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I

I
SHADOW OPEN MARKET COMMITTEE
Policy Statement and
Position Papers

September 21-22, 1986

PPS-86-6

CENTER FOR
RESEARCH IN
GOVERNMENT
POLICY
& BUSINESS

Graduate School of Management
University of Rochester

SHADOW OPEN MARKET COMMITTEE
Policy Statement and
Position Papers

September 21-22, 1986

EPS-86-6

1.
2.
3.

Shadow Open Market Committee Members, September 1986
SOMC Policy Statement, September 21, 1986
Position papers prepared for the September 1986 meeting:
Economic Outlook,

Jerry L. Jordan, First Interstate Bancorp

Circumventing
the Intent
Fidelity Bank

of Gramm-Rudman-Hoilings,

Mickey D. Levy,

Time Series
Analysis
of "Velocity"
Concepts,
Robert Rasche,
Michigan State University and Arizona State University




SHADOW OPEN MARKET COMMITTEE
The Committee met from 2:00 p.m. to 7:30 p.m. on Sunday, September
21, 1986.
Members of SOMC:
PROFESSOR KARL BRUNNER, Director of the Center for Research in Government Policy and Business, Graduate School of Management, University of Rochester, Rochester, New York.

PROFESSOR ALLAN H. MELTZER, Graduate School of Industrial Administration, Carnegie-Mellon University, Pittsburgh, Pennsylvania.

MR. H. ERICH HEINEMANN, Chief Economist, Ladenburg, Thalmann & Company,
Inc., New York, New York.

DR. JERRY L. JORDAN, Senior Vice President and Economist, First Interstate Bancorp, Los Angeles, California.

DR.

MICKEY D. LEVY,
Pennsylvania.

Chief Economist,

Fidelity

Bank,

Philadelphia,

PROFESSOR ROBERT H. RASCHE, Department of Economics, Michigan State
University, East Lansing, Michigan; and Department of Economics,
Arizona State University, Tempe, Arizona.

DR. ANNA J. SCHWARTZ, National Bureau of Economic Research, New York,
New York.




POLICY STATEMENT
Shadow Open Market Committee
September 21, 1986
Pessimism about the current economy and its near-term prospects is
overstated.
years.

The

This

economy has grown at a 2 1/2% rate for the last

two

is slightly lower than the average for the last century,

but the difference is small.
Concerns about near-term prospects have encouraged a return to the
policies

of fine-tuning that failed in the past and will

fail again.

The Treasury Department, Wall Street economists and various seers urge
the

Federal

Reserve,

the Bundesbank and the Bank of Japan

to

lower

interest rates.
Efforts
and

to force interest rates lower,

to depreciate the

dollar

to stimulate the economy to head off protectionist legislation are

based on the mistaken belief that we have learned how to stimulate
and prevent inflation later.
to

now

Efforts to get Germany, Japan and others

replace stable, noninflationary policies with additional

stimulus

are similarly short-sighted and wrong-headed.
The

administration is repeating the mistakes of the Carter Admin-

istration.

We

have been playing "locomotive," and we are now

urging

others to play locomotive in turn.
A Long-Term

Problem

The U.S. has a long-term problem.

We spend more than we produce

and finance the difference between spending and production by borrowing
from the rest of the world.
tive

investments,

there

If more of the spending were for produc-

would be no problem.

The returns from

the

productive investments would retire the debt and pay the interest as it




1

came due. We would have more capital to work with, higher productivity
and

a higher standard of living as a result.

Living standards

would

rise.
If,

instead,

tion, we

will

we

borrow to maintain or increase current consump-

live better today but worse tomorrow.

To

repay

the

increased debt, we must lower our standard of living in the future.
Our

problem is NOT the twin deficits in the government budget and

in the trade balance.
-- the

fact

that

Our problem is the way in which we use resources

we are increasing consumption at a high

rate

but

increasing investment in productive capital at a more modest rate. If,
as

a nation, we continue to borrow overseas between

$50- and $150-

billion

annually for the next few years -- and do not invest more

consume

less --by the end of the decade our standard of

and

living will

fall in absolute terms and relative to other countries.
During the 35 years 1951-1986,

the share of GNP used for personal

consumption has remained between 61.6% and 65.6%.
most recent quarters,
of

its range.

For 1985 and the two

the consumption share is close to the upper

end

During the same period since 1951, the share of gross

non-residential investment has remained between 9.0% and 12.1%.
Despite
other
or

accelerated depreciation, the investment tax

credit

and

encouragements to investment -- measures that will be eliminated

curtailed

in

the new tax code -- the share of

stayed near the middle of its postwar range.
quarters,
investment

GNP

invested

has

For the most recent

two

the share of gross non-residential investment was 11%.
is much lower,

Net

only 2.2% of GNP in the second quarter (see

the attached chart).
If we do not invest more and consume less now, we will have less
from which to consume and invest in the future.




2

Each addition to

our

foreign

debt

carries an obligation to pay interest.

The

delay closing the gap between production and spending,
est we

will

production

have to pay and the larger the amount

must exceed future spending.

longer we

the more inter-

by

The reason is

which

future

that, event-

ually, we have to close not just the deficit in the net exports but the
current
and

account deficit.

the

net

The latter includes the net export

deficit

interest payments which will be due to the rest

of

the

world.
Choices
The current account deficit problem will not remain unaltered.
we do nothing to increase production,
lower

our

imports
hold

standard of living,

increase our exports

and

This will
reduce

our

until households and firms around the world become willing

the

rate.

the dollar will fall.

available stock of dollars at a relatively

To

If

stable

to

exchange

solve the problem by depreciating the dollar will require a

reduction of about 4% in the U.S. standard of living by the end of this
decade.

This will amount to more than $400 per person.

loss will not be uniform.
lose at all.
The

Some will lose much more, and some will not

Exchange rate intervention cannot prevent this loss.

administration's

current effort to depreciate the dollar

one way to reduce living standards.
restrict

Of course, the

It is not the only way.

is

We could

imports by protectionist measures, or by forming or joining

cartels, as we have done with textiles, steel and microchips.
Protectionism

would run the risk of retaliation,

would

shrink and everyone would be made worse off.

where

would

goods

at competitive prices.




lose the opportunity to purchase higher

so

that

trade

Consumers

every-

quality

foreign

Producers would be forced to use higher
3

cost

domestic

increasing
lower

inputs, thereby reducing their ability to

costs and reducing efficiency.

compete

Retaliation would

by

further

our standard of living by reducing our exports and the benefits

of trade for everyone.
The

administration

has

recently added a cartel

microchips

to the existing cartels in

textiles.

Cartels raise costs to consumers and producers.

fits

steel,

they

are

will

products

that

use microchips will be at a

effect.

and

The beneAlthough

intended to maintain output and employment in

almost certainly have the opposite

in

food

of trade are lost and standards of living are lowered.

cartels

The

automobiles,

arrangement

the U.S.,

Producers

competitive

of

disadvantage.

administration also uses export subsidies to sell goods, particu-

larly farm output,
consumers

and

abroad.

business,

These subsidies will be paid for by taxing
thereby

lowering standards

of

living

and

raising costs at home.
The growth of dollar-denominated debt held by foreigners increases
the temptation to inflate away part of our obligations.

