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____________ Review____________
Vol. 67, No. 3
March 1985
5 Why the Big Rise in Business Loans at
Banks Last Year?
14 Money Demand Dynam ics: Som e New
Evidence
24 The Federal Reserve Reaction Function:
Does Debt Growth Influence
M onetary Policy?
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Federal Reserve Bank of St. Louis
Review
M arch 1985
In This Issue . . .
In th e first article in th is Review, "W hy th e Big Rise in B u sin ess L oan s at Banks
Last Y ear?” R. Alton Gilbert an d M ack Ott exam in e th e rea so n s for th e u n u su al
p atte rn o f b u sin ess lo an s at large co m m ercial banks d uring th e cu rre n t e co n o m ic
exp an sio n . T h e au th o rs find that, b o th before an d after th e first h alf o f 1984,
b u sin ess lo an s w ere grow ing at rates sim ilar to th o se fo r co m p arab le p erio d s in
earlier ec o n o m ic ex p an sio n s. A surge o f b u sin ess lo an s at large co m m e rcia l banks
d uring th e first h a lf o f 1984, how ever, raised su ch lo an s above th e level th at w ould
have b ee n ex p ected on th e basis o f p ast cy clical p attern s.
Am ong th e p o ssib le exp lan ation s for th e surge in b u sin e ss lo an s in th e first h alf
o f 1984 is th e u nu su ally rapid rise in th e p a ce o f ec o n o m ic activity d urin g th at
p eriod ; th is co u ld have in d u ced an u nu su ally large rise in cred it d em an d by
b u sin ess firm s. Gilbert an d Ott do n ot find em p irical su p p o rt for th is exp lan ation .
In stead , they co n clu d e th at th e m o st im p o rtan t fa cto r co n trib u tin g to th e surge o f
b u sin ess lo an s w as ban k fin an cin g o f co rp o ra te m ergers an d leveraged bu youts.
Unlike th e o th e r exp lan ation s, b o th th e tim ing an d m agn itu d e o f th e u nu su ally
large am o u n t o f m ergers an d bu youts in early 1984 m a tch up w ith th e su rge o f
b u sin ess loans.
In th e seco n d article in th is Review, “M oney D em and D ynam ics: Som e New
E vid en ce,” D aniel L. T h o rn to n briefly reviews th e n atu re o f th e th ree stand ard
d ynam ic m o d els o f m o n ey d em an d a d ju stm en t. T h e a u th o r p o in ts out th at th ese
sp ecificatio n s are n ot statistically co m p arab le. In stead , h e n o te s th at th ese
m od els sh o u ld be co m p ared in term s o f th e ir co n fo rm ity w ith th eo ry an d th e ir
stability over tim e. E stim atin g th e se sp ecificatio n s for th ree su b p erio d s b etw een
II/1951-II/1984, T h o rn to n finds th at (1) all th ree sp ecifica tio n s are sensitive to the
sp ecificatio n o f th e long-run d em an d for m oney, (2 ) n o n e is co n siste n t w ith
th eo ry over all th ree su b p erio d s an d (31 n o n e exh ib its tem p o ral stability. He
co n clu d e s, how ever, that, sin ce n o n e o f th e se sp ecifica tio n s m ay ad equ ately
re p resen t th e sh o rt-ru n d em an d for m o n ey w h en estim a ted u sin g aggregate data,
th e resu lts m ay say little abou t th e instability o f m o n ey d em an d .
T h e p ro sp ect o f large federal d eficits has ren ew ed co n c e rn s abou t th e Fed eral
R eserve’s ability to co n d u ct in d e p en d e n t m o n etary policy. In th e th ird article in
th is issue, “T h e Fed eral Reserve R eactio n F u n ctio n : D oes D ebt G row th In flu en ce
M onetary P olicy?” R ichard G. S h eeh a n offers so m e evid en ce on th e ex ten t to
w h ich th e Fed eral Reserve h as altered m o n etary p o licy in re sp o n se to federal
deficits.
T h e relatio n sh ip s betw een th e deficit, th e m o n ey stock an d in terest rates
d ep en d on th e n atu re o f th e d eficit an d th e targeting p ro ced u res u sed by the
Fed eral Reserve. T h e a u th o r u ses a sim p le m od el to sh o w th a t a p o licy -in d u ced or
stru ctu ral d eficit m ay lead to h ig h er in terest rates u n d e r a m o n etary aggregate
targeting strategy o r to h ig h er m o n ey grow th u n d e r an in tere st rate targeting
strategy. In co n trast, a cy clica l deficit, in d u ced by a re cessio n for exam p le, will be
a cco m p an ie d by low er in terest rates o r slow er m on ey grow th.
Using a reactio n fu n ctio n ap p roach , Sh eeh a n finds evid en ce th at stru ctu ral
d eficits led to h ig h er m o n ey grow th before 1971 w h en th e Fed eral Reserve tar-
3
In This Issue . . .
Digitized
4 for FRASER
geted in tere st rates. Sin ce th en , th e Fed eral Reserve h as, at le a st in part, fo cu sed
on a m o n etary aggregate target, an d th ere is n o ev id en ce th at m o n ey grow th h as
b ee n in flu en ced by stru ctu ral d eficits. F urther, th ere is n o evid en ce suggesting
that h ig h er stru ctu ral d eficits have in crea sed in terest rates over any period .
Why the Big Rise in Business Loans
at Banks Last Year?
/{. Alton Gilbert and Mack Ott
B
u s in e s s loans at large commercial banks rose
sharply in the first half of 1984, after changing little in
the first year of the econom ic recovery from the 1 9 8 1 82 recession. Many analysts of business and financial
data cite the rate of growth of business loans at large
commercial banks as an indicator of the pace of eco
nomic activity.1 Given that interpretation, this pattern
of business loans would have signaled a sharp acceler
ation in econom ic activity in the first half of 1984. Some
analysts offer the alternative explanation for the rapid
rise in business loans that bank credit was being used
on an unusually large scale to finance corporate
mergers and leveraged buyouts.2 This article in
vestigates the empirical support for these alternative
explanations.
f t Alton Gilbert is an assistant vice president and Mack Ott is a senior
economist at the Federal Reserve Bank of St. Louis. Paul G. Chris
topher provided research assistance.
’See Berry (1984), Heinemann (1984), Jasinowski (1984) and Wei
ner (1984). In particular, Weiner recounts a banker as emphasizing
that
...loan demand has been real_It is being used to finance inventory,
plants and equipment — not mergers and acquisitions....
2See Giordano (1984). Economist Henry Kaufman is quoted by Busi
ness Week as crediting merger finance for the bulge in loans (see
“Do Mega-Mergers...” (1984)):
“Much of the recent credit growth was associated with the merger phe
nomenon." He says that merger activity explains why first-quarter busi
ness loans at large commercial banks showed an increase of $4.6 billion
rather than a decline, as they generally do at this stage of the business
cycle.
IS THE GROW TH OF BUSINESS LOANS
IN THE CURRENT EXPANSION ANY
DIFFERENT THAN IN PAST
EXPANSIONS?
The first step in analyzing the relationship between
the pace of econom ic activity and the growth of busi
ness loans is to examine the pattern of business loans
in the current expansion relative to the patterns in
previous expansions. If the pattern of business loans
in the current recovery is typical of the pattern in prior
expansions, alternative explanations such as bank
financing of mergers and buyouts are unnecessary.
Business loans by large (weekly reporting) banks
tend to stay at about the same level as at the recession
trough during the first year of a recovery period, with
this sluggish loan behavior giving way to moderate
growth in the second year (chart 1). Thus, for the first
year of the econom ic expansion following the 1 98 1-82
recession, the pattern of growth in business loans by
large commercial banks was similar to the pattern of
business expansions since 1960.
The growth of business loans at large banks in the
first half of 1984, however, was unusually rapid for that
stage of an econom ic expansion. By the spring of 1984,
the level of business loans, relative to their level at the
trough of the preceding recession, was substantially
above the average profile during previous expansion
5
FEDERAL RESERVE BANK OF ST. LOUIS
C hart
MARCH 1985
1
Business Loans at Large Commercial Banks Relative
to Levels at Recession Troughs
Retession Trough = 1.0
Av er a g e
—
1.2
Retession Trough = 1.0
1.2
- — Cur r ent cycl e
1.1
1.1
____
1.0
^____ y
v'—
.9
-
___ '
^
^
1.0
.9
S ’
.8
.8
1 1 1 I I ......................
-12
-10
-8
-6
-4
-2
1 1 1 1 1 II
0
2
4
6
1 1 1 1 1 ! 1 i II
8
10
12
14
16
1 1 11
18
20
II
22
24
Months to and from Recession Trough
NOTE: The shaded area represents the range of values observed in business cycles with reces
sion troughs in 1960 through 1975. The profile for the cycle around the 1980 trough was excluded
because its succeeding recovery did not last two years. The line labeled “ average” is the average
for these prior reference cycles.
Chart 2
Cycles in N o m in al GNP
Recession Trough = 1.00
1.24
Recession Trough = 1.00
1.24
. 9 2 ________ I_______ I________I_______ ________I_______ I_______ I_______ I_______ I________I________I----------- .92
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
Quarters to and from Recession Trough
NOTE: The shaded area represents the range of values observed in business cycles w ith recession troughs
in 1960 through 1975. Th e profile fo r the cycle around th e 1980 trough w as excluded because its suc
ceeding recovery did not last tw o years. The line labeled “ av era g e” is the average fo r these prior reference
cycles.
6
MARCH 1985
FEDERAL RESERVE BANK OF ST. LOUIS
Chart 3
Cycles in N onfarm Business Inventories
Recession Trough = 1.00
Recession Trough - 1.00
Quarters to and from Recession Trough
NOTE: The shaded area represents the range of values observed in business cycles with recession troughs
in 1960 through 1975. The profile for the cycle around the 1980 trough was excluded because its suc
ceeding recovery did not last two years. The line labeled “ average" is the average for these prior reference
cycles.
period s. Follow ing th e ir rapid ru n -u p during th e first
half o f 1984, th e grow th rate o f b u sin ess lo an s at large
banks h as b e e n clo se to th e average grow th rate during
co m p arable p erio d s o f exp an sio n . T h is ca n be see n by
th e parallel m ovem ent o f b u sin ess lo an s sin ce th e first
h a lf o f 1984 and that o f th e cy cle average. C o n se
quently, the only asp e ct o f th e grow th in b u sin ess
loan s by large co m m ercial banks that disting u ish es
the cu rren t ex p an sio n is th e rapid grow th in th e first
h alf of 1984.
PERHAPS ECONOMIC GROWTH WAS
UNUSUALLY RAPID LAST YEAR
T his u nu su ally rapid rise in b u sin ess lo an s in the
first h alf o f 1984 m ight reflect sim ply an u nu su ally
rapid rise in the p ace o f eco n o m ic activity. T h is p o ssi
bility is investigated in ch art 2 , w h ich p resen ts n o m i
nal GNP for several qu arters befo re an d after recessio n
trou ghs in ratio to n om in al GNP in trough qu arters. If
th e p ace o f e co n o m ic activity h ad b eco m e unusually
rapid by th e first h a lf o f 1984, th e ratio in ch a rt 2 for the
cu rren t ex p an sio n w ould b e su b stan tially above th e
range for previous ex p an sio n p eriod s. Yet, w hile the
ch art show s th at n om in al GNP did rise to th e top o f
th e range for previous referen ce cy cles d uring th e first
h alf o f 1984, it did n o t rise su b stan tially above the
range o f ex p e rie n ce in p rio r ex p an sio n period s.
An im portan t link b etw een th e p a ce o f eco n o m ic
activity and th e grow th o f b u sin ess lo an s involves the
grow th o f b u sin ess inventories. B u sin ess inventories
tend to rise w ith th e p ace o f ec o n o m ic activity during
ex p an sio n period s, an d b u sin e sse s co m m o n ly fin an ce
th eir inventory in v estm en t th rou gh b an k lo a n s .3 Thus,
th e u nu su ally rapid grow th o f b u sin ess lo an s last y ea r
m ight reflect an u n u su ally rapid grow th o f b u sin ess
in v en to ries. C h art 3, how ever, in d ic a te s th a t th e
grow th o f b u sin ess in v en tories h as n o t b e e n u nu su ally
rapid in th e cu rren t ex p an sio n . In fact, inventory ex
p an sion has b een slow er in this reco v eiy th an in any
recovery o f th e past 25 y ears.
3See Hicks (1980).
7
FEDERAL RESERVE BANK OF ST. LOUIS
MARCH 1985
Chart 4
R atio of Fixed Pius Inven to ry Investm ent to Intern al Funds
1952 54
56
58
60
62
64
66
68
70
Source: Board of Governors of the Federal Reserve System
NOTE: Data are for the nonfinancial corporate sector.
Shaded areas represent periods of business recessions.
C hart 4 provides an ad d itio n al p ersp ectiv e on th e
rise in th e d em an d for cred it by b u sin e sse s in th e
cu rren t and previous ex p an sio n s. T h is ch art plots the
ratio o f th e fixed an d inventory investm en t o f n o n
financial b u sin ess co rp o ratio n s to th e ir internally g en
erated funds. N onfinancial co rp o ratio n s requ ire ex ter
nal fin an cin g o f th e ir fixed an d inventory investm ent
w h en ev er th is ratio is above unity, bu t in tern ally g en
erated fund s su b stitu te for extern al fin an cin g w h en
ever this ratio is below unity.
As illu strated in ch art 4, in tern ally g en erated fund s
ten d to rise m ore rapidly th a n b u sin ess in vestm ent
during th e early stages o f ec o n o m ic exp an sio n s, so
th at th e ratio is belo w unity. After a few qu arters o f
expan sion , b u sin ess in vestm ent beg ins to ex ceed in
ternal funds, an d b u sin esses th e n m u st tu rn to ex ter
nal fin an cing. T h e relatio n sh ip betw een internally
g en erated funds and b u sin e ss investm en t is o n e o f th e
reason s for th e typical lag in th e grow th o f b u sin ess
loan s after th e beginn ing o f ec o n o m ic ex p an sio n s il
lu strated in ch a rt 1. C hart 4 clearly in d icates th at the
relatio n sh ip betw een b u sin ess investm en t an d in ter
http://fraser.stlouisfed.org/
8
Federal Reserve Bank of St. Louis
72
74
76
78
80
82
1984
nal funds in th e cu rren t ex p a n sio n is typical o f prior
exp an sio n s. T h u s, ch a rt 4 provides n o exp lan ation for
the u nu su al rise in b u sin ess lo an s in th e first half
of 1984.
Finally, co n sid e r th e co n tra st b etw een th e p attern
of b u sin ess lo an s at large an d sm all co m m ercia l banks
in th e cu rren t recovery. If b u sin ess lo an s at large
banks reflect th e in flu en ce o f th e p a ce o f eco n o m ic
activity on b u sin ess cred it d em an d , th e se effects
w ould ten d to b e sim ilar for b o th large an d sm all
banks. C hart 5 in d icates, how ever, th at th e p attern of
b u sin ess lo an s at small banks in th e cu rre n t ex p a n
sion is very sim ilar to th e p a ttern s in previous ex p a n
sio n s .4 T h u s, th e in flu en ces th at co n trib u te d to th e
u nu su ally rapid grow th o f b u sin ess lo an s at large
co m m ercial banks in th e first h alf o f 1984 did n ot have
sim ilar effects in bo o stin g th e grow th o f b u sin ess loan s
at sm all banks.
