Ben S Bernanke: Monetary aggregates and monetary policy at the Federal Reserve ¿ a historical perspective
Central bank: fed | Type: speech | Date: 2006-11-10

Ben S Bernanke: Monetary aggregates and monetary policy at the Federal
Reserve – a historical perspective
Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, at the Fourth ECB Central Banking Conference “The role of money: money and monetary
policy in the twenty-first century”, Frankfurt am Main, 10 November 2006.
* * *
My topic today is the role of monetary aggregates in economic analysis and monetary policymaking at
the Federal Reserve. I will take a historical perspective, which will set the stage for a brief discussion
of recent practice.
The Federal Reserve’s responsibility for managing the money supply was established at its founding in
1913, as the first sentence of the Federal Reserv e Act directed the nation’s new central bank "to
furnish an elastic currency." 1 However, the Federal Reserve met this mandate principally by issuing
currency as needed to damp seasonal fluctuations in interest rates, and during its early years the
Federal Reserve did not monitor the money stock or even collect monetary data in a systematic
The Federal Reserve’s first fifteen years were a peri od of relative prosperity, but the crash of 1929
ushered in a decade of global financial instability and economic depression. Subsequent scholarship,
notably the classic monetary history by Milton Friedman and Anna J. Schwartz (1963), argued that the
Federal Reserve’s failure to stabilize the money supply was an important cause of the Great
Depression. That view today commands considerable support among economists, although I note that
the sources of the Federal Reserve’s policy errors during the Depression went much deeper than a
failure to understand the role of money in the econo my or the lack of reliable monetary statistics.
Policymakers of the 1930s observed the correlates of the monetary contraction, such as deflation and
bank failures. However, they questioned not only their own capacity to reverse those developments
but also the desirability of doing so. Their hesitancy to act reflected the prevailing view that some
purging of the excesses of the 1920s, painful though it might be, was both necessary and inevitable.
In any case, the Federal Reserve began to pay more attention to money in the latter part of the 1930s.
Central to these efforts was the Harvard eco nomist Lauchlin Currie, whose 1934 treatise, The Supply
and Control of Money in the United States , was among the first to provide a practical empirical
definition of money. His definition, which incl uded currency and demand deposits, corresponded
closely to what we now call M1. Currie argued that collection of monetary data was necessary for the
Federal Reserve to control the money supply, which in turn would facilitate the stabilization of the price
level and of the economy more generally. 4 In 1934, Marriner Eccles asked Currie to join the Treasury
Department, and later that year, when Eccles was appointed to head the Federal Reserve, he took
Currie with him. Currie’s tenure at the Federal Reserve helped to spark new interest in monetary
Board of Governors of the Federal Reserve System (1998), 1-001. In his recent history of the Federal Reserve, Allan
Meltzer (2003, p. 66) notes of some of the Act’s proponents that: "[o]ne of their principal aims was to increase the seasonal
response, or elasticity, of the note issue by eliminating the provisions of the National Banking Act that tied the amount of
currency to the stock of government bonds."
See Mankiw and Miron (1986) for a discussion of the Fed’ s seasonal interest-rate smoothing. The Federal Reserve did
publish data on the issuance of Federal Reserve notes from its inception. Federal Reserve notes were only part of total
currency in circulation, however, the remainder being made up of national bank notes, United States notes, Treasury notes,
gold and silver certificates, and gold and silver coin. Beginning in 1915, the Federal Reserve Bulletin included data on
currency that had been collected by the Treasury and data on total bank deposits that had been collected by the Office of
the Comptroller of the Currency as a byproduct of its regulatory role, but publication was irregular.
Indeed, the Federal Reserve’s adherence to the real bills doctrine - which couns eled against active monetary management
in favor of supplying money only as required to meet "the ne eds of trade" - gave the new institution little reason to pay
attention to changes in the money stock. See Humphrey (1986) fo r a history of the real bills doc trine. The constraints of the
gold standard also restricted (without entirely precluding) active monetary management by the Federal Reserve.
In the second edition of his book, Currie (1935) wrote: "The ac hievement of desirable objectives … rests entirely upon the
effectiveness of control. The achievement, for example, of the obj ective of a price level varying inversely with the productive
efficiency of society demands a highly energetic central banking policy and a hi gh degree of effectiveness of monetary
control… Even for the achievement of the more modest objective of lessening business fluctuations by monetary means, the
degree of control of the central bank is of paramount importance." (pp. 3-4).
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statistics. In 1939, the Federal Reserve began a projec t to bring together the available historical data
on banking and money. This effort culminated in 1943 with the publication of Banking and Monetary
Statistics, which included annual figures on demand and time deposits from 1892 and on currency
from 1860.