Current

Fed-

eral Reserve and administration policy of raising money growth to lower
interest

rates temporarily -- and depreciate the dollar permanently --

carries high risks of inflation.
Inflation
the

burden

investment.
reduce
lower

will raise the effective corporate tax rate.

of

this tax will fall on capital,

expand,
However,

In addition,

inflation

will

wage payments and real costs of production.

unemployment
currency




will

get

of

less

Inflation, particularly if it is unanticipated, also will

the exchange rate.
real

so we

Much

will

fall and the trade

depreciation,

4

deficit

temporarily
Output will

may

decline.

achieved by inflation, will produce

little

lasting

reflect

the

benefit.

inflation,

As wages and costs of production

rise

to

the trade balance will worsen once again and

unemployment will rise.
Each of these measures -- currency depreciation, protection, export

subsidies

months.
solve

Each

and inflationary policy -- has been

our

in recent

of them will work to lower the standard of living.

our current international imbalance while

creasing,

tried

standard

maintaining,

of living, we must invest more

to

To

or inincrease

productivity.
This year's tax reform has many desirable features.

It should be

the first of a two-part reform to increase efficiency and productivity.
The second step should be substitution of a broad-based consumption tax
for the corporate income tax. This step would encourage investment and
cause
will

a temporary postponement of consumption.
lead

to higher productivity and a rising

Increased
standard

investment
of

living.

Productive investment also would help to service the nation's debt owed
to domestic and foreign lenders.
To
we

must

increase our living standards in a world with low cost
have

efficiently

low-cost

capital,

without

and increase productivity.

subsidies,

to

labor,
produce

Reductions in taxes on capital

would reduce the cost of capital, and, by improving the capital stock
would increase labor productivity.

Elimination of the corporate income

tax,

and substitution of a broad-based consumption tax, would be

most

useful

step government could take to reduce our trade

without reducing living standards.




5

the

imbalance

Monetary

Policy

Current Federal Reserve policy is irresponsible.
high

price to reduce inflation,

administration, has

After paying

a

the Federal Reserve, urged on by the

returned to the short-sighted policies that pro-

duced the inflation of the 1970s.
For
between

more

than

the monetary base

an 8% and a 9% annual rate.

annual rate.
with

two years,

the

has

increased

at

Output has increased at a 2 1/2%

Base velocity has been little changed.

current growth rate of base money,

average 5% to 6% over the next several years.

This means that

inflation is

likely

to

As the effect of dollar

depreciation spreads through the economy, prices are likely to rise at
more than a 5% to 6% rate for a time.
Supply-side incantations are not a substitute for rational policy.
Encouraging Germany and Japan to expand demand does not solve the longterm trade problem.
To
base

avoid

should

Nor does it avoid inflation.

the coming inflation,

be

the growth rate of the

reduced to a rate consistent

with

price

monetary

stability.

Research prepared for this committee suggests that that rate is in the
neighborhood

of 3% to 4%.

This goal should be achieved by the end of

the decade.

Policy

Coordination
For the past year,

coordination.
should

act

there has been increased discussion of

policy

The meaning usually given to this term is that countries
to dampen fluctuations in spending.

In the

most

common

formulation, nations are urged to adjust monetary and fiscal actions so




6

that

world

trolled.

demand and its distribution among countries would be conProponents

argue

enhanced in this manner.
There

is

that

exchange rate

no known way for central banks and governments

exchange stability this way.

caused

by

that

could be

This is coordination by concerted action.

crease

Speculation

stability

Most exchange rate variation

shifts in policy actions and
about

to in-

other

unpredictable

monetary and other policies has been a main

is

events.
reason

interest rates, exchange rates and other asset prices have

been

extremely variable.
Greater
policies.
price

certainty

be

achieved

by

setting

compatible

If all countries were to adopt credible policies to achieve

stability,

actions

could

one major source of variability -- unstable monetary

-- would be removed.

This is coordination by

common objec-

tives .
We urge the Federal Reserve,

the Bundesbank and the Bank of Japan

to adopt price stability as their common objective.
the

furthest from this objective,

mainly on the United States.
of

the

the burden of adjustment will

fall

But this burden would be lighter if all

countries were to accept the same goal and

strategies to achieve it.




Since the U.S. is

7

announce

credible

INVESTMENT IS DOHN AND CONSUMPTION IS UP
P
E
R
C
E
N
T

12.5/
Net Investnent Left Scale, Line
10. 0Z

66,25'/
65.00V;

7.5'/
63.75'/

0
F
G
N
P

5.0-/.
2.5'/

[62.50*/
Consumption Right Scale, Dot

61.25'/

1952 1956 1960 1964 1968 1972 1976 1980 1984
Notes: Net investnent equals business fixed investnent plus
residential investnent plus inventory investnent. less
econonic depreciation plus net foreign investnent.
Consumption equals personal consumption expenditures.
Sources: Wharton Econonetries; Heinenann Econonic Research



P
E
R
C
E
N
I
0
F
G
N
P




ECONOMIC OUTLOOK
Jerry L. JORDAN

First

Interstate

Bancorp

Bancorp

August 5, 1986

QUARTERLY HI 1986 ECONOMIC UPDATE

Inflation

Policy Assumptions

• Inflation should move higher in 1987 because of ending of oil price
decline, impact of dollar's drop, and delayed affects of rapid money growth.

• Monetary policy will continue expansive, with Ml growth of
approximately 12% in both 1985 and 1986 and 8% in 1987.
• Federal deficit will remain large: $212 bit. in FY 85, $216 bit in FY
86, and $175 bil. in FY 87.

• Consumer prices up 3.5% in 85 (fourth qtr. to fourth qtr.), 1.5% in 86
and 4.8% in 87.

• Impact of Gramm-Rudman still in question.

Interest Rates
• Tax reform implies lower real interest rates than would otherwise exist
because of restraining impact on investment. Much of reduction may have
already occurred.

• Tax reform represents major structural change for U.S. economy.
Nonresidential building, capital spending, housing, and consumer borrowing
and expenditures on durables will be restrained by tax changes. Lower tax
rates, however, will help many firms, especially in services and retailing,
and raise disposable income and spending of many consumers.

• Interest rates arc expected to remain relatively flat during third quarter.
Fed uncertainty about economy and low inflation arc likely to offset concern
about foreign demand for U.S. securities and deficit.

Economic Growth
• There is no shortage of demand. Consumer spending has grown at an
annual rate of 4% during the past 6 qtrs., 6% last quarter.
• Forces depressing growth should start to be mitigated:
(1) Auto inventories - now under control
(2) Net exports-gradual improvement
(3) Oil priccs--$i M5/b in 86, $12-16/b in 87
(4) Tax reform -. removal of uncertainty. Initial negative impact on
investment, followed by higher consumer spending when tax rates are
reduced.
• Real GNP growth, equal to 2.4% in first half of 86, should average 3.5%
in second half, 3.9% in 1987.




• Interest rates should then move gradually higher in fourth qtr. and in 87
because of:
(1)
(2)
(3)
(4)
(5)

Faster economic growth
Continued concern over deficit
Weakness of the dollar
Firming of oil prices
Higher inflation.