4The series on business loans of small commercial banks was calcu
lated by subtracting business loans of weekly reporting banks from a
series on business loans of all commercial banks.
FEDERAL RESERVE BANK OF ST. LOUIS
Chart
MARCH 1985
5
Business Loans at Small Commercial Banks Relative
to Levels at Recession Troughs
8 __I__I__I__I__I__I__I__I__I__I__I____I__I__I__I__I__I__I__I__I__I__L_l__I__I__I__I__I__I__I__I__I__I__I__
-12
-10
-8
-6
-4
-2
0
2
4
6
8
10
12
14
16
18
20
22
g
24'
Months to and from Recession Trough
NOTE: The shaded area represents the range of values observed in business cycles with reces
sion troughs in 1960 through 1975. The profile for the cycle around the 1980 trough was excluded
because its succeeding recovery did not last two years. The line labeled “ average" is the average
for these prior reference cycles.
Chart 6
Cycles in Nonfinancial Commercial Paper
-4
-3
-2
-1
0
1
2
Quarters to and from Recession Trough
3
4
5
6
7
8
NOTE: The shaded area represents the range of values observed in business cycles with recession troughs
in 1960 through 1975. The profile for the cycle around the 1980 trough was excluded because its suc
ceeding recovery did not last two years. The line labeled “ average" Is the average for these prior reference
cycles.
9
FEDERAL RESERVE BANK OF ST. LOUIS
MARCH 1985
Chart 7
Ratio of Funds Raised by Long-Term Borrowing
to Total Funds Raised by Borrowing1-1
Source: Board of Governors of the Federal Reserve System
LI The ratio of funds raised by issuing bonds and mortgages to total funds raised in the financial markets,
net of new equity issues.
NOTE: Data are for the nonfinancial corporate sector.
Shaded areas represent periods of business recessions.
PERHAPS THERE WAS A SHIFT IN
THE COM POSITION OF EXTERNAL
FINANCING BY BUSINESS FIRMS
T h e previous sectio n in d icates th at th e rapid rise in
b u sin ess lo an s at large banks last y ea r did n o t reflect
an u nu su ally rapid rise in th e d em an d for external
fin an cin g by b u sin ess firm s. T h e u nu su al p attern of
b u sin ess lo an s at large banks, therefore, m u st reflect
an u n u su al ch an g e in th e composition o f extern al
financing by b u sin ess firm s. T h is sectio n co n sid ers
various p o ssib le ch an g es in th e co m p o sitio n o f b u si
n ess fin an ce th at m ight a cc o u n t for th e rise in b u si
n ess lo an s at large banks.
A Shift to Bank Loans from Other
Forms o f Short-Term Credit
One p o ssib le shift m ay have involved an unusually
large re d u ctio n in sh o rt-term bo rrow in g by b u si
n esses from so u rces o th e r th a n co m m ercial banks.
T h is p ossibility is investigated by exam in ing th e p at
terns o f co m m ercial p ap er o u tstan d in g issu ed by n o n
fin an cial firm s in th e cu rren t an d previous eco n o m ic
10
exp an sio n s. C hart 6 in d ica tes that, ra th er th an d eclin
ing in th e first h a lf o f 1984, th e grow th o f n o n fin an cial
co m m ercial p a p e r d uring th at perio d w as relatively
rapid. T h u s, th e u nu su ally rapid grow th o f b u sin ess
loan s at large banks in 1984 d oes n o t reflect a shift of
b u sin ess cred it from th is type o f sh o rt-term cred it to
loan s at large banks.
A Shift from Long-Term to ShortTerm Debt
A nother p o ssib ility is th at n o n fin an cial b u sin ess
co rp o ratio n s re d u ce d th e ir issu a n ce o f lon g-term d ebt
to an u nu su ally large d egree in th e first h a lf o f 1984,
su bstitu tin g sh o rt-term for lo n g -term d eb t as a so u rce
o f funds. C hart 7 p re sen ts th e ratio o f fu n d s raised by
n o n fin an cial firm s by issu in g b o n d s an d m ortgages to
total fu n d s raised th rou gh borrow ing. T h is ratio has
fallen during th e cu rre n t e c o n o m ic exp an sio n , b u t its
d eclin e is sim ilar to th e d eclin es in p ast ex p an sio n
period s. C on sequen tly, th e u n u su ally rapid grow th of
b u sin ess lo an s at large ban k s d o es n o t ap p e a r to b e
the result o f an u n u su al ch an g e in th e co m p o sitio n of
sh o rt-term an d lon g-term d ebt as so u rces o f fund s for
n o n fin an cial b u sin ess co rp o ra tio n s.
FEDERAL RESERVE BANK OF ST. LOUIS
MARCH 1985
Chart 8
Ratio of N e t N e w Equity Issues to N e t Funds Raised
1952 54
56
58
60
62
64
66
68
70
Source: Board of Governors of the Federal Reserve System
NOTE: Data are for the nonfinancial corporate sector.
Shaded areas represent periods of business recessions.
Reductions in Corporate Equity
Accounts Financed Through
Short-Term Borrowing
O ne featu re o f b u sin ess fin an ce th a t d o es stan d out
as u n u su al in th e cu rren t ex p an sio n is th e large n ega
tive values for th e n et fund s raised by n o n fin an cial
firm s throu gh equity issu es (chart 8 ). A negative value
im plies that th e tran sactio n s th at reduced th e equity
cap ital a cc o u n ts on th e b alan ce sh e e ts o f so m e p u b
licly h eld co rp o ratio n s w ere larger th an th e funds
raised by o th e r su ch co rp o ratio n s throu gh n ew equity
issues. T h e net red u ctio n s in equity o f the n o n fin a n
cial co rp orate se c to r as a result o f fin an cial tra n sa c
tion s in ea ch o f th e first th ree q u arters o f 1984 w ere the
largest quarterly red u ctio n s ever in th e flow o f funds
data series. (T hese qu arterly d ata are available from
1952.) T h e co n tem p o ran eo u s, rapid rise in b u sin ess
loan s at large banks su ggests th at n o n fin an cial co rp o
rations fin an ced at least part o f th e tran sactio n s in
volved in red u cin g th eir equity a cc o u n ts through
lo an s from large banks.
Types o f financial transactions that reduce co rp o
rate equity — O ne type o f tra n sa ctio n th at co n trib u tes
72
74
76
78
80
82
1984
to a negative value for fu n d s raised th rou g h n et co rp o
rate equity issu es involves a b u sin ess buying back
sh ares o f its ow n co m m o n stock. A n oth er is co rp orate
equity red u ctio n s d ue to m ergers in w h ich th e sh a re
h o ld ers w ho sell th e ir sh ares receive c a s h .5 T h e re w ere
som e large m ergers involving c a sh p aym en t in 1984. In
re cen t y ears, leveraged b u yo u ts (LBOs) also have re
d u ced co rp o ra te equity cap ital a cc o u n ts. In an LBO,
an investor or group o f investors borrow s funds, often
from co m m ercial banks, to buy th e sh a res o f publicly
traded co m p a n ies an d con vert th em to privately held
co m p an ies. T otal p u b licly h eld co rp o ra te equity is re
d u ced by th e value o f th e co rp o ra tio n ’s equity w h en it
is taken private. A list o f large LBOs (each o f value over
$ 10 m illion) tabu lated by an in d u stry so u rce in d icates
that investors b orrow ed $13.5 billion to fin an ce LBOs
5For a cash purchase of its own stock, the corporation’s assets and
equity decline by the same amount. In the case of a purchase of its
own stock financed by borrowings, the debt liability rises by the
same amount as equity declines. When a merger is effected by one
corporation buying another with cash, the equity of the surviving
corporation will be the same as before the merger. Thus, aggregate
corporate equity is reduced by mergers effected through cash pay
ments to shareholders of the corporations being purchased.
11
MARCH 1985
FEDERAL RESERVE BANK OF ST. LOUIS
Chart 9
Stock Retirements and the Change in Business Loans
at Large Commercial Banks
1970
71
72
73
74
75
76
77
78
79
80
81
82
83
1984
Shaded areas represent periods of business recessions.
in 1984, up from $3.2 billion in 1982 and $2.8 billion in
1983.
equity retirem en ts by n o n fin an cial co rp o ra tio n s rose
su bstan tially in 1984 relative to th e p ast.
T h e negative values for net fund s raised throu gh
issuing eq u ities reflect tra n sa ctio n s th at re d u ce p u b
licly h eld co rp o rate equity. T h e m ag nitu d e o f th ese
tra n sa ctio n s can be m easu red by developing a series
o f stock retirem en ts. R etirem en ts are red u ctio n s in
co rp o ra te equity claim s held by th e p u blic as a result
o f (1 ) re p u rch a ses o f th e ir ow n sh ares by co rp oratio n s,
(2) m ergers tra n sa cted as ca sh p u rch a se s an d (3) LBOs.
R etirem en ts are co m p u ted as th e d ifference betw een
th e total fund s raised by co rp o ratio n s throu gh th e sale
o f n ew sh ares m inu s th e n et fund s raised through
equity is su e s .6 T h e n et fu n d s raised reflect th e retire
m en ts o f equity as a d ed u ctio n . As show n in ch a rt 9,
Magnitudes o f Equity Retirements and Changes in
Short-Term Debt — T h e tim ing o f th e equity retire
6The series on stock retirements should be considered an approxi
mation, rather than a census of retirements at all firms. The retire
ments series is negative in some quarters because of differences in
the transactions covered in the series on total funds raised by
nonfinancial corporations through the sale of new shares and in the
series on net funds raised through equity issues. The series on net
funds raised includes estimates of dividend reinvestments and con
versions of debt to equity, which are not reflected in the series on
funds raised through new equity issues. The series on retirements
has a downward bias because of these differences in its compo
nents.
12
m en ts show n in ch art 9, as w ell as th e ir cum ulative
m agnitude, m a tch es up w ith th e a n o m alo u s behavior
o f b u sin ess lo an s by large banks sh o w n in ch a rt 1. T h e
m agnitude o f th e ru n -u p in th e se lo a n s during th e first
th ree qu arters o f 1984 — over $26.5 billion — is about
40 p ercen t o f th e total value o f equity retirem en ts in
this period, $65.7 billion. Ind eed , th e largest q u a rter of
equity retirem en ts w as th e seco n d quarter, $30.2 bil
lion, w h ich w as also the largest loan deviation from
th e past p attern — a rise o f $14.5 billion in b u sin ess
loan s co m p a red w ith th e average o f $2.5 billion d uring
previous ex p a n sio n s .7
'Financing stock retirements is only one reason why businesses
borrow from commercial banks. Chart 9 indicates that, from 1970
through about 1976, there was no relationship between the patterns
of stock retirements and changes in business loans. The major
reason for the pattern of changes in business loans during that
period appears to be inventory investment financed through bank
loans. Businesses increased their inventories substantially in 1973
and 1974, then gradually reduced them during 1975 and 1976. For
an analysis of the determinants of business loan demand during that
period, see Gilbert (1976).
FEDERAL RESERVE BANK OF ST. LOUIS
CONCLUSIONS
B u sin ess lo an s o f large co m m ercial banks follow ed
th e u su al cy clical p attern d uring th e first y e a r o f the
cu rren t ec o n o m ic ex p an sio n . T hey rem ain ed at about
th e sam e level as at th e trou gh o f th e prior recessio n .
During th e first h alf o f 1984, how ever, b u sin ess loan s of
large co m m ercial banks ro se at rates ex ceed in g th o se
o f co m p arable p eriod s o f previous e co n o m ic ex p a n
sions, before resu m in g norm al grow th in th e seco n d
h alf o f 1984.
T h e u nu su ally rapid rise in b u sin ess lo an s at large
co m m ercial banks in th e first h a lf o f last y ea r d o es not
reflect an u nu su al rise in b u sin ess d em an d for ex ter
nal financing. T h e rise in th e p ace o f e co n o m ic activity
an d th e req u irem en ts o f b u sin ess firm s for extern al
fin an cing in th e cu rren t ex p an sio n have b een sim ilar
to p attern s in previous exp an sio n s. T h e m ost im p or
tant factor that a cc o u n ts for th e u nu su ally rapid
grow th o f b u sin ess lo an s in th e first h alf o f 1984 is th e
in crease in co rp o rate m ergers an d leveraged buyouts
fin an ced w ith lo an s from large banks. T hu s, o u r analy
sis o f th e p attern o f b u sin ess lo an s in th e cu rren t
MARCH 1985
eco n o m ic ex p an sio n in d ica tes th at th e grow th rate of
b u sin ess lo an s ca n b e an u n reliab le in d ica to r o f the
p ace o f eco n o m ic activity, sin c e it ca n b e in flu en ced
su bstantially bv ch a n g es in th e co m p o sitio n of ex ter
nal fin an cin g by b u sin ess firm s.
REFERENCES
Berry, John M. "Money Supply Figures on Target,” Washington
Post, July 13, 1984.
“Do Mega-Mergers Drive Up Interest Rates?”
16, 1984), pp. 176-80.
Business Week (April
Gilbert, R. Alton. “Bank Financing of the Recovery,” this Review
(July 1976), pp. 2-9.
Giordano, Robert M. “Financial Market Perspectives: Look Before
Your Leap,” Economic Research, Goldman Sachs Financial Mar
ket Research (July 1984).
Heinemann, Sally. “Fixed Income Markets Still Stabilizing,” New
York Journal of Commerce (June 18, 1984).
Hicks, Sydney Smith. "Commercial Banks and Business Loan Be
havior," Journal of Banking and Finance (June 1980), pp. 125-41.
Jasinowski, Jerry J. "Less Stockpiling, More Stability,” New York
Times, June 17,1984.
Weiner, Lisabeth. “Banks Lag Behind as Business Borrowing
Booms,” American Banker (August 22, 1984).
13
Money Demand Dynamics:
Some New Evidence
Daniel L. Thornton
J CONSIDERABLE em p irical w ork an d a significant,
b u t co n sid erab ly sm aller, volum e o f th eo retical effort
has b een devoted to th e q u estio n o f th e short-ru n,
d ynam ic a d ju stm en t o f th e d em an d for m oney. M uch
o f the im p etu s for th e em p irical w ork cam e from the
cla ssic stud y by C how (1966), w ho em ployed th e p ar
tial ad ju stm en t m odel to ch a ra cte riz e th e ad ju stm en t
o f a ctu al to d esired real m o n ey b alan ces.
C how an d th e alternative n o m in al m o n ey an d p rice
ad ju stm en t sp ecifica tio n s.- T h e se sp ecifica tio n s have
received co n sid era b le atten tio n in th e literatu re, w ith
m u ch o f th e em p irical w ork devoted to d eterm in in g
w h ich o f th e se sp ecifica tio n s is m o st co n siste n t w ith
th e data, for exam p le, G oldfeld (1976), Hafer an d Hein
(1980), Ju d d and Scad d in g (1982a), C oats (1983), Milb o u rn e (1983), H etzel (1984) an d M otley (1984).
