1 – Introduction
1One can hardly ignore the influence of monetarism on the history of economic thought, at least since the Nobel Memorial Prize in Economic Sciences was awarded to Milton Friedman in 1976. Monetarist ideas, especially advocated by the Chicago school of economics, gained a great deal of influence, leading to what could be called a paradigm shift, making Keynesian ideas out of date.  As a result, the community of central bankers may have been deeply influenced by the monetarist precepts.  Tobin [1981, p. 30] even stated: “the central banking community embraced monetarism”. According to Goodfriend , “Monetary theory and policy have been revolutionized in the two decades since October 1979, when the Federal Reserve under the leadership of Paul Volcker moved to stabilize inflation and bring it down”. However, according to Friedman himself [1984, p. 397], “Though the Federal Reserve System’s rhetoric was ‘monetarist’ the actual policy that it followed was antimonetarist”.
2This paper analyzes the influence of monetarism on the Fed’s policy during the 1980s. We focus not only on the adoption of money supply targets in setting monetary policies, but also on the way the Governors of the Federal Reserve System (FRS) define their monetary policies with reference to monetarist ideas. Such an investigation can be carried out using the testimonies of Paul Volcker, and by studying the primary sources from the FRS: we especially use the Minutes of the Federal Open Market Committee (FOMC), where the members could speak freely and in confidence about the current monetary problems and express their positions with regard to monetarism. Such archives allow us to point out the degree of acceptance of monetarist ideas in the Fed during the 1980s. In addition, our analysis of the influence of monetarist ideas in the Federal Reserve in the 1980s is reinforced by our use of the archives of the Shadow Open Market Committee (SOMC). Founded in 1973 by Karl Brunner and Allan H. Meltzer,  the SOMC brings together the most influential monetarist economists  who express their opinions on the economic policies implemented, and particularly on the monetary policy decisions made by the Fed. Finally, no analysis of the influence of monetarism on the Fed would be complete without looking at the statistical relationship between variables of the quantity theory of money (QTM).
3In Section 2 of this paper, we investigate why what is known as the “monetarist counter-revolution” [Tobin, 1981], the “great monetarist experiment” [Pierce, 1984] or the Federal Reserve’s “attempt at practical Monetarism” [Wray, 1993, p. 561] has never been regarded as monetarist by the monetarist economists themselves. We underline Friedman’s criticisms and then point out the positions of the members of the SOMC with regard to Volcker’s policy. Section 3 briefly sums up the monetary policy implemented from the “Volcker shock” and provides an analysis of the Federal Reserve Economic Data (FRED), highlighting the role of the velocity of money. In Section 4, we investigate FOMC members’ views on monetarism. Contrary to the statement that “the Federal Open Market Committee never really embraced Monetarism” [Modigliani, 1988, p. 7], we claim that the influence of monetarism on the FOMC was twofold: a direct influence, by the adhesion of some members to monetarist ideas; and an indirect influence, because monetarist views were permanently taken into account in the determination of US monetary policy, even after 1982, at the beginning of the “gradual loss of influence” of the reserve position doctrine  emphasized by Bindseil [2004a, p. 31].
2 – Monetarist rhetoric but antimonetarist policy?
4In this section, we show that Friedman and the monetarists of the SOMC harshly criticized the Federal Reserve’s monetary policy. While they did not consider the Fed’s policy to be monetarist, this was not for theoretical reasons, but because of the failure of the policy implemented in 1979 and for political reasons. We emphasize that the members of the FOMC were fully aware of the reasons behind this criticism.
5On 13 December 1976, in his Nobel Memorial Lecture entitled “Inflation and Unemployment”, Friedman deeply criticized the Phillips curve, regarded as a cornerstone of the Keynesian corpus [Phillips, 1958]. The Nobel laureate stated that the empirical estimates of the Phillips curve relation — i.e. the Keynesian negative correlation between inflation and unemployment rates — were unsatisfactory.  Friedman promoted the idea of “adaptive expectations”,  entailing a return to a Phillips curve that is actually a vertical line, with the “natural rate of unemployment” in abscissa corresponding to an unemployment rate linked to the degree of rigidity on the labour market. As a result of adaptive expectations, the monetarist framework is characterized by a renewal of the old quantity theory of money:  Friedman stated that an increase in the money supply will entail a proportional increase in the price levels ceteris paribus, and assuming an exogenous money supply and a stable money demand function [Friedman, 1974]. The velocity of money is therefore claimed to be constant in the short term, and characterized by a slow and steady decline in the long term. In the long term, expansionary monetary policy is therefore ineffective, according to the monetarist principle of the neutrality of money. In the “rules versus discretion” debate, Friedman argued in favour of strict and clear monetary rules and recommended money supply targeting. Among his proposals, the most forceful refers to the growth of the monetary aggregates: Friedman’s k-percent rule states that “The stock of money [should be] increased at a fixed rate year-in and year-out without any variation in the rate of increase to meet cyclical needs” [Friedman, 1960, p. 93]. This rule implies that the central banks give up their discretionary policies and remain transparent with regard to the money supply.
6Friedman recommended a growth rate of the money supply close to the natural growth rate of the real national income so that the rate of inflation would remain low [Aftalion & Poncet, 1981, pp. 102–3]. To be operational, such a rule needs a mechanism allowing for control of the aggregate money supply. Through the mechanism of the money multiplier, the aggregate money supply is actually considered to be the result of the monetary base or high-powered money, composed of banknotes and reserves, in the liabilities of the central bank. Monetarists argue that the multiplier has a sufficient degree of stability and is therefore predictable [Johannes & Rasche, 1979]. The central bank determines the prior liquidity provided to the banking system, although the second-tier banks are constrained to provide credits to companies and households proportionally to the central bank money. Friedman [1969, pp. 4–5] even compared the exogenous money supply determined by the central bank to a helicopter dropping banknotes from the sky. These are the main elements of the monetarist framework, but monetarism did not remain merely theoretical: this framework had an influence on several central banks, and especially the Federal Reserve, under the chairmanship of Paul Volcker. Like Friedman, Volcker was sceptical about the validity of the Phillips curve when he was appointed Chairman of the FRS:
The idea associated with Keynesians of a so-called Phillips curve trade-off between unemployment and inflation did not seem to be working well. What was plainly happening over a period of time, as the monetarists emphasized, was that both unemployment and inflation were rising, and further delay in dealing with inflation would only ultimately make things worse, including the risk that any recession would be large.
8Volcker recognized this monetarist influence on his monetary policy and justified such a policy for two main reasons, namely discipline and transparency:
The change in policy was announced in early October 1979. I thought that there were two great advantages of the monetarist approach… First, it was a good way of disciplining ourselves. When we had announced that we were going to meet certain money supply targets, and not by manipulating interest rates but by working directly through the reserve base, we were committing a lot of prestige to that commitment, and it would have been very hard to rationalize a retreat. Second, it seemed to be a good device, given the spirit of the times, to convey what we were doing to the public. We said, in effect, that the United States was experiencing high inflation that needed to be dealt with and that inflation is a monetary phenomenon. Thus, we were not going to try to reduce inflation by manipulating interest rates but were instead going to go directly to the money supply.
10The monetarist influence on Fed policy was clearly stated by Volcker, and the statement that “inflation is a monetary phenomenon” refers directly to Friedman’s assertion.  The “Volcker shock” was said to be consistent with Friedman’s ideas:
Improbable as it may sound, Friedman’s extraordinary proposition was firmly believed in at the turn of the last decade in a number of important countries — by Mr Volcker, the chairman of the Federal Reserve, Mrs Thatcher and her close personal advisers in England, and by leading people in other countries. Its outward expressions were the setting of “targets” for the increase in money supply… as the first priority of policy.
12Volcker’s policy was therefore severely criticized as being monetarist, especially by Keynesian economists such as Kaldor,  while others like Tobin remained moderate in their criticism.  More fundamentally, the monetarist view of the exogenous money supply was brought into question by the endogenous money supply approach, where the second-tier banks determine the money supply by providing credits to the economic agents, while the central bank passively refinances the banks after having fixed the key interest rate. While in 1969 Friedman compared the powerful central bank to a helicopter, one year later, Nicholas Kaldor conversely compared the central bank to a constitutional monarch, a figurehead with no real powers.  According to Kaldor’s statement to the Radcliffe Committee in 1958, money is endogenously created and the velocity of money is unstable, and the quantity theory of money is therefore no longer relevant. The money supply is infinitely elastic with respect to the interest rate so that it can be depicted a “horizontal supply curve of money” [Kaldor, 1982, pp. 22–5]. Moreover, Kaldor’s study of the level and movement of the velocity of circulation from 1958 to 1978 confirms his statement: “In some communities the velocity of circulation is low, in others it is high, in some it is rising and in others it is falling, without any systematic connection between such differences and movements and the degree of inflationary pressure, the rate of increase in monetary turnover, etc.” [Kaldor, 1982, p. 78]. Minsky explained this instability by introducing the impact of financial innovation on the endogenous velocity of money:
These markets create instruments that seem to assure both those who use and those who supply short-term financing that money will be available when needed as long as they hold appropriate assets or have good enough profit prospects. The effectiveness of this assurance depends upon financial markets functioning normally; financial innovation results in there being both asset holders and potential borrowers who depend upon the continued normal functioning of some new financial market or institution.
