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Monetary Policy Lessons of Recent Inflation and Disinflation

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  • Poole, William

Abstract

The decline of velocity in the 1980s is a surprise that should not have been. Economists unwisely relied on a velocity trend of 3 percent per year when they should have insisted on an economic explanation for rising velocity. An analysis of velocity and interest rates from 1915 to 1986 suggests that the interest elasticity of money demand is substantially higher than previously thought. The postwar increase of rates followed by a major decline of rates in the 1980s explains velocity behavior. The large decline in velocity almost certainly would have caused severe economic problems had the Federal Reserve not accommodated the decline through more rapid money growth. Federal Reserve policy between October 1979 and October 1982 emphasized control of money growth. Money market behavior during this period, compared to periods before and after, provides strong evidence that the market sets interest rates on the basis of a sophisticated understanding of monetary policy. The evidence makes clear that the monetary authorities cannot use interest rates to provide information on the state of the economy unless they know the extent to which interest rates reflect expectations of future monetary policy.

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Bibliographic Info

Article provided by American Economic Association in its journal Journal of Economic Perspectives.

Volume (Year): 2 (1988)
Issue (Month): 3 (Summer)
Pages: 73-100

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Handle: RePEc:aea:jecper:v:2:y:1988:i:3:p:73-100

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References

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  1. Deaves, Richard & Melino, Angelo & Pesando, James E., 1987. "The response of interest rates to the Federal Reserve's weekly money announcements : The 'puzzle' of anticipated money," Journal of Monetary Economics, Elsevier, vol. 19(3), pages 393-404, May.
  2. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
  3. Philippe Bacchetta & Martin Feldstein, 1987. "How Far Has the Dollar Fallen?," NBER Working Papers 2122, National Bureau of Economic Research, Inc.
  4. Campbell, John Y. & Clarida, Richard H., 1987. "The dollar and real interest rates," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 27(1), pages 103-139, January.
  5. Goodfriend, Marvin, 1985. "Reinterpreting money demand regressions," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 22(1), pages 207-241, January.
  6. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
  7. Brunner, Karl & Meltzer, Allan H., 1985. "Understanding monetary regimes," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 22(1), pages 1-8, January.
  8. William Poole, 1970. "Whither Money Demand?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 1(3), pages 485-501.
  9. Mankiw, N Gregory & Miron, Jeffrey A & Weil, David N, 1987. "The Adjustment of Expectations to a Change in Regime: A Study of the Founding of the Federal Reserve," American Economic Review, American Economic Association, vol. 77(3), pages 358-74, June.
  10. Richard G. Sheehan, 1985. "Weekly money announcements: new information and its effects," Review, Federal Reserve Bank of St. Louis, issue Aug, pages 25-34.
  11. Nelson, Charles R. & Plosser, Charles I., 1982. "Trends and random walks in macroeconmic time series : Some evidence and implications," Journal of Monetary Economics, Elsevier, vol. 10(2), pages 139-162.
  12. Rasche, Robert H., 1987. "M1 -- Velocity and money-demand functions: Do stable relationships exist?," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 27(1), pages 9-88, January.
  13. Laidler, David, 1980. "The demand for money in the United States-- Yet again," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 12(1), pages 219-271, January.
  14. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, vol. 65(3), pages 269-82, June.
  15. V. Vance Roley, 1982. "Weekly money supply announcements and the volatility of short-term interest rates," Economic Review, Federal Reserve Bank of Kansas City, issue Apr, pages 3-15.
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