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Federal Reserve Bank o f Philadelphia
March* April 1993

ISSN 0007-7011

Leaning Against the Seasonal Wind:
Is There a Case for Seasonal Smoothing
of Interest Rates?
Satyajit Chatterjee



The BUSINESS REVIEW is published by the
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Laurence Ball
As suggested in this article, inflation is like
the weather: everyone complains about it,
but no one does anything about it. And,
like the weather, inflation affects almost
everybody. Some favorite candidates for
the causes of inflation include OPEC, ex­
cessive government spending, and the
climbing costs of medical care. What does
cause inflation, and can it be eliminated?
In answer to these questions, Larry Ball
tells us, "There's good news and bad news."
Satyajit Chatterjee
Financial and banking panics occurred
regularly in the United States in the 19th
and early 20th centuries, triggered by a
seasonal increase in the demand for money
and short-term interest rates. The Federal
Reserve System was established, in part,
to insulate the financial system from such
panics. But the introduction of federal
deposit insurance in 1933 greatly lessened
the need for a seasonal monetary policy to
fight panics. Consequently, the primary
effect of such a policy is to smooth the
seasonal path of short-term interest rates,
which leads Satyajit Chatterjee to pose the
question: Is there a case for seasonal
smoothing of interest rates?


What Causes Inflation?
Laurence Ball*
I nflation is universally unpopular; everyone
from ordinary consumers to top government
officials bemoans the perpetual process of ris­
ing prices. Frequently, discussions of inflation
have an air of resignation. Inflation is like bad
weather: we can complain about it, but it seems
to be a fact of life. For most people, the causes
of inflation are murky. Popular writers lay the
blame on a variety of scapegoats: governments

^Laurence Ball is an assistant professor of economics at
Princeton University and a visiting scholar in the Research
Department of the Philadelphia Fed.

that spend too much money, the OPEC cartel,
skyrocketing costs of medical care. What causes
inflation, and is there any way to eliminate it?
Economists have both good news and bad
news about inflation. The good news is that we
know a lot about its causes and how it could be
ended. The bad news— and the reason that
inflation has not been ended—is that doing so
could be costly. This article describes what
economists understand about inflation and what
issues remain mysterious. There is a clear
consensus about the long-run causes of
inflation—the determinants of average infla­
tion over a decade or more. The short-run


behavior of inflation— the ups and downs from
year to year— is only partly understood.


The year-to-year movements in inflation that
make newspaper headlines are small compared
with the differences in inflation across different
eras or different countries. In the United States,

consistently decreases relative to output there
is deflation: the price level falls. (The most
recent example of deflation in the United States
is the early 1930s.)
Why does too rapid growth in the money
supply cause inflation? To see the answer,
consider how the economy responds when the
money supply rises. According to mainstream

in flation as m easu red by the gro ss-n atio n al-

econ om ics, firm s do n o t im m ed iately ad just

product deflator averaged 7.4 percent per year
from 1970 through 1979, but only 2.4 percent
from 1950 through 1959.1 From 1930 through
1939, inflation averaged -1.7 percent per
year— the price level was lower at the end of the
decade than at the beginning. And these differ­
ences across periods in the United States, while
substantial, are dwarfed by differences across
countries. From the 1950s to the mid-1980s,
inflation averaged 4.2 percent per year in the
United States, only 2.7 percent in Switzerland,
but 8.0 percent in Italy, 21.2 percent in Israel,
and 54.4 percent in Argentina (see Ball, Mankiw,
and Romer, 1988).2 What causes these differ­
ences in inflation over long periods?
The Culprit: Too Rapid Money Growth.
While economists disagree about many issues,
there is near unanimity about this one: continu­
ing inflation occurs when the rate of growth of
the money supply consistently exceeds the
growth rate of output. In the long run, as
Milton Friedman puts it, "inflation is always
and everywhere a monetary phenomenon."
When the money supply grows much more
quickly than output of goods and services,
inflation is high; when it grows only slightly
faster than output, inflation is low; and when it

their prices in response to an increase in the
money supply. Because prices do not respond
immediately, there is an increase in the real
money supply—the money supply relative to
the price level. The increase in the real supply
of money pushes down the price of money—that
is, the interest rate. Over time, lower interest
rates stimulate borrowing and spending by
firms and consumers, and the economy ex­
pands. The story ends when firms react to the
booming economy and their strained capacity
by raising prices. Prices rise until they match
the increase in the money supply, pushing the
real money supply back to its original level and
choking off the boom. That is, the long-run
effect of a 10 percent increase in the money
supply relative to output is a 10 percent in­
crease in the price level and no change in the
ratio of money to prices. It follows that if the
money supply increases 10 percent faster than
output every year, prices must eventually rise
10 percent per year. The gap between the
average rate of money growth and the average
growth rate of output determines average in­

aUnless otherwise noted, all inflation figures refer to the
percentage change in the GNP deflator. This variable is a
broad index of the level of all prices in the economy. The
more famous Consumer Price Index covers only prices paid
by consumers, not those paid by governments or businesses.
2Citations to all papers mentioned in the text are in­
cluded in the "References" section at the end of this article.

3To be complete, inflation depends on the growth rate of
the "velocity" of money— the frequency with which money
is turned over—as well as on the gap between the average
growth rates of money and output. For the United States,
the average growth rate of velocity (for the M2 measure of
money) has been zero over the past 40 years. In practice,
then, money growth of 2 or 3 percent per year is consistent
with stable prices. This rate of money growth matches the
natural growth of output and spending.

Laurence Ball

What Causes Inflation?

In principle, differences in in­
flation across countries or time
periods could be explained by dif­
ferences in either money growth
or output growth, since the gap
between the two determines infla­
tion. In practice, however, the
most important factor is money
growth, which varies widely, with
levels near zero in some countries
and over 100 percent per year in
others. Variation in output growth
is smaller and thus is a secondary
factor in explaining differences in
the gap between money growth
and output growth. As a first
approximation, then, differences
in inflation across time periods or
countries can be explained by dif­
ferences in money growth.
To provide evidence for this


Money Growth and Inflation (U.S.)
(1870 -1980)
Inflation Rate (Percent Per Year)
1970s1 11910s
1980s ■

1950s ■

1890s" _


■ 1880s

■ 1920s
'4 0


Growth in Money Supply (Percent Per Year)


Recreated from: Milton Friedman and Anna J. Schwartz, Monetary
Trends in the United States and the United Kingdom. Chicago: University
of Chicago Press, 1982, with permission.

p oin t, F ig u re 1 p lots av erage in­

flation and money growth in the
United States for various decades.
Figure 2 presents average infla­
tion and money growth from
1986-89 for a number of coun­
tries.4 In Figure 1, the decades
with the highest inflation, such as
the 1910s and the 1970s, are those
with the highest money growth.
Similarly, Figure 2 shows a close
relationship between inflation and
money growth across countries.
Countries such as Switzerland
and France produce low inflation
through low m oney grow th;
countries such as Turkey and
Mexico produce high inflation

4The data for Figures 1 and 2 are taken
from Friedman and Schwartz (1982) and
Abel and Bernanke (1992), respectively.


