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FRBSF WEEKLY LETTEA
Number 94-25, July 15, 1994

Should the Central Bank Be Responsible
for Regional Stabilization?
In a recent editorial, a prominent West Coast
newspaper suggested that the Federal Reserve's
decision to tighten monetary policy was premature, partly on the grounds that the California
economy remains weak. It pointed out that although the economy in other parts of the country
is doing quite well, the recovery in California
continues to lag behind, and it suggested that the
Fed should have kept interest rates low in order
to address this regional imbalance.
The editorial raises the question what role monetary policy should play in responding to regional
recessions. This Weekly Letter discusses some
basic principles of the theory of regional stabilization policy. First, it explains why the Federal
Reserve System cannot engage in region-specific
monetary policies. Second, it discusses the problems associated with a policy of systematically
easing whenever some region of the country experiences a local recession. Finally, it explains
why fiscal policy is better suited to the problem
of regional stabilization.

The recovery in California
and across the nation
First, we consider whether the continuing weakness in California represents a local problem or
reflects a general weakness in the national economy. Figure 1 shows three measures of the civilian unemployment rate for the period since 1989:
one for the United States, another for California,
and a third for all states except California. While
the recession in California began around the
same time as the national recession, the recovery
in California started later than the national recovery and has proceeded at a slower rate. Unemployment rates for the nation as a whole and for
the U.S. excluding California began falling in the
middle of 1992 and are now in the vicinity of the
"natural rate" of unemployment (which is the
long-term unemployment rate around which the
economy fluctuates and which economists estimate to be somewhere around 6 to 6.75 percent). In California, however, the unemployment
rate peaked near the end of 1992 and has fallen
only gradually since then.

This suggests that the continuing weakness in
California is not a symptom of a slow recovery
throughout the nation. Instead, California appears
to be suffering from lingering regional problems,
especially defense and aerospace cutbacks and
weakness in commercial real estate (see SherwoodCall 1993 and Cromwell 1994).

Why the Fed cannot target regions
The problem of regionally oriented monetary policy can be analyzed using a framework developed
by international economists to study the effects
of international trade in financial assets on the
power of monetary and fiscal policies. Instead of
focusing on financial flows across countries, we
focus on financial flows across states. When
viewed in this context, California has two special
features. First, there are no barriers to the flow of
financial assets across state borders, so investors
will buy a security wherever it offers the highest
yield. Second, since California uses the same
currency as the rest of the nation, its exchange
rate with respect to the other states is irrevocably
fixed at one; that is, you can always trade California dollars for New York dollars one for one.

Figure 1
Unemployment Rates

Percent

11
10

, I,
"/

9

California "'
I

\
'/\

",':'

,

v'

I·

...

"

1

1 'I

01

".

'" I

8
7

/

6

.

US Excluding
California

5

.

4-t----,.--"'T"""---,.--"'T"""---,.----,

89

90

91

92

93

94

FRBSF

Since there are no barriers to the flow of financial assets across states, interest rates on securities are equalized across locations within the
For example, in the market for
Treasury
bills, investors can choose between brokers in
San Francisco and New York. The transactions
costs of trading in the two markets are essentially
the same, so this will not affect the choice of
where to buy the security. Bills sold in New York
are denominated in the same currency and
backed by the same government as those sold in
San Francisco, so inflation and sovereign risk will
not affect the choice of the location. Finally, the
exchange rate between New York dollars and
California dollars is irrevocably fixed at one, so
exchange risk will not affect the choice of location. If brokers in New York quoted a lower yield
than brokers in San Francisco, investors would
sell bills in New York and buy them in San Francisco. This would reduce the yield on bills sold
in San Francisco and increase the yield on bills
sold in New York. Investors would continue this
operation until the yields were equalized.

u.s.

u.s.

