THE IMPACT OF THE FEDERAL RESERVE'S MONEY

POLICIES ON THE ECONOMY

HEARINGS

BEFORE THE

SUBCOMMITTEE ON

DOMESTIC MONETARY POLICY

OF THE

COMMITTEE ON

BANKING, CURRENCY AND HOUSING

HOUSE OF REPRESENTATIVES

NINETY-FOUKTH CONGRESS

SECOND SESSION

JUNE 8, 9, 10, AND 24, 1976

Printed for the use of the

Committee on Banking, Currency and Housing

U.S. GOVERNMENT PRINTING OFFICE

73-959 WASHINGTON : 1976

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Federal Reserve Bank of St. Louis
COMMITTEE ON BANKING, CURRENCY AND HOUSING

HENRY S. REUSS, Wisconsin, Chairman

LEONOR K. (MRS. JOHN B.) SULLIVAN,

Missouri

THOMAS L. ASHLEY, Ohio

WILLIAM S. MOORHEAD, Pennsylvania

ROBERT G. STEPHENS, JR., Georgia

FERNAND J. ST GERMAIN, Rhode Island

HENRY B. GONZALEZ, Texas

JOSEPH G. MINISH, New Jersey

FRANK ANNUNZIO, Illinois

THOMAS M. REES, California

JAMES M. HANLEY, New York

PAR REN J. MITCHELL, Maryland

WALTER E. FAUNTROY,

District of Columbia

LINDY (MRS. HALE) BOGGS, Louisiana

STEPHEN L. NEAL, North Carolina,

JERRY M. PATTERSON, California

JAMES J. BLANC HARD, Michigan

CARROLL HUBBARD, JR., Kentucky

JOHN J. LAFALCE, New York

GLADYS NOON SPELLMAN, Maryland .

LES AuCOIN, Qr^gon

PAUL E. TSONGAS, Massachusetts

BUTLER DERRICK, South Carolina

PHILIP H. HAYES, Indiana

MARK W. HANNAFORD, California

DAVID W. EVANS, Indiana

CLIFFORD ALLEN, Tennessee

NORMAN E. D'AMOURS, New Hampshire

STANLEY N. LUNDINE, New York

ALBERT W. JOHNSON, Pennsylvania

J. WILLIAM STANTON, Ohio

GARRY BROWN, Michigan

CHALMERS P. WYLIE, Ohio

JOHN H. ROUSSELOT, California

STEWART B. McKINNEY, Connecticut

JOHN B. CONLAN, Arizona

GEORGE HANSEN, Idaho

RICHARD T. SCHULZE, Pennsylvania

WILLIS D. GRADISON, JR., Ohio

HENRY J, HYDE, Illinois

RICHARD KELLY, Florida

CHARLES E. GRASSLEY, Iowa

MILLICENT FENWICK, New Jersey

RON PAUL, Texas

PAUL NELSON, Clerk and Staff Director

WILLIAM P. DIXON, General Counsel

MICHAEL P. FLAHERTY, Counsel

GRASTY CREWS II, Counsel

• ORMAN S. FiNfc, Minority Staff Director

GRAHAM T. NORTHUP, Deputy Minority Staff Director

SUBCOMMITTEE ON DOMESTIC MONETARY POLICY

STEPHEN L. NEAL, North Carolina, Chairman

JOSEPH G. MINISH, New Jersey JOHN B. CONLAN, Arizona

MARK W. HANNAFORD, California GEpRGE HANSEN, Idaho

JAMES J. BLANCHARD, Michigan ^WILLIS D. GRADISON, JR., Ohio

LEONOR K. (MRS. JOHN B.) SULLIVAN,

Missouri

CLIFFORD ALLEN, Tennessee

NORMAN E. D'AMOURS, New Hampshire

(n)

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Federal Reserve Bank of St. Louis
CONTENTS

Hearings held on—

June 8, 1976 _.- 1

June 9, 1976 29

June 10, 1976 115

June 24, 1976 - 147

Text of H. Con. Res. 133 12

STATEMENTS

Adams, Hon. Brock, a Representative in Congress from the State of

Washington : _ _ 13

Buckley, Hon. James L., U.S. Senator from the State of New York 5

Fiedler, Edgar R., vice president, economic research, general, the National

Industrial Conference Board 31

Jordan, Jerry L., vice president and chief economist, Pittsburgh National

Bank 36

Meiselman, David I., professor of economics, Virginia Polytechnic Institute

and State University 55

Meltzer, Dr. Allan H., Graduate School of Industrial Administration,

Carnegie-Mellon University 178

Partee, Hon. J. Charles, member, Board of Governors of the Federal

Reserve System 115

Perry, George, senior fellow, Brookings Institution 64

Pierce, Dr. James L., economic consultant and professor of economics,

University of California, Berkeley 149

ADDITIONAL INFORMATION SUBMITTED FOR THE RECORD

Adams, Hon. Brock, letter dated May 27, 1976, from Chairman Stephen L..

Neal, requesting testimony on specific economic questions and policy

issues 13

Buckley, Senator James L., prepared statement 7

Fiedler, Edgar R.:

''Constructing a Balance Sheet for the United States," summary of

study from the Morgan Guaranty Survey, May 1976 1 105

Prepared statement SB

Gradison, Hon. Willis D., Jr.:

"All That Worry About Fed Policy," article from the Washington

Post of June 10, 1976 130

"The Critics Ask: Is Monetarism Dead?" article from Business Week

magazine, June 7, 1976 128

Jordan, Jerry L., prepared statement with attached charts 40

Meiselman, David I., document submitted entitled "Money, Factor

Proportions, and Real Interest Rates," presented at the Zurich meetings

of the Econometric Society, September 10, 1964 67

Meltzer, Dr. Allan H., papers submitted on studies of inflation abroad:

"An Empirical Analysis of Inflation, Unemployment and Macroeconomic Policy in Open Economies," by Michael J. Hamburger

and Robert D. Reisch 194

"Some International Evidence on Output-Inflation Tradeoffs," by

Robert E. Lucas, Jr 222

(in)

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IV

Neal, Chairman Stephen L.:

"A Vote for Today's System," article by Dr. Allen H. Meltzer, from Page

the Wall Street Journal of May 19, 1976 243

"Congress and the Federal Reserve," article by Dr. Milton Friedman,

from Newsweek magazine, June 2, 1975 242

Exhibits submitted entitled "Yearly Money Supply Changes," showing percentage changes from 1 month in 1 year to the same month

in the next year with yearly changes in the cost of living occurring

23 months later 3, 4, 148

"The Coming Problem of Inflation," article by Hobart Rowen from

the Washington Post of May 13, 1976 241

"Where the Economy Goes From Here," interview with Dr. Arthur

F. Burns, Chairman of the Federal Reserve Board, from U.S.

News & World Report magazine, May 17, 1976 234

Partee, Hon. J. Charles, letter dated June 22, 1976, containing reading

references on central bank operations and the conduct of monetary policy

in other countries with attached data on high employment Federal

budget surplus or deficit (quarterly data provided from the Council of

Economic Advisers, 1952-75) 143

Pierce, Dr. James L.:

Papers submitted on monetary policy formulation:

"Monetary Aggregates and Money Market Conditions in Open

Market Policy" 162

"Quantitative Analysis for Decisions at the Federal Reserve" __ 157

Prepared statement 152

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Federal Reserve Bank of St. Louis
THE IMPACT OF THE FEDERAL RESERVE'S MONEY

POLICIES ON THE ECONOMY

TUESDAY, JUNE 8, 1976

HOUSE OF REPRESENTATIVES,

SUBCOMMITTEE ON DOMESTIC MONETARY POLICY

OF THE COMMITTEE ON BANKING, CURRENCY AND HOUSING,

Washington, D.O.

The subcommittee met, pursuant to notice, at 10:01 a.m., in room

2128, Rayburn Office Building, Hon. Stephen L. Neal (chairman of

the subcommittee) presiding.

Present: Eepresentatives Neal, Hannaford, Blanchard, and

D'Amours.

Mr. NEAL. This morning the Subcommittee on Domestic Monetary

Policy will begin hearings on the impact of the Federal Reserve's

money policies on the economy. To many people, the functions of the

Federal Reserve System and its Open Market Committee, which decides the Nation's money policy, remain a mystery. Many Americans

do not know how important money policy is to the prices of the goods

they buy, the interest rates they pay, their job opportunities, wages,

and profits.

Our hearings are intended to cover several specific points which

include:

1. How money policy affects the cost of living;

2. How it affects production and employment;

3. How interest rates are affected by money supply changes, both

directly and through changes in prices, production, and employment;

4. How government spending and tax policies affect money policy

and their relationships to prices, interest rates, production, and employment; and

5. Whether Congress should set goals for economic growth, unemployment, inflation, and interest rate levels and require the Federal

Reserve to promote achieving these goals.

In preparation for these hearings, I have asked the staff to compile

statistical data on our economy's performance and the growth of money

supply, and the level of Federal Government surpluses or deficits since

1954. This work is going forward. To date, it has centered on how

money growth and Federal deficits have affected the rate of inflation

and the frequency of recessions. We have prepared an exhibit to bring

these relationships into focus. As our exhibit shows, the rate of growth

of money supply has followed a roller-coaster pattern, which tilted

upward since 1964. As a result, we have suffered periodic recessions

and since 1964, they have been imposed on waves of inflation.

(l)

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Our exhibit maps the relationship between inflation measured from

1 month this year to the same month next year to money growth, also

measured over 12-month periods, occurring 23 months earlier. The

relationship between inflation and money growth was mapped with a

23-month lag because it takes time for changes in money supply to

affect the inflation rate; and the staff found, using computer studies,

that the effects of increases or decreases in money supply on the rate of

inflation peak after approximately 23 months. As the exhibit indicates,

the rate of inflation rises and falls in the wake of increases and decreases in the growth of money. About 60 percent of our inflation can be

explained by changes in money growth occurring 23 months earlier.

And this, let me emphasize, holds as much, perhaps even more, for

the 1970's as for the 1950's and 1960's.

[The exhibit referred to by Chairman Neal follows:]

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EXHIBIT 1

YEARLY MONEY SUPPLY CHANGES

Percentage Changes From One Month in One Year to the Same Month in the

Next Year

Percent Change

J351 'S 5 '5 5 '5 7 '5 i '6 9 '6 0 '51

 l i l '6 3 't i '5 5 '6 5 '6 7 '6 3 .'59 - '7 0 '7 1 '7 2 '7 3 '7 4 '75/7 5

Percent Change

EXHIBIT 1 (OVERLAY A)

RECESSION PERIODS

SiK Oil OEC-N'CV. NOV. MAS.

'65 '57 ' « '70 '73 '75

' '•••••0!. ' ' '.....'..."..'..,.. !UA.,..I.,,...,J..,..^1;

ISS1 '55 '55 '57 '55 '69 '60 '61 "^ .'6 3

 lh\ 'S3 '65 '57 '53 .'5 9 '70 !7I '72 '73 '74 '75 '75

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EXHIBIT 1 (OVERLAY B)

YEABLY MONEY SUPPLY CHANGES

Percentage Changes From One Month in One Year to the Same Month in the

Next Year

YEARLY CHANGES IN THE COST OF LIVING OCCURRING 23 MONTHS LATER

RECESSION PERIODS

Percent Change

1951 '55 '« '57 '56 '59 '60 '61 '6i '63 '64 '55.'65 '57 '68 '69 '70 '71 '72 '73 '74 '75 '7?

EXHIBI T 1 (OVERLA Y C)

YEARL Y MONE Y SUPPL Y CHANGE S

Percentage Changes From One Month in One Year to the Same Month in the

Next Year

YEARLY CHANGES IN THE COST OF LIVING OCCURRING 23 MONTHS LATER

RECESSION PERIODS

FEDERAL GOVERNMENT SURPLUS OR DEFICIT

Percent Change $ Billions

-20

- 0

-2

' 1354 '55 '58 '5? 5ft '63 '60 '61 '61 '63 '64 '65 '65 '67 '68 '63 'TO' '7! '72 '73 '74 '7$ '76

D

E

F

I

C

I

T.

-(60)

(CO}

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The exhibit also shows that each time our economy experienced a

recession since 1954, it occurred after the Fed moved to sharply decrease the growth of money supply. Finally, the exhibit maps the

relationships between recessions, inflation and money supply and Federal deficits. In this regard, the conclusion that emerges is that the

impact of deficits on the inflation rate and recession is weak as compared to that of money growth.

While the subcommittee will refine its work in these areas, the staff

also is studying the relationships involving unemployment and interest i^ates. We hope that the results of this work will produce a better

understanding of the ways our economy is affected by Federal Keserve policies and promote the use of responsible guidelines for coordinating monetary and fiscal policies.

This morning we are fortunate to open our hearings by receiving

testimony from our distinguished colleagues. Senator James L. Buckley and Congressman Brock Adams. We will question the witnesses

together after testimony is presented.

Senator Buckley, we will hear from you first. Senator Buckley is

on a tight schedule this morning, and we want to accommodate that

as much as possible.

Senator, welcome. We are trying to determine in a very objective

way the importance of the Federal Reserve's monetary policy to the

economy, how well that policy has been administered over the last

several years, and any recommendations our witnesses might have.

The public debate, as you know, centers on fiscal policy; and we

know that that is important. But we are trying to now determine the

importance of monetary policy.

I know you are on a tight schedule, Senator. If you would like to

summarize your statement, please do so, or proceed as you wish.

STATEMENT OF HON. JAMES I. BUCKLEY, A U.S. SENATOR PROM

THE STATE OF NEW YORK

Senator BUCKLEY. In my statement I have woven in some statements

about fiscal policy. Frankly, in terms of the perceptions in this body,

these things are interwoven. If I may, I will omit some portions of

my statement. I probably will read most of it.

Mr. NEAL. I did not mean to hurry you. We will be interested in

every word.

Senator BUCKLEY. Thank you very much, Mr. Chairman. They will

call me if I have to go for a vote. I want to express my appreciation

for the opportunity to speak before your subcommittee, Mir. Chairman.

To its credit, the Congress has established in the last 2 years, a

method for dealing with burgeoning Federal expenditures. The new

House and Senate Budget Committees have been assigned the responsibility of channeling Federal spending so as to make it more responsive

to the overall macroeconomic picture.

I am a member of the Senate's Budget Committee and believe that

there is great potential for this body to reestablish control over Federal spending and bring it in line with our national priorities and to

take a better oversight of the whole economic picture.

I am concerned, however, with the unspoken assumptions that are

reflected in much of the work performed by the new Congressional

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Budget Office. As you know, this organization was created by the

Budget Control Act of 1974. Its mission is to provide nonpartisan

technical support for the new Budget Committees and to the Members

of both Houses.

However, the evidence suggests a disturbing bias in this Office toward

the type of economic policy which was first popularized 40 years ago

and which has since proven itself to be unrealistic and costly.

It is unrealistic and costly because it advocates the transfer of

resources from the most productive private sector to less productive

uses under the supervision of a growing Federal bureaucracy.

It should be quite clear at this point in our economic history that

larger Federal deficits will not be stimulative. Larger deficits require

large borrowing from the Nation's capital markets.

This same capital could be better employed to produce real goods

and services, instead of adding to the ranks of unproductive central

planners and public service employees.

Because of its Keynesian bias, much of the analysis emanating from

the Congressional Budget Office is shortsighted and often patently

incorrect. CBO has advised us, for example, that present inflation

rates are not affected by present policy changes.

Therefore, CBO concludes, we need not fear greater Federal spending, larger deficits, and a rapid increase in the money supply.

While CBO is correct that inflation rates are not changed this

month by a liberal dose of spending and money creation, the inflation

rates a year and a half later are determined by such policies.

A year and a half later we would bear the burden of excessive growth

in the money supply designed to help with a short-term problem in

the present.

The truth is that the impact of stimulative policies may arrive at a

time when the economic expansion is already in full swing; that the

stimulative policies supported by CBO projections would generate

unnecessary inflation and probably lead to another recession.

These are the policies that a majority in the Congress is inclined

to support, but which Presidential vetoes have kept under some sort

of rein.

I suggest that the Congress should be wary about placing too much

reliance on CBO projections, as these may prove somewhat less than

a thousand percent reliable.

CBO predicted inflation in 1976 would be in the range of 6.5 percent

to 8.5 percent, and yet we are currently experiencing an inflation rate

of about 3 percent. CBO advised against restrictive monetary policy

because, according to that Office, it would increase unemployment, and

yet the unemployment rate is now falling despite responsibly- restrictive rates of growth in the money supply.

And, the CBO warned that such a monetary policy would cause

interest rates to rise. Yet in yesterday's New York Times we find an

article attributing a rebirth of confidence in the credit markets in

part to "the decline in the Nation's narrowly defined money supply

over the last 2 weeks," and the expectation "that long-term rates could

once again begin declining."

It seems to be clear that investors are now sophisticated enough to

anticipate the inflationary effects of an expansive monetary policy,

even if the CBO computer models are not.

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I go on to suggest that neither the Congress nor the administration

should take too much credit for what is happening in terms of our

recovery. Actually, because we have not been too active in terms of

monetary stimulation, the private sector has more or less taken care

of itself.

I then go on to suggest that the Congress—this is beyond the particular scope of this hearing—should concern itself about taking off

some of the burden on our productive private sector.

Real gains can be achieved through the elimination of real constraints on commerce. At least, in the longrun, fiscal and monetary

policy can only permit real growth in production and income to be

achieved; it cannot induce such growth.

It is the perception of this fact that has in part caused Dr. Burns

and the Federal Reserve Board to restrain the growth in the money

supply at a time when others have been calling for the immediate ancl

rapid growth of the monetary aggregates in a largely illusory pursuit

of lower interest rates.

There seems to be little appreciation in some sectors for the intimate relationship that exists between rapid increases in the money

supply, high irates of inflation and high interest rates.

And yet, this is one of the best documented relationships in macroeconomic theory. The relationship between rising prices and high

interest rates was noted at the turn of the century. The connection

between the money supply and price levels was established long before

that and though lost sight of in recent decades, it is no less valid.

Recent restraint by the Federal Reserve Board in the growth of

the money supply has led to reduced inflation and lower short-term

interest rates. But there is still work to be done.

Long-term interest rates remain high, and they will be reduced

only when investors have regained faith in our management of the

money supply.

My emphasis on real growth for the economy brings me logically

to discuss next the type of legislation that would be most helpful in

our present economic situation. Again I would like to emphasize the

need for reducing the economic constraints which abound in our code

of laws.

I have got a vote, Mr. Chairman. I have a terribly eloquent statement toward the end.

Mr. NEAL. IS there any chance of youtr coming back ?

Senator BTJCKLEY. Let me get a feel for the floor and if I can, I shall.

Mr. NEAL. I am interested in your comments on the relationship of

the money supply and inflation.

Senator BUCKLEY. It is recognized in House Concurrent Resolution

133.1 was cosponsor of that.

Mr. NEAL. Thank you very much for coming.

[The prepared statement of Senator Buckley follows:]

PREPARED STATEMENT OF HON. JAMES L. BUCKLEY, U.S. SENATOR FROM THE

STATE OF NEW YORK

I would like to speak today on the subject of the role of the federal government in the country's economic system, on the capabilities we have to influence

that system, and on the responsibilities that we must accept for OUT intervention

in that system.

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We can only hope to realistically assist in the stable growth of the macroeconomic system if we fully understand our capabilities, our limitations and

our responsibilities, for we are dealing with a most delicate mechanism when

we attempt to direct the course of the economic system. Therefore, it is essential that the actions we take are those which are realistically complementary

to the rest of the decisions made in the private and public sectors.

Perhaps it would be useful, before talking about what the relationship between

the federal government and the economy should be, to note the present extent

of our expenditures. In the last five years, for example, federal spending averaged

twenty-one percent of our Gross National Product. It is quite clear that federal

spending activity is already a heavy burden for the economy.

My comments today are directed in part to the question of whether the burden

is necessary.

To its credit the Congress has established in the last two years a method

for dealing with burgeoning expenditures. The new House and Senate Budget

Committees have been assigned the responsibility of channeling federal spending

so as to make it more responsive to the overall macroeconomic picture. I am

proud to be serving as a Member of the Senate's Budget Committee and believe

that there is great potential for this body to re-establish control over federal

spending and bring it in line with our national priorities.

But this potential has not been fully demonstrated, as I believe that we can

do more toward realistically assessing the value of certain costly programs and

substituting for them policies which allow for a more efficient allocation of our

finite national resources.

One area of concern which I have watched closely in recent months has been

the development of the new Congressional Budget Office. As you know, this

organization was created by the Budget Control Act of 1974. Its mission is to

provide nonpartisan technical support for the new Budget Committees and to

the Members of both Houses. However, the evidence available to date indicates

a disturbing bias in this Office towards the type of economic policy which was

first popularized forty years ago and which has since proven itself to be unrealistic and costly. It is unrealistic and costly because it advocates the removal of

resources and initiative from the more productive private sector so that these

same scarce resources can be placed under the control of a growing federal

bureaucracy for the production of services which are far down on our nation's

list of priorities.

In the long run, Keynesian prescriptions for recovery should be recognized as

either inflationary, wasteful or unstimulative to the private sector. Econometric

analysis has shown fiscal policy to be ineffective.

It should be quite clear at this point in our economic history that larger federal

deficits will not be stimulative. Larger deficits require large borrowing from the

nation's capital markets. This same capital could be better employed to produce

real goods and services, instead of adding to the ranks of unproductive central

planners and public service employees.

One additional problem with the approach used by CBO is that they assume

that increases in government spending add immediately to our national product.

Therefore, under these assumptions, solving the problem of unemployment merely

requires the addition of more federal expenditures to national income. This

approach totally ignores the fact that there are lags in the fiscal system.

Under the CBO model, there is little need to worry about inflation, the exact

target for full employment levels, or the miscalculation of the timing of impact

of these fiscal initiatives. Unfortunately, each of these issues provide, in the real

world, the source of additional problems for the economy.

Because of this Keynesian bias, much of the analyses emanating from the

Congressional Budget Office are shortsighted and often patently incorrect. CBO

has advised us, for example, that present inflation rates are not affected by

present policy changes. Therefore, CBO concludes, we need not fear increased

spending, larger deficits, and a rapid increase in the money supply.

While CBO is correct that inflation rates are not changed this month by a

liberal dose of spending and money creation, the inflation rates a year-and-a-half

later are determined by such policies. A year-and-a-half later we would bear the

burden of excessive growth in the money supply designed to help with a shortterm problem in the present. The truth is that the impact of stimulative policies

may arrive at a time when the economic expansion is already in full swing; that

the stimulative policies that CBO indirectly recommends would generate unnecessary inflation and probably lead to another recession.

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Wliile the Congressional Budget Office was set up as a nonpartisan organization, the analyses which it provides reflect a total dedication to a Keynesian fiscal

emphasis type of approach.

Perhaps it is this lack of analytical quality which forces the Budget Office into

the series of erroneous predictions which we have recently observed. CBO predicted in 1975 that recovery in the automobile industry would not be sufficient to

lead a strong recovery, and yet both a strong recovery and a rapid increase in

automobile production are realities.

CBO advised against restrictive monetary policy because, according to that

office, it would increase unemployment, and yet the unemployment rate is now

falling, despite responsibly restrictive rates of growth in the money supply.

Perhaps the lackluster record of CBO in making these predictions reflects the

lack of confidence in the private sector which underlies so many of the economic

proposals in the Congress and which find support in the CBO projections.

This brings us to the question of who might take credit for the present economic expansion which is solid and expected to continue through 1977. I have

watched with some amusement as some individuals on Capitol Hill take paing

to ensure that the Congress, rather than the Administration, is credited with the

recovery. At the same time, Administration spokesmen are claiming the credit

for themselves. I am reminded of the old description of monetary policy as being

like a string—you can pull on it, but you can't push. Really, all government economic policy is like that string, and the best that we can do is fail to pull on it.

I suggest then that we—along with the Federal Reserve Board—only take credit

for failing to rein in economic growth and leave the real credit for economic

expansion to the private sector where it belongs.

On the other hand, we in the Congress might best help out the recovery by

eliminating the great many structural constraints which are now imposed on the

private sector. These constraints function to reduce real gross national product

and impose heavy, yet needless costs on businesses and consumers alike. Examples of these types of constraints include unnecessary regulation by the Interstate Commerce Commission over many forms of ground transportation, which

distorts their efficiency and adds many billions annually to shipping costs;

uncalled-for regulation of airlines rates by the Civil Aeronautics Board; and there

is also the unfortunate rigidity of the minimum wage laws which do not take

into consideration the need to create differential minimums for teenagers who

are less skilled and who do not have an opportunity to be hired at the present

minimum wage rates; any employer who might find it attractive to hire these

unemployed youths at a lower wage would be in violation of the law, thus many

unemployed but ambitious teenagers are, in effect, outlawed from the labor

market

There are many more examples in this list of constraints, but my purpose

here today is to emphasize the need for real gains in the economy. Real gains

can be achieved through the elimination of real constraints on commerce. At

least, in the long-run fiscal and monetary policy can only permit real growth in

production and income to be achieved; it cannot induce such growth. It is the

perception of this fact that has in part caused Dr. Burns and the Federal Reserve Board to restrain the growth in the money supply at a time when others

have been calling for the immediate and rapid growth of the monetary aggregates to reduce interest rates in the short run.

There seems to be little appreciation in some sectors for the intimate relationship that exists between rapid increases in the money supply, high rates of

inflation and high interest rates. And yet this is one of the best documented

relationships in macroeconomic theory. The relationship between rising prices

and high interest rates was noted at the turn of the century. The connection

between the money supply and price levels has been more recent, but is no less

valid.

Recent restraints by the Federal Reserve Board in the growth of the money

supply has led to reduced inflation and lower short term interest rates. But

there is still work to be done. Long term interest rates remain high, and they

will be reduced only when investors have regained faith in our management

of the money supply.

My emphasis on real growth for the economy brings me logically to discuss

next the type of legislation that would be most helpful in our present economic

situation. Again, I would like to emphasize the need for reducing the economic

constraints which abound in our code of laws. But I fear that such attractively

labelled but counter-productive legislation as S. 50. The Humphrey-Hawkins "Full

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10

Employment Bill," may prove far too tempting to the Congress. This bill is a

blueprint for catastrophe. Let me review some of its more disturbing features.

The bill would set about to achieve an unemployment rate for adults of 3 percent,

regardless of the cost. It would do this, in part, by making the government the

employer of last resort. Plans call for the creation of well-paying public service

employment jobs to artificially reduce unemployment statistics. The bill, in

effect, calls for a broad centralized planning response to solve the problems of

youth unemployment, price level inflation, efficiency in the federal bureaucracy,

and a reordering of our priorities in the fields of energy, transportation, health

care, the environment and several other key areas of concern to all of us.

While these goals are certainly laudable by any standards, the most notable

feature of the Humphrey-Hawkins proposal is that it provides us, with one

exception, no indication of how these goals are to be achieved. Thus, we stand

right where we are. The bill makes no progress in finding viable solutions to

our national problems. The one prescription which is specified in the bill is the

use of public service employment to ensure that the unemployment rate is reduced

to three percent.

How realistic is a goal of three percent unemployment, and what will it

<?ost? These are questions which must be addressed before a thorough understanding of the bill's destabilizing potential can be grasped. The last time that

our economy saw unemployment rates anywhere close to three percent was

during the height of the Vietnam War, but these same years also witnessed the

beginning of the inflation which we are still fighting. Unfortunately, given the

method of calculating the unemployment rate, a goal of three percent is unquestionably beyond reach, given any reasonable assumptions about the growth of

the money supply and sympathy for long-range goals.

Should such a goal become law, inflation rates of fifteen percent and above

could become a reality. The truth is that this legislation pays only lip-service

to the goal of fighting inflation, since monetary policy under Humphrey-Hawkins

would be used primarily to attempt to bring unemployment down to a three

percent level. Inflation would be induced by the need for large federal deficits

to pay for the millions of public service employees required to meet the employment goals and the need to monetize these deficits in order to avoid any increase

in taxes.

The public service employment, then, while providing jobs for only a few,

would have the wages of the remaining population devalued by inflation. This

would hit hardest those Americans living on fixed incomes and would generate

pressure for yet another recession.

Another, and perhaps ironic, consequence of S. 50 is that it would most likely

hurt those who the sponsors intend to help: the unemployed, unskilled labor.

The jobs "created" by S. 50 will be filled with primarily unskilled persons who

actually need jobs where training and advancement are possible. HumphreyHawkins consigns a large portion of the population, including a disproportionate

number of minorities, to a lifetime of unskilled, unrewarding public employment.

Government programs, such as Humphrey-Hawkins, would move these groups into

a permanent, second-best status and thus are cruel and socially destructive.

How does Humphrey-Hawkins plan to handle the problem of rising prices? By

developing a policy for price and wage controls. Again a policy which has never

been shown to be effective in the long run for controlling inflation!

Economists really see one limited role for price and wage controls, and this is

as a method of demonstrating dedication to the control of runaway inflation. But

this is a short-run use for these controls and is based on the logic that if people's

expectations about the future course of prices can be altered at the same time

that realistic control is established over the growth of the money supply, then the

pressure for increases in interest rates and other prices can be eliminated. But

we have long ago passed the point where anyone but the least sophisticated

observer believes that price controls alone are effective in halting inflation.

Monetary policy is not capable of controlling the inflation rate under this

legislation, inasmuch as it is being used to attempt to achieve an unemployment

rate of three percent. It is quite clear that, under any set of assumptions, controlling inflation would not be a major feature of the Humphrey-Hawkins Bill.

What, then, can be done to accommodate the real growth of the economy? I

suggest that we address our attention to the achievement of longer-range goals,

such as price level stabilization and a reduction in the present amplification of

the business cycle.

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These goals can be achieved by a reasonable control of monetary growth and an

attempt to eliminate the large deficits presently incurred in the federal budget

Large deficits are undesirable because they either reduce the amount of capital

available in the private sector, thereby restricting real growth, or they induce

an increase in the money supply which will generate price level inflation.

Thus, fiscal policy by itself, in the form of deficit spending, has never been

shown to produce a net gain in real income. At best a deficit might induce a

temporary gain for a few months, but this gain is offset shortly by decreased

private investment when the increased interest rates in capital markets reflect

borrowing by the Treasury.

Alternatively, the use of monetary policy can have short-run positive effects

on the real income of the nation, but I must emphasize the short-run qualification

in this statement. For, while the increase in the money supply can make additional capital available to a limited extent, the unpredictability of the results of

such action can easily lead to an increase which is too rapid and inflation is the

unfortunate result. We do not have sufficient knowledge to make predictions about

the results of today's monetary policy on tomorrow's income and price levels to

use it well.

Rather, I would like to see a commitment to a fiscal policy which eliminates

deficit spending while capping the growth of government spending, and a monetary policy which limits growth in the money supply to a rate cpps^stent with

the long-term real growth potential of the economy and a legislative program

which eliminates the constraints on commerce that I noted above.

In the early part of 1975, at the nadir of the downturn, I joined with Senator

Proxmire in supporting a resolution which contained two very important points

involving monetary policy. That resolution, which passed as House Concurrent

Resolution 133, established the practice that the Chairman of the Federal Reserve

Board announce quarterly the monetary growth targets for the Open Market

Committee. But as important as this provision is, I am of the opinion that the

adoption by the Congress of a new policy by which monetary growth is guided

is more important. Under the resolution the Federal Reserve is directed to

establish targets which are in line with the economy's long-term ability to grow.

Onr problem in the past is that the Federal Reserve's monetary policy has been

constructed along lines which were only haphazardly related to this fundamentally important guideline. Monetary targeting which is set independently

of the economy's growth potential produces the kind of erratic monetary growth

policies which take us from inflationary rates to a constricting zero level, as

was the case in the latter half of 1974. It is my view that the stability and duration of the recovery is intimately linked to keeping monetary targets within

the ranges recently achieved, and not to the following of false guidelines, such

as short-term fluctuations in interest rates.

[At the request of Chairman Neal, the text of H. Con. Res. 133 is

inserted at this point in the record:]

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94TH CONGRESS

1ST SESSION H. CON. RES. 13 3

IN THE HOUSE OF REPRESENTATIVES

MARCH 24,1975

Ordered to be.printed as passed

CONCURRENT RESOLUTION

Whereas article I, section 8. of the Constitution provides that Congress

shall have the money power, namely "to coin money and regulate

the value thereof7';

Whereas Congress established the Federal Reserve Board as its agent,

and delegated to its agent the day-to-day responsibility for managing the money supply;

Whereas the United States economy is now suffering from excessivelyhigh unemployment and a decline in production and the gross,

national product, together with inflation; and

Whereas the economy's performance in part is affected by changes in

the rate of growth of the monetary and credit aggregates: Now,,

therefore, be it

. Resolved by the House of Representatives (the Senate concurring),.

That it is the sense of Congress that the Board of Governors of the

Federal Reserve System and the Federal Open Market Committee—

(1) pursue policies in the first half of 1975 so as to encourage

lower long term interest rates and expansion in the monetary

and credit aggregates appropriate to facilitating prompt economic;

recovery; and

(2) maintain long run growth of the monetary and credit

aggregates commensurate with the economy's long run potential to*

increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long term interest,

rates.

Pursuant to this resolution, and taking into account the international

flows of funds and conditions in the international money and credit,

markets, the Board of Governors shall consult witli Congress at semiannual hearings before the Committee on Banking, Housing and.

Urban Affairs of the Senate and the Committee on Banking, Currency

and Housing of the House of Representatives about the Board of

Governors' and the Federal Open Market Committee's objectives and

plans with respect to the ranges of growth or diminution of monetary

and credit aggregates in the upcoming twelve months. Nothing in this,

resolution shall be interpreted to require that such ranges of growth or

diminution be achieved if the Board of Governors and the Federal

Open Market Committee determine that they cannot or should not be

achieved because of changing conditions. The Board of Governors shall

report to the Congress the reasons for any such determination duringthe next hearings held pursuant to this resolution.

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Mr. NEAL. Senator Buckley just gave most of his testimony. He was

called to a vote in the Senate chamber. We don't know whether he is

coming back or not. Mr. Adams, we would certainly like to welcome

you this morning.

Thank you very much for coming. This subcommittee is trying to

determine the importance of monetary policy to the economy, how

well it has been administered over the last several years, and what our

witnesses would recommend as changes for the future.

I know the public debate centers around fiscal policy and we are of

the opinion that monetary policy plays an equally important, if not

more important role in the economic health of this country.

I say again how grateful we are for your coming. Please proceed

in any way you would like.

STATEMEm: OP HON. BROCK ADAMS, A REPRESENTATIVE IN

CONGRESS PROM THE STATE OP WASHINGTON

Mr. ADAMS, AS far as public debate is concerned, the number of

editorials that have appeared around the country criticizing me for

criticizing Dr. Burns on monetary policy indicates that there is an

enormous national debate going on concerning monetary policy. I

feel strongly about it. I would like to proceed with my testimony

which answers the question raised in your letter to me, particularly

emphasizing point 5.

[The letter referred to by Mr. Adams from Chairman Neal follows:]

U.S. HOUSE OF REPKESENTATTVES,

SUBCOMMITTEE ON DOMESTIC MONETARY POLICY,

COMMITTEE ON BANKING, CURRENCY AND HOUSING,

Washington, D.C., May 27, 1976.

Hon. BROCK AI>AMS,

Rayburn House Office Building,

Washington, D.C.

DEAR BROCK: The Subcommittee on Domestic Monetary Policy is scheduling

hearings on Federal Reserve policy and the economy on June 8. Many believe

that how well or badly our economy performs depends crucially on what the

Fed does and, in particular, on how fast or slow it allows the money supply

to grow.

Our hearings are intended to sharpen Congressional and public understanding

of what the Fed does and how this affects our economy's performance. In specific,

we are seeking testimony on:

1. How money policy affects the cost of living;

2. How it affects production and employment;

3. How interest rates are affected by money supply changes, both directly

and through changes in prices, production and employment;

4. How government spending and tax policies affect money policy and their

relationships to prices/interest rates, production and employment; and

5. Whether Congress should set economic growth, unemployment, inflation

and interest rate goals and require the Fed to promote achieving these goals.

We would benefit from your testimony on the above economic questions and

policy issues. If convenient, we will schedule you to appear as a witness on

June 8 at 10 a.m. in Room 2128 of the Rayburn Building. Please inform me at

your earliest convenience about your availability, or have your administrative

aide contact Dr. Robert Weintraub at 225-7315.

We look forward to hearing your testimony.

Sincerely,

STEPHEN L. NEAL, Chairman.

73-959—76

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Mr. ADAMS. I thought perhaps the subcommittee might want to ask

me some questions about specific items I may not have covered in depth

in my prepared statement.

I will preface my remarks by saying that I think monetary policy

must be coordinated with, and supportive of, fiscal policy or else we in

the Congress will go through an enormous and futile exercise trying

to control Federal spending and trying to bring fiscal policy into a

coherent operation. I think what we are doing is essential to the

Nation's economic well-being, and I would hate to have our efforts

frustrated by a Federal Reserve implemented monetary policy going in

a different direction.

I think that that is wron<*. I don't think that we can continue that

kind of an operation and be at all successful, either in making the

country's economic health better or in having some type of control

over the Federal debt.

The present point of debate between myself and the Chairman of

the Federal Reserve Board is that the actions of the Fed in the field of

monetary policy can both increase our expenses in the existing mandatory Federal programs by stopping the recovery and, if the interest

rate for short-term 91-day bills is raised 1 percent it will add between

"$2 billion and $3 billion to the interest expenditures of the Federal

Government and thus bust the budget.

The elements of my debate with Arthur Burns have been misinterpreted around the country but it is a simple thing.

Mr. Chairman, members of the Subcommittee on Domestic Monetary

Policy, it is a pleasure to appear before you today. As you know, the

Congress is in the process of instituting a major reform of one of its

processes.

This year, we are fully implementing the Congressional Budget and

Impoundment Control Act of 1974. For the first time, the Congress has

the mechanism for establishing budgetary priorities and developing

a coherent national fiscal policy. We not only have the mechanism but

•we are using it. The first concurrent resolution on the fiscal 1977 budget

as we all know was passed on May 13.

In the conference report accompanying the first resolution are the

economic assumptions underlying the fiscal policy set forth in the resolution. I think this is a key point where monetary policy and fiscal

policy have to mesh.

We stated:

The fiscal policy contained in the conference substitute, in conjunction with a

supportive monetary policy, is designed to produce a 6 percent rate of increase in

total output (gross national product adjusted for inflation.)

A supportive monetary policy is extremely important to achieve the

economic goals set forth by the Congress. We have at this time no way

to ensure that fiscal and monetary policy are coordinated. A restrictive

monetary policy could off set the expansionary fiscal policy developed

by the Congress to move the economy and the country out of the

recession.

If there is not enough money to facilitate the real growth, then, of

course, the economy, not the price level will stall.

In fact, last summer the Federal Reserve tightened monetary policy,

shortly after the tax rebate, causing interest rates to rise and delaying

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the full impact of the tax refund. More recently, during tlie month of

May 1976, the Federal Reserve again tightened monetary policy apparently in response to the rapid growth in Mt

 that occurred in April.

The rapid increase in Mr—^currency plus demand deposits—is very

puzzling. Commercial and industrial loans declined and large certificates of deposit—a form of loans made primarily to corporations—

also declined. Treasury deposits at the Federal Eeserve did decline

and that could explain part of the increase in Mx.

Treasury drew down some money and spent it. In response to this,

the Fed tightened up on policy and short-term interest rates rose from

the 4.9-percent range at the end of April to 5.5 percent during the

week of May 28.

This increase in interest rates occurred with the unemployment rate

still at 7.5 percent and utilization of manufacturing capacity at only

71.8 percent, up only 4.8 percentage points—that is our industrial

capacity usage—from the first quarter 1975 recession low of 67 percent.

Our plant and equipment are not nearly being fully utilized. We are

still almost at the recession level of utilization.

Efforts to increase the utilization of the plant are not inflationary.

You are trying to use what is already in place to produce more goods.

In fact it has the opposite impact on inflation because productivity

increases and more goods are available at lower unit costs.

Monetary policy is an extremely blunt instrument to deal with

most of the price increases that have occurred in the recent inflation.

The prime causes of that inflation were the OPEC-induced rise in oil

prices and large and unusual sales of grain to Russia, and yet changes

in monetary policy could not have provided a defense against either

of these. In fact, it could have exacerbated them.

Extraordinarily tight monetary policy and extremely high interest

rates were used by the Fed to stop the feverish speculation in inventories in 1974. What was really needed in this instance were selective

controls on inventory loans rather then general monetary tightness

which affected not only speculation in inventories but the entire U.S.

economy.

The monetary policy stopped the entire economy, because it is such

a blunt instrument. This was a case of using the wrong medicine for

the disease, and I sincerely hope that we don't make a similar error

again this year.

Because monetary policy can offset the congressionally determined

fiscal policy, additional mechanisms for coordinating the two are

needed.

The statement of managers that accompanied the conference report on the first budget resolution for fiscal 1977 contained nine major

economic indicators: gross national product, gross national product

adjusted for inflation (real GNP), personal income, wages and salaries, corporate profits, two unemployment rates, the annual average

and what might occur at the end of the year, the consumer price index,

and the expected rate on 3-month Treasury bills.

Additional monetary goals could also have been included in the

statement of managers. All of this is obviously too much information

to put in the resolution itself, although it is useful to put this in the

report. Many of these economic variables are interrelated.

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Personal income, profits and wages and salaries are part of the

gross national product. The unemployment rate is related to the rate

of growth in GNP adjusted for inflation.

If the economy, or some substantial portion of it, is not operating

at full capacity, there is not enough economic activity, people are not

hired, and the unemployment rates go up. I have found in my discussions with people such as Walter Heller, that many of us concerned

with the national economic outlook find our philosophies were shaped

in an earlier generation where economics and the political activity of

the country were closely interrelated.

We find now that everything has become so specialized in economics

that we are using bigger and bigger words and dealing with more

and more esoteric specialties. All of this can often cloud some very

simple relationships such as—if the economy is not working very

well, people don't have jobs to go to whether they want to work or not.

Prices are also related to rates of growth in GNP, particularly

when unemployment rates are low. But when unemployment rates are

high and manufacturing utilization rates are low, high interest rates

do not control inflation because there is no excess demand by business

for money to expand plants, hire people, or increase inventories.

Classic inflation is usually handled by a tight money policy. We

have not had that in this country in years. We have not had the unemployment rate down into the range where it was in the sixties since

1970. We do not have too many dollars chasing too few goods.

The only time we find ourselves chasing too few goods is in a certain

number of limited bottleneck situations on raw materials or an increasein the price in oil or an increase in price in food such as occurred

when we did away with our grain reserves by selling them overseas.

But those are spot situations and you don't handle them in the classic

way by saying you can't borrow any money because of high interest

rates.

Prices may be affected by other factors: wage settlements; oil price

increases; grain deals; weather; and business speculation, to name a

few. Interest rate increases do not control these kinds of inflation

and can make it worse.

It is also extremely important that the economic goals included in

the statement of managers be realistic. Two economic targets that

should be included are a rate of growth for real GNP—that is adjusted

for inflation—and a rate of price increase, since these drastically affect

the revenues and spending total contained in the resolution.

Ideally these targets should be ranges, for example, the statement

of managers accompanying the current resolution calls for a rate of

growth in total output—GNP adjusted for inflation—of 5y2 to G1/^

percent.

We know that we cannot be precise with these targets, but will

have to keep them within a range. A range on the price target—that

is, rate of inflation—is politically more difficult to specify—especially

the lower end of the range, because ideally we would like that to liezero.

Realistically we cannot expect the inflation rate to be zero. Our

price indices are not perfect. Not all changes in quality are fully

filtered out. Thus it may be feasible to have only a price ceiling rather

than a range.

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In other words, we should place in the resolution something to the

effect that the inflation rate should be no more than 5 percent or 4

percent, realizing that we are trying to get it down to zero.

That greatly affects fiscal policy because we now have so many

programs that are indexed to the inflation rate such as pension programs and others.

These two major economic indicators that I mentioned may be

enough to give direction to the Federal Reserve Board on monetary

policy. Monetary policy should aim to achieve the rate of real growth

in total output. However, if the rate of increase in the general price

level begins to exceed the price ceiling, it would be a signal to the

Federal Reserve to restrict monetary growth.

A third economic goal could be included—a range on the short-term

Treasury bill rate since that affects category 900 of the Federal

budget—interest costs—and has a major impact on the total business

activity in the Nation.

However, I have not yet decided whether to advocate the inclusion

of bill rate targets until we have had more experience in this area.

I would like to start with the real growth and inflation targets first

and see if they are sufficient to bring about the desired coordination

of fiscal and monetary policy. If they prove not to be sufficient, further thought must be given on how to achieve that integration.

Mr. Chairman, that completes my prepared statement. I do have,

of course, information that can respond to the other questions in your

letter but I thought we might possibly handle that in the question

and answer period.

Mr. NEAL. I would like to thank you, our distinguished chairman

of the House Budget Committee for coming. Have you given any

thought to including in the budget resolution—I don't want to say

targets, but I would like to say specific interpretations—of what

the budget resolution means in terms of levels of inflation and

unemployment ?

Mr. ADAMS. We have given thought to putting that into the budget

resolution. It has been my position that we should not do so this year

until we have put the new budget process through one Congress and

everybody has a chance to see how it works.

However, I think that eventually the budget resolution is a logical

place to include such data. That is what I was trying to address in

my prepared statement. We probably should start with the statement

of the managers on the conference and then we can build a legislative

history around it.

We can see then whether or not monetary policy responds to it. If

it does not, then perhaps we will have to take the next step.

Mr. NEAL. The reason I mentioned those goals specifically is because

it seems to me that those are goals that the Fed could deal with, could

understand and they could address these problems directly as opposed

to some other measures.

Mr. ADAMS. I think you are right. I think those are key indices

that certainly can give a coherent package to the Federal Reserve

to show them clearly what we are doing. One of the problems we get

into is that the Fed operates on a week-to-week basis, sometimes on an

almost day-to-day basis.

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I am always concerned that they react too quickly on unexpected

movements in the market rather than not quickly enough. What is

happening today is that the Fed is reacting on an almost day-to-day

basis on what they perceive as an increase in the velocity of money.

We are operating under a budget resolution that is of course taking

us a year to complete and will go into place in October. That is why

I am having the argument with Dr. Burns. I am trying to say to him

that the 91-day bill rate should stay within the averages referred to in

the underlying materials accompanying the resolution. The reason

is that we are going to roll over nearly $200 billion worth of debt this

year and most of it will be in the short-term market.

An increase of interest rates of 1 percent starting in October and

going through the fiscal year—and that is the dilemma we are approaching—can add some $3 billion to the Federal deficit.

We assumed in the resolution an average interest rate for the year

of 5.5 percent. If the Fed increases that to an average of 6.5 percent

for next year, category 900 will go up $2.5 billion. Everyone will

wonder why the deficit has to be raised by $2.5 billion when we did

not do anything. The answer will be that the Fed did it.

Mr. NEAL. Mr. Adams, if I can, I would like to draw your attention to this chart. We have charted with the black line yearly money

supply changes in the economy.

Over that, we have superimposed a line showing the yearly change

in the cost of living occurring 23 months later. The reason for the

23-month lag is because our staff, through computer studies, found

that the maximum effects of increased or decreased money supply on

the rate of inflation occurred at that point. It wouldn't look much

different if the lag were 20 months, or 22 months, or 24 months. The

point is that the rate of inflation in the economy does not respond

immediately to changes in the money supply but responds with a lag

averaging about 23 months.

Senator Buckley, welcome back. I would like to draw your attention

to this chart also. The black line shows the yearly percentage changes

in the money supply. The red line is what I call the rate of inflation

with a time lag of 23 months.

We were just explaining the 23-month lag. And as I just stated^

our staff's computer studies show that the maximum effects of increased

or decreased money supply on the rate of inflation are evident 23

months after money supply fluctuations.

When the money supply rose dramatically, the cost of living increased rather dramatically as we charted it through time. Now the

next feature on the chart shows the recent periods of recession, shown

by the periods between the green lines. What this also shows is that

when there is a sharp decrease in the money supply, we experience

periods of recession soon after.

The most dramatic thing about the chart, I think, is its rollercoaster

nature. We have had increases and decreases in the money supply and

this seems to be reflected in the pattern of economic life in America. It

seems to be from looking at this chart—we have been working with this

now for seA^eral weeks, discussing and revising it—it appears that the

money supply is very important in determining levels of inflation and

levels of recession.

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This orange line represents Federal budget surpluses and deficits.

Here we find a relatively weak relationship to the whole picture.

Mr. ADAMS. I was never able to find any because we charted those

factors precisefy the same way, Mr. Chairman. Obviously the deficit

can become too large and, you can overload monetary growth. But as

far as year-to-year relationships are concerned, we have never found

any.

Mr. NEAL. TO me that is very fascinating. The public debate is on

the level of budget deficits—the popular subject is that deficits are the

total cause of inflation. We find they are hardly the whole cause.

Our staff economist tells us that we can attribute statistically something like 60 percent of recent inflation to monetary policy with that

23-month lag. The deficit appears to count for no more than 30 percent.

Obviously there are other factors that affect the rate of inflation, such

as oil and food prices. But our statistics indicate that monetary policy

gyrations were primarily responsible for 60 percent of the recent levels

of inflation. Of course, this is preliminary; and we would be grateful

for your comments on these facts.

Mr. ADAMS. Let me say that we have done the same thing in terms

of charting the relationship between deficit, money supply, gross national product, and unemployment. As you heard me say many times,

I advocate that we go to a balanced budget at full employment. The

Government should live within its revenues.

That will be the thrust of our effort in the next 3 or 4 years, to accomplish that. But I do not think that that is going to solve the problem of

inflation and unemployment. I think it is simply a stabilizing factor

which is important for the whole economic climate of the United

States.

Coupled with that what we need in money supply is a matching of

the money supply to the real growth in the economy. The argument

which is being made by the Federal Reserve at the present time is that

their instruments of either their open market activities, changes in the

reserve rate, or changes in the rediscount rate all of which as I said

before are very blunt instruments, should take into account the velocity

of the money supply as well as the absolute amount.

This has led to the Federal Reserve saying Ave can tighten the

money supply because people are using their money more efficiently

and still match the growth in the economy.

I do not believe that. I don't think we know enough about the

money supply. What we are looking for in the way of monetary policy

from the Fed is that as economic growth occurs, not that MT be

pumped up and we use the money supply to stimulate the economy,

but that we not use it to crunch the economy. That argument has not

been resolved and that is something that I hope this subcommittee

will both communicate to the Federal Reserve and to the other

members.

Mr. NEAL. What you are advocating, if I understand you, is a rather

consistent rate of increase of money supply in keeping with the goals

of the budget—full employment without inflation.

Mr. ADAMS. If you will look at the period between 1960 in the middle

of your chart and continue up through the beginning of the Vietnam

war, which was February of 1965, you will see that we had a rate of

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inflation that ran below 3 percent. Our unemployment rate was coming down. It had been at 6 percent in the early sixties. The reason I

take that particular time period is because the Vietnam war period

does distort things. In other words, if you are very conservative, you

say the only reason we got unemployment down is because we had

a war.

If you are liberal, you say that general economic policies were successful. During that period some of us were saying, and the Council

of Economic Advisers was in agreement, and the Federal Reserve and

the Congress was in agreement—that we were trying to come out of

the recession period of 1958. You also had at that time a relatively

low deficit and you had a low interest rate. I am saying that that

condition of low unemployment and low interest rates can be repeated

again and that is my personal goal.

Mr. NEAL. Senator Buckley, welcome again.

Senator BUCKLEY. I find myself in substantial agreement. I believe

there is an obvious correlation, and studies have gone further in pointing out the relationship between money supply and rate of inflation.

Way back, banks did not issue credit instruments unless you had production to match the instruments that were being handed out.

But I do agree that our goal has got to be toward creating a stable

environment, a predictable environment. We should have as a goal the

increase in money to match the increase in productivity and labor

force growth.

This will create stability in which other factors in the economy can

operate. Then we are talking about whether or not we are going to

raise taxes. We have had pressures. Whether we are going to raise

taxes to meet current higher levels of higher spending, or are we going

to in effect lower the Federal take out of the economy to leave more

behind in the private sector with which to produce the jobs.

Mr. N*EAL. YOU would advocate a moderate and steady growth in

the money supply

Senator BUCKLEY. TO match the average growth that we project

for the economy?

Mr. NEAL. If the economy is growing at the rate of 5 percent, you

would advocate a growth of 5 percent in the money supply? If the

economy's growth potential decreased, would you advocate a decrease

in money growth?

Senator BUCKLEY. Yes.

Mr. NEAL. I will now yield to the gentleman from California.

Mr. HANXAFORD. Both of you coming from different directions say

the same thing about money supply. Both of you advocate a balanced

budget perhaps with less fervor or enthusiasm. Would you apply

something of the same standard that you are applying to the growth

of the money supply and that is we would try to balance the budget

but would not get too upset about it if the growth of debts did not

grow as fast as GNP ? Senator Buckley ?

Senator BUCKLEY. Well, I personally would like to see some black

ink once in a while. My fear is that if we start talking about a permissible level of deficit which can be financed in a manner that does not

require creating money faster than projected growth, yes; we can

absorb the burden. But I recall when President Nixon unveiled the

-concept of full employment and budgetry, it started fine. But at the

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same time it seems to me that it is awfully hard for a legislative body

to say that $12 billion of deficit is OK but $13 billion is not. I would

like us to reach black ink and over a period of years average it out.

Mr. HANNAFORD. Realistically, it is difficult to achieve a balance

between red and black ink over the long run. We would like to balance

the—between red and black ink out in the business cycle.

Has the Senator completed his statement, or did he have anything

more in the way of a formal statement ?

Senator BUCKLEY. I had one which was interrupted by a vote, and I

don't know how to pick up the pieces again. Basically, I urge that the

Congress not follow—not yield to the temptations to politicize the

Federal Eeserve—which is inherent in the Humphrey-Hawkins legislation—and that it maintain the posture it took a year ago with House

Concurrent Resolution 133, to adopt standards to guide and govern the

monetary policy.

Mr. HANNAFORD. Mr. Buckley, I guess I am a little out of step here

because the purpose of these hearings is to establish the importance of

monetary policy. I have always had a very strong feeling about its

importance.

So I am going to, I guess, shift to the politics of it. Accepting that

these facts are true and that it is of fundamental importance and that

it does contribute some 60 percent of the inflation problem, we must

follow the simple dictum that Chairman Adams suggested that we

create enough money to buy the things that need to be bought.

Also, there has to be a coordination between monetary policy and

fiscal policy if we accept these things. Do we accept that ?

Senator BUCKLEY. I would disagree. I would suggest that the role

of monetary policy is to create a stable environment by the more or less

predictable increase in the money supply to match the projected increase in production so you have a price stability which establishes the

expectations within which the private sector can operate.

Then the fiscal policy has its impact within that spectrum. If we

spend too much and the Federal Government has to borrow too much

out of the capital markets, you run up your interest rates. This ought

to be the leverage on the Congress to have self-discipline.

Mr. HANNAFORD. Well, I am bothered by the fact that Brock Adams'

statement regarding the cause of inflation recently being in relation to

increasing energy prices and food prices is diametrically opposed to

Chairman Burns' previous statement here. We had the Chairman of

the Federal Reserve Board here consistent with the requirements of

House Concurrent Resolution 133 last summer. He said he was increasing interest rates or following a more restrictive monetary policy

because of increases in commodity prices and because the tax cut which

we instituted, $22 billion, was beginning to take effect, and there were

too many dollars floating around and we had to react to that with

monetary policy. It disturbs me a great deal that we have conscious

and intelligent efforts conflicting with one another.

I don't see how we can run the economy of the country having the

left hand taking away what the right hand is doing.

Mr. ADAMS. That was precisely the reason why we have gotten into

the argument that is going on now between some of us on the Budget

Committee and the Chairman of the Federal Reserve. Simply put,

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my statement to him is that if you are going to, in effect, soak up the

money supply after we had gone through great efforts to provide

increased fiscal stimulus to come out of the recession, you should have

told us in the first place, and we would not have bothered to pass the

tax cut.

There is just no value in going through enormous exercises hero

which are finally agreed upon between the Congress and the Executive,

and then to have our efforts frustrated in the name of independent

monetary authority. I am not saying that the Congress should be

operating on the size of the money supply. We should not be doing

that. But we should not expect that the obvious policy established is

going to be frustrated as we proceed.

I am concerned that this is about to occur again. We are concerned

that next year the economy will go into recession. That is the reason

there are several portions of the total budget package saying that

we must continue Federal assistance for a few years until we are sure

the recovery is solidly in place. And if that is frustrated by a rapid

increase in the interest rates, we should not be involved in making

such an effort in the first place.

Mr. HANNAFORD. Would both of you agree that your major criticism

of the Fed policy is that it operates in fits and starts instead of looking a long way down the road?

Senator BUCKLEY. Precisely. This is where I hope House Concurrent Resolution 133 sets some guidelines to take the longer range.

Dr. Burns has testified about the fine tuning. If you pull the string,

you just push it. I have a live quorum. I might have to leave soon.

I would like to make one observation. You were talking about the

contribution to inflation of the rising energy costs. Even though we

had wage and price controls, we reached an annual rate of 9.5 percent

inflation before the Arab oil embargo. Energy was a one-time price

increase.

We had as a result of dickering with the money supply the pressures

for that inflation that just burst through the seams.

Mr. NEAL. Mr. Hannaford, would you yield? Senator, you mentioned the problem of politicizing the Fed. I would like to ask if you

think this chart is accurate and if you think that Fed policies have

been well administered over these years ?

Senator BUCKLEY. My answer would have to be no.

Mr. NEAL. If you don't think it has been well administered what

would you suggest?

Senator BUCKLEY. I would like to think in the last year it has been

better administered than it has in the past. Before that it was always

reacting too late or too early.

Mr. NEAL. When you say you don't want to see it politicized, do you

mean you don't want to see us go further than House Concurrent

Resolution 133?

Senator BUCKLEY. I would hate to see us establish legislation of a

Humphrey-Hawkins type to manipulate the economy. I am sorry I

have to run. I appreciate the opportunity of being here.

Mr. NEAL. Thank you very much.

Mr. HANNAFORD. Mr. Chairman, I yield the balance of my time.

Before I do, though, I want to say that I am very glad that at the

time in history when we established the budget process that Brock

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Adams was in Congress because if he had not been, I'm not sure it

would have worked.

I think it is a historic achievement which you have accomplished,

Mr. Chairman, and I thank you.

Mr. NEAL. Mr. D'Amours?

Mr. D'AMOURS. I thank the chairman for recognizing me after

Senator Buckley left. My questions were going to be directed to Senator

Buckley.

Congressman Adams has referred to a problem and I wondered,

Congressman Adams, if you could tell me what positive directions

do you think we might be taking to go beyond House Concurrent

Resolution 133 which is nice frosting but not very substantial in terms

of—it is a control but certainly not a very strict or definite control.

What can we do short of politicizing the Fed which I don't suppose

anybody wants—not that anybody does not believe it is already politicized—what kind of controls short of Humphrey-Hawkins are available to us?

Do you see any range of options?

Mr. ADAMS. I think you can consider, one, specifying to the Fed

the ranges of the money supply that we in Congress deem necessary

for the next fiscal year and that we not simply allow the Federal

Reserve to say they agree with us and then go off and do something

different. For example, the Federal Reserve indicated to this committee and the Congress originally that the range in the rate of growth

in money supply should be 4 to 7y2 percent this next year. Yet Dr.

Burns, within the last 2 months, has said no, it is going to be 4 to 7

percent. This means that we have a year's program laid out in that

budget resolution and yet one of the key assumptions, one man or the

whole Federal Reserve Board has at some point sat down and said we

are not going to do that.

Second, you can actually go to a range on interest rates. I don't

think you could call that politicizing the Fed but I certainly think

that once you establish a fiscal policy for fiscal year 1977, let's say,

from October 1, 1976, through to October 1, 1977, that you can indicate a range for interest rates and you would take off from the range

where you are now. In this way you would not be signaling to the

money markets that there is going to be some big pump up or a crunch

down, but that these ranges are necessary. That is what I was referring

to. I have not staked out a flat position to you that you ought to use

the 91-day bill as the key, but you can do that.

A third principle is this: This subcommittee should consider recommending to the full committee the potential of using selective reserve

requirements and fuller regulation of the banking system. The reason

your chart reflects an inflationary increase goes to a belief that I

personally have. Now, this is my personal opinion. A great portion of

the inflation in the past 8 or 9 years—other than the war inflation

which was obvious—came in the financial community. By financial

I mean financial tied in with business—in speculation in inventories

and in the establishment of conglomerates.

I think the formation of conglomerates has added to inflationary

pressures. It works like this. I have a glamorous electronics system

that is selling at $50 per share. You own a smelting company in Montana that is selling at $12. Without changing my plant or without

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changing your plantyl form a conglomerate and buy you out. In buying you out, you get a rise in your stock price of anywhere from 12 to

maybe 20 points.

The drop that occurs in the merging, glamorous stock, would be

very slight. You would end up with the stock of both plants selling

at 45 which is, for your smelting plant, 30 points of pure water.

There is no more production, there are no more people working.

Nothing has changed except the total price went up. Even worse, I

don't have any money so I go out and borrow. In other words, I increase the money supply by going to my bank and signing a note for

$30 million to buy you out.

Now somebody is in there competing with me, at say, the First

National Bank of whatever town you want to go to and they are trying

to borrow for their inventory to buy enough widgits to produce for

the year ahead and they are only willing to pay 7 percent.

I have a sure-fiire deal with you so I can afford to bid that interest

rate up to 9 percent, 10 percent, 11 percent, 12 percent, because I am

going to write it off on any income tax and I am going to make the

profit out of the rise of the stock cost. So I have had a double inflationary impact.

You can also do it with inventory. I don't need any, but I think

there is going to be inflation so I go out and borrow money and I buy

up parts for my inventory, borrowing the money, not putting any

more people to work. I speculate if I buy it today, it will cost me $10

and if I buy it next year it will cost me $12. I buy up at $10 all I can

get my hands on. I stock my warehouse completely. I use borrowed

money. I write off the interest rate. If the inventory goes to $12 next

year, I shift my accounting system from first in first out to last in

first out and I pick up $2 an item on everything I have got.

There is no more production. It is pure speculation. That cannot

be controlled by simply raising interest rates because I will bid anybody out of the market on those conditions. I will bid you out as you

try to borrow money to buy a house. I will bid you out as you try

and raise money for your small business. I will bid the farmer out

for whatever he is trying to borrow in order to produce that year

because I am in the speculative end of it. The only way you can control

that is with selective reserves. You are saying to the bank well, we

will not allow more than 15 percent or 20 percent of your lending to

be done for these kinds of purposes.

That was advocated by Board Member Andrew Brimmer back in

the sixties and we fought that back and forth with the Federal Reserve

for years. They, say, well, we can't do it. But to me, raising the interest

rates does not control inflation. In fact it can feed it. Because when

I push the interest rates up to 12 percent you, in your small business,

have got to borrow at 12 percent rather than 8 percent, you have got

to tack on to your prices what you can't write off. If you are going

broke like the railroads and W. T. Grant and everyone else, you can't

write it off because you don't have any income. You have to raise

your price.

Mr. HANNAFORD. I believe we are simply talking about allocating

credit in this manner.

Mr. ADAMS. In a gross sense.

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Mr. HANNAFORD. We have fought the same battle in this room

last year. It gave the Chairman of the Federal Reserve Board the

suggestion.

Mr, ADAMS. There are new days coming.

Mr. D'AMOURS. I have no further questions. Thank you.

Mr. NEAL. Mr. Adams, I would like to pursue your comments on

interest rates again. How would you like to see those interest rates

regulated?

Mr. ADAMS. Well, I think the best you can do is to use a range. In

other words, we don't want to have the Congress involved in saying,

all right, the interest rate on the 91-day Treasury bill will be 5 percent

in January and 5.2 percent in February and so on. Obviously the

money managers—the Fed must control that sort of thing. But I do

think—and I mentioned this in my testimony—this committee should

consider whether we should have a range of interest rates such as we

put in the statement of managers accompanying the resolution this

year, 5.5 percent average from the period of October 1, 1976, to October 1, 1977, with a trigger mechanism by which the Fed comes back

before the committee and says conditions are thus and so and we

think there should be a change in the range. At that point you

make a recommendation to the Congress. If you want to include it in

the budget package, we can go with another concurrent resolution

saying it is going to cost us this much more. I would have no objection

to our coming in and redoing it. You could get a photograph of the

economy at various points during the year.

If tilings have changed drastically in commodities or food prices,

this committee recommends to the House and the same on the Senate

side that a change is necessary to fit the new picture. We all know

what we are doing.

Mr. NEAL. The only way the Fed has of changing interest rates is

to change the money supply. Isn't that right ?

Mr. ADAMS. They can change their discount rate. They can change

their Federal funds rate through open market activities.

Mr. XEAI,. But these actions change the money supply, don't they ?

Mr. ADAMS. Yes. In the very sophisticated society, if you change

any of these factors, money supply will follow. But money is not in

and of itself. Money supply is a factor that changes by Federal Reserve policy. That is why there is this argument about velocity that

we are into now. We have so many new sophisticated financial instruments and people creating new ones all the time. But the money supply

was created by the Fed and is the underlying factor. All these other

things follow.

Mr. JSTEAL. Including interest rates probably.

Mr. ADAMS. Including the interest rates, but not on a 1-to-l factor.

In my opinion, at the present time interest rates on the short-term

bills are going up strictly from Federal Reserve, and not from anything else going on in the economy. In other words, there can be times

when the interest rates are going up because of other factors in the

economy and not the Federal Reserve. The Federal Reserve has had

in effect a loose money supply since about September 1975. But they

were pushing the string. The money supply did not ;grow during that

period because all they can do is make it available and if nobody

conies to the window and takes it away, Mi does not grow.

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We don't know what caused Mt to rise so in April. What I am

saying to you is that bank demand was down, corporate demand has

been down and other demand has been down so the market is not

pushing up interest rates at this particular moment. The Fed is. T

think that is wrong. It does not have anything to do with the growth

of money supply right at the moment. They are not in a 1-to-l ratio.

Mr. NEAL. But by fiddling with the interest rates, they will also be

fiddling with the money supply ?

Mr. ADAMS. That is correct. The optimism in the economy or lack

of it, costs in key commodities and individual decisions made by

companies as to whether they want to have more money available

is the multiplier effect that goes with the Fed action.

Mr. NEAL. There is another interesting thing on this chart and that

is whenever we have an expansionary money supply, we have inflation.

Whenever we have contracted money supply, we have recession.

Somewhere in between it seems to me we have the right course.

Perhaps as a result of these hearings, we will be able to formulate a

target range of money growth for continued economic recovery and

avoid fighting that battle of politicizing the Fed.

Mr. ADAMS. I think politicizing the Fed is an enormous red herring.

Mr. NEAL. I think it is, too, but it has popular support.

Mr. ADAMS, It has popular support in the elitist part of the United

States. The activities that took place in 1961—and I would strongly

suggest that if you have not already contacted him that you have in

for example either Walter Heller or Charles Schultz to ;give you

specifics on it because a lot of us were involved much more peripherally

than they were.

But I think the people support the Government making a conscious

effort to see that the economy runs smoothly and well. That is a very

different political position from those who say the Government should

get out of all fiscal activity. In spite of the hammering, in spite of the

public positions, in spite of the television every night saying that

everybody hates Washington, if you go to the people and not just keep

polling the top, you will find an underlying feeling that the Government is the one place where people elect their representation. And as

bad as the Government may be in getting things done, at least people

can communicate with elected Government officials concerning somethinqr. that affects their destiny.

The people don't want to throw the Government out. They don't

want it to be dictatorial but they think it should be involved in seeingthat they have a job, that the prices are not going out of sight, and

if they want to buy a house that the interest rates are low enough

that they can afford it. I still believe that in this country, most of the

people believe the Government should have a role in that because

thev can get at the Government.

Thev can throw you and me out. But you can't throw out the head

of A.T. & T. and you can't throw out the head of the First City Bank

and you can't throw out the head of the labor unions that are involved

in your city and you can't get at anybody else. Government becomes

the forum where you can try to make your life a little better. You,

Mr. Chairman, and this subcommittee, are directly involved in one

of the key factors that people are interested in. They want to know

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why it is they cannot buy a house today, for example, which is in the

jurisdiction of this overall committee on which you sit. They can't

understand why interest rates that they grew up with running from

4 percent to 6 percent can't ever by found anymore. I think that that

is part of our job, to produce an answer.

Mr. HANNAFORD. Would the chairman yield ?

Mr. NEAL. Certainly, the gentleman from California is recognized.

Mr. HANNAFORD. I am afraid that you are more optimistic than

I am, having had short experience on this committee. We have had

two experiences that convinced me that the Federal Reserve is so

enshrined that you can't approach it politically. We did early last

year try to get some allocation of credit action.

By the time it had gone through the influence of Dr. Burns and

the minority, we came out of this committee with something that was

a watery statement of good intentions about allocating credit. It

went to the floor of the House and I think lost by something like

2tol .

