1970sA

We have now examined the money supply process so it is time to move on to the next important question: So what? Unless changing the money supply has an impact on the output or labor markets, then there is little reason to be particularly concerned. If you return to the mission of the Fed, included in the list of goals were price stability and full employment, but there was no mention of the money supply or interest rates. Interest rates and the money supply are simply targets the Fed establishes to help the economy achieve the ultimate goals of full employment and price stability. We examined this question in our discussion of the 1930s and concluded at that time the answer was simple - there was no role discretionary for monetary policy. In the Keynesian view of the world things were quite different. First, the economy was not operating at capacity so an increase in aggregate demand would not simply drive up prices. Rather than a change in spending translating into a change in prices (D P), we could now expect a change in spending would translate into a change in output ( D Y). Second, the monetary authorities could influence the level of interest rates in the economy because Keynes saw interest rates as the price of money. If the Fed wanted to decrease interest rates it could increase the money supply (outward shift in the S curve). It could accomplish this by either lowering the discount rate, lowering the required reserve rate, or buying government securities on the open market. The impact of the increase in the money supply on the money market can be seen below in Diagram 1.

But so what? To understand why people care about the Fed's policies we need to look into the transmission mechanism - the link from a change in the money supply to a change in income /and employment that is traced out in Diagram 2 below.

(0) The first of these links we discussed previously when we built in timing. If policy lags are long and variable, and our ability to accurately forecast the movements in the economy is quite limited, then monetary policy may not only prove to be ineffective, but even counterproductive and destabilizing. To conduct successful monetary policy the FOMC must sift through the available economic data to determine the direction of the economy and the appropriate policy response. This involves two lags:

Keynesians tended to downplay the importance of these lags, while monetarists believed " [a]ny sound approach to stabilization policy must recognize the limits of stabilization policy, including the long lags and low multipliers associated with fiscal policy, and the long and variable lags and uncertain magnitudes of the effects of monetary policy."₁ In this situation you can see why monetarists had an aversion to discretionary monetary (and fiscal) policy - even the best intentioned policies were likely to be counterproductive.

(1) Once the policy choice has been made, attention turns to how this is reflected in interest rates? The interest rate is the price of money, and based on our earlier discussion of supply and demand, the change in the interest rate depends on the slope of the money demand curve. If the demand curve is flat, then the increase in money supply will have a limited effect on interest rates. [Diagram 3] A flat demand curve, meanwhile indicates demand is very responsive to interest rate changes, as it might be if interest rates were at low levels. In the Keynesian depression model, the assumption was interest rates were already as low as one could expect and an expansionary monetary policy would not work to drive down interest rates [horizontal money demand curve]. The name given to this extreme version of money demand elasticity was the Liquidity Trap and some observers believe the situation in Japan in the late 1990s offers another example of the liquidity trap. Interest rates are so low in Japan, reaching .5 percent on government securities, the monetary authorities are simply unable to push down rates any further.

Monetarists, on the other hand, believed that the interest elasticity of demand for money was quite low, but that this did not translate into the ability of the Fed to affect the economy by altering interest rates. The key piece of their thinking were the Fisher equation that linked real (r_r) and nominal interest rates (r_n) with the inflation rate (p) [ r_n = r_r + p], and the Equation of Exchange [m + v = p = y] that linked the growth in money supply (m ) and the inflation rate (p). According to the monetarists, the increase in the money supply would drive up inflation which would increase nominal interest rates, but leave unaffected the real interest rates that would ultimately affect the level of real spending.

