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Announcem ent of new publications
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Department is in the process o f redesigning the bank's existing publications to satisfy the interests o f a
wide variety of readers. As an example, we have begun a new publication, Midwest Update, a monthly
letter focusing on regional econom ic developm ents.
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scribers will automatically receive this new publication. During the 1982 transition period, Economic
Perspectives will be published less frequently. In addition to the Midyear 1982 issue, two other issues will
be published, one in the autumn and one in the winter.

Review and outlook: 1981-82

The M idwest was hit harder than
other regions o f the country by the
stubborn recession that began in the
spring or summer o f 1981.
Hard times—the M idwest in trauma
Prolonged slump for agriculture
W orld econom y is slow to im prove

CO N TEN TS

3
9
14

Fiscal policy—a new approach

Financial markets and monetary policy

Prelude to recovery

Econom ic events in 1981—a chronology

Lagged reserve accounting and the
Fed’s new operating procedure 32
Under lagged reserve accounting
the Fed's new operating procedure
adopted on O ctober 6, 1979 led to
increased week-to-week volatility in
deposits.

The effects of usury ceilings

ECONOMIC PERSPECTIVES
Midyear 1982, Volume VI, Issue 1

The evidence suggests that usury
ceilings reduce the supply o f credit to
those whom the ceilings are designed
to protect.

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Review and outlook:

1981-82

Hard times—the Midwest in trauma
In early 1982, the nation remained in the grip
of a painful business recession that began in
the spring or summer of 1981. The Midwest,
with its heavy concentration of durable goods
manufacturing, was the region of the country
most severely affected. Declines in produc
tion were reported for most types of manu
facturing, agriculture, trade, transportation,
and even government. Coming on the heels
of the downturn that ended in the second
quarter of 1980, the 1981 recession was an
unprecedented second recession in two years.
Moreover, in contrast with most downturns
of the past, the 1981 recession began at a time
when the economy had significant margins of
unused capacity, both material and human.
In the first quarter of 1982, reports on
output, orders, and employment suggested
that the rate of decline had slowed. Price dis
counting and cuts in production were reduc
ing excessive inventories of finished goods.
There were hopes for an early end to the
downturn and for a gradual improvement in
activity later in the year, aided by slower infla
tion, lower interest rates, and the July 1 reduc
tion in personal income taxes. Nevertheless,
pessimism about the long-term course of the
economy was more profound than at any
time since the 1930s. Widespread financial
distress, high prices, high interest rates, intense
competition (both domestic and foreign),
and a lack of job opportunities combined to
depress public morale.

activity in the first half of the year, followed by
at least a modest improvement in the second
half. Instead, the first quarter proved to be
surprisingly (and deceptively) robust, possi
bly aided by a mild winter. Total economic
activity was about unchanged, on balance, in
the second and third quarters. However, a
sharp downturn occurred in the fourth quar
ter when constant dollar gross national prod
uct (real GNP) declined at an annual rate of
almost 5 percent. The Federal Reserve's
Industrial Production Index, measuring phys
ical activity in manufacturing, mining, and
electric and gas utilities, hit a peak in July and
then declined at an accelerating pace through
year-end. Wage and salary employment
peaked at 92 million in September and then

Economic activity declined while
inflation slowed in late 1981 and
early 1982
percent change

A disappointing year

In early 1981, the typical professional
forecast called for little or no growth in real

F e d e ra l R e s e rv e B a n k o f C h ica g o

dropped to an average of 91 million in the first
quarter of 1982. Unemployment rose to 9
percent nationally, and to substantially higher
levels in the Midwest.
National growth slows

Consumption expenditures and
government purchases remained
strong in early 1982, while other
sectors declined further
billions of 1972 dollars

The sluggishness of the economy since
1979 ended three decades of vigorous growth
and remarkable resiliency. From 1947through
1973, real CNP grew at an average annual rate
of over 3.8 percent despite recessions in 1954,
1958, and 1970. After each downturn the
economy not only regained its previous high
within a year or so, but also reasserted a
strong long-term rate of growth.
The 1973-75 recession, associated with
the Arab oil embargo, was the longest (five
quarters) and the deepest (a 5 percent reduc
tion in real GNP) since the 1930s. Neverthe
less, after some far-reaching and painful
adjustments, the national economy struggled
back to a level of reasonably full prosperity in
1978 and 1979. However, economic growth
slowed in 1979 and has been weak ever since.
Real GNP declined 0.2 percent in 1980 and
rose only 2 percent in 1981. The standard
forecast for 1982 calls for a slight decline or, at
best, no significant growth. (Despite inaccu
rate predictions of the quarterly pattern for
1981, the typical forecast for the year-to-year
change was substantially correct.) Assuming
that real GNP this year equals the 1981 level, it
will be 15 percent below the 3.8 percent
growth path of 1947-73, extrapolated through
1982. The shortfall in production would cum
ulate in future years if slow growth continues.
Such a prospect has sobering implications for
the national standard of living.
Inflation moderates

World War II was followed by a surge of
inflation after price controls were removed.
Another surge occurred during the Korean
War. In 1953, the GNP deflator, a measure of
the general price level, was 90 percent above
the level of 1941. From 1953 through 1965 the
deflator rose at an average rate of only 2 per-

E c o n o m ic P e rsp e c tiv e s

O ver the past decade, total output
dropped below its long-term trend;
inflation accelerated
billions of 1972 dollars

index 1972 = 100

cent annually—in retrospect, a very favorable
record.
After American combat forces entered
the Viet Nam War in 1965, large federal defi
cits and excessive money and credit growth
contributed to a sharp acceleration in the rate
of inflation. Between 1965 and 1973, the GNP
deflator increased at an annual rate of 4.5
percent. The Arab oil embargo and the result
ing rapid rise in energy prices were associated
with a further speed-up of inflation between
1973 and 1981, when the deflator rose at an
average annual rate of 8 percent.
In 1981, the deflator rose 9 percent, the
same as in 1980, but with a significant slowing
late in the year. Most analysts expect the infla
tion rate to decline to 7 percent in 1982.
Unfortunately, even a 7 percent inflation rate,
when compounded, implies a doubling of
the price level in only 10 years.
Labor costs and productivity

Worker compensation, including bene
fits, continued to rise rapidly in 1980 and 1981,

Federal Reserve Bank o f Chicago

despite reduced job opportunities and rising
unemployment. On average, compensation
in the nonfarm business sector rose 10 per
cent in 1981, the same as in 1980, which is the
record high for this series starting in 1948.
Some large unions in construction, mining,
and manufacturing won substantially larger
first-year gains.
Rising labor compensation need not push
up unit labor costs if productivity—output
per worker hour—rises at a similar pace. If
productivity improvement in the entire
economy matches growth in compensation,
the supply of goods and services can keep up
with rising labor income. Labor costs per unit
of output, and prices of this output, can
remain relatively stable. Unfortunately, in
recent years labor cost per unit of output has
fully reflected increases in compensation
because productivity, breaking the long-term
trend, has been declining or, at best, showing
sporadic gains.
From 1947 through 1977, hourly compen
sation in the nonfarm private economy rose
at an average annual rate of 5.8 percent. Out
put per hour rose 2.4 percent annually, offset
ting part of the rise in compensation. Unit
labor costs and prices both rose at an annual
rate of about 3.4 percent over this 30-year
period, closely approximating the excess of
the increase in compensation over the rise in
productivity.
From 1977 through 1981, compensation
increased at a rate of 9.6 percent, while pro
ductivity d e c lin e d slightly. Unit labor costs,
therefore, rose slightly faster than compensa
tion. Prices rose at an annual rate of about 9
percent. For three consecutive years, 1978-80,
productivity declined slightly. Last year it
rose, but by only about 1 percent.
The reasons for the recent poor record
on productivity are many and varied. Shifts in
production methods due to increased fuel
prices, irregular production schedules, low
operating rates relative to capacity, and re
strictive work rules each played a role. In
periods of precipitous decline, like the fourth
quarter of 1981, measured productivity drops
abruptly because workers are not released as

Slumping productivity and rapid
wage and benefit gains boosted unit
labor costs
percent change from year earlier

percent change from year earlier

quickly as production schedules are cut back.
Productivity usually rises rapidly in the early
stages of a business expansion because few
bottlenecks impede rising production, and
because experienced workers and the most
efficient facilities are put back to work.
The analysis above implies that the rise in
compensation must slow, or productivity must
rise, preferably both, if inflation is to moder
ate. This must be accomplished in an envi
ronment of monetary and fiscal restraint. This
is the aim of the negotiations between man
agement and labor unions in recent months
to reopen existing agreements in such sectors
as motor vehicles, meat packing, and truck
ing. Managements wish to reduce compensa
tion, or at least slow its rate of increase and to
alter work rules that impede efficient use of
men and facilities. Writing a new chapter in
U.S. labor relations, unions have shown some
willingness to consider such concessions. In
return, they are asking for greater job security
and a larger voice in future decision making

The recession in the Midwest

The region of the Seventh Federal
Reserve District, encompassing much of what
is frequently referred to as the Midwest,
includes both the nation's industrial heart
land and its most productive agricultural
area. With 15 percent of the country's popula
tion, the five District states produce almost a
fourth of its manufactured durable goods and
much larger shares of its motor vehicles, farm
and construction equipment, industrial
machinery, and steel. These states also pro
duce half of the nation's corn, soybeans, and
pork and a fourth of its milk.
Growth of population and employment
in the Midwest has lagged the performance
of the South and West since 1950, and espe
cially since 1970. As in earlier decades when
growth in the Midwest equaled or exceeded
that of the nation, its durable goods industries
have been vulnerable to cyclical fluctuations.
Until the last three years, however, autos,
steel, farm equipment, and the other volatile
industries always rode through periods of
adjustment and snapped back unimpaired to
new highs. The region remained basically
healthy and vigorous.
In early 1982, wage and salary employ
ment in the Midwest was 6 percent below the
prosperous level of early 1979. Nationally,
total employment declined in the fourth
quarter of 1981 and in early 1982, but was still
3 percent above the level of early 1979. Out
put of durable goods nationally was 10 per
cent below the rate of the recent peak in july,
and 13 percent below that of March 1979,
which still marks the record high. Nondura
ble goods output was down 7 percent from
the all-time peak reached last August.
Fuel prices hit hard

Many of the present problems of the
Midwest are attributable to the rapid escala
tion of world oil prices. Followingthe imposi
tion of the oil embargo in 1973, the bench
mark price for Saudi Arabian light crude oil
rose from $3.00 per barrel in October 1973 to

E c o n o m ic P e rsp e c tiv e s

Output has fallen sharply in
important Seventh District industries
in d e x ,1967 = 100

J — i— i— I— i— i__i__ I__i__i__i__ I__i__ i__i__ I__i__i__i I i i i
1976
1977
1978
1979
1980
1981

construction which hit the Midwest very
hard. Nationally, housing starts in 1981 were
50 percent below the peak of the early 1970s.
In the Midwest, starts were 60 to 80 percent
below the peak. Slower residential construc
tion activity reduced demand for construc
tion equipment.
Aside from reducing sales of goods manu
factured in the Midwest, the energy crisis had
other serious effects on the region. Primarily
because of its colder winters and aging build
ings and equipment, the Midwest consumes a
disproportionate share of the nation's oil,
natural gas, and low-sulfur coal (mandated by
anti-pollution regulations). It produces only a
very small share of its needs. Consequently,
the Midwest is an energy "importer” both
from abroad and from other states. High fuel
prices, which increase production and living
costs, partly reflect severance taxes imposed
by the producing states. Increasingly, Mid
west companies have chosen to move at least
a portion of their operations to the Sunbelt
where costs of fuel, labor, and government
are lower.
Some other problems

$11 in 1974, and to $13 in 1977. The price was
boosted further by the cutoff of oil from Iran
in 1979, and it reached $34 in 1981.
With decontrol in 1981 domestic oil
prices approached this level. The effects were
far reaching. High fuel prices had an espe
cially severe impact on the motor vehicle
industries of the Midwest, whose sales were
further, depressed in 1980 and 1981. The
number of autos produced domestically
declined 2 percent in 1981 from the depressed
level of 1980, and was 32 percent below 1978.
Truck output was up 2 percent last year, but
55 percent below the 1978 level. Imported
cars, mainly small economical models from
Japan, increased their share of the market
from 18 percent in 1978 to 27 percent in 1981.
For trucks the import share was 26 percent last
year, up from 7 percent in 1978.
Also in 1979, tightening credit started a
precipitous nationwide decline in residential

F e d e ra l R e se rv e Bank o f C h ica g o

While the Midwest leads the nation in
output of business equipment, it produces a
relatively small portion of the equipment
used to develop, exploit, and refine resources
of oil and natural gas. Oil and gas operations

Housing slump has been especially
severe in Seventh District states
80

percent change
0
+

l---------1-------- 1---------1---------1---------1---------1---------1-------- ]---------1-------- 1
1978-81
ys
new housing permits

1 9 8 0 -8 1 ^ ^ ^ ^ ^ ^ ^ ® !

Illinois
Indiana
Iowa
Michigan
I Wisconsin

have attracted a large share of the nation's
investment dollars. Not only have the energy
companies enjoyed a heavy cash flow, but
they are able to pay interest rates that keep
other sectors from raising all of the outside
funds that they desire.
Another growing sector is defense pro
curement. Here, too, the Midwest produces a
relatively small share of the high-technology
items demanded. Defense production is con
centrated on the West Coast and in several
states in the Southwest and Northeast.
Among the more serious side effects of
the agricultural depression of 1980-81 were a
reduction in sales of farm equipment and
sharp slowdowns in the economies of smaller
cities serving the farm community. In contrast
with earlier periods of industrial recession
when agriculture had often remained pros
perous, declines in farm income have
accompanied and reinforced the recent
decline in industry.
Similarly, state and local governments
experienced shortfalls of revenues and cuts in
federal grants, forcing them to curtail pro
grams and employment. In previous reces
sions, state and local outlays had continued to
grow, thereby helping to offset declines in
private sector activity.
Most Midwest producers of materials
and finished goods have faced increasing for
eign competition in recent years. Imports of
foreign goods—produced, in many cases, in
modern plants with lower labor costs—have
made inroads in many lines, but especially in
motor vehicles, electronics, and steel. Exports
of most Midwest products, meanwhile, have
declined or grown more slowly. Imported
components also have become common in
products assembled here. In 1981, the high
value of the dollar provided an important
additional advantage to foreign competitors.
Lagging sales reduced cash flow, eroded
business confidence, and created excess
capacity. These factors, coupled with record
high interest rates, caused a sharp drop in
demand for equipment produced in the
Midwest, which accelerate^ in the final
months of 1981 and in early 1982.

Some sectors prosper

Not all important lines of business in the
Midwest have suffered reverses in the recent
troubled years. Some have continued to
expand at a vigorous pace. In manufacturing,
these include pharmaceuticals, medical
diagnostic and treatment apparatus, and
advanced business communications systems.
Among the service industries, law, accoun
tancy, financial and managerial consulting,
and futures trading have required additional
personnel and larger facilities. This develop
ment is particularly noteworthy in Chicago
where a boom in office buildings has coun
tered sluggishness in most other types of
construction.
The outlook remains somber

For three decades the U.S. economy has
enjoyed unprecedented prosperity in an
exhilarating atmosphere generated by infla
tionary expectations. But, in the words of
Federal Reserve Board Chairman Paul Volcker:
“Sustainable growth cannot be built on infla
tionary policies." Domestic raw materials have
proved to be inadequate to accommodate
peak level demand and the nation has become
heavily dependent upon imported supplies
of oil, natural gas, metallic ores, and steel.
Rising prices have encouraged a flood of
imports over a broad spectrum. Low, or nega
tive, real interest rates have resulted in a
transfer of wealth from savers to borrowers,
an untenable process which came to an
abrupt end in the 1980s.
The nation's current problems developed
over a period of three decades and cannot be
corrected in a year or two. For many workers
and businesses, especially those located in
the Midwest, the transition to stable and sus
tainable growth will be painful and arduous.
Despite the prevailing gloom in early
1982, there are hopes for a reversal of the
downturn in the second quarter. Personal
income remains at a high level and will be
augmented by a tax cut in mid-1982. A clear
trend towards a reduced rate of domestic
inflation in late 1981 and early 1982 raises real

E c o n o m ic P e rsp e c tiv e s

incomes and tends to improve the competi
tive position of U.S. producers in world
markets. Inventories of most materials and
components are lean, partly because of heavy
financing costs, and production cuts are
reducing excessive stocks of finished goods.

Any improvement in final sales will quickly
bring a rise in factory orders. As confidence is
restored and excess capacity is reduced,
investment incentives provided by the Tax
Act of 1981 are expected to encourage capital
spending.

