Does Monetary Policy Matter? A New Test in the Spirit of Friedman

This PDF is a selection from an out-of-print volume from the National

Bureau of Economic Research

Volume Title: NBER Macroeconomics Annual 1989, Volume 4

Volume Author/Editor: Olivier Jean Blanchard and Stanley Fischer,

editors

Volume Publisher: MIT Press

Volume ISBN: 0-262-02296-6

Volume URL: http://www.nber.org/books/blan89-1

Conference Date: March 10-11, 1989

Publication Date: 1989

Chapter Title: Does Monetary Policy Matter? A New Test in the Spirit

of Friedman and Schwartz

Chapter Author: Christina D. Romer, David H. Romer

Chapter URL: http://www.nber.org/chapters/c10964

Chapter pages in book: (p. 121 - 184)

Christina

D.

Romer and David H.

Romer

UNIVERSITY OF

CALIFORNIA,

BERKELEY

Does

Monetary

Policy

Matter?

A

New

Test

in

the

Spirit

of

Friedman

and

Schwartz

1.

Introduction

This

paper investigates

whether nominal disturbances have

important

real

effects.

What differentiates the

paper

from the

countless others on

the

same

subject

is that

it

focuses not on

purely

statistical

evidence

but

on

evidence

derived

from

the

historical record-evidence based

on what

we call

the

"narrative

approach."

This

approach

was

pioneered

by

Fried-

man and

Schwartz

in

their

Monetary

History

of

the

United

States

and has

provided

the evidence

that we

suspect

has been most

important

in

shap-

ing

economists' beliefs about the real effects of

monetary

shocks.

Despite

its

significance,

however,

the

narrative

approach

has been

largely

ne-

glected

in formal

research

in

the 25

years

since Friedman and

Schwartz's

work. In

this

paper

we

both

assess the evidence

presented

in

the

Mone-

tary

History

and,

more

importantly,

conduct

a

test

of

the link between

monetary

disturbances and real

output

for the

postwar

United States

in

the

spirit

of

Friedman

and

Schwartz's

approach.

The reason that

purely

statistical

tests,

such

as

regressions

of

output

on

money,

studies of the

effects

of

"anticipated"

and

"unanticipated"

money,

and

vector

autoregressions, probably

have not

played

a

crucial

role

in

forming

most economists' views about the

real effects of mone-

tary

disturbances is that such

procedures

cannot

persuasively identify

the direction of

causation.

On

the

one

hand,

if

firms that are

planning

to

expand

their

output

first

increase their demands for

liquid

assets

(or

for

loans

from

commercial

banks),

money

could rise before

output

rises

even

though

money

had

no

causal role

(King

and

Plosser

1984;

Tobin

122

*

ROMER

& ROMER

1965).

On the other

hand,

if the Federal Reserve

were

actively

using

monetary policy

to offset the

effects of

other

factors

acting

to

change

output,

there

might

be no discernible relation

between

money

and

out-

put

even

though money

had

large

real effects

(Kareken

and Solow

1963).

The Narrative

Approach.

The

approach

that

we

suspect

in

fact

underlies

most economists'

beliefs

concerning

whether

nominal disturbances mat-

ter

is

quite

different

from

any

purely

statistical

approach.

We call it

the

narrative

approach

because its central

element is the identification

of

"monetary

shocks"

through

non-statistical

procedures.

Whether

carried

out

systematically

or

casually,

the

method involves

using

the historical

record,

such

as the

descriptions

of the

process

and

reasoning

that led

to

decisions

by

the

monetary authority

and accounts of

the

sources of mone-

tary

disturbances,

to

identify episodes

when there were

large

shifts

in

monetary

policy

or in the behavior of

the

monetary

sector that

were not

driven

by developments

on

the real side of the

economy.

The

test of

whether

monetary

disturbances matter is

then

simply

to see whether

output

is

unusually

low

following negative

shocks of this

type

and un-

usually high following

positive

shocks.

In

their

Monetary History,

Friedman

and

Schwartz

argue

that the

study

of

U.S.

monetary history

does

indeed

provide

clear

examples

of

large,

independent

monetary

disturbances.

They argue

further

that

economic

developments subsequent

to the disturbances

they identify

provide

over-

whelming

evidence

that

monetary

shocks have

large

real

effects. Evi-

dence

of

the same

kind,

gathered

and

analyzed

less

systematically

than

that

presented by

Friedman

and

Schwartz,

is also often cited

in

support

of

the view that

monetary policy

matters.

References to the "Volcker

deflation"

represent

a

common

example

of this

type

of

argument.

It

is

frequently argued

that the fact that the

commitment

by

the Federal Re-

serve

in

1979

to

a

highly contractionary monetary policy

to

reduce infla-

tion

was followed

by

the

most severe

recession

in

postwar

U.S.

history

provides powerful

evidence of the

real

effects of

monetary policy.

Both

this casual

analysis

and

the more

systematic

analysis

of Friedman and

Schwartz have

probably

been more

persuasive

than

purely

statistical

studies

because

the

isolation of shocks from the

historical record can

overcome the reverse causation

problem

that

plagues

any regression

of

output

on

money.1

While the narrative

approach

has

many

virtues,

implementing

it

is

not

straightforward.

There are two

specific problems

that

must be ad-

dressed. The

first

and

more

important possible

difficulty

involves the

1.

Summers

(1987)

provides

a

cogent

discussion of the

persuasiveness

of

narrative studies.

Does

Monetary Policy

Matter?

*

123

isolation

of

monetary

shocks.

Inherently,

there cannot be

a

completely

mechanical rule for

determining

when the

historical

record indicates

that

a

shock has occurred.

Moreover,

the

identification of shocks

generally

occurs

retrospectively,

and thus the researcher

may

know the

subse-

quent

behavior of

money

and

output.

The fact

that

the selection

of

disturbances is

judgmental

and

retrospective

introduces the

possibility

that there

may

be

an

unconscious

bias

toward,

for

example,

searching

harder

for

negative

monetary

shocks

in

periods preceding sharp

declines

in

money

and

output

than

in

other

periods.

Such

a

bias could cause one

to

misclassify

shocks

and to conclude

that

monetary

disturbances

had

real

consequences

when

they

had none.

The second

potential

difficulty

arises

in

determining

whether

the

shocks

that are

identified are followed

by

unusual

output

movements.

Neither

Friedman

and

Schwartz

nor

those

who cite

similar

informal

evidence

in

support

of the

importance

of

monetary

disturbances test

formally

whether

the

behavior

of

output

in

the aftermath of the

distur-

bances that

they

identify

is

in

fact

systematically

unusual.

Indeed,

Fried-

man

and

Schwartz

explicitly

deny

that

monetary

shocks have

consistent

and

precise

real

consequences,

arguing

their

effects occur

with

long

and

variable

lags.

Carried

to an

extreme,

an

absence of

statistical tests

and

a

belief

in

irregular

and often

quite

long lags

could render the

hypothesis

that

monetary

shocks have

important

real effects void of testable

implica-

tions. More

moderately,

these factors could cause the

strength

and

sig-

nificance of the

effect

to

be

overstated,

and could

compound

the

effects

of

biases

in

the

selection

of

shocks.

Overview.

This discussion of the benefits and

dangers

of the narrative

approach

leads us

to believe

that to

answer

the

question

of whether

nominal

disturbances

have

real

effects,

the narrative

approach

should be

used,

but that

it should be used

carefully

and

systematically.

That is

the

goal

of this

paper.

We

pursue

that

goal

in

two

ways.

The

first

is

by

reexamining

Friedman

and

Schwartz's

evidence

concerning

the

real

effects

of

monetary

policy,

particularly

their identification

of

monetary

disturbances.

Despite

the

immense

importance

of their work

in

forming

economists' views con-

cerning

the real effects of

monetary

forces,

little research has been de-

voted

to the

question

of how

successful Friedman

and

Schwartz in

fact

are

in

isolating

independent monetary

disturbances.

In

Section

2

we

therefore

investigate

whether

there

appears

to be

any

unintended bias in

Friedman and

Schwartz's choices of

monetary

shocks.2 We

also use this

2.

Many

other

authors have

explored

various

aspects

of Friedman and Schwartz's

work. To

cite

only

a

few

of the most

prominent examples,

Temin

(1976),

Gordon and

Wilcox

124

*

ROMER

&

ROMER

critical

analysis

of

the

Monetary

History

to

suggest improvements

to

Fried-

man

and Schwartz's

techniques.

The second and more

important

way

in

which we

pursue

the

narra-

tive

approach

is

by proposing

and

implementing

a

test

using

this

ap-

proach

for the

postwar

United States. Friedman and

Schwartz,

writing

in

the

early

1960s,

necessarily

focused

on

the

period

before World War

II.

We

argue,

however,

that

the

postwar

era

provides

a

better

setting

for

employing

their

approach.

In

particular,

we

argue

that

it

is

possible

to

come

much

closer

in

the

postwar

than

in

the

prewar

or interwar

periods

to

the

ideal

of

using

a

precise

and

unambiguous

rule for

identi-

fying

a central

set

of

major

monetary

disturbances. Thus we

believe

that

the

postwar

era

provides

not

just

additional,

but

superior

evidence

concerning

whether nominal

shocks

matter.

This

new

test

is

the

subject

of

Section 3. We describe the

class of disturbances that we

wish to

identify,

our

procedures

for

identifying

them,

and our

tests of

whether

the

behavior of

output

in

the wake

of those disturbances

provides

evidence for or

against

the view

that

nominal disturbances have

impor-

tant

real

consequences.

Finally,

in

Section

4

we return to

the evidence from

the interwar era.

Having

discussed

in

Section 2 whether Friedman

and

Schwartz's identifi-

cation of

monetary

disturbances

might

involve some

unintended

bias,

in

this

section

we

propose

what we think

is

a

more

appropriate

list

of

major

independent

monetary

disturbances for the interwar

period.

Then,

paral-

leling

the test in

Section

3,

we

ask

whether real

activity responds

system-

atically

to those

disturbances.

2.

Friedman and

Schwartz

Challenged

The

purpose

of

this section

is to examine how

successful

and

persuasive

Friedman and

Schwartz

are in

isolating

independent monetary

distur-

bances. We

do

this for two

reasons.

First,

because the

Monetary

History

has

been

so influential in

shaping

economists'

beliefs,

it

is

important

to

ap-

proach

the

work

critically

and to

evaluate anew

the

quality

of

the

evidence

that it

presents.

Second,

because the main

purpose

of our

paper

is to

extend

the

narrative

approach

to

the

postwar

era,

it

is

useful to

identify

any

potential

shortcomings

in

Friedman

and

Schwartz's

classic

work

so

that

we

can avoid them in

our own

study

of

the historical

record.

(1981),

and

Hamilton

(1987)

study

Friedman

and

Schwartz's

analysis

of the Great

Depres-

sion,

and

Bordo

(1988)

assesses

their contributions to

monetary

history

more

generally.

Hendry

and

Ericsson

(1987)

criticize Friedman and

Schwartz's

econometric

methods,

focusing mainly

on their later

work.

Does

Monetary Policy

Matter?

*

125

2.1

FRIEDMAN AND SCHWARTZ'S

MAJOR

MONETARY

SHOCKS

To

set

the

stage,

we

begin by

describing

the

episodes

that Friedman

and

Schwartz

identify

as the

most

important monetary

shocks

during

the

period

covered

by

their book. In

keeping

with

the view that

the

most

compelling

evidence

that

Friedman and Schwartz

provide

of the

impor-

tance of

monetary

shocks comes from the

most

dramatic

events that

they

describe,

we limit our attention to the

episodes

they

emphasize

in

sum-

marizing

their

work

(1963a,

ch.

