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targets: It wants to keep the money supply and interest rates just where they are.
If the demand curve for money holds still, everything works out fine. But suppose the
demand for money is not so obliging. Suppose, instead, that the demand curve shifts out-
ward to the position indicated by the brick-colored line M1D1 in Figure 2. We learned in
the previous chapter that such a shift might occur because output increases or because
prices rise, thereby increasing the volume of transactions. Or it might happen simply be-
cause people decide to hold more bank deposits. But whatever the reason, once the shift
occurs, the Fed can no longer achieve both previous targets.
If the Fed does nothing, the outward shift of the demand curve will push up both the
quantity of money (M) and the rate of interest (r). Figure 2 depicts these changes as the
move from point E to point A. In the example, if the demand curve for money shifts out-
ward from M0D0 to M1D1, and monetary policy does not change (leaving the supply curve
unchanged), the money stock rises to $840 billion and the interest rate rises to 7 percent.
Now suppose the Fed is targeting the money supply and is unwilling to let M rise. In
that case, it must use contractionary open-market operations to prevent M from rising. But
in so doing, it will push r up even higher, as point W in Figure 2 shows. After the demand
curve for money shifts outward, point E is no longer attainable. The Fed must instead
choose from among the points on the brick-colored line M1D1, and point W is the point on
this line that keeps the money supply at $830 billion. To hold M at $830 billion, the Fed
must reduce bank reserves just enough to pull the money supply curve inward so that it
passes through point W. (Pencil this shift in for yourself on the diagram.) But the interest
rate will then skyrocket to 9 percent.
Alternatively, if the Federal Reserve is pursuing an interest rate target, it might decide
that the rise in r must be avoided. In this case, the Fed would be forced to engage in expan-
sionary open-market operations to prevent the outward shift of the demand curve for money

If you need to review this process, turn back to Chapter 12, especially pages 252“258.

For further details on this proportionality relationship, including some numerical examples, see Test Yourself

Question 5 at the end of this chapter.

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Part 3
286 Fiscal and Monetary Policy

from pushing r up. In terms of Figure 2, the interest rate can be held at 5 percent by adding
just enough bank reserves to shift the money supply curve outward so that it passes through
point Z. But doing this will push the money supply up to $850 billion. (Again, try penciling
in the required shift of the money supply curve.) To summarize this discussion:
When the demand curve for money shifts outward, the Fed must tolerate a rise in inter-
est rates, a rise in the money stock, or both. It cannot control both the supply of money
and the interest rate. If it tries to keep M steady, then r will rise even more. Conversely,
if it tries to stabilize r, then M will rise even more.

Two Imperfect Alternatives
For years, economists debated how a central bank should deal with its inability to control
both the money supply and the rate of interest. Should it adhere rigidly to a target growth
path for bank reserves and the money supply, regardless of the consequences for interest
rates”which is the monetarist policy? Should it hold interest rates steady, even if that re-
quires sharp gyrations in reserves and the money stock”which is roughly what the Fed
does now? Or is some middle ground more appropriate? Let us first explore the issues
and then consider what has actually been done.
The main problem with imposing rigid targets on the supply of money is that the
demand for money does not cooperate by growing smoothly and predictably from month
to month; instead it dances around quite a bit in the short run. This variability presents
the recommendation to control the money supply with two problems:
1. It is almost impossible to achieve. Because the volume of money in existence de-
pends on both the demand and the supply curves, keeping M on target in the face
of significant fluctuations in the demand for money requires exceptional dexterity.
2. For reasons just explained, rigid adherence to money-stock targets might lead to
wide fluctuations in interest rates, which could create an unsettled atmosphere for
business decisions.
But powerful objections can also be raised against exclusive concentration on interest
rate movements. Because increases in output and prices shift the demand schedule for
money outward (as shown in Figure 2), a central bank determined to keep interest rates
from rising would have to expand the money supply in response. Conversely, when GDP
sagged, it would have to contract the money supply to keep rates from falling. Thus, in-
terest rate pegging would make the money supply expand in boom times and contract in
recessions, with potentially grave consequences for the stability of the economy. Ironically,
this is precisely the sort of monetary behavior the Federal Reserve System was designed
to prevent. Hence, if the Fed is to control interest rates, it had better formulate flexible tar-
gets, not fixed ones.

What Has the Fed Actually Done?
For most of post“World War II history, the predominant view held that the interest rate
was much the more important of the two targets. The rationale was that gyrating interest
rates could cause abrupt and unsettling changes in investment spending, which in turn
would make the entire economy fluctuate. Stabilizing interest rates was therefore believed
to be the best way to stabilize GDP. If doing so required fluctuations in the money supply,
so be it. Consequently, the Fed focused on interest rates and paid little attention to the
money supply”which is more or less the Fed™s view today as well.
During the 1960s, however, this prevailing view came under withering attack from
Milton Friedman and other monetarists. These economists argued that the Fed™s obses-
sion with stabilizing interest rates actually destabilized the economy by making the money
supply fluctuate too much. For this reason, they urged the Fed to stop worrying so much
about fluctuations in interest rates and, instead, make the money supply grow at a con-
stant rate from month to month and year to year.