Prolonged slump for agriculture
The financial problems that struck agri
culture in 1980 became more acute last year.
Analysts had expected significant improve
ment in farm earnings in 1981. Aggressive
bidding by foreign buyers and the shrinkage
in U.S. supplies due to the drought-reduced
harvest of 1980 were expected to keep crop
prices high. Livestock prices were expected
to rise as farmers cut production in response
to their prolonged financial squeeze. Early
1981 projections also envisioned substantial
upward pressures on food prices and a
marked recovery in farm capital expenditures.
Actual 1981 developments deviated
sharply from these expectations. Grain prices
declined because of a softening in world
demand for U.S. grains and oilseeds, and
record harvests worldwide. New peaks in
livestock production combined with sluggish
demand to hold the line on livestock prices.
Because of these developments, most mea
sures of farm earnings declined again in 1981,
culminating a steep two-year slide. Inflation
outstripped the rise in farm asset values, low
ering the real equity in the farm sector for the
second consecutive year. Agribusiness firms
suffered another year of depressed sales. But
upward pressures on food prices moderated
appreciably. Last year was the sixth out of the
past seven that the average rise in retail food
prices has been lessthan the rise in all consum
er prices.
Farm prices declined all year

The composite measure of farm com
modity prices averaged 3 percent higher in

F e d e ra l R e s e rv e B a n k o f C h ica g o

1981 than in 1980, but trended lower through
out the year. By year-end, the measure was 12
percent lower than the year before and 2
percent lower than two years earlier. The
slide intensified financial losses of many Dis
trict farmers, particularly livestock producers
and crop farmers who were hit hard by the
1980 drought.
Prices of corn and soybeans, which ac
count for 40 percent of the roughly $32 billion
in annual sales of farm commodities from Dis
trict states, were a fourth lower at year-end
than the year before and well below the cost
of production. Cattle and hog farmers, who
also account for nearly 40 percent of farm
commodity sales in this region, experienced
operating losses during most of last year, con
tinuing a trend that has prevailed since mid1979. Dairy farmers, whose receipts account
for 15 percent of farm commodity sales in
District states, fared relatively well again in
1981. Sustained by the federal support pro
gram, milk prices averaged higher in 1981
than the year before, despite excess produc
tion. Because of its high cost, the dairy sup
port program was significantly modified in
1981 farm legislation.
Bumper harvest, weaker exports

Supply factors probably accounted for
most of the decline in farm prices last year.
But weakening demand factors also played a
significant role.
Grain and oilseed prices surged to high
levels in the latter part of 1980. But prices
began to weaken in early 1981 when it became

apparent that world supplies of grains and
oilseeds would be bolstered by a large spring
harvest in the Southern Hemisphere. Simul
taneously, domestic utilization of grains for
livestock feed was declining and soybean
exports were lagging. The downward pres
sures on grain and oilseed prices intensified
by late spring as the weakness in exports
spread to corn. Reflecting this, combined
U.S. export shipments of corn and soybeans
in the third quarter were a fourth lower than
the year before. For the year, corn exports
were down a tenth. A fourth-quarter surge,
however, held soybean exports close to the
1980 level.
The downturn in world demand was in
sharp contrast to the 1970s when U.S. export
shipments of grains and oilseeds rose at a
compound annual rate of 10 percent. The
downturn reflected, in addition to the large
supplies in other exporting countries, the
higher value of the U.S. dollar, high interest
rates, and slow economic growth in almost
every major industrialized country of the
world. These factors encouraged hand-tomouth buying patterns in major importing
countries.
Crain and oilseed prices fell sharply dur
ing the second half of last year. Despite the
third consecutive year of poor crops in the
Soviet Union, it became increasingly clear
that the Northern Hemisphere harvest would
be very large, particularly in North America.
According to final 1981 estimates for the
United States, the index of all crop produc
tion rose to 117 (1977=100), up 17 percent
from the year before and up 4 percent from
the previous high two years earlier. The 1981
corn harvest, at 8.2 billion bushels, was 23
percent larger than the year before and 3
percent above the previous record of 1979.
Wheat production, at 2.8 billion bushels,
exceeded the 1980 record by 18 percent and
was up 31 percent from two years earlier.
Soybean production, at just over 2.0 billion
bushels, was up 13 percent from the year
before, but 10 percent below the 1979 record.
District states contributed heavily to the
bountiful harvest, accounting for 55 percent

of the corn production and 43 percent of the
soybean crop. The combined corn and soy
bean harvests hit new highs in all District
states except Indiana, where production was
held down by a wet planting season.
Losses mounted for livestock producers

Most livestock producers suffered oper
ating losses through most of 1981, continuing
a trend that began in 1979. Cattle and hog
prices were held below breakeven levels by
record meat production and a softening in
demand. A decline of 4 percent in pork pro
duction last year was offset by gains of 3 per
cent for beef and 6 percent for poultry.
Determining the reasons for the down
turn in domestic demand for livestock pro
ducts is difficult. Most analysts trace it to the
effect of high interest rates on inventory
stocking practices of processors and to shifts
in consumer preferences. Changing consum
er preferences may reflect secular trends
associated with the maturing population
(fewer big meat eaters) and the growing di
etary issues linked to red meats. Recently, the
depressing effects of these trends on meat
purchases were reinforced by slow growth in
real earnings and rising unemployment.
Livestock prices fluctuated widely again
in 1981. Monthly hog prices ranged from
$39.50 per hundredweight in March to $51 in
August. For the year, hog prices averaged
$44.50, a tenth higher than the year before,
but unchanged from the 1975-79 average.
Monthly choice steer prices ranged from
$59.25 in December to $68.25 in June. For the
year, steer prices averaged $64 per hundred
weight, down 5 percent from 1980 and the
lowest since 1978.
Dairy farmers enjoyed another relatively
prosperous year in 1981. Their receipts were
bolstered by a 6 percent increase in average
milk prices and a 3 percent increase in milk
production. Higher prices, in the face of
record production and lackluster consumer
demand, were made possible by the dairy
support program.
During periods of surplus production,

E c o n o m ic P e rsp e c tiv e s

the federal government maintains the sup
port price of milk by purchasing manufac
tured dairy products and removing them
from commercial market channels. Such pur
chases have been very costly the past couple
of years. In fiscal 1981, the government's net
purchases of dairy products were equivalent
to a tenth of all milk produced by farmers and
cost more than $2 billion. The cost would
have been even greater except for special
legislation that overrode a scheduled April 1
increase in the support price of milk. Costs
may be even higher this year, but will likely
decline over the next few years as a result of
the comprehensive farm bill enacted in
December that lowers the relative support
level for milk.

Real per farm earnings of farm
operator families declined in 1981

•Continuity of series interupted by change in definition of a farm.
••Prelim inary.

Financial strains evident

With commodity prices trending lower
throughout the year and higher interest ex
penses pacing the rise in production costs,
farm earnings were depressed for the second
consecutive year. Net cash income in the
farm sector, which had declined 12 percent in
1980, is estimated to have fallen an additional
6 to 10 percent last year. Excluding changes in
inventory values, net farm income fell 20 per
cent in 1980 and another 13 to 18 percent in
1981. After falling nearly 40 percent in 1980,
net income after inventory adjustment rose
last year, largely reflecting the swelling in
inventories following the record 1981 crop
harvest.
On a per farm basis, the purchasing
power of farm sector earnings the past two
years was 40 percent lower than the average
for the 1970s and the lowest for any two con
secutive years since 1959-60. That striking
comparison is illustrative of the very low
returns to labor, management, land, and
other farm assets owned or provided by farm
operator families. However, the comparison
somewhat exaggerates the financial difficul
ties facing many farm families. Over the years,
farm families have increasingly supplement
ed farm earnings with income from nonfarm
sources. In fact, off-farm earnings of farm

F e d e ra l R e s e rv e B a n k o f C h ica g o

operator families have consistently exceeded
farm earnings for several years. When the
earnings of farm families from both farm and
nonfarm sources are added together, their
purchasing power, on a per farm basis, was no
lower in the past two years than the levels that
prevailed until the early 1970s.
The financial pressures created for most
farmers by the severely depressed earnings
the past two years are also cushioned by the
large gains in farm asset values (mostly land)
in the 1970s. The gains provided many farmers
with substantial equity. Equity in farm sector
assets now approximates $400,000 per farm,
almost four times the level of a decade ago.
Although inflation has outstripped the rise in
farm asset values the past two years, the real
purchasing power of the equity in farm sector
assets—on a per farm basis—is 75 percent
higher than a decade ago.
Operating farm families own approxi
mately 50 to 60 percent of the equity in assets
of the agricultural sector. The equity, how
ever, is not evenly distributed among all
farmers. In general, young farmers, tenant
farmers, and highly leveraged farmers have
less equity than others. But most farmers do
have substantial equity in their assets. During
periods of depressed earnings, they can use

that equity—either by borrowing against it or
by liquidating assets—to generate the cash
needed to meet family living expenses and/or
debt service requirements.
Capital markets weaken

Depressed earnings and record high in
terest rates led to further weakness in farmers'
capital expenditures and in land values in
1981. Cross capital expenditures in the farm
sector fell 7 percent in 1980. Further declines
occurred last year, extending a slide that is
unparalleled in recent decades. Much of the
decline was concentrated in farm equipment.
The Farm and Industrial Equipment Institute
reported that unit retail sales of farm tractors
with 40 or more horsepower were down 13
percent in 1981 from the year before, and
down 25 percent from the strong perfor
mance in 1979. Combine sales, though up
slightly in 1981, remained 17 percent below
their level two years earlier.
Over the past two years, farmland values
in the Midwest have exhibited wide fluctua
tions. Quarterly surveys conducted by the
Federal Reserve Bank of Chicago showed an

District farmland values were down
sharply in last two quarters
percent change (quarterly)

-i— i— i— I------ 1------- 1— i— I------- 1-------1_____i____ I____ I_____I_____I____ I_____L-

1978

1979

1980

1981

1982

unusual 4 percent decline in land values dur
ing the first half of 1980. But the downtrend
reversed sharply in the second half of that
year as commodity prices surged with the
spreading impact of the drought. The uptrend
continued through the summer of 1981, but
at progressively smaller rates of gain. A sharp
decline in the fourth quarter left District land
values at year-end only nominally higher than
the year before and up only 6 percent from
two years earlier.
Farmland values have held up better in
other parts of the United States than in the
Midwest the past two years. Nevertheless, the
increases have not kept pace with inflation
and have fallen far short of the average
annual gains of 14 percent recorded in the
1970s.
Debt growth slows

With high interest rates and low earnings
discouraging capital expenditures and en
couraging greater reliance on equity financ
ing, last year's rise in farm debt again was
modest. During the latter half of the 1970s
farm debt rose at an average annual rate of 14
percent. The increase slowed to 10.5 percent
in 1980 and edged up to only 11.5 percent last
year.
Federal land banks (FLBs) have domi
nated farm mortgage lending for years. (FLBs
are borrower-owned cooperatives that lend
almost exclusively to farmers). Over the past
decade, their share of all farm mortgages held
by reporting institutional lenders has risen
from 39 percent to 59 percent. In 1981, the rise
in farm mortgages held by FLBs exceeded 20
percent for the third consecutive year. In
comparison, farm mortgages held by life
insurance companies rose only 1 percent last
year, while farm mortgages held by banks
declined 3 percent.
In nonreal estate farm lending, activity at
banks picked up slightly from the very slug
gish pace of the year before. Nevertheless,
farm loans held by banks rose only 4 percent
last year, faster than the 2 percent rise the year
before but well below normal. Outstandings

E c o n o m ic P e rsp e c tiv e s

held by government agencies continues a
marked trend that has been evident since the
mid 1970s. Government agencies now hold 31
percent of all nonreal estate farm debt held
by reporting lenders, up from 14 percent a
decade ago. The most rapid growth has
occurred in the economic emergency and
disaster loan programs sponsored by the
FmHA and the SBA.

Growth in farm debt slowed
the past two years
billion dollars

Pessimism prevails for 1982

1965 '67

'69

'71

'81*

year-end
•Prelim inary.

at Production Credit Associations (PCAs) rose
7 percent, the smallest rise since 1954. Nonreal estate farm loans held by government
agencies—the Farmers Home Administration
(FmHA), the Small Business Administration
(SBA), and the Commodity Credit Corpora
tion (CCC)—rose a third in 1981. The faster
growth in nonreal estate farm loan portfolios

Banks’ share of farm debt has
declined since mid-1970s, while that
of government agencies has soared
percent

cooperative farm
credit system

1965

'67

'69

F e d e ra l R e s e rv e B a n k o f C h ica g o

'81

Most analysts believe that farm commod
ity prices hit bottom in late 1981. But only
modest increases are expected in the months
ahead, particularly for crops. Consequently,
despite an expected slowing of the persistent
rise in production expenses, many analysts
believe farm sector earnings will decline
again this year. These prospects point to
further moderation in the rise in retail food
prices, but may compound the financial prob
lems facing farmers.
For livestock producers, the year ahead
promises some easing of the prolonged finan
cial squeeze that has existed since mid-1979.
Further declines in pork production portend
a slight decline in per capita supplies of all
meats in 1982. All livestock producers will
benefit from sharply lower feed costs which,
in turn, will tend to lower total costs of pro
duction. Although hog prices are expected to
average considerably higher in 1982, con
tinued sluggishness in consumer demand is
likely to prevent any substantial rise in cattle
prices. Despite the cutback in the dairy sup
port program, the decline in earnings of dairy
farmers will be cushioned by the drop in feed
costs.
Much of the burden of the depressed
farm earnings will be borne by crop farmers
in 1982. Last year's record harvest and soft
demand, especially from abroad, will lead to a
huge increase in carryover stocks, particularly
for corn and soybeans. Crop prices, though
trending higher from the very depressed
levels of late 1981, will probably remain well
below cost of production for the next several
months. Prospects for a slight upturn in crop

prices depend largely on government pro
grams. Large amounts of corn under CCC
loan and in the grain reserve could lead to
tight “free-market" supplies unless prices rise
to levels that encourage or permit farmers to
repay the loans and markettheir grain. More
over, a voluntary acreage reduction program
will likely result in smaller crop plantings in
1982. Such a reduction .in plantings would
improve the prospects that this year's harvest
will be less burdensome than that of 1981.
Vagaries of weather and the narrow mar
gin between surplus and deficit production
could quickly alter the outlook for agricul

ture. But all indications now point to con
tinued problems for the next several months.
Any recovery in farm earnings in 1982 will be
modest at best and a further decline seems
more probable. The possibility of three con
secutive years of depressed earnings indi
cates that more farmers will have to liquidate
assets to meet debt service and/or family liv
ing expenses. Their ability to do so will
depend on how well the value of land, which
accounts for the bulk of farm sector assets,
holds up in the face of the prolonged slide in
farm income.

World economy is slow to improve
“Stagflation" again cast its pall over the world
economy in 1981. For the second consecutive
year, the economies of virtually all industrial
countries experienced little or no economic
growth, high and rising unemployment, and
generally high rates of inflation. Because of
the growing interdependence of all nations,
the adverse economic conditions in the major
industrial countries were gradually trans
mitted to the developing countries: sluggish
demand in the industrial world curtailed
exports of raw materials by the developing
nations and depressed their prices. At the
same time, inflation in the industrial world
and higher prices of oil pushed up the cost of
goods these nations import. Together, these
forces produced a sharp worsening in the
combined balance-of-payments deficit of the
developing countries, increasing their depen
dence on external financing. Their interna
tional debt rose, while their capacity to ser
vice it diminished.
The problems encountered by the world
economy in 1981 were further compounded
by an outbreak of protectionist sentiment in a
growing number of countries as they sought
to protect their domestic economies from
foreign competition. The sum total of these
trends was the gloomiest outlook for the
world economy that has been seen in many
years.

The fight against inflation continues

Inflationary pressures have been intensi
fying throughout most of the industrial world
for a number of years. Several factors con
tributed to this trend. The more than ten-fold
increase in the price of oil and the “permis
sive" economic policies pursued by many
countries head the list. But other factors also
exerted their influence. In many cases, wages
are now indexed to price increases, usually
with a lag, thus assuring that labor costs will
continue to rise even after prices have begun
to slow. This increases the short-term costs in
employment and output of any effort to slow
inflation. Labor productivity has been reduced
by the expansion ofthe proportion of employ
ment in the comparatively low productivity
service industries, by the increased participa
tion in the labor force of inexperienced
workers, and by the shift from energy inten
sive production to more labor intensive
methods.
In 1981, governments in many countries
began to come to grips with the inflationary
problems. The restrictive monetary and fiscal
policies adopted by many governments played
an important role in moderating the rate of
price advance during the year. A substantial
weakening in commodity prices throughout
the year presaged and contributed to the

E c o n o m ic P e rsp e c tiv e s

Consum er prices decelerated
in major industrial countries
percent change (monthly)

These trends are expected to continue in
1982, pushing the total number of unem
ployed in the OECD countries from 25 million
in 1981 to over 28 million.

Balance-of-payments
disequilibria ease

deceleration in the overall price advance.
From January to the end of the year, the price
index for the primary internationally traded
food commodities decreased more than 25
percent, while the prices of raw industrial
materials declined about 15 percent. Although
petroleum prices continued to exert upward
pressure on the general price level during
1981, the pressure was much less severe than
in 1980.
Reflecting these trends, the average rate
of price increase for the 24 nations of the
Organization for Economic Cooperation and
Development (OECD) dropped from 11 per
cent in 1980 to about 9V2 percent in 1981.
Stagnation persists in the industrial
countries

Attempts to slow inflation resulted in a
slowdown in economic activity in virtually all
the industrial nations. The combined real
GNP of the 24 industrial countries comprising
the OECD increased only about VA percent in
1981, a rate of increase that was essentially
unchanged from 1980 and far below the aver
age yearly gain of 3.5 percent between 1969
and 1979.
The sluggishness in economic activity
created a substantial unemployment prob
lem for the industrial countries. Unemploy
ment rates throughout the area rose from 6.2
percent in 1980 to about 7Va percent in 1981.

