replacing the fomc by a pc

REPLACING THE FOMC BY A PC

THOMAS MAYER*

Recent behavior of velocity suggests that a stable monetary growth rate rule could have dangerous consequences. Hence this paper suggests a compromise-adjusting the money growth rate only in accordance with past changes in velocity. This preserves most of the benefits of a stable monetary growth rate rule.

1. INTRODUCTION

This paper presents a compromise solution to the debate over a monetary rule by advocating a “semirule,” that is, a rule that sets out not a predetermined course for a policy instrument, but a predetermined response to certain developments in the economy. While most semirules are anchored in a Keynesian framework, this semirule comes from a monetarist background. It is not new, as it is a modified version of a rule advocated by Martin Bronfenbrenner (1961a,b, 1963) and similar to a rule proposed by Robert Weintraub (1983) and Allan Meltzer (1984, 1986). It does not require velocity to be stable, and yet preserves all but one benefit of the traditional version of a stable money growth rate rule. To motivate such a compromise solution at a time when the erratic behavior of velocity seems to invalidate any monetary growth rate rule, one must first show that a monetary growth rate rule has benefits worth preserving.

I I . THE CASE FOR STABLE MONEY GROWTH

The case for monetary rule is not that it is the best monetary policy con- ceivable by the mind of man, but that given our lack of knowledge and the Federal Reserve’s inadequacies, it is the best we can do. It is a monetary policy for a world of limits-not limits to our resources, but limits to our capacities. These limits are of two kinds: limits to our knowledge of the economy and limits to our administrative ability.

The first of these limitations arises from a combination of long and variable lags in monetary policy and our modest forecasting ability-a combination that can easily lead to serious errors in the timing of policy. Obviously, if a policy is badly timed so that its effect on GNP is procyclical, or if it is well timed but too large, then it will destabilize rather than stabilize GNP. More than a generation ago, Milton Friedman (1953) formalized this point and showed that implausibly large errors are not necessary for discretionary policy to be destabilizing. Since Friedman’s analysis was theoretical, he could not use

*Professor of Economics, University of California, Davis. I am indebted for helpful comments to Elmer Bartley, Martin Bronfenbrenner, Kevin Hoover, Steven Sheffrin, and Carl Walsh. An earlier draft of this paper was presented at the 61st Annual Western Economic Association International Conference, San Francisco, Calif., July 1986, in a session organized by the author.

Contemporary Policy Issues Vol. V, April 1987

31

32 CONTEMPORARY POLICY ISSUES

it to show that countercyclical policy has actually been destabilizing. It was just a possibility argument.l

There is nothing necessarily “Chicago” about this. A. W. Phillips (1954), who can hardly be considered a member of the Chicago school, presented his own formalization of the problem and suggested that stabilization policy may well be destabilizing. Despite its origin in both the Keynesian and the monetarist camps, this issue has been heavily ideologized. Hard-core monetarists firmly believe that our abilities to forecast GNP and to predict the timing and impact of monetary policy are insufficient for countercyclical policy, while hard-core Keynesians are firmly convinced of the opposite. Neither side has much evidence to offer.

But monetarists do not rest their case only on long and variable lags. They also reject the Keynesian assumption that the Fed uses its knowledge efficiently and in the public interest rather than yielding to political pressures or to its own bureaucratic interests. Thus, Friedman stated that “I have increasingly moved to the position that the real argument for a steady rate of monetary growth is at least as much political as it is economic” (Modigliani and Friedman,

Monetarists frequently have argued that the Fed puts its own bureaucratic interests ahead of its stabilization goal (Brunner, 1981; Friedman, 1982). Such an argument is hard to evaluate, though some public choice theorists have tried to confirm it empirically. Keynesians have generally responded by ig- noring this issue. Perhaps this is because they consider such arguments ad hominen and hence unworthy of an answer, or perhaps it is because they know from personal contacts that central bankers are devoted public servants. But even honorable central bankers can fail to act on the best available information because of organizational problems or political pressures. Since the problem of Fed inefficiency lies somewhere between economics and political science, it has not been explored sufficiently and no theory of Fed X-efficiency exists. But a number of papers analyzing the Federal Open Market Committee’s (FOMC’s) or the Federal Reserve Board of Governors’ minutes have found numerous examples of inefficiency or surrender to political pressures (Brunner and Meltzer, 1964; Hetzel, 1985; Lombra and Moran, 1980; Mayer, 1982a,b).

