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november/december 1976


Money Growth, Jobs, and Expectations: Does
a Little Learning Ruin Everything?
A Lower Profile for the U .S . Balance of Pay­
F E D E R A L R E S E R V E B A N K of P H IL A D E L P H IA
Federal Reserve Bank of St. Louis


Donald }. Mullineaux



.. .It might, the author suggests. The effec­
tiveness of monetary policy in producing jobs
may well depend on how people expect
prices to behave.
Janice M. Westerfield



. . . Recent changes in world trade conditions,
including the shift from fixed to floating
currency-exchange rates, have reduced the
importance of surpluses and deficits. Accord­
ingly, the U.S. has altered its trade policies and
modified its system for reporting interna­
tional transactions.

V___________________________ w

Business Review November/December 1976
On Our Cover: American Commissioners of the Preliminary Peace Negotiations with Great Britain. Oil
on canvas by Benjamin West (1738-1820). Courtesy, The Henry Francis du Pont Winterthur Museum.
Born in Springfield, Pennsylvania, West early showed an aptitude for painting. At the age of nine he
studied in Philadelphia with the English portraitist, novelist, and mariner William Williams,and by thetime
he reached eighteen he had established himself as a painter. He left America to study in Europe in 1759 and
settled in London in 1763. West enjoyed the patronage and friendship of King George III for several
decades, and he served as president of the Royal Society from 1792 forward. Although he never returned to
this country, West exercised an important influence on American painting through his students John
Singleton Copley, Charles Wilson Peale, Rembrandt Peale, Gilbert Stuart, and John Trumbull.
This unfinished painting depicts the American commissioners at Paris in 1782—John Adams, Benjamin
Franklin, John Jay, and Henry Laurens—with William Temple Franklin, who was their secretary and Dr.
Franklin's grandson. West showed the picture to John Quincy Adams when the latter was in London in
1817. Adams pronounced the likeness of Jay “ striking,” those of the Franklins “ also excellent,” and those of
his father and Laurens, though less perfect resemblances, yet “ very good.” West told him, Adams records,
that he could not complete the canvas because Richard Oswald, the British Plenipotentiary, had died
without leaving any likeness of himself.
The Treaty of Paris, ratified in 1783, recognized United States sovereignty, set the northern and western
boundaries, regulated the use of fishing grounds and rivers, and recommended efforts to restore to
loyalists the property they had lost.
BUSINESS REVIEW is edited by John J. Mulhern for the Department of Research. Artwork is directed by
Ronald Williams.
Please direct requests for copies and subscriptions to the Department of Public Services, Federal
Reserve Bank of Philadelphia, Philadelphia, Pennsylvania 19106, telephone (215) 574-6115.


Money Growth,
Jobs, and
Does a Little
Learning Ruin
By Donald J. Mullineaux*

Should the Federal Reserve actively adjust the rate of money growth to try to affect the pace
of economic activity, or should it announce a money-growth target and stick to it regardless of
the state of the economy? Economists have debated this important question for many years. The
way people form expectations bears directly on the impact of a change in money growth, and
the present article surveys some recent developments concerning this issue. Until more
evidence is accumulated, however, the question whether the Fed should sponsor an active or a
passive money-growth stance must remain open.
Money is a veil, but when the veil flutters,
real output sputters.—John Gurley.

publicizing this fact that Congress has con­
sidered legislation—the Full Employment and
Balanced Growth Act of 1976—that requires
the Federal government to set a numerical
target for the unemployment rate. If such a
bill became law, the Federal Reserve would
be required to adjust its policies, including its
target for growth in the money supply, to help
achieve this unemployment goal—or, alter­
natively, to explain to the Congress and the
public why it chose not to do so.
This legislation would mandate that the Fed
do what it at times has done on its own
initiative—speed up money growth to stimu­
late the economy and create new jobs in

Professor Gurley's clever comment high­
lights a fact well known to monetary econo­
mists: that changes in the quantity of money
can affect the pace of economic activity and
hence the number of people holding jobs.
Indeed, economists have done so well at
*D o nald j. M u llin e a u x , Research O ffic e r and Eco no­
mist at the Ph iladelp hia Fed, jo in e d th estaff upon re c e iv­
ing his Ph .D . from Boston C o lle g e in 1971. He w rites on
fin an cial institutions and m arkets as w ell as on m onetary
th eo ry and p o licy.




periods of higher unemployment. But it also
would make the target rate of unem­
ployment—3 percent of the adult labor force1
in the Balanced Growth Act—a matter of
public record. At present, neither the Fed nor
the Congress announces an unemployment
rate target.
The Balanced Growth Act takes for granted
that policymakers are able to achieve a certain
unemployment rate whenever they want to.
But this assumes that money growth is linked
firmly and permanently to jobs. Unfortu­
nately, it seems that faster money growth
produces more jobs only in the short run. In
the long run, many economists believe, more
money yields only higher prices; employ­
ment is not affected.
The policymaker is faced with a dilemma.
Should the government act on Keynes's fa­
mous dictum—“ in the long run, we are all
dead” —and tinker with the money-growth
rate to take advantage of the temporary rela­
tion money has to jobs? Or should it set a
steady course for money growth, regardless
of the pace of economic activity, to minimize
the threat of fluctuations in prices and pro­
Almost all the market-oriented economies
in the world have opted for at least some
tinkering. Some economists have suggested,
however, that a reassessment of these policies
may be in order. They argue that once we
acknowledge the simple fact that people
learn from their mistakes, the best policy is to
set a money-growth rate and stick to it what­
ever the momentary state of the economy.
While the call for constant money growth
hardly is new, the logic in its favor recently has
been bolstered, ironically enough, by in­
vestigations of the reasons for the short-run
link of money to jobs.
As early as the eighteenth century, econo­
mists realized that accelerating the growth

