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December 27,1974

In this difficult period which com­
bines both inflationary and reces­
sionary influences, financial analysts
tend to disagree over what the
future direction of Federal Reserve
policy should be. To complicate
matters, they are not always in
agreement about the target appro­
priate for the monetary authority to
use to determine its present policy
stance.
Prior to this decade, Fed watchers
would have been less uncertain,
since the central bank previously
emphasized money-market condi­
tions, such as interest rates and
bank-reserve positions, in develop­
ing its policy actions. (By these
standards, especially given the
trend of interest rates, they would
have concluded until fairly recently
this year that the Fed was pursuing
a very tight policy.) But in 1970 the
Fed shifted its emphasis somewhat,
from an overriding concern with
money-market conditions to a
greater concern with monetary ag­
gregates— the most popular aggre­
gate being M!r currency held by
the public plus demand deposits in
banks.
Real vs. nominal
Nonetheless, even with the in­
creased emphasis on the aggregates,
it is sometimes difficult to decide
which aggregate should be given
the most consideration. The prob­
lem arises because there are several
different ways of measuring money
and its effects. We could simply
consider the number of dollars in
circulation; these are known as
nominal balances. Alternatively, we
1



could consider money in terms of
the goods and services the nominal
dollars will buy— that is, adjust
them for the effects of inflation.
Considered this way, money is
called real balances, real for reasons
painfully obvious to those on fixed
incomes.
There is no necessary reason for
these two notions of money to
behave in a like manner. In fact, in
this period of high inflation they
have moved in opposite directions,
compounding the task of analysis.
Nominal money balances recently
have been rising at more than a
6-percent annual rate, while real
balances have been falling at a
comparable 6-percent rate.
The controversy over this point can
be summed up in the titles of two
recent articles— "(Real Balances):
The Money Stock That Really
Matters," (First National City Bank)
vs. "Real Money Balances: A Mis­
leading Indicator of Monetary
Actions" (Denis Karnosky, of the
Federal Reserve Bank of St. Louis).
It is not especially newsworthy that
economists disagree, on this as on
any other subject. In fact, the
authors agree on many points.
Karnosky says, "The initial effect of
a change in aggregate demand
stemming from the excess supply
of money balances will tend to be
manifested in attempts to increase
output to meet the new demand.
Thus the rise in real balances will
tend to be associated with a rise in
output." (Emphasis added.) From
Citibank: "The nominalists . . . are
fearful, with good reason, that the
(continued on page 2)

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

pursuit of real balance targets will
lead to ever-escalating inflation."
So Karnosky agrees that increasing
real balances sometimes leads to
growth in real income, while the
Citibank authors concede that in­
creasing real balances occasionally
is self-defeating, in the sense that its
bad effect on inflation more than
offsets its favorable impact on
recession.
Shift in focus
The basic difference between these
two approaches can be simply
stated. The Citibank authors believe
that the single best measure of the
thrust of monetary policy is the rate
of growth of real balances, because
real balances are most closely
related to the growth of real in­
come, the most common measure
of national well-being. Karnosky, on
the other hand, believes that the
best measure of policy is the rate of
growth of nominal balances, since
this is the number most closely
related to the rate of inflation.
A problem in understanding arises
here because the rate of change of
money balances of any kind is not
always enough information to de­
termine the relative expansiveness

2




of monetary policy. If there is a
great deal more money, real or
nominal, in the economy than
people need to purchase the goods
and services they desire, telling the
public that real balances are de­
clining is a little like telling a
drowning man that the water level
in the lake is falling. It is the actual
level of money balances relative
to the desired level that tells the
direction of policy. So the problem
of interpreting policy hinges not
upon what kind of money is increas­
ing at which rate, but rather upon
the desired (or equilibrium) level
of money, be it real or nominal.
If this desired level is higher
than the actual level, monetary
policy is restrictive; if lower,
expansive.
Historical lessons
Attention recently has been
focussed upon changes in nominal
and real balances during the Great
Depression, especially the 1929-33
period. In their classic Monetary
History of the United States,
Milton Friedman and Anna Schwartz
describe the decline in nominal
balances of that period: "In terms
of annual averages . . . the money
stock fell at a decidedly lower rate
than money incomes . . . in the
four years from 1929 to 1933, a total
of 33 percent, or an annual rate
of 10 percent." But real balances
declined about 8 percent over this
period, in the wake of a 25-percent