14The Keynesian criticisms of the money supply targets state that such monetary control is inefficient because economic agents create financial products that are close substitutes for money, such as commercial paper and negotiable debt securities, developed during the 1980s. These financial products entail the development of quasi-money and raise the inherent difficulties of monetary control, as pointed out by Keynesian economists, but also by Frank Morris from the FOMC (see below). Since the quantity of money is endogenously created by the second-tier banks, according to opponents of monetarism, loans make deposits and the central banks only control the price of money, i.e. the interest rate, as emphasized by Moore [1988, p. 381].  The monetarist view of the exogenous money supply was therefore challenged by the Keynesian view, which did not have the same influence during the 1980s.
15Monetarism was the most influential monetary theory of the 1980s. Some defenders of Volcker’s policy still attribute the success of the disinflation policy to Friedman’s rule.  Paradoxically, Friedman himself considered that the policy implemented by Volcker between 1979 and 1982, controlling bank reserves, had never been a monetarist one. In 1979, in a letter facetiously dated 31 July 1912 — Friedman’s own birthday, Friedman wrote to Volcker:
My condolences to you on your “promotion”. I am delighted for the country at your accession to chairmanship but sympathize with respect difficulties you are doomed to face. You have, however, a great advantage and consolation. Your predecessors have, most unfortunately on every other count, left records that it will not be difficult to improve on.
17In some papers published during the “Volcker shock”, Friedman criticized the policy undertaken by the FRS. He defined a monetarist policy in five points:
First, the target should be growth in some monetary aggregate — just which monetary aggregate is a separate question; second, monetary authorities should adopt long-run targets for monetary growth that are consistent with no inflation; third, present rates of growth of monetary aggregates should be modified to achieve the long-run target in a gradual, systematic, and preannounced fashion; fourth, monetary authorities should avoid fine-tuning; fifth, monetary authorities should avoid trying to manipulate either interest rates or exchange rates.
19He specified that every central banker in the world at that time agreed verbally to at least the first three points and most of them to the fourth, whereas the fifth point remained the most controversial. He distanced himself from the SOMC, stating that the resignation of the Federal Reserve’s Governors at the end of any year in which the monetary targets were overshot was not feasible (see below). Friedman suggested two solutions: to put the Fed under the authority of the Secretary of the Treasury or under the direct control of the US Congress. Friedman [1983, p. 6] pointed out that the “most dramatic episode” took place on 6 October 1979 when Volcker announced the changes in the monetary policy, having come under pressure at the IMF Meeting in Belgrade. If the purpose of the new policy — lower and steadier monetary growth — was said to be “excellent” [Ibid., p. 8], the execution of the Fed’s monetary policy was wrong: Friedman described an economic world characterized by violent fluctuations. He pointed out the hindrance played by the lagged reserve requirements, along with the fact that monetary growth became more variable after October 1979, with shortened gyrations. Interest rates and even economy activity followed suit, with great fluctuations over shorter periods than before the Volcker shock. Friedman underlined that the lag between changes in monetary growth and changes in economic activity, inflation and interest rates also shortened. As a result, the Federal Reserve reverted to its old operating procedures: the monetary aggregate targets were replaced with interest rate targets  entailing an increase of 14 per cent in M1 between July 1982 and July 1983. For Friedman: “it is not irrelevant that, if asked, ‘Are you now or have you ever been a monetarist,’ not a single member of the Board of Governors of the Federal Reserve System would answer ‘yes’” [Ibid., p. 7]. Later on, he reinforced these criticisms. Friedman  stated that many observers, having misinterpreted the nature of the “Volcker shock”, had described the failure of this policy as the “demise of monetarism” [Gordon, 1983].  But for Friedman [1984, p. 397] the Fed’s rhetoric was monetarist, but its actual policy was antimonetarist: although containing growth of the monetary aggregates was a monetarist objective, a major element in the monetarist framework was to achieve a steady and predictable rate of growth of the monetary aggregates targeted.  Friedman asserted that the volatility of the monetary growth had tripled from October 1979 to July 1982, giving the Fed’s monetary policy a “purely rhetorical character” [Ibid.]. He was therefore deeply critical of the “Volcker shock” and never considered the monetary policy implemented to be monetarist.
20Furthermore, the monetarist economists gathered in the Shadow Open Market Committee (SOMC), under the direction of Brunner and Meltzer, closely monitored the development of US monetary policy.  Their support for the “Volcker shock” appeared to be short-lived and their analysis of the Fed’s actions was actually deeply critical. Initially, the SOMC welcomed the new policy implemented by the FRS from October 1979, stating: “The October 6 Federal Reserve statement accepted one part of the program that this Committee has recommended for the past six years. We applaud the Fed’s move toward monetary control exercised through the control of monetary aggregates.”  Brunner [1980, p. 20] acknowledged that “Chairman Volcker offered the most explicit and clearest recognition ever presented by a high official of the Federal Reserve Board that monetary control is a necessary instrument of an anti-inflationary policy.” But in March 1981, the tone had already changed because monetary growth in 1980 — the aggregate M1-B increased by 7.1% — had exceeded the target range of 4–6.5%. The SOMC therefore made three proposals:
(1) The Federal Reserve should choose a single target rate of growth for an observable monetary aggregate of its own selection, and should announce the target publicly.
(2) If the Federal Reserve misses the annual average target rate of growth by more than one percentage point, each member of the Board of Governors would submit his resignation to the President.
(3) Governors may accompany their letters of resignation with an explanation of the failure to achieve the target rate of growth. The President may choose to accept the explanations instead of the resignations, and thereby, himself, accept responsibility for the policy. If the President accepts the resignations, new Governors should be chosen to fill the unexpired terms, subject to confirmation by the Senate. 
22The SOMC’s support of the FRS had evaporated. Brunner [1981, p. 79] even changed his mind about the “Volcker shock” launched in October 1979: “The meaning was not clear and subsequent elaborations by various officials hardly contributed to clarify the intent of the announcement. The observations bearing on volatile interest rates and  monetary growth made in 1980 reinforce the inherited uncertainty about the Fed’s policies and policymaking.” Such an opinion was shared by the SOMC,  which stated in March 1982 that “the Federal Reserve does not make any of the changes that would improve monetary control” and even that “no one can have any confidence in Federal Reserve statements that reaffirm its commitment to slower money growth and lower inflation.”  The SOMC pointed out that the Fed actually targeted the daily federal funds rate instead of bank reserves and the money growth and therefore was misleading the public and Congress. They contested the fact that the development of money substitutes increased the problem of monetary control, as claimed by Anthony M. Solomon  in a widely publicized address. Brunner [1982a, pp. 10–11] henceforth underlined “the appearance of a change in policymaking” since October 1979 and even asserted that the framework used by the Fed was “supplemented by a standard Keynesian analysis”, i.e. the monetary growth targeting entailed a great variability of interest rates and more generally that there was a trade-off between the variability of monetary growth and the variability of interest rates. A minor turning point came in September 1982, when the monetarist economists of the SOMC renewed their confidence in the FRS, due to the success achieved with regard to disinflation, stating: “We applaud the Federal Reserve’s commitment and the success of its policy to reduce inflation. If the Federal Reserve continues to reduce monetary growth, inflation will continue to fall.”  But the SOMC remained critical: Brunner [1982b, p. 14] criticized Frank E. Morris,  who “dramatically articulated” the problem of financial innovations for monetary control,  whereas H. Erich Heinemann  [1982, p. 65] emphasized that “the ‘Keynesian Option’ of trying to use easy money to induce lower interest rates is an illusion”, as pointed out by Henry C. Wallich  in an important address during the summer of 1982.
23The Fed’s policy continued to come under criticism in 1983: the monetarists of the SOMC stated that “the current inflationary policy should end” and “urge[d] the Federal Reserve to improve control procedures”.  Brunner [1983a, p. 8] no longer seemed to consider the US monetary policy to be monetarist, as he underlined “a pronounced re-affirmation of discretionary policymaking”, instead of a rule of monetarist inspiration. In September 1983, he stated that “A major inflation battle had been won. But the war on inflation had meanwhile been lost” [Brunner, 1983b, p. 7] because of the substitution of explicit interest rate targeting for monetary control in the late summer of 1982, entailing the sharpest accelerations in monetary growth since World War II, from 4.5% to about 12–13% per year. In March 1984, the SOMC stated: “Current monetary actions are short-sighted and irresponsible”,  because the Fed had abandoned monetary control and was repeating the “major mistake of the seventies”, i.e. maintaining the federal funds rate in a narrow range. Such a policy was said to be procyclical, making monetary growth a function of changes in market credit demand, erratic, unplanned, and consistent with the Federal Reserve’s targets only by chance. After the “Volcker shock” implemented from October 1979 to August 1982, the Fed was therefore exposed to growing criticism.
