Marginal Revolution: On the Variability of Money and Real Output

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On the Variability of Money and Real Output

In one of Milton Friedman's last papers (circa 2006) is this stunning graph. The graph (click to enlarge) shows the standard deviation of real output and money (M2) from 1879 to 2005. The sharp break in the series around the late 1970s and early 1980s is evident - the standard deviation of money fell dramatically and so did the standard deviation of output.

Money is partially endogenous so one could interpret this as running from output to money. The rapidity of the break, however, suggests otherwise. It's easy to understand how policy could quickly have made money growth more stable. It's much more difficult to understand how or why real output could quickly become more stable. Moreover, the fact that money stabilized as Volcker and then Greenspan headed the Fed is also suggestive of monetary policy as the driving force.

In one way this is a testament to better monetary policy beginning circa Volcker but in another it's a damning indictment of how poor monetary policy has been over most of the history of the Federal Reserve.

Posted by Alex Tabarrok on April 3, 2007 at 07:22 AM in Economics | Permalink

Comments

We are watching Commanding Heights in my American Government class. I want to show them this graph and explain it to them. Unfortunately, I don't totally understand it.

I get that a lower standard deviation means that things are less volatile - here in regard to the money supply and real output (is that GDP?) What tangible effects can we definitively link to the more volitile pre-Volcker period? How do I show my students "where the rubber meets the road" regarding the free market with sound money ideas they've learned about and what this graph represents?

Posted by: anne at Apr 3, 2007 8:16:00 AM

the date on x-axis refers to years elapsed since 1879; the break would then be in 1950's and 60's.

Posted by: sa at Apr 3, 2007 8:17:25 AM

The sharp break in the series around the late 1970s and early 1980s is evident

When does the sharp break begin? To me it looks like the large break begins around 77 - but that's not 1977, it is "year 77" in this series, where year 1 is 1879 (or 1880). That puts the beginning of the break around "actual year 1957". And it looks like it is about year 85, maybe year 89, in the series when real income growth and money have "reunitied" (it's early, I can't think of the correct phrase), which puts it around "actual year 1969". The "actual year 1980" would be year 100 in the series, and by year 100 there seems to be 10 years or so where the two standard deviations are lower. So maybe it's McChesney who deserves the credit.

Posted by: AZ at Apr 3, 2007 8:22:54 AM

I said it was early. Should be "reunited" not whatever I wrote. And it would be nice if I actually got the Fed Chairman's name correct - William McChesney Martin, Jr.

Posted by: AZ at Apr 3, 2007 8:31:09 AM

sa and az may be right. Friedman,however, also refers to the break as being at the end of the 1970s but he could be wrong also.

Posted by: Alex Tabarrok at Apr 3, 2007 8:35:14 AM

Morover, both variables are defined with reference to 10-year moving periods, which makes it tricky to give a substantive account of what a change in one year means.

Posted by: Jacob T. Levy at Apr 3, 2007 8:53:14 AM

after looking at the pdf, it appears to me that friedman is using a 10 yr lagging period std deviation for both the variables. that's perfectly fine, but the data series is a little confusing. if it's 10 yr lagging then the time series should start at 10 yr elapsed, if it's leading it should end at 115 yr elapsed. this graph is puzzling to say the least.

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Posted by: venkataramana at Apr 3, 2007 10:57:34 AM

Trying to get an understanding of what this means - this is a very confusing way of labeling the graph, imo. Can we at least say that what is stunning about this graph does not obviously correlate to the Volcker era?

From what I can tell, it appears that the dramatic shift correlates to the post war stabilization following the great depression and WWII. What this says, I do not know -- perhaps avoiding world wars makes things more stable?

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Posted by: Swan at Apr 3, 2007 11:20:54 AM

After reading his article quickly, it seems that the "break" he is referring to is not the drop in volatility around 1960, but the loss of coordination between the two series in the late 70's and early 80's. At that point, the two series often move in opposite directions. What that means - I don't know.

Posted by: Rich Berger at Apr 3, 2007 12:13:13 PM

I didn't read the article but just guessing that he is looking at the dramatic decrease in the level. These are graphs of volatility, not price series, so the difference between volatility regimes is what he would be talking about, not 1:1 movement matches between the two series.

Note that this graph, published just before his death, is extremely strong support for his view that monetary policy is of huge importance. He made a prediction, and here was the graphic validation of that prediction.

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