NBER WORKING PAPER SERIES THE GREAT INFLATION: DID THE SHADOW KNOW BETTER? William Poole Robert H. Rasche David C. Wheelock

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1 NBER WORKING PAPER SERIES HE GREA INLAION: DID HE SHADOW KNOW BEER? William Poole Rober H. Rasche David C. Wheelock Working Paper 690 hp:// NAIONAL BUREAU O ECONOMIC RESEARCH 050 Massachuses Avenue Cambridge, MA 028 March 20 he auhors hank he conference paricipans, especially Allan Melzer and Chrisina Romer, and wo referees for heir commens on previous versions of his paper. he views expressed in his paper do no necessarily reflec hose of he ederal Reserve Bank of S. Louis, he ederal Reserve Sysem, or he Naional Bureau of Economic Research. NBER working papers are circulaed for discussion and commen purposes. hey have no been peerreviewed or been subjec o he review by he NBER Board of Direcors ha accompanies official NBER publicaions. 20 by William Poole, Rober H. Rasche, and David C. Wheelock. All righs reserved. Shor secions of ex, no o exceed wo paragraphs, may be quoed wihou explici permission provided ha full credi, including noice, is given o he source.

2 he Grea Inflaion: Did he Shadow Know Beer? William Poole, Rober H. Rasche, and David C. Wheelock NBER Working Paper No. 690 March 20 JEL No. E,E2,E7,E4,E52,E58 ABSRAC he Shadow Open Marke Commiee was formed in 97 in response o rising inflaion and he apparen unwillingness of U.S. policymakers o implemen policies necessary o mainain price sabiliy. his paper describes how he Commiee s policy views differed from hose of mos ederal Reserve officials and many academic economiss a he ime. he Shadow argued ha price sabiliy should be he primary goal of moneary policy and favored gradual adjusmen of moneary growh o a rae consisen wih price sabiliy. his paper evaluaes he Shadow s policy rule in he conex of he New Keynesian macroeconomic model of Clarida, Gali, and Gerler (999. Simulaions of he model sugges ha he gradual sabilizaion of moneary growh favored by he Shadow would have lowered inflaion wih less impac on oupu growh and less variabiliy in inflaion or oupu han a one-ime reducion in moneary growh. We conclude ha he Shadow ariculaed a policy ha would have ouperformed he policies acually implemened by he ederal Reserve during he Grea Inflaion era. William Poole ederal Reserve Bank of S. Louis 4 Locus Sree S. Louis, MO 602 gswpoole@sprinmail.com Rober H. Rasche ederal Reserve Bank of S. Louis 45 Radcliffeborough C Cheserfield, MO rasche@sls.frb.org David C. Wheelock Research Division ederal Reserve Bank of S. Louis P.O. Box 442 S. Louis, MO david.c.wheelock@sls.frb.org

3 he failure o conrol inflaion was no ineviable. he policies did no fail because hey were poorly execued. hey failed because hey were poorly conceived. Shadow Open Marke Commiee, Augus 2, 97 he Shadow Open Marke Commiee (SOMC held is firs meeing on Sepember 4, 97. he SOMC was formed in response o rising inflaion in he Unied Saes and he apparen failure of eiher he Nixon adminisraion or he ederal Reserve o formulae effecive policies o conrol inflaion. Under he leadership of Karl Brunner and Allan Melzer, he SOMC me wice a year o review U.S. economic policy and discuss policy-relaed research. A he conclusion of every meeing, he Commiee issued a saemen evaluaing curren policy and proposing an alernaive course of acion. 2 In his paper, we describe he moneary policy framework of he SOMC and he saemens he Commiee issued during he Grea Inflaion period. urher, we simulae a New Keynesian macroeconomic model embedding a represenaion of he SOMC policy rule o evaluae wheher he Commiee s proposals could have resuled in a lower average and more sable rae of inflaion han acually occurred. irs, we describe he economic environmen in which he SOMC was creaed and he policy views ha he SOMC sough o couner. We hen describe he SOMC policy framework by highlighing how he views of SOMC members differed from mos ederal Reserve officials and many academic macroeconomiss. ha discussion is followed by a descripion of he SOMC policy rule. Imporanly, he SOMC rule called for a ransparen and gradual adjusmen of money sock growh o a seady-sae rae. We simulae a New Keynesian macroeconomic model embedding he SOMC policy rule o gauge how Inviaion issued o he press and oher guess o aend he firs meeing of he Shadow Open Marke Commiee, held on Sepember 4, 97. Quoed in Melzer ( See Melzer (2000 for a shor hisory of he SOMC.

4 2 differen he pah of inflaion migh have been if he ederal Reserve had followed he SOMC s policy recommendaions. Our simulaions illusrae ha a gradual adjusmen of money sock growh similar o ha advocaed by he SOMC is likely o resul in less impac on oupu growh and less variabiliy in inflaion or oupu growh han a large one-ime adjusmen. he Grea Inflaion and he SOMC When he SOMC firs me in Sepember 97, he Unied Saes had already experienced eigh years of rising and increasingly variable inflaion. Whereas inflaion averaged a mere.4 percen beween January 952 and December 964, i averaged.9 percen beween January 965 and Augus 97, and reached 7.4 percen for he 2 monhs ending in Augus 97. he Nixon adminisraion s response o inflaion, wih he srong suppor of ederal Reserve Chairman Arhur Burns and many academic and professional economiss, was o impose conrols on wages and prices. 4 A firs round of conrols was announced on Augus 5, 97, and some conrols remained in effec ino 974. Burns coninued o champion wage and price conrols even when mos observers had concluded ha hey were no working. or example, in a speech on June 6, 97, Burns argued ha he persisence of rapid advances in wages and prices in he Unied Saes and oher counries, even during periods of recession, has led me o conclude ha governmenal We measure he inflaion rae here as he year-over-year percenage change in he seasonally adjused alliems Consumer Price Index ( = Nearly 9 percen of respondens o a 97 survey of members of he Naional Associaion of Business Economiss favored he use of wage and price conrols or guidelines ( op Economiss Are Exremely Ebullien Over 972 Prospecs, Back Nixon Program, Wall Sree Journal, Sepember 28, 97, p., and 6 percen of surveyed members of he American Economics Associaion suppored he adminisraion s freeze on wages and prices ( Presiden o Give Pos-reeze Plan in Speech onigh, New York imes, Ocober 7, 97, p..