rate of money (typically defined today as the
sum of currency and checking accounts in the
hands of the public) would stimulate produc­
tion of goods and services and hence create
more jobs. David Hume declared in 1750, for
example, that “ in every kingdom, into which
money begins to flow in greater abundance
than formerly, everything takes on a new
face; labour and industry gain life, the mer­
chant becomes more enterprising, and even
the farmer follows his plow with greater alac­
rity and attention.” 2 Yet Hume and other
classical economists recognized the transitory
nature of the money-jobs nexus. Hume went
on to say that “ some time is required before
the money circulates through the whole state,
and makes its effect be felt on all ranks of
people. At first, no alteration is perceived; by
degrees the price rises, first of one commod­
ity, then another; til the whole at last reaches
a just proportion with the new quantity of
specie [money] which is in the kingdom. In
my opinion, it is only in this interval or inter­
mediate situation, between the acquisition of
money and the rise of prices, that the increas­
ing quantity of gold and silver is favorable to
With over two hundred years of hindsight,
many economists believe that Hume cap­
tured the essence of the effects of changes in
money growth on the economy. What has
been far less clear all along, however, is why
boosting the growth rate of the money supply
has a permanent effect on price levels—
inflation—but only a temporary effect on
such real-sector items as jobs and production.
Several explanations have been suggested,
and one increasingly popular view attributes
the money-jobs tie-in to imperfect informa­
tion. Buyers and sellers make plans based on
the current state of the economy and their
best guesses of what lies ahead. If they make
mistakes either in assessing the present situa­
tion or in forecasting the future, they'll have
to revise their plans. When they do, the pace

M e m b e rs of Congress thus far have had som e tro ub le
agreeing about th e ap propriate d e fin itio n of ‘ad u lt’.

2David H u m e, “ O f M o n e y ,” Essays (O x fo rd : O xfo rd
U niversity Press, 1750).




of economic activity will be affected. Thus the
answer seems to be that the short-run effects
of changes in the money-growth rate differ
from the long-term results because people
act on imperfect information and, hence,
frequently make mistakes.
Relative Prices: The Key Information Varia­
ble. In a free-market economy, both busi­
nesses and households face a plethora of
complex decisions. Firms must consider how
much output to produce and how many
workers to hire, households must calculate
how many hours to work and what basket of
goods to purchase. Buyers and sellers could
rely on divine inspiration for guidance; but,
instead, they turn to more mundane signalsto
tell them what to do. The information is
contained in changes in market prices. An
increase in wages relative to machine rentals,
for instance, signals employers to hire fewer
workers and buy more machines. Similarly, an
increase in demand for some item a firm
produces relative to demand for other goods
and services induces a price rise; and the
price rise signals that this item has become
more profitable and that production sche­
dules should be accelerated. If the price of
television sets, for example, rises 5 percent
relative to the price of everything else (as
measured by, say, the price index for GNP),
then television manufacturers can increase
their profits by upping production. But if the
price tags on all other goods and services also
are marked up 5 percent, then the relative
price of television sets is unchanged and
manufacturers shouldn't speed up produc­
tion. The reason is that, in this case, the cost
(or price) of everything used in making televi­
sion sets is 5 percent higher too, so that
bringing more TVs to the market won’t payoff
in higher earnings.
Relative prices are the key items that firms
need to consider in everyday decisionmak­
ing, and the same is true for households.
Unfortunately, however, it’s often hard to
recognize a change in relative prices. Busi­
nessmen probably become aware of changes
in demand and price developments in

markets for their own products sooner than
they recognize changes in the overall level of
prices. Dress manufacturers, for example,
probably will take note of an increase in
garment prices before they perceive that the
prices of other goods and services reflected in
the GNP price index also are rising. Hence,
when inflation—a general rise in all prices—is
just getting underway, or when it’s accelerat­
ing or decelerating unexpectedly, firms may
interpret a change in the price of their own
product as a relative price change when in
fact its price is changing at the same rate and
in the same direction as everything else. It’s
this tendency to think one sees relative price
changes during periods of inflation and defla­
tion that allows policymakers to use the lever­
age of changes in money growth to affect
output and jobs.3
More Money, More Jobs? Suppose that the
money supply has been growing for some
time at 2 percent a year, that there has been
no inflation to speak of, and that the unem­
ployment rate is 5 percent. The Fed then
speeds up money growth to, say, 6 percent, to
create more jobs. What will be the impact of
this policy change?
As the money supply increases, people will
acquire more money than they want to hold
at prevailing interest rates. They’ll attempt to
get rid of their excess money by spending it
on assets such as government or corporate
securities, and perhaps on goods and services
as well. Interest rates will fall; and since more
funds will be available for lending, it will
become cheaper to finance expenditures
with borrowed funds. As a result, the sum
total of demand for goods and services in the
economy (aggregate demand) will begin to
rise, and the increase in demand will put
upward pressure on prices. Businessmen in
3Som e econom ists argue that jobs are linked to m oney
by other u ncertainties as w ell as by m isperceptions of this
kin d. See, for e xa m p le , James T o b in , “ Inflation and
U n e m p lo y m e n t,” A m erica n E co n o m ic R e v ie w 62 (1972),
pp. 1-18. A cco rd in g to T o b in , this lin k , far from being
m erely tem p o rary, may carry over into the long run.



