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March 2, 1 979

Moneyand Prices
Everyone agrees that inflation
accelerated in 1978, as consumer
prices rose by 9.0 percent over the
course of the year, compared with a
6.8-percent increase in the previous
year. However, not everyone agreeson
the causes of this acceleration. While
some point to the avarice of workers
and firms in demanding more than the
economy can del iver, others blame the
acceleration on the money-supply
growth experienced in the U.S. from
late 1 976 through mid-1 978.lt's important to real ize that the two views are not
necessarily inconsistent.
Those who advocate a monetarist view
of inflation see a higher money supply
as stimulating demand in the economy
without affecting the supply of goods
and services, and so inevitably leading
to higher prices. The metaphor of iJtoo
much money chasing too few goods,"
while not entirely precise, captures
much of the flavor of this argument.
On the other hand, advocates of costpush explanations can be divided into
two groups. Some see developments
in the labor or commodity markets as
affecting the price level regardless of
what happens to the money supply.
They believe that wage or commodity
price hikes increase costs, which are
then passed on in higher prices for other
goods, and that this process can continue indefinitely on its own momentum. This approach raises several
questions, however. If all prices
increase autonomously, with no monetary expansion or other impetus to
aggregate demand, then the resulting
situation could not be sustainable.
Underlying demand and supply condi-

tions would not have changed, but
prices would have, so that something
would have to give. Either prices will
eventually return to their previous
levels, or the growth rate and employment will fall. But it isn't consistent
to expect continuing cost-push inflation
with no other impetus to aggregate
demand.
The other group of cost-push advocates
therefore includes the money supply in
a more sophisticated explanation. They
agree that the money supply must grow
for inflation to persist, but they argue
that prices and wages usually rise first,
and that the faster money growth is then
necessary to avoid the slow growth and
unemployment described in the previous paragraph. Thus, the money growth
merely ratifies or accommodates an inflation that has its seeds in excessive
wage or price demands. These excessive
demands raise prices directly in the
short-run, and indirectly in the longrun by causing monetary expansion.

Consistentexplanations?
The latter cost-push theory is logically
consistent within itself, and it is also
consistent with much of the monetary
explanation of inflation. Both theories
agree that inflation can continue if and
only if the money supply is expanded.
Both would agree that once money
growth is stopped, a painful period of
depressed output and employment
would ensue before inflation would
start to fa".
Still, the two views have quite different
policy implications. If autonomous
wage and other types of cost hikes do
typically precede monetary expansion,
(continued on page 2)

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Opinions expressed in this newsletter do not
.
necessarily reflect the views of the management 01 the
Federal Reserve Bank of San Francisco, nor of the Board
at Governors of the FederalReserve System.

in the context where monetary nonaccommodation by itself will 'induce a
recession, then the least painful way to
halt inflation would be through administrative restraints on wages and prices
(and concomitant monetary restraint).
In this case, excessive wage and price
demands wou Id be the real roots of
inflation, and they should therefore be
attacked directly.
On the other hand, so-called monetarists dispute this view that prices and
wages typically play such an autonomous role. Rather, they bel ieve that
independent monetary-policy
decisions are the more typical cause of
monetary expansion. Once monetary
expansion has stimulated aggregate
demand, inflation i's inevitable, and
workers and firms will demand higher
wages and prices merely to keep up
with the inflation. Thus, wage and
commodity price increases followrather than precede - money growth.
In this view, slower growth and lower
employment would still follow in the
wake of a move to restrictive monetary
policy. However, controls (whether
jawbone or otherwise) would only
impede households and businesses
from protecting themselves against an

2

inflation they did not start. Also, the
controls would not prevent a future
expansionary policy from starting the
next inflationary spiral a few years
hence.

Empirical
evidence
Once again, both views are economically self-consistent. Therefore, it's an
empirical question which is correct. Do
autonomous wage and price hikes
systematically precede and so cause
monetary expansion, or is the opposite
. typically the case?
To throw more I ight on the subject,
"causality tests" utilizing 1957-78 U.S.
data were conducted between the (M1
and M2) money supply and a number
of cost-push variables - namely, Consumer prices (total and food), wholesale prices (total, farm, nonfarm, metal,
and stee/), wages (nonfarm and manufacturing), and unit labor costs (private
business, nonfarm business, and manufacturing). M 1 includes currency plus
bank demand deposits; M2 includes
currency pJus aU bank deposits except
large time certificates.
In these tests, the statistical evidence
suggested that the money supply (both
M 1 and M2) strongly affected prices,
whereas the cost-push factors exerted
very I ittle if any effect on the money
supply. Both M1 and M2 showed
strong one-way effects on the aggregate
consumer and wholesale price indexes.
M1 significantly affected all the subindexes except wholesale nonfarm and
steel prices, and nonfarm and manu-

