Of the financial world nearly fluttered out. What could new fed chairman Alan Greenspan do to revive the patient . During the 1970s and 80s, the Federal Reserve adopted longterm policies to halt inflation and ease unemployment. But what would the fed do in an economic emergency . Monetary policy how well does it work . Thats the question economic analyst richard gill and i will investigate on this edition of economics usa. Im david schoumacher. The Federal Reserve board is responsible for deciding how much money the economy needs to grow. In the early 1970s, the fed held to a policy of using the money supply to try to keep the economy on course. In times of inflation, the fed tightened the money supply to squeeze excess dollars out of the economy. In times of recession, it increased the money supply to stimulate growth. But in 1975, the fed, under the chairmanship of arthur burns, faced a new and troubling dilemma caught between persistent inflation and a growing recession, how did chairman burns keep the economy on course . By late 1974, inflation had become a serious economic problem. Under pressure from rising fuel prices, inflation rose to a staggering 12 . Inflated Interest Rates had driven up the price of mortgages and brought the building industry to a standstill. Sales of new cars and Home Appliances plunged. In september, president gerald ford asked congress to join him in a battle against inflation. My First Priority is to work with you to bring inflation under control. Inflation is domestic enemy number one. Schoumacher the Federal Reserve was also committed to fighting inflation and, under the chairmanship of arthur burns, held to a policy of keeping money tight. Robert c. Holland served on the feds policymaking board of governors. When the Federal Reserve wants to fight inflation, what it does is provide funds basic funds we call reserves, funds to the Banking System less fast than Bank Customers are asking for money and credit to finance the kind of spending theyre trying to do in this inflationary period. That means banks have to hold back a bit in terms of the amount they lend, may have to sell some assets, sell some securities to adjust. That puts a little more restraint on borrowers, they dont get quite as much money. Banks typically charge higher Interest Rates. Those higher Interest Rates lead borrowers and investors of all sorts to think a bit more before they decide to make that next expenditure. And in that slow, pervasive, percolating way, a sort of a gentle, restraining hand is laid on the economy. Schoumacher but the feds restraining hand began to have a negative effect when unemployment started to rise in late 1974. By january of 75, 7. 5 million americans were out of work. The pressure was on washington to act. Representative henry c. Reuss was chairman of the house banking committee. Several million men and women were losing their jobs, and unemployment, the statistics, shot up to 9 , which was the worst since the great depression, the worst in 30 years. Schoumacher in march, congressional banking committees under senator William Proxmire and representative reuss began to pressure arthur burns and the fed to relent and allow the money supply to grow more rapidly. The nations money supply has been increasing at an annual rate of only 1. 3 since midjune. And you may call that a middle course, but i consider it a very restrictive course. We will not open up the spigot. Anpermit the money supply to increase rapidly, because if we did, in our judgment, we would not be helping significantly to relieve unemployment, and we would be, on the other hand, releasing forces that could accelerate what is already a dangerous inflation. Schoumacher burns predicted that the modest easing that the fed had permitted would be sufficient to stimulate the economy due to an increase in the velocity or turnoverof. The high dynamic variable in the Business Cycle the velocity or turnoverof. Is not the stock of money, but the rate of turnover of money. Velocity is simply the number of times, the rate, at which a dollar of money turns over. And, of course, if you have a lot of velocity people spending their dollars before they stop rolling then you can get by with a net increase of fewer dollars than if the velocity is not all that strong. The hitch is that nobody can tell or project what velocity is going to be, and hence, we felt and i think we were right whthat you had to beng to be, a little less stingy about the money supply itself. The critics of the issue wereaying,weeemo m1. E ngterm analysis sws m1 velocity is se, orufcieb so tise course is to keepushing itut. Weaid, but theyou can see themeasons in the marketplace, you can see it in the bank. You can see it in the offers being made to people. You can see how people and businessesre reacting. We need to recognize that reality. Oh, sure, we could do more. We could do a lot more. We could even wreck this country, but were not going to do it, senator. Schoumacher burns stuck to his guns and kept the money supply growing at a modest rate. By summer, indicators began showing the first signs of a recovery. By fall, the Unemployment Rate had dropped substantially. But most important for the fed, the recovery did not lead to new inflation. By the years en it had fallen to 9 . Arthur burns had taken a difficult and certainly controversial stand. Caught in the currents of political pressure, he had managed to keep Monetary Policy on course. Using velocity as a guide, he had succeeded in fostering a recovery without further fueling inflation. How exactly does this concept