individual markets will recognize that
demand is on the rise, but, because there has
been no inflation for some time, they'll con­
clude that there has been a relative shift in
demand for their own products rather than an
increase in demand for all goods and services.
In response to the perceived shift in demand,
businessmen will begin to increase prices for
their own goods. And because they haven’t
recognized yet that other prices also are rising
(including their costs for labor and machin­
ery), they'll step up production in concert. To
produce more output, firms will hire more
workers and the unemployment rate will
fall—much as Hume said it would.
But as Hume recognized, this euphoric
state is temporary. Eventually, businessmen
wake up to the fact that inflation makes them
pay more for labor and materials; so they cut
back on production and lay off workers.
Business activity returns to previous levels and
the unemployment rate returns to 5 percent;
but, unless the money-growth rate is re­
duced, inflation proceeds at a higher rate.
Many economists would accept this as a
long-run scenario. They agree that as people
become aware of inflation and adjust their
expectations of the future to reflect it, the Fed
will find it harder and harder to reduce unem­
ployment, even by following ever more
expansionary monetary policies. At the same
time, however, they disagree about the
appropriateness of changing the moneygrowth rate to try to alter the pace of eco­
nomic activity in the short run. One school of
thought suggests that the Fed should seldom
if ever tinker with the growth rate of the
money supply. This policy prescription—that
the money supply should be expanded at the
same rate year in and year out—isn't new.4 Its
popularity is growing now, however, as a
result of recent research into how households

4 o econom ists from the U n ive rsity of C h ica g o have
been the strongest propon ents of constant m oney
grow th. H enry Sim ons argued the position in the 1930s,
and M ilto n Friedm an has secon ded it on in n u m erab le
occasions sin ce the 1950s.


and businesses form expectations about the
outlook for future prices.
The information that buyers and sellers
possess plays a key role in determining the
impact of a change in the money-growth rate.
When people make mistakes and interpret a
general increase in prices as a relative price
change, their behavior affects the economy
both at the time they err and also when they
correct their mistakes. Indeed, these misper­
ceptions are at the root of the relations money
growth has to production and jobs. In fact,
monetary policy must generate unexpected
increases in prices in general in order to add
to the number of jobs. For if the inflation that
results from an increase in money growth is
expected, it will not boost production (since
people will not err in perceiving inflation as a
relative price rise).
This is why some economists believe that
shifts in money growth can't have a perma­
nent effect on the unemployment rate and
that the Fed isn't able to peg the rate wher­
ever it wants to. Suppose the demand and
supply of workers are consistent with an
unemployment rate of 5 percent (the unem­
ployed are those in transition from job to job
or out of work on their own initiative seeking
employment). The Fed can depress the unem­
ployment rate temporarily by accelerating
money growth and causing people to believe
that relative prices have changed. As people
become aware of inflation, however, unem­
ployment will move back toward 5 percent. In
order to maintain a low unemployment rate
permanently, the Fed would have to generate
the appearance of relative price changes on a
continuing basis.
Most economists would agree that keeping
the public in the dark about inflation would
be a difficult job. People eventually will catch
on to the process that produces inflation
simply because it's in their economic interest
to do so. And once they stop making syste­
matic errors in recognizing and forecasting



inflation, then changes in money growth
won't affect the production and employment
The fact that people won't stay ignorant of
the influences that make for inflation is a
source of bedevilment to policymakers.
When people recognize that changes in
money growth affect the inflation rate, they'll
learn to take money growth into account as
they form expectations about the future. As
stock market analysts frequently say, people
will discount the effects of policy changes;
they'll build this information into their deci­
sions. When the money-growth rate in­
creases, they'll respond by raising their infla­
tion forecasts. Similarly, any other develop­
ments that affect inflation, such as fiscal policy
moves, will be taken into account in generat­
ing a forecast. Economists refer to this method
of forming expectations—where all the avail­
able information is built into the forecast—as
a rational expectations process.
If people become aware of what normally
causes inflation (if expectations become
rational), policymakers will have a hard time
bringing about unexpected inflation. One
thing they might try is generating unexpected
changes (on average) in money growth. The
Fed currently announces its long-term targets
for money growth. If the public believes these
declarations, then the Fed should be able to
generate unexpected money growth by sys­
tematically missing its target. The Fed proba­
bly would come under heavy attack if it was
off target all the time; but even if this weren't
so, it's doubtful that the public would con­
tinue to accept the announced targets at
face value. For, after watching the actual
money-growth numbers, people eventually
would figure out what the Fed was respond­
ing to and then would use this information to
predict the actual (rather than announced)
rates of money growth and inflation. So unex­
pected money growth probably won't do as a
systematic source of unexpected inflation.5
5 e m oney stock is not pe rfectly co n tro llab le , h o w ­
ever, so that it is q u ite like ly that exp ectations about


The consequences for monetary policy are
radical. The spread of rational expectations
would shatter the link that connects employ­
ment to the money supply. When people at
large use all available information to forecast
inflation, accelerating money growth will
produce only higher prices, not more jobs;
slowing money growth, though it will check
inflation, won't affect employment either. In
this scheme, if policymakers were satisfied
with the rate of inflation, there would be no
justification for changing the money-growth
rate. In fact, the best policy would be to let the
money supply grow at some constant rate
year in and year out. In a world where expec­
tations are rational, a variable money-growth
rate simply makes the level of economic
activity more uncertain. This happens
because changes in money growth cloud the
picture and make it more difficult for busi­
nessmen and households to recognize shifts
in relative demands and supplies.
Consider the shoe producer who notices an
increase in his orders. He must ask whether
this represents an increase in demand for
shoes relative to everything else (so that he
should step up production) or whether the
demand for everything, shoes included, is on
the rise (and production should not be
increased). If the Fed has sworn off a policy of
tinkering with money growth, the shoe
manufacturer can be more confident that the
increase in orders represents a relative
demand shift. A constant growth rate in
money, however, would not mean constant
growth in income and production. Unpre­
dictable factors that affect economic activity,
such as weather, wildcat strikes, and political
upheavals, will continue to produce varia­
tions in income. But constant money growth
m oney growth fre q u e n tly w ill be d isapp ointed . These
surprises w ill p ro d u ce unexp ected tem p orary inflation
and a consequen t effect on pro d u ctio n and em ploym ent.
The u n co n tro lla b le random factors that push and pull
m oney growth away from its exp ected path w ill tend to
cancel each oth er o ver tim e, h o w e ve r, so that on average
the Fed w ill not be ab le to alter pro d u ctio n in som e
arbitrarily chosen fashion.



