Monetary Policy Frameworks and Indicators for the Federal Reserve in the 1920s

Abstract

The 1920s and 1930s saw the Fed reject a state-of-the-art empirical policy framework for a logically defective one. Consisting of a quantity theoretic analysis of the business cycle, the former framework featured the money stock, price level, and real interest rates as policy indicators. By contrast, the Fed’s procyclical needs-of-trade, or real bills, framework stressed such policy guides as market nominal interest rates, volume of member bank borrowing, and type and amount of commercial paper eligible for rediscount at the central bank. The start of the Great Depression put these rival sets of indicators to the test. The quantity theoretic set correctly signaled that money and credit were on sharply contractionary paths that would worsen the slump. By contrast, the real bills indicators incorrectly signaled that money and credit conditions were sufficiently easy and needed no correction. This experience shows that policy measures and measurement, no matter how accurate and precise, can lead policymakers astray when embodied in a theoretically flawed framework.

Keywords: quantity theory, real bills doctrine, scissors effect, policy indicators

JEL Classification: E5, B1