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Chapter 14 287
The Debate over Monetary and Fiscal Policy

Monetarism made important inroads at the Fed
during the inflationary 1970s, especially in October 21
1979 when then-Chairman Paul Volcker announced a 20
major change in the conduct of monetary policy.
Henceforth, he asserted, the Fed would stick more 17
closely to its target for money-stock growth regardless 16
of the implications for interest rates. Interest rates Bank prime rate

would go wherever supply and demand took them. 13
According to our analysis, this change in policy 12
should have led to wider fluctuations in interest rates”
and it did. Unfortunately, the Fed also ran into some 9
bad luck. The ensuing three years were marked by un- 8
usually severe gyrations in the demand for money, so 3-month Treasury bills
the ups and downs of interest rates were even more ex- 5
treme than anyone had expected. Figure 3 shows just 0
1979 1980 1981 1982 1983 1984 1985
how volatile interest rates were between late 1979 and
late 1982. As you might imagine, this erratic perform- Year
ance provoked some heavy criticism of the Fed.
Then, in October 1982, Chairman Volcker announced F I GU R E 3
that the Fed was temporarily abandoning its attempts to stick to a target growth path for The Behavior of
the money supply. Although he did not say so, his announcement presumably meant that Interest Rates,
the Fed went back to paying more attention to interest rates. As you can see in Figure 3,
interest rates did become much more stable after the change in policy. Most observers
think this greater stability was no coincidence.
After 1982, the Fed gradually distanced itself from the proposition that the money sup-
ply should grow at a constant rate. Finally, in 1993, then-Chairman Alan Greenspan offi-
cially confirmed what many people already knew: that the Fed was no longer using the
various Ms to guide policy. He strongly hinted that the Fed was targeting interest rates,
especially real interest rates, instead”a hint that has been repeated many times since then.
In truth, the Fed had little choice. The demand curve for money behaved so erratically and
so unpredictably in the 1980s and 1990s that stabilizing the money stock was probably im-
possible and certainly undesirable. And at least so far, the Fed has shown little interest in
returning to the Ms.

Another lively debate over stabilization policy revolves around the shape of the econ-
omy™s aggregate supply curve. Many economists think of the aggregate supply curve as
quite flat, as in Figure 4(a) on the next page, so that large increases in output can be
achieved with little inflation. But other economists envision the supply curve as steep, as
shown in Figure 4(b), so that prices respond strongly to changes in output. The differences
for public policy are substantial.
If the aggregate supply curve is flat, expansionary fiscal or monetary policy that raises
the aggregate demand curve can buy large gains in real GDP at low cost in terms of infla-
tion. In Figure 5(a) on the next page, stimulation of demand pushes the aggregate demand
curve outward from D0D0 to D1D1, thereby moving the economy™s equilibrium from point
E to point A. The substantial rise in output ($400 billion in the diagram) is accompanied
by only a pinch of inflation (1 percent). So the antirecession policy is quite successful.
Conversely, when the supply curve is flat, a restrictive stabilization policy is not a very
effective way to bring inflation down. Instead, it serves mainly to reduce real output, as
Figure 5(b) shows. Here a leftward shift of the aggregate demand curve from D0D0 to D2D2
moves equilibrium from point E to point B, lowering real GDP by $400 billion but cutting
the price level by merely 1 percent. Fighting inflation by contracting aggregate demand is
obviously quite costly in this example.

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Part 3
288 Fiscal and Monetary Policy

F I GU R E 4
Alternative Views of
the Aggregate Supply
Price Level

Price Level
Steep aggregate
supply curve
Flat aggregate S
supply curve



Real GDP Real GDP
(a) (b)

D1 D0

D0 D2
Price Level

Price Level

101 101
Rise in price E S
100 100
Fall in price B
99 99
D0 D1 D0
Rise in output Fall in output

6,000 6,400 5,600 6,000
Real GDP Real GDP
(a) Expansionary Policy (b) Contractionary Policy

NOTE: Real GDP in billions of dollars per year.

F I GU R E 5
Stabilization Policy
Things are just the reverse if the aggregate supply curve is steep. In that case, expan-
with a Flat Aggregate
sionary fiscal or monetary policies will cause a good deal of inflation without boosting
Supply Curve
real GDP much. This situation is depicted in Figure 6(a) on the next page, in which expan-
sionary policies shift the aggregate demand curve outward from D0D0 to D1D1, thereby
moving the economy™s equilibrium from E to A. Output rises by only $100 billion but
prices shoot up 10 percent.
Similarly, contractionary policy is an effective way to bring down the price level with-
out much sacrifice of output, as shown by the shift from E to B in Figure 6(b). Here it takes
only a $100 billion loss of output (from $6,000 billion to $5,900 billion) to “buy” 10 percent
less inflation.
Thus, as we can see, deciding whether the aggregate supply curve is steep or flat is
clearly of fundamental importance to the proper conduct of stabilization policy. If the sup-


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