Federal Reserve Bank o f Chicago

Depressed economic activity and intensi
fied conservation efforts reduced the demand
for oil in 1981, exerting strong downward
pressure on oil prices. The resulting declines
in prices and levels of consumption sharply
reduced the earnings of the OPEC countries
and cut their aggregate surplus on current
account from $110 billion in 1980to about $60
billion in 1981.
The beneficiaries of the reduced OPEC
surplus have been the industrial countries.
Their aggregate current account deficit fell
from $73 billion in 1980 to $35 billion in 1981.
In contrast, the non-oil developing countries
were hit hard by external economic develop
ments during the year. Not only did the slug
gish economic activity in the industrial world
depress the prices of their primary commod
ity exports, but rising import prices taxed
their ability to pay for essential imports. As a
consequence, their aggregate current ac
count deficit increased from $60 billion in
1980 to $68 billion in 1981.
Banks in the industrial countries con
tinue to finance a substantial share of these
mounting deficits. By mid-1981, banks' claims
on the non-oil developing countries totaled
more than $200 billion, up from $193 billion at
the end of 1980. Concern has arisen recently
over the ability of banks to continue to
finance these deficits and, especially with the
current high level of interest rates, the ability
of the developing countries to service a rising
level of debt. The potential seriousness of
these problems has prompted the IMF and
the World Bank to enlarge their lending facili
ties so that, if necessary, they can take a more
active role in financing the non-oil develop
ing countries' increasingly oppressive debt
burden.

Pressures for trade restrictions
intensify

The depressed economic conditions here
and abroad contributed importantly to an
ominous development during the year—
mounting sentiment worldwide for protection
from foreign competition. Concrete actions
growing out of this sentiment included: the
antidumpingduties imposed by Japan on U.S.
aluminum allegedly dumped in the Japanese
market; the "voluntary" export limits imposed
by the Japanese government on auto exports
to the United States, Canada, and the Euro
pean Economic Community in response to
threats of more severe formal import restric
tions on autos by the governments of these
countries; the antidumping and countervail
ing duty investigations by the U.S. govern
ment and American steel firms of alleged
dumping and export subsidies in connection
with steel exports from Europe, South Africa,
and Brazil; the threatened imposition of
duties by Western European countries on
U.S. vegetable oils; and the restrictions placed
on steel imports by the European Common
Market.
The trade policy picture was not entirely
negative, however. During the year certain
trade restrictions were relaxed and the grad
ual implementation of the trade-promoting
provisions of the 1979 Multilateral Trade
Agreement proceeded on schedule. None
theless, the atmosphere of protectionism
pervaded legislative deliberations through
out the world as corporations faced substan
tial losses, workers became unemployed or
increasingly fearful of losing their jobs, and
governments faced mounting social unrest
and political pressures to "do something
about imports."
U.S. balance of payments improves

Divergent trends were evident in U.S.
international trade during 1981. Reflecting
sluggishness in economic activity worldwide,
the growth in the value of U.S. merchandise
trade slowed dramatically. Exports increased

less than 6 percent compared with more than
20 percent in 1980. Imports increased about 6
percent compared with about 18 percent in
1980. The trade deficit, which had declined
for two consecutive years to $25.3 bil
lion in 1980, increased to $27.8 billion in 1981.
What strength there was in U.S. exports
came primarily from the increased value of
machinery shipments and, to a lesser degree,
agricultural shipments. Nonetheless, both
sagged late in the year as the volume of ship
ments declined and prices weakened. Much
of the deceleration in the growth of imports
in 1981 was concentrated in petroleum im
ports, the value of which declined about 2
percent to $77 billion (the volume of imports
declined about 13 percent). Non-oil imports
increased 9 percent from the 1980 level, com
pared with a 13 percent increase in 1980.
U.S. trade was also influenced by a sharp
appreciation of the dollar relative to other
major currencies during the first eight months
of the year. The appreciation made foreign
goods cheaper in terms of the dollar and U.S.
goods more expensive in terms of foreign
currencies, thereby tending to boost imports
and reduce exports. The result was a rise in
the U.S. trade deficit.
Despite the increased merchandise trade
deficit in 1981, the U.S. current account
balance—which in 1980 had recorded its first
surplus since 1976—continued to improve. It
registered a surplus of $6.6 billion in 1981, up
sharply from the $3.7 billion surplus in 1980.
An improvement in the balance in the ser
vices account in recent years has more than
offset the merchandise deficit. The services
surplus exceeded $41 billion in 1981, well
above the services surplus of about $25 billion
in 1978 when the deficits on merchandise
trade ($33.8 billion) and current account
($14.1 billion) were at record levels.
The strength in the services account has
been derived primarily from the receipts of
income on U.S. assets abroad, which have
greatly exceeded income payments to for
eigners on their assets in the United States.
Net income from direct investment typically
has been a major contributor to the services

E c o n o m ic P e rsp e c tiv e s

surplus. While income from direct invest
ment abroad continued to be an important
component of the services surplus in 1981,
much of the improvement in the services
account for the year came from an increase in
net receipts to U.S. firms and individuals derived
from investments in foreign financial instru
ments. Much of the increased investment was
reflected in the substantial increase in claims
on foreigners reported by U.S. banks during
the year.

Value of the dollar moved in
tandem with U.S. interest rates
index, March 1973 = 100

The dollar was strong

Movements in exchange rates are nor
mally associated with changes in one or more
fundamental factors such as the current ac
count balance, relative rates of inflation be
tween countries, relative rates of economic

The dollar was strong through
1981 and early 1982*
percent change (weekly)

F e d e ra l R e s e rv e B a n k o f C h ica g o

growth, and considerations of political stabil
ity. Changes in some of these factors appar
ently played a role in the movement of the
dollar relative to other currencies in 1981.
However, the primary cause of the extra
ordinary strength of the dollar during the first
eight months of the year and the subsequent
weakening later in the year appears to have
been the movement in U.S. interest rates relativeto those abroad. During 1980the valueof
the dollar gyrated widely in concert with the
broad fluctuations in the differential between
U.S. and foreign interest rates.
The differential widened after midyear
1980 as U.S. interest rates increased and
remained at a high level through midyear
1981. Reflecting this, the dollar strengthened
from its low level in 1980 and by August 1981
had attained record highs against the Cana
dian dollar, French franc, and Italian lira, and
a five-year high against the West German
mark. On a trade-weighted basis (taking into
account the relative importance of individual
foreign currencies, based on their volume of
trade with the United States) the dollar had

appreciated 20 percent from its 1980 low.
Increases vis-a-vis specific currencies were:
10 percent against the Canadian dollar, 54
percent against the French franc, 59 percent
against the Italian lira, 48 percent against the
German mark, 19 percent against the British
pound, and 38 percent against the Japanese
yen.
As U.S. interest rates declined later in the
year, the dollar weakened. Another factor
contributing to the weakening of the dollar
was the shift in sentiment regarding the out
look for the U.S. economy as economic activ

ity declined in the fourth quarter and unem
ployment continued to increase. On the
other hand, unsettled political conditions in
Poland and the Middle East apparently served
to strengthen the dollar as foreign investors
sought a "safe" currency for their invest
ments. At the end of November the tradeweighted value of the dollar had declined
about 10 percent from its 1981 high but it
moved upward again in December. The dol
lar closed the year about 8 percent below its
August high and 12 percent above its 1980
low.

Fiscal policy— a n e w approach
The new Reagan administration moved
to honor the pledges made during the elec
tion campaign concerning fiscal policy. Spe
cifically, the administration introduced legis
lation designed to:
1. reduce tax rates on personal income.
2. provide accelerated depreciation
allowances and other incentives for business
investment.
3. slow the growth of all areas of
government spending except defense.
4. gradually reduce the deficit, aiming at
a balanced budget in fiscal 1984.
The key phrase in the new administration's
approach to fiscal policy was "supply side"
economics. A major thesis of supply side eco
nomics is that the growth of the economy has
been hindered by high marginal tax rates that
strongly favor consumption over investment
and reduce the incentive to work. By reduc
ing marginal tax rates and providing other
investment incentives, the administration
hoped to guide the economy into an extend
ed period of strong growth. It was expected
that the immediate loss in revenues resulting
from the lower rates would be recovered in a

few years because the total national income
would be substantially larger than it would
have been without these incentives for
investment.
There was a second aspect to the Reagan
administration's view of government spend
ing. It believed that the federal government
had assumed responsibility for many activities
that are properly the function either of state
and local government or of the private sector.
Among the most important and controversial
features of the first Reagan administration
budget were its proposals that spending for
these programs be reduced, transferred to
the local level, or eliminated. The major
budget category to be spared sharp spending
cuts was national defense, an area in which
the administration believes the United States
has lagged dangerously behind the Soviet
Union. Consequently, substantial growth in
real defense expenditures was called for
over the next several years.
Little impact in fiscal 1981

The new administration had virtually no
impact on fiscal 1981, which had begun in
October 1980. The focus has been primarily
on fiscal 1982 and beyond. Although the
administration revealed its plans in a series of
messages during March and April of 1981, the

E c o n o m ic P e rsp e c tiv e s

detail regarding the timing
and the exact shape and
magnitude of its major pro
visions, and the final version
Actual
contained several additions
September 1981
that the President had wished
to defer for later considera
602.6
tion. But the basic objective
660.5
of a general tax reduction
57.9
2 1 .0
designed to favor saving and
78.9
investment was achieved,
and marginal personal in
come tax rates above the 50
percent bracket were cut sharply. Business
taxes were reduced primarily by providing
more rapid amortization of investment and
by making the investment tax credit transfer
able by lease arrangements. The most recent
administration estimates are that these
changes reduced receipts by $38.3 billion in
1982, $91.6 billion in 1983, $139.0 billion in
1984, and $176.7 billion in 1985.
Getting the Congress to act on the spend
ing cuts proved to be more difficult than get
ting the tax revisions passed. When the fiscal
year ended on September 30, very little had
been completed in passing the necessary
authorization and appropriation bills. Al
though both houses passed the first budget
resolution—which adopted in principle all
that the administration had asked for—that
resolution has no legal status as far as actual
spending is concerned. During early October,
most of the government was functioning
under a continuing resolution which permit
ted continued spending at the fiscal 1981 rate.
This was extended to year-end, but even then
much work was undone. Just before the
Christmas recess, a third continuing resolu
tion was passed running to September 30,
1982. The Congress still had to complete
appropriations action and pass a second
budget resolution to complete action for this
fiscal year.

Estimated and actual budget figures for
fiscal year 1981

(billions of dollars)
Carter estimate

Receipts
Outlays
Deficit
O ff-b u d g e t

Total deficit

Reagan estimates

January 1981

March 1981

July 1981

607.5
662.7
55.2
23.2
78.4

600.3
655.2
54.9
23.6
78.5

605.6
661.2
55.6
24.0
79.6

length of the congressional budget process
made it impossible to alter the 1981 program.
In its January budget message, the Carter
administration had forecast receipts of $607.5
billion and outlays of $662.7 billion for fiscal
1981, giving a deficit of $55.2 billion. The rees
timates by the Reagan administration in March
and July were very similar. The actual out
come showed receipts of $602.6 billion and
outlays of $660.5 billion. The resulting deficit
of $57.9 billion was slightly below the $59.6
billion deficit incurred in fiscal 1980. How
ever, if the $21 billion of off-budget borrow
ing in fiscal 1981 is included, the total deficit
was $78.9 billion, an all-time record.
Virtually all off-budget outlays consist of
loans made by government departments and
agencies under a wide variety of programs.
These loans are sold to the Federal Financing
Bank, so that, within the budget, the outlays
are offset by the proceeds. The Federal
Financing Bank, in turn, borrows the money
from the Treasury, but these borrowings have
not been included in the Unified Budget.
They are, however, part of the total the Treas
ury must raise each year to meet the cost of
government.
Implementing the Reagan program

The new administration had remarkable
success in getting the tax portion of its pro
gram approved by the Congress. The Eco
nomic Recovery Tax Act became law on
August 13. In the legislrrive process the n-?w
tax law underwent a number of changes in

F e d e ra l R e s e rv e B a n k o f C h ica g o

Reworking the Reagan program

No revised estimates for fiscal 1982 were
published by the administration prior to re-

Principal provisions of the Economic Recovery Tax Act of 1981

Personal income tax provisions
1. Across-the-board reductions in personal income tax rates from 1980 rates:
1981
1982
1983
1984 and after

VA percent

10 percent
19 percent
23 percent

2. Reduction of maximum rate to 50 percent.
3. Indexation by the Consumer Price Index of bracket ranges, the zero bracket amount, and the
personal exemption beginning in 1985.
4. Introduction of “ Marriage Tax" deduction for two-earner families up to a maximum of $1,500
in 1982 and $3,000 in subsequent years.
5. Authorization of IRA accounts for all workers, permitting tax-free saving of up to $2,000 per
year ($2,250 with non-working spouse). Raising of Keogh plan maximum to $15,000.
6. Authorization of All Savers Certificates, providing tax-exempt interest at 70 percent of
Treasury bill rate up to $1,000 per individual or $2,000 per couple. (Expires December 31,
1982.)
Estate and gift taxes
1. Elimination of taxes on inheritance (or gift) to spouse in any amount.
2. Gradual increase in the tax credit on estates from the $47,000 of current law to $192,800 in
1987. (This means that estates up to $600,000 will become tax-exempt by 1987.)
3. Reduction of maximum estate tax rate from 70 percent to 50 percent in steps of 5 percent a
year.
4. Raising of gift tax exclusion from $3,000 to $10,000 effective January 1, 1982.
Business tax provisions
1. Classification of all personal property into four classes which may be written off over 3, 5,10,
or 15 years, respectively. (Except for public utility equipment, virtually all business equipment
is in either the 3- or 5-year class).
2.

Authorization to write off real property in 15 years using 175 percent declining
balance.

3. Liberalization of leasing provisions to permit transfer of unused investment tax credits and
depreciation between firms.

E c o n o m ic P e rsp e c tiv e s

The changing face of federal spending plans
Fiscal 1981

Fiscal 1982
Carter Estimate

Actual

January '81

Fiscal 1983
Reagan Estimates

M arth '81

January '82

(billion dollars)
Receipts
Outlays
Total deficit, including off-budget

599.3
657.2
78.9

711.8
739.3
45.8

650.3
695.3
61.7

626.8
725.3
118.3

666.1
757.6
107.2

Outlays by function
National defense
International affairs
General science, space, technology
Energy
Natural resources, environment
Agriculture
Commerce and housing credit
Transportation
Com m unity, regional development
Education, training, social services
Health
Income security
Social Security
Other
Veterans benefits
Administration of justice
General government
Fiscal assistance (S&Ls)
Interest

159.8
11.1
6.4
10.3
13.5
5.6
3.9
23.4
9.4
31.4
66.0
225.1
138.0
87.1
23.0
4.7
4.6
6.9
82.5

184.4
12.2
7.6
12.0
14.0
4.8
8.1
21.6
9.1
34.5
74.6
255.0
159.6
95.4
24.5
4.9
5.2
6.9
89.9

188.8
11.2
6.9
8.7
11.9
4.4
3.1
19.9
8.1
25.8
73.4
241.4
154.8
86.6
23.6
4.4
5.0
6.4
82.5

187.5
11.1
6.9
6.4
12.6
8.6
3.3
21.2
8.4
27.8
73.4
250.9
154.6
96.2
24.2
4.5
5.1
6.4
99.1

221.1
12.0
7.6
4.2
9.9
4.5
1.6
19.6
7.3
21.6
78.1
261.7
173.5
88.2
24.4
4.6
5.0
6.7
112.5

lease of the 1983 budget. However, estimates
by non-government economists projected
much higher deficits for both 1982 and 1983
than the last official forecasts, released in July,
had indicated. The President's budget mes
sage on February 8,1982 confirmed these pri
vate estimates. The administration's estimate
of the total deficit for 1982, including offbudget borrowing of $19.8 billion, almost
doubled from $61.7 billion to $118.3 billion.
This massive revision had three major sources,
all related to the poor performance of the
economy relative to the assumptions underly
ing both the March and July estimates. On the
revenue side the major factor was a lowering
of the estimated receipts from the corporate
income tax by about $20 billion. On the out
lays side there were two major increases.
Interest cost estimates were raised by over $16
billion, and income security programs, pri

F e d e ra l R e se rv e B a n k o f C h ica g o

marily unemployment insurance payments,
were raised about $10 billion from the earlier
estimates.
The hope of producing a balanced budget
during the present administration's current
term in office has evaporated. The deficit for
fiscal 1983 is projected at $91.5 billion. Longer
range forecasts show continuing deficits,
though progressively smaller ones, through
at least 1987.
The budget outlook

Virtually every member of the Congress
who has spoken out publicly on the budget
message has been insistent that the deficits
must be reduced. However, except for minor
alterations, it does not appear possible to do
very much about fiscal 1982. Furthermore, a
detailed examination of both the 1982 and

1983 budgets makes clear that there are few
available categories in which changes can be
made that are large enough to have any
measurable impact. Taxes could be raised and
defense spending, income security programs,
and, perhaps, veterans benefits could be
reduced. No other categories are large enough
in total that even drastic cutting, say as much
as 20 percent, would have a significant impact
on the deficit.
Of the three large outlay categories, only
defense is at all likely to be reduced by more
than a token amount in an election year. Nor
does it seem likely that any major tax increase
is going to be passed so soon after the tax
reduction bill was enacted.

