THE SUCCESS OF THE FED AND THE DEATH OF MONETARISM

I. INTRODUCTION There has been a significant reduction in the macroeonomic volatility in the U.S. economy during the last 20 yrs. The standard deviation of the central bank's target variables like inflation and nominal gross domestic product (GDP) declined substantially; however, at the same time, the standard deviation of monetary aggregates has increased. (1) This unique macroeconomic phenomenon is also associated with the disappearance of correlation between inflation and money growth. This is in contrast to the monetarist argument that suggests that an important cause of economic instability is excess variation in the growth rate of money. The most famous monetarist prescription for monetary policy is Milton Friedman's proposal that the growth rate of money should be constant. There is, however, no evidence of falling variations in the growth rate of money over the last 20 yrs. In fact, the standard deviation of the rate of growth of monetary base has increased from 1.63% during 1960-1982 to 3.1% during 1983-2003. Milton Friedman, in an interview with Taylor (2001), pointed out that there was a breakdown in the relationship between money and GDP after 1980, which came along with a dramatic reduction in the variability of growth rate of GDP. Friedman says, "I am puzzled about is whether, and if so how, they suddenly learned how to regulate the economy. Does Alan Greenspan have an insight into the movements in the economy and other shocks that the people don't have?" Friedman further says, "It looks as if somehow in 1991-1992 they were able to install a good thermostat instead of a bad one. Is Alan Greenspan a good thermostat compared to other Fed chairmen?" (Taylor 2001). There is widespread consensus on the effect of monetary policy on inflation in the long run. However, there is no consensus on how monetary policy affects real output in the short run. There is now a consensus among economists that the original monetarist proposition that there is no long-run trade-off between inflation and unemployment is correct. Monetarism can also be viewed as the platform from which the rational expectation revolution took off. However, the monetarist proposition that economic fluctuation is caused by excessively variable monetary growth has largely been abandoned. Authors like Estrella and Mishkin (1997) and Feldstein and Stock (1994) find that monetary aggregates do not have a significant informational content after 1979 and, hence, cannot be used as an information variable for the stance of monetary policy. Their finding is also consistent with Dwyer (2002) and Dwyer and Hafer (1999), who find that there is little correlation of inflation and money growth across countries on quarterly and annual bases after 1979. The literature finds significant correlation (e.g., Lucas 1980) between money growth and inflation in the pre-1979 period, but this correlation has disappeared after 1979. (See Table 1 and Figures 1-4). If stabilization policy makes inflation a constant, then there will be no correlation between inflation and policy as no variable is correlated with a constant. According to Kochin (1973), if the monetary authority is able to stabilize the economy by optimally setting the variability of the control variables (e.g., monetary aggregates and interest rate), then there will be no correlation between the goal variable (e.g., inflation and nominal GDP) and the control variable even if the policy is not perfect. If the policy is too variable and even if it is well timed, then a countercyclical policy adopted by the central bank might lead to greater variability in the goal variable, as argued by Friedman (1953). Poole (1993, 1994) and Tanner (1993) also argue that one predictable consequence of optimal monetary policy is that the correlation between monetary policy instruments and policy goals will be driven to zero. Poole further contends that it is obvious to any careful reader of Theil (1964) that optimally variable policy will give rise to a zero correlation between policy and goal variable. …