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Federal
because
and

the

trends

In chart

are masked

temporary

other

random

1 we have plotted

coefficient

calculated

in period
following.

between

quarters

are significant

coefficients

deviations.

marize

briefly-

at 7, 8, 9, and 10
con-

significant
twelfth

the

the

The most

growth

sixth

quarters.

with

in chart

These

results

correlations

indicates

tween

the

growth

speed

reports

with

results

tions,

reported

recognize

growth

changing

inflation

may tend

suppressing

people

If slower

in rapidly

Past inflation

will

and

money
expecta-

fall

is embodied

more
in con-

to slow the inflation-

effects

of

reduced

money

Even the most optimistic

indicate

a lag well in excess of one year be-

reduced

felt.
run

money

effect

long as four

and

supply

on inflation.

years

It is possible
output

suggest

other

th at

the
in

depends

the

money

the non-monetary

unless

dated by an increasing
The

model

supply.

used

money

n
~

(2) U

m.Mt_·

t=o

I

+

= pU _
t 1

factors
a tem-

accommo-

supply.

to generate

in table 2 is given in equations
(1)Pt=

are

aggre-

However,

have only

they

and

sh ort-term
the

on many

shocks

effect

defini-

Both theory

change

level

than

the growth

and various

supply.

esti-

the results

1 and 2:

I

t

(P)

was re-

before
that

estimates

growth

has a

It may be as

the full effect
the negative

unemployment

is

short-

effects

of

the slower money growth

will be substantial.

However,

effects are both less

these short-run

H:

o
l:m.=1

xm.

n

I

t

t

SE

as the

rate.

(U),

so

the

was

used

to

coefficient
degrees

estimate

residuals

in the money

to fit a third-order
constraints.
in table

2. Some

For every
standard

The

for multiseries, the

interesting

monetary

are
results

variable

the

error (SE) of the regression

growth

on

of a change
inflation

over

as the

of

the

This
price

indexes

in the
point

short
here

short-run

criterion,

error

is

model

money

the

1.
All

of the

M-1 B best "ex-

0.883
0.905
0.885
0.864

8

1.136
1.140
1.130
1.078

20
16
12
8

1.089
1.105
1.097
1.047

and capital

interest

rates risen to unprecedented

The

or "explain"

0.707
0.712
0.700
0.639

NOTE:
cent

Reject

if the

equal to

both

deflator;

and

growth

relation-

GNP

this

this

in-

of the aggregates and economic

see John B. Carlson and Theresa Gwazdaus-

kas,

"The

New

and

Monetary

Aggregates,
Pol icy,"

Economic

Economic

Activity,

Commentary,

10.27
11.46
12.29
11.52

1.474
1.473
1.480
1.474

1.60
1.82
1.73
0.73

13.36
14.81
15.07
10.07

1.449
1.429
1.448
1.533

1.17
1.52
1.49
0.57
-5.33
-5.33
-5.17
-3.80
Ho with

p
0.637
0.639
0.637
0.657
0.562
0.553
0.558
0.685

14.33
16.01
16.88
12.77

1.417
1.403
1.416
1.486

this

measure

of

inflation.

Other

Federal

Reserve Bank of Cleveland,

Federal

March

10,1980.

Research

BULK RATE
U.S. Postage Paid
Cleveland,OH

Reserve Bank of Cleveland
Department

P.O. Box 6387
Cleveland,OH

Permit

44101

period,

Reserve

the

12.85
13.19
12.07
6.73

1.432
1.429
1.475
1.608

0.618
0.613
0.639
0.768

region

of 5 perthan

and

money

the

supply

is estimated,

and operating

reserves

and the money

less likely to change
the

relationship

During

the

money

Federal

change,

reduce

initiates

adjustments

rates by gradually

the

lowering

In principle,

the growth

of the money stock could be coneither

interest

rates

to return
desired

between

supply.

subsequently

accurately,

interest

The desired

aggregates,

gress pursuant

Address correction

or

No. 385

money

terest

requested

between

supply,

rate on federal

that was estimated
sired

growth.

This

money

between

supply
and

because

often

money

not

supply

adherence
money

changed

changes

to

rates

and

the

acceler-

to

rates

control

Address

interest-rate

targets

to deviate further

flation,

Each

its plans to Con-

of 1978

and

(the

Hum~

Act). Because the Federal Retargets that are low enough
we can expect
markets.

is necessary,

continued
To see why

it is important

the basic relationships

between

to
in-

interest rates, and the money supply-

the topic of this Economic Commentary.

caused

Inflation
Inflation
the volume

T. Gavin is an economist,

Federal

Reserve

available

is defined
of money

as "an

increase

and credit

goods resulting

in

relative to

in a substantial

and

Bank of Cleveland.
The

Please send mailing label to the Research Department,
Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland,

Act

in the credit

understand

and further

Change
William

phrey-Hawkins

serve has selected

this pressure

by the Fed-

(FOMC).

to the Full Employment

Growth

pressure

to its

or, more

In this environment

from desired targets.

D Correct as shown
D Remove from mailing list

Balanced

Committee

to slow inflation,

the re-

in interest

enough

growth.

growth

procedure

as inflation

large

range

with de-

because

interest

and

the in-

funds in a narrow

to be unsatisfactory,

lationship
ated

"targeted"

to be consistent

monetary

were

interest

then

growth

are chosen

rates

relationship

and

rates that tend
paths,

year the FOMC must report

the

is a

ranges for each of the

estimated

Reserve

rates and

reserves

supply

eral Open Market

Federal

run than

if there

in bank

the target

monetary

interest

or bank reserves. Under the former operating
the

targets
between

of the new procedure

money

path."

and

may be no

However,

market
the

supply

in the short

the operation

eventually

the relation-

of reserves

are set for reserves. The relationship

of the

and

by controlling

new procedure,

supply

of the money stock.

strained

the

between

money

constant-to

pressures

have

heights,

Under
ship

volatile.

objectives

have remained

in the

the growth

proved

0.512
0.508
0.514
0.619

a critical

rates

that

Not only

have been unusually

inflationary

index.

of turbulence

markets.

interest

the
-1.36
-1.20
-1.60
-1.81

absol ute val ue of t is greater

1.96.

but

one

for

following

money

level of interest
activity,

The period

or supply

a long-term

M-2

20
16
12
8

policy.

Reserve

procedures

procedure,

plains"

M-1A

20
16
12
8

monetary

its operating

has been

St. Louis Base

20
16
12

6, 1979, the Federal

changed

change

omitted.

growth

On October
System

affect

that

demand

in

Growth

by William T. Gavin

that

of inflation.

to forecast

growth

it is to show

flation

suggests

been

Inflation, Interest Rates,and Monetary

systematic

variables

run have

between

was sig-

missing from equation

th rough

is not

This

term

non-monetary

~£Q,Clomic
Commentary

reflect
the hy-

parameter

error

23, 1981

growth

one

We can reject

is a quarterly

2. For a discussion

standard

than

a

period.