Of the various means available for in
creasing revenues, the most likely to be
adopted are the introduction of some new
user fees, the tightening of leasing rules just
relaxed by the 1981 tax changes, and the revi
sion of several minor provisions of the tax
laws. The combined effect of these changes
would be to raise revenues by about 5 percent.
With military spending already under
attack, the projected 18 percent increase for
1983 may be spread into future years. How
ever1, a final deficit total for fiscal 1982 which is
as much as $10 billion below the present fore
cast of $98.6 billion is not likely to be achieved,
and, in fact, an even higher figure is not an
unlikely outcome.

Financial markets and monetary policy
Conditions in financial markets during 1981
reflected not only current economic condi
tions but also uncertainties about future
trends in light of the fundamental shift in the
strategy of economic policy. The new focus
on long-run reforms in public policy to stimu
late investment, increase productivity, and
promote economic growth—combined with
continued monetary restraint to reduce
inflation—made transitional problems inevit
able. Inflation expectations built up over
almost two decades cannot be erased quickly.
Yet a change in those expectations is a neces
sary condition to the success of a program
that depends heavily on increased private sav
ing to finance expanding investment expen
ditures.
In 1981, the Federal Reserve continued to
pursue monetary objectives consistent with
lowering the rate of inflation. For the year as a
whole, growth in the narrow concepts of
money was well below that for 1980 and
somewhat less than intended, while the
broader measures grew a bit faster than the
targeted pace. These divergences, as well as
the uneven pattern of growth within the year,
largely reflect shifts by consumers to new
financial instruments and changing cash

management practices in an environment of
high and volatile interest rates.
Given the Fed's policy of supplying nonborrowed reserves at a rate believed consist
ent with the desired rate of money growth,
the fluctuations in the level and pattern of
interest rates were largely determined by
variations in private credit demand. Unex
pectedly strong economic activity early in the
year led to relatively heavy borrowing and
kept short-term interest rates high. The reluc
tance of investors to commit funds for long
periods at fixed rates resulted in record yields
in the bond markets, discouraging businesses
from funding short-term debt. High market
rates also accelerated the flow of funds out of
instruments still subject to interest rate ceil
ings. For example, shares in money market
mutual funds rose by more than $100 billion
during the year, part of which flowed back
into large bank CDs.
Thrift institutions and smaller banks ex
perienced very little growth, but their aver
age cost of funds rose sharply as they were
forced to rely on time certificates of deposit
and the new interest-bearing NOW accounts
in place of traditional funding through de
mand and savings accounts. Because these

E c o n o m ic P e rsp e c tiv e s

institutions hold a large proportion of their
assets in the form of mortgages and other
fixed-rate assets, they experienced severe
pressure on earnings. A number of them
failed, and an even greater number—includ
ing some of the largest thrift institutions in the
country—were kept operating only through
merger into other institutions.
Toeasethis problem,the Federal Reserve
arranged to provide extended credit to thrift
institutions and banks experiencing sustained
liquidity pressures at a rate varying with the
duration of borrowing. As much as $450 mil
lion of credit was outstanding under this pro
vision at one time last year. In these circum
stances, the Depository Institutions Deregula
tion Committee proceeded slowly in carrying
out the deregulation of interest rates man
dated by the Monetary Control Act of 1980.
Meantime, nonbank financial institutions con
tinued to expand their role in providing
financial services. The innovations introduced
by these institutions, together with shifts of
both savings and transaction balances, in
creased the problems of interpreting and
controlling the monetary aggregates.
M onetary aggregates and m onetary

policy actions

At its February meeting, the Federal Open
Market Committee (FOMC) agreed that the
achievement of its objectives would be fur
thered by somewhat slower monetary and
credit growth than had been experienced in
1980. Specifically, the FOMC adopted the fol
lowing ranges of growth for the monetary
and credit aggregates from fourth quarter
1980 to fourth quarter 1981: 3V2 to 6 percent
for M-1B, 6 to 9 percent for M-2, 6 1/2 to 9 1/2
percent for M-3, and 6 to 9 percent for total
bank credit.1 It was recognized that some of
the observed growth in M-1B during 1981
would result from shifts of funds from savings
deposits into NOW accounts following the
nationwide introduction of such accounts on
December 31, 1980. Because it was believed
that some of these funds are held as invest
ments, rather than as transactions balances,

F e d e ra l R e s e rv e Bank o f C h ica g o

the actual M-1B figures were adjusted down
ward to take these shifts into account.
For the year, shift-adjusted M-1B grew
2.3 percent, well below its 1981 range. (Unad
justed M-1B also grew slower than expected.)
The slowdown in M-1B growth in 1981 con
tinued the deceleration of monetary growth
that began in 1979. After peaking at 8.3 per
cent in 1978, M-1B growth slowed to 7.5 per
cent in 1979 and 6 .6 percent in 1980 (adjusted
for shifts to NOW accounts). Growth rates of
the broader monetary aggregates, however,
not only exceeded their 1981 ranges but were
higher than in the preceding year: M-2 grew
9.5 percent in 1981 compared with 9.1 percent
in 1980, while M-3 expanded 11.4 percent in
1981 compared with 9.9 percent in 1980. Bank
credit grew at a rate of 8 .8 percent in 1981,
within its range but somewhat faster than its 8
percent rate of growth in 1980 when the
credit restraint program was in place.
Short-run monetary policy actions dur
ing the year were designed to keep monetary
growth in line with the established ranges for
1981. Since October, 1979, the Fed has used a
reserves targeting approach in seeking to
achieve desired monetary growth. Although,
under the current lagged reserve accounting
system, the Fed cannot control total reserves
directly, it can affect the proportion of total

1A 3 to 5V2 percent range, adjusted for shifts to NOW
accounts, was also established for M-1A, which was
defined to include currency held by the public, demand
deposits at com m ercial banks other than those due to
domestic banks, the U.S. government, and foreign banks
and official institutions, and travelers checks of nonbank
issuers. The M-1A measure, however, did not play an
important policy role during 1981, and was dropped
beginning in 1982. M-1B, which in 1982 is designated as
M-1, includes M-1A plus other checkable deposits con
sisting of negotiable order of withdrawal (NOW) and
automatic transfer service (ATS) accounts at banks and
thrift institutions, share drafts at credit unions, and
demand deposits at mutual savings banks. In 1981, M-2
was defined to include M-1B plus overnight repurchase
agreements (RPs) and Eurodollars, money market mutual
fund (M M M F) shares, and savings and small time depos
its at banks and thrift institutions; in early 1982, retail RPs
were included and institution-only M M M F shares were
excluded from M-2. M-3 includes M-2 plus large time
deposits at banks and thrift institutions, and term RPs.
Growth rates given in the text are based on the early 1982
revisions and redefinitions of monetary aggregate data.

Reserve mix responded to deviations
from monetary growth targets
billion dollars

percent

•Beginning August 1981 nonborrow ed reserves include
borrowings under the extended credit program.

reserves supplied as nonborrowed reserves.
Under this approach, when monetary growth
falls below (above) its desired path, a greater
(lesser) proportion of the total reserves needed
to support targeted monetary growth is pro
vided as nonborrowed reserves.2 Increasing
the proportion of reserves supplied as non2Because borrowings under the extended credit
program do not have to be repaid as promptly as tradi
tional adjustment borrowings, their money market im
pact is similar to that of nonborrowed reserves and they
were treated as such in implementing monetary policy
during 1981.

borrowed reserves reduces the need for banks
to borrow at the discount window and, thus,
lowers the effective cost of borrowing. This
occurs because a major component of the
cost of borrowing—the nonpecuniary cost
associated with the surveillance exercised by
Fed discount officers—varies directly with the
amount and duration of borrowing. As a con
sequence, so does the total effective cost of
borrowing—i.e., the nominal discount rate
plus the nonpecuniary cost of borrowing.
Thus, the higher the level of nonborrowed
reserves—and therefore the lower the level
of borrowing—the lower is the effective cost
of funds to banks and the more attractive it is
for them to purchase additional earning
assets, expanding the money supply. Changes
in the effective cost of borrowing are imme
diately transmitted to banks that do not bor
row at the discount window via changes in
the federal funds rate.
Through the first quarter of 1981, growth
in shift-adjusted M-1B was below its annual
range while growth in M-2 was within its
range. To encourage more rapid monetary
expansion, the Fed increased the proportion
of total reserves supplied as nonborrowed
reserves. These short-run policy actions con
tributed to the decline in short-term interest
rates during the first quarter.
Monetary growth accelerated sharply in
April, with shift-adjusted M-1B moving into
its annual range and M-2 moving above its
range. In response, the Fed became less
accommodative in supplying nonborrowed
reserves, and the proportion of total reserves
provided as nonborrowed reserves declined
through May. In addition, the Fed raised the
discount rate from 13 percent to 14 percent
and increased the surcharge imposed on
large, frequent borrowers from 3 percent to 4
percent in early May.
In reconfirming its 1981 monetary and
credit aggregate growth ranges in July, the
FOMC noted that the shortfall in M-1B growth
reflected a shift in the public's holdings of
liquid assets in response to rising yields on
instruments not subject to interest rate ceil
ings. For example, shares of money market

E c o n o m ic P e rsp e c tiv e s

mutual funds increased almost $50 billion dol
lars from December 1980to June 1981. Because
of these strong flows into components of the
broader aggregates, and the likelihood that
such aggregates would be in the upper parts
of their ranges, the FOMC expressed a will
ingness to accept growth in shift-adjusted
M-1B toward the lower end of its 1981 range.
For the remainder of the year, shiftadjusted M-1B remained below its 1981 range
while M-2 fluctuated around the upper limit
of its range. Policy actions were generally
aimed at encouraging somewhat more rapid
growth in M-1B while keeping M-2 close to or
within its 1981 range. From June through
November, the Fed increased the proportion
of total reserves supplied as nonborrowed
reserves. In addition, in a series of steps
beginning in September, it lowered the basic
discount rate to 12 percent and eliminated
the surcharge. In belated response to these
policy actions, monetary growth accelerated
in November and December.
The growth of M-2 relative to M-1B was
also affected by a number of developments
that enhanced the ability of depository insti
tutions to compete for small time deposits.
Effective August 1, the Deregulation Commit
tee removed the cap on rates payable by
depository institutions on 21/2-year Small Sav
ers Certificates. Beginning October 1, deposi
tory institutions were allowed to offer All
Savers Certificates paying interest at a rate
related in a specified way to the one-year
Treasury bill. Interest on these certificates is
tax-exempt up to $1,000 for individuals and
up to $2,000 on a joint return. Beginning
November 1, the maximum rate payable on
six-month Money Market Certificates was
tied to the higher of the average discount rate
on six-month Treasury bills established by the
latest auction or the average of the four most
recent auctions. Also, beginning December
1, depository institutions could offer Individ
ual Retirement Accounts (IRAs) and Keogh
plans having maturities of 18 months or more
completely free of interest rate ceilings. Such
IRA accounts would be available in 1982to all
employed individuals.

F e d e ra l R e se rv e Bank o f C h ica g o

Interest rates high and volatile

On average, interest rates were higher in
1981 than in 1980. Although fluctuations within
the year were again wide, they were less
extreme than the swings associated with the
imposition and subsequent removal of the
1980 credit restraint programs. While the high
levels of rates generally—and long-term rates
in particular—reflected expectations of a con
tinued high rate of inflation, they may also
have been affected by investors' efforts to
compensate for the uncertainty associated
with the rate volatility of the past two years.
Short-term rates undoubtedly reflected, in
addition, the Fed's persistence in pursuing its
goal of a gradual deceleration in monetary
growth.
In October, long-term yields reached
new record highs and money-market yields
reached levels very close to the record highs
set in 1980. Monthly average bond equivalent
yields on three-month Treasury bills reached
a May high of 17.23 percent and finished the
year at 11.35 percent, about 5 percentage
points below their level at year-end 1980. At
the other end of the maturity spectrum,
monthly average yields on 30-year Treasury
securities ranged from a low of 12.14 percent
in January to a high of 14.68 percent in
October and ended 1981 at 13.45 percent—
about 1 percentage point above the Decem
ber 1980 level.
The swings in interest rates in 1981 were
roughly coincident with efforts to return
money growth to the desired path following
large and prolonged deviations above or
below the targeted ranges. Early in the year,
money-market interest rates were pushed
downward as the Fed increased the rate at
which it supplied nonborrowed reserves in
response to weak growth in the narrowly
defined shift-adjusted monetary aggregates.
This downward trend in short-term interest
rates was sharply reversed in April when
M-1B growth rapidly accelerated and the Fed
again slowed the growth of nonborrowed
reserves. The ebullience of the economy in
the first quarter of 1981 heightened investor

concern about inflation and put upward pres
sure on interest rates. After peaking in May
and June, most short-term rates trended lower
over the remainder of 1981 as a slowdown in
economic activity again led to sluggish growth
in narrowly defined money.
The behavior of longer-term yields fol
lowed a somewhat different pattern. Interest

rates on bonds trended irregularly upward,
with 30-year Treasury securities reaching a
weekly average record high of about 15 per
cent in early October. Following the October
peak, long-term interest rates declined sharply
in the face of mounting evidence of a signifi
cant slowdown in economic activity, a sub
stantial decline in the rate of inflation, and the

Long-term interest rates declined from recent highs . . .
percent

percent

. . . with short-term rates following a similar but more
pronounced pattern
percent

percent

‘ Last day of the month.
“ Bond equivalent yields.

E c o n o m ic P e rsp e c tiv e s

increasing momentum of the fall in short
term rates.
By mid-October short-term rates had
declined enough to restore a positive yield
spread between 30-year and three-month
maturities of Treasury securities for the first
time since September 1980. In the past, a wid
ening in the positive spread between longand short-term interest rates has often been
associated with declining long-term rates.
In the tax-exempt sector, yields on state
and local securities not only hit record highs,
but rose relative to yields on comparable tax
able securities. Among the factors combining
to produce this relative increase in yields on
municipal securities were: (1) weak demand
for these issues by their major traditional
buyers—commercial banks and casualty in
surance companies; (2) increased competi
tion from alternative tax-exempt investments
such as the All Savers Certificate introduced
in October; and (3) higher borrowing result
ing from anticipated cutbacks in federal fund
ing of state and local governmental services
and increased efforts to take advantage of the
tax-exempt status of industrial revenue bonds
and mortgage bonds.
The record high yields in the fixedincome markets occurred in an environment
of relatively weak real economic growth,
moderating inflation, and declining private
sector credit demands relative to nominal
GNP—ordinarily an environment conducive
to declining interest rates. The net amount of
funds raised in the credit markets by busi
nesses and households declined in the second
half of the year and the amount of Treasury
financing was actually less than a year earlier.
However, skepticism that federal expendi
ture would be reduced enough to offset the
effects of the scheduled tax cuts was a major
element depressing the bond markets through
out the year. Investors' fears intensified at
year-end as the recession dashed all hopes of
reducing the federal deficit according to
plan. The perception that new pressures on
financial markets would develop as large
deficits combined with an expected resur
gence of private credit demands was strength

F e d e ra l R e se rv e Bank o f C h ica g o

ened by the release of revised projections of
the deficit for fiscal 1982. Most of these pro
jections centered around $100 billion, with
relatively modest reductions expected in suc
ceeding years. The widespread concern over
these figures was reflected in the rebound in
interest rates that began in December.
Shifts in credit structure

The total amount of funds raised in the
credit markets was a little greater in 1981 than
in 1980, but fell short of the record 1979
financing volume. Given the significantly
higher price level, the real volume of funds
raised was sharply lower than in 1980. Most of
the shifts in the composition of credit and in
the market shares of different types of institu
tions that had characterized 1980 continued
in 1981. Savings continued to flow into instru
ments paying market-determined rates. As
the year progressed, individuals reduced their
purchases of consumer durables and houses
in response to high financing costs and con
cern over the economic outlook. Net exten
sions of consumer credit, though up sharply
from their low levels under the credit re
straint programs in 1980, slowed after the first
quarter, while the savings rate rose. Mortgage
lending, which was well below the depressed

Com m ercial paper’s share of business
credit was up sharply
billion dollars

net short and interm ediate
term business credit
advanced via:

-finance companies
-commercial paper

-small banks
- foreign related
institutions
-large banks*

1980

1981

•Banks with dom estic assets of $750 m illion dollars or more at the
end of 1977. Includes loans to U.S. residents booked at foreign branches
of U.S. banks. Banking data for the end of 1981 have been adjusted to
elim inate the shifting of assets from dom estic banking offices to Internat
ional Banking Facilities.