called velocity fit into the economic picture . We asked analyst richard gill. Economists like terms like velocity because they suggest were scientists, like physicists. Well, perhaps we arent quite that scientific, but we do have our own concept of velocity, specifically the income velocity of money. Briefly, income velocity tells us how many times a year a dollar circulates through the economy to buy final goods and services. We measure it by dividing annual Money National inco by the stock of money in the economy. Annual Money National income equals the average price of a good, p, times the quantity of goods produced, q. This is really our old familiar gnp concept in money terms. If we now divide Money National income by the stock of money our currency and demand deposits, m we get velocity, v. Thus v equals. We can put the m on the other side and get. This is called the equation of exchange. Now, the economic question facing the monetary authorities like arthur burns was, what would happen to the economy when you changed the money supply, m . Roughly speaking, congressional critics were saying that you needed a bigger increase in m, on the lefthand side, to get a bigger increase in q more output, jobs, employment. What burns was saying was that you could get this bigger increase in q without such a large increase in the money supply because v, velocity, would also be going up. But then, unfortunately, another problem comes up. Suppose both m and v are increasing . How can we be sure that the effect will be on q and not mainly on p . Will we get more q output and jobs or simply a higher price level, p . Will the feds actions bring us prosperity or simply more inflation . By the late 1970s, inflation had taken over again, and there was a widespread feeling that the fed had to exercise restraint on the economy. But how . Up until this period, most economists felt that the best way to cool inflation was to raise Interest Rates, keeping the price of money high. That would slow down Business Investment and spending and put inflation back in the box. But others felt that it was best to work on the money supply directly and to focus on the long run rather than the short run. In august 1979, anpaul volcker becameonthe ne. Rather than the short run. What course would he take . The fed was already facing enormous criticism, much of it coming from a group of economists called monetarists. At the head of the monetarist attack was economist milton friedman. In my opinion, given that there is a Federal Reserve, the best way for it to operate would be to set targets for a single monetary aggregate and stick to those targets and keep to them as closely as possible. And those targets should be set so as to go from wherever you start to a rate of growth in the money supply which is consistent with zero inflation. Schoumacher on october 6, 1979, paul volcker announced that the fed would no longer target Interest Rates, but would focus instead on targeting the money supply itself, restraining it until inflation was broken. In a speech before the National Press club, he stressed his determination to stick to this longterm course. Volcker will the fed stick with it . My short and simple answer to that question is yes. And i dont innd to qualif i dont intend to qualify that answer. But i do want to be clear, cleaabout whatheit is at we in to stick with [ laughter ] it, in the sense of our october 6 actions, is restrain on the money supply, recing its growth over time toward levels consistent with price stability. Schoumacher fred schultz was vicechairman of the fed board under volcker. But the major change was a difference in how Monetary Policy was going to be carried out. Before that, there habeen an effort to try to have relatively slow Interest Rate changes. That clearly was not doing the job of controlling the economy in this kind of a very volatile inflationary environment that had appeared in 1979. And so, the change was to go to strict targeting on the money supply alone. The effect of that is, if youre not paying any attention to the price of money which is what Interest Rates are the effect of targeting entirely on the supply is that the price of money is going to change a good deal more. Schoumacher by the end of the year, Interest Rates began to rise, and rise dramatically. By febary, the prime rate had reached a record 20 . Among the first to feel the squeeze were small businessmen. We understand what the objective of the National Government is, what the objective of the fed is, but we think that what can be a cure for the countrys ills can be fatal to the small businessman. Schoumacher the Carter Administration reacted to the skyhigh rates by imposing a limit on the amount of credit banks could offer. Suddenly, the buyingpree ended, and the fed was pulled offcourse. They were forced to expand the money supply to rescue the plummeting economy. But in late 19, the situation change the election of Ronald Reagan gave volcker the opportunity to return to his longterm plan. As part of his Economic Program reagan encouraged and supported monetary restraint. But in 1981, restraint began to take its toll. High Interest Rates caused a collapse in the building industry. The high cost of consumer loans puauto dealers out of business and auto workers out of jobs. Still, volcker held to his longterm course. Consolidating and extending the heartening progress on inflation will require a continuing restraint on monetary growth, and we intend to maintain the necessary degree of restraint. Schoumacher by 1982, the economy had fallen into the deepest recession since the great depression. Even the Reagan Administration was urging the fed to relent. But volcker and the fed board, determined to bring inflation down, held tight. Finally, in late 1982, the fed saw inflationdropy and eased the money supply. This last week, the Federal Reserve bank the fed saw inflationdropy decided to lower its discount rate to 9. 