysis proceeds on two levels. First, he derives a representative bank’s desired balance sheet position. For this purpose he postulates wealth maximization subject to the bank’s balance sheet relation between assets and liabilities, and subject to reserve requirements on deposits. On closer examina- tion, this analysis is only applicable to a monopoly bank with no conversion of deposits into currency or reserve flows to other banks. In order to render the analysis relevant for a representative bank in the world of reality, additional constraints would have to be introduced which modify the results quite substantially. it is also noteworthy that the structural properties assigned by Kareken to the system of market relations are logically inconsistent with the implications one can derive from the author’s analy- sis of finn behavior developed on the first level of his investigation. This disregard for the construction of an economic theory relevant for the real world is carried into the second level of analysis where the author formulates a system of relations describing the joint determina- Page 14 jectures. The results are quite unambiguous on this score. Additional information is supplied by Table I. For each postwar cycle beginning with the downswing of 1948-49, the average annual growth rate of the money stock was computed. The expression M mB was then used to compute the contribution to the average growth rate of money from three distinct sources: (i) the behavior of monetary authorities (i.e., the monetary base and reserve requirement ratios), and the public’s currency behavior, (ii) the time de- posit substitution process, and, (iii) the variations in the excess reserve and borrowing ratios of commercial banks (Wicksell-Keynes mechanism). TABLE I: A Comparison of Alternative Contributions to the Average Annual Growth Rote of the Money Stock and Bank Credit Rank Correlations Contribution made by~ Public’s currency and authorities’ behavior Time deposit substitution mechanism Wicksell-Keynes mechanism Remarks The figures listed state the rank correlation between the average growth rate of the money stock and bank credit with three different contributing sources. The rank correlations between each contribution, and the average growth rate of the money stock over all postwar half-cycles clearly support the con- clusion of the previous analysis that cyclical move- ments in the money stock are dominated by Federal Reserve actions. Table I also presents the results of a similar examination bearing on causes of movements in bank credit. The reader should note the radical difference in the observed patterns of correlation coefficients. The behavior of monetary authorities, supplemented by the public’s currency behavior, does not appear to dominate the behavior of bank credit. The three sources contributing to the growth rate of money all exerted influences of similar order on bank credit. It appears that bank credit is comparatively less exposed to the push of Federal Reserve actions than was the money stock. On the other hand, the money stock is less sensitive than bank credit to the time-deposit substitution mechanism emphasized by Gramley- Chase, and the Wicksell-Keynes mechanism suggested by Cacy. Most astonishing, however, is the negative association between the average growth rate of bank credit and the Wicksell-Keynes mechanism em- phasized by Cacy. It should also be noted that the average growth rate of money conforms very clearly to the business cycle. Such conformity does not hold for bank credit over the postwar half-cycles. This blurring occurred particularly in periods when the ceiling rate on time deposits was increased. These periods exhibit rela- tively large contributions to the growth rate of bank credit emanating from the time deposit substitution mechanism. A regression analysis (Table II) of the reduced form equations derived from the Gramley-Chase model confirms the central role of the monetary base in the money supply process. Estimates of the regres- sion coefficient relating money to income are highly unstable among different sample periods, relative to the coefficient relating money to the monetary base. Furthermore, estimates of regression coefficients re- lating money to income occur in some periods with TABLE II: Regressions of the Money Supply On the Monetary Base and Gross National Product* Moneta ry Base Gross National Product First Log FirstFirst Log First Differences Differences Differences Differences 2.03 .77 .04 .11 9.80) (10.02) (3.12) (3.39) .92 .93 .62 .65 ‘The monetary base was odiusted for res erye requirement changes and shift, in deposits. All data are quarterly averages of neasonally adiusted figures. The tirst entry in a column for each cycle is the regression coefficient. I-statistics are it pareetheses. and partial correlation coefficients are below the t-stottstics. signs which contradict the proposition of Gramley- Chase and Cacy, or exhibit a very small statistical significance. These diverse patterns of coefficients do not occur for the estimates of coefficieilts relating money and the monetary base. It is also noteworthy that the average growth rate of the