1980 pace in the first half, declined further in
the second half.
Although businesses raised somewhat
more funds, net, in the credit markets than in
1980, they concentrated their borrowing in
short-term debt instruments, given the high
rates and unreceptive conditions in the secur
ities markets. Short- and intermediate-term
business debt rose an estimated $80 billion,
about 70 percent more than in 1980.
Bank loans to business borrowers by
domestic offices of both U.S. and foreign
banks rose more than 13 percent in 1981,
compared with 12 percent in 1980. Business
loans expanded more rapidly at small and
medium-sized banks than at large money
center banks or U.S. branches and agencies of
foreign banks. To a considerable extent this
was attributable to the greater access of large
firms to the commercial market paper; out
standing commercial paper of nonfinancial
issuers rose 45 percent last year. Business
loans extended to U.S. corporations by for
eign branches of large U.S. banks were also

up sharply, largely because the cost of funds
from these sources was generally less than
that of bank loans based on the bank prime
rate. To meet competition from foreign bank
ing institutions and the commercial paper
market, many large domestic banks made
credit available to large national market cus
tomers with options for alternative pricing
based on market rates or on the cost of funds.
With liabilities shorter and rates more
volatile, financial institutions were under grow
ing pressure to keep assets returns in line with
the cost of funds. Most business loans were
written with floating rates, and few mortgage
lenders were willing to put more fixed-rate
loans on their books. At the same time, the
high yields available on short-term obliga
tions and continued concerns about inflation
discouraged investors from making long-term
commitments. All of these factors contrib
uted to heavier reliance on short-term debt.
Borrowers must now face the problems of
rolling it over in the future or refinancing in
long-term markets when conditions permit.

Prelude to recovery
In the summer of 1982 the American
economy remained in the grip of a stubborn
recession. However, the rate of decline appear
ed to have slowed and most observers believed
that an upturn was at hand. The decline in
total activity that began in mid-1981 was not
nearly as steep as in various past cycles, nota
bly in late 1974 and early 1975. Nevertheless,
morale was at a lower ebb than at any time
since the 1930s. Several unusual characteris
tics of the 1981-82 recession help to account
for this extreme pessimism:
• The recession followed closely on the
heels of the recovery from the 1980 decline.
• The unemployment rate, which was rela
tively high at the onset of the recession, later
increased to a postwar record high.
• The downturn affected all sectors of the
economy—agriculture, manufacturing, min-

ing, construction, transportation, public utili
ties, trade, finance, and government.
• Real interest rates (nominal interest rates
less the rate of inflation) rose to unprece
dented heights, placing a heavy burden on
borrowers.
• Despite efforts to cut spending, the fed
eral deficit was expected to remain in the $100
billion range for years to come.
• Forced closings, liquidations, and bank
ruptcies soared to the highest levels since the
1930s.
• Intense foreign competition, aided by
the high valueofthedollar,stimulated imports
and discouraged exports.
Signs of revival

Despite the unrelieved gloom in some
sectors in early 1982, there were encouraging

E c o n o m ic P e rsp e c tiv e s

signs that the worst was over. A paramount
objective of economic policy was being
achieved. Price inflation had been dampened
to a greater degree than the most optimistic
forecasts had envisaged. In early spring both
the consumer and producer prices indexes
declined, reversing an uptrend that had been
virtually uninterrupted since the early 1960s.
Doubtless price inflation will revive once
recovery begins, but the specter of double
digit inflation has receded.
Price competition is present to a degree
unknown in recent decades. Deregulation of
the transportation industries has been a major
factor in bringing this about and has resulted
in substantial savings to customers. Similar
trends are underway in the public utility and
financial services sectors.
Another promising sign was the increased
willingness of labor organizations to help re
store financial health to distressed industries
by renegotiating the terms of existing con
tracts. In some cases, unions agreed to modify
restrictive work rules that hamper produc
tivity and increase production costs.
Inventory liquidation, at a $40 billion
annual rate in the first quarter, reduced
excess stocks and set the stage for higher pro
duction to keep supplies in line with current
demand. Ample supplies of all types of goods
and services, including energy, provided
assurance that bottlenecks would not impede
the expected rise in activity.
Consumer spending remained depressed
in the spring relative to after-tax income, and
consumers remained cautious in using instal
ment credit lines. But backlogs of demand for
vehicles, housing, appliances, and home fur
nishings were building up. As in past reces
sions, a restoration of confidence could be
expected to lead to an uptrend in consumer
purchases, especially durables.
Business capital spending weakened
further as cash available from operations was

curtailed and margins of surplus capacity
increased. Many projects were postponed,
awaiting an improved outlook. The powerful
investment incentives provided in the 1981
tax law, especially rapid depreciation and
expanded tax credits, will encourage deci
sions to reactivate these projects. But any
major revival of capital spending must await a
further decline in real interest rates.
A hard road ahead

The monetary and fiscal authorities are
charged with the responsibility for providing
an environment conducive to stable growth
and reasonably stable prices. Judged by these
two criteria, the record of the past two
decades has not been favorable. Recessions
have been countered by excessively stimula
tory monetary policy actions, leading to unsus
tainable booms followed by new recessions
and successively higher levels of unemploy
ment. Meanwhile, government programs to
assist individuals and industries have created
a vast array of "entitlements" which provide
income or special benefits without a com
mensurate rise in output. Most of these pro
grams are being reevaluated and modified.
Resisting pressures for a "quick fix," the
Federal Reserve System has committed itself
to a policy of restrained growth in money and
credit aggregates. These aggregates have con
tinued to grow, but not at rates that would
lead to a revival of inflationary excesses. Such
a policy should eventually result in reduced
inflation expectations and a gradual decline
in interest rates, assuming that some progress
is m ade to w ard m atchin g g o ve rn m e n t re v
e n u e s and e x p e n d itu re s . G ive n a re su m p

tion of growth in money turnover, or "veloc
ity," the Federal Reserve's current growth
targets should provide adequate funds for
gradual economic recovery.
■■■■■■■■■■■■■■■■■■

F e d e ra l R e s e rv e Bank o f C h ica g o

Economic events in 1981
a chronology

—

J*n 1 M inim um wage rises from $3.10 to $3.35. (It remains unchanged
on January 1,1982.)

Jan 1 Social Security wage base rises from $25,900 to $29,700, and tax

May 19 FSLIC finances merger of troubled Chicago S&L.
May 22 Prime rate rises to 20.5 percent. Investm ent rate at threemonth Treasury bill auction rises to record 17.7 percent.

May 26 O P EC extends price freeze. (See Oct 29.)
Jun 3 Prime rate reduced from 20.5 to 20 percent.

rate rises from 6.13 percent to 6.65 percent. (O n January 1,1982, base

Jun 6 Coal m iners ratify 40-month contract raising com pensation 38

rises to $32,400 and tax rate rises to 6.7 percent.)

percent, ending 72-day strike.

Jan 1 Chicago area pu blic transport fares rise by one-third. (Further

Jun 8 Israeli jets bom b nuclear reactors in Iraq.

sharp increases occur in July.)

Jun 8 Suprem e Court rules w om en can sue for equal pay on "com

Jan 9 Bank prime lending rate reduced from 20.5 to 20 percent.
Jan 20 President Reagan inaugurated. He freezes federal hiring.
Jan 20 Iran releases 52 U.S. hostages held 444 days.
Jan 27 Remaining price controls on dom estic crude oil and allocation
regulations on gasoline lifted.

parable” jobs.

Jun 11 Farm and construction equipm ent m anufacturers announce
extended vacation layoffs.

Jun 21 French Socialists win a solid majority in assembly for five years.^
(See May 10.)

Jan 29 President Reagan announces 60-day freeze on new regulations.

Jun 30 Plan to trade bank C D futures approved by Com m odity
Futures Trading Com m ission (CFTC).

Jan 29 Federal Reserve begins charging for w ire transfers. Fees for

Jun 30 im poit restrictions on shoes from Taiwnn and South Korea

other services are phased in over subsequent months.

allowed to expire.

Feb 2 Chrysler w orkers agree to forego increases in com pensation.

l u l l Social security checks increase by 11.2 percent.

Feb 10 W estern coal m iners accept 37 percent raise over three years.

Jul 1 Com m onw ealth Edison is granted 14.5 percent rate hike.

Feb 18 Auto makers broaden custom er rebates.

Jul 2 Suprem e Court upholds Montana's severance taxes on coal.

Feb 25 Federal Reserve announces m oney growth targets for 1981.

Jul 3 Law signed permitting multibank holding com panies in Illinois

Feb 27 Federal loan guarantee for Chrysler raised to $1.2 billion.

beginning January 1,1982.

M ar 2 Poland orders meat rationing, first time since 1960.

Jul 6 DuPont offers to purchase C o n o co , biggest merger ever.

Mar 14 Ford’s steel w orkers agree to cut incentive pay to prevent

Jul 6 U.S. dollar hits new highs against European currencies.

plant closing.

Jul 7 Sandra O ’C on no r is first wom an named to Suprem e Court.

Mar 15 Two Chicago-area banks closed by examiners.

Jul 8 Prime rate rises from 20 to 20.5 percent.

Mar 22 First class mail goes from 15 to 18cents. (Rate goes to 20cents

Jul 8 D ID C adopts sch edule for elim ination of interest rate ceilings.
(See Jul 31.)

on Novem ber 11.)

Mar 26 Treasury Secretary Regan elected chairm an of Depository
Institutions Deregulation Com m ittee (D ID C ). (Volcker elected vice
chairm an June 25.)
M ar 30 President Reagan and three others w ounded in assassination
attempt.
Apr 1 S e m ia n n u a l a d ju stm e n t in s u p p o rt p ric e of m ilk is
rescinded.

Apr 9 Some exporters reduce posted prices for crude oil.
Apr 10 Ford rejects m erger offer from Chrysler.

Jul 9 California debates spraying for M ed Fly.
Jul 14 FHLBB allows federal S&Ls to issue graduated payment adjus
table mortgage loans.

Jul 15 M idyear budget review projects deficits of $56 billion for fiscal
1981 and $43 billion for fiscal 1982. (See Oct 28.)
>4

Jul 17 Volcker expresses con cern over surge in bank loans to finance
mergers.

Jul 21 Federal Reserve announces lower 1982 m oney growth targets

Apr 14 Space shuttle lands after three-day orbit.

for 1982.

Apr 23 Federal H om e Loan Bank Board (FHLBB) gives federal S&Ls

Jul 23 Chairm an Pratt of FHLBB says S&L losses are at record pace.

broad discretion on variable rate mortgages (VRMs).

Jul 23 W ashington Star announces it will cease publication.

Apr 24 Embargo on grain shipm ents to Russia ended after 16 months.

Jul 24 Some Detroit city unions agree to wage freeze.

Apr 24 Prime rate rises from 17 to 17.5 percent.

Jul 31 Schlitz announces perm anent closing of its original M ilwaukee

Apr 27 Dow Jones industrial average closes at 1024, high for the yea;.
(See Sep 25.)

Jul 31 Judge blocks D ID C ’s plan to lift ceiling on C D s with maturities

May 1 Japan agrees to limit car exports to the United States during
the period April 1981 to M arch 1983.

Jul 31 Canadian dollar closes at 80.9 U.S. cents, lowest since 1931.

May 1 Rate on EE bonds rises from 8 to 9 percent.
May 5 Federal Reserve raises discount rate from 13 to 14 percent, and
surcharge on frequent, large borrowers from 3 to 4 percent.
M ay 7 Treasury 30-year bonds yield a record 14 percent.

brewery.

of four years or more.

Aug 1 Below -m arket cap on 2V2-year Small Savers Certificates
rem oved.

Aug 3 Phibro Corp. to acquire Salomon Brothers.
Aug 3 Air controllers (PATCO ) begin strike. (They are terminated

May 10 Socialist Mitterrand elected French president. (See Jun 21.)

August 5.)

May 13 Pope John Paul II is w ounded in assassination attempt.

Aug 4 Warsaw populace protests food shortages.

E c o n o m ic P e rsp e c tiv e s

Aug 5 Ten-year Treasury notes yield a record 15 percent.

Nov 5 Various sales reported of tax benefits by corporations in deficit

Aug 5 U .S./U SSR grain agreem ent extended one year beyond origi

positions.

nal expiration date of Septem ber 30.

Nov 12 President Reagan ann ounces retention of O M B director

Aug 13 Econom ic Recovery Tax Act of 1981 signed into law, cutting

David Stockman despite magazine article casting doubt on policies.

personal incom e tax rates and providing investment incentives.

Nov 12 USDA forecasts a record crop harvest, with corn up 22 per

Spending cuts also becom e law.

cent from the drought-reduced outturn in 1980.

’Aug 20 Federal Reserve makes discount w indow available to thrifts

Nov 13 FHLBB reports that com m itm ent rates on conventional mort

and all banks with severe liquidity problems.

gages reached a record 18.2 percent in O ctober.

Aug 24 Six-month Treasury bills auctioned at a record 17.5 percent

Nov 16 Flood of corporate issues hits bond market as rates ease.

investment yield.

Aug 25 Postal w orkers ratify three-year pact raising wages about 11
percent in first year.

Sep 1 Indiana Bell’s AA A debentures yield record 17.1 percent.
Sep 1 FN M A conventional com m itm ent yields jum p to record 18.7
percent.

Sep 8 FHLBB approves merger of two failing S&Ls in the East with a
California S&L.
Sep 15 Prime rate declines from 20.5 to 20 percent.
Sep 16 Federal Reserve reports that industrial production declined in
August, start of an extended downturn.

Sep 17 Teamsters Union agrees to reopen Master Freight Agreement.
Sep 21 C hicago-area construction equipm ent operators end twomonth strike, winning 14 percent first year wage boost.

Sep 22 Federal Reserve discount rate surcharge reduced from 4 to 3
percent.

Sep 24 C eilin g rate on Federal credit union deposits rises to 12
^percent effective O cto ber 1.
Sep 25 Illinois law rem oves usury ceilings on all loans to consum ers.
Sep 25 Dow Jones index closes at 824, low for the year. (See Apr 27.)

Nov 17 Federal Reserve ends discount rate surcharge.
Nov 18 Housing starts in O cto ber reported at 15-year low.
Nov 23 President Reagan vetoes spending bill as excessive.
Dec1 C eiling-free IRA and Keogh accounts becom e available. (Eligi
bility for these accounts is broadened January 1,1982.)

Dec 1 Prime rate reduced to 15.75 percent.
Dec 3 U.S. banks authorized to establish International Banking
Facilities.

Dec 4 Federal Reserve reduces discount rate to 12 percent.
Dec 4 Jobless rate of 8.4 percent in Novem ber was highest since 1975.
(It rises further in Decem ber.)

Dec 7 Press reports indicate that administration projects $109 billion
deficit in fiscal 1982, without tax or spending changes.
Dec 8 M cLouth Steel announces filing for bankruptcy after default
ing on loan payment.
Dec 9 Chicago M ercantile Exchange begins trade in Euro-dollar
futures.
Dec 9 Saudi Arabia says $34 unified O P E C oil price will continue
through 1982.
Dec 10 Business C ou ncil expects recession to end early in 1982, with

Sep 30 FHLBB permits S&Ls to amortize losses on sales of mortgages.

interest rates lower and inflation reduced.

Oct 1 All Savers C ertificates, with tax-exempt yields tied to market
rates, becom e available.

Dec 13 Polish governm ent institutes martial law to quell political
unrest.

Oct 1 Federal em ployees receive 4.8 percent general pay boost, in

Dec 14 Treasury bill yields increase sharply, reversing downtrend.

addition to annual step increases. M ilitary pay rises 14.3 percent.
^Oct 5 Sears Roebuck announces agreem ent to buy Coldw ell Banker.
(Sears announces plan to buy Dean Witter Reynolds on O cto ber 8.)

Dec 14 Mortgage bankers report mortgage delinquencies at record
rate.

Dec 17 President Reagan announces that Department of Energy will

Oct 6 Egyptian president Sadat assassinated.

be abolished.

Oct 8 Two Chicago-area S&Ls merged by FSLIC.

Dec 19 G eneral M otors, following Ford, announces benefit cuts for
salaried workers.

Oct 12 Federal Reserve discount rate surcharge lowered from 3 to 2
percent.

Oct 14 James Tobin wins Nobel Prize in econom ics.
'Oct 16 President Reagan says a "lig ht” recession is underw ay.
Oct 19 D ID C postpones one-half percentage point increase in pass
book savings ceiling previously scheduled for N ovem ber 1.

Oct 27 Senate approves A W A C S sale to Saudi Arabia.
Oct 28 Treasury ann ounces fiscal 1981 budget deficit was $57.9 bil
lion. (See Jul 15.)
Oct 29 O P FC agrees on unified oil base price of $34 per barrel.
Nov 1 C eilin g on six-m onth m oney market certificates tied to higher
of most recent bill auction or four-w eek average.

Dec 21 U AW bargaining cou ncils agree to discuss concessions on
contracts with Ford and G M .
Dec 22 President Reagan signs hotly debated four-year farm bill.
Dec 22 Adm inistration plans to nom inate Preston Martin as vice
chairm an of Federal Reserve Board.
Dec 23 International Harvester announces agreem ent on restructur
ing $4.2 billion debt.
Dec 23 President Reagan announces econo m ic sanctions against
Poland’s governm ent to protest imposition of martial law.

Dec 24 M any durable goods producers will extend holiday shut
downs into January.

Nov 2 Federal Reserve discount rate reduced to 13 percent.

Dec 31 Purchasing managers report that orders, output, and
em ploym ent continued to decline in Decem ber..

Nov 5 M ergers of two large New York mutual savings banks arranged
by FD IC .

Dec 29 President Reagan announces sanctions against Russia for its
role in Polish crisis.