• Short-term interest rates, flat in third qtr. of 86, should rise about 25 basis
points in fourth qtr. and 100 basis points in 87. Similar pattern for longterm rates, depending on instrument Some steepening of yield curve.
For further information contact Lynn Reascr at (213) 614-3486

FCC 1205 6/86

ft

1

MONETARY BASE AND M1 NET OF OTHER CHECKABLES
QUARTERLY PERCENT CHANGE OVER YEAR AGO
10.0 j

MONETARY BASE

8.0 -h
6.0
4.0 4

M1 NET

2.0
0.0
-2.0 4

-6.0 4
.0 -\ 1
1980:1




1

1 1 1
1981:1

1

1—I
1
1982:1

h

H 1
1983:1

FIRST INTERSTATE ECONOMICS

1

1 1 1
1984:1

1

1 1 1
1985:1

1

SEPT. 4, 1986

1 1 1
1986:1

2

MONETARY BASE AND M1
QUARTERLY PERCENT CHANGE OVER YEAR AGO
14.0 T

2.0 H 1
1980:1




1

1 1 1
1981:1

1

1 1 1—I
1982:1

1 1 1
1983:1

FIRST INTERSTATE ECONOMICS

1

1 1 1
1984:1

K—I

1 1
1985:1

1

SEPT. 4, 1986

1 1 1
1986:1

3

M1 AND M1 NET OF OTHER CHECKABLES
QUARTERLY PERCENT CHANGE OVER YEAR AGO

1980:1




1981:1

1982:1

1983:1

FIRST INTERSTATE ECONOMICS

1984:1

1985:1

SEPT. 4, 1986

1986:1

4

ST. LOUIS AND BOARD ADJUSTED MONETARY BASE
QUARTERLY PERCENT CHANGE OVER YEAR AGO
u.u -

ADJUSTED MONETARY
BASE

9.0 - r*"V.
8.0 -

K^/\_^

7.0 ST. LOUIS FED
MONETARY BASE

6.0 5.0 4.0 3.0 -

2.0 -1— i — i — i — i — i — i — i — i — i — i — i — i — i i — i — i — i — i — H
1980:1
1983:1
1984:1
1981:1
1982:1




FIRST INTERSTATE ECONOMICS

1

1

1

1

1985:1

SEPT. 11, 1986

1

1

1

1986:1

5

GROSS DOMESTIC PURCHASES & LAGGED MONETARY BASE
QUARTERLY PERCENT CHANGE OVER YEAR AGO
16.0 -r
GROSS DOMESTIC
PURCHASES
ADJUSTED
MONETARY BASE
LAGGED 2 QTRS

H
1980:1




1—I
1—I—I 1 i
1981:1
1982:1

\
1
1983:1

1

FIRST INTERSTATE ECONOMICS

1 1 h
1984:1

1985:1

.,—I—|
1986:1

SEPT. 11, 1986

3-MONTH TREASURY BILL & INFLATION RATE*
20.00

T

-5.00 1111111 f 1111 f f f 111 i 111111111111111111111111J111111)I»)1111111111111111111111111111111111
1979:1
1980:1
1981:1 • 1982:1
1983:1
1984:1
1985:1
1986:1
* Percent change in CPI from 3 months ago, annual rate




FIRST INTERSTATE ECONOMICS

SEPT. 4, 1986

2

3-MONTH TREASURY BILLS - INFLATION RATE*

REAL INTEREST RATES

-8.00 1111 f 11111111111! 111111111111111111111111) I
1982:1
1983:1
1979:1
1981:1
1980:1




1111111)111)]1111111111111111111111
1984:1
1985:1
1986:1

* Percent change in CPI from 3 months ago, annual rate

FIRST INTERSTATE ECONOMICS

SEPT. 5,1986

1 YEAR TREASURY BILLS & INFLATION RATP

oo

1111111 i 11111111111111111111111111111111111111111111111111111111111111111111111111111111
1979:1
1980:1
1981:1
1986:1
1982:1
1983:1
1985:1
1984:1
Percent change in CPI over year ago




FIRST INTERSTATE ECONOMICS

SEPT. 4, 1986

ONE YEAR TREASURY BILLS - INFLATION RATE*

REAL INTEREST RATES

111111M11111111111 li 11111111111111111111111111111111111111111111111111111111111111111111
1982:1
1983:1
1979:1
1980:1
1981:1
1984:1
1985:1
1986:1




* Percent change in CPI over year ago

FIRST INTERSTATE ECONOMICS

SEPT. 5, 1986

5

5 YEAR TREASURY BOND & INFLATION RATE*

5 YEAR BOND

3.00 I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I I 1 1 I I I I H I I I I I H I I I I I I I I H I I I I I 1 I I I I I I I I I I I 1 I I I I I I I I I I I I I I I I I
1979:1
1980:1
1981:1 •
1982:1
1983:1
1984:1
1985:1
1986:1
Percent change in CPI over five years ago




FIRST INTERSTATE ECONOMICS

SEPT. 5, 1986

6

FIVE YEAR TREASURY BOND - INFLATION RATE*

REAL INTEREST RATES

* Percent change in CPI over five years ago




FIRST INTERSTATE ECONOMICS

SEPT. 5, 1986

10 YEAR TREASURY BOND & EXPECTED INFLATION
16.00 -r
10 YEAR BOND

14.00 4

8.00 4

6.00 4
4.00 11111111111111111111111111111111111111111111111111111II11111111 f 111111111111111111111111
1986:1
1980:1
1981:1 •
1982:1
1985:1
1983:1
1984:1
1979:1




* Drexel Burnham Poll

FIRST INTERSTATE ECONOMICS

SEPT. 4, 1986

8

TEN YEAR TREASURY BOND - EXPECTED INFLATION RATE*

REAL INTEREST RATES
8.0 -r

0.0 H-H-H+H+H
1979:1
1980:1




1981:1

1982:1

1983:1

1984:1

1985:1

Drexel Burnham Poll

FIRST INTERSTATE ECONOMICS

SEPT. 11, 1986

1986:1

9

SPREAD BETWEEN LONG AND SHORT-TERM
REAL INTEREST RATES

1979:1

1980:1

1981:1 •

1982:1

1983:1

1984:1

1985:1

* 10 YEAR REAL INTEREST RATE - 3 MONTH REAL INTEREST RATE




FIRST INTERSTATE ECONOMICS

SEPT. 11, 1986

1986:1

QUARTERLY ECONOMIC UPDATE
1986-1987

IV)




First IntersMte Economics
August 18, 1986

FEDERAL

DEFICIT

(Billions, fiscal years)

-50 •+

CTN

-100 -+

-150 •+

-200 •+

-250




TRADE-WEIGHTED VALUE OF THE DOLLAR
(Index, March 1973=100)

160 -r

150 -f

120

100




1982

1983

1984

1985

1986c

1987f

DOMESTIC DEMAND vs. PRODUCTION
(Cumulative Change From 4th Qtr. 1983

83:4




84:1

2

3

4

85:1

2

lndex=1.00)

3

4

86:1

2




REAL GNP
(Percent change over prior quarter, annua! rate)

1982

1983

1984

1985

1986e

1987f

TOTAL MOTOR VEHICLE SALES
(Millions of units)
16 nr

14 •+

12

o

10 •+

8 •+

2 •+




1982

1983

1984

1985

1986e

1987f

HOUSING

STARTS

(Millions of units)
2.0 - r

1.5 -+

oo

1.0 •+

0.5

0.0




1982

1983

1984

1985

1986e

1987f

INFLATION
(Percent change in year-end CPI over prior year)

1976




1977

1978

1979

1980

1981

1982

1983

1984

1985

1986e

1987f

3-MONTH TREASURY BILLS & INFLATION
(Percent)

14 T

\
1982

1983

* Percent change In CPI from prior qtr., annual rate



1984

1985

1986e

1 1 1 1 1
1987f

30-YR. GOVT. BOND AND MORTGAGE RATES
(Percent)
18 - r

e-l

1




1
1982

1

1

1

1
1983

1

1

1

1
1984

1

;

1

1
1985

1

1

1

1

1

1986e

1

1

1

1

1987f

1

NONFARM EMPLOYMENT: FIRST INTERSTATE TERRITORY
AND THE U.S.
(Percent change from prior year)

1982




1983

1984

1985

1986e

1987f

PERSONAL INCOME: FIRST INTERSTATE TERRITORY AND THE U.S.
(Percent change from prior year)

.

11 T

4H

1982




1
1983

1
1984

1
1985

|

1

1986e

1987f

CIRCUMVENTING THE INTENT OF GRAMM-RUDMAN-HOLLINGS
Mickey D. LEVY
Fidelity
Bank

The
and

positive trends in the federal budget outlook forecast by OMB

the

CBO in February 1986 were exaggerated.