24A new change in tone appeared briefly in September 1984, when the SOMC commended the Fed for having kept the growth of M1 within its pre-announced target range for 1984, welcomed the reduction in the inflation rate and applauded its management of the Continental Illinois crisis.  But the support was again temporary: in March 1985, the SOMC stated: “The Federal Reserve concentrates on short-term policy decisions and lurches from excessive money growth to slow growth and back to excessive money growth, with no long-term program to achieve noninflationary money growth.”  Brunner [1985, p. 13] spoke of the “erratic and uncertain sense of our monetary policy” and of a “random walk through history”. The monetarist economists also blamed the Fed for its interventions in the exchange markets — undertaken by the main central banks from September 1984 to halt the strengthening of the US dollar —  seen as counterproductive and destabilizing. They stated that the control of monetary growth and the management of the exchange rate could not be implemented simultaneously.  In March 1986, the SOMC pointed out that these interventions increased uncertainty on exchange and interest rates.  The opposition to the interventions was reiterated in September 1986, when the monetarists highlighted the permanent depreciation of the dollar, which carried high risks of inflation.  Brunner [1987, p. 51] stated that the concerted interventions of the main central banks on the exchange markets might be useful, with the aim of moderating some prevailing political pressures, but would also entail “an indefinite series into the future of such ‘policy coordinations’ with a built-in longer-run inflationary bias combined with intermittent recessions”. The SOMC’s criticisms had become virulent by the end of the 1980s. In March 1986, the monetarists of the SOMC urged the Federal Reserve to replace interest rate targets with a control of the monetary base.  In September 1986, they highlighted that for more than two years the monetary base had been growing at between 8% and 9% at an annual rate, whereas they expected an inflation rate of 5% or 6% over the next several years, stating that: “Current Federal Reserve policy is irresponsible.”  The SOMC made some vehement criticisms in March 1987, stating that “Federal Reserve actions are inflationary” and pointing out the stop-and-go policies implemented by the Federal Reserve System: “Economic growth will accelerate in 1987 in response to powerful stimulative actions by the Federal Reserve. These actions have been excessive. As a result, inflation — and ultimately another recession — now loom on the horizon.” 
25In September 1987, the SOMC welcomed the new Federal Reserve Chairman Alan Greenspan with an open letter in which they recommended major changes in three areas, namely monetary policy, internal debt and financial regulation. On the first point, the members of the SOMC criticized the faster money growth implemented by the Fed to decrease the dollar exchange rate and urged Greenspan to target an annual growth rate of the monetary base of 6%, as a first step to achieving price stability.  In March 1988, the SOMC pointed out that the Fed paid less attention to money growth and more to commodity prices, exchange rates and the term structure of interest rates. They claimed: “Central banks that are most successful in controlling inflation — Germany, Japan and Switzerland — use the growth of money relative to output as a principal, often the principal, indicator of the inflationary force of monetary policy.”  The monetarists therefore claimed that the monetary policy could only have a short-term effect on the exchange rate and that the Fed should ignore the dollar exchange rate. Although they briefly supported the Federal Reserve’s policy, the monetarist economists of the SOMC therefore never considered US monetary policy to be monetarist and never abandoned their strong criticisms, nor did Milton Friedman.
26Now we can examine why Friedman and the monetarists of the SOMC were so critical of Volcker’s policy. We claim that Friedman did not want the Federal Reserve to be successful, rather for political reasons and because of his personal enmity with the Fed than for theoretical reasons. Moreover, Friedman could not recognize the Fed’s policy as monetarist because of the failure of the “Volcker shock” linked to the Mexican debt crisis. According to Friedman, the only monetarist aspect might be the official rhetoric developed by the Fed during this period,  but Friedman’s point of view appears to have been influenced by the fact that Volcker was considered a Democrat, whereas Friedman had been an adviser to Pinochet, Thatcher, Nixon and Reagan,  therefore close to the Republicans.  Volcker was absolutely clear on this point:
I knew from Arthur Burns  that at the start some advisers,  led by Milton Friedman and the extreme monetarists, who had long carried on an intellectual crusade against the Federal Reserve, would have liked to have ended our independence, if not the institution itself. Burns was apoplectic about it. We were indeed fortunate that even in his retirement, his intellectual stature, his public standing, and his old friendships were brought to bear to keep the wilder views of some of his Republican friends at bay.
28The idea that Friedman wished for the Fed to fail was expressed within the FOMC. This was the case during the FOMC Conference Call in June 1980, when Wallich stated: “I would like to postpone the time when we drop below our checkpoints as long as possible. I know that Milton Friedman is tremendously excited about our failing to hit our targets”.  In July 1981, Morris claimed that a shift in the aggregates targets was required because broader aggregates targets provided fewer comments than the narrower one: “the noise factor, which is huge in M-1B, gives the monetarists a shot at us several times a year. They say the money supply is either growing too fast or too slow.”  Lawrence K. Roos’s reply  — “Monetarists don’t shoot at other monetarists, Frank, and we’re all monetarists”  — therefore does not seem very persuasive. J. Charles Partee,  while discussing the best aggregate to target in March 1982, pointed out: “after all, until he found that he didn’t have so much to hit the Federal Reserve over the head with, Milton Friedman was for M2: it’s only recently that he has changed to M1.”  Volcker himself seemed sometimes to distance himself from Friedman: this was the case in November 1982, when Volcker underlined his own competencies and the fact that Friedman had to reconsider his position on the velocity of money:
When velocity has declined for five [successive] quarters for the first time in the postwar period, something is different… I used to watch velocity figures in the ‘50s and I will tell you they were rising, because I used to write stories about the belief that they had risen so much they had to stop rising. And they’ve risen every year since then!… That shows you how great an expert I am on velocity! I remind you of Milton Friedman who, looking at a hundred years, wrote his book and said that velocity will always fall. Money is a luxury good and the most certain thing about monetary policy is that velocity is going to fall. Like all scholars he has caught up. 
30It was also the case in July 1986: when Wayne D. Angell  stated, “From 1918 to 1947 V1 fell from over 4 to under 2”, Volcker immediately underlined, “That’s when Milton Friedman wrote his great tome saying there was an inexorable secular decline in velocity”, and added: “At which point it rose from 2 to 4.”  Alan Greenspan, Chairman of the FRS from 1987 to 2006, also pointed out some of the weakness in the monetarist analysis in 1988, stating:
If you go back to the 1960s, and especially the 1970s, my recollection is that toward the latter part of the 1970s we still had this acceleration of inflation expectations. You remember Milton Friedman used to draw the lines where the top of the highs of inflation were always successively higher and the bottoms of the lows of inflation were always successively higher. Despite that, until very late in the 1970s — I suspect really the middle of 1979 — inflation expectations never took hold. 
32Recognition of the FRS’s monetary policy as monetarist in nature undoubtedly depended on the economic success of such a policy, as pointed out by Volcker in May 1983: “If we don’t have a great explosion of inflation in the next year around the world, the monetarists had better run for cover.”  In November 1984, Partee also underlined that Friedman expected the failure of the disinflation policy implemented by the Federal Reserve, stating: “inflation expectations may have subsided over the last six months… You may remember in the spring that it wasn’t hard to find outliers like Milton Friedman who thought that inflation would be at double digits by the end of this year.” 
33The Fed’s policy was therefore deeply criticized by Friedman for theoretical reasons, but it clearly appears that these were not the only reasons: Friedman had always been a Fed prosecutor  and the members of the FOMC had been fully aware of this parameter. Moreover, the failure of the Volcker shock in 1982 explained why this policy has never been recognized as monetarist even though it was of monetarist inspiration. Another reason is provided by Bindseil [2004b, p. 222], stating that the Volckerian implementation of monetarist principles was “overly complex in its formulation of various operational and intermediate targets”.
3 – Implementation of the Volcker shock
34In this section, we sum up the policy implemented by the Fed beginning in October 1979, and highlight that rather than a technical change, it was a significant change in the orientation of monetary policy. We emphasize its consequences for the exchange rate of the dollar, the key interest rates of the European central banks, and finally the Mexican debt crisis. We underline the Fed’s inability to target the money supply, and we run an econometric analysis showing that the monetarist framework was irrelevant for the period, because of the instability of money velocity and the endogenous nature of the money supply.
