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july 8, 1977

u.s. nd Worl d
a
The nation's relatively low rate of
inflation in 1976clearly could have
been anticipated, and the sameis
true of the accelerating inflationof
1977.That, at any rate, is the
conclusion suggestedby the world
monetary developments of the
1970's,which have been reflected in
U.S.price movements several years
later.
The rates of monetary expansion in
the ten major industrial countries
went through three phasesin the
first half of the decade. First was the
expansionary period of 1971-73,
which generated the severe inflation of 1973-74.This was followed
by the 1973-74contraction in world
money supplies, which showed up
in the decelerating inflation of the
1975-76period. But a new monetary
expansion in 1974-75,undertaken
largely in responseto the severe
recessionof that period, created
the tinder for the recent speed-up
in prices.
Basicassumptions
This close relationship between
world money and U.S. inflation is
based upon two key assumptions.
First, the United Statescan no longer be treated, in either theoretical
or empirical terms, as a closed
economy. Improvements in communications and reductions in
transportation costs have so expanded the range of potential
internationally ..
traded goods that
foreign influences now exert a major impact on the U.S.economy. In
fact, roughly 50 percent of the

I n fl ati on
wholesale price index, 25 percent
of the consumer price index, and 20
percent of the GNP price index are
influenced significantly by world
market prices.
The second key assumption is that
flexible exchange rates cannot
completely isolate the United States
from foreign inflation pressuresin
the short run. According to the
standard theory, if the British inflation rate is 10 percent higher than
the U.S.inflation rate, the exchange
value of the pound will decline
relative to the value of the dollar,
leaving the dollar price of British
goods in the United Statesunchanged. While this proposition
continues to be true for the U.S.visa-vis anyone country, it is not
necessarilytrue for the U.S.vis-a-vis
all other countries.
When the rest of the world moves
in a synchronized business-cycle
pattern, the U.S. responds in effect
as a small open economy would-it
cannot completely
itself
from the inflationary influences of
the rest of the world. Given a .
change in the world price of an
internationally-traded good, competitive pressureswill insure that
U.S. producers of thatgood keep
their price in line. The resulting rise
in U.S. prices will not be limited
simply to export and import goods,
but to all those U.S.goods which
are potentially tradeable. No goods
will be sold in the U.S. at a lower
price than they could be sold
abroad.
(continued on page 2)

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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.

Consequently, the prices of at least
one-fifth of the nation's output of
goods and servicescould rise (at
least temporarily) as a result of
world inflation. Such increases
could be made a permanent part of
the U.S. price structure if labor
responds to the higher prices by
demanding proportionally higher
wages.The available evidence suggeststhat roughly 60 percent of the
higher prices would be translated
into higher wages after about a
year's time. In other words, about
40 percent of the higher world
prices would eventually be offset by
an appreciation of the dollar, and
60 percent by higher prices in the
United States.
This approach suggeststhat the
appropriate monetary variable to
be considered in an analysisof
inflation is the world money supply,
aswell as the domestic money supply. The implications are important,
not just for domestic prices, but
also for employment, output, and
interest rates.To the extent that
world monetary developments increasethe variance in U.S. inflation,
they wili create uncertainty in the
minds of U.S. households and businessmen,and thereby affect their
spending decisions.
Householdswill typically, in the face
of uncertainty, raisetheir savings
rate and reduce consumption out of
a given level of disposable income.
Businesses
similarly will reduce
investment becauseof difficulties in
analyzing the cost of new investment and the expected rate of

2

return from that capital stock. Thus,
an increasein both the inflation rate
and its variance will reduce consumption and investment, and
thereby increasethe rate of unemployment. Inflation in this context
will lead to a higher rate of unemployment, even in the short runcontrary to the standard Phillipscurve analysisof the inflationunemployment relationship.

What the data show
How does this theory of international inflation stand up against our
actual inflationary experience?
First, there was no systematic
worldwide business-cyclepattern
during the 1950'sand 1960's,except
briefly in 1958; generally, an expansion in one country was balanced
by a contraction in another, so that
worldwide monetary growth (and
thus aggregatedemand) grew at a
relatively stable rate. This was measured by the movements of the
Hworld" money supply-that is, the
weighted average of the money
supplies of the ten major industrial
countries. In the 1950'sthe average
growth in the world money supply
was in a narrow range around 6
percent, and in the 1960'sit was
around 8
This pattern was
roughly consistent with stable
prices for internationally traded
goods in both decades.Substantial
fluctuations occurred in sensitive
commodity prices, and to a much
lesserextent in export prices, but
alwaysaround a zero trend line.
The pattern changed sharply in the
1970's.World money growth accelerated from a 6-7 percent range in
1970to a 13 percent range in the
period from 1971through early