monetary base (adjusted for changes in reserve requirement ratios), over the upswings, exceeds without exception the average growth rate of adjacent downswings. This observation is not compatible with the contention made by Gramley-Chase that policy is countercyclical. Additional information is supplied by Table III, which presents some results of a spectral analysis bearing on the monetary base and its sources. Spectral analysis is a statistical procedure for decomposing a tune series into seasonal, cyclical, and trend movements. After such an analysis was conducted on the monetary base and its sources, a form of correla- tion analysis was run between movements in the monetary base and movements in its various sources. Money 905 .048 .143 Bank Credit .333 .381 —-333 Regression Coefficients For: Cycle lV/48 to lI/S 3 11/53 to Ill/S 7 111/57 to 11/60 11/60 to Ill/os 1 .75 1.89) .44 4-59 (11.76) .97 2.76 7.56) .87 .63 1.96) .45 1.66 (11.81) .97 1.08 8.54) .89 .02 (1.02) .26 .06 (5.10) .86 —.01 (‘.33) -.08 .07 (1.23) .30 .19 (5.34) .67 -.03 (.27) Page 17 The results of this procedure (Table III) indicate that movements in Federal Reserve credit dominate sea- sonal and cyclical movements in the monetary base. TABLE III: Special Correlation Between Monetary Base Monetary Base Period in and Federal and Other Sources Months Reserve Credit of the Base 00 .65 .24 120 .69 .61 60 .74 .71 40 .74 .45 30 .73 .25 24 .71 .18 20 .60 .11 17.14 .43 .1) 15 .51 .07 13.33 .82 .48 12 .94 .71 6 .91 .2) 4 .92 — 3 .90 — Remarks: The monetary base equals Federal Reserve Credit plus other sources of the base. The spectral analysis is based on first differences between adjacent months. The data used were not seasonally adjusted. In summary, preliminary investigations yield no support for the contention that the behavior of banks and the public dominates cyclical movements in the money stock. The conjectures advanced by Gramley- Chase or Cacy are thus disconfirmed, whereas Davis’ second conjecture that fluctuations in monetary growth may be attributed to Federal Reserve actions seems substantially more appropriate. However, further investigations are certainly useful. D. Relevance of Money and Monetary Actions With Respect to Economic Activity At present, a broad consensus accepts the relevance of money and monetary policy with respect to eco- nomic activity. But this consensus concerning the relevance of money emerges from two substantially different views about the nature of the transmission mechanism. One view is the Keynesian conception (not to be confused with Keynes’ view), enshrined in standard formulations of the income-expenditure framework. In this view, the interest rate is the main link between money and economic activity. The other view rejects the traditional separation of economic theory into parts: national income analysis (macro economics) and price theory (micro economics). Ac- cording to this other view, output and employment are explained by a suitable application of relative price theory. With regard to discussions of the impact of money and monetary actions on economic activity, this latter view has been termed the Monetarist posi- tion. This position may be divided into the weak Monetarist thesis and the strong Monetarist thesis. In a sense, both the New View and the Monetarist extension of the “traditional view” are represented in the weak Monetarist position. The following discussions develop the weak and the strong Monetarist thesis. The weak thesis is compared with some aspects of the income-expenditure approach to the determination of national economic activity. The strong thesis supplements the weak thesis with special assumptions about our environment, in order to establish the role of monetary forces in the business cycle. 1. The Weak Monetarist Thesis — According to the weak Monetarist thesis, monetary impulses are trans- mitted to the economy by a relative price process which operates on money, financial assets (and liabili- ties), real assets, yields on assets and the production of new assets, liabilities and consumables. The general nature of this process has been described on numerous occasions and may be interpreted as evolving from ideas developed by Knut Wicksell, Irving Fisher, and John Maynard Keynes.17 The operation of relative prices between money, financial assets, and real assets may be equivalently interpreted as the working of an interest rate mech- anism (prices and yields of assets are inversely re- lated). Monetary impulses are thus transmitted by the play of interest rates over a vast array of assets. Variations in interest rates change relative prices of existing assets, relative to both yields and the supply prices of new production. Acceleration or deceleration of monetary impulses are thus converted by the varia- tion of relative prices, or interest rates, into increased or reduced production, and subsequent revisions in the supply prices of current output. This general conception of the transmission mech- anism has important implications which conflict sharply with the Keynesian interpretation of mone- tary mechanisms expressed by standard income-ex- Spectral Correlation Between