Last month, just 2 or 3 weeks ago, we had something that we called

the Federal Reserve Reform Act that we reported out of the committee. A central feature of that Reform Act was to try to bring the

Fed more within the point of view of contemporary Congress and

the administration—in other words, have the President appoint Federal Reserve presidents.

That was thought to be by the authors in the committee, the subcommittee, the central feature of that piece of legislation and that

was stricken out by the House committee and that prevailed on the

floor of the House of Representatives.

I might say I supported that view because I knew it would never

pass the House without it. But one does have to be pessimistic, Mr.

Adams, about the future in this regard.

Mr. ADAMS. Mr. Hannaford, we are in a period of divided Government. Two very conflicting philosophies are in collision and have been

for the last 8 years. If this continues, next year your frustrations will

continue. If it does not, then you may have a coordinated Government

with one economic philosophy going ahead. Then you will be successful. All I can say to you is that my frustrations have lasted longer

than yours only because I have been here a little longer.

Mr. HANNAFORD. It occurs to me if we are going to enshrine this

thing, put the whole thing in one basket and let the Fed make the

decisions regarding both fiscal and monetary policy. To give one

to us and the other to them without ever having the twains meet is

counterproductive.

Mr. ADAMS. Maybe at some point we will run the Government by

experts as opposed to elected representatives. I hope that is far in the

future. I have seen some experts in 1965 make some horrendous mistakes. I am not over-awed by expertise.

Mr. HANNAFORD. I was saying that in jest. If we are going to do

the wrong thing, we should be at least doing it consistently.

Mr. NEAL. If you could set monetary policy for next year, what

would it be ? What would the money growth figure be ?

Mr. ADAMS. I would go with a short-term bill rate of 5.5 percent

average. I would anticipate an inflationary rate of 5 percent, maybe

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a little bit less. If speculation began to "reoccur in the financial community of volume that occurred in 1974, I would make threatening

noises. I would come to the Hill for support on those threatening

noises so we used coordinated policies against the spot inflation. My

point is there is no point in panicking and trying to raise interest

rates. I would try to maintain them on a constant level. We are coming

out of a recession and there is no reason to crunch the money supply

now.

Mr. NEAL. Would you go over the Fed?s upper money growth bound

of 7 percent ?

Mr. ADAMS. NO. If it happened for a month or two, I would not

panic. I would first determine where the velocity problem was occurring and operate on that specifically before I used the blunt instrument of increased interest rates.

Mr. NEAL. Are there any further questions?

Mr. ADAMS. I thank you, Mr. Chairman, for inviting me this

morning.

Mr. NEAL. Thank you very much.

The subcommittee stands adjourned until tomorrow morning at

10 a.m., when we will continue our hearings in this same room.

[Whereupon, at 11:20 a.m., the subcommittee adjourned, to reconvene at 10 a.m. Wednesday, June 9,1976.]

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Federal Reserve Bank of St. Louis
THE IMPACT OF THE FEDERAL RESERVE'S MONEY

POLICIES ON THE ECONOMY

WEDNESDAY, JUNE 9, 1976

HOUSE OF REPRESENTATIVES,

SUBCOMMITTEE ON DOMESTIC MONETARY POLICY

OF THE COMMITTEE ON BANKING, CURRENCY AND HOUSING,

Washington, D.C.

The subcommittee met pursuant to notice, at 10:20 a.m., in room

2128, Rayburn House Office Building, Hon. Stephen L. Neal [chairman of the subcommittee], presiding.

Present: Representatives Neal, Hannaford, Allen, and Hansen.

Also present: Dr. Robert Weintraub.

Mr. NEAL. Gentlemen, I would like to thank you all for coming this

morning. The House is in session, but hopefully we will have a minimum of quorum calls and be able to proceed in an orderly way.

This morning we are continuing our hearings on the impact of the

Federal Reserve's money policies on the economy. As I stated yesterday, I will again say that the functions of the Federal Reserve System

and its Open Market Committee, which decides the Nation's money

policies, remain a mystery to many people.

Most Americans do not know how important money policy is to

the prices of the goods they buy, the interest rates they pay, their job

opportunities, wages and profits.

The hearings are intended to cover several specific points which

include:

One: How money policy affects the cost of living.

Two: How it affects production and employment.

Three: How interest rates are affected by money supply changes,

both directly and through changes in prices, production and

employment.

Four: How government spending and tax policies affect money

policy and their relationships to prices, interest rates, production and

employment, and,

Five: Whether Congress should set goals for economic growth,

unemployment, inflation and interest rate levels and require the

Federal Reserve to promote achieving these goals.

In preparation for these hearings, I have asked the staff to compile

statistical data on our economy's performance and the growth of

money supply, and the level of Federal Government surpluses or

deficits since 1954.

This work is going forward. To date it has centered on how money

growth and Federal deficits have affected the rate of inflation and the

frequency of recessions.

(29)

73-959 O - 76 - 3

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We have prepared an exhibit to bring these relationships into focus.

As our exhibit shows,the rate of growth of money supply has followed

a roller-coaster pattern, which tilted upward after 1964. As a result,

we have suffered periodic recessions; and since 1964 they have been

imposed on waves of inflation.

Our exhibit maps the relationship between inflation measured from

one month one year to the same month the next year, to mone}^

growth also measured over 12-month periods, but occurring 23 months

earlier.

The relationship between inflation and money growth was mapped

with a 23-month lag because it takes time for changes in money supply

to affect the inflation rate; and the staff found, using computer studies,

that the effect of increases or decreases in money supply on the rate

of inflation peak after approximately 23 months.

As the exhibit indicates, the rate of inflation rises and falls in the

wake of increases and decreases in the growth of money. About 60

percent of our inflation can be explained by changes in money growth

occurring 23 months earlier, And this, let me emphasize, holds as

much, perhaps even more, for the seventies as for the fifties and sixties.

The exhibit also shows that each time our economy experienced a

recession since 1954, it occurred after the Fed moved to sharply

decrease the growth of money supply. Finally, the exhibit maps the

relationships between recessions, inflation and money supply and

Federal deficits. In this regard, the conclusion that emerges is that

the impact of deficits on the inflation rate and recession is weak as

compared to that of money growth.

While the subcommittee will refine its work in these areas, the

staff also is studying the relationships involving unemployment and

interest rates. In addition, we are endeavoring to ascertain the impact of money supply on the economy by simulations of large econometric models using different money growth patterns. Preliminary

results from these runs indicate, among other things, that the economy

is far more tolerant of interest rate fluctuations than it is of money

supply gyrations.

We hope that the results of our work will produce a better understanding of the ways our economy is affected by Federal Reserve

policies and promote the use of responsible guidelines for coordinating

monetary and fiscal policies.

This morning we will hear from four very distinguished witnesses:

Edgar R. Fiedler, who is the vice president of economic research,

general, at the National Industrial Conference Board; Jerry L.

Jordan, who is vice president and chief economist of the Pittsburgh

National Bank; David I. Meiselman, professor of economics at the

Virginia Polytechnic Institute; and George Perry, senior fellow at

Brookings Institution.

I would like for you all to proceed in any way with which you are

comfortable. If we could, it would be helpful to try to keep your remarks under 10 minutes or so, so we can leave some time for some

discussion.

At this time I would like to recognize Mr. Fiedler.

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STATEMENT OF EDGAR R. FIEDLER, VICE PRESIDENT, ECONOMIC

RESEARCH, GENERAL, THE NATIONAL INDUSTRIAL CONFERENCE

BOARD

Mr. FIEDLER. I am pleased to be here and have a chance to participate in these hearings. I can summarize the full statement which is

available for the record. I can summarize some of the major points

fairly quickly.

Mr. NEAL. We will insert your statement in its entirety in the record.

Mr. FIEDLER. Thank you, sir.

The economy is in a moment of cyclical tranquility. We are past

the last effects of the recession and everybody now recognizes there

is a recovery in process but we are not yet in the later stages

of prosperity, and the later stages of the business cycle where some of

the distortions come into view.

We are betwixt and between. We still have a below average rate of

resource utilization in the economy. The key analytical aspect of this

is how much capacity there is in the economy. We run into trouble

immediately with the analytics and the measurement here because

capacity is one of the slipperiest concepts and measurement problems

we have in economics.

Most people think of how much room there is to grow in the economy

simply by looking at the unemployment rate. Certainly the labor

markets are one of the key dimensions of the economy, of how much

capacity there is, but only one of several dimensions. At this point

it seems to me, in this particular series of years that we are in now,

the key dimension of capacity is the productive facilities available to

process raw materials, the first processing of raw materials: steel,

nonferrous metal, basic chemicals, paper and so forth.

This is where we ran into the bottlenecks in 1973-74. This is also

where we are now closest to full utilization of our resources. If we

run into the limits of capacity in this cycle sometime in the year or

two coming up, it will not be in the labor markets, it will not be in

the advance processing industries, it will be in those major materials

industries.

My guess is given the vigorous recovery that I expect to continue,

we have about another year, maybe 18 months, before we hit the

limits of capacity to expand.

I claim no expertise. Not much exists. I labeled this in my statement

as a guess but it is my best guess. It is too important an issue to ignore.

If that judgment is correct, given the lags in monetary policy, we

would have some possibility of applying a more stimulative monetary

policy for the short run to obtain a more rapid growth of economic

activity and put more people back on the payroll sooner.

That would be a respectable bit of advice. I would like to express

a couple of points of caution about that idea, however. One is that a

faster rate of growth in monetary expansion now would imply that

rather soon given the lags again, we would have to cut back even

further on it.

This kind of scenario, experience suggests to me, has given us a

lot of trouble in the past. It is what economists have come to call

"fine tuning" of monetary policy and it implies an ability to forecast

and a delicate touch on the monetary policy levers that is probably

beyond our ability to handle.

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It also suggests that it won't be very long if you raise the rate

of monetary expansion now, temporarily, before you would have to

make an abrupt downward adjustment and that would raise questions

and uncertainties about the possibility of that leading into a recession.

So here, I believe, these kinds of considerations lead me to suggest

caution on this idea of adding more monetary stimulus at the present

time.

Second, we have our shortrun goals of fostering as vigorous a

recovery as we possibly can. We have a longrun goal of reducing

inflation, which is still high by historical standards. The longrun goal

calls for the opposite prescription for policy, namely reducing the

rate of monetary expansion.

There is no way to reconcile the two prescriptions instantly and

automatically. In the past we have paid too little attention to the

longrun goals and we ought to give them at least equal weight, and

this, too, argues for caution.

I would like to add one more point about capacity. The fact that

we run out of capacity in terms of the major materials industries

indicates an imbalance between capital facilities available in our

economy and the labor. In other words, when we hit the limits of

our ability to expand and we still have an unemployment rate high

by historical standards. This argues in my mind for policies—not

necessarily monetary policies though they could play a role—policies

that will foster a vigorous expansion in capital formation so we can

avoid hitting those bottlenecks at too early a point in terms of

unemployment.

When we get to prosperity we ought to shoot for a balance between

the capital facilities and the labor facilities so everything is fully

utilized as is consistent with a smoothly operating, efficiently operating

economy. If you have to have an imbalance, however, it ought to be

the opposite way. We ought to have idle machines and not idle men.

This argues strongly for some kind of policies, incentives for saving

and investment over the next few years. This is not a shortrun, thisyear, next-year policy suggestion. It is for the long run: 5, 10, 15

years.

Finally, I would like to make a comment about the relationship

between fiscal and monetary policy. In my statement there is a

table I would like to refer to.

It points to what I would regard as the divergence between the

relative status of fiscal policy and monetary policy at the present

time. Normally, I think it is fair to say, fiscal and monetary policy

usually point in generally the same direction.

In 1972 both were overly stimulative. At the present time, however,

it seems to me we have a divergence with fiscal policy relatively more

expansive, monetary policy more moderate. The table shows monetary

policy—that the Federal Reserve target growth rate for the narrowly

defined money supply, Mi, 6 percent.

I would compare that with 1972, also the second year of a business

cycle recovery, where the growth in the narrowly defined money

supply was over 9 percent.

The Federal Reserve's target for policy at this time is therefore

clearly more cautious than it was in 1972. If one were to take account

of the fact that the base rate of inflation that is built into the system

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at the present time is a couple of percentage points higher than it

was back in 1972, that suggests an even more striking comparison

in those terms that our monetary policy is now more restrictive, more

cautious, more moderate than it was in 1972—and I would regard

1972 as having been a vigorous, stimulative policy.

Fiscal policy is a different story. If we look at fiscal 1976 and 1977,

we have budget deficits estimated at 4.7 and 2.8 percent of GNP

respectively for those 2 years. Back in fiscal 1972 and 1973 we had

deficits of 2.1 and 1.2 percent.

I am sure there is not a perfect relationship or a perfect parallelism

between 1972 and 1976 but I believe that in a general way it is an

appropriate comparison. I regard fiscal policy as too stimulative in

1972. It is more stimulative now. Here we have monetary policy more

constrained and fiscal policy more stimulative. There is a serious

divergence between the two.

It raises some questions, more than I have answers for, but the

questions are nevertheless interesting. As long as this divergence lasts,

it suggests that we will have some upward pressures on interest rates,

particularly short term rates, which are always unsettling to the

economy in general.

Second, we have the question of whether this divergence can last

indefinitely. I doubt that it can. Then we have to figure out whether

the reconciliation between fiscal and monetary policy is going to take

place with both of them coming together in a compromise or whether

it involves a more expansive monetary policy to fall into line with fiscal

policy, which would raise questions about a new outbreak of inflation

and all the problems of a boom or an excessive boom of economic

activity a year or two or three down the road, or in turn whether fiscal

policy pulls back, becomes more cautious and gets into line with

monetary policy.

This would raise questions in people's minds about the expansion

for the next year or two. I don't know if there is any way to decide

specifically that one way is appropriate and the other is not to reconcile

this divergence of policies.

But it seems to me to be an interesting question and raises a lot of

uncertainties about the next few years. I think that is all the summary

I need to give you. We can go into any other parts of the statement

later as you wish, Mr. Chairman.

[Mr. Fiedler's prepared statement follows:]

PEEPAEED STATEMENT OF EDGAE R. FIEDLER, VICE PRESIDENT, ECONOMIC

RESEAECH, THE CONFEEENCE BOAED

This Subcommittee is studying some of the most fundamentally important,

the most interesting and the most difficult issues of economic policy, and I am

glad to have an opportunity to participate.

The main focus of this investigation, the impact of monetary policy on economic activity and inflation, is an extraordinarily complex matter about which our

understanding is very imprecise and incomplete. One of the few aspects of this

topic that seems reasonably well established is the long-term relationship between

monetary growth and inflation. In the very long run, say a decade or two, the

growth of money is clearly the dominant factor determining the rate of inflation;

the faster money increases, relative to total economic output, the faster prices

will rise. This association is not perfect for all times and all places and there is

some uncertainty about the precise definition of money, but by and large the long

run relationship between money growth and inflation is impressively close and

consistent.

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At the same time, although perhaps this is not so well established, there appears

to be very little long-run relationship between money growth and economic

activity.

In the short run, however—say one to two years—monetary policy has a significant impact on both inflation and economic activity, but in varying and highly

uncertain proportions. I have no doubt that the effect of an expansionary monetary

policy on real activity is more pronounced (and the effect on inflation less pronounced) when resource utilization in the economy is, as now, below average.

But I have great doubts that anyone can tell you the extent to which that is true.

How much impact monetary policy will have on output vs. inflation depends on

many factors including, importantly, the state of peoples' expectations about the

economy. Consequently, how much additional output would be generated by a

more stimulative monetary policy in the near term, as against how much additional inflation, is a highly uncertain proposition.

If the short run were all we had to worry about, the low current rate of resource

utilization in the economy would surely tempt us to recommend a more rapid

growth of money on the expectation that it would speed up economic expansion,

and in particular put more workers back on the payrolls sooner, at an acceptably

moderate risk of exacerbating inflation.

There are, however, two points that must be raised about such a policy move.

First, it is not enough simply to demonstrate that a low rate of resource utilization

exists currently. It is also necessary, because of the significant lags in the implementation and impact of policy shifts, to be persuaded that the economy will

still require an additional boost about a year ahead. For this purpose a series of

forecasts are needed: forecasts of the level of economic activity and how fast it

will be expanding at that time, and also forecasts of the total capacity of the

economy and how fast capacity will be expanding.

Here, too, we run into great analytical uncertainty. What constitutes economic

capacity is very difficult to conceptualize and even more difficult to measure.

Most people, when they think about the limits of capacity and how much room

there is left in the economy for continued expansion, tend to think of this question

only in terms of the unemployment rate. With 7.3 percent unemployment at

present and with the labor force expanding by 1.5-2 percent per year, it seems

rather obvious that the economy has plenty of room to grow.

However, the labor markets represent only one dimension of our economic

capacity—a very important dimension, but only one of several. The key dimension

these days appears to be in the materials processing industries—steel, nonferrous

metals, paper, basic chemicals, and other industrial materials. This was the

sector where the U.S. economy, indeed the entire world economy, ran into the

limits of its ability to expand in 1973-74, and where we are most likely to do so

again in the current cyclical upswing. If we are destined for another collision

with capacity in the present cycle, it is not likely to come in the labor markets,

or in the financial markets, or in the advanced processing industries; it is likely,

rather, to take the form of a new round of shortages and bottlenecks and price

pressures in the major materials industries.

There is already some talk that we are now closing in on full capacity operations

in paper, steel and chemicals, and will reach our productive limits before the

year is out. My own guess (I make no claim to expertise, but there isn't much of

it around) is that with a few bearable exceptions there is probably enough materials

processing capacity to support a continued cyclical upswing in the economy for

twelve to eighteen months more.

If that be an accurate judgment, it suggests that there might be a little room

for additional near-term monetary stimulus without taking too much risk of

accelerating inflation, but not very much. Indeed, it appears that the capacity

limits of the economy (focused in the major materials industries) are close enough

that we will soon have to be thinking in terms of slowing down the cyclical expansion to something approximating a normal long-run rate of growth.

Before leaving this discussion of capacity, there is one further aspect of it that

needs to be emphasized. The fact that the limiting element in our economic

expansion is the major materials industries means that we have a serious imbalance

between capital and labor. That is, we reach our capacity limits when the unemployment rate is still significantly higher than it would otherwise have to be,

which is a terrible human cost. For this reason, I believe it is of the utmost importance to redress the balance between capital and labor by fostering a rapid

expansion of new capital formation, especially in the materials industries. Hopefully, then, in the next round of prosperity when the next cyclical expansion reaches

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full capacity, the limiting factor will be the availability of labor rather than the

availability of capital facilities. If there are any productive resources that must

remain idle during prosperity, let them be idle machines rather than idle workers.

LONG-RANGE GOALS

But to return to the hypothesis I put forth earlier that a more rapid growth

of money in the near term might add to economic expansion without adding very

much to the inflation rate, there is a second point to be raised, namely, that we

cannot ignore our long-range economic goals. A primary long-term goal is to help

create a prosperous noninflationary economy by gradually reducing the growth

of money to a rate consistent with the long-run growth of physical economic

output. The policy prescription for this goal is thus just the opposite of the policy

prescription (more monetary stimulus) called for by our primary short-run goal

of fostering vigorous economic recovery.

In the past we have consistently given a very low priority to this long-term

objective. Indeed, we ignored it almost entirely on occasions. The result was severe,

persistent, unyielding inflation. In the process we failed completely to achieve

sustainable prosperity. Instead, the inflation was accompanied by the familiar

boom-bust rollercoaster for economic activity. In the future, I hope we can give

due consideration simultaneously to both near and more distant goals.

Some economists would argue in this situation for a "fine tuning" of monetary

policy: temporarily increase the rate of monetary expansion now, and then

reduce it even farther a little later. Under ideal circumstances, this might be a

respectable scenario, but past history strongly suggests it would require a forecasting accuracy and a delicate touch on the policy levers that are beyond our

abilities. In addition, such a process would seem to require at some not too distant

point a significant tightening of monetary policy on a fairly abrupt schedule that

would seriously raise the spectre of recession. In other words, although the idea

would be to gently brake the momentum of expansion down to a sustainable rate,

the process would run a serious risk of breaking the expansion altogether.

POLICY COORDINATION

Another important issue that is worth discussing is the relationship between

fiscal policy and monetary policy. Most of the time the two operate in tandem;

both tend to be stimulative together, or neutral, or restrictive. On occasions,

however, the fiscal and monetary policy positions diverge significantly for a time,

although because there is no common denominator for measuring both of them

it is not always easy to recognize such a development on a current basis.

I suspect that a divergence of policies is now taking place, with fiscal policy

relatively expansive and monetary policy decidedly more moderate. To illustrate

this divergence, it is useful to compare 1976 with 1972, which was also the second

year of a business cycle upswing. I believe many economists would agree that both

fiscal and monetary policy were rather stimulative in 1972, perhaps (as is my view)

too much so. (It might be argued that 1976 and 1972 are not quite comparable

in that the economy in 1976 is at a somewhat lower level of resource utilization

than in 1972. While there may be some validity to that argument, I believe there

is more similarity than difference, and thus that the comparison of policies for the

two years is an appropriate one.)

FRB target, calendar 1976

midpoints Calendar 1972

Monetary policy (percent)-.

M-l growth

6

Unified budget

1976

M-2 growth

9

deficits as a

1977

M-l growth

9.2

percent of GNP,

1972

M-2 growth

11.4

fiscal year—

1973

Fiscal policy 4.7 2.8 2.1 1.2

The 1976 target growth rates for money, either narrowly or broadly defined,

are 2}£-3 percentage points below the 1972 experience. Thus monetary policy is

clearly less expansive this year (assuming the targets are met) than it was in 1972.

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Furthermore, this comparison is even more striking if one takes account of the

fact that the rate of inflation is a couple of percentage points higher in 1976 than

in 1972.

On the other hand, with budget deficits equal to 4.7 percent of GNP in fiscal

1976 and 2.8 percent in fiscal 1977, compared to 2.1 percent in fiscal 1972 and 1.2

percent in fiscal 1973, fiscal policy is much more stimulative at the present time

than it was four years ago.

This divergence of the stance of fiscal policy from monetary policy raises

several interesting questions. For one thing, as long as the divergence continues,

it suggests upward pressures on interest rates, especially short-term rates. Another

question is whether these divergent policy positions can continue very long.

Historically, that has not happened; after a time one policy has adjusted to be

consistent with the other. If, in the present circumstances, fiscal policy were to

adjust to monetary policy by moving toward significantly less stimulus, serious

questions would be raised about the vigor of the business uptrend. On the other

side, if monetary policy were to become substantially easier, to conform more

closely to the present position of the budget, fears of a new acceleration of inflation

would be generated. Thus any reconciliation of the two divergent positions is

sure to raise many economic doubts and uncertainties.

CONCLUDING REMARKS

Throughout this discussion I have stressed the limitations of economic forecasting the shortcomings of analysis, and the difficulties of implementing monetary

policy in a precise and ideal way. That is, I believe, an appropriate emphasis.

In expressing these doubts, however, I trust I will not be misinterpreted. I do

so not out of any belief that monetary policy is ineffective or otherwise doomed

to failure, but rather in the hope of imparting some realism to our expectations

about what monetary policy can achieve. Policy makers, politicians and economists

have all oversold both fiscal and monetary policy during the past couple of decades.

I would hope we can correct that situation. I would hope we can understand that

there are no easy answers.

Let us use our monetary and fiscal tools vigorously. But let us use them with

care. Most important, let us use them with a proper understanding of both their

value and their limitations.

Mr. NEAL. Thank you very much indeed, Mr. Fiedler. Mr. Jordan?

Mr. JORDAN. Thank you, Mr. Chairman.

Mr. NEAL. Well, why don't you let us catch this vote?

We will be back shortly.

[Voting recess.]

Mr. NEAL. What we have been trying to do here—and I want to

make this clear to all of you and to anyone else interested in this

hearing—is to start by asking questions about the economy with no

preconceptions about what has been right or not and let the facts

unfold as they are, so we might objectively understand what has been

going on in our economy.

This chart is a result of asking those kinds of questions. It is preliminary. We would very much appreciate you all at the appropriate

time looking at it and seeing if you see any problems with it at this

point. See if you think we are painting a picture of these relationships

that does not exist. (See exhibit 1 and overlays A-C, pages 3-4.)

If you see any flaw, please let us know. It would be helpful to us if

all of you would examine the exhibit and give us your suggestions.

Let's go on now and at this point hear from Mr. Jordan.

STATEMENT OF JERRY I. JORDAN, VICE PRESIDENT AND CHIEF

ECONOMIST, PITTSBURGH NATIONAL BANK

Mr. JORDAN. Thank you, Mr. Chairman. I will not read my statement. I appreciate this opportunity to give my views on the conduct of

monetary policy since it is now at the center of the debate about

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appropriate stabilization policies for dealing with our inflation problem and unemployment at the same time.

Now, in contrast to a decade ago, most economists acknowledge

that monetary policy is important. It is my view that the growth rate

of the money supply is the most reliable indicator of the thrust of

monetary policy actions. There is still a large number of economists

who emphasize interest rates, and in public discussions it is generally

held that the level of interest rates is still a very important measure

of the tightness or ease of monetary policy. I want to address specifically that point.

In my view, interest rates can be a misleading indicator. In recent

weeks, the rise in interest rates that we have seen in the short-term

money markets has led some people to say that the Fed is tightening

policy prematurely. I don't think that is correct. I think the sharp

acceleration in monetary growth that we have had at the same time

is an indication of an expansionary policy—not a more restrictive

policy—in spite of the rise in interest rates. I don't think monetary

policy should be viewed as a choice between high interest rates and

rapid money growth, or between slow money growth and low interest

rates. You have to set targets for the future in order to have the interest rates you want in the future.

Before discussing this relation further, I want to comment on the

relationships between the money supply, inflation, output, and unemployment. I have brought a few charts to illustrate the basic relationships.

The basic analysis is that fluctuations in the growth of the money

supply are related to fluctuations in output and unemployment, and

the trend growth of the money supply determines the trend of prices

or inflation.

The heavy, solid line in the top tier of chart I l shows the growth

rate of the narrowly defined money stock, Mi, over two quarters or

6-month periods. The fine line is the average growth in money over

5-year periods. The second tier on the chart shows the average growth

of prices over 5-year periods. The third tier shows the fluctuations in

output over two quarters. The gray shaded areas are the recession

periods when real output declined. On the third tier, you see that

real output contracted sharply and unemployment rose sharply

during recessions. The contraction in money growth shown at the

top [the decline in the dark, heavy line] coincided with contractions in

real output growth, precipitating the recessions.

The continuing rise in the trend growth of money over the sixties

and seventies has been accompanied by a rise in the trend of inflation.

Now we have an average growth of the money supply of about 6

percent, so we have an average inflation that seems to be built into

the economy in the range of 5 to 6 percent.

Some economists are arguing that we should have twice as rapid

growth in money as the Fed wants, maybe 10 or 12 percent. That

would raise the solid line at the end of the top tier on the chart up

off the top of the chart. Once that has occurred, the Fed would be

faced with two choices at the end of this year or going into 1977. If

high growth in money is maintained, the trend will rise and that will

raise the trend of inflation. But if money growth is contracte , you

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 The chart referred to may be found at the end of Mr. Jordan's prepared statement.

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are going to precipitate a recession. The only time you can fight

recession is during the previous expansion. To me, money is sort of

like a narcotic—the economy can get hooked on too much of it and if

it does, it has got to face going through withdrawal symptoms

eventually.

Let's look at chart II,1 the relationship between inflation and interest rates. The top line is simply a series of high quality corporate

bonds. The lower line is the average rate of inflation over a 5-year

period, similar to the second tier on the first chart. The idea is that

there is an inflation premium in market interest rates, there is a real

yield—a real return on capital and people's savings after taking account of inflation. Borrowers are willing to pay a premium for what

they expect inflation to be, and lenders are demanding it in order to

compensate them for inflation.

Some people would like to see a decline in the long-term bond yield

in order to encourage capital expansion or growth in investment, and

maybe a stronger housing market. It is tempting to try to push interest rates down to help the economy. My point is, it would be selfdefeating because investors in the market would look at the rapid

growth of the money supply and would expect future inflation to be

higher, and they would try to protect themselves from the losses in

capital markets that would accompany another round of accelerating

inflation and rising interest rates. They would invest in short-term

assets. They would avoid long-term commitments. Long-term interest

rates would rise. You would get rates rising, not declining. The only

way I think we are going to get lower long-term interest rates is simply

to wait it out until we get an average rate of inflation down to something much lower than seems to be built in. The 8- to 9-percent level

of long-term interest rates implies the markets expect about a 5- to

6-percent rate of inflation, and only when they can expect a lower rate

of inflation than that can we expect to get a decline in interest rates.

Short-term interest rates are shown on chart III.1 I think that

chart speaks for itself. The solid line is the interest rate, the prime

commercial paper, a series I picked to illustrate a relationship. The

dotted line is the rate of inflation. It shows how the market responds to

inflation in the short run.

Mr. NEAL. May I interrupt you? Can we pick up on this chart

when we return? We have to make it to the vote.

Mr. JORDAN. Yes.

[Voting recess.]

Mr. NEAL. Mr. Jordan?

Mr. JORDAN. Thank you, Mr. Chairman. Let me proceed in the

following way. Suppose the Federal Reserve achieves its targets

for the growth rate of the money supply, what can be expected, and

what sort of alternatives are there and what would they imply? If

they do not exceed their midpoints for growth of the money supply,

we will have a durable, healthy growth in real output, and a further

decline in the unemployment rate. Growth in total employment has

been stronger than people would have believed, and the unemployment rate has declined more than most people would have expected.

1

 The chart referred to may be found at the end of Mr. Jordan's prepared statement.

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We can continue to see that kind of development. If so, then we also

would not expect a reacceleration in inflation nor a rise in long-term

interest rates.

Mr. NEAL. I am sorry. If what?

Mr. JORDAN. If the Federal Reserve does not exceed the midpoints

for its money supply growth targets. In the past, we have seen rapid

monetary growth in an election year followed by a year of more

restrictive policy—slower money growth and higher interest rates.

We can and should avoid that kind of pattern.

However, if the economy continues to strengthen, you are going

to have upward pressure on short-term interest rates. They will

rise toward the level of long-term rates. This is a natural, cyclical

phenomenon. It should not be resisted by rapid money growth.

The alternative is not to expand money rapidly to hold interest

rates down until we get full employment. The alternative would be

to hold it down this year, and pay the price next year. I think that

can and should be avoided.

Let me turn to congressional oversight. Concurrent Resolution

133 is a valuable contribution to monetary policy. Oversight by

Congress of monetary policy is desirable. But I do think there are

dangers of excessive involvement in the formulation and implementation of policy. The primary role should be to maintain the checks

and balances that are inherent in the whole political system.

Certainly the Federal Reserve should be held accountable for their

actions. Congress should scrutinize the actions of monetary policy

to insure that they are not used to achieve short-term political gain.

But, there is a risk of asking too much from monetary policy—asking

more than it can deliver in terms of offsetting the mistakes inherited

from others, or trying to correct for some of the real shocks to the

economy, such as agriculture, quadrupling of oil prices, and some

other things.

You can ask the monetary policy actions not be destabilizing as

they have been in the past. They have caused worse recessions and

more unemployment than we otherwise would have had. I think it is

possible to avoid destabilizing actions and Congress should use its

oversight to hold the Fed accountable on that ground.

Two things that oversight can do. It can insure that monetary

policy actions promote conditions of stability to minimize the uncertainty in the markets so the real economy can adjust most easily

and rapidly to its natural full employment, full capacity state. They

can prevent the accelerations and decelerations that have occurred

in the past that have caused credit crunches and waves of higher

interest rates.

There are two objectives in setting money targets that the Federal

Reserve should be held to. One is to gradually lower the trend growth

of money so you lower the rate of inflation, and the other is to eliminate

the fluctuations in money growth so that it does not contribute to

fluctuations in unemployment that occur.

Thank you.

[The prepared statement of Mr. Jordan, along with the charts referred to, follows:]

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DOMESTIC MONETARY POLICY

Testimony By

Jerry L. Jordan

Vice President & Chief Economist

Pittsburgh National Bank

Mr. Chairman and members of the Sub-Committee:

I am pleased to have this opportunity to present

my views on the conduct of monetary policy, and how it affects

production, employment, and the cost of living.

The conduct of monetary policy, and especially the

growth rates of the nation's money supply, has moved to

the center of the debate about appropriate stabilization

policy actions at a time of simultaneous inflation and high

unemployment. Even economists who have spent much of their

careers arguing that monetary policy was not important,

and that especially the money supply was irrelevant, are

now advocating specific growth rates of money supply in

the present circumstances. It appears safe to conclude

that we have established that "money matters" and all that

we are doing is haggling over the growth rates.

However, the role of interest rates remains very

much an issue among economists as well as in public discussions.

Let me state at the outset that I am one who finds it most

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useful to gauge the stimulus or restraint emanating from

monetary policy actions by the growth rate of the money

supply. There is substantial evidence, both in the U.S.

experience and around the world, that the level of market

interest rates can be a false indicator of the tightness

or ease of monetary policy.

Yet, in recent weeks, some members of the economics

profession have cited the rise in short-term market interest

rates as an indication of a move by the Fed towards "tight

money" even though there has been a pronounced acceleration

in the growth rate of money supply. In a few moments I

will elaborate on my view that monetary policy actions should

not be viewed as a choice involving rapid money growth versus

high interest rates, nor slow money growth versus low interest rates. But first I will direct my attention to the

relation between monetary policy and inflation, production,

and employment.

I draw your attention to Chart I. One of the cornerstone propositions of monetary analysis is that fluctuations

in the growth of the money stock around its underlying trend

result in fluctuations in output and employment, whereas

the trend growth of the money stock determines the trend

growth of prices. A substantial body of empirical evidence

has demonstrated repeatedly that an acceleration in the

growth of the money stock initially will have an expansionary effect on output and employment, but, subsequently,

prices will begin to rise (over an extended period of time)

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as the trend growth of money also rises. The corollary

is that a contraction in the growth rate of the money stock

relative to its trend will result in a contraction in the

growth of output and employment.

The heavier line on the top tier of Chart I is the

growth rate of the money stock over a two-quarter or sixmonth interval, while the trend line is the average rate

of increase of money over a five-year period. The second

tier shows the rate of increase of the GNP implicit price

deflator over a five-year period and the third tier shows

fluctuations in the growth of real output over two-quarter

periods. The basic point is that fluctuations in money

growth around the underlying trend, as shown in the top

tier, are reflected in fluctuations in real output. The

average rate of inflation reflects the trend growth of the

money stock.

The average growth in the money supply in recent

years has been around 6 percent. The center of the Federal

Open Market Committee's target growth for Ml is also about

6 percent and, therefore, is a policy of returning to and

maintaining the prevailing trend growth of money over the

next year. As long as that policy is continued, something

around a 5 to 6 percent average rate of inflation should

be expected. In order to make progress towards further

reducing the rate of inflation, it will be necessary to

gradually reduce the trend growth rate of the money supply.

Ultimately, if we are to ever return to the rate of inflation

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that prevailed on balance in the 1950s and early 1960s,

it will be necessary to reduce the trend growth of the narrow

definition of the money stock to only about 2 percent.

However, the immediate problem in pursuing that

objective is that there is still an unacceptably high rate

of unemployment in the economy, and there is every reason

to expect that the strengthening credit demands that will

occur as the recovery continues will produce upward pressure

on short-term market interest rates. Because of this, there

are economists who advocate increasing the money stock twice

as rapidly as the announced targets of the Federal Reserve

(if necessary) in order to prevent increases in market interest

rates before a much lower rate of unemployment is achieved.

It is my view that if the Federal Reserve were to

allow the money supply to increase at a 10 to 12 percent

rate the balance of this year, in order to prevent interest

rate increases and to promote a higher level of employment

and capacity utilization, they would be left with a very

unpleasant dilemma next year. The pursuit of "low interest

rate policies" would prove to be self-defeating. At some

point the monetary authorities would be faced with two choices.

They could sustain those extremely high growth rates, but

that would raise the trend and cause quite high rates of

inflation. Or they could produce a marked contraction in

the growth of money as we approached a higher level of resource

utilization which, in turn, would necessitate an economic

contraction.

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In other words, if a low interest rate policy were

to result in double digit money growth for the balance of

this year, then we would be faced with either double digit

inflation or another credit crunch and major recession within

two to three years. This paradox of low interest rate policies

resulting in high interest rates stems from the fact that

inflation and high market interest rates are both a product

of excessive monetary growth.

It is a myth that rapid money growth can maintain

low interest ratesr except in the very short run. The reason

Switzerland has low interest rates is because they have

had moderate money growth. The reason Brazil has high interest

rates is because they have had rapid monetary growth.

Chart II shows the yield on high-quality corporate

bonds plotted along with the average rate of inflation over

a five-year period. Most people accept the idea that the

level of long-term interest rates includes some "premium"

for the average rate of inflation that is expected to prevail over the life of the bond. Lenders demand compensation

for the erosion in purchasing power that takes place when

there is inflation, and borrowers are willing to pay the

premium because they are aware they will pay off their debts

with "cheaper dollars."

The prevailing level of long-term bond yields reflects

expectations of about an average 5 to 6 percent rate of

inflation in the future. There is no reason to expect longterm interest rates to decline until there is reason to

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believe that inflation will be less than the 5 to 6 percent

that seems to be the consensus view. It is tempting to

seek a more rapid decline in long-term interest rates in

order to foster conditions conducive to increased private

investment and lower mortgage rates to stimulate housing

demand. However, to the extent that investors pay attention

to the growth rate of the money supply in forming their

expectations about future inflation, policy actions by the

Federal Reserve that resulted in sharply higher growth rates

in the money supply would cause long-term interest rates

to rise, rather than fall. This is because managers of

investment funds would attempt to avoid incurring a capital

loss that would occur when the price of long-term bonds

declined as the inflation premium in bond yields was revised

upwards. The precautionary actions by investors in the

money and capital markets would thwart actions of the central

bank designed to aggressively push interest rates down.

Turning to short-term market interest rates, Chart

III shows the relation between the average rate of inflation

over six-month periods and the short-term commercial paper

rate. I think that the chart speaks for itself. The way

to avoid a return to the level of short-term interest rates

that was reached in 1974 is to avoid the kind of acceleration

in inflation that occurred at that time. This leads us

back to the role of monetary policy in avoiding another

inflationary outburst.

73-959 O - 76 - 4

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It is useful to distinguish between inflation as

an ongoing process, and a change in the price of one or

more commodities or a one-time increase in the average level

of prices. A continuous inflation is the result of aggregate

demand rising more rapidly than aggregate supply over a

prolonged period of time. That development usually has

occurred as a result of the growth of the nation's money

supply being excessive so that we have a case of "too much

money chasing too few goods."

Some economists argue that the high rate of unemployment and low rate of capacity utilization indicates that

there is no danger of a spill-over of excess demand into

renewed inflation in the immediate future. I disagree with

them on the grounds that the economically usable capacity

is smaller than the capacity utilization or potential GNP

data indicate. Most people attribute a large share of the

economic problems of the past few years to the following

factors: the major crop failures in 1972 and 1974, the

two devaluations of the dollar, the after-effects of wage

and price decontrol, the increased production costs associated

with devoting a greater proportion of our resources towards

cleaning up our environment, the production of safer products

and providing an improved environment for workers, and the

very pervasive effects of the quadrupling of the price of

petroleum energy. These forces resulted in a loss of wealth

and a decline in the real economic capacity in our economy

and a temporary bulge in the.rate of inflation. I am suggesting

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that the major initial forces contributing to the long and

deep recession were shocks to the supply side of the economy

that left us with both a higher level of prices and a lower

real output potential. Consequently, the dangers of reigniting

inflationary pressures are much greater than conventional

measures of economic capacity might suggest.

There is no doubt in my mind that if the growth

in the money supply does not exceed the mid-points of the

target ranges announced by the Federal Reserve, a healthy,

durable economic recovery will continue and renewed inflationary

pressures will be avoided. However, as a natural cyclical

phenomenon, short-term market interest rates will rise as

strengthening private sector credit demands compete with

government borrowing. But it would be a mistake to interpret

the rising short-term interest rates as a sign of restrictive

monetary policy at a time when the quantity of money is

also increasing at a historically high trend rate.

The alternative to a natural rise of short-term

interest rates of as much as 2 or 3 percentage points over

the next year is not to simply hold them down through more

rapid monetary growth. The alternative is to artificially

suppress the level of short-term interest rates during 1976

through excessively easy policies, and then pay the price

in 1977 and 1978 in terms of even higher interest rates

and eventually another credit crunch and recession.

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Congressional Oversight of Monetary Policy

I believe that Concurrent Resolution 133 has made

a desirable contribution to the monetary policy process.

However, I also believe that former Congressman and Speaker

of the House, Sam Rayburn, was correct in warning of the

dangers of excessive Congressional involvement in the formulation and implementation of monetary policy actions.

I would think that one of the primary roles of Congressional oversight of the Federal Reserve would be to maintain the

checks and balances that have been a central ingredient

of our entire system of government and were very much a

part of the Congressional deliberations that created the

Federal Reserve over sixty years ago. Our independent and

decentralized system of Reserve Banks has served us very

well, and the safeguards against potential abuse of power

to create money must be preserved. >

It seems that Congress would want to scrutinize

actions of the Federal Reserve to insure that monetary policy

actions are not used to achieve short-term political gain.

I would not want to see members of the Federal Open Market

Committee adopt policies designed to achieve political objectives either of their own choosing or as a result of

pressure from the executive branch, the legislative branch

of government, or other political groups.

Regarding the setting of economic goals, I think

that the Federal Reserve should promote conditions conducive

to full employment, minimum inflation, and low interest

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10

rates. And I think that every member of the Federal Open

Market Committee and every professional economist, as well

as the general public, would agree. But disagreement would

arise over the weighting to be assigned to each objective

in the near term, and the time frame in which the goals

are to be pursued, as well as the tools and techniques that

are to be employed.

There is a risk of asking more of monetary policy

than it can deliver. I believe that a market-oriented economic

system is naturally resilient and inherently stable at a

high rate of capacity utilization, including full employment

of labor. But the system is frequently subject to destabilizing shocks, sometimes from monetary and fiscal policy

actions and sometimes from uncontrollable natural forces.

We can and should ask that monetary policy not be

destabilizing, but should the monetary authorities be asked

to try to correct the mistakes made in the implementation

of fiscal policy? When the economy is subject to the disruptive effects of unsound financial policies of a major

city or state government, should monetary policy be used

to try to offset these effects? Should we try to counter

the adverse real economic effects of social policies, such

as cleaning up the environment and providing safer products

and safer working conditions by monetary policy actions?

Should monetary policy be used to try to offset the wealth

loss associated with a quadrupling of oil prices or failure

of the wheat crop?

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li

I do not believe any of these efforts would be successful, even if they were desirable. I think it is possible

to avoid destabilizing actions, and certainly the central

bank should be held accountable for any actions that contribute

to a worse situation. And I do believe that in the past

monetary policies have resulted in worse recessions and

worse inflation than would otherwise have occurred. Congressional oversight can insure that monetary policy actions

are designed to promote stable monetary conditions and to

minimize the uncertainty in financial markets in order that

the real economy can adjust most easily and rapidly to its

natural full employment, stable price condition.

It is my hope that Congressional scrutiny of monetary

policy actions will prevent the erratic accelerations and

decelerations in monetary growth that have occurred through

most of our history. I think that Concurrent Resolution

133 will contribute towards that objective.

I would like to make a suggestion that I think would

help Congress to oversee achievement of money supply growth

targets. The growth rates for the money supply announced

by the Federal Reserve should be used to set the upper and

lower levels for the stock of money that the FOMC thought

appropriate in the one-year-ahead quarter. Once the upper

and lower levels for the aggregates are set for a quarter,

they would remain in effect unless specifically changed.

As each quarter passed, the shifting base would be used

only to establish the upper and lower bounds for the money

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12

stock in the quarter one-year ahead. But the target levels

for the intervening quarters would not be affected. It

would be desirable to use narrower target growth ranges

than the 2-1/2 to 3 percentage points that the Fed has been

using in the past year. Otherwise, if money moved from

the lower limit in one quarter to the upper limit in the

subsequent quarter, (and the reverse) as each successive

quarter passed, a very high variance in the growth rate

of money would occur.

The approach I propose in interpreting the Fed's

long-run money supply growth targets would prove most useful

in dampening fluctuations in money growth if a single target

growth rate were announced for each measure of the money

supply or if a very narrow growth range, such as one percentage point, were used. In analyzing the procedures for

setting money growth targets, it must be kept in mind that

two objectives are being pursued. One is to bring about

a lowering in the trend growth of the money supply in order

to reduce the average rate of inflation in the economy.

The second is to minimize fluctuations in money growth around

the underlying trend in order to minimize any adverse impact

on output and employment.

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Chart I

Trends and Fluctuations of Money, Prices, Output, and Unemployment

1952 1953 1954 1955 1956 1957 1958 1959 1940 19*1 1962 1963 1964 1965 1966 1967 1961 1969 1970 1971 1972 1973 1974 1975 1976 1V77

195? 1953 1954 1955 1956 1957 1958 1959 I960 1961 1962 1963 1964 1965 1966 196/ 1961 1969 1970 1971 1972 1973 1974 1975 19)6 1977

The shaded areas represent periods of business recessions as defined by the National Bureau of Economic Research.

* A 'mini-recession' occurred in 1/1967.

Catest data plotted: 1st quarter.

^ ^ PITTSBURGH NRTIONOL BONK

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12

Chart II

Inflation and Interest Rates

»—-"-

-

Corporate Aaa Bonds j

Rate of Inflation U_

y

/

********

A

/

/

/

« ^ —

Percent

12

1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976

[1_Rates of change in consumer prices over the previous five years.

Latest data plotted: Aaa-May preliminary; Inflation-April

yST PITTSBURGH NATIONAL BANK

Or

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Chart III

Inflation and Short-Term Interest Rates

Percent

13

12

11

10

9

8

7

6

5

4

3

2

1

1969 1970 1971 1972 1973

H.Yield on 4- to 6-Month Prime Commercial Paper.

12. Rates of change in consumer prices over the previous six months.

Latest data plotted: CP Rate- May preliminary

Inflation- April

/

J

A

 A

J

Prlnu Commer

v Paper Rate

V\ i

\

\\r\

Rate

clal

1

j

/

r

r\\f

of Inflatior

n

m l / HZ

K

\

i

i

/

t k

\ I

\

v

i

1

i

i

i

i

i

i

\

L

1974 1975

Percent

13

12

11

10

9

8

7

6

5

4

3

2

1976

PITTSBURGH NflTIONRL BONK

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Mr. NEAL. Thank you very much. Now we will hear from Mr.

Meiselman.

STATEMENT OF DAVID I. MEISELMAN, PROFESSOR OF ECONOMICS,

VIRGINIA POLYTECHNIC INSTITUTE AND STATE UNIVERSITY

My name is David Meiselman, and I am a professor of economics at

Virginia Polytechnic Institute and State University where I am also

director of its new Northern Virginia graduate program in economics

located in Reston, Va. I am also a consultant to Bache Halsey Stuart,

Inc. The views I express today are my own.

I have devoted most of my professional career to the study of money

and its relationship to economic and financial conditions. I appreciate

the opportunity to appear before the Subcommittee on Domestic

Monetary Policy of the House Committee on Banking, Currency and

Housing to present my views on the important questions you are

examining in these hearings on monetary policy and the economy.

The Congress, and especially this subcommittee and its counterpart

on the Senate side, has unique responsibilities in guiding and monitoring the conduct of monetary policy because of the constitutional

provision that "The Congress shall have the power to coin money and

regulate the value thereof."

The Congress created the Federal Reserve and delegated to it

vast powers to control the Nation's money supply and thereby the

value of money. The Federal Reserve was given a large measure of

independence, but the independence of the Federal Reserve is to be

interpreted only in the sense that under the law the Federal Reserve

is independent of the executive branch of the Government, but not

the legislative branch. The Fed is a creature of Congress and reports

to the Congress. In that sense, the Federal Reserve is different from

most agencies of Federal Government which are involved in making

and carrying out public policy, especially where economic policy is

concerned. To fulfill its constitutional responsibilities, the Congress

must exercise close and continuing oversight of the Federal Reserve,

and these hearings are a most welcome part of the process.

Although the past record of Congress in monitoring the actions of

the Federal Reserve has not been a good one, in the past several years

there has been heightened awareness of the importance of monetary

policy and of the unique role of Congress in the conduct of monetary

policy. One result was the passage, in 1975, of House Concurrent

Resolution 133 requiring that the Federal Reserve report to Congress

on its intended targets for money change.

The resolution has facilitated systematic congressional oversight of

monetary policy which has contributed significantly in turning the

economy around in the past year during which we have seen a progressive decline in the pace of inflation at the same time that the unemployment rate has been falling, a happy combination of events many

economists, excluding some on this panel, hardly believed possible.

I therefore support H.R. 12934 which makes the concurrent resolution

a permanent part of the law.

Before commenting on the specific questions which have been put

before this panel, I wish to make one general observation about the

role of monetary policy. The best attainable goal of monetary policy

is to avoid the problems caused by poor monetary policy. The best

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attainable monetary policy does not produce goods and services,

employ willing workers, promote efficiency or generate economic growth

and progress, but poor monetary policy can, and has disrupted and

destroyed both freedom and plenty in country after country. Belief

that monetary policy can either offset or paper over the consequences

of poor public policies which create unemployment by reducing incentives to work or to employ labor, or which discourage economic

growth by imposing differentially high taxes on saving and investment, has been a major factor in the inflationary bias of monetary policy over the past decade, the consequences of which have been

both more unemployment and less economic growth and progess

than would have been the case had we continued the moderate and

steady policies of the early 1960's during the Kennedy administration.

Appropriate Federal Reserve policy can eliminate the scourge of

inflation and attain the desirable goal of stable prices. In turn, stable

prices will increase employment, speed growth and lower interest

rates, but stable prices or the best possible monetary policy cannot

solve all our problems. I know of no informed or responsible student

of monetary affairs who asserts that money matters, that monetary

policy is important, who has ever claimed otherwise.

By contrast, inflationary monetary policy can only temporarily

reduce interest rates or increase employment but at the later costs of

higher interest rates, more unemployment and less growth than before

the hyp. Repeated experience with excessive monetary expansion has

taught enough people about its effects that these lags have become

shorter and shorter. In some instances, there is no lag at all, and

financial markets adjust almost instantaneously to the latest information and statistics of Federal Reserve actions.

The Fed has announced that it intends to achieve stable prices by

gradually slowing the rate of monetary expansion. The Congress

would do well to monitor and to support this wise and attainable

policy.

I turn now to the specific questions of this set of hearings. Monetary

policy is the single most important factor determining the average

level of all prices, the cost of living. Monetary policy is mainly concerned with the quantity of money. The Federal Reserve controls

the money supply and could do so more effectively if it also did not

attempt to control other things at the same time, such as short-term

interest rates. The relationship of money to prices, especially longperiod or secular changes in prices, is perhaps the single most tested

and validated proposition in all of economics, covering a wider range

of economic experience in time, place and circumstances than any

other, and with essentially the same results.

Prices depend on a ratio of money to output. The rule is that prices

rise when money grows faster than output, prices fall when money

declines relative to output, and prices tend to stable when money

grows at the same pace as output. I know of no important exception

to these rules in at least the past 400 years of recorded history.

Because it is generally easier to change the quantity of money than it

is to alter output, the quantity of money rather than the volume of

output tends to dominate price movements. Recent experience both

in the United States and around the world is consistent with these

historic norms. There is no basis at all for recent contentions that, at

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least for this area, the old laws of economics no longer work. Indeed,

over the past 15 years the connections between money and prices

have been closer than tended to be the case in the past. Chart 1

shows the close connection, since I960,,between the U.S. Consumer

Price Index and the ratio of money to output using the broad M2

measure of money. .>•-•

100 -

CHART 1

United States

Money and Prices, 1960-1975

Index numbers

(1965=100)

' /'•••••••.]•:•. . : • •. ::-: : :;:. :i :

Key: M2/real GKP . I

CPI

... .

~T 1

1970 71

There is another way of looking at the same phenomena. There is a

close connection between the quantity of money and nominal GNP.

This is true for both the narrow Mx measure of money, currency and

demand deposits, and M2, the broader measure of money, currency

and all bank deposits less large Certificates of Deposit. Chart 2 shows

the close connections between M2 and GNP since 1960. Income

velocity, the ratio of GNP to the M2 measure of money, has been

essentially constant for M2 since at least 1960. There has also been a

close connection between Mx and GNP over the same period, except

that there has been an upward drift in the ratio of GNP to Mi. It

has been rising at the rate of approximately 2.7 percent per year

for Mu typically rising faster than trend during business cycle expansions and slower than trend during business cycle declines. (See

chart 3.)

In the past year the behavior of monetary velocity has conformed

to these historic norms, M2 velocity remaining constant, Mx velocity

rising above its 2.7 percent trend increase.

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Nominal GNP depends on the nominal stock of money, but nominal

GNP has two component parts, the one is the volume of output, real

GNP, and the other is the prices of goods and services measured by the

GNP deflator or some other price index. This is the reason that for

given nominal GNP, the higher output, the lower prices, and vice

versa. Because nominal GNP is essentially fixed by nominal money,

it is equivalent to stating that prices depend on the ratio of money to

output.

CHART 2

United States

Index Numbers of Honey (NL)

and GNP, 1960-1975

 c

(1965 = 100)

G.

?00-

100-

160-

140-

100-

ao60-

.P.

• 73

•72

•71

©70

68

r 65

.•". ' %64

.•62 '

• 61

• 60 .

00

•:::«::•!••:::•: •

100 120 110 1G0 100 200 H,

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220

210-

200-

190-

180-

170-

160*

150-

140-

130-

120-

110-

100-

9 0 -

8 0 -

70-

" *. • : CHART 3

• • • United States

Index Numbers of Money (M,)

and GHP, 1960-1975 '

(1965=100)

• . .

•71

... .

•70 ^

••69

-

 :

•68

• 67-

•66

. »65 . ' : '

• 64 . * ' ' ''•

• 63 • * :

•C2 '.•.. •

• 6 i . .'::. '

60

1 1 1 1 » \

•

<72

•75

i

 :"-::

•74

* -73

•

•

•

•

00 90 loo no 130 MO 150 1G\O r 170

 > K

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For a given stock of money, which fixes nominal GNP, an increase

in spending for one class of goods means that there must be a decrease

in the spending for other goods. Thus, for given money, an increase

in Government expenditures tends to be at the expense of a decrease

in private expenditures. The public sector crowds out the private

sector. Alternatively, a decrease in Government expenditures, given

the quantity of money, generally makes it possible for the private

sector to expand. If more Government expenditures are financed

by an increase in the public debt, the resulting higher interest rates

bear most heavily on expenditures most sensitive to interest rates

such as housing. Government crowds out housing. If Government

expenditures are financed by higher taxes, the specific results are

more difficult to generalize because different taxes have different

effects. In any event, when allowance is made for the quantity of

money, the short-run stabilization impact of changes in fiscal policy,

that is variations in the size of the budget or in the schedules of tax

rates have been either minor or absent. Moreover, I know of no country

which has brought inflation under control by means of fiscal policy

alone, that is, without correspondingly limiting the stock of money.

Indeed, many countries have tried, but as far as I know, none has

succeeded.

Taxes and expenditures should be determined by considerations

of long-run efficiency and equity. I see no useful purpose in varying

tax rates or expenditures to achieve hoped-for stabilization results,

especially in the face of overwhelming evidence of the ineffectiveness

of fiscal policy, especially of the fine-tuning variety. To vary the old

saw, if money policy is properly used, fiscal policy is unnecessary.

If money policy is not properly used, fiscal policy won't do any good.

I briefly turn to the question of interest rates and the relationship

of interest rates to monetary policy. Although there is growing

understanding of the connections between money and interest rates,

there is still widespread confusion between money and credit and

between cause and effect. Market interest rates have two components,

the real rate of interest and the inflation premium, the expected rate

of change of prices. It turns out that an expansionary monetary policy

tends to drive up market interest rates, not lower them, and a contractionary policy tends to lower market rates, not raise them. The

main reason is that more money leads to more spending. In turn, more

spending means higher output or higher prices, or some combination

of the two. If the increase in aggregate spending increases only output

and employment, business becomes more profitable. The productivity

of capital rises, inducing more borrowing, which pushes up real interest

rates. On the other hand, if the increase in aggregate spending merely

drives up prices, interest rates rise to incorporate the inflation,

especially as people come to anticipate more future inflation. Concerning both effects, expansionary monetary policy leads to higher

interest rates as in recent years, contractionary monetary policy

causes lower interest rates, as in the great depression of the 1930;s.

In other words, easy money leads to tight credit. Tight money leads

to easy credit. I have done extensive statistical and theoretical studies

of these relationships and will submit some of them for the record.

I understand that at yesterday's hearing there was some support

expressed by Congressman Adams for a policy that would require

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that the Federal Reserve peg the Treasury bill rate at b% percent,

partly to hold interest costs of the public debt within budget totals.

This policy is certain to lead to disaster, either of cumulative and

explosive inflation, or cumulative and implosive deflation. If free

market interest rates are above 5% percent, the Federal Reserve

can initially force them down to 5% percent by creating additional

Federal Reserve credit and thereby additional bank reserves to bid

up bill prices (bid down bill yields). But once the new money was

out in the economy, following the mechanism I have just summarized,

the increased quantity of money would cause both more inflation and

still higher interest rates than before the attempt to lower rates.

The longer the Federal Reserve tried to maintain the artificially low

rate, the more inflation and the higher interest rates would go.

If free market rates were less than b% percent, trying to force rates

up or keep them up would require cumulative decreases in money,

and a corresponding downward spiral of prices and interest rates.

In the process, output and employment would also suffer.

I turn finally to the relationships between money and employment.

It is important to distinguish the initial from the later impacts of

monetary change. When there is an increase in the stock money which

correspondingly causes an increase in aggregate spending, in many

markets the first impact is seen in an initial set of events that includes

increased sales and rising output and employment before later changes

in prices. In other words, there are quantity adjustments before price

adjustments. Thus, as in 1972, expansionary monetary policy leads

first to the good results of increased output and employment before

the later bad results of higher prices, whereas monetary restraint

may, as in 1974 and 1975, lead to the bad results of reduced output

and employment before the later good results of moderating inflation,

as in 1976. This asymmetry has been one of the major sources of

widespread myopia about the inflation process and of the inflationary

bias of public policy.

I may add that I see no evidence for the contention, usually labeled

the Phillips Curve, that inflation is not only helpful, but necessary,

to achieve and maintain high levels of employment and growth.

(See chart 4.) Indeed, I have recently argued elsewhere

 1 that, on the

contrary, more inflation leads to more unemployment. The initial

burst of inflation may temporarily reduce unemployment in the first

instance if it comes as a surprise because product or output prices

rise relative to labor costs, thereby inducing an increase in the demand

for labor. If inflation continues, the entire economy, including all

wages and prices, adjusts to the ongoing inflation. Because there are

no permanent surprises, there are no permanent employment gains.

I suppose I could quote Abraham Lincoln at this point.

To affect output and employment, inflation must be unanticipated.

For public policy to use inflation to make employment and output

different from what it would otherwise be means that public policy

must be directed at fooling people—which is hardly a proper or effective basis for public policy in the first place. But as time goes on,

it becomes progressively more difficult to fool people. This is why

this kind of policy leads to greater and greater instability, heaped on

top of more and more inflation. In the stop-go policies, the "stops"

and "go's" inevitably become more pronounced.

1

 David Meiselman, "More Inflation: More Unemployment," Tax Review (Tax Foundation, January 1976).

73-959 O - 76 - 5

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Chart4: The Inflation Rate and the Unemployment Rate, 1048-197S

Inflation f late

(Porccrit por Year)

12

10

0

6

4

2

A

V

-

-

f 1

0 2

fewer Drptrtnwnt of l*U>r. 6w

1 V /

I \^ \ \ \

\

 S \ | \ \

( 1 1

4

Unomplo/mont Rato

ttmj o» L*bo« Sutulic*

\

\ / u

O 72

/ .

49O —

1 1

6 8

Trying to fool participants in one area of the economy by the use

of policies affecting the entire economy leads to a vast widening of

the range of uncertainty about future events, which undermines the

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efficiency of intertemporal decisionmaking involving saving, investment, a,sset management, and the like. It also effectively destroys

economic information essential to the efficient operation of the

economy.

The price system which characterizes the market economy is a very

efficient means for conveying large amounts of information. One of the

characteristics of variable and unanticipated inflation is that people

effectively have less information about current prices and markets.

Individuals and business firms tend to learn about prices and markets

in a sequential manner. As they keep receiving new information, old

information is revised or discarded.

Large-scale unanticipated inflation impairs the orderly learning

and adjustment process. The loss of information can be overcome by

devoting more resources to data gathering, updating price lists and

the like. Doing so uses time and resources, and is costly. Information

and search costs rise, which alone cause an increase in unemployment,

a decrease in efficiency, and a deadweight loss to the economy. One

manifestation of how inflation destroys information is that ordinary

accounting statements mean less and less as the inflation process

proceeds.

The increased uncertainty and lack of information about future

events weakens the basis for rational and efficient decisionmaking and

economic activity. It becomes more difficult, and in many respects

impossible, to plan for the future including making provisions to

accumulate real resources for retirement, for sending children to

college, for contingencies and for all the other reasons people wish

to save so they can attain and depend on future real income and real

wealth. For the same reasons, even highly skilled financial managers

cannot plan efficiently, business managers have less firm bases for

making judgments about future products, labor and materials markets

and capital outlays—partly because the effects of inflation are not

uniform.

Unfortunately, there is no effective way to hedge against inflation,

to insure against its consequences, or to make contracts in units of

stable purchasing power.

Thus, the continued process of variable, unanticipated inflation

does not increase employment. Rather, it has a cumulative and negative impact on efficiency and on resource allocation. Returns to both

labor and capital suffer. This, taken together with the distortions of

the inflation process, impairs the flexibility of markets and thereby

causes an increase in unemployment. And, when rising unemployment

has called forth public policies that lead to still more inflation, the

unemployment rate ends up still higher, even though there may be

some initial and temporary improvement.

These are some of the reasons it is essential to abandon the deliberate

use of inflation as an instrument of public policy, even for short periods

of time. To avoid abrupt shocks to the economy, the inflation should

be slowed gradually and eliminated over a 3- to 5-year period. The

maintenance of general price stability will require steady, noninflationary courses for monetary and for fiscal policies. For monetary

policy this means a long-term growth of money in the range of 2

percent to 4 percent per year for M1 or 4.5 percent to 6.5 percent for

M2; for fiscal policy, relatively stable taxes and expenditures close

to or at a balanced budget.

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In the past year, Federal Reserve policy has been consistent with

these goals and targets. The Congress would make a great contribution

to the Nation's welfare if it continued its close and informed oversight of Fed activities to help achieve the attainable goal of price

level stability.

Thank you.

Mr. NEAL. Thank you for your testimony. Just one question.

How did you arrive at that goal?

Mr. MEISELMAN. TWO to 4 percent?

Mr. NEAL. Right.

Mr. MEISELMAN. I explained that in detail before this subcommittee a year and a half ago. First, long-term economic growth of the

United States has been in the range of 3.5 to 4.5 percent per year.

Second, the Consumer Price Index is generally acknowledged to

have an upward bias in the range of 1.5 to 2 percent. Because of

quality improvements and related technological factors not adjusted

for in the statistical construction of the index, consumers have just

about as much purchasing power for each one of their dollars when

the official index is increasing in the 1.5- to 2-percent range.

This was generally the situation that prevailed in the first half of

the 1960's. Third, on the other side, the income velocity of Mx, the

ratio of gross national product to Mi, has been drifting up at about

2.5 percent per year. For M2, the ratio of gross national product to

M2 has been essentially constant since at least 1960. Taken together,

we get a range of 2 to 4 percent for Mx, and 4.5 to 6.5 percent for M2.

(A study submitted by Professor Meiselman appears on page 67.)

Mr. NEAL. NOW we will hear testimony from Mr. Perry.

STATEMENT OP GEORGE PERRY, SENIOR PELLOW, BROOKINGS

INSTITUTION

Mr. PERRY. It is a pleasure and a privilege to testify before this

subcommittee today on the important issue of monetary policy and

the economy. You raised several specific questions that you were

interested in, and my answers to these questions will be very brief.

I shall, of course, be happy to expand on them or on any other questions you may have.

Questions 1 and 2: How Monetary Policy Affects the Cost of Living,

Production and Employment.

I have grouped the first two questions into one because they are

best answered together. Monetary policy is a potent instrument for

affecting the level of aggregate demand in the economy. Its impact

on the economy is transmitted through interest rates and falls most

heavily on private demands that depend heavily on borrowing, such

as the demand for autos, business investment, and housing.

It also influences other spending by affecting equity prices and

hence consumer wealth and possibly consumer sentiment.

The effect of monetary policy on prices, production and employment follows from its effect on total demand. But how any change

in total demand is divided between a change in prices, on the one

hand, and a change in production and employment, on the other,

basically has nothing to do with monetary policy.

It is determined by a great many other things, such as how tight

labor and product markets are and what expectations about inflation

are. Our understanding of this inflation process is far from perfect.

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But the evidence is clear that, how a given GNP growth is

achieved—whether the spur is a push from fiscal policy, a rise in

demand from abroad for our exports, a consumer love affair with the

automobile models, or a lift from monetary policy—the consequences

for inflation and production are generally the same.

There is simply no evidence of what I call the X-ray theory of

monetary policy whereby it affects the price level directly without

affecting the real economy along the way.

Next your question 3: How Interest Rates are Affected by Money

Supply Changes.

Basically interest rates bring the demand for money in line with

the supply. If either real output or prices rise, the demand for money

will rise. If the supply of money is not increased enough to meet this

higher demand, interest rates will be driven up. Then this will

restore the balance between demand and supply in two ways: First

by causing individuals and businesses to hold less of their liquid assets

as money and more of their assets in some interest bearing form; and

second, by curtailing the demand for goods in the economy and thus

curtailing the rise in GNP.

To the extent that a rise in prices enters expectations about future

inflation rates, it enters the picture in a second way; by raising the

level of interest rates that is associated with any given level of real

output in the economy.

Your question 4: How Government spending and tax policies

enter the picture.

Government spending and tax policies taken together constitute

fiscal policy, which is the other arm of Government stabilization

policy. Changes in fiscal policy influence aggregate demand just as

changes in monetary policy do. The two can substitute for each other

or can complement each other at any particular time.

And just as with monetary policy, how a given increase in aggregate

demand divides up between higher prices and higher production does

not depend on whether that rise in demand prices arises from fiscal

policy or from some other source.

Your question 5: Should Congress set economic targets?

Particularly at a time when we face both high unemployment and

inflation, and the goal of policy is to reduce both, the conduct of

stabilization policy is difficult because measures affecting demand

can only promote the achievement of one goal at the expense of the

other. It seems entirely proper for the Congress to again set priorities

between these goals and to ask that the Fed respect those priorities.

However, the Fed cannot solve the dilemma that is posed by conflicting goals. Nor can it necessarily pursue economic targets while

constrained to follow some particular path for the money supply.

Nobody knows, with any useful degree of accuracy, what growth

in the money supply would be needed to achieve a particular growth

rate of GNP over the coming year. However, it seems reasonable to

ask the Fed to aim for some agreed upon targets for the economy,

as opposed to targets for money supply, and to explain any policy

moves that do not contribute to hitting that target.

Thank you. Would you like us to comment on your chart at this

time?

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Mr. NEAL. I would. I want to thank you all for your excellent,

thoughtful testimony. It will be a great help to us. Mr. Meiselman,

you mentioned some statistical work you have done and offered to

submit that for the record. I think that would be most helpful. The

work you mentioned concerns the long-term relationships between

money supply and inflation.

Mr. MEISELMAN. The connections between inflation and interest

rates and also the connections between changes in the stocks of

money and changes in inflation, on the one hand, and changes in

interest rates, on the other.

Mr. NEAL. The subcommittee would appreciate copies of that

work, and without objection I request that it be inserted in the

record at this point.

[The material submitted for the record by Mr. Meiselman follows:]

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MONEY, FACTOR PORPORTIONS, AND

REAL INTEREST RATES*

David I. Meiselman

Virginia Polytechnic Institute and State University

Res ton, Virginia

Introduction

I shall argue that an increase in the quantity of money when

an economy is not fully employed leads to an increase in the real

rate of interest in theory as well as in fact. I shall also argue

that attempts to raise rates of interest by means of monetary restriction will cause interest rates to fall. The theory is generated

by an old friend, the Law of Variable Proportions. The facts have

been generated by much sad experience.

The apparatus invented by J.R. Hicks in his famous article,

"Mr. Keynes and the Classics," has become standard equipment

for economists for the analysis of a wide range of macro phenomena.

