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TheCase of t he Missing Money THE RELATION between the demand for money balances and its determinants is a fundamental building block in most theories of macroeconomic behavior. Since it is also a critical component in the formulation of monetary policy, it is not surprising that the money-demand function has been subjected to extensive empirical scrutiny. The evidence that emerged, at least prior to 1974, suggested that only a few factors (essentially income and interest rates, with due allowance for lags) were needed to explain adequately the quarterly movements in money demand. There were episodes that, during their course, gave the impression that the moneydemand function was shifting. On the whole, however, in the time allowed for final data revisions by a "wait and see" attitude, the apparent puzzles tended to clear up.' As has been widely documented,2 the U.S. economy is once again experiencing an apparent shift in the money-demand function. In particular, when money-demand functions that have been successfully fitted to pre-1974 data are extrapolated into the post-sample period, they consistently and significantly overpredict actual money demand. Furthermore, as the economy has moved into the upturn phase of the business cycle, the forecasting errors have mushroomed. While one might hope that subsequent data revisions could "solve" the present puzzle, this sanguine attitude seems unwarranted for a variety of reasons.First, the sheer magnitudes of the forecasting errors suggest that im-1. Such econometric "benign neglect" begs the real problems facing the monetary authorities, who are striving to make reasonable policy choices during these episodes.2. See, for example, Jared Enzler, Lewis Johnson, and John Paulus, "Some Problems of Money Demand," BPEA, 1:1976, pp. 261-80. 684Brookings Papers on Economic Activity, 3:1976 plausibly large data revisions would be required to explain current developments with equations of the sort I reported earlier. Second, the large forecasting errors for 1974-76 coincide with unusual conditions. Among other things, that period saw the most severe recession of the postwar era; an extended bout of double-digit inflation; the highest interest rates in many years; and many institutional changes in the financial structure. While the failure of an empirical macro relationship under such extreme conditions is perhaps not surprising, it should at least prompt the question of whether the specification was adequate to cope with them. In short, a reassessment of the current state of knowledge on the demand for money balances seems called for. OutlineThe plan of the paper is as follows. The next section reviews the forecasting experience with "conventional" money-demand equations, documenting the source and magnitude of the recent errors. It also considers whether the deterioration in the money-demand equation observed in the current cyclical episode had any counterpart in previous periods of recession and recovery. The second section reexamines the specification of the conventional equ...

THE ECONOMY IS ALWAYS VULNERABLE to a variety of external influences or shocks that have important impacts on income, employment, and prices. While these external shocks are unforeseeable and unavoidable, economic policy must somehow deal with their consequences.Lately an alarming number of upward jolts to prices have come from sources beyond the normal interaction of production, wages, and prices. One was the relative decline in the value of the dollar following the abandonment of the system of fixed exchange rates, which raised the prices of imported goods and contributed to the rise in farm prices as exports competed with domestic consumption. A number of other events shook the economy at about the same time. Crop failures in the Soviet Union resulted in a gigantic sale of American grain. The Peruvian anchovy catch mysteriously Note: The views expressed in this paper are our own and do not necessarily reflect those of the Federal Reserve Board or its staff. We want to thank members of the Brookings panel for their many constructive comments on an earlier version of this paper. 13 1. While fiscal policy can, and probably should, play an important role in combating the effects of external shocks, this paper will deal only with monetary policy.

Global Mone tar/sn and the Monetary Approach t o t he Balance of PaymentsA DECADE OR SO ago, when the twin concerns about the balance of payments of the United States and the functioning of the international monetary system began to impinge on the consciousness of a public theretofore indifferent to such esoterica, the opinions of those who were already paying attention fell into a neat dichotomy. Government officials and "men of affairs," on the one hand, insisted that the continued health of international trade, investment, and the world economy required the maintenance of the Bretton Woods system of pegged exchange rates, under which changes in rates were made infrequently and as a last resort. Academic experts, on the other hand, were nearly unanimous in pressing the advantages of greater flexibility of exchange rates, with many urging that governments abstain altogether from intervention and allow exchange rates to be determined by the interplay of supply and demand in the market-This paper was supported partially by financial assistance from the Departments of State, Treasury, and Labor under Contract No. 1722-520176. However, the views contained herein are solely the author's and do not necessarily represent the official position of the U.S. government. I am grateful to Edmond Alphandery, Rudiger Dornbusch, Jacob A. Frenkel, Peter B. Kenen, Norman C. Miller, and to the discussants and members of the Brookings panel for their helpful suggestions.491 sent a return to a tradition far older than the Keynesian approach they are challenging-to the price-specie-flow mechanism of David Hume, who argued that the international flows of reserves engendered by a payments imbalance would, through their effects on national money supplies and price levels and thus on the trade balance, automatically restore external balance.6 Nonetheless, these views pose a direct challenge to the current orthodoxy, and they have revolutionary implications for balance-of-payments policy and even for balance-of-payments accounting. The Skeleton Model: A Tripartite StructureTo assess these implications, and evaluate the relative merits of the Keynesian and the global-monetarist prescriptions for contemporary U.S. policy, requires first describing the analytical underpinnings of this new-old approach and ascertaining where it can, and cannot, be reconciled with current orthodoxy.7 These tasks, in turn, call for an examination of the various, frequently intertwined, intellectual strands that together give the pp. 31-52. The economists referred to in the title are Robert Mundell and Arthur Laffer, two leading proponents of global monetarism. The modern incarnation of global monetarism was developed during the late 1950s and 1960s, primarily in a series of articles by Mundell, many of which are collected or further developed in two books by him:

Fiscal-Monetary Activism: Some Analytical Issues IN RECENT YEARS, ECONOMISTS have intensely debated the appropriate degree of activism in fiscal-monetary policy making. The "new economics" of the 1960s emphasized activism, particularly in fiscal policy, relying "less on the automatic stabilizers and more on discretionary action responding to observed and forecast changes in the economy-less on rules and more on men."l When the economy's performance deteriorated after 1965, the activism of the policy strategy came under attack. In particular, the dissatisfaction led to a renewed espousal of rules for policy such as had long been advocated by Milton Friedman for monetary policy and by Herbert Stein for fiscal policy.2 The critics of activism argue that changes in fiscal and monetary instruments designed to narrow deviations of the economy from a target path are likely to widen them instead, whereas the maintenance of appropriate fixed instrument settings would achieve greater economic stability. Specifically, the critics question the contribution of fiscal activism to the success story of the early sixties and emphasize that economic performance was * I am indebted to Robert E. Litan for assistance in the research, and to George Jaszi and several of the senior advisers and members of the Brookings Panel on Economic Activity for helpful comments.