13; 1963b,

pp.

48-55);

we do not

consider

the

various

more

minor or

less

clear cut

episodes

that

they

cite as

provid-

ing

further evidence

of

the

importance

of

monetary

disturbances.

In

addition,

we

limit

ourselves to the shocks

in

the

period

after

1919.

For

the

period

before

World War

I,

all of the

shocks

that

Friedman and

Schwartz

emphasize

are related to financial

panics.

We

do not focus on

the

panics

both because

the

degree

to which

panics

represent indepen-

dent

monetary

disturbances is

a

particularly

complex

issue and because

Friedman and

Schwartz

place

less

emphasis

on

the

panics

than on the

interwar

shocks.3

With

these

restrictions,

there

remain

four

episodes

that

Friedman and

Schwartz

identify

as

major

monetary

shocks. Three

of

these

episodes

involve overt actions on the

part

of the Federal Reserve. In

their

chapter

entitled

"A

Summing

Up,"

Friedman and Schwartz

state:

On three

occasions

the

System

deliberately

took

policy steps

of

major magnitude

which cannot

be

regarded

as

necessary

or

inevitable economic

consequences of

contemporary changes

in

money

income and

prices.

Like

the crucial

experiments

of

the

physical

scientist,

the

results are so consistent and

sharp

as to

leave

little

doubt

about their

interpretation.

The

dates are

January-June

1920,

October

1931,

and

June

1936-January

1937

(1963a,

p.

688).

The fourth

episode

that

Friedman and Schwartz

characterize as a

major

monetary

shock is the

Federal Reserve's

inaction

in

the

face of

the severe

economic

downturn of

1929-31.

They

describe

the

events of this

period

as

representing

"a

fourth crucial

experiment"

(1963a,

p.

694).

Before we

sketch

Friedman

and Schwartz's

interpretations

of

these

3. We

also

exclude the

episodes

that

Friedman and Schwartz cite as

providing

evidence of

the

effects of

monetary

disturbances on nominal

income,

notably

the secular

deflation of

1879-1897

and the

secular inflation

of 1897-1914. In

the

early

1960s,

when

Friedman and

Schwartz

wrote,

there

was

widespread agreement

that

shifts in

aggregate

demand

had

important

real effects but not that

changes

in

money

had

important

effects on

aggregate

demand.

Thus

to

Friedman and

Schwartz,

evidence that

monetary

disturbances affected

either

output

or

prices

was evidence that

"money

mattered."

Today,

of

course,

the

central

motive for

interest

in

the

effects

of

monetary

disturbances is the

desire to

gain

insight

into the

question

of

whether

aggregate

demand shocks have real

effects.

126

*

ROMER & ROMER

four

episodes,

it is useful

to

point

out that

by

a

monetary

shock Fried-

man and

Schwartz

do not

mean

a

monetary

movement

entirely

unre-

lated to

underlying

economic

developments.

Instead,

what

they

mean

by

a

monetary

shock

is

a

movement

that

is

unusual

given

economic

developments-that

is,

a movement that would

not

have occurred

in

other

periods

or other

circumstances

given

the

pattern

of real

activity.

For the four

critical

episodes

described

below,

the

unusual

movements

in

money

arose,

in Friedman and Schwartz's

view,

from

a

conjunction

of

economic

events,

monetary

institutions,

and the

doctrines

and

beliefs of

the time and of the

particular

individuals

determining policy.

January-June

1920.

Despite

high

output,

low

unemployment,

and

con-

siderable

inflation,

monetary policy

remained loose

in

the aftermath of

World War

I.

The

major

reasons for

this

monetary

ease included

a

desire

to avoid

raising

the costs

to the

Treasury

of

financing outstanding

debt,

a

desire not to

inflict

capital

losses

on

the

purchasers

of the final

issue of

war

bonds,

and a belief that

persuasion

rather than

high

interest rates

should

be

used

to

discourage

borrowing.

Then,

in

November

1919 the

Federal

Reserve

tightened policy

somewhat,

raising

the

discount rate

from

4

to 4.75%.

In

1920 the Federal Reserve

raised the

discount rate two

additional

times,

from 4.75 to 6%

in

January

and from 6

to 7%

in

June.

According

to Friedman

and

Schwartz,

there were two central

reasons for

the

adoption

of this

extraordinarily

restrictive

policy

at a

time

when a

downturn

was

in

fact

already beginning.

The first

was a

concern

with

the

System's

own

reserve

position

rather

than with broader

economic

conditions.

The

second

was the

fact-hardly

surprising, given

the brief

history

of the

System-that

the Federal Reserve misunderstood the

lags

with which

monetary policy

affected

the

economy.

As

a

result,

the Fed-

eral Reserve

repeatedly tightened policy

before

had

had a

chance

to

have

an

impact.

(1963a,

pp.

221-39.)

October

1931. Britain's

departure

from the

gold

standard led to wide-

spread

fears that the United

States would

also leave

gold,

and

thus to

a

vast

gold

outflow.

The Federal Reserve

responded

by raising

the dis-

count rate

from

1.5

to 3.5%

in

two

steps

in

October 1931. Friedman and

Schwartz

consider this restrictive

policy highly

unusual because

the

economy

was

so

severely

depressed

in

1931

and

its condition was con-

tinuing

to deteriorate.

(1963a,

pp.

315-17,

380-84.)

June 1936-January

1937.

By

1935

banks had

accumulated vast excess re-

serves.

Federal Reserve

officials

believed that

these

excess

reserves

re-

flected a low demand for loans and that

as

a result

open-market opera-

Does

Monetary Policy

Matter?

* 127

tions would

for

the most

part

simply

alter the relative shares of

excess

reserves and

government

bonds

in

banks'

portfolios.

Motivated

mainly

by

a

desire to

put

the

System

in a

position

where it could use

open-market

operations

to affect

the

economy

in

the future should

it

wish to do

so,

and

partly by

a

wish

to

respond

to

the

inflation

and

rapid output

growth

that

had

occurred since

1933,

in

1936

and 1937 the Federal Reserve doubled

reserve

requirements

in

three

steps.

Friedman and Schwartz

believe

that

the excess

reserves were

in

fact a reflection

of

banks'

desire

for

increased

liquidity

in the

aftermath of the

widespread banking

panics

of 1929-33.

As

a

result,

the

increase

in

reserve

requirements

led to a

massive contrac-

tion of

lending

as banks worked

to restore their excess

reserves.

Thus,

according

to Friedman and

Schwartz,

the Federal Reserve

inadvertently

caused

a

major

monetary

contraction

because

it

misundertood the

mo-

tives

of

bankers.

Furthermore,

they

believe that the

unfamiliarity

of

re-

serve

requirements

as

a

policy

instrument

(the

System

had

been

granted

authority

to

vary

reserve

requirements only

in

1933)

led to an

unintention-

ally

large

shift

in

policy,

and that the

discreteness of the

policy

shift made

reversal

politically

difficult.

(1963a,

pp.

449-62,

515-45.)

The

early stages of

the Great

Depression.

Friedman

and

Schwartz

argue

that,

beginning

most

likely

with the

evidence

of a

severe downturn in

the

spring

of

1930

and

certainly

by

the time of the

first

wave

of

banking

failures in late

1930,

similar economic

developments

would

not

have

led

to such

large

declines

in

the

money

stock under the

National

Banking

System,

or under the

Federal Reserve either

in

the

1910s

and

1920s

or in

the

post-World

War

II

era.

They

therefore conclude that

despite

the

absence

of

any

acts of commission on the

part

of the Federal

Reserve,

the

large

fall

in

money

during

the first

year

and a half

of the

Depression-

before

Britain's

departure

from

the

gold

standard

in

September

1931-

represents

a

monetary

shock.

(1963a,

pp.

308-16, 367-80,

691-94.)

2.2

IS THERE

BIAS

IN

FRIEDMAN AND

SCHWARTZ'S

SELECTION

OF

MONETARY

SHOCKS?

Friedman and

Schwartz's

definition of what

constitutes a

monetary

shock or a

"crucial

experiment"

is

not

highly precise:

an

episode

in-

volves

a

monetary

shock

if

monetary

developments

were

highly

unusual

given

all of

the relevant

developments

on the real side

of

the

economy.

As

a

result,

Friedman and

Schwartz's

judgment

is central

to their identifi-

cation of

shocks;

they

must

weigh

a

broad

range

of

factors and

decide

whether

the

evidence as a

whole indicates that a shock

occurred.

There

is

therefore

a

potential

for subtle

biasing

of the

selection of

shocks.

If,

for

example,

their

hope

was to find

evidence

of

the

importance

of

monetary

128

*

ROMER

& ROMER

forces,

they

may

have had an unintentional

tendency

to search some-

what harder for

negative

monetary

shocks

in

periods

before

large

de-

clines

in

economic

activity

than at other times.

In

this

section

we

argue

that

this

danger

is

genuine.

We

suggest

that

there does

appear

to be some

unintended bias

in

Friedman

and

Schwartz's choice of shocks.

This conclusion

is based both on

an

analy-

sis

of

episodes

that Friedman

and

Schwartz do not

identify

as shocks

and on

the

consistent

presence

of

contractionary

non-monetary

forces

in the

shocks

that

they

do

identify.

2.2.1

Candidate

Episodes

not Included

by

Friedman

and Schwartz.

Suppose

that Friedman and Schwartz had a

tendency

to

search more

carefully

for

"exogenous" negative

monetary

shocks before

times

of

large

falls

in

output

than

at

other

times. One would

then

expect

there to be events

Friedman

and

Schwartz

did not

include

in

their list of

independent

negative

monetary

disturbances

that it

is reasonable

to

think

they

would

have

included

had those events

been followed

by significant

declines

in

output.

We believe

that there are two such

episodes

in the interwar

period.

1933.

A

massive

wave

of

banking

failures

began

in

the

final

months of

1932

and worsened

in

early

1933.

In

addition,

expectations

that

Roose-

velt

might

devalue

or abandon the

gold

standard

on

taking

office caused

large gold

outflows

and

led

to an

increase

in the

discount rate from 2.5

to

3.5%

in

February

to defend

gold. By February banking

conditions

had

degenerated

into

panic,

causing widespread

bank

failures.

The

failures

were

in

turn followed

by

the declaration

of bank

holidays

in

many

states.

On

his

inauguration

in

March,

Roosevelt

imposed

a

nationwide

banking

holiday-a step

that,

in Friedman and Schwartz's

view,

was

extraordinarily disruptive

of the

financial

system

and much more drastic

than

was needed.

(Friedman

and Schwartz

1963a,

pp.

324-32, 349-50,

389-91,

421-34.)

The

events

of these months

have the

features of

what

under different

circumstances

Friedman and Schwartz would be

willing

to describe as a

monetary

shock,

or indeed

as

several shocks.

At

other

times

widespread

banking

failures

and

panic

conditions much

milder than

those of

early

1933 are considered to

be

monetary

disturbances.

The

gold

outflow

and

the increase in the discount rate to

defend the

gold

standard

despite

the

depressed

level

of real

activity

clearly

represent

unusual

monetary

devel-

opments,

similar

to those of

the

fall

of

1931.