Academic interest in monetary aggregates increased after World War II. Milton Friedman’s volume
Studies in the Quantity Theory of Money , which contained Phillip Cagan’s work on money and
hyperinflation, appeared in 1956, followed in 1960 by Friedman’s A Program for Monetary Stability ,
which advocated that monetary policy engineer a constant growth rate for the money stock.
Measurement efforts also flourished. In 1960, William J. Abbott of the Federal Reserve Bank of St.
Louis led a project that resulted in a revamping of the Fed’s money supply statistics, which were
subsequently published semimonthly.
5 Even in those early years, however, financial innovation posed
problems for monetary measurement, as banks intr oduced new types of accounts that blurred the
distinction between transaction deposits and ot her types of deposits. To accommodate these
innovations, alternative definitions of money were created; by 1971, the Federal Reserve published
data for five definitions of money, denoted M1 through M5.6
During the early years of monetary measurement, policymakers groped for ways to use the new data.7
However, during the 1960s and 1970s, as researchers and policymakers struggled to understand the
sharp increase in inflation, the view that nomi nal aggregates (including credit as well as monetary
aggregates) are closely linked to spending growth and inflation gained ground. In 1966, the Federal
Open Market Committee (FOMC) began to add a proviso to its policy directives that bank credit growth
should not deviate significantly fr om projections; a similar proviso about money growth was added in
1970. In 1974, the FOMC began to specify "ranges of tolerance" for the growth of M1 and for the
broader M2 monetary aggregate over the period that extended to the next meeting of the Committee.
In response to House Concurrent Resolution 133 in 1975, the Federal Reserve began to report annual
target growth ranges, 2 to 3 percentage points wide, for M1, M2, a still broader aggregate M3, and
bank credit in semiannual testimony before the Congress. In an amendment to the Federal Reserve
Act in 1977, the Congress formalized the Federal Rese rve’s reporting of monetary targets by directing
the Board to "maintain long run growth of m onetary and credit aggregates … so as to promote
effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."
In practice, however, the adoption of targets for money and credit growth was evidently not effective in
constraining policy or in reducing inflation, in part because the target was not routinely achieved.10
The closest the Federal Reserve came to a "monetarist experiment" began in October 1979, when the
FOMC under Chairman Paul Volcker adopted an oper ating procedure based on the management of
non-borrowed reserves.11 The intent was to focus policy on controlling the growth of M1 and M2 and
thereby to reduce inflation, which had been running at double-digit rates. As you know, the disinflation
Board of Governors of the Federal Reserve System (1960).
In 1971, M1 was currency and demand deposits at commercia l banks. M2 was M1 plus commercial bank savings and small
time deposits, and M3 was M2 plus deposits at mutual savi ngs banks, savings and loans, and credit unions; data from the
latter type of institution were available only monthly. M4 was M2 plus large time deposits, and M5 was M3 plus large time
deposits. Changes in definitions make it difficult to track the historical development of t he various monetary aggregates.
Approximately, the 2006 definition of M1 is equivalent to this older definition, the 2006 definition of M2 is equivalent to the
older definition of M3, and the definition of M3 at its date of la st publication was equivalent to the older definition of M5. M4
and M5 were dropped in a 1980 redefinition of the monetary aggregates. See Board of Governors of the Federal Reserve
System (1976), pp. 10-11 and Anderson and Kavajecz (1994).
For instance, in late 1959 and early 1960, money growth dec lined as other economic indicato rs rose. The minutes of the
December 1959 FOMC meeting report Chairman Martin as saying, "I am unable to make heads or tails of the money
supply," but those of the February 1960 meeting record his comm ent that "the System ought to be looking at the growth of
the money supply." For further discussion, see Bremner (2004), pp. 141-142.
M2 now includes currency and demand deposits (the componen ts of M1) plus time deposits, savings deposits, and non-
institutional money market funds.
Board of Governors of the Federal Reserve System (1998), 1-017
Monetarists criticized the use of multip le targets, rather than a single objective. Another object of criticism was "base drift," a
set of practices that had the effect of re-setting the base from which money growth targets were calculated when the growth
of one or more monetary aggregates exceeded the upper end of the Federal Reserve’s target range.
Whether the Federal Reserve’s policies under Chairman Vol cker were "truly" monetarist was a much-debated question at
2 BIS Review 110/2006
effort was successful and ushered in the low-inflation regime that the United States has enjoyed since.
However, the Federal Reserve discontinued the pr ocedure based on non-borrowed reserves in 1982.
It would be fair to say that monetary and credit aggregates have not played a central role in the
formulation of U.S. monetary policy since that time, although policymakers continue to use monetary
data as a source of information about the state of the economy.