35After having informed his fellows at the Annual Meeting of the International Monetary Fund in Belgrade in September 1979 — particularly the German President of the Bundesbank Ottmar Emminger, who was very receptive to his ideas [Volcker & Gyohten, 1992, pp. 167–8], — Volcker launched a new monetary policy as the head of the Federal Reserve. He was influenced by monetarist ideas, and convinced to act to decrease high inflation rates. Such a monetary “revolution”, managing the money supply by controlling the volume of bank reserves directly, was clearly stated by the record established by the Federal Open Market Committee on 6 October 1979:
In the Committee’s discussion of policy for the period immediately ahead, the members agreed that the current situation called for additional measures to restrain growth of the monetary aggregates over the months ahead. The members felt that growth of the aggregates at rates within the ranges previously established for 1979 remained a reasonable and feasible objective in the light of the available information and the business outlook. Given that objective, most members strongly supported a shift in the conduct of open market operations to an approach placing emphasis on supplying the volume of bank reserves estimated to be consistent with the desired rates of growth in monetary aggregates, while permitting much greater fluctuations in the federal funds rate than heretofore. 
37The technical change in US monetary policy was justified by the FOMC. It aimed to tackle inflation, but also to influence the domestic levels of wages and prices and the exchange rate of the dollar:
The principal reason advanced for shifting to an operating procedure aimed at controlling the supply of bank reserves more directly was that it would provide greater assurance that the Committee’s objectives for monetary growth could be achieved. In the present environment of rapid inflation, estimates of the relationship among interest rates, monetary growth, and economic activity had become less reliable than before, and monetary growth since the first quarter of 1979 had exceeded the rates expected despite substantial increases in short-term interest rates… Altogether, the System’s action would tend to moderate inflationary expectations, thereby exerting a constructive influence over time on decisions affecting wages and prices in domestic markets and on the value of the dollar in foreign exchange markets. 
39The new procedure focused on the reserves of the second-tier banks, particularly on the bank reserves net of funds loaned by the Federal Reserve under the discount procedure, called “non-borrowed reserves”.
40The non-borrowed reserves on which the Fed operated its control therefore appeared in the elements followed in its targeting policy with the monetary aggregates, as shown by Figure 1. In his press conference at the Federal Reserve Building, Volcker underlined: “What will differ is that more emphasis will be placed upon a translation of those aggregates objectives, which in themselves have not changed, into their implications for the Reserve Banks for actual reserves and for non-borrowed reserves”.  He specified that this new policy could lead to greater fluctuations in short-term US interest rates, to which less attention was paid:
Now what is implied here is a somewhat different approach where the primary emphasis is put on the supply of reserves which ultimately controls the money supply. I don’t want to suggest that the control is so precise that it works week by week or even with precision month by month. But by emphasizing the supply of reserves and constraining the growth of the money supply through the reserve mechanism, we think we can get firmer control over the growth in the money supply in a shorter period of time — greater assurance of that result. But the other side of the coin is in supplying the reserves in that manner, the daily rate in the market… is apt to fluctuate over a wider range than has been the practice in recent years. We at the Federal Reserve will take less interest, if you will, in the daily fluctuations of that very short-term rate. 
The US targeting policy and results, 1979–80
The US targeting policy and results, 1979–80
42The new procedures implemented by Volcker in 1979 had therefore replaced Federal funds rate targeting with non-borrow reserves targeting.  This policy was completed on 8 February 1980 by a redefinition of US monetary aggregates. The aggregate M1 was renamed M1A without changing its definition, whereas the new aggregate M1B was defined as including M1A, but also the NOW  and ATS  accounts of the banks and thrift institutions, credit union share draft accounts, and demand deposits at mutual savings banks. M2 was redefined to be M1B plus overnight repurchase agreements (RPs) issued by the commercial banks to the non-banking sector, overnight Eurodollars issued by the Caribbean branches of US banks to the non-banking US customers, money market mutual funds shares, savings deposits and small time deposits  in commercial banks and thrift institutions. M3 therefore included M2 plus large time deposits  and term RPs at commercial banks and thrift institutions, net of term RPs held by money market mutual funds. Finally, a new aggregate called L was created: it included M3 plus the non-bank public’s holdings of US savings bonds, short-term treasury bills, commercial paper and bankers’ acceptances.  Another aggregate was introduced in May 1981: M1B shift adjusted, defined to be M1B less shifts to other checkable deposits (OCD) from non-demand deposits sources. All the aggregates were redefined again in January and February 1982, and once again in February 1983.
43The new regulatory procedure of the Federal Reserve System focused on targeting the narrow monetary aggregate M1 (or M1A), because of the proximity between the bank reserves and this aggregate [Kavajecz, 1994], but the Fed tried hard to target the growth of both monetary aggregates M1 and M2 [B. Friedman, 1996, p. 43]. The change undertaken in 1979 involved targeting the inflation rate implicitly through an explicit interest rates policy [Goodfriend, 2005]. The announcement of the federal funds rate and of money supply targets thus served to control the general price level, in accordance with monetarist precepts. Defining such a policy had entailed several consequences. First of all, a very strong increase in US interest rates.  The federal funds rate reached its historical peak in 1982, as shown by Figure 2: rather than the technical supports pointed out, it was the orientation of US monetary policy that was clearly changing under Chairman Volcker. West German Chancellor Helmut Schmidt even complained about “the highest real interest rates since the birth of Christ”. 
Effective Federal Funds Rate, January 1976 – December 1989
Effective Federal Funds Rate, January 1976 – December 1989
44The strong rise of the US federal funds rate thus entailed some increases in the key interest rates of the European central banks, as shown in Figure 3. The spillover effect of the “Volcker shock” was immediate and European key interest rates increased from the fourth quarter of 1979 [Bourguinat et al., 1985, p. 12]. The fluctuations in US interest rates therefore triggered variations in the key interest rates of the Bank of France and the German Bundesbank, which were actually unable to implement fully independent monetary policies [Reichart, 2015].
Key interest rates of the Federal Reserve, the German Bundesbank and the Bank of France, 1979–88
Key interest rates of the Federal Reserve, the German Bundesbank and the Bank of France, 1979–88
45In addition, the “Volcker shock” had led to a large rise of the dollar on the exchange markets from 1980 until 1985, as shown by Figure 4: the dollar increased not only against the German mark, but also against all the EMS currencies. Against the French currency, the dollar rose from FRF 4.50 at the beginning of 1981 to more than FRF 10.50 at its peak in February 1985. Indeed, the greenback reached its historical peak in February 1985.
Germany / United States Foreign Exchange Rate, January 1979 – December 1990
Germany / United States Foreign Exchange Rate, January 1979 – December 1990
46The Volcker shock was therefore a major turning point in US monetary policy and had important consequences for the US economy — i.e. an economic recession at the beginning of the 1980s — but also for the main economic powers, and finally for developing countries, as highlighted by the Mexican debt crisis that took place in August 1982. On 12 August, the Mexican Minister of Finance Jesus Silva Herzog informed Don Regan, US Secretary of the Treasury, Volcker and Jacques de Larosière, Managing Director of the International Monetary Fund, that Mexico was not able to meet its commitments. Three days later, Mexico effectively stopped the reimbursement of its debt and the United States provided a credit of USD 2 billion to Mexico. The Mexican debt crisis took the US completely by surprise, in spite of a report by the Federal Reserve’s staff in April 1982, which did not receive high-level attention [Krugman et al., 1994]. The Mexican net banking indebtedness sharply increased from 1975 — when it was lower than USD 20 billion — until 1982, when the debt came to USD 60 billion,  and the interest expense was linked to the trend in US interest rates. The developing countries had public debts whose interest rates were indexed to the three-month or six-month Eurodollar rates: the interest paid by these countries increased by 45% in 1980 and by 65% in 1981 and therefore became unsustainable [Denizet, 1984]. Mexican President José Lopez Portillo attributed the economic disturbance to a “conspiracy of the American monster” [Attali, 1993, p. 346]. The Mexican debt crisis undoubtedly played an important role in the end of the US’s strictly monetarist period begun in 1979, as noted in the Annual Report of the FRS for the year 1982:
The link between the Federal Reserve’s decision to lower its discount rate on 27 August 1982 and the Mexican debt crisis therefore appeared in the Annual Report of the Federal Reserve System, whereas the overshoots of the monetary targets shown in Figure 5 called for a tightening of US monetary policy.After three months of weakness, M1 grew rapidly in August and September; growth in M2 accelerated in August from an already rapid pace but appears to have slowed markedly in September… The Federal Reserve discount rate was reduced from 10.5 per cent to 10 per cent in late August. Meanwhile, reflecting some well-publicized problems in recent months of a few banks here and abroad and the financing difficulties of Mexico, a more cautious atmosphere in private credit markets has been reflected in wider spreads between US government and some private credit instruments. The Federal Open Market Committee seeks to foster monetary and financial conditions that will help to reduce inflation, promote a resumption of growth in output on a sustainable basis, and contribute to a sustainable pattern of international transactions. 