Money Growth and
Inflation Across Countries
(1986 -1989)
Inflation Rate (Percent Per Year)
M exico




M alaw i
C ote DTv oire


1 r £ fi:

C had t-C



E G hana

■ | fiil
_ ■ M ada »ascar
® ■N epal

“ itzer la id , R w an da, Belgiun

Sen egal France


Growth in Money Supply (Percent Per Year)



Recreated from: Andrew B. Abel and Ben S. Bernanke,
Macroeconomics. Reading, MA: Addison-Wesley, 1992, p. 141, with



through high money growth. Along with the
theoretical arguments discussed above, this
evidence has convinced economists that trend
or average inflation is determined by money
Why Is Money Growth Excessive? The
question of what causes inflation has, at one
level, an easy answer: money growth. This


Budget deficits are not, however, the basic
source of inflation in the United States or in
most European economies. The U.S. govern­
ment has, of course, run large deficits over the
past decade. But these deficits have been fi­
nanced primarily by borrowing, not by print­
ing money. That is, the government covers its
deficit mostly by issuing bonds. The Federal

answ er, h o w ev er, raises ano th er, d eep er qu es­

R eserve co n trib u tes to g ov ern m en t rev en u e b y

tion: why do policymakers allow the money
supply to grow quickly? The Federal Reserve
and corresponding monetary authorities in
other countries possess effective techniques for
controlling the average growth rate of the money
supply.5 Policymakers could slow average
money growth enough to keep the average
inflation rate at zero (although shocks to the
economy would cause temporary movements
above and below zero). Since both the public
and the Federal Reserve dislike inflation, why
isn't it eliminated?
The answer to this question is different in
different types of economies. In some coun­
tries, the answer is simple: the government
prints money at a rapid rate to finance budget
deficits. This explains most episodes of very
high inflation—the annual inflation of several
hundred percent or more that has afflicted
South American countries and Israel within the
past decade. These countries have had high
levels of government spending and have been
unable politically to match this spending with
tax revenues; thus they have financed their
spending by creating new money. Predictably,
rapid money creation has produced high infla­
tion. Inflation has been brought under control
only when the underlying budget deficit was
reduced. (In Israel, for example, such a stabili­
zation occurred in 1985.)

creating new money, but this "seignorage" is
small: less than 1 percent of total revenue. In
countries like the United States, policymakers
would gladly eliminate inflation through lower
money growth if the only cost were a small
revenue loss. The deterrent to lowering infla­
tion must arise from a different source.
The reason U.S. policymakers are reluctant
to push inflation to zero is that doing so is likely
to cause a recession, or at least slower economic
growth. This fear is supported by both
macroeconomic theory and historical experi­
ence. Slower money growth reduces inflation
in the long run, but there is a lag, as discussed
earlier. When money growth falls, firms ini­
tially continue to raise prices at the rate to
which they are accustomed. With money grow­
ing more slowly than prices, the real money
supply falls, causing a recession. Only the
experience of the recession causes inflation to
This theoretical story fits much of the U.S.
experience. One cause of the recession that
began in 1990 was, arguably, the Fed's efforts to
reduce inflation in the late 1980s. More clearly,
disinflation was a major cause of the recession
of 1981-82—the worst recession since the 1930s.
Paul Volcker, the chairman of the Federal Re­
serve from 1979 to 1986, moved decisively to
eliminate the double-digit inflation of the late
1970s. He succeeded, but at a price: inflation
fell from 10.1 percent in 1980 to 4.0 percent in
1983, but unemployment rose from 5.8 percent
in 1979 to 9.5 percent in both 1982 and 1983.
Research by economic historians has shown
that this experience is part of a regular pattern:

Specifically, the Fed manipulates the supply of
money through "open market operations"—purchases
and sales of government bonds. Buying bonds with
money adds to the economy's money stock, and selling
bonds drains money out of the economy.

Digitized for 6


What Causes Inflation?

Laurence Ball

when the Fed slows money growth substan­ 5.0, 7.6, and 9.6 percent. One source of these
tially to reduce inflation, a recession occurs inflation movements is temporary fluctuations
almost invariably.6
in the growth of the money supply. In contrast
While some policymakers are willing to pay to the long run, however, too rapid money
this price to reduce inflation, others are not. growth is not the only, or even the primary,
And the Fed's eagerness to fight inflation ap­ determinant of inflation. Figure 3 plots infla­
pears to depend on the severity of the inflation tion against money growth for each year during
problem. Volcker was sufficiently
concerned about double-digit infla­
tion to implement the monetary
tightening needed to reduce infla­
Money Growth and
tion. But inflation of around four
Inflation During the 1970s (U.S.)
percent, the level through much of
Inflation Rate (Percent)
the 1980s, did not create enough
distress to prompt a further tight­
□ 1974
ening. Thus inflation continued.
(For more on this subject, the reader
c >1978
is referred to "W hat Are the Costs
n 1975
of D is in fla tio n ?" by D ean
□ 197 3
a 1977
Croushore, in the May/June 1992
issue of this Business Review.)
Although money growth deter­
mines average inflation in the long
run, the short-run behavior of infla­
tion is more complicated. Inflation
fluctuates around its long-term
trend from year to year; for ex­
ample, annual inflation rates in the
second half of the 1980s varied
around their average of 3.6 percent,
with annual rates from 1985 to 1989
of 3.6, 2.5, 3.3, 4.3, and 4.2 percent.
Short-term fluctuations in inflation
were larger in the 1970s: the annual
rates from 1970 to 1974 were 4.7,5.6,

3 1970

Growth in Money Supply (Percent)


Money Growth and
Inflation During the 1980s (U.S.)
Inflation Rate (Percent)


19 8 9 b B19!38 19841a
6Romer and Romer (1989) identify six
episodes since World War II in which the Fed
sharply tightened policy to reduce inflation.
In each case, a recession occurred within two
or three years.

1971 H

a 1987




Growth in Money Supply (Percent)




the 1970s and 1980s. Clearly, annual inflation
can differ considerably from money growth.
What causes this short-run divergence?
Demand Shocks. One source of short-run
changes in inflation is shifts in aggregate
demand—in desired spending by government,
businesses, and consumers. Suppose that the
government spends more to finance a war or
businesses become more confident about the
future and invest in factories and machines. As
the demand for military hardware or for facto­
ries rises, the economy expands: firms increase
production and hire more workers, cutting
unemployment. But again, high output and
low unemployment eventually spur faster in­
creases in wages and prices: inflation rises.
Similarly, a fall in aggregate demand causes a
recession, leading firms to raise prices more
slowly. The economy's short-run movements
between booms and recessions produce fluc­
tuations in inflation as well.
A good example of inflation arising from a
shift in aggregate demand—a shift that was not
initiated by monetary policy—is the increase in
inflation in the late 1960s. Annual inflation
varied from 0.8 percent to 2.3 percent over the
period of 1960-64, but rose to 5.3 percent in
1969. The consensus explanation for this expe­
rience is increased government spending. As
the Vietnam War escalated, the Johnson admin­
istration raised military spending while also
continuing the social programs of the "Great
Society." As a result, the federal budget deficit
grew from $1.4 billion in fiscal year 1965 to
$25.2 billion in 1968, and the economy over­
heated: unemployment fell, but inflation rose.
Price Shocks. Until the early 1970s, most
economists believed that shifts in aggregate
demand were the dominant source of short-run
movements in inflation. This view had to be
modified, however, after the experience of the
1970s, when price shocks— a.k.a. "supply
shocks"—caused large increases in inflation.
These shocks were sharp increases in the prices
of particular goods, namely food and energy


products, arising ultimately from poor weather
and the emergence of the OPEC cartel. These
shocks created "stagflation": inflation rose while
unemployment rose and real output fell (in
contrast to the experience of demand shocks,
which push inflation and unemployment in
opposite directions). From 1972 to 1974, annual
inflation rose from 5.0 percent to 9.6 percent as
a result of a rise in food prices and the first
OPEC price increase. OPEC II raised inflation
from 7.1 percent in 1977 to 10.1 percent in 1980.
These increases dwarfed the fluctuations in
inflation arising from the demand shocks of the
previous 20 years. More recently, the spike in
oil prices during the gulf crisis raised inflation
in the second half of 1990.
Why do rises in food and energy prices
create inflation? The reader will be forgiven for
thinking that the answer is obvious: food and
energy are a significant fraction of the economy,
and rises in prices are the definition of inflation.
Economists, however, believe that the issue is
not so simple because of the distinction be­
tween the overall price level and relative prices.
In classical economic theory, the price level
is determined by the money supply, as de­
scribed above. Changes in supply and demand
for various products arising from weather con­
ditions, cartel decisions, and so on affect not the
price level but relative prices: OPEC makes oil
more expensive relative to other goods. Theo­
retically, this is accomplished partly by an
increase in the absolute price of oil and partly
by decreases in all other prices. With these price
adjustments, oil can become relatively more
expensive while the price level remains un­
changed at the equilibrium level determined by
the money supply. In practice, this is not what
happens: OPEC in fact raised the average price
level. But it is not obvious why this is so.7

7Writing in 1975, Milton Friedman puts the point this
way: "It is essential to distinguish changes in relative prices
from changes in absolute prices. The special conditions that

What Causes Inflation?

