Structural change in the demand for money following the treasury-federal reserve accord of 1951: an application of the loanable funds model
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1993
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University of Hawaii at Manoa
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In adopting an interest-pegging policy to finance the "Second World War, the Federal Reserve had essentially surrendered its ability to control the money supply. Monetary policy was implicitly abandoned. During the pegging period, monetary growth had to be whatever was required to keep interest rates at their pegged level. If some exogenous shock tended to increase interest rate, the Fed would have to purchase government securities and thus caused the money supply to increase. As interest rates tended to fall, the Fed would have to sell government securities to absorb excess liquidity at the pegged rates and therefore money supply would fall. The Treasury-Federal Reserve Accord of 1951 provides a unique opportunity to explore the impact of a change in a monetary regime. The shift in the monetary regime - away from pegging the interest rate - was a well-publicized event. People were aware of the implications and adjusted their economic behavior accordingly. Inflationary expectations were lowered and so was the substitutability of government securities for money balances due to the Accord. Higher interest rate volatility means higher risk in terms of capital losses on the part of holders' of government securities as the price of government securities varies inversely with the interest rate. Government securities were no longer a close substitute for money balances as they were during the price-pegging era. The revival of an independent monetary policy was possible only after the Accord. Instead of being an "engine of inflation," the Fed returned to the "driver's seat" for the first time since 1942. By abandoning the pegging of long-term rates, the Fed regained its ability to control the money supply. Ironically, the Fed did not tighten up the money supply despite enormous inflation generated by the Korean War. Money supply increased at an even faster rate, and yet wholesale prices started to fall. This was one of the few episodes in American financial history that the economy experienced decreasing inflation along with an acceleration in the rate of monetary growth. This observation contradicts most macro-economic theories which maintain a positive relationship between monetary growth and change in the price level. The apparent paradox can be explained by an increase in demand for money after the Accord applying the loanable funds model. The thesis of the study is to 1) demonstrate the ability of the loanable funds model to explain the monetary actions during the price-pegging period and 2) examine the structural change in the demand for money as a result of the shift in the monetary regime recognizing the endogeneity of the money supply.
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Theses for the degree of Doctor of Philosophy (University of Hawaii at Manoa). Economics; no. 2865
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