Using the smallest

money

instance.

are variables

ship

in money

occurs

there

rather,

with 16 lagged quarters;

that is, the full effect

a

the sum of the coefficients

in every

of the

with no endstatistics

greater

that

February

will lead to an

to the

autocorrelation

behavior

(m ) was constrained
i

Summary

equal

that

coeffi-

to one implies

in velocity.2

2. To preserve

polynomial

equal

the sum

lagged

rate of money

rate

nificant

growth

of the

equal to zero in all cases.

technique

and to adjust

of the weights

point

the

of

autocorrelation

the

in equation

of freedom

pattern

in

presence

Cochrane-Orcutt

(p)

collinearity

the

be used include

Coefficients

autocorrelation

regression

I

alternatively

positive

four-year

o
l:m.=O

I

growth

inflation

pothesis

supply

H:

steady

growth

was in the equation

1, the GNP deflator

A sum

Various

rates of change).

indicated

might

distribution

cients.

results

emerged.

.

that

the

(approx-

8, 12, 16, and 20) were used on the
defined

and

liminary

lowest
E

criteria

St. Louis base, M-1A, M-1B, and M-2. Pre-

given

+Ut·

of the logarithm

continuous

supply

by taking

M-1B

growth.

significant

price

money

of lower in-

supply

expectations.

growth

fore

evidence

we have

ip between

(quarter-to-quarter)

t

how long will depend

which

in money

their

that

the

are

of time be-

of slower

rates. Precisely

quickly.

tions of the money

presented

period

and subsequent

tracts

the relationsh

that we should ex-

achievement

change

analysis,

Table 2 Estimates of the Price Equation
1964: 110 - 1980: 1110

pect to wait a substantial

adjust

mated

In equation

The evidence

the

supply,

the

1.

on the

money

regression

on in-

through

Conclusion

flation

Using

=

16 lagged

growth.

on past values of the money

All variables were transformed

lags (n

porary

best fitting

including

of money

in

lagged

consistent

of the definition

supply

impacts
occur

using reTo sum-

used-the

are those

of money

flation

results

in the appendix.

supply

specifications
quarters

some

regardless

of the money

(M).

imating

gate

analysis

gressed

rate of the GNP deflator

Only

level.

gression

adverse
growth.

than

Appendix

in the

at a 95 percent

We have included

the

of fast money

less enduring

price effects

the first difference

M-1 B growth

Few of the correlation

are greater than two standard
calculated

and

long-run

in period t and the 16 quarters

the correlations

certain

the correlation

t and each of the changes

GNP deflator

fidence

by cycl ical
fluctuations.

Reserve Bank of Cleveland

author

OH 44101.

opinions
and

Reserve
Governors

not

Bank

stated

herein

necessarily
of

Cleveland

are those

those
or of

of

of

the

the Federal

the Board

of the Federal Reserve System.

of

1. For
the
"The

a detailed

new

discussion

operating

New Procedure,"

of the

procedure,
Economic

Reserve Bank of Cleveland,

mechanics

see E.J.
Review,

forthcoming.

of

Stevens,
Federal

continuing

rise in the

general

price

level"

(Webster's New Collegiate Dictionary, 1973
ed.). More precisely, inflation is a substantial
and continuing increase in the volume of
money

and credit relative to available

resulting

in a substantial

in the general
tant

a popular

and continuing

price level. There

distinction

between

measured

is an impor-

that

results

from
price

the general

by assessing

price level is

prices

of individual

goods and services and constructing
such as the consumer
wholesale

price

deflator.
think

Through

(WPI), and the GNP

so that

labeled

we tend to

as an increase

of inflation

in the price

"inflation."
increases

WPI are not

any increase

the

many

As an ex-

in 1980
farm

decreased

products.

In one

sense,

of food

caused

inflation.

important

we do not

sense,

the

In another

they

Inflation

the

not likely

price

a continuing

will

an increase

level. Such

in
is

unless it causes or is ac-

by a substantial
to

available

goods.

reflected

in the

prices

and credit

Moreover,

in-

of all goods

and

examina-

in prices in the past two

decades

demonstrates.

inflation

rate for the United States since 1961

is shown

in table

to 9.9

percent

The

1, column

grown rather steadily

Ex post
real interest rate

1.9
1.2
2.5
3.2
3.8

4.7
4.6
4.5
4.6
4.6

3.7
3.2
4.6
5.2
5.0

4.0
4.3
5.2
5.5
5.2

5.3
5.8
6.5
7.4

1.6
2.6
1.9
2.2

8.5

3.5

1971
1972
1973
1974
1975

4.6
4.0
7.2
10.5
7.2

5.4

7.9
7.6
7.8
9.0
9.6

3.3
3.6
0.6
-1.5
2.4

1976
1977
1978
1979
1980

4.7
6.1
7.9
8.5
9.9

4.8
5.8
6.8
7.9
7.2

9.0
8.4

4.3
2.3

9.1
10.1
12.8

1.2
1.6
2.9

5.9
6.8
6.0
5.5

average

annual

2. In 20 years,

in the GNP deflator
from 1 percent

in 1980.

this

in so
shall

not

a subject

economists.

relationship

many

has

policy

include

of contro-

To

been

ignored

recommendations,

a discussion

we

of interest

rates

est rates

funds.

demand.

two

The

premium

life of the

the expected
Open

market

Reserve
funds.

is maintained

money

has

money

supply

many

rate minus

are a major determinant
supply

A purchase

function

of

for loanable

of government

securities

measure
used,

because

reserves

bank

have

the

The

has

in 1961

low rates

in

probably

istration's
reported
the

multiple
riods.

Even
individual

the

growth

money

there

short-run

trend

the

over the three

and

the

3.

is no clear relationship
changes

price

in the

level.

money

However,

the

over time are clearly correlated.
long-run
supply

relationsh
and

the

ip between

price

will rise (see table

corresponds

between

inflation,

growth

rate

and

years is shown in table 1, column

As is evident,

The

supply

continues

inflation

in the

bond

deflator.
that

as the

minus

the

Viewed

level is well

reflects

the

fact

interest

have

grown

too

versing this trend

rate

rise in the short

and

immediate

real interest

real interest

average

increase

corporate

in the

real interest

rate is independent

is no trend

GNP

it is evident

rates have not

standards.

There

High

been high

In the long run, the

and money

of both

supply

in the real interest

series, as there is in the other series.

re-

growth.
rate

stage

rapidly

in the

on how quickly
in money

come to believe that

and decreases

and

slow growth

reduced,

aggre-

interest

Correlations

fects

to th is question,

of slower

money

the

of funds

second

deflationary

rates will

difficult

Reserve

and Future

and

third

pol icy.

to discern

recent

re-

experi-

deflationary

supply

show up in lower reported

in the ag-

to wait bewill lower

rates? While there is no defin-

ence suggests that significant

growth

M-1B Growth

growth

growth

inflation

efwill

rates in

years

following

the

Changes

in trend

are

from the data in table 1,

- 1975:1110

Correlation

between

we expect

money

inflation

itive answer

empirical

run. If the Federal

Chart 1

smaller.

reduced

ported

pre-

Inflation

Rates

10

12

coefficient

0.45
0.40

0.35
0.30

0.20
0.15
0.10
0.05

supply

growth

it will persist.

inflation

expectations

a substantial

and

in

and

In other

-0.10

interest

rates

marginal

-0.15

decrease

When money supply growth

are crowded

-0.05

will not drop

continual

in the face of continuing
rise and

o

Moreover,

people recognize

reduced
mands

markets

fore

inflation

on prices. The lag between
and variable.

is recognized.