5 , the first time this key Interest Rate has gone below two digits since 1979 and the fifth reduction in just four months. This demonstrates the feds confidence that inflation and market rates will continue coming down and its confidence that we can Work Together for a healthy, noninflationary recovery. Schoumacher throughout the recovery that followed, inflation held at. Though inflation had been substantially reduced, the monetarists criticized the fed for t adhering to a strict growth rate of the money supply. In my opinion, the actions of the Federal Reserve have added to the uncertainty, have added to the instability of the economy rather than reduced it. And let me emphasize, stable monetary growth is not a guarantee of a stable economy. Its a guarantee that you will not have disturbing elements introduced by the operation of Monetary Policy. Its a way, as it were, to keep the Federal Reserve from doing mischief, and not a way to produce nirvana. The idea of monetarism is that theres a stable relationship between money and the Gross National product. Well, weve seenhat thats not the case. Furthermore, if you were to be very precise in your targeting and just stayed on that target path daytoday, Interest Rates would fluctuate enormously, and that wouldnt be good for the economy. So we took a pretty monetarist approach in october of 1979 because it called for extreme measures. But as youve seen, since then, that position has been ameliorated. Now, does that mean that money doesnt count . Of course not money is very important. But i think this strict monetarist approach is not workable over a long period of time, but it was necessary when we did it. Focusing on the money supply appears to have worked, but the cost was high. Chronic inflation, which had plagued the economy for more than a decade, was reduced and contained, but at the price of forcing the economy through two deep recessions. Why was the fed willing to pay such a high price in its battle against inflation . We asked economic analyst richard gill. Basically, they were willing to pay this high price because they saw no alternative. What happened in the late 1970s in the field of Monetary Policy can be read either, a, as a confession of failure, or b, an expression of hope. The failure side was an admission that Monetary Policy whether focused on Interest Rates or the money supply couldnt do much to avoid shortterm difficulties in the economy. And the recession of the early 1980s was serious. People lost jobs, basic industries faltered, and volckers policy was often cited as responsible. But the pocy was also an expression of hope. It said, in effect, lets shift our attention to the longer run. We may be able to do something to wring inflationary pressures out of the economy over a period of years. In terms of our equation of exchange, it was admitted that, in the short run, v and q might jump around all over the place, but that, in the long run, you could control prices, p, by keeping at least a somewhat firmer hand on the money supply throttle. Failure and hope the latter justified by what did, in fact, happen to the rate of inflation. It did fall and, in many ways, more sharply than anyone might have prected. So then, has hope won out . Perhaps, though we discovered in the 1980s that there are times when the short run has to take precedence over the long run. October 1987 gave us a dramatic case in point. Schoumacher 1929 the plunging stock market causes a panic. The Federal Reserve clamps down on the money supply, stifling the economy. Banks, starvedor ready cash liquidity fail by the thousands. Businesses close. Soon, 18 million americans are unemployed, hopeless, and hungry. This is wall street day buying and selling by computer, Trusting Congress and the Federal Reserve to prevent a repetition of 1929. After many years of experimentation, wall street and the nation have learned that a longterm, consistent Monetary Policy is good medicine to keep an economy healthy. But in 1987, the question remained unanswered what could Monetary Policy do in an economic emergency . I have a statement for you. Paul volcker has advised me of his decision t toccept a third term as a member and chairman of the Federal Reserve board. I accepted mr. Volckers decision with great reluctance and regret. Its my intention to nominate dr. Alan greenspan to a fouryear term as chairman of the Federal Reserve. Schoumacher on his first day in office, chairman greenspan revealed his wish list a dollar which is always stable, schoumacher on his first day in office, Interest Rates which stay low, and employment which stays high. Schoumacher is first action as chairman of the board of governors was eairm schoumacher is first action volckes tight money policy, a longrange policy that most economists believed was crucial to maintaining orderly economic growth. But if there was one sector of the economy that was far from orderly in 1987, it was the stock market. 40. Asia, 784. Schoumacher greenspan feared a collapse. But what could the fed do . Securities analyst roger kubarych. When chairman greenspan came in office in august, one of the first things he did was to launch a series of studies call them war games if you li