money. To this day, the financial markets closely watch the Fed chair-
man’s biannual testimony, which takes place in February and July.^9
Unfortunately, the Fed largely ignored the money targets it set in
the 1970s. The surge of inflation in 1979 brought increased pressure on
the Federal Reserve to change its policy and seriously control inflation.
On Saturday, October 6, 1979, Paul Volcker, who had been appointed in
April to succeed G. William Miller as chairman of the board of the Fed-
eral Reserve System, announced a radical change in the implementation
of monetary policy. No longer would the Federal Reserve set interest
rates to guide policy. Instead, it would exercise control over the supply
of money without regard to interest rate movements. The market knew
that this meant sharply higher interest rates.
The prospect of sharply restricted liquidity was a shock to the fi-
nancial markets. Although Volcker’s Saturday night announcement
(later referred to as the “Saturday Night Massacre”) did not immedi-
ately capture the popular headlines—in contrast to the abundant press
coverage devoted to Nixon’s 1971 New Economic Policy that froze
prices and closed the gold window—it roiled the financial markets.
Stocks went into a tailspin, falling almost 8 percent on record volume in
the 2^1 ⁄ 2 days following the announcement. Stockholders shuddered at
the prospect of sharply higher interest rates that would be necessary to
tame inflation.
The tight monetary policy of the Volcker years eventually broke the
inflationary cycle. European central banks and the Bank of Japan joined
the Fed in calling inflation “public enemy number 1,” and they conse-
quently geared their monetary policies toward stable prices. Restricting
money growth proved to be the only real answer to controlling inflation.THE FEDERAL RESERVE AND MONEY CREATION
The process by which the Fed changes the money supply and controls
credit conditions is straightforward. When the Fed wants to increase the
money supply, it buys a government bond in the open market—a market
where billions of dollars in bonds are transacted every day. What is
unique about the Federal Reserve is that when it buys government
bonds in what is called an open market purchase, it pays for them by cred-
iting the reserve account of the bank of the customer from whom the Fed
bought the bond—thereby creating money. Areserve accountis a depositCHAPTER 11 Gold, Monetary Policy, and Inflation 195
(^9) In 2000, Congress allowed to lapse the Humphrey-Hawkins Act, but legislation still required the
Federal Reserve chairman to report biannually to Congress.