The targeting policy of the Federal Reserve and its results, 1981–82
The targeting policy of the Federal Reserve and its results, 1981–82
47The role played by the Mexican debt crisis in the mitigation of US monetary policy was also underlined by Volcker himself:
[U]nder Jimmy Carter in 1978, the defence of the dollar eventually became an important element in domestic policy. That all merged into the war on inflation at home, where I had been drafted to play a role at the Federal Reserve. One cost of that war was the highest interest rates we had ever seen, a good lesson in why we shouldn’t let inflation get the upper hand. The fight against inflation complicated the Latin American debt crisis that came to a head in Mexico in 1982 and later contributed to a strong rise in the international value of the dollar.
49The Mexican debt crisis and its consequences were the main factor that led to the end of the monetary policy launched in October 1979.  This policy was therefore abandoned in August 1982, not for domestic reasons but rather because of its consequences on the Mexican economy, in which US banks had strong interests. The money supply targets nevertheless continued to be used throughout the 1980s. Starting from 1984, the policy implemented by the FRS was also characterized by the interventions on the exchange markets, together with the main central banks, to stop the increase and then organize the decrease of the dollar. After the “Volcker shock”, US monetary policy was therefore characterized by a return to discretionary policies, but monetarism kept its influence, through money supply targeting.
50Despite this remaining influence, an econometric analysis of this period allows us to underline the weakness of the monetarist framework to explain inflation developments in the United States during the 1980s. The econometric analysis of the money supply defined as M2, the velocity of money, the price level of consumption goods and real Gross Domestic Product, during the period from 1979 to 1989, given by the Federal Reserve Economic Data base, cast light onto three results.
51Firstly, we obtain very high correlation coefficients averaging 0.97 between money supply and real output, and 0.99 between money supply and price level, respectively. These observations are consistent with the quantity theory of money, according to which a change in money supply involves either a proportional variation in real output given the price level, or a proportional variation in the price level given the real output. Nevertheless, it does not mean any causality between these variables, since the Fisherian Quantity Money Equation is much more an accounting identity than a causal relation. Secondly, a correlation analysis shows coefficients averaging -0.73 between the velocity of money and the money supply, -0.63 between the velocity of money and real output, and a coefficient averaging -0.69 between the velocity of money and price level. Our results do not validate the quantity theory of money as far as this theory assumes independence between money supply and the velocity of money.
52Thirdly, the regression gives an R-squared of 0.9878 for the following equation:
53P = -5.063 + 0.002 M + 1.479 V
54This result is not consistent with the monetarist prediction, which assumes that P is independent of V. Causality can be reversed between the price level and money supply such that:
55M = 2774.859 + 478.116 P – 874.996 V
56Endogenous money makes central bankers unable to control M3, M2 and even M1 and to apply any quantitative rule. The following figures show that it is not the trend in the money supply but the velocity of money that allows the variations in real output and price levels. We observe steady growth in the money supply during the period.
M2 Money Stock, 1979–89
M2 Money Stock, 1979–89
Velocity of M2 Money Stock (right) & Consumer Price Index for All Urban Consumers: All Items (left)
Velocity of M2 Money Stock (right) & Consumer Price Index for All Urban Consumers: All Items (left)
57We observe a comparatively high variance in the velocity of money, such that the velocity cannot be considered a constant or even a stable parameter. The velocity of money is so unstable that the quantity theory of money is no longer an explicative theory of output or the price level.
Velocity of M2 Money Stock & Consumer Price Index for All Urban Consumers: All Items, 1979–89
Velocity of M2 Money Stock & Consumer Price Index for All Urban Consumers: All Items, 1979–89
58The acceleration of the circulation of money, made possible by changes in banking rules and financial innovations, was not sufficient to avoid both brutal recession and disinflation implied by the Mexican crisis.
Real Gross Domestic Product, Quarterly, Seasonally Adjusted Annual Rate
Real Gross Domestic Product, Quarterly, Seasonally Adjusted Annual Rate
59According to these observations, the failure of Volcker’s policy was attributable to the irrelevance of Friedman’s k-rule. It led practitioners to manage instruments of monetary policy more pragmatically. The Volcker shock had failed and monetarist economists had no interest in recognizing this inheritance. However, the FOMC was deeply influenced by monetarism, during but also after the Volcker shock, in spite of the statements made by Friedman and the SOMC.
4 – The direct and indirect influence of monetarism on the FOMC
60In this section, we show that monetarism had an influence of a twofold nature on the Federal Reserve: direct — by the adoption of the monetarist ideas by some members of the FOMC — and indirect — because monetarism was the hegemonic school of economic thought on monetary questions during the 1980s and even the members of the FOMC who were not monetarists took monetarist influence into strong consideration. The Fed’s policy was therefore highly influenced by monetarism.
61Since 1935, the Federal Open Market Committee has been the main organ of the Federal Reserve System, in charge of the open market operations.  The FOMC is composed of twelve members, including the seven members of the Federal Reserve Board, the President of the Federal Reserve Bank of New York,  and four of the remaining eleven Federal Reserve Bank Presidents, who serve one-year terms on a rotating basis. It is chaired by the President of the FRS, i.e. Volcker from 1979 until 1987. 
62In the United States, Paul Volcker is known as something of a financial legend for having crossed political lines. After having worked as financial economist at the Federal Reserve Bank (FRB) of New York, at the Treasury Department and at Chase Manhattan Bank, Volcker was appointed Deputy Undersecretary of the Treasury for Monetary Affairs by President John F. Kennedy in 1963. In the Nixon Administration, he served as Undersecretary of the Treasury for Monetary Affairs from 1969 to 1974, before becoming President of the FRB of New York in 1975. He was appointed Chairman of the Federal Reserve System by Jimmy Carter in 1979, and reappointed in 1983 by Ronald Reagan. More recently, he served as Chairman of the President’s Economic Recovery Board from 2009 until 2011, under Barack Obama. Known to be a Democrat, he has also served under Republican presidents. His economic ideas have been influenced by different schools of thought. Volcker’s favourite author as an undergraduate was Friedrich Hayek [Silber, 2012, p. 33]. In his undergraduate thesis, he harshly criticized the Federal Reserve for having failed to tackle inflation after World War II [Volcker, 1949]. Under Nixon, who described himself as a Keynesian, Volcker contributed to the suspension of the dollar’s convertibility into gold in August 1971, “the most significant single event” in his career.  At the head of the FRB of New York, Volcker pointed out both the benefits of the monetarist ideas, particularly the ineffectiveness of monetary policy in terms of growth and employment in the long run, and its only consequence in terms of inflation:
There is a lot of evidence that the relation between money and prices is not very close in the short run. But there is also a hard core of truth in the central theme of the monetarist school: over time, an excess supply of money contributes nothing to employment, nor to real income, nor to real wealth, but only to inflation. In its modern dress, monetarism has also helped clear up a good deal of confusion in other respects.
64Volcker explained that monetarism helped him to become more aware of the difference between nominal and real interest rates, defined as the return after adjustment for expected changes in purchasing power. He also underlined the greater importance given to the expectations in explaining behaviour in financial markets and in economic life generally thanks to monetarist thought and, by extension, that lenders and borrowers were able to anticipate inflation and were therefore sensitive to economic policies they interpreted as contributing to inflation and could react in unaccustomed ways. Having explained the benefits of monetarist ideas, Volcker claimed that monetarism had henceforth a deep influence on the main central banks:
In a sense, the long run of which the monetarists speak has caught up with us. The lessons have not been lost on central banks, in the United States or elsewhere. They have responded, in their policies and policy pronouncements, by putting new emphasis on the behaviour of the money supply and its related monetary aggregates. In particular, it has become the practice in the United States, in Canada, and in a number of other important countries to specify quite precisely the growth ranges, or targets… for certain monetary aggregates over a period of a year or so ahead.