As pure apparatus, the Hicksian constructs of the LM and the IS

curves are generally taken to be devoid of empirical content. Of

course, some cases are ruled out on the basis of stability considerations. Unstable situations, while possible, are not sufficiently

characteristic of free markets, and because markets ordinarily do not

behave as if they are unstable, we separate the formal conditions which

are consistent with this observed behavior in free markets from those

which are not.

Presented at the Zurich Meetings of the Econometric Society, September

10, 1964. Preliminary versions were presented at the Johns Hopkins University,

the University of Chicago, Northwestern U., the University of Minnesota,

and Columbia.

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It is in this spirit that many students of macro phenomena have

tended to postulate that the slope of the Hicksian IS curve typically

has a negative slope, but may in principle range between zero and o o .

Thus, given conditions of less than full employment, the standard

analysis would assert that a shift to the right of the LM curve, an increase

in the stock of money, moves along the negatively sloped IS curve so that

at the new equilibrium we will have higher income and lower interest

rates, provided, of course, that there is no "liquidity trap" and that

either investment and/or saving have non-zero interest elasticities.

This is to say that the LM curve is not infinitely elastic and the IS

curve is not perfectly inelastic with respect to the rate of interest.

Also, a shift to the right of the IS curve, a "real" disturbance, will

lead to both higher income and interest rates as we move along the

positively sloped LM curve, and vice versa for a downward shift of the

IS curve. This, in brief, is "traditional" post-Keynesian theory.

The facts of cyclical change appear to be that the chang€'.s in the stock

of money lead business cycle turning points. On the other hand, interest

rates, and also private investment spending, are generally synchronous with

the cycle, but with some tendency to lag behind business cycle turns. The

facts do not appear to square with traditional theory.

Moreover, if, indeed, money is the principal determinant of business

cycles, why do we observe that interest rates appear to end up at higher

rather than lower levels after a monetary expansion, and vice versa for a

monetary contraction?

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One approach to this problem has been to emphasize the role of price

expectations in the determination of market yields on fixed nominal value

obligations, but these considerations have little bearing on real rates of

return or on short period changes over the cycle. In addition, interest

rates in money terms, and often in ex post real terms too, end up at higher

rather than lower levels after monetary expansions which start at periods of

less than full employment, with the opposite change for a monetary contraction .

These facts in the context of the standard analysis have been used to

try to distinguish between monetary and real sources of cyclical change—

which is to say, whether the LM or the IS curve has shifted. The procedure

follows the familiar lines of examining price and quantity data to identify

whether the observed change in price stems from a shift of supply or of

2

demand. The identification process appears to suggest several paradoxes,

both for those who maintain that shifts of the LM curve generally arising

from changes in the stock of money are the source of cyclical change and

for those who assert that changes in "real" factors summed up in the IS

curve, especially investment spending, dominated the cycle.

"Monetarists" can, and do, point to the cyclical lead of money and the

1. See D. Meiselman, "Bond Yields and the Price Level: The Gibson Paradox

Regained," in Banking and Monetary Studies in Commemoration of the

Centennial of the National Banking System, ed. D. Carson (1963).

2. For example, see J.L. Stein, "A Method of Identifying Disturbances

which Produce Changes in Money National Income, " IPE , February 1960.

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general conformity of the magnitude of monetary change and income change

as supporting their case. They also cite the lag of investment and perhaps

the lack of a statistically dependable link between investment and income

as weakening the case of the "realists." "Monetarists" may also argue

that the lag of investment behind money is also indicative of the direction

of effect.

Yet, if monetary change is the principal contributor to cyclical change,

why are interest rates high in boom times and low in depressions? The

"realists" have no problem here because they easily explain the cyclical

association of income and interest rates as stemming from the same source,

the shift in investment. However, "realists" may also be in trouble because

of the cyclical lead of money and the occasional lag of investment. Although

many "realists" assert that changes in interest rates cause corresponding

changes in the money supply, they cannot explain the cyclical lead of

money over both interest rates and income.

The purpose of this paper is to show that the usual assumptions regarding the IS curve in the standard analysis are unnecessarily restrictive

and may lead to analytically erroneous results, such as the requirement

3

that the IS curve have a negative slope for stable general equilibrium.

3. There are other problems with the apparatus which are beyond the current

scope of this paper, among them the lack of distinction between real and

nominal interest rates, the specification of equilibrium especially with

respect to "time," and the implied requirement that an initial change in

the money supply shifts the LM curve which moves along the given IS

curve. This is a formal way of stating that only the "bond" market is

used to adjust actual to desired cash. If money shares a margin with

goods, a shift of the LM curve may cause a short-run shift of the IS

curve in the same direction. In other words, disequilibrium on money(cont'd)

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First, I shall examine the formal conditions for a positively sloped IS

curve, and I shall show that these are consistent with the range of plausible

assumptions regarding the values of the parameters determining the slope of

the IS curve. The paper will go on to suggest how the facts of cyclical

change cited above can be rationalized in the context of elements of a

theory of business fluctuations which follow from this critique. The theory

also suggests processes—in some respects strikingly similar to Wesley

Mitchell's—by means of which monetary change may lead to important

changes in real variables which are often held constant in the standard

analysis.

The Slope of the IS and LM Curves

Consider the Hicks model presented in "Mr. Keynes and the Classics"

for the joint determination of income and the rate of interest.

I = I(r,Y)

S =S(Y,r)

L =L(Y,r)

where I, S, and L are desired or ex ante investment spending, saving

(current income not spent for consumer goods), and the quantity of money

demanded, respectively. Y is current real income or output and r is the

rate of interest.

3. account ought to be arguments in the short-run consumption and

investment spending functions. In addition, the LM and IS curves

may not be independent. For a given IS curve, a shift in the LM curve, by

causing income to change in this period may lead to a shift of the IS curve

in the same direction, which may be another way of discussing a positively

sloped IS curve. However, for purposes of this paper let us wear Hicks' hat.

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General equilibrium requires that

I = S •

and

L = M

where M is the stock of money. To avoid complications not directly

pertinent to this discussion, assume static expectations with respect to

prices. The more general analysis requires real rates of return in the

goods equations and money rates of interest incorporating price level

expectations in the money equations.

The LM curve is defined as the locus of points of alternative

combinations of Y and r where L = M, and the IS curve is similarly

defined for I = S. (The schedules are usually drawn for Y on the

horizontal axis and r on the vertical axis.) The simultaneous clearing

of both "goods" and "money" markets is at the point of Intersection of

the two curves, and this point shows the equilibrium values of r and Y

for the system.

Consider first the slope of the LM curve, dr . Each point on the

dY

schedule is defined so that L = M. If L = M, dL = dM.

Also,

dL = dL dr + <3 L dY

and ^

dM = O M dr + ^ M dY, the least restrictive formal assumptions about M in the present context. Therefore,

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Solving for dr when all variables are functions of r and Y we have

and

dr

dY

By

dY ^

d M

hypothesis _

-

-

.^ L

^ M

O

d

M --> 0

so that the denominator is <=, 0. Because it is usually assumed that OO L

the denominator becomes <^ 0.

In the numerator, by hypothesis,

~*d M = 0

^ ^ Y

and o L '^ n

~£)

 Y

making the numerator also <C^0-

With both numerator and denominator<Co, dr for the LM curve becomes

dY

^> 0, with dr varying directly with the income and inversely with the

dY

interest elasticity of the demand for money.

Similarly, the slope of the IS curve can also be determined. Each point

on the IS schedule is defined so that I = S, or dS = dl.

Now JC _ O S

and dl = dY.

7)

 Y

Solving for dr as above, we have

dY

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dr

dY

s_

^ > Y

^ ) r

Regarding the terms in the denominator, by hypothesis 3 S ^> 0 and

Q I <^0- The sum in denominator must be ^ > 0 as a formal matter,

~~() r

but let us rule out the zero value, the popularity of the extreme Keynesian variant

of Stigler's Law notwithstanding, making the denominator ^?> 0

under the usual assumptions. A clear case for the sign of the expression in

the numerator cannot be made, even though many economists have

erroneously done so. By hypothesis,

greater than or equal to 0. Therefore,

dr - ^ n if 3_ l \

~~dY~ ~> ° ?)~Y~X

i C

•• 0

c) I and CL_S_

 ar e

 both

7) Y "2) Y

and

u i

 Cj •*•

Many have ruled out the case where _2)_JL_ " ^ 3 S because they presumed

that this situation was not consistent with stability, it is taken to mean that

the marginal propensity to spend out of income, the sum of the marginal propensity to consume plus the marginal propensity to invest (desired "induced"

investment) was greater than unity and thereby explosive. Yet, stable

general equilibrium is consistent with 0 I ^ T^ S provided the slope of

1) Y ^ ~^>

 Y

3a. According to Stigler's Law, "All Demand Curves are Inelastic, and AU Supply

Curves are Inelastic Too." See "Stigler's Law" in George J. Stigler, The

Intellectual and the Market Place and Other Essays.

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the LM curve is greater than the slope of the IS curve, which is to say,

that the LM curve cuts the IS curve from below. Under these circumstances,

shifts of either schedule are possible without unstable effects. Except

for the unlikely case where the IS and LM curves coincide, a case

of metastable equilibrium, if the schedules are linear there

is but one combination of income and the rate of interest consistent

with equilibrium. If points off the equilibrium are examined it will be

found that the set of forces summed up in the curves will drive the

system towards the point of intersection. In other words, when one

considers total rather than partial derivatives the marginal propensity

to spend need not be greater than unity.

Although the adjustment patterns are by no means clear, a positively

sloped IS curve does mean that an increase in the stock of money or a

decrease in the demand for money ultimately leads to a rise in both

interest rates and income, and a decrease in the stock of money or an

Increase in the demand for money leads to both lower interest rates

and lower income. Shifts of the IS curve follow the standard analysis

because we would be moving along the same positively sloped LM curve.

Therefore, shifts of either positively sloped schedule lead to movements

in the same direction of both income and the rate of interest.

The reason for these apparently bizarre results is that desired investment is more responsive to income than is desired saving when interest

rates are held constant. In other words, a shift to the right of the LM

curve, by causing income to rise initially, somehow causes a shift in

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desired investment which is greater than the induced rise in saving

for given interest rates. As we shall see below, it is not unlikely

that this is the case under a broad range of plausible real world

assumptions.

Factor Inputs, the Law of Variable Proportions, and Investment

Let us now move on to consider the source of a shift in the

marginal efficiency of investment. It is generally agreed that sticky

money wage rates are a principal cause of the cyclical variability of

employment, and thereby output. Further, it is also generally accepted

that shifts in aggregate demand induce corresponding short-run shifts in

employment and output by changing the relationship between money wage

rates and other prices, which is to say, the real wage rate. To isolate some of the consequences of the usual analysis of the labor

market, assume the following:

1. Money wage rates are fixed.

2. Unemployment exists, and the supply of labor is infinitely

elastic at the money wage rate.

3. The stock of capital is fixed and is equal to the desired

stock of capital for all firms.

4. The production function is Cobb-Douglas with constant

returns to scale, and is given.

5. All goods are produced by both capital and labor, and

relative prices of goods are given.

6. The flow supply schedule of capital goods is infinitely

elastic at its real price.

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7. The demand for money is a function of both income and interest rates.

8. All values are "permanent" in the sense that everybody expects

today's prices and quantities to persist beyond the relevant

horizons.

These assumptions will be relaxed at later stages in the analysis.

Consider an increase in aggregate demand stemming initially from an

increase in the stock of money - a shift to the right of the positively

sloped LM schedule. The higher level of aggregate demand will tend to

raise product prices relative to labor costs, thereby inducing a movement

along the demand schedule for labor, where the quantity of labor demanded

4

is a function of the real wage rate and the marginal product of labor. If

the production function is Cobb-Douglas and markets are competitive, the

elasticity of demand for labor is given by 1 , where a is the labor

1 - a

share and (1-a) is the the capital share. If a is 2/3, the elasticity of demand

for labor with respect to the real wage rate is 3. Therefore, a 1 percent

decline in the real wage stemming from a 1 percent rise in prices will

increase employment by 3 percent, which in turn will increase output by

2 percent. Money income will therefore rise by slightly more than 3 percent. In other words, the elasticity of the aggregate supply curve with

respect to the price level is a ; here two.

1 - a

4. Note also that average variable costs in real terms fall, an important

element in the business cycle theories of Mitchell and many others.

5. In the process some capital will be added to the pre-existing stock, but

the relative change in the capital stock will be small so that for the

time being we may safely overlook it.

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As more labor is added to the fixed capital stock, the marginal product

of labor declines by a factor of (1-a) times the percentage increase in the

labor input. In the above example, the 3 percent rise in employment would

be associated with a 1 percent fall in the marginal productivity of labor,

which is also the decline in the real wage rate. Total payments to labor in

real terms will rise by 2 percent, and in money terms by slightly more

than 3 percent.

The increase in the ratio of labor to capital will increase the productivity of capital, the other side of the Law of Variable Proportions coin.

It is this change, some manifestations of which run through the literature on

the Acceleration Principle, which is the source of the corresponding shift in

the demand for capital goods and investment spending. The marginal product

of capital will rise by a factor of (a) times the percentage increase in the

labor input. To continue the example, when employment rises by 3

percent and the capital stock is fixed, the marginal product of capital,

as well as total payments to capital in real terms, increase by 2 percent,

which is also the percentage increase in output. The rise in the

productivity of capital, a source of higher interest rates, follows from a

decline in the real wage rate when capital and labor are substitutes in

production, as they are in the Cobb-Douglas production function.

In other words, the endogenous change in the productivity of capital is

the endogenous basis for a change in the desired stock of capital in order

to arrive at an optimum stock under the new conditions.

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In turn, the rise in the desired stock of capital will tend to increase

the marginal efficiency of investment and thereby induce a rise in

investment expenditures, and a further sequence of higher income, a

rise in employment and in the ratio of labor to capital, a further shift

in the marginal efficiency schedule, and so forth.

As investment and income rise there will be upward pressure on

interest rates, causing a rise in income velocity as we move along

the given LM curve. The rise in rates will be tempered by the additions

to the stock of capital, velocity changes, and a rise in induced saving.

To answer the question whether rates will end up at a higher level than

before the once for all monetary change, one must also include the

initial partial effects of the increase of money, which would be

consistent with lower rates. Taken together, it is not at all clear

where the rate of interest will finally come to rest when we return to

simultaneous equilibrium in the "money" and "goods" markets.

Starting from equilibrium, a mirror image of this sequence would take

place when the stock of money was reduced in the presence of sticky money

wage rates - the initial rise in rates perhaps, the fall in aggregate demand,

reduced employment and a rise in average variable cost, a rise in the

ratio of capital to labor and a corresponding decline in the productivity of

capital, and so forth, until perhaps we end up with interest rates at lower

levels than before the monetary contraction that caused the downturn.

6. If the cumulative expansion proceeds far enough, there will also be

pressure on wage rates and the relative prices of capital goods,

further moderating the expansion.

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To help focus on the specific formal problem, let us hold the interest

rate constant and examine the partial effects, "income" effects, of the

increase in the money supply. If a I v ^ ~^> S it means that the preexisting rate of interest, rQ , is below its new equilibrium value. On

the other hand, if

to say, that rates would end up lower after the monetary expansion.

To move from considerations of the marginal productivity of capital to

the value of O I consider the variables K*, A, and B, where K*

is the desired stock of capital, A is the partial derivative of K* with

respect to income, O K* , and B is an adjustment coefficient denoting

the rate per period at which the economy desires to close the gap between

K* and K, the actual stock of capital. B is measured in the same units of

time as Y.

Neither A, B, nor —£— can properly be considered constants. A

and B will vary inversely with the rate of interest and will also depend

on such variables as technological factors, supply conditions, expectations,

and cost conditions associated with "capacity" discussions, and so,forth.

B may also depend on the size of the "gap," (K*-K). Similarly, the

desired capital output ratio, K* , where Y is "permanent" or "expected"

Y

income is not a constant but will depend upon the production function

and will also vary inversely with the rate of interest and the uncertainty

and other equalizing difference adjustments required to equate the

expected rates of return per period on all assets.

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Under my assumptions, where K* = K before the increase in the

stock of money, A = —— for a given rate of interest; it is larger

for rates below ro and smaller for rates above rQ. The same relationship

holds for £^— . This means that the assumption of a given ratio of the

desired capital stock to expected income associated with holding

interest rates constant will tend to bias the analytical conclusions

towards a lower value for the responsiveness of desired investment

spending to a change in income. Because desired saving may vary

directly with the rate of interest, holding rates constant will tend

to overstate the responsiveness of desired saving to the initial change

in income and its associated decline in interest rates, thus biasing

the results in the same direction. These biases work against my case.

Thus, if

dY = f(dM),7

^ ^ =A ,

and ->. „ . ~ B,

we have -=r

 :

o r , _2Ll — = (A) (B).

0

Because A - —~— when r = r_, J2•• = (B)

7. Note that income can also change initially because of other factors.

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Therefore, the IS curve has a positive slope if (R)(

 K ) \ O S ,

where V S is the marginal propensity to save, holding interest

rates constant.

Consider high and low guesses regarding the values of B and

8

K in the U.S.; for B 0.4 and 0.1 and for _K_ 3.5 and 2.5. Pairing the

Y Y

high and low guesses for each variable we find that the entire range for

~\

I of from 1.40 to .25 may well be higher than (•' S which is

?) Y ?> Y

usually taken to be in the neighborhood of a range from 0.1 to 0.2

when expenditures for consumer durables are included in the consumption

function. In other words, under these assumptions it is not unlikely

that 0 I ^ ^ d s . which is to say, that the IS curve has a

positive slope.

What prevents the economy from exploding, even under these highly

restrictive assumptions? It is essentially the limitation placed on the

expansion of income by the fixed money stock plus the relative interest

inelasticity of the demand for money. As income and interest rates

rise there may be some increase in income velocity, but it will not be

sufficient to permit income to expand indefinitely. Moreover, the

rise in rates will dampen desired investment and encourage desired

saving until the two return to equilibrium." If, however, the demand for

money is sufficiently interest elastic so that the slope of the LM curve

is less than the slope of the IS curve, velocity would be more highly

sensitive to interest rates, tempering the rise in rates. Thus interest

rates would never rise fast enough to overtake the investmentFor more precise estimates see A. Harberger, The Demand for Durable

Goods, and S. Kuznets, Capital in the American Economy.

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saving disequilibrium. Moreover, even if the demand for money

were highly interest inelastic, this system may still explode if the IS

curve had a still lower interest elasticity. In the case of the stable

system, if the monetary authorities continue to increase the stock of

money, possibly in order to keep rates from rising or because of

devotion to some form of the "real bills" doctrine, income would

g

continue to expand and equilibrium interest rates would be still higher.

(Rates "pegged" too long will cause the system to explode.)

Perhaps much of the essence of business cycles has been set

aside in the assumptions I have made to isolate some of the mechanisms

of short-run fluctuations. In modifying or relaxing each of them we

can see other forces containing and shaping the apparent cumulative forces

in booms and recessions, even granted the simplifying assumptions

regarding homogeneity among industries and a given technology. First,

the supply of labor cannot long be taken as infinitely elastic at the money

wage rate, particularly in the face of a substantial reduction in unemployment. If the expansion progressed far enough or long enough

one would expect to find wage rates rising in both money and real terms,

increasing variable costs and reducing incentives to change the ratio of

labor to capital which was the source of the desired expansion in capital

goods in the first place. Second, the supply schedule of capital goods

cannot long be taken as infinitely elastic either, particularly in the

length of run covered by a typical business cycle, so that a

substantial shift in the demand for capital goods would lead to higher

9. Thus, it would seem that those who hold that multiplier and accelerator

values are large may need the Quantity Theorist's traditional assumption

of a low interest elasticity of the demand for money to keep their

formal systems from blowing up—or down—but not vice versa.

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prices, postponements, etc. Third, additions to the stock of capital

would change factor proportions and lower the productivity of capital.

Fourth, the assumption of static expectations may bias the analytical

conclusions in the direction of making some elements of the theoretical

system even more subject to instability than they, in fact, are. For

example, if the initial rise in income is viewed as largely temporary,

desired investment will be lower and desired saving will be higher than

if the same change in measured income is taken to be a permanent change.

If, however, the demand for money is a function of permanent rather than

current income, small changes in the stock of money will have greater

consequences for spending, and changes in income will be associated

with smaller changes in the quantity of money demanded. At this point

it is difficult to see what the net analytical bias is for the aggregate

or for the mechanisms I have discussed.

In addition, the initial capital stock may not be the desired one.

If, before the disturbance, the desired capital stock was greater than

the actual stock, the same analysis would seem to follow. However,

if the desired stock was less than the actual stock, a not unlikely deepdepression phenomenon, the increase in the productivity of capital may

merely bring the two somewhat closer together but not spill over into a

shift in the demand for additions to the stock. In other words, perhaps

cv I was so low during the 1930's that the IS curve generally

has a negative slope at that time. (The same factors may also have made

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investment relatively unresponsive to changes in interest rates too.) More

recent experience with long periods of relatively full employment conditions may be consistent with a positively sloped IS curve.

Further, in moving to a more powerful and general analysis undoubtedly

one must also take into account more explicit roles for lags, adjustments,

expectations, and more complex dynamic and other interactions.

A positively sloped IS curve and the adjustment processes generating

it may also explain the procyclical behavior of measured income velocity. If,

as this analysis indicates, monetary expansion leads to increases in both income and interest rates, and if the demand for money is inversely related to

nominal interest rates, then it follows that rising interest rates resulting

from monetary expansions will cause velocity to rise and declining interest

rates following monetary contractions will cause velocity to fall.

These patterns would appear to be consistent with the observed empirical business cycle regularities that money, interest rates and velocity

all tend to be procyclical, with money tending to lead business cycle turns

and interest rates to lag them. These mechanisms not only explain why an

expansionary monetary policy generally leads to an increase in nominal and

real interest rates but also why an expansionary (contractionary) increase (decrease) in the stock of money causes velocity to rise (fall) as well, thus amplifying the initial impact of monetary change on aggregate nominal expenditures.

Finally, let us briefly consider elements of several analyses which

crucially depend on the assumption of a negatively sloped IS curve.

First, many critiques of the contribution of the monetary authorities to

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cyclical change generally come down to attempts to identify which of

the schedules has shifted. If the IS curve Is taken to have a negative

slope and if the monetary authorities are understood to affect the LM

curve, it looks easy indeed, and even intellectually defensible under many

circumstances, to point to high interest rates in booms and low interest

rates in recessions as stemming from shifts of the IS curve, not the LM

curve. It is no less difficult to interpret interest rate changes or credit

market conditions as consistent with stabilizing shifts of monetary policy

towards "tightness" in booms and "ease" in recessions when, in fact,high

interest rates of booms and low interest rates of the recessions more

accurately reflect the high or low productivity of capital and the good

or poor business conditions brought about by the procyclical change in the

money supply. This confusion is one of several reasons why the stock of

money, not interest rates or credit market conditions, is the appropriate

policy variable for the monetary authorities and for any critique of

their effectiveness.

Second, the assumption of a negatively sloped IS curve is a central

feature of many analyses of balance-of-payments adjustment processes.

This assumption helps to provide the theoretical basis for the presumption

that monetary policy must take into account an inevitable trade-off

10. For example, see R.A. Mundell, "The Appropriate Use of Monetary

and Fiscal Policy for Internal and External Stability," I.M.F. Staff

Papers (March, 1962).

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between the quantity of money and interest rates, and perhaps between

income and interest rates. It leads to the conclusion that expansionary

monetary policy will deteriorate a country's balance of payments on

capital account, especially in a regime of fixed exchange rates. My

analysis suggests that this conclusion may be in error; if so, an error

of serious consequences. No doubt the initial effect of more money is

to lower rates. But, by ringing down the curtain after the first scene

in the drama, the standard analysis neglects the remainder of the story.

We would do well to recall that pursuit of a restrictive monetary

policy in 1931 in order to raise interest rates for the purpose of moderating the U.S. balance of payments deficit and external gold drain, by

causing the ensuing economic collapse, lowered interest rates for many

years thereafter. More recently, repeated attempts to lower interest

rates by expanding money have been major factors in the contemporary

era of inflation and high interest rates.

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Mr. NEAL. Please, if you would, take a look at our exhibit. It is

self-explanatory. I find the conclusions mapped in the exhibit astounding. The public debate has centered around fiscal policy almost

entirely, it seems to me. Yet these charts indicate that monetary

policy has had a much greater impact on inflation and recession.

Several of you alluded to that in your testimony.

How about just commenting on the chart? Do you see any problems with it? Is it inaccurate, in your opinion, in any way?

Would it bear out what your experience is? Mr. Perry?

Mr. PERRY. The chart has several parts. In the first place, the

chart on the budget deficit clearly points out that deficits are not

quite the scary thing that they are sometimes made out to be.

The fact is that the big swings in the budget are largely induced

swings. They are not changes that represent active movements in

the budget designed to move the economy in a particular way. Rather,

they reflect the automatic stabilizers of the budget. This is very

clear today when the huge deficits we are looking at represent a weak

economy with its reduced levels of profits and income rather than

any great runaway spending propensities on the part of the Congress

or the administration.

So the budget deficits as actually experienced mainly mirror the

health or the lack of it in the economy rather than anything else and

that fact is shown up clearly. In particular, they don't show the sort

of correlation that the public frequently imagines between inflation

and deficits.

Mr. NEAL. In fact, quite the opposite.

Mr. PERRY. That is right. You get the huge deficits when you have

a very soft economy, when markets are weak and therefore when the

pressure on prices is at a minimum. Furthermore, inflation raises

Government revenues. It is not a particularly good way to raise them

but it has that effect and therefore you get the healthiest looking

budget surpluses at times like 1973 when the economy is strong and

we have some inflation.

I find the other aspects of the chart, in particular the apparent

connection between money supply growth rates and inflation rates,

somewhat misleading. Let me outline what I see as the relation of

money growth and inflation.

There is a well-established relationship, wedded in theory and documented again and again empirically that the higher the price level,

the correspondingly greater the demand for money. If the price level

were 1 percent higher this year, everything else being equal, the

demand for money in the economy would be 1 percent higher.

As inflation proceeds, whatever its source, the Fed is faced with the

fact that the demand for money is larger. It has one of two choices.

It either accommodates that extra demand for money, keeping the

real impact of monetary policy unchanged, or it refuses to accommodate it and thereby tightens the real impact of the money supply

on the economy.

If, as in 1973, and 1974, you got an extraordinary burst of inflation

and the Fed did not accommodate it at all, pursuing the same monetary policy it would have in the absence of that inflation, then in real

terms, monetary policy will have Severely tightened.

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Historically it has always confronted this choice, whether Federal

policy was conducted by a feel of the market, whether it was oriented

to interest rates and the housing industry, or whatever, it could not

avoid the choice to A, accommodate the inflation, whatever it may

have been at that moment or B, if not accommodate it, tighten money

in real terms.

I think this is basically what we see reflected in these historical

relationships.

Mr. NEAL. Perhaps I did not point it out, but there is a time lag

of 23 months between the rate of inflation and the growth in the

money supply.

Mr. PERRY. I appreciate that but these are smooth series and by

and large what I think we are picking up is a rather substantial

trend in the two that is common. If we look at

Dr. WEINTRAUB. If we dropped every month but January for

prices and every month but February for money and then let the

first differences in prices be related to the first difference in money

two Februaries ago, we get the same results.

So although you are quite correct that the way this experiment was

formed, there is obvious serial correlation. The same result occurs if

you just use one month and without serial correlation.

Mr. PERRY. That's not enough. Let me just say that the rate of

inflation very gradually increases and though we can find a place

it peaks, by and large it is gradually increasing. It is not that you

have cycles and can identify lags very sharply with them. The other

thing to note is that money influences future inflation; but in a

different way than is implied by the chart.

Dr. WEINTRAUB. I think if you look at the chart, you will see

that the inflation rate has subsided as well as gone up in the period

since 1964. Although there is a trend, there is a roller coaster pattern

around the trend.

Mr. PERRY. If you put the real state of the economy into an equation

Dr. WEINTRAUB. We have done that.

Mr. PERRY. And you do a conventional attempt to explain inflation—relying on how tight the market is, what is the history of

inflation—you don't add to the explanation by adding the past

money supply.

Since money matters very much in determining GNP, you will

still get relationship between monetary growth and the subsequent

inflation rate but you will not get a relationship that, as sometimes

is suggested or implied, operates without affecting the real economy.

I would like to make this point as clear as I possibly can. Monetary

policy matters very much. If monetary policy is very expansionary

and pushes the economy very far very fast, the consequences of that

will be more inflation. But the inflation arises because the real economy

has been pushed too far too fast, not because of any magical property

of the money supply.

Mr. NEAL. What pushes the economy too far?

Mr. PERRY. It can be any number of things. It can be a boom

originating in the budget. I think when defense spending in the budget

in 1966 suddenly stepped up sharply, we were pushing the economy

basically because of fiscal policy. It could also be a surge in demand

from monetary policy or from the animal spirits in the private sector.

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Mr. MEISELMAN. Why was there a recession in 1966?

Mr. PERKY. I am not aware there was one.

Mr. MEISELMAN. There was a recession at the end of 1966 and the

beginning of 1967.

Mr. PERRY. There was a slowdown but it has never been called a

recession before to my knowledge. But the point is not that monetary

policy isn't very potent and that monetary policy does not track GNP

very well and therefore is not closely associated. The point is, whatever our real goal—an unemployment goal or an output goal, we do not

choose between achieving it without inflation by making the money

supply grow slowly or achieving it with inflation by making the money

supply grow fast. Rather, we have to concern ourselves with what it is

that makes the economy inflation prone and try to deal with that.

If we succeed, then we can resolve the dilemma between output goals

and inflation goals. We don't resolve that dilemma by pretending that

the particular setting of a dial on money growth rate is going to solve

it for us. That will just give us a particular combination of inflation

and output.

Mr. NEAL. Mr. Jordan?

Mr. JORDAN. Thank you. This is a very interesting discussion, in

part because we have been through it before.

I would like to go back to 1966, 1967 and 1968. 1966 was a year of

very expansionary fiscal policies by most conventional measures. There

was a sharp contraction in the rate of monetary growth in the last

9 months of that year. Some people said the economy would be strong

at the end of 1966 because of fiscal stimulus. Others said that, in view

of the slower monetary growth, we were going to have rising unemployment and maybe a recession. We did have a sharp contraction in

output in the first quarter of 1967, as is shown on my chart I. It was

not considered long enough by the National Bureau to be called a real

recession, so it was referred to as a mini-recession. Then the argument

was advanced that restrictive monetary policy could slow the economy

in spite of the expansionary fiscal policy, but "you can't push on a

string." Rapid monetary growth can't keep the economy going if you

have restrictive fiscal policies.

The test of that proposition came in the second half of 1968. In 1968

you had a very rapid growth in the money supply. The Federal Reserve

kept talking about restrictive monetary policy as measured by the

level of interest rates. The public record shows that they voted for

restrictive policy, but they felt it was restrictive because the level of

short-term market rates was rising even though the money supply was

growing very rapidly.

We had a surtax that year. President Johnson imposed a 10-percent

surtax on personal and corporate income, and a reduction in the growth

of Government expenditures. There was concern about overkill of the

economy because of the fiscal restraint. The Federal Reserve decided

to offset, in part, the fiscal restraint through monetary ease. The

money supply kept growing rapidly, interest rates declined in the

second half of that year, and we continued to have a strong economy.

It was only in 1969, after the Federal Reserve moved to a sharp

contraction in the growth of money, did you get true restraint that

brought about the recession in 1970. Then, in 1971 and 1972, we had

expansionary monetary policies.

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Now people are telling us that rapid monetary growth would not

spill over into a new round of inflation until we reach some threshold

of full employment or full capacity by the conventional measures.

They argue that we have a sufficient amount of slack that we don't

have to worry about a danger of excess demand causing inflation until

we get to a higher level of employment and capacity. My argument

there is that this comes from a view that most of the oscillations in

the economy were due to accelerations and decelerations in demand

relative to supply. Aggregate supply was viewed as growing at a

steady trend rate. If this excess capacity and high unemployment had

been caused only by a contraction in aggregate demand, then the

appropriate cure would be to expand aggregate demand, to put the

people and the capital back to work.

Most of us agree that the shocks to the economy during the last

few years came initially on the side of supply, the failures in agriculture

in 1972 and 1974, the devaluations of the dollar, and especially the

quadrupling of energy prices. Energy is an important input to production at all levels as well as being a consumer good. This reduced

our real economic capacity, our ability to meet demand, to produce

goods and services profitably at prevailing output prices. The basic

phenomenon was much like the Irish potato famine. It was a contraction of the real economic ability of the economy to produce,

relative to the demand, at a time when demand continued to grow.

The reason we had a sharp acceleration in inflation and a sharp

drop in real output was not because of restrictive monetary and fiscal

policies, but because we had a contraction in the real economy.

That leads me to believe that the capacity utilization numbers that

we see, and the so-called gap between real output and potential GNP,

are misleading. We cannot return to producing at those former rates

and volumes of output, given the much higher cost of production

associated with the cost of energy and also because we are devoting

more of our resources toward social goods. We want to close the gap

between the social costs and private costs of production. We want to

clean up the air and the water, provide safer working environments

and safer products, and that takes resources. Because of this, we

should not try to push the economy back toward the levels of output

that we saw a few years ago.

It is my view that our upper limit on real economic capacity is

closer than the conventional measures indicate, and we are in danger

of tipping over into a new round of inflation if the Federal Reserve

were to expand the money supply rapidly to try to get unemployment

down too quickly.

Mr. NEAL. Let me ask you, if I can, to comment on the chart

specifically. Do you have any problem with that relationship between

money policy and inflation?

Mr. JORDAN. NO; I don't at all The basic relationship is one that

I think is correct.

Mr. NEAL. Let me make very clear that if there is another element

that we ought to have in the equation, we want to get it in there.

Mr. Perry?

Mr. PERRY. Mr. Jordan has said much that I agree with. I did

not say we have no inflation ahead for a long time. I think I said we

have a choice between being more vigorous in our pursuit of output

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and employment goals and thereby taking the risk of more inflation,

or going the other direction.

Mr. Jordan pointed out carefully and clearly that it is a question of

what capacity is in the real economy, of what cost increases are

coming from conditions the real economy that is going to govern how

far we can go before running the risk of a lot more inflation. That is

precisely the way I would analyze the problem myself.

I would remind you that that analysis he gave you did not say the

rate of growth of Mx causes these real capacity problems that he is

worried about. Those happen from real things in the economy and

they should be analyzed that way.

The relationship I think you should be looking at here in place of

the one that relates simply Mi to the inflation rate is one that deals

with real economy capacity problems, both of labor and capital, and

then tries to see whether, knowing what you do about those things,

the sort of things Mr. Jordan was talking about, you get more information by putting money in one of the equations. Some attempts to

do this appeared in recent articles by Modigliani and Papademos

and by R. S. Gordon in Brookings Papers on Economic Activity in

1975.

The point I am making is not that Mx is not very important in

this process. The periods when we have run ourselves into inflationary

situations have usually been periods when Mx has grown rapidly. In

growing rapidly, it pushed the real economy up fast and far and ran

us into inflation.

That is the distinction that I am trying to make. There is not a

magical relationship between Mx growth and inflationary problems.

Mx growth is associated with how far and fast the economy is going

at any point in time.

Mr. NEAL. Mr. Fiedler?

Mr. FIEDLER. I would like to comment on the relationship between

money and inflation by drawing a distinction between the short run

and the long run and also by distinguishing in what may be partially

an artificial way, but nevertheless valid, between three types of

inflation.

One I call a basic built-in rate of inflation. It represents an accumulation of past experience reaching back a decade and more, often

related to bad economic policies over the longer term. Second, a

cyclical inflation, an acceleration or deceleration of that basic built-in

rate of inflation, depending on the degree of resource utilization,

whether we are in prosperity or recession.

Third, special factor inflation, the kinds of food, fuel, devaluation,

and price controls events that have temporary impact—events that

are big enough and important enough to have an impact on the overall

rate of inflation but one which is essentially temporary. I think this

last component of inflation that I am talking about, special-factor

inflation, is illustrated on your chart at least in part by the fact that

your rate of inflation line, the red line on that chart in 1973-74, gets

up well above the money line.

Those are sort of one shot impacts, or what we might call inflationary accidents. The distinction I want to make is that the relationship in the long run that you are referring to, it seems to me, is very

well established.

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There is a casual relationship, that is, the more rapid rate of increase

in money over any decade is clearly going to be reflected on the

average over that decade in a more rapid rate of price inflation.

I think most of the testimony you have heard here today is consistent with that long-term kind of relationship. Then in the short

run, what happens within a given year and whether the inflation

accelerates from the base rate or decelerates, depends, it seems to me,

on the questions of the sort that Mr. Perry has raised, such as how

close are we to full utilization and what are the expectations of the

economy.

It is important to appreciate that distinction between long-run

impact and short-run impact. I would add that when we say that

there is a casual relationship in the long run between money and

inflation, we should also recognize that money is only the proximate

cause, the mechanism through which inflation is created.

The original causes, the fundamental causes, it seems to me, are in

the political and social goals that the people of America have that

tend to cause us to try to achieve a great deal more than the economy

has capacity to achieve in any short-run period.

We really have to go back to social and political things when we

want to look for the reason why monetary growth does get too rapid

in some periods and tends to impart that kind of an inflationary

bias to the economy.

It seems to me that the 23-month lag that you have built into the

chart is something that you should not view as a highly specific,

accurate, precise kind of a thing. Certainly the lag is variable. In one

business cycle, it would be longer, and in another business cycle, it

would be shorter, depending on a lot of different things.

There is no magic in that relationship. Also I would like to comment

on your conclusions that you have reached here tentatively. I am glad

you are cautious about the conclusions. Your conclusion is that the

deficit in the budget is much less important or less of a factor in causing

inflation or recession. I have some doubts because it seems to me that

we are dealing here with a situation where all of the factors—money,

budget and inflation-recession—all react on each other and it is

difficult to mathematically disentangle all the relationships.

The position of the Federal budget is important not only to what is

happening to the economy but also^—not necessarily more important

but also very important—to what is happening to the supply. I mentioned in my testimony that there is a divergence now between fiscal

and monetary policy stances. I also mentioned that most of the time

those two move in concert.

Any time you can say that monetary policy has a relationship as

close as this chart suggests to the rate of inflation, that would also

suggest that fiscal policy has a role. How much the role of fiscal policy

is independent of monetary policy and how much the role of monetary

policy is independent of fiscal policy is something that I do not think

our analytical tools are sufficient to properly disentangle.

There was some testimony by Secretary Simon about a year and a

half, 2 years ago, if I remember correctly, before one of the Budget

Committees that stressed the relationship between inflation and the

budget deficits properly adjusted to what is known as the full employment or high-employment budget.

73-595—76 7

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That testimony, it seems to me, stresses that there is an impact of

Federal deficits that does not show on your chart and does not come

out in your conclusion. You might want to test not simply the budget

deficit in billions of dollars as you have here but look at that highemployment budget deficit.

There are many difficulties in calculating such a budget figure. But

I think that would be a fruitful area for further research.

Mr. NEAL. We will certainty look at that. Do you see some problem

with the way that we have shown this on the chart? Obviously there

is no apparent relationship using the deficits. We might want to chart

not only the deficits but the levels of the budget itself.

Mr. FIEDLER. I think that is correct. I would suggest that you look

at—for example, try the budget calculated as a high-employment

deficit as a percentage of GNP and see if that chart does not give

you some correlation, not within the cycle but over a 5-year span.

Mr. MEISELMAN. In Mr. Jordan's article he asks a question involving what the separate effects of the stock of the money and of

changes in the budget measured either by the high employment figures

for expenditures taken separately or the figures on expenditures and

taxes taken together.

The results of his research, which came as a great surprise to large

numbers of people, was essentially that fiscal policy measured either

way at most has only a very temporary and weak effect on GNP.

Some research I did jointly with Milton Friedman several years

earlier had come to much the same conclusion, and was also received

with a great deal of suspicion and disbelief.

Both pieces of research provoked a huge amount of research.

There are many economists who are skeptical of the research

findings, who felt there was something wrong either with the calculations or the analysis. It turned out that neither was the case. The

main thrust still stands.

Mr. PERRY. I feel I should set the record straight on that. There is

a good deal of analysis that disputes that conclusion. The most recent

I have seen has been by Professors Blinder and Solow who reviewed

it and found that fiscal policy is a potent instrument and monetary

policy is a potent instrument as well.

Mr. JORDAN. Fiscal policy is a very important factor in determining

the real economic growth over time, and how much of the economy is

in the public or Government sectors versus the private sector. As

economists we make suggestions to the lesser developed countries of

the world, how they can use fiscal policies to tax current consumption

and promote investment. Fiscal policy can have an effect on standards

of living and on the distribution of income in society.

But what it cannot do is independently determine the level of

prices unless you take account of the stock of money. You can finance

deficits, or increase spending, either by selling the bonds to the people

or by selling them to the central bank.

Mr. NEAL. There are two separate questions, is that right?

Mr. JORDAN. Right.

Mr. NEAL. All we are dealing with in this chart is the one question.

Mr. JORDAN. Right. Also you should ask whether it is possible to

relate the size of the deficit to monetary growth. In a study a few

years ago, we first tested the proposition to find out if you can make a

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statement about fiscal stimulus if you ignored monetary policy. You

cannot.

The second question is can 3^011 draw a relationship between the

size of the deficits and monetary growth? There is an indirect link.

The Federal Reserve formerly used a concept called "even keeling/'

When there was borrowing by the Treasury, there would be temporary

upward pressure on short-term market interest rates. The central

bank had a responsibility to steady the market. The way they did that

was to buy securities in the market at the same time the Treasury

was selling their securities, maintaining the prevailing level of interest

rates. This was a dominant part of policy in the record for the Federal

Reserve in 1967 and 1968. One of the reasons there was such expansionary monetary growth was an indirect result of the deficit spending

associated with the Vietnam war.

Sometimes the fiscal influence is in the same direction as monetary

policy. The important test is not where they are going in the same

direction, but in opposite directions. The record is clear that where

monetary and fiscal policies diverge and go in opposite directions, the

monetary impulse will dominate. That was our conclusion from the

experience in late 1966 and again at the end of 1968 where they

diverged.

If you don't finance deficits by monetary growth you will not

produce the kind of inflation we have had. If you have rapid monetary

growth, even if you have balanced budgets or surpluses in the budget,

you are going to have inflation. The growth of the money supply will

determine the level of prices, independent of the size of the deficit.

Mr. NEAL. Would you agree with that, Mr. Perry?

Mr. PERRY. NO; I would not. But I hate to keep repeating myself.

Mr. NEAL. It would be of great help to me in trying to understand

this.

Mr. PERRY. Both fiscal policy and monetary policy can have effects

on the level of demand and therefore the level of GNP. This is my

reading of the most careful statistical analyses. It is also what you

would get out of most of the carefully constructed large econometric

models.

Granting that there are many ways for GNP to rise—strong

fiscal policy, strong export demand from abroad and so forth—there

are various ways that policy can pull in opposite directions. You can

have a strong rise coming from one area and monetary policy can head

this off. Monetary policy in that sense is potent.

It can confront strongly rising demands* refuse to supply the

money that corresponds to the demand, drive interest rates up

sharply, break the housing industry, cause a recession and the demands

will not materialize. There is no disagreement on that point.

But now, granted that GNP can rise and can be influenced by a

variety of factors, how that rise divides between inflation and real

output is something which basically rests with an analysis elsewhere in

the system, not with the question of how much Mi accompanied that

rise.

If the rise occurs, then you start asking how inflationary is it going

to be. But whether Mx growth is very rapid or not in the process of

generating that rise is not the thing which tell you how inflationary it

is going to be.

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There really is quite—if one looks at it carefully, there is quite a

lot of evidence of that in the chart before us. We have had a very

modest sort of Mi growth for the last 2 or 3 years and we have had

historically huge gyrations in the inflation rate and in the real economy.

I think that I understand how much of this happened. My explanation does not rest on what was happening to Mi. The rise in the price

of oil caused a lot of price increases and it really is not true that OPEC

read the St. Louis bank statement on Mx growth before they did that.

The rise in the price of food is a similar story. These things are a

legitimate way to look at the huge inflation that we ran into. None of

them had anything to do with rates of growth of Mi.

Mr. NEAL. Our calculations indicate that money supply accounts

for something like 60 percent of the rate of inflation. We see this jump

in the rate of inflation over the money growth rate in the period that

you mentioned earlier when there were dramatic increases in oil and

food prices. Our chart captures these effects as well as the impact of

money.

Let me ask now, would you say that monetary policy has been well

administered over the period of time charted here? Whatever your

answer is, what would be your prescription for the future?

Mr. JORDAN. I think that monetar}/" polic}^ in the post-war period

was procyclical making the inflations worse than they would have

been, making the recessions and the unemployment worse than they

would have been.

My prescription would be stop trying to use monetary policy to

solve problems, but to let it be the one steady thing that the real

economy and other policies revolve around. That would be indicated

by a steady rate of monetary growth. The first thing is to achieve

steadiness and the next thing is to reduce the trend growth. The sharp

fluctuations we have had have caused the fluctuations in interest

rates and the housing market. I would not want to see us try and put

the housing market through another quick feast-famine cycle by

expansionary policies this year and restrictive policies next year.

Mr. NEAL. It was suggested by someone yesterday that we might

want to arrive at a formula for the money growth. It would be something like a percentage measure of gross national product. If we said

the GNP ought to be 5 percent, then the money growth ought to be

5 percent.

Mr. JORDAN. There should be a relationship between growth rate

in the money supply and nominal GNP. You can make a projection

of what the nominal growth of GNP will be in a year. We are concerned with what kind of economy we are going to have in the future.

What your chart shows is that with the 2-year lag, approximately,

between inflation and money growth, you have to go out into 1978

to trade off the costs of more rapid money growth. If you expand

money more rapidly now because you want more nominal GNP,

how do policymakers evaluate whether it is worthwhile, a good idea,

in terms of the higher inflation in 1978?

It is easy to say we will worry about that problem 2 years from

now. Because of the long lag that your chart illustrates between

inflation and money growth, it is very hard to make this judgment.

I think because of our past experience with stop and go policies,

swinging first to restraint and then toward expansion, I think we

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should err on the side of more stable, slower monetary growth, and

be willing to be wrong, rather than to err on the side of easier monetary

policies like in 1972 and 1973 and pay the terrible cost of readjustment,

both in inflation and unemployment, to get back down again.

We are starting this business cycle expansion with the highest

level of ongoing inflation we have ever had. We continue to reach

upward to higher and higher levels of inflation and interest rates.

That disturbs me to begin the expansion with this level of inflation

built in, and to talk in terms of more rapid monetary growth and not

worry about the implications a couple of years from now. The midpoints of the Federal Reserve's range would be adequate.

We would like to have the kind of expansion that occurred in the

sixties. Fiscal was active, but monetary was stable. We did have a

brief slow-down at the end of 1962. I do not see any prospects of

that at the present time.

I think we have a chance for 1977 to look much like the early

sixties. But there is also a risk it will look like 1971-72. We would

prefer to have the sixties kind of expansion rather than the seventies

kind of expansion. It depends almost completely on what the rate

of the growth of money supply is this year.

Mr. NEAL. Mr. Meiselman?

Mr. MEISELMAN. The hour is late. I wish to note that I am in

general agreement with Mr. Jordan's analysis. I would like to add

that we now have a great deal of inflation already built into the

system because of poor public policies in the past.

I believe the best way to achieve price stability is to eliminate the

remainder of the inflation gradually, step by step, not abruptly.

This would avoid the shocks that cause unemployment. I w^ould

start with the Federal Reserve's current target for monetary growth

and recommend that it be lowered by something like 1 percent each

year.

That means that several years down the road, we will be within the

targeted range for monetary growth that I mentioned before, which,

based on historic evidence, would give us stable prices.

Once we achieve stable prices, we should and can stay there by remaining in the range of moderate and steady monetary growth. I

would urge the Congress and the Federal Reserve to resist vigorously

any attempts to move outside that range. To do so would start this

whole stop-go cycle again that does nobody any good.

Mr. NEAL. Mr. Fiedler?

Mr. FIEDLER. My judgment on the monetary policy of the past

two decades is that it was very much better than the previous two

decades. Monetary policy still left quite a bit to be desired and did, as

Mr. Jordan suggested, on occasions make some things worse than

they otherwise would have been.

The monetary policy has been part of the process over the past

decade where we have had a continuous acceleration in this base,

built-in rate of inflation where we have gotten up from the early

1960's of 1 percent, virtually zero and now we are up to 5 percent or

6 percent.

That is unfortunate, but perhaps we should have some sympathy

for policy authorities who are dealing with very difficult processes

which are not well understood.

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As to the future, there was a suggestion in the prescriptions offered

by both Mr. Jordan and Mr. Meiselman that we should pursue a very

steady rate of increase in money and credit growth.

While I would like to see more steadiness in the future than in the

past, I think we can carry that prescription too far. I do believe

that at any given time, monetary policy must take account of not

only some fixed, long term-goals, but also the short-term goals and

that some kind of an accommodation does have to be made between

those two often conflicting sets of goals.

The idea of gradually reducing the rate of increase in money has

great appeal. I would not try to put it on a specific 1 percentage point

a year basis. I would be very cautious in doing it at the present time.

At the present time, my own inclinations are for the upper range

of the current Federal Reserve targets.

Mr. NEAL. Thank you.

Mr. Perry?

Mr. PERRY. I would say that monetary policy has been conducted

reasonably well over the period you have charted. Its worse marks

probably come during periods of recession when the Fed has allowed

money growth to slow very sharply.

This has been a characteristic of all the recession periods we have

had. It could have been fighting harder against downturns. In recent

years, it has been confronted with impossible problems.

It has been asked to deal with inflation that it could not possibly

deal with and the results have been very mixed. And, depending on

how one views what is important, you can end up thinking the Fed

has done very well or very poorly.

For now, there are two issues regarding monetary targets. One is

that you still face the problem of inflation and unemployment and

you are not sure exactly where you are going to come out on that.

A year from now, we could be looking at 6-percent inflation. If so,

low money growth rates could easily lead to another recession.

A second issue is that the money demand relationship has been

wildly unstable over the past 2 years.

Money demand, based on the sort of estimates that most researchers

work with, has shown enormous errors from past historical relationships which take account of the influence of interest rates and the

influence of prices and real output on money demand.

The error that has accumulated is in the neighborhood of 8

percent over the last couple of years. You can shop around for an

equation with a 7-percent error or another one that has a 9-percent

error. But any of them is a huge error.

If the equation had been error-free, it would have required 9

percent more money today than we have gotten to achieve the

same situation in the economy. We do not know whether the source

of that error is going to unwind or reverse itself over the next year

or two. It is possible.

Research has tried to track down where those errors have come

from. Partly they have come from the fact that there are a great many

substitutes for money and new institutional arrangements being made

between banks and their customers.

We cannot predict the future of these, but if we tie ourselves to a

number for a thing called Mi and if some of these institutional

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arrangements start to go the other way, the Fed could find itself

driving interest rates through the roof and causing another recession

in the name of sticking to an Mi target when the demand for that

thing called Mj has reversed itself and gotten strong.

Therefore, I think what we ought to be doing is setting some kind of

economic targets for the Fed and asking them to pursue those economic targets as best it can. If that means getting out of the target

range on Mx on the upside or the downside, then let it.

If the money demand function is very unstable, it is very important

to look at interest rates. I think we are now in the period when monetary policy, all things considered, has been quite easy.

Interest rates are at fairly modest levels. A modest rise in interest

rates would be appropriate. But if it turns out that, to hold an Mx

target, you have to drive interest rates up sharply, I would find that

unjustified.

I think it is more important for the Congress to come to some understanding with the Fed about the economic goals that are being pursued

and leave the nuts and bolts of how to conduct its operations more to

the Fed itself. If what it is doing seems to be contrary to the economic

goals, it should answer for its actions and explain why it has pursued

the path it has.

I believe that is the most important oversight that the Congress

could make of the Federal Reserve's activities.

Mr. NEAL. Thank you very much.

I would like to yield to the gentleman from Tennessee.

Mr. ALLEN. Thank you, Mr. Chairman.

Mr. Jordan, you mentioned some mismanagement in monetary

policy in recent years by the Fed. Do you agree that the present

economic recession was precipitated in large measure because of the

tight money policy and the high interest rate policy adopted by the

Fed about 2}{ to 3 years ago. Was this what precipitated the downturn?

Mr. JORDAN. I would say "no" to the word "precipitated." The

monetary policy remained quite stimulative until mid-1973. There was

a moderate slowing from mid-1973 to mid-1974—in the appropriate

direction, in my mind.

My third chart shows the relationship between the short-term rate

of inflation and the level of short-term interest rates. There is a good

correlation there.

What happened was, you had shocks to the supply side of the

economy plus the after effects of wage and price controls in which

prices were artificially suppressed. Inflation accelerated sharply in

1973. You had credit demand building very strongly in the economy,

bidding up interest rates to high levels.

The contraction in output and moderate rise in unemployment we

had through mid-1974 (up until August or September of 1974, I

think) were not initially or primarily due to excessively tight monetary policies.

I do believe in the second half of 1974 that monetary growth contracted much too sharply, as is shown on my chart I, and was too

late and too much. Monetary policy became overly restrictive bringing

a demand induced recession right on the heels of a very severe contraction in aggregate supply. As a result, the recession was deeper and

longer than it would have been if the Federal Reserve had not allowed

this sharp contraction in the growth of the money supply.

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Early in 1975, they turned sharply, growth of the money supply

accelerated rapidly, and it has continued to be uneven and erratic

over the past year. I guess the word "precipitate" I would not agree

with.

Mr. ALLEN. YOU are arguing about semantics, really. When Dr.

Arthur Burns was sitting in the middle chair there sometime back, I

asked him the question about whether or not he agreed with the accepted premise of most economists that if we sought to bring about a

sharp reduction in unemployment, that it would precipitate—I am

using that word again—and rekindle the fires of inflation.

I asked him the specific question of whether or not he agreed with the

economists who say that we cannot afford to have as our goal 2-percent

or 3-percent or 4-percent unemployment.

His answer was, "I think that if properly handled, our goal should

be zero unemployment so long as those who are employed are gainfully and productively employed."

In answer to my questions and suggestions, he agreed that if they

are gainfully employed, it would offset any inflationary pressures.

Those words came from Dr. Arthur Burns.

I am asking you gentlemen here what do you suggest, monetary

policywise or otherwise, that we can do to substantially reduce unemployment and put back to work in gainful and productive employment

the millions of people today who are unemployed, many of whom are

being paid money not to produce but simply to consume, which, of

course, is obviously an inflationary force in our society, being given

spending power for not producing.

That, I guess, you agree, is inflationary. If, for what you receive

in wages you are producing in services or commodities that are being

on the market for sale, then it is not inflationary.

Now, this is what I want to know: What approach do any one of

you gentlemen have to suggest about getting at the root cause of our

whole problem and that is getting back to work the millions of

unemployed in this country into gainful and productive employment?

To my mind, you talk about wasted government money. The most

indefensible waste that is going on in this country today is the failure

of this economy and this society to utilize to the fullest the talents

and the energies of all of its people who are able to work and contribute

to the wealth of this Nation.

Do any one of you gentlemen want to respond?

Mr. MEISELMAN. Congressman, I would like to comment on that.

I think it is important when you are talking about reducing unemployment that we be very clear about the means that we select

to achieve that end.

There are certain things that monetary policy can do and certain

things it can't do. As I discussed in my prepared testimony, belief

that speeding up the printing press would put people to work has been

one of the primary sources of the inflation and also the rising unemployment.

This policy does not work, even though initially and temporarily

there may be some additional jobs. The main goal of monetary policy

ought to be the achievement of stable prices. If there is excessive

unemployment, we have to ask ourselves very serious questions about

conditions in the labor market rather than focus almost exclusively

on monetary and fiscal policy.

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Why is it that we have so many people who are not working?

Millions of people are out of work, not because of the dislocations of

the business cycle, but because of permanent changes in the incentives

to work or to hire labor that have resulted in a permanently higher

level of unemployment.

If you want to get into these tremendously important questions

of the labor market—you must have to think along these lines. For

example, the Congress has passed large numbers of bills that essentially pay people more not to work. Consequently, fewer people want

to work. Congress has also passed large numbers of bills which make

it more expensive to hire people.

When you put the two together, there are going to be more people

out of work. For many people it just does not pay to work. In fact

I keep a running poll among my economist friends and colleagues to

ask them to explain to me not why the unemployment rate is so high

but why are so many people working in this country? Under current

incentives, that is the intriguing intellectual puzzle.

Mr. JORDAN. The first thing that should be done would be to

decide not to use aggregate demand policies, not to use stimulative

overall monetary policies and to rely on that to achieve it. Don't

leave it to the Federal Reserve to promote those goals. Don't use

the shotgun. Let's use the rifle approach. Find out who the unemployed are, where they are, and provide job training and relocation

of workers. Also, exempt teenagers from the minimum wage or have

a special lower apprentice minimum wage until they get some experience, and get people employed.

The national rate of frictional unemployment is about 3 percent.

I have no problem in thinking in terms of a 3-percent unemployment

rate. What I do have a problem with is trying to achieve it this year

or maybe even next year through excessively rapid monetary growth.

Mr. ALLEN. I am not suggesting that in any way. I am asking you

how do we go about it. You are the economists.

Mr. MEISELMAN. I believe that unemployment compensation is

too high for too long for too many people. That is a huge incentive

for people not to work. It is a huge incentive for employers to depend

systematically year after year on people working part of the year.

We are subsidizing seasonal employment and seasonal unemployment.

Mr. PERRY. Have you looked at the unemployment statistics before

unemployment compensation was invented? We had unemployment

then and before we had welfare. This is not what causes unemployment. You had rates much higher then in the postwar period 50

years ago.

Mr. FIEDLER. I would like to offer some suggestions. Since the end

of 1974 general public economic policy, fiscal and monetary policy

has tended to be expansionary in an effort to reduce the unemployment associated with the recession.

The unemployment rate has come down a good ways. There is still

a good deal farther that we can go by the use of those positive, stimulative money and fiscal policies. What we have been arguing today

is how fast we change. But it seems to me there is further cyclical

expansion that can take place and is taking place that will reduce the

rate of unemployment and my tenuous guess is that we can get the

unemployment rate down to 5% percent to 6 percent by that means.

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I would encourage us to avoid trying to do too much too fast for

fear of undoing what we are accomplishing that way. The second

suggestion I would have relates to my point in my testimony about

the imbalance that now exists between capital and labor where there

is not enough capital stock and capital facilities particularly in the

major materials industries to permit the economy to operate in a

way that would get unemployment down to where it could otherwise

be before it would run into the bottlenecks associated with the labor

market itself.

I would think that a program that would foster rapid capital

formation over the next 5 to 10 years would permit us to take that

5}i percent unemployment rate and reduce it to 4% or maybe even 4.

The third point I would try to do simultaneously with these others,

is several structural measures to which there has been reference here,

a separate minimum wage for teenagers, some change in the unemployment insurance system, perhaps making that compensation taxable, a negative-income-tax type of welfare reform with a careful

look at the disincentives to which reference has been made.

I don't think those reforms can do a great deal. Maybe they can

lower the unemployment rate by a few tenths. That is still worth

pursuing.

Fourth, further experimentation with manpower training. We are

spending about $5 billion per year for manpower training in this

country. There is no evidence to my knowledge that those programs

have been particularly successful in achieving the provision of the

unskilled with the skills to be productively emp^e d in today's

economy.

But we should keep trying. We should keep trying to shape those

manpower training programs to hopefully be able to achieve that.

We should not give up. I don't think we should have any major

expansion of them, but I think we should not give up in those efforts.

Finally, I would echo the point that I think Mr. Meiselman made a

minute ago that we should not attempt to get to zero unemployment

because there is such a thing as voluntary unemployment that shows

up in the unemployment rolls, people changing jobs, willing to work in

seasonal trades that mean they are unemployed for part of the year,

willing to take extra time off between jobs. That is one of the measures

of the success of our economy, the high standard of living that the

American people enjoy. We should not be shooting for zero.

Mr. ALLEN. I don't think Dr. Burns meant that every single individual who was able and willing to work should be working 5 days a

week 52 weeks out of the year. He meant that our objective should

be that every person who is able and willing to work should be able to

find gainful and productive employment in this society.

And to the extent that this society and this economy does not

provide that opportunity to that extent we are failing.

Mr. FIEDLER. I agree, sir.

Mr. ALLEN. NOW with respect to inflation—of course, inflation is

devaluation of the dollar. Devaluation of the dollar is devaluing, of

course, the amount of the outstanding debts. Is that not true?

Mr. JORDAN. It is reducing the real debt; it is an indirect hidden

tax on the consumer.

Mr. FIEDLER. It devalues the money that is in circulation.

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Mr. ALLEN. IS it not true this society's present financial system—I

am not speaking about just the Federal Reserve but our whole

financial system is predicated on the proposition that the assets of

insurance companies and banks and savings and loan associations

and all the rest must increase year by year.

Do you agree with that?

Once you find particularly let's say insurance companies whose

assets are not increasing, you have got a danger flag in that that

insurance company is heading for real financial trouble.

Isn't that true?

Mr. JORDAN. The principle you are referring to is involved in

pension funds and in the New York City problem. It is also involved

in the social security system of the United States, in the sense that

you are drawing in new participants and new contributors faster than

you are paying the recipients.

Mr. ALLEN. All the assets of these financial institutions are in one

form or another debts of society to those financial institutions. Isn't

that true?

Mr. MEISELMAN. That is why interest rates rise during inflation to

adjust to that loss, to gain on interest account what is lost on capital

account.

Mr. ALLEN. But when a portion of the price of everything must

be calculated to take into account interest and also to put back into

circulation the money that goes into insurance premiums and savings

and loan associations and so forth, in order to get that back into circulation, society has to go deeper and deeper in debt by going back to these

same banks and pension funds and reborrowing the same money

we put in it at interest.

Isn't that true?

Mr. JORDAN. It is, but the interest rate on that borrowing depends

on everybody's expectations about inflation. When a financial

institution agrees to lend someone some money, the interest rate it is

charging reflects expectations about inflation. It if turns out that

inflation is more rapid than they expected, the value of those assets—

the market value—declines.

Mr. ALLEN. In view of this, is there any way we can operate and

function without going into a catastrophic depression except by a

moderate rate or an ever increasing rate of inflation, thereby devaluing

the debts to devalue the dollars and the currency in which those

debts are payable?

Mr. FIEDLER. I don't agree at all with that proposition. It seems to

me we will incur more debt as the economy grows. There is every

reason to do so. It is part of the process of saving and investment

that is a fundamental component of our progress, a fundamental part

of the increase in productivity, efficiency and the standard of living

of the American people.

There is no reason that that debt has to grow more rapidly than the

total economy and no reason that therefore has to produce any

catastrophic consequences.

Mr. ALLEN. In other words, you think we can function prosperously

in this society with zero inflation. Is that what you are telling me,

sir?

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Mr. FIEDLER. Yes, sir. I think we can function prosperously with

5 percent inflation or minus 2 percent inflation. I don't know how

far I would want to go out, but there is a considerable range, I believe,

in which we can operate because people do in fact get used to a continuing rate of inflation.

It seems to me that for the most part our economy presently is

used to a built-in rate of something on the order of 5 or 6 percent.

Most people are compensated for it. Social security is indexed and we

can get along.

Mr. ALLEN. Social security and other obligations are going up.

Wages have to go up. The entire cycle is over every time the wheel

turns over, we have higher prices, higher wages and thereby reduce

the debts to the extent that the value of the dollar in which those

debts are payable is devalued.

' Mr. FIEDLER. Yes, sir. But the higher interest rate being paid on

those debts compensate. If I am a lender and lend you $1,000 and

you pay me 7 percent interest and we have 5 percent inflation, I am

getting that 5 percent inflation back plus 2 percent real interest.

I am willing to do that, as a general proposition.

Mr. JORDAN. The volume of debt—both Government and public—-

and the interest rate associated with that debt tell us something about

our economy, our society's preferences and choices about current

consumption and consumption in the future. You are identifying a

long-run problem of future liabilities of these institutions at a time

when Government policy has been geared toward encouraging people

to spend and consume now. The tax rebate and the other policies we

have had show this. They are saying "don't preserve for the future,

but go ahead and live it up now and let the future worry about itself."

But the high interest rates that the financial institutions are demanding is a way to try and bid the funds away from doing what Government policy has been trying to encourage people to do in the first

place. If the inflation rate turns out to be less than the market has

expected and discounted, the financial institutions would find that they

are better off. In the past, they were worse off year after year finding

inflation was worse than they had planned on, and they kept trying

to recoup and catch up with this. We could be on the other side of that

and have less inflation than the markets expect and they will find

that they are in an improved position and better able to meet their

liabilities.

By so doing it would be an indication that the behavior of the

people of the country has become more conservative, that we have

gotten away from the attitude of the sixties, that we will have guns

and butter and therefore we won't have investment.

We are concerned about our future, about capital formation, about

the growth of standards-of-living in the future, and not just our

consumption this year. That would be a very healthy thing. In that

way I think we could return to both stable prices and viable financial

institutions with a much lower level of interest rates.

Mr. ALLEN. I am interested in reducing the interest rates by whatever means necessary, because interest rates affect prices and it is

compounded five times by the time it gets to the merchant's shelf.

But do any one of you economists have in your minds the round

figures of the latest census study or study by any other agency of the

Federal Government of the total appraised value or the total value of

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all tangible property in the United States as against the total public

and private debts and how they compare?

Do any one of you have those figures?

Mr. FIEDLER. NO, sir. I can't remember them, Mr. Allen, but The

Conference Board has just published a study on the national wealth

of the United States. I may have something in my bag. Dr. John

Kendrick, consultant to the Board has published a study. There is

certainly some information along that line.

Mr. ALLEN. Would you expect to find that the total public and

private debt far exceeds the value of all the tangible property today?

Mr. JORDAN. That would surprise me.

Mr. ALLEN. I am speaking of the tangible wealth.

Mr. MEISELMAN. It would not surprise me at all because there are

many kinds of debts that are counted over and over again. So, if in

fact you counted all the debt, my hunch is that it is substantially

larger than the tangible assets.

For example, if I have a mortgage on my house and if I got the

mortgage at a savings and loan, that is one debt. At the same time

the savings and loan borrows it from other sources. The other side of

the balance sheet of my mortgage may well be a whole string of debts

as people borrow and lend to finance the mortgage.

The same would be true if I financed the purchase of a car. You

could have a sales finance company that has the paper, the sales company borrows from somebody else who in turn borrows from somebody

else.

There is an elaborate financial network. I believe it is impossible to

measure all those numbers. Twenty years ago when I was a young

researcher at the National Bureau of Economic Research, we tried to

do that. We did the best we could but at that time we didn't even

get the total debt.

Even official U.S. statistics cannot calculate the total debt. There

is always double or triple or quadruple counting. Unfortunately, many

people who look at the statistics come away with the impression that

there is an excessive amount of debt because the ratio is overstated.

Mr. JORDAN. When making that comparison you would want to net

out air triple counting of the debt.

Mr. MEISELMAN. Once you start netting out double counting there

is no good way you can draw the line. At one extreme, private debt is

essentially zero, we owe it to ourselves, That is wiry some people

conclude, if net private debt close to zero, don't worcy about it.

Mr. FIEDLER. There is a summary of the study I mentioned a

moment ago printed in the May 1976, "Morgan Guaranty Survey"

the monthly letter. I will, with the chairman's permission, submit

that for inclusion in the record.

[The summar}^ of the study submitted by Mr. Fiedler follows:]

[From the Morgan Guaranty Survey, May 1976] 1

CONSTRUCTING A BALANCE SHEET FOR THE UNITED STATES

A national balance sheet for the United States combining the tangible wealth

estimates with financial asset and liability data prepared by the Federal Reserve

Board has been constructed for 1973 and is presented in the accompanying table

(balance sheets for other years have not yet been completed). Holdings of domestic

U.S. financial assets are shown by major categories, along with a single figure

representing U.S. ownership of foreign financial assets, including U.S. equity

interest in direct investments abroad. To these are added monetary gold and

domestic tangible assets comprising inventories, structures, equipment, and land,

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in order to obtain total assets. From these are subtracted liabilities and corporate

equities (since stock values were included with assets) in order to calculate net

worth.

The domestic financial assets and liabilities to U.S. residents cancel one another

so that national net worth equals tangible assets, plus monetary gold, plus net

foreign assets (financial claims on foreigners less foreign claims on U.S. residents).

This is what economists understand as national wealth. On the one hand, it is

the net worth of the nation. On the other hand, it is the productive tangible

resources of the country plus our net claims on the productive resources of other

countries. The equality between net worth and productive resources at the

national level is, of course, not matched by equality in individual sectors. The

personal sector's net worth is generally larger than its tangible assets, since its

financial claims exceed liabilities. The opposite is true of business which is a debtor,

on balance.