facturing wages; M2 significantly
affected all the sub-i ndexes except nonfarm wages and several wholesale
prices (farm and nonfarm, and metal
and steel). However, none of the costpush variables showed significant
effects on M 1, and only wholesale
metal and steel prices showed significant effects on M2.
Some analysts argue that cost-push
factors exert a more indirect influence
on the money supply, with policymakers reacting to the higher
unemployment caused by higher
wages. If this were true - if wages
affect unemployment, and unemployment affects money - then we sti II
should have seen some influence of
, wages on money in the tests just described. Still, as a means of directly testing for these indirect effects, causality
tests were ru n between wages and
unemployment and between
unemployment and money. These tests
showed significant effects of wage
increases on unemployment, but no
effects of unemployment on money
growth. Thus, this indirect test showed
no evidence of cost-push effects on the
money supply.

Monetary view supported
In sum, these results support a monetary view of inflation. The tests did not
attempt to take account of the various
transmission mechanisms through
which money can affect prices. Nor did
they attempt to distinguish between
those increases in the money supply
that matched money demand, and

3

those which exceeded money
demand. Yet using a very simple
approach, the data found a systematic,
statistically significant effect of the
money su pply on the price level.
Changes in the rate of money supply
growth (M 1 or M 2) were able to
accou nt for some 60 percent or more of
quarter-to-quarter changes in the consumer-price inflation rate. Finally, the
data failed to yield a significant effect of
any cost-push type variable on M 1, and
very little significant evidence of an
effect on M 2. The evidence is-consistent with a world where autonomous
money-supply fluctuations are the primary cause of price fluctuations, and
where wages and prices move together
mainly because both are responding to
previous money growth.
Of course, the present approach looked
only for systematic effects. It's still possible that cost-push factors could have
been important in particular isolated
circumstances. One such case, and an
obviously relevant one, is the 1978
acceleration in inflation. We are now _
examining the link between money,
otherfactors, and inflation in 1978,and
what this suggests for the inflation
outlook in 1979.

MichaelBazdarich

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BANKING DATA-TWELfTH FEDERAL
RIESER.VE
DISTRICT
(Dollar amounts in millions)

Selected
Assets liabilities
and
largeCommercial
Banks

Amount
Outstanding
2/14/79

Loans (gross,adjusted)and investments*
Loans(gross,adjusted)- total#
Commercial and industrial
Realestate
Loansto individuals
Securitiesloans
U.s. Treasurysecurities"'
Other securities*
Demand deposits - total#
Demand deposits - adjusted
Savingsdeposits - total
Time deposits - total#
Individuals, part. & corp.
(LargenegotiableCD's)

120,408
98,415
28,967
35,167
20,245
1,665
7,598
14,395
39,815
29,839
29,643
50,923
41,378
18,847
W=ekended
2/14/79

Averages
of Daily Figures
MemberBankReserve
Position
Excess
Reserves )/Deficiency (-)
(+
Borrowings
Net free reserves(+ )/Net borrowed(- )

Change
from
2/7/79

57
79
22
75
22
18

Changefrom
year ago @
Dollar
Percent
NA

NA

8

144
174
527
59
146
92
82
W=ekended
2/ 7/79

Comparable
year-agoperiod

23
64
41

20
32
12

11
3

637

881

1,949

422

346

1,023

8

Federal
Funds Seven
large Banks
Net interbanktransactions
[Purchases )/Sales(-)]
(+
Net, U.s. Securitiesdealer transactions
[Loans(+)/Borrowings (-)]

* Excludes
tradingaccount
securities.
# Includes
itemsnot shown
separately.
@ Historical
dataarenot strictlycomparable to changes thereporting
due
in
panel;
however,
adjustments
havebeenapplied 1978datato remove muchaspossible effects thechanges coverage.
to
as
the
of
in
In
addition,for some
items,
historical
dataarenot available to definitional
due
changes.
Editorial
comments be addressed theeditor(WilliamBurke) to theauthor....
may
to
or
Freecopies this andotherFederal
of
Reserve
publications be obtained callingor writingthe Public
can
by
InformationSection,
Federal
Reserve
Bankof SanFrancisco, Box7702,SanFrancisco
P.O.
94120.
Phone
(415)544-2184.