the Monetary Base, Federal Reserve Credit and Other Sources of the Bose ‘ 7 The reader may consult the following studies on this aspect: Milton Friedman and David Meisehuan, “The Relative Sta- bility of Monetary Velocity and the Investment Multiplier in the United States, 1897-1958,” in Stabilization Policies, pre- pared by the Commission on Money and Credit, Englewood Cliffs, 1963. The paper listed in footnote 21 by James Tobin should also be consulted. Harry Johnson, “Monetary Theory and Policy,” American Economic Review, June 1962. Karl Brunner, “The Report of the Commission on Money and Credit,” The Jourrsal of Political Economy, December 1961. Karl Brunner, “Some Major Problems of Monetary Theory,” Proceedings of the American Economic Association, May 1961. Karl Brunner and Allan H. Meltier, “The Role of Financial Institutions in the Transmission Mechanism,” Pro- ceedings of the American Economic Association, May 1963. Karl Brunner, “The Relative Price Theory of Money, Output, and EmpIoyment,’~unpublished manuscript based on a paper presented at the Midwestern Economic Association Meetings, April 1967. Page 18 penditure fonnulations.18 In the context of standard income-expenditure analysis, fiscal actions are con- sidered to have a “direct effect” on economic activity, whereas monetary actions are considered to have only an “indirect effect.” Furthermore, a constant budget deficit has no effect on interest rates in a Keynesian framework, in spite of substantial accumulation of outstanding government debt when a budget deficit continually occurs. And lastly, the operation of in- terest rates on investment decisions has usually been rationalized with the aid of considerations based on the effects of borrowing costs. These aspects of the income-expenditure approach may be evaluated within the framework of the weak Monetarist thesis, The effects of fiscal actions are also transmitted by the relative price mechanism. Fiscal impulses, i.e., Government spending, taxing, and borrowing, operate just as “indirectly” as mone- tary impulses, and there is no a priori reason for believing that their speed of transmission is sub- stantially greater than that of monetary impulses. The relative price conception of the transmission mechanism also implies that a constant budget deficit exerts a continuous influence on economic activity through persistent modifications in relative prices of financial and real assets. Lastly, the transmission of monetary impulses is not dominated by the relative importance of borrowing costs. In the process, mar- ginal costs of liability extension interact with marginal returns from acquisitions of financial and real assets. But interest rates on financial assets not only affect the marginal cost of liability extension, but also influ- ence the substitution between financial and real assets. This substitution modifies prices of real assets relative to their supply prices and forms a crucial linkage of the monetary mechanisms; this linkage is usually omitted in standard income-expenditure analysis. The description of monetary mechanisms in Davis’ article approaches quite closely the notion developed by the weak Monetarist thesis. This approximation permits a useful clarification of pending issues. How- ever, the criticisms and objections advanced by Davis do not apply to the weak Monetarist position. They are addressed to another thesis, which might be usefully labeled the strong Monetarist thesis. 2. The Strong Monetarist Thesis — If the theoreti- cal framework of the weak Monetarist thesis is 18The paper on “The Effect of Monetary Policy on Expendi- tures in Specific Sectors of the Economy,~’presented by Dr. Sherman Maisel at the meetings organized by the American Bankers Association in September 1967, exemplifies very clearly the inherited Keynesian position. The paper will be published in a special issue of the Journal of Political Economy. supplemented with additional and special hypotheses, the strong Monetarist thesis is obtained. An outline of the strong thesis may be formulated in terms of three sets of forces operating simultaneously on the pace of economic activity. For convenience, they may be grouped into monetary forces, fiscal forces, and other forces. The latter include tecimological and organiza- tional innovation, revisions in supply prices induced by accruing information and expectation adjustments, capital accumulation, population changes and other related factors or processes. All three sets of forces are acknowledged by the strong thesis to affect the pace of economic activity via the relative price process previously outlined. Moreover, the strong Monetarist point of view ad- vances the crucial thesis that the variability of mone- tary forces (properly weighted with respect to their effect on economic activity) exceeds the variabil- ity of fiscal forces and other forces (properly weighted). It is argued further that major vari- abilities occurring in a subset of the other forces (e.g., expectations and revisions of supply prices in- duced by information arrival) are conditioned by the observed variability of monetary forces. The conjec- ture thus involves a comparison