Should policymakers accept the rational
expectations view and passively peg the
growth of money at some constant rate?
Those who answer No and favor an activist
monetary policy believe that the rational
expectations scenario isn't now and isn’t
likely to become a faithful representation of
the real world. They emphasize reasons for
thinking that changing money growth will
affect the pace of production and the number
of jobs available. It has been pointed out, for
instance, that if policymakers have better
information than the public about the state of
the economy or the way money growth will
be altered, then monetary policy can affect
employment despite the fact that expecta­
tions are rational. Policy works when the
public has an information disadvantage
because the Fed can induce buyers and sellers
to behave in ways that create additional jobs.
It seems doubtful, however, that the Fed
possesses better information than the public.
Economic data are made available with only a
short lag in the U.S. and are well publicized in
the media. And forecasts of economic activity
can be purchased from a number of private
firms that use methods quite similar to those
employed by the Fed. Thus it seems reasona­
ble to conclude that the relevant information
is there for those who want it—including the
outlook for future money growth which the
Fed announces each quarter—and that infor­
mational advantages for policymakers cannot
establish a firm foundation for an activist
monetary policy.6
Others have argued for an activist policy by
contending that predictions become rational

(correct on average) only over a very long
period of time. On this view, there’s consider­
able room for monetary policy to operate
during the transition period. In fact, though,
very little is known about how fast people
learn and how long it takes them to adjust
their expectations accordingly. But even if
they learn only gradually, policymakers still
may have a problem. The difficulty is that the
Fed’s forecasts of the outcomes of policy
changes assume there will be virtually no
learning at all. Thus, to the extent that people
gradually are catching on and adjusting their
expectations, the Fed’s predictions of the
effects of a change in policy will be systemati­
cally wrong.7 In other words, to take advan­
tage of the time lag in getting to a state of
rational expectations, the Fed must know how
people learn and adjust their behavior.
Researchers only now are beginningto tackle
this problem. Hence, there remains some
doubt that the Fed currently has enough
information to temper fluctuations in eco­
nomic activity despite the lag in forming
rational expectations.
Finally, there is a school of thought that
questions the assumptions employed in the
rational expectations argument. The rational
expectations scenario presumes, it’s argued,
that prices are flexible—that they change
promptly when there’s a shift in demand or
supply. Yet there seems to be a lot of evidence
that many prices are sticky—that they have
little tendency to go down and that they go up
fairly gradually, at least in the beginning
stages of an inflationary period. In a world
where prices don’t change at all, any disturb­
ance to the economy (such as a drought, an oil
embargo, or a change in the money-growth
rate) must be reflected by quantity adjust­
ments rather than price changes. If prices are
rigid and some workers are unemployed

6lf the Fed does have better inform ation than the
p u b lic, changing the m oney-grow th rate is not the only
way it can stabilize p ro d u ctio n . It can ach ieve its goal also
by sim ply m aking its su p erio r inform ation available to the

rThis point has been argued fo rce fu lly in Robert E.
Lucas, “ Eco nom etric Policy Evalu atio n : A C rit iq u e ,’’ in
Karl B ru n n er, ed ., The Phillips C u rv e and La b or M arkets
(1976), supplem ent to the Jo u rn a l o f M o n e ta ry E co n o m ­

would eliminate one source of income varia­
tion so that, on average, income changes
should be less uncertain.



against their wishes, then an increase in
money growth will stimulate production and
create new jobs.
In reality, of course, prices are neither
perfectly flexible nor completely rigid. Some
economists have argued that there's enough
stickiness in prices to justify an activist mone­
tary policy. One way to resolve this issue is to
ask whether what has happened in the past is
consistent with the notion that monetary
policy can affect production and employment
systematically. Over the last fifteen to twenty
years, economists have amassed a great deal
of evidence which shows that increasing the
money-growth rate would produce more
jobs (but at the cost of higher prices). None of
these studies, however, considered the
impact of learning on people's behavior. A
recently completed investigation took a dif­
ferent tack and assumed that people do form
expectations rationally. No evidence
emerged which tended to show that money
growth is related to employment.8While one
study hardly amounts to a closed case, these
results do indicate that expectations are an
important factor and that more effort should
be devoted to studies of how people forecast
and how they adjust their behavior to what
they expect.
Policymakers themselves



“See Thom as J. Sargent, “ A C lassical M acroeconom etric M o del for the U nited States, “ Jo u rn a l o f Political
E co n o m y 84(1976), pp. 207-237.

bought the view that a little learning destroys
the jobs-money nexus. The Fed hasn't sworn
off adjusting money growth to changes in the
state of the economy, and Congress hasn't
stopped considering ways to influence the
Fed’s targets for money growth. But the
rational expectations argument at the very
least should have increased our skepticism
about what policy can do. After all, it's hard to
quarrel with the notion that people act in
their own best interest and use all the infor­
mation they profitably can get their hands on
to do so. Indeed, once economists discard this
notion, they find it quite difficult to justify
their analyses and predictions of how people
will behave.
Monetary policy of late has been directed
toward gradual reductions in money-growth
rates. The Fed is aiming for a reduced rate of
inflation along with an adequate recovery in
production. Once inflation has slowed to a
satisfactory rate, it might well be desirable to
consider an experimental period of constant
money growth. After subjecting an
announced policy of unchanged money
growth to the acid test of a real-world experi­
ment, the policymakers and the public would
be in a better position to judge the case for a
passive monetary policy on its merits. No one,
of course, can guarantee that such an experi­
ment would reduce fluctuations in economic
activity. But neither can anyone show from
past experience that policy activism has a
strong claim on our confidence.