5 power o resrain direcly he advance of prices and money incomes consiues a necessary addiion o our arsenal of economic sabilizaion weapons. 5 Burns aribued he inflaion of he lae 960s and early 970s mainly o rising facor coss, especially labor and energy coss, as well as o governmen budge deficis, social programs, and regulaions. 6 He argued ha wage and price conrols were necessary o sem cos-push inflaion. or example, in a 970 speech, he conended ha Governmenal effors o achieve price sabiliy coninue o be hwared by he coninuance of wage increases subsanially in excess of produciviy gains. he inflaion ha we are sill experiencing is no longer due o excess demand. I ress raher on he upward push of coss mainly, sharply rising wage raes. He argued, moreover, ha moneary and fiscal ools are inadequae for dealing wih sources of price inflaion such as are plaguing us now ha is pressures on coss arising from excessive wage increases. 7 Burns s views abou inflaion were widely shared by leading economiss and policymakers hroughou he 960s and 970s. or example, Samuelson and Solow (960, p. 8 argued ha he essence of he [inflaion] problem semmed from he absence of perfec compeiion in facor and produc markes, whereas Bronfenbrenner and Holzman (96 cied he power of economic pressure groups, such as labor unions and monopolisic firms. hroughou he 960s, he Economic Repor of he Presiden blamed inflaion on excessive wage and price increases. or example, he Economic Repor for 965 explained ha in a world where large firms and large unions play an 5 Some Problems of Cenral Banking. Quoed in Burns (978, p Rerospecively, Burns (979 cas blame for he Grea Inflaion widely bu emphasized he effecs of governmen budge deficis, social programs, and regulaions, as well as a poliical and economic climae ha favored he pursui of full employmen over price sabiliy. 7 he Basis for Lasing Prosperiy (speech December 7, 970. Quoed in Burns (978, pp. 2-.

6 4 essenial role, he cos-price record will depend heavily upon he responsibiliy wih which hey exercise he marke power ha sociey enruss o hem (966, p. 79. Like Burns, some economiss and policymakers claimed ha governmen budge deficis conribued o rising inflaion. ederal Reserve Governor Sherman Maisel (97, p. 2, for example, wroe ha he increasing rae of inflaion of he lae 960s and early 970s was caused by governmen deficis; speculaive invesmen in plan, equipmen, and labor by business corporaions; use of economic power o raise wages and profis; Bu mos significan were he governmen deficis. he SOMC was formed o promoe an alernaive o hese widely enrenched views abou he causes of inflaion and o recommend policies for resoring price sabiliy. he policy analysis and recommendaions of he SOMC refleced he monearis orienaion of is members. Acceping Milon riedman s dicum ha inflaion is always and everywhere a moneary phenomenon, he SOMC argued ha price sabiliy could be resored only by slowing he growh of moneary aggregaes. he SOMC advocaed a policy rule characerized by an announced, gradual reducion in money growh o a rae consisen wih long-run price sabiliy. he SOMC made specific recommendaions for money sock growh a is wice-yearly meeings hroughou he Grea Inflaion period and for several years hereafer (provided in Appendix. he Shadow s ramework he SOMC represened a monearis challenge o he Keynesian views ha dominaed he economics profession and he ederal Reserve during he 960s and 970s. 8 he fundamenal differences beween he monearis and Keynesian views have 8 We do no wish o leave he impression ha all ederal Reserve officials shared he same views. In paricular, Darryl rancis, presiden of he ederal Reserve Bank of S. Louis from 966 o 975, advocaed

7 5 been elaboraed a lengh elsewhere. 9 Here we highligh key differences beween he SOMC and ederal Reserve policymakers abou he causes of inflaion and conduc of moneary policy o bolser our conenion ha moneary policy would have been radically differen during he 970s under a Shadow-led ed. 0. Inflaion is a moneary phenomenon: ed officials ofen blamed inflaion on labor unions, monopolisic pricing, energy price shocks, and governmen budge deficis and dismissed he noion ha money growh and inflaion are closely conneced. Burns, for example, esified in 974 ha he role of more rapid moneary urnover raes warns agains assuming any simple causal relaion beween moneary expansion and he rae of inflaion eiher during long or shor periods. Burns acknowledged ha excessive increase in money and credi can be an iniiaing source of excess demand and a soaring price level. Bu he iniiaing force may primarily lie elsewhere, as has been he case in he inflaion from which his counry is now suffering. By conras, SOMC members and oher moneariss dismissed special facors explanaions for inflaion and remained adaman ha inflaion is caused solely by excessively rapid growh of he money sock. or example, Karl Brunner argued ha Persisen increases in he price level are hardly likely o occur wihou a similarly persisen moneary growh. Alernaively, in he absence of persisen and excessive policies ha were much closer o hose recommended by he SOMC han o hose acceped by a majoriy of his ed colleagues. See Hafer and Wheelock ( or example, see Laidler (98 or Nelson and Schwarz ( Romer and Romer (2004 argue ha hroughou he ed s hisory, he success of moneary policy, or lack hereof, has been mainly due o policymakers views abou how he economy works and wha moneary policy can accomplish. hey aribue he ed s inflaionary policy during he 960s and 970s iniially o a belief in a permanen rade-off beween inflaion and unemploymen, and laer o a naural rae view wih a highly opimisic esimae of he naural rae of unemploymen and a highly pessimisic esimae of he sensiiviy of inflaion o economic slack. Key Issues of Moneary Policy (saemen before he House Banking Commiee, July 0, 974. Quoed in Burns (978, p. 77.