F e d e ra l R e s e rv e Bank o f C h ica g o

Lagged reserve accounting and the
Fed’s new operating procedure
Robert D. Laurent

Adoption of the Fed's new reservesoriented operating procedure on October 6,
1979, was greeted with praise by both admir
ers and critics of the Federal Reserve System.
Especially encouraged were those who, for
many years, had urged the Fed to abandon its
interest rate operating procedure in favor of a
reserves targeting procedure. These critics
viewed the proposed new procedure as a
major step in the right direction, even as they
withheld final judgment until they saw how
the new procedure was implemented.
There was a broad consensus, both within
the Fed and elsewhere, that adoption of the
new procedure would result in better shortrun control of money at the expense of
greater volatility in short-term interest rates.
The expected increase in interest rate volatil
ity was observed in 1980 and 1981. However,
the effects of the new procedure on money
stock growth were partly obscured by special
influences during the early part of 1980,
including the credit restraint program intro
duced in March, sharp increases in oil prices,
and—for a short time during the spring—
concern by policymakers over the conse
quences of sharply falling interest rates for
the international value of the dollar.
Many special circumstances disturbed
the “ normal" operation of the money and
capital markets in 1981. Most notable among
these were the anticipation of record federal
budget deficits and the redirection of gov
ernment priorities and spending programs.
These nonrecurring events make it especially
difficult to separate the effects of the Fed's
new operating procedure from the effects of
other forces.
The likely effects of the new operating
procedure on interest rates and money are
examined in this article within an analytical

framework that differs considerably from
those used in most other studies. Rather than
focusing on the longer-run demand for
money as the major determinant of money
creation, this framework emphasizes the ef
fects of short-run developments in the re
serves and credit markets on the behavior of
banks as suppliers of credit. In contrast to the
usual textbook treatment of the money supply
process as a mechanistic response by banks to
their basic reserve positions, the article focuseson the key role of the federal fundsrate.
Drawing on these elements, the article then
describes the implications for the new oper
ating procedureof the lagged reserve account
ing system that is now in effect. Finally, a
number of conclusions are drawn about the
behavior of interest rates and money under
the new procedure that appear to be consist
ent with the observed data.
Money demand
The broad consensus regarding the ef
fects of the new operating procedure rested
on the prevailing theory of money stock
determination. This theory assigns a very
important role to the demand for money, the
relationship between the quantity of money
the public desires to hold and the level of
interest rates, economic activity, and other
variables. The curve DD shows the relation
ship between the quantity of money de
manded and interest rates at a given level of
economic activity. The quantity of money
demanded increases as interest rates fall
because the cost of holding money (in the
sense of the interest foregone) falls. If the
level of economic activity were to rise, more
money would be demanded at every level of
the interest rate, as indicated by the curve
D'D'.

Econom ic Perspectives

The prevailing model of money
stock determination
in te r e s t rate

According to the prevailing theory, the
money stock is determined by the intersec
tion of the money demand curve and the
money supply curve. The curve SS represents
a money supply curve. It shows how the
quantity of money that will be produced out
of a given level of reserves varies with the
interest rate. The reason why the quantity of
money increases with interest rates is that
higher interest rates make it profitable for
banks to manage their liquidity positions
more closely, reducing their holdings of ex
cess reserves and producing a greater quan
tity of money out of any given quantity of
reserves. By changing the level of reserves
supplied, the Fed can shift the money supply
curve, so that S'S' could represent the money
supply curve at an increased level of reserves.
According to the prevailing view, the old
operating procedure of concentrating on
interest rates required that the Fed determine
which interest rate on the demand for money
schedule was consistent with the desired
money stock. This proved to be a difficult
task. More importantly, the interest rate tar

Federal Reserve Bank o f Chicago

geting procedure transformed unexpected
shifts in the money demand function into dis
turbances to the money stock. To see this,
consider a shift in the money demand curve
from DD to D'D'. In order to maintain the
target interest rate r, the monetary authority
must increase reserves until the money supply
curve has shifted to S'S', thus reestablishing
the target interest rate. But the money stock
has clearly increased from M to M'. Given the
pattern of shifts in the demand for money, the
old operating procedure bought interest rate
stability at the cost of increased volatility in
money.1
Like the old procedure, the new opera
ting procedure focuses on the demand for
money as the basic determinant of the level of
the money stock. It requires the Fed to
choose a target level of reserves which, given
the expected demand for money, will pro
duce the desired money stock. FHowever,
when a shift occurs in the demand for money,
there is a definite advantage to the new
procedure. Suppose that the demand for
money shifts, as described previously, from
DD to D'D'. Under the new operating proce
dure, the Fed leaves reserves unchanged, and
the new equilibrium point is b. Interest rates
rise to rb and money to Mb- Evaluated in
terms of the prevailing theory of money stock
determination, the new operating procedure
should reduce the volatility of money and
increase that of interest rates.
The supply approach
As indicated above, the demand for
money and shifts in the demand for money
play a key role in the prevailing theory of
money stock determination. This seems natu
ral, inasmuch as economists usually think of
quantities being determined jointly by supply*
’T h e r e c o u ld a lso b e sh ifts in t h e s u p p ly o f m o n e y
f u n c tio n (e .g ., in t h e r e la t io n s h ip b e t w e e n e x c e s s r e
s e rv e s a n d in te r e s t ra te s ), in w h ic h c a s e an in te r e s t rate
s ta b iliz a t io n p o lic y w o u ld r e d u c e th e v o la tility in m o n e y .
T h e a d o p tio n o f th e n e w o p e ra t in g p r o c e d u r e a ssu m e s,
a n d e m p ir ic a l e v id e n c e (e .g ., t h e lo w le v e l of e x c e s s
r e s e r v e s ) su g g e s ts , th a t n o n - p o lic y sh ifts in s u p p ly a re
s m a lle r th a n sh ifts in t h e d e m a n d fo r m o n e y .

and demand. There is, however, an alterna
tive way of looking at money stock determi
nation that focuses on the supply of money
and completely ignores the demand for
money. In effect, this alternative approach
rests on the assumption that the public will
hold whatever quantity of money the Fed and
the banking system combine to supply.
This alternative approach depends criti
cally on the unique property of money as a
means of performing transactions. Because of
this unique function of money, certain mone
tary transactions must be interpreted care
fully. For example, suppose that the Fed pur
chases securities from bond dealers with
newly created money. The dealers' accep
tance of money in exchange for the bonds in
no way implies that they now wish to hold
permanently higher checking balances. In
deed, it is highly unlikely that this is the case.
It is more reasonable to assume that, because
the Fed has offered a good price for the secur
ities, the dealers have exchanged them for
money as a prelude to buying other assets.
But while the dealers can easily eliminate
that part of their increased money balances in
excess of the amount they want to hold by
buying other assets, that newly created money
does not disappear. For the economy as a
whole there is no reduction in money, but
simply a redistribution. Similarly, when a
bank creates new money by making a loan or
buying securities, there is no presumption
that the borrower or the seller of securities
desires a permanent increase in his money
balances. Again, however, when the money is
used to purchase other assets it does not dis
appear, but simply becomes a temporary
excess money balance held by another party.
This exclusive emphasis on the supply
side in determining the stock of money may
seem strange at first to economists. They are
taught at an early stage in their training not to
neglect either supply or demand in determin
ing the quantity of a good or service actually
produced and sold. The supply approach
described here does not really violate the tra
ditional approach, but may be considered a
polar case of it. The essence of the supply

approach is that, because of money's unique
quality as a means of transfer, the public's
willingness to accept money in exchange for
goods or services is virtually unlimited in the
short run. In the long run, the demand for
money is the mechanism by which the econ
omy as a whole adjusts to the quantity of
money supplied by the Fed and depository
institutions.
There are some clues that an exclusive
concentration on the supply side might be a
valid approach to money stock determina
tion. In the wake of the Great Depression of
the 1930s, many economists advocated a sys
tem of 100 percent reserve requirements on
demand deposits to prevent undesired
changes in the money stock. While there may
be problems with these proposals, it is widely
conceded that they would give accurate con
trol over money. Yet, the proposals never
mentioned the demand for money. Rather,
by eliminating excess reserves, such propos
als would have made the supply curve of
money perfectly vertical at any given level of
reserves. Under these conditions, for money
as for any other good, demand would affect
only price; it would play no role in determin
ing quantity. In this way the proposals for 100
percent reserve requirements would have
translated the Fed's control over reserves
directly into control over money.
A second clue to the validity of the
supply approach to money stock determina
tion is the widely acknowledged fact that the
full response of the economy to a change in
money occurs only with a considerable lag.
This suggests that the public does not—
indeed, cannot—immediately adjust its
money balances to their long-run equilibrium
levels. Rather, in the short run, the public
passively accepts whatever level of money is
supplied. Although individuals can adjust
their holdings quickly, their actions in doing
so simply displace other economic units from
equilibrium. It is only through the repeated
efforts of a long succession of individuals to
adjust that a change in money has its impact
on the economy While the public cannot
change the aggregate quantity of money, it

Econom ic Perspectives

can eventually reach long-run equilibrium by
inducing changes in economic activity (and/
or prices) to the point where it is satisfied to
hold whatever nominal quantity of money
has been supplied.
The time interval between a change in
the money stock and completion of the eco
nomic changes which makethat money stock
acceptable is what is usually referred to as the
impact lag of monetary policy. For example, if
the money stock is increased, holders will
initially attempt to purchase other assets,
both financial assets and existing and newly
produced real assets. This will stimulate eco
nomic activity (and/or raise prices) until all of
the increased money stock is demanded be
cause of the higher volume of monetary trans
actions. Conversely, a decrease in the money
stock will induce a fall in economic activity
(and/or prices) until the reduced money
stock is just adequate to handle the lower
volume of monetary transactions.
The money supply process
The money supply process is the process
by which the Fed induces banks to buy or sell
assets, thereby creating or destroying depos
its and changing the money stock. Textbooks
generally describe the money supply process
as a mechanistic response by banks to changes
in their reserve positions. In this textbook
scenario, a bank changes its asset holdings in
response to the relationship between reserves
and required reserves. If reserves exceed
required reserves, the bank eliminates its
excess reserves by buying an equal amount of
assets, thereby creating deposits and increas
ing the money stock. Conversely, if a bank’s
reserves are less than its required reserves,
then the bank eliminates its deficiency by sell
ing an equal amount of assets, initially de
stroying deposits in the banking system (since
in all likelihood the purchaser will pay for the
asset with a deposit) and reducing the money
stock. The process is pictured as continuing at
each individual bank until aggregate required
reserves equal aggregate reserves.
However useful the textbook scenario

Federal Reserve Bank o f Chicago

may be as a pedagogical device for demon
strating how the banking system translates a
change in reserves into a multiple change in
money, it is not an accurate description of
how banks.behave. It is important to under
stand that banks respond primarily to the
price of reserves, specifically the federal funds
rate, in deciding whether to buy or sell assets,
and thereby to create or destroy deposits.
A bank is a profit-maximizing interme
diary that views the federal funds market as a
potential source or outlet for funds. The bank
neither knows nor cares about the aggregate
level of reserves in the banking system and
cares but little about its own preexisting level
of reserves. Of course, it must have enough
reserves to meet its required reserves, but it
can always purchase or dispose of reserves in
the federal funds market. If the spread be
tween the rate of return on an asset and the
federal funds rate is sufficiently wide, even a
bank deficient in reserves will purchase the
asset, creating deposits in the process, and
cover the added reserve loss by purchasing
even more reserves than otherwise in the
federal funds market.
That bank asset adjustment decisions are
affected by the price of reserves (federal
funds rate), and not by preexisting reserve
positions, is clearly demonstrated by the fact
that many large banks consistently purchase
more reserves in the federal funds market
than their entire level of required reserves.
Without the federal funds purchases, these
banks would not only be deficient, but would
actually have negative reserve levels. If banks
responded solely to their basic reserve posi
tions, these banks would long ago have sold
assets to cover their basic reserve deficiencies.
The effect of the federal funds rate on the
money stock is clear. Other things being
equal, the higher the federal funds rate, the
lower the money stock. A higher federal
funds rate, in relation to the rates on other
assets) makes it more attractive for banks to
sell other assets and channel the reserves
thereby obtained into the federal funds mar
ket, reducing deposits and the money stock.
A lower federal funds rate makes it more

attractive to borrow reserves in the federal
funds market and usethem to purchase other
assets, thereby increasing deposits and the
money stock.
The basic relationship between the fed
eral funds rate, the rate on bank assets, and
the money stock is not dependent on the
particular operating procedure or reserve
accounting system that the Fed is using. How
ever, the operating procedure and reserve
accounting system do affect the manner in
which the federal funds rate is determined
and, consequently, the Fed's ability to control
the money stock.
Interest rate targeting
An interest rate targeting procedure such
as that followed by the Fed before October 6,
1979, is easily described within the supply
approach to money stock determination. The
first task of the Fed was to choose a federal
funds rate which it believed would induce
banks to hold a quantity of assets just consist
ent with the desired level of the money stock.
Then, the Federal Open Market Desk (Desk)
varied nonborrowed reserves through sales
and purchases of securities in such a way as to
keep the federal funds rate within a narrow
range about this chosen level. The Desk was
able to do this quite well.
But it proved to be extremely difficult to
determine what interest rate was consistent
with the desired money stock. That difficulty,
together with an apparent reluctanceto move
the federal funds rate sufficiently to bring
money quickly back to the target path follow
ing unanticipated deviations sometimes led
to large cumulative departures from the an
nounced ranges for as long as a quarter or
more. Dissatisfaction with the results of the
interest rate operating procedure ultimately
led to the October 6, 1979 shift to the new
operating procedure.
Reserves targeting
For many years academiceconomists and
others have urged the Fed to adopt a reserves

targeting procedure for controlling the
money stock. Before discussing the major fea
tures of the operating procedure adopted on
October 6,1979, it may be useful to describe
the operation of a hypothetical reserves tar
geting procedure from the vantage point of
the supply approach to money stock deter
mination. Crucial to understanding such a
procedure is the assertion made earlier that
banks respond to the federal funds rate,
rather than to their basic reserve positions, in
changing deposits. This is not to say that the
level of reserves is unimportant. Indeed,
because reserves and the federal funds rate
are interdependent, it makes no sense to say
that one is important, while the other is not.
But since the precise relationship between
the federal funds rate and deposits may be
difficult to ascertain, it may make sense to use
reserves to guide the federal funds rate to the
proper level to produce the target money
stock.
Advocates of reserves targeting are ask
ing that the money stock be allowed to adjust
to a predetermined level of reserves. As dis
cussed above, individual banks would be
guided in making this adjustment by move
ments in the federal funds rate. However, it is
precisely the difficulty of knowing the appro
priate federal funds rate that argues for a selfequilibrating mechanism to set the rate and
achieve the money target. Under a reserves
targeting procedure, the role of the Fed is
confined to providing a level of reserves
believed consistent with the desired money
stock, given the level and structure of reserve
requirements. The reserves market is then
supposed to guide the federal funds rate to
whatever level is required to obtain the
desired level of deposits, as illustrated in the
accompanying schematic diagram.
Suppose, for example, that required re
serves are greater than the level of reserves
(presumably meaning that the actual money
stock exceeds the targeted level). The short
age of reserves causes banks to bid up the
federal funds rate. As the federal funds rate
rises, banks respond by selling assets—there
by destroying deposits and reducing the

Economic Perspectives

money stock—and channeling the funds into
the federal funds market. The federal funds
rate will continue to rise until banks have sold
enough assets, thereby raising other interest
rates, and destroyed enough deposits to
reduce required reserves below the level of

Federal Reserve Bank o f Chicago

reserves provided. Conversely, if required
reserves are below the level of reserves pro
vided, the federal funds rate will fall and
banks will buy assets, lowering other rates
and increasing deposits (and money), until
required reserves move up into equilibrium

with reserves.
In a system in which current deposits
affect current required reserves, the purchase
(sale) of assets can raise (lower) required
reserves by increasing (decreasing) deposits.
This does not change the aggregate level of
reserves, of course, but simply redistributes
them. Indeed, the essential characteristic of a
total reserves targeting procedure is that the
federal funds rate, deposits, and required
reserves all adjust to a preestablished level of
reserves.
Lagged reserve accounting

The reserves targeting procedure de
scribed above depends critically on the exist
ence of a direct relationship between current
deposits and current required reserves. How
ever, under the lagged reserve accounting
system in use since 1968, current required
reserves are determined not by deposits in
the current week but by deposits two weeks
earlier. In two ways this system is difficult to
reconcile with the hypothetical reserves tar
geting procedure described above.
First, lagged reserve accounting con
strains the level of reserves that the Fed can
provide. If the level of deposits two weeks
before were such that required reserves are
greater than the targeted level of reserves,
the Fed has little choice but to provide
enough reserves to cover the predetermined
level of required reserves. This explains what
may appear to be a common misunderstand
ing about the new operating procedure. Al
though the new procedure is often referred
to as a reserves targeting procedure, the de
scription just given makes it clear that the Fed
cannot always closely control total reserves,
but only the mix between borrowed and
nonborrowed reserves.2The fact that the Fed
2T h a t is, a lth o u g h t h e F e d

M arket volatility

Lagged reserve accounting has profound
implications for the new operating proce

m u st p r o v id e at least

e n o u g h r e s e r v e s to c o v e r th e le v e l o f r e q u ir e d re se rv e s , it
has a c h o ic e o f h o w to p r o v id e th e re s e r v e s . T h e g r e a te r
th e a m o u n t o f r e s e r v e s p r o v id e d t h r o u g h o p e n m a rk e t
o p e r a t io n s (n o n b o r r o w e d r e s e r v e s ), t h e s m a lle r th e
a m o u n t o f r e s e r v e s th a t b a n k s m u st b o r r o w t h r o u g h th e
d is c o u n t w in d o w , a n d t h e r e f o r e t h e lo w e r th e fe d e ra l
fu n d s rate.

targets nonborrowed reserves would seem to
be implicit recognition that there are times
when hitting a targeted level of total reserves
is not feasible.
The second problem posed by lagged
reserve accounting for a reserves targeting
procedure is always present, even when the
Fed is not constrained from hitting the tar
geted level of total reserves. Consider a situa
tion in which the level of deposits two weeks
ago was below the desired level. This means
that the quantity of reserves demanded—
which reflects primarily the level of required
reserves—is below the level of total reserves
that would be consistent with the Fed's
desired level of the money stock. In this case,
the Fed could achieve the necessary level of
total reserves simply by supplying a sufficient
amount of nonborrowed reserves.
However, because the quantity of re
serves demanded is less than the quantity
supplied, the federal funds rate must fall. As it
falls, banks respond by purchasing assets and
increasing deposits. But, unlike a system in
which an increase in current deposits in
creases required reserves, raising the demand
for reserves and thereby halting the decline
in the federal funds rate, under lagged reserve
accounting there is nothing in the increasing
deposit levels to cushion the fall. Required
reserves were determined two weeks earlier
and cannot be changed. Deposits could go
literally anywhere in the current week and
not affect the federal funds rate at all.3 Under
lagged reserves, banks continue to purchase
assets and create deposits until the rate on
bank assets moves into equilibrium with the
lower federal funds rate.