Barro, Robert J. “ Rational Expectations and the Role of Monetary Policy,” Journal of
M onetary Economics 2 (1976), pp. 1-32.
Friedman, Milton. “ The Role of Monetary Policy,” American Econom ic R eview 58 (1968),
pp. 1-17.
Gordon, Robert J. “ Recent Developments in the Theory of Inflation and Unemploy­
ment,” Journal o f Monetary Economics 2 (1976), pp. 185-219.
Lucas, Robert E. “ Econometric Policy Evaluation: A Critique,” in Karl Brunner, ed., The




Phillips Curve and Labor Markets, a lournal of Monetary Economics supplement
--------------- “ Expectations and the Neutrality of M oney” , Journal of Economic Theory 4
(1972), pp. 103-124.
Sargent, Thomas J. “ A Classical Macroeconometric Model for the United States/' Journal
of Political Economy 84 (1976), pp. 207-237.
Sargent, Thomas J. and Wallace, Neil. “ Rational Expectations and the Theory of Economic
Policy," Journal of Monetary Economics 2 (1976), pp. 169-183.
Taylor, John B. “ Monetary Policy During a Transition to Rational Expectations," Journal of
Political Economy 83 (1975), pp. 1009-1021.

Though inflation has fallen off sharply,
it could become severe again. Can
policymakers curtail it? If so, how
much will their actions cost society?
Are there ways of living with
inflation that cushion its impact?
Six articles reprinted from the
Philadelphia Fed's Business Review
address these questions in
detail and seek to promote
an understanding of the
problem among both
and the general
Copies are available free of charge. Please address all requests to the Department
of Public Services, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsylva­
nia 19106.



A Lower Profile
for the
U.S. Balance
of Payments
By Janice M. Westerfield*
People reacted with surprise last May when
the government accepted an advisory panel’s
recommendation that it stop publishing sum­
mary payments balances. Not long ago, the
balance of payments was front-page news.
Continuing U.S. payments deficits caught the
attention of policymakers at the highest lev­
els, and they responded with programs to
combat deficits and maintain the value of the
dollar—in a word, to prevent devaluation.
Payments imbalances posed a serious threat
to international stability when the U.S. and its
trading partners bought and sold one anoth­
er’s currencies at fixed exchange rates. But
since 1973, when the fixed-rate system was
abandoned, deficit and surplus measures no
longer mean what they used to. Many econo­
mists believe that the payments restrictions of
the fixed-rate era, which were intended to
*Janice M . W e ste rfie ld , w ho jo in ed the bank in 1973
and received her P h .D . fro m the U niversity of Pennsylva­
nia the fo llo w in g year, w rites fre q u e n tly on international
fin an ce and trade.


reduce deficits, may have outlived their use­
fulness. And now these restrictions are being
eased in the belief that relaxed payments
policies will foster economic health in an
atmosphere of expanded consumer and
investor choice.
It’s usual to define a nation’s balance of
payments as a record of the transactions its
residents have carried on with foreign resi­
dents over a period of time. This record
follows the principles of double-entry book­
keeping: every credit is balanced by an offset­
ting debit somewhere on the statement. The
credit and debit entries can be grouped into
different accounts which bring out distinct
features of the payments picture.
A payments balance yardstick often used by
policymakers was the balance on current
account and long-term capital—the basic
balance. This measure was designed to pick
out long-term trends in the balance of pay-



merits by excluding volatile capital flows. The
current account portion of this balance
records sales of goods and services as well as
remittances and government grants. This
account reflects all international transactions
except capital movements. It's the mirror
image of changes in capital flows (excluding
errors and omissions). Thus a deficit in the
current account is matched by a surplus of
roughly the same size in capital accounts.
Payments balances and the financing of
deficits were items of central importance to
the international economic system that was
established after World War II. Policymakers
were very much interested in the stability of
this system. Balanced international trade and
fixed currency exchange rates both were
considered important for achieving stability.
But there wasn't much give in the system.
Imbalances in international payments threat­
ened to change currency exchange rates and
vice versa. A nation that imported more
goods and services than it exported had to
make up the difference with financing or
reserves—whose effect may be to make a
currency more available and drive down its
value against other currencies. Under the
fixed-rate system, however, central banks
stepped in to hold a currency's value steady if
it threatened to move outside agreed-on
limits. Where fundamental changes occurred
in a nation's economic circumstances, the
monetary authorities were able to set a new
official value for that nation's currency in
terms of other currencies and gold. But it was
expected that the United States, with the
cooperation of other countries, would main­
tain the value of the dollar in terms of gold.
U.S. policymakers were faced with a choice:
either take domestic measures to keep
exchange rates and trade balances in order, or
face international pressures to redress imbal­
ances. They reacted by developing a combi­
nation of domestic economic policies and
exchange controls to correct international
financial difficulties.
International currency exchange is a many­