Why have monetary aggregates not been more influent ial in U.S. monetary policymaking, despite the
strong theoretical presumption that money growth should be linked to growth in nominal aggregates
and to inflation? In practice, the difficulty has been that, in the United States, deregulation, financial
innovation, and other factors have led to recurrent instability in the relationships between various
monetary aggregates and other nominal variables. For example, in the mid-1970s, just when the
FOMC began to specify money growth targets, econometric estimates of M1 money demand
relationships began to break down, predicting faster money growth than was actually observed. This
breakdown - dubbed "the case of the missing money" by Princeton economist Stephen Goldfeld
(1976) - significantly complicated the selection of appropriate targets for money growth. Similar
problems arose in the early 1980s - the period of the Volcker experiment - when the introduction of
new types of bank accounts again made M1 money demand difficult to predict.
12 Attempts to find
stable relationships between M1 growth and growth in other nominal quantities were unsuccessful,
and formal growth rate targets for M1 were discontinued in 1987.
Problems with the narrow monetary aggregate M1 in the 1970s and 1980s led to increased interest at
the Federal Reserve in the 1980s in broader aggregates such as M2. Econometric methods were also
refined to improve estimation and to accommodate more-complex dynamics in money demand
equations. For example, at a 1988 conference at th e Federal Reserve Board, George Moore, Richard
Porter, and David Small presented a new set of M2 money demand models based on an "error-
correction" specification, which allowed for transitory deviations from stable long-run relationships
(Moore, Porter, and Small, 1990). One of these models, known as the "conference aggregate" model,
remains in use at the Board today. About the sa me time, Board staff developed the so-called
P* (P-star) model, based on M2, which used the quantity theory of money and estimates of long-run
potential output and velocity (the ratio of nominal income to money) to predict long-run inflation trends.
The P* model received considerable attention both within and outside the System; indeed, a
description of the model was featured in a front-page article in the New York Times.13
Unfortunately, over the years th e stability of the economic relationships based on the M2 monetary
aggregate has also come into question. One such episode occurred in the early 1990s, when M2 grew
much more slowly than the models predicted. Indeed, the discrepancy between actual and predicted
money growth was sufficiently large that the P* model, if not subjected to judgmental adjustments,
would have predicted deflation for 1991 and 1992. Experiences like this one led the FOMC to
discontinue setting target ranges for M2 and othe r aggregates after the statutory requirement for
reporting such ranges lapsed in 2000.
As I have already suggested, the r apid pace of financial innovation in the United States has been an
important reason for the instability of the relationships between monetary aggregates and other
macroeconomic variables. 14 In response to regulatory changes and technological progress, U.S.
banks have created new kinds of ac counts and added features to existing accounts. More broadly,
payments technologies and practices have change d substantially over the past few decades, and
innovations (such as Internet banking) continue. As a result, patterns of usage of different types of
transactions accounts have at times shifted rapidly and unpredictably.
Various special factors have also contributed to the observed instability. For example, between one-
half and two-thirds of U.S. curr ency is held abroad. As a consequen ce, cross-border currency flows,
which can be estimated only imprecisely, may l ead to sharp changes in currency outstanding and in
the monetary base that are largely unrelated to domestic conditions.15,16
The new accounts included negotiable-order-of-withdraw al (NOW) accounts and money market deposit accounts.
Hallman, Porter, and Small (1991) and Kilborn (1989).
Another possible explanation for this instability is the Goodhar t-Lucas law, which says that any empirical relationship that is
exploited for policy purposes will tend to break down. This la w probably has less applicability in the United States than in
some other countries, as the Federal Rese rve has not systematically exploited t he relationships of money to output or
inflation, except perhaps to a degree in 1979-82.
For a recent summary, see U.S. Department of the Treasury (2006).
BIS Review 110/2006 3
The Board staff continues to devote considerable effort to modeling and forecasting velocity and
money demand. The standard model of money demand, which relates money held to measures of
income and opportunity cost, has been extended to include alternative measures of money and its
determinants, to accommodate special factors and structural breaks, and to allow for complex dynamic
behavior of the money stock. 17 Forecasts of money growth are ba sed on expert judgment with input
from various estimated models and with knowledge of special factors that are expected to be relevant.
Unfortunately, forecast errors for money growth are often significant, and the empirical relationship
between money growth and variables such as inflation and nominal output growth has continued to be
unstable at times.18
Despite these difficulties, the Federal Reserve will continue to monitor and analyze the behavior of
money. Although a heavy reliance on monetary aggregates as a guide to policy would seem to be
unwise in the U.S. context, money growth may still contain important information about future
economic developments. Attention to money growth is thus sensible as part of the eclectic modeling
and forecasting framework used by the U.S. central bank.