8 6 moneary growh we will no experience any persisen inflaion. Moreover, any persisen acceleraion of he money sock evenually unleashes a rising inflaion. On he oher side, no inflaion was ever erminaed wihou lowering moneary growh o he relevan benchmark level he marke sysem is inherenly sable and economic growh revers o a naural rae: Keynesians ofen argued ha expansionary fiscal or moneary policy migh be required o ensure ha aggregae demand is sufficien o generae full employmen, especially in he face of downwardly rigid wages and prices. Samuelson (960, p. 265, for example, wroe ha wih imporan cos-push forces assumed o be operaing, here are many models in which i can be shown ha some sacrifice in he requiremen for price sabiliy is needed if shor- and long-erm growh are o be maximized, if average long-run unemploymen is o be minimized, if opimal allocaion of resources as beween differen occupaions is o be faciliaed. urher, Samuelson and Solow (960 argued ha policies direced a limiing inflaion in he shor run migh increase srucural unemploymen and reduce economic growh over he long erm. he long-run rade-off beween inflaion and unemploymen would worsen, hey argued, because an increase in srucural unemploymen would increase he amoun of inflaion required o achieve a given reducion in he unemploymen rae. Moneariss held a very differen view. Brunner, for example, argued ha he marke sysem acs as a shock absorber and ends o esablish a normal level of oupu. his means ha we consider he marke sysem o be inherenly sable. urher, he argued ha he rend in oupu is dominaed by real condiions and shocks summarized 2 Anoher View a ashionable allacies. SOMC posiion paper, ebruary 4, 980. Reprined in Lys (997, pp

9 7 by echnology, preferences, and insiuions. And, moneary impulses do no produce permanen real effecs on oupu, employmen and real ineres raes, apar from longerrun real effecs exered via he expeced inflaion rae or disorionary insiuional consrains (e.g., ax raes specified in nominal erms. 4 In oher words, as riedman (968 and Phelps (967 argued, in he long run, oupu growh converges o a naural rae ha is independen of he rae of inflaion. 5. Moneary policy should focus on price sabiliy. In addiion o believing ha moneary policy has lile or no impac on oupu in he long run, moneariss were skepical of using policy o fine-une economic aciviy in he shor run. Moneariss argued ha he ed s aemps o seer a pah beween inflaion and unemploymen in he face of ineviable uncerainy abou he shor-run impac of policy acions and oher shocks had exacerbaed insabiliy in boh inflaion and unemploymen. or example, William Poole (975 argued ha By rying o do oo much, policymakers have pu hemselves ino a vicious sop-go cycle wih ever-widening oscillaions. Each period of moneary expansion has been higher han he previous one considering he 965, , and he expansions. Each of he inflaions since 965 has been worse han he previous one. And each seback in real aciviy since 965 has been deeper han is predecessor in he sequence 967, , his paern mus be broken, and he only mehod in which I have any confidence is ha of sabilizing money growh. 6 Brunner argued similarly: he bes conribuion moneary policy can make o lower he variabiliy of oupu relaive o normal oupu is he commied adherence o a Conversaion wih a Monearis. Quoed in Lys (997, p Has Monearism ailed? Cao Journal (, Spring 98. Quoed in Lys (997, p If anyhing, moneariss believed ha inflaion would depress economic growh (e.g., riedman, Quoed by Karl Brunner in Moneary Policy, Recovery, and Inflaion (SOMC posiion paper, Sepember 2, 975, p. 2.

10 8 predicable and sable moneary conrol pah credibly undersood by he mass of price and wage seers Adverse supply shocks reduce poenial oupu: SOMC members argued agains basing policy acions on esimaes of he gap beween acual and poenial oupu, noing ha here was lile evidence ha doing so reduces flucuaions in oupu. or example, Brunner argued ha shor-run adjusmens of moneary growh o he magniude of he gap in he conex of an economy wih long inflaion experience conribues lile o he closure of gaps over ime. urhermore, he occurrence of supply shocks reminds us ha we canno infer from oupu movemens alone wheher or no a recession has occurred. 8 he decline in oupu and increase in unemploymen ha followed he firs oil shock in 97 promped calls for expansionary moneary policy o reurn he economy o full employmen. Brunner, however, argued ha he shock had increased he naural rae of unemploymen and lowered poenial oupu. urher, he argued ha he disincion beween a real shock decline in oupu and a cyclic decline in oupu [is] imporan for policy making. he laer creaes an oupu gap absen from he former. A disregard of he wo disinc processes hus magnifies esimaes of he poenial gap o be removed by expansionary policies. An inadequae analysis of he decline in oupu observed since November 97 hus reinforces he danger of inflaionary financial responses on he par of policymakers. 9 He also argued ha if a decline in oupu reflecs a decline in poenial, hen no increase in money sock whaever is magniude 7 Our Perennial Issue: Moneary Policy and Inflaion (SOMC posiion paper, Sepember 979, p. 7. Reprined in Lys (997, pp Our Perennial Issue: Moneary Policy and Inflaion (SOMC posiion paper, Sepember 979, pp Reprined in Lys (997, pp Brunner, Moneary Policy, Recovery and Inflaion (SOMC posiion paper, Sepember 2, 975, p. 5.

11 9 will raise oupu again. 20 Allan Melzer argued similarly: Money canno replace oil, and moneary policy canno offse he loss of real income resuling from he oil shock. he aemp o do so convers he one-ime increase in he price level ino a permanenly higher mainained rae of inflaion. 2 Alhough he impac of oil shocks on poenial oupu was noed in he academic lieraure (e.g., Phelps, 978, ed policymakers seem o have relied on overly opimisic esimaes of full-employmen oupu growh produced by he Council of Economic Advisers he cos of disinflaion reflecs he moneary auhoriy s credibiliy: Whereas he SOMC argued ha money growh should be gradually reduced o lower he inflaion rae, Burns and many oher economiss ofen claimed ha reducing money growh o he exen required o hal inflaion would resul in excessively high unemploymen and los oupu. or example, in esifying abou he rise of inflaion in he lae 960s and early 970s, Burns argued ha an effor o use harsh policies of moneary resrain o offse he excepionally powerful inflaionary forces of recen years would have caused serious financial disorder and economic dislocaion. ha would no have been a sensible course for moneary policy Our Perennial Issue: Moneary Policy and Inflaion (SOMC posiion paper, Sepember 979 p. 8. Reprined in Lys (997, pp Draf of proposed saemen (SOMC, Sepember 7, 979, p.. 22 Orphanides (200 and Romer and Romer (2004 conclude ha reliance on an over esimae of poenial oupu can explain much of he ed s failure o rein in inflaion during he 970s. Orphanides (200 esimaes a aylor rule using original (i.e., real-ime daa and concludes ha policy was broadly consisen wih a 2 percen inflaion arge hroughou he 960s and 970s. Orphanides shows, for example, ha esimaes of poenial oupu available o policymakers a he ime suggesed ha during oupu was far below poenial when in fac revised daa sugges a much smaller gap in and lile or no gap in he SOMC esimaed ha he 97 oil shock had reduced normal oupu by abou 5 percen (SOMC policy saemen, Sepember 7, 979. or an exended discussion, see Brunner s SOMC posiion paper, Moneary Policy, Inflaion and Economic Expansion (Sepember, 976, pp Key Issues of Moneary Policy (saemen before he House Banking Commiee, July 0, 974. Quoed in Burns (978, pp