of monetary varia- bility with the variability of fiscal forces and indepen- dent “other forces.” According to the thesis under consideration, the variability of monetary impulses is also large relative to the speed at which the economy absorbs the impact of environmental changes. This predominance of variability in monetary impulses implies that pronounced accelerations in monetary forces are followed subsequently by accelerations in the pace of economic activity, and that pronounced decelerations in monetary forces are followed later by retardations in economic activity. The analysis of the monetary dynamics, using the relative price process, is accepted by both the weak and the strong Monetarist theses. This analysis implies that the regularity of the observed association be- tween accelerations and decelerations of monetary forces and economic activity depends on the relative magnitude of monetary accelerations (or decelera- tions). The same analysis also reveals the crucial role of changes in the rate of change (second differ- ences) of the money stock in explanations of fluctua- tions in output and employment. It implies that any pronounced deceleration, occurring at any rate of monetary growth, retards total spending. it is thus impossible to state whether any particular monetary growth, say a 10 per cent annual rate, is expansionary with respect to economic activity, until one knows the previous growth rate. The monetary dynamics of the Monetarist thesis also explains the simultaneous I Page 19 TABLE IV: Periods 11/49- 5/53 6/53 - 11/54 12/54- 10/55 11/55- 7/56 8/56 - 7/57 8/57- 7/58 7/58 - 6/59 7/59 - 1 2/60 i/oi - 12/62 Cumulative Scores of Policymakers’ Interpretation over the Period —4.75 + 2.63 —3.37 +1.12 —1.00 +3.50 —2.12 +2.62 — .63 —1030 + 286 — 818 + 352 — 44 + 1017 —1059 +1239 — 428 Changes in the Monetary Base over the Period in $ Mittion + 5216 +1321 + 345 + 399 + 657 +1203 + 531 — 53 +3288 An examination of the sequence of scores easily shows that the period covered can be naturally par- titioned into subperiods exhibiting an overwhelming occurrence of scores with a uniform sign. These subperiods are listed in the first column of Table IV. The second column cumulated the scores over the subperiods listed in order to yield a very rough ranking of the policymakers’ posture according to their own interpretation. Table IV reveals that the FOMC interpreted the subperiods from August 1957 to July 1958, and from July 1959 to December 1960 as among the most ex- pansionary policy periods. The period from Novem- ber 1949 to May 1953 appears in this account as a phase of persistently tight or restrictive policy. The next two columns list the changes of two important variables during each subperiod. The third column describes changes in free reserves, and the fourth column notes changes in the monetary base. A cursory examination of the columns immediately shows substantial differences in their broad association. The rank correlation between the various columns is most informative for our purposes. These rank correlations are listed in Table V. The results expose the absence of any positive associa- tion between the policymakers’ own interpretation or judgement of their stance and their actual behavior, as indicated by movements in the monetary base. The correlation coefficient between the monetary base and cumulated scores has a negative value, suggesting that a systematic divergence between stated and actual policy (as measured by the monetary base) is probable. On the other hand, the correlation be- TABLE V: Rank Correlation Between Changes in the Monetary Base, Changes in Free Reserves and the Cumulated Scores of Policymakers Interpretations Cumulated scores and base Cumulated scores and free reserves Free reserves and base tween the policymakers’ descriptions of their posture, and the movement of free reserves, is impressively close. This correlation confirms once again that the Federal Reserve authorities have traditionally used the volume of free reserves as an indicator to gauge and interpret prevailing monetary policies. Yet little evidence has been developed which establishes a causal chain leading from changes in free reserves to the pace of economic activity. Another observation contained in Table IV bears on the issue of policymakers’ interpretation of their own behavior. Changes in the cumulated scores and free reserves between the periods listed always move together and are perfect in terms of direction. By comparison, the co-movement between cumulated scores and changes in the monetary base is quite haphazard; only three out of eight changes between periods move together. This degree of co-movement between cumulated scores and the monetary base could have occurred by pure chance with a probability greater than 2, whereas the probability of the perfect co-movement between cumulated scores and free reserves occurring as a matter of pure chance is less than .004. The traditional selection of free reserves or money market conditions as an indicator to inter- pret prevailing monetary policy and to gauge the relative thrust applied by policy, forms the major reason for the negative