The Money Supply Process under Alternative Federal Reserve Operating Procedures: An Empirical Examination

Abstract

Increasing reliance on the monetary aggregates as indicators of economic activity in conducting monetary policy led the Federal Reserve to change its operating procedure in October 1979. In an attempt to gain greater control over the monetary aggregates, the Fed switched from using the federal funds rate as its operating instrument to operating by means of nonborrowed reserves. Subsequent increased volatility in interest rates coupled with sharp fluctuations in money growth and economic activity led the Fed to modify its procedure once more in the autumn of 1982, switching its operating target from nonborrowed to borrowed reserves. This paper examines empirically the money supply process from 1970 to 1986. We find that the process itself was not invariant to the Fed's changes in operating procedure.' Thus, the effect of these changes did not lead to more or less control of money by the Fed under the same money supply process. Rather, the changes in the Fed's procedure led to changes in the money supply process which, in the case of the first change in procedure at least, largely thwarted the aims of the Fed regarding money control. We show that the switch to a reserves operating procedure, which has since been modified but not completely abandoned, has failed to overcome the short-run endogeneity or demand-determination of money which the Fed had experienced prior to October 1979 because the banking system has changed its behavior with respect to the link between reserves and money supply under the newer procedure.