Laurence Ball

This issue is the subject of recent research by
me and Gregory Mankiw of Harvard Univer­
sity (Ball and Mankiw, 1992). Our explanation
for the inflationary effects of price shocks rests
on two ideas. First, there is some inertia in
prices. Firms do not instantly adjust prices to
every change in circumstances; instead, they
adjust only if their desired price change is large
enough to justify the costs of adjustment. For
example, a mail-order company will print a
new catalog to announce a 50 percent sale, but
it is not worth the effort to announce a one-cent
price change arising from a tiny change in costs;
instead, the firm will simply keep its prices
fixed. This behavior implies that large shocks
have disproportionately large effects on prices:
firms adjust to them quickly, while they make
smaller adjustments more slowly.
The second key idea is that "price shocks"
are episodes in which certain relative prices rise
or fall by unusually large amounts. In the

The large relative shocks to oil-related prices
triggered quick upward adjustments. For ex­
ample, given the large increase in oil prices, gas
stations would have suffered huge losses had
they not quickly raised prices at the pump. In
contrast, while prices of many other goods
came under downward pressure, the required
price decreases were small and hence occurred
more slowly.
When consumers spent more money on oil,
they had less available for toothbrushes, soft
drinks, and all other nonoil goods, creating an
incentive for the sellers of these products to
reduce prices. But the desired decreases were
only a few percentage points because OPEC did
not cut heavily into toothbrush or soft drink
demand. Thus firms were slow to adjust prices
downward. In the short run, oil-related prices
rose, and the offsetting decreases did not fully
occur. Thus prices rose on average: there was
This th eoretical story exp lain s a large num­
O P E C ep iso d es, for exam p le, som e relative
prices— those for oil-related products—rose 50 ber of the rises and falls in inflation in the
percent or more in response to the trebling of oil United States. The oil and food price episodes
prices. By definition, other relative prices went in the 1970s are examples. Another example is
down to balance these increases: if some prices the large decrease in oil prices in 1985-86. Our
are relatively higher, others must be relatively theory predicts that inflation should fall in this
lower. It was not the case, however, that episode because the decreases in oil prices
equilibrium prices of some nonoil products occur more quickly than the smaller increases
needed to fall by more than 50 percent. Instead, in other prices. And, indeed, inflation fell from
the relative price decreases were spread over 4.4 percent in 1984 to 2.5 percent in 1986.
Our theory also explains episodes before the
all nonoil goods: a fraction of relative prices
rose a large amount, balanced by smaller rela­ famous supply shocks of the 1970s. For ex­
ample, inflation rose above 10 percent in 1951,
tive decreases in the majority of prices.
Combining this idea with the previous largely due to a demand shock: the Korean
one— that large shocks have disproportionate War. Inflation then plummeted to near zero in
effects— explains why OPEC was inflationary. 1952, and the cause appears to be a price shock.
Specifically, the prices of meat, rubber, veg­
etable oil, and several other products fell steeply.
More generally, my research with Mankiw sug­
drove up the prices of oil and food required purchasers to
gests that a combination of demand and price
spend more on them, leaving them less to spend on other
shocks explains most of the year-to-year fluc­
items. Did that not force other prices to go down or to rise
tuations in U.S. inflation since 1950.
less rapidly than otherwise? Why should the average level
Although some relative price increases are
of prices be affected significantly by changes in the price of
inflationary according to our theory, others are
some things relative to others?"



not. One example is the steady increase in the
cost of medical care. These price increases
probably have little to do with inflation, despite
frequent claims to the contrary in popular dis­
cussions. A relative price increase affects infla­
tion only if there is an unusually large shock
during a particular year, so that the upward
price adjustment occurs more quickly than the
offsetting downward adjustments. Medical
costs have risen faster than the overall price
level for several decades, but the rise has been
steady; there are no cases of 50 percent or 100
percent increases within a year, as in the case of
oil. This smooth adjustment of relative prices
could occur without inflation. If the Federal
Reserve pursued noninflationary monetary
policy, the average price level would remain
steady, with rises in the price of medical care
offset by price decreases in other industries.
According to the analysis so far, the average
rate of inflation over a long period is deter­
mined by the amount that average growth of
the money supply exceeds average output
growth. Inflation fluctuates around its trend
from year to year in response to various de­
mand and price shocks. We have seen that
these ideas explain much of the U.S. inflation
experience, but they do not capture one aspect:
the link between the short run and the long run.
Suppose that inflation is proceeding at the
level determined by trend money and output
growth and that oil prices rise sharply. The
theories reviewed so far suggest that this price
shock should raise inflation in the short run but
that inflation should then return to its long-run
trend if trend money growth is unchanged. In
fact, shifts in inflation arising from demand or
price shocks appear quite persistent. When
government spending raised inflation in the
late 1960s, and when OPEC raised inflation in
the 1970s, there was little sign that inflation
would naturally return to its previous level.



Instead, inflation continued until the Federal
Reserve became sufficiently concerned to tighten
policy, producing a recession. (Such policy
tightenings occurred in 1970 in response to the
high inflation of the late 1960s and in 1974 and
1978-79 after the OPEC shocks. See Romer and
Romer, 1989.) Absent a policy tightening and
recession, inflation arising from price or de­
mand shocks seems to continue indefinitely:
short-run shifts in inflation have long-run ef­
fects on trend inflation. How can this evidence
be squared with our earlier theories?
Recall the crucial fact that trend inflation is
ultimately caused by faster growth in the money
supply than in output. Logically, if shocks such
as OPEC shift trend inflation, they must induce
the Federal Reserve to raise trend money growth
(until the point when policymakers decide that
inflation is too high and accept the cost of
disinflation). Why does a short-run spurt in
inflation lead the Fed to raise the average level
of money growth?
The usual answer to this question focuses on
the behavior of inflationary expectations. In
past experience, individuals have seen that
increases or decreases in inflation usually per­
sist for a substantial period. Thus, when they
see a new rise in inflation (because of an OPEC
shock, for example), they expect inflation to
stay high. Crucially, this expectation is selffulfilling: the expectation that inflation will stay
high causes it to stay high. The reason expecta­
tions affect actual inflation is that they affect
decisions about wage- and price-setting. If
everyone expects a 10 percent rate of inflation
to continue, workers will demand 10 percent
wage increases to keep up. Firms will raise
prices 10 percent to match the higher wages
they pay and also the 10 percent increases they
expect from their competitors. Thus inflation
will continue at 10 percent, fulfilling expecta­
The Federal Reserve is not helpless in the
face of this self-fulfilling inflationary spiral.
The spiral can continue only as long as it is

What Causes Inflation?