On

the

plus

side,

deficits should decline from current levels, and the disturbing, sharp
rise in the federal debt-to-GNP ratio is projected to recede, marking a
clear improvement.
looned

to

On the negative side,

a record high --it may reach $230 billion -- and the sub-

stantially

lower deficit targets legislated by the

Control Act of 1985 (Gramm-Rudman-Hollings,
achieved.
report

Deficit

estimates

Emergency

Deficit

or GRH) are unlikely to be

prepared for the Initial

Sequestration

are biased downward by accounting requirements mandated by

Balanced Budget Act.
across-the-board

$144 billion
in

sequestration order for FY1987, but actual

GRH target.

FY1988

budgetary

the

Certain tactics will probably be used to avoid an

will be at least $180 billion,

target

the FY1986 deficit has bal-

and perhaps $200 billion, far above the

This will make the

$108

nearly impossible to attain.

maneuvering,

it

deficits

billion

In light

is unclear whether the

of

deficit
recent

Administration

or

Congress take the deficit targets of the Balanced Budget Act seriously.
Nor is it clear that GRH, with its overly ambitious scheduled

deficit

cuts and its porous sequestration process, provides a viable guideline
that contributes to sound fiscal policy.
The

record-breaking

deficit

in FY1986

reflects

weak

economic

growth that suppressed tax revenues, and higher-than-expected expenditures
for

due largely to rising agricultural subsidies,

deposit insurance,




and the rapid pace of defense

37

a jump in outlays
spending.

The

deficit remains well above 5 percent of GNP,
GNP

ratio

has

risen substantially,

and the federal debt-to-

to nearly 42 percent

from

38.3

percent in FY1985, reflecting the rising debt and sharp slowdown in GNP
growth.

Achieving

cutting

over

GRH's FY1987 $144 billion deficit target

$80 billion from deficits

-- slicing

the

requires

deficit

to

approximately 3.2 percent of GNP.
The

sharply lower deficit targets legislated by GRH

remain

even though the original process was declared unconstitutional.
the

fallback

General

mechanism

now in place,

the role

of

the

law,
Under

Comptroller

is replaced by the Temporary Joint Committee on Deficit Reduc-

tion, composed of the entire memberships of the Senate and House Budget
Committees.
submitted

In

accordance with GRH,

on August 15, the CBO and

their budget base levels for FY1987 to the Joint

0MB

Committee.

TABLE 1
Budget Base Levels for FY1987
(in Billions)
Budget Aggregates

0MB Estimates

CBO Estimates

Average

Revenues

826.4

827.8

827.1

Outlays

982.6

998.5

990.5

156.2

170.5

Deficit

163.4

Memo:
GRH Deficit Target

144.0

0MB forecast the FY1987 deficit to be $156.2 billion and the CBO forecast
above

$170.6

billion;

the $163.4 billion average was

the $144 billion GRH target (see Table 1).

Since this

estimate is more than $10 billion above the GRH target,




38

$19.4 billion
average

the report for

FY1987 includes calculations for the amounts to be sequestered.
removing

numerous

applying

special rules that limit cuts to other programs,

sequestration
programs

spending

report

programs exempt

from

calculates that qualified

sequestration

To avoid this sequestration process,

October

non-defense

1 to enact deficit cutting legislation.

and

the initial
spending

be cut 7.6 percent and defense spending programs be

percent.

After

cut

5.6

the Congress has until
A revised and

final

sequestration order, reflecting any change in laws or regulations since
August 15, will be submitted on October 6 and effective October 15.
The OMB-CBO average deficit forecast is significantly below FY1986
levels

and

allowed,
made

only

modestly

suggesting

above the

$154 billion

maximum

deficit

that substantial progress on the deficit has been

and that the 1987 GRH target is easily within

reach.

Moreover,

sharply lower deficit forecasts for FY1988 through FY1991 by the Administration

(Mid-Session

Economic and Budget

Review

Outlook:

of the FY1987 Budget)
An Update)

and the

(The

CBO

imply that future GRH deficit

targets are also possible to achieve.
However, a closer look at the budget base estimates in the Initial
Sequestration Report reveal a different story:
for

the deficit

estimates

FY1987 based on the accounting principles imposed by GRH are

tematically
avoid

the

biased

downward;

sys-

several methods likely will be used

GRH across-the-board sequestering for

deficits will be much higher than estimated.

FY1987; and

to

actual

This deceptive maneuver-

ing by economic policymakers adds to public confusion about the deficit
and reduces credibility in the budget process. The GRH deficit targets
in later years likely will be impossible to achieve and,
Balanced Budget Act may lead to poor fiscal policy.




39

in fact, the

GRH Budget Base Levels for 1987
The average OMB-CBO deficit estimate for FY1987 under Gramm-Rudman
accounting rules is $163.4 billion, but a more realistic deficit estimate would be at least $180 billion and as high as $200 billion.
OMB-CBO

estimates

August

15.

The

reflect

laws and regulations that were

budget base estimates for the

Balanced

in

The

effect

Budget

Act

(called the "Gradison base", named after Congressman Gradison, a member
of

the House Budget Committee) include the deficit-cutting

provisions

of the Budget Reconciliation Act of 1985 and the initial GRH sequestering

in March 1986.

levels, without

However,

they are based on FY1986

adjustment for inflation, because no

have yet been enacted for FY1987.
projections

for

appropriation
appropriations

This significantly reduces spending

programs that require appropriations,

downward bias to the deficit estimates.

and imposes

a

Exact measurement of this bias

is difficult to calculate, but it is instructive that the CBO baseline
projections,

also published in August,

be $184 billion,

estimate the FY1987 deficit to

or $13.4 billion higher than the budget base

deficit

it estimated, based on the Balanced Budget act accounting requirements.
OMB
line

seems particularly guilty of artificially lowering the base-

deficit estimates in the Initial Sequestration Report.

mates

$15.9

billion lower spending in its budget base than

and the lower estimates in several spending programs are
OMB's budget base does not

tionable.
a

1987

though

President's Mid-Session

the

highly

CBO,
ques-

include additional money to fund

pay increase for civil servants or
the

It esti-

military

personnel, even

Review proposes a 4 percent

raise

for military personnel effective October 1, 1986, and a 2 percent raise
for civilian employees effective January 1,
exclusion




1987.

OMB justifies this

on the grounds that the FY1987 appropriations bill
40

has

not

yet passed.

This omission biases down OMB's spending and deficit base

by $2.9 billion,

compared to the CBO budget base.

OMB also estimates

defense outlays in FY1987 to be $4.7 billion lower than the CBO because
it

assumes

spending
major

slower spending rates.

rate

source

is not new;

is

higher

not,

defense

OMB's slower assumed spending rate

was

a

Congressional

Since CBO's spending rate is based on the histori-

relationship between defense budget authority and

OMB's

the

of contention in the recent debate on the

Budget Resolution.
cal

This argument about

outlays, while

and because defense outlays in FY1986 have

than anticipated,

OMB's estimate seems suspect.

been much

The CBO also

estimates $5.1 billion higher outlays for the Commodity Credit Corporation

(CCC)

farm

price supports,

largely

reflecting

advanced

deficiency payments for the 1987 crop year.

approach

is the more conservative,

light

CBOfs

assumed

Again, the

CBO

and probably the more accurate

in

of recent patterns of agricultural outlays and continuing weak-

ness in agricultural prices.
Other
deficits

sources

of higher-than-anticipated

higher than forecast.

For example,

spending

may

drive

a surge in failures

of

depository institutions could lead to higher outlays for deposit insurance,

as in FY1986.