66In 1977, “after two years of experience with projecting monetary growth ranges”, Volcker stated that he became “increasingly convinced that this experiment in ‘practical monetarism’ is proving useful” [Volcker, 1977, p. 25]. When he became Chairman of the FRS, Volcker consciously implemented a monetarist-oriented policy. In January 1980, he stated in front of the National Press Club: “Our policy, taken in a long perspective, rests on a simple premise – one documented by centuries of experience – that the inflationary process is ultimately related to excessive growth in money and credit” [Brunner, 1980, p. 18]. The primary sources of the Federal Open Market Committee clearly underline such an orientation, as was the case in February 1980, during the preliminary discussion before a vote on new monetary targets when Volcker argued that the three-point range that he defended and which was approved by the members of the FOMC was the strongest worldwide, stating: “I don’t know of another central bank in the world, however monetarist oriented, that has a narrower target than three percentage points.”  Volcker was therefore well aware that the Federal Reserve was undertaking the strictest monetarist policy. Another important point is that, although not all members of the FOMC claimed to be pure monetarists, the point of view of monetarist economists was constantly taken into account by them: the influence of monetarism on the Federal Reserve System was therefore direct — because of the support of some members of the FOMC for monetarist ideas — and indirect — when monetarism appeared to be a constraint for the implementation of US monetary policy because monetarism was the most important school of economics during the 1980s. In February 1980, Henry Wallich worried about satisfying the monetarists by changing the Fed’s policy, and wondered about the potential gain the central bank had “in terms of the monetarists’ analysis”.  Robert P. Black,  who represented the monetarist wing of the FOMC along with Lawrence Roos [Goodfriend & King, 2005, pp. 34–5], expressed a desire to quiet the monetarist criticisms. 
67In April 1980, Volcker clearly stated that US monetary policy belonged to a monetarist framework, claiming: “people of monetarist persuasion will believe it more than others. Some people don’t believe the underlying theory, so they have no reason to believe it.”  In turn, Roos defended the target policy implemented by the FRS by referring to monetarist theory, stating that an overshoot or undershoot in the short term needed to be put into perspective and should not change the pace of US monetary policy:
Before we feel that our inability to forecast monthly behaviour of the aggregates reflects some sort of weakness in what we’re doing, I think we should keep in mind the fact that even the most ardent monetarists have never believed it is possible to control money or to avoid fluctuations on a month-to-month basis. 
69E. Gerald Corrigan  also underlined the strong indirect influence of monetarists on US monetary policy, stating in December 1980: “I would hope we could keep the focus in terms of aggregates more or less where it is… I don’t want to get trapped in a cage with your 200 monetarists either.”  Friedman’s ideas concerning the required reserves and the loans to commercial banks were also mentioned by Volcker and Lyle E. Gramley  in February 1981,  whereas Black argued that if the Fed were inclined to hide behind lagged reserve accounting and to use that as an excuse for not really pursuing the aggregate targets, “we’d get the monetarists off our back on that particular issue and maybe they could make some positive contribution toward improving the control mechanism.”  If Frank Morris spoke in favour of a decrease in the federal funds range in October 1981, this was because of the dangers of monetarist ideas. He stated: “I would be very reluctant to see us repeat the mistakes of the spring of 1980 and in our monetarist zeal allow interest rates to get to levels that produce the big reactions.”  In November 1981, a discussion took place between the members of the FOMC that undoubtedly underlined the monetarist framework of US monetary policy: when Morris wondered whether people understood that the Federal Reserve had become “completely monetarist”, Volcker answered: “I think for sure, at this point”, and then Morris claimed, “Milton Friedman has finally won!”  The Fed claimed to undertake a monetarist-oriented policy. The implementation of such a policy nevertheless entailed some problems underlined within the FOMC, where some members remained critical. Nancy H. Teeters  stated that she had “a strong feeling that we’re monetarists when the economy is expanding and we’re interest rate targeters when it begins to collapse.”  In December 1981, Morris pointed out the difficulties experienced by the Fed in targeting the money supply and underlined the instability of the velocity of money, contrary to the monetarist theory in which the velocity of money should gradually decrease in the long run. He asserted that:
It is ironic that the Federal Reserve has switched to monetarism at the very time when our ability to measure the money supply has eroded dramatically and our ability to differentiate money from liquid assets is rapidly disappearing. And, therefore, the relationship between what we call money and nominal GDP, which is really what we are after, is becoming increasingly unstable… Monetarism does require that we are able to measure accurately the money supply. That is absolutely essential to the monetarist approach. And once you take the position that you can no longer differentiate money from liquid assets, you are in real trouble trying to pursue a monetarist course. 
71A few months earlier, opening the Meeting of the FOMC in February 1981, Volcker called into question the implementation of the technique and raised the debate about the definition of the federal funds band in respect with the estimation of the multiplier:
Presumably, the objective of this discussion is to arrive at some judgement as to whether or not we’re generally satisfied with the technique that we adopted [in October 1979]… It implies judgmental adjustments in terms of the multiplier; it implies some kind of federal funds rate band… [T]here is some sense inherent in the technique, but maybe not openly stated, that the way the technique is run doesn’t bounce reserves up and down very sharply depending upon what happened last week of even last month. There is some sluggishness in adjustment which in itself presumably has a short-run stabilizing effect on money market interest rates even though that is not the stated objective. 
73Teeters shared this scepticism concerning the technique of implementation of the monetarist rules, but her point of view was based on the argument of the difficulty of estimating the credit multiplier because of its instability:
You took USD 540 million out in the multiplier adjustment, which is greater than I’ve ever seen before. That must mean that you had a very unstable multiplier relationship in your initial projections that you were constantly adjusting. 
Of course we have to change this each week as we get data and we lagged reserve accounting in some sense we are always perfect on it. But the current relationship doesn’t mean anything and the lagged one does. I don’t recall to what extent we have to change them. We’ve made considerable changes, but I don’t recall that as being a big source of error with the lagged reserve accounting. 
77The relevant point of this debate is that the question raised was not about the consistency of the monetarist principles but about whether these principles were operational. The monetarist theoretical framework therefore entailed doubts within the FOMC, but also practical difficulties. The influence of monetarist economists on the Fed’s policy was reaffirmed, however, during the Meeting of 30 June – 1 July 1982 of the FOMC, when Charles Partee reminded his colleagues that the federal funds rate limits had been changed exactly one year previously “under the pressure of the monetarists”.  Volcker even read an extract from a famous book during the meeting, close to his own ideas about the holding of money by the economic agents:
78Everybody is focused on the question of whether we have enough money and what is going on in terms of liquidity demands. I don’t have anything particularly to add there. I share the general feelings that have been expressed by most people, I think. I read an analysis the other day of this kind of problem, which I’ll read to you: “Other things being the same, it is highly plausible that the fraction of their assets individuals and business enterprises wish to hold in the form of money, and also in the form of close substitutes for money, will be smaller when they look forward to a period of stable economic conditions. After all, the major virtue of cash as an asset is its versatility. It involves a minimum of commitment and provides a maximum of flexibility to meet emergencies and to take advantage of opportunities. The more uncertain the future, the greater the value of such flexibility and hence the greater the demand for money is likely to be.” That almost sounds like my recent testimony. But it happens to be from Friedman and Schwartz, A Monetary History of the United States 1867 to 1960. 
79It appeared that the outbreak of the Mexican debt crisis — “a temporary phenomenon”  for the SOMC — did not change Volcker’s loyalty to monetarist ideas: in October 1982, when Lawrence Roos wondered whether anyone had been able to demonstrate any reliable relationship between the growth of the broader aggregates and economic activity, the Chairman of the FRS only answered that “Milton Friedman wrote a big book on the subject.”  Anthony Solomon pointed out that a modest decline in interest rates would undergo some questioning “not only in monetarist circles” — i.e. the hegemonic school of thought — “but more generally.”  In July 1983, J. Robert Guffey  took into account the monetarists’ point of view while discussing the monetary targets, stating: “an 11 per cent top suggests to anybody who chooses to figure it out — and the monetarists and market people or others will do so — about a 6-1/2 [per cent] increase for the remainder of the year. And in view of the uncertainty, that isn’t unreasonable.”  On the contrary, in November 1983, Teeters was still critical of the monetarist-inspired US monetary policy, stating: “one cost of our monetarist experiment that tends to be overlooked… was the extraordinary economic cost of the volatility of the rates. The volatility of short-term rates is not all that serious, but when it was transmitted totally and completely into long-term rates it helped to destroy the long-term market. I think not only the level of the rates but the volatility of the rates was just economically unacceptable.”  Whether or not the members of the FOMC agreed with monetarist ideas, they always referred to monetarism because the monetary policy was monetarist.
80Even after the end of what is generally regarded as the US “monetarist experience” in 1982, US monetary policy was still consistent with monetarist principles, as claimed by Volcker in December 1984: “I would point out that the money supply has been steadier when we depressed its importance and the automatic responses we have given to [the aggregates]. Not so many months ago we were being praised by the monetarists for this new way we had found to keep the money supply steady.”  The Chairman of the FRS was always sensitive to the monetarist point of view, but the influence of monetarism entailed a soft decline in the late 1980s. Volcker seemed to be mocking the monetarists in August 1985: “I’m very chary of the credibility argument… [We could have] a great increase of credibility with the monetarists in the short run if the economy plunges into recession or we have a great financial crisis.”  In turn, Vice Chairman Corrigan asserted: “Long term, we’ve advanced from pragmatic monetarism to full-blown eclecticism.”  He defined himself “by no stretch of the imagination a monetarist”,  but monetarism still seemed to have an influence within the FOMC. If Lawrence B. Lindsey  underlined that the relation between the gross national product and the monetary aggregates was not as systematic as stated by the monetarists,  Wallich stated that the trend in the monetary aggregates was unsatisfactory and claimed: “I would go with the monetarists and say we cannot go on with the M1 and M2 growth that we have been having. That’s just can go on immediately.” 