12 0 Brunner counered ha he cos of disinflaion reflecs he clariy and credibiliy of he announced policy, and, echoing Lucas (976, argued ha esimaes of he resuling loss in oupu associaed wih igher policy generaed by sandard models are highly suspec: he srucural properies and response paerns of an economic sysem are no invarian relaive o differen policies and policy paerns. he mechanical simulaion of a policy program subsanially differen from he policy paerns prevailing over he sample period used o esimae he model yield lile informaion abou he consequences of he program proposed. In paricular, he simulaions of a model esimaed over a period of acceleraing inflaion probably exaggerae he longer-run unemploymen effecs of an ani-inflaionary program. 24 Brunner (98 argued ha he social cos of a disinflaionary policy is no predeermined by he magniude or duraion of moneary reardaion. he social cos depends crucially on he public s belief in he persisence of he disinflaionary acion. And, Credibiliy depends on he hisory of policymaking and he behavior of he policy insiuion. Low credibiliy offers lile incenive o modify price-wage seing behavior, and he social cos of disinflaion rises correspondingly. urher, A dominan convicion by marke paricipans ha he ederal Reserve Auhoriies ruly, unwaveringly and persisenly lower moneary growh produces a decline in he rae of inflaion wih a comparaively small and rapidly eroding gap [beween acual and poenial oupu]. Emergence and magniude of a gap in he conex of an ani-inflaionary policy depends foremos on he credibiliy of he policy Assessmen of Moneary Policy (SOMC posiion paper, Sepember 6, 974, p Anoher View a ashionable allacies (SOMC posiion paper, ebruary 4, 980. Reprined in Lys (997, pp

13 6. Policy should be rules based and ransparen: Mos ed officials rejeced he call for rules-based policy, especially hose involving conrol of moneary aggregaes. ed Governor Andrew Brimmer, for example, argued ha i would be a disasrous error for he ederal Reserve o ry o conduc moneary policy on he basis of a few simple rules governing he rae of expansion of he money supply (972, p. 5. And Burns claimed ha he appropriae moneary growh raes will vary wih economic condiions. hey are ap o be higher during periods of economic weakness han when he economy is booming. Special circumsances may, however, call for moneary growh raes ha deviae from his general rule. 26 By conras, he SOMC favored rules-based policy, arguing ha discreionary policy can succeed only if moneary auhoriies have full knowledge of he deerminisic and sochasic srucure of he economy. Hence, Brunner (98 argued, A consan moneary growh regime [is] an opimal risk-minimizing sraegy in a sae of uncerain and shifing informaion. Brunner s preferred policy did, however, allow changes in he moneary growh rae in response o changes in he rend of normal real growh and velociy. 7. Money marke (nominal ineres rae argeing is flawed: he ed used a money marke sraegy o implemen is policy. his sraegy evolved from he ed s borrowed reserves sraegy of he 920s and he ineres rae-pegging regime of World War II. 27 Afer he ed-reasury Accord in 95, he ed remained commied o mainaining an orderly marke for governmen securiies and policy ofen refleced a desire o keep he governmen securiies marke on an even keel, especially when he 26 Key Issues of Moneary Policy (saemen before he House Banking Commiee, July 0, 974. Quoed in Burns (978, p See Brunner and Melzer (968, Calomiris and Wheelock (998, and Melzer (200.

14 2 reasury was issuing new deb. ed officials gauged he one and feel of he money markes and judged he sance of policy by movemens in nominal ineres raes rising raes were inerpreed as reflecing igher policy and falling raes as looser policy. 28 ed officials jusified heir focus on he money marke by claiming ha financial marke behavior is oo complex for simple moneary rules o work (Gramley and Chase, 965, pp Burns explained ha we pay close aenion o ineres raes because of heir profound effecs on he working of he economy. 29 Moneariss, however, argued ha he ed s focus on ineres raes had misled policymakers ino hinking ha hey were ighening policy in response o rising inflaion when, in fac, policy was increasingly loose. Brunner, for example, noed ha An ineres rae arge policy misleads moneary auhoriies and many specaors ino believing ha expansive (or resricive acions have been iniiaed when nohing has been done or even worse, when acually resricive (expansive measures have been inroduced. A decline in ineres raes resuling from falling credi demand possesses no expansionary meaning and simply reflecs one aspec of he ongoing deflaionary process. Is inerpreaion as an expansive acion by he ed is a dangerous illusion. 0 Allan Melzer argued similarly in esimony before he Senae Banking Commiee in 975: Changes in ineres raes convey inaccurae informaion abou he direcion or hrus of curren moneary policy. He described he use of nominal ineres raes as a guide o 28 or addiional discussion of ed policy during he 950s, see Brunner and Melzer (964a; Calomiris and Wheelock (998; and Romer and Romer ( Moneary arges and Credi Allocaion (esimony before he Subcommiee on Domesic Moneary Policy, U.S. House Banking, Currency, and Housing Commiee, ebruary 6, 975. Quoed in Burns (978, p Moneary Policy and he Economic Decline (SOMC posiion paper, March 7, 975, p. 2.

15 policy as one of he principal errors ha he ederal Reserve has made hroughou is hisory. 8. Money demand is sable. Many economiss and moneary policymakers dismissed moneary growh rules, arguing ha money demand is oo unsable o permi he use of such rules. Policymakers ofen claimed ha financial innovaions and changes in regulaion unpredicably alered he relaionship beween moneary growh and nominal spending. Burns, for example, claimed ha rom one monh o he nex, he public s demand for money is subjec o variaions ha are usually of a shor-run naure. If he ederal Reserve ried o mainain a rigid moneary growh rae [hen] ineres raes could flucuae widely, and o no good end. he coss of financial inermediaion would be increased, and he course of moneary policy would be misinerpreed. 2 SOMC members quesioned he ed s analysis, however, especially esimaes of money demand equaions ha included only shor-erm ineres raes. Brunner, for example, conjecured ha money demand funcions using long erm in lieu of shor erm ineres raes supplemened wih a measure of reurns on equiies produces differen resuls. 9. he money sock is conrollable: ed officials ofen claimed ha hey had lile conrol over he money sock and, hence, ha moneary aggregae argeing would no be feasible even if i were desirable. Board saff economiss Lyle Gramley and Samuel he Senae Concurren Resoluion on Moneary Policy (esimony before he Senae Commiee on Banking and Currency, ebruary 25, 975, p.. 2 Key Issues of Moneary Policy (saemen before he U.S. House Banking, Currency, and Housing Commiee, July 0, 974. Quoed in Burns (978, p. 75. Moneary Policy, Inflaion and Economic Expansion (SOMC posiion paper, Sepember, 976, p. 8.

