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Disagreement about how to measure monetary policy leads to very different interpretations of the past. For example, the United States experienced rapid growth in 1964 and 1965. A monetary explanation notes that the growth of money kept increasing during the first half of the 1960s. From 1961 to 1962, money stock rose by 2.1%, and in the next three years it rose by 2.9%, 3.9%, and 4.2%. The monetary explanation interprets this monetary growth as an easing of policy, so no other factors are necessary to explain the rapid growth in spending.

An alternative explanation notes that interest rates changed little during these years, rising very slightly from 1963 to 1965. Thus, this view does not see the source of economic growth in monetary policy. Rather it looks to the large fiscal expansion, primarily in the form of a major tax cut in February of 1964. In this view, the tax cut was the force that propelled the expansion and monetary policy merely accommodated it, that is, did not stand in its way. Arthur Okun summarized this view as follows:

"[T]he monetary policy that was actually pursued would not in itself have quickened the pace of the economy. It supplied a good set of tires for the economy to move on, but fiscal policy was the engine of growth."1

The dispute about why output dropped in the U.S. from 1929 to 1931 is another example of the importance of the indicator. For a person using money as an indicator of monetary policy, the explanation of the drop is straightforward. The amount of money fell throughout the period from late 1929 until early 1933, and thus "tight" money explains the drop in output for the entire period. Milton Friedman and Anna Schwartz draw this conclusion in their A Monetary History of the United States, 1867-1960 (Princeton University Press, 1963). In their interpretation an ordinary recession was turned into a severe depression by the large number of bank failures. As people lost faith in the banking system, they converted deposits into currency. The loss of currency reduced bank reserves, and since a dollar of bank reserves could support several dollars of checking-account money, this conversion of deposits into currency reduced money. If the banks had not been allowed to fail, or if the Federal Reserve had offset the withdrawal of currency, the Depression, according to this view, would have been an ordinary, minor recession.

For a person who watches interest rates, the story looks very different. How can one be sure that the fall in spending did not cause the fall in money, rather than vice versa? Peter Temin argued that if a change in money is autonomous, that is, not caused by a change in income, "then we should be able to observe a temporary [change] in the rate of interest on assets bearing some resemblance to money."2 To use an analogy, one expects that if there is a shortage of apples, one should be able to see effects in the prices of closely related goods, such as in the price of oranges or pears.

Interest rates rose late in 1929 and again late in 1931, so Temin conceded that monetary forces probably played some role in the start of the Depression and in its later stages. But from 1929 until late 1931, short-term interest rates fell, from about 6% to about 2%. In particular, Temin saw no rise in November and December of 1930, months of the first runs on banks and an episode that Friedman and Schwartz said changed the character of the decline. Long-term rates did increase, from about 5 1/2% to about 6 1/2%, but this was not enough evidence to stop Temin from concluding that money was passive from October of 1929 until September of 1931. Temin attributed much of the decline in spending during this period to an autonomous and unexplained drop in consumption.

Economics can be frustrating when two contradictory explanations can interpret the data equally well. Temin explained away the drop in money as the effect rather than the cause of the drop in income. Friedman and Schwartz explained away the failure of short-term interest rates to rise by arguing that in a time of a banking crisis, there is a demand for liquidity by both banks and the public. Thus "banks and others were inclined to dispose of their lower-grade bonds; the very desire for liquidity made government bonds ever more desirable as secondary reserves; hence the yield on lower grade securities rose...while yields on government bonds fell."3 Temin argued that an autonomous decrease in money should cause short-term interest rates to rise as people sell short-term assets trying to regain their lost money balances, while Friedman and Schwartz argued that when a banking panic reduces money, the desire for safe, liquid assets causes people to buy short-term assets.

The dispute among economists about how monetary policy should be measured reflects a division on how they view the economy. The economy is too complex for any human brain to fully understand. As a result, people try to make sense of it in terms of simplified mental pictures. In some of these pictures, changes in money are more directly and closely related to the determination of spending than in others.

Both sides of the dispute appeal to feedback (or reverse causation) in arguing their position. Those who believe that interest rates are the best way to measure monetary policy argue that some movements in money stock are caused by changes in economic activity, and thus it is misleading to try to explain movements in total spending in terms of movements in money. Those who believe that a monetary aggregate is the best way to measure monetary policy argue that many forces affect interest rates besides monetary policy. Expectations about the future course of economic growth and about future rates of inflation, both of which depend in part on past and present economic conditions, can cause large changes in interest rates.

Next we take a peek at the topic of policy rules.

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1 The Political Economy of Prosperity, (New York: Norton, 1970) p. 59.

2 Did Monetary Forces Cause the Great Depression? (New York: W.W. Norton & Co., 1976) p. 102. Temin may no longer hold these views. He has more recently written several papers with Barry Eichengreen who argues that faith in the gold standard explains central bank decisions not just of the Federal Reserve but of other central banks during this period.

3 A Monetary History, p. 312.

Copyright Robert Schenk