sided enterprise, and policymakers had many
reasons for trying to avoid deficits. Some were
economic, others were political; some had to
do with the economy of a single nation,
others with the economies of several nations.
Deficits Drain Off Reserve Assets. During
the late 1950s and 1960s, the U.S. was piling
up deficits in its basic balance and other
overall balances. Stocks of gold, foreign cur­
rencies, and other reserve assets were used to
ensure the value of the dollars that were used
to cover deficits with trading partners. There
was little bodily movement of metals or cur­
rency; gold wasn't shipped out of Fort Knox
every month. But as time went on and deficits
continued, many U.S. dollars—or dollar
credits—were accumulated by foreigners. As
the foreign dollar holdings grew larger, the
willingness to accept still more dollars sof­
tened and so the increasing supply of dollars
overseas threatened to undercut the value of
U.S. currency and upset the fixed-rate sys­
The U.S. and its trading partners cooper­
ated to head off sharp movements in currency
exchange rates, but they did so at a cost.
Foreign central banks bought up excess dol­
lars with their own currencies, and they could
present these dollars to the U.S. Treasury for
payment in gold. Thus the U.S. lost a lot of its
gold to dollar holders in the late 1960s. With
no end to balance-of-payments deficits in
sight, the threat of a continuing gold loss
persuaded the U.S. to suspend its redemp­
tion of dollars in 1971. The end of dollar-togold convertibility touched off other
changes—including the shift from fixed to
floating exchange rates—that have altered
our outlook on payments deficits.
U.S. Deficits Produce Resentment
Abroad. . . During the Vietnam conflict, the
U.S. supplied more and more dollars, over­
loading currency markets. Other nations had
to absorb these dollars to avoid revaluing and,
under the fixed-exchange-rate system, they
usually bought them up with their own cur­
rencies. The West German government, for



example, had to buy up dollars with marks in
order to prevent the mark from gaining in
value against the dollar. But pumping more
marks into circulation swelled the German
money supply; and as the money supply
expanded, prices shot up. The German
government, stuck with dollars it didn't want
and with inflation besides, traced many of its
difficulties to U.S. policies. And Germany
was not the only nation that blamed its high
inflation rates of the late 1960s and early 1970s
on the U.S.
. . . and at Home. Many Americans also
were unhappy about their country's owing
money to foreign creditors, but that's what
happens when the payments balance shows a
deficit. With deficits piling up year after year,
the nation had to borrow continually to
finance its spending.
Since the total balance—counting goods
and services, capital, and reserve assets—must
be zero, dollar outflows in one portion of the
statement must be offset by dollar inflows in
another. So, for example, if the U.S. has a
deficit (net dollar outflow) in the current
account, it ordinarily would show a surplus
(net dollar inflow) in the capital account, say
from foreign purchases of U.S. Treasury
securities. And such a net inflow of short-term
private capital may mean that the U.S. is
borrowing money abroad to tide itself over
instead of paying cash on the barrelhead for
consumption and investment goods. It's been
argued that the U.S. lived beyond its means
by running up large international bills this
way, especially in the later 1960s, and that
neither a nation nor a household can run up a
lot of bills without making arrangements to
repay its creditors. Without an expansion of
national output large enough to liquidate
foreign debt as it comes due, a trading coun­
try faces the possibility of default and of
difficulty in obtaining further credit. Any
nation that runs deficits for a prolonged
period must gear up to transfer sizable
resources to other nations in the future. No
wonder international deficit financing goes
against the grain of people who don’t like to


owe anything to anybody.
Interest Groups Fear Loss of Jobs and Prof­
its. Some groups oppose payments deficits for
reasons peculiar to their own situation. Labor
unions, for example, use media spots and
billboard advertisements to tell the story of
U. S. workers knocked out of jobs by foreign
imports. Of course, domestic industries may
be vulnerable even in times of surplus; it
doesn't take a deficit to imperil workers in an
industry that faces stiff foreign competition.
But labor groups have lobbied consistently in
favor of tariffs, quotas, and international
agreements to restrict the influx of foreignmade goods. Policymakers have had to
reckon with the likelihood that large deficits
would galvanize labor into taking further
political action and would revive the coun­
try’s latent but deep-seated protectionism.
Nor is industry all out for free trade. Indus­
try may oppose deficits for much the same
reason as labor—fear of competition from
abroad. It's believed in many quarters that
budding domestic industries have to be
helped along until they’re able to compete
with established foreign producers in world
markets. The infant company is supposed to
grow up and throw off its protective blanket
after a while, but that isn't always the way it
works. Many well-established U. S. industries
retain powerful lobbies to keep trade controls
that were set up when those industries were
just getting off the ground. And American
industry is not unique in its protectionist
tendencies. Foreign producers often lobby to
obtain similiar protection from their own
The Government Responds. The combina­
tion of fixed exchange rates with declining
reserve assets, resentment at home and
abroad, and pressure from special interest
groups led the U . S . to adopt deficit-reducing
policies during the 1960s. These policies pro­
duced restrictions on long-term foreign
investment by American citizens, guidelines
for bank lending to foreigners, and ceilings
on overseas direct investment—all programs
designed to slow capital outflows. In another


