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Like many countries, Canada experienced historically high inflation rates in the 1970s. At the start of 1975, inflation topped 10 percent. In response, Bank of Canada Governor Gerald Bouey announced in November of that year the policy which became known as gradualism: The Bank would target the growth rate of the narrowly defined monetary aggregate M1, made up of currency plus demand deposits at chartered banks. Over time, the Bank would set gradually declining M1 growth rates (for these target ranges and actual Ml, [ILLUSTRATION FOR FIGURE 1 OMITTED]). The idea was that as the Bank met its early M1 growth targets, it would win credibility for its later targets and would be able to break both high inflation and high inflation expectations without increasing unemployment.

But gradualism was a failure. Although inflation fell in 1975 and 1976,(1) it trended upward again from 1977 on; by the early 1980s, it had passed 10 percent once more.(2) In November 1982, the Bank formally abandoned gradualism, although it was clear to many observers that the policy had effectively been dropped by mid-1981.(3)

This article considers why Canada tried using money targets to curb inflation, what went wrong with that effort, and what lessons policymakers can learn from it. The argument, in brief, is that the relationship between the Bank's intermediate target (money growth) and its ultimate target (inflation) broke down. In February 1991, the Bank implemented a new solution - targeting inflation directly - a policy that has been markedly more successful than gradualism. Since 1991, inflation in Canada has averaged around 2 percent.

* In Theory ...

The quantity theory of money states that

MV = PY,

where M is the stock of money, V is velocity, P is the price level, and Y is real income. Thus, the right side of the equation is nominal, or current dollar, income. Velocity is the number of times a dollar is used to provide a dollar of final output. This equation can be thought of as defining velocity, since both nominal income and the stock of money are easily measured.

Two important factors affect velocity. First, higher interest rates encourage individuals to conserve on money balances, thus raising velocity. In other words, velocity reflects the interest sensitivity of money demand. Second, velocity can be influenced by financial innovations. Prior to automated teller machines (ATMs), the inconvenience of bank visits made individuals more likely to obtain large amounts of cash each time they went to the bank, and so to hold high average money balances. Following the introduction of ATMs, we would expect people to make more frequent, but smaller, cash withdrawals. since using a machine is more convenient than visiting the bank. As a result. individuals would hold lower average cash balances. Financial innovation turns out to be an important part of the story of Canada's gradualism years.

An implication of the quantity theory of money is that

Money Growth + Velocity Growth = Nominal Income Growth,

or, stated another way,

Money Growth + Velocity Growth = Inflation + Real Output Growth

If changes in velocity are negligible, then (over sufficiently long periods), nominal income growth equals the growth rate of money. If, in addition, long-run real output growth is independent of monetary policy, then money growth translates directly into inflation. For example, if real output expands at a rate of 2 1/2 percent, then 10 percent money growth will lead to 7 1/2 percent inflation (again, over a long enough horizon). This is the basis of Milton Friedman's often-quoted assertion that "inflation is always and everywhere a monetary phenomenon."

From this perspective, the Bank was clearly responsible for Canada's predicament in 1975: Excessive money growth had led to unacceptably high inflation. From 1970 to 1975, M1 grew at a 14.5 percent annual rate, while real output grew 5.5 percent; the result was an average yearly inflation rate of 7.5 percent.

If excessive money growth was the cause of high inflation in the early 1970s, the cure was obvious: Slow money's growth rate. With gradualism, Governor Bouey was in effect declaring a policy of slowly reducing the inflation rate: The Bank would publish growth rate bands - or target ranges - for M1,(4) and the average growth rate target would fall over time.(5) The Bank would gain credibility by meeting its early targets, so future announcements would moderate inflation expectations. In this way, the Bank hoped to avoid large real output losses.

As an alternative, the Bank could have gone cold turkey, reducing money growth to its lower long-run value immediately instead of over several years. Using my earlier example to achieve zero inflation, the Bank would have reduced money growth to 2 1/2 percent to match long-run real output growth. The Bank rejected the cold turkey approach (at least in the 1970s), fearing that entrenched high inflation expectations would adjust sluggishly to such a policy, causing large losses in real output and correspondingly high unemployment rates.(6)

Notice that Canada used monetary targeting as a means to an end: low inflation. In other words, money growth rates were an intermediate target of monetary policy and inflation was the ultimate target.

* ... But in Practice

During the late 1970s, Canada's inflation rate remained high. In fact, by the start of 1980, it had regained its 1975 level and was still rising. The experiment ended with Governor Bouey's official renunciation of gradualism in 1982.(7) It was only when the Bank effectively took the cold turkey approach, dramatically reducing money growth, that inflation finally fell.

The Bank's biggest problem was a series of downward shifts in M1 demand, starting in 1976 and continuing throughout the gradualism period.(8) By one estimate, these shifts amounted to 28 percent of M1 by 1982,(9) implying that monetary policy was much looser than the Bank had intended. One can think of these shifts as increases in velocity. According to the quantity theory of money, a 1 percent increase in velocity has the same effect on the inflation rate as a 1 percent increase in money growth.

One set of shifts in M1 demand affected corporations.(10) First, banks offered them preferable loan rates, provided that part of the loan was held in a demand deposit (known as a compensating balance). Since the demand deposit paid no interest, this practice increased the effective loan rate. In the mid-1970s, banks started eliminating compensating balances and raised corporate loan rates. As a result. the level of demand deposits fell.

Second, banks started unbundling their products. For example, they had previously offered a package of free services to corporate clients who maintained a minimum level of demand deposits. When banks began charging for these services, clients reduced demand deposits further.

Third, banks introduced corporate cash-management strategies. For example, at the end of a day, they would place a firm's demand deposits in an overnight account that earned interest. This decreased reported M1, since it is end-of-day demand deposits that banks report to the Bank of Canada.

Two important innovations affected personal deposits: the introduction of daily interest savings accounts (DISAs) in 1979 and daily interest checking accounts (DICAs) in 1981. Before DISAs, savings account interest was based on a minimum monthly balance. Thus, if a customer had $1,000 in a savings account for 30 days of a month and $10 in it on the thirty-first day, that month's interest would be paid only on the $10. This practice gave depositors little incentive to move funds between savings accounts (outside M1) and checking accounts (inside M1). By paying interest on daily balances, DISAs encouraged people to make such transfers, thus reducing average M1 balances. By allowing checking, DICAs obviated the need to move funds in and out of M1 deposits, although technically, DICAs were notice deposits and so were excluded from M1.(11)

The net result of these institutional changes was higher velocity. This meant that while M1 growth moderated under gradualism, inflation remained high. Some analysts argued that the continued high growth of broader monetary aggregates like M2 and M3 was a truer reflection of monetary policy during this period [ILLUSTRATION FOR FIGURE 2 OMITTED].(12) Evidently, the Bank of Canada was running a loose monetary policy at a time when it believed policy was fairly tight.

* Why M1?

Perhaps it was merely bad luck that the financial innovations just described coincided with the Bank's gradualism policy. Many of these innovations would have occurred in any case. For example, the corporate cash-management strategies were adopted from U.S. practices. DISAs and DICAs were initially offered by credit unions and later by trust companies; the chartered banks surely had to follow their competitors' lead.