Re-

rates to

run, but it will not have an
growth

until

in

today

past.

will cause interest

in money

words,

theoretical

price level. With the supply

rise in the short

to

rate by lower-

suggest that slowing money

to credit

mium becomes

however,

0.25

al i of the aggregates

is lengthy

the reduction

differ-

inflation

inflation
it depends

inflation

will not immediately
gregate

to fall as the expected

How long should

rates of the monetary

all of the

evidence

gradually

policy may be committed

the long-run

ing the growth
gates,

rates

begins to decrease.

Even though
slowing

will come

The

growth,

to slow and interest

and in-

target-setting

that

effect

of this policy

as inflation

pol icy.

money

inflation

interest
differences

decreases

by historical

inflation

respond

However,

formulation.

interest

in th is way,

ported
the

policy

in inflation

5, the ex post

is calculated
rate

to ex-

anti-inflationary

in slowing

we can expect

can vary, as many of

can be observed

the ex-

supply growth.

In column
rate

bond

trends

in

the

4). The

in the
1, column

corporate
to the

past money

connection

and current

supply

pand,

premium

and

moves

to technology,

trends

benefits

an

adjustment

pe-

income.
into

of

persists

unemployment,

the temporary

adopt

aggregate

components

respect

in long-run

money

to

long run, the trends

in the

corporated

inflation

the

cvcl ical

each of the aggregates

may be the case.

pected

Reserve

seasonal

and

and

in circulation
with

cost

lead to increased

represents

1964:10

monetary

in defin ing

over

rates,

will accelerate

of

which

0.50

Each

differently

of

of reserves

sup-

variable

The
deposit

targets.

with

the

accompanying

of world oil prices.

average money

trends

The high

of those controls

increase

illustrate

past money

supply

admin-

rates in 1973 th rough 1975

the relaxation

quadrupling

between

the Nixon

wage and price controls.
inflation

temporary

previous

reflect

government

on

Federal

the long run, the opposite
1971-72

base is often

of currency

problems

led

ently

rates to fall. In

in theoretical

Reserve System.

the

interest

(M-2). As a

and a control

plus
Federal

supply

authorities.
sum

of the

savings and various

it represents

monetary

in

will cause

plus check-

the monetary

ply of fiat money
the

In

in the supply

the money sup-

as currency

of the money

and leads to an increase

reserves

will be used. As a meabalances,

models,

the

on the

also are included

deposits

of loans that banks can make.
run, this increase

depends

time

banking
the short

is calculated

word

way

function,

Reserve

system

The

store-of-value

by the Federal
the amount

adds reserves to the

the

(M-1 B). As a measure

Practical
Federal

variable

able deposits

premium.
of the

because

meanings.

base is the

The real in-

interest

operations

System

so that the

contract.

inflation

the short-run

empirically,

economic

rate. The pre-

lent

rate is the market

rate has

is the amount

must pay lenders
funds

inter-

in supply

for expected

inflation

of the

over the
terest

prices,

interest

and the real interest

real value

in markets

changes

market

for expected

that borrowers

a. The inflation rate is measured as the average
annual percent change in the GNP deflator.
b. This is a moving average of the past three years
of M-l B growth. For example, the 1980 figure,
7.2, represents
the average annual growth in
M-1B for 1978, 1979, and 1980.
c. This interest rate is a simple average of the interest rates on Moody's Aaa, Aa, A, and Baa
corporate bonds.

with

components-a

inflation

define

is a difficult

ply usually is defined

Like other

fluctuate

and

mium

to

This may

supply

sure of transaction

rates are determined

for loanable

The money

way the calculations

Interest Rates and Inflation
Interest

The Money Supply

understand

in our analvsis.

3.7
2.6
3.0
3.2
2.2

1966
1967
1968
1969
1970

and

among

why

1.0
2.0
1.5
1.4
2.4

To

in corresponding

as even the most cursory

tion of the upsweep

the rate of increase

Corporate
bond interest rate,
percentC

1961
1962
1963
1964
1965

reflect

and continuing

relative

services,

of

increase

in the vol ume of money

movements

price

of food

increase

is generally

and if

understood
versy

Money
supplY
b
growth

Inflation
Year
ratea

in Prices, Money,

level.

to occur

companied

If

Trends

If the

component

causes

general

flation

did not.

in 1981

return to its previous

that

increased

have a drought

farm-product

the

As food

else is unchanged,

everything

the

CPI or the

food.

and more

the

the

rose, so did all the price indexes

include
prices

individual

inflationary.

drought

of

many

affect

truly

ample,

in an index is

Yet

that

supply
prices

(CPI), the

this procedure,

indexes
price

indexes,

price index

index

and

the general

to measure

level. By necessity,

rise

this definition

misconception

our attempts

goods,

Table 1 Long-Run
and Interest Rates

is

inflation,
credit

de-

out of the marketplace.

-0.20

o

NOTE: The standard

2
deviation

3

4

5

is calculated

line is drawn at two standard deviations.

6

7

8

9

11

13

14

15

16

as one over the square root of the sample size. The dotted

continuing

rise in the

general

price

level"

(Webster's New Collegiate Dictionary, 1973
ed.). More precisely, inflation is a substantial
and continuing increase in the volume of
money

and credit relative to available

resulting

in a substantial

in the general
tant

a popular

and continuing

price level. There

distinction

between

measured

is an impor-

that

results

from
price

the general

by assessing

price level is

prices

of individual

goods and services and constructing
such as the consumer
wholesale

price

deflator.
think

Through

(WPI), and the GNP

so that

labeled

we tend to

as an increase

of inflation

in the price

"inflation."
increases

WPI are not

any increase

the

many

As an ex-

in 1980
farm

decreased

products.

In one

sense,

of food

caused

inflation.

important

we do not

sense,

the

In another

they

Inflation

the

not likely

price

a continuing

will

an increase

level. Such

in
is

unless it causes or is ac-

by a substantial
to

available

goods.

reflected

in the

prices

and credit

Moreover,

in-

of all goods

and

examina-

in prices in the past two

decades

demonstrates.

inflation

rate for the United States since 1961

is shown

in table

to 9.9

percent

The

1, column

grown rather steadily

Ex post
real interest rate

1.9
1.2
2.5
3.2
3.8

4.7
4.6
4.5
4.6
4.6

3.7
3.2
4.6
5.2
5.0

4.0
4.3
5.2
5.5
5.2

5.3
5.8
6.5
7.4

1.6
2.6
1.9
2.2

8.5

3.5

1971
1972
1973
1974
1975

4.6
4.0
7.2
10.5
7.2

5.4

7.9
7.6
7.8
9.0
9.6

3.3
3.6
0.6
-1.5
2.4

1976
1977
1978
1979
1980

4.7
6.1
7.9
8.5
9.9

4.8
5.8
6.8
7.9
7.2

9.0
8.4

4.3
2.3

9.1
10.1
12.8

1.2
1.6
2.9

5.9
6.8
6.0
5.5

average

annual

2. In 20 years,

in the GNP deflator
from 1 percent

in 1980.

this

in so
shall

not

a subject

economists.

relationship

many

has

policy

include

of contro-

To

been

ignored

recommendations,

a discussion

we

of interest

rates

est rates

funds.

demand.

two

The

premium

life of the

the expected
Open

market

Reserve
funds.

is maintained

money

has

money

supply

many

rate minus

are a major determinant
supply

A purchase

function

of

for loanable

of government

securities

measure
used,

because

reserves

bank

have

the

The

has

in 1961

low rates

in

probably

istration's
reported
the

multiple
riods.