In general, the legislative slippage in the fight

to reduce budget deficits, reflected mainly by supplemental appropriations, is perpetually underestimated.
Besides
projections
optimistic.
real

GNP

through

these biases in the base calculations,

are based on economic growth assumptions that seem
OMB
gains

assumes real GNP to grow 3.7 percent in
of at least 4 percent in each quarter

1987:111)




the lower deficit

and

the CBO assumes slightly
41

slower

overly

1987

from
3.2

(with

1986:111
percent

growth

rate.

Both assume approximately a 3 percent rise in

deflator and modest interest rate increases.
that

Importantly, GRH requires

the final sequestration report (due October 6) be based on

August
in

the GNP

these

15 economic assumptions, even though the downward GNP revision

second quarter and the clear weakness this quarter

nearly

assures

real

GNP to be lower than the level used to calculate the budget base.

This

implies a shortfall in tax revenues and a higher deficit than

the budget base.
too optimistic,

in

Moreover, the growth assumptions through 1987 may be
and continued economic weakness would generate a fur-

ther shortfall in revenues.
By eliminating this downward bias in OMBfs budget base levels

and

assuming somewhat slower economic growth, the FY1987 deficit will be at
least

$180 billion -- far above the maximum deficit amount that

trig-

gers sequestration.
Suspension or Avoidance of Sequestration
The

Balanced

sequestration

Budget

there
If,

that

the

quarters

or if either OMB or the CBO forecast a decline in

Real GNP rose at a 0.6 percent annual rate in 1986:11, but

is only a slim chance it will be below 1 percent
in

suspends

process if real GNP growth for two consecutive

is below 1 percent,
real GNP.

Act includes a provision

fact,

growth

is sufficiently slow to halt the

this

quarter.

GRH process,

deficits would rise and move even further away from the GRH targets.
With

the 0MB-CB0 average estimate deficit of $163.4 billion

$9.4 billion above the maximum allowable deficit, several avenues

only
are

available to reduce the deficit base estimates by October 1 and avoid a
sequestration order.
October 1,




If the pending tax reform bill is passed prior to

then an estimated $12 billion revenue gain in FY1987 may be
42

used

to reduce the budget base deficit below the magical $154 billion

level.

Unfortunately,

this would give only temporary deficit relief.

Since the tax reform bill is designed to be revenue neutral, presumably
there is a combined $12 billion revenue loss in FY1988-1990, adding to
deficits in those years. Furthermore, these are static revenue impacts
that

assume

shift.

no change in economic behavior in response to the policy

If the tax bill has a short-run adverse economic

impact, the

initial year revenue impact may be negative, not positive. More generally,

lowering

the

deficit

by increasing taxes is not

solution to the budget dilemma.

Nevertheless,

a

desirable

this estimated revenue

gain in, FY1987 may be used to avoid sequestration for FY1987 if the tax
bill passes.
A second method of temporarily escaping GRH sequestration would be
the

sale of certain government financial assets,

such

as

government

housing loans. The proceeds of these asset sales, which are counted as
negative

spending, would legally reduce the deficit

estimates.

The

government's loan holdings are sufficiently large that such sales could
reduce

the

selling

estimated

deficit in FY1987 below

$154 billion.

While

the government's financial assets and dropping its participa-

tion in certain credit markets has merits on other grounds, doing so to
avoid

sequestration in FY1987 is deceptive.

The transfer

of

assets

would provide a one-time reduction in spending which would be offset by
higher

future

deficits

due to the loss in interest

income

from

no

longer owning the assets.
Some combination of these methods will likely be used to avoid the
sequestration
meeting

order

for FY1987.

However,

these methods

will

GRH deficit targets more difficult -- if not impossible

FY1988 and beyond.




43

make
-- in

Another
Congress

possible action should not be ruled

out.

Suppose

merely declines to vote on the joint resolution based on

Final Sequestration Report, or votes to delay consideration?
this

that

scenario

will be unfolding one month before the

the

Remember,

national

elec-

tions, and nobody in Congress would benefit from across-the-board cuts.
Without any precedent, the outcome is uncertain.
The Outlook for the Balanced Budget Act
Forcing Congress and the Administration to become constantly aware
of

the enormous deficit problem and to consider lower deficit

are

two

positive

several
It

aspects of the Balanced Budget Act.

large weaknesses.

calls

strictly
because

GRH has

The required cuts are dramatic and

for a balanced budget in FY1991.
ad hoc requirement whose

an

But

targets

Balancing the

appropriateness

rigid.

budget

is

is uncertain,

it is not based on or supported by theoretical considerations.

Reducing

the

deficit to $144 billion in FY1987 requires

cutting

the

standardized-employment deficit from 4.3 percent of GNP to 2.5 percent.
Excluding
deficit

net
of

billion.
are

are

approximately $90 billion in FY1986 to a surplus

of

uncertain.

They depend on the exact composition

$1.3

policy
of

the

the extent to which spending reductions in some federal programs
offset by private sector or state and local provision of the pro-

gram,
this

this involves shifting from a primary

The economic impacts of such a large shift in fiscal

highly

cuts,

interest costs,

and

the Federal Reserve!s monetary policy

response.

However,

shift in deficit policy will occur simultaneously with major

reform,

tax

whose short-run impact on the economy is likely negative. The

weak economic expansion may be threatened by this turmoil in budget and
tax policy.




44

The

task of achieving the ambitious GRH deficit targets in later

years intensifies.

Excluding net interest costs, the deficit target of

$108 billion in FY1988 requires running a primary surplus of $36 billion.

If

in

fact,

the actual deficit in FY1987 is closer

to

$180

billion, the FY1988 GRH target will be virtually unachievable.
Numerous

exemptions from the across-the-board sequestration pro-

cess and special provisions that limit cuts to other programs introduce
additional
defense

serious

spending

security,

flaws.
is

In FY1987, over two-thirds of

excluded from

net interest,

sequestration,

the earned income credit,

all non-

including

social

certain low-income

programs such as AFDC, child nutrition, medicaid, food stamps, SSI, and
WIC,

veterans compensation and pensions,

state unemployment benefits,

and outlays from prior year appropriations.
Medicare
cuts.

and
Over

Other programs,

guaranteed student loans, are subject to

such as

only

limited

one-third of defense spending is also exempt from seques-

tration

due to prior contractual obligations.

Clearly,

these

rules

grossly

violate GRH's original intent that the burden of deficit

cut-

ting be distributed evenly.
GRH's

exemptions

and

uneven application

may

actually

inhibit

efforts

to substantially lower the deficit because they protect spend-

ing

social security and transfer payments, a primary

in

rising

spending and deficits.

spending
GRH's

programs

exemptions

As a practical matter,

should be considered candidates
severely

for

source

of

all government
budget

hinders the simple arithmetic

of

cuts.

deficit

reduction.
So far,
cutting

the Balanced Budget Act has elicited short-term

actions




that

may

not be consistent
45

with

deficit-

long-run program

reform.

These "quick fixes" are not necessarily good public policy if

they

not generate long-run savings or if they fail to

do

address, or

preclude addressing, some of the structural flaws of spending programs.
These

flaws probably doom the Balanced Budget

Act.

Yet

rather

than consider changes that would improve the effectiveness of GRH,

the

Administration and Congress are effectively taking steps that undermine
the Act.

These actions only contribute to poor public policy by breed-

ing public misunderstanding and cynicism.
eventually

will take GRH seriously,

or make improvements to

they are off to a rather inauspicious start.




46

Perhaps budget policymakers
it,

but

TIME SERIES ANALYSIS OF "VELOCITY" CONCEPTS
Robert RASCHE
Michigan State
University
and
Arizona State
University

A

significant

related

innovation of the last decade

in

the

literature

to the demand for money function has been the investigation of

the time series properties of the ratio of a measure of the money stock
to

a measure of income (or the inverse of this

concept.