81While discussing the comments on the behaviour of the money supply and of the market rates in the last Bluebook of the FRS, in July 1987, Wayne Angell pointed out: “That’s not too bad. It doesn’t make the monetarists angry. It doesn’t make anybody angry.”  Volcker was also concerned by reassuring “some of our monetarists”,  whereas Vice Chair of the Federal Board of Governors Manuel H. Johnson  wondered: “What do you say to monetarists who have focused on M1A and tried to take out the highly sensitive interest component and still find a similar pattern… in M1 growth?”  and still referred to the monetarist ideas: “The only thing I can think of is that the monetarists would say that there’s a lag and that to look at contemporaneous inflation and to adjust monetary policy is chasing the tail.”  In June 1988, while discussing the monetary targets for 1989, H. Robert Heller  answered Chairman Alan Greenspan by referring to the monetarists, stating: “I think, Mr Chairman, that the problem will go away anyhow, now that we’re getting them down to a range — you know the midpoint is 5 per cent — which Professor Friedman has always advocated as a permanent growth range from now until eternity.”  But Corrigan was definitely distancing himself from monetarism, speaking about the “naive monetarist model” and the “naive monetarist perception of things.”  This was also the case for Greenspan, stating in December 1989: “I must say that the P* model  on prices is better than any monetarist model on prices that I’ve seen.”  If the influence of monetarism had been important under Chairman Volcker, its influence declined at the end of the 1980s.
82The influence of monetarism on the FRS during the Volcker era was therefore of two kinds: a direct influence due to the adhesion of some FOMC members to the monetarist concepts, whereas the others clearly rejected these ideas; and an indirect influence whereby the FOMC members paid attention to monetarist criticisms and implemented a policy consistent with monetarism. Despite the criticisms made by Friedman and the Shadow Open Market Committee, the monetary policy implemented by the Federal Reserve during the 1980s was deeply influenced by monetarism.
5 – Concluding remarks
83In this paper, we provide a thorough analysis of the influence of monetarism on the Federal Reserve System in the 1980s, thanks to the use of the Fed’s primary sources (especially the Minutes of the Federal Open Market Committee), the monetarist literature and Federal Reserve Economic Data. We show that Friedman and the monetarists of the Shadow Open Market Committee led by Brunner and Meltzer never recognized Volcker’s policy as being monetarist, and we explain that their position was political rather than theoretical.  We emphasize that the members of the FOMC were fully aware of the fact that Friedman was a prosecutor of the Fed who ultimately wanted US monetary policy to fail. We show that the monetarist framework was irrelevant for this period and emphasize the role of the velocity of money to explain the trend in the US price levels and gross domestic product, rather than that of the US money supply thanks to an econometric analysis. Despite monetarists’ criticisms and this irrelevant monetarist framework, we show that the monetary policy of the Federal Reserve System was deeply influenced by monetarism, due to the adhesion of some FOMC members to monetarist ideas and due to the importance of monetarism in the 1980s: even the members of the FOMC who were critical took the monetarists’ points of view into account. The Fed’s policy had to be implemented in conformity with monetarist ideas. The analysis of the influence of monetarism in the 1980s could be improved by focusing on the European central banks, in which quantitative target policies had been implemented from the mid-1970s and central bankers had been influenced by monetarist principles.
Modigliani claimed: “Milton Friedman was once quoted as saying, ‘We are all Keynesians, now’ and I am quite prepared to reciprocate that ‘we are all Monetarists’ — if by monetarism is meant assigning to the stock of money a major role in determining output and prices” [Modigliani, 1977, p. 1].
The work of Friedman and Schwartz was still mentioned by Fed Chairman Bernanke in his decision to lower interest rates and increase money supply to stimulate the economy during the global recession that began in 2007 in the United States [Jahan and Papageorgiou, 2014, p. 39].
Meltzer is said to have belonged to the “hard-line monetarists”, along with Bennett McCallum, William Poole and Thomas Mayer [Modigliani, 1988, p. 12].
With the exception of Milton Friedman.
All reserve quantity oriented techniques were classified as variants of an approach coined by A. James Meigs, in his PhD thesis supervised by Milton Friedman and published in 1962, as the “reserve position doctrine” [Bindseil, 2004a, p. 7].
“This relation was widely interpreted as a causal relation that offered a stable trade-off to policy makers… Unfortunately for this hypothesis, additional evidence failed to conform with it. Empirical estimates of the Phillips curve relation were unsatisfactory. More important, the inflation rate that appeared to be consistent with a specified level of unemployment did not remain fixed: in the circumstances of the post-World War II period, when governments everywhere were seeking to promote ‘full employment’, it tended in any one country to rise over time and to vary sharply among countries” [Friedman, 1976].
Monetarism is a heterogeneous corpus, with notable differences between monetarism of the first generation, supported by Friedman’s writings, and monetarism of the second generation, that of “rational expectations”, led by Robert Lucas. See for instance Hoover , or Guerrien, in Kaldor [1985a, pp. 5–16].
Notably pointed out by Nicole Oresme during the 14th century [Oresme, 1365], by Jean Bodin during the 16th century [Bodin, 1568] and by Irving Fisher in the beginning of the 20th century [Fisher, 1911].
“Inflation is always and everywhere a monetary phenomenon” [Friedman, 1963, p. 17].
“The ‘new’ policy of the Federal Reserve, formally announced by Mr Volcker, the Chairman of the Federal Reserve Board, on 6 October 1979, was to secure a slow and steady growth of the monetary aggregates M1 and M2 by varying the reserves available to the banking system through open-market operations, irrespective of the accompanying movements in the rates of interest. From that day on dramatic changes started to happen which were quite different from those expected. The money supply failed to grow at a smooth and steady rate; its behaviour exhibited a series of wriggles. The rate of interest and the rate of inflation, though both were very high at the start, soared to unprecedented heights in a very short time. By March 1980 the rate of interest rose to 18.6 percent and the rate of inflation to 15.2 percent… and a little later both were at 20 percent — which had never occurred before in the United States since the Civil War, whether in peacetime or in wartime” [Kaldor, 1985a, p. 22].
“Some economists, myself included, had suggested combining the announcement of a firm disinflationary monetary policy, with some variant of incomes policy, at least guideposts” [Mussa et al., 1994, p. 152].
“More fundamentally (and semi-consciously rather than in full awareness) it may have sprung from the realization of the monetary authorities, be it the Federal Reserve or the Bank of England, that are in the position of a constitutional monarch: with very wide reserves powers on paper, the maintenance and continuance of which are greatly dependent on the degree of restraint and moderation shown in their exercise” [Kaldor, 1970, p. 9].
“Monetary endogeneity implies that central banks do not exogenously determine the quantity of credit money in existence, but rather the price at which it is supplied, that is, the short-term interest rate. The money supply is endogenously determined by market forces. Credit money is credit driven, so loans make deposits rather than the reverse… The central argument for the endogeneity of credit money may be very simply put: Banks are price setters and quantity takers in both retail loan and their deposit markets” [Moore, 1988, p. 381].
“In 1979, Paul A. Volcker became chairman of the Fed and made fighting inflation its primary objective. The Fed restricted the money supply (in accordance with the Friedman rule) to tame inflation and succeeded. Inflation subsided dramatically, although at the cost of a big recession” [Jahan & Papageorgiou, 2014, p. 39].
The federal funds rate targets were implemented in the early 1970s [Schwartz, 2005, p. 350].
N. Kishor Kundan and Levis Kochin speak about the “death of monetarism” [Kundan & Kochin, 2007]. James K. Galbraith emphasizes that the result of the policy launched in 1979 was a “cascading disaster” and that “monetarism collapsed” [Galbraith, 2008, p. 3].
Schwartz emphasizes that: “For monetarists, the Fed’s new procedure was a travesty of their prescription of a pre-announced steady and predictable growth of a monetary aggregate. The Fed missed its monetary target more often than it hit it” [Schwartz, 2005, pp. 350-1].
In 1980, the SOMC was composed of Karl Brunner, Allan H. Meltzer, H. Erich Heinemann, Homer Jones, Jerry Jordan, Rudolph Penner, Robert Rasche, Wilson Schmidt, Beryl Sprinkel and Anna Schwartz.
Shadow Open Market Committee (SOMC), 3–4 February 1980, p. 6.
Ibid., 15–16 March 1981, p. 6.
Underlined by Brunner.
But also by Bennett T. McCallum, who states that “money stock ‘targeting’ as practised by the Fed has been characterized by ambiguity” [McCallum, 1984, p. 4].