Diagram 3
Potential Impact on Interest Rates of Increase in Money Supply

(2) Once it is known how much interest rates could be affected by monetary policy choices, the question is: how sensitive is aggregate demand to changes in interest rates? One sector that is responsive to interest rates is residential construction - a component of investment spending. Homes are paid for with mortgages and when the interest rate rises, monthly payments will also rise. An increase in the interest rate from 6.25 to 8.25 percent will increase the monthly payment on a fifteen year, $200,000 mortgage by $220 each month. The result of the higher payment will be a reduction in demand for homes that will translate into lower levels of construction activity. A second sector of demand would be consumer durables - appliances and automobiles households tend to purchase with loans. Demand for nonresidential investment in plant and equipment - new factories and machines - would also decrease with rising interest rates as the present value of the future earnings from these machines would be reduced and the cost of purchasing them increased.

This is the theory, but what about the reality? In the Keynesian view there were doubts about the impact of a policy aimed at lowering interest rates. A drop in interest rates could lower the financing costs for businesses and consumers, but if their outlook on the future of the economy was sufficiently bleak, then this would not make a prospective investment profitable. Consumers who did not have jobs would be unlikely to rush out and buy new homes, and businesses, already suffering with excess capacity, would be hard pressed to justify building new plants or adding on new machinery. In the Keynesian world, while both of the situations described in Diagram 5 would be possible, we were likely to encounter the situation depicted in the right side diagram where a decrease in the interest rate (i* to i**) will produce only a negligible increase in investment spending (I* to I**). Discretionary monetary policy, while a theoretical possibility, is unlikely to work in practice in this environment. Some would come to describe the implementation of expansionary monetary policy as equivalent to pushing on a string.

Monetarists, meanwhile, downplayed the role of interest rates as the primary transmission mechanism. In the Classical world of monetarists, if the supply of money increased (D M) then this would translate directly into an increase in the value of transactions ( D PY) - either higher prices ( D P) or more transactions ( D Y). When we add in the Classical assumption that the level of output / transactions is unaffected by the supply of money, then the additional money shows up as higher prices ( D P). The link between the money supply and the economy is described in Diagram 4.

(3) We are now at the final stage in the process - the Fed has been successful at altering aggregate spending (demand). We have now traced through the monetary transmission process from the time the problem was perceived through the impact of the policy change on aggregate demand. The question now is once again: so what? What will happen to income (output) and prices as a result of the increase in aggregate demand? The answer depends upon two factors.

First, would be the original spending multiplier 1/(1-MPC). If this multiplier is small, which would be the case if consumption spending were insensitive to income (low value for MPC), then any initial increase in demand would have a small "multiplier" effect on aggregate demand. This would likely be the situation for an open economy with high levels of imports where leakages from the system would be high. The multiplier would also be decreased by income taxes and unemployment benefits that act as an automatic stabilizer - taking income out of the system as it expands without any change in government policy. We will not show this graphically, but we would get a higher multiplier when the slope of the aggregate spending line (C+I+G+X-M) was steeper.

Second, there is the allocation of the increase in aggregate demand to increases in prices and increases in output. If the monetary authorities are successful at stimulating demand - a BIG if, how much of this will show up as higher prices and how much will show up as higher output?

You should see the pattern by now - the answer can be reflected in the slope of a curve. In this case it is the slope of the AS curve. As we can see in the graphs below, if the aggregate supply curve is steep, we can expect the impact of the monetary policy will be felt primarily in the price level, while if the slope is relatively flat, the impact will show up in output. Which situation the monetary authorities are likely to be facing depends in large part upon the state of the economy. The steep AS represents the situation where the economy is operating close to capacity and there is little impact on output - the world envisioned by the monetarists. The flat AS curve is likely to be a reasonable representation of the situation in the short-run and when there is considerable excess capacity - the situation we had in the 1930s when Keynes was writing his "general theory." Under these conditions the expansionary monetary policy would result in substantially higher levels of output (Q* to Q**) and a slightly higher price level.