Can this issue be settled by looking at the outcome of discretionary policy? Unfortunately, no. Keynesians can cite simulations with the Massachusetts Institute of Technology-University of Pennsylvania-Social Science Research Council (MPS) model and show discretionary policy to be superior to a monetary growth rate rule (Modigliani, 1977; Craine et al., 1978). But the Data Resources, Inc. (DRI) model shows just the opposite (Eckstein and Sinai, 1986). Such disagreement is not unusual. Other simulations of econometric models also generate divergent results. For example, when the Chase and DRI models

1977, pp. 17-18).

1. Friedman and Schwartz (1963) provide much historical evidence on destabilizing Fed policy. But their evidence deals with cases in which the Fed followed erroneous principles, such as the real bills doctrine, and not with cases in which Fed policy was destabilizing due to lags.

MAYER: REPLACING THE FOMC BY A PC 33

were used to simulate the effects on GNP of certain monetary policies, the mean difference between their results was equal to 60 percent of the estimated mean impact of the policies ( U S Congress, 1982). Moreover, as Robert Lucas has taught us, model results may be specific to the monetary regime under which they were generated. Hence econometric models cannot tell us whether to employ a monetary rule or a discretionary policy.

An alternative solution might be to compare money growth rates in recessions and expansions. Monetarists have pointed out that during the post-World War I1 period, money grew faster during expansions than during recessions. On the surface, this seems to suggest that monetary policy has been destabilizing. But it is not necessarily so, partly because of the lag in monetary policy. By coincidence, this lag might be just long enough to turn a procyclical monetary growth rate into a countercyclical monetary policy. The impact on GNP of the higher monetary growth rate during the expansion might occur when GNP is low during the next recession. Second, a successful countercyclical policy does not raise income during recessions and lower it during expansions. During a stylized cycle, income is below its trend-adjusted mean for half the expansion and above its mean during half the recession. To be stabilizing, then, policy should raise GNP during half the expansion as well as during half the recession.

As I have argued elsewhere (Mayer, 1985b), there exists no compelling evidence as to whether countercyclical monetary policy can succeed. My own belief is that discretionary policy is more likely to be procyclical than countercyclical. This is based largely on a reading of the FOMC minutes, and hence cannot be demonstrated in ways that others would necessarily find convincing.

All the same, suppose that countercyclical policy is destabilizing. Does this mean that a stable money growth rate is appropriate? Not necessarily. Mon- etary regimes must be evaluated not just by whether they are countercyclical or procyclical, but also by two other criteria: their long-run effects and their episodic effects.

111. LONG-RUN EFFECTS OF DISCRETIONARY POLICY

A major argument against discretionary policy is that it generated, or at least permitted, substantial inflation during the 1960s and 1970s. One possible explanation for this is that the friends of easy money have more political power than do the friends of tight money. Another explanation is that the Fed generates inflation in an attempt to raise output (Barro and Gordon, 1983). Still another explanation is internal to the FOMC. Its members are inclined toward policies that are too expansionary because a central banker whose utility function includes a clear conscience has an asymmetric loss function. The central banker blames himself less for having been too expansionary than for having been too restrictive. One reason for this is that the harm done by a too restrictive policy, e.g., greater unemployment, is more apparent than is the harm done by inflationary consequences of a too expansionary policy. Little effort is needed to comprehend the misery caused by unemployment,


while the losses caused by inflation are more subtle and less graphic. Though we know that the latter exist, we know little about them. Moreover, the costs of inflation are spread out over a long time, while the costs of unemployment are concentrated in time and hence are more apparent. Furthermore, the adverse consequences of a too restrictive policy appear sooner than do those of a too expansionary policy. This makes it harder for the FOMC to avoid feeling responsible for a too restrictive policy than for a too expansionary policy. A rise in the inflation rate two years after a rise in the money growth rate can be blamed on other events during those two years. But if unemployment rises six months after a drop in the money growth rate, fewer events have occurred during those six months on which the rise in unemployment can be blamed.