And the

banking

holiday

shares

with the

episodes emphasized

by

Friedman and Schwartz the

feature

that it

appears

to be

a

major contractionary step arising

from

an

Does

Monetary Policy

Matter?

*

129

inadequate understanding

of the

workings

of

the

financial

system.

In

sum,

it

seems

extremely plausible

that

if

the

Depression

had

continued

to worsen

in

1933,

Friedman and Schwartz would have

characterized the

events of

January-March

1933 as a fifth "crucial

experiment."4

1941.

In

September

1941 the Federal

Reserve announced a

decision

to

raise reserve

requirements

from 22.5 to 25%

in

November.

The

increase

was

the

same size as

each

of the last

two

steps

of the

three-step

increase

in

reserve

requirements

in

1936-37. This is

important

because it

is these

last two

increases

that

Friedman and Schwartz

emphasize

in

analyzing

1937.

Furthermore,

as Friedman and Schwartz

note of the

1937

in-

creases,

the

open-market

operations

needed to

create

a

comparable

re-

duction

in

excess reserves would have been

extraordinarily

large

(1963a,

pp.

531-32).

But

they

attach little

importance

to the 1941

increase.

They

simply

state that:

[banks]

made no

attempt

to rebuild their

excess

reserves,

as

they

had

after

the

increases

of

1936 and

1937,

but rather

proceeded

to

continue to

reduce their

remaining

excess

reserves.

The

effect

of

the reserve

requirement

increase

shows

up

only

in a

slackened rate

of

rise

of

the

deposit-reserve

ratio

. . .

(p.

556).

The

striking

contrast between Friedman and

Schwartz's

interpretations

of the

reserve

requirement

increases of 1936-37 and 1941

suggests

that

they

commit

the

natural

error of

using

the

subsequent

behavior

of

money

as

a

critical

factor

in

identifying monetary

disturbances. This is

inappropri-

ate

because

the

central

reason

for

employing

the

narrative

approach

is

that

monetary

changes may

be

partly endogenous.

If

money

is

in

part

governed

by output,

money

could have

risen even after a

contractionary

monetary

shock,

because

non-monetary

factors were

clearly expansion-

ary

in

1941. If

the 1941 increase

in

reserve

requirements

had

been

followed

by

falls

in

the

deposit-reserve

ratio and

in

money,

it

appears plausible

that

Friedman and

Schwartz

would have

described the

action as a

monetary

shock.

Because

the

Federal

Reserve remained

unfamiliar

with

changes

in

4.

It

can be

argued

that

this

negative

shock was

followed

by

a

positive

shock from

Roose-

velt's

gold policies.

While

changes

in

competitiveness

arising

from

the rise

in

the

dollar

price

of

gold

in

1933 could

certainly

have

stimulated the

economy

through

increased net

exports,

Chandler stresses that

Roosevelt's

gold policies

"did

not

begin

to make

addi-

tions to the

monetary

base

or

bank reserves until

after the

adoption

of the

Gold Reserve

Act at the

end of

January

1934"

(1970,

p.

164).

Thus,

any

monetary component

to

this

positive

shock did

not occur until

nearly

a

year

after the

negative

monetary

shock of

early

1933.

Furthermore,

if

one follows the

logic

of Friedman

and

Schwartz,

there

may

be no

monetary

shock

at

all

in

1934

because

an

expansion

of

high powered

money

is the

usual and

expected

reaction to severe

depression.

130

*

ROMER

&

ROMER

reserve

requirements,

Friedman

and Schwartz could

reasonably

have

argued

that the

System again

committed

the

error

of

causing

a

drastic

shift

in

policy

when

only

a modest one

was intended.5

2.2.2 The

Episodes

Included

by

Friedman and Schwartz.

A

second

argument

that

Friedman and Schwartz's

identification

of

monetary

shocks

may

be

biased focuses

on the

episodes

they

do select.

If

their

selections

are unbi-

ased,

the effects

of

non-monetary

factors will not be

systematically

different

following

the

monetary

episodes

identified

from what

they

are at other

times.

If

the selections

are

biased,

on

the other

hand,

there will

be

a

tendency

for

episodes

in

which other

factors were

acting

to increase out-

put

to be excluded

from

a

list

of

negative monetary

disturbances and for

episodes

in

which other forces

are

acting

to reduce

output

to

be

included.

We

argue

that in all of the

episodes

identified

by

Friedman and Schwartz

as

involving

independent negative monetary

shocks

(with

the

possible

exception

of the

period following

Britain's

departure

from

gold

in

1931),

non-monetary

forces

appear

to have been

strongly

contractionary.

January-June

1920.

It is not difficult to

find

candidate

nonmonetary

explanations

of the decline

in

output

from 1919 to 1921. With the

end

of

World War

I

and the

large-scale

immediate

postwar

relief

efforts,

govern-

ment

spending

fell

sharply.

In

addition,

it

is

often

argued

that

the

post-

ponement

of

purchases

of durable

goods during

the war

contributed to

the

high

level

of

demand

in

1919

and

the

subsequent

fall

in

1920-21

(Gordon

1974,

pp.

19-20,

for

example).

Indeed,

Friedman and Schwartz

agree

that

non-monetary

forces contributed to

the

downturn and

may

have made it

inevitable

(1963a,

p.

237).

Two

comparisons

suggest

that

non-monetary

forces were

important

in

1920-21.

The

first

comparison

is

with

other countries.

Declining

output

was not

unique

to

the United States.

In

1919-21,

there were falls in

5. A final

episode

that is not identified

in the

Monetary History

as a

major

shock,

but that

could be considered a

change

in

monetary

policy,

is

the

contractionary

open

market

operations

and

increases

in

the

discount rate that

began

in

January

1928

(see,

for

exam-

ple,

Hamilton

1987;

Schwartz

1981;

and Temin

1988).

While

we

agree

that

money

be-

came

tighter

in this

period,

it is

not clear

whether this

tightening

should

be viewed as

unusual or

simply

as a usual reaction to

real

economic events such as the boom

in

real

output

and stock

prices.

Furthermore,

we also

agree

with

Friedman

and

Schwartz

that

the

tightening

in

1928 was

fairly

small,

especially

when

considered

relative

to the

con-

tractionary

shocks

in

1920, 1931,

and 1937. As

they

note,

the

Federal Reserve "followed

a

policy

which was too

easy

to break the

speculative

boom,

yet

too

tight

to

promote

healthy

economic

growth"

(1963,

p.

291).

(Gordon

and

Wilcox,

1981,

and

Hamilton,

1987,

also

provide

evidence that the

monetary

shock

in

1928-29 was small relative to the

subsequent

decline

in

real

output.)

Hence,

unless one uses

a

procedure

that calibrates

shocks

according

to

severity,

it

is

prudent

not to

identify

the 1928

tightening

as

a

monetary

shock.

Does

Monetary

Policy

Matter?

*

131

output

much

larger

than that in the United States in the United

King-

dom,

Italy,

Norway,

and

Canada

(Maddison

1982,

Table

A7).

The

breadth of

the

downturn

suggests

that

the

contractionary

forces

were

broader

than the

idiosyncracies

of

U.S.

monetary policy.

The

second

comparison

is with

the aftermath of World

War

II.

From

1918 to

1921,

government

purchases

as a fraction

of GNP fell

by

13

percentage

points;

real GNP rose

1.1% from

1918 to 1919 and then

fell

3.5% between

1919

and

1921.6

From

1944 to

1947,

the

share of

government

purchases

in

GNP fell

by

35

percentage

points;

real GNP fell

by

25.8%.

That

is,

the

fall

in

total

output

relative

to the

fall in

government

purchases

was consider-

ably

larger

after

World

War

II than

after World War

I.7

This

comparison

suggests

that in

isolation,

the decline

in

government

spending

between

1919

and

1921

may

have

been

depressing

the

economy greatly.

October 1931. We

view

the Federal Reserve's

response

to Britain's

depar-

ture

from

gold

as

perhaps

Friedman

and

Schwartz's

clearest

example

of

a

monetary

disturbance

not

obviously complicated by strongly

contrac-

tionary non-monetary

forces.

Nonetheless,

two

non-monetary

forces do

appear

to

have

been

acting

to reduce

output

after

October

1931.

First,

fiscal

policy

turned

contractionary,

though

less

sharply

than in

1918-20.

The enactment of

a

massive

tax increase

in

1932

reduced

E.

Cary

Brown's measure of the

full

employment

deficit

from

3.6% of GNP in

1931 to

1.8%

in 1932 and then to 0.5%

in

1933

(Brown

1956,

Table

1,

col.

14).

Second,

it

was

during

the

period

1930-32 that

the

erection of mas-

sive tariff

barriers

and

the

consequent

collapse

of world

trade reached

its

height,

a

development

often

thought

to

be

central to the

deepening

of

the

Depression (Kindleberger

1986,

pp.

123-26).

June

1936-January

1937.

Two

non-monetary

forces were

acting

to de-

crease

output

in

1937. The first

was fiscal

policy.

From

1936

to 1937

Brown's measure

of

the full

employment

deficit moved toward

surplus

by

2.4%

of

GNP,

reflecting

the end of the 1936 veterans' bonus and the

first

widespread

collection of social

security payroll

taxes.

The

second

was labor

market

developments.

The

enactment of the

Wagner

Act in

1935

led,

in

a

common

interpretation,

to

large inventory

accumulation

in

anticipation

of labor market strife and

wage

increases;

both the

end of

the

inventory

accumulation

and the

appearance

of the

anticipated

strikes

and

wage

increases

then

contributed to

the

downturn in

1937

(Kin-

6.

Throughout

the

paper,

percentage changes

refer to

differences

in

logarithms.

7. For

1918-21,

the

GNP

data are

from Romer

(1988a,

Table

5)

and

the

government

pur-

chases data are from

Kendrick

(1961,

Table

A-IIa).

The data for 1944-47

are from the

National

Income

and

Product Accounts.

132

*

ROMER & ROMER

dieberger, pp.

270-71).

Over

half of the fall

in

real

GNP

from

1936 to

1937 took

the form of

a

sharp

reversal

of

inventory

investment.

In

addition,

it

is essential

to

Friedman

and Schwartz's

interpretation

of

economic

developments

in

this

period

that

banks

strongly

desired to

hold

large

excess reserves

and that

they

therefore

responded

to

the

increase

in

reserve

requirements by moving

to restore their

excess re-

serves.

But the behavior of reserve

holdings appears strikingly

counter

to

this

interpretation:

there

was no discernible

change

in

the behavior of

reserves as

a

fraction of

deposits

until December

1937,

seventeen

months

after the first increase

in

reserve

requirements

was announced.

By

this time the declines

in

money

and industrial

production

were

largely

complete.8

The

early stages

of

the Great

Depression.

The

issue

of whether

monetary

or

non-monetary

forces

were

primarily responsible

for the

initial

two

years

or

so of

the

collapse

of economic

activity

that

began

in

1929 has been

sufficiently

debated that there is

no need

for us

to

argue

that the case in

favor of

a

monetary interpretation

is

not clear cut. As

in

the

other

epi-

sodes

we have

discussed,

non-monetary

forces were

strongly

contrac-

tionary during

this

period

(see

Temin

1976,

and Romer

1988b).

Indeed,

Friedman and

Schwartz

do not

argue

that

monetary policy

(or

some

other

aspect

of

monetary developments)

was

unusually contractionary

from

the

stock

market crash

in

October 1929

through

the

spring

of

1930,

a

period

that

saw industrial

production

fall

by

13%.