Even
individual

the

growth

money

there

short-run

trend

the

over the three

and

the

3.

is no clear relationship
changes

price

in the

level.

money

However,

the

over time are clearly correlated.
long-run
supply

relationsh
and

the

ip between

price

will rise (see table

corresponds

between

inflation,

growth

rate

and

years is shown in table 1, column

As is evident,

The

supply

continues

inflation

in the

bond

deflator.
that

as the

minus

the

Viewed

level is well

reflects

the

fact

interest

have

grown

too

versing this trend

rate

rise in the short

and

immediate

real interest

real interest

average

increase

corporate

in the

real interest

rate is independent

is no trend

GNP

it is evident

rates have not

standards.

There

High

been high

In the long run, the

and money

of both

supply

in the real interest

series, as there is in the other series.

re-

growth.
rate

stage

rapidly

in the

on how quickly
in money

come to believe that

and decreases

and

slow growth

reduced,

aggre-

interest

Correlations

fects

to th is question,

of slower

money

the

of funds

second

deflationary

rates will

difficult

Reserve

and Future

and

third

pol icy.

to discern

recent

re-

experi-

deflationary

supply

show up in lower reported

in the ag-

to wait bewill lower

rates? While there is no defin-

ence suggests that significant

growth

M-1B Growth

growth

growth

inflation

efwill

rates in

years

following

the

Changes

in trend

are

from the data in table 1,

- 1975:1110

Correlation

between

we expect

money

inflation

itive answer

empirical

run. If the Federal

Chart 1

smaller.

reduced

ported

pre-

Inflation

Rates

10

12

coefficient

0.45
0.40

0.35
0.30

0.20
0.15
0.10
0.05

supply

growth

it will persist.

inflation

expectations

a substantial

and

in

and

In other

-0.10

interest

rates

marginal

-0.15

decrease

When money supply growth

are crowded

-0.05

will not drop

continual

in the face of continuing
rise and

o

Moreover,

people recognize

reduced
mands

markets

fore

inflation

on prices. The lag between
and variable.

is recognized.

Re-

rates to

run, but it will not have an
growth

until

in

today

past.

will cause interest

in money

words,

theoretical

price level. With the supply

rise in the short

to

rate by lower-

suggest that slowing money

to credit

mium becomes

however,

0.25

al i of the aggregates

is lengthy

the reduction

differ-

inflation

inflation
it depends

inflation

will not immediately
gregate

to fall as the expected

How long should

rates of the monetary

all of the

evidence

gradually

policy may be committed

the long-run

ing the growth
gates,

rates

begins to decrease.

Even though
slowing

will come

The

growth,

to slow and interest

and in-

target-setting

that

effect

of this policy

as inflation

pol icy.

money

inflation

interest
differences

decreases

by historical

inflation

respond

However,

formulation.

interest

in th is way,

ported
the

policy

in inflation

5, the ex post

is calculated
rate

to ex-

anti-inflationary

in slowing

we can expect

can vary, as many of

can be observed

the ex-

supply growth.

In column
rate

bond

trends

in

the

4). The

in the
1, column

corporate
to the

past money

connection

and current

supply

pand,

premium

and

moves

to technology,

trends

benefits

an

adjustment

pe-

income.
into

of

persists

unemployment,

the temporary

adopt

aggregate

components

respect

in long-run

money

to

long run, the trends

in the

corporated

inflation

the

cvcl ical

each of the aggregates

may be the case.

pected

Reserve

seasonal

and

and

in circulation
with

cost

lead to increased

represents

1964:10

monetary

in defin ing

over

rates,

will accelerate

of

which

0.50

Each

differently

of

of reserves

sup-

variable

The
deposit

targets.

with

the

accompanying

of world oil prices.

average money

trends

The high

of those controls

increase

illustrate

past money

supply

admin-

rates in 1973 th rough 1975

the relaxation

quadrupling

between

the Nixon

wage and price controls.
inflation

temporary

previous

reflect

government

on

Federal

the long run, the opposite
1971-72

base is often

of currency

problems

led

ently

rates to fall. In

in theoretical

Reserve System.

the

interest

(M-2). As a

and a control

plus
Federal

supply

authorities.
sum

of the

savings and various

it represents

monetary

in

will cause

plus check-

the monetary

ply of fiat money
the

In

in the supply

the money sup-

as currency

of the money

and leads to an increase

reserves

will be used. As a meabalances,

models,

the

on the

also are included

deposits

of loans that banks can make.
run, this increase

depends

time

banking
the short

is calculated

word

way

function,

Reserve

system

The

store-of-value

by the Federal
the amount

adds reserves to the

the

(M-1 B). As a measure

Practical
Federal

variable

able deposits

premium.
of the

because

meanings.

base is the

The real in-

interest

operations

System

so that the

contract.

inflation

the short-run

empirically,

economic

rate. The pre-

lent

rate is the market

rate has

is the amount

must pay lenders
funds

inter-

in supply

for expected

inflation

of the

over the
terest

prices,

interest

and the real interest

real value

in markets

changes

market

for expected

that borrowers

a. The inflation rate is measured as the average
annual percent change in the GNP deflator.
b. This is a moving average of the past three years
of M-l B growth. For example, the 1980 figure,
7.2, represents
the average annual growth in
M-1B for 1978, 1979, and 1980.
c. This interest rate is a simple average of the interest rates on Moody's Aaa, Aa, A, and Baa
corporate bonds.

with

components-a

inflation

define

is a difficult

ply usually is defined

Like other

fluctuate

and

mium

to

This may

supply

sure of transaction

rates are determined

for loanable

The money

way the calculations

Interest Rates and Inflation
Interest

The Money Supply

understand

in our analvsis.

3.7
2.6
3.0
3.2
2.2

1966
1967
1968
1969
1970

and

among

why

1.0
2.0
1.5
1.4
2.4

To

in corresponding

as even the most cursory

tion of the upsweep

the rate of increase

Corporate
bond interest rate,
percentC

1961
1962
1963
1964
1965

reflect

and continuing

relative

services,

of

increase

in the vol ume of money

movements

price

of food

increase

is generally

and if

understood
versy

Money
supplY
b
growth

Inflation
Year
ratea

in Prices, Money,

level.

to occur

companied

If

Trends

If the

component

causes

general

flation

did not.

in 1981

return to its previous

that

increased

have a drought

farm-product

the

As food

else is unchanged,

everything

the

CPI or the

food.

and more

the

the

rose, so did all the price indexes

include
prices

individual

inflationary.

drought

of

many

affect

truly

ample,

in an index is

Yet

that

supply
prices

(CPI), the

this procedure,

indexes
price

indexes,

price index

index

and

the general

to measure

level. By necessity,

rise

this definition

misconception

our attempts

goods,

Table 1 Long-Run
and Interest Rates

is

inflation,
credit

de-

out of the marketplace.

-0.20

o

NOTE: The standard

2
deviation

3

4

5

is calculated

line is drawn at two standard deviations.