association (or at least ran- dom association) between stated and actual policy. Attempts at rebuttal to the above analysis often emphasize that policymakers are neither interested in the monetary base, nor do they attach any signifi- cance to it. This argument is advanced to support the claim that the behavior of the monetary base is irrelevant for a proper examination of policymakers’ intended behavior, This argument disregards, how- — ~ ever, the facts stated earlier, namely, movements in .70 the monetary base are under the direct control and — .26 are the sole responsibility of the monetary authorities. The Association between Policymakers’ Interpretation of Policy, Changes in the Monetary Base and Changes in Free Reserves Changes in Free Reserves over the Period in $ Million Page 22 It also disregards the fact that actions may yield con- sequences which are independent of motivations shaping the actions. These considerations are sufficient to acknowledge the relevance of the monetary base as a measure sum- marizing the actual behavior of monetary authorities. However, they alone are not sufficient to determine whether the base is the most reliable indicator of monetary policy. Other magnitudes such as interest rates, bank credit, and free reserves have been ad- vanced with plausible arguments to serve as indi- cators. A rational procedure must be designed to determine which of the possible entities frequently used for scaling policy yields the most reliable results, This indicator problem is still very poorly under- stood, mainly because of ambiguous use of eco- nomic language in most discussions of monetary pol- icy. The term- ‘<indicator” occurs with a variety of meanings in discussions, and so do the terms “targett and “guide.” The indicator problem, understood in its technical sense, is the determination of an optimal scale justifying interpretations of the authorities’ actual behavior by means of comparative statements. A typical statement is that policy X is more expansionary than policy Y, or that current policy has become more (or less) expansionary. Whenever we use a comparative concept, we implicitly rely on an ordering scale. The indicator problem has not been given ade- quate treatment in the literature, and the recognition of its logical structure is often obstructed by inade- quate analysis. It is, for instance, not sufficient to emphasize the proposition that the money supply can be a “misleading guide to the proper interpretation of monetary policy.” This proposition can be easily demonstrated for a wide variety of models and hy- potheses. However, it establishes very little. The same theories usually demonstrate that the rate of interest, free reserves, or bank credit can also be very misleading guides to monetary policy. Thus, we can obtain a series of propositions about a vast array of entities, asserting that each one can be a very misleading guide to the interpretation of policy. We only reach a useless stalemate in this situation. The usual solution to the indicator problem at the present time is a decision based on mystical insight supplemented by some impressionistic arguments. The most frequently advanced arguments emphasize that central banks operate directly on credit markets where interest rates are formed, or that the interest mech- anism forms the centerpiece of the transmission proc- ess. Accordingly, in both cases market interest rates should “obviously” emerge as the relevant indicator of monetary policy. These arguments on behalf of market interest rates are mostly supplied by economists. The monetary authorities’ choice of money market conditions as an indicator evolved from a different background. But in recent years a subtle change has occurred. One frequently encounters arguments which essentially deny either the existence of the indicator problem or its rational solution. A favorite line asserts that “the world is very complex” and consequently it is im- possible or inadmissible to use a single scale to interpret policy. According to this view, one has to consider and weigh many things in order to obtain a “realistic” assessment in a complicated world. This position has little merit. The objection to a “single scale” misconstrues the very nature of the problem. Once we decide to discuss monetary policy in tenns of comparative statements, an ordinal scale is required in order to provide a logical basis for such statements. A multiplicity of scales effectively elimi- nates the use of comparative statements. Of course, a single scale may be a function of multiple argu- ments, but such multiplicity of arguments should not be confused with a multiplicity of scales. Policy- makers and economists should therefore realize that one either provides a rational procedure which justifies interpretations of monetary policy by means of comparative statements, or -that one abandons any pretense of meaningful or intellectually honest discus- sion of such policy. Solution of the indicator problem in the technical sense appears obstructed on occasion by a prevalent confusion with an entirely different problem confront- ing the central banker — the target problem. This problem