3C h a n g e s in d e p o s it s in th e c u r r e n t w e e k d o not
a ffe c t th e d e m a n d fo r re s e r v e s in t h e c u r r e n t w e e k ,
w h ic h w a s d e t e r m in e d by t h e d e p o s it le v e l tw o w e e k s
e a r lie r . E v e n t h o u g h c h a n g e s in d e p o s it s in t h e c u r r e n t
w e e k w ill a ffe c t th e d e m a n d fo r r e s e r v e s tw o w e e k s fro m
n o w , t h e r e is n o w a y that th is w ill in f lu e n c e t h e d e m a n d
o r s u p p ly o f r e s e r v e s in th e c u r r e n t w e e k .

Econom ic Perspectives

dure. It was noted earlier that, according to
the prevailing view of money stock determi
nation, the new operating procedure was
expected to stabilize short-run changes in
money at the expense of increased short-run
volatility in interest rates. But under lagged
reserve accounting, the supply approach to
money stock determination suggests a differ
ent result.
According to the supply approach,
changes in deposits occur because of changes
in the spread between the rate banks can earn
on assets and the rate charged for reserves
(federal funds rate). Deposits will change if,
and only if, banks have an incentive to ex
change assets with the public. The key to
understanding the effects of the change in
operating procedure on the volatility of in
terest rates and money lies in examining the
implications of different reserve accounting
schemes as well as different operating proce
dures for the process by which the rate spread
is returned to equilibrium.
Consider an example using the supply
approach to money stock determination. As
sume that the banking system is in equili
brium when the rate that banks can earn on
assets increases. According to the supply
approach to money stock determination, such
an increase may arise not only from an
increase in the demand for money, but from
any change in the credit market which raises
interest rates. The initial response to the
increase in the rate on bank assets is that
banks will attempt to buy assets and thereby
increase deposits.4 The final result depends
on the reserve accounting system as well as
the operating procedure.

Reserves targeting. Consider the case in
which deposits in the current week deter
mine current required reserves and the Fed is
targeting total reserves—i.e., the situation
usually assumed when speaking of a reserves
targeting procedure. In this situation, as soon
as banks attempt to buy assets and increase
the money supply, required reserves increase
and the shortage of reserves causes the fed
eral funds rate to rise. It continues to rise until
there is no longer any incentive for banks to
increase their asset holdings. That is, the fed
eral funds rate increases until it has returned
the gap between it and the rate on bank assets
to an equilibrium level.
In the end, interest rates have risen and
the money stock has increased only to the
extent that the higher interest rates have led
banks to reduce excess reserves. In this situa
tion, according to both the prevailing view
and the supply approach, more volatile inter
est rates are associated with less volatile shortrun changes in money.
The old operating p rocedure. Now con
sider a second situation, in which lagged
reserve accounting is being used, but the Fed
is targeting an interest rate—i.e., the old
operating procedure. Again, assume that the
rate on bank assets rises. Banks again buy
assets, increasing deposits and money. But
because current required reserves were deter
mined by deposits two weeks earlier, the
change in deposits has no effect on the
demand for reserves and no impact on the
federal funds rate. The only way that a change
in the federal funds rate can occur would be if
the Fed decided to make it occur. The sche
matic diagram of the old operating proce-

4The supply approach assumes the following bank
response mechanism:

reserve loss with purchases in the federal funds market.
Conversely, if the rate on bank assets is below the
expected rate on federal funds of the same maturity,
banks will reduce their asset holdings obtained from the
public, thereby reducing deposits, and sell the funds
obtained in the federal funds market. Policy affects the
money stock through the impact of the current federal
funds rate on expected federal funds rates in the future.
The greater is the impact of a movement in the current
federal funds rate on expected future federal funds rates,
the greater is the impact on money.

A Deposits ft* A Bank Assets =
f(Ratebank assets " Expected Ratefecjera| funds)
This response mechanism says that banks exchange assets
with the public on the basis of the difference between
the rate on bank assets and the expected rate on federal
funds of the same maturity. If the rate on bank assets is
above the expected rate on federal funds of the same
maturity, banks will purchase assets (loans or securities)
from the public, thereby creating deposits, and cover the

Federal Reserve Bank o f Chicago

The old operating procedure

dure shows that the Fed directly sets the fed
eral funds rate and that the connection be
tween deposit changes and required reserves
in the current week is severed by lagged
reserves. Since, under an interest rate target
ing procedure, the Fed is only moving the

federal funds rate by small increments, the
disturbances to the spread between the rate
on bank assets and the federal funds rate from
movements in the federal funds rate are
small. Under a lagged reserve system there is
no mechanism that automatically matches

Econom ic Perspectives

movements in the federal funds rate to
movements in the bank asset rate. The distur
bances to the spread are thus the sum of two
independent interest rate movements—the
movement in the bank asset rate arising from
shifts in the credit market and the small
movements in the federal funds rate pro
duced by the Fed. In the example being con
sidered, banks achieve equilibrium by pur
chasing assets and increasing deposits until
the rate on bank assets has been lowered to its
previous level and the equilibrium spread has
been reestablished. In the short run money
increases but interest rates are unchanged.
Notice that even if the reserve account
ing system had been one in which current
deposits determined required reserves, the
results would have been the same as long as
the Fed operates through interest rates. This
result is consistent with the widely acknowl
edged fact that the reserve accounting sys
tem is irrelevant if the Fed is targeting an
interest rate.
The new operating procedure. Finally,
consider a situation in which the reserve
accounting system is again lagged reserves,
but the Fed is targeting a level of nonborrowed reserves—i.e., the new operating pro
cedure. Again, under lagged reserve account
ing, banks reach equilibrium by changing
their asset holdings (and the money stock)
until the interest rate on bank assets moves
into equilibrium with the federal funds rate.
The new operating procedure does not differ
from the old procedure in this respect. The

main difference between the new procedure
and the old one is that the Fed no longer
stabilizes the federal funds rate in the short
run. Consequently, short-run movements in
the federal funds rate are much more volatile.
Although this increased volatility of the
federal funds rate was anticipated when the
new procedure was adopted, it was viewed as
the necessary cost of improved control of the
monetary aggregates. However, another im
portant consequence of the new procedure
seems not to have been fully appreciated.
This is the fact that the short-run changes in
bank assets and deposits necessary to equili
brate the bank asset rate to this more volatile
federal funds rate will generally be larger
than under the old procedure.
The key to understanding this seemingly
implausible result is to keep in mind that fed
eral funds rate volatility is beneficial in stabil
izing short-run movements in money only if it
serves to reestablish equilibrium between the
rate on bank assets and the federal funds rate,
as it would under a reserves targeting proce
dure in which current deposits determine
current required reserves. Greatly increased
federal funds rate volatility that is unrelated
to the rate in the credit market—which, as
was discussed previously, is characteristic of a
lagged reserve accounting system—will serve
to widen the departure from equilibrium
more often than to narrow it.
The dramatic increase in the volatility of
the federal funds rate under the new operat
ing procedure makes the departure from

Weekly interest rate and deposit volatility
Demand deposits
Nonseasonally adjusted

Federal funds rate
Period

Average absolute
deviation

Standard
deviation

Average absolute
deviation

Standard
deviation

Seasonally adjusted
Average absolute
deviation

Standard
deviation

O ct. 20,1976 - O ct. 10,1979

1.375

1.810

.799

1.028

.574

O ct. 20,1976 - O ct. 12,1977

1.668

2.153

.805

1.004

.588

.735

O ct. 19, 1977 - O ct. 11, 1978

1.136

1.423

.756

.932

.579

.778

O ct. 18, 1978 - O ct. 10,1979

1.320

1.813

.837

1.151

.557

.750

O ct. 17,1979 - O ct. 8, 1980

5.700

7.326

1.110

1.384

.651

.820

O ct. 17, 1980 - O ct. 7, 1981

4.020

5.183

.992

1.271

.651

.846

O ct. 17 ,1 9 7 9 - O c t. 7, 1981

4.860

6.315

1.016

1.333

.663

.845

.756

A ll data use w eekly percentage changes. M easures of volatility are the average absolute deviation about the mean and the standard deviation.
Seasonally adjusted demand deposits are adjusted by taking the difference between the current figure and the figure 52 weeks earlier.

Federal Reserve Bank o f Chicago

equilibrium much larger, on average, than
under the old procedure. The further the two
rates are from an equilibrium relationship to
one another, the larger are the changes in
deposits required to achieve equilibrium.
Thus, the new operating procedure yields not
only increased volatility in interest rates—
which was generally expected when the new
procedure was adopted—but also somewhat
increased week-to-week volatility of depos
its. That the volatility of both the federal funds
rate and deposits has increased since adop
tion of the new operating procedure isshown
in the table. However, as will be noted later,
this increased week-to-week volatility in
deposits could well be accompanied by a
reduced volatility in deposits over longer
periods of time.
The change in procedure

It is a truism of economics that the fed
eral funds rate, like any other price, is deter
mined by the interaction of supply and de
mand. Yet, there are important differences
under different operating procedures in how
supply and demand interact to determine this
basic link in the money supply process. The
usual conception of a reserves targeting pro
cedure implicitly assumes that the supply of
reserves is set first and that the federal funds
rate responds to shifts in the demand for
reserves through the impact of current de
posit changes on required reserves.
Under lagged reserve accounting, how
ever, it is impossible for deposit changes in
the current week to affect the federal funds
rate, because required reserves were deter
mined by deposit levels two weeks earlier.
With the demand for reserves in the current
reserve maintenance week essentially fixed,
the federal funds rate and deposits respond
only to changes in the supply of reserves. The
structure of the present reserve accounting
system prevents the federal funds rate from
performing the role that it should in a re
serves targeting procedure. The effect of the
shift to the new operating procedure is to
change the way the supply of reserves deter

mines the federal funds rate.
Under the old operating procedure, it
was clear how the Fed used the supply of
reserves to determine the federal funds rate.
Having chosen a target level of the federal
funds rate, and with required reserves set two
weeks earlier, the Desk varied the level of
nonborrowed reserves to achieve that target.
Under those conditions the Fed knew the
federal funds rate it was producing, and the
levels of borrowed and nonborrowed reserves
fell out as a consequence of the discount rate
and the operation of the discount window, as
shown in the schematic diagram of the old
operating procedure.
Under the new operating procedure, the
Fed begins implementing policy by providing
some level of nonborrowed reserves. As be
fore, given the discount rate and the manner
in which the discount window is adminis
tered (i.e., the nonpecuniary costs of borrow
ing), the level of nonborrowed reserves
determines the federal funds rate. But under
the new operating procedure the Fed does
not know precisely the level of the federal
funds rate that will result from the level of
nonborrowed reserves provided. As shown in
the schematic diagram of the new operating
procedure, the supply of nonborrowed re
serves still determines the federal funds rate,
but at one step removed. And that determina
tion has become much more complex be
cause the federal funds rate associated with a
particular level of nonborrowed reserves now
depends on the discount rate and the nonpe
cuniary costs of borrowing at the discount
window.
The preceding analysis explains why the
increased short-run volatility in the federal
funds rate that accompanied adoption of the
new operating procedure has resulted in
increased short-run (weekly) deposit volatil
ity. However, the adoption of the new operat
ing procedure could well bring an improve
ment in monetary control. The major criticism
of the old operating procedure was not that
short-run (weekly) deposit volatility was too
large, but that the monetary authority was
reluctant to move the federal funds rate

Econom ic Perspectives

The new operating procedure

enough to prevent longer-run deviations of
money stock growth from target. If the new
operating procedure allows the federal funds

Federal Reserve Bank o f Chicago

rate to move more in response to deviations
of money stock from target, then it is likely to
improve longer-run monetary control.

The effects of usury ceilings
Donna Vandenbrink

Regulations designed to prevent usury, or the
taking of “ excessive" interest, have been
debated from the time of Moses. Today, as a
result of a prolonged period of high inflation,
record interest rates, and sluggish economic
growth, the usury ceilings in effect in many
states are the center of controversy. Are the
critics of these usury ceilings simply speaking
out of self-interest when they argue that
interest rate ceilings work to consumers' dis
advantage by restricting credit flows and dis
torting financial markets? Do usury ceilings
protect consumers from abusive lending
practices and enable them to obtain loans at
reasonable rates, as their advocates claim?
Recent legislation, at both the federal
and state levels, has been in the direction of
relaxing interest rate controls. The 1980 De
pository Institutions Deregulation and Mone
tary Control Act overrode state interest ceil
ings on some categories of loans, and
additional federal action may be forthcom
ing. At the same time, many state legislatures
have revised their usury statutes. In large part,
these recent changes in usury regulation have
been in response to the current economic
situation. But is deregulation of usury ceilings
desirable? And if it is desirable, should it be
left to the states or is it best accomplished by
federal preemption? This article surveys the
economic research on usury ceilings in order
to help answer these questions.
Usury ceilings in a com petitive m arket:
theoretical argum ents

credit; the price of credit is the interest rate.
The credit market is easily represented in a
conventional supply and demand diagram
(see figure). The demand curve indicates the
amount of credit borrowers are willing to
purchase at various prices (interest rates). The
supply curve indicates how lenders' marginal
cost of funds varies with the amount of credit
supplied and, thus, the amount of credit they
are willing to grant at various interest rates,
assuming the market is competitive. Accord
ing to theory, borrowers and lenders will
eventually establish an equilibrium in the
market at a price which just balances the
supply and demand for credit. We can call
this price the market rate of interest. Such a
rate is shown as rm.
Usury laws stipulate a maximum rate of
interest which lenders may legally charge.
When a usury law is introduced, it may alter
the way in which both price and quantity are
determined in the credit market. Exactly what
happens depends on the level of the usury
ceiling relative to the market rate. When the
legal ceiling is above the market rate of inter
est (rm), the law has no effect at all. The

The effects of a binding
usury ceiling
interest rate

the

In economic theory, the credit market is
viewed like any other market.1 There are
buyers (borrowers) and sellers (lenders) of
^ or a simple theoretical treatment of usury ceilings
see Chapter 9 in James Van Horne [25]. For a more
advanced discussion see Rudolph C. Blitz and M illard F.
Long [2],

Econom ic Perspectives

market forces of supply and demand are
unconstrained by the usury ceiling, and the
equilibrium price and quantity of credit are
unchanged. However, when the legal ceiling
is below rm, the regulation does affect the
market outcome. Such a usury ceiling, like
the rate ru in the figure, is said to be binding
or effective.2 A binding ceiling obviously
alters the price of credit—the ceiling rate
becomes the rate of interest charged. There
fore, if the market rate rm were considered
too high,a usury ceiling of ru would lowerthe
rate of interest for those borrowers who were
able to obtain credit.
However, establishing a lower-thanmarket interest rate by means of a usury ceil
ing will also bring about a decrease in the
quantity of credit supplied. Given lenders'
costs (as reflected in the supply curve shown
in the figure), the most credit which they will
provide when the interest rate is held down
to ru is Q u. Therefore, the binding usury ceil
ing will lead to a reduction from Q m to Q u in
the amount of credit supplied. Furthermore,
in contrast to the situation in the unregulated
market, this amount of credit will not satisfy
all those who are willing to borrow at the
ceiling price. The usury ceiling creates a situa
tion of excess demand with borrowers seek
ing an amount of credit, Q j, that exceeds the
amount supplied by lenders, Q u. Borrowers
are prevented by the ceiling from bidding.to
obtain more credit and lenders will not pro
vide any more credit at the legal maximum
interest rate. Thus, at the legal ceiling price
the reduced amount of credit must be ra
tioned among borrowers by some means
other than price.
The important implication of this straight
forward supply-demand analysis is that usury
laws can succeed in holding interest rates
below their market levels only at the expense
of reducing the supply of credit to borrowers.
2What has happened in many states over the last
decade is that for various economic reasons market
interest rates have risen above what were initially non
binding statutory ceilings. W hile the ceilings always
existed, only recently have they begun to impinge on the
market.

