Phillip Cagan

The Choice among Monetary Aggregates as Targets and Guides for Monetary Policy

DIFFICULTIES IN MEETING its monetary targets led the Federal Reserve in October 1979 to adopt a new operating procedure to achieve firmer control over monetary aggregates. Yet the inflationary environment has fostered financial developments that affect the behavior of the traditional monetary aggregates and that raise questions whether different aggregates may not be better. This paper compares the various monetary aggregates for their usefulness as guides for monetary policy in the light of recent financial developments. The criterion of usefulness is the ability to influence and predict GNP growth. This ability is tested in two ways, first by the stability of the velocities of the monetary aggregates, and second by the advance information they provide of GNP growth. It is presumed that the aggregates with the most stable velocities make the best targets for monetray policy, and that those containing the most advance information make the best guides for policy. The paper has three main sections. The first discusses the criteria for using monetary aggregates as targets and guides. The second two sections describe and report tests of the various monetary aggregates as targets and guides. A summary of findings is presented as a final section.

The National Bank Note Puzzle Reinterpreted

We previously calculated the profit in issuing notes by national banks to be quite attractive after the late 1890s until all notes were retired in 1935. Yet the banks took until the 1920s to approach the maximum quantity allowed. Proposed explanations in the subsequent literature of this slow response were that redemption costs made note issues unprofitable or that banks had more attractive alternative investments. We show that these explanations are not satisfactory, and that a reinterpretation of the puzzle is why banks did not bid up the market prices of the eligible bonds to reflect their value in securing note issues. Copyright 1991 by Ohio State University Press.

Expectations in the German hyperinflation reconsidered

Abstract Data on forward foreign exchange rates during the German hyperinflation after World War I provide direct observations of expected changes in the spot rate. Although levels of these forward rates seem to be efficient predictors of the spot rate, the predicted changes in the spot rate are biased downward substantially and do not meet the specific conditions of rationality. Indeed, the bias in the forward rate predictions is similar to bias in adaptive expectations of the spot rate. The behavior of the forward rate can be rationalized as a gradual market adaptation to a new regime of volatile and escalating inflation, reasonably represented by adaptive expectations. The strict definition of rational expectations needs to be broadened to allow for the difficulty of distinguishing between permanent and transitory shocks.

Reflections on Rational Expectations

The hypothesis of rational expectations has rapidly gained attention because it is so natural and appealing. It must make its opponents furious, because, absurd as they think it is, to attack it is to appear to deny that behavior is rational, an uncomfortable position for an economist. Indeed, it is so appealing that one wonders why it took so long to develop. I must confess that I was no help. MIhen I was testing adaptive expectations in my study of hyperinflations almost thirty years ago, I rejected a contemporaneous effect of price changes on real money balances because it did not fit the data well, and I used adaptive expectations as a more attractive alternative. I had some qualms about my estimates which showed very slow adaptations under hyperinflation. Nevertheless, the alternative formulation of expectations without a lag seemed to go too far. At that time, who would believe that price changes not only resulted from changes in the money supply but did so without a lag? Of course, technical developments in statistical technique since then have brought several problems to light, and it is now not so clear that these episodes are inconsistent with rational expectations as now formulated. As a footnote to the historical discussion in Lucass paper, I am impressed by the irony of the fact that thirty years ago very few economists thought that money had an important effect on aggregate demand. I remember the anonymous review in the London Economist that said of our Studies in the Quantity Theory of Money that, well perhaps money can explain prices during hyperinflation, but that surely is the only situation in which it plays an important role. Today, in contrast to that earlier view, not only does the profession assign money an important role in all situations, but in the models of rational expectations the public knows exactly how money affects aggregate demand and follows monetary policy expertly in forming expectations of those effects. Did the public always know this despite the earlier ignorance of economists? If the public is dependent on what economists know, it has made progress but its expectations still cannot be very good. Nevertheless, rational expectations are not only intellectually appealing but have received uncontested empirical support in their application to financial markets and

The Use of Wealth to Compare Households' Average Saving

Abstract To identify the determinants of saving, cross-sectional studies of households usually collect and compare the current values of variables. A frequent difficulty is correlation of the known variables with unknown characteristics of households. Stratification of the sample may not always eliminate such correlation, making for biased estimates. A method of avoiding the bias is to sum the regression equation over the working life of the head of each household, which eliminates much of the correlation between the included independent variables and many of the excluded (unmeasurable) factors. In the new equation, the sum of past saving-income ratios can be approximated by the ratio of net wealth to current years income. The method involves certain problems of its own, but none that appear to outweigh the advantages. The feasibility of the procedure is illustrated by an analysis of how group pension plans affect non-pension saving.

Does endogeneity of the money supply disprove monetary effects on economic activity

Abstract The well-established covariation between money and business activity is traditionally explained by causal influences in both directions. But recent theories of “real business cycles” attribute the covariation entirely to the one-way influence of activity on an endogenous money supply. Although some statistical “causality tests” find an exogenous monetary effect, it appears to be quite small. A different kind of test is presented here that distinguishes the endogenous (inside) and exogenous (outside) components of money, and finds their effects to be roughly equal. Both components of money appear to act in the traditional way as a combined unit in affecting activity.

Monetarism Yesterday and Today

The volatile financial environment of the 1980s has revived doubts about the reliability of monetary targets, reversing the growing acceptance monetarism had attained in the 1970s. Long-time opponents of monetarism see its fall from favor as overdue justification of their opposition; its proponents see a serious but not fatal setback. A middle view is that the monetarist proposal of constant money growth no longer inspires confidence in its capacity to stabilize output and the price level, but that monetarism’s monetary theory and policy continues. I shall comment on those developments and on the current status of monetarist ideas.