6

7

8

9

11

13

14

15

16

as one over the square root of the sample size. The dotted

continuing

rise in the

general

price

level"

(Webster's New Collegiate Dictionary, 1973
ed.). More precisely, inflation is a substantial
and continuing increase in the volume of
money

and credit relative to available

resulting

in a substantial

in the general
tant

a popular

and continuing

price level. There

distinction

between

measured

is an impor-

that

results

from
price

the general

by assessing

price level is

prices

of individual

goods and services and constructing
such as the consumer
wholesale

price

deflator.
think

Through

(WPI), and the GNP

so that

labeled

we tend to

as an increase

of inflation

in the price

"inflation."
increases

WPI are not

any increase

the

many

As an ex-

in 1980
farm

decreased

products.

In one

sense,

of food

caused

inflation.

important

we do not

sense,

the

In another

they

Inflation

the

not likely

price

a continuing

will

an increase

level. Such

in
is

unless it causes or is ac-

by a substantial
to

available

goods.

reflected

in the

prices

and credit

Moreover,

in-

of all goods

and

examina-

in prices in the past two

decades

demonstrates.

inflation

rate for the United States since 1961

is shown

in table

to 9.9

percent

The

1, column

grown rather steadily

Ex post
real interest rate

1.9
1.2
2.5
3.2
3.8

4.7
4.6
4.5
4.6
4.6

3.7
3.2
4.6
5.2
5.0

4.0
4.3
5.2
5.5
5.2

5.3
5.8
6.5
7.4

1.6
2.6
1.9
2.2

8.5

3.5

1971
1972
1973
1974
1975

4.6
4.0
7.2
10.5
7.2

5.4

7.9
7.6
7.8
9.0
9.6

3.3
3.6
0.6
-1.5
2.4

1976
1977
1978
1979
1980

4.7
6.1
7.9
8.5
9.9

4.8
5.8
6.8
7.9
7.2

9.0
8.4

4.3
2.3

9.1
10.1
12.8

1.2
1.6
2.9

5.9
6.8
6.0
5.5

average

annual

2. In 20 years,

in the GNP deflator
from 1 percent

in 1980.

this

in so
shall

not

a subject

economists.

relationship

many

has

policy

include

of contro-

To

been

ignored

recommendations,

a discussion

we

of interest

rates

est rates

funds.

demand.

two

The

premium

life of the

the expected
Open

market

Reserve
funds.

is maintained

money

has

money

supply

many

rate minus

are a major determinant
supply

A purchase

function

of

for loanable

of government

securities

measure
used,

because

reserves

bank

have

the

The

has

in 1961

low rates

in

probably

istration's
reported
the

multiple
riods.

Even
individual

the

growth

money

there

short-run

trend

the

over the three

and

the

3.

is no clear relationship
changes

price

in the

level.

money

However,

the

over time are clearly correlated.
long-run
supply

relationsh
and

the

ip between

price

will rise (see table

corresponds

between

inflation,

growth

rate

and

years is shown in table 1, column

As is evident,

The

supply

continues

inflation

in the

bond

deflator.
that

as the

minus

the

Viewed

level is well

reflects

the

fact

interest

have

grown

too

versing this trend

rate

rise in the short

and

immediate

real interest

real interest

average

increase

corporate

in the

real interest

rate is independent

is no trend

GNP

it is evident

rates have not

standards.

There

High

been high

In the long run, the

and money

of both

supply

in the real interest

series, as there is in the other series.

re-

growth.
rate

stage

rapidly

in the

on how quickly
in money

come to believe that

and decreases

and

slow growth

reduced,

aggre-

interest

Correlations

fects

to th is question,

of slower

money

the

of funds

second

deflationary

rates will

difficult

Reserve

and Future

and

third

pol icy.

to discern

recent

re-

experi-

deflationary

supply

show up in lower reported

in the ag-

to wait bewill lower

rates? While there is no defin-

ence suggests that significant

growth

M-1B Growth

growth

growth

inflation

efwill

rates in

years

following

the

Changes

in trend

are

from the data in table 1,

- 1975:1110

Correlation

between

we expect

money

inflation

itive answer

empirical

run. If the Federal

Chart 1

smaller.

reduced

ported

pre-

Inflation

Rates

10

12

coefficient

0.45
0.40

0.35
0.30

0.20
0.15
0.10
0.05

supply

growth

it will persist.

inflation

expectations

a substantial

and

in

and

In other

-0.10

interest

rates

marginal

-0.15

decrease

When money supply growth

are crowded

-0.05

will not drop

continual

in the face of continuing
rise and

o

Moreover,

people recognize

reduced
mands

markets

fore

inflation

on prices. The lag between
and variable.

is recognized.

Re-

rates to

run, but it will not have an
growth

until

in

today

past.

will cause interest

in money

words,

theoretical

price level. With the supply

rise in the short

to

rate by lower-

suggest that slowing money

to credit

mium becomes

however,

0.25

al i of the aggregates

is lengthy

the reduction

differ-

inflation

inflation
it depends

inflation

will not immediately
gregate

to fall as the expected

How long should

rates of the monetary

all of the

evidence

gradually

policy may be committed

the long-run

ing the growth
gates,

rates

begins to decrease.

Even though
slowing

will come

The

growth,

to slow and interest

and in-

target-setting

that

effect

of this policy

as inflation

pol icy.

money

inflation

interest
differences

decreases

by historical

inflation

respond

However,

formulation.

interest

in th is way,

ported
the

policy

in inflation

5, the ex post

is calculated
rate

to ex-

anti-inflationary

in slowing

we can expect

can vary, as many of

can be observed

the ex-

supply growth.

In column
rate

bond

trends

in

the

4). The

in the
1, column

corporate
to the

past money

connection

and current

supply

pand,

premium

and

moves

to technology,

trends

benefits

an

adjustment

pe-

income.
into

of

persists

unemployment,

the temporary

adopt

aggregate

components

respect

in long-run

money

to

long run, the trends

in the

corporated

inflation

the

cvcl ical

each of the aggregates

may be the case.

pected

Reserve

seasonal

and

and

in circulation
with

cost

lead to increased

represents

1964:10

monetary

in defin ing

over

rates,

will accelerate

of

which

0.50

Each

differently

of

of reserves

sup-

variable

The
deposit

targets.

with

the

accompanying

of world oil prices.

average money

trends

The high

of those controls

increase

illustrate

past money

supply

admin-

rates in 1973 th rough 1975

the relaxation

quadrupling

between

the Nixon

wage and price controls.
inflation

temporary

previous

reflect

government

on

Federal

the long run, the opposite
1971-72

base is often

of currency

problems

led

ently

rates to fall. In

in theoretical

Reserve System.

the

interest

(M-2). As a

and a control

plus
Federal

supply

authorities.
sum

of the

savings and various

it represents

monetary

in

will cause

plus check-

the monetary

ply of fiat money
the

In

in the supply

the money sup-

as currency

of the money

and leads to an increase

reserves

will be used. As a meabalances,

models,

the

on the

also are included

deposits

of loans that banks can make.
run, this increase

depends

time

banking
the short

is calculated

word

way

function,

Reserve

system

The

store-of-value

by the Federal
the amount

adds reserves to the

the

(M-1 B). As a measure

Practical
Federal

variable

able deposits

premium.
of the

because

meanings.

base is the

The real in-

interest

operations

System

so that the

contract.

inflation

the short-run

empirically,

economic

rate. The pre-

lent

rate is the market

rate has

is the amount

must pay lenders
funds

inter-

in supply

for expected

inflation

of the

over the
terest

prices,

interest

and the real interest

real value

in markets

changes

market

for expected

that borrowers

a. The inflation rate is measured as the average
annual percent change in the GNP deflator.
b. This is a moving average of the past three years
of M-l B growth. For example, the 1980 figure,
7.2, represents
the average annual growth in
M-1B for 1978, 1979, and 1980.
c. This interest rate is a simple average of the interest rates on Moody's Aaa, Aa, A, and Baa
corporate bonds.

with

components-a

inflation

define

is a difficult

ply usually is defined

Like other

fluctuate

and

mium

to

This may

supply

sure of transaction

rates are determined

for loanable

The money

way the calculations

Interest Rates and Inflation
Interest

The Money Supply

understand

in our analvsis.

