Money Growth Targeting

The money growth targeting framework rests on the monetarist proposition that inflation and nominal GDP growth are determined primarily by growth in the money supply. Rather than adjusting short-term interest rates or targeting inflation directly, the central bank commits to a steady, predictable growth rate in a monetary aggregate—typically M2 (cash, checking accounts, and certain savings deposits)—allowing inflation and output to find their natural levels. This approach dominated central banking theory in the 1970s–1980s but has fallen into disuse as the relationship between money and inflation weakened.

The monetarist foundation

Money growth targeting rests on Milton Friedman’s quantity theory of money: MV = PQ, where M is the money supply, V is velocity (how fast money circulates), P is the price level, and Q is real output. If V and Q are roughly stable (or change slowly), then the growth rate of M directly determines inflation and nominal GDP growth. A central bank seeking 2% inflation and 2% real growth (4% nominal growth target) should aim for roughly 4% money growth, adjusting for any secular changes in velocity or trend growth.

The appeal of this framework is its simplicity and rule-like clarity. Rather than watching dozens of economic indicators and making discretionary interest rate adjustments, the Fed would simply commit to, say, 3% M2 growth—perhaps allowing a narrow band of 2.5–3.5%—and let the economy adjust. This removes fine-tuning and reduces policy uncertainty. Monetarists argued that discretionary rate-setting was a source of volatility; policymakers, acting on incomplete information and subject to political pressure, often tightened too late or too much, triggering recessions. A constant growth rule would smooth expectations and improve outcomes.

Implementation and peak influence

The Federal Reserve, under Paul Volcker’s leadership from 1979 onward, adopted a version of money growth targeting as the primary tool to break the inflation of the 1970s. Rather than directly targeting the federal funds rate (the overnight interest rate between banks), the Fed announced targets for the monetary base and M1 growth, aiming for a steep decline to disinflationary levels. Volcker’s commitment to the money growth target was credible and front-loaded: he was willing to accept high unemployment and recession to prove he meant it. By the mid-1980s, inflation had fallen sharply, and the framework was credited with the victory.

The German Bundesbank (now part of the European Central Bank) adopted explicit money growth targeting from 1974 onward and maintained it through the 1990s. The target was centered on M3 growth of 4–6%, consistent with their inflation goal of around 2%. This framework also acquired a strong reputation: Germany maintained low inflation through the 1980s and 1990s while many peers struggled. In both cases, the framework’s strength came not from mechanical simplicity but from the central bank’s commitment to it as a public anchor for expectations.

Why the relationship broke down

The critical assumption in money growth targeting—that V (velocity) is stable—began to fail in the 1980s and accelerated thereafter. Several factors drove this:

Financial innovation. New deposit products, money-market funds, and credit instruments changed how households and firms held and deployed cash. The line between M1 (narrowly defined as cash and checking) and M2 (including savings) blurred. A household might park funds in a money-market fund that earned interest, then transfer to checking when needed; this blurred the boundary between “money” and “other assets.”

Globalization and capital flows. As financial markets integrated internationally, interest rate differentials and currency movements became powerful forces. Money might flow into foreign assets, pulling it out of the domestic money stock. The Fed’s money-growth target might be on path, but capital flows could offset it, changing domestic liquidity.

Declining demand for physical cash. Over decades, electronic payments, credit cards, and later digital wallets reduced the need to hold cash in checking accounts. People could hold less M1 relative to spending, driving down velocity. A central bank hitting its M2 target might find nominal GDP or inflation uncooperative, because the relationship had shifted.

By the early 1990s, even the Bundesbank was acknowledging that the relationship between M3 and nominal growth was loose. The Fed abandoned explicit money growth targeting in the 1980s, reverting to interest rate management. This was not a sudden policy U-turn; rather, the Fed simply stopped announcing numerical targets for money growth, focusing instead on the federal funds rate and inflation expectations.

Why interest-rate targeting took over

Interest-rate targeting—directly managing the short-term rate (SOFR, the federal funds rate, or similar) and using it as the lever to move inflation and growth—became the standard approach. This framework is more flexible: the central bank can adjust the rate in response to incoming data without being locked into a predetermined money-growth path. If velocity shifts (as it did), an interest-rate framework can absorb the shock. If the natural rate of interest changes, the central bank can adjust, moving the policy rate to maintain the desired degree of stimulus or restraint.

Interest-rate targeting also proved more operationally reliable. The Fed can directly control the federal funds rate by adjusting the rate paid on bank reserves and managing the amount of reserves in the system; the money supply adjusts endogenously to accommodate the rate target. In contrast, targeting the money supply requires the Fed to control reserve growth and hope that banks lend at the desired pace—but in a credit crunch, banks may hoard reserves despite ample monetary base. The 2008 crisis showed that the Fed could expand M1 enormously through quantitative easing without moving inflation or nominal GDP much, because demand for credit had collapsed.

Residual influence and current debates

Money growth targeting is not entirely extinct. Some economists and central bankers, particularly those influenced by the Nominal GDP Targeting school or Modern Monetary Theory, argue that an explicit target for nominal GDP growth—a close cousin of money growth targeting—would be superior to the current inflation-only focus. Japan’s central bank, under Governor Haruhiko Kuroda (2013–2023), engaged in massive money-growth expansion (Abenomics), explicitly using monetary base growth as a signal of commitment. And some critiques of the Federal Reserve’s response to 2021–2023 inflation pointed out that the Fed allowed the money supply to grow very rapidly in 2020–2021, and tighter money-growth discipline earlier might have prevented the overshoot.

Cryptocurrency enthusiasts sometimes invoke money-growth targeting rhetoric, arguing that Bitcoin’s fixed supply (21 million coins) provides a form of “non-political” money growth rule (namely, zero growth once all coins are mined). This is more ideological appropriation than serious central banking doctrine.

See also