All of this may seem rather speculative, and so it is. But surely few would deny that had we instituted (and stayed with), say, a 4 percent monetary rule in 1965, the price level now would be much lower than it is.

IV. INADEQUACY OF THE TRADITIONAL MONEY GROWTH RATE RULE

All the same, the traditional money growth rate rule suffers from one major defect and one minor defect. The major defect is that its success requires either of two conditions. One is that velocity is changing at a predictable rate, and the other is that the economy can adapt with little cost to fluctuations in aggregate demand. Since this second condition is highly unlikely, a plausible case for stable monetary growth presupposes that velocity is predictable, or more precisely that variations in the velocity growth rate do not generate more instability than does a discretionary policy. It may be that a monetary growth rate rule is superior to a discretionary policy during most business cycles, but that episodically-when the velocity trend changes-it is much worse.

The assumption of a predictable velocity trend would seem to be rejected decisively by the great velocity decline of the 1980s. However, monetarists can counter that the 1980s experience does not conflict with the following monetarist story. Suppose that money had grown at a stable and moderate rate during the 1960s and 1970s. Supply shocks and technological developments that reduced money demand would have generated some inflation at least temporarily, but surely not as much inflation as we actually experienced. Hence, the nominal interest rate would have risen much less than it did during the 1960s and 1970s. The interest rate, having risen much less, could not have declined by as much as it actually did during the 1980s. The evidence from money demand functions suggests that much, though not all, of the great velocity decline can be explained by the fall in interest rates (McGibany and Nourzad, 1985, p. 525). Hence, had we adopted a stable monetary growth rate rule in, say, 1960, we would not have experienced anything like the great break in the velocity trend that occurred during the 1980s. And had we adopted another recommendation of monetarists (and of many other economists) that

MAYER: REPLACING THE F O M C BY A P C 35

Regulation Q be eliminated and also that interest be paid on demand deposits, there would have been less financial innovation to induce velocity changes.

The real trouble with the hypothesis of a stable velocity trend is not that the recent evidence refutes it, but rather that no persuasive evidence exists to support it. No a priori reason exists as to why velocity should be stable or changing at a stable rate. Money demand is the demand for a capital good, and therefore is subject to change as relative prices, incomes, tastes, and technology vary.

Ultimately, whether velocity is stable is an empirical issue. But it is one that our current techniques cannot resolve with any certitude. Thus the stable velocity trend from 1960 until 1980, which then seemed like such a persuasive argument for a monetary growth rate rule, is not convincing evidence that velocity follows a stable long-run trend. It could have been due to the Fed’s accommodative policy. When the money demand and hence interest rates rose, the Fed raised the money growth rate; conversely, when money demand fell, the Fed reduced the money growth rate. Had the Fed not followed this particular discretionary policy, interest rates-and hence velocity-might have been more variable.2 Moreover, even if one were to ignore this problem somehow, the data would not support the assumption of a stable trend-adjusted velocity. Although velocity grew at a stable rate during the postwar period until 1980, this was not so in earlier years. During the period 1890-1929 (excluding 1917-1919), velocity was not stable. When regressed on time, the standard error of old M2 velocity is 5 percent of its mean. To be sure, a money demand function might give a good fit for that period, but the money growth rate rule requires that velocity be stable in a numerical (trend-adjusted) sense and not merely in a functional sense.