Although th ere w as early co n c e rn over th e e c o
n o m ics o f C how 's sp ecificatio n and its relatively slow
estim ated sp eed o f ad ju stm en t, th is sp ecificatio n did
n o t co m e u n d e r p articu larly clo se scru tin y u ntil the
u n an ticip ated rise in velocity in the m id-1970s and the
d eclin e in velocity in th e early 1980s.1 As a result, a
n u m b er o f alternative d yn am ic a d ju stm en t sp e cifica
tion s have b ee n developed. W hile th e se sp ecificatio n s
differ in several fu n d am en tal resp ects, they fall into
two g en eral categ o ries: th o se th at assu m e th e p rice
level ad ju sts to exo g en o u s ch an g es in th e m on ey stock
and th o se th at assu m e th e n o m in al m oney stock ad
ju sts to exo g en o u s ch an g es in th e p rice level. C o n se
quently, th ree fu n d am entally different, sh o rt-ru n dy
n am ic a d ju stm en t p ro cesse s have b een co n sid ere d in
th e literatu re: th e real a d ju stm en t sp ecificatio n of
T h e p u rp o se o f th is p a p e r is th reefold . First, we
review th e literatu re on th e se sp ecifica tio n s an d point
out th at n o n e o f th em ca n b e th ou gh t o f as re p rese n t
ing ad equ ately th e sh o rt-ru n a d ju stm en t o f actual
to d esired m o n ey w h en ap p lied to aggregate data.
Second , w e d em o n stra te th at n o n e o f th ese th ree
sp ecificatio n s are d irectly co m p arab le statistically .3
C onsequently, th e relative p erfo rm an ce o f th e se alter
natives can b e a sse ssed only bv th e ir con form ity w ith
Daniel L. Thornton is a senior economist at the Federal Reserve Bank of
St. Louis. John G. Schulte provided research assistance. The author
would like to thank Tom Fomby for useful comments on an earlier draft.
’See, for example, Goldfeld (1976), Carr and Darby (1981), Coats
(1982), Laidler (1980, 1982, 1983), Chant (1976), Judd and Scadding (1982a, 1982b), Hetzel (1984) and Motley (1984).
Digitized
14 for FRASER
2Nearly all of the specifications that have been suggested in the
literature fall into one of these basic categories, at least to the extent
that they have the price level, nominal money or real money as the
dependent variables. Furthermore, many of the specific alternatives
are concerned with how the demand for real money balances ad
justs to changes in its arguments and, as such, are consistent with
any of the three fundamental adjustment processes considered
here.
3lt has been recognized, especially recently, that these alternatives
are nonnested, i.e., none can be obtained by placing restrictions on
any of the others. Consequently, most studies compare the fore
casts of real money [e.g., Hafer and Hein (1980) and Goldfeld
(1976)], or the residual sum of squares [e.g., Judd and Scadding
(1982a) and Coats] of alternative models. To date, only Motley
(1984) has recognized that the nominal and price specifications are
not comparable.
MARCH 1985
FEDERAL RESERVE BANK OF ST. LOUIS
theory and th e ir stability. Finally, w e investigate the
p erfo rm an ce o f ea ch sp ecificatio n u sing th e sam e data
and th e sam e estim atio n period, II/1951-II/1984. T h e
evidence suggests th at n o n e o f th e se sp ecificatio n s
have perform ed w ell over th e en tire period and n on e
have b een stable.
T h e p ecu liarity o f th is p ro cess w as quickly p oin ted
out by W alters (1967). He n o ted that, in th e aggregate,
m arket equilibriu m req u ires th at th e d em an d for real
m o n ey b a la n ces eq u als th e su pply o f real m oney. If the
n o m in al m o n ey sto ck is e x o g e n o u s, eq u ilib riu m
requires
T h e issu e o f tem p o ral stability is particu larly im p o r
tant if on e is to rely on sh o rt-ru n m o n ey d em an d in
form ulating sh o rt-ru n stabilizatio n policy. If th e shortrun d em an d for m o n ey is u nstable, th e n attem p ts to
stabilize ou tp u t an d p rices in th e sh ort run through
131 M /P* = m",
m on etary co n tro l will be u n su ccessfu l b ec a u se differ
en t levels o f ou tp u t and p rices will be co n siste n t w ith
a given stock o f m o n ey at d ifferent p o in ts in tim e. T h is
type o f sh o rt-ru n instability, how ever, d oes not rule
out the u sefu ln ess o f m o n eta iy co n tro l for achieving
e co n o m ic stabilization over th e lo n g er run.
DYNAMIC SPECIFICATIONS OF
MONEY DEMAND
All sh o rt-ru n m o n ey d em an d sp e cifica tio n s are
b ased on th e long-run d em an d for m oney,
111 m" = fix, a, u,l = fIZ,),
w h ere m d en o tes real m o n ey b alan ces, X is a set of
en d o g en o u s and exog en ou s variables w h ich usually
in clu d es som e m easu re o f real in co m e o r w ealth and
on e o r m ore in terest rates, an d a is a v ecto r o f u n
know n param eters. T h e erro r term is d en o ted by u. All
variables are in natu ral logs.
Chow based h is sh o rt-ru n sp ecificatio n on th e sim
ple and co n ven ient partial a d ju stm en t m ech an ism ,
(21 m , — m,_, = X lm 1' —
141 P, -
P, , = XIP,* - P,
T h e co m b in atio n o f eq u atio n s 3 an d 4 resu lts in a
sp ecificatio n that reflects W alters’ criticism o f the
Chow m od el an d exp licitly rep rese n ts th e so-called
p rice a d ju stm en t sp ecifica tio n co n sid ere d by G ordon
(1984), Laidler (19831, an d Hetzel.
Goldfeld (1973, 19761, on th e o th e r hand , argued
a g a in st C h o w ’s s p e c ific a tio n o n m ic r o e c o n o m ic
ground s. He co n te n d e d th at it is defective b eca u se it
im plies th at an individual ad ju sts real m o n ey b a la n ces
fully an d in sta n ta n eo u sly to p rice level ch an g es, but
only partially to m o n ey d em an d c h a n g e s .11 As an
alternative, h e offered th e n o m in al a d ju stm en t sp ecifi
cation,
151 M, - M, , = XIM;1 -
M,_,)
0 < X .< 1,
w here M '1d en o te s th e d esired level o f n om in al m oney.
He argued th at eq u atio n 5 m akes m o re sen se than
0 < X < 1.
He sp ecified his a d ju stm en t p ro c e ss on th e basis of
individual e co n o m ic behavior, arguing that individ
uals m ight ad ju st th e ir actu al stock o f real m oney
b a la n ces to th e d esired level in m u ch th e sam e way as
th ey m ight a d ju st th eir actu al stock o f c o n su m e r d u ra
bles to th eir d esired level. T h is sp ecificatio n h as b een
rationalized in a m icro eco n o m ic fram ew ork in w h ich
th e sp eed o f a d ju stm en t (X) is d eterm in ed by th e co st
o f bein g out o f equilibriu m relative to th e co st o f mov
ing to equilibrium [for exam ple, M otley (1967) and
Feige (1967)].
40ne could compare the ability of each model to forecast its depen
dent variable by, say, comparing percentage forecast errors (e.g.,
Hetzel). Such an exercise, while interesting, has little to say about
the demand for money. Moreover, no objective comparison can be
made, because there is no agreement about which variable is most
important.
w h ere M an d P* d en o te th e n o m in al m o n ey stock and
the long-run eq uilibriu m p rice level, respectively. If M
is fixed in th e aggregate an d th e p rice level is ad ju stin g
to ch an g es in M, eq u atio n 2 ca n b e th ou gh t o f as the
price a d ju stm en t eq u atio n :
Substituting equation 3 into equation 2 and holding M fixed so M, =
M ,, = M, the resulting expression is equation 4.
The reader should note that, while we have not changed notation,
the interpretation of X in equation 4 is fundamentally different from
that of equation 2. The same is true of the interpretation of \ in
equation 5 below.
6This is most easily understood by noting that combining equation 2
with equation 1 implies not only that the long-run demand for nomi
nal money is unit elastic with respect to price, but that the short-run
nominal demand is as well.
This aspect of the real adjustment specification is not odd if one
believes that money and bonds are close substitutes for each other,
i.e., if a strict Keynesian liquidity preference holds. If money and
fixed-dollar-denominated financial assets are held in some desired
proportion given the interest rate, an unanticipated change in the
price level will affect both money and financial assets proportionally
so that an individual’s relative holdings of financial assets and
money will be unaffected. This will hold in either a pure asset model
or in inventory theoretic transactions models. Thus, it is not unrea
sonable to assume that an individual’s demand for real money
holdings adjusts instantaneously (or at least very quickly) to unantic
ipated price level changes if one believes that the only link between
the real and financial sectors is the interest rate.
15
FEDERAL RESERVE BANK OF ST. LOUIS
eq u ation 2 , a priori, b ec a u se th e a d ju stm en t o f n o m i
nal m on ey to a p rice level ch an g e is partial rath er than
in sta n ta n eo u s as eq u atio n 2 im p lies .7
G ordon also argues for th e nom inal ad ju stm en t
sp ecificatio n on m icro eco n o m ic grounds." He m ain
tains th at th ere are no a d ju stm en t co sts asso ciated
w ith p rice-in d u ced ch an g es in real m on ey holdings
and, co n seq u en tly , th e only co sts involved in a d ju st
ing o n e ’s portfolio are th o se a sso ciate d w ith ad ju stin g
n om inal m o n ey b a la n c e s .'1
Laidler (1983) notes, how ever, th at w h en eq u atio n 5
is applied to aggregate data, on e co m m its th e fallacy o f
co m p ositio n if th e aggregate n om in al m on ey stock is
exogenous. Individuals are free to ad ju st th e ir n o m i
nal b alan ces, but so ciety as a w h ole is not. M oreover,
Hetzel observes th at applying eq u ation 5 to aggregate
d ata is tan tam o u n t to assu m in g th at th e p rice level is
exogenous to an en d o g en o u s n om in al m oney stock.
A ccord ing to th is in terp retation , th e m on etary au th o r
ity su p p lies th e n o m in al m o n ey b a la n ces d esired by
th e p u b lic w ith a lag. In th is co n tex t, th e n om inal
ad ju stm en t m odel is view ed as an eq u atio n re p rese n t
ing th e m arket equilibriu m , w h ere X is th e ad ju stm en t
p aram eter in th e so -called F ed eral Reserve reactio n
fu n ctio n ra th er th an th e sp eed o f ad ju stm en t of
m o n ey d em an d . Given th is in terp retatio n , m arket
equilibrium requ ires
(6) M'VP = m 11,
MARCH 1985
w here Mli d en o te s th e aggregate level o f n om in al
m oney b a la n ces d esired by th e p u b lic given th e p rice
level, P.
The Short-Run Specifications
T h e above eq u atio n s ca n b e u sed to o b tain th e th ree
sh ort-ru n m oney d em an d sp ecifica tio n s. E qu ation s 1
an d 2 can be co m b in ed d irectly to obtain
(7) m , = XflZ.I + I t - X l l m , ,1,
the real a d ju stm en t sp ecifica tio n o f C how (1966).
Likewise, w e ca n co m b in e eq u a tio n s 3 w ith 4, an d 5
w ith 6 , to o b tain w hat Laidler (1983) has term ed quasired u ced -form eq u atio n s:
(8 ) m, = XflZ.) + (1 —XHM,_, —P,)
and
(91 m, = XflZ.I + (1 —X)(M, —P, ,).
B ecau se, o sten sibly, all o f th e se eq u atio n s have real
m on ey on the left-h and side, it a p p ears th at th ese
m od els can b e co m p ared u sin g sta tistica l tech n iq u es.
T h is is in co rrect.
Note th at th e eq u atio n s 8 an d 9 co u ld ju st as w ell b e
specified and estim ated as
18'I M, = XflZ, I + ( 1 - X lM , , + XP,
and
(9') P, = -X f(Z ,l + (1 -X IP , , + XM,.
7By the same reasoning, one could argue that the nominal adjust
ment specification implies that individuals never fully adjust to ex
pected inflation — see Carr and Darby. Both of these characteriza
tions may be off the mark, however. A more reasonable model might
allow both price level and nominal money shocks to affect the
demand for money in the short run, but require them to average out
to zero in the long run. This has been suggested recently by Gordon.
For example, let (M? - P*) = f(Zt) and combine this equation with
equations 4 and 5. The result is an equation that can be estimated
given a further normalization rule: the residual sum of squares can
be minimized in the direction of M, or P,. Unfortunately, the results
are extremely sensitive to the normalization rule. In general, if one
normalizes in the direction of M„ the results are similar to (and often
not statistically distinguishable from) those of the nominal specifica
tion. If one normalizes in the direction of P„ the results are similar to
the price adjustment specification. These results are available upon
request.
8lt is not clear exactly how Gordon means this. Certainly, individuals
are free only to adjust their nominal money holdings since price must
be taken as given; however, Gordon cites the energy price shock as
his only example. He argues that the supply shock reduces real
income and, hence, the demand for real money (presumably pro
portionally) so that no portfolio disequilibrium occurs.
9Using the standard quadratic adjustment cost approach, it can be
shown that the nominal specification results if adjustment costs are
associated only with nominal money and if prices are given. See
Hwang (1984).
16
Comparing equations 7, 8' and 9' reveals that they all
have different dependent variables. Furthermore, no
trivial transformation exists that will make these equa
tions comparable; that is, regression equations cannot
be manipulated algebraically to change the left-handside variable to anything one pleases. Therefore, noth
ing can be said about which specification is preferred
based on comparisons of these specifications, despite
claims to the contraiy. (See the appendix for a more
detailed discussion.)
Alternatively, on e ca n n o te th at eq u a tio n s 8 ' an d 9'
make different a ssu m p tio n s about w h ich variable is
exog en ou s (i.e., p rices an d n o m in al m oney, re s p e c
tively). Sin ce, at best, only o n e o f th e se a ssu m p tio n s is
co rrect, co n siste n t estim a tes o f th e erro rs ca n b e o b
tained from only o n e o f th e se eq u atio n s. H ence, any
co m p ariso n b ased on the resid u als o f th e se two s p e c i
fication s is in ap p ro p riate. F u rth erm o re, th eo ry alon e
ca n n o t serve as a guide b eca u se , at th e m icro e c o
n o m ic level, th e a ssu m p tio n o f ex o g en o u s p rices
seem s m ost relevant, w hile in th e aggregate th e exoge
neity o f n om in al m on ey is m o st p lausible.
FEDERAL RESERVE BANK OF ST. LOUIS
EMPIRICAL RESULTS
B ecau se th e se alteratives are n ot statistically co m
parable, ea ch sh o u ld be evaluated for its co n siste n cy
w ith the theory an d its stability .1" E stim ates o f th e real,
n om inal and p rice a d ju stm en t sp e cificatio n s are p re
sen ted in th is sectio n . T h e estim ates rep o rted h ere
cov er th e period II/1952-II/1984, w h ich h as b ee n d i
vided into th ree su b p erio d s: II/1951-IV /1961, 1/1962IV/1973 and I/1974—II/1984. T h is division is som ew hat
arbitrary; n evertheless, it h as several a sp e cts w h ich
m ake it d esirable. First, th e tw o earlier su bp erio d s
co rresp o n d clo sely to p eriod s for w h ich Goldfeld
(1973) found th e b asic C how eq u atio n to be stable.
H ence, it will be in terestin g to co m p are th e estim ates
o f th e nom inal and p rice a d ju stm en t sp ecificatio n s
over th e se p erio d s. Second , IV/1973 m arks an observed
break in th e n om inal and real a d ju stm en t sp e cifica
tio n s." Third, all th ree p eriod s differ rath er signifi
can tly w ith re sp ect to th e grow th and variability o f
b o th m o n ey and p ric e s .12 Finally, d uring th e first two
periods, th e Fed eral Reserve w as relying alm ost ex clu
sively on an in terest rate target, w hile, in th e third
period, m o re co n sid eratio n w as given to m o n etary
aggregate targets. H ence, w e m ight ex p e ct to see som e
d eterio ration in th e p erfo rm an ce o f th e nom in al s p e c
ification over th e third period.
