Tuesday, October 6, 2009

Some History of Monetary Policy...When Disco Was Dying

Here's something for those of us who are economic history nerds. (HT to Bill Polley.)

Those of us who were around in the late 1970s can remember a day in October, 1979 when the Fed changed its approach to monetary policy and took a hard stand against inflation. The idea was to focus on monetary aggregates via bank reserves, instead of targeting interest rates. It was, in effect, a return to one of the ideas of Irving Fisher. His equation M*V = P*Q (or P*T), is an important identity linking money growth to prices. (And, obviously, it is the title of this blog.)

There are a couple of Federal Reserve Bank publications that examine that important decision. This first one from the Federal Reserve Bank of San Francisco is, by far, the more concise - amounting to a handful of pages. This second, from the Federal Reserve Bank of St. Louis, is more comprehensive and, at over 80 pages, may be preferred by the wonkiest among us - the same group that has been waiting patiently for the second volume (now scheduled for two separate books) of Allan Meltzer's History of the Federal Reserve.

Fisher's idea is still a handy classroom tool for explaining the connection. The equation state that the money supply (M) multiplied by the velocity (V) or number of times the money supply turns over equals prices or the price level (P) times the level of goods and services transactions (Q or T, depending on your preference). By use of some simple algebra, it becomes (M*V)/Q = P. And we see that money multiplied by its velocity, divided by the output gives us prices. And if we examine the change in MV relative to the change in Q, the result is change in P (inflation). If the change in money is greater than the change in output, there is upward pressure on prices. Change in output greater than the change in money results in downward pressure on prices.

It is the relationship illustrated by Fisher's equation that is causing a lot of concern about the result of current monetary policy, and has many pundits speculating about the Fed's exit strategy from the current accommodative (easy money) stance.

Regardless, if you would like to know more about the mechanics of monetary policy at the time of the last major bout of inflation, these publications may make a good place to start.

I look forward to your comments.


bill greene said...

I'm not sure how Fisher's "law" works in today's economic scenario, or without considering the demand side. If people are cutting back on expenditures because of the economic crisis, an increase in supply (output) would not necessarily lead to higher proces--inventories would build up, but prices might even go down.

Further, if inflation can be tamed by simply pumping up output to match the growth in the money supply, all a nation has to do when they are printing money like crazy, is to also produce product like crazy!

Of course, private business managers would not overproduce to that extent, but in a centrally planned and managed economy it might actually be tried, and of course, it would be a disaster.

Tim Schilling said...

I may not have been clear. It is not the increase in supply (output) that leads to higher prices, it is an increase in the money supply relative that is greater than an increase in output. That scenario, when applied to the equation, would give you a value greater than one and that is reflected in a rising price level.

Your comment about demand is appropriate. The equation assumes other things remain equal - hence its use as tool for introducing the concept to students.

Your point about pumping up output is also well taken. This is why central banks study things like capacity utilization and productivity. There are limits to output for a given level of resources. That means there needs to be a corresponding limit to money growth or you risk inflation.

Thanks for your comment.