The same principle applies to monetary policy.
The Federal Reserve influences credit conditions
primarily through transactions in the market for
bank reserves. On any given day, individual
banks may be above or below their desired reserve positions. Since reserves do not earn interest, banks that have a surplus will lend to banks
that have a deficit. The yield on reserve lending
is known as the federal funds rate, and it adjusts
to equate supply and demand for loans. When
the Federal Reserve wants interest rates to rise, it
reduces the aggregate quantity of bank reserves,
and this puts upward pressure on the federal
funds rate. But like all other interest rates, the
federal funds rate must be equalized across locations within the U.S. If the federal funds rate were
lower in San Francisco than in New York, banks
would borrow less expensive reserves in San
Francisco and lend them at a profit in New York.
This would put upward pressure on the federal
funds ratein San Francisco and downward pressure on the federal funds rate in New York. Banks
would continue this operation until the federal
funds rates in San Francisco and New York were
the same. Thus, interest rate equalization across
locations within the U.S. implies that the Federal
Reserve cannot conduct region-specific monetary
policies.
This means that monetary policy is a blunt instrument. The Federal Reserve cannot simultaneously ease credit conditions in California while

taking a neutral stance in the Midwest, where
local economies are booming. If the Federal Reserve wanted to ease credit conditions in California, it would have to ease credit conditions
throughout the rest of the nation as well. This
might improve conditions in California, but it
would also generate inflationary pressures in
much of the rest of the country, where unemployment is already near the natural rate. Monetary
policy would be an appropriate instrument if
the weakness in California were a symptom of
weaknessthroughout the national economy. But
California is lagging far behind the rest of the
economy.

Inflationary bias of regionally oriented
monetary policy
Furthermore, consider the consequences of a
policy of systematically easing whenever any
state is in recession. The problem with a policy
of this kind is that in a heterogenous multiregional economy such as the United States, there
is almost always some state that is experiencing
bad times, even when the national economy is
doing well. To illustrate this, we collected data
on unemployment rates in the largest 20 states
(measured by the size of the labor force) over the
period 1978 to 1994. For each month in the sample, we ranked the states according to their unemployment rates, and then we graphed the
unemployment rate in the weakest state. The
results ar~ shown in Figure 2, along with the
national unemployment rate. The shaded areas
mark the dates of recessions, as determined by
the National Bureau of Economic Research.
Figure 2 shows that there is often some state that
has high unemployment even when the national
economy is not in recession. If the Federal Reserve System were to ease credit conditions
whenever some state had high unemployment, it
would almost always be easing. Although a monetary expansion might increase output and employment in the weak region, it would aggravate
inflationary pressures in the strong ones. Hence,
a policy of this kind would produce a significant
inflationary bias.
If California had its own currency and flexible exchange rates with respect to the rest of the U.S.,
it could conduct its own independent monetary
policy, just as other countries do. For example,
when the Bank of Canada lowers its bank rate,
the Canadian dollar depreciates relative to the
U.S. dollar. This reduces the price of Canadian
goods relative to U.s. goods and shifts aggregate
demand from the U.S. to Canada. To our knowledge, no one has proposed that California issue
its own currency or establ ish its own central
bank.

Regional fiscal policy
Although open capital flows among states frustrate regionally oriented monetary policy, they
enhance regionally oriented fiscal policy. For
example, if California were to undertake a fiscal
expansion, local credit demands would increase.
In the absence of capital flows, local interest
rates would also increase, and some investment
projects would be crowded out. But since capital is highly mobile across states, an expansion
in California would attract capital from other
parts of the country, and this would reduce the
degree to which local investment projects are
crowded out.
This means that fiscal policy can be targeted to
specific regions. Unlike the Federal Reserve, state
and federal fiscal authorities can simultaneously
expand in some regions wh iIe contracti ng in others. Thus, fiscal efforts at regional stabilization do
not suffer from the inflationary bias that plagues
monetary pol icy.
In fact, the federal government already provides
an important source of insurance against regional income shocks. When one part of the
country experiences a local recession, its federal
tax payments fall and its federal transfer receipts
rise. These receipts include payments to state
and local governments, social security benefits,
food stamps, and supplementary secondary income payments, among others. At the same time,
tax payments rise and transfer receipts fall in

