The Success of the Fed and the Death of Monetarism

Abstract

Monetarists blamed fluctuations in inflation on excessively volatile growth in monetary aggregates. The data supported this hypothesis until 1982. Since 1983 monetary aggregates have been essentially uncorrelated with subsequent inflation in the US. Kochin (1973) argued that well designed monetary policy would lead to zero correlation between any measure of monetary policy and subsequent inflation. We modify Kochin's criterion showing that if the effects of fluctuations in monetary aggregates were not precisely known then optimal policy would produce negative correlations between monetary aggregates and inflation. We find that in the period 1960-1982 the variance in the growth rate of monetary base in the US was too large and in fact destabilizing. However, from 1983 to 2003 variations in the monetary base growth rate were just right. In both periods the fluctuations in the federal funds rate were too small since federal funds rate in both periods was positively correlated with subsequent inflation. The fluctuations in the federal funds rate were close to optimal size during 1983-2003. Using a similar criterion we could not reject the idea that deviations from the Taylor Rule in the federal funds rate were of optimal size in both periods.