The statement that velocity has not been stable enough to justify a stable money growth rate rule may seem inconsistent with Friedman and Schwartz’s (1982) finding of a remarkably stable velocity over the long run in both the United States and the United Kingdom. But Friedman and Schwartz used several dummy variables. While such dummy variables are justified when one tries to explain money demand, they cannot be used to defend a stable money growth rate rule. They take care of some shocks to velocity-shocks which we know about only after the event, and which we therefore could not in- corporate into a monetary growth rate rule. Moreover, as David Laidler (1983) has pointed out, Friedman and Schwartz selected their definition of money ex post, that is, at a time when they knew how previous institutional changes had affected money demand. Someone setting up a monetary growth rate rule would have to use foresight rather than hindsight in selecting a definition of

2. Interest rates would not necessarily have been more variable, because the policy of trying to stabilize them destabilized the economy. This, in turn, led to greater interest rate variability. From time to time, the Fed had to generate large increases in interest rates to counteract its previous too expansionary policies.


money. Furthermore, David Hendry and Neil Ericsson (1985) have presented criticisms of how Friedman and Schwartz’s function fits the British data.

Even small changes in the velocity trend could cause a monetary rule to be deleterious. Suppose, for example, that instead of growing at the predicted 3 percent rate, velocity grows at a 2.5 percent rate. After five years, aggregate demand would be 2.5 percent below its projected level. The 1980s experience suggests that for a long time, much of this shortfall in aggregate demand would show up as a reduction in output rather than in prices.

V. A MONETARY GROWTH RATE RULE WITH VELOCITY FEEDBACK

An obvious solution to the problem of velocity changes is to change this period’s growth rate of money ( M l ) to offset the velocity change during the previous p e r i ~ d . ~ Thus, if velocity falls, income falls only temporarily before returning to its previous level. By contrast, under the conventional monetary growth rate rule, the velocity decline would lower nominal income perma- nently. Suppose, for example, that when a traditional monetary growth rate rule is inaugurated, velocity is expected to rise at a 3 percent rate. Instead, it now ceases to rise. If the money growth rate had been selected to be consistent with zero inflation, a return to the natural unemployment rate would require money wages to fall by enough to permit prices to fall by 3 percent a year. This would require substantial unemployment. By contrast, if the velocity feedback rule specifies that the money growth rate be revised yearly, there would be only a single 3 percent fall in aggregate demand instead of a 3 percent fall every year. (The one-time decline in aggregate demand would occur because the adjustment for the lower velocity trend always would lag one year behind.)

This feedback version of the monetary growth rate rule would preserve all but one advantage of the traditional rule. It too would eliminate the two central problems of discretionary policy: (1) the need to predict both GNP and the impact and timing of the policy on GNP, and (2) the need to give the Fed discretion. Since velocity data are readily available, the public could monitor Fed behavior. The price level over the longer run would be predictable except for the Fed’s error in estimating output growth-an error that also occurs in the traditional version of the rule. The only advantage of the traditional rule which the feedback version lacks is that, as discussed below, the traditional version is much simpler than the feedback version would be.

The feedback version, however, has the great advantage that it should prove more acceptable to Keynesians than does the traditional version of the rule. James Tobin (1983, p. 516) who, like many Keynesians, advocates a GNP target for monetary policy, has pointed out that using a GNP target is equivalent to targeting a “velocity-adjusted monetary aggregate.” Two differences

3. Specifically, the money growth rate, m, would be mf = a - of-l, where Q is a constant and z, is the percentage change in velocity.


exist between Tobin’s preferred policy and the feedback version of the monetary growth rate rule. One is that Tobin wants to target real GNP rather than nominal GNP. The second is that presumably he wants to forecast the change in GNP, while the feedback rule is equivalent to predicting velocity from a naive model.4 On the latter point, the issue between Tobin and feedback rule supporters then comes down to three questions. First, can the Fed predict velocity better than does the naive model embedded in the feedback rule?5 Second, should the Fed be given discretion to act on its forecast? Third, should the nominal GNP growth rate be targeted once and for all-as it is in the monetary growth rate rule-or should the Fed set it, say, yearly?