This

(1974),

literature,

Nelson

concerned

including

and Plosser (1982),

studies

ratio)

-- "velocity"

by Gould

and

Nelson

Haraf (1986) and Poole (1986) is

with the question of whether the "velocity" measure is more

appropriately

characterized as a difference stationary (DS) or a

time

stationary (TS) univariate time series process. This question involves
whether an autoregressive component
a

unit

root.

addressing
root

in an ARMA model of "velocity" has

A corresponding statistical literature

has

the question of the appropriate test statistic for the unit

hypothesis in simple univariate ARMA models (Dickey

1979,

developed

1982; Evans and Savin, 1981, 1984).

on velocity

has

and

Fuller,

The time series literature

applied some of these univariate tests to

century of annual GNP velocity measures for the U.S.

and to

almost

a

quarterly

GNP and Final Sales velocity measures for the 60s and 70s. The general
conclusion

is that the data do not reject the simplest DS process --a

random walk with drift.
Several
research
rather

and

criticisms




been levied against

the derived conclusions.

widespread

"velocity"

have

model

feeling

First,

that the issue

this

time

series

there seems to be

of whether

a univariate

is "TS" or "DS" is irrelevant -- the whole issue

47

a

is

clearly "BS" since such tests are plagued by specification error.
argument

for specification error starts with the proposition

"velocity"

is

a meaningful concept,

"well

known"

that

it must be founded in

aggregate demand for money function (Wallich,

1984).

The

a

stable

However,

it is

that the income elasticity of aggregate money demand

significantly less than unity,

if

is

and the interest elasticity is signifi-

cantly

less

than zero, both in the short run and in

Hence,

univariate tests on "velocity" impose inappropriate constraints

on the parameters of the money demand function,
addressed

in

an

unconstrained

multivariate

the

long run.

and the issue must
framework.

A

be

second

criticism of this approach concerns the interpretation of the events of
the

past several years.

process

for

1959-79

is

argues,

without

univariate

Haraf (1986) concludes that a univariate

several quarterly measures of "velocity" over the
rejected in favor of a univariate

DS

explicit

tests,

DS

process.

"shift"

is the source of the "velocity slowdown" of

problem

with

rejection

this

this

He

the

then
the

unexplained
1980s.

arbitrary selection of a shift point is

The

that

the

of the TS univariate process in favor of the DS process

was

developed under the restriction that no parameter instability
in

period

that a "shift in the drift" of

process occurred in about 1980, and

TS

either model during the sample period.

occurred

It is not evident that the

rejection of the TS process in favor of a DS process is robust with re-

Gould and Nelson (1974) are quite careful to note that their
conclusions on the random walk nature of velocity do not rule out an
interest
elastic velocity function if interest rates are
also
characterized by a random walk process (H4 and H5, p. 417). They did
not
address the implicit income elasticity constraint
in
the
construction of the velocity measure.




48

spect to parameter shifts within the sample period.
ring

allegations

of

shifts in the aggregate

Given the recur-

money

demand

function

during the 1970s, this problem needs to be considered.
Fortunately, the issue of "shift in the drift" can be investigated
using

more

formal techniques that the visual examination of velocity

series undertaken by Haraf.
shift

in

The likelihood ratio test statistic for a

location parameter at an unknown point

a

within

a

sample

developed by Hawkins (1977) and Worsley (1979) applies directly to

the

"drift shift" problem.
Three

measures of "velocity" are investigated in Table 1.1.

involved the Ml measure of the money stock with a shift
nationwide
concept

NOW accounts in January-April,

is

1981.

All

adjustment

for

The first velocity

the traditional GNP measure of velocity.

The

second

is

based on final sales to domestic purchasers (GNP - inventory investment
+

net exports),

deficits

have

since inventory changes and the large current account

been

mentioned prominently in

recent

discussions

velocity.

The third measure is based on personal income.

typically

does not show up in "velocity" discussions, but is used

the

relevant

(or

only available proxy) in monthly

demand specifications (Farr,

1985; Judd, 1984).

of

This measure

aggregate

as

money

It has the advantage

of being measured independently on a monthly basis,

so that the effect

of time aggregation can be investigated on three levels.
The
1952.

sample

This choice was somewhat arbitrary, but is motivated by

considerations.
Accord period.
for

periods for the tests in Table 1.1 begin in January,

First it marks, roughly,
Second,

the beginning of the Post-

it is typically the starting point of samples

money demand specifications estimated in the late 1960s and




three

49

early

1970s -- the "golden age" of short run money demand estimates.
several

experiments

with

testing for "drift shift" in

Third,

samples

that

extended back to 1947 suggested parameter shifts around 1951.
Two

major

Table 1.1,

conclusions emerge from the test results

"drift

measures

in

regardless of the velocity measure chosen and regardless of

the level of time aggregation.
of

reported

shift"

in

The first is that there is no evidence

a random walk model

of

the various

during the 1952 through 1981 sample period.

that when

the sample is extended through 1985 the

The

velocity
second

is

tests

unanimously

second of these two conclusions is particularly

interesting

point to a change in the drift parameter in 1981.
The
because

of the existing controversy over the timing of velocity and/or

money demand shifts.
early

as

occurred
bearing

Haraf (1986) appears prepared to date a shift as

late 1979 or early 1980.

Others have

that

shifts

as a result of financial deregulation that permitted interest
checkable deposits such as NOW and SNOW accounts (Higgins

Faust, 1983; Roth, 1984; Paulus, 1986).
or

argued

1980

admits

and

Dating shifts as early as 1979

the possibility that the shift could

result

from

a

monetary policy regime change in 1979 or the credit controls experience
in

1980.

Dating

the shifts as late as the end of

conclusions dubious.
the

nationwide

measured

money

1981 makes

such

Dating shifts in late 1981 would seem to suggest

extension
stock

of NOW accounts as an

influence, but

here has already been adjusted

to

the

filter

the impact of portfolio shifts associated with this regulatory

out

change.

Dating shifts as early as late 1981 casts doubt on the proposition that
the

shift

is related to the introduction of checkable

deposits

with

market determined own rates, since SNOWs did not become available until
January,

1983.




Thus,

the

time series properties of the various
50

Ml

velocities do not seem to support many,
alizations

about

if any, of the popular ration-

what has caused the early 1980s to differ

from

the

preceding 30 years.
The possibility remains that the conclusions about velocity shifts
are

illusions

investigated

created by misspecification.
later

This

question will be

while the adequacy of the (0,1,0) ARIMA

model

of

velocity will be discussed here.
Table

1.2

presents estimates of the univariate (0,1,0) velocity

model for the 1952-85 sample period at all three levels of time aggregation,

after

ning of 1982.

allowing for a shift in the constant term at the beginThis dating of the shift is off by one-quarter from the

point identified by the Hawkins1 likelihood ratio tests

shift
monthly

and

quarterly

data above, but it was chosen

comparisons across monthly,
gation.
81

to

in the

facilitate

quarterly and annual levels of time aggre-

The estimated autocorrelati ons of the residuals for the 1952-

sample

equations from Table I.l and the estimated

equations

from

Table 1.2 are given in Table 1.3.
With one marginal exception (quarterly GNP velocity), the hypothesis that the residuals of these velocity models are white noise
be

rejected.

A

second

feature of Tables I.l and 1.2

is

cannot

that

the

introduction of the shift in the constant term at the beginning of 1982
has

greatly

reduced the difference in the residual standard error

the

1952-85

sample compared with the

regardless

corresponding

1952-81 sample,

of the velocity concept or level of time aggregation.

money and income measures used in these regressions are constructed
conventional arithmetic
and

if

averages.