"accommodated" by the Fed—as long as the
Fed raises money growth as much as inflation
has risen. However, a price shock such as that
caused by OPEC is not only inflationary for the
U.S., it also is contractionary. Because the
higher price of imported oil leaves Americans
with less of their incomes to spend on domestic
goods and services, it causes output and em­
ployment to fall, at least temporarily. The
Federal Reserve could bring inflation back down
by slowing money growth. The result will be to
reduce output further, causing a recession that
eventually forces inflation down. Over sub­
stantial periods, however, such as the 1970s,
the Fed has been unwilling to impose this cost
on the economy. Thus, once a shock such as
OPEC raises inflation, it can stay high for a long
period before a Paul Volcker takes charge and
disinflates. The price shock creates a vicious
circle in which persistence in inflation creates
the expectation of persistence, which in turn
creates persistence.
While this story is widely accepted, it is not
airtight. At an empirical level, it appears true
that changes in inflation are expected to persist.
Surveys of the expectations of forecasters and
of ordinary citizens show that a rise in current
inflation leads to higher forecasts of future
inflation. At a deeper level, however, it is not
clear why expectations behave that way. Since
the expectation of persistence is self-fulfilling,
it proves itself correct. But there are other
expectations that would also be self-fulfilling.
Suppose that a price shock raised inflation in
one year, but everyone expected that inflation
would return to its original level in the next
year. With the expectation of moderate infla­
tion, workers would moderate their wage de­
mands, and firms would moderate their price
increases. Thus the expectation of low inflation
would also prove itself correct. Since expecta­
tions of either persistent or nonpersistent infla­
tion are self-fulfilling, it appears that either
expectation would be rational. The U.S.
economy has settled into a situation in which

Laurence Ball

people expect inflation to persist, perhaps only
because it has in the past.
The behavior of inflation is one of the betterunderstood areas of macroeconomics. There is
a wide consensus about the long-run determi­
nants of inflation and, arguably, a consensus
about much of its short-run behavior. The
average inflation rate over long periods is de­
termined by the extent to which the average
rate of money growth (which, in the United
States, is chosen by the Federal Reserve) ex­
ceeds the average growth rate of real output.
Short-run inflation fluctuates around its longrun average because of demand shocks, such as
large increases in government spending, and
supply shocks, such as sharp rises in the prices
of food and energy.
Some countries have persistently high infla­
tion because they continuously create new
money to finance large, ongoing budget defi­
cits. Such countries are unable to reduce money
growth enough to halt inflation because their
governments have been unable to eliminate
budget deficits and because they do not have
effective alternatives for financing those defi­
cits. In the United States, however, the govern­
ment budget deficit is financed almost entirely
with Treasury debt, not money creation. The
United States had low average inflation in the
1980s because money growth, on average, only
slightly exceeded output growth.
Finally, the distinction between short-run
and long-run determinants of inflation is blurred
by the fact that short-run changes often influ­
ence the long-run trend. When a demand or
price shock raises short-run inflation in the
United States, expectations of future inflation
rise. Historically, the Fed often accommodated
these expectations by allowing money growth
to rise, so expectations were fulfilled. Not
allowing money growth to rise would have
slowed output growth and perhaps caused a


These conclusions— a summary of the think­
ing of mainstream economists—partly fit ideas
that are popular among journalists and the
public and partly contradict such ideas. It is
common, for example, to blame inflation on
excessive deficit spending by the government.
This view is on target for the case of Argentina,
but not for the United States. Little of the U.S.
d eficit is financed by p rin tin g m oney . Thus it
was possible for U.S. inflation to fall between
the 1970s and the 1980s even though the U.S.
budget deficit rose substantially. On the other
hand, the view that government spending fuels
U.S. inflation has a grain of truth. There are
periods, notably the Vietnam era, when too
much spending overheats the economy, pro­


ducing inflation that persists as long as mon­
etary policy is accommodative.
Perhaps the most common scapegoats for
inflation are the particular prices that the public
observes to rise most rapidly. In some eras,
these are oil or food prices; a current favorite is
medical care. When journalists and citizens
blame individual prices for inflation, they con­
fuse average and relative prices. Particular
prices could rise just as much in relative terms
even if the overall price level were constant.
Again, however, there is a grain of truth in
conventional thinking. Particularly sharp in­
creases in prices, such as OPEC shocks, are

Abel, Andrew, and Ben Bernanke. Macroeconomics. Addison-Wesley, 1992.
Ball, Laurence, and N. Gregory Mankiw. "Relative-Price Changes as Aggregate Supply
Shocks," mimeo, Princeton University (April, 1992).
Ball, Laurence, N. Gregory Mankiw, and David Romer. "The New Keynesian Economics and
the Output-Inflation Trade-off," Brookings Papers on Economic Activity (1988:1).
Croushore, Dean. "W hat Are the Costs of Disinflation?" this Business Review (May/June,
Friedman, Milton. "Perspectives on Inflation," Newsweek (June 24,1975).
Friedman, Milton, and Anna J. Schwartz. Monetary Trends in the United States and the United
Kingdom. University of Chicago Press, 1982.
Romer, Christina, and David Romer. "Does Monetary Policy Matter? A New Test in the Spirit
of Friedman and Schwartz," NBER Macroeconomics Annual, 1989.



Leaning Against the Seasonal Wind:
Is There a Case for Seasonal
Smoothing of Interest Rates?


ince it began in 1914, the Federal Reserve
System has followed a policy of allowing the
supply of money to vary over the seasons. At
present, the Fed allows the money supply to
grow faster than average in the third and fourth
quarters of each year to meet the seasonally
high demand for money during summer and
the holiday shopping season and forces it to
grow slower than average in the first and sec­
ond quarters. In other words, the Fed injects

* Satyajit Chatterjee is a senior economist in the Research
Department of the Philadelphia Fed.

Satyajit Chatterjee *
additional money into the economy during the
last two quarters of a year, then withdraws this
addition during the first half of the following
This seasonal pattern in the growth rate of
money supply and the Fed's role in generating
it is evident in Figure 1. The two lines show the
seasonal deviations in the quarterly growth
rate of M l and the monetary base (the sum of
bank reserves and currency in circulation) from
their average quarterly growth rates in the
post-WWII period. The Federal Reserve,
through its open-market operations, increases
the growth rate of the monetary base in the



seasonal monetary policy. In his
well-known lecture A Program for
M onetary S tability , M ilton
Seasonal Pattern in Quarterly Growth
Friedman saw no "objection to
Rates of Monetary Base
seasonal fluctuations in short­
and Money Stock
term interest rates" and recom­
1948 I - 1980 IV
mended that the Fed desist from
following such a policy. More
recently, Gregory Mankiw and
Jeffrey Miron, in an article titled
"Should the Fed Smooth Interest
Rates? The Case o f Seasonal Mon­
etary Policy," have also raised
doubts about the wisdom of such
a policy. Indeed, why should the
Fed accom m od ate seaso n al
changes in money demand and
stabilize short-term interest rates?
After all, the increase in rental
rates for vacation properties on
the New Jersey shore in August is
third and fourth quarters as money demand a natural outcome of market forces and does
rises, then reverses this increase in the follow­ not call for a program of rent stabilization by
ing two quarters when money demand shrinks. the government. By the same token, why
Correspondingly, the seasonal growth rate in shouldn't the Fed tolerate an increase in the
M l is above average in the third and fourth rental price of money (interest rates) caused by
quarters when the quantity of money demanded natural forces in the third and fourth quarters
rises quickly and falls below average in the first of each year?
In this article I examine this question by
two quarters when quantity of money de­
looking first at the historical reason underlying
manded shrinks.
Because it accommodates seasonal variation the Fed's seasonal monetary policy and deter­
in the demand for money, the Fed's seasonal mining whether the historical rationale is still
monetary policy has the effect of reducing valid. In light of the major institutional changes
seasonal variation in short-term interest rates.
Indeed, by some measures, there does not ap­
pear to be any evidence of seasonal movements
1In a recent article, Robert Barsky and Jeffrey Miron
in short-term interest rates in the post-WWII
report the absence of seasonal movements in the threeperiod.1If the Federal Reserve were to stop this month T-bill rate over the period 1948:2-1985:4. However,
seasonal variation in the growth rate of the there have been periods when short-term interest rates have
monetary base, short-term interest rates would shown some seasonal fluctuations. Stanley Diller, in an
rise in the third and fourth quarters in response article written in 1971, used measures of seasonality differ­
to the higher demand for money during these ent from the ones employed by Barsky and Miron and
documented that T-bill rates showed some seasonality in
times and fall in the first two quarters in re­ the 1950s, but this seasonal pattern all but disappeared in
sponse to the lower demand for money.
the 1960s. Citations may be found in the "References"
Economists have questioned the need for a section at the end of this article.