16 4 Chase (965 argued, for example, ha radiional [i.e., monearis] analysis fails o recognize ha subsiuion beween ime deposis and securiies may be an imporan source of pro-cyclical variaions in he sock of money even in he face of counercyclical cenral bank policy. 4 Burns argued similarly ha he growh of moneary aggregaes can give a misleading indicaion of he sance of policy. In esimony before he House Banking Commiee in July 975, he saed ha he narrowly defined money supply, M, can acually be a misleading guide o he degree of moneary ease or resricion. or example, in periods of declining economic aciviy boh he ransacion demand for cash and he privae demand for credi will end o weaken and hus slow he growh of M. 5 By conras, Brunner and oher SOMC members argued ha he apparen endogeneiy of money o movemens in income refleced he ed s pracice of argeing nominal ineres raes. According o Brunner (98, Ineres rae argeing is he mos imporan condiion conribuing o reverse causaion. Ineres rae policy convers he moneary base, and consequenly he money sock, ino an endogenous magniude sensiively exposed o all ongoing shocks affecing marke raes of ineres. hese shocks are ransmied via ineres rae argeing ino acceleraions or deceleraions of moneary growh. urher, he argued, he effec on he base is a consequence of he ederal Reserve s ineres arge policy and would disappear wih proper moneary conrol. 6 In 975, Congress adoped House Concurren Resoluion, which required he ed o esablish arge ranges for moneary growh. he ed se ranges as required, bu growh frequenly fell ouside hose ranges. ed officials blamed he deviaion of 4 Quoed in Brunner (968, p Quoed by Brunner in Moneary Policy, Economic Expansion and Inflaion (SOMC posiion paper, March 8, 976, p Moneary Policy, Economic Expansion and Inflaion (SOMC posiion paper, March 8, 976, pp. 8-9.

17 5 moneary growh from he arge ranges on financial innovaions and changes in regulaion ha affeced money demand. he SOMC rejeced ha explanaion, however, conending ha heir sudies showed ha by conrolling he growh of he moneary base, he ed could conrol he growh of he money sock a a horizon of some wo o four quarers. 7 Brunner noed, however, ha effecive moneary conrol also requires some adapaions of inheried insiuions [including] radical simplificaion of reserve requiremens [and] in he manner of compuing required reserves. 8 he preceding discussion should clarify how he SOMC s views diverged from hose of he ed. he SOMC refleced he emerging New Classical views of riedman, Lucas, and ohers, many of which are feaures of mainsream macroeconomic models oday. Alhough oday here are few proponens of money supply policy rules, many aspecs of he SOMC policy framework are now widely acceped. hese include he naural rae hypohesis; he value of ransparen, rules-based policies; he imporance of credibiliy; and he noion ha in he long run, inflaion is deermined solely by moneary policy. 9 Like many moneary economiss oday, he SOMC held ha price sabiliy should be he paramoun objecive of moneary policy, and ha effors o limi flucuaions in economic aciviy or o promoe financial sabiliy are unlikely o succeed in he absence of price sabiliy. 7 See Brunner, Moneary Policy, Economic Expansion and Inflaion (SOMC posiion paper, March 8, 976, and Our Perennial Issue: Moneary Policy and Inflaion (working paper, Universiy of Rocheser, Sepember Moneary Policy and he Economic Decline (SOMC posiion paper, March 7, 975, p See McCallum (999 for a favorable recen discussion of money supply rules. Long-run moneary neuraliy is a feaure many New Keynesian and hybrid macroeconomic models (e.g., Goodfriend and King, 997; Kimball, 995; King and Wolman, 996; McCallum and Nelson, 999, as well as sandard real business cycle models (e.g., Presco, 986. Clarida, Gali and Gerler (999, Woodford (200 and many ohers emphasize he imporance of credibiliy and of ransparen, rules-based policies.

18 6 he following secion describes he SOMC policy rule and presens resuls from simulaion of a modern macroeconomic model ha embeds he SOMC rule in an effor o deermine how differen he pah of inflaion migh have been if he ed had followed such a rule. he Shadow s Policy rule he SOMC ariculaed a consisen and ransparen policy rule hroughou he Grea Inflaion era. Karl Brunner explained he rule in a posiion paper wrien in Sepember 979: his procedure is based on an esimae of he desired arge of moneary growh. his selecion depends on he desired longer-rae movemens of he price-level and he economy s normal real growh. A second sep formulaes esimaes of he ime profile for he moneary muliplier. hese wo seps imply he required growh rae of he moneary base. Projecions of he source componens of he base oher han ederal Reserve Credi deermine ulimaely he anicipaed pah of he ed s ne open marke operaions over various horizons ahead. []he ulimae arge for he growh of he moneary base should be announced ogeher wih he sepwise reducion proceeding over he nex hree o five years. 40 Alhough he SOMC policy rule specified a seady-sae growh rae for he moneary base, i was more han a simple, fixed-rae moneary rule. As noed previously, Brunner indicaed ha i migh be necessary o adjus he seady-sae moneary growh rae in response o permanen changes in economic growh or velociy. Moreover, he SOMC rule emphasized he ransiion from he curren moneary growh rae o he seady-sae growh rae. As he saemen above makes clear, he SOMC rule implied ha he adjusmen of moneary base growh o he ulimae arge should be gradual and publicly announced. 40 Our Perennial Issue: Moneary Policy and Inflaion (SOMC Posiion Paper, Sepember 979, p. 5. Reprined in Lys (997, pp