Once the link between the capital market and output market is explicitly acknowledged, however, it is important to revisit our analysis of fiscal policy and the Keynesian multiplier. In Diagram 7 the impact of fiscal policy on the economy is once again traced out except that this time we acknowledge the potential interdependency between the capital and output markets. In the Keynesian world, the expansionary fiscal policy (G) would by definition increase aggregate demand (AD) which would, via the multiplier, increase aggregate output (Y). This increase in income would increase demand for money (M_d) which would put upward pressure on interest rates ( r), and this would "crowd-out" investment and consumption spending (C, I) which would put downward pressure on income, thereby lowering the value of the spending multiplier.

As Keynes saw things, however, this crowding-out effect in depressed times could be expected to be quite small for two reasons. First, given the existence of surplus of funds in the capital market, the fall in interest rates would be minimal. Second, the depressed state of the economy could be expected to lower business and household confidence which would limit the responsiveness to interest rate changes. If business conditions are quite bad when the policy is undertaken, then the increase in aggregate demand and income could raise business expectations which could actually raise their investment demand - a crowding-in phenomenon.

The result is the initial increase in spending / or tax cut will produce a multiplied effect on output with little crowding-out. If this is the case, however, we can expect monetary policy to be ineffective as a demand management policy since the link between the interest rate and aggregate demand is weakened. If interest rates cannot be pushed down and / or spending is insensitive to interest rates, then monetary policy will be ineffective and fiscal policy, because of a limited crowding out effect, will be an effective policy.

Who had it right - the steep AS of classical (monetarist) economists, or the flat AS of Keynesians? In the 1970s what began to emerge was a "compromise" of sorts. The Phillips Curve had been an accepted piece of the Keynesian macro model in the 1960s and the gradualism of president Carter and his Fed Chairman G. William Miller was grounded in the belief that lower inflation's short term cost was higher unemployment. Carter, accepting the trade-off as inescapable, had hoped to use wage and price guidelines to reduce inflation without incurring the cost of higher inflation.

The key piece of the compromise was expectations. Few would argue with the notion that expectations matter. Certainly the level of spending (consumption) would depend upon an individual's expectations. A medical student and a coal miner earning the same income would be expected to have different spending levels - the student spending more due to the expectations that future income will support the higher level of spending. The same would be true for businesses whose spending on factories, offices, and equipment would depend upon the firm's expectations of sales. As we saw in our discussion of the 1930s, it was the low level of expectations on the part of businesses that limited the effect of interest rates on investment spending.

Once we accept the importance of expectations, there is a need to explain how to build them into macroeconomic analysis and how the expectations are formed. As a first step toward solving this, ask yourself the question: what will the weather be tomorrow?

The simplest answer would be: tomorrow will be just like today. Your forecast for tomorrow is just what it is today. There's nothing exciting about this, but it is one way of capturing expectations. Not surprisingly, this was the dominant view among Keynesians. Expectations were grounded in current and past experience, what is called adaptive expectations. For example, consider the problem of forecasting inflation. Inflation next period (i₊₁) would simply be equal to the current inflation rate (i). This is equivalent to a weather forecasting strategy of forecasting tomorrow to be the same as today. If the inflation rate last year was 5%, then you would expect it would be 5% this year.

How about a little more "realistic" approach? What if you saw a trend when you looked backward? Would you assume it would continue and build it into your expectations? You could, and you would have the basis for a slightly more complicated model of adaptive expectations model. According to this model, expected inflation (i₊₁) is equal to the current rate (i) plus the change in inflation between this year (i) and last (i_-1). If the inflation rate last year was 5% and the year before it was 3%, then you would expect that it would be 7% [ 7 = 5 +(5-3)].

One of the weaknesses of these models of expectations is they are backward looking and people are going to get fooled by any changes. If it was sunny yesterday and you brought no umbrella today, you would not enjoy your walk across campus in the rain. Unfortunately, with the adaptive expectations model, there was no way of anticipating the rain. Milton Freidman, in his presidential address to the American Economic Association in December of 1967, introduced inflationary expectations into macroeconomic thinking - a way of dealing with this backward looking problem. The new concept central to this discussion was the natural rate of unemployment and the new conclusion to be drawn from his work was that the policy tradeoff between inflation and unemployment - the Phillips Curve - was an illusion. The possibility of "buying" lower unemployment with inflation existed, but it was only temporary. It was the result of unexpected inflation "fooling" decision makers whose expectations adjusted to reality only slowly.

