Did Financial Innovation Hurt the Great Monetarist Experiment

Abstract

In October 1979, the Federal Reserve announced a new commitment to fight inflation. It signalled its resolve by a shift in policy tactics that placed greater emphasis on reducing the growth of money and less emphasis on limiting short-run fluctuations in interest rates. This shift in tactics was accomplished by a change in operating procedures that placed primary emphasis on controlling the growth of reserves available to depository institutions while greatly expanding the allowable range of fluctuations in the federal funds rate. The growth of MI and other monetary aggregates did slow on average, but money growth experienced large short-term fluctuations. Interest rate movements increased, as advertised, but the extent of their fluctuation was severe. Inflation slowed markedly, but this was primarily the consequence of a severe recession. Events gave grim testimony to the truth that it is possible to reduce inflation quickly by producing a sufficiently severe recession. In the second half of 1982, with the economy in disarray and with growing concern about the ability of the financial system to withstand further strain, the Federal Reserve abandoned its new operating procedures. There was a shift back to the more comfortable world of stabilizing fluctuations in the federal funds rate. There is considerable controversy over whether the Federal Reserve actually pursued a policy strategy that was consistent with the teachings of the Book of Monetarism. Concern about limiting money growth and using reserves as the operating variable are consistent with monetarism. The extreme fluctuations in money growth during the period are not consistent with monetarist doctrine, however. Perhaps the Fed had not really embraced monetarism. It may have found that focusing on money growth was a convenient means of absolving itself from responsibility for the record-high interest rates that occurred. Conversely, perhaps the Fed did embrace the principles of monetarism, but was unable to achieve steady money growth. We shall never know for sure whether or not the Federal Reserve was really trying to perform a monetarist experiment on the American economy. We do known, however, that the experiment was far from pure because of the substantial moneygrowth volatility that occurred. There is also substantial controversy over the of the Some observers argue that the primary aim of reducing inflation was achieved; they proclaim the experiment a success. Others point out that this success was the consequence of a severe recession produced by high real interest rates and had nothing to do with monetarism per se. This paper does not contribute to the debates concerning the nature and of the monetarist experiment. Rather, it looks at the role played by financial innovation in complicating the pursuit of monetary policy during the period. Was the great experiment hurt by financial innovation? More specifically, did rapid financial innovation make it infeasible to target on MI (or some other monetary aggregate), and did innovation contribute to the extreme fluctuations in money growth and interest rates that occurred? The conclusions from the discussion that follows is that financial innovation did not make it any less feasible to target on MI during 1979-82 than for other periods. Financial innovation does not appear to have made money growth an unusually unreliable target, and innovation was not the source of the volatility of money growth and interest rates that occurred.

Cite this work

No public copy is stored for this record, so only the metadata is cited.

Stored only when both papers are in the corpus — 19 citations exist upstream.

Papers that cite the same references — the relational fallback while embeddings are still backfilling.