T h e real (R), nom inal (N) and p rice (P) ad ju stm en t
eq u atio n s are estim ated w ith ord inary least squ ares
(OLS) to facilitate co m p ariso n s a cro ss tim e period s.
D urbin's h -statistic is rep o rted to illu strate how the
erro r stru ctu re h as varied am on g sp ecificatio n s and
th rou gh tim e .13 Fu rth erm o re, all th e eq u atio n s w ere
estim ated w ith real m o n ey b a la n ces on th e left-hand
'““Consistency with the theory" means that the coefficients should be
statistically significant, correctly signed, and the adjustment coeffi
cient should obey its restriction. Thus, these equations are inter
preted (as they have been in the literature) as money demand
equations. It should be noted, however, that since equations 8' and
9' are really quasi-reduced forms, neither is a particularly likely
equation for explaining the nominal money stock or price level,
respectively. I am indebted to Tom Fomby for this observation. He
noticed that equation 9' did not capture the monetarist notion of a
long lag from money to prices.
"Hafer and Hein (1982) mark the break at IV/1973, while Lin and Oh
(1984) record it at 11/1974.
,2The variances (x 100) of M and P, respectively, are (0.3449,
0.4599), (3.2210, 1.8107) and (4.6474, 4.7701) for the three peri
ods. The simple correlations between M, and P, over these periods
are 0.9601, 0.9947 and 0.9911.
,3The equations also were estimated adjusting for first-order serial
correlation using a maximum likelihood, grid-search procedure to
estimate the coefficient of autocorrelation directly. In all instances,
the qualitative conclusions were unaffected by the serial correlation
correction.
MARCH 1985
side, so th at th e signs o f th e co efficien ts are th e sam e
for all sp e cifica tio n s .14 Also, sin ce th e n om in al and
p rice sp e c ific a tio n s re p re se n t o v er-id en tified , red uced -form eq u atio n s, th e rep o rted F -sta tistic is for a
test o f th e over-identifying restrictio n s; th e resu lts re
p orted are for eq u atio n s w ith th e restrictio n im
p o sed .” Finally, th e eq u atio n s w ere estim ated using
real in co m e (y), th e co m m ercia l p a p er rate (CPR) and
th e passb ook savings rate (PBR) as in d ep en d en t varia
bles. T h is sp ecifica tio n o f lon g-run m oney d em and
rep resen ts a fairly stan d ard version, follow ing Gold
feld (1973). T h e eq u atio n s are estim ated w ith and
w ithout th e PBR b ec a u se n u m ero u s stu d ies have
found that sim ilar variables have n ot b een statistically
significant over la ter p eriod s, for exam ple, Hafer and
H ein (1980), M ilb o u rn e an d Ju d d a n d S ca d d in g
(1982al.
The Three Adjustment Equations
E stim ates o f th e th ree a d ju stm en t sp ecifica tio n s for
th e th ree p eriod s ap p e a r in table 1. N eith er th e real
n o r th e n o m in al sp ecifica tio n s perform s w ell in the
early perio d u n less th e PBR is in clu d ed . Real in co m e is
insignificant in b o th eq u atio n s an d the over-identifying restrictio n is re je cte d at a very low sign ifican ce
level in th e n o m in al sp ecifica tio n w h en th e savings
rate is ex c lu d e d .16 Furth erm o re, b o th th e real and
n om in al sp ecifica tio n s p ro d u ce sim ilar estim a tes of
th e co efficien ts over th is period . T h e only striking dif
feren ce is th e ap p aren t first-o rd er serial co rrelatio n in
the n om in al sp ecificatio n , n ot p resen t in th e real
equation.
B oth th e real an d n om in al sp ecifica tio n s perform
well in th e last two p erio d s in th at all th e param eters
(save th e co n sta n ts) are sign ifican t and have th e a n tici
pated sign if th e PBR is exclu d ed . In clu d in g th e PBR
for th e I/1962-IV /1973 period, how ever, ten d s to in
crea se th e estim a ted co efficien t on real in co m e m ark
edly, w hile it re d u ce s it in th e 1/1974—II/1984 period.
Indeed, real in co m e is in sign ifican t in th e real sp ecifi
catio n in th e last period if th e PBR is in clu d ed .
In co n tra st w ith th e real an d n om in al sp ecificatio n s,
real in co m e is n ot significant in th e p rice a d ju stm en t
sp ecificatio n in th e first period . Fu rth erm o re, it is sig-
,4The adjusted R2s are calculated for their respective dependent
variable, however.
'5The over-identifying restriction for the nominal specification 8' is that
the coefficients on M ,, and P, sum to one. The over-identifying
restriction for this price specification is that the coefficients on P,_,
and M, sum to one.
l6The t-tests are one-tailed if the coefficient has an anticipated sign,
two-tailed otherwise.
17
MARCH 1985
FEDERAL RESERVE BANK OF ST. LOUIS
Table 1
Estimates of the Three Basic Adjustment Equations
Equation
Constant
y
CPR
PBR
Mw - P,.,
M,_, - P,
M ,-P _ i
h
R2
SEx 102
F
11/1951—IV/1961
R
N
P
.854*
(3.72)
.001
(0.06)
-.0 1 5 *
(4.62)
.674*
(3.19)
.129*
(3.20)
-.0 1 7 *
(5.83)
.610*
(2.79)
.001
(0.05)
-.0 1 2 *
(4.06)
.445*
(2.33)
.132*
(3.78)
-.0 1 5 *
(5.66)
.444*
(2.44)
.000
(0.04)
-.0 0 4 *
(1.77)
.424*
(2.31)
.034
(0.93)
-.0 0 5 *
(2.00)
-.034 *
(3.31)
.842*
(22.02)
1.52
.9418
.4828
—
.724*
(14.66)
0.96
.9537
.4310
—
.890*
(24.12)
2.99*
.9943
.4434
14.29*
.764*
(17.04)
2.55’
.9959
.3783
0.50
-.035 *
(3.95)
-.0 0 9
(0.95)
.917*
(29.87)
-0 .4 3
.9971
.3621
0.01
.880*
(17.87)
-0 .3 8
.9971
.3626
2.04
1/1962-1V/1973
R
N
P
.407
(1.21)
.094*
(2.54)
-.019 *
(4.50)
.730*
(2.20)
.188*
(3.98)
-.018 *
(4.79)
.051
(0.15)
.081*
(2.41)
-.0 1 4 *
(3.77)
.379
(1.09)
.159*
(3.42)
-.0 1 4 *
(4.08)
.385*
(2.84)
.020
(1.10)
-.007 *
(3.25)
.491*
(3.50)
.060*
(2.29)
-.007 *
(3.70)
-.0 7 3 *
(2.89)
.812*
(7.58)
4.26*
.9879
.5242
—
.651*
(5.72)
4.16*
.9896
.4853
—
.894*
(8.74)
3.90*
.9993
.4813
5.53*
.749*
(6.45)
4.45*
.9993
.4591
1.20
.903*
(19.11)
0.09
.9996
.2610
4.07
.841*
(15.45)
0.00
.9997
.2517
0.84
.894*
(16.11)
-0 .1 4
.8795
1.0080
—
.913*
(15.92)
-0 .5 0
.8809
1.0020
—
.941*
(19.93)
-0 .7 4
.9985
.8332
0.04
.939*
(19.30)
-0 .7 5
.9985
.8437
0.37
-.0 5 7 *
(2.32)
-.028 *
(2.08)
1/1974-11/1984
R
N
P
-.0 6 9
(0.20)
.096*
(4.13)
-.0 2 3 *
(4.20)
-.0 6 0
(0.18)
.057
(1.44)
-.024 *
(4.36)
-.0 0 5
(0.02)
.051*
(2.61)
-.0 1 1 *
(2.28)
- .0 1 3
(0.05)
.057*
(1.71)
-.011 *
(2.20)
-.1 4 6
(0.87)
.050*
(4.29)
-.014 *
(4.77)
-.1 3 3
(0.91)
-.001
(0.08)
-.015 *
(5.84)
.107
(1.21)
-.0 1 8
(0.24)
.139*
(3.55)
Absolute value of the t-statistic in parentheses. 'Significant at 5 percent level.
18
.962*
(33.83)
3.15*
.9995
.5055
19.61*
.988*
(38.11)
1.73
.9996
.4424
5.50*
MARCH 1985
FEDERAL RESERVE BANK OF ST. LOUIS
F urth erm ore, m u ch o f th e a p p aren t instability in
th ese sp ecificatio n s is a sso cia te d w ith th e scale varia
ble, th e co n sta n t term , th e PBR an d th e stan d ard error
itself, ra th er th an w ith th e CPR o r th e ad ju stm en t
coefficient.
Table 2
Likelihood Ratio Test Results
Tests of Equality of Parameters
Periods 1 and 2
Specification
PBR
No PBR
R
N
P
9.61
5.55
6.70
20.90*
13.63*
2.73
Periods 2 and 3
PBR
22.82*
10.30
42.28*
No PBR
22.48*
9.43
12.25*
Tests of Equality of Variances
Periods 1 and 2
Periods 2 and 3
Specification
PBR
No PBR
PBR
R
N
P
0.10
1.84
5.77*
0.01
0.49
4.67*
26.52*
20.07*
13.48*
No PBR
23.77*
17.67*
11.97*
‘Significant at the 5 percent level.
Critical values: x20S(1) = 3.84,
X205 (4) = 9.49,
X2m (5) = 11.07.
n ificant in th e se c o n d period, but only if the passbook
rate is in clu d ed , and, in th e third period, only if the
PBR is exclu d ed . In this in stan ce, th e PBR en ters w ith
th e w rong sign. Finally, th e over-identifying restrictio n
ca n n o t be re je cte d at th e 5 p e rce n t level d uring the
first two p eriod s in th e p rice sp ecificatio n , bu t is re
jecte d for th e I/1974-II/1984 period.
It is in terestin g to n o te that, although real in co m e is
n ot significant in th e p rice eq u atio n in th e first period
(or in th e seco n d if th e PBR is exclu ded ), th e stand ard
error from th is sp ecificatio n is low er th an th at o f ei
th er th e real or n om inal sp ecificatio n s. If on e thought
that all th ese eq u atio n s had th e sam e d ep en d en t vari
able, on e w ould co n clu d e in co rrectly that the price
equation is th e p referred sp e cifica tio n .17 M oreover, the
results are in c o n siste n t w ith L aid ler’s (1983) c o n je c
ture th at th e se eq u atio n s are so sim ilar that, if eith e r
the real o r n om inal sp ecificatio n s perform s well, then
so will the p rice sp ecification.'"
17Hence, it is not surprising that Coats and Judd and Scadding
(1982a) concluded that these specifications are preferred.
16ln fairness to Laidler, he goes on to argue that none of these specifi
cations is likely to be stable over time, a conjecture that our empirical
results support.
Formal Tests o f Stability
In o rd er to test the stability o f th ese sp ecificatio n s
through tim e, likelih ood ratio tests w ere perform ed on
general sp ecifica tio n s th at allow ed for d ifferences in
th e v arian ces o f th e eq u atio n an d th e co efficien t of
au to co rrelatio n as w ell as th e stru ctu ral p a ra m e te rs .19
T h e resu lts of te sts o f th e equality o f th e co efficien ts
an d v arian ces are p resen ted in table 2. T h e results
suggest that G oldfeld’s (1973) co n c lu sio n abou t the
stability o f th e real sp ecifica tio n over th e first two p eri
od s is critically d ep en d en t u p o n th e sp ecifica tio n of
th e long-run d em an d for m oney. If th e PBR is in
clud ed , the n ull h yp o th esis th at th e stru ctu ral p aram
eters are stable ca n n o t be re je cted . If it is exclu d ed , the
h yp oth esis is re je cte d . Fu rth erm o re, th e h yp o th esis of
stru ctu ral stability b etw een th e se co n d an d third p eri
od s is re je cte d for th e real sp ecifica tio n regard less o f
w h eth er th e PBR is in clu d ed .
T h e p rice a d ju stm en t sp ecifica tio n d oes n ot fare
m u ch better. W hile th e null h y p oth esis o f th e equality
o f th e stru ctu ral p aram eters ca n n o t be re je cte d for the
first two period s, th e in sig n ifican ce o f real in co m e in
eith e r period m akes th e resu lt o f little in terest. M ore
over, th e h y p oth esis is re je cte d decisively in a co m p a r
ison o f th e last tw o period s.
T h e results for th e n om in al sp ecifica tio n are m ore
encouraging. T h e null h yp o th esis is re je cte d during
the first period only if th e PBB is exclu d ed . M ore im
portantly, th e h yp o th esis is n o t re je c te d at the 5 p e r
mit is well known that the standard F-test for structural stability is
sensitive to heteroscedasticity. See Toyoda (1974) and Schmidt
and Sickles (1977). Thus, likelihood ratio tests were constructed to
allow for heteroscedasticity. This procedure is complicated by the
presence of statistically significant serial correlation across some of
the partitions. This was handled by obtaining maximum likelihood
estimates of the coefficient of autocorrelation over each partition.
The tests were conducted with the model transformed appropriately
to adjust serial correlation. If there was no statistically significant
autocorrelation in a subperiod, the untransformed data were used. If
there was prior evidence of serial correlation, the Prais-Winsten
transformation was used. If there was no evidence of prior serial
correlation, the initial observation was included unweighted (see
Fomby, Hill and Johnson (1984), p. 213, and Thornton (1984)].
Maximum likelihood estimates of the restricted model were obtained
using an iterative procedure. The resulting likelihood ratio statistics
are asymptotically distributed x2(J). where J is the number of
restrictions.
19
FEDERAL RESERVE BANK OF ST. LOUIS
MARCH 1985
Table 3
Estimates for the 1/1974-11/1984 Period With Dummy Variables for Credit Controls
Specification
Variable
R
N
P
Constant
-.1 4 1
(0.52)
-.1 5 5
(0.54)
-.1 0 2
(0.46)
-.0 9 9
(0.45)
-.0 8 1
(0.59)
-.1 0 0
(0.61)
y
.047
(1.50)
.095*
(5.02)
.050’
(193)
.048*
(3.17)
-.0 0 3
(0.18)
.052*
(4.58)
CPR
-.0 2 3 *
(5.16)
- .022*
(4.77)
- .009*
(2.41)
- .009*
(2.47)
-.0 1 5 *
(6.35)
-.0 1 3 *
(4.92)
PBR
.133
(1.89)
Mm - P
mm
m,
-
-
m
.933*
(20.18)
-.0 0 6
(0.11)
.148
(4.10)
.910*
(19.71)
.961*
(24.91)
p,
.961*
(25.64)
pm
.978*
(40.71)
.952*
(34.25)
Dummy 11/1980
- .038*
(4.66)
- .036*
(4.35)
- .028*
(4.27)
-.0 2 8 *
(4.35)
-.0 1 0 *
(2.50)
-.0 1 0
(1.91)
Dummy 111/1980
.011
(1.37)
.012
(1.40)
.019*
(2.79)
.019*
(2.83)
-.0 0 7
(1.78)
-.0 0 6
(1.23)
SE x 102
.7935
.8214
.6518
.6427
.4057
R2
.9253
.9200
.9991
.9991
.9997
h
.267
.811
.400
.414
.528
Coefficient equality
27.44*
24.59*
Variance equality
12.44*
11.73*
10.19
7.04*
.4868
.9995
2.713*
9.30
48.45*
13.87*
5.56*
8.61*
10.62*
Absolute value of the t-statistics in parentheses. 'Significant at 5 percent level.
ce n t level during th e latter period, regard less o f the
sp ecificatio n . T h e test statistic is bord erline, however,
esp ecially w hen th e PBR is exclu d ed . Fu rth erm ore,
th ere is a significant in crease in th e variance o f th e
sp ecificatio n as well as a m arked ch an g e in th e serial
co rrelatio n o f th e erro r stru ctu re. (T hese resu lts are
co n siste n t w ith re cen t findings o f Lin and Oh.I T h u s, it
ap p ears th at th is sp ecificatio n h as ch an g ed in som e
fun d am ental way during th e last period.
variance o f b o th th e real an d n o m in al sp ecifica tio n s
may be due to cred it co n tro ls. Given th e im p o rta n ce of
h etero sced a sticity in te sts o f p a ra m e te r stability, it is
im portan t that this p ossibility b e a cc o u n te d for. T h u s,
cred it co n tro l dum m y variables for II/1980 an d III/1980
w ere in clu d ed in all sp ecifica tio n s. (They w ere in
clu d ed in th e p rice sp ecifica tio n ou t o f cu riosity, sin ce
a priori it is difficult to d eterm in e th e ir effect on the
p rice level.)