Leaning Against the Seasonal Wind

that have occurred in the banking industry
since 1933,1 argue that the historical reason for
the Fed's seasonal monetary policy is now
much less relevant. On the other hand, im­
provements in economists' understanding of
the different ways in which monetary policy
could affect the functioning of the economy
suggest benefits and costs of a seasonal mon­
etary policy that were not apparent in 1914. In
the rest of the article, I discuss the nature of
these costs and benefits.
Throughout the latter part of the 19th cen­
tury and the early years of the 20th, the U.S.
financial system was plagued by recurrent cri­
ses. Edwin Kemmerer, a Cornell University
scholar who testified before the National Mon­
etary Commission in 1910, listed no less than
six major crises and 15 minor crises in financial
markets between the years 1890 and 1910. These
fin an cial p an ics were a co m bin atio n of bank
failures, bank runs, and stock-market crashes.
Kemmerer, as well as other contemporary schol­
ars, believed that most of these crises had a
seasonal connection.2 The United States, at that
time a still heavily agricultural nation, experi­
enced large increases in the demand for cur­
rency and short-term loans during early spring
and autumn when farmers were planting and
harvesting. The increased demand for currency
drained cash from country banks precisely at a
time when their farming customers clamored
for loans. As a result, the country banks would
call in their reserves with the city banks and
thereby transmit the seasonal pressure on bank
reserves to the city banks as well. To try to
accom m odate having fewer reserves and
greater loan demand, many banks tried to make
do with reserve-deposit ratios that were pre-

2In addition to Kemmerer's testimony, see, for example,
the testimony of O.M. W. Sprague and the book by Laurence

Satyajit Chatterjee

cariously low and left them vulnerable to unex­
pected cash withdrawals. Bankers and deposi­
tors were quite aware that during these times
the banking system's ability to absorb unex­
pected adverse shocks was low. Thus, an
unexpected loan default or an unexpectedly
heavy withdrawal that caused a city or a coun­
try bank to fail would generate panic with­
drawals from other banks as well. Even if the
withdrawal or default did not lead to a bank
failure, the episode made banks nervous enough
to call in more of their loans, many of which
were stock-market call loans, which, in turn,
led to sharp drops in stock prices.3
The seasonal element in these financial pan­
ics is evident in the historical record. Of the 21
financial panics documented by Kemmerer,
seven occurred in September and October and
another seven between March and May. Thus,
fall and spring accounted for all but a third of
the total number of panics between 1890 and
While these panics differed in severity, some
were quite serious. For instance, the panics of
May 1893 and October 1907 resulted in the
suspension of convertibility of deposits into
currency. In general, these disturbances were
considered disruptive enough to warrant seri­
ous attention and led to the creation of the
National Monetary Commission to investigate
the source of the problem facing the U.S. bank­
ing industry.4 The deliberations of the commis-

3See Jeffrey Miron's 1986 article for a description of the
connection between seasonality and financial panics.
4Unfortunately, there is no quantitative estimate of the
disruption caused by these financial panics. Jacob Hol­
lander, a professor of political economy at Johns Hopkins
University who also testified before the National Monetary
Com m ission, noted the im portance of bank loans
collateralized by stock certificates in the financing of busi­
ness activity in the U.S. This suggests that U.S. businesses
probably faced considerable difficulty in carrying out their
normal operations during times when panic conditions
made such collateralized loans unattractive.



sion, published in 1910, identified the seasonal reserves, respectively.5 In Figure 2, the vertical
pressure on bank reserves as one of the princi­ axis measures the average difference in call
pal contributory factors in these panics. Three money rates across adjacent months in the preyears later, the Federal Reserve Act of 1913 Fed and post-Fed era. For example, in the preestablished the Federal Reserve System and Fed era, call money rates were, on average, 1.02
charged it with the task of eliminating the percentage points per annum higher in Septem­
seasonal pressure on bank reserves by allowing ber than in August and 1.15 percentage points
banks to borrow additional reserves and cur­ per annum higher in December than in Novem­
rency (“to furnish.... an elastic currency") dur­ ber. In contrast, in the post-Fed era, call money
ing times of increased seasonal demand for rates were only 0.13 percentage points per
annum higher in September than in August and
Thus, a seasonal monetary policy came to be only 0.089 percentage points per annum higher
one of the key goals of the Federal Reserve in December than in November. More gener­
System. The policy was remarkably successful ally, Figure 2 clearly shows that the call money
in that in the 15 years following November rate was considerably more seasonal in the pre1914, there were no financial crises in the U.S. Fed era than in the post-Fed era.
Figure 3 shows the other side of the same
Aside from eliminating panics triggered by
seasonal shortages of liquidity, the Fed's sea­
sonal monetary policy also had another impor­
tant effect. Because of the seasonal pressures
5The information on which these plots are based was
on bank reserves, the period before the found­ obtained from Truman Clark's 1986 article, Table 2 (p. 82)
ing of the Fed was characterized by prominent and Table 4 (p. 84).
seasonal fluctuations in short-term
interest rates. As bank reserves
tightened in the fall and spring
and the commercial banks called
Seasonal Pattern in Call Money Rates
in their loans, short-term interest
Before and After Founding
rates rose. Then, as the seasonal
of Federal Reserve System
pressure on reserves ebbed, short­
term interest rates declined in the
winter and summer. After the
Fed went into operation in 1914
and eliminated the seasonal pres­
sure on bank reserves, it also elimi­
nated the seasonal fluctuation in
short-term interest rates. Thus,
the seasonal smoothing of short­
term interest rates that continues
to characterize Federal Reserve
policy to this day originated in the
battle against financial panics.
Figures 2 and 3 display the preand post-Fed seasonal patterns in
the call money rate (an overnight
interest rate) and commercial bank
Digitized 16 FRASER


Leaning Against the Seasonal Wind

Satyajit Chatterjee

cial tranquility ended rudely with the stock
market crash in October 1929; the terrible years
of the Great Depression followed. A seasonal
monetary policy notwithstanding, five major
banking crises occurred between the years 1929
and 1933.6
The experience of the Great Depression con­
vinced American business and legislative com­
munities that monetary policy alone was inad­
equate to insulate the economy from financial
and economic disasters. In a far-reaching insti­
tutional change, the Banking Act of 1933 intro­
duced federal insurance of bank deposits, which
made bank deposits completely safe for the
majority of depositors. While deposit insur­
ance does not cover all commercial bank depos­
its, the FDIC has acted in the past to protect all
deposits, even the so-called uninsured ones.
Typically, in the event of a bank failure FDIC
policy is to merge the failed institution with an
ongoing one. This way, the liabilities of the
failed bank become the liabilities of the ongoing
institution, and uninsured deposi­
tors emerge unscathed as well.
However, what often goes
unnoticed is that the existence of
Seasonal Pattern in Bank Reserves
deposit insurance greatly reduces
Before and After Founding
the need for a seasonal monetary
of Federal Reserve System
policy to fight banking panics.
Seasonal pressures on bank re­
serves and short-term interest
rates may cause some unlucky or
ineptly managed banks to fail,
but because of explicit and de
facto deposit insurance such fail­
ures are unlikely to lead to bank
runs or financial panics. Since

coin. The vertical axis measures the average
difference in bank reserves (in millions of dol­
lars) across adjacent months. In the pre-Fed
era, the bank reserves declined by about $10.68
million in September, reflecting the withdrawal
of currency for farm expenditures. A decline of
similar magnitude is also evident in the month
of February. In contrast, bank reserves rose
$22.79 million in September in the post-Fed era,
fueled by Federal Reserve purchases of Trea­
sury securities from banks. This increase in
reserves allowed banks to meet the currency
drain and, at the same time, expand the volume
of their agricultural loans. In general, the Fed­
eral Reserve's seasonal monetary policy made
bank reserves much more responsive to the
pace of commercial activity and thereby elimi­
nated the pronounced seasonal pattern in short­
term interest rates.
Seasonal pressures on currency and credit
demand, alas, are not the only reason for finan­
cial disruptions. The 15-year stretch of finan­

6Milton Friedman and Anna Schwartz
provide in-depth discussions of the ori­
gins and dynamics of these panics in their
book A Monetary History o f the United States
1867-1960. Miron's article discusses the
seasonal factors that may have contrib­
uted to these banking crises.