The situation envisioned by Friedman is depicted in Diagram 8. Let's assume we start at point A with an unemployment rate of U* and an inflation rate of i*, a rate accepted as the prevailing inflation rate. In the mid 1990s, the prevailing inflation rate was in the 3 - 2.5 percent range. If a policy maker wanted to lower unemployment to U**, the Phillips curve provided a guide to the cost which would be higher inflation as the economy moved toward point B. This inflation rate was pushed above the expected rate (i** > i*) and the unemployment rate fell as the economy expanded.

But how did this happen? It happened by fooling decision makers who were banking on an inflation rate of i*. Here's how it worked in a simple example where today's inflation rate is 3%. Workers bargaining for wage increases would want to be compensated for the higher prices so they would ask for wage increases of at least 3%. Businesses would pay the higher wages because their prices were also going up. In fact, if inflation rose to 4% then prices would be rising faster than wages and businesses would see the real cost of labor decline by 1% and they would hire more workers at the lower "real wage." The result is what the Phillips Curve predicted - higher inflation rates, higher employment, and lower unemployment.

This is not the end of the story. The workers were fooled and next year when they bargain for wages they will build in the higher inflation rate of 4%. With prices and wages rising at 4%, we find businesses cutting back on employment and eventually we end up at the same level of employment, and unemployment, but now with a 4% inflation rate. Once the new higher inflation rate has been built into the expectations, unemployment returns to its "natural rate" with a higher inflation rate and there would be a new Phillips curve where the short-run choice was now between points C and D. In the long run, however, there was no trade-off between inflation and unemployment, and we began to see discussion of vertical long-run Phillips Curves.

This innovation focused attention on the determinants of the natural rate of unemployment - the rate that would be sustainable when expected inflation equaled actual inflation, and on disinflation strategies - how do we move the economy from point C to A. What was clear from the analysis was that any effort to reduce inflation from i** to i* with traditional macro policy tools would get us to point A via point D. Of equal importance was the speed of adjustment which was expected to be slow since inflationary expectations were assumed to change only slowly. Slowly, as inflation fell, the Phillips curve would shift inward and the economy would return to an unemployment rate of U*- an idea that did not go over well with Carter.

The prospect of a painful, slow adjustment downward in inflationary expectations would tend to limit the use of discretionary policies designed to wring inflation out of the system. The gradualism of Carter was grounded in the belief that lower inflation's short term cost was higher unemployment. If inflation was to be reduced / eliminated, it would come at a substantial cost as the economy slowly adjusted its inflationary expectations. The problem was American people had come to expect inflation and built it into their thinking - workers built it into their wage demands and bankers built it into their interest rates. This was the sentiment reflected in Jacob Viner's statement: "In a world organized in accordance with Keynes' specifications, there would be a constant race between the printing press and the business agents of trade unions, with the problem of unemployment largely solved if the printing press could maintain a constant lead�"

The limits to macro policies, both monetary and fiscal, were becoming evident by the late 1970s as the speed of the racers accelerated. It sounded so simple, a little money here - a little tax increase there and we could keep the economy on the straight and narrow growth track. But as we saw in the 1970s things didn't quite work out as planned. One of the problems we will look into is the policy dilemma faced by the Fed. Should the Fed worry about interest rates or money supply, because as we will see now, it could not worry about both.

What is a monetary authority to do when confronted with high inflation rates and a second OPEC price shock? The US economy seemed to be mired in a stagflation trap in the late 1970s - high levels of unemployment and inflation that could be traced to the OPEC decisions to dramatically raise the price of oil in 1973 and 1979. The simple policy prescriptions of the 1960s - a little money here, a little tax increase there and we could keep the economy on the straight and narrow growth track - had failed to effectively solve the stagflation that hit in 1973.