19 7 SOMC saemens ofen called for ransparen, consisen policies, and he SOMC was criical of he OMC s pracice of announcing moneary growh arges saring from he mos recenly observed level of he money sock a pracice ha came o be known as base drif. In conras, he SOMC s rule avoided base drif by esablishing a growh rae from he previous arge value: ( ln( M, ln( M, where M, is he arge value for he money sock a ime + esablished a ime. Base drif was avoided by recognizing he mos recen policy error: (2 ln( M ln( M, An example of his approach can be found in he SOMC policy recommendaion of March 975: We renew he recommendaion made a our Sepember meeing ha he growh rae of money be held a 5-/2 percen. However growh should no sar a ha rae from he curren low level. We recommend ha he money sock be brough o a level i would have reached in March 975, if our policy had been followed. A one-ime increase in money currency and demand deposis o $290 billion should be announced and provided by April 5. his increase would pu money growh back on he pah leading he economy oward full employmen a lower raes of inflaion han in recen years. 4 he SOMC s policy rule was forward looking, exending reducions in he money growh rae ino he fuure unil a noninflaionary moneary growh rae had been achieved. he SOMC never advocaed an abrup, cold urkey adjusmen of he moneary growh rae o a long-run arge. Insead, he policy rule was inherenly gradualis, calling for adjusmens in he moneary growh rae depending on iniial condiions and he hisorical rend. 4 Policy Recommendaions of he Shadow Open Marke Commiee, March 7, 975.

20 8 ypically, SOMC recommendaions advocaed a percenage poin reducion in he arge growh rae of he money sock per year unil a noninflaionary rae of growh was achieved. A ha poin, he policy rule called for a consan noninflaionary moneary growh rae. 42 ( ln( M, 2 ln( M,. 0 (4 ln( M, ln( M, (5 ln( M, n ln( M, n (6 ln( M, nk ln( M, nk, k =, or example, his approach is refleced in he policy saemen of March 978: One, he rae of moneary expansion in he pas year was beween 7% and 7.5%. We urge ha he rae be mainained a 6% in 978. wo, we recommend reducions of % a year in he average rae of moneary expansion unil a noninflaionary rae of moneary expansion is achieved. 4 SOMC policy saemens generally specify 4 percen as he noninflaionary rae of money growh. 44 We use his value in our simulaion of a model of money demand discussed below. wo equaions are necessary for a complee specificaion of he SOMC policy rule: i a definiion of velociy: 42 he SOMC rule also permied adjusmens o moneary base growh for srucural shifs in velociy. Noe ha he SOMC rule differed from ha of McCallum (988, who proposes a moneary base growh rule ha responds o deviaions beween acual and desired growh in nominal oupu, as well as o long-run shifs in velociy. 4 Policy saemen, Shadow Open Marke Commiee, March, See for example he SOMC policy saemens of Sepember 6, 974 (4% M growh, March 8, 976 (4.5% M growh is oo high for price sabiliy, Sepember, 976 (4% M growh, Sepember 2, 986 (-4% base growh, March, 996 (4% base growh and Sepember 4, 998 (4% base growh.

21 9 (7 ln( V ln( Y ln( P ln( M ; and ii a model of he demand for money (or he moneary base. SOMC documens rarely ariculaed an explici demand for money. 45 However, Brunner and Melzer (96, Melzer (96, and Brunner and Melzer (964b presen a demand for money (or velociy ha depends on a long-erm ineres rae. Subsequen research found evidence of a sable money demand relaionship, a leas hrough he 970s. 46 he relaionship beween base-money velociy and a long-erm nominal ineres rae is shown in igure, which is adaped from Anderson and Rasche (200. his figure shows a scaer plo of annual daa on he naural log of base velociy and he inverse of he Aaa bond rae over he years 99 hrough he years of he Grea Depression saring in 9 and exending unil 940 are ouliers, bu oherwise he relaionship is highly linear. he values for he years are also highlighed in igure. hese years are afer he sample ha Anderson and Rasche (200 examined. Noe ha he daa for fall on op of he scaer from he earlier sample. able, reproduced from Anderson and Rasche (200, shows he esimaed values of he slope of he scaer in igure over a sample period from 99 hrough 999. he esimaed equaion is also augmened wih an addiional variable ha measures he rae of defaul on corporae bonds o capure he increase in risk during he Grea Depression period and he fligh o currency ha occurred afer he firs wave of bank failures in 9. he esimaed slope of he relaionship beween he log of base velociy and he inverse of he long rae is robus across esimaors and invarian o he addiion of he risk variable. he 45 However, see Brunner, Moneary Policy, Inflaion and Economic Growh (SOMC posiion paper, Sepember, See, for example, Hezel (984, Hoffman and Rasche (99 or Rasche (987.

22 20 lower par of he able relaxes he resricion ha he income elasiciy of he demand for real base money is uniy. he resricion is no rejeced. ollowing he SOMC, and in ligh of he evidence from Anderson and Rasche (200, we specify he following a nonlinear demand funcion for base money: (8 ln( V L 2 ( i where i L is he long-erm nominal ineres rae. he noninflaionary rae of money growh,, can be defined in erms of his model. If inflaion is consan and expeced o be consan, hen, assuming ha he equilibrium real rae of ineres is consan, he long-erm nominal ineres rae is also expeced o be consan. hus, velociy is expeced o be consan in his equilibrium. he noninflaionary money growh rae is hen he growh rae of rend oupu plus he * rend inflaion rae ha is defined as price sabiliy. or simpliciy, we assume * 0. A low posiive and seady rend in measured inflaion could be consisen wih he SOMC s posiion on price sabiliy, alhough various SOMC policy saemens explicily advocaed a arge of zero inflaion or a sable price level. 47 Under hese condiions, he number of years expeced unil a reurn o price sabiliy under he SOMC s rule is n = 00*(, and he noninflaionary growh rae of money is. he model of money supply and demand can be respecified in erms of deviaions of money growh from he assumed rend growh of real oupu and in erms of an oupu gap. Define: 47 See SOMC policy saemens of Sepember 9, 996; March, 997; and Sepember 4, 998.