The Impact o f Credit Controls
OLS estim ates o f th e se eq u atio n s fo r th e th ird p e
riod ap p ear in table 3. T h e likelih ood ratio sta tistics for
tests o f th e equality o f th e p aram eters an d v arian ces
over th e last tw o p eriod s also ap pear. In clu d in g th e
cred it co n tro l dum m y variables su b stan tially low ered
the estim ated stan d ard errors for th e real an d n om in al
sp ecificatio n s, as an ticip a ted ; how ever, th e red u ctio n
for th e p rice sp ecifica tio n (not surprisingly) is n o t as
large. B oth cred it co n tro l dum m y variables are signifi
can t in th e n o m in al sp ecificatio n , roughly eq u al in
All th ree sp ecificatio n s in d icate a significant in
crea se in th e v ariance o f th e eq u atio n during th e latter
period. Hein (1982I h as p resen ted so m e evid ence that
this ch an g e m ay be d ue in part to th e cred it co n tro ls of
1980; m ore recently, G ordon and Hafer and T h o rn to n
(1985) have show n that th e cred it co n tro ls had a sta tis
tically significant im p act on co n v en tion al m o n ey d e
m an d eq u ations. H ence, th is m arked in cre a se in th e
20
MARCH 1985
FEDERAL RESERVE BANK OF ST. LOUIS
Table 4
Estimates of the Nominal Specification
With M1 Net of OCD
1/1974-11/1984
1/1974-1V/1980
Constant
-.1 8 8
(0.48)
-.3 2 2
(0.59)
y
0.27
(0.58)
0.26
(1.18)
CPR
- .020*
(3.12)
- .007*
(1.80)
PBR
-.0 0 2
(0.01)
-.0 4 2
(0.34)
1.010
(25.70)
1.018
(13.27)
Dummy 11/1980
-.0 2 1
(1.65)
-.0 2 9
(4.94)
Dummy 111/1980
0.20
(1.65)
.014
(2.23)
M ,,- P ,
1.1691
.5194
R2
.9963
.9983
h
.159
SE x 102
-.3 3 3
Absolute value of the t-statistics in parentheses. 'Significant at 5
percent level.
m agnitude and o p p o site in sign. O nly th e first dum m y
variable is sign ifican t in eith e r th e real o r p rice sp ecifi
catio n s; its co efficien t in th e real m o n ey sp ecificatio n
is approxim ately equal to th e su m o f th e co efficien ts
o f th e n o m in al m o n ey an d p rice a d ju stm en t sp e c i
fications.
D espite th e obvious im p o rtan ce o f th e cred it c o n
trols to th ese sp ecificatio n s, esp ecially th e nom inalone, th e co n clu sio n s o f th e stability tests are not differ
en t from th o se rep o rted in table 2. C on sequen tly, the
cred it co n tro ls had no effect on th e o u tco m e o f tests
for stru ctu ral stability.
Additional Evidence on the PBR
T h e p erfo rm an ce o f th ese eq u atio n s is greatly af
fected by th e p re se n c e o r a b se n c e o f th e PBR. In p ar
ticular, it bears greatly on th e te sts o f th e stability of
the stru ctu ral co efficien ts o f th e n om in al an d real
sp ecificatio n s. T h e h yp o th esis o f stability is re je cted
over th e first two p erio d s and is bord erlin e over the
last two p erio d s if th is variable is exclu ded . F u rth er
m ore, th e sw itch o f th e PBR itself from statistical sig
n ifican ce to in sign ifican ce m ight be co n sid ered evi
d en ce o f instability. T h e sensitivity o f th e se sp e cifica
tion s to th e PBR co u ld have a so u n d e c o n o m ic basis or
b e a m ere sta tistica l artifact. If th e la tte r is co rrect, it
w ould ap p ear th at th e se sp ecifica tio n s have b ee n c o n
siderably le ss stab le tem p o rally th a n is gen erally su p
posed . C on sequen tly, th e role o f th is variable deserves
ad d itional a tten tio n .
Over m o st o fth e estim atio n period co n sid ere d here,
M l w as co m p o se d prim arily o f n o n -in terest-b earin g
d em an d d ep o sits an d cu rren cy . C on sequen tly, on e
cou ld argue th at th e PBR co n stitu ted an im portan t
op p ortu n ity co st variable — esp ecially over th e first
two p eriod s — an d th at th e eq u atio n s are seriously
m issp ecified if th is variable is exclu d ed . In th e last
period, how ever, th e PBR m ight b e co n sid ere d a proxy
for th e ow n rate, as in terest-b earin g tra n sa ctio n a c
co u n ts (paying ex p licit rates clo se to th e PBR) m ad e up
a large part o f M l .20
In o rd er to test th is exp lan ation , M l less o th e r
ch eck ab le d ep o sits (OCD) w as u sed in p la ce o f M l in
th e n o m in al sp e cifica tio n over th e last period . T his
m easure co rresp o n d s clo sely to th e old cu rren cv p lu s-d em a n d -d ep o sits d efin ition o f m on ey. If th e
above co n je c tu re is co rrect, th is sp ecifica tio n sh ould
perform w ell in th e se n se th at b o th real in co m e and
th e PBR sh o u ld e n te r significantly. If th e p erfo rm an ce
is poor, eith e r th ere h as b een an u nd erlying shift in
m on ey d em an d in th e m o st re ce n t period o r m on ey
d em an d has never b een stable.
T h is a p p ro a ch is lim ited by th e fact that th e p ro p o r
tion o f d em an d d ep o sits h eld by individuals d eclin ed
after th e n ation w id e in tro d u ctio n o f NOW a cc o u n ts in
1981. T his co u ld b ias th e resu lts for estim a tes over the
en tire I/1974-II/1984 period . T h u s, th e ad ju sted M l
m easu re w as estim a ted for th e en tire th ird p eriod and
for th e su b p erio d 1/1974—IV/1980.21 T h e results, re
p orted in table 4, sh o w th at n e ith e r th e PBR n o r real
in co m e e n te r sign ifican tly in th is eq u atio n for eith e r
tim e period. F u rth erm o re, th e a d ju stm en t coefficien t
is negative, in d icatin g an u n sta b le d yn am ic sp e cifica
tion. T h e resu lts are n ot co n siste n t w ith the c o n je c
ture th at th e PBR re p rese n ts a critica l variable in the
long-run d em an d for m on ey. T h u s, th e co n clu sio n
th at n o n e o f th e sh o rt-ru n m o n ey d em an d sp e cifica
tion s have b ee n stab le is m o re attractive.
“ The PBR might not be a good proxy for the own rate on NOW
accounts over this period because it does not account for service
charges associated with these deposits.
21The real and price specifications were estimated but not reported.
Also, the equations using adjusted M1 were estimated over the first
two periods but are not reported because they differ little from those
reported in table 1.
21
FEDERAL RESERVE BANK OF ST. LOUIS
SUMMARY AND CONCLUSIONS
T h is article h as d ealt w ith alternative sp ecificatio n s
o f th e sh o rt-ru n d em an d for m oney. It h as p o in ted out
that, although th ree b a sic form s o f th e d ynam ic ad
ju stm e n t o f m o n ey d em an d have b ee n co m p ared in
th e literatu re, they are n o t strictly am enab le to statisti
cal testing. T h e sp ecificatio n s w ere estim ated for th ree
su b p eriod s over th e perio d II/1951-II/1984. It w as
fou nd th at (1 ) all th ree sp ecificatio n s are very sensitive
to w h eth er th e passb ook savings rate is inclu d ed , (2 )
n o n e p ro d u ce resu lts co n siste n t w ith ec o n o m ic th e
ory for all th ree p erio d s an d (3) n o n e exh ibit tem poral
stability. W hile, strictly speaking, th e h yp o th esis o f
tem p oral stability co u ld not b e re je cte d at th e 5 p e r
ce n t level for G oldfeld’s n o m in al m o n ey a d ju stm en t
sp ecificatio n for th e last tw o period s, it cou ld be re
je c te d at a slightly h ig h er sig n ifican ce level. F u rth er
m ore, th e variance o f th is sp ecificatio n an d th e serial
co rrelatio n o f th e erro r stru ctu re ch an g ed signifi
can tly in th e last period.
MARCH 1985
Chant, John F. “Dynamic Adjustments in Simple Models of the
Transactions Demand for Money,” Journal of Monetary Economics
(July 1976), pp. 351-66.
Chow, Gregory C. “On the Long-Run and Short-Run Demand For
Money,” Journal of Political Economy (April 1966), pp. 111-31.
-------------- - "A Comparison of Alternative Estimators for Simultane
ous Equations,” Econometrica (October 1964), pp. 532-53.
Coats, Warren L., Jr. “Modeling the Short-Run Demand for Money
With Exogenous Supply," Economic Inquiry (April 1982), pp. 22239.
Feige, Edgar L. “Expectations and Adjustments in the Monetary
Sector,” American Economic Review (May 1967), pp. 462-73.
Fomby, Thomas B., R. Carter Hill and Stanley R. Johnson.
vanced Econometric Methods, (Springer-Verlag, 1984).
Ad
Goldfeld, Stephen M. “The Demand for Money Revisited,” Brook
ings Papers on Economic Activity (1973:3), pp. 577-638.
________ _ “The Case of the Missing Money,” Brookings Papers on
Economic Activity (1976:3), pp. 683-730.
Gordon, Robert J. "The Short-Run Demand for Money: A Reconsid
eration,” Journal of Money, Credit and Banking, (November 1984),
pp. 403-34.
Hafer, R. W., and Scott E. Hein. “The Dynamics and Estimation of
Short-Run Money Demand,” this Review (March 1980), pp. 26-35.
M oreover, th e stability test re su lts for b o th th e n o m
inal and real a d ju stm en t sp ecificatio n s over th e first
two p eriod s d ep en d critically on in clu d in g th e p a ss
book savings rate in th e sp ecificatio n o f long-run
m o n ey d em an d . Su b seq u en t investigation p ro d u ced
resu lts th at raise q u estio n s abo u t th e role th e p a ss
book rate h as played in m o n ey d em an d . If th e perfor
m a n ce o f th e p assbo o k rate in th e first tw o su bp eriod s
is m erely a statistical quirk, then, co n trary to co m m o n
belief, n e ith e r o f th e se sp ecificatio n s is stable over
th ese period s.
________ _ "The Shift in Money Demand: What Really Hap
pened?" this Review (February 1982), pp. 11-16.
T h e instability o f th e se p articu lar sp ecificatio n s is
n o t too su rprising w h en it is reco g n ized th a t they
rep rese n t red u ced form s o f th e d yn am ic ad ju stm en t
o f m oney and p rices, ra th er th a n stru ctu ral m on ey
d em an d eq u atio n s. C onsequently, w hile th e se sp ecifi
ca tio n s are stan d ard in th e literatu re, th e ir instability
m ay say little abou t th e in stability o f m o n ey dem and .
Thu s, o u r resu lts cast d oubt on th e u sefu ln ess o f th ese
sp ecificatio n s for sh o rt-ru n m o n etary co n tro l, w ithou t
in d ictin g m o n ey d em an d in g en eral o r u sefu ln ess o f
m on etary co n tro l for sh o rt-ru n ec o n o m ic stabiliza
tion. In any event, th e instability o f th e se eq u atio n s
certain ly d oes n o t p re clu d e th e u sefu ln ess o f m o n e
tary grow th targets in achieving lo n g er-ru n eco n o m ic
stability.
Judd, John P., and John L. Scadding. “Dynamic Adjustment in the
Demand for Money: Tests of Alternative Hypotheses,” Federal
Reserve Bank of San Francisco Economic Review (Fall 1982a),
pp. 19-30.
Hafer, R. W., and Daniel L. Thornton. “Price Expectations and the
Demand for Money: A Comment," Review o f Economics and Sta
tistics (forthcoming 1985).
Hein, Scott E. "Short-Run Money Growth Volatility: Evidence of
Misbehaving Money Demand?” this Review (June/July 1982), pp.
27-36.
Hetzel, Robert L. “Estimating Money Demand Functions,” Journal
of Money, Credit and Banking (May 1984), pp. 185-93.
Hwang, Hae-shin. “Test of the Adjustment Process and Linear
Homogeneity in a Stock Adjustment Model of Money Demand,”
processed (1984).
________ _ “The Search For A Stable Money Demand Function: A
Survey of the Post-1973 Literature,” Journal of Economic Literature
(September 1982b), pp. 993-1023.
Laidler, David E. W.
Press, 1982.)
Monetarist Perspectives. (Harvard University
________ _ "The 1981-82 Velocity Decline: A Structural Shift in
Income or Money Demand?” Monetary Targeting and Velocity,
Proceedings of a Conference held at the Federal Reserve Bank of
San Francisco (December 1983), pp. 100-03.
________ _ “The Demand for Money in the United States — Yet
Again," in Karl Brunner and Allan M. Meltzer, eds., On the State of
Macro-economics, Carnegie-Rochester Conference Series on
Public Policy (North-Holland, Spring 1980), pp. 219-71.
REFERENCES
Lin, Kuan-Pin and John S. Oh. “Stability of the U.S. Short-Run
Money Demand Function, 1959-81," Journal of Finance (Decem
ber 1984), pp. 1383-96.
Carr, Jack, and Michael R. Darby. “The Role of Money Supply
Shocks in the Short-Run Demand For Money," Journal of Monetary
Economics (September 1981), pp. 183-99.
Milbourne, Ross D. “Price Expectations and the Demand for
Money: Resolution of a Paradox,” Review of Economics and Statis
tics (November 1983), pp. 1287-305.
22
FEDERAL RESERVE BANK OF ST. LOUIS
MARCH 1985
Motley, Brian. “Dynamic Adjustment in Money Demand,” Federal
Reserve Bank of San Francisco Economic Review (Winter 1984),
pp. 22-26.
Thornton, Daniel L. "On the Treatment of the Initial Observation in
the AR(1) Regression Model," Federal Reserve Bank of St. Louis
Working Paper No. 84-003 (1984).
_________ “The Demand-for-Money Function for the Household
Sector — Some Preliminary Findings," Journal of Finance (Sep
tember 1967), pp. 405-18.
