Both with respect to inflation and productivity, macroeconomic performance in the last decade or so has been disappointing. Promises of policymakers to improve things have been frequently thwarted, not only in terms of inflation and growth, but also in terms of achieving targets for such summary measures of policy as the budget deficit or the money supply. Moreover, critics have charged that policy failures are to blame for many of our economic difficulties. The net effect has been to raise the practical question of whether the political process as now constituted can produce good economic policies. The last decade or so has also been marked, more than coincidentally, by substantial professional criticism of conventional neoKeynesian macro models and the theory of policy associated with them. One of the major punch lines of this research is that activist macroeconomic policy is misguided-indeed, at best it is seen as ineffective and at worst highly counterproductive. As a consequence, the so-called new classical economists argue that policymakers should avoid activism or and instead be guided by simple rules. The issue of rules vs. discretion, has, of course, been a source of long-standing professional debate and, while the new classical economists have provided some additional intellectual ammunition for rules, this hardly serves to explain the apparent popular resurgence in advocacy of rules. Recent interest in rules is reflected in the emphasis on monetary targeting, in proposed legislation-even constitutional amendments-for controlling the federal budget, and in attempts to untarnish the gold standard. This paper reviews the current state of the rules vs. discretion debate. I. The Nature of Policy: Some Preliminaries

Stephen M. Goldfeld, Allan H. Meltzer, Session Topic: The Flow of Funds and Interest Rates-I: U.S. Financial Models: Discussion, The Journal of Finance, Vol. 29, No. 2, Papers and Proceedings of the Thirty-Second Annual Meeting of the American Finance Association, New York, New York, December 28-30, 1973 (May, 1974), pp. 358-363

THE Federal Home Loan Bank Board (FHLBB), a government regulatory agency for member Savings and Loan Associations (SLA), provides advance loans (advances) to members. Advances are considered a major policy tool for the FHLBB in stabilizing deposit, mortgage, and housing markets. Indeed, the FHLBB has characterized advances as providing 'a central credit resource, capable of expanding and contracting to meet the needs of its member institutions for housing credit.' Debt issues in the government agency capital market are the primary source for FHLBB funds.2 The quantity of advances outstanding has grown from $5.3 billion at year-end 1968 to $32.7 billion at year-end 1978, and with considerable variation in between. A key issue in evaluating the role of advances has been whether or not the FHLBB uses nonprice rationing in allocating advance loans. Without nonprice rationing, the FHLBB sets the interest charge for the advances and member SLAs determine the quantity of loans they wish to borrow. In this case, an appraisal of FHLBB policy is relatively straightforward and can be based on the level of the advances rate. With nonprice rationing, in contrast, an appraisal of FHLBB policy is more complicated because the unobserved availability of advances must also be considered. The relevance of this issue is underscored by a recent report of the existence of nonprice rationing.3 Existing econometric models of the advances market treat the question of nonprice rationing in different ways. Hendershott (1977) has the quantity of advances determined by SLA demand without regard to interest rates, so there is neither price nor nonprice rationing. As a consequence, advances policy is viewed as purely passive. Kearl and Rosen (197-4) have the quantity of advances determined by a FHLBB reaction function, again with no role for interest rates, so they have a pure nonprice rationing system. In the MPS model (see Gramlich and Jaffee (1972)) both the quantity and interest rate for advances are set exogenously by the FHLBB, which then implies a combination of interest rate and nonprice rationing. Finally, Silber (1973), in the most sophisticated of the studies, has two versions, one with interest rate and one with nonprice rationing. The version with interest rate clearing has a FHLBB reaction function determining the interest rate and an SLA demand function determining the quantity. The version with nonprice rationing has the FHLBB determine the quantity of advances and no equation for the interest rate, in much the same spirit as Kearl and Rosen. The treatment of rationing in these models is not satisfactory. First, the models specify a priori the presence or absence of rationing, but without providing a test of the hypothesis that rationing takes place. Second, among the rationing models, the specifications are deficient in assuming either that only rationing occurs (Kearl and Rosen, and Silber) or that price and nonprice rationing always occur together (the MPS model). In this paper we develop a model based on optimizing behavior on the part of the FHLBB. Whether market clearing or nonprice rationing behavior obtains in a given time period depends on both economic conditions and the nature of the FHLBB's objective function. As a polar case, the general model collapses into an ordinary market clearing simultaneous equation model and we are able to offer statistical evidence as to which model is to be preferred. In section II.A we develop a market clearing model and in II. B a rationing model. A geometric interpretation is given in section II.C. Section III provides the empirical specification for impleReceived for publication November 6, 1978. Revision accepted for publication July 12, 1979. * We are indebted to NSF Grant SOC77-07680 and the Federal Home Loan Bank Board for support, to Naoyaki Yoshino for helpful comments, and to David Romer for expert research assistance. An earlier version of this paper was presented at the Econometric Society Meetings, Vienna, September 1977. 1 FHLBB Journal, April 1972, p. 24. 2 See Jaffee (1976) for a recent survey of FHLBB structure and policies. 3 Wall Street Journal, May 4, 1979, p. 18.

The paper first reconciles a variety of specification tests for partial adjustment money demand models and points out a fundamental identification problem which makes it impossible to distinguish between the real and nominal partial adjustment models if inflation has an independent effect on the long-run demand for money. The paper also finds that empirical estimates of simple partial adjustment models have some undesirable properties and then considers the shortand long-run effects of inflation in a more general distributed lag model.