Moreover,

from

the

spring through

October

1930,

when

industrial

production

fell an

addi-

tional

16%,

according

to

Friedman and

Schwartz

monetary

develop-

ments were

unusual

in at most a

passive

sense-monetary

authorities

failed to

intervene

in

the

way they normally

would

have

in

such

a

crisis.

This view

appears

to

imply

that

although monetary

forces

played

a

role,

the

initiating

shocks

during

this

period

were

not

monetary.

And

indeed,

as has been

extensively

discussed,

the

behavior of interest

rates

appears

more consistent

with

the

non-monetary

than the

monetary interpreta-

tion of the initial downturn

(Temin

1976;

Hamilton

1987).

In

addition,

by

late

1930

there were additional

non-monetary

forces at

work: the col-

lapse

of world

trade

(discussed

above)

and

possible

non-monetary

ef-

fects of

bankruptcies

and bank

failures

(Bernanke 1983).

8. As an

accounting

matter,

the

swing

from

rapid growth

of the

money

stock from

1934

to

1937 to

a

decline in 1937-38 was

primarily

the result of a

sharp

decline

in

the

growth

rate of

high-powered

money.

This

in turn

appears

to have

stemmed

largely

from

a

switch

by

the

Treasury

to

sterilizing gold

inflows in

the first three

quarters

of 1937.

Friedman and

Schwartz

do not

discuss

the reasons for this

change

in

Treasury

policy

(1963a,

pp. 509-511).

Does

Monetary

Policy

Matter?

*

133

2.3 CONCLUSION

This discussion

of

possible

bias

in

Friedman and Schwartz's identifica-

tion of

shocks is not meant to

imply

that the evidence from the

interwar

era is

unsupportive

of

the

view

that

monetary

disturbances have

impor-

tant real

consequences.

It

does,

however,

suggest

that their evidence

may

not be as decisive

as it

once seemed.

The

fact that Friedman

and

Schwartz

exclude

some

apparent negative

shocks

that were

followed

by

improvements

in

economic

performance,

and the fact that

the effects

of

the

monetary

shocks

they identify appear

to

have been

compounded

by

adverse

non-monetary

factors,

both

imply

that

monetary

shocks

by

themselves

may

be less

potent

than

Friedman and Schwartz

argued.

Our

analysis

of Friedman and Schwartz's

identification

of

shocks also

suggests

an

important

lesson

about

using

the

narrative

approach.

The

main

reason there is

room for unconscious bias

in

Friedman and

Schwartz's

identification

of

shocks

is that

they

use a

very

broad

defini-

tion

of what

constitutes a shock:

a

shock occurs whenever

monetary

policy

is

"unusual"

given

the

state of the real

economy.

Friedman

and

Schwartz

are

forced to

adopt

this

definition

because

there

is

so much

variation

in

monetary

institutions,

in

the

theoretical framework adhered

to

by

central

bankers,

and in

the

particulars

of

important

monetary

episodes

in

the

interwar era.

Because of

this

variation,

it

is

impossible

to

lay

out a

clear

and

workable set of criteria that can be

used to

identify

monetary

shocks

throughout

the

interwar

period.

Therefore,

a

natural

way

to

attempt

to

improve

on

what

Friedman and Schwartz do

is to

apply

the

narrative

approach

to an

era where a

more

precise

definition of

a

shock can be

specified.

3.

Friedman and

Schwartz

Extended

As

a

laboratory

for

a

test of

the real

effects

of

monetary

disturbances,

the

postwar

era

stands

in

admirable

contrast to the interwar

years.

At least

in

comparison

to the interwar

era,

the

Federal

Reserve

in

the

postwar

era

has had a

reasonably

stable view

of

the

functioning

of

the

economy

and

of the

role of

monetary

policy.

As

a

result,

there

have been

important

similarities

across

major

monetary

episodes.

Thus,

while

judgment

still

plays

a

role in

the

identification

of

shocks,

as

it

must do

when

identifica-

tion

is

based on

the

historical

record,

its

role can be much

smaller

than in

the earlier

period.

In

addition,

for

the

postwar

period

there

are

extensive

contemporary

records of

the

nature

and

motives

of

Federal Reserve

policy.

This is

useful because

reliance on

contemporaneous

judgments

of

the

sources

and

intents

of shifts

in

policy again

reduces

the

scope

for

judgment

and

unconscious

bias.

134

*

ROMER

&

ROMER

In

this

section

we therefore

use the narrative

approach

to

study

whether

monetary policy

shocks

in the

postwar

era have had

important

real

effects.

The

section

is divided into two

parts.

Section

3.1

discusses

our

procedures

for

identifying

monetary

shocks

in

the

postwar

era and

sketches the

evidence

underlying

our

choices

of

monetary

shocks.

Sec-

tion 3.2

presents

evidence

on whether these

monetary

shocks affect

output.

It

includes both

informal evidence

and a

statistical

test

of

whether

the

monetary

disturbances we

identify

are followed

by

unusual

movements

in

real

output.

3.1 THE

IDENTIFICATION

OF MONETARY SHOCKS

3.1.1

Definition.

Like Friedman and

Schwartz,

we use the historical rec-

ord to

identify monetary

shocks.

We

employ,

however,

a

much narrower

definition of what

constitutes

a

shock.

In

particular,

we

count

as

a shock

only

episodes

in

which

the Federal

Reserve

attempted

to exert

a

contrac-

tionary

influence on the

economy

in order

to

reduce inflation. That

is,

we

focus on times when the Federal Reserve

attempted

not

to offset

per-

ceived

or

prospective

increases

in

aggregate

demand but to

actively

shift

the

aggregate

demand curve back

in

response

to

what it

perceived

to be

"excessive" inflation.

Or,

to

put

it another

way,

we look for times when

concern about the

current

level of inflation

led the Federal Reserve to

attempt

to induce

a

recession

(or

at

least

a

"growth

recession").

This definition

of

a

monetary

shock

is

clearly very

limited.

It

excludes

both

monetary

contractions

that are

generated by

concerns

other than

inflation and

all

monetary expansions.

This

single-minded

focus

on

nega-

tive

shocks

to

counteract inflation has two crucial

advantages.

Its most

obvious

advantage

is

that it defines a

shock

in

narrow

and

concrete

terms.

Rather than

looking

for

times when

monetary policy

was unusual

given

everything

else that was

going

on

in

the

economy,

as

Friedman

and

Schwartz

do,

we look

only

for times when the Federal Reserve

specifically

intended

to use the tools it had available to

attempt

to create

a

recession

to cure inflation.

This

precise

definition

greatly

limits the role

of

judgment

in

identifying monetary

shocks.

The

second

reason for

our limited

focus is

that we

believe

that

policy

decisions to

attempt

to cure inflation come as close as

practically possible

to

being

independent

of factors that affect

real

output.

In

other

words,

we do not

believe that the

Federal Reserve states

an

intent to cause

a

recession

to lower inflation

only

at

times

when a

recession

would occur

in

any

event.

This

belief rests

partly

on

an

assumption

that trend infla-

tion

by

itself

does not affect the

dynamics

of real

output.

We find

this

assumption

reasonable: there

appears

to

be

no

plausible

channel other

than

policy

through

which

trend inflation could cause

large

short-run

Does

Monetary Policy

Matter?

*

135

output

swings. By

contrast,

other factors that are

important

to the

forma-

tion

of

monetary policy

are

likely

to affect real

activity

directly.

For

exam-

ple,

because

shifts to

expansionary

monetary policy

in the

postwar

era

almost

always

stem from

a

desire

to halt declines

in

real

output,

these

policy changes

are

obviously

far

from

independent

of

factors

that

affect

the

path

of

output.

As

a

result,

it would be difficult

to

distinguish any

real

effects of

expansionary

shifts

from

whatever

natural

recovery

mecha-

nism the

economy may

have. It is

for

exactly

this reason that we

focus

only

on

negative

shocks.

Our

belief that

anti-inflationary

shifts in

policy

are not

simply

occur-

ring

whenever

a

recession is

about to occur also

rests

on a

belief

that the

Federal Reserve

is

not

always

in fact

reacting

to some other factor-such

as

a

large

adverse

supply

shock

or

a

temporary output

boom-that

might

by

itself

lead to

a

recession.

As

our

descriptions

of the

specifics

of

the

episodes

that we consider

will

show,

this does

not

appear

to

be

the

case.

Indeed,

as

we

describe,

the inflation

to

which the

Federal Reserve

responds

often

appears

to

be

largely

the

result

of

past

shocks rather than

of current real

developments.

Furthermore,

in

our

statistical work below

we

attempt

to

test

both

for the

possibility

that

anti-inflationary

policy

shifts

are

correlated

with other factors that

potentially

affect real

output

and

for the

possibility

that inflation

directly

affects real

output.

We find

no evidence

of

either of these effects.

To

actually

discern

the

intentions of the Federal

Reserve,

we

rely

en-

tirely

on

contemporary

Federal

Reserve records-the "Record of

Policy

Actions"

of the

Board of Governors

and

the

Federal

Open

Market

Com-

mittee

(FOMC)

and,

until their discontinuance

in

1976,

the

minutes of

FOMC

meetings.

To

identify

a shock from these

sources we look

both

for

a

clear statement

of

a

belief

that the

current

level

of

inflation needed to

be

lowered

and

some indication

that

output consequences

would be

sought,

or at least

tolerated,

to

bring

the reduction about. In

this

process

we

only

consider

contemporaneous

(or

nearly contemporaneous)

state-

ments of

the Federal Reserve's

intent.

We do not

consider

retrospective

discussions of intent because such

descriptions

could be

biased

by

a

knowledge

of the

subsequent

behavior of real

activity.

3.1.2

Results. On

the

basis

of

Federal Reserve

records,

we

identify

six

times since World War II when the

Federal Reserve

moved to

attempt

to

induce

a

recession

to

reduce

inflation.

They

are

October

1947,

September

1955,

December

1968,

April

1974,

August

1978,

and

October 1979.

In

each

case,

the Federal Reserve

appears

to have

made a

deliberate

deci-

sion to sacrifice

real

output

to lower inflation. In

this

section

we

describe

the evidence

from

contemporaneous

Federal

Reserve sources of

shifts

in

136

*

ROMER & ROMER

the

objectives

of

monetary policy

during

these

episodes.

In

addition,

to

provide

further information about our selection

procedure,

we

describe

two

episodes

that

we do not

classify

as

independent

monetary

distur-

bances. One occurred

in

1966

when the

System

shifted to a

tighter

policy

out of

a desire

to

prevent

increases

in

aggregate

demand

rather than out

of

a

desire to contract

demand. The other occurred over

the extended

period

1975-78 when the Federal Reserve

expressed

considerable con-

cern about inflation but did not

appear

to be

willing

to

sacrifice

real

output

to reduce

it.

October

1947. With

the

end

of

World

War

II,

inflation

became the Fed-

eral Reserve's central concern. Two

factors,

however,

stopped

the Fed-

eral

Reserve from

shifting

to a

significantly tighter

policy

in the

first few

years

after

the war. The first was

the

wartime

policy

of

pegging

interest

rates on

both

short-term

and

long-term

government

bonds.

By

June

1946

there

was considerable

sentiment

on the

FOMC

in

favor of

pursuing

policies

that would cause short-term

interest rates to

rise

(Minutes,

1946,

pp.

55-56,

for

example).

But

obtaining

a

consensus

in

favor of such

policies

and then

reaching

an

agreement

with

the

Treasury

to

permit

short-term rates

to

increase

was a

lengthy process;

the

pegging

of short-

term

interest rates

did not end until

July

1947.