If geometric

averages




The
as

had been used

the residuals at the monthly level are white noise,

51

of

then the

only

consequence

of

residual variation.
intervals

the

aggregation would be

a

reduction

in the

In fact, aggregating from quarterly to annual time

produces a greater reduction in the residual that the

1.731

factor predicted by a white noise process.
The

conclusion from this analysis is the data do not

reject

the

hypothesis that the random walk model of Ml velocity is well characterized by a "shift in the drift" at the beginning of 1982.
explanation of this phenomenon is the financial

One possible

deregulation

hypothesis

(FDH).

As noted above, a number of analysts have argued over the past

several

years

that

the introduction of

interest

bearing

checkable

deposits both in the form of NOWs with effective interest rate ceilings
above

zero

or in the form of SNOWs with market determined rates

fundamentally
(e.g.,
Ml

changed the nature of the current measure of Ml.

Paulus,

measure

have
Some

1986) have gone so far as to argue that if the current

is stripped of the other checkable deposit

money is measured as what was called MIA in 1980-1,

component

and

then the

velocity

investigate the FDH we have examined the time series

behavior

relationship of the 60s and 70s reasserts itself.
To

of a number of other monetary aggregates, including the currency component of Ml, the adjusted monetary base published by the Federal Reserve
Bank

of

Under

St.

Louis, and

Ml net of other checkable

deposits

(MlA) .

FDH, none of these aggregates should exhibit any "shift in the

drift" in the early 1980s.
The

results for the currency component of Ml are shown in Tables

1.4 and 1.5.
of

the

Regardless of how velocity

level of time aggregation,

there appear to be

breaks in the "drift" of currency velocity.
at

the

is measured,

and regardless
two

distinct

The first of these occurs

end of 1961 or beginning of 1962 and the second occurs




52

around

the

third quarter of 1981.

With different velocity concepts

the

other of these shifts may appear stronger,

one or

and in some cases

the

shift in late 1981 is either not significant or only marginally significant when measured by the Hawkins likelihood ratio
However,

in

location

parameter

tests.

of

case,
at

statistic.

this test points a possible change

the same point indicated for the

in the

Ml

velocity

The hypothesis that the same "shift in the drift" occurred

currency
1.5

every

test

in

velocity as occurred in Ml velocity is investigated in Table

where dummy variables are introduced for a shift at the beginning
1962 (D62) and at the beginning of 1982 (D82).

In every case

the

estimated coefficients on these dummy variables are highly significant.
The

magnitude of the estimated coefficients on D82 also suggests

the

1981

"event" should not be considered solely an

Deposit problem.
1981 measured
shift

Checkable

The shift in the growth rate of currency velocity in
in Table 1.5 is of the order of 40-60 percent

in the growth rate of Ml velocity measured in Table

strong
rency

Other

of

1.3.

result in support of a shift in the drift parameter of
velocity

against

that

ARIMA

model

can be interpreted

as

strong

the
This

a curevidence

the FDH that the difference behavior of Ml velocity should be

attributed solely to the advant of interest bearing checkable deposits.
Certainly interest rates on currency have not been deregulated,

nor is

there anything in the financial deregulation literature to suggest that

It should be noted that the currency component of Ml
manipulated for NOW shifts in 1981.




53

has

not

been

an

implication

of this deregulation is a continuing increase
3

in the

demand for current relative to various income measures.
The

hypothesis

occurred

a

"shift in the drift"

simultaneously with that of Ml currency

Table 1.6.
is

that

ingly similar to those in Table 1.2 and 1.5.
the

there

it is not

or quarter-to-

In every case, regardless
of

a highly significant shift in the drift

the beginning of 1982.

income

applied,

of base

velocity

The estimated coefficient of the shift

dummy variable is generally 65-75 percent of the estimated
for the corresponding Ml velocity concept in Table 1.2.
were
the

necessarily

The results are strik-

level of time aggregation or the concept
is

around

in

growth rates of the base, hence the results presented here do

not immediately follow from those in Table 1.5.

of

is investigated

that currency should dominate the month-to-month

quarter

velocity

While the dominant component of the adjusted monetary base

currency in terms of the level of the base,

true

of base

coefficient
Several tests

undertaken that are not reported in detailed tables here.
Adjusted

Monetary Base velocities were investigated for

a

First
shift

around the beginning of 1962 such as found for currency velocity above.
In

no case was the estimated coefficient of a shift dummy variable

at

The underground economy hypothesis could be invoked to argue that much
of the shift in the drift of Ml velocity should be attributed to the
change in behavior of currency velocity,
and the latter is a
consequence of the rapid growth of the cocaine and other hard drug
industries, which are necessarily currency oriented transactions and
are not properly measured in GNP or other income concepts.
There are
several problems with this hypothesis.
First, it cannot be refuted,
since accurate data on the demand for currency for such transactions
will never be available. Second, the shift in the currency velocity is
smaller than the shift in Ml velocity and since currency is only about
20 percent of total Ml, there remains a large shift in the velocity of
the checkable deposit component of Ml.




54

this

point significant for the Adjusted Monetary

Base.

Second,

autocorrelation functions of the residuals of the regressions
in Table
residual

1.6

were examined carefully.

The

monthly

and

the

reported
quarterly

autocorrelation functions gave no indication of any signifi-

cant

serial correlation.

some

evidence of a weak first order moving average process, but given

the

relatively

In some of the annual regressions there

small samples, these estimated coefficients

significantly different from zero.

is

are not

Third, after introducing the shift

dummy beginning in 1982, the estimated standard error of these (0,1,0)
ARIMA
as

models of Adjusted Monetary Base velocity are virtually constant

the

sample period is extended from the end of 1974 to the

end

of

1981 to the end of 1985.
The
results
ments
erties

logical question that follows from all of these
is "Why?".

time

The following section will review numerous

series
argu-

in the money demand literature that suggest the above time propshould not be observed.




55

TABLE 1.1
Tests of the Stability of DS Models of Velocity
m*[lnVt - lnVt ] - a + e
Full Sample
Drift Estimate
(Annual Rate)

Velocity
Measure

Data
Interval

1.

Personal
Income

Monthly
(m=1200)

52,1-85-12

2.800
(.36)

7.21

81,9

5.66**

2.

Personal
Income

Monthly
(m-1200)

52,1-81,12

3.455
(.36)

6.90

81,9

2.50

3.

Personal
Income

Quarter
(m-400)

52,1-85,4

2.77
(.34)

3.93

81,3

6,40**

4.

Personal
Income

Quarter
(m=400)

52,1-81,4

3.44
(.29)

3.18

54,3

2.50

5. GNP

Quarter
(m-400)

52,1-85,4

2.58
(.41)

4.73

81,3

4.76**

6.

GNP

Quarter
(m-400)

52,1-81,4

3.20
(.39)

4.25

54,3

2.15

7.

Final
Sales

Quarter
(m=400)

52,1-85,4

2.76
(.31)

3.66

81,3

4.91**

8.

Final
Sales

Quarter
(m-400)

52,1-81,4

3.26
(.30)

3.29

67,1

2.01

9.