An attractive compromise would be to revise, perhaps every three years, the real GNP growth rate estimate that is implicit in the nominal GNP target. Or a three-year moving average might be used, as Meltzer (1984) has suggested. This revised target would then be used to determine the appropriate money growth rate for the feedback rule. Given the puzzling decline in productivity growth and the uncertainty over its continuation, one should not try to predict what the productivity growth rate will be, say, 30 years from now. It is true, of course, that allowing the Fed to change its estimate of real GNP growth every few years does give it some discretion, but this discretion is extremely narrow. The Fed could hardly start a significant inflation by assuming that productivity would grow secularly at, say, a 6 percent annual rate. Such an estimate could easily be ridiculed. And, if necessary, the Fed could be required to estimate productivity changes mechanically by a moving average.

VI. MONEY OR THE BASE?

An alternative version of the feedback rule, advocated by Meltzer (1986), is to apply it to the monetary base rather than to M1. The Fed then would not target money directly, but would adjust the base in accordance with previous changes in velocity of the base. The advantage of this base version is that the Fed can control the base much more precisely than it can control money. This would allow the public to monitor the Fed’s performance precisely. Suppose that M1 rises above what the rule requires. The Fed could argue for a few months that this is not its fault, and that it does not control M1 that accurately. It could not make this argument about the base. On the

4. The possibility also exists that Tobin and other Keynesians might not want to offset some prospective GNP changes because doing so might result in excessive interest rate variability.

5. Perhaps one could modify the semirule in the direction of some implicit forecasting by including an adjustment for serial correlation in velocity changes, thus coming somewhat closer to Tobin’s position. In a regression for 1961:Ql-l985:Q4 of the percentage change in velocity on its own value one period earlier, the coefficient is 0.2 with a t statistic of 2.1. However, if the period is terminated in 1979:Q4, the coefficient becomes trivial and far from significant. If the relatively minor regime change of October 1979 could change the serial correlation of velocity that much, the much more significant move to a semirule regime might change the serial correlation of velocity much more radically. Hence, one cannot say whether the Fed could forecast velocity changes usefully from a serial correlation.


other hand, a rule stated in terms of money probably would generate more public support than would a rule stated in terms of the base-an unfamiliar concept to most people.

Since a feedback rule yields the ideal monetary policy only if velocity in the current period is equal to velocity in the previous period, it may seem that correlating this period’s and the previous period’s velocities could tell us whether the money version or the base version is better. But this is not so because, at least under our present regime, the correlations are equally good for money and for the base. For the period from the first quarter 1960 to the fourth quarter 1985 (1960:Q1-1985:44), the correlation between velocity in one quarter and that in the previous quarter is 0.996 for M1 and 0.995 for the base (in either its Board of Governors or St. Louis Fed versions).

Whether to apply the feedback rule to M1 or to the base is essentially a technical detail. The arguments made here for an M1 feedback rule generally apply to the base version, too.

VII. FEEDBACK PERIOD

Under the feedback version of a monetary rule, the Fed would adjust the monetary growth rate in each period in accordance with the velocity change in the previous period. How long should these periods be? An obvious advantage exists to using short periods, say, quarters. In this way, changes in the velocity trend would do less harm. Suppose, for example, that the velocity trend falls from 3 to 1 percent per annum. The resulting deficiency in aggregate demand would be only 0.5 percent with a quarterly feedback rule compared with 2 percent with an annual feedback rule.

But a short period has two disadvantages. First, the feedback must be based on early estimates of money and GNP, and since these early data are less accurate than the subsequently revised data, they would show more spurious velocity changes. The Fed would be responding to many apparent velocity changes that actually never occurred. To estimate the importance of such false responses, I calculated velocity from the preliminary money and GNP data published in the Federal Reserve Bulletin two months after the end of each quarter. When such a preliminary estimate of the percentage change in velocity for the period 1976:Q4-1982:43 is correlated with the percentage change in velocity derived from data published in 1986, R2 is 0.69.6 Since most errors in the money data are due to errors in the seasonal adjustment coefficients, much of the error in estimating velocity could be avoided by using yearly data in making the feedback ad j~s tment .~ Second, with a quarterly feedback rule, the Fed frequently would be responding to velocity changes that are

6. To get around the changing definition of M1, I used the sum of only currency and demand deposits in calculating velocity.