results from the prevailing uncertainty con- ceming the nature of the transmission mechanism and the substantial lags in the dynamics of monetary processes. In the context of perfect information, the indicator problem becomes trivial and the target problem van- ishes. But perfect information is the privilege of economists’ discourse on policy; central bankers can- not afford this luxury. The impact of their actions are both delayed and uncertain. Moreover, the ultimate goals of monetary policy (targets in the Tinbergen- Theil sense) appear remote to the manager executing general policy directives. Policymakers will be in- dined under these circumstances to insert a more immediate target between their ultimate goals and their actions. These targets should be reliably ob- servable with a minimal lag. Page 23 It is quite understandable that central bankers traditionally use various measures of money market conditions, with somewhat shifting weights, as a target guiding the continuous adjustment of their policy variables. This response to the uncertainties and lags in the dynamics of the monetary mechanism is very rational indeed. However, once we recognize the rationality of such behavior, we should also consider the rationality of using a particular target. The choice of a target still remains a problem, and the very nature of this problem is inadequately understood at this state. This is not the place to examine the indicator and target problem in detail. A possible solution to both problems has been developed on another occasion.23 The solutions apply decision theoretic procedures and concepts from control theory to the determination of an optimal choice of both indicator and target. Both problems are in principle solvable, in spite of the “complexity of the world.” Consequently, there is little excuse for failing to develop rational monetary policy procedures. CONCLUSION A program for applying economic analysis to finan- cial markets and financial institutions is certainly ac- ceptable and worth pursuing. This program suggests that the public and banks interact in the deterrnina- tion of bank credit, interest rates, and the money stock, in response to the behavior of monetary author- ities. But the recognition of such interaction implies nothing with respect to the relative importance of the causal forces generating cyclical fluctuations of monetary growth. Neither does it bear on the quality of alternative empirical hypotheses, or the relative usefulness of various magnitudes or conditions which might be proposed as an indicator to judge the actual thrust applied by monetary policy to the pace of economic activity. 23 The reader may consult the chapter by Karl Bnmner and Allan H. Meltzer on “Targets and Indicators of Monetary Policy,” in the book of the same title, edited by Karl Brunner. The book will be published by Chandler House Publishing Co., Belmont, California. The Monetarist thesis has been put forth in the form of well structured hypotheses which are supported by empirical evidence. This extensive research in the area of monetary policy has established that: (i) Federal Reserve actions dominate the movement of the mone- tary base over time; (ii) movements of the monetary base dominate movements of the money supply over the business cycle; and, (iii) accelerations or decelera- tions of the money supply are closely followed by accelerations or decelerations in economic activity. Therefore, the Monetarist thesis puts forth the proposition that actions of the Federal Reserve are transmitted to economic activity via the resulting movements in the monetary base and money supply, which initiate the adjustments in relative prices of assets, liabilities, and the production of new assets. The New View, as put forth by the counter- critique, has offered thus far neither analysis nor evidence pertaining relevantly to an explanation of variations in monetary growth. Moreover, the counter- critique has not developed, on acceptable logical grounds, a systematic justification for the abundant supply of statements characterizing policy in terms of its effects on the economy. Nor has it developed a systematic justification for the choice of money market conditions as an optimal target guiding the execution of open market operations. But rational policy procedures require both a re- liable interpretation and an adequate determination of the course of policy. The necessary conditions for rational policy are certainly not satisfied if policies actually retarding economic activity are viewed to be expansionary, as in the case of the 1960-61 recession, or, if inflationary actions are viewed as being restric- tive, as in the first half of 1966. The major questions addressed to our monetary policymakers, their advisors and consultants remain: How do you justify your interpretation of policy, and how do you actually explain the fluctuations of mone- tary growth? The major contentions of the academic critics of the past performance of monetary author- ities could possibly be quite false, but this should be demonstrated by appropriate analysis and relevant evidence. This article is available as reprint series No. 30 Page 24