3.7
2.6
3.0
3.2
2.2

1966
1967
1968
1969
1970

and

among

why

1.0
2.0
1.5
1.4
2.4

To

in corresponding

as even the most cursory

tion of the upsweep

the rate of increase

Corporate
bond interest rate,
percentC

1961
1962
1963
1964
1965

reflect

and continuing

relative

services,

of

increase

in the vol ume of money

movements

price

of food

increase

is generally

and if

understood
versy

Money
supplY
b
growth

Inflation
Year
ratea

in Prices, Money,

level.

to occur

companied

If

Trends

If the

component

causes

general

flation

did not.

in 1981

return to its previous

that

increased

have a drought

farm-product

the

As food

else is unchanged,

everything

the

CPI or the

food.

and more

the

the

rose, so did all the price indexes

include
prices

individual

inflationary.

drought

of

many

affect

truly

ample,

in an index is

Yet

that

supply
prices

(CPI), the

this procedure,

indexes
price

indexes,

price index

index

and

the general

to measure

level. By necessity,

rise

this definition

misconception

our attempts

goods,

Table 1 Long-Run
and Interest Rates

is

inflation,
credit

de-

out of the marketplace.

-0.20

o

NOTE: The standard

2
deviation

3

4

5

is calculated

line is drawn at two standard deviations.

6

7

8

9

11

13

14

15

16

as one over the square root of the sample size. The dotted

Federal
because
and

the

trends

In chart

are masked

temporary

other

random

1 we have plotted

coefficient

calculated

in period
following.

between

quarters

are significant

coefficients

deviations.

marize

briefly-

at 7, 8, 9, and 10
con-

significant
twelfth

the

the

The most

growth

sixth

quarters.

with

in chart

These

results

correlations

indicates

tween

the

growth

speed

reports

with

results

tions,

reported

recognize

growth

changing

inflation

may tend

suppressing

people

If slower

in rapidly

Past inflation

will

and

money
expecta-

fall

is embodied

more
in con-

to slow the inflation-

effects

of

reduced

money

Even the most optimistic

indicate

a lag well in excess of one year be-

reduced

felt.
run

money

effect

long as four

and

supply

on inflation.

years

It is possible
output

suggest

other

th at

the
in

depends

the

money

the non-monetary

unless

dated by an increasing
The

model

supply.

used

money

n
~

(2) U

m.Mt_·

t=o

I

+

= pU _
t 1

factors
a tem-

accommo-

supply.

to generate

in table 2 is given in equations
(1)Pt=

are

aggre-

However,

have only

they

and

sh ort-term
the

on many

shocks

effect

defini-

Both theory

change

level

than

the growth

and various

supply.

esti-

the results

1 and 2:

I

t

(P)

was re-

before
that

estimates

growth

has a

It may be as

the full effect
the negative

unemployment

is

short-

effects

of

the slower money growth

will be substantial.

However,

effects are both less

these short-run

H:

o
l:m.=1

xm.

n

I

t

t

SE

as the

rate.

(U),

so

the

was

used

to

coefficient
degrees

estimate

residuals

in the money

to fit a third-order
constraints.
in table

2. Some

For every
standard

The

for multiseries, the

interesting

monetary

are
results

variable

the

error (SE) of the regression

growth

on

of a change
inflation

over

as the

of

the

This
price

indexes

in the
point

short
here

short-run

criterion,

error

is

model

money

the

1.
All

of the

M-1 B best "ex-

0.883
0.905
0.885
0.864

8

1.136
1.140
1.130
1.078

20
16
12
8

1.089
1.105
1.097
1.047

and capital

interest

rates risen to unprecedented

The

or "explain"

0.707
0.712
0.700
0.639

NOTE:
cent

Reject

if the

equal to

both

deflator;

and

growth

relation-

GNP

this

this

in-

of the aggregates and economic

see John B. Carlson and Theresa Gwazdaus-

kas,

"The

New

and

Monetary

Aggregates,
Pol icy,"

Economic

Economic

Activity,

Commentary,

10.27
11.46
12.29
11.52

1.474
1.473
1.480
1.474

1.60
1.82
1.73
0.73

13.36
14.81
15.07
10.07

1.449
1.429
1.448
1.533

1.17
1.52
1.49
0.57
-5.33
-5.33
-5.17
-3.80
Ho with

p
0.637
0.639
0.637
0.657
0.562
0.553
0.558
0.685

14.33
16.01
16.88
12.77

1.417
1.403
1.416
1.486

this

measure

of

inflation.

Other

Federal

Reserve Bank of Cleveland,

Federal

March

10,1980.

Research

BULK RATE
U.S. Postage Paid
Cleveland,OH

Reserve Bank of Cleveland
Department

P.O. Box 6387
Cleveland,OH

Permit

44101

period,

Reserve

the

12.85
13.19
12.07
6.73

1.432
1.429
1.475
1.608

0.618
0.613
0.639
0.768

region

of 5 perthan

and

money

the

supply

is estimated,

and operating

reserves

and the money

less likely to change
the

relationship

During

the

money

Federal

change,

reduce

initiates

adjustments

rates by gradually

the

lowering

In principle,

the growth

of the money stock could be coneither

interest

rates

to return
desired

between

supply.

subsequently

accurately,

interest

The desired

aggregates,

gress pursuant

Address correction

or

No. 385

money

terest

requested

between

supply,

rate on federal

that was estimated
sired

growth.

This

money

between

supply
and

because

often

money

not

supply

adherence
money

changed

changes

to

rates

and

the

acceler-

to

rates

control

Address

interest-rate

targets

to deviate further

flation,

Each

its plans to Con-

of 1978

and

(the

Hum~

Act). Because the Federal Retargets that are low enough
we can expect
markets.

is necessary,

continued
To see why

it is important

the basic relationships

between

to
in-

interest rates, and the money supply-

the topic of this Economic Commentary.

caused

Inflation
Inflation
the volume

T. Gavin is an economist,

Federal

Reserve

available

is defined
of money

as "an

increase

and credit

goods resulting

in

relative to

in a substantial

and

Bank of Cleveland.
The

Please send mailing label to the Research Department,
Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland,

Act

in the credit

understand

and further

Change
William

phrey-Hawkins

serve has selected

this pressure

by the Fed-

(FOMC).

to the Full Employment

Growth

pressure

to its

or, more

In this environment

from desired targets.