Second,

although

inflation

was

the

primary

concern,

there was also fear that the end

of

the war

would

lead

to

another

depression.

In October

1947,

with

short-term interest rates

no

longer

fixed and

fears

of

depression

allayed,

the

Federal Reserve

began

a

series of contrac-

tionary

measures. These

actions

included

open-market operations

de-

signed

to

increase short-term interest

rates,

an

increase

in

the

discount

rate,

and an increase

in

reserve

requirements

for banks

in

central

reserve

cities. The

motive behind

these

measures was a

desire to reduce infla-

tion.

At the

June

1947 FOMC

meeting,

it

was

[the]

opinion [of

the

chief

Federal Reserve economist

present]

that

through-

out the

war

and

postwar period

there

had been

too

many

fears of

postwar defla-

tion,

with

the

result

that actions

which

should have been

taken to counteract

inflation

were not

taken,

because

of

the

fear

that

they

would result in

contraction,

and

that,

although any

downturn should

be

taken care

of

at the

proper

time,

the

important

thing

at the moment was to

stop

abnormal

pressures

on the

inflation-

ary

side.

(Minutes,

1947,

p.

111.)

He held this view even

though

he believed that economic

conditions

were

not

strengthening.

The views

of

the

other Board

economist

present

Does

Monetary Policy

Matter?

?

137

were summarized

succinctly:

"He

thought

that there would and

should

be a mild recession"

(Minutes,

1947,

p.112).

In

sum,

beginning

in late

1947 the Federal Reserve was

actively

attempting

to reduce

aggregate

demand in

order

to reduce inflation.

September

1955.

Beginning roughly

in

June

1954,

in

response

to evi-

dence

of

the end of the 1953-54

recession,

the Federal Reserve ceased

pursuing

what

is

perceived

to be

an

active

expansionary policy.

This

change,

of

course,

does not

represent

a

monetary

shock. The Federal

Reserve was not

attempting

to

reduce

aggregate

demand; rather,

it sim-

ply

believed

that

an

active stimulus was

no

longer

needed for

output

to

grow.

Beginning

in

early

1955 considerable

concern was

expressed

by

the

Federal Reserve

about

inflation.9

This

concern does

not

seem to have

had an

important

effect

on

policy

during

the first

part

of the

year.

But

in

approximately

September

1955

the character

of

policy appears

to have

changed.

The Federal Reserve

actively

began

to

attempt

to contract

ag-

gregate

demand even

though

members

of

the FOMC

did

not believe

that

output growth,

or

expected

future

output growth,

was

stronger

than

before.

At the

FOMC

meeting

of

September

14,

for

example, despite

the

fact

that

"review of the available

data

suggested

that the

economy

had

entered

a

phase

of

decelerating

advance,

.

. . it was the

judgment

of the

Committee

that

[the]

situation called

at

least

for

the maintenance

of,

and

preferably

some

slight

increase

in,

the

restraining pressure

it

had been

exerting through

open

market

operations."

The

reason

was that

"price

advances were

occurring

in

considerable

numbers,

with

further

wide-

spread

increases

in

prospect"

(both

quotations

are from 1955 Annual

Report,

p.

105).

In

October

they suggested

that a mild

downturn

might

not

be undesirable: "the Committee concluded the

situation called for

continuing

the

present policy

of

restraint"

despite

the fact that

a

"ten-

dency

toward

a

downturn in the

economy

...

might develop"(1955

Annual

Report,

p.

106).

In

November the Committee

wished to

dispel

"any

idea of an

easing

of

System policy"

(1955

Annual

Report,

p.

108;

emphasis

added).

The Federal

Reserve's

conduct

in the first

part

of 1956 lends additional

support

to the view that

System

policy

shifted

in

the fall of

1955.

During

this

period

the

FOMC

felt that

no

change

in

policy

was called for in the

face of

evidence

of

essentially

zero

output

growth.

This

indicates that

9.

See,

for

example,

the FOMC

meetings

of

January

11,

June

22,

and

July

12,

1955

(1955

Annual

Report, pp.

90,

98,

100).

138

*

ROMER & ROMER

expansion

at less

than trend rates was what

they

were

seeking.?1

In

March the Committee

explicitly

took

the view that

it

should "combat an

inflationary

cost-price

spiral" despite

"the risk of

incurring

temporary

unemployment"

(1956

Annual

Report,

p.

26).

We

conclude

that the Fed-

eral Reserve shifted

to a

policy

of

actively

attempting

to reduce

aggre-

gate

demand to

combat

inflation in late

1955.

1966.

Despite

its

fame,

the "credit crunch" of 1966

does not

represent

a

monetary

shock

by

our criteria.

The reason is that the Federal Reserve's

stated intent was

clearly

not to reduce

aggregate

demand,

but

rather

to

prevent

outward shifts

in

aggregate

demand that

it

believed

would other-

wise have occurred.

In December

1965,

for

example,

the

System

raised

the discount rate and acted to

increase other interest

rates in

response

to

evidence

that

"economic

activity

was

increasing vigorously

and that

the

outlook

appeared

more

expansive

than

previously,"

not

out of a desire

to

induce

a

contraction

(1965

Annual

Report,

p.

150).

The

perception

of the

economy's strength

was based

not

just

on

current

data but

also

on

projections

of

growing

military expenditures

because of the Vietnam

War

and

survey

evidence

that consumers

and firms were

planning

to

increase their

spending.

The Federal Reserve

stated

explicitly

that the

purpose

of

the

shift

in

policy

"was not to cut

back the

pace

of

credit

flows but to

dampen

mounting

demands on banks

for

still

further credit

extensions"

(1965

Annual

Report,

p.

64).

The same

pattern

continued

through August

1966.

In

February,

the

Committee's

perception

was that "business

activity

continued

to ad-

vance

vigorously-and

the

outlook was

becoming increasingly

ex-

pansive,"

and that "recent and

prospective

economic

developments

clearly

called for added

policy

measures

to

dampen

the rise in

aggre-

gate

demands"

(1966

Annual

Report, pp.

127,

129).

In

August,

"the

economic

outlook remained

expansive,

and

prospects

were for con-

tinuing high

levels of resource

use and

strong upward

pressures

on

wages

and

prices."

Military,

investment,

and

consumption

spending

were

all viewed

as

contributing

to

the

expansion

(1966

Annual

Report,

p.

171).

Thus

the

Federal

Reserve's shift to

a

tighter monetary

policy

in

1965-

66 does not

belong

on

a

list

of

episodes

in

which

the

Federal

Reserve

was

actively

attempting

to induce

a

downturn.

By

our

criteria,

it would be

no

more

appropriate

to

include this

episode

than to

include,

for

example,

10.

See,

for

example,

the

Record

of

Policy

Actions for the FOMC

meetings

of

January

10,

February

15,

March

6,

and

April

17,

1956.

Does

Monetary Policy

Matter?

*

139

the shift to a

tighter policy

in 1950

to

counteract

the

expansion

that

the

Federal Reserve

expected

because of

the outbreak of the Korean

War."

December 1968. From

mid-1967 to late

1968,

the

Federal Reserve

gradu-

ally

tried to

adopt tighter

policies

as

it

became

clear that

the

"mini-

recession" of 1966-67 would

not turn into

a

full-fledged

downturn and

as

growth

became

stronger.

As

before,

such

a

shift

in

the

specifics

of

monetary policy

in

response

to

economic

developments

does not

repre-

sent

a

monetary

shock.

But at

roughly

the

end of 1968 there

appears

to

have

been

a

change

in

the

goals

of

policy:

the Federal Reserve

began

to

feel that

it

should act to reduce inflation. There

were

frequent

references

to "the

prevailing inflationary

psychology,"

to

the

fact

that

"inflationary

expectations

remained

widespread,"

to

"expectations

of

continuing

infla-

tion,"

and so

on.12

Concern about inflation caused the Federal Reserve

to

attempt

to

main-

tain

tight monetary policy despite

evidence of

considerably

weaker real

growth.

In

March

1969,

for

example, despite

reductions

in

present

and

11.

On

the

basis of

the

Record

of

Policy

Actions,

one

could

argue

for

a

similar

interpreta-

tion of

the

shift to

tighter policy

in

October

of 1947. The

record for the

FOMC

meeting

of

October 6-7

states:

"In

the

period

since

the

previous meeting

of the

Committee

conditions

affecting

the

money

market had

changed considerably.

Inflationary

pres-

sures had increased and there were

indications that

they

would continue to

be

strong

in

the months

immediately

ahead"

(1947

Annual

Report,

p.

95).

The

interpretation

that

the Federal

Reserve was

attempting

to do more than

offset shocks to

aggregate

demand

appears

more

compelling,

however,

for two reasons.

First,

it is

very

plausible

that

the

minutes could be

much

franker than the

Record

of

Policy

Actions

concerning any

desire to cause a recession.

Second,

inspection

of

the reasons that

the Federal

Reserve

gave

in

support

of the

view

that

inflationary pressures

were

increasing strongly sug-

gests

that what

they

meant

was

simply

that

in

the absence of

tighter policy,

inflation

and

high

output

would

continue. For

example:

Inflationary

pressures

have been

strong

in our

economy

during

the

past few

months,

and

there is

ample

indication that

these

pressures

will continue

strong,

and

perhaps

be

accentuated,

in

the

months

immediately

ahead.

The basic causes

of

this

situation are well known. A

vast

supply of

money

and other

liquid

assets was created

during

the war and

there have been additions

to this

accumulation

of

purchasing

power

since the end

of

the war. There

has

also been

an

inadequate

supply of

goods

and services

. . .

growing

out

of

the destruction

of

war and the

deferment

of

civilian demands

when

a

large

part of output

was

destined

for

military

use .... The

existing

situation,

therefore, spells

continuing

pressure

toward

higher

prices.

In addition

we must take

cognizance

of

the

fact

that

conditions are

highly

favorable

to

further

credit

expansion.

.. .

(From

a

letter

from

the

FOMC

to the

Secretary

of

the

Treasury;

Minutes

1947,

pp.

183-84).

Aside from

the

phrase

"and

perhaps

be

accentuated,"

what

was

being argued

was

simply

that,

in the absence

of

tighter

policy,

prices,

credit,

and

money

would

continue

to increase.

12. The

quotations

are from

the Records of

Policy

Actions of the

FOMC

meetings

of

December

17,

1968,

January

14, 1969,

and

March

4,

1969-1968

Annual

Report,

p.

224,

and 1969 Annual

Report, pp.

109,

117.

140

*

ROMER & ROMER

projected

growth,

"the Committee

agreed

that,

in

light

of the

persis-

tence of

inflationary pressures

and

expectations,

the

existing degree

of

monetary

restraint should be

continued

at

present"

(1969

Annual

Report,

p.

121).

In

May,

"The Committee took

note of the

signs

of

some

slowing

in

the economic

expansion

and

of the indications of

stringency

in

finan-

cial

markets.

In

view

of the

persistence

of

strong inflationary pressures

and

expectations,

however,

the

members

agreed

that a

relaxation of

the

existing

degree

of

monetary

restraint would

not be

appropriate

at

this

time"

(1969

Annual

Report,

p.

145).

In

October,

faced with

projections

of

essentially

no real

growth

over the

coming

three

quarters,

"the Commit-

tee decided that a relaxation

of

monetary

restraint would

not

be

appropri-

ate at this time

in

light

of the

persistence

of

inflationary pressures

and

expectations"

(1969

Annual

Report,

pp.