Figure 2
Maximum Unemployment Rates
Percent

booming regions, so the federal government
automatically transfers resources from strong to
weak regions. Xavier Sala-i-Martin and Jeffrey
Sachs (1992) estimate that a one dollar reduction
in a state's income results in a 34 cent reduction
in federal tax payments and a 6 cent increase in
federal transfer receipts. Thus the federal government absorbs roughly 40 percent of the fall in
regional income. Since this operates primarily
through the federal tax system, the policy is fully
automatic and does not require discretionary
action by Congress or the President.
State governments also can try to stabilize regional incomes by increasing spending during
local recessions and cutting back during local
booms. This is likely to be less effective than federal fiscal policy because individual states have
to finance a spending increase by raising their
own taxes. On the other hand, under the federal
system, tax reductions and spending increases in
weak states are partially financed by tax revenues from other regions. Even so, state level fiscal policy is a more flexible instrument than
monetary policy.

Conclusion
While a monetary expansion might reduce
unemployment in weak regions, it would also
aggravate inflationary pressure in strong ones.
Systematic use of monetary policy for regional
stabilization would therefore impart an inflationary bias in an economy with many heterogenous
regions. Fiscal policy does not suffer from this
inflationary bias, since the fiscal authorities can
simultaneously expand in weak regions and
contract in strong ones. Hence the problem of
regional stabilization should be assigned to the
fiscal authorities.

Timothy Cogley
Senior Economist

Desiree Schaan
Research Associate

References
Cromwell, Brian. 1994. "California Recession and
Recovery:' FRBSF Weekly Letter (April 29).
Sala-i-Martin, Xavier and Jeffrey Sachs. 1992. "Fiscal
Federalism and Optimum Currency Areas: Evidence
for Europe from the United States:' Working Paper
No. 632, Center for Economic Policy Research
(March).

78

80

82

84

86

88

90

92

94

Sherwood-Call, Carolyn. 1993. "Whither California?"
FRBSF Weekly Letter (August 8).

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author..•. Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.

Research Department

Federal Reserve
Bank of
San Francisco

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San Francisco, Calif.

P.O. Box 7702
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P~inted on recycled paper ~ ~,
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Index to Recent Issues of FRBSF Weekly Letter
DATE NUMBER TITLE
1/7
1/14
1/21
1/28

2/4
2/11
2/18
2/25
3/4
3/11
3/18
3/25
4/1
4/8
4/15
4/21
4/29
5/6

5/13
5/20
5/27
6/10
6/24
7/1

94-01
94-02
94-03
94-04
94-05
94-06
94-07
94-08
94-09
94-10
94-11
94-12
94-13
94-14
94-15
94-16
94-17
94-18
94-19
94-20
94-21
94-22
94-23
94-24

Market Risk and Bank Capital: Part 1
Market Risk and Bank Capital: Part 2
The Real Effects of Exchange Rates
Banking Market Structure in the West
is There a Cost to Having an Independent Central Bank?
Stock Prices and Bank Lending Behavior in Japan
Taiwan at the Crossroads
1994 District Agricultural Outlook
Monetary Policy in the 1990s
The IPO Underpricing Puzzle
New Measures of the Work Force
Industry Effects: Stock Returns of Banks and Nonfinancial Firms
Monetary Policy in a Low Inflation Regime
Measuring the Gains from International Portfolio Diversification
Interstate Banking in the West
California Banks Playing Catch-up
California Recession and Recovery
Just-In-Time Inventory Management: Has It Made a Difference?
GATS and Banking in the Pacific Basin
The Persistence of the Prime Rate
A Market-Based Approach to CRA
Manufacturing Bias in Regional Policy
An "Intermountain Miracle"?
Trade and Growth: Some Recent Evidence

AUTHOR
Levonian
Levonian
Throop
Laderman
Walsh
Kim/Moreno
Cheng
Dean
Parry
Booth
Motley
Neuberger
Cogley
Kasa
Furlong
Furlong/Soller
Cromwell
Huh
Moreno
Booth
Neuberger/Schmidt
Schmidt
Sherwood-Call/Schmidt
Trehan

The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.