combating financial panics was the main rea­
son for a seasonal monetary policy in the first
place, has this policy outlived its usefulness?
Even though seasonal changes in interest
rates probably would not cause financial panics
today, a seasonally varying short-term interest
rate results in a loss of economic efficiency.
This loss of efficiency, while not as dramatic
and severe as that imposed by a banking panic,
could nevertheless provide a rationale for con­
tinuing a seasonal smoothing of short-term
interest rates. To understand how this effi­
ciency loss occurs, we need to understand how
changes in short-term interest rates affect indi­
viduals' and corporations' demand for money.
Consider the case of Sadie Wherebucks, who
must decide how much money to hold, on
average, in her wallet or checking account and
how much to put in a time deposit or a short­
term security such as T-bills. When short-term
interest rates are low, the convenience pro­
vided by holding money is more important to
Sadie than the small amount of income that she
gives up by holding money instead of interestbearing assets, so Sadie will hold more money.
When short-term interest rates are high, Sadie
will reduce the amount of money she holds so
that she can hold greater time deposits or invest
in T-bills.
If Sadie holds more financial wealth in a
savings account or in the form of T-bills, she
will have to use her bank or broker more often
to convert her assets into money to meet her
daily expenses. This will impose additional
costs on Sadie either because she has to make
frequent trips to her bank or because she has to
pay her broker's commission fees more often.
Therefore, one effect of an increase in short­
term interest rates will be to increase Sadie's
transaction costs as she attempts to make do
with smaller average holdings of money.
What is true of Sadie as an individual is even


more true of corporations. Because firms deal
with large flows of funds, higher short-term
interest rates present them with even greater
inducement to tighten up on their cash manage­
ment. They spend considerably more time and
resources on making sure that they reduce their
holdings of currency or checking account bal­
At the other end, because of the increased
flow of customers, banks would probably be
forced to incur additional expenses. For in­
stance, a bank might have to hire an extra teller
or put up an extra ATM. Similarly, as individu­
als and corporations use the services of their
brokers more frequently, brokerage firms would
have to spend more resources to deal in a timely
fashion with the additional business.
This means that if the Fed were to stop
accommodating the seasonal variation in money
demand and thereby let short-term interest
rates rise during Christmas and summer and
decline other times of the year, it would in­
crease the level of transaction costs during
Christmas and summer and lower it at other
times of the year.
However, the net effect of this move would
be to increase the level of transaction costs over
the course of a whole year. The reason for this
is intuitive and quite simple. By letting short­
term interest rates rise at a time when the
economy is in greater need of money, the Fed
would force individuals and corporations to
conserve on money holdings at a time when the
cost of doing so is high. In contrast, by letting
interest rates fall when the demand for money
is low, the Fed would encourage individuals
and corporations to relax their conservation
efforts at a time when conserving money bal­
ances is relatively less costly. In other words,
the Fed would be withdrawing money from
circulation when the economy has more need
for it and would be putting it back in circulation
when it has less need for it. Clearly, such a
policy would impose an additional cost on the

Leaning Against the Seasonal Wind

How big might this cost be? How much
more time, effort, and resources would be used
to conserve on money holdings if the Federal
Reserve did not accommodate the seasonal
increase in demand for money? The answer
depends on how much short-term interest rates
would rise during the period of seasonally high
money demand: if interest rates need to rise a
lot to induce people to hold interest-bearing
assets such as bonds instead of money, it indi­
cates that the value of resources used up in
reducing money balances (the cost of trips to
the bank, brokers' fees) is large. Empirical
studies typically find that people adjust their
money holding very little in response to changes
in short-term interest rates.7 This result sug­
gests that the gains from following a seasonal
monetary policy (or the cost of following a
nonseasonal policy) may be worth worrying
But that is not the whole story. A nonsea­
sonal monetary policy would cause not just
seasonal changes in short-term interest rates,
but also seasonal adjustments in the price level.
Those price adjustments would reduce the size
of seasonal changes in interest rates and also
reduce the extra transaction costs generated by
following a nonseasonal monetary policy. For
this reason, and because there is skepticism
about the reliability of estimates of how sensi­
tive the demand for money is to changes in
interest rates, it is difficult to draw firm conclu­
sions about how big the costs imposed on the
economy by a nonseasonal monetary policy
would be.
In any event, regardless of the size of the
benefit from a seasonal monetary policy, we
now have an answer to the question we posed
in the introduction: what is the difference be­
tween seasonal variability in the rental price of

7For a review of the empirical literature on the sensitiv­
ity of money demand to interest rates and other variables,
see Judd and Scadding's 1982 article.

Satyajit Chatterjee

shore property and seasonal variability in the
rental price of money? In the former case, the
seasonal rise in rents reflects a real scarcity of
rental space during times of high demand, and
the increase in rents is an efficient way of
allocating the limited amount of available space
to families that value it most. In contrast, the
scarcity of money is artificial in that the Federal
Reserve can change the quantity of money
available at very little cost. Therefore, since
families and corporations gain more from a
lower rental price of money during Christmas
and summer than they lose from a higher rental
price of money at other times of the year, it
makes sense for the Fed to smooth the rental
price of money over the seasons.
Macroeconomists agree that a nonseasonal
monetary policy will increase the overall level
of transaction costs, but they do not agree on
whether there are other costs of following a
nonseasonal policy.
To see where these disagreements come from,
let's take a closer look at the statement that a
nonseasonal monetary policy would raise short­
term interest rates during Christmas and sum­
mer and lower it at other times of the year.
So far we have talked about interest rates
without being specific about what type of inter­
est rates we mean. In reality, there are two
distinct types of interest rates, and it is impor­
tant that we keep them separate. The type that
people are most familiar with is the money, or
nominal, interest rate reported in the financial
columns of newspapers. For instance, if the
interest rate on a one-year Treasury bill is listed
as 3.4 percent, then each $1 invested in a T-bill
today will fetch $1,034 in a year. The nominal
interest rate does not adjust for change in the
purchasing power of the dollar; that is, it does
not take into account that the purchasing power
of a dollar available a year from now may be


less than that of a dollar given up today because
the general level of prices in the economy may
be higher a year from now. In contrast, the real
interest rate does take changes in the purchas­
ing power of the dollar into account. The real
interest rate is calculated by subtracting the
inflation rate expected over the maturity pe­
riod of the asset from its nominal interest rate.
For instance, if the annual inflation rate is ex­
pected to be 3.0 percent, the real interest rate on
the one-year T-bill is only 0.4 percent.
This distinction between nominal and real
interest rates raises two questions about our
previous discussion. First, when we asserted
that people's demand for money depends on
short-term interest rates, which interest-rate
concept did we mean? Second, would a nonseasonal monetary policy lead to seasonally
varying short-term real interest rates or season­
ally varying short-term nominal interest rates
or both?
The first question is easy to answer. People's
demand for money depends on nominal inter­
est rates. Consider, again, the case of Sadie
Wherebucks, who must decide how much
money to hold in her wallet or checking account
and how much to invest in T-bills. As an
investor, Sadie is concerned with the real inter­
est rate she expects to receive on her T-bill
investments. By holding money instead of Tbills, she forgoes this real interest rate, and, in
addition, her money loses value over time be­
cause of inflation. Consequently, the total cost
to her of holding a dollar is the real interest rate
she could have received on the T-bill plus the
inflation rate she expects. But this sum of the
real interest rate and expected inflation rate is
simply the nominal interest rate. Therefore, in
deciding how much money to hold it is the
nominal interest rate that counts.
Unfortunately, answering the second ques­
tion is not as easy and opinions differ. The
classical view is that a change in monetary
policy affects only price levels and inflation
rates. Real variables, such as real interest rates,