185-86).

The considerations

guid-

ing monetary policy

were

similar at most other

meetings during

the

year,

and inflation

and

inflationary expectations

received

great

attention and

concern

throughout.

The intent

to do more

than

offset

expected

in-

creases

in

aggregate

demand

is clear.13

April

1974. The

Federal

Reserve

responded

to the oil

embargo

that

started

in

October 1973

with an

attempt

to loosen

policy

somewhat to

mitigate

the

contractionary

influences

and

uncertainty generated

by

the

embargo.

With the

lifting

of the

embargo

in

March 1974 and the end of

wage

and

price

controls

in

April,

the Federal

Reserve was

faced with a

rate

of

inflation even

higher

than one that it had

already

considered

excessive

in

the

fall of 1973. It

responded

with

an

active effort at contrac-

tion.

Throughout

the

spring

and

early

summer,

whenever

there

was

conflict

between the

System's

short-run interest rate

and

money targets,

the

FOMC,

in

contrast to

its

practice

in

earlier

years,

resolved the

doubts

in

whichever

way produced

the

higher

interest rate.

Indeed,

on several

occasions

the

Committee

pursued

(or

accepted)

higher

interest rates

despite

the fact that

monetary

growth

was

within its

target range.'4

This

occurred in an environment

where

little

or

no

real

growth

was

taking

place

or

was

expected

in the

near

future. The

motive

for

the

attempts

at

contraction was inflation. There were references to

"the

persistence

of

inflation and of

inflationary

psychology"

and

"the need for

policy

ac-

13. One can

plausibly argue

that the shock could

be

dated a

month or two later

than

December

1968.

The

tightening

that occurred

in

December was

in

part

a

response

to

evidence

of

stronger growth. By early

1969,

however,

it

was

clear that

the

change

in

policy

involved

more.

We

choose

December 1968 because the Federal Reserve

cites this

as

the time when "the

Federal Reserve

System

embarked on a

policy

of

increased

monetary

restraint"

(1969

Annual

Report,

p.

75).

Dating

the shock

in

March 1969 has no

important

effect on our results.

14.

See

especially

1974

Annual

Report,

pp.

165,

173,

180-81.

Does

Monetary Policy

Matter?

*

141

tions to counter

inflationary expectations."

In one

typical

discussion,

the

central considerations

were described

as "the rise in market

interest

rates,

the

strong performance

of the

monetary aggregates,

and-more

broadly-the rapid

advances

in

prices

and costs."15

1975-78. At the

end

of the 1973-75 recession

in

early

1975,

the Federal

Reserve faced

a

rate of inflation

that

was

high by

historical standards.

Over the next

few

years,

inflation was

a

constant concern of the

System.

The level of inflation was often cited

as

a

reason for

tight

policy,

and

policy

was

frequently

described

as

"anti-inflationary"

or as based on

an

underlying

objective

of a

gradual

return

to stable

prices.

Thus

one can

argue

that the Federal Reserve was

attempting

to shift the

aggregate

demand

curve back

throughout

this

period.

In

our

judgment,

however,

this

interpretation

of Federal

Reserve

objec-

tives would be incorrect. Given the level of

inflation,

expressions

of con-

cern

about

inflation,

and of desires

to

reduce

inflation,

were

inevitable.

But

the actual

commitment to

combat inflation

appears

to have been

weak. It

was not

until

April

1976

that "it

was observed

that

this

might

be

an

opportune

time for the

Committee to take

a small

step

toward

its

longer-range

objective

of

returning growth

in

the

monetary aggregates

toward

rates consistent with

general price stability"

(1976

Annual

Report,

p.

203).

Target

annual

monetary

growth

rates,

which were not the

central

focus of

policy,

were lowered

only

one or two

percentage points

over the

years,

and

little other

explicit anti-inflationary

action was

taken.

More

important,

the few comments that relate to the

output

or

employ-

ment

goals

of

policy

reveal that the Federal

Reserve

was not

attempting

to

cause discernible

output

sacrifices to reduce

inflation.

In

February

1978,

one

FOMC member

expressed

the view that "a

realistic

objective

for the

unemployment

rate now was

considerably higher

than

it

used

to

be,

perhaps

as

high

as

5.5 to

6

per

cent"

(1978

Annual

Report, p.

132).

This

suggests

that

previously

policy

had been

aiming

at an even

lower rate.

In

May

of that

year,

when

the

unemployment

rate

was

6%,

"a few

members

observed

that ... it would be

desirable for

growth

in

real

output

to

dimin-

ish

in

the

second half of this

year

toward

a rate that

could be sustained for

the

longer

term,"

again implying

that

the

Federal

Reserve

had

previously

been

aiming

for

growth

above trend rates

(1978

Annual

Report,

p.

176).

August

1978. After

several

years

of

expressing

concern

about inflation

but

taking

little concrete

action to combat

it,

Federal

Reserve

policy

15.

1974 Annual

Report,

pp.

109,

108,

and

108,

respectively.

The

statments occur in

explana-

tions of decisions

by

the

Board of

Governors to

deny proposed

increases in the dis-

count rate.

Nonetheless,

they

are meant to describe the basic

stance of

policy.

142

*

ROMER &

ROMER

changed

significantly

in

1978.

In

August,

the FOMC

recognized

the

"pos-

sibility

that an

appreciable

slowing

of inflation would

prove

more difficult

to achieve

than

previously

had been

anticipated"

(1978

Annual

Report,

p.

210).

Steps

to

tighten

policy began

in

August,

and in

November

the

gov-

ernment announced

a

major

program

to

strengthen

the

weak dollar

and

combat inflation.

The discount

rate was

raised from 7.25 to 9.5%

in

four

steps

from

August

to November

1978,

and reserve

requirements

were also

increased

in

November.

By

November the

System

was

fairly explicit

that

its

objective

was to

cause

a

growth

recession. The

tightening

of

policy

was

continued

despite

forecasts of

sluggish growth,

and

despite

the

fact

that

"skepticism

was

expressed [by

some members of the

FOMC]

.

that

growth

in

output

could

be

tapered

down to a

relatively

slow rate without

bringing

on

a

recession"

(1978

Annual

Report,

p.

247).

The

tightening

of

policy

continued

in 1979.

The

discount

rate

was

raised

another 1.5

percentage points

in

three

steps

from

July

to

Septem-

ber.

During

this

period

almost

all

questions

about the conduct of mone-

tary policy

were resolved on

the

side of

tightness.

When

money growth

was

high

the

System

acted to raise interest rates

and

dampen growth;

when

money

growth

was

low

no actions were taken to

lower

interest

rates

and

spur growth.

All of this occurred

against

a

background

of

a

deteriorating

forecast

for short-run

real

growth

(including

a belief in the

summer of 1979

that a

recession was

under

way),

which would

typically

have led to efforts to stimulate

the

economy.

This

clearly

indicates

a

desire to contract

the

economy

rather than

just

hold

it

steady.

October 1979. There was

another

major anti-inflationary

shock to mone-

tary policy

on

October

6,

1979.

In

effect,

the Federal Reserve decided

that

its

measures over the

previous year

had been unsuccessful

in

reducing

inflation and that

much

stronger

measures

were

needed.

Although

the

shift in

policy

was to some extent

presented

as

a

technical

change,

the

fact that it was

intended to lead to

considerably

higher

interest rates and

lower

money

growth

was clear.

For

example,

"the Committee

antici-

pated

that

the shift

. . .

would result

in ... a

prompt

increase

... in

the

federal

funds rate"

(1979

Annual

Report, p.

204).

The

upper

end

of the

short-run

target

range

for the federal funds rate was raised

by

3.75

percentage points,

while the

lower

end

was

essentially

unchanged.

It

was also clear that a

central

underlying

objective

of the

change

in

policy

was

a reduction in inflation. For

example:

"the

purpose

of this

series

of

actions

[taken

on October

6]

was to assure better control over the

expan-

sion

of

money

and bank credit

and

to

help

curb

speculative

excesses

in

financial,

foreign

exchange,

and

commodity

markets,

thereby dampen-

ing inflationary

forces

in the

economy"

(1979

Annual

Report,

p.

109).

Does

Monetary

Policy

Matter?

*

143

Intents versus Actions.

Our definition of a shock and

our

discussion of

particular

episodes

makes it clear that

our central concern

has been with

the

intentions rather than

the actions of the Federal

Reserve. We

do this

because the

same actions can occur both

independent

of the real

economy

and

in

response

to real events. For

example,

the

monetary

base could

fall

because the

Federal Reserve wished to

cause

a

recession or

because it

was

attempting

to

dampen

an

expansion

that it

believed would

otherwise

have occurred.

Thus,

only

a

narrative

analysis

of intentions can

identify

changes

in

policy

that are

independent

of the real

economy.

At the

same

time,

however,

intentions not backed

up by

actions

would

not

be

expected

to have

large

real effects. It is

for this

reason

that

we

only

consider as

shocks

episodes

when the Federal

Reserve

genuinely

appeared

willing

to

accept output

losses. We feel that it

is

only

in

these

instances

that

the Federal

Reserve is

likely

to

actually

use the

tools

it

has

available to

contract the

economy.

In

this

regard,

it

is useful to

note that

while

actions were not

explicitly

considered

in

our

identification of

shocks,

financial market

conditions did

change greatly

in

each of the

episodes

in

which we

identify

a

shock.

In

particular,

interest

rates rose

sharply.

For

example,

from three

months before our

shocks

to three

months

after,

the six-month

commerical

paper

rate

rose

by

an

average

of

29%. The

smallest increase

was 16%

(for

the

1968

shock)

and

the

largest

40%

(for

the

1955

shock).

Thus,

the Federal

Reserve's

intentions

appear

to

have been

supported

by

actions.16

3.2

DOES

REAL

ACTIVITY

RESPOND TO

MONETARY

SHOCKS?

Having

identified

this

sequence

of six

postwar episodes

in

which

the

Federal

Reserve

appears

to

have

deliberately

tried to

cause

a

recession to

reduce

inflation,

the natural

question

to ask is

whether

recessions

in

fact

followed

these

disturbances.

In

this

section,

we

provide

both

informal

evidence and a

statistical

test of the

relationship

between our

monetary

shocks and

the

subsequent

behavior

of

industrial

production

and

unem-

ployment

in

the

post-World

War II

period.

3.2.1

Informal

Evidence. We

first

examine the

behavior of

output

and

unemployment

after each

of the

postwar

shocks we have

identified.

The

16.

Using

the

federal funds rate for

the five

episodes

that

have occurred

since the

develop-

ment of the

federal

funds market

does not alter

these results.

The

growth

rate of the

monetary

base

also

generally

slows around the

times of

the

shocks,

though

its move-

ments

across

episodes

are

less

consistent than

those of the

commerical

paper

rate. The

reason for

this

greater

variability

is

very

likely

simply

that in all

of the

episodes

(includ-

ing

the 1979

one)

the Federal

Reserve

focused to a

considerable extent

on

interest rate

movements,

while in

many

of the

episodes

it

was

relatively

unconcerned with the

monetary

base.

144

*

ROMER & ROMER

data used

in

this

analysis

are

the

monthly

total industrial

production

series

compiled by

the Federal Reserve

Board

and the

monthly

unem-

ployment

rate of

all

civilian

workers

compiled by

the Bureau

of Labor

Statistics.17 In both cases we

use the

seasonally unadjusted

version

of

the series

and

then account for seasonal

movements

by

regressing

the

series on a set of seasonal

dummy

variables.