On the domestic front, as the U.S. economy moved into 1979, the unemployment rate had fallen to 5.5 percent from a high of 9.5 percent. Inflation was on the rise again and the second round of OPEC price increases threatened to set off another round of double digit inflation. Real wages continued their fall. Internationally the news was certainly no more comforting as the dollar resumed its slide and the current account deficit in the matter of one year swung from substantial surpluses to deficits. [Diagram 9] The stage was set for either another round of substantial stagflation or a dramatic policy move.

So what was the Fed to do? There was a real problem - what we might call a dilemma. And once again we can see the problem with a simple graph - or maybe a few.

First let's look at the situation with the help of our money market graph. The increase in the price level in 1979 will drive up demand for money - if you are paying higher prices you will need to carry more money to pay your bills. The increase in money demand would put upward pressure on interest rates (i* to i**) and on the money supply (M* to M**). [Diagram 10]

The Fed needed to respond to the upward shift in the money demand curve - and there were only two choices - either the Fed could adopt a policy targeting interest rates, or one targeting the money supply. What it could not do is simultaneously hit a money supply (quantity) target and an interest rate target (price). For example, if the Fed wanted to keep interest rates from rising as a result of the increase in money demand, then it would need to change the money supply in such a way as to relieve the upward pressure on interest rates. The Fed could return rates back to their original level if they increased the supply of money. The impact of the increase in the supply of money can be seen in the left-side of Diagram 11. In this situation the Fed would undertake policies to increase the money supply (outward shift in the supply curve). This would bring interest rates back to their initial level (i*). To reestablish the original interest rate, the money supply would increase from M* to M**. By targeting the interest rate the Fed had to give up control of the money supply since money supply increased as the Fed hit its interest rate target.

A second option for the Fed would be polices to target the money supply. In the face of increased demand that put upward pressure on the quantity of money, the Fed would respond with policies aimed at reducing the money supply - an inward shift in the money supply curve in the right-side diagram. The result would be a constant money supply (M*) and a higher interest rate.

What should be clear is that the policies could be expected to have substantially different effects on the economy. But which policy route to take? The advice from the theorists was, as you would expect, mixed. It was a difference that could be traced to fundamentally different views of money's role in the economy.

On the one side we had the Keynesians who believed that interest rates mattered and an easy money policy (increase in money supply) would be in order keep the economy from falling into another OPEC induced recession. On the other side we had the monetarists who believed the Fed should focus on controlling the money supply since they saw money as the most important cause of changes in GDP. sm. At the heart of monetarism is the Equation of Exchange which linked the money supply (M) with the price level (P), real income (Y), and velocity (V).

According to the monetarists, the Fed should adopt a tight money policy to slow the growth in the money supply which would allow the US to avoid another round of inflation. The basis for their view is captured in the dynamic version of the Equation of Exchange which linked the inflation rate (p) directly to the growth rate in the money supply (m).

Some economists were even arguing for adoption of a monetary rule - essentially replacing discretionary monetary policy with a simple formula derived from the above relationship. By plugging in the growth rate in potential output (y) and velocity (v), the Fed would need to set the growth rate in the money supply at a rate that would achieve the desired inflation rate. For example, if the Fed had a goal of 0 inflation and expected the economy to grow at 2 percent per year and velocity to remain constant, then it should undertake policies designed to keep money supply growth at 2 percent [ 2 = 2 + 0 - 0). In essence we would replace the Fed with a computer programmed to meet the target levels for the money supply growth.