To be consistent with gross national product (GNP), which is valued in market

prices or approximations thereto, national and sector balance sheets and the

tangible wealth components must be valued likewise rather than at acquisition

or original costs as is customary in corporate balance sheets. In the case of tangible

assets, land is valued at market prices. Inventories have been revalued from book

to current market replacement costs. Newly purchased equipment and structures

are valued at market. But since most aging fixed assets are not traded in organized

markets, their values are estimated in terms of depreciated replacement costs as a

proxy for market values. Theoretical^, market values represent the present (discounted) value of the expected net income from the capital goods over their lifetimes. Obviously, depreciated replacement costs are only a rough approximation

of true values. Also, for purposes of relating capital to production, we estimate

capital on a gross basis (that is, with no subtraction of depreciation), since the

current productive capacity of fixed assets generaly does not decline in step with

depreciated value.

Real wealth (i.e., wealth in constant prices) grows as a result of saving and investment. In the case of depreciable capital goods, the change in net wealth between successive dates equals gross investment less depreciation charges during

the period; the change in gross wealth equals gross investment less retirements

(all in constant prices). In fact, depreciable wealth is generally estimated by the

"perpetual inventory" method, whereby real net investment by type is cumulated

over time, and then revalued to current prices. In current prices, changes in wealth

reflect not only net investment but also price changes.

The Commerce Department defines investment narrowly to include only business

capital formation, residential construction, and net foreign investment. This

analysis defines tangible investment and the resulting wealth more broadly to

include purchases of structures and equipment and inventory accumulation ©f all

sectors—households and governments as well as business.

Combined balance sheet of the United States on December SI, 197S

Assets: Billions Assets: Billions

Demand deposits and Structures 1,042. 1

currency1 $296.0 Equipment 2,202.1

Time and savings ac- Land 848.4

counts 703.1

Insurance and pension Total 9, 922. 2

reserves 458. 1 =

Corporate equities 896. 7 Liabilities and net worth:

Government obligations._ 612. 1 Liabilities:

Corporate bonds 247. 4 To U.S. residents

 3

__ 4, 142. 9

Mortgages 429. 8 To foreigners 163. 5

Other credit instruments. 788.8 Corporate equities 896.7

Security and trade credit- 261. 6 Net worth (or net naOther2

 346. 0 tional wealth) 4, 719. 1

U.S. foreign assets 213.7

Monetary gold 11.7 Total 9,922.2

Inventories $564. 6

1

 Includes Treasury currency and IMF position.

2

 Includes interbank claims, taxes payable, and miscellaneous.

3

 The breakdown of this aggregate is the same as shown for domestic financial assets

owned by U.S., residents, except for corporate equity shares, which are shown separately.

Sources : Tangible assets (net of depreciation reserves) are estimates of The Conference

Board. The foreign assets, liabilities, and monetary gold estimates are from the U.S.

Department of Commerce, Survey of Current Business, October 1975. The other estimates

are derived from the Federal Reserve Board, Introduction to Flow of Funds, February 1975.

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Mr. ALLEN. DO you have the totals there?

Mr. FIEDLER. I don't have any part of the study with me.

Mr. ALLEN. I suggest that you are going to find that the ratio of

public and private debt to the value of the property in this country

has increased and has had to increase every year under our financial

type of system and that the only way that you can continue to

function is by continuing to increase the debt, increase the amount

of interest that is having to be paid and undertaking to meet those

debts by deflating the value of the dollar through inflation.

Mr. NEAL. I am interested in Mr. Perry's suggestions on lowering

the levels of unemployment. The other three members of our panel

have already presented their views on this topic.

Mr. PERRY. I pretty much agreed with some of the very sensible

comments that Mr. Fiedler was making. Here I guess the one thing

I would add is that the main barrier to our reducing unemployment,

not to zero, but to much lower levels than it is today is the fact that

we have this ongoing inflation.

I think you can't separate the achievement of one goal from the

achievement of the other. Therefore anything we can do to deal

directly with the inflation would permit us to pursue higher employment levels at the same time.

Now the list of things that one could do to deal directly with the

inflation problem and slow down this merry-go-round that we are on

at the moment, which we inherited from the past, is not terribly long.

It would be frankly experimental. There is a great deal of feeling

against experimenting in this way.

I have in mind some new attempt to do a better incomes policy

than we have had in the past. If we can get wages to rise more slowly

and prices to rise more slowly, we will be freer to pursue our employment goals.

Right now we confront a problem. All of the things that anyone has

mentioned to me that would expand employment substantially,

reducing unemployment substantially, run the risk of perhaps worsening the inflation rate that we now have or at least not slowing to a

rate that is acceptable to people.

I think we are in a position where the inflation rate is gradually

slowing. If we are prepared to wait what may be a very long time, it

will probably go away. But that is a very long time and it runs into

the problem you raise and that we have not faced up to nearly as

much as we should have in the last few years—what are we going to

do about having this societ}' provide all the job opportunities that

people want?

Fundamentally that is the most important problem before us.

I think it really gets

Mr. ALLEN. It is the No. 1 priority.

Mr. NEAL. HOW specifically would you do it? Would you keep

money growth at some level?

Mr. PERRY. I am not really concerned with money growth. If I

could have an incomes policy—let me be hypothetical—have an

incomes policy under which all the labor unions and large companies

in the country agree they were going to trim 3 percent off the rate of

increase of their wages and prices from what they were over the last

12 months, then I would feel much more comfortable and have no

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inhibitions about pushing demand further to create more jobs and

lower the unemployment rate.

That would involve more money growth than would a slower

path for the economy. It would involve less money than the one

we are contemplating now. To lower the spiral would mean you

would not have to feed the system money just to stay even.

I would guess we could get by with less money growth if we could

slow down inflation and at the same time get more real output. This

is hypothetical. I don't know of any way of getting all these decisionmakers together and getting them to agree to slow down the wage

and price increase by 3 percent.

I do know those people are not looking at Mi. When the rubber

workers go out on strike, that is not what they are looking at. When

their settlement comes in, that is not what determines their settlement. In a long run sense, if we keep this economy very slack, we

will find that unions are settling for less and companies are shaving

their margins.

That happens to be a long, painful process, and completely ignores

what should be a very strong commitment to low unemplo3^ment

and high employment opportunities.

Mr. NEAL. Would you pursue a more stimulative fiscal policy?

Mr. PERRY. If you grant me my hypothetical exercise, then we

have options. We can pursue stimulative policies by undertaking

goals that we might like in the public sector or by reducing taxes.

There is room to use some tax reductions to help reduce the inflation rate. I am speaking specifically of those taxes that get directly

into the price level such as the sales taxes at the State and local

level and the payroll taxes on employers that we now have.

Those are directly in the price level. When you talk about an

ongoing wage-price spiral, anything you can do to buy yourself 2

points less inflation this year is going to have some permanent effect

of lowering inflation in the future.

Those would be specifically fiscal policy moves and in the conventional sense that we measure it, they would be stimulative fiscal

policy measures. But at the same time we might want iio take some

of this added room out in the form of a more expansionary monetary

policy, pushing money growth more and encouraging investments.

You have a choice. If you got yourself the working room so you

can raise output 3 percent more next year than you otherwise would

have, you have a lot of leeway to do a lot of things. Some of them

would involve fiscal steps. Some would involve more expansionary

monetary policy. In other words, we have got 3 percent of output

and can decide what to do with it—private sector consumption,

public need, energy independence or whatever.

One does not lack for where to expand if we were prepared to give

ourselves 3 percent more real output next year. The expansion could

involve fiscal changes. It might very well involve more expansionary

money policy.

Mr. NEAL. YOU have all commented—several of you commented

oi capital formation problems. Now how do they relate to monetary

li?y

Mr. JORDAN. The greatest disincentive to long-term capital formation now to investors is not the fear that short-term money market

interest rates are going to go up this year, but that we are going to

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repeat these waves of inflation and high interest rates that are shown

in your chart. They are concerned that there will be so much stimulus

this year and next year that we will have to have very restrictive

policies, in one form or another, in another couple of years, precipitating another recession, high unemployment, and that by the time any

new investment that is undertaken now gets on stream producing a

product, we will be in a recession and there won't be a market.

The greatest thing that could be done to encourage businessmen to

engage in more long range planning, more investment expenditures to

expand capital, and to plan for an increase in employment would be to

insure them that we are going to have stability, continued growth like

in the 1960's that is going to last for a few years.

I would like to comment on the possible use of incomes policy or

wage and price controls. It is tempting to think that you can get some

shortrun gain by, in a sense, shortening the lag to bring about a condition in the near term that would not otherwise occur for 2 or 3 years.

We have had more restrictive monetary policies in the past which

was supposed to bring inflation down. We recently have had much

more stimulative monetary policies trying to get output and employment up. The idea would be that through some proper use of wage

and price controls you can achieve (this year, or at least next year)

both full employment and stable prices that otherwise would not

happen for a few years.

This is the kind of thinking that was going on in 1971. I admit that

if there were ever ideal conditions for playing that game and using

controls trying to get you there faster, 1971 was a good time to try it.

And they did. But the problem with controls is that their existence

reduces the perseverance on the part of monetary authorities, and

even fiscal authorities, in getting the trend of money down and getting

the real fundamental inflationary force out because you have another

weapon for dealing with inflation.

This frees up monetary policy to pursue full employment and full

capachy goals. That is what happened in 1972. You had a tendency

to resist market rate increase as interest rates were rising during the

expansion. Money supply grew very, very rapidly, mainly because

this other tool was dealing with the inflation problem.

Well, inevitably controls broke down, inflation erupted, and the

price level went back to where it would have been anyway. The only

way controls would work in theory was if you had appropriate money

and fiscal policies, monetary growth being constrained.

Then, of course, the controls are not necessary. But the existence

of the controls makes it less likely that you will get appropriate

monetary policies (winding down the trend of money and the trend of

inflation) for the kind of reason Mr. Perry cites. Then monetary policy

is "free to be stimulative," to do these other things. I think that is a

very dangerous approach to take.

Mr. MEISELMAN. In terms of your question about the relationship

of monetary policy and inflation, there are several things about the

inflation process that are clear to us, especially after the experience

of the last few years.

When the inflation rate goes up, it is as if the inflation itself is an

excise tax on business property because under the law, the profits

of a business firm are calculated on the basis of historic costs. That

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means that when profits are calculated, the profits are overstated

because a business firm does not take the correct amount of depreciation in order to replace its capital used up in the production process.

The costs of replacing inventories are not adequately taken into

account either, so it is as if the inflation per se is a form of an excise

tax on business activity.

That by itself would reduce capital formation, both in fixed plant

and equipment and in inventories. At the same time, the inflation

throws people now into higher tax brackets, even when their real

incomes are unchanged and are falling. My own effective tax rate

has gone up very substantially because of the inflation, even though

my real income has not increased. When people get thrown into

higher marginal tax brackets, the incentive to save is changed, and

people have less because the returns to saving fall. Instead people try

to accumulate assets in a form that does not yield them any money

income that is taxable.

In addition to high marginal tax brackets there is the fact there

is no way to hedge against inflation, although we have talked about

several mechanisms which result in some protection against inflation

in the form of market adjustments involving higher interest rates.

These go only part of the way. There is no way that a person can

typically get complete or sufficient protection.

The usual way that you Accumulate assets is through saving and

making funds available to business enterprises and the Government.

But saving and investment are subject to differentially higher taxes.

So one of the things that happens during inflation is that large numbers of people want to protect themselves and they tend to accumulate

all kinds of other assets. Among them are durables, houses, gold,

antiques, jewels, and so forth. You see this especially in countries

that have a large amount of inflation over long periods of time.

We are starting to see similar events in the United States, with

people buying all kinds of junk which they call "collectibles" because

it is something?tangible. That is really just a small indication of what

would happen if we continue this process.

Both from the standpoint of saving and investment, even a steady

rate of inflation produces these economic impacts. Steady inflation

makes a country as a whole much less efficient. Stop and go policies

make it even worse.

Under conditions of erratic inflation, people have less information

about the current prices of many goods and of their market conditions.

They also have less certainty atout what the future will bring. Thus,

you cannot make the kind of contemporaneous price comparisons that

are necessary to know whether a pair of shoes at $50 is such a good buy

or that one you ought to run in and buy two pairs of shoes or whether

the price is much higher than the prices of shoes available elsewhere.

At the same time, you cannot make efficient comparisons between

today's cost of capital goods and what returns the capital will yield

in the future. You cannot have efficient capital management.

Inevitably there are more and more mistakes.

Inflation, especially variable inflation, makes the economy as a

whole much less efficient. Those are some of the reasons that the kind

of stop-go policy envisaged as necessary to offset an erratic private

sector ends up being bad for jobs, bad for growth, bad for the economy

as a whole.

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After many, many years of it, we really ought to ask ourselves what

we have to show for the last decade of inflation? We have a higher

unemployment rate and much reduced economic growth. What had

been a good situation with respect to growth in the private sector

in the mid-1960's and even the growth of the public sector, has, in

most respects fallen apart right under our feet.

Mr. PERRY. I am going to have to excuse myself, Mr. Chairman.

I have an appointment at 2 o'clock at the other end of town. I am

sorry.

Mr. NEAL. I am sorry to go on so long.

Thank you for coming. This has been fascinating and most helpful.

Mr. Allen.

Mr. ALLEN. If a constitutional amendment or any other means

should be provided that would prohibit any and every government

from the Federal to the State to the local government from spending

more than it collects in taxes, what would happen to this economy?

Mr. JORDAN. I think if it happened overnight, we would have a

little bit of transition problem. But I think, ultimately, it not only can,

but should be done. I think I would add an amendment, if I could

propose one, that not only they can't spend more than they raise in

taxes, but they can't spend more than a certain percent of personal

income of that State—or the national income. At a minimum, this

freezes the proportion of our economy that is government and

maintains the proportion in the private sector. It would be desirable

to have a gradual reduction in State, local and Federal spending as a

percent of income so we can free resources to be emploA^ed in the private sector. That is where 3^011 get efficiency and improvement in

people's standards of living.

Mr. FIEDLER. I share some of the goals, the long-term goals that

were implicit and in some cases explicit in Mr. Jordan's answer,

but I would give a completely different answer. The constitutional

amendment of the sort you proposed

Mr. ALLEN. However

Mr. FIEDLER. I think that would be a disaster. There are many

occasions when governments do need to increase their debt. There are

many occasions when capital investment by the public sector is stimulative to the improvement of the standard of living of the American

people.

I want that freedom to exist when it is appropriate to do so. I

share the goal of less government as a percent of the total economy.

I share the goal of more appropriate management of the public debt

and the inflation and monetary policy and all the rest.

But I don't think we can achieve that by any strict prohibition on

deficits.

Mr. ALLEN. Maybe I stated it wrong. Let's say that every single

governmental agency in the United States from the local community,

city, county, State, Federal government levels should decide tomorrow that we are going to live within our tax revenues collectible each

year.

What would happen? Would it not precipitate a plunge, an economic

plunge?

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Mr. MEISELMAN. There would be problems with adjusting to that

because we alread3^ have large deficits. In the area of fiscal policy as in

monetary policy, I think it is wise that we change direction in a way

that is not too abrupt.

But we have to keep our eye on the ball with respect to where we

want to be. If the Federal Government is now running a deficit in

the order of $70 billion or $80 billion per 3rear, and you propose that

the deficit be eliminated overnight, it is a question of how that is to

be accomplished. If expenditures were reduced to eliminate the

deficit, there would be some adjustment because there would be people

who would temporarily be without jobs.

But the typical person who works for the Federal Government

has more education and training and is relatively more mobile than

the average worker. They would seem to be, on the average, among

the most capable of finding alternative employment. It would be

difficult for some of them just as it might be costly to me if I lost the

major source of my income as a professor of economics.

In view of the fact that there is some implied commitment between

an employer and employee that lasts beyond the week or two of the

current pay period, the honorable thing to do would be to change

.gradually, but systematically.

However, I don't think that these considerations touch on an

important problem. The important question that you bring up, which

is crucial for much of current discussion of public policy reflects the

fact that, on average, the goodies from expenditures come first and

the costs come later.

Mr. ALLEN. I am not recommending any such thing as that.

Mr. MEISELMAN. NO; but I think it is clear that there is an imbalance of incentives for those who vote the expenditures and vote

the taxes. As you know, you are a hero in your district if you get some

expenditures that are particularly favorable to them. At the same time

the taxes to pay for the spending are highly diffuse. So, there is a bias

in the procedures of the Congress as between expenditures and taxes.

The economic effects of going into debt which are also very diffuse.

It takes a trained eye to see them. Many trained eyes claim they

can't see them at all. Put it all together, it suggests that there is art

inevitable bias toward more spending, more debt and larger government as well as a deferral of the diffuse costs.

These are some of the reasons that some people who are very

concerned about the size of the public sector and who don't believe

that people are getting their taxes worth—and I am one of them—

have asserted that one way to help bring expenditures under control

as well as have an efficient size of government—not to get rid of

government but to have an efficient size of government—is to have a

closer link between taxes and expenditures. You do the same thing in

your own budget when you are effectively led to make a comparison

between the cost of an item and the value you receive for it. That is

essential for efficient choice. But, that element is missing in the way

governments make choices because there are other ways to finance

expenditures.

The other ways are print new money or incur vast debt. I live in

the Commonwealth of Virginia and in Virginia, we have no public

debt. For many years, people in other parts of the country used to

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laugh at Virginia's pay-as-you-go policies. But I do not think they are

laughing any more. I suspect that there are now many people in New

York and the State of my birth, Massachusetts, that now think that

Virginia was wise all along.

Mr. ALLEN. The real purpose of my question was to point out one

thing and that is that we cannot consider monetary policy just within

the sphere of how it may be influenced by the Fed.

But this is monetary policy, too, the operation of all of your various

agencies of Government, whether or not they are undertaking to live

within their budgets. Whether that is inflationary or deflationary.

I do not see how you can consider the whole question of monetary

policy without taking that into account.

Mr. FIEDLER. Yes, sir. I agree.

Mr. NEAL. In your opinion, if I understand you all correctly, are

you saying big Federal spending and big Federal deficits are not to

be desired not because the}^ are especially inflationary, but for other

reasons?

Mr. FIEDLER. Yes, sir.

Mr. MEISELMAN. In terms of the inflationary impact, it depends

primarily on how the deficit is financed. If the deficit is financed by

"monetizing" the new debt, then it is inflationary.

If you have a larger government, it is inflationary to the extent

that resources are generally taken from the private sector, where

they are more efficiently used, and brought into the public sector

where the}" are less efficiently used.

This means that a larger budget per se is inflationary. There would

be even more inflation if it were financed by newly vested money.

Mr. NEAL. Can you put a number on that?

Mr. MEISELMAN. There is no way, except to evolve some assumption about the true value of government services, most of which

have no market where prices and values can be recorded.

Mr. NEAL. Would you agree with our conclusion that the rate of

money growth is responsible for approximately 60 percent of our

inflation?

Mr. MEISELMAN. In that one episode when there was a sharp

reduction in the supply of certain kinds of goods, that itself was an

independent supply element in the inflation. I did make some ballpark estimates in testimony before this subcommittee 2 years ago

about the inflationary impact of the devaluation of the dollar between

1971 and 1973.

I do not have the numbers offhand. But for a given stock of money,

if the output goes down, the supply of money goes up. My calculations at that time which were very rough, were that the major factor

in the inflation was the sharp increase that money had taken in 1972

and 1973 rather than the reduction in output.

Mr. NEAL. Let me thank you all for coming. I apologize for keeping

you so long, but this session really has been quite informative.

Let me announce that Governor Partee of the Federal Eeserve

Board will testify tomorrow at 10 a.m.

The subcommittee will now be adjourned until tomorrow morning

at 10 a.m., when we will continue our hearings in this same room.

[Whereupon, at 1:43 p.m., the hearing was adjourned until 10 a.m.,

Thursday, June 10, 1976.]

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Federal Reserve Bank of St. Louis
THE IMPACT OF THE FEDERAL RESERVES MONEY

POLICIES ON THE ECONOMY

THURSDAY, JUNE 10, 1976

HOUSE OF REPRESENTATIVES,

SUBCOMMITTEE ON DOMESTIC MONETARY POLICY

OF THE COMMITTEE ON BANKING, CURRENCY AND HOUSING,

Washington, D.C.

The subcommittee met, pursuant to notice, at 10:06 a.m., in

room 2128, Rayburn Hoxise Office Building, Hon. Stephen L. Neal

[chairman of the subcommittee], presiding.

Present: Representatives Neal, Hannaford, and Gradison.

Mr. NEAL. Let us go ahead, please. I am afraid we will have a

quorum call before too long.

The hearing this morning on the impact of the Fed's money policies

on the economy marks the third day of such hearings being held by

this subcommittee. I am pleased to say that the six witnesses who

have already testified before the subcommittee have greatly contributed to our attempts to get a handle on the responsible conduct of

monetary policy, and its relationship to fiscal policy, inflation and

unemployment.

While there is not one right answer that will solve our economic

problems, testimony presented before the subcommittee has indicated

past money policy deficiencies and errors and put forth constructive

suggestions on restoring stable prices with continued recovery.

Just as we hope that these hearings will help to promote sound

economic policies, we also hope that they will prove to be educational.

We are trying to ask questions about the importance of monetary

policy as it relates to the whole economy, how well it has been administered in the past, and what, if anything, we might want to do

to bring about a change in it for the future.

We are trying to be just as objective as we possibly can, trying to

let the facts unfold as they are without prejudice. We really are making

every effort to do that to the best of our ability.

We are pleased to receive as our witness today Governor Partee

of the Federal Reserve Board. Governor Partee, I welcome you to

our hearing.

Please proceed as you wish.

STATEMENT OF HON. J. CHARLES PARTEE, MEMBER, EOARD OF

GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Governor PARTEE. Thank you, Mr. Chairman.

I am pleased to participate in these hearings on monetary policy

and its effects on the economy. During the past year, aided by the

(115)

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implementation of House Concurrent Resolution 133, a contructives

dialogue has developed between the Federal Reserve and Congress

on the course of monetary policy. I am hopeful that this morning's

session, which I understand to be exploratory and educational in

nature, will help further our mutual understanding of the issues

involved. I would like to begin with some brief, comments on the

monetary policy process, based on my experience over the years

working in this area, and then I shall be happy to respond to any

questions the members of the subcommittee may have.

Although economists differ in their theoretical approaches to the

channels through which monetary policy works, there is little or no

disagreement in the profession that monetary conditions have a

profound impact on the performance of the economy. One view is

that monetary policy influences economic events primarily by changing the stock of liquidity—particularly, the supply of money and nearmoney substitutes—and thereby the willingness of consumers and

businesses to spend and invest out of these more, or less, ample balances. Another view is thai the influence of monetary policy stems

mainly from its effects on the money and capital markets; by affecting

the cost and availability of credit, policy actions will tend to encourage

more, or less, consumption and investment based on the use of credit.

In fact, these theoretical approaches are not contradictory. They

both find that an expansive monetary policy will tend to encourage

more spending while a restrictive policy will tend to restrain it. But

they do approach the process from different vantage points, and the

quantitative measures they suggest we look to in monitoring the conduct of monetary policy differ sharply. The liquidity approach emphasizes the rates of growth in the various measures of the money

supply—Mi, M2, M3, and still broader definitions encompassing successively larger proportions of what might be considered to be the public's total stock of liquid financial assets. The credit approach to monetary policy, on the other hand, emphasizes changes in the flows of

credit through banks, other financial institutions, and the securities

markets, as well as changes in the terms—including interest rates—on

which such credit is made available. This difference in measurement

technique, I believe, gives rise to much of the confusion and disagreement in the evaluations of current monetary policy that one often encounters in the press and elsewhere.

The fact is that observed monetary measures, regardless of current

policy intent, will always reflect also the interaction over time of

monetary policy with underlying conditions in the economy. Output,

employment, and prices are affected directly by powerful forces apart

from monetary policy, such as governmental tax and spending policies,

the attitudes and spending proclivities of businessmen and consumers,

the wage increases being obtained by labor and the pricing policies

of business firms, the availability of foodstuffs, energy supplies and

essential industrial raw materials, and economic conditions and developing trends abroad. In these circumstances, whether interest rates

are comparatively high or low, or whether the demand for credit is

strong or weak, will depend on many factors other than the rate at

which the Federal Reserve is providing reserves to the banking

system—the basic policy instrument at its disposal. Indeed, even the

observed pace of expansion in the various measures of money supply

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may reflect short-run variations in the public's demand for such balances or longer-run changes in liquidity preference in response to

technological innovations in financial management, the level and trend

of interest rates, and present and prospective rates of inflation.

It is important also to recognize that the impact of changes in monetary policy on various aspects of the economy tend to be reflected

with differing time lags. If financial conditions tighten, for example,

the effects are likely to appear much more promptly in securities

market values, and hence on such wealth-sensitive variables as consumer purchases of durable goods, than in business-fixed capital outlays, which require long lead times from planning to fruition. Similarly,

the effects of a change in financial conditions will be more pronounced

in markets that are heavily dependent on the use of credit—such as for

housing and other large investments—than in markets where demand

is financed mainly b}^ current income flows, such as for consumer soft

goods and services. Ultimately, of course, these areas of the economy

too will be affected by induced changes in the income flows themselves.

There is one further timing aspect that requires especially careful

evaluation in the formulation and conduct of monetary policy. As I

have already noted, the economic influence of monetary conditions—

whether measured in aggregate or financial market terms—will be to

encourage either faster or slower expansion in spending, depending on

whether such conditions are easing or tightening. But this effect on the

nominal GNP does not distinguish between real activity and inflation.

In my view, a shift in monetary policy can be expected to affect real

activit}^, as demands for goods and labor tend to be augmented or

restricted, before it reflects itself in the rate of inflation. This is because

it ordinarily takes some time for business and labor to adjust wage

and price policies to changing market conditions. The time lag involved, and the intensity of the inflationary effect, will depend on the

initial state of the econonry and the sensitivity of expectations. But

the inflationary effects will sooner or later develop, and this argues

strongly against a policy course that calls for large injections of liquidity into the economic system as a temporary panacea. In theory, it

might be possible to withdraw the excess liquidity in time, before the

inflationary forces begin importantly to work. But in practice this will

likely be very difficult—if not impossible—to do.

The complexity of the relationship between monetary policy and

the economy, and the need to move cautiously in modulating financial

conditions as economic circumstances and investor and saver attitudes

change, indicate clearly the importance of flexibility in the conduct of

monetary policy. House Concurrent Resolution 133 fully recognizes

this need. Under this resolution, the Board reports quarterly on

economic and financial developments, and specifies the current

expectations of the Federal Open Market Committee for the probable

growth rate ranges in a variety of monetary aggregates, alternately

before the House and Senate Banking Committees. This procedure

is one that permits frequent revaluation, and appropriate adjustments

in current monetary policy aims to the economy's changing needs,

which I believe to be a highly desirable attribute. Quarterly accounting

for the stewardship of monetary policy also implicitly recognizes the

difficulty of projecting economic developments very far into the

future with any high degree of confidence—an assessment with which,

on the basis of experience, I heartily concur.

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In the congressional deliberations leading to the present wording

of House Concurrent Resolution 133, and in further discussions

since then, a recurring issue has been the question of whether monetary

policy intentions should be specified in terms of interest rates as well

as monetary aggregates. The resolution does of course require that the

Board specify 12-month growth ranges for the various monetary

aggregates, and it provides ample leeway for adjustment of such

ranges as conditions change. In my view, this approach is far preferable

to any attempt to specify interest rate objectives.

While it is theoretically possible to specify the course of monetary

policy in terms of interest rate levels as well as the monetary aggregates, it must be recognized that interest rates are particularly exposed

to the influence of many variables external to the scope of monetary

policy, and that there is thus a large risk of specification error. The

announcement of interest rate intentions or expectations could lead

borrowers and lenders to believe that the Federal Reserve could—and

in practice would—guarantee particular levels of interest rates. But

the System does not have the power to do so, for interest rates are

influenced not only by the interaction of demands for credit with the

available supply of funds, but also by the strength of the economy and

public's willingness to defer current consumption in order to save for

the future. Interest rates are also importantly affected by the expectations of both borrowers and lenders about the rate of inflation.

If the Federal Reserve did nevertheless attempt to maintain

selected interest rates at some predetermined level, the effort could

well lead to inappropriate rates of growth in bank reserves and the

money stock. If interest rates came under upward pressure because of

rising demands for funds, for example, System efforts to prevent

interest rate increases would inevitably generate more rapid monetary

expansion, thereby feeding new inflationary pressures. If, on the

other hand, interest rates came under downward pressure because of

slackening business activity and declining demands for funds, System

efforts to prevent the decline in rates would inevitably retard monetary

growth rates and quite possibly exacerbate the recessionary problem.

Thus, any serious effort to specify monetary policy aims in terms

of interest rate intentions or expectations could well prove inconsistent with stated objectives for growth rates in the monetary

aggregates. Of course, the central bank might attempt to hold to the

interest rate objectives, regardless of the performance of the monetary

aggregates. But even in this extreme case the result would very likely

be self-defeating, as lenders and borrowers moved to protect themselves against the prospect cf accelerating inflation or deepening

recession, foreshadowed by what might be very high or very low

monetary growth rates. Needless to say, these effects would be quite

perverse from the standpoint of economic stabilization.

In closing, I would like to stress that monetary policy alone cannot

be expected to deal with all of the Nation's economic problems.

Fiscal policy has a powerful influence on the course of economic

activity, and outsized deficits can and do contribute to inflation.

Monopolistic behavior with respect to the setting of wages or prices

lies outside the scope of monetary policy, and strongly influences the

character of the inflationary bias also. Restrictive trade practices,

whether imposed by private power or government regulation, serve

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to limit productivity and raise costs to the same end. It will require

the efforts of all elements of our complex society if healthy economic

growth is to be sustained, unemployment reduced to appropriately

low levels, and inflation brought under control.

Mr. Chairman, at your request, I have tried to be brief in my

treatment of a very complicated topic. It may be that I have raised

more questions than I have answered. But I will be glad to respond

to questions that subcommittee members have.

Mr. NEAL. I thank you for your very thoughtful statement and

for coming this morning.

Let me draw your attention to this chart, if I may. We have mapped

the yearly money supply changes, shown by the black line, from 1954

up to this year.

Governor PARTEE. That is the narrow money supply, I assume.

Mr. NEAL. That is right.

I would like to ask you a couple of questions about it.

From your knowledge, would you say that that is essentially

accurate?

Would you have any questions about the chart itself?

Governor PARTEE. Well, it looks roughly right. I would have no

way of knowing whether there would be inaccuracies. We do revise

the figures. There has been a benchmark revision in recent weeks that

affected 1975 and 1976 data, so there probabry are small differences;

but I do not think they are significant, sir.

Mr. NEAL. I think we have included the revisions that have been

published in these figures.

In looking at that chart, what I see, of course, is a roller-coaster

type of pattern. I have to ask the question, has that been beneficial

to our economy?

Please respond to that. Would you say that that has been beneficial?

Governor PARTEE. Mr. Chairman, I do not think you can just

look at a chart in the abstract and draw a conclusion from it.

There are two features of that chart that stand out to me and I am

quite sure stand out to you. One is that there seems to be an upward

trend in the rate of money growth over a period of time spanning

many years. The second is that there is a good deal of volatility in

the series; that is, shortrun sweeps up and down in the rate of growth.

But it must be recognized that those changes reflect a host of circumstances that affect not only the economy, but the observed rates

of increase in money supply.

In a recession, for example, the tendency is for the demand for

money to decline sharply. Interest rates also decline sharply at that

time, and often the tendency will get ahead of the Federal Keserve

and there will be a period of slow growth in the money supply before

the basis for increases in money growth is restored. In periods of boom,

of high level activity, the demand for money will be very strong.

There will be very strong upward pressures on interest rates. There

will also be a great deal of anguish about the effect of tight credit

on housing, on automobile dealers, on farmers, on small businesses,

and at those times there is a tendency, because of the rate at which

interest rates have increased, for the money supply to grow more

rapidly. In that environment, the Federal Eeserve would be trying

to hold back the rate of growth, but nevertheless there can be a period

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where money supply growth is more rapid. So that, accounts, I think,

for a large amount of the fluctuation that occurs—the shortrun

fluctuation.

Now, so far as the upward trend is concerned—and I would note

that it does appear from the chart that it has been interrupted over

the last couple of years—I think what is reflected there is the fact

that society has required, legitimately in my opinion, that economic

activity be reasonably good and that employment be reasonably

strong. We have had a growing labor force. We have had to have

rising business activity. We have had to have rising opportunities

for jobs. But, given the social structure that has provided large wage

increases well in excess of productivity gains, and given the structure

of business which has permitted these wage increases and other cost

increases to be passed through in the form of higher prices, there has

been an inflationary bias—I believe a growing inflationary bias—-

in the economy.

Had the money supply not grown in that kind of environment,

the result in the first instance would have been reduced levels of

economic activity, higher unemployment, and a good deal of difficulty

with the economy. So, it is not that I am disagreeing with what the

chart shows; I just wanted to explain the background.

Mr. NEAL. It was the volatile nature of the chart that particularly

interested me.

Governor PARTEE. Yes. I addressed that in my first comments.

Mr. NEAL. YOU state that without an increase in the money supply

during these years we could not have increased our gross national

product and so on. There is no question about that. But could the

Fed have kept the growth of money supply on a more even keel if it

so desired?

Governor PARTEE. Yes. It could have been done; that is, in abstraction. What would then have been required would be a willingness to

see larger interest rate changes than did occur; that is, during those

periods when that line on the chart is going down—periods which

tend to occur very late in the boom or very early in the recession—•

in order to prevent that line from going down, interest rates would

have declined much more sharply than in fact they did. When the

line goes up, as it did, for example, in 1967 and 1968, and again in the

early seventies, it would have required much higher interest rates

than in fact developed during that period in order to keep the line

from moving that high.

It is a question of the tradeoff between the interest rate effects

and the credit availability effects and what they do to the structure

of the economy, and the desire to keep money growth relatively constant. That is our continuing problem.

Mr. NEAL. SO, you would assume that the economy is much more

tolerant of swings in the money supply than it is of interest rate

changes?

Governor PARTEE. NO ; I cannot reach that judgment.

I would say that one has to take into account the effect of interest

rate changes and credit availability changes on the economy and that

one cannot have as his only objective a growth rate in the monetary

aggregates that is stable over time, or moving in a stable manner

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over time, because there are times when the interest rate movement

required is something that society simply will not tolerate.

As I explained at the beginning, there are monetarists and there are

nonmonetarists in the economic profession. I have never chosen up

sides, and the Federal Reserve tends to blend the two points of view.

There were many other things going on. We have had different

boards of governors and different Federal open market committees

during the period to which the chart refers. We have had different

administrations; we have had wars and nonwar periods; and all of

those affect the environment with which we are dealing. The point is

that one must deal in practical terms on a day-by-day basis with what

is going on in the economy, and often the price—the shortrun price—•

of holding monetary growth stable is more than society will tolerate.

Mr. NEAL. YOU mentioned interest rates. Is there a demonstrable

relationship between the level of interest rates and the level of increases in prices—the level of inflation?

Governor PARTEE. I think the causality runs from inflation to

interest rates; that is, I do not think that high interest rates make a

very material contribution to inflation. But a high rate of inflation

over a sustained period, and the expectation that there will be future

inflation, does affect interest rates simply because lenders are not

willing to see the real value of their wealth decline, and therefore they

want an interest rate that will compensate for inflation. Borrowers are

willing to pay the rate because they feel that what they invest in

with the proceeds is going to go up in value, too.

Mr. NEAL. If I understand the process—and I would like for you

to respond to this—if }^ou set targets for short-term interest rates,

then you change the growth of the mone}^ supply; if you increase

the growth of the money supply to keep interest rates down for the

short term, you increase the likelihood of inflation, as I understand it.

Is that essentially right?

Governor PARTEE. Mr. Chairman, we prefer to say that when we

restrict the growth of reserves, which is what we provide to the

banking system, in an environment where demand is strong the

result will be rising interest rates. We do not put interest rates up,

but by holding down on the supply of reserves, the effect is to put

interest rates up. If we do permit overly large sustained increases

in the money supply, I have no doubt that that eventually leads to

inflation with a lag, and that the inflation will in the end put interest

rates higher.

Mr. NEAL. What is emerging here is fascinating to me. Our chart

maps the increase in the yearly changes in the cost of living occurring

23 months after fluctuations in money supply—Mi. A consistent

relationship is shown here, indicating that the sharp growth or

contraction in Mx is reflected in the level of prices.

According to this exhibit the rate of growth of money supply has

resulted in increased inflation.

Governor PARTEE. Mr. Chairman, I do not disagree with the thrust

of that chart. I am sure that you will understand when I say that it

is not an elaborate analytic chart. It is simply an arithmetic exercise.

If one, say, were to have plotted the change in unit labor costs and

compared them with the Consumer Price Index, you would find a

high correlation also.

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There are some possible statistical difficulties with the chart. But

I think that it is true that a rate of increase in the money supply

above a minimal rate that would be associated with real growth in the

economy, given our limited capacity to increase output in real terms

in the economy over the years will in time bring an inflation. In

effect what is being measured here is the subsequent cost of the

earlier decision to try to keep the economy going at a reasonable rate.

There is a process being described here and you are measuring the

cost side. I am very mueh in favor of your doing that because I think

so often the inflationary consequences of an expansive monetary

policy are lost sight of because of the lag effect; and I think it is very

constructive to examine it. But I would point out that there is an

entire process involved. If in looking at this chart, you tend to conclude

that had the money supply not gone up we would not have had inflation—everything else would have been just the same and we

would not have had the inflation—that is a wrong conclusion because

in fact the economy would have been for a time—perhaps for a time

be}^ond the willingness of the public to see it—the economy would

have been much weaker in the process.

What would have to happen in order to reduce that rate of inflation

23 months hence is that wage increases, cost increases, price increases,

and profit shares for companies would have had to be held down. That

process is very difficult to deal with in our economy—that is, the

tendency for costs to rise more than productivity in the economy.

Mr. NEAL. Let me repeat that we are not attributing 100 percent

of our inflation level to the growth of money supply—M2. Our estimates show that about 60 percent of inflation can be traced to the

growth of Mi. We are fully aware of the consideration that must be

given to the dramatic increase in oil and food prices, the aftermath of

wage and price controls, large wage settlements, and a host of other

factors. The astounding thing that is emerging, though, is the magnitude of the influence of Fed policy. We see that one component in

all of this—the Fed's money policies—accounts for 60 percent of the

rate of inflation.

Governor PARTEE. Mr. Chairman, I do not quite know how to go

about explaining this. Let me try again.

I do not mean to say that monetary policy is not very important.

I do not mean to say that Federal Reserve action does not have a lot

to do with the rate of inflation in the economy in subsequent periods.

Mr. NEAL. Sixty percent.

Governor PARTEE. But I can add the contributions of other variables to come to more than 100 percent—by using various components

more than 100 percent of the variation in the rate of inflation can be

explained. If I take unit labor costs as an explanatory variable, I am

sure I will get more than 60 percent out of that. If I take some kind of

measure of world demand and availability of industrial supplies, I

think I can get some percentage there.

My point is that one tends to measure things—one of which is the

rise in the money supply—that have a lot of the same causes in them,

and are associated with the economic situation of the time, and do

contribute to later inflation. I do not disagree; but I would not say the

60 percent flows purely from the money supply to the rate of inflation.

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You mentioned the federal deficit. I think we must recognize that

the Federal deficit's inflationary effect may well show up in monetary

policy, in the monetary aggregates, because a large Federal deficit

will, other things being equal, put substantial upward pressure on

interest rates and it will tend to induce a faster rate of monetary

expansion just in order to hold the system together. Therefore, a

large Federal deficit may—not as a deliberate matter, and not because

the Secretary of the Treasury says it must be so—it may give you a

higher monetary growth rate, and then the monetary growth rate is

later reflected in inflation.

What I am saying is you cannot just separate the sources of inflation into finite separate pieces.

Mr. NEAL. Let me ask this question if I might. You mentioned

wage increases several times as being highly inflationary. Why were

wage increases relatively moderate during the early sixties? What

would explain that?

Governor PARTEE. That is a very interesting question. I have

thought long and hard about how to reestablish those conditions.

I think as a matter of fact that the economy is closer to doing so now

than it has been for the whole decade that has gone by.

My view of the matter is that we had a period of very slow growth

in the economy in the latter part of the fifties. We had a number of

recessions—in 1953, 1954, and in 1957, 1958 and in 1960 and early

1961. It was a painful process—and I might say that monetary policy

was very widely blamed for the poor performance of the economy

in the latter half of the fifties. But, as a result of that process, expectations and aspirations did tend to fall back and expectations of inflation

tended to moderate so that we found ourselves in the early sixties

with moderate growth rates in wages, quite slow increases in consumer

prices, good increases in profits based not on rising profit margins

but on rising volume—a very decent situation. I think that is what we

are trying to restore at this time.

Mr. NEAL. Also during this period you had a very moderate

and steady monetary policy.

Governor PARTEE. But we could have that, you see, because the

other parts of the economy were not performing badly.

I was on the Board's staff in the early sixties and I remember well—

we would argue about this or that detail of the movement in interest

rates, but in fact credit availability throughout the period was very

good. Kates were not trending up. They moved up somewhat cyclically

in the early sixties, but not a great deaL The economy was performing

well. We had a set of conditions that did not call for a great deal of

increase in the money supply, and were really quite suitable except

that there was a degree of unutilized resources in the economy that

was gradually being absorbed during that period. It is not unlike, as

I say, the current situation.

Mr. NEAL. That is right. It is also interesting to note that when

there is a rapid increase in the money supply, you have a corresponding increase in the level of prices, with about a 2-year lag.

Now, when you suddenly turn your supply of money off, we have

recessions. Would you agree with that?

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Governor PARTEE. I would agree that the two are associated.

You are reading a cause-and-effect relationship into this that is

stronger than I would like to agree to.

I think that when there is a boom in the economy, that is, when

there are all kinds of demand increases and sizable wage settlements

are being given, there exist conditions that tend to create both inflation

and strong demand for a rapidly rising money stock. When there is a

recession in the economy, there tends to be a decline in the demand

for money, so that it is easier to have smaller money growth. In fact,

there is the danger of too low a growth rate in the mone}7' supply

during such periods. Also, during those periods the inflationary pressures tend to come off the economy.

There is an association here that is very strong. And if we have the

will to hold monetary growth within reasonable ranges—and I do not

mean at any fixed number, month by month, or even quarter by

quarter, but within reasonable ranges—if we can have the will to do

that I think we can reduce the instability in the economy. And we can

gradually reduce the rate of inflation in the economy. But you must

recognize that this runs the risk that business profits will be poor at

times; that wage increases will be hard fought and hard to get. There

will be long strikes such as we are now having in the rubber industry.

There may be periods of unemployment, regionally or nationally, that

are very offensive to the sense of social justice of the modern U.S.

economy. These are the issues that we are always struggling with.

Mr. NEAL. AS I understand it, though, you are saying that there

is a very strong relationship. In other words, if we do moderate the

growth of money supply, we could expect a lessening of the rate of

inflation and also should not expect these recessions.

Governor PARTEE. If we could moderate the growth over a significant period of time, we should expect a lessening in the rate of inflation.

But we might very well have during that period of time an economy

that is not performing well from the standpoint of providing employment opportunities, from the standpoint of profits, that kind of thing.

Mr. NEAL. Well, why? We had that in the sixties.

Governor PARTEE. Yes; but the conditions resulted from an economy that previously had not performed up to many people's expectations. And you need to have the precondition of ample resource

availability, I believe, in order to have the basis for sustainable,

noninflationary expansion.

As I said in my statement—and I think it is a very important thing

for you to keep in mind—the effect of greater or lesser monetary provision in the economy falls on the nominal GNP. And the break that

occurs between prices and real activity is unfavorable in the first

instance. That is to say, if you lower monetary growth rates you will

have in the first instance an effect on real activity that is unfavorable.

And only after a lag—and the lag may be short compared with what

it used to be—only after a lag will you start to get the benefits of a

lower rate of inflation. If you expand the rate of monetary growth, I

think the initial effect will be stronger markets, more employment,

better conditions, all of things that are extremely favorable. But you

will, again with a lag—and the lag may be shorter than before—with

a lag you will be setting the conditions for heightened inflation.

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It is that conflict between short run and longer run effects that has

always been extremely difficult for us to deal with in explaining ourselves to the public.

Mr. NEAL. I am sorry to take so much time. Let me make one more

point and I will be happy to yield to the gentleman from Ohio.

You started to comment on the deficits. We also charted the

Federal deficits, and we see far less significant relationship between

the level of deficits and the rate of inflation or recession than between

Mi growth and inflation and recession. And in fact as you know, at

this point we have the biggest deficits in our history and one of the

lowest rates of inflation.

I had always assumed that there was a strong relationship between

the level of Federal deficits and the rate of inflation, and I never

understood it; so I find this quite interesting.

Would you agree with this sort of conclusion? What kind of comment

would you have on that?

Governor PARTEE. If you will bear with me for a moment while I

find the table, I think I can make a contribution to this. I really have

two points to make. One I already alluded to, and I will come back to it.

The first point is that deficits tend to be high in times of recession

when the economy is not providing the revenue that one would ordinarily expect it to provide. But in such times of recession, you also

have a decline in private credit demand. In effect, a deficit or a large

part of the rise in the deficit simply substitutes for what previously

was a private credit flow. And the total credit flow, the total credit

expansion in the economy is not much different than before.

The Federal Reserve keeps quite elaborate figures on credit market

flows by major sectors which are called the flow of funds accounts.

Realizing that this would probably be a question, I had my assistant

put together a table that compares credit flows; that is, the rate of

credit expansion relative to the GNP by year for the nonfinancial

sectors of the economy. We exclude the financial sectors to remove

double accounting. For example, the banks have debts but they also

make credit available, and to include both sides would be double

accounting.

Let me just give you four figures from that table. In relation to the

total GNP, the U.S. Government deficit in 1973 amounted to seventenths of 1 percent. And in 1975, it amounted to 5.7 percent. That is,

it was 5 percent of the GNP larger in 1975 than in 1973. But if you

look at the total flow of funds in relation to the GNP in 1973, the

relationship was 14.3 percent. That is, the total increase in credit

amounted to 14.3 percent of the GNP, and in 1975, when you had this

very large Government deficit, the total was 13.6 percent of GNP

lower than it had been in 1973.

I would argue therefore that the kind of deficit that simply substitutes for private credit demand and reflects basically the inability

of the economy to provide the revenues to the Government that might

ordinarily be expected, is not inflationary, and it does not tend to

raise interest rates. Indeed, that was the case in 1975, and again this

year there has been no upward trend in interest rates even though

the Government is borrowing a great deal of money.

Therefore, I think you ought to try another chart. While I have no

analytic trust in the particular level of any full employment deficit

7S-959—76 9

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number, I do think the changes that it shows from one period to another are significant. And I think you ought to try a chart using the

full employment deficit or something like a full employment deficit

concept.

Mr. NEAL. Excuse me a second. Do you have the series?

Governor PARTEE. Well, we have a series. There are various high

employment surplus or deficit series. We have one that we keep

within the shop.

There are some hard decisions to be made in working up a series

as to what constitutes full employment, and also what to do with

rates of inflation which have a powerful effect on revenues and how

you wash them out in the figures. But I can provide the numbers to

Dr. Weintraub.

Mr. NEAL. I wish you would.

Governor PARTEE. The second point which is more fundamental

is the one I made before—I have to be very careful in stating this

because I do not mean to imply political pressure or anything else by

this. It is that when the deficit is pressing very strongly on credit

availability and causing tight credit conditions in the economy and

sharply rising interest rates—and we have had some occasions when

that has been true—because interest rates are rising so sharply, and

because there is so much structural impact occurring from this, there

is a tendency to let monetary growth go a little faster than would

otherwise be the case. Therefore, to the extent that the Government

deficit constrains, if you will, policymakers to do what they judge to

be in the best interest of the economy—to have a somewhat faster

monetary growth rate—why the inflation effect of the deficit is

showing up indirectly through that money growth rate.

Mr. NEAL. But if I understand it correctly that is still a relatively

minor influence.

Governor PARTEE. I do not think it is so minor.

Mr. NEAL. Well, you know, the Fed does not always react the way

you are saying that the public would like it to react or the way the

Congress might like it to react.

Governor PARTEE. NO.

Mr. NEAL. Could you possibly try to quantify that effect?

Governor PARTEE. NO, I cannot really quantify it.

Mr. NEAL. Well, let's try to get something that would help in the

public debate. You know, if we go on in this country assuming that

Federal spending and the Federal deficit are the major causes of

inflation, and they are not, then, you know, we will be fighting straws

in the wind.

Governor PARTEE. Mr. Chairman, I do not think it can be quantified because the difficulty is that it is just a part of the whole picture.

Mr. NEAL. What kind of part? A very minor part?

Governor PARTEE. At times it is a strong part. It was a very strong

part in 1965 and 1966 and during the beginning of the Vietnam War-

And at other times it is not an important part. It varies from time

to time. It varies also depending on the political attitudes of Washington, and so forth, during the period.

But I do argue that it is a very real potential danger. Indeed, the

fear that one could just print money in order to finance deficits is

the reason why we have an independent Federal Reserve System.

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It has happened in many countries in the world at different points

in time, and it could happen here.

Now it has been proposed by some that we ought to be very careful

to see that monetary policy decisions do not in any way affect the

fiscal policy intent of the Congress. And usually that proposal is

stated in terms of maintaining interest rates—having a target for

interest rates that does not change. Thus if the Congress decides that

it wants to have a very much larger deficit as a matter of public

policy, that will not tighten up the private sector at all; well, if you

do that it means that you may get a rapid monetary expansion and

that you will have the inflationary effect of that policy. It is precisely

undoing what the concept of independence is intended to guard

against.

Mr. NEAL. Let me say that I certainly share that concern and that

I could not agree with you more that by monetizing deficits we were

just kidding ourselves and the inflation problem was made worse.

Governor PARTEE. Right.

Mr. NEAL. May we catch this vote and then we will be right back.

I know that Congressman Gradison has some questions and Congressman Hannaford has just come. I am sure that he will want to

talk with you. We will be back in just a few minutes.

Governor PARTEE. That is quite all right.

[A brief recess was taken.]

Mr. NEAL. Let's see, you were commenting about the full employment budget and you were going to supply us with your series on that.

We do not have those figures. Are you suggesting that we would see a

significantly different relationship between Government deficits and

inflation by using your series?

Governor PARTEE. I am not sure, Mr. Chairman. That would be

something I would want to test because from the standpoint of analysis

one would think that there would be more impact using the full

employment deficit. It is a part of the whole and it seems to me that it

is the whole of credit demand, if you will, that is important. We can

speak of the deficit either in terms of its spending effects or in terms

of its financing effects, but it is the whole of credit demand that does

determine the kinds of pressures that develop and, subsequently, the

rate of inflation. The independent contribution of the Federal deficit is

better stated, I think, in terms of full employment financing.

Mr. NEAL. Well we will get that. But, I would still like for you to

comment on the accuracy of the relationship our exhibit shows between the deficit and the rates of inflation.

Governor PARTEE. The full employment numbers would look

entirely different than those, entirely different.

For example—let me see if I can find it here—in calendar year 1975,

the actual Federal deficit on a national income basis was almost $75

billion.

Mr. NEAL. I am sorry, I did not hear that.

Governor PARTEE. The Federal deficit this last year on a national

income basis—that is, the actual deficit but in national income

terms—was $75 billion, and the full employment deficit was $10

billion. So, there is a $65 billion difference. There was a shift from a

surplus of $18 billion in 1974 on our figures in the high employment

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series to a deficit of $10 billion in 1975, which is quite a sharp shift. I

just do not know how the results would look. We have not done it.

Mr. NEAL. Well, let me return to this in a minute. Mr. Gradison

has to leave, and so I would like to yield to him at this timeMr. GRADISON. Thank you, Mr. Chairman.

Mr. Chairman, first of all I want to recognize the fact that the

subjects we are discussing today are not only important to us but

there is a lot being written about them, and I would ask unanimous

consent to include in the record at this point two recent articles.

One is from the June 7, 1976 issue of Business Week in their economic

section under the title, "The Critics Ask: Is Monetarism Dead?"

And, the second is from today's, June 10, 1976 Washington Post,

an article by Hobart Rowen, under the title, "All That Worry About

Fed Policy."

These both are related to what we are discussing and therefore I ask

unanimous consent that they be included in the record.

Mr. NEAL. Without objection, so ordered.

Mr. GRADISON. Thank you, Mr. Chairman.

[The articles referred to by Mr. Gradison follow:]

[From Business Week magazine, June 7, 1976]

THE CRITICS ASK: IS MONETARISM DEAD?

Money alone sets all the world in motion—Publilius Syrus, circa 42 B.C.

Monetarists who, like Publilius, consider the money supply the prime mover in

the economy, received a sharp jolt last week. The Commerce Dept. revised its

estimate of the growth of the gross national product (adjusted for inflation) in

the first quarter from an already high 7.5% to 8.5%. The monetarists had been

hoping that the revision would be in the opposite direction—and for good reason.

Although it has speeded up since (page 18), from the third quarter of 1975 through

this year's first quarter the nation's money supply had grown at an anemic 2.5%

annual rate. In the monetarists' view this could mean only one thing—the recovery would be slow and might even peter out. Instead, the continued strong

growth of the economy despite meager money growth means to nonmonetarist

William Nordhaus of Yale University that "the simplistic relationship that

money determines national income has fallen apart."

The meaning.—If Nordhaus is right, then the impact of the monetarists on

policy will be severely blunted. Since the late 1960s the monetarists have gained

an important voice in Washington. Today the money supply numbers are watched

by bankers, brokers, and bureaucrats alike. Even the Keynesians, the arch rivals

of the monetarists, use the money supply in their forecasts. But if monetarism

continues to prove a feeble guide to forecasting, it will cast doubt about the use

of the money supply as a key policy objective in controlling both real output and

inflation. The result may be a return to an emphasis on interest rates and fiscal

measures as the best tools in the economic arsenal.

Furthermore, the Keynesians have been taking it on the chin since the late

1960s. The debate between them and the monetarists, after lying largely dormant

since the Keynesians caved in, once again is very much alive.

Some Keynesians, to be sure, also missed the strong upsurge in the economy.

However, as Nordhaus notes, "Keynesians look at money, interest rates, inventory levels, tax cuts, rebates and consumer savings, among other things."

The monetarists "put all their bets on their money equation, and when that goes

down the drain it means the whole ballgame."

MONETARISTS DEPENDED ON GROWTH IN MONEY SUPPLY AND MISSED THE RECOVERY

The fact that the equation linking money and national income has gone down

the drain, at least temporarily, is undeniable. For example, on Mar. 8, Dudley D.

Johnson, a monetarist economist at Citibank, presented his forecast for 1976

to the Shadow Open Market Committee, a group of monetarists who meet twice

a year to advise the Federal Reserve. Based on his money model, Johnson projected

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a first-quarter real GNP growth rate of .69%. The actual increase was 12 times as

great. Clearly, the monetarists blew it, and the question is: was it a reflection of

fundamental fault in theory or interesting aberration? The answer lies in the

nature of the demand for money.

What went wrong.—The cornerstone of monetarist thinking is that the demand

for holding money by companies and consumers alike is basically stable and

depends critically on the level of national income. This means that if the amount of

money increases then the public will find itself with excess cash and will therefore

step up the level of spending until the balance between money holding and

national income is once again struck.

Thomas Mayer, a monetarist economist at the University of California, now

worries "whether there has been a shift in the demand for money." What Maj^er

means is that now a relatively smaller stock of money is supporting a relatively

larger GNP. Monetarists have traditionally maintained that the velocity of

circulation—the number of times money turns over relative to national income—

does not change drastically from period to period. Therefore, once the stock of

money is known, the level of GNP is foreordained. But if velocity, is shifting and

unpredictable, then there is little that a monetarist can say about where and at

what speed the economy will be headed.

Allan II. Meltzer, a monetarist theorist at Carnegie-Mellon University, argues,

however, that even if the demand for money has shifted, monetarists are in no

real trouble if it is a one-time shift. "If, however," he says, "the demand for

money keeps shifting, then all economists, not only monetarists, will have a

tough time explaining what is happening in the economy." Meltzer believes that

velocity, which has been increasing at more than three times its historical growth

trend, will "very soon move back to trend."

Another monetarist, Jerry L. Jordan, economist for Pittsburgh National Bank,

agrees with Meltzer. "Velocity should show only a 2% increase in the current

quarter, down sharply from the more than 9% increase in velocity in the first

quarter," says Jordan. And he estimates that, because of the 2.7% increase in

money stock in the first three months of the year, real GNP should slow to less

than half the 8.5% rate in the current quarter. "But if it's as strong this quarter,

then I would rethink the linkage between the money supply as measured bjr Mi

and income," Jordan says.

Monetarists have often been chided for the difficulty they have in agreeing on

a definition of the money supply. Such monetarists as Meltzer, Jordan, and

Johnson insist on using Mi, which includes currency and checking account balances. Milton Friedman, on the other hand, often uses M2, which adds time

deposits at commercial banks. Indeed, the definitions of the money supply go as

far as M7, which also includes mutual savings bank deposits, savings and loan

and credit union shares, large CDs, short-term government securities, savings bonds,

and short-term commercial paper.

Over the past year, M2 growth has accelerated much more than the rate of

Mi. Those who, like Friedman, use M2 in defining the money supply have a lot

less to explain in the economic recovery. And Meltzer concedes that if "we continue to get these kinds of movements in M2 relative to Mi, I would reconsider

which money aggregate is the most accurate indicator." Says Franco Modigliani,

president of the American Economic Assn. and a leading critic of monetarism:

"That's just the point. They don't tell us which M to choose, and when Mi and

M2 diverge, they don't tell us what to do." Says James L. Pierce, economist on

the House Banking Committee, "It seems to me, given the importance of money

to the monetarists, that unless monetarism is some sort of religion, then they

ought to be able to define money and stick with the definition."

THE LINK BETWEEN MONEY AND THE NATIONAL INCOME HAS GONE

DOWN THE DRAIN

A mystery.—Aside from the difficulties in choosing the precise measure of the

monejr supply, the monetarists' explanation of the channels through which,

money growth causes nominal GNP to increase remains shrouded in mystery.

In the monetarist scenario an increase in the stock of money has spill-over

effects on spending in every nook and cranny of the economy, from the purchase of printing presses to pretzels.

On one level, Friedman has compared the link between money and spending

to a helicopter raining down money on people. Even Robert H. Rasche, a monetarist at the University of Michigan, finds that this makes little sense. He says:

"In that case we are talking about an increase in consumer wealth, which of

course affects spending. When it comes to the Fed's market operations it's another

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story." When the Fed buys bonds the sellers end up with more money but with

fewer bonds, so there is no material increase in wealth.

On a more sophisticated level, Friedman argues that the process operates

through a ripple effect of changes in relative prices. When the Fed buys bonds

in the open market, the price of bonds rises, and other assets like stocks become

cheap relative to bonds. This stimulates the purchase of stocks and raises their

prices, making other assets more attractive. The process continues down the

line to all goods and services until the economy as a whole has adjusted its

increased money to a new and higher level of income and prices.

To Mayer this transmission needs rethinking and testing. "It's not a fiction,"

he says, "however, I would like to see these steps laid out clearly in detail so that

we could test and watch the process all along the way. So far the monetarists

have not done this."

But to many Keynesians, the Friedmanian process is indeed a fiction—a

black box. And their view of how monetary policy works differs sharply from

the monetarists. They say the major impact of an increase in the money supply

is on interest rates and the availability of credit. When the Fed buys bonds,

interest rates fall because the price of bonds rises and the banks have more funds

to lend when the bond sellers deposit their checks. The decline in rates and the

infusion of reserves makes credit more available and cheaper, stimulating spending

on capital investment and inventories.

As the Keynesians see it, the impact of increasing the money supply on prices

depends critically on the level of utilization in the economy. Therefore, they

argue, with unemployment at 7.5 percent and industry operating well below

capacity, there is little danger of rekindling inflation, even if money growth

accelerates.

Another split.—Here, too, the monetarists part company with the Keynesians.

Because, according to them, an increase in the money supply signals that price

increases are on the way, inflationary expectations quickly force interest rates

up—especially but not exclusively on long-term bonds. Trying to lower interest

rates by hyping the money supply is self-defeating, because rates will rise instead.

Moreover, says Meltzer, "Given anticipations, the level of capacity utilization

in the economy makes little difference. An increase in the money supply in the

1930s would have had the same impact on prices as a similar increase in the

1960s." Pierce finds Meltzer's position completely unacceptable. "It's mindboggling," he says. "It defies all common sense."

The debate between the Keynesians and the monetarists may have been going

on under other labels perhaps as far back as Publilius. And it may take that long

to resolve the issues. But if the recovery in the next few quarters is robust, then

the monetarists may suffer the same skepticism that befell the Keynesians in

the late 1960s.

[From the Washington Post, June 10, 1976]

ALL THAT WORRY ABOUT FED POLICY

(By Hobart Rowen)

Until very recently, the Federal Reserve Board, under the skilled hand of

Chairman Arthur F. Burns, had been enjoying something of a honeymoon.

Interest rates and inflation were trailing off, and the economy and stock market

were moving up together.

The economy continues to move forward at a moderate rate, and the inflation

numbers are still the envy of the rest of the industrial world. But interest rates

have started to edge up—and the stock market, ultrasensitive to money rates, has

started down.

What Wall Street would like to know, of course, is just what Chairman Burns

has in mind. Is he fearful that the recovery has already generated too much steam?

Will he drive interest rates up even more, to ward off the threat of a resurgent

inflation?

Worse, is he so sensitized to charges that in 1972 the Fed followed too easy a

money policy, that he will now over-compensate, and—willy-nilly—pursue an

austerity course in this campaign year?

Rep. Brock Adams (D-Wash.) recently articulated some of these fears by accusing Burns of tightening up money in small, almost imperceptible steps that he

said were frustrating congressional policy.

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"The Congress, through the medium of the Budget Resolution," Adams said

in a speech to the House, "has provided Mr. Burns with a clear and unambiguous

signal—-don't drive up the interest rates; we need them kept low to maintain the

recovery and prevent its disruption."

It is clear from the actions of the Federal Open Market Committee that Burns

has clamped down on what he considers to be an excessive rate of growth of about

9 per cent in the money supply since February. Key short-term interest rates have

risen about one full percentage point.

But there is reason to believe that the money and stock markets have read

into Fed actions a willingness to take extreme steps to curb the growth of the

economy that doesn't match the intentions of the canny chairman of the U.S

central bank.

Although the Ford administration, for political reasons, is making the current modest recovery sound like a boom, the Federal Reserve Board believes that the economic upturn so far is mild, fairly well-balanced, and not at

all sharp. "It's just an average recovery," says one insider at the Fed.

The notion put forward by Treasury Secretary William E. Simon as an excuse

for "Rambouillet II"—the summit meeting in Puerto Rico at the end of June—

is that the recovery has accelerated beyond expectations, and that one must worry

about latent inflationary consequences. This view is greeted with total skepticism

at the Fed.

The recovery just about matches Burns' predictions. Moreover, given the

amount of persistent excess capacity and high unemployment, the Fed doesn't

think that the economy is getting out of hand.

I'm aware that this is not the conventional picture of the Fed one gets from

market letters and some other partially informed sources on the Fed.

The fact is that much of the conventional wisdom and current criticism about

the Fed has been floated by devotees of monetarist theory. They look only at

one number—the growth of the money supply—to try to figure out what Arthur

Burns is doing.

Yet, with only a small growth in the money supply in the last 9 or 10 months, the

economy has moved up to a level that the monetarists failed to predict.

Chances are that Burns will try to squeeze back an excessive rate of money

supply growth—more because of the public relations impact of these numbers

than anything else. But that shouldn't be read on Wall Street as a sign that the

Fed has plans to put the economy through a wringer. The Fed is very close to the

view expressed by many liberal Democratic forecasters that the recovery has a

long way to go.

To sum it up, the time hasn't come to worry about the rate of growth in the

economy, if I read Fed policy correctly. That won't arrive until consumer credit

starts exploding, plant capacity is stretched, and labor markets are tight. Until

those conditions are present, and none of them is yet in sight, the financial community ought to put its worries about the Fed aside, and concentrate on more

important issues, like the problems of the British pound, and the total absence of

a federal energy policy.

Mr. GRADISON. Governor Partee, I recognize the significance of

your statements about the reason that the Fed at times would perhaps

like to see the interest rates somewhat higher in order to send a signal

to the economy that the Fed is not going to sit idly by at a time that

there might be a resurgence of inflationary pressures or inflationary

expectations. We seem to be in a period like that now.

I am interested in the way in which this message is transmitted or

the way in which it is interpreted. It appears that the message has

been sent and it has been interpreted in such a way that there has

been a substantial weakening in the securities market, certainly the

equity market, as well as an increase in short-term interest rates.

Do you think that this reaction is overdone? Are you disturbed by

the extent of change that has taken place in the equity values or

interest rates during the last month, taking into account the relatively

small changes in the Fed funds rates which have triggered these

reactions?

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Governor PARTEE. Mr. Gradison, I do not know that I would ever

want to seek a particular interest rate level or a particular change in

interest rates as a signal. It is a dangerous game to be involved in,

and, I am not sure that I would want to characterize policy in that

way.

I would say that in recent months, in February and March, there

was a good increase in monetary growth rates, and then in April

there was a very large increase in monetary growth, and if you put

the period together, you get a rather high rate of expansion. In the

case of the Mi, for example, it is close to a 9-percent annual rate over

the period, which is above the target ranges that we have given to

the House Banking Committee and the Senate Banking Committee.

And I would rather say that the increase in the Federal funds rates

has occurred because we were trying to hold back somewhat in the

provision of reserves as a reaction to this strength in the monetary

aggregate.

Now the change in interest rates—market interest rates—has been

rather substantial for the changes that have occurred in these monetary

conditions. The funds rate is up only a little less than three-quarters

of a percent, and yet the interest rate changes in the market have been

quite substantial, in the long-term market as well as in the short-term

market.

I think the main reason for this is the expectational influence;

before, people were surprised that rates were as low as they were and

that they were turning down, but they began operating on that basis.

And, then when the rates turned, people tried to anticipate the future

again and decided that rates would be still higher in the period to

come, so they had better make their adjustments quickly. It seems

to me that this anticipation of the future could very well be wrong.

It has been wrong before. Or, the intensity of the movement that is

expected in the market could be wrong, and so we very well might

get a correction in those rate levels.

In the long-term market there is no real reason for rates to move

upward. I think what we have had is a sympathetic reaction to the

short-term rate movement. Given the demand for funds, which is

substantial but not overwhelming in the long market, and given the

reduction in the rate of inflation that has occurred, it seems to me

that there is little reason for long rates to be higher. We could have

just seen a sympathetic reaction that will now be corrected in that

area.

I happened to read Bart Rowen's column this morning; I thought

it was an interesting column, and I agreed with the thrust of it.

We at the Board do not like to prejudge what is going to happen

to interest rates in the future and we do not like to prejudge them

because we do not know what events will transpire. The market is

prejudging, to a degree, interest rates in the future, and it may be as

wrong as we can be if we try to do it.

Mr. GRADISON. My understanding of what you have just said is

that you believe that the market may have overreacted.

Governor PARTEE. Yes, I think it may have. There is a rhythmic

cyclical thing here that the market people are looking at. That is,

when we have business recoveries and they become more vigorous as

they extend over a period of time, one expects interest rates to go

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higher simply because there is more tension in the credit markets and

more credit demand.

I think it is that cyclically-oriented analysis that has led to the

strong reaction, and it may or may not be right.

Mr. GRADISON. Governor Partee, the charts that we have had do

not appear to take into account the factor of velocity.

Chairman Burns in his appearances before us has indicated that

during a cyclical recovery it is not unusual for velocity to increase,

indeed it has increased rather sizably, maybe even faster than might

have been anticipated during this recent recovery. Do we not have

to take velocity into account in interpreting these charts?

Governor PARTEE. Yes, I think so. Of course, the charts have to

do with retrospective data and velocity would fall out arithmetically

from the lines in those charts.

Indeed, velocity over the whole range of the year shown in that

chart has been pretty predictable. It is only in the last six quarters or

seven quarters that velocity has moved really quite a bit more than

one would have anticipated. Let me give an example of that from

recent experience. As a part of its research activity the Board maintains

a quarterly econometric model, which was developed to show maximum monetary influence on the economy. As a part of that model

one can forecast the relationship between interest rates, nominal GNP

and the money supply.

In terms of forecasting accurac}^ that model has roughly been on

target. However, in the last six quarters, given the realized nominal

GNP and given the level of interest rates, the model, as of the first

quarter of this year, had made a cumulative error, overpredicting the

money stock by $20 billion. Now, that is almost 7 percent of the money

stock.

That is a massive error as these things go. What really bothers

people is not so much the cyclical movements in velocity which can

be expected and understood, but the possibility that something more

fundamental may be going on that may change the relationship

between money and GNP.

It is a highly technical issue, but it shows the looseness in relationships that in fact exists.

