[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

M1 (the total of currency, traveler’s checks, and checking accounts). Rather than
letting reserve supply adjust automatically to achieve an interest rate target, the
Fed could decide on a target for the money supply or the quantity of reserves, letting
the funds rate adjust automatically to clear the federal funds market.
Under a money supply procedure, just as under an interest rate procedure, monetary
policy discussions start with an assessment of the state of the economy and a
determination of what changes in policy are needed, if any, to achieve the agreed-on
goals. Once the path for the money supply consistent with those goals of policy is
determined, open market operations are conducted to supply a level of reserves
that leads to the desired level of the money stock.
During the 1970s, many economists argued that the Fed should focus on controlling
the money supply. They had two reasons. First, inflation was then the primary
policy problem. Our full-employment model shows that the average rate of inflation
and the average rate of money growth are related; if the monetary authority controls
money growth, it can control inflation. Second, economists at the time saw a
tight link between a measure of the money supply such as M1 and total dollar GDP.
By controlling M1, the argument went, the Fed could control total aggregate income.
In the 1980s, however, the tight link between M1 and nominal GDP appeared to break
down, making a money supply operating procedure less useful for implementing
monetary policy.
INFLATION, MONEY SUPPLY, AND THE
NOMINAL RATE OF INTEREST
Because the link between money and nominal GDP became unstable in many countries,
most central banks now implement monetary policy by setting a target interest
rate. But such policies can lead to problems when inflation rises, as it did in the
late 1960s. The full-employment model tells us that increases in the money supply
provide the fuel for inflation. Under an interest rate policy, an initial increase in inflation
can lead to automatic increases in the money supply that allow the inflation to
continue.
Suppose prices have been stable in the economy—an inflation rate of zero. Then,
suppose inflation rises to 5 percent. As prices rise, the dollar value of transactions
in the economy increases. A sandwich that costs $5.00 one year will cost 5 percent
more annually, or $5.25 after one year, $5.51 after two years, and $8.14 after ten years.
People will want to hold, on average, about 5 percent more money each year, both as
cash for everyday transactions and in their checking accounts. Thus the demand
for money grows.
Because the volume of transactions through the banking system has increased,
banks will need to hold more reserves to balance their payment flows. This increase
in the demand for reserves at each value of the funds rate shifts the reserve demand
curve to the right. If its target for the funds rate is kept unchanged, the Fed will need
to increase the supply of reserves over time, allowing the money supply to rise with
the increased demand for money. From our money multiplier analysis, we know that
by allowing the supply of reserves to increase, the Fed also ensures that the quan-
722 ∂ CHAPTER 32 THE FEDERAL RESERVE AND INTEREST RATES