Figure

1

shows

the

resulting

seasonally

adjusted

industrial

production

(in

logarithms)

and

unemployment

rate series.

We

have

drawn

vertical

lines

in

the six

months

of the

postwar

era

in which we

identify monetary

shocks.

From

these

graphs

it

appears

that real economic

activity

de-

creases

substantially

after

each

of our

monetary

shocks. The

results

are

particularly striking

for the

unemployment

series:

the

unemployment

rate rises

sharply

after

each shock.

Industrial

production

also falls sub-

stantially

after each

shock,

although

these movements are

somewhat

obscured

by

the

high monthly

variation

in the

series and the

strong

upward

trend. Another

striking

characteristic of

Figure

1

is that there

are

only

two

major

decreases

in

real

activity

that are not

preceded

by

mone-

tary

shocks.

Again,

this feature is most

apparent

in the

unemployment

series. The two

significant

rises

in

unemployment

that are

not

preceded

by

a

monetary

shock occur

in

1954

(at

the end of

the

Korean

War)

and

in

1961.

While

these

graphs

are

suggestive, simple plots

of the data

cannot

distinguish

between movements

in

real

activity

caused

by

monetary

shocks

and

movements

that occur because the

economy

may

naturally

tend to

cycle

up

and down.

To abstract

from the

typical cyclical

behavior

of real

activity,

we

do

the

following.

We first estimate univariate

forecast-

ing

equations

for

both industrial

production

and

unemployment,

and

then

examine

the difference between

the

forecasted behavior

and the

actual behavior of each series

following

each shock.

If

actual

activity

is

less

than

one would

expect

on the basis of the univariate

forecast follow-

ing monetary

shocks,

this would

suggest

that the

change

in

Federal

Reserve

policy

caused

real

activity

to

be lower than

it

otherwise would

have

been.

The data

used

in the

regressions

are the same

two

seasonally-

unadjusted

series described above. For industrial

production

we exam-

17.

The industrial

production

series is from

Industrial

Production,

1986

Edition,

Table A-11.

The

unemployment

series

is

from Labor

Force

Statistics Derived

from

the Current

Population

Survey,

1948-87,

Table

A-31. The

unemployment

series for 1946

and

1947 is taken

from

various issues of

the

Monthly

Labor

Review. The

data for 1946

and 1947

are based

on the

same

household

survey

as

later

estimates,

but have not been

revised to take

into

account

modern

changes

in the

definition of the labor force. To

prevent

a

spurious

jump

in the

series in

January

1948,

we

splice

the

old

and

new

series

together

in

this

month.

Does

Monetary

Policy

Matter?

?

145

ine the data

in

percentage changes

to account

for

the

non-stationarity

of

the series. For

the

unemployment

rate,

we look at the data

in

levels and

include

a

simple

linear

time trend

to

account for the

apparent upward

drift

of the series

over

time.

For

each

series,

the

simple forecasting

equation

includes

a

set

of

monthly dummy

variables to account

for

typi-

cal

seasonal fluctuations

and 24 own

lags.

The own

lags

are

included to

capture

the normal

dynamics

of the

series. Most

important,

we wish to control for the

possibility

that Federal

Reserve

policy

tends to turn

contractionary

after

periods

of

strong

growth

that

might

naturally

be

followed

by

downturns

even

in the ab-

Figure

1

ECONOMIC ACTIVITY

AND

MONETARY SHOCKS.

a. Index

of Industrial

Production

(in

logarithms)

5.0

b.

Unemployment

Rate

(percent)

11.0

8.5

6.0

3.5

1.0

I

1

I I I I I

I~~~t

1950

1960 1970

1980

Notes: Vertical

lines are

drawn at the

dates

of

monetary

shocks. The actual dates are

October

1947,

September

1955,

December

1968,

April

1974,

August

1978,

and October

1979.

The sources

of

the data are

described

in

the text. The data have

been

seasonally

adjusted

by

a

regression

on

monthly

dummy

variables.

. . . . .

. .

.

I

I I i

I

I I

146

*

ROMER & ROMER

sence

of a shift

in

monetary policy.

The

estimation

of the

unemployment

equation

in

levels

with a trend term included

is done as an

additional

precaution

in

this

regard.

Because

including

a

trend term

can introduce

bias toward

detecting

trend reversion

when none is

present, by using

this

procedure

we

may

in

fact be

introducing

some bias

against

finding

real effects of

monetary

policy.

The results of

estimating

the

equations suggest

that

our

specifications

are

adequate

to

capture

the

typical

behavior of

the

two series. The

Q-

statistics of the estimated

regressions

show that

no

significant

serial

correlation remains when

24

own

lags

are included.

Furthermore,

ex-

panding

the

regressions

to

include as

many

as 48 own

lags

does not

alter

any important

features of the results.

The

forecasting equations

are estimated

over the

period

1948-87. We

then do a

dynamic

forecast of both

the

percentage

change

in

industrial

production

and the level of the

unemployment

rate for

the

36 months

following

each of

the

six

shocks identified above. The

differences

be-

tween these forecasts

and

actual

behavior

are

shown in

Figures

2 and

3.

For

industrial

production,

the

figure

shows

the cumulative error

at

each

point

so that one can more

readily

identify

the

impact

of the shock on

the

level of

industrial

production.

Consider first industrial

production. Figure

2

shows

that after

each of

the six

times

in

the

postwar period

that the Federal Reserve shifted to

a

policy

of

attempting

to contract

output

to

reduce

inflation,

industrial

production

over the next several

years

was

considerably

lower

than

would be

predicted

on the

basis

of

the

past

history

of

the series.

The

average

maximum

departure

of

industrial

production

from its forecasted

path

over the

three-year

horizon considered

in the

figure

is

-14%.

The

smallest

maximum

forecast error is -8%

(for

the

August

1978

shock);

the

largest

is -21%

(for

the October 1979

shock).

Figure

3 shows

that

the results

using

unemployment

are,

with

one

exception,

similar to those

using

industrial

production.

The

unemploy-

ment

rate two

years

after

a

monetary

shock is

typically

1.5 to

2.5

percent-

age points higher

than the value

predicted

from the univariate

forecasting

regression.

The

exception

is the behavior of

unemployment

following

the

policy

shift

of

December

1968.

In

this

episode,

though

industrial

produc-

tion fell

sharply

below

its

predicted path,

the

unemployment

rate

rose

only slightly

more than the

univariate

forecasting

model

predicts.

Figure

1

shows

that

unemployment

rose

sharply

after December

1968,

but from

an

extremely

low

level.

Thus,

our

forecasting

equation

is

implying

that

the rise

in

unemployment

was

largely predictable simply

on the basis

of

normal reversion toward

trend.

Since,

as

mentioned

above,

the inclusion

of

a

trend term in

the

forecasting equation

can cause

the

amount of trend

Does

Monetary

Policy

Matter?

*

147

Figure

2 CUMULATIVE

FORECAST

ERRORS OF

UNIVARIATE

AUTOREGRESSIVE

MODEL

FOR

LOG

INDUSTRIAL

PRODUCTION

FOLLOWING

MONETARY

SHOCKS.

a. October

1947

1948

b.

September

1955

LI I .. II III

I I I

JL W.LL W

1949

1950

1956 1957

1958

c. December 1968

I7

7

I

1i

iIIi"

iTT

11

1

IIlI

1111

III

liii

111111

II I iiilillill

I

-

u z

z 1969 - 197

1971-

.

_

0.08

0.03

-0.02

-0.07

-0.12

-0.17

-0.22

0.08

0.03

-0.02

-0.07

-0.12

-0.17

1969

1970

1971

148

*

ROMER &

ROMER

Figure

2

(CONTINUED)

d,

April

1974

1975

1976

e.

August

1978

0.08

0.03

-0.02

-0.07

-0.12

-0.17

111111111

III

111111 . I

1

I

11111I

1979

f.

October

1979

1 1 1 1 1 1

I

1

1 1

11

I

1

1 1

I

11

I

1

,

l

,

II

-[

90[III

19

1982I[i[[

l

[ [ I

1980

1981

0.08

0.03

-0.02

-0.07

-0.12

-0.17

-0.221

W . . . . . . . .

.

. . . . .

I I I I

.

. . . . . .

I.I

I I I I

1980

1981

1982

Does

Monetary

Policy

Matter?

*

149

reversion to be

overestimated,

Figure

3

may

understate the size

of

the

unforecastable increase

in

unemployment

in

this

episode.

In

short,

the

figures

show that the

negative monetary

shocks that we

have identified

are

followed

by

marked downturns

in

real

economic

activity

that

cannot

be

predicted

from the

past

behavior of the

economy.

Furthermore,

the

consistency

of the results

suggests

that

no one shock

will be crucial

to

any

statistical

summary

of the

relationship

between

monetary

disturbances

and real

output.

This

finding

is

important

be-

cause

although

one could

imagine

that

in

specific episodes

some omitted

variable

(supply

shocks

in

1974,

for

example)

might

be the source of both

the real decline and the Federal Reserve's

policy

shift,

it

seems

unlikely

that

some

omitted factor

is

present

in all

six

of the

episodes.

Another

important

feature

of the results

is that the

forecast errors

typically

do not return

to zero. For

every

shock

except

that in

1947,

industrial

production

is

substantially

below its forecasted

path

three

years

after the shock. On

average

over

the six

shocks,

industrial

produc-

tion after

three

years

is

7% below

the

predicted

level;

that

is,

only

about

half

of

the maximum

departure

from

the

forecasted

path

has been re-

versed.

Carrying

the forecasts

out further shows

only

a

very gradual

return to the

predicted path:

the

average

forecast

error

is 6% after four

years

and 4% after

five. The

same

pattern

is

present, though

somewhat

less

strongly,

for

unemployment;

after four of the six

shocks,

the forecast

errors for

unemployment

remain

substantially

above zero

after three

years.

An

extreme

interpretation

of this

finding

would be that

monetary

shocks have real

effects

that are not

only

substantial but

permanent.

However,

as Cochrane

(1988)

shows,

simple autoregressive

procedures

such as

ours

cannot

reliably distinguish

between

permanent

effects and

very

long-lasting

but nonetheless

transitory

ones.

Hence,

a

more moder-

ate

interpretation

is that our

results

imply

that

monetary

shocks

have

very

long-lived

effects.

In

either

case,

since

we find that

purely

nominal

disturbances have

highly

persistent

effects,

our

results cast

grave

doubt

on

arguments

that the

considerable

persistence

of

output

movements

suggests

that

demand disturbances cannot be an

important

source

of

output

fluctuations

(Nelson

and Plosser

1982;

Campbell

and Mankiw

1987).

Similarly,

our results

suggest

that

using

the

assumption

that de-

mand

shocks

have

only

temporary

effects as an

identifying

assumption

is

likely

to

yield highly misleading

results

(Blanchard

and

Quah

1988).

3.2.2

Statistical Test. To test

formally

whether

there is an identifiable

statistical

relationship

between the

monetary

shocks

that we

have

identi-

fied

and

movements

in

real

output,

we

employ

the

following

test.

To the

150

ROMER &

ROMER

Figure

3

FORECAST ERRORS

OF UNIVARIATE

AUTOREGRESSIVE

MODEL

FOR

THE

UNEMPLOYMENT

RATE

FOLLOWING

MONETARY

SHOCKS.

a. October

1947

2.8

1.8

0.8

-

-0.2,

-I.2

i112

11111 1 111 111111111111111

1948

1949

1950

b.