In the 1970s the Fed was following policies that were generally Keynesian, but there was a dramatic policy reversal announced on October 6, 1979. At that time the Fed's chairman Paul Volcker announced the Fed was changing the focus of its policies. Prior to the announcement, the Fed, under the influence of Keynesian economists, was far more concerned with targeting interest rates and trying to keep them low to get the economy growing. According to Volcker and the monetarists, however, there was a fundamental flaw in the accommodating monetary policies adopted by the Fed. The flaw was the inability of the Fed's policy officials to make the distinction between real and nominal interest rates.

The relationship between the real interest rate (r_r), which is what we believe affects decision makers and should be the concern for policy officials, the nominal interest rate (r_n), which is the rate we actually see reported in the financial press, and the expected inflation rate (i_e) is given by the equation:

In normal times the inflation rate remained rather stable and information on the real rate of interest, what matters to the Keynesians, could be used to determine what was happening to nominal interest rates. By 1974 inflation rates had risen above the rate on short-term government securities and remained there through the end of the 1970s so real rates were actually negative [Diagram 12. By 1979 it was beginning to look like an inflationary spiral as G. William Miller's program of gradualism poured money into the system to moderate interest rate increases. The result of the money supply increases would be an increase in inflation which would push nominal rates even higher.

It also could be said, as De Long did, that until the policies of the Fed during this period could be directly tied to the aftereffects of the Great Depression - the political sensitivity to rising unemployment. According to De Long, "[h]ow were economic advisors to deal with a situation in which they found the Phelps-Friedman argument - that reducing unemployment would require a period during which inflation would have to be above its natural rate - convincing, and yet in which their political superiors did not authorize such a policy." It would have taken a bold move on the part of the Fed to take up the fight against inflation in the 1970s by raising the unemployment rate, and it may have been that the Fed had not yet achieved the level of independence necessary to lead the fight. The opening came in 1979 as the US economy appeared on the brink of yet another round of stagflation.

The policy of monitoring interest rates came to an end on October 6, 1979 when recently elected FED chairman Paul Volcker returned home early from an IMF meeting in Belgrade to announce the FED would redirect its efforts toward hitting its monetary targets and let interest rates seek their own level. The Keynesian policies of gradualism were over as inflation in the US surged - in part a reaction to the second round of OPEC oil price increases, and in part a reaction to the declining US dollar. The experiment with pegging interest had come to an end - or at least it seemed so at that time - and the Fed would now establish money supply targets and hit them, what the monetarists had been pushing for many years. The target ranges for M-1 and M-2 for 1979 were set at 3-6 and 5-8 percent, low enough to pretty much guarantee a slowdown in the economy. In fact, Volcker was actually not the first to move in the direction of monetarism, as the United Kingdom under Margaret Thatcher, had adopted monetarism to reduce inflation. The "beauty" of this change in approach was the Fed could now allow interest rates to rise to indefensible levels impossible if policies were focused on interest rates.

The FED was clearly successful at lowering the growth rate of the money supply, and Volcker indicated that the Fed's policies would continue. In February, 1980, Volcker testified before the House Banking Committee:

And interest rates did respond to the restrictive policies. The Fed raised the discount rate to 13 percent in early 1980, and after a quick reversal in mid 1980 to avert a deep recession, raised it again to 14 percent by late 1981.

The impact on market interest rates was very clear from the two graphs below. In the first we see the prime rate - the rate banks charge their best customers - not the rates they would charge you or me. The second chart is for long-term government bonds. In both cases in the fourth quarter of 1979, rates reached a record-high, and by mid 1980 huge losses were being racked up in the bond market as a result of rising interest rates and it became difficult to find anyone willing to lend long-term money. And to make matters worse, Iran's Ayatollah Khomeini repudiated the deposed shah of Iran's debt - a prelude to the November 1979 takeover of the US embassy in Iran.

