The Behavior of Money and Other Economic Variables: Two Natural Experiments

Every once in a great while, history provides us with a natural experiment, an episode in which a major change in a key economic variable occurs that has no direct relation to the contemporaneous behavior of the variables that theory suggests it ought to effect.1 A classic example was the currency reform during the U.S. Civil War by the Confederacy in spring 1864. A second was provided by the massive inflow of specie from the New World to Spain in the sixteenth century. In the first of these examples, a rapidly growing money stock suddenly fell and a decline in the price level followed. In the second, a century-long upward movement in price levels occurred throughout most of Europe. The question that researchers addressed in both instances had to do with the links between the monetary changes and the price behavior that followed (Lerner, 1956; Hamilton, 1934). In this paper, we investigate a similar set of questions using data from two much more recent episodes, both involving changes in the inflation and monetary-policy regimes: the move to floating exchange rates following the breakdown of Bretton Woods in the early 1970s, and the shifts toward less expansive monetary policy that to varying degrees occurred throughout the industrialized world a decade later. In the case of the float, inflation which had been rising since the mid-1960s, surged throughout the industrial world, in some countries like the United Kingdom reaching peaks well into the double digits. Following the shifts to less expansive domestic policy, inflation peaked in most of those same countries and has continued to decline more or less unabated until the current day. John Taylor (2002) in reviewing the monetary history of this era, described it as “the Great Inflation flanked by two periods of relative price stability.”