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The Choice of a Monetary Policy Framework: Lessons from the 1920s
By Thomas M. Humphrey
Introduction
Anyone who studies the early history of the Federal Reserve is bound to notice a singular curiosity. In the 1920s and early 1930s, when U.S. gold holdings were sufficiently large to relax the constraint of the international gold standard and permit domestic control of the money stock and price level, the Fed deliberately shunned the best empirical policy framework that mainstream monetary science had to offer.
The Quantity Theory
Developed by Irving Fisher and other U.S. quantity theorists, this framework was the outcome of an evolution in numerical measurement that had been occurring in monetary economics since the early years of the 1900s. Although somewhat crude and unsophisticated by today's standards, the quantity theory framework had by the mid- 1920s progressed to the point where, statistically and analytically, it was state of the art in policy analysis. Its constituent variables, all expressed in a form amenable to empirical measurement, had been fitted with relevant data series. It boasted the ability to establish empirical causality between certain variables at cyclical and secular frequencies. It had survived rigorous testing, by the standards of the time, for accuracy and usefulness. Most of all, as the basis of a coherent and well worked out monetary theory of the cycle, it claimed to predict the effects of Fed monetary policy on output and prices in both the short run and the long. Here, ready-made, seemed to be the answer to a central banker's prayers. Here was a framework the Fed could use to conduct policy and to stabilize the economy.
Yet the Fed refused to have anything to do with this framework and its components. Instead of concentrating on the money stock, the price level, and other indicators featured in the quantity theory, the Fed focused on such measures as the level of market interest rates, the volume of member bank borrowing, and the type and amount of commercial paper eligible for rediscount at the central bank.
Why would the Fed, seemingly in need of reliable and accurate gauges of the quantity and value of money, eschew them and the framework featuring them? Why would it deny itself the opportunity to take advantage of the improved empirical knowledge—and potential policy advances stemming therefrom—embodied in the quantity theory and its associated monetary approach to the trade cycle?
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