reduction in consumer prices. By
either standard— but especially by
the standard of nominal balances—
a perverse tightening of monetary
policy contributed to the severity
of the business decline.
However, there are some historical
occasions when we should not
ignore changes in the relative desir­
ability of money in comparison to
other assets. The depression was
one such occasion, and the present
period may be another. During the
depression, cash was a growth
asset, in sharp contrast to most
other assets. (Indeed, a 25-percent
gain in the purchasing power of an
asset in a four-year period repre­
sents good earnings at any time,
especially during a depression.)
Prices had already been falling
since 1925, so that the 1929-33
decline did not come as a surprise.
Consequently, in view of the high
yield of money, its desirability
increased far more rapidly than the
Federal Reserve's accommodation
to this shift, leading to a restrictive
(and perverse) monetary policy.
Another uncharacteristic period
may have developed in the 1970's,
although for opposite reasons than
those governing the 1930's. In
normal times, with no dramatic
change in prices, either real or
nominal balances will tell the same
story. The desired share of money in
people's portfolios undergoes no

3




dramatic change, so that we
needn't worry about the effects of
such changes. But we are not living
in normal times today.
The nation has undergone several
brief periods of double-digit infla­
tion during its history. The cost of
holding money rises in such periods,
so people tend to hold less money
— just as in deflationary periods they
hold more.
In past inflationary periods, desired
holdings of money did not substan- .
tially change, mainly because peopie expected these episodes to be
short. The evidence indicates that
the desired balance between real
goods and real money holdings will
be affected only if the public ex­
pects a substantial, long-lasting shift
in the yield on money. So the
question of desirability of money
vis-a-vis goods hinges on whether
holders of money consider the
current inflation to be only a shortrun phenomenon, the result of
temporary influences— or whether
they believe it to be a long-run
phenomenon, the result of a sub­
stantial change in the way the price
level is determined in the United
States.
Kurt Dew

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BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks

Amount
Outstanding
12/11/74

Change
from
12/04/74

Change from
year ago
Dollar
Percent

+
-

+ 7,603
+ 8,370
+ 448
+ 3,398
+ 1,758
+ 752
- 668
99
+ 8,428
+ 1,281
78
+ 7,364
- 367
+ 385
+ 6,751
+ 5,511

Loans (gross, adjusted) and investments*
Loans (gross, adjusted)— total
Security loans
Commercial and industrial
Real estate
Consumer instalment
U.S. Treasury securities
Other securities
Deposits (less cash items)— total*
Demand deposits (adjusted)
U.S. Government deposits
Time deposits— total*
States and political subdivisions
Savings deposits
Other time depositsj
Large negotiable CD's

86,059
67,598
1,765
24,204
19,980
9,775
5,521
12,940
82,398
23,575
351
57,031
6,103
17,944
29,330
16,510

Weekly Averages
of Daily Figures

Week ended
12/11/74

438
234
—
309
—
67
27
+
12
+ 437
+ 235
+ 1,226
+ 372
—
104
+ 1,095
+ 468
— 54
+ 331
+ 618

Week ended
12/04/74

+ 9.69
+ 14.13
+ 34.02
+ 16.33
+ 9.65
+ 8.33
10.79
— 0.76
+ 11.39
+ 5.75
—
18.18
+ 14.83
5.67
+ 2.19
+ 29.90
+ 50.10

Comparable
year-ago period

Member Bank Reserve Position
Excess Reserves
Borrowings
Net free (+) / Net borrowed (—)

+

50
26
24

-

47r
148
101r

-

93
101
8

Federal Funds— Seven Large Banks
Interbank Federal fund transactions
Net purchases ( + ) / Net sales ( - )
Transactions of U.S. security dealers
Net loans ( + ) / Net borrowings ( —)

+ 1,761

+ 1,690

+ 1,396

+

+

+

879

736

106

""Includes items not shown separately. Jlndividuals, partnerships and corporations.

Information on this and other publications can be obtained by calling or writing the
Administrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco, California 94120. Phone (415) 397-1137.



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