Personal
Income

Annual
(m-100)

52-85

2.87
(.39)

2.28

81

5.32**

10. Personal
Income

Annual
(m=100)

52-81

3.43
(.27)

1.46

54

2.70

11. GNP

Annual
(m=100)

52-85

2.66
(.42)

2.46

81

4.28**

12. GNP

Annual
(m-100)

52-81

3.19
(.33)

1.79

54

2.78

13. Final
Sales

Annual
(m-100)

52-85

2.84
(.33)

1.95

81

4.52**

14. Final
Sales

Annual
(m-100)

52-81

3.28
(.26)

1.39

73

2.26




Sample
Period

56

LR
Statistic

s

TABLE 1.2
(0,1,0) ARIMA Models of Velocity
1952-85 with Constant Shift
a + @ D, fc + e
m*[lnVt - lnVt J
kt
Velocity
Measure

Data
Interval

a

B

Personal
Income

Monthly
(m=1200)

3.45
(.37)

-5.56
(1.07)

7.00

1.99

Personal
Income

Quarter
(m-400)

3.44
(.32)

-5.71
(.93)

3.48

1.48

3. GNP

Quarter
(m-400)

3.20
(.40)

-5.28
(1.18)

4.42

1.62

4.

Final
Sales

Quarter
(m=400)

3.26
(.31)

-4.28
(.91)

3.40

1.67

5.

Personal
Income

Annual
(m=100)

3.43
(.31)

-4.78
(.90)

1.69

2.27

6.

GNP

Annual
(m-100)

3.19
(.36)

-4.55
(1-06)

2.00

2.48

Annual
(m=100)

3.28
(.28)

-3.72
(.82)

1.55

2.39

7. Final
Sales




57

d-w

TABLE 1.3
Estimated Autocorrelations for (0,1,0) ARIMA
Models of Velocity

Table ( l i n e )

1

2

Lag
3

4

5

6

Chi
Squared(6)

1.

1.1(2)

-.07

.07

.01

-.03

-.04

.05

5.2

2.

1.2(1)

.00

.08

.04

-.02

-.03

.03

4.6

3.

1.1(4)

.17

.06

.04

-.05

.03

.03

4.4

4.

1.2(2)

.25

-.06

-.04

-.13

-.06

-.09

12.7

5.

1.1(6)

.11

.13

.16

-.06

-.06

.08

8.5

6.

1.2(3)

.18

-.11

-.09

-.12

-.12

.03

11.2

7.

1.1(8)

.08

.09

.10

-.14

.07

.14

8.0

8.

1.2(4)

.16

-.05

-.10

-.16

-.02

.06

8.7

9.

1.1(10)

.06

-.09

-.01

.02

-.10

-.02

.7

10. 1 . 2 ( 5 )

-.17

.04

.06

-.01

-.09

.04

1.4

11. 1.1(12)

-.17

.14

.02

.08

-.18

.00

2.5

12. 1 . 2 ( 6 )

-.28

.04

.16

-.03

-.14

.02

4.1

13. 1.1(14)

-.06

.10

.04

.05

-.28

-.02

2.9

14. 1 . 2 ( 7 )

-.20

.03

.14

-.01

-.22

.02

3.5




58

TABLE 1.4
Tests of the Stability of DS Models of Currency Velocity
m*[lnVt - ln(v tl )] - a + €
Full Sample
Drift Estimate
(Annual Rate)

Velocity
Measure

Data
Interval

1.

Personal
Income

Monthly
(m-1200)

52,1-85,12

1.937
(.31)

6.27

81,9

4.42**

2.

Personal
Income

Monthly
(m-1200)

52,1-81,12

2.364
(.33)

6.31

61,6

3.43**

3.

Personal
Income

Monthly
(m-1200)

62,1-81,12

1.573
(.39)

6.09

81,9

2.55

4.

Personal
Income

Quarter
(m=400)

52,1-85,4

1.904
(.27)

3.12

81,3

5.44**

5.

Personal
Income

Quarter
(m=400)

52,1-81,4

2.367
(.26)

2.87

61,4

4.19**

6.

Personal
Income

Quarter
(m=400)

62,1-85,4

1.10
(.30)

2.96

81,3

4.57**

7. GNP

Quarter
(m=400)

52,1-85,4

1.71
(.37)

4.29

62,1

3.55**

8. GNP

Quarter
(m=400)

52,1-81,4

2.12
(.39)

4.25

62,1

2.86

9.

Quarter
(m=400)

62,1-85,4

.93
(.40)

3.94

81,3

2.95**

10. Final
Sales

Quarter
(m=400)

52,1-85,4

1.89
(.28)

3.23

62,1

4.57**

11. Final
Sales

Quarter
(m-400)

52,1-81,4

2.19
(.28)

3.11

62,1

4.05**

12. Final
Sales

Quarter
(m-400)

62,1-85,4

1.14
(.31)

3.07

81,3

2.29

GNP




Sample
Period

59

s

k

LR
Statistic

TABLE 1.4 (continued)
Tests of the Stability of DS Models of Currency Velocity
m*[lnV

ln(vtl)] - a+ e
Full Sample
Drift Estimate
(Annual Rate)

Velocity
Measure

Data
Interval

Sample
Period

13. Personal
Income

Annual
(m-100)

52,1-85,1

1.96
(.35)

2.03

62,1

4.16**

14. Personal
Income

Annual
(m-100)

62,1-81,1

1.21
(.34)

1.67

81,1

3.97**

15. GNP

Annual
(m=100)

52,1-85,1

1.75
(.40)

2.35

62,1

3.34**

16. GNP

Annual
(m-100)

62,1-85,1

1.06
(.40)

1.97

81,1

2.84

17. Final
Sales

Annual
(m-100)

52,1-85,1

1.94
(.32)

1.86

62,1

4.83**

18. Final
Sales

Annual
(m=100)

62,1-85,1

1.21
(.31)

1.51

81,1

2.33




60

k

LR
Statistic

TABLE 1.5
(0,1,0) ARIMA Models of Currency Velocity
1952-85 with Constant Shifts
m*[lnV4
a + BD62 + 0T)82 + e
lnV
t-i>
Velocity
Measure

Data
Interval

6

a

e

d-w

Personal
Income

Monthly
(m=1200)

3.94
(.55)

-2.37
(.68)

-2.84
(.28)

6.09

2.09

2.

Personal
Income

Quarter
(m«400)

3.82
(.43)

-2.18
(.52)

-3.21
(.74)

2.70

1.60

3.

GNP

Quarter
(m-400)

3.56
(.64)

-2.16
(.79)

-2.78
(1.11)

4.05

1.65

4.

Final
Sales

Quarter
(m=400)

3.68
(.47)

-2.24
(.58)

-1.77
(.81)

2.99

1.82

5.

Personal
Income

Annual
(m-100)

3.77
(.45)

-2.09
(.55)

-2.84
(.78)

1.42

1.71

6.

GNP

Annual
(m=100)

3.41
(.62)

-1.90
(.76)

-2.67
(1.08)

1.96

2.22

7.

Final
Sales

Annual
(m=100)

3.68
(.44)

-2.17
(.54)

-1.76
(.77)

1.40

2.21




61

TABLE 1.6
(0,1,0) ARIMA Models of Adjusted Monetary Base Velocity
1952-85 with Constant Shifts
m*[lnV - l n V t l ] - a + BD82t + e
Velocity
Measure

Data
Interval

a

6

s

d-w

1.

Personal
Income

Monthly
(m-1200)

2.74
(.36)

-3.98
(1.04)

6.78

2.17

2.

Personal
Income

Quarter
(m-400)

2.74
(.28)

-4.20
(.82)

3.09

1.55

3.

GNP

Quarter
(m-400)

2.49
(.39)

-3.78
(1.13)

4.26

1.60

4.

Final
Sales

Quarter
(m-400)

2.55
(.31)

-2.78
(.90)

3.37

1.86

5.

Personal
Income

Annual
(m-100)

2.76
(.28)

-3.70
(.82)

1.55

1.95

6.

GNP

Annual
(m=100)

2.52
(.36)

-3.44
(1.03)

1.95

2.45

7.

Final
Sales

Annual
(m-100)

2.61
(.28)

-2.65
(.81)

1.52

2.19




62


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102