Toyoda, Toshihisa. “Use of the Chow Test Under Heteroscedastic
ity," Econometrica (May 1974), pp. 601-08.
Schmidt, Peter, and Robin Sickles. “Some Further Evidence on the
Use of the Chow Test Under Heteroscedasticity,” Econometrica
(July 1977), pp. 1293-98.
Walters, A. A. “The Demand For Money — The Dynamic Properties
of the Multiplier,” Journal of Political Economy (June 1967), pp.
293-98.
APPENDIX
T h e p u rp o se o f th is ap p en d ix is to show that eq u a
tion s 7, 8 and 9 m inim ize th e resid ual sum o f squ ares
in different d irectio n s and, b ec a u se o f this, th e re sid
uals from th ese sp ecificatio n s are not statistically
com p arable. T h is ap p en d ix draw s heavily on the work
o f C how (1964). C on sid er th e stand ard regression
m odel
Y = X (3 + u,
w here Y is a T by 1 v ecto r o f th e d ep en d en t variable, X
is a T by k m atrix o f in d e p en d e n t variables, (3 is a k by 1
v ecto r o f u nknow n p aram eters an d u is a T by 1 vecto r
of rand om errors. It is now co m m o n ly u nd ersto o d
th at th e least sq u ares estim ate o f th e v ecto r (3 is
g eom etrically th e p articu lar lin ea r co m b in atio n o f th e
regresso r variables th at m inim izes th e squ ared d is
ta n ce b etw een th e v ecto r Y and th e sp ace sp an n ed by
th e co lu m n s o f X. It is less well know n that this e sti
m ate is obtain ed by im p o sin g a p articu lar d irectio n
an d sca le n o rm alizatio n rule. To see this, co n sid e r th e
m ore general m od el
(3,Y, + [3,Y2 —
+ U,
w here Y„ Y,, X, and X, are T by 1 vectors w ith scalar
param eters (3,, |32, jjl, and (x2. C how n o tes that estim ates
o f th e p aram eters o f th is m od el cou ld be o btain ed by
least squ ares by p ro jectin g the lin ear co m b in atio n of
th e Y’s (that is, P,Y, + (3,YJ on th e sp ace sp an n ed by X,
an d X2. In th is case, least sq u ares estim ates w ould be
ob tain ed by p ro jectin g th e v ecto r (3,Y, + (3,Y, in the
d irectio n o f (X,XJ. T h is w ould esta b lish th e d irectio n n orm alization . O n ce th is is a cco m p lish ed , th e scale
ca n b e o b tain ed by ch o o sin g an y scale-n o rm alizatio n
(for exam ple, (3„ (3,, |x, or |x, = 1). In th is case, d irectio n n orm alization an d scale-n o rm alizatio n are sep arate.
C how p o in ts out, how ever, th at if th e re strictio n (3, = 1
w ere im p o sed b efo re th e m inim ization , th e v ecto r Y,
alon e is p ro jecte d o n th e sp a ce sp a n n ed by (Y2 X, X J.
Th at is, th e analyst is assertin g th a t th e v ecto r Y„ h as a
m ean v ecto r in th e sp a ce (Y, X, X J an d an additive
rand om erro r orth o g o nal to th e sp a ce sp a n n ed by (Y,
X, X2). Alternatively, if th e re strictio n (3, = 1 w ere im
posed , th e least sq u a res estim a tes w ould b e o b tain ed
by p ro jectin g th e v ecto r Y, on th e sp a ce sp a n n e d by (Y,
X, X J. T his w ould im ply th a t th e analyst view ed Y, as
having a m ean v ecto r in th e sp a ce (Y, X, X J an d an
additive ran d om erro r v ecto r orth o g o n al to (Y, X, X J.
Clearly, th e resid u al vecto rs ob tain ed from th ese
different orth ogonal p ro je c tio n s are in gen eral differ
en t ran d om variables an d are, th erefo re, n o t co m p a ra
ble. T h e sam e is tru e o f erro r v ecto rs from eq u atio n s 7,
8 an d 9. We ca n estab lish th is by n oting that m inim iza
tion is o b tain ed after im p o sin g d ifferent restrictio n s
(norm alization rules). F o r exam ple, th e im plicit co ef
ficient on (M-P), is set equal to o n e in eq u ation 7.
Likewise, th e co efficien ts on M, an d P„ respectively, are
set equal to o n e in eq u atio n s 8 an d 9.
23
The Federal Reserve Reaction
Function: Does Debt Growth
Influence Monetary Policy?
Richard G. Sheehan
T
M . HE p ro sp e ct o f fed eral governm ent d eficits to ta l
ing $907 billion b etw een 1985 an d 1990 h as renew ed
d oubts abou t th e Fed eral R eserve’s ability to co n d u ct
in d ep en d en t m o n etary p olicy. O ften im plicitly u n d e r
lying th e se d o u bts is th e fear th at in crea ses in federal
debt will drive up in terest rates an d slow eco n o m ic
grow th in th e a b se n c e o f ex p an sio n ary m on etary p o l
icy. Given th e m agnitu d e o f p ro jecte d federal deficits,
m any an alysts are co n c e rn e d th at th e Fed eral Reserve
m ay feel obliged to in crea se th e m o n ey stock faster
than it oth erw ise w ould to keep in terest rates from
rising.'
It is th e p u rp o se o f this p ap er to offer som e evidence
on th e ex ten t to w h ich th e F ed eral Reserve h as altered
m o n etary p o licy in re sp o n se to fed eral d eficits .2 T h e
focus h ere is to d eterm in e if m onetary policy h as re
a cted to fed eral d eficits in a co n siste n t m a n n er over
tim e. T h e sensitivity o f m o n etary actio n s to debt
grow th is co n sid ered over different tim e p eriod s and
Richard G. Sheehan is an economist at the Federal Reserve Bank of
St. Louis. Larry J. DiMariano provided research assistance.
'Sargent and Wallace (1981) have gone so far as to argue that the
Federal Reserve has only a choice between increasing the money
stock sooner or later. While Darby (1984) has disputed this conten
tion, the issue apparently remains unresolved. See Miller and
Sargent (1984).
2The process of a debt increase directly leading to expansionary
monetary policy is often labeled "monetizing the debt." Given the
ambiguities surrounding that phrase, it is not used here. See Thorn
ton (1984) for a detailed explanation of alternate definitions of the
phrase.
24
u n d er alternative m easu res o f m on etary a ctio n s and
debt.
MONETARY POLICY AND DEBT
T h e textbook view o f th e relatio n sh ip betw een m o n
etary policy an d fed eral d eb t ca n b e d em o n stra ted in
the co n tex t o f a sim p le co m p arative sta tic m o n ey m ar
ket m odel, w h ich is su m m arized in figure 1. Let us
assu m e th at m o n ey d em an d (MD) is a fu n ctio n o f the
in terest rate an d th e level o f in co m e an d th at th e
Fed eral Reserve ca n effectively fix th e m on ey su pply
(MS). W ith so m e initial level o f in co m e, m o n ey d e
m and an d su pply fu n ctio n s m ay b e rep resen ted by
MD„ an d MS„, respectively. Given a stru ctu ral (or exog
en o u s o r active) ch a n g e in fiscal policy, say, an ex p a n
sionary a ctio n in creasin g th e deficit, in co m e will rise
in th e sh ort ru n .3 T h is in crea se in in co m e, in turn, will
lead to an in crea se in m on ey d em an d , shifting th e
m on ey d em an d curve from MD„ to MD, in figure 1 an d
driving u p in terest rates. If th e F ed eral Reserve is
o peratin g w ith a m o n etary aggregate target, m o n etary
policy will not resp o n d to th e deficit. T h e stru ctu ral
3A change in fiscal policy, that is, a change in the behavior of fiscal
policymakers, is considered structural, exogenous or active. Thus, a
fiscal-policy-induced change in the deficit, as one measure of fiscal
policy, also is considered exogenous. It is assumed that the fiscal
policy change and resulting deficit change are not prompted by a
change in the business cycle. A change in the deficit resulting from a
change in, say, real GNP is considered cyclical, endogenous or
passive. See Tatom (1984) for a more extensive discussion of the
distinction between active and passive deficits.
FEDERAL RESERVE BANK OF ST. LOUIS
F ig u r e 1
Comparative Static M o n e y M arket M odel
MARCH 1985
eral fund s rate as its target, th e in cre a s e in th e stru c
tural d eficit an d th e resu lting in crea se in m o n ey d e
m an d w ill p ro m p t it to re sp o n d d ifferently. T h e
in crea se in in tere st rates as m o n ey d em an d in crea ses
from MD„ to MD, w ould lead th e F ed eral Reserve to
in crea se th e m on ey su pply (from MS„ to MS,) suf
ficiently to drive in tere st rates in g en eral an d th e fed
eral fund s rate in p a rticu la r b ack to th e ir original lev
e ls :’ W ith an in terest rate target, th e exo g en o u s d eficit
in crea se w ould n o t in flu en ce th e in tere st rate but
w ould in crea se the m o n ey stock.
If th e Fed eral Reserve h as n o t follow ed a p u re in ter
est rate o r m on etary aggregate target bu t in stea d has
follow ed a m ixed strategy u sin g both , a stru ctu ral defi
cit w ould still shift th e m o n ey d em a n d curve o u t as
before, bu t th e m o n ey su p p ly curve w ou ld shift out
only partially, say, from MS„ to M S ,.8 T h u s, th e stru c
tural debt in crea se w ould lead to b o th h ig h er in terest
rates an d h ig h er m o n ey grow th.
d eficit will n ot alter th e m on ey stock bu t will in crease
the in terest rate from r„ to r,.J
W ith cy clical (or en d o g en o u s or passive) fiscal p o l
icy ch an g es, how ever, th e im p act o f ch an g es in th e
stru ctu ral d eficit is qu ite different. A ssum e th e e c o n
om y en ters a re cessio n as a result o f a n o n -p o licy
sh o ck to th e system . T h e au to m atic stabilizing p ro p e r
ties o f federal taxes and ex p en d itu res will lead to a
cy clical in crea se in th e d eficit as in co m e d eclin es.
Further, th e d eclin e in in co m e w ill re d u ce th e d e
m an d for m oney, shifting th e m o n ey d em an d sc h e d
ule, say, from MD, to MD„ in figure 1. Again, if the
Fed eral Reserve is u sing a m o n etary aggregate as its
target, th e m o n ey stock will rem ain co n sta n t. An in
crea se in th e cy clical d eficit will now be acco m p an ied ,
however, by a red u ctio n in th e in terest rate from r, to
r„. W ith a m o n eta iy aggregate target, th is m od el im
plies that stru ctu ral d eficits will lead to in crea ses in
th e in terest rate, w hile cy clical d eficits will be a cc o m
pan ied by d ecrease s in th e in terest rate.
In co n trast, if th e Fed eral Reserve is using th e fed-
4This discussion assumes loanable funds demand is not completely
elastic. It further assumes the Federal Reserve is focusing on a
monetary aggregate and will not change its desired value of that
aggregate in the face of temporary fluctuations in income.
W ith a federal fun d s target an d an in crea se in the
cy clical d eficit lead in g to a d ecrea se in m o n ey d e
m an d from MD, to MD„, th e Fed eral Reserve w ould
d ecrea se th e m o n ey stock from MS, to MS,, to keep the
in terest rate u n ch an g ed . W ith a m ixed targeting stra t
egy an d an in crea se in th e cy clica l deficit, th e m o n ey
su pply w ould b e ex p e cted to shift partially dow nw ard
from MS, to MS,. T h u s, th e in crea sed d eficit w ould be
acco m p a n ied by a lo w er in terest rate an d a low er
m on ey supply.
W h eth er an in crea se in th e d eficit is a cco m p a n ie d
by in crea ses o r d e crea se s in th e m o n ey stock and
in terest rates d ep en d s on th e so u rce o f th e d eficit and
on th e m a n n er in w h ich th e Fed eral Reserve is c o n
d u ctin g policy. T h e alternatives are su m m arized in
table 1 .
It sh o u ld b e n o ted th at a given d eficit m ay co m b in e
stru ctu ral an d cy clica l elem en ts. In that case, the im
p act o f th e d eficit o n th e in tere st rate is am bigu ou s if
th e Fed eral Reserve targets on a m o n etary aggregate;
its im p act on th e m o n ey su p p ly is am bigu ou s if the
Fed targets on in terest rates. B oth im p acts w ould be
am bigu ou s w ith a m ixed targeting p ro ced u re. Further,
th ere is n o g u aran tee th at th e Fed eral Reserve has
follow ed (or will follow) a co n siste n t p attern o f target-
5lf the Federal Reserve is operating with an interest rate target, it is
also necessary to assume that the Federal Reserve believes that
money changes can alter interest rates — as they do in this simple
model — and that the Fed has a willingness to alter the money stock
based on that belief.
6Lombra and Moran (1980) cite evidence suggesting this is typical of
Federal Reserve behavior.
25
FEDERAL RESERVE BANK OF ST. LOUIS
MARCH 1985
Table 1
Expected Coefficient on Debt Term in
Measures of Monetary Policy
Structural
debt
increase
Cyclical
debt
increase
Combination
debt
increase
Monetary
aggregate target
M
r
0
+
M
r
0
-
M
r
0
?
Interest rate
target
M
r
+
0
M
r
-
M
r
0
Mixed targeting
procedure
M
r
+
+
M
r
-
M
r
?
?
0
—
?
ing on either. T h u s, th e d ebt co efficien t n eed not be
stable over tim e.
From 1958 to 1984, th e Fed eral Reserve in term ed iate
policy targets ap p aren tly u nd erw en t su bstan tial revi
sion. F o r exam ple, th rou gh th e 1960s, it is generally
assu m ed th at th e Fed eral R eserve’s prim ary co n c e rn
was co n tro llin g in terest ra te s .7 M onetary aggregates
began to receive m ore atten tio n in th e early 1970s.
From O cto b er 1979 to O cto b er 1982, th e re w as an em
ph asis on m o n etary aggregate targeting; sin c e th en
aggregate targeting h as b e c o m e m ore flexible w ith less
p ro m in en ce given to M l.” T h u s, at least fou r regim es
can b e id entified : (1) from 1958 to approxim ately 1970,
ch a ra cte rized by in terest rate targeting, (21 from the
early 1970s to O cto b er 1979, a m ixed targeting strategy,
(3) from O cto b er 1979 to O cto b er 1982, a m onetaryaggregate target, an d (4) from O cto b er 1982 to the
p resen t, again a m ixed targeting strategy. W hile it
w ould prove fruitful to ex am in e “reactio n fu n c tio n s”
estim ated sep arately over e a c h o f th e se period s, the
sh ort tim e fram es o f th e la tte r tw o p eriod s p reclu d e
that op tion. T hu s, th e sam p le is divided into two subperiods, th e first p rio r to 1971 ch a ra cte riz ed by in ter
est rate targeting an d th e se c o n d from 1971 w ith a
greater focu s on m onetary aggregates.
THE “REACTION FUNCTION”
APPROACH
T h ere have b ee n a n u m b er o f previous stu d ies that
have exam in ed th e relatio n sh ip b etw een m onetary
7See Lombra and Moran (1980) and Wallich and Keir (1979).
8See Thornton (1983) and the sources cited there.