Mr. GRADISON. I want to ask just one more question. Really, this

gets back to the discussion which you had with the chairman. My

understanding is that you were suggesting that the economy can have

a direct effect on the money supply just as the money supply can

have a direct effect on the economy and therefore, as we look at these

charts, we had best recognize, when we think of cause and effect, that

we cannot be necessarily sure which is the cause and which is the

effect, that it may work both ways.

I am not trying to oversimplify it at all. I just want to make sure

I understand you.

Governor PARTEE. I think I would agree with that completely.

In abstraction one might say we will not let the economy have an

effect on the money supply, we will simply hold money supply growth

to a predetermined rate. That is usually the basis for most of the

academic approaches to this subject, and it is reasonable to say that.

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But one has to recognize that if you do that there will be effects on

the economy that can be quite substantial and quite adverse from the

standpoint of political and current social and economic perception.

Therefore, I do believe that the money supply, if you will, is to a

high degree, a captive of the economy.

Mr. GRADISON. I notice on page 2 you refer to differences in measurement technique between the monetarists and fiscalists, if that is

the word. Did you really mean technique, measurement technique or

did you just mean maybe they are putting greater emphasis on different factors, one on the measurements of monetary growth and one

perhaps more on credit flows and changes of interest rates? I was not

quite sure what you meant by measurement techniques.

Governor PARTEE. I do think there is a tendency to exaggerate the

differences. At exactly the same point in time you can read in the

paper that monetary policy is, let's say, stimulative because the

monetary aggregates are growing rapidly; and then you can turn the

page and read an article that says the monetary policy is restrictive

because interest rates are rising. It happens all the time. Sometimes I

believe the newspapers, you know, shift over from the one to the other

argument so that monetary policy will always be shown as being

wrong. At one time the amount of supply is not going up, or it is going

up too fast; and at another time, the interest rates are not moving

appropriately.

That is the variation in measurement technique to which I referred.

What I really meant to say—and I am sorry, I do not think I captured

it well at the very beginning of the statement—is that all these

measurements are a part of one economic system. That is, there is a

logical relationship between monetary aggregates, GNP interest

rates and credit flows. It should be possible to take any one of those

and then specify the rest. And so, the tendency is for the monetarists

to take the money supply and specify the rest, and for those who are

more credit market oriented, to take interest rates and specify the

rest.

But, in practice, I have found that the error that you may make is

a good deal more substantial when you try to specify interest rates

than when you specify monetary aggregates.

The reason for that is not any superiority in the monetary aggregate

technique, but simply that we have a lack of knowledge about how

the economy works in all its relations. Having been through a period

on the staff of the Board when we were looking principally at credit

conditions and interest rates, and then through a period where we

were looking more at monetary aggregates, I am inclined to say you

may not always get the optimal result by looking at the aggregates

but you tend to minimize the chance of major mistakes.

Mr. GRADISON. Thank you, Governor Partee, thank you, Mr.

Chairman.

Mr. NEAL. Thank you. We have another vote but we will be right

back if you would please stay with us.

Governor PARTEE. Certainly.

[A brief recess was taken.]

Mr. NEAL. Thank you for waiting for us, Governor, I would like

to yield now to the gentleman from California, Mr. Hannaford.

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Mr. HANNAFORD. I was not here for your testimony, and frankly

I have not yet had time to read it either.

Let me just touch on some general questions. We were discussing

3^esterday during a discussion on the current full employment bill,

the record of unemployment in some of the countries of Western

Europe. This is not precisely related to our subject, but is their record

not dramatically better than ours? The record of unemployment of

something like to 1 to 2 percent, is that in your field of expertise?

Governor PARTEE. Well, I do not have particular knowledge about

each of those unemployment statistics, Mr. Hannaford, but I would

say that there are measurement differences in a good many countries

that make direct comparisons difficult.

There are structural differences among economies also that sometimes hide unemployment. To give you some examples, in Japan the

unemployment rate is always low. But that is because there is a

movement of people back into the countryside—into agriculture—

when the jobs are not there, so you do not get a rise in recorded unemployment. In the case of Germany, there is a lot of foreign labor.

And that foreign labor is exported when the demand for labor is not

there, so it does not show up in their unemployment rate. There are

things like that.

It certainly was true earlier in the postwar period that the perceived unemployment rate was lower elsewhere. It is now not so much

the case. England, for example, has over 5 percent. In most of the

continental countries it ranges between 4 and 7 percent. The differential between the United States and other industrialized countries

is much less marked than they were earlier in the postwar years.

Mr. HANNAFORD. I asked the question simply because you regard

the money supply, the monetary policy as a central feature in that;

and I was wondering if it was related to the differences in the way

those countries and ours handle their money supplies?

Governor PARTEE. I do not think so, no.

Mr. HANNAFORD. YOU mentioned the unpredictability of velocity

in the last 6 months or so. Is that perhaps because of mechanical

changes in the greater use of credit cards and other instruments for

larger transactions in industry, and so on?

Governor PARTEE. We think that is a factor. Credit cards; overdraft checking, which lets you keep a smaller balance, for if you

write checks in excess of your balance there will just be an automatic

credit; the development of NOW accounts in quite a number of

States; the bill-paying service that is done now through savings

accounts at savings and loans and banks, all are factors. I have to

tell you that we have spent a great deal of time and effort—or our

staff has—on this question. And we do not have a fully satisfactory

explanation for what is going on.

My own view—and I do not have the advantage of strong, analytic backup for it—but my own view is that what has happened has

in part been a change in attitude in the economy—toward a more

expansive, optimistic frame of mind after a long period of depression

in 1973 and 1974. That has meant that we get more spending relative

to the money stock measure; people have been more willing to spend;

and they are less conservative than they have been in the past. I

believe that people are much more optimistic and much more comfortable about the future than they were when we were having double

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digit inflation, rising unemployment, political difficulties in Washington, all of those kinds of things that affected attitudes.

Mr. HANNAFORD. I see, a combination there of the mechanics, plus

the optimism.

Governor PARTEE. Yes.

Mr. HANNAFORD. If you could remove the politics from it, do you

think it would be desirable to have monetary policy and fiscal policy

being made by the same hand?

Governor PARTEE. That is a very important qualification.

Mr. HANNAFORD. Yes it is, is it not, almost an absurd qualification?

Governor PARTEE. I do not think I would favor it. Now let me tell

you why.

There is no reason, in principle, that good analysts could not manage

both fiscal policy and monetary policy in the best interest of the economic health of the country. But I am afraid there would come times

when, even as analysts, people would want to have a monetary policy

that would confirm what they had done in the fiscal end or a fiscal

policy that would confirm what was done in the monetary end. And I

think there would be a slippage—a slopover of attitude between the one

field and the other which eventually could get us into difficulty.

It often is asked, Mr. Hannaford, what is wrong with having the

Secretary of the Treasury determine monetary policy? After all, it is a

financial activity and the Secretary or the Minister of Finance is the

chief financial executive of a country's government. Why not have

him do it? Well, he might ordinarily do it very well. But there might

come the day when, in order to succeed in his latest bond issue or in

order to keep the budget down by having lower interest rates, he would

decide to take a monetary policy action that was not truly in the

interest of the country. I think we have something of the same sort

of problem here.

Mr. HANNAFORD. Our testimony has indicated the general feeling

that there is too much fussing done with monetary policy and shortterm adjustments, and that we are something like the overly protective parent that suffocates the child; that, if we could take monetary

policy and set money growth at a constant rate that would allow for the

real growth in GNP. And maybe everyone would step back and let it

go. Do you think we do a bit too much of that fits-and-staxts kind of

adjustment?

After all, the main problem with inflation is its unpredictability.

If we could predict inflation at a given rate of 3, 4, or 5 percent and

knew what it was going to do and could read everything into it, then

a lot of the inequities could be read out of it.

Governor PARTEE. Well, Mr. Hannaford, I have never been a

believer in a rule calling for a constant rate of growth in the money

supply because I have been too concerned that it would not take

into account structural changes in the economy, which would require

different rates of input. A rule would give up entirely any countercyclical influence that monetary policy could contribute in dealing

with holding back the economy when it was booming, or bringing it

back up when it was in recession. It also would run the risk of changes

of a kind that I was just talking about in the relationship of the

observed measures, money supply and GNP. If people should come

to perceive the money supply differently, and 3^011 do not realize it,

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one would be running on the wrong rule. So I have always felt that

there should be more flexibilit}^ than a constant rule would impose.

I have two more comments on this subject. I would have to say

in retrospect that there has been more variation in the rate of monetary growth over the postwar period than I think would have been

desirable. That is, as I look back, if I could do it over and I were the

dictator, I would do it a little differently. There would be more

stability than the chart that has been before us through these 3 days

of hearings has demonstrated. I would rather have a little more

stability than that shows.

My final comment is that I think the reasons for these variations

in money suppfy growth, and the tolerance of the variations of the

money supply growth, are to be found principally in the behavior of the

economy and the behavior of interest rates. There are times when

the economy requires a more expansive growth in the money supply

because it is doing very poorly and every pressure there is is on the

Federal Reserve to follow a more expansionary policy. There are

also times when interest rates are rising sharply, the distribution of

funds among various sectors of the economy—housing, consumers,

businesses, and Government—is chaDging and hurting various parts

of the economy. When that rapid increase in interest rates is so

antagonistic to what people perceive as their shortrun interest, there

often is some tolerance for a higher monetary growth rate—simply

in order to not have the rates go all the way up.

The very peak in short-term rates during the postwar period was

in the summer of 1974, when the prime rate at banks was 12 percent.

That was regarded as an extraordinarily high rate; and I think it

was an extraordinarily high rate for business, borrowers and consumer borrowers to deal with. But the more stability you induce in

the monetary growth rate, the more likely it is that you will have

wide fluctuations of that kind in interest rates. I think most people

perceive them as being adverse to their interests.

Mr. HANNAFORD. Yes. Is this increase in velocity that has been

rather dramatic more recently—that no doubt is one of the factors

of the more restraining monetary policy of recent months. I suppose

it would be.

Governor PARTEE. DO you mean in terms of monetary growth

rate?

Mr. HANNAFORD. Yes.

Governor PARTEE. Yes. We constantly analyze what is going on

in the economy, the fact that the economy was doing well, that the

indicators were good, that our projections of the future weie quite

satisfactory in terms of real growth, and that all of this was being

accomplished with stable to declining interest rates and a lower rate

of monetary growth, made us tolerant of that lower rate of monetary

growth.

If the outlook had been different, if pioblems had been developing,,

or had interest rates been behaving differently, we might have wanted

to step up the monetary growth rate. But in these circumstances,

it seemed appropriate.

Mr. HANNAFORD. One last question. I am very sorry I missed your

statement. Would you just give me a little primer on how the economy

influences the money supply, this relationship of the one influencing

the other?

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I understand the money supply on the economy, but how does

the change in the economy cause a change in the growth of the money

supply? It should be obvious, I suppose.

Governor PARTEE. Well, it is a very complicated subject. Let me

give you two illustrations of it.

One is that the increase in the GNP, the nominal dollar GNP,

tends to bring with it a need for an increase in money in order to

service, if you will, the expanding volume of transactions that occur

in the economy. Thus, if economic activity is rising rapidly, the

nominal GNP is going up rapidly, one would expect the demand for

money to be quite strong simply because the economy itself was

expanding. And therefore, other things equal, the result would be

an accelerated increase in the money supply in a time like that.

The accelerated growth can be stopped over time—not immediately, but over time—by holding back in the provision of reserves

that are required to support that money supply. But that brings

a rise in interest rates. And so interest rates, at a time like that, would

rise pretty sharply if the Federal Reserve were following a constant

money supply target.

Let me give you an even more basic example. The nominal GNP

is a function of costs and prices and real volume. Costs are things

like wage rate increases that unions and employees negotiate; the

cost of raw materials which is affected by supplies like foodstuffs;

international demand for goods. There may well be a situation

in the country in which there is a tendency to produce rather large

increases in costs, for example, wage costs far exceeding productivity

gains. In that case, that part of the increase in nominal GNP is, in the

short run, rather fixed.

If, let's say, that produces an inflation of 6 or 7 percent, which it

has in the past year, and we want to have real growth in the economy

sufficient to reduce unemployment, say 6 or 7 percent, then we must

have a nominal GNP as a matter of arithmetic that rises by 12 to 14

percent. It may be that in order to get that nominal GNP, there

needs to be an increase in the money supply in excess of a predetermined normal amount.

Many economists say—and I would tend to agree—that if there

were no inflation in the economy, one would want to have an increase

in money supply somewhat slower than the growth in real capacity

to produce, which is about 4 percent. We would want perhaps a 2-

or 3-percent increase in the money supply. But as a practical matter,

in order to keep the economy going, given the wage deals that are

being made and the cost pressures that exist, you may have to settle

for a larger increase in the money supply.

That is why I say that the economy affects the money supply.

Mr. HANNAFORD. YOU say that the money supply should expand

slightly slower than the nominal GNP.

Governor PARTEE. Yes. There is a trend increase in velocity. It

is not clear exactly what it is, but it is about 1 or 2 percent

Mr. HANNAFORD. A trend of increase in velocity would cause you

to adjust the money supply increase?

Governor PARTEE. SO if we have zero inflation and are operating

at a satisfactory level of unemployment, the increase in population,

labor force, and productivity would give us the latitude for about a

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4-percent increase in real output each year. We would normally

expect a somewhat smaller increase in the money supply that would

be consistent with that steady state condition.

Mr. HANNAFORD. NOW, if you thought that the economy was behaving independently of your action in an inflationary way, that is,

wage demands were too great or what have you, you would try to

restrain them. Fed policy would try to restrain them with tightening

up of monetary policy. Is that right?

Governor PARTEE. In a general way, Mr. Hannaford. Strong

actions at a time like that are likely to topple the economy. Monetary

policy gently exerts pressure on the system to try to moderate it

over time.

Mr. HANNAFORD. The problem that I have—and we have discussed

this with your chairman—is that there are some things that would

respond to that, perhaps wage rates or some such, and there are other

things which more recently do not appear to respond to it, such as

costs of fuel and food.

Governor PARTEE. Yes.

Mr. HANNAFORD. It is hard to say how we can allow or have a

monetary policy that restrains those things that will yield and subject

themselves to such restraint and not turn back the whole economy.

It seems that we are punishing two different subjects. And one of

them is innocent and the other one needs the punishment. Is that

accurate?

Governor PARTEE. Well, it is a little harsh. But the fact of the

matter is that monetary policy is an aggregate policy. It affects the

economy as a whole. You cannot direct it toward one thing or another

thing because it falls like rain on everyone. And so there is something

to what you are saying.

Analytically, you might say that if there is a source of inflation

that is external to the operation of the economy—let's say crop

failure, or a quadrupling in oil prices by the OPEC countries—that

you could make provision for that by having a little faster increase

in the money supply than you otherwise would think was appropriate.

That is a sound position, I think, simply because otherwise there

would be a shortage of funds relative to the higher prices and the

level of real demands needed to keep the economy employed.

It is an extremely treacherous operation, though, for if more

money is provided and continues to be provided, we will start to

validate the inflation that will be spiraling, that will be accumulating

from those initial external forces. That is, if food prices go up the

next thing is that wage increases need to be larger in order to keep

people's incomes in real terms moving ahead. If people had their way,

they would like to have growing real incomes. If you also validate

that wage increase by having more money expansion, then you are

on the way to an increase in inflationary forces. So it is a very delicate

business.

But in principle, where there is an external source, an identifiable,

clear, external source of price pressure, there can be a compensation

made for it.

Mr. HANNAFORD. The dollars being released by your policy do not

know what they are being released for and they do not know to run

over and buy oil with it instead of paying higher wages.

Governor PARTEE. NO.

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Mr. HANNAFORD. Governor, I appreciate your responses and your

patience for my not having been with you earlier. Thank you very

much, Mr. Chairman.

Mr. NEAL. Thank you, Mr. Hannaford.

I am curious about another subject. What precisely did the Fed

and the Treasury do the other day, do to help Great Britain? Did

they buy pounds? Was it a purchase of pounds?

Governor PARTEE. NO, sir. There is a standing set of agreements

between central banks called the swap network, that in effect provides

a line of credit among central banks for borrowing currencies as they

need to do so.

So far as the Federal Reserve was concerned, what happened was

that we activated $1 billion of that $3 billion line of credit that the

Bank of England had with us, and the Treasury also provided another

$1 billion line of credit, and other countries provided another $3.3

billion line of credit.

In fact, that money has not been borrowed, but it is a tap. That is

to say, if England comes to need the funds, the funds will be there

to the extent of $5.3 billion. There is an obligation, on the part of

England to repay it with interest, of course, and to repay it in dollar

terms so that there is no foreign exchange risk for the United States.

What I would say has happened is that the English, in an effort

to defend their currency and get their house in order, have arranged

for a line of credit.

Mr. NEAL. IS that qualitatively different than the Federal Government's relationship with New York?

Governor PARTEE. The difference is that it is a short-term borrowing and there is a firmer basis for repayment by the English;

namely, the English can get funds from the International Monetary

Fund by agreeing to their terms and conditions, I presume, and therefore the potential creditors involved in this arrangement can be taken

out.

In the case of New York there just was not any near-term prospect

of repayment short of substantial changes in the fiscal management

of the city of New York. Now, those changes are in process. It still

is not a short term prospect of repayment, but there is now, I would

say, some prospect for repayment.

Mr. NEAL. IS there some requirement for Great Britain to do

things differently than it has been doing as a part of this?

Governor PARTEE. It has been working hard, I am sure. As you

know the British have had an incomes policy for a year. They are going

into a second year of incomes policy and are attempting to obtain an

agreement that would hold wage-rate increases to about 4.5 percent.

They have had some success with the unions; in England, labor is

very highly organized, so that is very important. It so happens that

this week the coal miners voted for it and the coal miners are one of

the more militant groups calling for large wage increases. So there is,

at least in terms of the management of the wage deal, quite an effort

going on to reduce the rate of inflation in England, and to improve their

circumstances.

There is also, I think, a general recognition of the need to reduce

national governmental expenditure or at least the proportion of

national government expenditure relative to the total outlays in the

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country. There is not so much occurring in the short run on this issue,

but I think there is a recognition that the governmental role needs to

be moderated.

So, there are a number of constructive developments occurring in

the British situation, I believe.

Mr. NEAL. The comparison between the public responses to the

fiscal problems of New York City and Great Britain seems very

interesting. Although Great Britain's fiscal dilemma was fairly well

publicized, there was no particularly political outcry similar to the

one we had when New York City asked for help.

Governor PARTEE. I dare say there would be if we do not get the

money back.

Mr. NEAL. I would imagine there would be. I think then the

American public would be wondering why Congress was not on its

toes, do you not think, at that time?

Governor PARTEE. I was not directly involved, in any way with

this, Mr. Chairman.

Mr. NEAL. I was not either.

[General laughter.]

Mr. NEAL. Let me ask you one other question. I have never understood why the Fed concentrates on the Federal funds rate instead of

on reserves or some other element. Could you help me understand

that better?

Governor PARTEE. Well, Mr. Chairman—are you talking about an

interest rate as against an aggregate?

Mr. NEAL. Exactly.

Governor PARTEE. I would not say that we concentrate on the funds

rate as against the reserves. The members of the Federal Open Market

Committee have objectives in terms of rates of growth in the various

monetary aggregates. There are, for operational reasons, month

objectives as well as the year-long objectives which are given to the

Congress, and we try to see, within our ability, that the reserves that

are provided are appropriate to those objectives.

There are times, though, when there can be a change in the demand

for money—perhaps quite temporary—where, in order to hold to the

reserve target, there would have to be tremendous upward or downward pressure on interest rates, reflected in the first instance in the

Federal funds rate. And because we feel that sharp gyrations in interest

rates would not be constructive to the performance of the economy,

in the short run we constrain our efforts to achieve the monetary

aggregates by having limits on how far the Federal funds rate can move

in a short period of time. It is not true that we are looking only at the

funds rate. But the rate is, operationally speaking, a constraint on how

far, without looking again at the whole situation at the committee

level, how far the manger of the System Open Market Account can

move in terms of rate effect to get the aggregates that we are after.

It is an old, long-established system in the management of reserve

provision, and there are a lot of reasons behind it. But, I would say the

main one is that we are concerned that sharp gyrations in interest

rates would be upsetting to financial decisionmaking, and thus,

counterproductive from the economy's point of view.

Mr. NEAL. But you are making a judgment, are you not, that those

sharp turns in interest rates would be more upsetting than sharp turns

in the money supply, and we might try to look into that.

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Governor PARTEE. We have.

Mr. NEAL. IS that a demonstrable fact?

Governor PARTEE. We think it is. We have done elaborate econometric and analytic studies of the economy, and we have concluded

that the short run variations in money supply growth, or of growth in

any of the aggregates, have very little impact on the performance of

the economy so long as they are offset later on. Technically speaking,

what we have found is that a two-quarter variance in money supply

growth from a normalized rate does not affect the economy if it is

offset in the subsequent two quarters. That is pretty well researched.

We feel, as I say, that interest rate gyrations are unfavorable. Now,

I want to be absolutely clear about this. These are simply instructions

to the system account manager. Every 4 or 5 weeks the Federal Open

Market Committee meets and it considers what has gone on in the

interval between meetings. And if, in fact, we are not getting the

monetary aggregates that have been specified, even though the funds

rate has been run all the way to the limit that was given to the manager, then it is open season for the committee to say, "Well, we are

going to have to raise that funds rate range for the manager in the

period ahead/' or perhaps, "We think it would be so unfavorable in

the present circumstance for that to be done that we are going to

tolerate, for a period, the somewhat higher growth in the aggregates."

I am describing a decisionmaking process in which all of the people

are brought together, physically, to discuss this all day long every

4 or 5 weeks, during which the instruction for the manager is framed;

and any or all of these specifications may be changed.

I think it is a reasonable way of running the system. Monetarists

often say that we should simply supply the reserves to the banking

system and let the interest rates go where they will. But our view is

that it is a short-run day-to-day operating matter; that there are a lot

of difficulties with the monetarist approach operationally; and that

it would cause variations in interest rates that would be so large that

it would be very difficult for people to adjust to them.

That is the explanation, sir.

Mr. NEAL. YOU would anticipate a wide fluctuation in interest

rates during a year's period?

Governor PARTEE. It should not be all that much different during

a year. But I am really talking about day-to-day and week-to-week

movements, because we are presently speaking of operations.

Just as a hypothetical example, if the Federal Open Market Committee wanted a narrow money supply increase in a range between 4.5

and 7 percent, which is the one that is currently stated, and if nothing

happened to make them change their mind on that—such as a change

in the money demand function or a change in the definitions or a

change in the behavior of the economy—there is no reason, using the

operational technique that I have described, why we would not get

an increase in the narrow money supply within that range by permitting, over a time, interest rates to change consistent with that money

growth objective.

Tolerating some variation in money supply simply smoothes the

change in interest rates. But in fact, if there is no change in the view

of the committee, I would guess that the interest rates at the end of the

year would be about the same under either circumstance

Mr. NEAL. One further question. Do you operate substantially

differently than do other central banks throughout the world?

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First of all I would like some source on information on how other

central banks operate.

Governor PARTEE. I will have to talk to Dr. Weintraub about a

source. It is a pretty complicated question.

I have some knowledge of this although I have not been active in

the international field. I would say that we have a closer control,

market-oriented control, over the system than any other country that

I know of in terms of our open-market operations. We also have a

system of reserve requirements against member banks—unfortunately

not all banks, but only those banks that are members of the Federal

Reserve System—that many countries do not have.

I would say that in recent years we have paid comparatively more

attention to growth rates in the various monetary measures as an

intermediate aim of policy. Of course, in the end, the aim of policy is

always a good economic performance. But we have paid more attention

to the aggregate than has been generally true around the world.

In general, central banks can be divided into two groups: Those

who operate by providing reserves and taking out reserves or liquidity

through open market operations; and those who do it by making

loans to the banks or by taking out the loans. We are in that former

group. Many other countries are in the latter group.

I think we can probably get you some reference on foreign central

bank operations so you could read about the subject.

Mr. NEAL. I really appreciate that very much.

[The information referred to by Governor Partee follows:]

BOARD OF GOVERNORS,

OF THE FEDERAL RESERVE SYSTEM,

Washington, D.C., June 22, 1976.

Hon. STEPHEN L. NEAL, Chairman,

Subcommittee on Domestic Monetary Policy of the Committee on Banking, Currency

and Housing, House of Representatives, Washington, D.C.

DEAR MR. CHAIRMAN: At the recent hearings on Federal Reserve policy and

the economy, j^ou requested that I supply some reading references on central

bank operations and the conduct of monetary policy in other countries. I asked

the staff to look into the matter, and they recommend the following:

(1) Federal Reserve Bank of Boston. Monetary Policy in Twelve Industrial

Countries. Boston: Federal Reserve Bank of Boston, 1973.

(2) U.S. Congress. Joint Economic Committee. Comparative Features of Central

Banks in Selected Foreign Countries, prepared for the Joint Economic Committee

by the staff of the Board of Governors of the Federal Reserve System. Joint

Committee Print, Paper No. 1. Washington, D.C: Government Printing Office,

1963.

The first reference, a copy of which I am enclosing, provides a relatively nontechnical discussion of the institutions and instruments of monetary policy in

Austria, Belgium, Canada, France, Germany, Italy, Japan, the Netherlands,

Norway, Sweden, Switzerland, and the United Kingdom. It also provides a short

bibliography on each country. The second reference is admittedly dated but, we

believe, still largely accurate. The publication contains information on ownership

selection of boards, disposition of profits, relation to Finance Ministries, and roles

in Government finance of the central banks of Belgium, Canada, France, Germany,

Italy, Japan, the Netherlands, Sweden, Switzerland, and the United Kingdom.

In addition, you asked that we supply figures on the high employment Federal

Budget surplus or deficit. Quarterly data for the period 1952 through 1975 are

enclosed. I have taken the liberty of providing data from the Council of Economic

Advisors instead of our own Federal Reserve figures because our quarterly data

does not begin until 1964 and therefore would not be suitable to the requirements

of the Committee's staff. In any event, the CEA series is not very different from

our own.

I would be happy to respond to any questions about the material.

Yours truly,

J. CHARLES PARTEE.

[NOTE.—The 587-page document Monetary Policy in Twelve Industrial Countries

(Reference (1)), is not included in the hearing record.]

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COUNCIL OF ECONOMIC ADVISERS

High employment budgetl 3

(Surplus (+), Deficit (-),$ billions, S.A.A.R.)

1952: 1963:

I _ _ -1.0 I 10.6

II _ -3 . 8 II 11.9

III _ _ ___ -7.6 III 10.4

IV 5. 6 IV 9. 1

1953: 1964:

I -7.5 I 4.4

II __ _ -9.1 II -. 2

III -7.4 III 3.7

IV -8.3 IV 5.7

1954: 1965:

I -6.9 I 8. 7

II __ ___ -2.6 II 7.2

III -1.4 III -.6

IV . 1 IV -3. 5

1955: 1966:

I 1.7 I -.6

II 4.3 II .7

III 8. 6 III -3 . 5

IV 4. 5 IV -4.7

1956: 1967:

I ___ 6.2 I -9.4

II 5.4 II -9.3

III 7. 1 III -9. 9

IV __ 7. 1 IV -10.0

1957: 1968:

I 6.0 I -7 . 1

II 5. 5 II -9. 9

III 7.2 III -. 1

IV _ _ 6.7 IV 3.7

1958: 1969:

I 5. 7 I 10. 1

II 2. 3 II 12. 6

III -.4 III 10.7

IV -1 . 8 IV 11. 0

1959: 1970:

I 3.7 I 11.2

II 5. 9 II 3. 5

III 6. 3 III 3. 6

IV_ _ _ _ 7.2 IV 5.9

1960: 1971:

I 14.9 I 3.4

II 13. 6 II -1 . 6

III 13. 2 III -. 7

IV 13. 4 IV . 4

1961: 1972:

I 12. 1 I 2 -2 . 2

II 9. 8 II -9. 4

III 9. 4 III -1. 7

IV 8.2 IV -20.0

1962: 1973:

I 4.2 I .4

II 5. 6 II 6. 3

III 6. 9 III 10. 6

IV 7.0 IV 12. 5

See footnotes at end of table.

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COUNCIL OF ECONOMIC ADVISERS

High employment budget l 3

(Surplus (+), Deficit (-), $ billions, S.A.A.R.)

1974: 1975:

I 17. 9 I 4 14. 0

II 23.8 II -34.9

III 32. 0 III -7. 8

IV 27. 9 IV -6. 8

1

 Information on the assumed rates of growth of potential GNP and other factors involved in the calculation of the fullyemployment budget can be obtained from past issues of the Economic Report of the President. 2

 The $9.1 billion estimated increase in overwithholding of personal income taxes is not included in the

1972 estimates of full employment receipts, cf., Economic Report of the President, 1976, p. 55.

3

 Latest C.E.A. estimates which may be different from the data presented in earlier issues of the Economic

Report of the President. 4

 In estimating full-employment expenditures, adjustments were made only for those outlays made pursuant to those provisions in the unemployment insurance laws which are regarded as permanent. Policy

initiatives such as federal supplemental benefits and the special unemployment assistance programs are

treated as discretionary by the C.E.A., even though these programs might be made permanent at a later

date. For more information, see the Economic Report of the President, 1976, pp. 55-56.

Mr. NEAL. DO you concentrate more on interest rates than do other

central banks?

Governor Partee. Less so, I think.

Mr. NEAL. Less so?

Governor PARTEE. It certainly is true, historically, and I think it is

still true for the last few years. Eveiyone is moving toward more

emphasis on aggregates. But, I think we have been ahead of most

foreign countries in the attention we have given to that.

Mr. NEAL. Thank you very much for coming today. Your testimony

has been very helpful to us.

Governor PARTEE. Thank you very much, Mr. Chairman.

Mr. NEAL. We will recess now, subject to the call of the Chair.

[Whereupon, at 12:27 p.m., the subcommittee recessed, subject to

the call of the Chair.l

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THE IMPACT OF THE FEDERAL RESERVE'S MONEY

POLICIES ON THE ECONOMY

THURSDAY, JUNE 24, 1976

HOUSE OF REPRESENTATIVES,

SUBCOMMITTEE ON DOMESTIC MONETARY POLICY

OF THE COMMITTEE ON BANKING, CURRENCY AND HOUSING,

Washington, D.C.

The subcommittee met, pursuant to notice, at 10 a.m., in room

2128, Rayburn House Office Building, Hon. Stephen L. Neal [chairman

of the subcommittee], presiding.

Present: Representatives Neal, Hannaford, Allen, and Hansen.

Also present: Dr. Robert Weintraub, staff director.

Mr. NEAL. Gentlemen, I am going to go ahead and start if it is

all right with you. I will have to leave shortly and then return—however, our extremely able colleague from California will chair the

subcommittee for me in my absence.

The subcommittee held hearings on the impact of the Fed's money

policies on June 8, 9, and 10 and this morning we are continuing those

hearings. Primarily, we are interested in learning whether increases

and decreases in the money supply, which are decided by the Open

Market Committee of the Federal Reserve, significantly affect the rate

of inflation and production and employment. I have asked the staff

to conduct indepth research into these questions. Preliminary results

from several econometric experiments indicate that about 60 percent

of our inflation is attributable to changes in money supply. For convenience, we have prepared an exhibit which illustrates the effects of

fluctuations in money supply on inflation. The effects are mapped

23 months after actual changes in money supply growth occur. This

23-month lag was selected b}^ computer studies, which show that the

impact of changes in money supply on the rate of inflation are greatest

at that time. Other more complicated experiments, involving money

growth and the Federal deficit at several lags and changes in industrial production as well, reinforce the findings mapped in the exhibit—

for instance, inflation rises and falls in the wake of increases and

decreases in money growth.

Our exhibit also shows that recessions follow after sharp declines in

money supply growth. Preliminary results from our other experiments

lend support to the relationship depicted here between money growth

and production and unemployment.

[An exhibit mapping M-l money growth, the rate of inflation 23

months later and the recession periods experienced from 1954 to 1976

follows:]

(147)

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148

YEARLY'MONEY SUPPLY CHANGES

Percentage Changes From Ono Month in One Year to the Same Month !n the \'ext Year

YEARLY CHANGES IN THE COST OF LIVING OCCURRING U MOft

RECESSION PERIODS

LATER

Percent Chance

-2

,! I..I..I-I..I I.I I..I..I: '.•l'.l..l..l,,l..'..1-.l.,1.-l..l,.l..l..l..l..l..l..l..l..|.

1951 '55 '56 '57 '58 '69 .'6 0 '$1 'fit '83 '64 '65 '66 '57 '68 '69 • '70 '71 '72 '73 '74 '7$ '7$

As I noted, other factors that affect inflation, production and unemployment, such as the Federal deficit and interactions between

inflation and production are also being researched. Our results to date

indicate that the Federal deficit exerts some independent influence on

our economy's performance. But it is a relatively weak influence

compared to money growth. This finding does not condone excessive

Government spending. Federal deficits are an important factor in our

rate of inflation. It should be noted, however, that in the past, the

Fed responded to the pressures of large deficits by creating more

money to finance these debts. But by no means was the Fed required

to do so; and in the past year, the Fed has proved that it can withstand

pressures to monetize the deficit.

In our work, it is important not only to study the effects of changes

in money supply, but to hear what outside experts have to say.

Certainly, we hope that these hearings will provide increased knowledge in the area of monetary policy and guide us into more effective

means of carrying out congressional oversight responsibilities in this

area.

This morning we are pleased to welcome two very distinguished

witnesses: Dr. James L. Pierce, who is a consultant with the Banking

Committee, and Dr. Allan Meltzer of the Graduate School of Industrial Administration at Carnegie-Mellon University.

Let me make one additional comment if I may, gentlemen. We

really are trying to be as objective as we can and we welcome comments which can help us better understand the economic consequences

of increases or decreases in money supply.

We are very grateful for your coming this morning. Our hearings

will continue and will be conducted as a forum for various points of

view. So as we go along, if you have additional ideas that will help us,

please never hesitate to let us know about them.

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Dr. Pierce, we would like to bear from you firstl Please proceed as

you wish.

STATEMENT OF DR. JAMES I. PIERCE, ECONOMIC CONSULTANT

AND PROFESSOR OF ECONOMICS, UNIVERSITY OF CALIFORNIA,

BERKELEY

Dr. PIERCE. Thank you, Mr. Chairman.

Let me apologize in advance for having a relatively lengthy statement. I didn't have enough time to boil it down. So let me proceed

with trying to go through it.

Fiscal and monetary policies are the two tools the Government has

available to stabilize the Nation's economic activity. While the

spending and taxing programs of fiscal policy are highly visible to the

public, a mystique surrounds monetary policy. Nevertheless, there is

a growing awareness by the public that monetary policy somehow has

an important effect on the economic well-being of the Nation.

Virtually all economists agree that monetary polic}^ is extremety

important; they disagree on the relative strengths of monetary and

fiscal policy. Some economists argue that monetary policy is of paramount importance and that fiscal policy has, at best, only a transient

impact on economic activity. I, and many other economists, believe

that fiscal policy has an important and more lasting impact on income,

employment, and inflation. The extent of this impact, however, will

be conditioned by the monetary policy that the Federal Reserve pursues. The effects of Government taxing and expenditure policies can

be offset by monetary policy or they can be reinforced by it.

No matter what relative strengths various economists assign to fiscal

policy, there is also general agreement in the profession concerning

the importance of monetary policy in influencing inflation. The

economy cannot experience sustained inflation without a monetary

policy that underwrites it. The economy could not have enjoyed the

low inflation rates of the 1950's and early 1960's had monetary

policy created the rapid money growth of the past decade. Conversely,

the high inflation rates of the past decade could not have occurred had

the Federal Reserve pursued a growth in the money supply as low as

that experienced in the 1950's and early 1960's.

Mr. HANNAFORD. Doctor, I don't like to interrupt you this early.

Dr. PIERCE. NO, go ahead.

Mr. HANNAFORD. But we are almost as well off to just go on over

now before you really get steamed up into this, and get back. I kind of

enjoy this all-California team we have here, and of course, we have

Mr. Allen from Tennessee.

[A brief recess was taken.]

Mr. HANNAFORD. The subcommittee will resume with the testimony

of Dr. James L. Pierce of one of the great universities of the world.

Dr. Pierce, please proceed.

Dr. PIERCE. Thank you, Mr. Chairman.

Let me try to pick up where I left off, which was talking about the

importance of monetary policy for determining inflation rates, and relating it to the growth in money over a period.

But I would like to hasten to add, there is more to monetary policy

than the quantity of money. Such factors as bank reserves and

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interest rates also play important roles. The importance that economists

have come to attach to the money supply results, in part, from the

difficulties that have been encountered in attempting to assess the

implications of interest rates. The significance of interest rates in

the economy; that is, whether a particular level of interest rates

encourages expansion or contraction, depends at least in part upon

the inflationary expectations that exist in the economy as well as the

state of the economy as such. For example, interest rates normally

should decline in a recession and rise during a boom, but the question

remains, by how much? This is often very difficult to determine.

Furthermore, it is perfectly possible that interest rates should remain

high or even rise during recession if financial markets anticipate an

acceleration in inflation rates.

This is not to say that the behavior of the money stock is a completely reliable guide either, particularly in the short run. There are

times when the behavior of the money stock is extremely difficult to

interpret. One need only look at the behavior of money growth relative to output and inflation in late 1975 and early 1976 to confirm

this point. There was a near consensus that higher money growth than

was actually achieved was required to obtain the rapid expansion in

economic activity that we have recently experienced. But somehow a

less than 3-percent growth in money has accompanied a more than

12-percent growth in nominal GNP and a nearly 7-percent growth in

real output. Needless to say, this is not a normal pattern.

The behavior of money growth in 1974 is also an important example.

The growth of money during that year was relatively high by historical

standards, around 6 percent, but in light of the tremendous inflationary

shocks the economy experienced, shocks from OPEC, lagged effects of

decontrolling prices, the commodity boom and so on, this money

growth was, in an economic sense, really quite low. Money grew at

about half the rate that prices rose so that the same quantity of money

had to finance a much larger volume of nominal transactions. As a

result, the monetary policy during 1974 was highly contractionary

and the economy responded by producing the most severe recession in

the postwar era.

Historically, the Federal Reserve, like other central banks, has

exhibited a strong tendency to stabilize fluctuations in interest rates,

particularly short-run fluctuations. The Fed's penchant for stabilizing

interest rates has among other things helped produce a procyclical

behavior in the growth of the mone}^ stock; that is, money grows

rapidly during economic expansion and slowly during recessions.

The reason for this is clear enough: when the economy is expanding

rapidly credit demands also expand, tending to put upward pressure

on interest rates. The Federal Reserve attempts to constrain these

interest rate increases by providing more bank reserves through open

market operations. The increase in bank reserves in turn leads to

expansion in the money stock and underwrites an expansion in

economic activity.

During recessions, credit demands decline and interest rates begin

to fall; the Fed attempts to constrain the decline in interest rates by

selling securities on the open market, therein reducing bank reserves

and retarding growth in the money stock. The retardation of money

growth and constraint on interest-rate declines tend to exacerbate the

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decline in economic activity. It seems clear that attempts to stabilize

interest rates can and have produced greater cyclical fluctuations

in income, production, employment, and inflation than would have

been the case had the Fed not been so concerned about interest rate

fluctuations.

If the Federal Reserve adhered more closely to a target growth for

the money stock, interest rates would tend to move more quickly;

that is, fall more rapidly in recession and rise more rapidly in expansion

than has heretofore been the case. These sharper interest-rate movements would serve to moderate the fluctuations in economic activity.

If interest rates were allowed to react more quickly, aggregate demand

would be affected more rapidly and hence would not probably fluctuate

so widely. As a result, it is likely that interest rates would themselves

actually fluctuate less widely.

It is precisely because interest rates have important implications

for economic activity that many observers believe that the Fed

should adhere more closely to a money path and adhere less strictly

to constraining interest-rate fluctuations. This might produce sharper

cyclical fluctuations in interest rates, but smaller fluctuations in the

money stock and more importantly, economic activity. Thus, it is

perfectly possible to subscribe to an apparent nonmonetarist position,

that is, to stress the importance of interest rates, and at the same time

argue for a more steady growth in the money supply. It is because of

this consideration that the battle in the profession between monetarist

and nonmonetarist economists is more a flight of fancy by the press

than a.matter of substance.

It is instructive to observe in this context how the Fed has responded

to changes in the fiscal policy. Historically, the Federal Reserve has

been highly accommodative of shifts in fiscal policy—it is expansionary

when fiscal policy is expansionary and restrictive when fiscal policy is

restrictive. While it is difficult, if not impossible for an outsider to

determine why the Fed has behaved in this way, two reasons come to

mind. First, the Fed has attempted to go along with the fiscal policy

of the country. Second, swings in fiscal policy can have an important

impact on aggregate demand in the economy and on interest rates.

The Fed attempts to circumscribe the movement of interest rates

by speeding up money growth when aggregate demand is rising

rapidly in response to fiscal policy and slow down money growth

when interest rates are declining or not rising as rapidly when fiscal

policy becomes less expansionary.

Whatever the cause, the record seems clear. There is only one

important counter-example I am aware of and that occurred in 1975

when the Fed reacted strongly to the bulge in the money stock created

by the tax cuts and rebates that occurred. In that situation interest

rates rose sharply for a short period of time before they returned to a

more sustainable level. That performance appears to be quite unusual.

Now, Mr. Chairman, I gave a fairly lengthy analysis of the relationship between money growth and Federal deficits in an effort to try to

document my case that monetary policy has been accommodative,

and rather than go through that, I will just submit it for the record

and try to answer questions if there are any.

Mr. HANNAFORD. Proceed in whatever manner you would like.

Dr. PIERCE. Well, let's do it that way, then.

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Let me just conclude by making just one point, and that has to do

with the accountability of the Federal Eeserve, which is on the last

page of the testimony.

I would like to make the point that there are really two steps in

assessing monetary policy, the first, to determine what the Fed is

attempting to achieve by its actions in terms of employment, production, and inflation, and second, to determine whether its policies,

for example, money growth, will achieve those ends. If these two steps

are combined, one never knows whether a policy is technically wrong,

that is, will not achieve the chosen ends, or whether it only appears

to be wrong because perhaps you and I disagree with what the Federal

Reserve is trying to do. Until one can unravel these two steps, it will

be extremely difficult for any outsider including the Congress to assess

and oversee the execution of monetary policy.

I would like to conclude by saying that I understand this subcommittee is interested in knowing how monetary policy is actually

formulated. This is a large topic which I have only touched upon in

my statement. I would like to submit two papers for the record, that

describe in some detail how monetary policy is formulated, and I

would be happy to answer any questions on this topic as well as any

others that you care to ask.

[The prepared statement of Dr. Pierce and the above-mentioned

papers follow:]

PREPARED STATEMENT OF DR. JAMES L. PIERCE, ECONOMIC CONSULTANT AND

PROFESSOR OF ECONOMICS, UNIVERSITY OF CALIFORNIA, BERKELEY

Fiscal and monetary policies are the two tools the government has available to

stabilize the nation's economic activity. While the spending and taxing programs

of fiscal policy are highly visible to the public, a mystique surrounds monetary

policy. Nevertheless, there is a growing awareness by the public that monetary

policy somehow has an important effect on the economic wellbeing of the nation.

Virtually all economists agree that monetary policy is extremely important;

they disagree on the relative strengths of monetary and fiscal policy. Some economists argue that monetary policy is of paramount importance and that fiscal

policy has, at best, only a transient impact on economic activity. I, and many other

economists, believe that fiscal policy has an important and more lasting impact

on income, employment and inflation. The extent of this impact, however, will

be conditioned by the monetary policy that the Federal Reserve pursues. The

effects of government taxing and expenditure policies can be offset by monetary

policy or they can be reinforced by it.

No matter what relative strengths various economists assign to fiscal policy,

there is also general agreement in the profession concerning the importance of

monetary policy in influencing inflation. The economy cannot experience sustained inflation without a monetary policy that underwrites it. The economy

could not have enjoyed the low inflation rates of the 1950s and early '60s had monetary policy created the rapid money growth of the past decade. Conversely, the

high inflation rates of the past decade could not have occurred had the Federal

Reserve pursued a growth in the money supply as low as that experienced in the

1950s and early '60s.

But there is more to monetary policy than the quantity of money. Such factors

as bank reserves and interest rates also play important roles. The importance that

economists have come to attach to the money supply results, in part, from the

difficulties that have been encountered in attempting to assess the implications of

interest rates. The significance of interest rates in the economy—that is, whether

a particular level of interest rates encourages expansion or contraction—depends

at least in part upon the inflationary expectations that exist in the economy as

well as the state of the economy as such. For example, interest rates normally

should decline in a recession and rise during a boom, but the question is, by

how much* This is often difficult to determine. Furthermore, it is perfectly possible

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153

that interest rates should remain high or even rise during a recession if financial

markets anticipate an acceleration in inflation rates.

This is not to say that the behavior of the money stock is a completely reliable

guide either, particularly in the short run. There are times when the behavior

of the money stock is extremely difficult to interpret. One need only look at the

behavior of money growth relative to output and inflation in late 1975 and early

1976 to confirm this point. There was a near consensus that higher money growth

than was actually achieved was required to obtain the rapid expansion in economic

activity that we have recently experienced. Somehow a less than 3 percent growth

in money has accompanied a more than 12 percent growth in nominal GNP and

a nearly 7 percent growth in real output. This is not a normal pattern.

The behavior of money growth in 1974 is also an example. The growth in money

during that year was relatively high by historical standards—around 6 percent—

but in light of the tremendous inflationary shocks the economy experienced—

from OPEC, lagged effects of decontrolling prices, the commodity boom, etc.—

this money growth was, in an economic sense, quite slow. Money grew at about half

the rate that prices rose so that the same quantity of money had to finance a

much larger volume of nominal transactions. As a result, the monetary policy

during 1974 was highly contractionary and the economy responded by producing

the most severe recession in the post-war era.

Historically, the Federal Reserve, like other central banks, has exhibited a

strong tendency to stabilize fluctuations in interest rates, particularly short-run

fluctuations.

The Fed's penchant for stabilizing interest rates has among other things helped

produce a pro-cyclical behavior in growth of the money stock—that is, money

grows rapidly during economic expansion and slowly during recessions. The reason

for this is clear enough: when the economy is expanding rapidly credit demands

also expand, tending to put upward pressure on interest rates. The Federal Reserve

attempts to constrain these interest rate increases by providing more bank reserves

through open market operations. The increase in bank reserves in turn leads to

expansion in the money stock and underwrites an expansion in economic activity.

During recessions credit demands decline and interest rates begin to fall; the Fed

attempts to constrain the decline in interest rates by selling securities on the open

market, therein reducing bank reserves and retarding growth in the money stock.

The retardation of money growth and constraint on interest rate declines tend to

exacerbate the decline in economic activity. It seems clear that attempts to

stabilize interest rates can, and have, produced greater cyclical fluctuations in

income, production, employment and inflation than would have been the case had

the Fed not been so concerned about interest rate fluctuations.

If the Federal Reserve adhered more closely to a target growth rate for the

money stock, interest rates would tend to move more quickly, that is, fall more

rapidly in recession and rise more rapidly in expansion than has heretofore been

the case. These wider interest rate movements would serve to moderate the

fluctuations in economic activity. If interest were allowed to react more quickly,

aggregate demand would be affected more rapidly and, hence, probably would not

fluctuate so widely. As a result, it is likely that interest rates would themselves

actually fluctuate less widely.

It is precisely because interest rates have important implications for economic

activity that many observers believe that the Fed should adhere more closely to a

money path and adhere less strictly to constraining interest rate fluctuations. This

might produce sharper cyclical fluctuations in interest rates but smaller fluctuations in the money stock and economic activity. Thus, it is perfectly possible to

subscribe to an apparent "non-monetarist" position, that is, to stress the importance of interest rates, and at the same time argue for a more steady growth in the

money supply. It is because of this consideration that the battle in the profession

between monetarist and non-monetarist economists is more a flight of fancy by the

press than a matter of substance.

It is instructive to observe in this context how the Fed has responded to changes

in fiscal policy. Historically the Federal Reserve has been highly accommodative

ofshifts in fiscal policy—it is expansionary when fiscal policy is expansionary and

restrictive when fiscal policy is restrictive. While it is difficult, if not impossible, for

an outsider to determine why the Fed has behaved in this way, two reasons come to

mind. First, the Fed has attempted to go along with the fiscal policy of the country.

Second, swings in fiscal policy can have an important impact on aggregate demand

in the economy and on interest rates.

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The Fed attempts to circumscribe the movement in interest rates by speeding

up money growth when aggregate demand is rising rapidly in response to fiscal

policy and slow down money growth when interest rates are declining or not rising

as rapidly when fiscal policy becomes less expansionary. Whatever the cause, the

record seems clear. There is only one important counter-example I am aware of

and that occurred in 1975 when the Fed reacted strongly to the bulge, in the

money stock created by the tax cuts and rebates. In that situation interest rates

rose sharply for a short period of time before they returned to a more sustainable

level. That performance appears to be quite unusual.

The more normal behavior of the Fed with respect to fiscal policy can be seen

in Chart I. The top panel shows the high-employment surplus or deficit. These

surpluses or deficits are an imperfect, but useful, measure employed by economists

to assess the contribution to aggregate demand of fiscal policy. The high-employment deficit, rather than the actual deficit, is used because tax revenues vary

with economic activity. During recessions, an actual deficit will be incurred

simply because revenues have fallen even though expenditure levels and tax

rates have remained unchanged. Such a deficit is not expansionary. The highemployment deficit adjusts for this effect by using not actual revenue figures

but rather an estimate of the revenues that would have been generated if the

economy had been producing at high levels of employment. The relationship of

the high-employment measure to actual deficits or surpluses is shown in Chart II.

The bottom panel of Chart I shows the actual growth in the money stock.

When one compares the two panels it is clear that when fiscal policy is highly

expansionary, i.e., large high-employment deficits, money growth tends to be

high. When fiscal policy is restrictive, i.e., large high-employment surpluses,

money growth is low. Thus, the Federal Reserve underwrites fiscal policy. One

can see this effect very strikingly in the second half of the 1960s. During that

period, the Government was running large high-employment deficits at the same

time that the economy was, in fact, highly employed. These policies contributed

to the inflationary pressures that began to be felt by the end of the decade, and

which we are still living with today. The fiscal policies of the late 1960s have been

widely discussed and criticized but what has been mentioned much less frequently

is that the Federal Reserve was underwriting these policies and was in essence

monetizing the actual deficits, by purchasing the debt that the Treasury was

issuing to finance the deficits. The result was rapid money growth and a further,

and probably substantial, contribution to the inflationary pressures that were

being put into place during that period.

The relationship between money growth and actual deficits or surpluses would

have told the same story as illustrated in Chart I, except that it would have been

a little more difficult to discern. No matter what measure of deficits is used, the

moral of the story is the same. Monetary policy has been highly accommodative

of fiscal policy. This behavior of monetary policy makes one wonder just how

independent the Federal Reserve really is.

In my opinion it is up to the Congress and ultimately the electorate to determine whether or not the Federal Reserve should accommodate fiscal policy. No

matter what the answer is to that question, however, it is fair to say that one cannot judge the impact of fiscal actions without knowing how the Fed will react to

them. History suggests that it will accommodate fiscal policy, although the degree

is unknown. The experience of 1975 suggests that at times monetary policy will

attempt to offset fiscal policy. In either case, the effects of fiscal policy will be

profoundly affected by what monetary policy does. I know of no way that the

Congress and the Administration can go about determining appropriate fiscal

policy without knowing the Fed's intent and how the Fed will react to various

fiscal policies. If one knew what objectives the Fed sought to achieve in the economy

one would have some basis for deducing how it might respond to changes in tax

and expenditure policies. More generally, if one knew the Fed's objectives, one

could deduce how it might respond to any change in the economic situation. Without such knowledge it is virtually impossible to evaluate general economic policy,

including monetary policy.

It seems important to make an additional crucial point. There are really two

steps in assessing monetary policy: first, to determine what the Fed is attempting

to achieve by its actions in terms of employment, production and inflation and

second, to determine whether its policies, e.g., Mi growth, will achieve those

ends. If these two steps are combined, one never knows whether a policy is

technically wrong, i.e., will not achieve the chosen ends or whether it only appears

to be wrong because it seeks to accomplish something that you or I disagree with.

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Until one can unravel these two steps it will be extremely difficult for any outsider

including the Congress to assess and oversee the execution of monetary policy.

I would like to conclude by saying that I understand this Subcommittee is

interested in knowing how monetary policy is actually formulated. This is a large

topic which I have only touched upon in my statement. I would like to submit

two articles for the record that describe in some detail how monetary policy is

formulated, and I would be happy to answer any questions on this topic as well

as any others that you care to ask.

CM i-l r-l

in o in o

CM —• O

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billions of dollars

+30

Chart II -- Federal Government Surplus (or Deficit)

billions of dollars

FULL EMPLOYMENT SURPLUS (OR DEFICIT)

- -70

b3 *b4 '55 '56 '57 '53 '59 '60 '61 ^62 '63 ^6 4 *65 '66 »67 *68*6 9 7 0 7 1 7 2 7 3 74 ; '75 7 6

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QUANTITATIVE ANALYSIS FOR DECISIONS AT THE FEDERAL RESERVE

(By Dr. James L. Pierce)*

[The purpose of this paper is to describe how policy analysis and advice is made at the Federal Reserve Board as

well as to discuss the implications of the process for optimal control applications. An attempt is made to highlight

those areas where control applications might make the greatest contribution to improving the policy-making process.

Some of the problems that have been encountered in using control techniques at the Fed—problems with structural

models and specification of objective functions—are pointed out along with some of the insights that these applications

have provided.]

The way in which our work at the Fed bears on control theory applications can

probably best be illustrated by discussing how policy analysis and advice is

actually made at the Federal Reserve. To begin, it might be instructive to provide

a description of the policy-making process itself.

Every month in Washington, there is a meeting of the Federal Open Market

Committee (FOMC), which is the basic policymaking body of the Federal Reserve.

This Committee is composed of the seven members of the Board of Governors

plus five Federal Reserve Bank presidents. The presidents of the remaining seven

Federal Reserve Banks also attend these meetings and freely enter into the discussion, but do not vote. Thus, there are twelve voting members on the Committee.

Immediately, the severe problems involved in specifying an objective function for

monetary policy can be seen: there are twelve individuals with twelve separate

sets of preferences trying to reach a single decision. Somehow, however, decisions

do get made. The FOMC decides upon open market operations—the purchases

and sales of Government securities, which are made daily in New York—that affect

directly commercial bank reserves in the economy. This is the primary vehicle

through which monetary policy operates.

In addition to the FOMC, the seven members of the Federal Reserve Board

formally meet together several times a week and—among their other duties—

decide upon reserve requirements and approve discount rate changes, two additional monetary policy instruments. But because these actions are carefully

coordinated with the activities of the Committee, for purposes of this discussion,

the FOMC will be considered to be the ongoing policymaking body.

The staff periodically makes several kinds of presentation to the FOMC.

They will all be discussed in some detail here because each of them may provide

some insights for control applications.

Three or four times a year, depending on the behavior of the economy, a major

effort is made to prepare quarterly forecasts of the economy for the FOMC. These

usually run 4 to 6 quarters into the future. The forecasts are not extended any

further because generally not much credence is put in longer-run forecasting. I

must admit, as someone who has tried to do forecasting, I share these sentiments.

This basic forecast is conditional on explicit assumptions concerning monetary

policy.

To begin its analysis, the staff makes a conditional forecast that contains some

kind of simple policy assumption. For instance, it may be assumed that a particular

growth path for the money stock will obtain during the period, or maybe a simple

pattern in interest rates is taken as the policy. Given this basic assumption, we run

our econometric model—which is our own version of the FMP (FRB-MIT-Penn)

model—and obtain a set of results after judiciously adjusting the constant terms

in equations that have not been tracking well. These adjustments can be justified

as a means of building in prior information to make a conditional forecast for a

specific future time period.

At the same time, another forecast is being made by judgmental means—i.e.

without aid of a formal model. Judgmental forecasters at the Fed usually have a

very good feel for what is going on in the economy, and they often make better

short-term forecasts than the models do. The judgmental forecast is compared to

the model forecast. The differences between the two forecasts often lead to insights

and revisions in each forecast. A consensus forecast is then arrived at that is a

blend of the forecasts obtained from the two methods.

The consensus forecast provides figures for such target variables as GNP

and its major components, the unemployment rate, and the rate of inflation. At

this point, the quarterly model is adjusted in terms of intercept shifts in individual

equations so as to force its sectors and totals to agree quarter by quarter with the

consensus forecast. Once these adjustments are made, we run policy alternatives

off of the adjusted form of the model.

•Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve

System. The opinions expressed here are my own and do not necessarily reflect those of the Federal Reserve

Board or its staff. I wish to thank Mary Ann Graves for her valuable help and advice in converting the original taped version of this talk into an intelligible form for publications.

73-959—76 11

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Because we normally do not have to adjust the model very far in order to make

it agree with the consensus forecast, these adjustments have virtually no effect on

the multipliers in the model, even though the model is nonlinear. Thus, the policy

alternatives applied to the adjusted form of the model give us, for all intents and

purposes, the same marginal effects as would occur if we had not adjusted the

model to begin with. Its multipliers are left intact, but the adjustments allow

us to talk about a common level of the target variables.

The policy alternatives may be for different growth paths of a monetary

aggregate, such as the money stock, or for different patterns of an interest rate.

In the interests of clarity, this discussion will focus on the money stock. Alternative

growth paths of the money stock can be handled very conveniently with our neoKeynesian model. We usually run several alternatives—an easier alternative, a

tighter alternative, and then different time paths in between. This gives the

FOMC some feel for what the tradeoffs are among important target variables

such as employment, output, and the inflation rate.

We also do alternative simulations for those sectors about which we feel

particularly uncomfortable or uncertain. One of our biggest problems is predicting

fiscal policy over the policy horizon. As you know, in the United States, monetary

and fiscal policy are determined separately. The Fed has to predict fiscal policy

just as anybody else does (including the President and Congress), and we sometimes make large errors in the predictions. Currently, for example, we have to guess

whether the President's impounding scheme will or will not work, how Congress

will react, and whether more or less money ultimately will be spent. When uncertainty about fiscal policy is particularly pressing, we work out various assumptions about the fiscal sector to examine the implications for some given monetary

policy. In addition to the bothersome fiscal sector, there are times when we feel

uneasy about a particular co-determined variable, like inventory investment. At

that time, we may try different patterns of inventory investment, again, to see

what the implications of variability in that sector are for the selection of a particular policy.

By the end of this process, the staff has compiled a large number of alternatives.

However, there is a real limit to the number of alternatives that can be presented to

any audience. A welter of detail seems to cause more confusion than assistance.

While the entire exercise is "quite useful to the staff, the presentation to the FOMC

must be more limited. Thus the staff determines what are the crucial issues at the

time, and presents the results relevant to those issues.

On the basis of the staff's presentation and its own evaluation of events, the

FOMC sets a policy for the next six months or more in terms of say, the growth

path of the money stock. In principle, the FOMC's longer-run strategy can be

updated each month: in practice, however, it does not change that often—for no

other reason than new and useful information does not arrive on a monthly basis.

While we do not go through a full-scale forecasting and policy alternative analysis

each month, we do update our forecast for each meeting based on the policy

trajectory previously chosen by the Committee and on any new data. As events

warrant, the FOMC does change its basic policy trajectory.

I would like to point out that while we have never formally presented an

optimal control solution to the FOMC, we have produced such solutions for a

certainty version of our model. The outcome has been very useful in designing

policy alternatives and as background for policy advice. In the cases studied so far

it has been possible to come very close to the optimal solution with some very

simple policy moves. One of our big fears had been that in the optimal solution, the

money stock or interest rates might explode right off the charts. Of course the

policymakers would not believe this sort of result, and probably rightfully so. In

fact, however, we have been able to come very close to an optimal trajectory with

quite a gradual and smooth movement in the path of both interest rates and the

money stock. Thus, even in a rudimentary form, we have found these exercises to

be very helpful.

While the FOMC meets once a month, its open market operations go on daily.

Thus, every month, the Committee must decide upon its "operating strategy/'

that is, it has to give instructions to the trading desk in New York, where securities

are actually bought and sold, as to what to do during the month that will lapse

before the next Committee meeting. These instructions are composed of two parts.

First, the Committee states its decision regarding its longer-run strategy, say, some

growth path in the money stock. Then it must decide about how to return the

targeted variable—whether the money stock or an interest rate—to the desired

path when it strays off course. For instance, the money stock is very rarely exactly

on course because it cannot be determined with complete accuracy. The FOMC's

decision on how quickly to bring the money stock back towards the desired longerrun path is not independent of its decision concerning the variability in short-term

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interest rates that it will tolerate—or vice versa. Thus, there is a tradeoff between

control of the money stock, or any other monetary aggregate, and variability of

short-term interest rates.

Each month the staff presents short-run operating strategy alternatives to the

FOMC in very much the same manner that it presents longer-run GNP projections.

Namely, we have a model, a form of which was described by Pindyck and Roberts

at this conference, that is used to generate monthly forecasts of the money market.

The forecasts are conditional on income estimates derived from the quarterly

forecast and on a specific pattern of bank reserve growth. The forecasts from the

monthly model are blended with independent judgments (along with the results

of other models) to arrive at a set of alternatives to present to the FOMC. For

instance, if the money stock is off track, then the alternatives are in the form of

various growth paths of bank reserves required to move the money stock from its

current value back to the desired long-run path over different time horizons.

Predictions of the implication for short-term interest rates of the various alternatives are also presented. The more quickly that the money stock is brought back to

the long-run path, the greater will be the movement in interest rates, other things

equal. Since there is some concern about interest movements in their own right, the

estimated tradeoff between hitting the money stock target and movements in

interest rates are also presented. On the basis of this presentation and its own

evaluation of the money market, the FOMC decides on its short-run operating

strategy.

In general, the longer-run movements in the money stock, or some other

monetary aggregate, are viewed as stabilizing the economy (income, employment,

and inflation), and the shorter-run movements, in part, are viewed as stabilizing

the money market (e.g., short-term interest rates). One can think of the situation

in terms of spectral analysis: the high frequency movements in the money stock are

really those used to stabilize the money market and the low frequency ones are

used to stabilize the economy. There is a conflict between these movements in the

money stock, but the conflict need not be very great so long as the money stock

tends to fluctuate evenly around the long-run trajectory. Sometimes this is not so,

and the money stock gets too far off the trajectory to allow it to be returned in any

short period of time without unacceptable movements in interest rates. As a result,

longer-run stabilization policy itself may be affected. Unfortunately for our

purposes, the money stock is not solely set by the Federal Reserve but rather is

co-determined in the economy; it is the path of bank reserves that is under policy

control. While the stock of money is highly influenced by Federal Reserve policy,

it is still difficult both to predict and control. Furthermore, the money stock is not

the only intermediate target for monetary policy; interest rates, credit conditions,

etc. also compete for the FOMC's consideration. When these other factors are

given heavier weight, the money stock can stray even farther from its predetermined growth path—perhaps, with no cost to the objectives of policy.

I would like to suggest some implications of these procedures for optimal

control applications. The first concerns the use of an intermediate target variable

as a means for obtaining the ultimate ends of monetary policy. The FOMC really

makes two decisions: it makes the decision as to what is the preferred time path of

the economy, and then makes the decision as to what intermediate target, say, the

growth path in the money stock, will be consistent with this goal. In other words, it

aims at the money stock—or at other times interest rates—as a vehicle for accomplishing its ends with respect to the real sectors of the economy.

It is not obvious that this is the appropriate thing to do. One is certainly

entitled to ask: why not go directly from the true instruments of policy (open market operations, the discount rate, and reserve requirements) to the real economic

targets? Why go through this intermediate vehicle at all? Clearly, this sort of procedure would not make any sense in a world of certainty, where we knew the exact

relationships between the instruments and the ultimate targets. To the contrary,

however, we operate in a world with a high degree of uncertainty. The rationale for

using an intermediate target lies in the fact that its data are more frequently available than are data on the real sectors; movements in the intermediate target can

provide early information on how the real sectors are responding to policy. In

addition, it must be under some degree of policy control and it must be causally

related to the ultimate objectives of policy. Thus, the difficulty or ease with which

a target for the money stock can be hit in a particular situation, presumably,

indicates what is happening in the real sectors. While this idea of using an intermediate target has appeal, no one has proved that it is appropriate.

One very useful application of optimal control procedures would be to analyze

the conditions under which it is desirable to use an intermediate target for monetary policy. Furthermore, if these conditions are likely to exist, what is the best

intermediate target to use? If the conclusion were to be that it is never or hardly

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ever appropriate to use an intermediate target variable, then it is important to

know the costs incurred by pursuing one.

The next issue I want to discuss is uncertainty in general. It is difficult to

overemphasize the degree of uncertainty with which policy decisions must be made.

A high degree of uncertainty concerning future values of exogenous variables is

one of the reasons why it is difficult to make reliable forecasts very far into the

future. The forecasting errors in the exogenous variables become so large, or at

least the variance around some expected value becomes so large, that the worth of

our GNP projections diminishes greatly as the forecast horizon is extended.

Another area of uncertainty has to do with our models. I want to stress this

because users of control theory often tend to take models as given and work out

solutions without seriously questioning the reasonableness of the models. This

tendency is not very harmful when one is working on technique. However, there is

a real danger of giving more credence to model results than they deserve, especially

if a particular policy trajectory is highly influenced by the choice of a model.

The problem lies not only with uncertainty concerning the true value of model

parameters, but also with the structure of models themselves. I cannot state

with much certainty that we have a good approximation to the economy with our

models at the Federal Reserve Board. I have even more doubt about other models

that are used for policy analysis. My particular concern involves whether or not

we have correctly approximated the impact of monetary policy in the models. For

example, we have found that with some relatively minor changes in the specification of our quarterly model—changing just three or four equations—we can

importantly alter its policy multipliers; I believe this is true of other models as

well. A couple of examples should make the point.

We have a wide variety of money demand functions from which we can choose,

&11 estimated with about the same R2, with about the same standard error of estimate, and all about as intuitively sensible or unsensible as the other. However, the

results from the full model are quite different just because of the different interest

elasticities of money demand implied by these functions. The way that this and

other structural models work is to impose clearing in the money market; shortterm interest rates must move sufficiently to equate money demand with money

supply. Other things equal, the smaller the short-run interest elasticity of money

demand, the greater the movement in interest rates required to induce the public to

change its holdings of money balances by a given amount. For a given change in the

growth in the money stock, different money demand functions with their different

elasticities will imply different changes in short-term interest rates. The changes in

short rates then feed to longer-term rates, to wealth, and to spending. Thus, the

short-run impact of a change in the money stock predicted by the model will depend rather crucially on the money demand function selected. At this time, we

simply have no reliable guidelines to help us choose among the functions available.

Another example is provided by the model's consumption function. Theoretically, consumption should depend upon wealth and it does in our model. Unfortunately, as soon as we have consumption dependent upon wealth, we have to

predict the impact of monetary policy on the stock market, because the major

component of the variance in wealth is the variance in stock prices. Given a choice,

I think any of us would far prefer to just go ahead and forecast consumption than

to forecast the stock market. However, because we would be losing a major

channel through which monetary policy works b3^ leaving wealth out, we leave it in.

We then have all kinds of ad hoc procedures for explaining the stock market. The

way that the stock market is specified to adjust to monetary policy variables is

crucial to estimating the impact of these variables on consumption and hence,

GNP. Again we have no reliable means of selecting the "correct" specification.

Another question I want to raise is: what is an acceptable way of evaluating a

model? How do we know when it is right? There are many models that explain

their sample period well and also do pretty well outside the sample period, but

which differ drastically in their specifications and also in their implied policy

multipliers. Unfortunately, there is no very reliable method of choosing among

alternative models. In a related vein, we have learned that individual structural

equations might look sensible, but when they are put together in a full model,

they can give some very strange results. Thus, it becomes very difficult to know

when an equation is good nor not. Should it be judged as an individual equation

or in terms of how it contributed to the full model?

An excellent case in point has to do with stability of models. Should one impose

stability on a model or not? By stability, I mean if the model is shocked with, say,

a permanent change in the growth rate of the money stock, does the model go

through explosive cycles? The real world might be like that, but then again it may

not. It is not possible to know because the real world never gets shocked in the

way that models are shocked. Instability per se does not bother control theorists

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because they point out that the system can be stabilized even though it is structurally unstable. Perhaps that may be what happens in the economy. Perhaps the

economy is inherently unstable but policy at least has been good enough on average

to keep it from exploding. It is difficult to determine where the truth lies. The

problem is clearly an important one because the kind of stability conditions

imposed will have implications for a models dynamic policy multipliers. It seems

fair to say that there is no firm basis for knowing what kind of stability conditions

to impose on our models, if any.

There is an additional problem that plagues any user of models for forecasting

and policy analysis. There is no solid basis for establishing a practical method of

incorporating prior information into models. This information comes from such

sources as recent performance of the model, judgmental assessments of the

economy, and special survey information. Adjustments of a model's constant

terms is a rough and ready way to deal with this problem, but the method is clearly

deficient. Slope coefficients as well as intercepts should be adjusted when appropriate. The development of better procedures for incorporating prior information

would provide a major contribution to policy analysis.