7. This problem of seasonal adjustment errors would not arise if the monetary growth rate rule were set in terms of seasonally unadjusted money. On the desirability of using seasonally unadjusted money, see Mayer (1986).


soon reversed. Third, given a quarterly feedback, the adjustment for endog- enous changes in velocity (discussed below) would be much larger.

It is therefore not surprising that Meltzer (1984) prefers semiannual or annual adjustments, with a full adjustment to permanent changes in the velocity growth rate after only three years. But given the danger of sharp velocity changes, Meltzer’s adjustment period seems too long. It probably is better to respond frequently to false signals than to postpone responding to a major turn in velocity. But this is just a surmise based on the likelihood of negative correlation in the successive errors in the preliminary estimates of the velocity growth rate.8 With such a negative correlation, if the monetary policy lag is several quarters, then such quarterly errors should wash out to some extent. Unfortunately, we have several estimates of the monetary policy lag, and some are long while others are short.

A related issue is how to respond to data revisions that occur subsequent to the Fed’s feedback response. Should the Fed adjust this period’s money growth rate to account for errors in its response in previous periods? For revisions of the data based on a much earlier period, the answer is clearly no. Suppose that 10 years ago, the Commerce Department overestimated the GNP growth rate, which induced the Fed to reduce the money growth rate. By now, the resulting decline in the inflation rate is history and should not be offset by a higher inflation rate.

VIII. TESTS OF A FEEDBACK MONEY GROWTH RULE

Several tests of a feedback version of a monetary growth rate rule have been undertaken. Bronfenbrenner’s original test was f a~orab le ,~ but Modigli- ani’s (1964) reworking of this test with improved methods was unfavorable. However, Modigliani’s test (as well as Bronfenbrenner’s original test) is ques- tionable because it makes an arbitrary assumption about the monetary policy lag, and is also open to other criticism (Attiyeh, 1965; Mayer, 1967). Many of these criticisms do not apply to a subsequent study (McPheters and Redman, 1975) which, like Modigliani’s, concluded that discretionary policy is superior to Bronfenbrenner’s feedback rule.

In a subsequent simulation analysis with the MPS model for the two highly volatile years, 1973:Q2-1975:42, Roger Craine et al. (1978) found that Bron- fenbrenner’s feedback rule gave the worst result of all the policies they tested. But this, as well as the McPheters-Redman results, could have been due to a characteristic of Bronfenbrenner’s rule not shared by the rule proposed here.

8. Previously, I discussed a regression of velocity derived from preliminary data on velocity calculated from revised data. In this regression, the Durbin-Watson statistic was 2.8.

9. Bronfenbrenner’s (1961a,b, 1963) rule was intended to stabilize the price level, not nominal GNP. Since writing these papers, Bronfenbrenner has modified his views in three ways. He now is unsure about how to handle international currency substitution; he is willing to allow the Fed to set the monetary growth rate on the basis of “published and checkable” forecasts of velocity changes, and he now would apply his rule to the growth rate of the base rather than of money (Bronfenbrenner, 1986).


In his rule, the monetary growth rate responds not just to velocity changes, but also to productivity changes and to changes in labor force size.l0 As Craine et al. point out, “both labor productivity and labor force participation vary procyclically, inducting Bronfenbrenner’s rule to vary the money stock with the cycle” (p. 778). Moreover, such tests are subject to the Lucas critique. Hence, while the empirical tests certainly provide no support for the feedback rule proposed here, they provide no plausible refutation.

IX. FEEDBACK RULE AND DYNAMIC STABILITY

The feedback rule described so far may not be dynamically stable.ll Suppose that velocity declines in period 1, and that the Fed raises the money growth rate in period 2. Due to the monetary policy lag, this increase in the money supply initially lowers velocity. As a result of this velocity decline in period 2, the Fed then raises the money growth rate in period 3, and so on. Would this potential for instability be large enough to matter? Due to the Lucas critique, one cannot answer this question with great certainty. But as the appendix shows, if one is willing to ignore this critique, this potential instability does not seem to be a serious problem. All the same, the Fed should not offset all of the velocity change in the previous period. Instead, it should estimate what the velocity change would have been had it not adjusted the money stock in the previous period for the prior velocity change. The Fed should then subtract this induced velocity change from the total velocity change and adjust the money growth rate for only the autonomous velocity change thus estimated.