26
policy an d fed eral d eficits. M ost o f th e se stu d ies fall
u n d er th e gen eral h ead in g o f estim atin g a “rea ctio n
fu n c tio n ” for th e Fed eral Reserve." T h e re a ctio n fu n c
tion a p p ro a ch assu m es th at th e Fed eral R eserve’s p o l
icy a ctio n s are b a sed on its goals, its m o d el o f th e
eco n o m y an d th e co n stra in ts th at th e m od el im plies.
Thus, th e estim ated rea ctio n fu n ctio n is b ased im p lic
itly — o r exp licitly in th e ca s e o f M cM illin an d B eard
(1980) — on o u tp u t an d fin an cial m arket m od els, to
geth er w ith a ru le (that is, an a ssu m p tio n abou t h ow
the Fed will rea ct to d istu rb a n ces to rea ch its goals) for
d eterm in in g Fed eral Reserve behavior. C om bining the
behavioral assu m p tio n s o f th e p o licy rule w ith th e
output an d fin an cial m arket m o d els p red icts h o w th e
Fed eral Reserve will re a ct to d istu rb a n ces to th e e c o
n o m ic system — h en ce, a “re a ctio n fu n c tio n .”
Previously estim ated re a ctio n fu n ctio n s have dif
fered w ith re sp e c t to th e c h o ic e o f d ep e n d en t and
in d ep en d en t variables, th e fu n ctio n al form em ployed,
the tim e period u sed for estim atio n an d the c o n c lu
sio n s b a se d on th a t e stim a tio n . T h e y also have
reach ed different co n c lu sio n s abou t th e stability o f
the estim ated re a ctio n fu n ctio n . T h u s, it is useful to
briefly survey previously estim ated rea ctio n fu n ctio n s.
T h ree variables co m m o n ly have b ee n em p loy ed as
th e d ep e n d en t variable, th at is, as th e m e a su re o f m o n
etary policy. N iskanen (1978) an d B arro (1977) am on g
oth ers u se a m e a su re o f th e m o n ey stock, M l, a ssu m
ing that th e m o n ey sto ck is th e b est in d ica to r o f m o n e
tary policy d uring th e p eriod o f estim atio n . Froyen
(1974), Levy (1981), an d B arth, Sickles, an d W iest (1982)
u se th e m on etary b a se in stead , co n ten d in g th at the
b ase co rresp o n d s m o re clo sely to o p en m arket o p era
tion s and is a good m easu re o f ex o g en o u s m onetary
policy a ctio n s. T h e th ird alternative, u sed by Abram s,
Froyen, an d W aud (1980), D eR osa an d Stern (1977), and
Havrilesky, Sapp, an d Sch w eitzer (1975), is th e federal
fund s rate. T h ey argue th a t th is variable is a m ore
ap p rop riate m easu re o f m o n etary p o licy in p erio d s in
w h ich th e F ed eral Reserve is targeting on in terest
rates. T h ey fu rth er co n te n d th at th e F ed eral Reserve,
in fact, h as targeted in tere st rates d urin g m o st o f th e
post-W orld W ar II period.
Previously estim ated re a ctio n fu n ctio n estim ates
also have u sed a w id e range o f in d e p en d e n t variables
an d have a ssu m ed altern a te goals o f th e F ed eral Re-
9For example, see Allen and Smith (1983), Barth, Sickles, and Wiest
(1982), Froyen (1974), Hamburger and Zwick (1981, 1982), Levy
(1981), McMillin and Beard (1980, 1982). Two studies that do not
use the reaction function approach are Dwyer (1982) and Thornton
(1984). For a detailed statement of the deficit problem, see Tatom
(1984).
MARCH 1985
FEDERAL RESERVE BANK OF ST. LOUIS
serve (e.g., p rice stability, low u nem p loy m en t, high
real grow th rates and fin an cial m arket stability). M ost
previous stu d ies have u sed ord inary least squ ares
(OLS) estim atio n te ch n iq u e s, and in d ep en d en t varia
b les generally are in clu d ed w ith n o m o re th an one
lag."'
T h e estim atio n resu lts have b een in co n sisten t in a
n u m b er o f resp ects. For exam ple, u sing th e m onetary
b ase as th e policy m easu re, Allen an d Sm ith (1983)
found that th e u nem p loy m en t rate w as significant,
w hile Levy (1981) fou nd it in significan t. On th e im p act
o f th e debt, in clu d ed as a m easu re o f fin an cial m arket
stability, Levy co n clu d e d th at d ebt grow th influ en ced
m on etary policy, w hile H am burger and Zwick (1981)
re a ch ed exactly th e o p p o site co n clu sio n . On th e sta
bility o f th e estim ated reactio n fu n ctio n , Allen and
Sm ith (1983) argued in favor o f a stable relatio n sh ip ;
Abram s, Froyen, an d W aud (1980) rep o rted findings of
instability. It is u n c le a r to w hat ex ten t th e se differ
en c e s are due to d ifferent sam p le periods, th e ch o ice
o f in d ep en d en t variables, th e sp ecificatio n o f th e m o n
etary policy variable o r th e u se o f d ifferent fu nctional
form s."
N either o f th e se tw o m easu res is a p erfect in d ica to r
o f th e p ressu re on th e F ed eral Reserve to a lter policy
in re sp o n se to ch a n g es in fed eral d ebt. NFD is p o te n
tially in flu en ced by m a cro e co n o m ic sh o ck s, w h ich
m ay also have an im p act on (or be th e result of) m o n e
tary policy. T h u s, NFD in clu d es b o th stru ctu ral and
cy clical co m p o n e n ts. NFD d o es have th e advantage of
in clu d in g off-budget item s, an d th e re ce n t grow th in
off-budget item s m ay re p resen t su b stan tial ad d itional
p ressu re on m on etary p o licy m ak ers .'4 T h e HEBD m ea
su re is a d ju sted for real in co m e c h a n g e s .13T h u s, it may
be co n sid ered a m easu re o f stru ctu ral policy ch an g es.
HEBD, how ever, d o es n ot in clu d e off-budget item s.
T h e eq u atio n s are estim ated over th e interval from
1/1958 to III/1984 (excep t w h ere noted) as w ell as over
th e su b p eriod s from 1/1958 to IV/1970 an d from 1/1971
to III/1984. T h e en tire perio d is b est ch a ra cte riz ed in
term s o f table 1 as a m ixed targeting p ro ced u re. T he
early su b p erio d is b asically a tim e o f in tere st rate tar
geting, w hile th e latter co n fo rm s m ost clo sely to a
m on etary aggregate targeting p ro ced u re.
T h e estim ated eq u atio n s are o f th e form p resen ted
below, a sp ecifica tio n sim ilar to th at o f F royen (1974):
EMPIRICAL M ETHODOLOGY
T h e b asic reactio n fu n ctio n ap p ro ach is also em
ployed here. Tw o alternative m onetary policy m ea
su res are u sed as d ep en d en t variables: th e m oney
stock (M l) and th e federal funds rate (iPF), given th at the
Fed eral Reserve h as alternately fo cu se d on in terest
rates and the m oney s to c k .12 T o fu rth er allow co m p ari
son o f th e estim atio n resu lts w ith th e p o ten tial rela
tio n sh ip s b etw een m o n etary p o licy an d d eficits as
p resen ted in table 1 , w e em ploy tw o m easu res o f debt
grow th in th e follow ing em p irical analysis: th e net
federal debt (NFD) an d the high em p loy m ent deficit
(HEBD ).'3
’“Levy (1981) used instrumental variables and Abrams, Froyen, and
Waud (1980) used 3SLS. Froyen (1974) and studies using Barro s
(1977) basic specification used more than one lag.
"See Barth, Sickles, and Wiest (1982) or McMillin and Beard (1981)
for a more extensive review of the reaction function literature.
Thornton (1984) uses a different framework focusing on the
“causal” relationships between monetary policy and debt rather
than using a reaction function approach. His results are consistent
with the findings of the reaction function literature. There apparently
exists a relationship between monetary policy and federal debt, but
this finding is sensitive to the period of analysis chosen as well as
the precise measure used for debt.
12The monetary base is not used as a measure of monetary policy
since Thornton (1984) has shown the linkage between debt growth
and the monetary base is influenced by a number of other factors.
,3Previous reaction functions have generally used either NFD or
HEBD although Froyen (1974) used both in the same equation.
I
(II X, = a„ +
J
K
2 a, X,, + 2 P, Zw + 2 7 , D,_t
i= 1
j= 0
k= 0
w here X = a m easu re o f m o n etary policy;
Z = a v ecto r o f m easu res o f th e goals an d c o n
strain ts o f th e Fed eral Reserve;
D = a m easu re o f debt;
and a, (3, an d 7 are th e estim ated p aram eters.
T h e righ t-h an d -sid e variables in clu d e lags of the
d ep en d en t variables as w ell as cu rren t an d lagged
values o f th e stab ilizatio n o b jectiv es or goals u sed by
th e Fed eral R eserve .'6 In clu d ed in th e sp ecifica tio n are
th e gen eral p rice level (P), th e u n em p loy m en t rate
(UR), an d alternately e a c h o f th e two m easu res o f fed
eral debt. Follow ing th e previous rea ctio n fu n ctio n
14For example, off-budget items totaled $17.3 billion in fiscal year
1982.
15See deLeeuw and Holloway (1982).
16Froyen has noted that the estimated reaction function actually rep
resents a joint test of the influence of the chosen stabilization goals
and constraints together with the appropriateness of the chosen
dependent variable. Lags of the dependent and independent varia
bles are included (1) to allow gradual adjustment to goals so that
monetary policy is not a source of instability and (2) to capture the
effect on monetary policy of variables omitted from the model.
27
FEDERAL RESERVE BANK OF ST. LOUIS
literature, in terest rate term s are in clu d ed in the
m o n ey eq u ation , w hile m o n ey term s are in clu d ed in
the in terest rate eq u ation.
All variables w ere in clu d ed in log d ifference form
excep t for HEBD, w h ich is in clu d ed in level form . M ax
im um lag len gth s w ere arbitrarily re stricted to 12 lags
on th e d ep e n d en t variables an d six lags for th e o th er
righ t-h and -sid e variables. T h e c h o ic e o f approp riate
lag length w as th e n d eterm in ed by Akiake’s final p re
d iction erro r (FPE) c rite rio n .17W hen th e FPE sea rch for
th e p referred lag sp ecificatio n in d icated th at no values
o f a righ t-h an d -sid e variable im proved th e sp e cifica
tion, th at variable w as d ro p p ed from th e b a sic eq u a
tion . E xcep t w h en n oted, a variable w as in clu d ed in
th e estim ated eq u atio n only w h en an F -test on its join t
coefficien ts in d icated it w as significant at th e 10 p e r
ce n t level. Tw o-stage le ast sq u ares w as u sed as th e
estim atio n te ch n iq u e to avoid problem s o f sim u l
tan eity .18
ESTIMATION RESULTS
MARCH 1985
Table 2
Basic Results Using NFD: 1/1958-111/1984
M1
*FF
c
.003
(2.01)
-.0 1 1
( - .3 3 )
SM
.833
(6.76)
3.316
(93)
2UR
-.0 4 3
(-2 .6 0 )
-1 .2 5 6
(-2 .9 7 )
ZiFF
-.0 2 1
(-2 .3 4 )
-.1 4 4
( - .8 6 )
ZP
2.746
(.77)
2NFD
R2
.39
RMSE
Q(20)'
T h e re actio n fu n ctio n resu lts estim ated over the
1 9 5 8 -8 4 perio d are p re sen ted in tables 2 and 3. T ables
4 and 5 in clu d e th e resu lts o f eq u atio n s estim ated
from 1958 to 1970, w hile tables 6 an d 7 p re sen t results
o f eq u atio n s estim ated over th e 1 9 7 1 -8 4 interval. T h e
focu s o f th e follow ing d iscu ssio n is o n th e d ebt varia
ble an d th e ex ten t to w h ich fed eral d eficits have in
flu en ced m o n e ta iy policy. T h e d ebt co efficien ts are
in terp reted in light o f th e p re d icted co efficien t signs
from table 1 .
Full Period Results
-2 .5 5 5
(-1 .9 7 )
.0065
9.09
.54
.122
17.90
Significance levels2
M
.0001
.0102
0)
(1)
UR
.0110
(0)
.0001
(2)
Iff
.0056
(2)
.0214
(2)
P
.0001
(4)
NFD
.1175
(1)
T able 2 p re se n ts th e eq u atio n s estim ated initially
w ith NFD as an in d e p en d e n t variable. T h e top part o f
th e table p re sen ts th e co efficien t su m s and th e tstatistics on w h eth er th at su m is significantly different
from zero. At th e bo tto m o f table 2, th e significan ce
'The Q-statistic tests for autocorrelation in the presence of lagged
dependent variables. It follows a chi-square distribution and is
calculated for 20 degrees of freedom. The critical value at the 95
percent level is 31.41.
2Given the varying degrees of freedom, the significance levels of
the joint F-statistics are presented. The number of lags are
included in parentheses.
17See Batten and Thornton (1984). In one instance below, the FPE
chose the maximum lag length allowed. In that case, the maximum
lag length was increased but further lags were insignificant.
values are p re sen ted for th e jo in t h y p oth esis th at all
the co efficien ts for a p a rticu la r variable are equal to
zero. T h e se sig n ifican ce levels are p re sen ted sin ce th e
lag len gth s an d co rresp o n d in g d egrees o f freedom
vary from o n e sp e cifica tio n to an o th e r. T h e lag len gth s
are in clu d ed in p a re n th e ses. Zero in d ica tes th at only
th e co n tem p o ra n e o u s variable is in clu d ed .
t8Only one equation is estimated, and this period’s inflation, unem
ployment rate, etc., may be influenced by this period’s monetary
policy. In the first stage, each of the dependent variables was re
gressed on 10 lags of itself and four lags of all other variables in the
model. The maximum lag lengths were arbitrarily restricted. The
second stage, reported in the text, replaces the current values of the
independent variables with the first stage estimates. If HEBD were
an exogenous policy tool, the use of an instrument for HEBD would
be unnecessary. There is no reason, however, to assume that
current fiscal policy is independent of, say, current monetary policy
actions.
28
Sin ce n et federal debt, on average, h ad n o significant
im pact on m o n ey d uring th e 1 9 5 8 -8 4 period, it w as
om itted from th e M l eq u atio n . NFD is in clu d ed in the
MARCH 1985
FEDERAL RESERVE BANK OF ST. LOUIS
the h yp oth esized m ixed targeting p ro c e d u r e .13
Table 3
Basic Results Using HEBD:
1/1958—111/19831
M1
Iff
c
.007
(3.74)
.003
(.10)
SM
.399
(2.50)
1.279
(.39)
SUR
-.0 2 9
(-1 .9 4 )
-1 .3 8 9
(-3 .1 2 )
SiFF
-.0 1 2
(-1 .6 8 )
-.1 4 9
(-■85)
IP
.214
(.06)
2HEBD
.00026
(4.08)
R2
.45
.53
RMSE
.0063
.125
Q(20)
14.47
23.14
.0392
(5)
(1)
.0554
(0)
.0001
(2)
.0379
.0965
(2)
Significance levels
M
UR
Iff
(1)
P
HEBD
.0058
.0001
(4)
.0003
(1)
NOTE: See footnotes to table 2.