real output, and real investment, are unaf­
fected by such changes. Therefore, a classical
economist would argue that the increase in the
short-term nominal interest rates at Christmas
that would accompany a nonseasonal mon­
etary policy would result from lower prices
during the Christmas season but higher prices
in winter—after Christmas—and in spring. In
his view, it is the faster rate of price increase
expected between Christmas and spring that
leads to the rise in the short-term nominal
interest rate during the Christmas season. Simi­
larly, a classical economist also would expect a
nonseasonal monetary policy to cause prices to
drop in summer, then rise in autumn, resulting
in an increase in the short-term nominal inter­
est rate in the summer. He would argue,
however, that real variables such as output and
employment would be unaffected by these sea­
sonal price changes (see Seasonal Monetary
Policy: The Classical View). Since real variables
are not affected, no additional costs or benefits
result from pursuing nonseasonal monetary
policy. Hence, from the classical perspective,
seasonal smoothing of interest rates is desirable
because it saves on transaction costs without
disrupting real economic activity.
This conclusion is not shared by monetar­
ists. Since monetarists adhere closely to classi­
cal views in regard to their perception of how
money supply changes affect the economy, the
rejection of seasonal monetary policy by econo­
mists such as Milton Friedman and Robert
Lucas, Jr., is at first surprising.8 However, their
reasons for jettisoning a seasonal monetary
policy has to do with their views on how the
Federal Reserve should conduct its businesscycle policy. Monetarists believe that a sound
monetary policy involves implementing steady
growth in the supply of money, with a view to

8For a more recent and more emphatic denial by Friedman
of the usefulness of seasonal monetary policy, see his 1982
article. For Robert Lucas's view, see his 1980 article.

Leaning Against the Seasonal Wind

Satyajit Chatterjee

Seasonal Monetary Policy: The Classical View
Does the Fed's choice of seasonal monetary policy affect the real interest rate? Classical
economists, who see the real interest rate as being determined primarily by real factors, such as the
population growth rate, the rate of technical progress, and people's propensity to save, argue that
changes in the money supply, after agents have adjusted to it, do not have any effect on the real interest
rate. In other words, they argue that while an unexpected increase in the money supply can reduce
the real interest rate for a considerable length of time, the rate returns to its original level as the extra
money diffuses through the economy. Once the economy adjusts to the new level of money supply,
the only effect of a higher money stock is a higher price level.
Applied to the choice of seasonal monetary policy, this argument suggests that in the immediate
aftermath of a shift to a nonseasonal policy, there will be a period when the real interest rate will be
affected. However, as the economy gets used to the new policy, the real interest rate will return to
its original level, and the only change will be in the seasonal path of prices.
To see how this works, consider the following numerical example. For simplicity, imagine that
there are only two seasons: Christmas and spring. Suppose that when the Fed follows a seasonal
monetary policy, the consumer price index is 100 and the real interest rate is 3 percent in both seasons.
Since there is no change in the price level from one season to the next, the expected rate of price
increase is zero for both seasons. Therefore, the real interest rate is 3 percent in both seasons as well.
Now suppose that the Fed switches to a nonseasonal monetary policy and refrains from
increasing the money supply during the Christmas season. Since the money supply during the
Christmas season is now lower than before, the level of Christmas prices will be lower. Suppose that
Christmas prices fall by 2 percent, to a level of 98. Because this nonseasonal policy lowers the average
stock of money over the year, it will exert downward pressure on prices in the spring as well and those
prices will fall, although not by as much as the Christmas price level.3 Suppose then that the spring
price level falls by one-half percent, to a level of 99.5. With these new price levels, the expected rate
of price increase from Christmas to spring will be 100 x (99.5 - 98)/98 = 1.53 percent, and the expected
rate of price increase going from spring into Christmas will be 100 x (98-99.5)/99.5 = -1.50 percent.
Since real interest rates do not change, the nominal interest rate will rise to 4.53 percent during the
Christmas season and fall to 1.50 percent in spring.

aSuppose that the seasonal monetary policy involved a money supply of 100 in spring and 105 during the
Christmas season. With the move to a nonseasonal policy, the money stock will be 100 in all seasons, which would
make the average money stock over a year 100 as opposed to 102.5 with the seasonal monetary policy. If the monetary
authorities moved to a nonseasonal policy but raised the constant stock of money to 102.5, then relative to the prices
that prevailed in the presence of seasonal monetary policy, prices during the Christmas season would fall and those
in spring would rise.

keeping the inflation rate steady and predict­
able. They view seasonal adjustments to the
growth rate of money supply as a nuisance that
distracts attention from the more important
task of keeping the money supply growing
smoothly over time. Thus, monetarists argue
that the benefits of a seasonal monetary policy
are small compared with the costs of poten­
tially erratic movements in the money supply

occasioned by attempts to "fine-tune" the
growth of money stock to match the seasonal
movements in money demand.
Keynesian economists also differ with the
classical view of a seasonal monetary policy,
but for entirely different reasons. A Keynesian
economist would disagree with both classical
economists and monetarists concerning the
likely consequences of a move to a nonseasonal


monetary policy. In the Keynesian view,
changes in interest rates that result from an
imbalance between the demand for and supply
of money show up in both nominal and real
interest rates because prices are not perfectly
flexible in the short run. The resulting changes
in real interest rates affect the aggregate output
of the economy by changing aggregate de­
mand. Therefore, by following a nonseasonal
monetary policy, the Fed would drive up real
interest rates and thus reduce the real output of
the economy to below current levels during the
Christmas season and in summer.
Therefore, in the Keynesian view, a move to
a nonseasonal policy would result in greater
seasonal variability in short-term real interest
rates and a lesser seasonal variability of output
and employment. Would these changes im­
pose ad d ition al costs on the econom y?
Keynesian economists would argue that a non­
seasonal policy almost certainly imposes costs
on the economy that go beyond the transaction
costs discussed earlier, but whether it imposes
more costs than existing seasonal monetary
policy is more difficult to know.
To appreciate the Keynesian point of view, it
is important to recognize that Keynesian econo­
mists regard the classical view on the function­
ing of a market economy as the ideal toward
which actual market economies tend, but which
they seldom attain. Because of various frictions
in the operation of markets, Keynesian econo­
mists believe that the outcome of an unregu­
lated market economy is typically quite differ­
ent from the outcome depicted by classical
economists. Consequently, Keynesian econo­
mists perceive a need for government policies
designed to steer market outcomes toward the
classical ideal.
In the present context, as already noted ear­
lier, Keynesian economists would challenge
the classical assumption that prices are fully
flexible over the seasons. They would argue
that if the Fed were to stop accommodating the
seasonal demand for money, the price level


would tend to fall during the Christmas season
and tend to rise in the spring, but not by as
much as in the classical argument. Therefore,
short-term real interest rates will rise above the
classical ideal during the Christmas season and
will fall below it in spring; correspondingly,
real output and employment will be below the
classical ideal during the Christmas season and
above it in spring. Consequently, Keynesian
economists would feel the need for a monetary
policy that works to reduce seasonal fluctua­
tions in short-term real interest rates. In other
words, they would perceive the need for a
seasonal monetary policy.9
That having been said, it does not follow that
Keynesian economists would necessarily en­
dorse the Fed's existing seasonal policy. The
Keynesian objective is to get to the classical
ideal, but the Fed's current policy may result in
too much seasonal variability in output and
employment and too little seasonal variability
in short-term real interest rates relative to it. In
the absence of quantitative information on what
the ideal seasonal pattern of short-term real
interest rates and output really is, it is not
possible for a Keynesian to know whether the
Fed's existing seasonal monetary policy is the
best one.
The Federal Reserve's policy of accommo­
dating seasonal movements in money demand
originated in an attempt to eliminate recurrent
financial panics. At the time the Federal Re­
serve System was established, it was widely felt
that the seasonal outflow of bank reserves that
occurred in the fall and spring jeopardized the
liquidity of the banking system and raised fears
on the part of depositors that banks would be
unable to honor their deposit liabilities. A key

9See Gregory Mankiw and Jeffrey Miron's 1991 article
for a detailed discussion of the Keynesian view on the
usefulness of seasonal monetary policy.

