T '-2c' --ral use-,e Bank of Cleveland

nnd-ALL - 1 i-_ L

by William T. Gavin

the 1900s, monetary systems were basedon commodity standards, usually met-als. There have been paper money sys-tems in the past (the first recordedinstance of state-issued paper money oc-curred in China in the ninth century),but they always degenerated with highinflation and consequently disappeared.2While metallic standards were oftensuspended during wars and nationalemergencies, they were usually rein-stated soon after the emergency ended.

The United States adopted a modi-fied gold standard in the Bretton WoodsAgreement after World War II. The dol-lar remained tied to gold until the late1960s or early 1970s. Officially, the dol-lar was freed from gold when PresidentNixon suspended convertibility forother central banks on August 15, 1971.But, effectively, the dollar had alreadybeen freed from a gold constraint in1-%38 when Congress removed the "gold

I. One notable exception was the late Michael j.Hamburger (Wall Street Journal, July 8, 1986, p.30) who argued that his money-demand equation,specified two decades ago, continued to explainthe relationship between M1 and nominal GNP.Note, however, that he implicitly recommended a

cover" linking currency issue to thegovernment's gold stock.

The problem for the Federal Reserve,both then and now, is how to maintainprice stability in a monetary systemwith unbacked paper money; no societyhas ever succeeded in doing so. Con-trary to the suggestions offered in text-oooks and treatises by monetary re-formers, experience shows that it is noeasy matter to stabilize the price levelwith a paper money system.

The monetarist solution to this prob-lem is to protect the value of money bylimiting its quantity. The intellectualfoundation for this solution is theQuantity Theory of Money. As refor-mulated by Milton Friedman (Studiesin the Quantity Theory of Money, 1956),it is essentially a theory of moneydemand, that is, a theory about whypeople want to hold money balances.3

The most important factor determin-ing the demand for Ml is the level oftransactions. It is common practice touse nominal GNP as an approximatemeasure of transactions because aggre-gate transactions data are not available.Over a relatively short period (say threemonths to a year), quantity theoristsexpect the demand for money to rise orfall in a predictable fashion with a riseor fall in GNP. The ratio of nominalGNP to the amount of money is termedthe velocity of money, in reference tothe turnover per year, or the velocity ofcirculation, of money.

Of course, velocity is not a constant.There are seasonal and other variablefactors affecting money demand andthere is error in measuring income andmoney. Of the nonseasonal factors, themost important are probably interestrates and technological innovations affect-ing the efficiency of the payments system,

procedure based on a constant growth rule fornominal GNP, not a constant growth rule for Ml.

2. See Elgin Groseclose, Atoney and Man, Freder-ick Ungar Publishing Co., 1961, p. 118, or RupertJ. Ederer, The Evolution of Money, Public AffairsPress, 1964, p. 91.

3. See Milton Friedman, "The Quantity Theoryof Money - A Restatement," in Studies in theQuantity Theory of Money, University of ChicagoPress, 1956, pp. 3-21. While Friedman advocatedalternative measures of money (M2 in his earlywork and, more recently, the monetary base), we

use the term money to refer to balances heldprimarily to conduct transactions. This corres-ponds to the definition of money known as MI.M1 includes currency, travelers' checks, demanddeposits, and other checkable deposits such asNOW accounts and credit-union share drafts. Fora more precise definition, see any recent issue ofthe Federal Reserve Bulletin, page A3.

4. For a detailed description, see John B. Carlson,"Methods of Cash Management," EconomicCommentary, Federal Reserve Bank of Cleveland,April 5, 1982.

5. Friedman recommends a 4 percent constantmoney growth rule in Chapter 4 of Milton Fried-

in Ill velocity was flat. When interestrates fell, velocity fell. After World WarII, rates began to rise - approximatelydoubling every decade to 1980 - and ve-locity also rose. If the decline in interestrates since 1982 is regarded as a perma•nent decline, then it should be associatedwith a decline in the velocity trend.

From this perspective, what seemsunusual is not the experience of the1980s, but rather the apparent stabilityof velocity from 1950 to 1980. It islikely that this relative stability wasmade possible by a combination of twoatypical circumstances. The first wasthe accelerating inflation and risinginterest rates of the period. The otherwas the prohibition against payinginterest on deposits. These two circum-stances, which combined to produce thesteady rise in velocity, were both elimi-nated in the early 1980s.

Not only was there a change in thegrowth trend of MI velocity in the1980s, but there was also an increase inthe variability as measured by changesin the level. This measure of the varia-bility in Ml velocity is shown in chart3, which illustrates annual percentchanges in Ml velocity from 1895 to1985. Once again, we see that the dif-ferent pattern for MI velocity in the1980s is not so different if we take alonger historical perspective. The vari-ability in recent years pales in compar-ison to the variability in the periodbefore World War II.

It is likely that the data for this earlyperiod are of low quality. But these aredata that Milton Friedman collectedand studied as he developed the mone-tarist rule of constant money growth.5Using these data, Friedman concludedthat the short-run (quarter-to-quarteror year-to-year) relationship betweenmoney and the economy was so unpre-dictable that monetary policy could notbe used to fine-tune the path for nomi-nal GNP. He also went to some lengthsto argue that the major episodes ofinstability in velocity were due to afailure to maintain stable growth in themoney supply.'

Friedman argued that the social costsof having the economy adjust to moneydemand disturbances would be less thanthe social costs of having the economyadjust to the uncertain environment as-

man, A Program for Monetary Stability, FordhamUniversity Press, 1959.

6. See Milton Friedman and Anna J. Schwartz, AMonetary History of the United States: 1867-1960,Princeton University Press, 1963. For example, in

Chapter 7, Friedman and Schwartz attribute thesteep decline in velocity to the severity of thedepression which, they contend, was due to the35 percent decline in the stock of money betweenAugust 1929 and April 1933.

that banks adjust their portfolios tomeet average reserve requirementsevery two weeks. This only makes senseif one wants to force the economy toadjust to a fixed path for Ml, no matterwhat the cost. Such an arrangement isnot likely to be optimal, however, if weview the money stock as a buffer tohelp lower transactions and other mar-keting costs associated with mis-matched income and commodity flows.

Setting a constant growth rule forthe monetary base under current regu-lations could lead to highly volatileinterest rates. To avoid sharp swingsin interest rates, the Federal Reservewould have to monitor constantly thedemand for reserves and attempt tocounter shifts in this demand withoffsetting changes in the supply ofreserves. The discount window pro-vides another safety valve that suppliesreserves whenever there is an unex-pected increase in demand. Currentreserve requirement regulations wouldhave to be changed before the FederalReserve could make operational a rulefor the monetary base.'

When asked to make monetary policyrecommendations based on our currentregulations, monetarists haveresponded by recommending that theFederal Reserve adopt a constant

7. There have been proposals for reserverequirement reforms that would make a mone-tary base target operational. For two examples,see the proposal for an expanded reserve carry-forward system in William Poole, "The Makingof Monetary Policy: Description and Analysis,"

New England Economic Review, March/April1975, pp. 21-30, and the proposal to staggerreserve maintenance periods among groups ofbanks in Albert H. Cox, Jr. and Ralph F. Leach,"Defensive Open Market Operations and the

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