In their search for funds, firms were increasingly avoiding the bond market and relying on bank loans - the result being an explosion in commercial bank loans in 1980 that produced calls for credit controls. On March 14, 1980, President Carter took the steps he felt necessary to deal with the crisis. Included was a directive to the Fed to control credit under the Credit Control Act of 1969, which the Fed did by having banks restrict their sale of securities to build up their loans. banks had been more than willing to trade lower interest earning government securities for higher interest earning commercial loans. The impact of the credit controls can be seen in the table below, with the growth rate in loan moving from +16% to -14% in a two month period.

Year	Month	Loans	Growth Rate
1980	1	287.8	10%
1980	2	291.1	15%
1980	3	294.7	16%
1980	4	294.5	-1%
1980	5	290.7	-14%
1980	6	289.6	-4%

To add further complexity to the situation, at the same time Congress was also working on legislation that would be finalized in the Depository Institutions Deregulation and Monetary Control Act of 1980. In recent years the financial system had 'hatched" a number of new financial services including negotiable orders of withdrawal (NOW accounts) and money market mutual funds prompting the Fed to adopt new measures for the monetary aggregates. Furthermore, as interest rates rose, the allure of high returns outside of traditional financial institutions was producing an outflow of funds from traditional accounts - a process known as disintermediation. The legislation had three provisions:

One result of all this activity was a sharp recession in 1980 as nominal interest rates plummeted - by April 1980 the federal funds rate had fallen nearly 50 percent to 10 percent. President Carter was able to fend off a challenge from Senator Kennedy in the 1980, but he could not defeat Ronald Reagan who was supportive of the Fed's anti-inflation policies.

A second effect was greater variability in the money supply measures. For the monetarists who supported the approach of setting targets for the monetary aggregates, the greater variability in growth rates after Carter's imposition of credit controls in 1979 and passage of the Depository Institutions Deregulation and Monetary Control Act of 1980 seriously weakened the value of the monetary aggregates as policy instruments.

The high real interest rates (Diagram 13) claimed a number of victims. In the US, the thrift institutions were adversely affected since their assets were often low interest rate loans, while their liabilities were high interest rate deposits. Internationally, the less developed countries (LDCs) that had borrowed heavily in the 1970s were hit with a lower demand for their products, a result of the world-wide recession, and higher costs of borrowing, the result of a stronger US $ and higher real interest rates. The LDC debt crisis began in earnest in August of 1982 when Mexico suspended interest payments on its debt.

It is not an overstatement to suggest that " Monetarism achieved its moment of apogee with both intellectual and policy triumph in the late 1970s. Its intellectual triumph came as the NAIRU grew very large and the multipliers grew very small in both journals and textbooks. Its policy triumph came as both the Bank of England and the Federal Reserve declared in the late 1970s that henceforth monetary policy would be made not by targeting interest rates but by targeting quantitative measures of the aggregate money stock."₂ The influence can also be seen in the following three quotes taken from this period, quotes pertaining to the monetary policies of the UK, US, and Japan - the world's largest previous giant, and its current leaders.

The first statement appeared in the Conservative manifesto of 1979 at the outset of Margaret Thatcher's tenure as prime minister. In the second, XX is the Fed and YY is 1980. Finally, in the last statement, ZZ refers to the Bank of Japan's policy in the mid 1970s.

As it turned out, the experiment with monetarism in the US was called off in 1982, but not before interest rates rose even higher by the end of 1981. According to Rukstad, "[t]he Fed could either accommodate the increased government spending by abandoning its monetary targets in future years and supplying additional credit, or it could meet its targets and thereby increase interest rates as federal credit demands compete with private demands for credit," and it initially chose to hit the monetary targets. The inflation spiral appeared to have been broken, but the cost was substantial as the US entered its most serious slowdown since the Depression. The move toward "rules" had been reversed and the FED was once again monitoring interest rates.

It's now time to move into the 1980s, where will shift our attention back to fiscal policy and examine the set of policies that became known as Reaganomics or Supply-side economics and the theory of economic growth.

2 De Long, "The Triumph of Monetarism?" Journal of Economic Perspectives, Winter 2000