D Correct as shown
D Remove from mailing list

Balanced

Committee

to slow inflation,

the re-

in interest

enough

growth.

growth

procedure

as inflation

large

range

with de-

because

interest

and

the in-

funds in a narrow

to be unsatisfactory,

lationship
ated

"targeted"

to be consistent

monetary

were

interest

then

growth

are chosen

rates

relationship

and

rates that tend
paths,

year the FOMC must report

the

is a

ranges for each of the

estimated

Reserve

rates and

reserves

supply

eral Open Market

Federal

run than

if there

in bank

the target

monetary

interest

or bank reserves. Under the former operating
the

targets
between

of the new procedure

money

path."

and

may be no

However,

market
the

supply

in the short

the operation

eventually

the relation-

of reserves

are set for reserves. The relationship

of the

and

by controlling

new procedure,

supply

of the money stock.

strained

the

between

money

constant-to

pressures

have

heights,

Under
ship

volatile.

objectives

have remained

in the

the growth

proved

0.512
0.508
0.514
0.619

a critical

rates

that

Not only

have been unusually

inflationary

index.

of turbulence

markets.

interest

the
-1.36
-1.20
-1.60
-1.81

absol ute val ue of t is greater

1.96.

but

one

for

following

money

level of interest
activity,

The period

or supply

a long-term

M-2

20
16
12
8

policy.

Reserve

procedures

procedure,

plains"

M-1A

20
16
12
8

monetary

its operating

has been

St. Louis Base

20
16
12

6, 1979, the Federal

changed

change

omitted.

growth

On October
System

affect

that

demand

in

Growth

by William T. Gavin

that

of inflation.

to forecast

growth

it is to show

flation

suggests

been

Inflation, Interest Rates,and Monetary

systematic

variables

run have

between

was sig-

missing from equation

th rough

is not

This

term

non-monetary

~£Q,Clomic
Commentary

reflect
the hy-

parameter

error

23, 1981

growth

one

We can reject

is a quarterly

2. For a discussion

standard

than

a

period.

Using the smallest

money

instance.

are variables

ship

in money

occurs

there

rather,

with 16 lagged quarters;

that is, the full effect

a

the sum of the coefficients

in every

of the

with no endstatistics

greater

that

February

will lead to an

to the

autocorrelation

behavior

(m ) was constrained
i

Summary

equal

that

coeffi-

to one implies

in velocity.2

2. To preserve

polynomial

equal

the sum

lagged

rate of money

rate

nificant

growth

of the

equal to zero in all cases.

technique

and to adjust

of the weights

point

the

of

autocorrelation

the

in equation

of freedom

pattern

in

presence

Cochrane-Orcutt

(p)

collinearity

the

be used include

Coefficients

autocorrelation

regression

I

alternatively

positive

four-year

o
l:m.=O

I

growth

inflation

pothesis

supply

H:

steady

growth

was in the equation

1, the GNP deflator

A sum

Various

rates of change).

indicated

might

distribution

cients.

results

emerged.

.

that

the

(approx-

8, 12, 16, and 20) were used on the
defined

and

liminary

lowest
E

criteria

St. Louis base, M-1A, M-1B, and M-2. Pre-

given

+Ut·

of the logarithm

continuous

supply

by taking

M-1B

growth.

significant

price

money

of lower in-

supply

expectations.

growth

fore

evidence

we have

ip between

(quarter-to-quarter)

t

how long will depend

which

in money

their

that

the

are

of time be-

of slower

rates. Precisely

quickly.

tions of the money

presented

period

and subsequent

tracts

the relationsh

that we should ex-

achievement

change

analysis,

Table 2 Estimates of the Price Equation
1964: 110 - 1980: 1110

pect to wait a substantial

adjust

mated

In equation

The evidence

the

supply,

the

1.

on the

money

regression

on in-

through

Conclusion

flation

Using

=

16 lagged

growth.

on past values of the money

All variables were transformed

lags (n

porary

best fitting

including

of money

in

lagged

consistent

of the definition

supply

impacts
occur

using reTo sum-

used-the

are those

of money

flation

results

in the appendix.

supply

specifications
quarters

some

regardless

of the money

(M).

imating

gate

analysis

gressed

rate of the GNP deflator

Only

level.

gression

adverse
growth.

than

Appendix

in the

at a 95 percent

We have included

the

of fast money

less enduring

price effects

the first difference

M-1 B growth

Few of the correlation

are greater than two standard
calculated

and

long-run

in period t and the 16 quarters

the correlations

certain

the correlation

t and each of the changes

GNP deflator

fidence

by cycl ical
fluctuations.

Reserve Bank of Cleveland

author

OH 44101.

opinions
and

Reserve
Governors

not

Bank

stated

herein

necessarily
of

Cleveland

are those

those
or of

of

of

the

the Federal

the Board

of the Federal Reserve System.

of

1. For
the
"The

a detailed

new

discussion

operating

New Procedure,"

of the

procedure,
Economic

Reserve Bank of Cleveland,

mechanics

see E.J.
Review,

forthcoming.

of

Stevens,
Federal

Federal
because
and

the

trends

In chart

are masked

temporary

other

random

1 we have plotted

coefficient

calculated

in period
following.

between

quarters

are significant

coefficients

deviations.

marize

briefly-

at 7, 8, 9, and 10
con-

significant
twelfth

the

the

The most

growth

sixth

quarters.

with

in chart

These

results

correlations

indicates

tween

the

growth

speed

reports

with

results

tions,

reported

recognize

growth

changing

inflation

may tend

suppressing

people

If slower

in rapidly

Past inflation

will

and

money
expecta-

fall

is embodied

more
in con-

to slow the inflation-

effects

of

reduced

money

Even the most optimistic

indicate

a lag well in excess of one year be-

reduced

felt.
run

money

effect

long as four

and

supply

on inflation.

years

It is possible
output

suggest

other

th at

the
in

depends

the

money

the non-monetary

unless

dated by an increasing
The

model

supply.

used

money

n
~

(2) U

m.Mt_·

t=o

I

+

= pU _
t 1

factors
a tem-

accommo-

supply.

to generate

in table 2 is given in equations
(1)Pt=

are

aggre-

However,

have only

they

and

sh ort-term
the

on many

shocks

effect

defini-

Both theory

change

level

than

the growth

and various

supply.

esti-

the results

1 and 2:

I

t

(P)

was re-

before
that

estimates

growth

has a

It may be as

the full effect
the negative

unemployment

is

short-

effects

of

the slower money growth

will be substantial.

However,

effects are both less

these short-run

H:

o
l:m.=1

xm.

n

I

t

t

SE

as the

rate.

(U),

so

the

was

used

to

coefficient
degrees

estimate

residuals

in the money

to fit a third-order
constraints.
in table

2. Some

For every
standard

The

for multiseries, the

interesting

monetary

are
results

variable

the

error (SE) of the regression

growth

on

of a change
inflation

over

as the

of

the

This
price

indexes

in the
point

short
here

short-run

criterion,

error

is

model

money

the

1.
All

of the

M-1 B best "ex-

0.883
0.905
0.885
0.864

8

1.136
1.140
1.130
1.078

20
16
12
8

1.089
1.105
1.097
1.047

and capital

interest

rates risen to unprecedented

The

or "explain"

0.707
0.712
0.700
0.639

NOTE:
cent

Reject

if the

equal to

both

deflator;

and

growth

relation-

GNP

this

this

in-

of the aggregates and economic

see John B. Carlson and Theresa Gwazdaus-

kas,

"The

New

and

Monetary

Aggregates,
Pol icy,"

Economic

Economic

Activity,

Commentary,

10.27
11.46
12.29
11.52

1.474
1.473
1.480
1.474

1.60
1.82
1.73
0.73

13.36
14.81
15.07
10.07

1.449
1.429
1.448
1.533

1.17
1.52
1.49
0.57
-5.33
-5.33
-5.17
-3.80
Ho with

p
0.637
0.639
0.637
0.657
0.562
0.553
0.558
0.685

14.33
16.01
16.88
12.77

1.417
1.403
1.416
1.486

this

measure

of

inflation.