References
Anderson, Richard G. and Kenneth A. Kavajecz (1994). " A Historical Perspective on the Federal
Reserve’s Monetary Aggregates: Definition, Co nstruction and Targeting (PDF 7.4 MB) ," Federal
Reserve Bank of St. Louis Review, March/April, pp. 1-31.
Board of Governors of the Fe deral Reserve System (1943). Banking and Monetary Statistics,
1914-1941. Washington: Board of Governors of the Federal Reserve System.
- - - - - (1960). "A New Measure of the Money Supply," Federal Reserve Bulletin, vol. 46 (October),
pp.. 102-23.
- - - - - (1976). Banking and Monetary Statistics, 1941-1970. Washington: Board of Governors of
the Federal Reserve System.
- - - - - - (1998). Federal Reserve Act and Other Statutory Provisions Affecting the Federal Reserve
System. Washington: Board of Governors of the Federal Reserve System.
Bremner, Robert P. (2004). Chairman of the Fed: William McChesne y Martin Jr. and the Creation of
the American Financial System. New Haven: Yale University Press.
Carpenter, Seth and Joe Lange (2003). "Money Demand and Equity Markets." Federal Reserve Board
Finance and Economics Discussion Series, 2003-3. Washington: Board of Governors of the Federal
Reserve System, February.
Currie, Lauchlin (1935). The Supply and Control of Money in the United States, 2nd ed. Cambridge:
Harvard University Press.
- - - - - -, ed. (1956). Studies in the Quantity Theory of Money. Chicago: University of Chicago
Friedman, Milton (1960). A Program for Monetary Stability. New York: Fordham University Press.
Friedman, Milton and Anna J. Schwartz. (1963). A Monetary History of t he United States, 1867-1960.
Princeton: Princeton University Press.
As another example, U.S. regulations require servicers of mortgage-backed securities to hold mortgage prepayments in
deposits counted as part of M2 before dis bursing the funds to investors. A wave of mortgage refinancing and the resulting
prepayments can thus have significant effects on M2 growth t hat are only weakly related to overall economic activity. See
O’Brien (2005) for more discussion.
See Judson and Carpenter (2006) for a summary. A special factor that helps to explain so me episodes of variable money
demand is stock market volatility (Carpenter and Lange, 2003).
A recent example of instability occurred in the fourth quarte r of 2003, when M2 shrank at the most rapid rate since the
beginning of modern data collection in 1959 without any evident effects on prices or nominal spending. Subsequent analysis
has explained part of the decline in M2 (t he transfer of liquid funds into a recove ring stock market was one possible cause),
and data revisions have eliminated an additional portion of the decline, but much of the drop remains unexplained even well
after the fact.
4 BIS Review 110/2006
Goldfeld, Stephen M. (1976). " The Case of the Missing Money ." Brookings Papers on Economic
Activity, 3:1976, pp. 683-739.
Hallman, Jeffrey J., Richard D. Porter and David H. Small (1991). "Is the Price Level Tied to the M2
Monetary Aggregate in the Long Run?" American Economic Review, 81(September), pp. 841-858.
Humphrey, Thomas M. (1986). " The Real Bills Doct rine (PDF 1.2 MB) ," in Thomas M. Humphrey,
Essays on Inflation. Richmond: Federal Reserve Bank of Richmond.
Judson, Ruth and Seth Carpenter (2006). "Modeling Demand for M2: A Practical Approach,"
unpublished manuscript, Board of Governors of th e Federal Reserve System, Division of Monetary
Affairs, October.
Kilborn, Peter T. (1989). "Can Inflation Be Predicted? Federal Reserve Sees a Way," New York Times,
Mankiw, N. Gregory and Jeffrey A. Miron (1986). " The Changing Behavior of the Term Structure of
Interest Rates," Quarterly Journal of Economics, 101(2), pp. 211-228.
Meltzer, Allan H. (2003). A History of the Federal Reserve. Volume 1: 1913-1951. Chicago: University
of Chicago Press.
Moore, George R., Richard D. Porter, and Davi d H. Small (1990). "Modeling the Disaggregated
Demands for M2 and M1: The U.S. Experience in the 1980s," in Peter Hooper et. al., eds., Financial
Sectors in Open Economies: Empirical Analysis and Policy Issues. Washington: Board of Governors of
the Federal Reserve System, pp. 21-105.
O’Brien, Yueh-Yun C. (2005). "The Effects of Mortgage Prepayments on M2 ." Federal Reserve Board
Finance and Economics Discussion Series, 2005-43.
U.S. Department of the Treasury (2006). The Use and Counterfeiting of United States Currency
Abroad, Part 3 (PDF 601 KB). Washington: Department of the Treasury.
BIS Review 110/2006 5