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An examination of the Federal Reserve's strategy for controlling the monetary aggregates

  • Economics


FEDERAL RESERVE BANK OF SAN FRANCISCO ECONOMIC REVIEW FALL 1882 John P. Judd* I. Introduction On October 6, 1979, the Federal Reserve changed the way it controlled money from establishing tar- gets for short-term interest rates to focusing on targets for bank reserves. The new procedure was expected to result in more interest rate volatility as the rates were freed to respond to market forces. The procedure was also intended to achieve better control of the monetary aggregates. Since October 1979, interest rate volatility has increased, and monetary control has improved on an annual basis. But surprisingly, the monetary aggregates became more volatile on a short-term basis. In February, 1981, the Federal Reserve published results of a System study evaluating the experience under the new control procedure. [ The study con- cluded that the increased volatility of the monetary aggregates in 1980 was caused, in part, by unusual- ly large shocks to the money and credit markets. The largest of these shocks came from the Special Credit Control Program implemented in the Spring of 1980. A second conclusion was that more accu- rate short-run control might have been achieved by more aggressive adjustments in the reserves targets when the quantity of money departed from target. 2 However, the study also concluded that closer *Research Officer, Federal Reserve Bank of San Francisco. I am indebted to Adrian W. Throop for enlightening discussions of the issues discussed in this paper. Lloyd Dixon provided research assistance. 7 short-run control would most likely entail large increases in interest rate volatility, which could seriously inhibit the performance of the economy. The present study therefore has two main pur- poses. The first is to describe how the reserve- oriented monetary control procedure works, in theory and in practice.** The second is to assess the effectiveness of the new procedure as it has been implemented. A key feature of any control proce- dure is how quickly it b

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