| | | | | | 2. Uncontrollability. With the exception of the money base, monetary aggregates are not tightly enough under the control of the Fed. Both M1 and M2 are affected by bank discount borrowing, public cash demands, banking innovations, and shifts among deposit types, for example. | | | | | | | | | 3. Velocity changes. All nonetary aggregates are not reliably linked to economic activity because of velocity fluctuations caused by financial innovations and deregulations. | | | | | | | | | 4. Money-demand shocks. Shocks to money demand, such as failure of a large bank, a postal strike, or a stock market crash, destabilize the economy under a monetary-aggregate growth target because the central bank won't react by matching the demand for money shock with a money-supply change. | | | | | | | | | Problems with both types of policy targets create a dilemma: how should monetary policy be conducted? The Fed appears to have solved this dilemma by adopting the following principles: | | | | | | | | | 1. Quickly adjust the money supply to meet shocks to money demand. Adopt stability of the financial system as a priority goal. | | | | | | | | | 2. Never use an interest-rate target in an inflationary environment. | | | | | | | | | 3. Use a monetary-aggregate target only in cases of strong inflation. | | | | | | | | | | Curiosity 11.2: Was the Fed Ever Monetarist? | | | | | | | | | | For a variety of reasons, in the 1970s the Fed allowed the money supply growth rate to creep up, producing a much higher inflation (over 10 percent) than normal. Paul Volcker was brought in as chairman of the Fed in late 1979 and shortly thereafter the Fed announced that it was following a new policy restricting M1 growth to fight inflation. The predicted happened: low money growth resulting from Fed collided with high money-demand growth caused by inflation; and real interest rates shot up, causing a severe recession that, after a long adjustment period in the early 1980s, squeezed inflation out of the economy | | | | | | | | | | This period is often thought of as a monetarist period in the Fed's history because of its announced policy of targeting on a monetary aggregate. Some economists, however, claim that this characterization is inaccurate. They note that during this period the Fed did not appear to be serious about its alleged targets because it consistently missed its target range. A more reasonable explanation of Fed behavior, they argue, is that the Fed was focusing on interest rates, moving them high enough create a severe recession needed to kill inflation, but claiming, as a smokescreen, to be using monetary targets so that it would not be blamed directly for the high interest rates. | | | | | | | | | | Currently, the Fed is definitely not monetarist, having abandoned in frustration any use of monetary aggregates because of their erratic velocities. | | | | | |
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