At this point I would like to offer a few comments about the objective function

used in the formulation of monetary policy. As mentioned earlier, it is particularly

difficult to talk about "the" objective function because there are really twelve

objective functions on the FOMC, and there has to be a majority of people on the

Committee to agree on policy. The different ways that the Committee members

grapple with uncertainty often condition disagreements more than their basic

underlying objectives. For instance, if someone places a high weight on avoiding

high inflation rates, he will be very worried that somehow future inflation rates

have been underestimated. He will be willing to pay a relatively high penalty, in

terms of higher expected unemployment rates, in order to avoid a bad draw in the

sense of getting inflation rates greater than anticipated. The same sort of argument

applies to a member who is worried about unemployment. Being central bankers

and being in a position where decisions have to be made, the Committee members;

are risk averse—they are willing to trade off expected value for decrease in variance*

Their aversion to risk often takes the form of restricting movements in policy

instruments. This occurs not because instrument stability is necessarily valued per

se, but rather stems from a fear of going outside the range of experience. Theseparticular restrictions, then, do not belong in the objective function. By restricting,

movements in its instruments, the FOMC has in a sense solved its own control

problem. I think there is too much tendency on the part of researchers doing

control applications simply to assume that there should be a penalty cost on

movements in the instruments, and then justify this assumption by observing that

the instruments, in fact, have not moved very much in the real world. This

procedure precludes us from ever being able to demonstrate whether or not the

movements have been too restrictive.

For monetary policy, there really is no cost (in an economic resource sense) of

large movements in the reserve instrument. It is no more costly to buy a billion

dollars of Government securities per unit that to buy a thousand dollars worth,

and there are probably great scale economies. Thus, movements in bank reserves

do not belong in the objective function. It is true that policymakers worry about

short-term variability of interest rates and, at times, about the level of rates.

These interest rate considerations should appear in the objective function, or at

least as side conditions in a control problem.

Three additional observations concerning objective functions may be in order

at this point. First, it is very difficult to convince a policymaker to move an instrument in what he views to be the wrong direction. That is to say, if income is expanding very rapidly and the models are predicting that it is going to fall in the future

unless he eases up, it is very difficult to get him to ease up because that sort of

policy recommendation is contrary to what is going on currently. I must say that

until our models do a lot better, his wariness may be justified. Again, the problem

is one of how to handle risk: what if the model were wrong? What if the economy

were expanding very rapidly, the policymaker eases up, but economic expansion becomes more rapid? The cost of the error to the policymaker would be very large.

Second, I have observed over time that risk aversion on the part of the policymakers leads to risk aversion on the part of those giving advice. The reason is

very simple: if advice is followed and it turns out to be wrong, the policymakers

probably will not listen next time. Thus, the people giving advice also have a loss

function that further compounds the risk aversion. As a result, policy advice

often goes only part way, trying to point policy in what appears to be the right

direction. Contrary to the opinion of some observers, policy advisers are not in

the habit of recommending "fine tuning" of the economy.

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Third, for optimal control studies, we need to know how crucial the weights

are in the loss function. We have done a few optimal control experiments in this

area using our quarterly model; they indicate that at least for some initial conditions, the choice of weights is not very important. In these experiments, wide

variations in the relative weights assigned to the unemployment rate and the rate

-of inflation resulted in surprisingly similar optimal policy trajectories. The reason

that this result occurs is that the inflation rate responds much less rapidly to

changes in policy variables than does the unemployment rate. In the longer run,

however, the effect of monetary policy is much more powerful on the rate of

inflation. Thus, even if the unemployment rate receives a relatively large weight

in the objective function, an attempt to bring it quickly back to target will set in

train forces leading ultimately to a relatively large rise in inflation above its target.

Thus, so long as the inflation rate receives a weight in the objective function, it

will reduce the incentive to move the unemployment rate quickly to its desired

value, although some movement is desirable. In the longer run, small changes in

the unemployment rate are associated with relatively large changes in the rate of

inflation, so again the inflation rate must enter importantly in computing the loss.

This would be a very powerful result if it held for a large number of initial

conditions. It would indicate that researchers would not have to worry so much

about getting the correct weights in the objective function. The result would also

be a demonstration of the robustness of the technique of optimal control. If it

turned out that the technique depended crucially on these weights, however, then

it becomes much weaker because we really have no way of knowing what the

weights are.

I would like to conclude my remarks with some observations on the complexity

of models used for control applications. There seems to be a great desire among

economists to work with the newest and biggest models. It is particularly difficult

to work with new models, especially if they are large, because their properties

are not well known and because their sheer size leads to severe technical problems.

The Federal Reserve only has about two or three instruments, so we are not

terribly interested in looking at results where sixty different instruments can

be varied. It would be extremely productive if we could talk in a more meaningful

way about movements in real output, employment, and inflation in response to

variations in one instrument. There probably is a very substantial payoff to

working with smaller models that describe the behavior of those two or three

target variables and their relation to a policy instrument. The use of small models

would clear away a great deal of the pure technical problems, particularly in

stochastic control problems. It is not at all clear to me that larger models are

needed in order to carry out this kind of experiment. In fact, we are currently

engaged in efforts to come up with a scaled down version of our own quarterly

model. Hopefully, we will then be able to do control problems more efficiently

than we have been able to do in the past.

I would like to conclude by saying that I think the work on optimal control is

very promising, and our applied work at the Fed indicates that control techniques

can and will provide important contributions toward solving stabilization

problems.

Board of Governors of the Federal Reserve System.

{From Open Market Policies and Operating Procedures—Staff Studies, Board of Governors of the Federal

Keserve System, July, 1971.]

MONETARY AGGREGATES AND MONE Y MARKE T CONDITIONS IN OPE N MARKE T

POLICY

(By Stephen H. Axilrod)

There has been widespread discussion over the past year or so about the emphasis given to monetary and credit aggregates, as compared with traditional operating variables such as money market conditions, in the formulation and

conduct of the Federal Reserve System's open market policy. This article discusses the role—in the decisionmaking process of the Federal Open Market

Committee (FOMC) * and in the day-to-day conduct of Federal Reserve open

1

 The Federal Open Market Committee is the statutory body responsible for open market operations

(purchase and sale of U.S. Government securities in the open market), the most flexible and frequently used

instrument by which monetary policy affects bank reserves, bank credit, money supply, and ultimately

over-all credit conditions. The FOMC consists of the seven members of the Board of Governors of the Federal

Keserve Bank of New York, and four of the remaining 11 Reserve Bank presidents serving in rotation. The

Chairman of the Board of Governors has traditionally been elected by the Committee to serve as Chairman

of the Open Market Committee, and the President of the Federal Reserve Bank of New York has traditionally been elected Vice-Chairman.

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market operations—of aggregates such as the money supply and bank credit in

comparison with other financial variables. Such aggregates, of course, represent

only a few of the many financial variables, including interest rates and credit

flows through nonbank institutions and the market directly, that are evaluated

in monetary policy decisions and their implementation. And financial conditions

as a whole are evaluated against the underlying purpose of monetary policy—the

Encouragement of a healthily functioning economy, both domestically and in

relation to the rest of the world.

The policy decisions of the FOMC are based on a full-scale evaluation by Committee members of likely tendencies in critical measures of economic performance

such as output, employment prices, and the balance of payments. In deciding on

the stance of monetary policy, the Committee considers whether these tendencies

in domestic economic activity and the balance of payments appear desirable, and

if not, how they might be influenced by changes in financial conditions—including

the pace of monetary expansion, credit availability, interest rates—and by expectational factors. Once a general policy stance is adopted guidelines are set for

the day-to-day conduct of operations in the open market. During 1970 somewhat

more emphasis was placed on the behavior of monetary aggregates—such as the

money supply and bank credit—in providing guidance for the day-to-day conduct

of open market operations.

Since it has always been recognized that the effect of monetary policy stems

from its influence on bank credit, money, interest rates, and financial flows

generally, the greater emphasis placed on monetary aggregates basically represented a modification of operating procedures rather than a change in the fundamental objective of policy. Under conditions of uncertainty—for example, uncertainty about the impact on interest rates of expectational factors or about the

strength of future demands for goods and services—some emphasis on the aggregates helps to guard against the risk that open market operations might in the

end supply either too large or too small amounts of bank reserves, credit, and

money as a result of unexpected and undesired shifts in demands for goods and

services and for credit.

At the same time, however, an approach that utilizes aggregates as one operating guide must take account cf shifts in the demand for money and liquidity

at given levels of income. Such shifts would have to be accommodated through

open market operations in order to help provide the money and liquidity demanded if interest rates and credit conditions generally were not to become unduly tight or easy. Thus, the longer-run path for monetary aggregates needs

to be evaluated in relation to emerging credit conditions and tendencies in economic activity, to help determine if demands for liquidity have been properly

assessed. And whatever longer-run path for the aggregates may be included as

guidance for open market operations, short-run, self-correcting variations in

money and credit demands need to be accommodated in order to avoid inducing

unnecessary, and possibly destabilizing, fluctuations in money market conditions.

In practice, allowance has to be made—in the formulation of monetary policy

and in the guides to the conduct of policy—for uncertainties with respect to both

the demand for goods and the demand for money and liquidity. And trends in

monetary aggregates, interest rates, and other financial variables have to be evaluated in relation to the continuing flow of evidence as to the likely course of

economic activity.

DIRECTIVES OP THE FOMC

The monetary policy decision of the FOMC—which in recent years has generally

met about every 4 weeks—are embodied in the Committee's current economic

policy directive, voted on near the end of each meeting. This directive is issued

to the Federal Reserve Bank of New York, which, because it is located in the

Nation's central money and credit market, undertakes open market operations

for the Federal Reserve System. The directive is carried out by a senior officer

of the Bank, who is designated by the FOMC as Manager of the System Open

Market Account.

Both the form and the content of the FOMC directive have changed over the

years. Since 1961 the directive has contained two paragraphs. The first paragraph

has contained statements about recent key economic and financial developments,

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and also a general statement of current goals of the FOMC with respect to economic growth, price stability, and the balance of payments.2

 The second paragraph

contains the FOMC's instructions to the Account Manager for guiding open

market operations in the interval between FOMC meetings. The second paragraph

is, in essence, a highly condensed summary of the Committee's discussion and

conclusions as to the sort of operations that will be required to reach its longer-run

policy goals. These directives are made public after a 3-month lag in a "record of

policy actions," which also includes a resume of prevailing economic and financial

conditions and of the Committee's discussion of policy implications at the meeting.

The nature of the operating instructions in the second paragraph of the directive

has changed from time to time. Money market conditions have remained as

important guides in determining day-to-day open market activity. Though

emphasis on various money market indicators has varied over the years in light

of changing economic and financial circumstances, money market conditions have

generally been construed to include member bank borrowings at the Federal

Reserve discount window, the net reserve position of member banks (excess

reserves of banks less^borrowings from the Federal Reserve), the interest rate on

Federal funds (essentially reserve balances of banks that are made available to

other banks, usually on an overnight basis), and at time the 3-month Treasury

bill rate.

At times when it was framing the operating instructions contained in the second

paragraph of its directive solely in terms of money market conditions, the FOMC

was nevertheless concerned with developments in monetary aggregates and

financial conditions generally as they affect the broad objectives of policy. Beginning in 1966, the Committee supplemented the reference to money market conditions in the second paragraph with a reference to certain monetary aggregates,

such as bank credit, and later the money suppty.3 The desired behavior of aggregates has been given increased emphasis since early 1970.

From mid-1966 through 1969 the reference to aggregates was generally to bank

credit and was contained in a so-called proviso clause. The second paragraph of

the directive issued on December 16, 1969, is illustrative:

"To implement this policy, System open market operations until the next

meeting of the Committee shall be conducted with a view to maintaining the

prevailing firm conditions in the money market; provided, however, that operations shall be modified if bank credit appears to be deviating significantly from

current projections or if unusual liquidity pressures should develop."

In 1970 monetary aggregates came to play a more prominent role in the phrasing

of the second paragraph, and references were made to the money supply as well as

to bank credit. In the directive issued on March 10, 1970, the Committee stated

more directly its desires with respect to the aggregates rather than referring to

them in the form of a proviso clause. The second paragraph of the directive of that

date read as follows:

"To implement this policy, the Committee desires to see moderate growth in

money and bank credit over the months ahead. System open market operations

until the next meeting of the Committee shall be conducted with a view to maintaining money market conditions consistent with that objective."

The operating instructions in the second paragraphs of FOMC directives are not

confined to money market conditions and a desired pattern of behavior in the

monetary aggregates. The System Account Manager has also been directed, when

appropriate, to take account of Treasury financings, liquidity pressures, and the

2 For illustrative purposes the first paragraph of the directive issued on Dec. 16, 1969, is quoted below:

"The information reviewed at this meeting indicates that real economic activity has expanded only

moderately in recent quarters and that a further slowing of growth appears to be in process. Prices and costs,

however, are continuing to rise at a rapid pace. Most market interest rates have advanced further in recent

weeks partly as a result of expectational factors, including concern about the outlook for fiscal policy. Bank

credit rose rapidly in November after declining on average in October, while the money supply increased

moderately over the 2-month period; in the third quarter, bank credit had declined on balance and the

money supply was about unchanged. The net contraction of outstanding large-denomination CD's has

slowed markedly since late summer, apparently reflecting mainly an increase in foreign official time deposits.

However, flows of consumer-type time and savings funds at banks and nonbank thrift institutions have

remained weak, and there is considerable market concern about the potential size of net outflows expected

around the year-end. In November the balance of payments deficit on the liquidity basis diminished further

and the official settlements balance reverted to surplus, mainly as a result of return flows out of the German

mark and renewed borrowing by U.S. banks from their foreign branches. In light of the foregoing developments, it is the policy of the Federal Open Market Committee to foster financial conditions conducive

to the reduction of inflationary pressures, with a view to encouraging sustainable economic growth and

attaining reasonable equilibrium in the country's balance of payments."

3

 There was also occasional reference to such aggregates in directives during the first half of the 1960's.

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possible impacts of bank regulatory changes in the process of achieving satisfactoryconditions in the money market and satisfactory performance of monetary

aggregates.

As the nature of economic and financial problems has altered, so has the phrasing

of the second paragraph of the directive. For instance, the second paragraph of the

directive issued on May 26, 1970, emphasized the need to moderate pressures on

financial markets; it read as follows:

"To implement this policy, in view of current market uncertainties and liquidity

strains, open market operations until the next meeting of the Committee shall be

conducted with a view to moderating pressures on financial markets, while, to the

extent compatible therewith, maintaining bank reserves and money market conditions consistent with the Committee's longer-run objectives of moderate growth

in money and bank credit."

The short-run bulge in bank credit expansion expected to result from the Board's

action around midyear in suspending ceilings on maximum interest rates payable

by banks on large certificates of deposit in the 30- to 89-day maturity range was

taken into consideration in the phrasing of the second paragraph of the directive

issued by the FOMC on July 21, 1970:

"To implement this policy, while taking account of persisting market uncertainties, liquidity strains, and the forthcoming Treasury financing, the Committee

seeks to promote moderate growth in money and bank credit over the months

ahead, allowing for a possible continued shift of credit flows from market to banking channels. System open market operations until the next meeting of the Committee shall be conducted with a view to maintaining bank reserves and money

market conditions consistent with that objective; provided, however, that operations shall be modified as needed to counter excessive pressures in financial markets

should they develop."

And in the directive issued on August 18, 1970, an easing of conditions in credit

markets was taken as an objective of open market operations parallel with desires

with respect to monetary aggregates, as follows:

"To implement this policy, the Committee seeks to promote some easing of

€onditions in credit markets and somewhat greater growth in money over the

months ahead than occurred in the second quarter, while taking account of possible

liquidity problems and allowing bank credit growth to reflect any continued shift

of credit flows from market to banking channels. System open market operations

until the next meeting of the Committee shall be conducted with a view to maintaining bank reserves and money market conditions consistent with that objective,

taking account of the effects of other monetary policy actions."

The first and second paragraphs of all directives issued from December 16, 1969,

through December 15, 1970, are shown in the appendix to indicate the variety of

considerations that the FOMC takes into account in formulating its policy and

framing its operating instructions.

POLICY FORMATION

The FOMC's basic concern is with the real economy—production, employment,

prices, and the balance of payments. But the Committee must translate its

broader economic goals into the monetary and credit variables over which the

Federal Reserve has a direct influence. Thus, whatever emphasis is given to the

financial variables that influence day-to-day open market operations, it is recognized that the immediate targets of day-to-day operations are not the goals of

monetary policy, but rather that those targets are set with a view to facilitating

the achievement of the broader financial and economic objectives of the FOMC.

In setting its immediate operating targets, the FOMC necessarily reviews

past and prospective relationships between financial conditions and economic

•objectives. A benchmark in this review is provided several times a year in a

presentation by the staff to the Committee of an interrelated set of longer-run

economic and financial projections. These exercises review in detail recent economic and financial developments, assess the outlook for and impact of fiscal

policy, and trace the likely patterns of change in such measures as income, output,

employment, prices, and the balance of payments for a period of about a year

ahead. Provisional estimates are also presented of the flow of funds—including

various monetary aggregates—and interest rates expected to be consistent with

these patterns of economic development. A reappraisal of current tendencies in

and prospects for economic activity, financial flows and credit market conditions

and the balance of payments is presented to the FOMC by the staff on the occasion

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of each meeting. Included in the regular documentation is an analysis of relationships among money market variables, paths for monetary aggregates, and interest

rates broadly considered for a period several months ahead.

At each FOMC meeting, most of the time is given over to a free interchange

of views by Committee members of their assessment of the current economic

situation and outlook and of the related appropriate monetary policies. As the

discussion proceeds, each Committee member indicates his assessment of the basic

tendencies in economic activity, prices, employment and so forth; his appraisal of

recent financial developments in relation to desired economic goals; and what

steps might be taken through open market operations (or other policy instruments that interact with open market operations) to help achieve financial conditions suitable to economic goals.

It may develop, for instance, that most of all Committee members believe

that economic prospects are deviating from those that had previously been

expected and desired. If so, the Committee may wish to modify its objectives

concerning money market conditions and desired rates of expansion in monetary

and credit aggregates, so as to promote over-all financial and credit conditions

that are more conducive to desired economic conditions. Or it may turn out that

economic activity is developing about in line with expectations but seems to be

entailing a pattern of financial flows different from that originally expected. Still

another possibility is that the relationship that is developing between the variables

specified for the System Account Manager for purposes of guiding day-to-day

open market operations and broader financial flows and interest rates is not what

was expected. Under any of such circumstances, the FOMC could react by changing its operating instructions.

The operating instructions in the second paragraph of the directive are expressed

qualitatively. But the specific variables involved—money market conditions and

monetary and credit aggregates—are typically indicated in terms of ranges in the

discussion.

Over the past year the operating instructions embodying the Committee's

policy thrust have changed in two general ways. First, as has been noted, somewhat more emphasis has been placed on monetary aggregates as a target for open

market operations rather than as an outgrowth of such operations. Second, the

time horizon for a path of monetary and credit aggregates (in relation to money

market conditions and other financial variables) has been viewed as encompassing

several months or, expressed in calendar quarters, at least one or two quarters

ahead. Longer-run paths provide the Committee with a means for focusing on the

emerging trend of growth in the money supply or in bank credit, while recognizing

that, over very short-run periods of a week or a month or so, there may be irregular

movements in rates of change in monetary aggregates because of erratic shifts

in the public's demand for deposits and such factors as Treasury financings, a

large change in U.S. Government deposits, or movements of funds between the

U.S. and foreign countries.

BOLE OP MONETARY AGGREGATES

The somewhat greater use of monetary aggregates in the formulation and

conduct of open market policy during the past year represents for the most part an

extension of the trend of policy over the previous several years. It has always been

recognized that monetary policy achieves its effects through its influence on bank

credit, money supply, interest rates, and financial flows generally. But the benefits

that might be expected from an increased degree of emphasis on monetary aggregates in the conduct of open market operations relate to the question of monetary control under conditions of uncertainty.

Greater emphasis on aggregates is consistent with a variety of economic theories,

and it does not necessarily imply any particular judgment as to the importance for

the economy of monetary flows relative to interest rates and credit conditions or

relative to other influences such as fiscal policy and technological innovation.

Operationally, however, by placing more emphasis on monetary aggregates in the

instructions to the Account Manager, the FOMC has a greater assurance that

unexpected and undesired shortfalls or excesses in the demands for goods and

services in the economy, and hence in the demands for credit and money, will not

lead more or less automatically to too little or too much expansion in bank reserves,

bank credit, and money.

Giving more weight to monetary aggregates means, for example, that if there

were an unexpected and undesired short-fall in business and consumer demand for

goods and services, the Federal Reserve would continue to provide reserves to

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try to keep growth in money and bank credit from weakening unduly at a time

when the public, with transactions demand for cash reduced, was seeking to invest

excess funds in various financial assets. In the process, there would be a greater

short-run decline in interest rates than would otherwise be the case. The drop in

interest rates and the easing of credit conditions would help to provide financial

incentives that would encourage a strengthening of demands for goods and

services.

While increasing the emphasis on monetary and credit aggregates tends to

increase the protection against undesired shifts in demands for goods and services,

it at the same time runs the risk of reducing protection against unexpected shifts

in the public's demand for cash and liquidity. Thus, for example, if the public

decides to hold more liquidity relative to income than had been earlier assumed,

failure to permit a faster rise in the money supply to accommodate this desire

would lead to higher interest rates and tighter credit conditions as the public

seeks to sell other assets to acquire cash. The tightening of credit conditions

would tend to lead to a weaker GNP than desired. In contrast, the tendency toward

tighter conditions could be averted if the Federal Reserve helped to meet the

desire for greater liquidity by increasing its purchases of financial assets (through

open market acquisitions of U.S. Government securities)—thereby providing

more bank reserves to support an increase in bank deposits and in the money

supply and to keep interest rates from rising.

In practice, allowance has to be made for uncertainties about both the demand

for goods and services and the demand for money and liquidity. Opinions differ

among professional economists as to the relative degrees of stability of these

types of demand, and practical experience over the past several years suggests

that there is a good deal of variation in both. There have been periods when large

increases in Federal Government purchases of goods and services and/or in

private sector demands for capital goods and inventories have caused marked

shifts in over-all demands for goods and services at given interest rates. But there

have also been periods when liquidity strains, greatly increased financial transactions, and various international uncertainties have resulted in a sizable upward

shift in the demand for cash and closely related assets at given interest rates.

Furthermore, open market policy not only needs to distinguish between, and take

account of, shifts in both the demand for goods and services and the demand for

money and liquidity at given interest rates, but also must evaluate the extent to

which such shifts are transitory or more permanent.

The late spring and the summer of 1970 are an example of a period when liquidity

strains in the economy—typified b}r rising long-term interest rates at a time when

economic activity was sluggish, by the bankruptcy of a major railroad, and

by a generally cautionary attitude on the part of investors toward securities,

particularly commercial paper—were giving rise to considerable uncertamt}^ and

were threatening a marked erosion in confidence. Under those circumstances

Federal Reserve policy stressed the need to moderate pressures on financial markets

and to accommodate liquidity needs.

In late June the Board of Governors suspended maximum ceiling rates on large

CD's maturing in 30- to 89-days as part of the effort to reliquify the economy.

This action made it possible for banks to compete for funds and to accommodate

borrowers who were not able, in the conditions of the time, to refinance their

borrowings in the commercial paper market, or were not able to do so without a

bank loan commitment as back-up. And open market operations during the period

were conducted in such a way as to provide the reserves to sustain the very large

increase in bank credit resulting from renewed ability of banks to obtain funds

through issuance of certain large CD's. The FOMC's policy directives in that period

(see directives in May 26 and July 21, 1970, on pp. 99 and 100) tended to subordinate, temporarily, longer-run objectives for monetary aggregates to the

shorter-run liquidity needs of the economy.

In general, in evaluating the appropriateness of particular operating guidelines

at a particular time, the FOMC has to make judgments about the nature of the

fundamental influences that are affecting the domestic economy and the international position of the dollar. If, for example, it developed that interest rates

were higher, and over-all credit conditions tighter, than expected for a given rate

of increase in bank credit or money, the FOMC would have to make a judgment

as to whether GNP was stronger than anticipated, whether inflationary expectations were affecting interest rates, or whether the demands for money and closely ,

related assets had shifted at given levels of income and interest rates. Or, as another

example, interest rate movements might be undesirably affecting capital flows

between the United States and foreign countries; in this case judgments might

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have to be made as to how the various policy instruments could be adapted to

such a development.

Judgments made with respect to interrelationships among policy objectives

would affect not only the open market policy instrument but also other monetary

policy instruments. With respect to open market policy, types of adjustments called

for in operating instructions would include, for instance, whether to change the

targets for aggregates and/or whether to put more stress on money or credit market conditions. Or adjustments might be called for in other policy instruments—

such as the discount rate or reserve requirements, including provisions such as

those recently made affecting Euro-dollar borrowings of U.S. banks—in order to

achieve a variety of policy objectives more effectively.

In looking toward a desired longer-run growth rate in monetary aggregates, the

FOMC has focused on money and bank credit in its operating instructions. The

concept of money used for these purposes has generally been the so-called narrowly denned money supply—currency in circulation outside the banking system

plus demand deposits other than U.S. Government and domestic interbank

deposits—but broader definitions have also been taken into account. The determination of what rates of growth may be desired for money takes into account not

only what is happening in credit markets but also the rates of growth in certain

types of assets held by the public that are closely related to narrowly defined

money and that the public holds as a store of value and as a source of immediate

liquidity.

A number of broader concepts of the money supply and of liquidity have been

utilized by economic analysts in relating money supply to economic activity.

These include, in addition to the narrowly defined money supply, a concept—

here termed M2—that adds time and savings deposits other than large CD's at

commercial banks to narrowly defined money; and a concept, termed M3, thnt

adds deposits at both mutual savings banks and savings and loan associations.

And even these concepts can be broadened by adding other money-like assets,

such as large marketable negotiable CD's issued by banks and other short-term

marketable securities. Annual, quarterly, and monthly rates of change over the

past year in the three concepts of money noted above are shown in the table

below.

VARIOUS MEASURES OF MONEY: RATES OF CHANGE

[Seasonally adjusted annual rates, in percent]

M8 M3

Mi (Mi plus coml. (M2 plus deposits

Period (Currency bank time deposits at S & L's and

plus demand other than mutual savings

deposits*) large CD's) banks)

1969 . .. .

1970

1970—Ql I.III I"_~I_II~I"I_IIIIIII I

Q2 . . _ _ _

1970—January

February

March

April.

May

June

July _

August

September

October

November

December

•Demand deposits other than interbank and U.S. Government.

Note: P/lonthly rates of change based on the daily-average levels outstanding. Quarterly and annual rates of changes

measured from daily-average levels outstanding in end-of-period months.

As may be seen, the rates of change for the various measures may diverge

noticeably, and they may show a high degree of fluctuation over the short run.

Differential tendencies in the various measures of money and liquidity have been

the result in large part of sharp shifts of funds by the public between deposits and

market securities when market interest rates moved above and then back below

3.1

5.4

5.9

5.8

6.1

3.4

9.4

-4.1

12.3

9.9

5.2

2.3

5.7

6.8

5.7

1.1

2.8

6.2

2.4

8.2

3.4

8.4

11.0

9.2

2.2

-1.5

9.6

10.8

7.6

6.7

9.9

12.5

10.3

7.3

7.0

13.0

2.8

7.9

2.6

7.9

10.5

9.7

1.2

-1. 2

7.8

9.7

7.2

6.6

9.9

11.4

10.0

8.1

8.1

12.6

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ceiling rates on deposits at banks and thrift institutions. But divergent movements,

particularly in the short run, may develop even when ceiling rates are not a

disturbing element. This highlights the need to evaluate a variety of money and

liquidity measures, among other things in gauging the impact of monetary policy

on the economy. Moreover, the relatively large month-to-month variations in

growth for any particular money measure—and variations are even larger from

week to week—emphasize the need to evaluate data over some long period of

time in judging the underlying tendency of the series.

As noted earlier, in addition to the money supply, the second paragraph of the

directive has emphasized bank credit. A current measure of bank credit for the

guidance of the Account Manager was provided by measuring bank credit from

the liability side, since liability data are available more quickly and can be used

to construct a series on a daily-average basis. This daily-average measure does

not encompass all bank liabilities (it excludes non-member bank deposits and

bank capital, for example) but it includes the most volatile ones. It encompasses

not only the member bank component of deposits included in M2 above, but also

funds obtained by banks through large time CD's, U.S. Government deposits,

and interbank deposits and through nondeposit sources such as Euro-dollars

and commercial paper issued by bank-related affiliates. The sum of these deposits

and nondeposit sources is called the adjusted credit proxy.

CREDIT PROXY ADJUSTED;

TOTAL RESERVES

BILLIONS OF DOLLARS

350

CREDIT PROXY ADJUSTED

300

250

0

30

25

TOTAL RESERVES

1967 1S68 1969 1970

Bank "credit proxy adjusted" is total member bank deposits plus funds provided

by Euro-dollar borrowings and bank-related commercial paper. Through the

first half of 1969, no data on bank-related commercial paper were available,

but amounts outstanding were not thought to be growing significantly in those

periods.

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Inclusion of bank credit in tiie directive might be considered as recognition of

a broader concept of money, since time and savings deposits at commercial banks

are a key source of bank credit. In addition, however, the inclusion recognizes

that bank credit is a key component of total credit availability and one that is

immediately sensitive to open market operations.

The amount of bank credit that the FOMC is willing to encourage or to countenance depends, like the money supply, on over-all economic and financial conditions. When, for example, banks have been unable for an extended period to

increase time and savings deposits because interest rate ceilings on time deposits

were unrealistically low relative to market rates, it was to be expected that outstanding bank credit would grow rapidly for a time after ceiling rates again became

competitive. This growth would represent mainly a shifting of credit flows from

market to banking channels as banks sought to restore their previous competitive

position and as the public restructed its financial asset portfolios to reflect the

changed yield relationships. Federal Reserve open market operations could

provide the reserves necessary to sustain the shift in the public's ability and

willingness to hold time deposits relative to other assets. The accompanying chart

shows monthly changes in bank credit, as measured by the adjusted credit proxy,

^along with total bank reserves.

DAY-TO-DAY OPEN MARKET OPERATIONS

"The day-to-day operations in the market by the System Account Manager

have continued to be guided mainly by money market conditions, in part because

the information that is available daily and continuously as to the state of the

money market—for example, the Federal funds rate and dealer loan rates—reflects

the interaction of the demand for and existing supply of bank reserves and hence

provides a basis for making daily decisions as to whether the System should be in

the market providing additional or absorbing existing reserves; and if so, by how

much and through what means. But the degree to which the Manager seeks to

influence money market conditions has been affected by the relationship that is

presumed to exist at any given time among money market conditions, reserves,

and the monetary aggregates and by the Committee's desires with respect to

monetary aggregates and over-all conditions in the credit market.

Changes in money market conditions, of course, may reflect factors other than

efforts to influence reserve flows in accordance with longer-run targets for monetary

aggregates. Some changes in money market conditions reflect no more than shifts

in the distribution of reserves among banks. Others represent the short-run effects

of bulges in demand for day-to-day credit at times of Treasury financings or in

tax payment periods. Yet others represent unanticipated, virtually random

changes in technical factors—such as float or currency in circulation—that supply

to or absorb from the market more reserves than was either expected or seemed

likely to be sustained. And as in the summer of 1970, open market operations in

relation to money market conditions may sometimes reflect primarily a concern

with liquidity pressures in the economy.

Although recognizing that money market conditions are subjeet to a number of

influences, the System Account Manager takes into consideration the relationship

between money market conditions and the trends in bank credit and money that

has prevailed in the recent past and the relationship that is expected to develop

in the future in making decisions concerning reserve provision or absorption

through open market operations. At the beginning of a statement week, for

example, his operations may be aimed at a condition of tightness or ease in the

money market roughly similar to that of previous weeks. This would mean that

such variables as the Federal funds rate, dealer loan rates, the net reserve position

of member banks, and borrowings by member banks from the Federal Reserve

would generally tend to fluctuate within the range of recent experience—although

there might be special, sometimes unforeseen developments (such as a mail strike)

that could cause marked short-run changes in money market conditions.

If and as it becomes evident that monetary aggregates are running above or

below the desired path, however, the Account Manager may aim at correspondingly tighter or easier money market conditions. Also, if it should turn out that

the apparent new relationship was not long-lasting, the Account Manager would

•subsequently have to reverse the direction of his operations. Thus, to the

extent that monetary aggregates are given more emphasis in the operating paragraph of the directive, money market conditions may be subject to a somewhat

greater degree of fluctuation.

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While the counterpart of greater sensitivity to monetary aggregates would be

a somewhat greater tendency for actual money market conditions to change

more frequently than otherwise, sharp short-run shifts in money market conditions

are not likely to develop, in part because the FOMC is concerned with the state

of money and credit markets as well as with tendencies in monetary aggregates.

There are a number of reasons for the continuing role of money market conditions

as a day-to-day guide for open market operations.

First, the money market reflects the pressure of demand for liquidity, and the

nation's central bank has a unique responsibility for maintenance of orderly

conditions in such a market.

Second, there are large and often unpredictable week-to-week and month-tomonth swings in the economy's demand for money and bank credit. These demands are often self-correcting, and as a result there is little purpose in permitting

the sharp fluctuations in money market conditions, and perhaps in credit markets

generally, that would be likely to develop should the flow and ebb of these demands

not be accommodated in Federal Reserve operations affecting bank reserves.

Third, because of the key role of the money market in quickly reflecting shifts

in the need for and availability of liquid funds, presumably in large part as a result

of the interaction of the public's spending decisions and monetary policy, sharp

shifts in money market conditions may be interpreted by market participants

as a harbinger of relatively permanent changes in credit demand or monetary

policy. Investors, businessmen, and consumer may vary their credit outlook,

and perhaps their economic outlook too, in response to the money market to the

extent that they regard changes in the market as a signal of events to come. This

prospect itself counsels caution in undertaking open market operations that lead

to large short-run changes in money market conditions until it becomes fairly

certain that longer-run tendencies in money supply, bank credit, and over-all

credit conditions require such changes.

While there are reasons for emphasis on money market conditions, it should be

stressed that money market conditions are only instrumental to the attainment

of the main financial objectives of policy—flows of monetary aggregates and overall credit conditions-—that are appropriate to achievement of over-all economic

goals. For the Account Manager, the day-to-day operations of the Account and

the effect of these operations on the money market are made even more complex

because he is aware that the FOMC generally has in mind not only some view

concerning the desired longer-run trend in various monetary aggregates but also

a view concerning what should be sought in the way of associated credit conditions.

These desires may sometimes turn out to be in conflict; for example, monetary

aggregates as a group may be rising more rapidly than desirable while credit conditions may be tightening more than desirable. Meeting one desire by holding

back on the provision of reserves in order to restrain growth in bank credit and

money would tend, at least temporarily, to thwart the other desire by leading to

even more tightening of credit conditions. Under such circumstances, the Account

Manager would have to adjust his operations—thereby affecting day-to-day

money market conditions—in line with the sense of priority among operating

objectives given by the FOMC.

While the whole set of objectives would be reconsidered at the next FOMC

meeting, the Account Manager's operations are monitored daily through a morning

telephone conference call. This call involves the Trading Desk in New York,

senior officials on the staff of the Board of Governors in Washington, and one of

the Reserve Bank Presidents (serving in rotation) who is a voting member of the

FOMC (other than the President of the Federal Reserve Bank of New York).

Individual Board members may also participate in the call from time to time, as

may the President of the New York Reserve Bank. In this call the Manager

explains his program for the day, and that program, or possible alternative approaches are discussed. As part of this process, not only are current figures on bank

reserve positions, money market conditions, and broader credit conditions reported, but also information on the latest deposit and bank credit figures and

how these compare with FOMC desires is appraised.

In general, as the FOMC's objectives with respect to monetary aggregates, and

also over-all credit conditions, have been given increased stress in the directive to

the Account Manager, the timing and extent of the System's day-to-day open

market operations have, of course, been altered, with consequent effects on day-today money market conditions. At the same time, the Manager still takes account

of the emerging tightness or ease in the money market as a factor affecting the

timing and extent of day-to-day open market operations. But this emerging

tightness or ease is evaluated against trends in money, bank credit, and over-all

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credit conditions, which are, and always have been, among the basic financial

objectives of monetary policy.

APPENDIX: CURRENT ECONOMIC POLICY DIRECTIVES ISSUED BY THE FOMC

MEETING HELD ON DECEMBER 16, 1969

The information reviewed at this meeting indicates that real economic activity

has expanded only moderately in recent quarters and that a further slowing of

growth appears to be in process. Prices and costs, however, are continuing to

rise at a rapid pace. Most market interest rates have advanced further in recent

weeks partly as a result of expectational factors, including concern about the

outlook for fiscal policy. Bank credit rose rapidly in November after declining

on average in October, while the money supply increased moderately over the

2-month period; in the third quarter, bank credit had declined on balance and

the money supply was about unchanged. The net contraction of outstanding

large-denomination CD's has slowed markedly since late summer, apparently

reflecting mainly an increase in foreign official time deposits. However, flows of

consumer-type time and savings funds at banks and nonbank thrift institutions

have remained weak, and there is considerable market concern about the potential

size of net outflows expected around the year-end. In November the balance of

payments deficit on the liquidity basis diminished further and the official settlements balance reverted to surplus, mainly as a result of return flows out of theGerman mark and renewed borrowing by U.S. banks from their foreign branches.

In light of the foregoing developments, it is the policy of the Federal Open Market

Committee to foster financial conditions conducive to the reduction of inflationary

pressures, with a view to encouraging sustainable economic growth and attaining

reasonable equilibrium in the country's balance of payments.

To implement this policy, System open market operations until the next meeting

of the Committee shall be conducted with a view to maintaining the prevailing

firm conditions in the money market; provided, however, that operations shall be

modified if bank credit appears to be deviating significantly from current projections or if unusual liquidity pressures should develop.

MEETING HELD ON JANUARY 15, 1970

The information reviewed at this meeting suggests that real economic activity

leveled off in the fourth quarter of 1969 and that little change is in prospect for

the early part of 1970. Prices and costs, however, are continuing to rise at a rapid

pace. Most market interest rates have receded from highs reached during December. Bank credit and the money supply increased slightly on average in

December and also over the fourth quarter as a whole. Outstanding largedenomination CD's held by domestic depositors have continued to contract in

recent months while foreign official time deposits have expanded considerably.

Flows of consumer-type and savings funds at banks and nonbank thrift institutions,

have remained weak, and there apparently were sizable net outflows after year-end

interest crediting. U.S. imports and exports have both grown further in recent

months but through November the trade balance showed little or no further

improvement from the third-quarter level. At the year-end the over-all balance

of payments statistics were buoyed by large temporary inflows of U.S. corporate

funds. In light of the foregoing developments, it is the policy of the Federal

Open Market Committee to foster financial conditions conducive to the orderly

reduction of inflationary pressures, with a view to encouraging substainable economic growth and attaining reasonable equilibrium in the country's balance of

payments.

To implement this policy, while taking account of the forthcoming Treasury

refunding, possible bank regulatory changes and the Committee's desire to see a

modest growth in money and bank credit, System open market operations until

the next meeting of the Committee shall be conducted with a view to maintaining

firm conditions in the money market; provided, however, that operations shall!

be modified if money and bank credit appear to be deviating significantly from

current projections.

MEETING HELD ON FEBRUARY 10, 1970

The information reviewed at this meeting suggests that real economic activity^

which leveled off in the fourth quarter of 1969, may be weakening further in

early 1970. Prices and costs, however, are continuing to rise at a rapid pace.

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Long-term market interest rates recently have fluctuated under the competing;

influences of heavy demands for funds and shifts in investor attitudes regarding

the outlook for monetary policy. Bank credit declined in Januaiy but the money

supply increased substantially on average; both had risen slightly in the fourth

quarter. Flows of time and savings funds at banks and nonbank thrift institutions

have remained generally weak since year-end, and they apparently have been

affected little thus far by the recent increases in maximum rates payable for such

funds. The U.S. foreign trade balance improved somewhat in December, as

imports fell off. The over-all balance of payments has been in substantial deficit

in recent weeks. In light of the foregoing developments, it is the policy of the

Federal Open Market Committee to foster financial conditions conducive to the

orderly reduction of inflationary pressures, with a view to encouraging sustainable

economic growth and attaining reasonable equilibrium in the country's balance

of payments.

To implement this policy, while taking account of the current Treasury refunding, possible bank regulatory changes and the Committee's desire to see

moderate growth in money and bank credit over the months ahead, System open

market operations until the next meeting of the Committee shall be conducted

with a view to moving gradually toward somewhat less firm conditions in the

money market; provided, however, that operations shall be modified promptly

to resist any tendency for money and bank credit to deviate significantly from a

moderate growth pattern.

MEETING HELD ON MARCH 10, 1970

The information reviewed at this meeting suggests that real economic activity,

which leveled off in the fourth quarter of 1969, is weakening further in early 1970.

Prices and costs, however, are continuing to rise at a rapid pace. Market interest

rates have declined considerably in recent weeks, partly as a result of changing

investor attitudes regarding the outlook for economic activity and monetary

policy. Both bank credit and the money supply declined on average in February,

but both were tending upward in the latter part of the month. Outflows of time

and savings funds at banks and nonbank thrift institutions, which had been sizable

in January, apparently ceased in February, reflecting advances in rates offered

on such funds following the recent increases in regulatory ceilings, together with

declines in short-term market interest rates. The U.S. foreign trade surplus

narrowed in January and the over-all balance of payments deficit has remained

large in recent weeks. In light of the foregoing developments, it is the policy of

the Federal Open Market Committee to foster financial conditions conducive to

orderly reduction in the rate of inflation, while encouraging the resumption of

sustainable economic growth and the attainment of reasonable equilibrium in

the country's balance of payments.

To implement this policy the Committee desires to see moderate growth in

money and bank credit over the months ahead. System open market operations

until the next meeting of the Committee shall be conducted with a view to maintaining money market conditions consistent with that objective.

MEETING HELD ON APRIL 7, 1970

The information reviewed at this meeting suggests that real economic activity

weakened further in early 1970, while prices and costs continued to rise at a

rapid pace. Fiscal stimulus, of dimensions that are still uncertain, will strengthen

income expansion in the near term. Most long-term interest rates backed up

during much of March under the pressure of heavy demands for funds, but then

turned down in response to indications of some relaxation of monetary policy

and to the reduction in the prime lending rate of banks. Short-term rates declined

further on balance in recent weeks, contributing to the ability of banks and other

thrift institutions to attract time and savings funds. Both bank credit and the

money supply rose on average in March; over the first quarter as a whole bank

credit was about unchanged on balance and the money supply increased somewhat.

The U.S. foreign trade surplus increased in February, but the over-all balance of

payments appears to have been in considerable deficit during the first quarter.

In light of the foregoing developments, it is the policy of the Federal Open Market

Committee to foster financial conditions conducive to orderly reduction in the

rate of inflation, while encouraging the resumption of sustainable economic growth

and the attainment of reasonable equilibrium in the country's balance of payments.

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To implement this policy, the Committee desires to see moderate growth in

money and bank credit over the months ahead. System open market operations

until the next meeting of the Committee shall be conducted with a view to maintaining money market conditions consistent with that objective, taking account

of the forthcoming Treasury financing.

MEETING HELD ON MAY 5, 1970

The information reviewed at this meeting indicates that real economic activity

weakened further in the first quarter of 1970. Growth in personal income, however,

is being stimulated in the second quarter by the enlargement of social security

benefit payments and the Federal pay raise. Prices and costs generally are continuing to rise at a rapid pace, although some components of major price indexes

recently have shown moderating tendencies. Most market interest rates have risen

sharply in recent weeks as a result of heavy demands for funds, possible shifts in

liquidity preferences, and the disappointment of earlier expectations regarding

easing of credit market conditions. Prices of common stocks have declined markedly since early April. Attitudes in financial markets generally are being affected

by the expansion of military operations in Southeast Asia and by concern about

the success of the Government's anti-inflationary program. Both bank credit

and the money supply rose substantially from March to April on average, although during the course of April bank credit leveled off and the money supply

receded sharply from the end-of-March bulge. The over-all balance of payments

was in considerable deficit during the first quarter. In light of the foregoing develments, it is the policy of the Federal Open Market Committee to foster financial

conditions conducive to orderly reduction the rate of inflation, while encouraging

the resumption of sustainable economic growth and the attainment of reasonable

equilibrium in the country's balance of payments.

To implement this policy, the Committee desires to see moderate growth

in money and bank credit over the months ahead. System open market operations until the next meeting of the Committee shall be conducted with a view

to maintaining bank reserves and money market conditions consistent with that

objective, taking account of the current Treasury financing; provided, however,

that operations shall be modified as needed to moderate excessive pressures in

financial markets, should they develop.

MEETING HELD ON MAY 26, 1970

The information reviewed at this meeting indicates that real economic activity

declined more than previously estimated in the first quarter of 1970, but little

further change is projected in the second quarter. Prices and costs generally are

continuing to rise at a rapid pace, although some components of major price indexes recently have shown moderating tendencies. Since early May most longterm interest rates have remained under upward pressure, partly as a result of

continued heavy demands for funds and possible shifts in liquidity preferences,

and prices of common stocks have declined further. Attitudes in financial markets

generally are being affected by the widespread uncertainties arising from recent

international and domestic events, including doubts about the success of the

Government's anti-inflationary program. Both bank credit and the money supply

rose substantially from March to April on average; in May bank credit appears

to be changing little while the money supply appears to be expanding rapidly.

The over-all balance of payments continued in considerable deficit in April and

early May. In light of the foregoing developments, it is the policy of the Federal

Open Market Committee to foster financial conditions conducive to orderly

reduction in the rate of inflation, while encouraging the resumption of sustainable

economic growth and the attainment of reasonable equilibrium in the country's

balance of payments.

To implement this policy, in view of current market uncertainties and liquidity

strains, open market operations until the next meeting of the Committee shall be

conducted with a view to moderating pressures on financial markets, while, to the

extent compatible therewith, maintaining bank reserves and money market conditions consistent with the Committee's longer-run objectives of moderate growth

in money and bank credit.

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MEETING HELD ON JUNE 23, 1970

The information reviewed at this meeting suggests that real economic activity

is changing little in the current quarter after declining appreciably earlier in the

year. Prices and costs generally are continuing to rise at a rapid pace, although

some components of major price indexes recently have shown moderating tendencies. Since late May market interest rates have shown mixed changes following

earlier sharp advances, and prices of common stocks have recovered part of the

large decline of preceding weeks. Attitudes in financial markets continue to be

affected by uncertainties and conditions remain sensitive, particularly in light of

the insolvency of a major railroad. In May bank credit changed little and the

money supply rose moderately on average, following substantial increases in

both measures in March and April. Inflows of consumer-type time and savings

funds at banks and nonbank thrift institutions have been sizable in recent months,

but the brief spring upturn in large-denomination CD's outstanding at banks has

ceased. The over-all balance of payments was in heavy deficit in April and May.

In light of the foregoing developments, it is the policy of the Federal Open Market

Committee to foster financial conditions conducive to orderly reduction in the

rate of inflation, while encouraging the resumption of sustainable economic growth

and the attainment of reasonable equilibrium in the country's balance of payments.

To implement this policy, in view of persisting market uncertainties and liquidity strains, open market operations until the next meeting of the Committee

shall continue to be conducted with a view to moderating pressures on financial

markets. To the extent compatible therewith, the bank reserves and money

market conditions maintained shall be consistent with the Committee's longer-run

objective of moderate growth in money and bank credit, taking account of the

Board's regulatory action effective June 24 and some possible consequent shifting

of credit flows from market to banking channels.

MEETING HELD ON JULY 21, 1970

The information reviewed at this meeting indicates that real economic activity

changed little in the second quarter after declining appreciably earlier in the

year. Prices and wage rates generally are continuing to rise at a rapid pace.

However, improvements in productivity appear to be slowing the rise in costs,

and some major price measures are showing moderating tendencies. Since midJune long-term interest rates have declined considerably, and prices of common

stocks have fluctuated above their recent lows. Although conditions in financial

markets have improved in recent weeks uncertainties, persist, particularly in the

commercial paper market where the volume of outstanding paper has contracted

sharply. A large proportion of the funds so freed apparently was rechanneled

through the banking system, as suggested by sharp increases in bank loans and

in large-denomination CD's of short maturity—for which rate ceilings were

suspended in late June. Consequently, in early July bank credit grew rapidly;

there was also a sharp increase in the money supply. Over the second quarter as

a whole both bank credit and money supply rose moderately. The over-all balance

of payments remained in heavy deficit in the second quarter. In light of the

foregoing developments, it is the policy of the Federal Open Market Committee

to foster financial conditions conducive to orderly reduction in the rate of inflation, while encouraging the resumption of sustainable economic growth and the

attainment of reasonable equilibrium in the country's balance of payments.

To implement this policy, while taking account of persisting market uncertainties, liquidity strains, and the forthcoming Treasury financing, the Committee seeks to promote moderate growth in money and bank credit over the

months ahead, allowing for a possible continued shift of credit flows from market

to banking channels. System open market operations until the next meeting of

the Committee shall be conducted with a view to maintaining bank reserves

and money market conditions consistent with that objective; provided, however,

that operations shall be modified as needed to counter excessive pressures in

financial markets should they develop.

MEETING HELD ON AUGUST 18, 1970

The information reviewed at this meeting suggests that real economic activity,

which edged up slightly in the second quarter after declining appreciably earlier

in the year, may be expanding somewhat further. Prices and wage rates generally

are continuing to rise at a rapid pace. However, improvements in productivity

appear to be slowing the rise in costs, and some major price measures are showing

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moderating tendencies. Credit demands in securities markets have continued?

heavy, and interest rates have shown mixed changes since mid-July after declining

considerably in preceding weeks. Some uncertainties persist in financial markets,

particularly in connection with market instruments of less than prime grade. In

July the money supply rose moderately on average and bank credit expanded

substantially. Banks increased holdings of securities and loans to finance companies, some of which were experiencing difficulty in refinancing maturing commercial paper. Banks sharply expanded their outstanding large-denomination

CD's of short maturity, for which rate ceilings had been suspended in late June,

and both banks and nonbank thrift institutions experienced large net inflows of

consumer-type time and savings funds. The over-all balance of payments remained

in heavy deficit in the second quarter, despite a sizable increase in the export

surplus. In July the official settlements deficit continued large, but there apparently was a marked shrinkage in the liquidity deficit. In light of the foregoing

developments, it is the policy of the Federal Open Market Committee to foster

financial conditions conducive to orderly reduction in the rate of inflation, while

encouraging the resumption of sustainable economic growth and the attainment

of reasonable equilibrium in the country's balance of payments.

To implement this policy, the Committee seeks to promote some easing of

conditions in credit markets and somewhat greater growth in money over the

months ahead than occurred in the second quarter, while taking account of

possible liquidity problems and allowing bank credit growth to reflect any continued shift of credit flows from market to banking channels. System open market

operations until the next meeting of the Committee shall be conducted with a

view to maintaining bank reserves and money market conditions consistent with.

that objective, taking account of the effects of other monetary policy actions.

MEETING HELD ON SEPTEMBER 15, 1970

The information reviewed at this meeting suggests that real economic activity

which edged up slightly in the second quarter, is expanding somewhat further in

the third quarter, led by an upturn in residential construction. Wage rates

generally are continuing to rise at a rapid pace, but improvements in productivity

appear to be slowing the rise in costs, and some major price measures are rising less

rapidly than before. Interest rates declined in the last half of August, but most

yields turned up in early September, as credit demands in securities markets have

continued heavy; existing yield spreads continue to suggest concern with credit

quality. The money supply rose rapidly in the first half of August but moved

back down through early September. Bank credit expanded sharply further in

August as banks continued to issue large-denomination CD's at a relatively rapid

rate, while reducing their reliance on the commercial paper market after the Board

of Governors acted to impose reserve requirements on bank funds obtained from

that source. The balance of payments deficit on the liquidity basis diminished

somewhat in July and August from the very large second-quarter rate, but the

deficit on the official settlements basis remained high as banks repaid Euro-dollar

liabilities. In light of the foregoing developments, it is the policy of the Federal

Open Market Committee to foster financial conditions conducive to orderly

reduction in the rate of inflation, while encouraging the resumption of sustainable

economic growth and the attainment of reasonable equilibrium in the country's,

balance of payments.

To implement this policy, the Committee seeks to promote some easing of

conditions in credit markets and moderate growth in money and attendant bank

credit expansion over the months ahead. System open market operations until;

the next meeting of the Committee shall be conducted with a view to maintaining

bank reserves and money market conditions consistent with that objective.

MEETING HELD ON OCTOBER 20, 1970

The information reviewed at this meeting suggests that real output of goods

and services increased slightly further in the third quarter but that employment

declined and unemployment continued to rise; activity in the current quarter

is being adversely affected by a major strike in the automobile industry. Wage

rates generally are continuing to rise at a rapid pace, but improvements in productivity appear to be slowing the increase in costs, and some major price measures

are rising less rapidly than before. Most interest rates have declined since midSeptember, although yields on corporate and municipal bonds have been sustained,

by the continuing heavy demands for funds in capital markets. The money supply -

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Tose slightly on average in September and increased moderately over the third

quarter as a whole. Bank credit expanded further in September but at a rate

considerably less than the fast pace of the two preceding months. Banks continued

to issue large-denomination CD's at a relatively rapid rate and experienced

heavy inflows of consumer-type time and savings funds, while making substantial

further reductions in their use of nondeposit sources of funds. The balance of payments deficit on the liquidity basis diminished in the third quarter from the very

large second-quarter rate, but the deficit on the official settlements basis remained

high as banks repaid Euro-dollar liabilities. In light of the foregoing developments,

it is the policy of the Federal Open Market Committee to foster financial conditions conducive to orderly reduction in the rate of inflation, while encouraging the

resumption of sustainable economic growth and the attainment of reasonable

equilibrium in the country's balance of payments.

To implement this policy, the Committee seeks to promote some easing of

conditions in credit markets and moderate growth in money and attendant bank

credit expansion over the months ahead. System open market operations until

the next meeting of the Committee shall be conducted with a view to maintaining

bank reserves and money market conditions consistent with those objectives,

taking account of the forthcoming Treasury financings.

MEETING HELD ON NOVEMBER 17, 1970

The information reviewed at this meeting suggests that real output of goods

and services is changing little in the current quarter and that unemployment

has increased. Part but not all of the weakness in over-all activity is attributable

to the strike in the automobile industry which apparently is now coming to an

end. Wage rates generally are continuing to rise at a rapid pace, but gains in

productivity appear to be slowing the increase in unit labor costs. Recent movements in major price measures have been erratic but the general pace of advance

in these measures has tended to slow. Most interest rates declined considerably

in the past few weeks, and Federal discount rates were reduced by one-quarter

of a percentage point in the week of November 9. Demands for funds in capital

markets have continued heavy, but business loan demands at banks have weakened. The money supply changed little on average in October for the second

consecutive month; bank credit also was about unchanged, following a slowing

of growth in September. The balance of payments deficit on the liquidity basis

was at a lower rate in the third quarter and in October than the very high secondquarter rate, but the deficit on the official settlements basis remained high as

banks repaid Euro-dollar liabilities. In light of the foregoing developments, it is

the policy of the Federal Open Market Committee to foster financial conditions

conducive to orderly reduction in the rate of inflation, while encouraging the

resumption of sustainable economic growth and the attainment of reasonable

equilibrium in the country's balance of payments.

To implement this policy, the Committee seeks to promote some easing of

conditions in credit markets and moderate growth in money and attendant bank

credit expansion over the months ahead with allowance for temporary shifts

in money and credit demands related to the auto strike. System open market

operations until the next meeting of the Committee shall be conducted with

a view to maintaining bank reserves and money market conditions consistent

with those objectives.

MEETING HELD ON DECEMBER 15, 1970

The information reviewed at this meeting suggests that real output of goods

and services has declined since the third quarter, largely as a consequence of the

recent strike in the automobile industry, and that unemployment has increased.

Resumption of higher automobile production is expected to result in a bulge in

activity in early 1971. Wage rates generally are continuing to rise at a rapid pace,

but gains in productivity appear to be slowing the increase In unit labor costs.

Movements in major price measures have been diverse; most recently, wholesale

prices have shown little change while consumer prices have advanced substantially.

Market interest rates declined considerably further in the past few weeks, and

Federal Reserve discount rates were reduced by an additional one-quarter of a

percentage point. Demands for funds in capital markets have continued heavy,

but business loan demands at banks have been weak. Growth in the money

supply was somewhat more rapid on average in November than in October,

although it remained below the rate prevailing in the first three quarters of the

year. Banks acquired a substantial volume of securities in November, and bank

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credit increased moderately after changing little in October. The foreign trade

balance in September and October was smaller than in any other 2-month period

this year. The over-all balance of payments deficit on the liquidity basis remained in October and November at about its third-quarter rate. The deficit

on the official settlements basis was very large as banks continued to repay

Euro-dollar liabilities. In light of the foregoing developments, it is the policy of

the Federal Open Market Committee to foster financial conditions conducive

to orderly reduction in the rate of inflation, while encouraging the resumption of

sustainable economic growth and the attainment of reasonable equilibrium in

the country's balance of payments.

To implement this policy, System open market operations shall be conducted

with a view to maintaining the recently attained money market conditions until

the next meeting of the Committee, provided that the expected rates of growth

in money and bank credit will at least be achieved.

Mr. HANNAFORD. Thank you, Dr. Pierce.

Fortunately, and in the nick of time the chairman has arrived

before I had to make any decisions about how to proceed.

Would it be best to proceed by questioning Dr. Pierce, or would

you—all right, let's proceed then with Dr. Meltzer's testimony, and

you can proceed in whatever manner you would like, Dr Meltzer.

STATEMENT OF DR. ALLAN H. MELTZER, GRADUATE SCHOOL OF

INDUSTRIAL ADMINISTRATION, CARNEGIE-MELLON UNIVERSITY

Dr. MELTZER. Thank you, Mr. Chairman and Mr. Hannaford.

The subcommittee's interest in the problem of maintaining appropriate monetary policy, as evidenced by regular hearings under

House Concurrent Resolution 133, is, I believe, one of the most

important developments in recent years. It will have an important

influence on the way in which we conduct our economic policy.

The rate of increase of consumer prices in the United States has

fallen, gradually, from nearly 14 percent in mid-1974 to an average

rate of about 6 percent for the past 6 months. Some further reduction

in the average rate of inflation is likely to occur in 1976.

Experience in the rest of the world covers a wide range. Some

countries substantially reduced the rate of price increase; in others

the rate of increase remained high. During the year 1975, consumer

prices rose by more than 20 percent in Britain, by approximately 10

percent in France, Italy and Canada, and by 5 percent or less in

Germany and Switzerland.

Why are the rates of price increase in these countries so different?

Why is inflation no longer proceeding at high or rising rates everywhere? Why have some countries succeeded in reducing inflation where

others have failed?

The answer to these questions is surprisingly simple. Government

policies toward inflation have differed. Some countries recognized

inflation as mainly a monetary phenomenon, the result of too much

money in circulation and too high a growth rate of money and took

effective action to control inflation. The countries that now have the

lowest rates of inflation, Switzerland, Germany, and the United

States, are the same countries that changed their approach to monetary

control. Each of the countries has, in its own way, chosen a target

rate of increase in money. Each has managed to keep the growth rate

of money close to the announced target.

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Where the rate of growth of money has been reduced, the rate of

inflation has been reduced. Where monetary growth has been kept

at a high rate, the rate of inflation has remained high or has increased.

Britain is an outstanding example. During the past year most

countries experienced less inflation, but Britain experienced more.

British consumer prices rose by 16 percent in 1974 and by more than

20 percent in 1975. Even Italy, with its severe political, social and

economic problems, was able to slow inflation, to reduce the rate of

increase in consumer prices from 1974 to 1975. But Britain did not.

Economists differ about why inflation starts and about how inflation

can be reduced and ended. For decades influential British economists

argued that it was unnecessary to control the rate of monetary expansion. Some argued that the way to end inflation was to stimulate

the economy by Government policies that create jobs and output. By

increasing output they hoped to lower prices or the rate of inflation.

Contrary to experience everywhere they sought to end inflation by

stimulating the economy.

The result was predictable, and both the predictions and the results

are part of British history. Inflation increased. An economically weak

Britain became weaker as measured by emplo^nnent and inflation.

Programs similar to those that failed in Britain are advocated and

at times adopted here. We followed the British into stop and go

policies—policies to stimulate the economy today and take care of

the inflation tomorrow. We achieved more inflation and currently

have more unemployment. We followed the British and other Europeans in attempting to control inflation by using government intervention in wage and price setting. Inflation did not stop, iti ncreased.

The policies of the past year and the results they achieved are a

means of discriminating between the differing opinions about the causes

of inflation and the means of ending inflation. Some prominent economists both here as well as in Britain urged rates of monetary expansion

in 1975 as high as 16 percent, and a rate of monetary growth of 10

percent in 1976. They argued that with unemployment high, strong

stimulus would reduce unemployment and reduce inflation.

If we had adopted very expansive policies, we, like the British, would

have experienced rising inflation in 1975 and 1976. Instead of a falling

rate of inflation we would now have a rising rate of inflation.

The marked difference in countries' experience with inflation during

1975 and 1976 is not a unique event. Recent experience is only a

repeat of the experience of the late forties with a change in the roles

chosen by the governments of particular countries. Then, and now the

countries that promptly reduced the rate of monetary growth ended

inflation promptly. Countries that experimented with controls on

prices and wages, with restrictions on credit or that engaged in fine

tuning of taxes and government spending continued to experience

inflation.

No sustained inflation has ever been ended until the growth rate

of money has been reduced. Inflations at the end of World War II,

after the Korean war, and in other times and places were ended b}^

controlling money. The experiences of the past 2 years are in this respect consistent with the past.

What of the future? Barring some new shock like the oil price

increase, a crop failure, or a war, we can expect the economy to approach full employment in about 2 years if Government policies are

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less erratic in the future than in the past. We cannot expect, however,

to reach full employment without inflation. In this respect, as in many

others, Government promises and performance differ.

Ending inflation means bringing the average rate of price change,

properly measured, to zero. We are fighting inflation. Inflation has

1>een reduced, but we will not end inflation unless we change some

Government policies and continue others.

I believe we can end inflation in the next few years. To do so, we

must adhere to four principles of economic policy.

First, we must continue the present international monetar}^ arrangement known as the fluctuating exchange rate system. The chairman

of this subcommittee has been very important in getting that system

of fluctuating exchange rates adopted as U.S. policy. Under the

fluctuating rate system, we rely on the market and not on governments to determine the current exchange value of our currency. The

exchange value of the dollar fluctuates, rising with increases in the

demand for dollars and falling when we speed up the printing press

and increase the supply of dollars. The fluctuating exchange rate

protects us against inflationary or deflationary economic policies

abroad. If foreign governments adopt policies more inflationary

than ours, and many governments have, the fluctuating dollar helps

us to avoid inflation. We are freer to pursue stable prices.

Second, we must reduce the growth rate of Government. A high

growth rate of Government transfers spending from private to public

hands, and reduces efficiency. Growth of public employment transfers

skilled labor from more productive to less productive activities and

slows the growth of the economy. Government regulation absorbs

skilled personnel in countless wrangles with the bureaucracy, increases

uncertainty and deters investment. But the principal effect of a growing

public sector on inflation is not from the loss of efficiency and growth.

A rising government budget creates strong pressure to finance the

Government by printing money. Our current inflation began when

we tried to finance war and social programs in the midsixties without

raising taxes. Despite a 400 percent increase in the Federal budget, in

little more than a decade, costs of social programs continue to increase

and the problem of financing the budget without increasing taxes

remains a force for inflation.

Third, we must continue to reduce the growth rate of money

gradually. Between 1973 and 1976, the rate of monetary growth has

been lowered from 9 percent to about 5 percent. This reduction is the

most important force working to reduce present and future inflation.

During the next 2 or 3 years, the rate of monetary expansion must be

brought, gradually, to about 3 percent. Once we fully adjust to the

lower rate of growth on money, the economy will be at full employment

without inflation.

Fourth, we must avoid price and wage controls and Government

interference in price and wage decisions.

If we do these things, we will achieve economic stability with high

employment and low inflation that we currently do not have.

Thank you.

Mr. HANNAFORD. Thank you, Dr. Meltzer.

One general question I would like answered would apply to both of

you. In your statements you ascribe a cause-effect relationship with

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the money supply and various other forces, but primarily with the

money supply that does not seem to take into account the 23-month

lag that we have discussed in our charts here, and as you describe

what we have done in money supply just very recently, Dr. Meltzer, in your last sentence or so, could you comment on that?

It seems to me that lacking precision as to how long an action

takes place, puts us all in the dark feeling around and not knowing

the cause and effect relationship.

Dr. MELTZER. First, the 23 months, or roughly 2 }^ears, is an.

average. It does not hold in any particular instant, but it is well

researched and I believe has been supported in a general way b}^ the

work of many different people. Therefore I think we can use it as a

reasonable rule of thumb in trjdng to think about the effects of monetary policy. We can think about a 2-year average lag between the

time we slow down the money growth rate and the time that the rate

of inflation slows down.

That means that the lower rate of inflation that we are currently

experiencing is mainly the result of slower monetary growth that

began sometime in 1974. We are now getting the benefits of the

slowing in policy, the very rapid slowing in policy in 1974 that

Dr. Pierce talked about in his statement. I believe that slower monetary growth, maintained for the past 2 years, has contributed to the

lower rate of inflation. Of course, it also contributed to the recession.

We experienced a recession, a severe recession in between.

We are now getting the benefits of the slow growth, having paid

most of the costs in the past. It is important to understand that

because we have paid those costs, and are now reaping the benefits,

that we must continue this policy so as to receive the benefits for

which we have already paid.

Mr. HANNAFORD. Your answer then is that your cause-effect relationship does indeed take into account the 2-year lag.

Dr. MELTZER. Indeed.

Mr. HANNAFORD. YOU know what happened to the Breton Woods

amendment last week under suspension. You made comments about

the importance of the floating rates of foreign trade and our committee got quite a shock last week on that bill.

Dr. MELTZER. It is quite important, I think, that we continue the

floating rate system and that we do not try to substitute the judgment

of governmental agencies for the market process determining exchange

rates. The main reason is that I don't believe that governments are

able to pick exchange rates that will be stable exchange rates. Most

of the experience that we have had in the past leads us to believe that

if countries pursue different monetary policies and have different

rates of inflation, there is no way that they can maintain fixed exchange

rates. The only choice that they are going to have will be a choice

between whether they want rates to change in large jumps, with

great dislocations, or in small, steady movements as they have been

doing since the floating exchange rate system has been in effect.

Mr. HANNAFORD. YOU expressed concern, some disagreement about

the various Government full employment programs as a contributor

toward inflation. If such programs created production for the marketplace instead of leaf-raking, you wouldn't be concerned about that,,

would you, if you used the recently experienced program in Germany

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to pay a small subsidy for employing people in the private sector, or

what have you?

Could you comment on that sort of program?

Dr. MELTZER. I believe that there are important and useful

things that Government can do to stimulate employment, but I don't

believe that they include either employing people in the public sector

in makework jobs or subsidizing the employment in the private

sector in the way in which you just described. I believe that there are

useful things that can be done, and one of the most useful is to try

to get people employed in meaningful jobs within the private sector.

In order to do that, it seems to me that there are some useful

things to be done. One of them is that instead of paying a subsidy for

training that minimum wage legislation be removed for selected classes

of employment, particularly for people who would be trained to do

useful work. With training, they would have the prospect of earning

higher wages at some time in the future. I think that kind of program—

I will be glad to expand on some other—that kind of program is more

meaningful and more helpful than either the kind of program envisaged, say, under the Humphrey-Hawkins bill or the kind of

program that would require some subsidy for private employment.

It is very difficult to administer the subsidies to private employment that would be required by many bills, and it is particularly

difficult to assure that the employees who are being subsidized, the

employment that is being subsidized directly by the Government

is in fact new creation of employment rather than just simply the

moving of people from one job, unsubsidized, to a job that is subsidized, with little net increase in employment.

Mr. HANNAFORD. Early in your statement you said that you

thought House Concurrent Resolution 133 was one of the most

important acts of recent years. I was pleased to hear that because

I didn't have that much faith in it when we did it. If a little bit is

good, is more better?

Dr. MELTZER. Well, that depends on what more.

Mr. HANNAFORD. I mean in terms of House Concurrent Resolution

133.

Do you think more exacting demands, congressional demands might

be made in terms of monetary policy and perhaps coordination of the

two, or do you think we are about where we should be in terms of

congressional interference with Fed policy?

Dr. MELTZER. I believe that we should not make exacting demands

that set up anticipations that we can deliver things that we, that is,

we economists are unable to deliver. If we set very precise targets for

what we want to achieve, I don't think that we have the ability now

or in the near term future to deliver.