program, called Operation Twist, policymak­
ers attempted to encourage economic
growth by lowering long-term interest rates
while raising short-term rates to attract for­
eign capital. Other measures subsidized
export credits with loans at below-market
rates and lowered duty-free allowances for
tourists bringing home foreign goods. The
government increased its preferences for
goods from domestic suppliers. Even defense
and foreign aid were affected by the balance
of payments. The Armed Services Procure­
ment Regulations required military depart­
ments to buy munitions at home under the
Buy American program despite the higher
cost. And receipt of foreign aid was tied to
purchase of American goods. Throughout,
the government acted to maintain a fixed
exchange rate for the dollar.
These initiatives may have held down the
size of succeeding deficits. But since they
were in basic conflict with an open trade and
payments system, they were not without costs
of their own. Capital controls restricted prof­
itable U.S. investment abroad. Higher short­
term interest rates raised the cost of domestic
borrowing at home. Restrictions on the entry
of foreign goods narrowed the range of
choices for the U.S. consumer at the same
time that export subsidies increased his tax
burden. And the Buy American program
raised the cost of maintaining a defense estab­
lishment which already had come under
intense public scrutiny for high spending.
Any measures to reduce deficits would
have produced costs somewhere, and under
fixed rates policymakers wanted deficits kept
small to maintain international economic
stability. But now fixed exchange rates are
gone, and deficit figures no longer mean what
they used to. Yet some of the policies linger
The system of fixed but adjustable ex­
change rates came under increasing pres­
sure in the late 1960s and early 1970s. This
pressure was reflected in larger movements of


speculative capital, tighter payments restric­
tions, and more frequent changes in currency
values. When dollar-to-gold convertibility
was suspended in 1971, many countries let
their currencies float against the dollar.
Exchange rates were fixed again, temporarily,
by the Smithsonian Agreement, but new
monetary crises facing the British pound and
other currencies hastened the evolution
toward floating rates. By spring 1973, all of the
leading currencies were floating jointly or
Now thedollar is relatively free to riseorfall
in value against other currencies. Capital still
moves from country to country, and some
countries' balances are in surplus while others
are in deficit. But whereas under fixed rates
the U.S. would face a loss of reserve assets
when the dollar was threatened, under flexi­
ble rates the exchange-rate mechanism itself
makes the required adjustment by letting the
dollar fall in value. Nowadays, governments
generally avoid trying to fix exchange rates at
predetermined levels as they did prior to
1973.1 Monetary authorities still intervene in
the exchange markets, but mostly to quiet
temporary disorders rather than to mask
underlying economic conditions. Thus the
floating-rate system eliminates some of the
undesirable repercussions of a deficit over
the long haul and reduces the usefulness of
some traditional measures of the balance of
payments (see Box).
In fact, floating rates actually tend to cor­
rect deficits and to move international pay­
ments balances back toward equilibrium.
Suppose, for example, that the U.S. were to
run a large current account deficit for a year
or two and the dollar excess were to reduce
nEven und er floating rates c u rre n cy values are m an­
aged to som e extent. The most im portant d e p artu re from
the floating-rate system as describ ed in the text is the
snake— a jo in t float adopted by several co u n tries of the
European C o m m u n ity. C en tral banks of the snake c o u n ­
tries intervene to keep c u rre n cy -va lu e fluctuatio ns
against one another w ithin narrow lim its, but they allow
th eir cu rren cies to float jo in tly against the d o llar and
other outside cu rren cies.




The new international monetary system not only reduces the importance of balance-ofpayments measures but also makes the old reporting system obsolete. Until recently, the major
focus of U. S. balance-of-payments policy was on the three overall balances—the basic balance, the
net liquidity balance, and the official reserve transactions balance. As the international monetary
system moved to floating exchange rates, these overall measures came to be misinterpreted by the
public. As a result, the President's Advisory Committee on the Presentation of Balance of Payments
Statistics suggested that none of these balances be used to measure international transactions of the
U. S. and that the words 'deficit' and 'surplus' be avoided as much as possible in press releases.*
Some partial balances, such as the merchandise trade and current account balances, will be listed as
memorandum items, but the emphasis has shifted from concentrating on one of the overall
balances to analyzing information on several classes of international transactions. Capital
transactions, for example, now are grouped so that foreign assets in the United States are broken
down into transactions with foreign official institutions and transactions with foreign banks or
Of the three measures that have been discontinued, the official reserve transactions balance was
most closely tailored to the fixed-exchange-rate system. This balance includes merchandise trade,
services, and remittances, as well as long-term and short-term capital flows. It indicates the
surpluses and deficits arising from all these transactions, which are financed by changes in official
reserve assets. (Official reserves include gold, Special Drawing Rights, foreign currencies, and
borrowings from the International Monetary Fund). In short, this balance was intended to reflect
the extent of official intervention required to maintain fixed exchange rates. A deficit, for instance,
was interpreted to mean that foreign countries had intervened to support the dollar. As the system
of floating rates evolved, the official reserve transactions balance lost much of its meaning.
Exchange market pressures on the dollar now are indicated mainly by changes in exchange rates,
not by changes in official reserves. And dollar accumulations by foreign official institutions
ordinarily are matters of preference rather than obligation—witness the large investment in dollar
assets by oil-producing countries.
The net liquidity balance focused on changes in the international liquidity position of the U. S. It
included all transactions except liquid private capital flows, liabilities to foreign official agencies,
and official reserve assets. Once thought to measure the potential pressure on U. S. primary reserve
assets, it was a way of checking that foreign claims did not become so large that the U. S. would be
unable to meet them if they were presented for payment. Since the dollar no longer is convertible
into gold, this threat is gone. And there are serious statistical problems in the distinction this balance
makes of liquid from nonliquid capital transactions.
The balance on current account and long-term capital (basic balance) was intended to capture
stable underlying economic trends. It included merchandise trade, services, remittances, and long­
term capital flows. This balance also presented statistical difficulties. Long-term capital flows
sometimes have effects quite similar to those of short-term flows. But the arbitrary methods of
distinguishing these flows made this balance an unsatisfactory indicator of long-term trends.
" “ R epo rt of the A d visory C o m m ittee on the Presentation of Balance of Paym ents Statistics,” Statistical
R e p o rte r 76 (1976), pp. 221-238.