Leaning Against the Seasonal Wind

objective of the Federal Reserve System was to
allow banks to borrow additional reserves dur­
ing these months of heavy currency demand so
that the natural pace of commercial activity
would cease to be a threat to the banking
This practice of increasing bank reserves and
the supply of currency during a time of season­
ally high demand continues to the present.
However, given the institutional changes that
have occurred in the banking environment since
1914, most notably the introduction of federal
deposit insurance, it is doubtful whether a
seasonal monetary policy is needed to protect
the banking system from panics. Therefore, a
different justification of seasonal monetary
policy is needed.
This article has suggested that a justification
for seasonal monetary policy may be found in

Satyajit Chatterjee

the argument that such a policy, by smoothing
the path of short-term nominal interest rates,
serves to reduce transaction costs.
The article also pointed out that a classical
economist would view the reduction in trans­
action costs as the only significant impact of a
seasonal monetary policy and would therefore
argue in favor of such a policy. In contrast,
monetarists would argue in favor of eliminat­
ing seasonal monetary policy on the grounds
that it interferes with what they see as the more
important task of keeping the money stock
growing smoothly and predictably over time.
Keynesian economists would concede that ex­
isting policy may be too seasonal but would
argue that some degree of seasonality in money
supply is desirable; therefore, they would cau­
tion against abandoning such a policy.





Barsky, Robert B., and J.A. Miron. "The Seasonal Cycle and the Business Cycle," Journal of
Political Economy 97 (1989), pp. 503-34.
Clark, Truman A. "Interest Rate Seasonals and the Federal Reserve," Journal of Political
Economy, 94 (1986), pp. 76-125.
Diller, Stanley. "The Seasonal Variation in Interest Rates," in Essays on Interest Rates, Jack
M. Guttentag, ed., National Bureau of Economic Research, New York, 1971, pp. 35-133.
Friedman, Milton, and A. J. Schwartz. A Monetary History of the United States 1867-1960.
Princeton: Princeton University Press, 1963.
Friedman, Milton. A Program for Monetary Stability. New York: Fordham University Press,
Friedman, Milton. "Monetary Policy—Theory and Practice," Journal of Money, Credit and
Banking, 14 (1982), pp. 98-118.
Hollander, Jacob H. Bank Loans and Stock Exchange Speculation. National Monetary Com­
mission, S. Doc. 589, 61st Congress, 2nd Session, 1910.
Judd, J.P., and J.L. Scadding. "The Search for a Stable Money Demand Function," Journal
o f Economic Literature, 20 (1982), pp. 993-1023.
Kemmerer, Edwin W. Seasonal Variation in the Relative Demand for Money and Capital in the
United States. National Monetary Commission, S. Doc. 58 8 ,61st Congress, 2nd Session,
Laughlin, Laurence J. Banking Reform. Chicago: National Citizens League for the Promotion
of Sound Banking, 1912.
Lucas, Robert E. Jr. "Rules, Discretion and the Role of the Economic Advisor," in Rational
Expectations and Economic Policy, Stanley Fischer, ed., Chicago: The University of
Chicago Press, 1980, pp. 199-210.
Mankiw Gregory N., and J. Miron. "Should the Fed Smooth Interest Rates? The Case of
Seasonal Monetary Policy," Camegie-Rochester Conference Series on Public Policy, 34
(1991), pp. 41-70.
Miron, Jeffrey A. "Financial Panics, the Seasonality of the Nominal Interest Rate, and the
Founding of the Fed," American Economic Review, 76 (1986), pp. 125-40.
Sprague, O.M.W. History of Crises Under the National Banking Act. National Monetary
Commission, S. Doc. 538, 61st Congress, 2nd Session, 1910.



Working Papers

The Philadelphia Fed's Research Department occasionally publishes working papers based on the current
research of staff economists. These papers, dealing with virtually all areas within economics and finance,
are intended for the professional researcher. The papers added to the Working Papers series in 1992 and
thus far this year are listed below. To order copies, please send the number of the item desired, along with
your address, to WORKING PAPERS, Department of Research, Federal Reserve Bank of Philadelphia, 10
Independence Mall, Philadelphia, PA 19106. For overseas airmail requests only, a $2.00 per copy
prepayment is required; please make checks or money orders payable (in U.S. funds) to the Federal Reserve
Bank of Philadelphia. A list of all available papers may be ordered from the same address.
No. 92-1

Leonard I. Nakamura, "Commercial Bank Information: Implications for the Structure of

No. 92-2

Shaghil Ahmed and Dean Croushore, "The Marginal Cost of Funds With Nonseparable
Public Spending."

No. 92-3

Paul S. Calem, "The Delaware Valley Mortgage Plan: An Analysis Using HMD A Data."

No. 92-4

Loretta J. Mester, "Further Evidence Concerning Expense Preference and the Fed." (Super­
sedes No. 91-6)

No. 92-5

Paul S. Calem, "The Location and Quality Effects of Mergers."

No. 92-6

Dean Croushore, "Ricardian Equivalence Under Income Uncertainty."
(Supersedes No. 90-8)

No. 92-7

James J. Me Andrews, "Results of a Survey of ATM Network Pricing."

No. 92-8

Loretta J. Mester, "Perpetual Signaling With Imperfectly Correlated Costs."

No. 92-9

Mitchell Berlin and Loretta J. Mester, "Debt Covenants and Renegotiation."

No. 92-10

Joseph Gyourko and Richard P. Voith, "Leasing as a Lottery: Implications for Rational
Building Surges and Increasing Vacancies."

No. 92-11

Sherrill Shaffer, "A Revenue-Restricted Cost Study of 100 Large Banks."
(Supersedes FRBNY Research Paper No. 8806)

No. 92-12

Paul S. Calem, "Reputation Acquisition and Persistence of Moral Hazard in Credit Markets."
(Supersedes No. 91-5)

No. 92-13

Sherrill Shaffer, "Structure, Conduct, Performance, and W elfare." (Supersedes No. 90-27)


Working Papers
No. 92-14

Loretta J. Mester, "Efficiency in the Savings and Loan Industry."

No. 92-15

Dean Croushore and Shaghil Ahmed, "The Importance of the Tax System in Determining the
Marginal Cost of Funds."

No. 92-16

Keith Sill, "An Empirical Investigation of Money Demand in the Cash-in-Advance Model

No. 92-17

Sherrill Shaffer, "Optimal Linear Taxation of Polluting Firms."

No. 92-18

Leonard I. Nakamura and Bruno M. Parigi, "Bank Branching."

No. 92-19

Theodore M. Crone, Sherry Delaney, and Leonard O. Mills, "Vector-Autoregression Forecast
Models for the Third District States."

No. 92-20

William W. Lang and Leonard I. Nakamura, "'Flight to Quality' in Bank Lending and
Economic Activity."

No. 92-21

Theodore M. Crone and Richard P. Voith, "Estimating House Price Appreciation: A Compari­
son of Methods."

No. 92-22

Shaghil Ahmed and Jae Ha Park, "Sources of Macroeconomic Fluctuations in Small Open

No. 92-23

Sherrill Shaffer, "A Note on Antitrust in a Stochastic Market."

No. 92-24

Paul S. Calem and Loretta J. Mester, "Search, Switching Costs, and the Stickiness of Credit
Card Interest Rates."

No. 92-25

Gregory P. Hopper, "Can a Time-Varying Risk Premium Explain the Failure of Uncovered
Interest Parity in the Market for Foreign Exchange?"

No. 92-26

Herb Taylor, "PSTAR+: A Small Macro Model for Policymakers."

No. 93-1

Gerald Carlino and Robert DeFina, "Regional Income Dynamics."

No. 93-2

Francis X. Diebold, Javier Gardeazabal, and Kamil Yilmaz, "On Cointegration and Exchange
Rate Dynamics."

No. 93-3

Mitchell Berlin and Loretta J. Mester, "Financial Intermediation as Vertical Integration."

No. 93-4

Francis X. Diebold and Til Schuermann, "Exact Maximum Likelihood Estimation of ARCH

Digitized for 26


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