'Equations including HEBD are estimated only through 111/1983
since the data series has been discontinued.
federal funds rate eq u atio n sin c e th e sum o f its co e f
ficien ts is significant at th e 10 p e rce n t level. A 1 p e r
ce n t in crease in NFD low ers th e fed eral fund s rate by
an estim ated 2.56 p e rce n t. Sin ce NFD co n ta in s both
stru ctu ral an d cy clical co m p o n e n ts, b ased on table 1 ,
it ap p ears that th e cy clical co m p o n e n t o f NFD d o m i
n ates th e stru ctu ral co m p o n e n t in th e fed eral fund s
rate eq u ation . F urther, sin c e NFD significantly en ters
the federal funds rate eq u ation, th e Fed eral Reserve
app aren tly did not follow a pure in terest rate strategy
over th e 1 9 5 8 -8 4 period . T h is result is co n siste n t w ith
T h e HEBD resu lts p resen ted in table 3 apparen tly
yield co n clu sio n s at od d s w ith th e se resu lts. W ith the
HEBD m easure, th e d eficit has a significant positive
im pact on th e m o n ey stock bu t no im p act on the
federal fund s rate; co n seq u en tly , it w as o m itted from
th e final estim ated federal fun d s eq u atio n . Given
HEBD as a m easu re o f th e stru ctu ra l deficit, th e im p act
o f HEBD on M l an d iKf is co n siste n t w ith th e Fed eral
Reserve, on average, p u rsu in g an in tere st rate target
ing strategy d uring th e 1 9 5 8 -8 4 period.
T h e co n d itio n s p re sen ted in tab le 1, how ever, re p re
sen t only su fficien t co n d itio n s for th e stru ctu ral defi
cit to have no im p a ct on th e fed eral fu n d s rate. In
o th e r w ords, it is n o t n ecessa ry fo r th e F ed eral Reserve
to b e targeting in terest rates in o rd er to g en erate th e
result that HEBD d oes n ot in flu en ce iFK. For exam ple, if
HEBD is sm all relative to th e lo an ab le fu n d s m arket or
if th e su pply o f lo an ab le fu n d s is in tere st-ela stic, th e n
HEBD w ould have little in flu en ce on itKeven w ith, say,
a m ixed targeting strategy.
Further, th ere is evid en ce to suggest th at th e stru c
tural d eficit re p rese n ts a relatively sm all fractio n o f th e
total d em an d for lo an ab le funds. F o r exam ple, in 1982,
HEBD averaged $32.6 b illion w h ile n et cred it m arket
borrow ing by n o n fin an cial se c to rs w as $404.1 billion.
Thu s, th e HEBD co m p o n e n t o f fed eral b orrow ing w as
only 8.1 p ercen t o f fund s borrow ed. In co n trast, on
average from 1975 to 1981, sim ilar figures in d icate
HEBD w as only 4.6 p e rce n t o f n et fund s borrow ed.
HEBD m ay have little o r no im p act on in terest rates
n o t b eca u se o f th e p articu la r targeting p ro ced u re
u sed by th e Fed eral Reserve, b u t ra th er b e c a u se o f th e
sm all relative size o f th e stru ctu ral deficit. Given this
in terp retation , th e resu lts in table 3 are also co n siste n t
w ith a m ixed targeting strategy.
19The coefficients on the non-debt terms in table 2 deserve comment.
Inflation does not significantly enter the M1 equation and unemploy
ment enters with a negative coefficient.
While the negative coefficient on the unemployment rate is signifi
cant in all equations, its economic impact is minor. For example, a
reduction in the unemployment rate from 7.5 percent to 7.0 percent
would increase the growth rate of money by only 0.2 percent. The
procyclical response of monetary policy to the unemployment rate is
certainly not intuitive; it is, however, consistent with the findings of
Abrams, Froyen and Waud (1980).
Although the sum of the coefficients on the inflation term in the
federal funds rate equation is not significant, the joint impact is
significant. The short-run impacts are large in magnitude although
approximately offsetting over a year. Similarly, the sum of the coeffi
cients on money growth in the federal funds rate equation are not
significantly different from zero. Again, it is the result of offsetting
individual coefficients.
29
FEDERAL RESERVE BANK OF ST. LOUIS
MARCH 1985
Table 4
Table 5
Interest Rate Target Using NFD:
1/1958-IV/1970
Interest Rate Target Using HEBD:
1/1958-I V/1970
M1
c
Iff
c
M1
Iff
.005
(3.02)
—.019
(- .5 4 )
.001
(.27)
-.0 0 8
(- .2 3 )
2UR
-.0 6 4
(-2 .8 6 )
-1 .8 6 0
(-5 .6 0 )
2UR
-.0 3 1
(-1 .4 2 )
-2 .0 1 7
(-5 .7 2 )
ZiFF
-.0 6 5
(-5 .1 5 )
-.1 5 9
(-1 .2 9 )
ZiFF
-.0 5 3
(-4 .0 3 )
-.0 4 4
(-3 5 )
IP
1.164
(6.83)
6.861
(1.58)
IP
.789
(3.60)
6.757
(1.42)
2NFD
.281
(2.29)
-.8 4 2
(-3 2 )
SHEBD
.00029
(3.09)
R2
.67
.67
R2
.69
.59
RMSE
.0038
.110
RMSE
.0037
.121
Q(20)
23.05
11.41
Significance levels
Q(20)
30.54
17.69
Significance levels
UR
.0001
(4)
.0001
(0)
UR
.0001
(4)
.0001
(0)
Iff
.0001
(2)
.0001
(2)
Iff
.0002
(2)
.0031
(2)
P
.0001
(1)
.0024
(1)
P
.0001
(1)
.0136
(1)
NFD
.0275
(0)
(1)
.0045
NOTE: See footnotes to table 2.
Subperiod Results
T h e re actio n fu n ctio n resu lts estim ated over the
interval from 1/1958 to IV/1970, w h ich co rresp o n d s to
w hat is com m only th o u g h t to be a perio d o f in terest
rate targeting, are p re sen ted in tab les 4 an d 5. T h e
estim atio n p ro ced u res are id en tical to th o se em
ployed for th e en tire period resu lts above. W hen NFD
is u sed as th e d ebt m easu re, its co efficien ts are jointly
significant in b o th th e m o n ey sto ck an d fed eral funds
rate eq u atio n s. A 1 p e rce n t in crea se in NFD w ould
result in a p erm an en t 0.28 p e rce n t in crea se in the
m on ey stock. In co n trast, in th e federal fund s rate
eq uation, w hile th e NFD co efficien ts are jo in tly signifi
cant, th e ir sum is n o t significantly d ifferent from zero.
An in crease in NFD th is period w ill be a cco m p an ie d
30
HEBD
.0132
(1)
NOTE: See footnotes to table 2.
by low er in terest rates th is period , b u t th at d eclin e in
th e fed eral fund s rate w ill b e offset n ex t period , w ith
th e fund s rate retu rn in g to its previous level. T h u s, the
NFD resu lts are co n siste n t w ith in terest rate targeting,
assu m in g a o n e-q u a rter lag b efore th e F ed eral Reserve
ca n effectively offset in terest rate ch an g es.
T h e HEBD resu lts in tab le 5 gen erally are co n siste n t
w ith th e NFD resu lts. HEBD is sign ifican t in th e m on ey
eq u ation bu t in sign ifican t in th e fed eral fu n d s rate
eq u ation . An in cre a se in th e stru ctu ra l d eficit lead s to
an in crea se in th e m o n ey sto ck d uring th e early period
bu t h as n o effect on th e fed eral fu n d s rate. T h is HEBD
result is also c o n siste n t w ith in tere st rate targeting.
T h e NFD and HEBD resu lts differ only in th e ir tim ing.
NFD has a slightly faster im p act on th e m o n ey stock
FEDERAL RESERVE BANK OF ST. LOUIS
MARCH 1985
Table 6
Table 7
Mixed Targeting Procedure Using NFD:
1/ 1971- 111/1984
Mixed Targeting Procedure Using HEBD:
1/ 1971- 111/1983
M1
c
.020
(4.69)
2M
-.1 4 6
(-1 .0 8 )
8.246
(1.26)
HJR
Sifp
2P
R2
RMSE
.020
(3.87)
2M
-.0 0 6
(- .7 7 )
-.5 4 7
(-2 .0 6 )
SiFF
-.3 5 0
8.549
(1.59)
.087
(1.14)
.0072
9.81
-3 .6 1 3
(-2 .2 8 )
-1 .5 6 2
(-3 .2 3 )
2P
-.0 0 5
(- .6 4 )
- .4 2 7
(-1 .5 9 )
-.2 9 8
(-1 .1 7 )
5.611
(1-06)
2HEBD
.00014
(1.64)
R2
.25
.57
.111
RMSE
.072
.116
11.34
Q(20)
9.06
6.38
Significance levels
M
.0097
(6)
UR
.0052
M
.0089
(6)
.0047
UR
(1)
(1)
.0202
(1)
.0228
(2)
P
.1047
(0)
.0967
(3)
NFD
.2616
(0)
(1)
.0882
NOTE: See footnotes to table 2.
and a tem porary effect on th e federal fund s rate. HEBD
takes on e q u arter lo n g er in reach in g its full im p act on
m o n ey an d h as n o effect on th e federal fund s rate.2"
E qu ation s estim ated only over th e 1 9 7 1 -8 4 period,
w h ich co rresp o n d s to a period o f g reater relian ce on a
m onetary aggregate target, are p resen ted in tables 6
and 7. T h e NFD and HEBD eq u atio n s b o th im ply that
debt grow th did n ot in flu en ce th e m oney stock over
this period. Again, w h en th e federal funds rate equa-
“ With respect to the non-debt terms, there are some interesting
differences between the early period and the full period results, in
particular for the money stock equation. The money stock continues
to respond countercyclically to unemployment, but it also responds
countercyclically to inflation in the early period. Also, lagged money
terms are insignificant.
-.2 1 0
(-1 .3 5 )
.58
Significance levels
Iff
•f f
9.589
(1.22)
2UR
.21
Q(20)
c
-1 .3 7 2
(-3 .0 1 )
( -1 .6 5 )
2NFD
M1
Iff
(1)
.0551
(2)
P
.2474
(0)
.0663
(3)
HEBD
.1083
(0)
If f
.0542
NOTE: See footnotes to table 2.
tion is estim ated w ith NFD, that variable is significant;
w h en it is estim ated w ith HEBD, th e d eficit m easu re is
in significant. As in th e d iscu ssio n o f th e co m p lete p e
riod results, th e find ing th at HEBD h as n ot in flu en ced
th e fed eral fund s rate m ay b e d ue m o re to th e sm all
size o f th e stru ctu ral d eficit vs. total cred it d em an d
th an it is to th e targeting p ro ced u res o f th e Fed eral
R eserve .’1 Thu s, th e later perio d estim atio n resu lts are
21Even for the first three quarters of 1983, the last period for which
HEBD is available, the structural deficit increases to only 10.4 per
cent of net credit market borrowing. Of course, the insignificance of
HEBD could also be a result of other causes. For example, believers
in currency substitution would argue that any increase in HEBD
leading to increased real interest rates would also lead to foreign
capital inflows that could drive interest rates back to approximately
their original levels.
31
FEDERAL RESERVE BANK OF ST. LOUIS
co n siste n t w ith th e Fed eral Reserve follow ing a m o n e
tary aggregate target.
T h e federal fund s rate eq u atio n s estim ated over th e
later p eriod w ere sim ilar to th o se for th e early an d th e
full periods. In co n trast, the m o n ey sto ck eq u atio n s
w ere su bstan tially different in th e la ter period . T h e
m on ey stock eq u atio n s c h o se n by Akiake’s FPE an d Ftests co n siste n tly im ply th at virtually all variables e n
tered, w ith th e p o ssible ex cep tio n o f th e federal funds
rate and th e inflation rate, are insignificant.
From th e p ersp ectiv e o f estim ating a reactio n fu n c
tion that “e x p la in s” m u ch o f th e variation in the
m on ey stock, th e 1 9 7 1 -8 4 resu lts leave m u ch to be
d esired. T h ey are, how ever, co n siste n t w ith tw o very
different th eo ries o f Fed eral Reserve behavior. First, it
is p o ssible th at over th is period th e goals of th e F ed
eral Reserve o r th e w eights on th o se goals w ere ch a n g
ing frequently, p erh ap s d ue to shifts in m o n ey d e
m and, deregu lation o r fin an cial innovations. If true, it
w ould be im p o ssible to estim ate a co n siste n t relatio n
ship betw een goals an d th e m o n ey stock. In th e ex
trem e, th e m o n ey stock after d etren d in g w ould b e a
rand om walk. Alternately, th e Fed eral Reserve, on av
erage, m ay have follow ed a co n sta n t m o n ey grow th
rate rule. In th is case, th e m oney stock after d etren d
ing w ould also be a rand om walk. E ith er o f th ese hy
p o th eses w ould be co n siste n t w ith a poorly perform
ing sh o rt-ru n reactio n fu n ctio n for th e m on ey stock.
SUMMARY AND CONCLUSIONS
T h is p ap e r h as exam ined w h eth er federal debt
grow th h as in flu en ced alternate m easu res o f m o n e
tary policy. It w as d em o n strated th at a stru ctu ral defi
cit w ould have very d ifferent im p licatio n s th an a cy cli
cal deficit. A stru ctu ral deficit in th e static m odel p re
sen ted h ere co u ld lead to an in crease in m oney
grow th an d /or in terest rates. In co n trast, a cy clical
d eficit co u ld be a cco m p an ie d by a d ecrea se in m on ey
grow th an d /or in terest rates. W h eth er debt alters
m on ey grow th or in terest rates d ep en d s on th e n atu re
o f th e targeting strategy u sed by th e Fed eral Reserve.
T h e resu lts o f a reactio n fu n ctio n , developed and
estim ated over altern ate intervals, suggest that p rior to
1971 d ebt grow th did lead to m o n ey grow th but did
not in flu en ce in terest rates. Sin ce th en , d ebt grow th
h as not altered m o n ey grow th bu t m ay have b een
a sso ciated w ith in terest rate ch an g es. Net federal debt
grow th, w h ich co m b in es bo th stru ctu ral and cyclical
debt ch an g es, is acco m p an ie d by a low er federal funds
rate for th e 1 9 7 1 -8 4 period. T h is resu lt su ggests that
cy clical debt ch an g es d o m in ate stru ctu ral in NFD’s
32
MARCH 1985
effect on in terest rates. In co n trast, th e h igh-em ploym ent budget deficit, a m easu re o f stru ctu ral debt
ch an g es only, has h ad no im p act on th e fed eral funds
rate over any tim e period . T h is resu lt m ay b e d ue to
H EBD’s sm all size in co m p a riso n w ith total cred it d e
m ands.
T h e resu lts p re sen ted h ere are co n siste n t w ith
m on etary policy bein g in d e p en d e n t o f federal deficits
even thou gh m on ey m arket variables do apparen tly
resp o n d to th o se d eficits. D uring th e p eriod w h en the
Fed eral Reserve w as targeting in tere st rates, th e as
su m ed policy m easu re, th e fed eral fund s rate, w as
unaffected by federal d eficits. W hile th e m o n ey stock
d oes resp o n d to d eficits in th e early tim e period, 1 9 5 8 70, th e m on ey stock w as n ot b ein g u sed as a policy
target in th at interval. Conversely, in th e later period,
1971-84, th e Fed eral Reserve paid m ore atten tio n to
th e m oney sto ck an d less to in terest rates. In that
interval, th e prim ary p o licy variable, th e m o n ey stock,
was again u naffected by fed eral d eficits w h ile th o se
d eficits m ay have h ad an im p act o n in tere st rates ~
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33
@FedFRASER