23 2 0.0 ; ln ln Y Y ln( ln( Y Y x ln( ln( P P hen he policy rule equaions and he definiion of velociy can be wrien in erms of deviaions from rend oupu growh as follows: (' m m Y M Y M,,,, ] ln [ln( ] ln [ln( (2' m Y M Y M m,, ] ln( [ln( ] ln [ln( (' 0. ] ln( [ln( ] ln( [ln(, 2,, 2 2, m m Y M Y M (4' 02. ] ln( [ln( ] ln( [ln( 2,, 2 2,, m m Y M Y M... (5' 0 0. ] ln( [ln( ] ln( [ln(,,,, n n n n n n m m Y M Y M (6', , ] ln( [ln( ] ln( [ln(,,,, k m m Y M Y M k n k n k n k n k n k n (7' m P x m P x Y M P Y Y V, ln ln ] ln( [ln( ln( ] ln( [ln( ln( o complee he analysis, we embed he SOMC s policy rule and he money demand funcion in a model of he real economy specifically, he New Keynesian model of Clarida, Gali, and Gerler (CCG, 999: IS curve (CGG, equaion 2.: 9 S g x E E i x ] [

24 22 Phillips Curve (CGG, equaion 2.2: 0 x E u We augmen he model wih a erm srucure approximaion from Shiller (979: n L,( n k i E ( i n k0 S k n, which for large n can be approximaed as:, 0 i L,( n k S ( ( i where i E i S n ( S k S L hen, or i ( i n, S L L 2 i i Ei ( n, Simulaion of he SOMC Policy Rule for he Grea Inflaion Linearized Model he only nonlineariy in he above model is he ineres elasiciy of he demand for money. In he following analysis, we presen a linearized version of he model, recognizing ha he semielasiciy of money demand ( below varies inversely wih he nominal ineres rae. We examine he sensiiviy of he model o various assumpions abou he value of his parameer. We define he linear operaor such ha j z E z j. Hence, j E z j z j L j z. Wih his noaion he five equaions (, (7', (9, (0, and ( can be wrien as

25 2 0 ( ( ln ln ( ( ln ln ln L L s s L u g m P P i i i x x i x P x V i V Equaions ( and (7' can be used o eliminae V ln from he model; equaions ( and (9 can be used o eliminae s i and he definiion of inflaion o eliminae leaving a hree-equaion model: L u g m i P x ( ( ln 0 ] ( [ ( ( (.0.0 or Y X A * (. Define he deerminanal polynomial of ( A as ( dea and he adjoin polynomial marix of ( A as ( adja. hen X adja Y dea ( (. he deerminan of ( A is ( ] ( [ ( ] ( [ ( ( ( ( ] ( [ A de and he adjoin marix of ( A is: ( ( ] ( [ ( ] ( [ ( ( ( ( ( ( ] (( ( [( ] ( [ ] ( [ ( ( However, ( ( ] ( [ L, which when subsiued ino he adjoin marix gives:

26 24 ( ( ( ( L ( ( ( ( ( L ( ( ( L ( ( L [( ( (( ] ( ( ( ( ( Deerminisic Seady Sae ( = L = he value of he deerminan in he seady sae is adjoin marix is, and he value of he seady-sae Hence, he seady-sae soluion of he model is independen of, and he only seadysae impac ha is affeced by is ha of he price level in response o a real ineres rae shock, g. rom one seady sae o anoher, he price level varies one-o-one wih he money sock. Across seady-sae equilibria wih a nonzero growh of money, boh he nominal ineres rae and he inflaion rae vary one-o-one wih he growh rae of he money sock. Hence, he isher effec holds across seady saes. Across seady saes wih nonzero money growh, he only effec ha depends on he value of is he response of real oupu o he change in money growh. Beginning in 968, moneariss consisenly assumed ha he long-run Phillips curve is verical (see, e.g., riedman, 968; Andersen and Carlson, 970; Poole, 978; Brunner and Melzer, 976, 99; and Mayer, 978, which, as noed previously, has become a sandard feaure of mainsream macroeconomic models. Hence we assume. 0, wih he resul ha he seady-sae impac of money growh on real oupu is zero.

27 25 Dynamics We need o calibrae he four remaining parameers o invesigae he dynamics of he model. We chose a range of values for corresponding o a nominal ineres rae from 4 percen o 8 percen and assume 2 = 0.02, consisen wih he esimaes repored in able. 48 We se = 0.94 following Shiller (979, able, p. 206, and we use esimaes of and , consisen wih ypical values found in he lieraure adjused o a model calibraed o annual daa. 49 Wih hese assumpions we compue he roos of he deerminanal polynomial of A (, which are he primary drivers of he dynamics of he model. hese roos are shown in able 2. or he parameer values ha we have chosen, he polynomial always has one real roo ha lies wihin he uni circle and wo roos ha lie ouside he uni circle. A high nominal ineres raes (> 0 percen he laer wo roos are real. A lower nominal raes hese roos are complex. However, when expressed in polar coordinaes, he polar angle of he complex roos ( in able 2 is always close o zero. 50 he deerminanal polynomial can be wrien in erms of is roos as 4 dea( ( /( r r ( r ( r ( r. 2 2 Assume ha r 2 and r are ouside he uni circle and define he inverible polynomial 5 R( ( /( r r ( r ( r, so he Aaa corporae rae in 98 was 4.7%. By 986 his rae had fallen o 7.78%. 49 We hank, wihou implicaing, Ed Nelson for helpful suggesions on values for hese parameers. 50 We compued he roos of his polynomial assuming values of in he range of [0.96,.0], in he range of [0.005, 0.045], in he range of [0.075, 0.45], in he range of [0.92, 0.98] and corresponding o nominal ineres raes in he range of [0.08, 0.4]. In all cases, we found one real roo less han uniy. he oher wo roos were someimes complex, bu in all cases were ouside he uni circle.