September

1955

* ,ll

I

lll

,l

I

,

l

i

,

l

I, I

l

I

IIII I-

2.8

1.8

0.8

-0.2

-1.2

1956

1957 1958

c.

December

1968

-

I

I II

I

I[

I

[I

I

['

I I

I

I I

T

2.8

-

1.8

-

0.8

-

-0.2

-

1.2

1

,

l l

1969

1970 1971

Does

Monetary

Policy

Matter?

151

Figure

3

(CONTINUED)

d.

April

1974

e.

August

1978

2.8

1.8-

0.8

-0.2

-1.2

I I I I I

IIa I

I IlI

IlIl

I

i

IiIl

I

Ii

I

I I

lI

i

llI

I

1979

1980 1981

f.

October 1979

1980

1981

........-

.*--

. .. . . . . ..

.

. . . . . . . . . . .

. . . .

. . . . . . . . . .

. . . . . . . .

1982

152

*

ROMER & ROMER

simple

univariate

forecasting

equations

for

industrial

production

and

unemployment

described

above,

we add current and

lagged

values of a

dummy

variable that

is

equal

to

one

in

each

of the six

months

in

which

we have identified a

change

in

Federal

Reserve

policy

and

zero

in

all

other

months. The

impulse response

function for

this

expanded

forecast-

ing

equation

provides

an

estimate

of the

total

effect of

a

policy change

after

some horizon. The standard error of the

impulse response

function

provides

a

way

of

gauging

whether

the

effects of

the

nominal distur-

bances are

statistically significant.

Since the

dummy

variable is the crucial indicator of

monetary

shocks,

it

is useful to

describe

its

specification

more

thoroughly.

This

variable

simply

identifies the six months when the Federal Reserve made

a

deci-

sion to

try

to cause

a

recession to reduce inflation.

The

variable does

not

indicate how

long

the shocks lasted

or

attempt

to

differentiate

the

shocks

by

size. The decision not to

specify

duration was

motivated

largely by

the fact that the

ends of these

contractionary policies

are often much

more

gradual

and difficult to

identify

than the

adoptions

of

the

policies.

The

decision to

give

each shock

an

equal weight

was motivated

by

the

fact that

our

reading

of

the

FOMC minutes

and

the Record of

Policy

Actions did not

provide

evidence of

large

differences

in

the

severities of

the intended

downturns

or a

way

of

calibrating

those intentions.

As

before,

the

equation

is

estimated

for

both

the

percentage

change

in

industrial

production

and the level of the

unemployment

rate. The ac-

tual

equation

that is

estimated is:

11 24

36

yt

=

ao+

Z

ai Mit

+

X

bjYt-j+

L

ckDtk,

(1)

i=l

j=1

k=0

where

y

is

either the

change

in

log

industrial

production

or

the

level

of

the

unemployment

rate,

M

is

a

set of

monthly

dummy

variables,

and D

is

the

dummy

variable

for

contractionary

monetary

shocks.

For

the

un-

employment equation

a

simple

linear time

trend is

also included. The

regressions

are run

over

the

period

1948-87.

The

estimation results for

the

industrial

production equation

are

given

in

Table 1.

Over two-thirds of the

coefficients

on the

monetary

shock

variable are

negative

and

twelve of them have

t-statistics

less

than

-1.0.

The

predominance

of

negative

coefficients,

like the

pictures

described

above,

suggests

that

negative

monetary

shocks do

indeed

depress

real

output.

The

fact that

many

of

the coefficients have

large

standard

errors

indicates that the

timing

of the

response

of real

output

is

somewhat

variable.

This,

however,

is not

surprising given

that we

are

trying

to

Does

Monetary Policy

Matter?

*

153

Table

1

BASIC INDUSTRIAL PRODUCTION

REGRESSION

SAMPLE

PERIOD:

February

1948-December

1987

DEPENDENT VARIABLE:

Percentage

Change

in

Industrial Production

Lagged Changes

in

Industrial

Dummy

for Shift

in

Monetary

Policy

Production

Lag

Coefficient

Standard Error

Lag

Coefficient Standard Error

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34

35

36

-.0041

.0081

.0014

.0020

-.0004

-.0061

-.0025

-.0071

-.0166

.0030

-.0067

.0020

.0032

-.0055

-.0001

-.0035

-.0056

-.0025

-.0105

-.0073

-.0116

.0021

.0009

-.0081

-.0100

.0009

-.0081

-.0021

-.0059

-.0078

-.0006

-.0055

-.0010

.0123

.0079

-.0024

-.0034

.0062

.0057

.0058

.0057

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

.2218

.0773

-.0294

.0566

-.0512

-.0937

.0504

-.0383

-.0485

-.0296

.0114

.1497

-.1242

-.1409

-.0810

-.0714

.1009

-.0452

-.0085

-.0568

-.0911

.0222

-.0607

.1175

.0492

.0503

.0498

.0496

.0491

.0489

.0485

.0483

.0487

.0491

.0493

.0494

.0482

.0473

.0467

.0470

.0451

.0434

R2

=

.825

S.E.E.

=

.0132

Q(63)

=

53.75

Coefficients and

standard errors for the constant term and

monthly

dummies are not

reported.

154

*

ROMER &

ROMER

pinpoint

the

response

at

a

monthly

frequency.

Indeed,

what

is

perhaps

more

surprising

is that the

response

in

some

of

the

months is estimated

so

precisely.

A

natural

way

to summarize

the

response

of

industrial

production

to

the

monetary

shock variable

is to examine the

impulse response

function

implied

by

the estimated

equation.

In

our

specification,

the

impulse

response

function traces

out the

effect

of

a

unit shock

to

the

dummy

variable

(D),

including

the

feedback

effect

through lagged output.

The

36-month

impulse response

function for the industrial

production

equa-

tion is

given

in

Figure

4.18

The

figure

also shows

the one

standard

error

bands

for the

impulse response

function.19

The

impulse response

function shows

that

for

the first several

months

following

a

monetary

shock

there is little

effect on

real

output. Output

then falls

drastically

at

the ends of both the first

and

second

years,

with a

slight

plateau early

in the second

year.

The maximum

impact

occurs

after

33

months

and

indicates

that

a

shock causes

the level of real

indus-

trial

production

to

be

approximately

12%

lower

than

it

would have been

had

the

shock not occurred.

From the confidence

bands,

it

is clear

that this

effect is not

only

large,

but also

highly

statistically significant.

For

example,

the

t-statistic for the

impulse response

function

at

33

months is -3.4. The effect of

monetary

shocks on real

production

is

thus

significantly

different from zero

at

the

99% confidence

level.

Another

way

to measure the statistical

significance

of our results is to

ask how

likely

one

would be to obtain estimated effects as

strong

as

those shown

in

Figure

4

using

random dates for shocks.

Specifically,

we

performed

200 trials of

an

experiment

in

which we

replaced

the

dummy

variable

in

equation

(1)

with a

dummy

set

equal

to

one in

six

months

chosen

randomly

over

the

period

1947-85.

The

estimated

maximum

depressing

effect of the Monte Carlo

dummy

on industrial

production

over a

36-month

horizon exceeded the 12%

figure

obtained with

our

dummy

for

genuine monetary

shocks

in

just

one trial.

Thus,

it is

ex-

tremely unlikely

that

our results could arise

by

chance.

Figure

4

also

confirms the

impression

gained

from

Figure

2

that

mone-

tary

shocks

have

real effects that

are

very long-lasting. By

the end of

36

months

only

a

quarter

of the

maximum

negative

effect of the

monetary

shock

has been

undone.

Furthermore,

if one

includes

an

additional

24

18. As in

Figure

2,

Figure

4

shows the cumulative sum

of

the

impulse

responses

so

that

the

effect of the shock on the

log

level of industrial

production

can be seen

more

easily.

19. The

standard errors are calculated

using

the

formula

for

the

asymptotic

standard error

of

a

non-linear function

of

the

regression paramenters.

See

Poterba,

Rotemberg,

and

Summers

(1986,

p.

668)

for details.

Does

Monetary Policy

Matter?

*

155

lags

of the

monetary

shock

dummy

in

the

basic

regression

and

then

continues

the

impulse

response

function out an

additional 24

months,

the

negative

effects of

a

monetary

shock still

linger.

Five

years

after

a

monetary

shock,

industrial

production

is still

7% lower

than it

would

have

been had the Federal

Reserve not

decided to

attempt

to cause

a

recession.

The

empirical

results for

unemployment

confirm

those for

industrial

production.

Table

2

shows the

coefficient estimates

for the

equation

for

the

unemployment

rate.

The

impulse response

function and

standard

error

bands for

the

unemployment

regression

are

given

in

Figure

5.

The

figure

shows

that

unemployment begins

to rise

sharply

18

months after

the

shock and

reaches its maximum at

34 months.

The total

impact

of

the

shock

after 34

months is that the

unemployment

rate is 2.1

percentage

points

higher

than it

otherwise

would have been.

The standard

error bands

for the

impulse

response

function

for unem-

ployment

indicate that the

depressing

effect of a

monetary

shock is

highly

statistically significant.

The t-statistics are

over

2.0 for all

the

impulse

responses

after month

20 and

are often over

3.0.

In

a

Monte

Carlo

experiment

analogous

to that

for industrial

production,

the

maxi-

mum

estimated

impact

of

the

Monte

Carlo

dummy

on

unemployment

over

a

36-month

horizon never

exceeded 2.1

percentage points

in

200

trials.

The

results of the

statistical

test

indicate that

monetary

policy

shocks

Figure

4

IMPULSE

RESPONSE

FUNCTION

FOR

BASIC

INDUSTRIAL

PRODUCTION

REGRESSION

0.050

i

ii

0.00

-0.10

-

-0.15

-

-0.15-

"1.2...

-

-0.20

"

'

"l[I

['

ll111

l l

l

ll

1

,,

I

lil

]l,lI

5

10

15

20

25

30

35

MONTHS AFTER

SHOCK

Notes: The

impulse

response

function

shows the

impact

of

a unit

shock to

the

monetary

dummy

variable.

The

impulse

responses

for the

change

in

industrial

production

have been

cumulated to

reflect

the

effect on the

log

level.

The

coefficient

estimates used to

generate

the

impulse response

function are

given

in Table 1.

The

dashed lines

show the one

standard

error

bands.

156

*

ROMER

&

ROMER

Table

2

BASIC

UNEMPLOYMENT REGRESSION

SAMPLE

PERIOD:

January

1948-December 1987

DEPENDENT

VARIABLE:

Unemployment

Rate

Dummy

for Shift

in

Monetary Policy

Lagged

Unemployment

Rates

Lag

Coefficient

Standard Error

Lag

Coefficient Standard Error

0 -.0979

.1272

1

-.1049

.1272

1

1.0539 .0496

2

.0460

.1274

2

.1091

.0718

3 .0692 .1167

3

-.1685 .0720

4 .0799 .1166

4

.0313 .0724

5 -.0004 .1164

5 -.0140 .0722

6 .1369

.1161 6

-.0659

.0714

7

.0266 .1163

7

-.0371 .0713

8

.0784 .1160

8

.0844 .0712

9 .2989 .1157 9 -.0360

.0704

10 -.0709

.1162 10 -.0389 .0704

11 -.1461 .1162

11

.0881 .0707

12

-.0692

.1165

12

.1659

.0693

13