Obviously, such a separation cannot be achieved without error.12 But the errors should be random and would not cumulate. Hence, secular inflation could not result. Making such a separation would provide the Fed with little autonomy. The Fed should be required to publish the equation that it uses, presumably a regression of velocity on lagged money. Outsiders could then monitor the Fed by seeing whether this equation is reasonable, and whether the money growth rate follows the path implied by this equation. It would even be feasible to allow the Fed to change the equation and the equation’s coefficients, say, only once a year. This is not to deny that under such a modified feedback rule the Fed would carry out a more responsible task than it would under the traditional rule, but the Fed’s task would be much simpler than that under current policy. The FOMC could not be replaced, as it could be

10. Bronfenbrenner (1963) suggested making an adjustment for the cyclical variation in labor force participation rates and productivity growth, but had not done so in his earlier empirical test.

11. I am indebted to Robert Hall for this point. 12. Such errors might be large if, as Friedman has argued, the monetary policy lag is highly

variable. But Friedman’s method of estimating the lags and, by implication, his method of estimating the variance of the lags have been challenged effectively by Tobin (1970). Moreover, even if one accepts Friedman’s method of estimating lags, his method overstates the lags’ variance (see Mayer, 1967).


under the traditional rule, by a high school graduate with a calculator, but it could be replaced by someone who has passed an undergraduate course in econometrics and has a personal computer.

X. POLITICAL FEASIBILITY

A rule under which the Fed would offset autonomous velocity changes that occurred in the previous period is more complex than a rule under which the money stock would grow at a fixed rate. In this respect, a modified feedback rule is less appealing politically. But in another way, it is more appealing since it does not rely on the assumption that velocity will change at a stable rate. Few politicians would want to stake their reputations on assurances that velocity has a stable trend, particularly when many highly respected economists-including some Nobel laureates-surely would tell them that this is not so.

In any case, the likelihood of being adopted by Congress is not what makes any monetary growth rate rule important. More significant is the lesson that it has for the Fed’s conduct. If a strong case can be made for a monetary growth rate rule, this might induce the Fed to move partly toward stable money growth, and also to be more coherent in its analysis. For example, the FOMC might focus on the velocity trend and pay less attention to more impressionistic “this went up and that went down” evidence. Those who have not read the FOMC minutes (which are available through March 1975) probably would be greatly surprised by the atheoretical way in which policy is made.13 And to convince the Fed to change its ways, a monetary growth rate rule would not have to be simple.

XI. CONCLUSION

The great velocity decline of the early 1980s has not invalidated the case for a monetary growth rate rule because it has not eliminated the disadvantages of discretionary policy. But it does require a modification suggested by Bron- fenbrenner a quarter of a century ago.

13. Hoping that the FOMC might be persuaded to use a more analytic framework may be naive. Robert Hetzel(l982) has argued that the absence of an analytic framework is useful because it allows the Fed to respond to political pressures.


APPENDIX Regressing the percentage change in velocity on the percentage change of money in prior

quarters yields the following results for the period 1961:Ql-l985:Q4.

Lag Coefficient t-statistic 1 -0.075 -0.49 2 0.275 1.67 3 -0.213 -1.32 4 0.151 0.99

Since none of these coefficients is significant or large, this regression does not suggest a strong potential for dynamic instability. If time is included as an additional variable, then the coefficients for the third and fourth lags become significant, though with an unexpected positive sign. If the period is terminated in 1979:Q4, then the second and fourth lag coefficients are positive and significant. With time excluded, only the second coefficient is significant, and again is positive. However, these results should not be taken as more than suggestive, since they may at least partly reflect money supply responses by the Fed rather than responses of velocity to money supply changes.

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replacing the fomc by a pc

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