28 26 6 dea ( r R(. ( Since r ( r ( r L (, he model can be rewrien as 7 ( r L Y R ( * Adj[ A( ] X B( X he elemens of he firs column of B ( (coefficiens of he curren and expeced fuure money sock for he parameer values in able 2 are shown in igures 2 hrough 4. he low-order polynomial coefficiens for he response of oupu and he long-erm nominal ineres rae are moderaely sensiive o he level of he nominal ineres rae around which he model is linearized, bu he sensiiviy of he higher-order coefficiens in hese polynomials disappears as he coefficiens rapidly approach zero. he polynomial coefficiens in he response of he price level die off much more slowly han hose for oupu and he long-erm nominal rae and he low-order coefficiens show considerable sensiiviy o he level of he nominal ineres rae around which he model is linearized. Consequenly, we simulae he model wih differen assumpions abou he value of corresponding o differen assumed levels for he long-erm nominal ineres rae. Policy Experimens Clearly, if money demand is sable, prices and wages are flexible, and supply shocks are limied, hen a moneary growh rule like ha advocaed by he SOMC would yield superior inflaion conrol wih less oupu variabiliy han he sop-go policies acually pursued by he ed during he 970s. Moneary policy can affec real oupu in he shor-run in he modern New Keynesian model, such as CGG (999 and some oher models wih nominal rigidiies. We compare wo policy rules for money sock growh in he model specified above. he firs experimen is he gradualis monearis proposal of. 5 5 Expressions for R( are shown in Appendix 2.

29 27 he SOMC. We assume he economy is iniially in a seady sae wih an expeced consan nominal money growh rae of 0 percen. his ranslaes ino a nominal ineres rae of 4 percen, since we assume a 4 percen equilibrium real ineres rae. A some poin in ime afer expecaions of fuure money growh, oupu, and inflaion have been se, he moneary auhoriy surprises privae agens by implemening an immediae one percenage poin reducion in he money growh rae and announcing ha money growh will be reduced by an addiional one percenage poin in each subsequen year unil he growh rae reaches 4 percen. We assume ha he policy announcemen is fully credible so ha agens adjus heir expecaions in fuure periods accordingly. he only policy shock occurs in he firs period. 52 he second policy experimen is a one-ime cold urkey adjusmen of money sock growh. We again assume ha he economy is iniially in a seady-sae equilibrium wih a consan nominal money growh rae of 0 percen. In his case, he moneary auhoriy surprises agens by implemening a one-ime six percenage poin reducion in money growh and announcing ha he money growh rae will be mainained a he new value. Again, he announcemen is assumed o be fully credible so ha agens adjus heir expecaions in fuure periods accordingly. igure 5 shows he response of he model economy o he gradualis experimen. Wih expecaions se for fuure periods, he economy moves along a very fla shor-run Phillips curve. he inflaion rae is almos unchanged in he firs period, while real oupu falls sharply. As a resul, real money balances fall (inflaion is higher han money growh and he long- and shor-erm nominal raes increase slighly. In subsequen periods, he 52 If he policy announcemen occurred before agens se heir expecaions, here would no be any policy surprise, oupu would be unaffeced, and inflaion would fall in advance of he expeced fuure reducions in money growh.

30 28 coninued reducion in he growh rae of he nominal money sock is fully anicipaed, so he inflaion rae falls in advance of he decline in money growh, as does fuure expeced inflaion, and real balances rise. Wih he sharp decline in near-erm expeced inflaion, he shor-run Phillips curve shifs down and oupu rises above he seady-sae level. he long-erm and shor-erm nominal ineres raes fall, bu he shor-erm nominal rae falls more precipiously. Adjusmen o full equilibrium akes ime because of he auoregressive srucure buil ino he model. he assumed credibiliy of he moneary policymaker s commimen o he announced policy is obviously a key deerminan of he adjusmen pahs raced by our simulaions, as is our assumpion of raional expecaions. he ime pah of he economy afer he iniial policy surprise depends on he announcemen being acceped a face value and expecaions being adjused accordingly. 5 he SOMC frequenly sressed ha he impac of a disinflaionary policy depends crucially on he ransparency and credibiliy of he change in policy. or example, Brunner and Melzer (99, p. 75 noe In our analysis, if he policy of moneary conrol is credible, conrol errors are perceived as ransiory deviaions, so hey are absorbed by changes in ineres raes a he shores end of he yield curve. he consequences differ, of course, if moneary conrol policies lack sufficien credibiliy. Conrol errors, paricularly hose exhibiing serial correlaion, are inerpreed parly as permanen changes. Clearly he ed did no have much credibiliy when i announced a disinflaionary policy in lae 979, and he rajecory of he economy in he early 980s was significanly differen from ha simulaed here. As Brunner and Melzer (99, p. 75 argue, 5 Ball (994 analyzes a model wih saggered price seing and a credible disinflaion. He finds ha a gradual disinflaion can produce a boom, defined as an oupu pah ha rises above he naural rae emporarily and never falls below he naural rae (p Ball s model differs from he one used here in ha his demand for real balances is no ineres sensiive (his equaion (2 and he pah of he money sock is perfecly perceived a all poins in ime (he assumes ha he announcemen of he disinflaion is made a =0 and ha he expecaions operaor can be dropped for all 0, because firms have perfec foresigh afer he ed s announcemen. (p.286

31 29 Experience in he Unied Saes from 979 o 982 is an example of he increase in uncerainy ha can resul from inappropriae conrol procedures and operaions ha lack credibiliy. 54 igure 6 shows he reacion of he model economy o he alernaive policy of an immediae reducion in money growh from 0 percen o 4 percen wih a credible announcemen ha i will be mainained a ha rae henceforh. Again, inflaion falls lile a firs in response o he surprise reducion in money growh as he economy moves along a fla shor-run Phillips curve. he reducion in real balances is much larger, however, because he insananeous reducion in nominal money growh is much larger han in he gradualis case (6 percen vs. percen. he increase in he long-erm nominal ineres rae is also much larger. In he subsequen period, assuming ha he pledge o mainain nominal money growh a he lower rae is fully credible, inflaion adjuss and overshoos he new seady-sae rae, real balances increase, long-erm and shor-erm nominal ineres raes fall, and oupu begins a gradual increase back o he new seady-sae equilibrium. During his adjusmen period he inflaion rae approaches he seady-sae rae from below, real balances coninue o rise, and he long-erm nominal ineres rae gradually declines o he equilibrium level. In sum, he ransiion o he seady sae implied by a large, one-ime reducion in money sock growh involves a larger decline in oupu growh, and more variabiliy in inflaion and oupu growh, han he implied by a gradual reducion in money sock 54 aylor (99, p. 207 argues similarly: In he period afer a new policy rule has been pu in place, people are unlikely eiher o know abou or undersand he new policy or o believe ha policymakers are serious abou mainaining i Because expecaions only gradually converge during his ransiion period, he impac of he policy rule on he economy may be quie differen han projeced by an analysis ha assumes raional expecaions.