On the other hand, I think the Congress could be more exacting in

its demands on the Federal Reserve. Among the things that it could

do would be to get greater precision in statements describing what the

Federal Reserve is trying to achieve. I agree with the general thrust of

Dr. Pierce's statement. It would be useful if the Federal Reserve

announced what it was trying to achieve and over what horizon it was

trying to achieve its goals, without being committed, necessarily,

to those goals. An announcement of what it is that the Government

is aiming at, what its policy seeks to achieve, and what kinds of

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programs it had adopted in order to achieve those ends, those would

be steps in the right direction. It would give information to people

without giving the impression that targets have been chosen that

necessarily must be achieved for the survival of the agency.

Mr. HANNAFORD. Mr. Neal, do you have some questions?

Mr. NEAL. I would like to pursue the point you made a moment

ago about other programs that you might have in mind for reducing

unemployment in noninflationary ways. How, in fact, can this be done?

It is certainly highly unlikely that the minimum wage laws would be

rescinded.

Dr. MELTZER. I would like to relax them to exclude some people,

particularly—we have an enormous problem of young unemployment.

When we look at the unemployment statistics, they are not an undifferentiated mass. There is a large group of people who are being

kept from gainful employment, in my opinion, because they have no

skill and there is no mechanism presently available to get them trained

in the kind of skills that would permit them to lead useful lives and do

productive labor.

Mr. NEAL. Well, if employers would substitute unskilled young

workers to whom they could pay reduced wages, wouldn't many

older, skilled workers—breadwinners, heads of households—be out of

work?

Dr. MELTZER. There is, of course, some tendency for that to occur.

I don't believe that the offset would be one to one. There would be

some incentive on the part of companies to take advantage of the

opportunity to hire people at lower wages and train them to do skilled

jobs that need to be done, and that are not now being done.

One observes in foreign countries when imported labor enters they

do jobs that local citizens often do not do. The same kind of situation

exists here. The choice is either to hire a foreign worker or not have the

job done. Labor in the domestic economy is not available at wage

rates that would permit the job to be done profitably.

Mr. NEAL. Would that be your No. 1 priority?

Dr. MELTZER. That would be one of my—I don't know that I

want to assign a priority. I would like to see considerably more done

to try to stimulate employment in the private sector than is currently

being done, but in a noninflationary way.

Mr. NEAL. Like what?

Dr. MELTZER. The second step—I'm sorry.

Mr. NEAL. What do you have in mind?

Dr. MELTZER. Well, I would believe that it would be salutary to

reduce the size of the public sector and reduce taxes, to reduce the

total size of the budget and taxes, and that I believe that would have a

stimulating effect on employment in the private sector.

Mr. NEAL. What programs would you do away with? Where would

you make this cut?

Dr. MELTZER. Specific programs I would do away with in the public

sector?

Mr. NEAL. Right.

Dr. MELTZER. I believe that there are two ways in which we can

reduce total costs of Government. One is that many of the programs

that we have are programs that employ large numbers of people

without accomplishing any specific end. I will begin to detail some of

the programs and some of the areas.

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Mr. NEAL. Well, I would be very interested in that.

Dr. MELTZER. All right.

I think that in the regulation of housing and in the regulation of construction there are a number of laws that require enforcement, that

are enforced, and that are supervised, that in fact have deleterious

effects on employment in this country. For example, Davis-Bacon is an

important law. Now, you may say it is politically impossible to remove

Davis-Bacon. Neverthless, Davis-Bacon has a negative effect on

construction in the private sector. So if we would remove that law

and remove the people who are responsible for enforcing that law, we

would reduce public employment and at the same time we would

remove a regulation that prevents people from building more buildings

at lower prices. That would be a step in the right direction.

There are a whole series of such laws, for example, the Jones Act,

which restricts interstate commerce to carrying cargo in American

bottoms. It raises the cost of carrying cargo.

There are a series of such laws.

Mr. NEAL. Well, excuse me. Even though I personally don't think

Davis-Bacon is a very good idea, it is not the kind of program employing large numbers of Federal workers, which I thought you had in

mind.

Dr. MELTZER. Well, we could take OSHA, where there is a large

number of public employees. One of the main reasons for that large

number of public employees is because the Congress has been unwilling

to make clear and definite rules regulating the practices that it seeks

to regulate. Consequently OSHA has put into the field a large number

of employees who are subject to very little direct control by the Congress and who are making rules and enforcing rules differently in

different districts and without very much control.

That has three effects. One, it creates employment in the Federal

sector; two, it deters private activity by diverting attention within

the private sector toward the administration of a series of rules;

and three, it creates uncertainty about what the consequences of

particular kinds of activities are. There are large numbers of programs,

particularly in recent years, that have passed in recent years, that

have similar effects on employment.

Now, I am trying very carefully to separate the public purpose'

that Congress may wish to achieve from the way in which that

purpose is achieved.

Mr. NEAL. HOW could the Congress attempt to achieve the statutory

objectives in the area of occupational safety and health, for instance,

without having regulators in the field?

Dr. MELTZER. It could outlaw certain kinds of practices. That

would be one way. It could require insurance type arrangements.

Certain kinds of activities that contributed, that were known to contribute, a considerable amount to lack of safety would be insured,,

perhaps at high cost, by those people who engage in the practices..

That would diversify the responsibility for those activities and

reduce the cost of administration and reduce the arbitrariness of the

ways in which those decisions are made. We could try to base the

costs of insurance on the historic frequencies with which the accidents

have occurred, and charge insurance premiums. Those insurance

premiums would be a deterrent to the type of activity that people

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may now engage in and that Congress may wish to prevent. I believe

that would be a cheaper way of doing it; it would leave much more

to private decisionmaking, and it would tend to reduce uncertainty.

Mr. NEAL. YOU would have private insurers increase the rates for

certain types of businesses; is that what you are saying?

Dr. MELTZER. Congress would require that people who produce

certain kinds of high risk where safety was involved, must carry

insurance; that's right.

Mr. NEAL. Must cany health insurance?

Dr. MELTZER. Either insure or not engage in activities.

Mr. NEAL. Or life insurance, in some cases, of some type, and then

naturally you would say the Government shouldn't set the rate

because it should be set by private industry.

Dr. MELTZER. It should be done in the private market.

Mr. NEAL. I will move briefly to another subject. Public debate

centers around fiscal policy as the main culprit in creating inflation,

but our preliminary findings indicate that monetary policy is probably

more to blame for inflation than fiscal policy. I did not hear everyone's

comments on this issue except for Dr. Meltzer's comment that the

Fed increases the money supply because of the pressures exerted on

it by the actions of Congress, but

Dr. MELTZER. Congress and the administration.

Mr. NEAL. Or of Government, right.

But you wouldn't say that the Fed necessarily had to respond

as it did.

Dr. MELTZER. NO; it did not.

Mr. NEAL. However, officials of the Fed and members of the business community back home who write me about the subject say that

the Fed had to respond to what the Congress and the administration

want.

Dr. MELTZER. The Fed has a choice.

Mr. NEAL. Dr. Pierce?

Dr. PIERCE. I think the record is clear enough that the Fed on

average has behaved in that way. It seems to me the importan t

point is that because the Fed makes no pronouncement to the effect

that it will accommodate fiscal policy, and often makes pronouncements to the contrary—that it is the institution that will fight inflation

and work against the profligate spending of either the administration

or Congress or both—but in fact ends up financing the deficits, that

there is a tendency to underestimate the inflationary impact of the

fiscal programs because in fact you are having two policies working

in locked step. You are having both a fiscal and a monetary effect

and I think that was part of the problem in the 1960's. There was

a lot of debate about fiscal policy, a lot of talk on the part of the

Federal Reserve about fighting the possible inflation that would come

from it, but in fact it was not, with a couple of spasms, such as 1966.

There was, therefore, a tendency to understate the inflationary impact

that the Government was having on the economy.

That was particularly important in light of the fact that there are

long lags between inflationary policies, either fiscal or monetary,

and the inflation itself. So it looked like this was a free thing to do

at the time. Prices weren't rising very rapidly. We could finance the

war and the social programs and not raise taxes and not even have

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interest rates rising very much. It looked like the best of all possible

worlds, and then we pay the price for it later.

And it seems to me the important thing is to be aware of the lags,

and second, to be aware of the importance of policing both monetary

and fiscal policy.

Mr. HANNAFORD. Would you yield?

Mr. NEAL. Yes.

Mr. HANNAFORD. We have talked about the lags and we have

talked in general terms about a 2-year lag in monetar}^ policy and its

effect.

What kind of a lag are we talking about in fiscal policy? It is

somewhat short, isn't it, it is much shorter, isn't it, almost immediate?

Dr. PIERCE. NO; the way I tend to view these things is I look at

inflation being generated by the effect that say a policy has on the

behavior of demand in the economy relative to the available supply.

Fiscal policy would only have a shorter lag than monetary policy

if somehow its effects on demand and the economy are more rapidly

than for monetary policy. There is a little bit of evidence on that,

but not a great deal.

Fiscal policy may be a little bit more rapid, but I don't really think

that is an important issue. I think the important thing is it takes time

to get going and that the effects are distributed over time. One place

where I would be at issue with some of the work that is being done is

that the effect of policy depends on where you are and how long the

policy is sustained. But I don't think that anyone has demonstrated

to any believable degree that if one puts money in today, out plops

prices 27 months from now. The relationship that is being looked at

is an average. It depends on the circumstances in the economy and how

long that policy is pursued.

The crucial issue, it seems to me, for basic policymaking is whether

these policies are pursued for sustained periods of time. If they are,

then their effects will be felt, I believe, on the rate of inflation in the

economy.

Mr. HANNAFORD. The Congress enacted a tax stimulus last year,

earlier in the year, which the President signed with one hand while

he held his nose with the other.

Dr. PIERCE. Right.

Mr. HANNAFORD. Subsequently we had an improvement in the

employment, in the general economic climate, and that was a very

shortrun situation, thereafter both Congress and the President

claiming credit for it.

Dr. PIERCE. Right.

Mr. HANNAFORD. What you are saying is that we have a 2-year

lag in both monetary and fiscal policy, more or less.

Dr. PIERCE. With respect to prices, not demand for output and

employment. That lag is much shorter. That is why the reading of

the situation can be deceptive. It looks like you can get a lot of employment with no inflation in the short run. The inflation will come later.

Mr. HANNAFORD. All right, I see.

I was afraid that any good work that I did would accrue to the

benefit of my successor.

Dr. PIERCE. That almost always is the case, but that is life.

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Mr. NEAL. Dr. Meltzer, you said in your comnients that you think

that the Federal Government has been too stimulative recently,

did you not say that?

Dr. MELTZER. NO; I did not. I would like to see the Federal Government gradually reduce the rate of growth in the money stock and

of course, the size of the budget deficit, and I would add, the level

of expenditure and tax rates, or at least the growth rate of the budget.

To talk to the monetary policy first, I said that I thought that the

policy has, on average, been stabilizing. The growth of the money

stock has come down from 9 percent to approximately 5 percent. I

think that over the next few years we have to bring it down even

more if we are going to be rid of inflation. That is a goal that I think

we want to achieve. We would have to bring the rate of the growth of

money down from approximately 5 percent at present to about 2 to

3 percent over the next several years, but I would like to see that done

gradually.

While I refer to the current reduction as gradual, we ought to

mention the fact that it is highly erratic as well. I would like to see

it much less erratic than it has been, but the average movement has

been one that seems to me to be appropriate.

Mr. NEAL. DO you think that fiscal policy hasfbeen conducted

appropriately, and that if we stay on the course thatfwe are on, that

that is responsible?

Dr. MELTZER. I favor the stimulus that the economy received from

the tax reductions in early 1975, and the continuation of those reductions. I would like to see larger tax reductions accompanied by reductions in the growth rate of Government expenditure.

Dr. PIERCE. May I respond to that?

Dr. Meltzer and I may agree that the Government should be

smaller, or we may disagree, but it seems to me that has nothing to

do particularly with controlling inflation. Inflation has to do with the

economic policies in general that the Government is pursuing, and

we could half the size of the Federal sector and still have monetary

policy generate tremendous inflation today.

I think it is productive to try to separate those two issues. I don't

think the cause of inflation in this country is Davis-Bacon or the

minimum wage. Those factors may introduce inefficiencies into the

economy and lead to a lower standard of living than we might otherwise have, assuming we can agree on how to measure standard of

living. If we always measure the standard of living by the output of

the private sector, which so many people are inclined to do, mistakenly, I believe, then those factors affect the standard of living,

not the inflation rate.

Imposing restrictions on private firms restricting competition on

the economy affect the potential for output of the economy. They

don't have any obvious effect on the rate of inflation in the economy.

And I think one would be misguided to say well, the way to really

solve the inflation in this country is to get rid of the minimum wage,

throw out the labor unions and stop all Federal regulations.

I think there is a tendency on some people's part—and I am not

accusing Dr. Meltzer of this, but one sees it elsewhere—these measures

would get inflation under control, and I think that is wrong. I think

the way to get it under control is with joint economic policies,, and if

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one doesn't like the mix between the public and private sectors of

the economy, fine, change those. But those should be separate decisions that are viewed in the context of their effects on the society.

Dr. MELTZER. We entirely agree. In fact, I have been careful to

keep the issues separate. I don't think that one wants to forget them

for that reason. There are questions of efficiency. Whether we add 0.1

of 1 percent to the growth rate, or one-quarter of 1 percent per year,

makes a substantial difference to the lives of individuals. The effect

accumulates over time. We can live in a society with zero inflation

and very low, slowly increasing standards of living, or we can live

in a society with zero inflation and rapidly increasing standards of

living. It is that question we have to address at some point.

The question is how efficiently and for what purposes we use resources? That is a very important question, and it is very much involved with the subject matter that this subcommittee either is or

should be interested in, and I believe that the members are interested

in.

Dr. PIERCE. Let me finish this little bit.

I agree with Dr. Meltzer, except I don't draw any necessary relationship between the output of goods and services in the economy

as measured by the GNP and the standard of living. If a society wants

to spend more of its time in leisure, if it wants to spend more of its time

on education, that is its business, and that is a social decision, and I

don't think that one wants to draw the inference because an economy

is growing in terms of the GNP accounts, that somehow it is inefficient

and wrong.

Dr. MELTZER. NO, no, we are not talking about that question. We

are talking about the inefficiencies built in by regulation. I am trying

to be careful to say that if Congress wants regulations, that is a

separate issue that we ought to discuss separately. A separate issue

is whether we provide the regulations or rules in such a way as to

permit the maximum efficiency under that set of rules. I am arguing

that the way that we go about regulating encourages inefficiencies.

We can separately decide whether we have good rules or bad rules.

Those are judgments that I believe Congress has to make.

Mr. NEAL. The subcommittee staff has conducted research on the

growth of money supply and preliminary results show that money

supply changes are responsible for 60 percent of inflation. What do

you say?

Dr. MELTZER. I would say more than 60 percent.

Mr. NEAL. But something in that neighborhood is right, and you

can account for the other 40 percent, say, with things like Federal

deficits, the aftermath of wage and price controls, the dollar devaluation, oil prices, and food prices, administered prices and the power of

labor unions and all of these other things that you can talk about.

Is that an accurate or essentially accurate description of the

situation?

Dr. PIERCE. That is a hard question to answer. Because monetary

and fiscal policies in this country move together, we really have no

way of separating with any degree of accuracy who the culprit is. If

every time that the administration or the Congress goes on a spending

spree the Fed prints money to finance that, then it is really a matter of

taste as to whether you lay the blame on Congress or the Fed. If the

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initiating influence is the Congress and the administration, then I

should think that we would have to blame most of the inflation on

them because all the Fed has done has been the good stepchild and

gone along.

And so much of the arguments are in terms of economists' controlled experiments. They say, well, what if money hadn't grown so

rapidly, yet fiscal policy had continued.

Now, to the best that we can estimate, that would truly influence

the rate of inflation, but if it never happens, the question is moot.

Mr. NEAL. Well, excuse me. It seems to me we do have the opportunity now, if Dr. Meltzer is correct, to move in the right direction

because we have suffered the consequences, or a majority of the

consequences of our previous mistakes.

Dr. PIERCE. Oh, I agree, indeed, and I would put a higher number

on the role of the Government policy than the 60 percent that you do.

I think there were some shortrun shocks, particularly OPEC, that

were unavoidable, but the basic inflation rate in this country has been

determined by the policies of the U.S. Government. They have not

been caused by shocks. A lot of them are hard to read: the effect of the

commodity boom. I think a reasonable person could argue that the

United States was not exactly blame-free in causing that commodity

boom as an exporter of inflation.

I put the rate very high. I don't know if I would put all the blame on

monetary policy, but on Government policies in general.

Dr. MELTZER. I would like to go back to that question, Mr. Neal,

because first I would put the percentage higher than 60 percent on

monetary policy. I would like to say a few words about the kinds of

evidence that will help us to find an answer. We don't have to look

solely at our own experience. We have a country like Brazil that has

gone from 80-percent inflation down to something like 10 or 15 percent

and back up to 60 or 70 percent. During the period that it went from 10

or 15 up to 60 percent, the government budget has been balanced

almost all the time. The inflation has been entirely produced by giving

credit to the private sector.

We can look back at our own experience. We have experience with

inflation when the public sector was extremely small. Central banks

are able to produce high inflation without a budget deficit.

Take the great German inflation of the 1920's. The public sector

in Germany was larger than the public sector in the United States at

the time, but by no means large by any of the standards we would

use today. Much of that inflation was produced by giving credit to

the private sector.

I can cite other examples. We have inflation where the Government

budget is financed by printing money. We have inflation where the

private sector is financed by printing money, and we have the experience repeated over and over again for as long as we have had

experience with money.

So it seems to me that we have a preponderant weight of evidence

which says that it doesn't really make very much difference—and I

want to emphasize, it doesn't make very much difference who is being

financed in the first round of spending. What is important is the

rate at which that financing occurs.

73-959 0—76 13

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Dr. PIERCE. The difference is more apparent, I think, than real.

I think that in the postwar period in the United States that there has

been a very close coincidence between monetary and fiscal policies.

That is not to say they had to be the same, they could have been

quite different. Had they been different, the results in the economy

would have been different. It is perfectly possible for monetary policy

to offset fiscal policy. It is perfectly possible for the two policies to

go their own way or to move together.

Mr. NEAL. Well, let me interrupt you gentlemen.

It has always troubled me, and it seems to me this has occurred,

I think it happened in 1974—the Fed said that the reason for the

inflation we are experiencing is the level of deficits, and their answer

was to cut off the supply of money, slow it sharply enough to promote

recession.

Now, that was not a reasonable response, it doesn't seem to me.

Nor is it reasonable to finance deficits by excessive money growth.

There is a middle ground I believe.

Dr. PIERCE. There is a human tendency I think to say that you

are to blame for the mistakes and we are going to correct them. The

deficits which they were talking about, which were important deficits

in my opinion, were the ones that occurred in the late 1960's, when

policy in this country was extremely expansionary, and there were

some later effects in 1972 for example, both fiscal and monetary

policies. Those deficits, particularly in the 1960's, were inflationary.

Now, the current deficit

Mr. NEAL. Well, excuse me. If monetary policy had been different

at that time

Dr. PIERCE. Then the effects would have been different, indeed.

Mr. NEAL. The effects would have been

Dr. PIERCE. In Dr. Meltzer's terms, if the Fed had not allowed

the money supply to grow more than 3 percent a year during the

late 1960's, the effect on the economy would have been far, far

different.

Dr. MELTZER. We can say what that effect would have been.

There would have been far less inflation.

Mr. NEAL. But to return to the 1970's, would we have had a recession with 3 percent money growth?

Dr. PIERCE. I think we would have had some recession from OPEC.

That is unavoidable. The degree of it was exacerbated by the policy

reaction to the shocks that occurred from the outside, and from the

distortions that we had built into the economy, wage-price controls,

higher demand, and so on and so forth. The recession was probably

unavoidable given the background, but the background was influenced so strongly by governmental policies.

So I basically believe that the economy is really a very stable animal

except for the Government, and it is the Government that imparts a

great deal of instability to it. And that is why I would put less emphasis

on the Fed underwriting a private boom in the economy than a

Government-induced boom. The private booms are hard to find, except maybe railroads. The booms seemed to come from the Government itself, and then feeding on it.

Dr. MELTZER. We entirely agree on that. We agree that in U.S.

history, the Government is the main source of instability. We have

a lot of evidence from other countries as well that shows that the

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Government can produce inflation by financing a private boom, and

of course, they have. There are examples from the past and in the case

of Brazil at present, where the budget is in balance yet the inflation

rate has gone up to 60 or 70 percent.

Dr. PIERCE. But with the current deficit, while very large, the

great bulk of that deficit is caused from the still depressed economy

and depressed tax revenues, not from any positive Government

action on the part of expenditures or taxes. There was a tax cut, but

it was a pretty small tax cut, given the size of the economy. It had an

effect, but it certainly couldn't turn things around when you are having a $20 billion tax cut and a $1 trillion economy. It was in the right

direction, but small. The bulk of the current deficit is simply depressed

revenues. There is some fiscal stimulus right now, but not very large.

Dr. MELTZER. May I take a slightly different tact on that question

and see if it is responsive to your question?

Recently, on average, the Fed has taken about 17 to 20 percent of

the deficit and financed it. If it did that this past year, we would

have a much more rapid rate of growth in the money stock, and

Dr. Pierce and I would both agree that we would currently experience

both, more stimulus in the economy than we currently enjoy, and we

would be running into the problem of rising prices.

Now, we may differ about whether the rising prices would have occurred 2 months ago or 6 months ago or whether they will occur

6 months from now. The precise timing around the 24-month, 2-year

average, we might differ about that in the particular instance. But we

would not differ, as far as I can tell, about what the effect would be.

We would run into a problem of inflation.

We would then have to face the probleln of how we get out of that

period of rising prices, or try to prevent its full effect. We would have

to slow down the growth rate of the money stock. Slowing down the

growth rate of the money stock would almost certainly mean that we

would reduce the stimulus in the economy. That would produce a

contractionary effect 6 months or 8 months later for the same reason

that we forced a contraction in 1974 when we slowed the money growth

rate suddenly.

Dr. PIERCE. Well, perhaps Dr. Meltzer is inferring more agreement

to me than he should.

I don't think that if we had a somewhat more expansive monetary

policy that the effect on inflation would have been very large, provided that policy were cut back as we came closer to fully employed

resources. But we do have some general information that if you have

sustained, rapid money growth, you can expect some inflation eventually, and probably it doesn't take all that long. It could be a matter

of a couple of years.

That, I think, is sufficient to keep the performance of monetary

policy within relatively narrow bounds, and I would hope would lead,

for both monetary and fiscal policy, to much more stable policies.

If we could give stability to economic policies in this country, a lot of

our problems would go away. The Government is continually reacting

to the mistakes of the past and overreacting to them, and I thought

for a while we were running the danger of having explosive policies.

The errors get bigger and bigger and the responses get bigger and

bigger, and that can go on until God knows what happens.

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Mr. HANNAFORD. YOU have both indicated that Government

policy is a major, overwhelmingly the major cause of the cycles, particularly inflation.

Dr. MELTZER. Yes, sir.

Mr. HANNAFORD. YOU are not suggesting that we should not pursue,

consciously pursue fiscal policy and consciously engage in monetary

policy by a central banking system.

Before the advent of the Federal Reserve and Keynes, going back

into the 19th century, it seems to me I remember an old Cleveland

Trust chart that was around for many years in which the peaks and

valleys looked like sharks' teeth and a much worse world than we

have had since that time; is that right?

Dr. MELTZER. That's correct. We have managed to take some of the

worst fluctuations out of the economy. Despite many claims 2 years

ago to the contrary, we have managed to avoid a really severe recession in the postwar period. We've had a big recession but by no means

the kind of recessions that people experienced during the 19th century or during the earlier part of the 20th century.

Mr. HANNAFORD. And when we say Government policy is the

cause, we say that now that we can second-guess Government policy

and there is such a thing, that we can sit back and——

Dr. PIERCE. Well, I think it depends on the kind of Government

policy. There are some basic policies, deposit insurance, a central

bank as lender of last resort, a taxation system that acts as a built-in

stabilizer of the economy, and a whole host of factors that serve as a

sort of basic background for the economy. These have imparted

greater economic stability. But at the same time, the Government

has often pursued active policies which have increased instability.

And maybe the standards are wrong. Maybe the Government

should follow the tack of saying, well, we only want to pursue those

policies which won't make the situation worse, and we will guard

ourselves against making the situation worse. We might have better

policies than ones that are based on the belief we know enough in

order to fine tune, to be able to second-guess what the economy is

going to be doing 18 months from now, but without a sufficient realization of what lags. Perhaps there should be a basic background of the

Government in its expenditures and taxation in the same sense that

there is a background in terms of deposit insurance, that it doesn't

change very rapidly.

And my guess is with the tremendous stability we have in the

economy now, that it will probably perform better. We have to

avoid excesses.

Mr. NEAL. Can you all stay with us for a while? We have a vote.

Mr. HANNAFORD. Well, I do not expect to return. I will not be

back, gentlemen. Thank you very much.

Mr. NEAL. I would like to return. If you can stay with us for a

while, we will be back.

[A brief recess was taken.]

Mr. NEAL. Have you had a chance to look at our exhibit?

Dr. MELTZER. Yes; I have looked at the chart.

Mr. NEAL. DO you see any problems?

Dr. MELTZER. I think in general the relationship is correct. It is a

careful reproduction and extension of earlier work. What the chart

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shows is there is about a 2-year lag with no absolute precision or

uniformity about the timing. Each time there is a ripple in money, as

Dr. Pierce has said, it doesn't show up in price changes. However, it

is certainly true that the main movements are shown on the chart.

When the rate of monetary growth expands, on average 2 years later

we have an increase in the rate of price change, and when the rate of

monetary growth slows down, about 2 years later we have a slowdown in the rate of inflation. We are now experiencing the results of

that process. We should be careful to avoid saying, and I think the

paper accompanying the chart does, that the only thing that has

any effect on the rate of price change is the rate in the growth of the

money stock. A very large fraction of the rate of inflation is explained

by past changes in the growth of the money stock.

Mr. NEAL. One thing that would be very helpful to me would be

some brief information on the relationships between money and

deficits and inflation in foreign countries. You mentioned Brazil, and

I imagine you could talk about Argentina and maybe Chile and

Germany. It is a fascinating story and one we just don't have.

Dr. MELTZER. I will submit two recent papers—neither of them

my own—one by Michael Hamburger and Rutbert D. Reisch and

the other by Robert Lucas looking at some of the relationships between rates of inflation in other countries. There has been no systematic study of what's happened in each and every country, but I

think there is some information about foreign countries that is consistent. I will be glad to make available what I have.

Mr. NEAL. Very well. Absent any objection, I would like to have

inserted in the record at this point both papers and other related

information.

Dr. MELTZER. Fine.

[The papers submitted by Dr. Meltzer on studies of inflation abroad

by Michael J. Hamburger and Rutbert D. Reisch entitled "An

Empirical Analysis of Inflation, Unemployment and Macroeconomic

Policy in Open Economies" and by Robert E. Lucas, Jr., entitled

"Some International Evidence on Output-Inflation Tradeoffs,"

follow :1

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AN EMPIRICAL ANALYSIS OF INFLATION, UNEMPLOYMENT

AND MACROECONOMIC POLICY IN OPEN ECONOMIES

Michael J. Hamburger and Rutbert D. Reisch*

Federal Reserve Bank of New York

During 1974, there was a sharp and unanticipated upward surge in the

United States' price level. The most common reaction to this development

among popular commentators and, to some extent, professional economists was

that something was seriously wrong with traditional economic analysis, in general, and its explanation of inflation, in particular. Although the force of this

argument was substantially weakened by the economy's apparently rapid

response to the restrictive monetary policy pursued during the second half of

1974 and the early part of 1975, it seems reasonable to consider this a temporary phenomenon. Future spurts of inflation or other unexpected events are

likely to renew the call for alternative approaches to analysis and policy which

promise greater control over the economy.

This study has two principal objectives. First, we seek to determine

the extent to which existing theory can explain fluctuations in prices and output

(employment). Within the limits of this knowledge, we then attempt to evaluate

the role that traditional economic policy can play in moderating these fluctuations. Consequently, the analysis is not restricted to the American experience in 1974. Instead, we examine the explanatory power of a set of relatively

standard macroeconomic models across a number of countries and time intervals. The work drawn upon is that of Lucas (1973), Stein (1976) and Korteweg

(1975). Lucas' model treats aggregate demand as an exogenous variable and

seeks to explain the trade-off between real output and inflation, under the

assumption that suppliers possess rational price expectations. The model is

tested using data for nearly twenty open economies, but no allowance is made

for any special effects which the international sector may have on the domestic

economy.

The Stein model, which was developed to help resolve some outstanding issues in the monetarist controversy as it pertains to the U.S. economy, is

more traditional. Aggregate demand is taken to depend on domestic policy

variables and little attention is devoted either to the foreign sector or to supply

behavior. Reduced-form equations are explicitly derived to explain the rate of

price change and the unemployment rate. Korteweg's work, which is specifically

* We are grateful to M. Arak and K. Brunner for helpful comments and suggestions, and are indebted to

H. Ferster and N. Marks for excellent research assistance. The views expressed are ours alone and should

not be attributed to the Federal Reserve Bank.

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oriented to the Dutch economy, relies heavily on the Brunner-Meltzer (1974,)

(1976) analyses of open and closed economies. The reduced-form equations

he develops for aggregate production and the inflation rate are similar in spirit

to Stein's. One important difference is that Korteweg includes two variables

to measure the influence of the foreign sector.

In the analysis which follows, we first update the Lucas equations for

the United States, the United Kingdom, Germany, France, and the Netherlands.

Second, we modify the Stein model in the manner suggested by Korteweg and

estimate the resulting equations for the U.S., the U.K., Germany, and the

Netherlands. Finally, we assess these alternative approaches to the inflation/real

output trade-off and draw implications for the efficacy of macroeconomic

stabilization policy.

I. INFLATION, OUTPUT AND AGGREGATE SUPPLY

In the final analysis, real output and inflation should result from a

two-equation system describing aggregate demand and aggregate supply. We

concentrate first on the supply side only and treat aggregate demand as an exogenous variable. To describe suppliers' behavior and to explain real output, we

adopt Lucas' (1973) approach. Lucas assumes that aggregate supply depends on

the discrepancy between actual and expected prices, and on the cyclical component of last period's real output. Aggregate demand - - determined exogenously and hence a proxy for all policy variables - - is assumed to be of unitprice elasticity, which implies that the breakdown of nominal aggregate demand

into prices and real output is entirely supply-determined.

More specifically, Lucas assumes rational suppliers distributed over a

large number of competitive markets with unevenly distributed demand in which

suppliers know the price Pt(z) in market z at time t and the history of the

system, but not the current general price level P^. In each market z, supply

consists of a long-run trend component yn t common to all markets, and a

cyclical component y^ :

(1) yt(z) = yn t + yct(z) (log of real output in z at t),

with

(2) yn t = a + 0t (log of trend component of real

output);

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and the cyclical component determined by Pt(z) relative to the general price

level Pt expected on the basis of information It(z) available in z at time t, and

by its own lagged value:

(3) yc t

 = 7[Pt(z) - E(Pt/It(z)] + XyCjM(z),

where all symbols denote the logarithms of the variables.

Assuming the unknown general price level Pt is normally distributed

with mean Pt and variance a , and that Pt(z) = Pt + z where z is distributed

normally with mean 0 and variance r 2 and independently of Pt, the joint

density function is:

-l/2L<pt-Pt)

2

f(Pt, Pt(z)) = _J _ e

2iror

= f(Pt,Pt) = f(Pt|Pt) . h (Pt),

OO

with h (Pt) = / f (Pt, Pt) dPt.

-oo

Collecting terms in Pt, substituting

P*-c

oo -p2/2

and using / e dp - y/2it.,

-oo

= P.

the marginal density function can be written as:

h(Pt) =

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Dividing this into f (Pt, Pt):

(4) f(pt|pt) = * + 7

— j¥f + %+

Hence_E(Pt{ Pt»

 p t( z

»

 =

and ^

Introducing 6 == , the mean and the variance can be expressed:

V2

E^P^U) ) = (1-a) Pt(z) + 0Pt,

and

V (Pt|Pt, Pt(z)) = Bo2 .

Combining E (Pti Pt, Pt(z)), (1), and (3), and averaging over all markets z yields

the aggregate supply function:

with k = yd

Lucas' aggregate supply function, which we will use for our empirical

analysis, is only one form to describe suppliers' behavior. For instance, the

aggregate supply function could depend only on the discrepancy between actual

and expected prices (Sargent, 1973):

(6) yt

 = yn t + k(Pt - E(Pt));

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or include several lagged values of the cyclical component:

T

(7) yt = y n t + k(Pt-E(Pt)) + 2 Xi(yt 4 - y

il M

or incorporate adjustments in expected future price movements:

(8) yt = ynt

 + k [p

t-E(

p

t)-(Tr2EPt+i42 E pt+

i=l t i=l t- 1

which could be further modified by introducing a more sophisticated weighting

pattern instead of-i-. Finally, E(Pt) has to be specified. A simple formulation is

the well-known adaptive expectations model:

oo

(9) E(Pt) = 1 WiPt 4 >

i=l

which will not be pursued further here. Rather, following Lucas, we assume

rational price expectations:

(10) E(Pt) = E(Pt|history of the system, policy variables, other exogenous variables).

In this framework, suppliers know past movements of nominal aggregate demand, past shifts of real output, the trend component of real output; and assess

current nominal aggregate demand xt on the basis of:

(H)

 x t = XM + Ax t'

where Axt is the proxy for a current policy shift which by assumption follows

(12) [Axt] - dn(5,ax

2

).

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Postulating the solution,

(13) Pt = 7T0

we obtain:

(14) E(Pt) = TT0 + *i(xtml + 5) + n2

x

t-\

To complete his model, Lucas assumes an exogenously determined

demand function with unit-price elasticity:

(15) xt = yt + Pt,

where xt = log of nominal aggregate demand.

Questions may be raised regarding the applicability of this function

to an open economy. At the very least, it seems appropriate to distinguish

between domestic and foreign prices, both of which, are included in Pt. Moreover, with foreign sources of supply available, we would expect the price elasticity of the demand for domestic output to rise and, at least with respect to

domestic prices, it could exceed unity. *

Returning to the standard Lucas model, we solve the system (5),

(15), for fluctuations in real output and the inflation rate to obtain:

(16) yc t = -TrS + TrAx^Xy^.j, with TT = -Ji -

1 + k;

(17) APt = -0 + (1 - TT) Axt + *AxtA - AAyc M ,

with APt = Pt - P M .

Lucas fitted these two equations to annual observations for 18 countries for the

period 1953-1967, to test the natural unemployment rate hypothesis by comparing the results for countries with different time patterns of nominal income.

Some support for the latter contention is provided by Arak (1975), who reestimated the Lucas model

for the U.S., and found the elasticity of aggregate demand with respect to P. (the general price level) to be

greater than one.

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This was not our objective. Instead, we sought to determine whether

the model would continue to adequately explain the real output/inflation tradeoff when high and fluctuating inflation rates became more the rule than the exception, as they were during Lucas' time period. In particular, we were interested in comparing the performance of the model with the more traditional analyses which focus on the explanation of aggregate demand. Moreover, there are

the questions of what effects, if any, the general increase in inflationary tendencies had on the real output/inflation trade-off in different countries, and the

extent to which the 1974 experience can be explained from the supply side.

The regressions performed for the period 1953-1973 (Table 1) indicate that the measures of goodness of fit are generally similar to Lucas1

 except

that, whereas his equations explain real output better than prices, we find

the same explanatory power to prevail for both output and price equations.

(Following Lucas, the unadjusted R2 is used as the measure of goodness of fit

in these equations. The equations are estimated without constraints. Comparing

the coefficients of the output and price equations shows that the model performs reasonably well. While it is interesting to note that the U.S. shows the

most favorable trade-off in the concurrent period, no conclusions can be drawn

from the price equations as to how the inflationary impact is distributed over

time, since the full effect on prices must be transmitted in the concurrent and

subsequent periods on the basis of the model's specification.

To test for structural shifts, we also ran our regressions for two subperiods '-"-1953-1962 and 1963-1973 - - in order to investigate whether the

trade-off terms have changed significantly during the period 1953-1973. The

Chow test reveals that eight of the 10 equations (five" for output, five for prices)

show no significant shift between the two sub-periods. This suggests that overall

the trade-off terms have neither improved nor deteriorated during 1953-1973.

The Chow test rejects the hypothesis of no shift only for the output equations

of Germany and the Netherlands. Since such a shift in the output equations

should be accompanied by a shift in the corresponding price equation - - which is

not the case here - - this result is probably of little relevance. However, the

deterioration in the trade-off terms observed for Germany and the Netherlands

is of some interest. The reason for any given stimulatory policy to be reflected in

a significantly smaller increase in real output in the later period may be the

changing labor supply conditions between the two periods; until 1961, there was

a continuous labor inflow from East Germany as some 3 million people were

absorbed by the German economy after 1945. On the other hand, labor migration from other E.E.C. countries into Germany did not take place on any substantial scale until the late sixties. Thus, the highly elastic labor supply in the

earlier period may account for the more favorable trade-off terms during that

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period. For the Netherlands (where the Chow test is far less significant), it is

conceivable that the results simply reflect the change in Germany's labor market

conditions, since the Dutch economy is closely linked to Germany's through its

export sector.

Finally, we tested the model's ability to predict. Using the results

presented in Table 1 to predict 1974 real GNP and the inflation rates for the

U.S. and Germany shows that real GNP is overpredicted and the inflation rate

underpredicted for both countries. For the U.S., the predicted GNP was $871.3

billion (1958 prices) versus the actual $821.6 billion; for Germany, it was DM

625.8 billion (1962 prices) versus the actual DM 596.4 billion. The annual inflation rates, on the other hand, are forecast at 6.2 percent for the U.S. versus the

actual 9.7 percent, and at 4.0 percent for Germany versus the actual 6.4 percent.

The difference between the actual and predicted GNP deflators - - 3.5 percentage

points for the U.S. and 2.4 percentage points for Germany - - may be accounted

for by the foreign sector, which is not explicitly included in Lucas' model.

Specifically, the sharp boost in import prices beginning in late 1973 - - largely

because of escalating oil prices - - must have caught suppliers by surprise, and

should help to explain the divergence of predicted from actual values. Therefore, it seems more appropriate to test the models' predictive ability for 1973.

Running the regressions for the period 1953-1972, and then predicting the 1973

values, reveals that real GNP is overpredicted for the U.S., Germany, and the

Netherlands; and underpredicted for the U.K. and France (Table 2). Conversely, inflation rates are underpredicted for the U.S. and the Netherlands,

overpredicted for the U.K. and France, and forecast correctly for Germany.

The absence of significant shifts over time suggests that the underlying structure is stable and that the model reflects basic trends. Short-run

predictions, however, remain problematic since various exogenous factors not

incorporated in the model can exert a sizable impact on output and prices. For

the 1974 predictions, the oil crisis is one such factor. For 1973, the forecast

errors are smaller for countries with stable import prices (Table 2). Price controls are another exogenous factor not incorporated in the model; they also help

to explain the comparatively large 1973 forecast errors in inflation rates for the

U.S. and the U.K. Presumably, the reported U.S. inflation rate was "catching

up" in 1973 after the 1971 and 1973 price controls, thereby overstating the

"true" inflation rate. On the other hand, the U.K. imposed a total price freeze

from November, 1972, to April 1973, which was followed by somewhat relaxed

controls, hence suppressing "true" inflationary pressures. Thus, the forecast

errors in the inflation rates are consistent with the impact of price controls on

the 1973 inflation rates in both countries.

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II. AGGREGATE DEMAND

We turn next to the more traditional approach to macroeconomic

analysis, i.e., models that focus on the determination of aggregate demand.

Stein's (1976) study is used as the basis for this analysis because of its simplicity,

its completeness, and the impressive empirical results that he reports. The purpose here is to evaluate the applicability of such models to countries with different economic structures, and to compare their explanatory power to that of the

supply-oriented approach discussed above.

Included in the Stein model are: a labor market characterized by

wage and price flexibility and an endogenously determined unemployment rate;

asset markets for capital and bonds; an excess demand equation for goods; two

price-change equations; and a government budget constraint.

In summary form, the model may be expressed by the following

equations:

(18) real wage change, ^L = a + TT* - TT + h(U),

w

where ir is the rate of price change, 7r* is the currently expected

rate of price change, and h(U) is a function of the unemployment

rate,h < 0;

(19) unemployment rate, U = F(

 w Gp,

A(tj,

where A(t) is the level of productivity which grows at rate a and

Gj is the government demand for labor (per unit of capital);

(20) bond market, p = g (U, TT*, m, 0),

where p, the nominal rate of interest depends on m, real money

balances (per unit of capital), 0, the ratio of government interestbearing debt to the money supply, U and TT*;

(21) government budget constraint,G -T = [A0 + (1 + 0)/i]m,

where G - T denotes real government purchases of goods and

services minus real taxes (both per unit of capital), and /i is the

rate of monetary expansion;

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(22) Change in real money balances/capital,— M - n - TT ,

where the only new variable, n, is the growth rate of capital;

(23) price change, ir = P(U, 7r*, m, G, 0);

(24) adaptive price expectations, TT* = b(;r - 7r*).

A key element of the model is the price-change relationship (23),

which is assumed to represent the sum of two elements: a demand-pull effect

and a cost-push effect. The cost-push effect is ^ - a, the growth of the

nominal wage in excess of the rate of labor augmenting technical change. The

demand-pull effect is a function of real excess demand for goods per unit of

capital, E. Letting Xp denote a finite speed of response, this hypothesis may be

expressed:

(25) ; = ( ^ - a) + XpE(-),

where the real excess demand for goods per unit of capital is the

sum of real planned investment (I) plus real planned consumption (C) plus real government purchases (G) less output (y)

all per unit of capital; i.e. :

(26) E = C + I + G - y.

Noting that AW/W = Aw/w + TT, substituting(18) into (25), and writing E as

a function of TT*, m, G, 0, and U yields the price-change equation (23).

Solving this system, Stein obtains estimation equations for the rate of

price change (IT) and the unemployment rate (U) in terms of three independent control variables: the rate of monetary growth Qu); real government purchases of goods and services per unit of capital (G); and the ratio of government

interest-bearing debt to the money supply.

5

(27) U(t) = const. + a j U(t - 5) + a27r(t - 5) + a32/x (t - 0

1

5 5

+ a 4 2G(t - i) + a520(t - i) + j j (t).

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6

(28) (t) = const. + b1U(t-5) + b27r(t-5) + b3Z/i(t-i)

5 5

+ b42G(t - i) + b520(t - i) + j2(t),

where jj and j 2 are error terms; 8 is an arbitrary constant; and t - 5 represents

some earlier time period. Thus, conditions at time t are assumed to depend on

the state of the world at t - 8 and on the pattern of control inputs applied from

that date to the present.

The Stein model is appealing but contains a number of deficiencies.

Among the more important ones, from our point of view, are the treatment of

price expectations, and the failure to make any explicit allowance for the influence of the foreign sector on the domestic economy. There is now considerable

evidence to suggest that an autoregression on past price movements may not be

the most appropriate model of inflationary expectations. ^ A prominent alternative is to assume that economic units form their expectations rationally, i.e.,

they make some effort to learn the structural model that describes the economy

and form their expectations accordingly. Given the current level of abstraction,

it is not clear how the model's solution would be altered by the replacement of

equation (24) with a rational expectations scheme. Hence, we have assumed that

7T* may be treated as an endogenous variable, and that this is why Stein failed to

obtain significant coefficients for the variable when it was included in equations

(27) and (28) Consequently, like Stein, but for different reasons, we do not

include an explicit measure of inflationary expectations in the estimation

equations.

On the other hand, it does seem important to modify the model to

incorporate the influences on the domestic economy emanating from the foreign

sector. Here we follow Korteweg (1975), who identifies two kinds of foreign

trade impulses: those relating to variations in the foreign sector's demand for

private domestic output; and those relating to changes in the prices the home

country has to pay for its imports of goods and services (the effects of international capital flows other than those which occur as a result of changes in the

domestic monetary base on the money supply, are not considered).

The foreign sector's demand for domestic output is measured by

Korteweg's weighted volume of world trade, e - - a measure of predetermined

exports:

e = 2wfif,

2

 See, for example, Fama (1975), Rutledge (1974), Sargent (1973), and Lucas (1973).

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where if denotes the total import demand of each of the home country's trading

partners; and Wf, a weighting factor, is measured as:

wf =

H -1

the share of trading partner f s imports in the preceding period which came

from the home country. In other words, e indicates the volume of a country's

exports, assuming that the distribution of all its trading partners' imports remain

unchanged from the previous period. ^

As a measure of the influence of foreign prices on the domestic

economy, we use the index of home country import prices denominated in the

local currency. The effect of changes in import prices, arising either from variations in foreign prices per se or from changes in exchange rates, depends on the

degree of substitutability between domestic and foreign goods, and whether the

effects are transmitted through the supply or the demand side of the domestic

economy. Thus, to the extent that there are no_domestic substitutes for imported goods, a rise in the price of the latter could be contractive with respect

to domestic employment (output) and prices.

To incorporate the above discussion in the Stein model, we rewrite

the price-change equation (25):

(25) 7T = [(AW . a ) - + 7 ( p )] + ApE(U,7r*,m,G,0,e,pm),

w

where p m , the percentage change in the index of import prices, is added to both

the cost-push and demand-pull components of (25); and e, the measure of predetermined export demand, is included as an additional determinant of excess

demand. As a result of this substitution equation (23) may be replaced by

(231) ir = P(U, 7T*, m, G, 0, p m , e).

An alternative measure of the foreign sector's demand for domestic output is the volume of the home

country's exports. The problem with this measure is that, to the extent a country's exports depend on the

current value of the domestic price level relative to foreign prices, it will be at least partially endogenous.

73-959 O - 76 - 14

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Solving this extended version of the model yields the estimation equations

relevant for an economy that is open to international trade:

5

(271) U(t) = const. + 1 2 3

5 5 5

+ a42G(t - 0 + a520(t - i) + a 6 2p (t - i)

1 °\ 1

5

+ a7le(t-i) + jjCt);

5

(28) 7r(t) = const. + bjU( t - 5) + b27r(t - 5) + b^nit - i)

1

5 5 5

+ b42G(t - i) + b520(t - i

5

-h b7 2e(t-i)+j 2 (t).

To test the proposition that the extended version of the Stein model

provides a general explanation of price and employment movements, our intention was to estimate equations (271

) and (28f) for the five countries under consideration. Unfortunately, data limitations restricted this portion of the analysis

to four countries: Germany; the Netherlands, the United Kingdom and the

United States. Furthermore, the data for Germany and the Netherlands are

measured on annual average bases and hence do not permit a reproduction of

Stein's lag structure.

 4

One modification that was introduced into the estimation procedure,

even for the U.S. where data is plentiful, is to take observations on the dependent variables spaced four quarters apart rather than every quarter. This is done

to eliminate any problems that might result from seasonal variation in the data,

and to reduce the serial correlation which might be introduced into equation

In estimating his equations, Stein assumed that 5=3 . This implies that each dependent variable is a

linear function of all the dependent variables three quarters ago and a simple unweighted average of each of

the control variables over the three previous quarters. While no justification is provided for this structure

and it seems doubtful that it represents a crucial element in the specification, the model did fit the U.S.

data more closely when we approximated Stein's lag structure, as opposed to incorporating the restrictions

imposed by annual average data.

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(28') because of the way ir is measured, i.e., as the rate of price change over the

past three quarters. ^ Finally, because 6 was the least significant policy variable

in Stein's tests and because of the well-known conceptual problems associated

with measuring the public debt, d is excluded as a control variable from all tests.

With these modifications, Stein's closed-economy equations, (27) and

(28) were fitted to U.S. data for the period 1954:IV to 1970:IV. Our purpose

was to determine the combined effects of: (1) the changes in the estimation

procedure; and (2) the lengthening of the sample period (the most common

period used by Stein was 1960:IV to 1970:IV). The results shown in the center

of Tables 3 and 4 are quite similar to Stein's, reproduced in the left-hand columns of the tables. The main differences in the results are a substantial drop in

the serial correlations of the residuals and a decline in the significance of money,

(ju) in the price-change equation. However, given the similarity in the parameter

estimates, and the much smaller number of degrees of freedom in our sample as

compared to Stein's (12 versus 36), this finding may be neither very surprising

nor disturbing. (To facilitate comparison of our results with Stein's, the unadjusted R2

 is used as the measure of goodness of fit in these tables; hereafter, we

use R2.)

We next test for the influence of exports and import prices on employment and the inflation rate. The right-hand columns of Tables 3 and 4

present the parameter estimates and other results for equations (27') and (28f),

when all insignificant variables are eliminated, and the lagged value of /u is substituted for the current value. Assuming that p m and e are at least approximately exogenous, the evidence provides strong support for the proposition that

the U.S. is an open economy. Exports are highly significant with the appropriate sign in both equations. Moreover, during the sample period, 1954-1970.

increases in import prices tended to reduce aggregate output (employment), but

apparently had little impact on the domestic price level. The latter result is a

bit puzzling, but it makes it somewhat difficult to attribute the open economy

results for the U.S. to the endogeneity of the index of import prices.

The effects of changes in the domestic policy variables are also interesting. According to the right-hand columns of Tables 3 and 4, a change in the

growth rate of the money supply first affects real output and employment, and

then, prices. Such a result is consistent with the generally accepted view of how

monetary policy influences the economy, and with our earlier findings for the

Lucas model. The estimates of the effects of fiscal policy are similar to most

Another adjustment incorporated in the estimation procedure - - as much for convenience as any other

reason - - was to. allow the control variables to begin to influence the state variables in the current period.

As a result, the summations associated with each of the control variables in equations (XT) and "H')now

begin at zero instead of one. With the dependent variables measured in the fourth quarter of the year, this

permits the use of annual averages for the control variables, which may be an important simplification for

countries other than the U.S.

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other analyses of this type. They suggest that such policy operations have no

significant effect on either employment or prices.

A final test of the applicability of the Stein model to the U.S. is provided by extrapolating the price and unemployment equations through 1974.

The results shown in Tables 5 and 6 are not very impressive, but the patterns of

the errors are informative. The open-economy equation, (28*), does a good, but

not outstanding, job of tracking the inflation rate during the post-sample period.

Considering the insignificance of the import-price-coefficient during the sample

period, this may not be very surprising. As far as the unemployment rate is concerned, the closed-economy model, equation (27), provides the superior predictions. There is a sense, though, in which the open-economy results are the more

reasonable of the two. Indeed,'the major problem with the 10.3 percent unemployment rate prediction for 1974:IV could be that it occurred one quarter too

soon.

Let us now turn briefly to the results for other countries. Those for

the U.K. do not support the open-economy version of the Stein model. Although the estimates of goodness of fit for the U.K. inflation and unemployment equations are similar to those for other countries, all efforts to obtain

statistically significant parameter estimates consistent with standard macroeconomic theory proved unsuccessful. The only variable whose parameter even

approached statistical significance was AG, and it invariably had the wrong sign,

both currently and with a one-year lag, i.e., increases in government expenditures were associated with increases in the unemployment rate and a fall in

inflation. Such results cast some doubt on the general applicability of the Stein

model. However, in the case of the U.K., the problem may simply be due to

multicolinearity among the variables included in equations (27') and (28').

Turning to the Netherlands, we again draw on the work of Korteweg

(1975). In explaining Dutch inflation during the 1953-1973 period, he finds the

most important determinants to be: the lagged rate of change in the narrowmoney supply; the rate of unused industrial capacity lagged one year, Q(t - 5),

which serves the same function as the lagged unemployment rate in our specification; and a summary measure of the effects of changes in government policy

variables, such as indirect taxes, subsidies, rents, and E.E.C. and Kennedy-round

adjustment measures, pau(t - 5).

The parameter estimates for Korteweg's price-change equation (fitted

to annual averages of the variables) are shown on the left side of Table 7. The

results on the right side are those for a similar equation estimated for the period

1953-1971. This shorter time interval was used in an attempt to obtain a consistent series for the unemployment rate. Although such a series is obtainable for

this period, it appears less appropriate than the rate of unused industrial capacity

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as an indicator of the slack in the Dutch economy. Consequently, we follow

Korteweg and use Q(t - 5), rather than U(t - 5), as a lagged state variable, and

do not report the parameter estimates for the unemployment rate equation.

Two aspects of the results warrant particular attention. First, regardless of the sample period, the most important determinant of year-to-year

variations in the Dutch price level (as measured by the t-statistics) is pa u , a

policy variable specific to the Netherlands. Its omission from the 1953-1971

regression causes the coefficients of most other variables to lose statistical significance. Second, when the sample period is extended to include 1972 and 1973,

the effects of import prices and fiscal policy (AG), become difficult to assess,

i.e., the t-statistics drop below 1.20. Since these were years in which the money

supply and the price level both rose very rapidly, the problem may be that the

parameter estimates are sensitive to the movements in the variables. Even if

the apparent instability in the Dutch price-change equation can be explained in

this way, the present results, like those for the U.K., raise questions regarding

the general usefulness of the Stein model. For example, the sensitivity of the

estimates of the parameters in the Dutch price level equation to the inclusion of

pa u suggest that unless all important policy variables are included in the specification, it may be difficult to measure the effects of those that are.

German data accord the Stein model a more favorable reception. The

inflation-rate equation (fitted to annual averages of the variables for the period

1960-1973) is quite similar to its U.S. counterpart (see Table 8). According to

both equations, the principal determinants of year-to-year movements in the

price level are: the lagged unemployment rate; the growth rate of the money

supply; and the foreign sectors' demand for domestic output. Moreover, unlike

the Netherlands, the results for Germany and the U.S. reveal no significant

instability in the parameters when the sample periods are extended beyond

1971. However, there are two interesting differences in the way the price level

responds to changes in its determinants in the latter countries. First, as might

be expected, increases in foreign demand appear to be more inflationary in

Germany than in the U.S. Second, the insignificance of the lagged price-change

term in Table 8 suggests that, regardless of the stimulus, the domestic price

level responds more quickly to changes in its determinants in Germany than in

the U.S. This may also be a consequence of the greater openness of the German

economy. Whatever the reason, the similarity between this result and the

corresponding one for the Lucas model would seem to increase our confidence

in both formulations.

However, these estimates were generally consistent with the implications of the Stein model.

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III. ASSESSMENT, INTEGRATION AND POLICY IMPLICATIONS

The empirical evidence presented in the previous sections does not

lend itself to an unambiguous interpretation of the ability of existing theory - -

as represented by the Lucas and Stein models - - to explain fluctuations in prices

and output. • Tests of the Lucas model suggest considerable stability on the

supply side of the Dutch, French, German, U.K., and U.S. economies. Moreover,

with the exception of the U.K., the constraints the model imposes on the parameters are generally fulfilled. On the other hand, the model fails to explain

the extent of the 1974 price increases in all the countries included in the sample.

Considering the focus of the Lucas model - - the supply side of the domestic

economy - - and one of the important causes of the 1974 disturbance - - a sharp,

unanticipated increase in the import prices - - it is difficult to assess the seriousness of this deficiency.

The results for the Stein model, which focuses on the sources of

variation in aggregate demand, differ in some respects from those for the Lucas

formulation. Nevertheless, the overall performance of the two approaches is

similar. For Germany, the Netherlands, and the U.S., Stem-type price equations

fit the data quite closely, and the specific determinants of the price movements

are readily identifiable. The difficulties with this formulation are: (a) the

equations do not fit the U.K. data very well; and (b) for other countries, there

is considerable variation in the parameter estimates both over time and across

countries. One noteworthy element of constancy, though, is that the growth

rate of the money supply always appears as a significant determinant of the

inflation rate. Finally, the errors involved in explaining the 1974 price movements are of the same order of magnitude as those for the Lucas model.

Three properties of the results are of particular interest. First, the

overall comparability in the explanatory power of supply-and demand-oriented

models suggests that the overriding attention macroeconomics devotes to the

latter may be misplaced. The qualitative similarity in results for the various

countries examined is also an important finding, implying that the underlying

structures of these economies may have more elements in common than not.

However, the variability of the parameters in Stein's aggregate demand model is

a matter of concern. It suggests that such a model, and the theory upon which

it rests, does not provide a general explanation of year-to-year fluctuations in

prices and output. __--•• "" '

A number of hypotheses could be put forward to account for this

deficiency. The one we wish to explore holds that although simple aggregate

demand models of the Stein type can identify longer term economic trends, a

year is too short a period in which to observe such movements. Such a view

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stands in sharp contrast to current econometric practice which seeks to explain

not only annual fluctuations in economic data but quarterly movements as well.

The specific formulation we use to test our hypothesis posits that, over five-year

periods, the growth rate of the money supply is a reliable predictor of the

growth of nominal income and, for all practical purposes, this is independent of

a country's institutional structure:

(29) Yit = a + bMit + eit,

where Y- is the five-year growth in nominal income of country, i, measured

from the average annual level of Y;

Mj is the five-year growth in the narrow-money supply of country, i,

measured from end-of-year to end-of-year, so that each observation leads the corresponding one for Y by approximately one-half

year;

a and b are constant both over time and across countries ;

€| is an error term.

Data for four countries (Germany, the Netherlands, the U.K., and the U.S.) are

used to estimate a and b, with five non-overlapping observations spanning the

sample period, 1951-1975, for each country. °

The parameter estimates and other results presented in the left-hand

column of Table 9 indicate that equation (29) fits the data rather closely. However, the key results - - the t-statistics for a and b - - do not provide a powerful

test of the hypothesis that these coefficients are the same for all countries. The

other results in Table 9 address this question directly. Those in the middle

column report the estimates for equation

(29a) Yit = a + bMit + ausDus + busDusMt.

This equation is similar to (29), except that it includes the dummy variable Dus

which equals 1, when U.S. data are used in the equation, and zero otherwise.

The choice of a five-year time period is somewhat arbitrary. For the U.S., though, such a period corresponds roughly to a complete business cycle. One problem in using such a long observation period is that

it substantially reduces the sample size and hence restricts the number of independent variables that can be

considered. We focus on the money supply because it is the one variable that was consistently found to be

significant in the Stein equations.

All observations are five-year growth rates, except those for the last period, 1971-74, which are threeyear rates extrapolated to five years. It is important that the observations be non-overlapping because

otherwise we run the risk of introducing complicated serial correlation patterns among the residuals. The

data are from the International Financial Statistics (IFSH972 Supplement. The most recent figures are

drawn from later IFS issues and/or national sources.

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It is easily shown that the estimated values of aus and t>us represent the differences in the parameters for the U.S. and the average of the other countries. ^

Since the t-statistics for both of these coefficients are less than 2, we may reject

the hypothesis that the U.S. parameters taken individually are significantly

different from the average of the others. The F-statistic presented at the bottom

of the column is substantially less than its critical value at the 5 percent confidence level. This implies that we may also reject the hypothesis that the two

U.S. parameters taken together are different from their counterparts in the other

countries.

The numbers in the right-hand column of Table 9 may be used to

assess the hypothesis that the parameters for each of the other three countries

(the U.K., Germany, and the Netherlands), taken separately, are different from

those for the U.S. Once again, both the F- and the t-statistics lead us to reject

this view. Numerous other combinations of parameters could be considered and

some of them were, in fact, evaluated. In every case, though, we were unable to

reject the hypothesis that the data for all countries were drawn from the same

population.

Given the difficulties encountered with the Stein model, it is also

relevant to test our simple quantity theory model for temporal stability. Here,

equation (29) was reestimated, dropping the last observation for each country.

The parameter estimates are essentially identical to those shown in Table 9,

while the standard error of the equation increases slightly to 8 percent (1.6

percent at an annual rate).

(29') Y = 27.38 + .61M.

(7.17) (6.21),

R

2

 = .72; S.E. = 1.96; DW = 1.44

(sample period, 1951-1970).

When equation (29') is extrapolated through the last observation, 1971-74, the

following error statistics are obtained.

Put another way, the regression coefficients for the other countries are given by a and b, while those for

the U.S. equal a + aus and b + b^.

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United 'States

United Kingdom

Germany

Netherlands

Predicted

Income Growth

46.9

68.0

62.1

67.2

Actual

Growth

54.1

72.1

51.1

71.9

Difference

-7.2

-4.1

11.0

-4.7

Relative to the standard error of the equation the predictive errors are small

and offsetting. Thus, the same stable long-run relationship appears to exist

between money and income in all the countries, explaining the events of the

early 1970s as well as it does those of the 1950s and 1960s. Considering the

differences in the money-supply processes in these economies and their evolution over time, the results are impressive.

 I 0

 They suggest that, over five-year

periods, variations in the growth of money have a significant and well determined effect on the growth of income, essentially independent of the process

that determines the money stock. * *

Over periods as long as five years, we would expect, and the data tend

to confirm, that most of the effects of changes in the money supply are on

prices. It would be desirable to go further and make more precise statements

regarding the effects of monetary policy and the determinants of inflation. At

the moment, we are unable to do so. Although all the economies we considered

exhibited considerable structural stability in both the short- and the long-run, in

the course of a year (or less), numerous exogenous factors can exert a sizable

impact on output and prices, and overshadow the effects of money. Over longer

periods, though, it is clear that increases in the money supply, which exceed the

growth in real output, will result in a predictable amount of inflation. Thus, we

find that, to the extent governments (or their central banks) are able to control

the domestic money stock, they will be able, within narrow limits, to determine

a country's long-run inflation rate. Whether they choose to exercise such control is, of course, another question.

Among the reasons for these differences and the variation over time are: the position of the dollar as a

reserve currency; the development of the international payments mechanism; and the emphasis each central

bank has given to the control of interest rates and the money supply.

1 1

 The close fit of our general model, equation (29), to the U.K. data (R2 = .88) suggests that, despite the

fact that the Bank of England has not sought to actively manage the growth rate of the narrow money supply, variations in this variable have had the same important impact on economic activity in Britain as they

have in other countries. Hence, the present results are in strong opposition to the views expressed by Kaldor

(1970).

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U.S.

U.K.

Germany

France

Netherlands

1953-73

1953-73

1953-73

1953-73

1953-73

Table 1

Lucas Output Equation

yc t

n Ax

t

APt = -0 + (1-1

- .050

(-7.566)

- .012

(-1.311)

- .052

(-3.521)

- .011

(-1.074)

- .037

(-3.415)

Lucas Price

0.782

(7.993)

0.184

(1.483)

0.614

(3.842)

0.103

(1.026)

0.408

(3.726)

Equation

0.756

(9.363)

0.550

(2.804)

0.862

(8.714)

0.741

(4.520)

0.655

(4.848)

0.8824

0.3258

0.8169

0.5351

0.6571

U.S.

U.K.

Germany

France

Netherlands

1953-73

1953-73

1953-73

1953-73

1953-73

- .038

(-4.533)

- .025

(-2.110)

- .061

(-3.282)

- .054

(-4.152)

- .037

(-2.359)

0.090

(1.460)

0.513

(2.823)

0.402

(3.200)

0.886

(8.229)

0.470

(4.021)

0.971

(7.296)

0.440

(1.900)

0.662

(4.053)

0.132

(1.483)

0.403

(2.710)

- .746

(-5.798)

- .046

(- .228)

- .666

C-3.706)

- .165

(- .799)

- .284

(-1.380)

R

2

0.7894

0.6921

0.6051

0.8236

0.6707

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Table 2

1973 - Forecasts of Real GNP and Inflation Rates on

Basis of Lucas 1953-1972 Regressions

U.S. (1958-$)

U.K.(1970-t)

Germany (1962-DM)

France (1970-FF)

Netherlands (1963-NG)

Import Prices

1968

U.S. 90.6

U.K. 92.7

Germany 98.1

France 84.8

Netherlands 91.

1969

93.4

95.5

100.0

90.2

93.

Real GNP

(billions of units)

Forecast

854.9

56.1

611.6

942.9

91.2

Actual

839.2

57.0

594.0

953.6

90.1

1970= 100

1970

100.0

100.0

100.0

100.0

100.

1971

105.2

105.2

99.0

103.5

104.

Inflation Rate

(percent;

Forecast

1972

113.0

109.1

96.5

104.4

103.

4.04

9.89

5.73

7.11

7.32

1973

134.3

138.1

102.7

112.1

111.

Actual

5.45

7.28

5.70

6.95

7.60

1974

198.8

210.3

128.7

165.5

154.

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Table 3

United States Unemployment Rate Equation

(t-statistic in parentheses)

constant

U(t-5)

ir(t - 5)

AG(t - 8)

Hit-8)

Pm

e

S.E.

R

2

D-W

Stein

Quarterly'

1960:IV

3.9

.41

.12

-.005

-.33

.36

.9

.5

's Results

Observations

- 1970:IV

(5.3)

(3.9)

(1.3)

(1.3)

(8.8)

Fourth Quarter Observations, 1954: IV -

Modified

2.4

.59

.30

-.002

-.28

.69

.65

1.67

Equation (27)

(1.9)

(2.8)

(1.9)

(1.1)

(3.0)

1970:1V

Open Economy Equation (27 )

1.74

.75

.27

-.312

.145

-.022

.52

.82

2.63

(1.7)

(4.2)

(2.3)

(4.3)

(2.2)

(3.4)

to

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Table 4

United States Price Change Equation

(t-statistic in parentheses)

constant

U(t - 5)

7T(t - 5 )

AG(t-5)

M(t - 5)

Pm

e

S.E.

R

2

D-W

Steins

Quarterly

1960:1

2.4

-.37

.72

-0.000

.097

.29

.96

.9

Results

Observations

[V - 1970:IV

(4.0)

(-4.4)

(10.0)

(-0.6)

(3.3)

Fourth Quarter Observations, 1954:IV -

Modified Equation (28)

4.7

- .72

.49

-.001

.105

.62

.86

2.30

(4.0)

(-3.8)

(3.4)

(-0.6)

(1.2)

1970:IV

Open Economy Equation (28')

3.6

-.56

.46

.19*

.014

.43

.93

2.32

(3.7)

(3.7)

(4.9)

(2.5)

(2.7)

to

• In equation (281) ju(t - 5) is lagged one year.

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Table 5

U.S. Unemployment Rate Predictions

Actual Predicted Unemployment

Unemployment Modified Eqn.(27) Simplified Eqn. (27')

5.6

6.0

4.9

10.3

1971:IV

1972:IV

1973:1V

1974:1V

6.0

5.3

4.8

6.6

5.3

5.0

4.4

5.8

Table 6

U.S. Price Change Predictions

Actual Predicted Inflation

Inflation Rate Modified Eqn. (28) Simplified Eqn.(28')

1971:IV

1972:IV

1973:IV

1974: IV

3.5

3.7

7.4

12.0

3.8

2.7

3.4

5.5

4.0

3.3

4.8

7.2

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Table 7

Netherlands Price Change Equations

(t-statistics in parentheses)

Korteweg Results

1953-1973

2.79

-.43

1.29

.14

.21

.10

-.02

1.21

2.12

.81

(3.34)

(2.80)

(3.73)

(1.14)

(2.81)

(0.95)

(0.23)

New]Results

1953-1971

3.46

-.30

-.37

1.44

.24

.11

.25

.77

2.00

.87

(4.96)

(2.63)

(3.04)

(5.75)

(2.82)

(1.94)

(3.33)

constant

7T(t-5)

Q(t-5)

Pau^5)

AG(t-5)

M(t-5)

M(t-l-5)

Pm

e

S.E.

D-W

Table 8

German Price Change Equation, 1953-1973

(t-statistics in parentheses)

constant 4.31 (3.66)

U(t-5) -

4 0 3

 (5.43)

M(t-5) .32 (3.45)

e(t-5) .21 (4.06)

S.E. 1.08

R

2

 .70

D-W 2.18

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Table 9

Pooled Nominal Income Equations, 1951-1974

(United States, United Kingdom, Germany, Netherlands)

Observations are Five-Year Growth Rates*

(t-statistics in parentheses)

constant

u

CU.S.

UU.S.

CU.K.

UU.K.

CG

"G

CN

UN

S.E.

D-W

R

2

F-stat.

Crit. Value (5%)

All

Ponied

27.37

(7.85)

.62

(7.62)

7.61

1.96

.75

United States

versus

Others Pooled

31.03

(7.07)

.55

(6.01)

-14.46

(1.50)

.44

(1.18)

7.53

2.09

.76

1.19

3.63

United States

versus

Others Individually

16.57

(2.11)

1.00

(2.98)

14.17

(1.54)

-.37

(1.02)

11.57

(0.61)

-.49

(1.09)

5.67

(0.46)

-.17

(0.43)

6.89

2.79

.80

1.65

3.00

•Except for the last periods (1971-74) which are three-year rates extrapolated to

five years.

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REFERENCES

1. Arak, M., "The Trade-Off Between Inflation and Output: A Comment on

the Lucas Model," Research Paper 7515, Federal Reserve Bank of

New York, 1975.

—— ' "Monetary and Fiscal Policy in Open Interdependent

Economies with Fixed Exchange Rates," mimeo, March 1974.)