the value of U.S. currency. What would
It would take more dollars to buy units of
other currencies and commodities priced in
other currencies, so the dollar prices of
imports would rise and Americans would shift
their demand toward domestic goods. At the
same time, the foreign currency prices of U. S.
goods sold abroad would drop, and foreign
consumers would shift their demand toward
U.S. goods. After a period of adjustment, the
lower dollar value would encourage Ameri­
cans to buy fewer imports and sell more
exports; and both actions would tend to
reduce the deficit.
Although floating exchange rates make
long periods of payments deficits unlikely,
some hefty short-term deficits still may occur.
Outside forces, such as sharp rises in foreign
commodity prices, could push an importing
country into a deficit position for several
years. The recent jump in oil prices, for exam­
ple, played hob with the payments balances
of many oil-importing nations. Or deficits
could be caused by fundamental internal
weaknesses, such as the high domestic infla­
tion rates that are plaguing some nations.
Policymakers may well want to take steps that
deal with domestic sources of economic
weakness. But whether they do or not, the
system of flexible exchange rates will lead al­
most inevitably to currency realignments that
tend to reduce deficits and some of their
undesirable repercussions.2

2Policym akers in som e co untries are suggesting that
the curren t system of floating rates has com e up short on
several counts. They contend that exchange-rate fle x ib il­
ity does not relieve the need to m ake painful dom estic
eco no m ic adjustm ents w hen a c o u n try ’s p rices, p ro d u c­
tion, and trade get out of alignm ent w ith those of sim ilar
countries. They argue that floating rates may have w o r­
sened inflation in such co untries as Britain and Italy. And
they m aintain that floating rates may im pose costs not
only on individual co untries but also on the intern ation al
eco no m ic system itself. For a discussion of both sides of
this issue see my “ W ould Fixed Exchange Rates C ontrol
In flatio n ?’’ Business R e v ie w , Federal R eserve Bank of
Ph iladelp hia, July/A ug u st 1976, pp. 3-10.


Though old ideas die hard, many
observers of international economic devel­
opments now think it better not to direct ad
hoc policies toward correcting a U.S. pay­
ments deficit. The basic strategy under float­
ing rates is for the government to pursue
monetary and fiscal policies that it expects will
lead to a desired rate of economic growth and
acceptable inflation, and it lets the payments
balance fall where it may.3 Current U.S.
domestic economic and payments policies
have as a goal the stability of the economic
system overall. Beyond that, these policies
aim toward allowing market forces to play a
major role in determining payments positions
and exchange rates. Despite some protec­
tionist provisions in the Trade Act of 1974, the
main thrust of U.S. trade policy is directed
toward establishing and preserving an open
trade and payments system.
The limitations on trade and investment
that were imposed in the 1960s do not fit well
with current U.S. payments policies. Because
of this, most controls on capital flows have
been removed. The way is open to move
further toward dismantling restrictive poli­
cies, but this movement probably will be
gradual. The U.S. may not be in a position to
alter its procurement practices or cut off
subsidized export credits, for example, until
other nations agree to do the same. And that
may take time. In the interim, having restric­
tions may serve the useful purpose of provid­
ing bargaining leverage with other countries.
In sum, the U.S. still seeks economic
stability, not only for itself but for all nations.
Under the fixed-rate system, stability
required the avoidance of payments deficits;
but with floating exchange rates, the relative
values of currencies constantly readjust to
changing international conditions. Therefore
deficit and surplus measures don't mean what
they used to mean and so they are being
deemphasized. Indeed it would be inconsist­
3See F. Lisle W id m an , “ U .S . Balance of Paym ents
P o licy,” D epartm ent o f the Treasury N ew s, M ay 24,1976.



ent with present developments to tie domes­
tic and foreign economic policy decisions to
these figures in the same way as before,

ignoring the flexibility of exchange rates and
the complexity of international capital move­



edited by
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The Philadelphia Fed’s Research Department occasionally publishes RESEARCH PAPERS written
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1. Intradistrict Distribution of School Resour­
ces to the Disadvantaged: Evidence for the
Courts, Philadelphia School Project by
Anita A. Summers and Barbara L. Wolfe

EH 4. Required Reserve Ratios, Policy Instru­
ments, and Money Stock Control by Ira


5. The Information Value of Demand Equa­
tion Residuals: A Further Analysis by James
M. O’Brien


6. Equality of Educational Opportunity Quan­
tified: A Production Function Approach,
Philadelphia School Project by Anita A.
Summers and Barbara L. Wolfe

EH 10.
EH 11.
EH 12.
EH 14.
EH 15.


7. Pennsylvania Bank Merger Survey: Sum­
mary of Results by Cynthia A. Glassman




8. Manual on Procedure for Using Census
Data to Estimate Block Income, Philadel­
phia School Project by Anita A. Summers
and Barbara L. Wolfe




9. Block Income Estimates, City of Philadel­
phia: 1960 and 1970, Philadelphia School

EH 18.

Project by Anita A. Summers and Barbara
L. Wolfe
Optimal Capital Standards for the Banking
Industry by Anthony M. Santomero and
Ronald D. Watson
A Unified Model of Consumption, Labor
Supply, and Job Search by John J. Seater
Utility Maximization, Aggregate Labor
Force Behavior, and the Phillips Curve by
John J. Seater
On the Role of Transaction Costs and the
Rates of Return on the Demand Deposit
Decision by Anthony M. Santomero
Spectral Estimation of Dynamic Economet­
ric Models with Serially Correlated Errors
by Nariman Behravesh
Empirical Properties of Foreign Exchange
Rates under Fixed and Floating Rate
Regimes by Janice Moulton Westerfield
A Model of Vacancy Contacts by Job
Searchers by John J. Seater
The Effect of the Local Public Sector on
Residential Property Values in San Mateo
County, California by Nonna A. Noto




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