Other

Federal

Reserve Bank of Cleveland,

Federal

March

10,1980.

Research

BULK RATE
U.S. Postage Paid
Cleveland,OH

Reserve Bank of Cleveland
Department

P.O. Box 6387
Cleveland,OH

Permit

44101

period,

Reserve

the

12.85
13.19
12.07
6.73

1.432
1.429
1.475
1.608

0.618
0.613
0.639
0.768

region

of 5 perthan

and

money

the

supply

is estimated,

and operating

reserves

and the money

less likely to change
the

relationship

During

the

money

Federal

change,

reduce

initiates

adjustments

rates by gradually

the

lowering

In principle,

the growth

of the money stock could be coneither

interest

rates

to return
desired

between

supply.

subsequently

accurately,

interest

The desired

aggregates,

gress pursuant

Address correction

or

No. 385

money

terest

requested

between

supply,

rate on federal

that was estimated
sired

growth.

This

money

between

supply
and

because

often

money

not

supply

adherence
money

changed

changes

to

rates

and

the

acceler-

to

rates

control

Address

interest-rate

targets

to deviate further

flation,

Each

its plans to Con-

of 1978

and

(the

Hum~

Act). Because the Federal Retargets that are low enough
we can expect
markets.

is necessary,

continued
To see why

it is important

the basic relationships

between

to
in-

interest rates, and the money supply-

the topic of this Economic Commentary.

caused

Inflation
Inflation
the volume

T. Gavin is an economist,

Federal

Reserve

available

is defined
of money

as "an

increase

and credit

goods resulting

in

relative to

in a substantial

and

Bank of Cleveland.
The

Please send mailing label to the Research Department,
Federal Reserve Bank of Cleveland, P.O. Box 6387, Cleveland,

Act

in the credit

understand

and further

Change
William

phrey-Hawkins

serve has selected

this pressure

by the Fed-

(FOMC).

to the Full Employment

Growth

pressure

to its

or, more

In this environment

from desired targets.

D Correct as shown
D Remove from mailing list

Balanced

Committee

to slow inflation,

the re-

in interest

enough

growth.

growth

procedure

as inflation

large

range

with de-

because

interest

and

the in-

funds in a narrow

to be unsatisfactory,

lationship
ated

"targeted"

to be consistent

monetary

were

interest

then

growth

are chosen

rates

relationship

and

rates that tend
paths,

year the FOMC must report

the

is a

ranges for each of the

estimated

Reserve

rates and

reserves

supply

eral Open Market

Federal

run than

if there

in bank

the target

monetary

interest

or bank reserves. Under the former operating
the

targets
between

of the new procedure

money

path."

and

may be no

However,

market
the

supply

in the short

the operation

eventually

the relation-

of reserves

are set for reserves. The relationship

of the

and

by controlling

new procedure,

supply

of the money stock.

strained

the

between

money

constant-to

pressures

have

heights,

Under
ship

volatile.

objectives

have remained

in the

the growth

proved

0.512
0.508
0.514
0.619

a critical

rates

that

Not only

have been unusually

inflationary

index.

of turbulence

markets.

interest

the
-1.36
-1.20
-1.60
-1.81

absol ute val ue of t is greater

1.96.

but

one

for

following

money

level of interest
activity,

The period

or supply

a long-term

M-2

20
16
12
8

policy.

Reserve

procedures

procedure,

plains"

M-1A

20
16
12
8

monetary

its operating

has been

St. Louis Base

20
16
12

6, 1979, the Federal

changed

change

omitted.

growth

On October
System

affect

that

demand

in

Growth

by William T. Gavin

that

of inflation.

to forecast

growth

it is to show

flation

suggests

been

Inflation, Interest Rates,and Monetary

systematic

variables

run have

between

was sig-

missing from equation

th rough

is not

This

term

non-monetary

~£Q,Clomic
Commentary

reflect
the hy-

parameter

error

23, 1981

growth

one

We can reject

is a quarterly

2. For a discussion

standard

than

a

period.

Using the smallest

money

instance.

are variables

ship

in money

occurs

there

rather,

with 16 lagged quarters;

that is, the full effect

a

the sum of the coefficients

in every

of the

with no endstatistics

greater

that

February

will lead to an

to the

autocorrelation

behavior

(m ) was constrained
i

Summary

equal

that

coeffi-

to one implies

in velocity.2

2. To preserve

polynomial

equal

the sum

lagged

rate of money

rate

nificant

growth

of the

equal to zero in all cases.

technique

and to adjust

of the weights

point

the

of

autocorrelation

the

in equation

of freedom

pattern

in

presence

Cochrane-Orcutt

(p)

collinearity

the

be used include

Coefficients

autocorrelation

regression

I

alternatively

positive

four-year

o
l:m.=O

I

growth

inflation

pothesis

supply

H:

steady

growth

was in the equation

1, the GNP deflator

A sum

Various

rates of change).

indicated

might

distribution

cients.

results

emerged.

.

that

the

(approx-

8, 12, 16, and 20) were used on the
defined

and

liminary

lowest
E

criteria

St. Louis base, M-1A, M-1B, and M-2. Pre-

given

+Ut·

of the logarithm

continuous

supply

by taking

M-1B

growth.

significant

price

money

of lower in-

supply

expectations.

growth

fore

evidence

we have

ip between

(quarter-to-quarter)

t

how long will depend

which

in money

their

that

the

are

of time be-

of slower

rates. Precisely

quickly.

tions of the money

presented

period

and subsequent

tracts

the relationsh

that we should ex-

achievement

change

analysis,

Table 2 Estimates of the Price Equation
1964: 110 - 1980: 1110

pect to wait a substantial

adjust

mated

In equation

The evidence

the

supply,

the

1.

on the

money

regression

on in-

through

Conclusion

flation

Using

=

16 lagged

growth.

on past values of the money

All variables were transformed

lags (n

porary

best fitting

including

of money

in

lagged

consistent

of the definition

supply

impacts
occur

using reTo sum-

used-the

are those

of money

flation

results

in the appendix.

supply

specifications
quarters

some

regardless

of the money

(M).

imating

gate

analysis

gressed

rate of the GNP deflator

Only

level.

gression

adverse
growth.

than

Appendix

in the

at a 95 percent

We have included

the

of fast money

less enduring

price effects

the first difference

M-1 B growth

Few of the correlation

are greater than two standard
calculated

and

long-run

in period t and the 16 quarters

the correlations

certain

the correlation

t and each of the changes

GNP deflator

fidence

by cycl ical
fluctuations.

Reserve Bank of Cleveland

author

OH 44101.

opinions
and

Reserve
Governors

not

Bank

stated

herein

necessarily
of

Cleveland

are those

those
or of

of

of

the

the Federal

the Board

of the Federal Reserve System.

of

1. For
the
"The

a detailed

new

discussion

operating

New Procedure,"

of the

procedure,
Economic

Reserve Bank of Cleveland,

mechanics

see E.J.
Review,

forthcoming.

of

Stevens,
Federal