A Credit Market Theory of the Money Supply and an Explanation of Two Puzzles in U.S. Monetary Policy

Federal Reserve policy in the early postwar years has frequently been described as an "engine of inflation". Continuation of the wartime policy of supporting the government bond market required the central bank to absorb securities sold by the private sector. Given the large stock of government securities left as a residue of wartime finance, the expectation that the support policy would lead to inflation was quite reasonable. The puzzling feature about the period is that substantial inflation did not occur. Instead, the growth rates of the money supply and of the monetary base collapsed shortly after the end of World War II. By 1949, the economy had moved to a position in which the policy problem was one of removing recession and deflation. Despite the continuation of the support policy, prices in 1949 were falling, not rising.