1973.This was followed by a monetary contraction in 1973-74and an
expansion in 1975-early1976.This
cyclical pattern of world money
growth induced, with a lag, a parallel movement in world aggregate
demand and later still in prices.
The accelerated money growth of
the 1971-73period was associated
with the breakdown of the Bretton
Woods regime of fixed exchange
rates.After that crisis ended with
the adoption of flexible rates in
March 1973,worldwide money
growth rapidly decelerated towards
an 8-percent trend growth in 197374. However, the resulting rise in
unemployment quickly triggered a
reversal in policy, and money
growth returned to growth rates
almost equal to those in the previous expansion, before slackening
off in the last half of 1976.
Given the lags in the system,a
change in the world money supply
tends to affect world commodity
prices after about one year, and the
broader-based measuresof industrial export prices in about two
years.Thus, the acceleration in
world money in 1971 led to rising
commodity prices in 1972and to
rising export prices in 1973.The
same pattern can be observed on
the downside; the deceleration of
world money growth in 1973 led to
a 1974deceleration in commodity
, prices and to a 1975deceleration in
general export prices.
, The effects of this pattern can be
, seen in the movements of the U.S.
wholesale-price index-and to a
, lesserextent (and with longer lags)
in the movements of the U.S.
I

3

consumer-price index. Apparently,
the sharp rise in U.S.wholesale
prices from late 1972through the
end of 1974was largely due to the
rise in world trade prices, and the
sharp deceleration in 1975-76
was
associatedwith the removal of that
influence. By the sametoken, this
year's upsurge in U.S.wholesale and
consumer prices-and the rise since
mid-1976in prices of internationally
traded goods-can be attributed to
the upsurge in world money which
occurred in 1975and early 1976.
However, the sameanalysiswould
suggestsome deceleration in U.S.
prices in late 1977and early 1978,asa
consequenceof the deceleration in
world money growth since mid1976.
'
it should be remembered, however, that despite the important
influence of foreign development!;
on U.S. prices, the dominant
ence comes from U.S. domestic
developments. Thus we can generate a home-grown inflation without
foreign' influences if we do not
control our domestk fiscal and
monetary policy. Nonetheless,our
analysissuggeststhat the way to
avoid an unstable world economy is
to follow policies which ,encourage
stable monetary conditions, not
only in the U.S., but also in other
major industrial countries. Efforts to
encourage other nations to follow
strongly stimulative policies could
be counterproductive, because
such policies soon thereafter would
contribute to yet another round of
world inflation.
Michael W. Keran

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BANKING DATA-TWELFTH FEDERAL
R.ESERVE
DISTRICT
(Dollar amounts in millions)
Selected Assetsand Liabilities
Large Commercial Banks

Amount
Outstanding

Change
from

6/22/77

6/15/77

-

Change from
year ago
Dollar
Percent

98,409
75,027
1,923
23,826
23,511
13,204
9,906
13,476
95,790
26,937
278
66,942
5,540
31,600
27,627
10,799

Wee!!dyAverages
of Daily Figures

Week ended

Week ended

6/22177

6/15/77

Member Bank ReservePosition
Excess
Reserves(+)/Deficiency H
Borrowings
Net free(+)lNet borrowed H
Federal Funds-Seven large Banks
Interbank Federal fund transactions
Net purchases(+)lNet salesH
Transactionswith U.S. security dealers
Net loans (+)lNet borrowings H

-

+
+
+

-

-

+

-

+

-

308
151
343
142
138
29
128
29
1,712
1,133
707
16

50
0
42
37

+
+
+
+
+
+
+
+
+
+

+ 9,448
+ 7,881

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 (lesscash items)-total*
Demand deposits (adjusted)
U.S. Government deposits
Time deposits-total*
Statesand political subdivisions
Savingsdeposits
Other time deposits:j:
Large negotiable CD's

10.62
11.74
30.91
7.57
16.09
18.29
1.61
11.69
8.34
12.18
- 36.38
+ 6.94
- 11.80
+ 21.93
- 1.42
- 15.02

+.

454
1,676
3,258
2,042
157
1,410
7,373
2,924
159
+ 4,342
- 741
+ 5,683
- 399
- 1,909

+
+
+
+
+
+
+

-

Comparable
year-ago period

50
32
82

+

8
20
12

733

+

370

+ 295
+
+ 689
*Includes items not shown separately.:j:lndividuals, partnerships and corporations.

176

+

1
4
3

+

83

+

Editorial comments may be addressedto the editor (William Burke) Oil' to the author••••
Information on this and other publications can be obtained by calling or writing the Public
Information Section, federal Reserve Bank of San Francisco,P.O. Box 7702, San Francisco94120.
Phone (415) 544-2184.