3 Brunner, K., and Meltzer, A.H., "An Aggregative Theory for a Closed Economy," in Monetarism,, (ed. J. Stein), Amsterdam: North Holland

1976.

4. Fama, E.F., "Short-Term Interest Rates as Predictors of Inflation," American Economic Review. LXV, No. 3, (June 1975), 269-282.

5. Kaldor, N., "The New Monetarism," Llovds Bank Review. No. 97, (July

1970), 1-18.

6. Korteweg, P., "Inflation, Economic Activity and the Operation of Fiscal,

Foreign and Monetary Impulses in the Netherlands - - A Preliminary

7. Lucas, R.E. Jr., "Some International Evidence on the Output-Inflation

Tradeoffs," American Economic Review. LXIIL No. 3. (June 1973),

326-334.

8. Rutledge J. A Monetarist Model of Inflationary Expectations. Lexington,

Mass.: Lexington Books, 1974.

9. Sargent, T.J., "Rational Expectations, the Real Rate of Interest, and the

Natural Rate of Unemployment," Brookings Papers on Economic

Activity, No. 2 ,Washington, D.C.: The Brookings Institution, (1973),

429-480.

10. Stein,J.L., "Inside the Monetarist Black Box" in Monetarism, (ed. J.L.

Stein), Amsterdam: North Holland, 1976.

11. Statistics Bureau of the International Monetary Fund. International Financial Statistics, Supplement, Washington, D.C., 1972.

73-959 O - 76 - 15

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Some International Evidence on

Output-Inflation Tradeoffs

By ROBERT E. LUCAS, JR.*

This paper reports the results of an

empirical study of real output-inflation

tradeoffs, based on annual time-series from

eighteen countries over the years 1951-67.

These data are examined from the point

of view of the hypothesis that average

real output levels are invariant under

changes in the time pattern of the rate of

inflation, or that there exists a "natural

rate" of real output. That is, we are concerned with the questions (i) does the

natural rate theory lead to expressions of

the output-inflation relationship which

perform satisfactorily in an econometric

sense for all, or most, of the countries in

the sample, (ii) what testable restrictions

does the theory impose on this relationship, and (iii) are these restrictions consistent with recent experience?

Since the term "natural rate theory",

refers to varied aggregation of models and

verbal developments,1 it may be helpful

to sketch the key elements of the particular

version used in this paper. The first

essential presumption is that nominal output is determined on the aggregate demand

side of the economy, with the division

into real output and the price level largely

dependent on the behavior of suppliers of

labor and goods. The second is that the

partial "rigidities" which dominate shortrun supply behavior result from suppliers'

lack of information on some of the prices

relevant to their decisions. The third

* Graduate School of Industrial Administration, Carnegie-Mellon University.

1

 The most useful, general statements are those of

Milton Friedman (1968) and Edmund Phelps. Specific

illustrative examples are provided by Donald Gordon

and Allan Hynes and Lucas (April 1972).

presumption is that inferences on these

relevant, unobserved prices are made

optimally (or "rationally") in light of the

stochastic character of the economy.

As I have argued elsewhere (1972),

theories developed along these lines will

not place testable restrictions on the coefficients of estimated Phillips curves or

other single equation expressions of the

tradeoff. They will not, for example, imply

that money wage changes are linked to

price level changes with a unit coefficient,

or that "long-run" (in the usual distributed lag sense) Phillips curves must be

vertical. They will (as we shall see below)

link supply parameters to parameters

governing the stochastic nature of demand

shifts. The fact that the implications of the

natural rate theory come in this form suggests an attempt to test it using a sample,

such as the one employed in this study, in

which a wide variety of aggregate demand

behavior is exhibited.

In the following section, a simple aggregative model will be constructed using

the elements sketched above. Results

based on this model are reported in Section II, followed by a discussion and conclusions.

I. An Economic Model

The general structure of the model developed in this section may be described

very simply. First, the aggregate pricequantity observations are viewed as intersection points of an aggregate demand and

an aggregate supply schedule. The former

is drawn up under the assumption of a

cleared money market and represents the

output-price level relationship implicit in

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the standard IS-LM diagram. It is viewed

as being shifted by the usual set of

demand-shift variables: monetary and

fiscal policies and variation in export demands. The supply schedule is drawn under the assumption of a cleared labor

market; its slope therefore reflects labor

and product market "rigidities."

The structure of this model, which is

essentially that suggested in Lucas and

Leonard Rapping (1969), will be greatly

simplified by an additional special assumption: that the aggregate demand curve is

unit elastic.2 In this case, the level of

nominal output can be treated as an

"exogenous" variable with respect to the

goods market, and the entire burden of accounting for the breakdown of nominal

income into real output and price is placed

on the aggregate supply side. In the next

subsection, A, a supply model designed to

serve this purpose is developed. In subsection B, solutions to the full (demand and

supply) model are obtained.

A. Aggregate Supply

All formulations of the natural rate

theory postulate rational agents, whose

decisions depend on relative prices only,

placed in an economic setting in which

they cannot distinguish relative from general price movements. Obviously, there is

no limit to the number of models one can

construct where agents are placed in this

situation of imperfect information; the

trick is to find tractable schemes with this

feature. One such model is developed

below.

We imagine suppliers as located in a

large number of scattered, competitive

markets. Demand for goods in each period

2

 An explicit derivation of the price-output relationship from the IS-LM framework is given by Frederic

Raines. Of course, this framework does not imply an

elasticity of unity, though it is consistent with it. Since

the unit elasticity hypothesis is primarily a matter of

convenience in the present study, I shall comment below

on the probable consequences of relaxing it.

is distributed unevenly over markets,

leading to relative as well as general price

movements. As a consequence, the situation as perceived by individual suppliers

will be quite different from the aggregate

situation as seen by an outside observer.

Accordingly, we shall attempt to keep these

two points of view separate, turning first

to the situation faced by individual suppliers.

Quantity supplied in each market will be

viewed as the product of a normal (or

secular) component common to all markets

and a cyclical component which varies

from market to market. Letting z index

markets, and using ynt and yrt to denote

the logs of these components, supply in

market z is:

(1) yt(z) =

The secular component, reflecting capital

accumulation and population change, follows the trend line:

(2) ynt = a + 0t

The cyclical component varies with perceived, relative prices and with its own

lagged value:

0 )

 v-t(2) =7[AW - E{Pt\ft(z))]

where Pt(z) is the actual price in z at t and

E(Pt\lt(z)) is the mean current, general

price level, conditioned on information

available in z at t, /t(z).3 Since ytt is a

deviation from trend, |\ | <1 .

3

 A supply function for labor which varies with the

ratio of actual to expected prices is developed and verified empirically by Lucas and Rapping (1969). The

effect of lagged on actual employment is also shown.

In our 1972 paper, in response to Albert Rees's criticism, we found that this persistence in employment

cannot be fully explained by price expectations behavior. Both these effects—an expectations and a persistence effect—will be transmitted by firms to the goods

market. In addition, they are probably augmented by

speculative behavior on the part of firms (as analyzed

for example, by Paul Taubman and Maurice Wilkinson).

For a general equilibrium model in which suppliers

behave essentially as given by (3), see my 1972 papers.

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The information available to suppliers

in z at t comes from two sources. First,

traders enter period t with knowledge of

the past course of demand shifts, of normal

supply ynt, and of past deviations yc,t-i,

yc,t-2, ... . While this information does

not permit exact inference of the log of the

current general price level, Pt, it does determine a "prior" distribution on Pt

, common to traders in all markets. We assume

that this distribution is known to be normal, with mean Pt

 (depending in a known

way on the above history) and a constant

variance a

2

.,

Second, we suppose that the actual price

deviates from the (geometric) economywide average by an amount which is distributed independently of Pt

. Specifically,

let the percentage deviation of the price in

z from the average Pt be denoted by z (so

that markets are indexed by their price

deviations from average) where z is normally distributed, independent of Pt

, with

mean zero and variance r2. Then the observed price in z, Pt(z) (in logs) is the sum

of independent, normal variates

(4) Pt(z) = Pt + 2

The information It(z) relevant for estimation of the unobserved (by suppliers in z

at t) Pt, consists then of the observed

price Pt(z) and the history summarized

in Pt.

To utilize this information, suppliers use

(4) to calculate the distribution of Pt,

conditional on Pt(z) and Pt. This distribution is (by straightforward calculation)

normal with mean:

(5)

E{l\\h{z))

= (l - d)Pt(z) + opt

where 6 = T2/(<J2+ r2), and variance 0(72.

Combining (1), (3), and (5) yields the

supply function for market z:

,A. yM = y,a + ey[pt(z) - pt]

(

6

)

Averaging over markets (integrating with

respect to the distribution of z) gives the

aggregate supply function:

(7)

yx »t + ey(Pt

 - Pt)

The slope of the aggregate supply function (7) thus varies with the fraction 6 of

total individual price variance, <T2-\-T2,

which is due to relative price variation. In

cases where r2 is relatively small, so that

individual price changes are virtually certain to reflect general price changes, the

supply curve is nearly vertical. At the

other extreme when general prices are

stable (a2 is relatively small) the slope of

the supply curve approaches the limiting

value of y.

4

B. Completion and Solution of the Model

A central assumption in the development above is that supply behavior is

based on the correct distribution of the

unobserved current price level, Pt- To

proceed, then, it is necessary to determine

what this correct distribution is, a step

which requires the completion of the

model by inclusion of an aggregate demand side.

As suggested earlier, this will be done by

postulating a demand function for goods of

the form:

(8) Pt = A-t

where xx is an exogenous shift variable—

equal to the observable log of nominal

GNP. Further, let {A#t} be a sequence of

independent, normal variates with mean 5

and variance <rx}

* This predicted relationship between a supply elasticity and the variance of a component of the price series

is analogous to the link between the income elasticity of

consumption demand and the variances of permanent

and transitory income components which Friedman

(1957) observes. As will be seen in Section II, it works

in empirical testing in much the same way as well.

5

 This particular characterization of the "shocks" to

the economy is not central to the theory, but to discuss

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The relevant history of the economy

then consists (at most) of ynt (which fixes

calendar time), the demand shifts xt,

xt-i, . . . , and past actual real outputs

3>t-i, ^t-2, ... . Since the model is linear in

logs, it is reasonable to conjecture a price

solution of the form:6

( 9 ) ^t = T0 + *1St + T2*t-l + T,at_2 +

Then Pt will be the expectation of Pt,

based on all information except xt (the

current demand level) or:

(10) +

• • • + i

. . . 4-

To solve for the unknown parameters

T,, tij and £0 we first eliminate yt between

(7) and (8), or equate quantity demanded

and supplied. Then inserting the right

sides of (9) and (10) in place of Pt and Pt,

one obtains an identity in \xt}, {yt}, and

ynt, which is then used to obtain the

parameter values. The resulting solutions

for price and output are:7

Byh

1+0 7

1

1 +

rational expectations formation at all, some explicit

stochastic description is clearly required. Independence

is used here partly for simplicity, partly because it is

empirically roughly accurate for most countries in the

sample. The effect of autocorrelation in the shocks

would, as can be easily traced out, be to add higher order

lag terms to the solutions found below.

6

 This solution method is adapted from Lucas (1972),

which is in turn based on the ideas of John Muth.

7

 If a demand function of the form yt—ZPt-\-xt had

been used, these solutions would assume the same form,

with different expressions for the coefficients. If £y^l,

however, xt is an unobserved shock, unequal in general

to observed nominal income. In this case, the model still

predicts the time-series structure (moments and lagged

moments) of the series yct and APt and is thus, in principle, testable. I have found empirical experimenting

along these lines suggestive, but the series used are

simply too short to yield results of any reliability.

07

H — #t-i —

1 +07

075

6y

1 +07 1 +07

In terms of APt and yct, and letting

ir = 6y/(l-\-dy), the solutions are:

(11) yei = - wb + irAxt + Xyc,t^

(12) APt = - |3 + (1 - 7r)Axt + irAxt-i

— XAjr,t_i

Let us review these solutions for internal

consistency. Evidently, Pt is normally distributed about Pt

. The conditional variance of Pt

 will have the constant (as

assumed) variance 1/(1+0Y)V*. Thus

those features of the behavior of prices

which were assumed "known" by suppliers

in subsection A are, in fact, true in this

economy.

To review, equations (11) and (12) are

the equilibrium values of the inflation rate

and real output (as a percentage deviation

from trend). They give the intersection

points of an aggregate demand schedule,

shifted by changes in xt, and an aggregate

supply schedule shifted by variables

(lagged prices) which determine expectations. In order to avoid the introduction of

an additional, spurious "expectations parameter," one cannot solve for this intersection on a period-by-period basis; accordingly, we have adopted a method

which yields equilibrium "paths" of prices

and output. Otherwise, the interpretation

of (11) and (12) is entirely conventional.

Not surprisingly, the solution values of

inflation and the cyclical component of

real output are indicated by (11) and (12)

to be distributed lags of current and past

changes in nominal output. A change in the

nominal expansion rate, Axt, has an immediate effect on real output, and lagged

effects which decay geometrically. The

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immediate effect on prices is one minus the

real output effect, with the remainder of

the impact coming in the succeeding period. We note in particular that this lag

pattern may well produce periods of simultaneous inflation and below average real

output. Though these periods arise because of supply shifts, the shifts result

from lagged perception of demand changes,

and not from autonomous changes in the

cost structure of suppliers.

In addition to these features, the model

does indeed assert the existence of a natural rate of output: the average rate of demand expansion, 5, appears in (11) with a

coefficient equal in magnitude to the coefficient of the current rate, and with the

opposite sign. Thus changes in the average

rate of nominal income growth will have no

effect on average real output. On the other

hand, unanticipated demand shifts do

have output effects, with magnitude given

by the parameter TT. Since this effect depends on "fooling" suppliers (in the sense

of subsection A), one expects that TT will be

larger the smaller the variance of the

demand shifts. We next develop this implication explicitly.

From the definition of w in terms of 6

and 7, and the definition of 0 in terms of

<r2 and r2 we have

r'y

V

2oT 7)

Combining with the expression for a

2

 obtained above, this gives

(13)

7)

For fixed r2 and y, then, -K takes the value

7/(1+7) at ax= 0 and tends monotonically

to zero as <J\ tends to infinity.

The prediction that the average deviation of output from trend, E(yrt), is invariant under demand policies is not, of

course, subject to test: the deviations from

a fitted trend line must average to zero.

Accordingly, we must base tests of the

natural rate hypothesis (in this context)

on (13): a relationship (between an observable variance and a slope parameter.

II. Test Results

Testing the hypothesis advanced above

involves two steps. First, within each

country (11) and (12) should perform

reasonably well. In particular, under the

presumption that demand fluctuations are

the major source of variation in APt and

Vet, the fits should be "good." The estimated values of TT and X should be between

zero and one. Finally, since (11) and (12)

involve five slope parameters but only two

theoretical ones, the estimated w and X

values obtained from fitting (11) should

work reasonably well in explaining variations in APt

.

The main object of this study, however,

is not to "explain" output and price level

movements within a given country, but

rather to see whether the terms of the

output-inflation "tradeoff" vary across

countries in the way predicted by the natural rate theory. For this purpose, we shall

utilize the theoretical relationship (13)

and the estimated values of IT and at.

Under the assumption that T2 and 7 are

relatively stable across countries, the estimated 7T values should decline as the sample variance of Axt

 increases.

Descriptive statistics for the eighteen

countries in the sample are given in Table

I.8 As is evident, there is no association

8

 The raw data on real and nominal GNP are from

Yearbook of National Accounts Statistics, where series

from many countries are collected and put on a uniform

basis. The choice of countries is by no means random:

the eighteen used are all the countries from which continuous series are available. The sample could thus be

broadened considerably by use of sources from individual countries. To obtain the variables used in the

tests, the logs of real and nominal output, yt and xt, are

logs of the series in the source. The log of the price level,

Pt, is the difference xt — >v> yr.t is the residual from the

trend line vt = a-\-bt, fit by least squares from the sample

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TABLE 1—DESCRIPTIVE STATISTICS, 1952-67

Country

Argentina

Austria

Belgium

Canada

Denmark

West Germany

Guatemala

Honduras

Ireland

Italy

Netherlands

Norway

Paraguay

Puerto Rico

Sweden

United Kingdom

United States

Venezuela

Mean

Ayt

.026

.048

.034

.043

.039

.056

.046

.044

.025

.053

.047

.038

.054

.058

.039

.028

.036

.060

Mean

A/\

.220

.038

.021

.024

.041

.026

.004

.012

.038

.032

.036

.034

.157

.024

.036

.034

.019

.016

Variance

yct

.00096

.00104

.00075

.00109

.00082

.00147

.00111

.00042

.00139

.00022

.00055

.00092

.00488

.00205

.00030

.00022

.00105

.00175

Variance

A/\

.01998

.00113

.00033

.00018

.00038

.00026

.00079

.00084

.00060

.00044

.00043

.00033

.03192

.00021

.00043

.00037

.00007

.00068

Variance

Axt

.01555

.00124

.00072

.00139

.00084

.00073

.00096

.00109

.00111

.00040

.00101

.00098

.03450

.00077

.00041

.00014

.00064

.00127

between average real growth rates and

average rates of inflation: this fact seems

to be consistent with both the conventional

and natural rate views of the tradeoff.

Since our interest is in comparing real output and price behavior under different time

patterns of nominal income, these statistics

are somewhat disappointing. Essentially

two types of nominal income behavior are

observed: the highly volatile and expansive

policies of Argentina and Paraguay, and

the relatively smooth and' moderately expansive policies of the remaining sixteen

countries. But if the sample provides only

two ''points/' they are indeed widely

separated: the estimated variance of demand in the high inflation countries is on

the order of 10 times that in the stable

price countries.

The first three columns of Table 2 summarize the performance of equation (11)

in accounting for movements in vrt. The

estimated values for T all lie between zero

and one; with the exceptions of Argentina

period. The moments given in Table 1 are maximum

likelihood estimates based on these series. The estimates

reported in Table 2 are by ordinary least squares.

and Puerto Rico, so do the estimated X

values. The R2s indicate that for many, or

perhaps most countries, important output-determining variables have been omitted from the model. The R2

s for the inflation rate equation, (12), are given in

column (4) of Table 2. In general, these

tend to be lower than for equation (11),

and not surprisingly the estimated coefficients from (12) (which are not shown)

tend to behave erratically. Column (5) of

Table 2 gives the fraction of the variance

of APt explained by (12) when the coefficient estimates from (11) are imposed.

(A " —" indicates a negative value.)9

With respect to its performance as an

intracountry model of income and price

determination, then, the system (11)-(12)

passes the formal tests of significance. On

the other hand, the goodness-of-fit statis9

 The loss of explanatory power when these coefficients are imposed on (12) can be assessed formally by

an approximate Chi-square test. By this measure, the

loss is significant at the .05 level for Paraguay only. As

Table 2 shows, however, this test is somewhat deceptive: for several countries the least squares estimates of

(12) are so poor that there is little explanatory power to

lose, and the test is "passed" vacuously.

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TABLE 2—SUMMARY STATISTICS BY COUNTRY, 1953-67

Country Rl

Argentina

Austria

Belgium

Canada

Denmark

West Germany

Guatemala

Honduras

Ireland

Italy

Netherlands

Norway

Paraguay

Puerto Rico

Sweden

United Kingdom

United States

Venezuela

.011

(.070)

.319

(.179)

.502

(.100)

.759

(.064)

.571

(.118)

.820

(.136)

.674

(.301)

.287

(.152)

.430

(.121)

.622

(.134)

.531

(.111)

.530

(.088)

.022

(.079)

.689

(-121)

.287

(.166)

.665

(.290)

.910

(.086)

.514

(.183)

-.126

(.258)

.703

(.209)

.741

(.093)

.736

(.075)

.679

(.110)

.784

(.110)

.695

(-274)

.414

(.250)

.858

(.111)

.042

(.183)

.571

(.149)

.841

(.096)

.742

(.201)

1.029

(.072)

.584

(.186)

.178

(.209)

.887

(.070)

!937

(.148)

.018

.507

.875

.936

.812

.881

.356

.274

.847

.746

.711

.893

.568

.939

.525

.394

.945

.755

.929

.518

.772

.418

.498

.130

.016

.521

.499

.934

.627

.633

.941

.419

.648

.266

.571

.425

.914

—

.661

—

.282

—

—

.358

.192

.914

.580

.427

.751

—

.405

.115

.464

—

tics are generally considerably poorer than

we have come to expect from annual timeseries models.

In contrast to these somewhat mixed results, the behavior of the estimated IT

values across countries is in striking conformity with the natural rate hypothesis.

For the sixteen stable price countries, it

ranges from .287 to .910; for the two

volatile price countries, this estimate is

smaller by a factor of 10! To illustrate this

order-of-magnitude effect more sharply,

let us examine the complete results for two

countries: the United States and Argentina. For the United States, the fitted versions of (11) and (12) are:

yct = _ .049 + (.910)A.vt + (.887)yflt_i

A/\ = - .028 + (.H9)Axt + (.758)A*t_i

The comparable results for Argentina are:

yet = - .006 + (.011)A*t - (.126)yf,t-i

APt = - .047 + (1.140)A*t - (.083)A*t-i

In a stable price country like the United

States, then, policies which increase nomiDigitized for FRASER 

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nal income tend to have a large initial

effect on real output, together with a small,

positive initial effect on the rate of inflation. Thus the apparent short-term tradeoff is favorable, as long as it remains unused. In contrast, in a volatile price

country like Argentina, nominal income

changes are associated with equal, contemporaneous price movements with no

discernible effect on real output. These

results are, of course, inconsistent with the

existence of even moderately stable Phillips

curves. On the other hand, they follow

directly from the view that inflation

stimulates real output if, and only if, it

succeeds in "fooling" suppliers of labor

and goods into thinking relative prices are

moving in their favor.

III. Concluding Remarks

The basic idea underlying the tests reported above is extremely simple, yet I am

afraid it may have become obscured by the

rather special model in which it is embodied. In this section, I shall try to restate this idea in a way which, though not

quite accurate enough to form the basis for

econometric work, conveys its essential

feature more directly.

The propositions to be compared empirically refer to the effects of aggregate demand policies which tend to move inflation rates and output (relative to trend) in

the same direction, or alternatively, unemployment and inflation in opposite

directions. The conventional Phillips curve

account of this observed co-movement says

that the terms of the tradeoff arise from

relatively stable structural features of the

economy, and are thus independent of the

nature of the aggregate demand policy

pursued. The alternative explanation of

the same observed tradeoff is that the

positive association of price changes and

output arises because suppliers misinterpret general price movements for relative

price changes. It follows from this view,

first, that changes in average inflation

rates will not increase average output, and

secondly, that the higher the variance in

average prices, the less "favorable" will be

the observed tradeoff.

The most natural cross-national comparison of these propositions would seem

to be a direct examination of the association of average inflation rates and average

output, relative to "normal" or "full employment." Unfortunately, there seems to

be no satisfactory way to measure normal

output. The deviation-from-fitted-trend

method I have used defines normal output

to be average output. The use of unemployment series suffers from the same difficulty, since one must somehow select the

(obviously positive) rate to be denoted full

employment.

Thus although the issue revolves around

the relation between means of inflation

and output rates, it cannot be resolved by

examination of sample averages. Fortunately, the existence of a stable tradeoff

also implies a relationship between variances of inflation and output rates, as

illustrated in Figure 1. With a stable

tradeoff, policies which lead to wide variation in prices must also induce comparable

variation in real output. If these sample

variances do not tend to move together

(and, as Table 1 shows, they do not) one

Var(yc,) ~ a2 Var(APt)

a Stable Price Country

O Volatile Price Ccruntry

FIGURE 1

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can only conclude that the tradeoff tends

to fade away the more frequently it is

used, or abused.

This simple argument leads to a formal

test if the output-inflation association is

entirely contemporaneous. In fact, however, it involves lagged effects which make

a direct comparison of variances, as just

suggested, difficult in short time-series.

Accordingly, it has been necessary to impose a specific, simple structure on the

data. As we have seen, this structure accounts for output and inflation rate movements only moderately well, but well

enough to capture the main phenomenon

predicted by the natural rate theory: the

higher the variance of demand, the more

unfavorable are the terms of the Phillips

tradeoff.

REFERENCES

M. Friedman, A Theory of the Consumption

Function, Princeton 1957.

, "The Role of Monetary Policy,"

Amer. Econ. Rev., Mar. 1968, 58, 1-17.

D. F. Gordon and A. Hynes, "On the Theory

of Price Dynamics," in E. S. Phelps et al.,

Micro-economics of Inflation and Employment Theory, New York 1969.

R. E. Lucas, Jr., "Expectations and the Neutrality of Money," J. Econ. Theor., Apr.

1972, 4, 103-24.

-, "Econometric Testing of the Natural

Rate Hypothesis," Conference on the Econometrics of Price Determination, Washington 1972, 50-59.

and L. A. Rapping, "Real Wages,

Employment and the Price Level," /. Polit.

Econ., Sept./Oct. 1969, 77, 721-54.

and , "Unemployment in the

Great Depression: Is There a Full Explanation?", /. Polit. Econ., Jan./Feb. 1972, 80,

186-91.

J. F. Muth, "Rational Expectations and the

Theory of Price Movements," Econometrica, July 1961, 29, 315-35.

E. S. Phelps, introductory chapter in E. S.

Phelps et al., Micro-economics of Inflation

and Employment Theory, New York 1969.

F. Raines, "Macroeconomic Demand and Supply: an Integrative Approach," Washington Univ. working paper, Apr. 1971.

A. Rees, "On Equilibrium in Labor Markets,"

/. Polit. Econ., Mar./Apr. 1970, 78, 306-10.

P. Taubman and M. Wilkinson, "User Cost,

Capital Utilization and Investment

Theory," Int. Econ. Rev., June 1970, 11,

209-15.

United Nations, Department of Economic

and Social Affairs, United Nations Statistical Office, Yearbook of National Accounts

Statistics, 66 and 68, New York 1958.

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Mr. NEAL. Dr. Pierce, I just asked Dr. Meltzer if he found any

problems with the chart. I know you've had the opportunity to see

it before. Do you have any comments?

Dr. PIERCE. Well, I guess not, really. Charts are simple things,

and they have to leave out a lot of complexity, but the relationship

is there. However, one thing that has always bothered me is that if

one shifts two charts around long enough, maybe he can make them

match up, and the question is has one really unearthed an underlying behaviorial relationship in the economy or has he simply fooled

around long enough until he has found the appropriate pairing.

I guess my instincts and experience say it is a combination of the

two. There is a great deal of empirical evidence that says that there's

a relationship between monetary policy and inflation, and that's

borne out by the chart. There's also a great deal of evidence in the

statistical literature which says that economic time series tend to

have steady patterns in their behavior, so-called serial correlation in

them, and that two series can appear to be related even though behaviorally they are not. I think there is some of that problem in

that chart.

But I would have to say that the chart dramatizes something that

is very important to dramatize. There is a relationship between

monetary policy and inflation.

All I would counsel you against doing is inferring that every time

there is an expansion in money growth, that as night follows day we

are going to have inflation 2 years from now. I don't know of any

empirical evidence that allows one to make that assertion, because

all we have is average relationships. On the average, the economy

tends to be fairly highly employed, and if the economy is fairly highly

employed and we have an expansion in monetary policy, then the

only place that that increase in demand in the economy can go is in

terms of bidding up prices. So, on average, there should be a relationship between accelerations in money growth and acceleration in

prices, with a lag, because the economy tends toward full employment.

When the economy is not fully employed, then it doesn't follow

that if we have a relatively rapid money growth for, say, two quarters,

if we wait 2 years, we will observe prices going up. I reject that proposition theoretically and I reject it empirically. The important

lesson is, though, don't keep it up.

Mr. NEAL. Well, let me ask this question. Why raise it to any

significant degree at all?

Dr. PIERCE. Well, because monetary policy has two effects. It

affects prices, indeed, but it also affects production and employment

in the economy. And if production and employment are depressed,

then monetary policy can have an effect of increasing production

and employment in the economy. And the point I would make is so

long as there is a substantial amount of idle resources, that those

resources can be brought back to work without a large impact on

inflation provided that that stimulus is not continued after the

economy becomes more fully employed.

But it is because you're trying to employ the economy. If the economy is always fully employed, then there's no reason. If we could

ever get to what economists call equilibrium, and the economy was

going along at a nice steady rate, then there's every reason to believe

that money ought to grow at a steady rate. There'd be no reason to

deviate.

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Mr. NEAL. Well, let me askDr. MELTZER. We ought to pursue that a little more.

Mr. NEAL. I do want to pursue that.

Last year was probably a pretty good example. The economy was

very poorly employed, and your recommendation might have been to

expand the money supply.

Now, it's my understanding that money growth has been adequate

recently, say, since we passed H. Con. Res. 133. Now if you increase

the money supply;, you're going to add to the pool of money available.

Dr. PIERCE. Right.

Mr. NEAL. Why would you add to the pool of money supply at

this time?

Dr. PIERCE. Well, I'm not sure that right now I would counsel a

rapid money growth. The reason I and some other people were counseling it several months ago is that the economy was badly depressed.

We made the mistake of basing our recommendations on past relationships in which it looked as though if we were going to get a 7-percent

or greater growth in real output, we were going to need a relatively

rapid growth in the money stock. Now, for once, the fates were kind

to us—to the economy, not to the people making these recommendations—and it turned out that it was possible to finance a fairly rapid

expansion without a very rapid money growth.

My reaction to that, after the fact, is fine. What I wanted to see

occur was & brisk recovery and it was accomplished. Recommendations

were made concerning correct Government policy, they turned out to

be in error. But that's one of the reasons that one looks not just at

the money stock in the short run. The economy was throwing off

information in terms of declining interest rates during the recovery

that not so much money growth was required. So it was possible to

have the expansion in the economy, declining interest rates and not

very rapid money growth. As soon as that information came in, along

with some others, then some people were led to say, well, that initial

prescription was wrong, we don't need as much money growth as we

thought.

And in trying to interpret short-run behavior of the economy, I

think it is a mistake to just look at one variable. A short-run situation

is too hard to interpret. If we're trying to interpret the sweep of history, then one can do an awful lot of simplification. One can say that

in every case we know of, if there's rapid money growth over a decade,

you'll get inflation over that decade. And so you don't have to know

a lot of the complexities. But if you're trying to give a prescription for

the next 2 months or the next two calendar quarters, then you have

to know more.

Now, there are uncertainties and there are potential errors in

short-term policymaking. Some people would say it's not worth trying

to do somewhat better by having more rapid money growth for a

while. Just stick to a steady path. And that may imply that the economy won't expand quite as rapidly as you would want, but it will

prevent errors on the other side being made of keeping the expansionary policy going too long, and I think that argument has merit.

My reaction in 1975 was that the economy was so depressed that

it was worth having a somewhat more rapid money growth for two

or three calendar quarters than a constant rate. But I certainly was

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never one of these people who said we ought to have a 15-percent

money growth for 2 years and let's see what happens. I think that

would not be good advice.

Dr. MELTZER. May I just take up some of that issue?

Mr. NEAL. Sure. But first, I want to ask one more question.

That is, at that time, wasn't there an ample pool of money in the

economy?

Dr. PIERCE. Well, I never know how to react to questions of that

sort. I don't know what "ample" means.

Mr. NEAL. Well, more money relative to the demand for it, I

would say.

Dr. PIERCE. We^> yes, it turned out that that was the case, based

in part on the evidence of declining interest rates. The only way that

the public could be made to hold increased money balances was with

declining interest rates. So it was ample in that sense.

The more general issue is, was money growth ample relative to

what one is trying to accomplish. If one is trying to accomplish deceleration in inflation rates as rapidly as possible, then it was probably

over ample. If one's trying to accomplish as rapid a recovery as possible, it wasn't ample enough. So you really can't put much meaning

on terms like "ample" until one says what he's trying to accomplish

with the given monetary policy. It appears after the fact that the

monetary policy was a fairly good one. Before the fact if someone had

said we're going to have a 3-percent growth of money during the early

stages of recovery, people would have screamed. But it turned out to

have worked. But it still wasn't the right policy to recommend ahead

of time. It just happened to work out that time.

Mr. NEAL. Yes, sir.

Dr. MELTZER. I'd like to separate out several issues that have come

up in the last few minutes. One is the question of looking at one

variable. I don't think that any serious economist argues that you

should only look at the money stock or the growth rate of money

stock for all purposes; there is capital, there's labor, there's the rate

at which people come into the labor force, there are many variables

important for judging what the near term prospect of the economy is.

What seems to me to be much more important is to think about

the problem as it occurs. As we look at the economy, there's always

room, ample room for doubt about what is going to happen. When we

look back at those charts, things seem crystal clear. That's the nature

of the problem that we face. Things are much easier to see with

hindsight than they are with foresight. In many cases our problem

is that we economists are trying to offer advice, prescriptions, that

are beyond what we can reasonably expect to deliver. That is how we

get into many of our problems. We try to do more than we reasonably

can do or know how to do.

We can improve the performance of economy. Perhaps we have

improved the performance of the economy to some extent over

the post-war period. But most of what we can do is give advice

that is useful for the average of the year or for the average of the next

2 years. That's the kind of advice that we can reasonably be expected to give. Recommendations that say, try to keep the money

supply growing at a relatively constant rate don't mean that it should

grow at 3 percent per year, hour by hour, minute by minute, but that

it ought to stay between 2 and 4 percent, a little bit faster during

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periods when the economy is slack and a little bit slower during the

period in which the economy is inflating. That is the kind of thing that

an economist can reasonably expect to do. To go back to an earlier

question of yours and I believe of Mr. Hannaford's, if we had done

that in 1965, we would not have experienced many of the problems

in the economy that we have experienced since that time. We would

not have had to devalue the dollar; we would not have had a great

many of the effects that we experienced because of the effects of

devaluation on domestic prices, particularly commodity prices and

farm prices. We might have avoided some of the worst features of the

OPEC cartel because the cartel, in part, was a response to the fact

that the real price paid for oil fell during the sixties.

Why did we not stabilize in 1964 or 1965 or 1966? The answer is

because we were too ambitious. We thought we could run the economy

and avoid the kinds of problems that we ultimately ran into. That was

a bad forecast. Many of the errors that we have made since that

time have been the result of similar bad forecasts. We are, I think,

a more chastened breed now. We ought not to make the kinds of

forecasts now that we made 10 years ago, and that some people

made last year, which called for very, very stimulative policies based

upon a model that is not capable of bearing the burden that is placed

upon it.

The best example I can offer, and I will close with that, is to look

at the error we would have made if we had followed the advice of

people who said let us have 16 percent growth rate in the money

stock in 1975 on the basis of extrapolating responses from previous

work that they had done. We would now be experiencing an inflation

rate substantially higher than the 5 to 6 percent that we are currently

experiencing and we would be faced with the problem that we were

faced with in 1973 and 1974.

Mr. NEAL. Excuse me, Dr. Meltzer, I have got to go catch this

vote. I am sorry I have to leave at this point. I really do want to thank

you both for appearing before the subcommittee.

We are going to continue these hearings, and any advice you have

for us as time goes along would certainly be appreciated.

Thank you again.

[Additional material supplied for the record by Chairman Neal

follows:]

[From U.S. News & World Report, May 17, 1976]

WHERE THE ECONOMY GOES FROM HERE

INTERVIEW WITH ARTHUR F. BURNS, CHAIRMAN OF THE FEDERAL RESERVE BOARD

Question. Dr. Burns, where does the economy of this country go from here?

Answer. If we have learned our lessons, an era of lasting prosperity is in

prospect.

Loose financial practices prevailed in our country from about 1965 through

1973 and into 1974. We first had speculation in corporate take-overs; then speculation in the stock market; later still, heavy speculation in the real-estate market

and, finally, speculation in inventories. And these speculative waves were partly

overlapping.

During this period, inflation got out of control, and a deep recession inevitably

followed. We're all, I think, a little wiser now than before. We realize that the

basic source of our inflationary problem was the tendency of the Federal Government to run large deficits, year in and year out. And we know that as a result

of this lack of financial discipline, the strength of our economy was undermined

and that a severe recession occurred.

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We now know that the business cycle is still very much with us; that fine tuning

of the economy is as yet an unattainable goal; that recessions are an ever-present

danger, and that a return to rapid inflation—if we allow that to happen—will

bring on new economic trouble, perhaps even greater trouble than we've gone

through recently. I see a mood spreading in our country to avoid this kind of

experience.

The Congress is now following new budgetary procedures. I think this is one of

the most promising developments that we've had in our country in a long while.

There also is a mood in the Congress at the present time to experiment with zerobase budgeting. That would be a very salutary step to take, and I believe it will

be taken before long.

We at the Federal Reserve are pursuing a moderate course of monetary policy.

We're firmly resolved not to permit money and credit to expand at a rate that

might release a new wave of inflation. Let there be no doubt about that.

A new mood is also spreading among private citizens. Our business people, our

bankers, even our trade-union leaders have learned a lesson. The recovery of our

economy is moving along in balanced fashion.

If we avoid the temptation to overstimulate the economy; if we realize—as

many people now do—that the current economic expansion has developed a momentum of its own; if we avoid any further governmental stimulation at this time

and prepare to apply some governmental restraint later on; if we keep all that in

mind, we may move into an era of lasting prosperity—an era that this country

deserves.

Question. How much danger is there that inflation will get out of hand again this

year or next?

Answer. I don't think there'*s much danger this year, but we'd better watch our

step next year.

Question. What do you mean?

Answer. Industrial raw-material prices have been advancing fairly briskly for

well over a year. And if you put aside erratic items such as foodstuffs and fuel,

we find that wholesale prices and consumer prices generally have been rising fairly

steadily at an annual rate of about 6 or 7 percent since the middle of last year.

Moreover, wage increases are still proceeding at a pace well above the rate of

increase in productivity. Some new collective-bargaining settlements are being

made with cost increases that average approximately 10 percent at an annual rate.

With wage costs rising and the economy continuing to advance, there is a fair

chance that price increases will multiply and we may have trouble on the inflation

front in 1977.

Question. Do federal deficits contribute to the danger of inflation?

Answer. With the economic advance gathering momentum, the Federal Government, unless it gets the budget deficit down sharply, will be adding to the inflationary danger.

What we have to do is to reduce the deficit, and we must also keep the growth

of money and credit at a moderate rate. That is the way to return to general

price stability. Unless we do that, inflationary expectations may worsen, and our

country would be headed for new and perhaps more serious trouble than we've

yet had.

Question. Do you mean another recession?

Answer. Yes. If we were to return to double-digit inflation, that recession

could be more severe than the one we've just gone through.

Question. Is there a chance that the recovery will be halted because the Federal

Reserve is restraining the availability of money and letting interest rates go up?

Answer. We're not restraining the availability of money. Pay no attention to

that kind of talk. The country is awash with liquidity.

You know, all this talk about the growth of money misses the point that what

is important about money, particularly in the short run, is the willingness to use

it—not the size of the stock of money or the rate at which the stock is growing.

Question. What's holding that back?

Answer. With confidence returning, nothing is holding back the willingness to

use money.

In fact, the turnover of existing money balances has been moving up at an

extraordinary pace. We've been able to finance a rapid economic expansion, along

with declining interest rates, with only a modest rate of growth of the money

supply. The basic reason is that confidence has returned. People are feeling better

about their future prospects and, therefore, are using their existing cash balances

more freely.

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Question. Is that true for corporations as well as individuals?

Answer. Sure. We all live in the same world.

Question. And you're afraid that a return to double-digit inflation would

destroy this confidence?

Answer. I don't think there is any doubt about that. Look at our own experience

in 1973 and 1974. Look at Great Britain and Italy today.

The three major countries that, by and large, have had the best economic

performance in the postwar period are the United States, Germany and Japan.

And the average inflation rate in these countries has been lower than in most of

the rest of the world.

Question. Many economists say the U.S. has a built-in inflation of around 5 or

6 percent a year. Do you agree with that?

Answer. I might set the figure a little higher than that—but, in any event,

the inflationary bias in our economy can and must be corrected.

Question. What should we be looking for in trying to figure out whether this

recovery will run beyond mid-1977?

Answer. We should be thinking of economic balance. The recovery thus far

has been well balanced except for a lag in business-capital investment, but there

are increasing signs that business-capital investment will experience a significant

expansion before this year is over.

We should be watching inventories. If inventories begin increasing rapidly

relative to sales, that could be a sign of trouble for the future.

We should certainly be watching the relation between costs of production and

prices. If we see the rate of inflation quickening, we should anticipate trouble a

year or two down the road.

If we see consumer credit expanding at a rate that is well above average, that

may be a sign that consumer spending particularly for durable goods, will turn

sluggish before long.

In short, we have to watch numerous indicators and try to judge whether reasonable balance is being maintained among the major economic factors.

Question. How do you as an economist decide whether any major segment of the

economy is getting out of balance?

Answer. Well, being a student of the business cycle, I've made a study of historical patterns: what the typical experience has been during previous businesscycle expansions. If the economy is deviating fairly significantly from those norms,

that gives me some clue to the future.

Question. Is there a minimum rate of inflation which is sustainable over a very

long period of time?

Answer. I doubt it. We should aim at price stability—that is, a zero rate of

inflation. If we set as our goal a rate of inflation of 2 per cent or 3 per cent a year,

as some have suggested, we will exceed that figure and get into trouble again.

Question. Is is politically possible tp put an end to inflation altogether?

Answer. I think we should strive for it.

Question. Would some form of guidelines or incomes policy be helpful in fighting

inflation?

Answer. I would not like to see a return to mandatory price and wage controls.

They rarely work well, even for a short period, and they never work well for a long

period.

I would, however, be inclined to breathe a little more life into the present

Council on Wage and Price Stability by giving it the authority to delay proposed

price and wage increases for a short period—perhaps 30 to 45 days.

I would hope that such a Council would limit its activity to price and wage

increases in key industries. It could hold public hearings, make recommendations

and follow them up to see if they're being observed. But it should not go beyond

that.

Question. Wouldn't mandatory wage-price controls be the next step?

Answer. I would consider that a very long step. We don't have to take it, I

wouldn't want to take it, and I hope we never take it.

Question. What's the real obstacle to getting rid of inflation?

Answer. I think it's mainly a political and psychological problem. The main

source of inflation is the tendency of modern governments to expand their outlays

at a rapid rate in response to incessant demands from the electorate.

Governments nowadays try to solve almost every economic and social ill by

spending money. With expenditures increasing faster than revenues, our own

Government has been persistenly paying out a great deal more to the public

than it takes in from the public by way of taxes.

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In the past 10 years, including the fiscal year that is just coming to a close, the

accumulated deficit under the unified budget comes to something like 220 billion

dollars. If you add in the off-budget outlays and the outlays of Governmentsponsored enterprises, as I think you should, the accumulated deficit comes to

about 300 billion dollars.

This has been the main cause of our inflation since the mid-60s.

Question. What happened to the idea that these massive deficits would soak up

all the available capital in the country and make it difficult for business to finance

needed investments in new plant and equipment?

Answer. That's an unfinished story.

The demand for bank credit by private enterprises diminished during the past

year. A lot of business corporations permitted their inventories to run down;

their profits, meanwhile, were improving.

Furthermore, they were able to borrow substantial sums in the capital market

and to float stock issues in large volume. So the pressure for bank loans that many

people expected did not develop.

With the economy continuing to expand and with the Federal Government

still running a huge deficit—having to borrow almost as much this calendar year

as it borrowed in 1975—there could be some "crowding out" before long. The

best way to avoid that, or to minimize this danger, is to reduce the budget deficit

sharply.

Question. Has the Federal Reserve taken steps to tighten credit?

Answer. We have modified our monetary-growth targets very slightly.

However, I have no way of knowing whether the money supply will increase

less rapidly in the months ahead than in the preceding months. What the Federal

Reserve has indicated is simply this: The recovery has now been running for a

full year. We're looking ahead to another full year of expansion, and a slight

reduction in the rate of growth of the money supply would thus be logical. Whether

that will actually occur or not is still uncertain. Our projections for the monetary

aggregates are specified as ranges. Over much of the past year, we've been well

below the lower limit of the range. It is hard to say where we will be three months

from now or a year from now.

Contrary to widespread opinion, our control over the money supply is quite

limited over short periods.

Question. We get the impression from bankers that there is plenty of money

for loans. Is that the way you see it?

Answer. I would agree with that. As I've said, this country is awash with

liquidity.

Question. When you announced a slightly lower money targets for the Federal

Reserve, you added that "further downward adjustments will be needed." Does

that mean we can look for slower monetary growth and higher interest rates later

this year?

Answer. What I had in mind is that if we're ever to regain general price stability

in our country, the rate of growth in currency and demand deposits, instead of

being in the 4*4 to 7 percent zone, will eventually have to come down to something

like 1 or 2 percent a year. That is something we should strive for, not this year

but gradually over the next few years.

Question. WTould you say the bond market found your policy statement reassuring?

Answer. Yes. They're sensible people.

They regard the Federal Reserve as a thoroughly responsible institution. They

know that we will act cautiously, and that nothing we have said or done threatens

the stability of the bond market.

Question. Does your policy imply that short-term interest rates have seen their

lows for the foreseeable future?

Answer. Not necessarily. We have merely signaled an intention to pursue a

monetary policy that will prevent any re-igniting of inflationary fires in this

country.

WHY INTEREST RATES COULD FALL

Question. Are higher interest rates to be expected as the recovery progresses?

Answer. All that I can tell you is that, historically, interest rates have moved

with the business cycle, tending to rise during periods of business-cycle expansion

and to decline during periods of business-cycle contraction.

Experience thus far in the present upswing of the economy has been unusual.

Interest rates, instead of rising, have actually come down during the past year.

73-959 0—76 16

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As for the future, I would not venture a prediction. But I would not lose sight

of the fact that history has something to teach us. Nor would I lose sight of the

fact that recent experience, which deviates from historical patterns, also has

something to teach us. Actually, I think that once people become fairly convinced

that the rate of inflation not only has come down but is going to stay down—once

this conviction spreads and grows among the people—very powerful forces making

for lower interest rates will come into being particularly in the long-term market.

Question. Are fiscal and monetary restraint all that is needed to curb inflation,

or are there other things that ought to be done?

Answer. There is also a range of structural policies that we need to follow. Far

too much attention is given to monetary and fiscal policies, while structural policies

are neglected.

Question. What kind of policies are you talking about?

Answer. The concept is very broad. Let me give you a few examples. First of all,

we need to improve productivity in our country. The trend of productivity has

flattened out, partly because people aren't working as hard as they used to.

Question. How can that be improved?

Answer. One way of improving the trend of productivity is to stimulate greater

investment in modern equipment. More modern facilities will help to enlarge the

output per man-hour.

As for getting people to work harder, there are habits that will have to be

changed. We still have featherbedding in many industries. Absenteeism has been

increasing. So have the number of holidays and the length of vacations, the

frequency of coffee breaks and their duration. These are habits that can be

changed.

"SLOW THE PACE" OF COSTLY PROGRAMS

Question. In addition to greater productivity, what other changes are needed?

Answer. Environmental and safety programs have been pushed very intensively

in the last few years, and they've been running up costs in numerous industries.

Without giving up our environmental and safety objectives, we can slow down

the pace at which we expect progress in those areas.

Next, we ought to try to increase employment and reduce unemployment by

changing some of our labor-market policies and not rely so heavily on expansionary

fiscal or monetary policies.

Question. What do you have in mind there?

Answer. One way would be to cut back on our unemployment-insurance programs.

They've become too liberal. Many people now are able to draw unemployment

insurance for a period of 65 weeks. Such a long duration tends to increase the

unemployment rate, as various studies have indicated.

Moreover the minimum wage ought to be reduced for teen-agers, many of

whom are being priced out of the labor market.

We didn't have a serious teen-age unemployment problem before the federal

minimum wage was enacted. Japan doesn't have any teen-age unemployment

problem now. In Japan, youngsters are underpaid relative to their productivity,

and therefore the demand for teen-age labor exceeds the supply. In our countrj^,

we have just the reverse.

We've also talked for years about establishing computerized job banks, so that

the labor market would be better organized and fractional unemployment could be

reduced. But we haven't done this on the scale that modern technology makes

possible.

Question. Should the Federal Government hire the unemployed?

Answer. Well, if it were to do it my way

Question. What's your plan?

Answer. You know, we've had debates for many years about what rate of

unemployment corresponds to full employment, and all kinds of numbers are

bandied about. To my mind, we as a nation should be aiming literally at a zero

rate of involuntary unemployment. To accomplish this, besides encouraging

private enterprise and investment, the Federal Government may need to serve as

the employer of last resort.

The wage paid by the Government, however, should not be so attractive as to

blunt incentives to find a job in private industry. The wage that would be appropriate for this purpose, I think, must be somewhat below the minimum wage.

I say that because we have something like 7 million people in our country who,

at the present time, are working in the private sector at a wage equal to or below

the minimum. If the Federal Government, acting as the employer of last resort,

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were to pay more than the minimum wage, there could be a large exodus of individuals from private employment into governmental work. That, I think, would

weaken private industry and burden the Government and taxpayers unduly.

Question. Does your concept envision taking many people off relief and forcing

them to take jobs?

Answer. Yes, it does. And it also calls for reducing drastically the length of

time that an individual could draw unemployment insurance. I've suggested a

period of 13 weeks.

Question. Is the country ready for that?

Answer. No, I don't think it is. Conservatives are afraid of it because they

fear that reliance upon Government would become even greater than it is at the

present time, and that budget expenditures would grow if such a responsibility

were assumed by the Federal Government. Liberals are opposed to my scheme

because they would like to have the Government pay prevailing wages, or something close to that.

However, I wouldn't be surprised if a plan such as mine received increasing

support 5 years from now or 10 years from now or 20 years from now.

The character of our society has changed. Ours is now an urban society. Very

few of us have folks back on the farm with whom we could stay and live for a

while. And family life is no longer as close, as intimate, as it once was. People

live preponderantly in cities, and many lead lonely lives.

When an economic society reaches a state such as that, the Government—in

the interest of the general welfare and in the interest also of economic and political

stability—should seriously consider undertaking the responsibility of becoming

an employer of last resort.

It should do so, however, in a manner that will respect free private enterprise

and in a manner that will not burden the federal budget.

I think if my scheme were applied, the added cost to the Government might

well be nil, because there would be large savings in welfare payments, unemployment-insurance payments and the like.

Question. Is it possible that your scheme would eventually run out of control

as Congress came under pressure to raise the wages for these Government jobs?

Answer. Yes, there is. The wage paid by the Federal Government might be

below the minimum at first, but then be increased year after year through congressional action. Congress has been known to do things like that. Conservatives

fear this, and rightly so.

To prevent such a "development," we might need a constitutional amendment

providing that, when the Government is acting as an employer of last resort,

this special wage would be linked irrevocably to the minimum wage.

ENERGY PLANS! BIG TALK, LITTLE RESULT

Question. Dr. Burns, do you think the U.S. still needs to worry about an

energy problem?

Answer. I think this country has a very serious long-range energy problem.

We've talked a great deal about energy independence, but we've done very

little about it.

As things stand now, this country is at the mercy of what a few foreign countries

may decide to do about the price of oil or about the amount of oil they are willing

to sell us. Our dependence on oil imports is growing, while our production of oil

and natural gas is declining. We are enjoying ourselves once again without

worrying about queues at the gasoline stations.

Question. Would you favor imposing quotas to hold down our imports of oil?

Answer. I wouldn't favor quotas, but I would favor building up our energy

resources. And I would favor businesslike negotiations at the financial, economic

and political level with the oil-producing countries in the Middle East and elsewhere.

I don't think we can count on being secure, militarily or economically, unless

we attend to the energy problem.

Question. How can we build up our energy resources?

Answer. I'm not an expert in this area. But we have enormous amounts of coal

available. Also, other countries in the world are making faster progress in utilizing

nuclear power than we are. And there are all kinds of sophisticated new energy

possibilities.

I think we've got to take our chances with new technology and be willing to

make some investment in it.

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Question. Should the Federal Government subsidize such development along the

lines of Vice President Nelson Rockefeller's plan, which would establish a 100-

billion-dollar federal corporation?

Answer. I would be willing to subsidize it, yes, but not on the scale suggested by

Mr. Rockefeller.

And I certainly would want to finance any subsidy through the regular budget

and avoid off-budget financing, which, I believe, was a part of the scheme originally

advocated by the Administration.

Question. Are you concerned about the impact on our trade balance of the rising

oil imports.

Answer. Fortunately, the position of the dollar is very strong at present. I

think we can reasonably count on its remaining strong for some time, but not

indefinitely.

If our imports of oil should continue to rise rapidly, as will happen if we continue

to be careless in our use of oil, that could well leave its mark eventually on the

value of the dollar in exchange markets.

Question. What, if anything, should be done to make more funds available to

industry for capital investment?

Answer. I think that changes in tax policy could be very helpful. We tax our

corporations more heavily than many countries around the world.

I would like to see the corporate income-tax rate reduced, the capital-gains

tax reduced, and double taxation of dividends diminished. Measures of this sort,

I think, would be helpful in stimulating capital investment.

Question. Should oridinary individual income taxes be reduced?

Answer. I'd like to see all kinds of taxes reduced, but we can reduce taxes

responsibily only if we reduce Government spending.

Question. Dr. Burns, are the nation's banks stronger today than they were during

the recession?

Answer. It's undoubtedly true that during the early 1970s many of our banks,

particularly the large banks, shared in the euphoria that spread through the

business community. I went to Honolulu in October, 1974, and lectured the American Bankers Association on some of the carelessness that had crept into banking

practices.

I must say that within the past year and a half, I have found no need to lecture

the bankers. They have mended their ways. We have better management in our

banks now than we've had in some years. The bankers have learned their lesson.

Banks around the country have improved their liquidity position dramatically

within the past year. Their reliance on volatile funds has diminished. Their

capital position has improved. They've put aside huge sums in the form of reserves

to cover loan losses. And in spite of that, their profits in 1975 were somewhat larger

than during 1974.

So our banking system is sound, improvements are taking place within it, and

our banks are well prepared to finance economic expansion.

Question. When you lectured the bankers, did you fear there would be failures

among the big banks?

Answer. I had some fears that, unless bankers mended their ways, some very

troublesome situations could develop. But bear this in mind:

We've had only a small number of bank failures in our country in recent years,

although two or three of these failed banks were quite large. During the 1920s

and early 1930s, by way of contrast, some 12,000 banks failed. Moreover, the few

bank failures that we've had recently have not resulted in losses to depositors.

The banks continued to do business under a new arrangement, and bank-customer

relationship were maintained.

So our banking system has been tested very severely in the course of the recent

recession—the deepest since the 1930s—and the test has been well met.

ON LOANS ABROAD, "RECORD IS GOOD"

Question. Are you worried about the loans American banks have made to

underdeveloped countries?

Answer. Thus far, losses in connection with loans made to foreign enterprises

or foreign governments have been much smaller than losses on loans made to

domestic borrowers. Some of those foreign loans are made to American enterprises

operating abroad.

As for loans to foreigners, a foreign government that has borrowed abroad and

has permitted its business firms to borrow extensively abroad has a strong stake

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in maintaining its reputation. Even when interest payments are difficult to meet,

a serious effort is made to keep payments current so that the reputation of the

country for financial integrity will not suffer.

The record so far is good. That doesn't mean it will necessarily remain good.

This is an area where I feel that our banking firms should be very cautious, since

their loans abroad have grown to very large sums.

One of the secrets of good banking is balancing your portfolio. Too large a fraction of loans made to the less developed countries—or to any single category of

borrowers—could be an invitation to trouble. This is something that our bankers

are aware of, and I think they are pursuing more prudent policies now than they

did two or three years ago, or even a year ago.

[From the Washington Post, May 13, 1976]

THE COMING PROBLEM OF INFLATION

(By Hobart Rowen)

Economic recovery has been moving along at a fast pace, and has now reached

a point where it can properly be called an expansion. Not a boom, mind you,

but a solid expansion.

No one takes greater satisfaction in the fast step-up in economic activity and

the sharp step-down in the rate of inflation than Federal Reserve Board Chairman

Arthur F. Burns.

Burns was not at all immodest in testimony before the House Banking Committee a few days ago in claiming that the Federal Reserve is entitled to a good

deal of credit. The Fed stubbornly resisted demands last year that a faster rate of

monetary growth was needed to stimulate recovery.

It is hard to argue with him. Burns and the Fed were right, and almost everybody else was wrong. Even Ford administration officials, who feared at the beginning of 1976 that money supply growth was too low, are ready to admit that

on this one Dr. Burns called the turn.

On the basis of past performance, Burns' forecast for what lies ahead deserves

close attention. He predicts, first of all, no letup "as yet" in the pace of expansion.

Financial market conditions remain favorable for a continuing upturn, he says.

Interest rates have been edging down, even for mortgage loans, which is a fillip

for the still depressed homebuilding industry.

Banks have been lowering the prime lending rate, with the First National City

Bank dropping its charge to best customers to 6.5 per cent. That's a far cry from

the peak of 12 per cent in mid-1974, and should encourage business borrowing.

Meanwhile, the Fed chairman notes, stock market prices have soared, which

not only makes everybody feel better, but makes it easier for companies to raise

funds, or build "equity cushions."

Even the banks that got overextended in the 1970's permitting "their financial

condition to deteriorate," are in better shape and have been giving "greater

attention to prudent management," Burns assures us.

Consumer confidence, evidenced by a faster pace in the sales of autos and other

goods, has improved. And there are signs of a "quickening tempo" of activity

in the sluggish capital goods industry.

It is not a perfect economic picture that the cautious Arthur Burns sketches.

The unemployment rate looks uncomfortably static at 7.5 per cent. But the general

condition of the economy is considerably better than it was just a few months

ago, and much perkier than anyone thought it would be at this stage.

Private economists agree with Burns. "So far," says economist Beryl Spinkel

of the Harris Bank and Turst Co. of Chicago, "it's a moderate recovery. The rise

is somewhat slower than the recovery from the 1957-58 downturn, and I'm glad

it is."

Otto Eckstein of Data Resources Inc., agrees with Burns that recovery is solid.

In fact, he predicts that the first quarter real GNP growth rate of 7.5 per cent

assures significant additional gains for the rest of the year, with 6.9 per cent for

1976 as a whole.

Jimmy Carter's chief economic adviser, Lawrence R. Klein of the Wharton

School, sticks to a 6.2 per cent real GNP forecast for this year, but sees a much

faster recovery in jobs, with consequent added pressure on prices.

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Thus, the big imponderable ahead may be the course of prices. No one seems

to believe that the extremely low annual inflation rate of the first quarter (around

3 per cent) can last very long.

Sensitive raw materials prices have been creeping upward. In the absence of

any meaningful government policy on wages and prices, big increases in wholesale metals prices are now working their way through the system, and will be

reflected later in consumer goods prices.

Burns decided, as a matter of insurance, to try to nudge latent inflationary

pressures down by reducing monetary growth targets a fraction. This may or

may not make an actual difference, as experience both in this country and West

Germany shows.

The way the economy is acting suggests that one bread-and-butter issue

for the Democrats in the fall may be an inflationary bubble. True, it's not going

to be a double-digit nightmare. But as the administration has made clear about

unemployment, it's not the level but the trend that counts.

[From Newsweek magazine, June 2, 1975]

CONGRESS AND THE FEDERAL RESERVE

(By Milton Friedman)

Two recent events have produced a major change in the structure of monetary

policy—perhaps the most important change since the banking acts of the mid1980s. These are a joint Congressional resolution on monetary policy and the

testimony by Federal Reserve chairman Arthur Burns in response to the resolution.

House Concurrent Resolution 133, sparked by Senators William Proxmire,

Hubert Humphrey and James Buckley, has two provisions expressing "the sense

of Congress": one, which is of minor and passing importance, that the Fed "pursue

policies in the first half of 1975 . . . appropriate to facilitating prompt economic

recovery"; the second, which is of major and potentially permanent importance,

that the Fed "maintain long-run growth of the monetary and credit aggregates

commensurate with the economy's long-run potential to increase production."

CONCURRENT RESOLUTION

The resolution has no teeth. It simply provides that the Fed "consult" Congress semiannually about its "objectives and plans" for monetary growth and

"report to the Congress the reasons" for any subsequent departure from those

objectives.

Though superficially innocuous, the resolution represents the first time since

the Fed began operation in 1914 that Congress has (1) specified monetary and

credit aggregates as the Fed's immediate target, (2) enjoined it to produce steady

monetary growth in line with output growth, (3) required it to state its objectives

publicly in advance, and (4) required it to justify publicly any departure from

them. All four elements are major changes. The Fed has shifted among alternative targets—monetary aggregates, interest rates, exchange rates; it has produced widely varying rates of monetary growth; it has never specified long-range

numerical objectives and has decided its short-term objectives in camera, making

them public only long after the event; it has reported to Congress in vague terms

that have resisted strict accountability.

Even if the Fed chooses precisely the same objectives under the new procedure

as it would have chosen under the old, the requirement that it state them publicly

in advance and justify failure to achieve them makes it far more likely that they

will be achieved. In the past few years, the Fed has erred less in the monetary

objectives it has chosen than in its unwillingness to make the changes in its

methods of operation required to achieve them.

CHAIRMAN BURNS' TESTIMONY

Burns' testimony is noteworthy for both its spirit of wholehearted cooperation

with the Congressional initiative, and its content.

Burns specified the Fed's objective for the "twelve months from March 1975

to March 1976" as an increase of 5 to 7}i percent for Mx currency plus demand

deposits).1 As he said, "this is a rather high rate of expansion by historical stand-

*For other aggregates, he listed increases of 8% to 10% per cent for MQ, 10 to 12 per

cent for Ma, and 6% to 9% per cent for the credit proxy.

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ards." I would prefer a lower rate. But it is more moderate than many critics

have been demanding, and, given both the abnormally low rates of monetary

growth in the prior six months and the severity of the recession, tolerable if not

long continued.

Chairman Burns recognized explicitly that these "rates of growth in monetary

and credit aggregates . . . could not be maintained indefinitely without running

a serious risk of releasing new inflationary pressures." In my opinion, these rates

would produce a long-run rate of inflation of some 6 or 7 percent a year and a

decidedly higher interim rate. I therefore applaud his statement that "as the

economy returns to higher rates of resource utilization, it will be necessary to

reduce the rate of monetary and credit expansion." This conclusion is entirely

consistent with the concurrent resolution's emphasis on "long-run growth . . .

commensurate with the economy's long-run potential to increase production"—

which implies roughly a 2 to 4 percent a year growth rate for M^

I have long feared that continuation of past patterns of monetary behavior

would produce an overreaction to the current recession, which would reignite

inflation by 1977 or so. On past performance, that is certainly the most likely

outcome. But these recent actions by Congress and the Fed give at least some

reason to hope that the lessons of the past have been learned and that a new

day has dawned for the Fed and for the country.

[From the Wall Street Journal, May 19, 1976]

A VOTE FOR TODAY'S SYSTEM

(By Allan H. Meltzer i)

The rate of increase of consumer prices in the United States has fallen, gradually,

from nearly 14% in mid-1974 to an average rate of about 6% for the past six

months. Some further reduction in the average rate of inflation is likely to occur

in 1976.

Experience in the rest of the world covers a wide range. Some countries substantially reduced the rate of price increase; in others the rate of increase remained high. During the year 1975, consumer prices rose by more than 20% in

Britain, by approximately 10% in France, Italy and Canada, and by 5% or less

in Germany and Switzerland.

Why are the rates of price increase in these countries so different? Why is inflation no longer proceeding at high or rising rates everywhere? Why have some

countries succeeded in reducing inflation where others have failed?

The answer to these questions is surprisingly simple. Government policies

toward inflation have differed. Some countries recognized inflation as mainly a

monetary phenomenon, the result of too much money in circulation, and took

effective action to control inflation. The countries that now have the lowest

rates of inflation—Switzerland, Germany and the United States—are the same

countries that changed their approach to monetary control. Each of the countries

has, in its own way, chosen a target rate of increase in money. Each has managed

to keep the growth rate of money close to the announced target.

Where the rate of growth of money has been reduced, the rate of inflation has

been reduced. Where monetary growth has been kept at a high rate, the rate of

inflation has remained high or has increased.

THE BRITISH EXAMPLE

Britain is an outstanding example. During the past year most countries experienced less inflation, but Britain experienced more. British consumer prices rose

by 16% in 1974 and by more than 20% in 1975. Even Italy, with its severe

political, social and economic problems, was able to slow inflation, to reduce

the rate of increase in consumer prices from 1974 to 1975. But Britain did not.

Economists differ about why inflation starts and about how inflation can be

reduced and ended. For decades influential British economists argued that it was

unnecessary to control the rate of monetary expansion. Some argued that the

way to end inflation was to stimulate the economy by government policies that

create jobs and output. By increasing output they hoped to lower prices or the

iMr. Meltzer is Maurice Falk Professor of Economics and Social Science, CarnegieMellon University. This article is adapted from a speech given before the American

Society of Newspaper Editors.

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rate of inflation. Contrary to experience everywhere they sought to end inflation

by stimulating the economy.

The result was predictable, and both the predictions and the results are part of

British history. Inflation increased. An economically weak Britain became weaker.

Programs similar to those that failed in Britain are advocated and at times

adopted here. We followed the British into stop and go policies—policies to stimulate the economy today and take care of the inflation tomorrow. We achieved

more inflation and currently have more unemployment. We followed the British

and other Europeans in attempting to control inflation by using government

intervention in wage and price disputes. Inflation did not stop. It increased.

The policies of the past year and the results they achieved are a means of

discriminating between the differing opinions about the causes of inflation and the

means of ending inflation. Some prominent economists urged rates of monetary

expansion in 1975 as high as 16%, and a rate of monetary growth of 10% in 1976.

Thejr argued that with unemployment high, strong stimulus would reduce

unemployment and reduce inflation.

If we had adopted very expansive policies we, like the British, would have

experienced rising inflation in 1975 and 1976. Instead of a falling rate of inflation,

we would now have a rising rate of inflation.

The marked difference in countries' experience with inflation during 1975 and

1976 is not a unique event. Recent experience is only a repeat of the expereince

of the late forties with a change in the roles chosen by the governments of particular countries. Then, and now, the countries that promptly reduced the rate of

monetary growth ended inflation promptly. Countries that experimented with

controls on prices and wages, with restrictions on credit or that engaged in fine

tuning of taxes and government spending continued to experience inflation.

No sustained inflation has ever been ended until the growth rate of money has

been reduced. Inflations at the end of World War II, after the Korean war, and in

other times and places were ended by controlling money. The experiences of the

past two years are in this respect consistent with the past.

Why can't we fight inflation? I will answer not only that we can, but we have.

Barring some new shock like the oil price increase, a crop failure, or a war, we can

expect the economy to approach full employment in about two years if government policies are less erratic in the future than in the past. We cannot expect,

however, to reach full employment without inflation. In this respect, as in so

many others, government promises and performance differ.

Ending inflation means bringing the average rate of price change, properly

measured, to zero. We are fighting inflation. Inflation has been reduced, but we

will not end inflation unless we change some government policies and continue

others.

I believe we can end inflation in the next few years. To do so, we must adhere

to four principles of economic policy.

REDUCE GOVERNMENT GROWTH

First, we must continue the present international monetary arrangement

known as the fluctuating exchange rate system. Under the fluctuating rate system,

we rely on the market and not on governments to determine the current exchange

value of our currency. The exchange value of the dollar fluctuates, rising with

increases in the demand for dollars and falling when we speed up the printing

press and increase the supply of dollars. The fluctuating exchange rate protects

us against inflationary (or deflationary) economic policies abroad. If foreign

governments adopt policies more inflationary than ours, and many foreign

governments have, the fluctuating dollar helps us to avoid inflation. We are

freer to pursue stable prices.

Second, we must reduce the growth of government. A high growth rate of

government transfers spending from private to public hands, and reduces efficiency. Growth of public employment transfers skilled labor from more productive

to less productive activities and slows the growth of the economy. Government

regulation absorbs skilled personnel in countless wrangles with the bureaucracy,

increases uncertainty and deters investment. But the principal effect of a growing

public sector on inflation is not from the loss of efficiency and growth. A rising

government budget creates strong pressure to finance the government by printing

money. Our current inflation began when we tried to finance war and social

programs in the middle sixties without raising taxes. Despite a 400% increase

in the federal budget, in little more than a decade, costs of social programs continue to increase and the problem of financing the budget without increasing

taxes remains a force for inflation.

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Third, we must continue to reduce the growth rate of money gradually. Between

1973 and 1976, the rate of monetary growth has been lowered from 9% to about

5%. This reduction is the most important force working to reduce present and

future inflation. During the next two or three years, the rate of monetary expansion must be brought, gradually, to about 3%. Once we fully adjust to the lower

rate of growth in money, the economy will be at full employment without inflation.

Fourth, we must avoid price and wage controls and government interference

in price and wage decisions.

Let me summarize the program. (1) Maintain fluctuating exchnage rates.

(2) Reduce the growth rate of government. (3) Gradually slow the rate of monetary growth. (4) Avoid controls.

[Whereupon, at 1:10 p.m., the subcommittee recessed subject to

the call of the Chair.]

o

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