SOMC, 14–15 March 1982, p. 2.
President of the Federal Reserve Bank (FRB) of New York and Vice Chairman of the FOMC from 1980 to 1984.
SOMC, 12–13 September 1982, p. 3.
President of the FRB of Boston from 1968 to 1988.
Also underlined by Pierce: “The waves of financial innovation that occurred during the last decade and a half have complicated monetary policy because they have produced unpredictable changes in the parameters of the system… Attempts by the Federal Reserve to combat inflation raised interest rates and helped produce innovations” [Pierce, 1984, p. 394].
Vice President of Morgan Stanley from 1974 to 1982.
Member of the Federal Reserve Board of Governors from 1974 to 1986.
SOMC, 6–7 March 1983, p. 5.
Ibid., 11–12 March 1984, p. 6.
Ibid., 30 September – 1 October 1984, pp. 1–2.
Ibid., 24–25 March 1985, p. 1.
See Reichart .
SOMC, 24–25 March 1985, p. 6.
Ibid., 16–17 March 1986, p. 6.
Ibid., 21–22 September 1986, p. 4.
Ibid., 16–17 March 1986, pp. 3–4.
Ibid., 21–22 September 1986, p. 6.
Ibid., 8–9 March 1987, p. 1.
Ibid., 13–14 September 1987, pp. 1–4.
Ibid., 13 March 1988, pp. 2–3.
See Snowdon et al. .
Another important point is that relations between the Federal Reserve System and the Reagan Administration were complicated. Ronald Reagan’s economic adviser Michael Mussa also criticizes Volcker’s policy [Mussa et al., 1994, pp. 81–164].
“Volcker’s obsession with inflation should have made Friedman a natural ally. Instead they went to war, like the biblical clash between David and Goliath, with the five-foot, three-inch Friedman battling the six-foot, seven-inch Volcker over how to conduct monetary policy. And it was not always cordial” [Silber, 2012, p. 150].
Chairman of the Federal Reserve System from 1970 to 1978.
Of Ronald Reagan.
Federal Open Market Committee (FOMC), 1980, 5 June Conference Call, p. 4.
Ibid., 1981, 6–7 July Meeting, p. 52.
President of the FRB of St Louis from 1976 to 1983.
FOMC, 1981, 6–7 July Meeting, p. 53.
Member of the Federal Reserve Board of Governors from 1976 to 1986.
FOMC, 1982, 29–30 March Meeting, p. 49.
Ibid., 1982, 16 November Meeting, p. 38.
Member of the Federal Reserve Board of Governors from 1986 to 1994.
FOMC, 1a986, 8–9 July Meeting, p. 46.
Ibid., 1988, 29–30 June Meeting, p. 37.
Ibid., 1983, 24 May Meeting, p. 20.
Ibid., 1984, 7 November Meeting, p. 15.
See Friedman & Schwartz .
FOMC, 1979, 6 October Meeting, Record of Policy Actions, p. 4.
Ibid., pp. 4–5.
FRB of St Louis, “Transcript of Press Conference with Paul A. Volcker, Chairman, Board of Governors of the Federal Reserve System”, 6 October 1979a, p. 11.
Ibid., pp. 2–3.
“The new procedure was intended to supply banks with the average level of total reserves (the combination of discount window borrowing and open-market provision of non-borrowed reserves) that would produce the rate of monetary growth the FOMC desired over the period from a month before a meeting to some future month, without regard for the accompanying possible movement of the federal funds rate outside a widened range of 400 basis points” [Schwartz, 2005, p. 350].
Negotiable order of withdrawal accounts.
Automatic transfer services.
In the United States, small time deposits are those under USD 100,000.
Large time deposits are those equal to or above USD 100,000. Net of the holdings of domestic banks, thrift institutions, the US government, money market mutual funds, foreign banks and official institutions.
Which excludes money market mutual funds holdings of these assets.
Rich claims that “the Fed realized that a significant rise in interest rates was needed to eradicate inflation, but it was unsure about the size of the required increase. Money stock targets were regarded as a useful device for bringing about the required increase in interest rates” [Rich, 1987, p. 3].
See for instance Putnam & Bayne [1984, p. 156].
Bank for International Settlements, Fifty-Third Annual Report, 1 April 1982 – 31 March 1983, p. 127.
Board of Governors of the Federal Reserve System, 69th Annual Report, 1982, p. 126.
Tobin states: “I hope that history will give Paul and his colleagues the praise that they deserve not only for fighting the war against inflation but also for knowing when to stop, when to declare victory. They reversed course in the summer of 1982, probably averting an accelerating contraction of economic activity in the United States and financial disasters worldwide. Many observers, knowing that the Fed takes seriously its responsibilities for financial stability, have assumed that the Mexican debt crisis and other financial threats were the main considerations in the Fed’s decisions in 1982” [Mussa et al., 1994, p. 152].
Created by the Banking Act of 1935.
He is a permanent member and serves as Vice Chairman of the FOMC.
On 6 October 1979, the FOMC was composed by Paul Volcker, John J. Balles, Robert P. Black, Philip E. Coldwell, Monroe Kimbrel, Robert P. Mayo, J. Charles Partee, Emmett J. Rice, Frederick H. Schultz, Nancy H. Teeters and Henry C. Wallich. Anthony M. Solomon was appointed President of the Federal Reserve Bank of New York on 1 April 1980.
As he said on 7 December 2011, during the Henry Kaufman Lecture, at the Museum of American Finance.
FOMC, 1980, 4–5 February Meeting, p. 58.
Ibid., p. 10.
President of the FRB of Richmond from 1973 to 1992.
FOMC, 1980, 4–5 February Meeting, p. 9.
Ibid., 22 April Meeting, p. 11.
Ibid., p. 8.
President of the FRB of Minneapolis from 1980 to 1984, and President of the FRB of New York from 1985 to 1993.
FOMC, 1980, 18–19 December Meeting, p. 47.
Member of the Federal Reserve Board of Governors from 1980 to 1985.
FOMC, 1981, 2–3 February Meeting, p. 62.
Ibid., p. 60.
Ibid., 5–6 October Meeting, p. 33.
Ibid., 17 November Meeting, pp. 54–5.
Member of the Federal Reserve Board of Governors from 1978 to 1984.
FOMC, 1981, 17 November Meeting, p. 34.
Ibid., 21–22 December Meeting, pp. 32–3.
Ibid., 2–3 February Meeting, p. 1.
Ibid., 1982, 1–2 February Meeting, p. 53.
Axilrod worked from 1952 to 1986 at the Board of the Governors of the Federal Reserve System and became Staff Director for Monetary and Financial Policy and Staff Director and Secretary of the Federal Open Market Committee. Together with Peter Sternlight, manager of the Federal Reserve Open Market Account at the Federal Reserve Bank of New York, he prepared the October 1979 reform. See Axilrod & Sternlight  and Axilrod .
FOMC, 1–2 February Meeting, p. 19.
Ibid., 30 June – 1 July Meeting, p. 56.
Ibid., p. 34.
SOMC, 6–7 March 1983, p. 5.
FOMC, 1982, 5 October Meeting, p. 35.
Ibid., p. 49.
President of the FRB of Kansas City from 1976 to 1991.
FOMC, 1983, 12–13 July Meeting, p. 50.
Ibid., 14–15 November Meeting, p. 56.
Ibid., 1984, 17–18 December Meeting, p. 21.
Ibid., 1985, 20 August Meeting, p. 34.
Ibid., 1 October Meeting, p. 33.
Ibid., 9–10 July Meeting, p. 11.
Associate economist of the FOMC.
FOMC, 1985, 16–17 December Meeting, p. 7.
Ibid., 1986, 19 August Meeting, p. 48.
Ibid., 1987, 7 July Meeting, p. 50.
Ibid., p. 57.
Vice Chairman of the Federal Reserve Board of Governors from 1986 to 1990.
FOMC, 1987, 7 July Meeting, p. 58.
Ibid., p. 60.
Member of the Federal Reserve Board of Governors from 1986 to 1989.
FOMC, 1988, 29–30 June Meeting, pp. 46–7.
Ibid., 1 November Meeting, p. 8.
The P* model, used for monetary targeting, states that inflation is determined by the level of and changes in the “real money gap”, defined as the deviation of current real balances from their long-run equilibrium level [Svensson, 2000].
FOMC, 1988, 18–19 December Meeting, p. 73.
The Federal Reserve System had been a scapegoat, not only for politicians [Kane, 1980], but also for monetarist economists in the 1980s. “Through some obscurantist arguments, Monetarists are able to distance their theory from any unfavourable real-world outcome” [Wray, 1993, p. 543]: they pointed out the demise of the Federal Reserve, which was not recognized as implementing a monetarist policy, instead of accepting their own failures.