Federal Reserve Bank o f Chicago

The effect of usury ceilings on the quantity
of credit supplied: the evidence

Potential borrowers would surely find it
less than desirable if binding interest rate ceil
ings did have the predicted effect on the
supply of credit. I n order to test this predicted
relationship and to measure its importance,
investigators have examined a number of dif
ferent credit markets.
Because commercial loans are usually
exempt from state usury ceilings, there have
not been many studies of the effects of usury
ceilings on commercial lending. In one of the
few such studies, Robert Keleher of the Fed
eral Reserve Bank of Atlanta [9] determined
that banks in Tennessee extended fewer
commercial loans the further market interest
rates rose above the state's 10 percent usury
ceiling.3
More widely studied has been the mort
gage market, where binding usury ceilings
also have been found to have very restrictive
effects on credit supplies. The Federal Reserve
Bank of Minneapolis [3, 20] analyzed Minne
sota's experience with an 8 percent usury ceil
ing on conventional home mortgages. In this
case, the usury ceiling had a significant impact
on the composition of mortgage credit even
though the total volume of mortgage lending
apparently was unaffected. The Minneapolis
study found that when market rates climbed
to between 9 and 10 percent in 1973-74, home
financing in Minnesota shifted substantially
from conventional mortgages that were sub
ject to the ceiling to FHA or VA loans that
were exempt from the ceiling. About 40 per
cent of all new mortgage loans issued in the
state in late 1974 were FHA-insured, almost
double the usual share, and conventional
mortgages were virtually unavailable in the
Twin Cities.
More formal analyses of the effect of
3The exceptions were loans to nondurable and
durable manufacturing and loans to service industries.
Keleher speculates that these loans were not adversely
affected by the ceiling because of previous commit
ments, strong customer relationships, and nonprice
rationing.

usury ceilings on the supply of mortgage
credit were carried out by James Ostas [16],
Philip Robins [19], and James McNulty [12].
Ostas and Robins approached the issue in
directly, looking at the impact of ceilings on
home building rather than on mortgage lend
ing. Ostas estimated that the number of autho
rized housing permits fell by 11 to 19 percent
for every one percentage point that the
market rate was above the usury ceiling. Rob
ins found that for each percentage point by
which market rates exceeded usury limits,
single-family housing construction was re
duced by 16 percent. Looking directly at
mortgage lending, McNulty found that usury
ceilings have an impact on the supply of
credit even before the average market rate
hits the ceiling. He estimated that as the aver
age market rate rose from a point below, but
still close to the ceiling, mortgage lending was
lowered 7.5 to 12.5 percent for each 1 percen
tage point rise in the market rate relative to
the ceiling.4
Usury ceilings appear to have some ad
verse effect on the supply of consumer credit
as well. In a technical study for the National
Commission on Consumer Finance (NCCF),
Robert Shay [21] found that state usury ceil
ings had a small but statistically significant
negative effect on the number of consumer
loans extended. Each 1 percentage point
decrease in the usury ceiling on small loans
was associated with 18 fewer loans per 10,000
families.5 In addition, Shay found that lower
rate ceilings were associated with fewer new
auto loans. However, he found no significant
effect on the supply of credit to purchase
other consumer goods (mobile homes, boats,
aircraft, and recreational vehicles).
“•Despite finding this impact on the number of loans
extended, M cNulty did not find that Georgia’s ceiling
had a significant impact on housing construction.
McNulty believed this was because Georgia’s ceiling was
only moderately, and briefly, restrictive during the period
under study.
5Shay also found a positive but insignificant relation
ship between the dollar volume of loan extensions and
usury ceilings. If the average size of each loan were to rise
while the number of loans fell, the usury ceiling might
not affect the total dollar volume of loans extended.

The Credit Research Center (CRC) at
Purdue University has conducted several stud
ies of usury ceilings and consumer credit. In
one such study, Johnson and Sullivan [8]
found that a 1977 change in Massachusetts
law which lowered the usury ceiling on small
loans was an important factor in the 12.5 per
cent drop in the amount of such loans out
standing in that state between 1975 and 1979.
In another study for the CRC, Richard
Peterson [17] compared urban consumer
credit markets in Arkansas, which had a 10
percent comprehensive usury ceiling, with
similar credit markets in Illinois, Wisconsin,
and Louisiana, which had less restrictive ceil
ings. Although he found that residents of
Arkansas obtained as much (or more) credit
overall as consumers in the other states stud
ied, he also found that consumers in Arkansas
obtained significantly less cash credit and
more point-of-sale credit (retail credit and
credit cards) than their counterparts in the
states with less restrictive ceilings. Here, as in
the Minnesota mortgage market, the usury
ceiling apparently did not reduce the total
supply of credit, but it did cause consumers to
substitute one type of credit for another—
and, importantly, the change in the mix of
credit favored lenders rather than consum
ers. Merchants and dealers who issue pointof-sale credit can compensate for the reduced
profitability of their credit operations by rais
ing prices on the goods they sell.
Noninterest credit cond itions: usury ceilings
and credit rationing

Altogether, the empirical research on
the effects of usury ceilings largely substan
tiates the argument that binding usury ceil
ings lead to a reduction in the amount of
credit provided by lenders. But credit transac
tions involve a number of terms other than
the interest rate. Usury ceilings determine the
price that lenders can charge, but they do not
constrain the other conditions that lenders
may choose to offer. Faced with a bind
usury ceiling, lenders may be expected
alter these noninterest conditions in order

Econom ic Perspectives

achieve a higher effective return on the
smaller amount of credit they will offer. For
example, by such means as strengthening
loan terms, adjusting borrower-screening
criteria, or increasing noninterest fees and
charges, lenders may be able to skirt the
impact of usury ceilings on their overall prof
itability. It is important to consider how these
strategies affect the borrowing public.
As pointed out above, under binding
usury ceilings borrowers demand more credit
than lenders are willing to provide. This
requires lenders to rely on nonprice means to
allocate credit among potential borrowers.
Many of the strategies lenders are likely to
follow in this situation can be expected to
concentrate the impact of usury ceilings on
certain borrowers. For example, making loan
terms more stringent reallocates credit away
from those who are unable to afford larger
down payments or the larger monthly pay
ments necessitated by shorter maturities and
higher minimum loan size. Determining
credit-worthiness according to individual
borrower characteristics rations credit away
from high-risk consumers who might be wil
ling to pay higher-than-ceiling rates. Finally,
adding noninterest charges eliminates from
the market those for whom these extra costs
are too great.
By encouraging these lending practices,
usury ceilings may fail to give consumers the
protection and benefits which they were
intended to provide. For example, usury laws
may work against the goal of ensuring that
credit is available to small, inexperienced
borrowers. When lenders ration credit by
some means other than price, small borrow
ers, low-income borrowers, and high-risk
borrowers are likely to find it more difficult to
obtain credit. Prime borrowers, on the other
hand, may obtain even more credit than they
would have at normal market interest rates.
Furthermore, when lenders institute nonin
terest charges to compensate for interest rate
ceilings, they effectively raise the cost of
credit for the successful borrower. This means
that, while a ceiling may reduce the explicit
price of credit (the interest rate), it may not

Federal Reserve Bank o f Chicago

result in lower overall costs of borrowing
even for those able to obtain loans. The non
interest charges also make it more compli
cated for customers to comprehend the total
cost of borrowing and make it more difficult
to make well-informed credit decisions.
These lending practices and their unde
sirable consequences may exist in the ab
sence of interest rate ceilings. However, some
empirical studies have found that the extent
to which these devices are used is influenced
by the restrictiveness of usury laws. Several
studies have established that loan terms do
become less favorable to borrowers when
usury ceilings become more restrictive. For
example, the Minneapolis Federal Reserve
Bank [3, 20] found that during one period
when Minnesota's ceiling on mortgage loans
was binding, the average maturity of conven
tional mortgages in the Minneapolis-St. Paul
SMSA fell significantly. The same study found
that required down payments increased much
more sharply in the Twin Cities compared
with SMSAs not subject to binding usury ceil
ings. Similarly, according to the New York
State Banking Department [10], down pay
ment requirements increased and maximum
maturities decreased during the 1974 credit
crunch when market interest rates rose above
New York's 8.5 percent ceiling on mortgage
loans.
Phaup and Hinton [18] actually measured
the magnitudes of the changes in noninterest
mortgage terms due to New York's usury ceil
ing. Using data on new mortgage lending for
single-family dwellings in Schenectady, New
York for 1961 through 1976, they estimated
that for each 1 percentage point the market
rate rose above the usury ceiling, there was a
4 percent shortening of mortgage maturities
and an 8 percent decline in loan-to-value
ratios.6
Peterson's study [17] indicated that usury
ceilings have similar impacts on noninterest
loan terms in the consumer credit market.
6Ostas also found mortgage down payments were
larger and maturities shorter, the more binding the usury
ceiling. The maturity effect, however, was not statistically
significant.

This study found that maturities of auto loans
in Arkansas were shorter than in states with
less restrictive usury laws. In addition, the
average minimum size for personal loans at
commercial banks and credit unions was 2.5
times larger in Arkansas than in other states
covered by the study. Peterson found that
Arkansas lenders charged higher fees for
mortgage credit investigations and appraisal
than did lenders in other states with less re
strictive interest rate ceilings. Arkansas resi
dents also paid higher charges for checking
accounts and overdrafts. (Moreover, retailers
faced bigger discounts and less desirable
terms when selling their retail credit contracts
to other creditors.)
Empirical research has also tended to
confirm the expectation that the burden of
usury ceilings falls unevenly on the borrow
ing public. The availability of credit to certain
groups of borrowers appears to depend on
the restrictiveness of usury ceilings. Peterson,
for example, found that cash credit was signif
icantly less available to low-income and highrisk borrowers when usury ceilings were
more restrictive. The lowest income group
and the three highest risk groups of consum
ers in Arkansas obtained a larger proportion
of their credit from point-of-sale sources than
in other states in the study with more liberal
interest rate ceilings. In their study of the
Schenectady, New York mortgage market,
Phaup and Hinton [18] found that lower
income areas felt the impact of usury regula
tions on mortgage lending activity more than
other areas. They found that mortgage activi
ty in census tracts of the lowest economic
stratum was more sensitive to the usury ceil
ing and to noninterest credit terms than
mortgage lending in tracts characterized by
higher economic status. Johnson and Sullivan
[8] found that Massachusetts' lowered ceiling
had a greater impact on the availability of
small regulated loans than of large ones, par
ticularly at small, local finance companies.
They concluded that less prosperous consum
ers who needed and could afford only small
loans “ were progressively excised from this
portion of the legal cash loan market" (p. 14).

The survey data collected by the National
Commission on Consumer Finance (NCCF)
have been used in several studies of the
impact of usury ceilings on consumer credit
markets. Greer's [7] analysis showed that dif
ferences in finance company rejection rates
were closely related to differences in state
usury ceilings. The lower were rate ceilings,
the higher was the rate of rejection for per
sonal loan applicants. Greer concluded from
this study that, with higher allowable interest
rates, lenders are more willing to accept risky
borrowers and, consequently, binding ceil
ings make it more difficult for riskier borrow
ers to obtain credit. Finally, using the same
NCCF data, Shay [21] found additional evi
dence that high-risk borrowers are most
affected by usury ceilings. Generally, higherrisk borrowers obtain credit through auto
dealers and finance companies rather than
banks. The fact that the higher rate ceilings
specifically applicable to auto dealers and
finance companies were found to be respon
sible for curtailed credit in the new auto and
personal loan markets led Shay to conclude
that the burden of the ceilings falls largely on
those whose credit standing is weakest.
The broad conclusion that emerges from
these empirical studies is that usury ceilings
create a climate in which lenders are able to
pursue practices unfavorable to some or all
borrowers. On balance, usury ceilings appear
to be a type of regulation whose benefits to
borrowers are extremely questionable. The
primary benefit is a lower-than-market inter
est rate. But, depending on lenders' actions,
borrowers may end up facing higher nonin
terest credit charges and less favorable terms
as a result of usury ceilings. Moreover, at
tached to the lower-interest benefit of usury
ceilings is a direct cost to the borrowing pub
lic in the form of a reduced supply of credit.
Furthermore, it is likely that the cost of re
stricted credit availability falls disproportion
ately on high-risk, low-income borrowers—
those whom usury ceilings are usually
designed to protect.
Thus far, usury ceilings have been dis
cussed in terms of their effect on individual

Econom ic Perspectives

borrowers. Usury ceilings also affect consum
ers and the economy in a more general way.
This broader impact is a consequence of the
particular way in which interest rate regula
tion has been implemented in the United
States.
Diversity o f usury ceilings. Since colonial
times, the responsibility for regulating inter
est rates on credit has rested with the states.
As credit markets have evolved since that
time, states have developed complex sets of
statutes which apply to specific types of lend
ers and specific types of credit, often with
different limits depending on the size of the
loan. As a result, there is great diversity in the
coverage of interest rate ceilings within indi
vidual states.7Furthermore, there is also great
diversity in ceiling rates and coverage across
states.
These legal arrangements have impor
tant implications for the economic impact of
usury ceilings. Lack of uniformity of limits and
coverage means that some forms of credit are
constrained by ceilings while others are not.
Under these circumstances, lenders will want
to shift their portfolios into loan categories
which are not subject to binding ceilings.8
State-imposed usury laws establish inter
est rate ceilings on credit extended to bor
rowers within a particular state. But, since
credit markets are not confined by state
boundaries, lenders may find it more attrac
tive to extend credit across state lines to bor
rowers in states which offer less constraining
7A 1981 listing by the Financial Institutions Bureau of
the M ichigan State Department of Commerce contains
25 different loan categories subject to interest rate ceilings
imposed by state law. The effective maximum rates
ranged from 5 percent on personal loans by individuals
for nonbusiness purposes to 36 percent on loans by
pawnbrokers. A 1980 survey of Iowa usury laws summar
ized that state’s current interest rate ceilings under 9
categories, with maximum permitted rates ranging from
5 percent (the legal rate) to 36 percent (the maximum rate
on the first $500 of a loan by a chattel loan licensee).
8For exam ple, according to an article in Business
W eek, M arch 22,1982, finance companies are switching
emphasis from consumer lending to commercial lending
in part because com m ercial loans are generally exempt
from usury regulation w hile consumer loan charges are
not.

Federal Reserve Bank o f Chicago

usury laws. Thus, interstate differences in lim
its and coverage will distort the geographic
distribution of credit and alter the allocation
of funds to credit-sensitive economic
activities.
Many of the studies cited previously pro
vide implicit support for the notion that the
diversity of usury ceilings among states affects
the geographic distribution of credit. Studies
comparing loan volumes across states with
different usury ceilings suggest also that credit
availability varies among states depending on
the restrictiveness of their usury ceilings.
A study by the staff of the New York State
Banking Department [10] shows somewhat
more directly how credit flows away from
states with restrictive usury ceilings. The study
found that during the period 1966 to 1974,
when national mortgage market rates were
almost continuously above New York’s usury
ceiling, savings and loans in New York in
creased their proportion of out-of-state
mortgage holdings from 6.5 percent to over
18 percent. Over the same period, in-state
conventional mortgage holdings by these
institutions fell from 67 percent of total assets
to 47 percent and from 75 percent of total
mortgages to 57 percent. Clearly, New York
State S&Ls responded to the ceiling which
bound in-state conventional mortgage rates
by increasing their relative holdings of un
covered loan categories, including out-ofstate mortgages.9
In the long run, state differentials in
usury ceilings may even influence the loca
tion of suppliers of credit and of creditsensitive economic activities. Arkansas, which
had a low, comprehensive 10 percent usury
ceiling, provides several examples of the loca
tional effects. There are no consumer finance
9Savings banks and state-chartered commercial banks
did not exhibit the same large, steady increase in the
proportion of out-of-state mortgage holdings. However,
New York State savings banks already held almost onehalf of their mortgages on out-of-state properties. Fur
therm ore, in-state conventional mortgages, those sub
ject to the ceiling, comprised very small proportions of
the total assets of savings banks (approximately 12 per
cent) and comm ercial banks (approximately 2 percent)
compared with S&Ls.

How ceilings vary among Seventh District states
First mortgage
Illinois

No limit by
state law

New auto loan
No limit

Unsecured personal
instalment loan*

Bank credit card
No limit

No limit
(

36% on unpaid balance to $540

Indiana
state law

*15% on unpaid balance over $1,800

Iowa

No limit by
state law

21%

18% on unpaid balance
to $500
15% on rem ainder

Michigan

No limit due
to federal
override

16.5%

18%

Wisconsin

No limit by
state law

31%
24%
18%
12%

of
of
of
of

unpaid
unpaid
unpaid
unpaid

balance
balance
balance
balance

to
to
to
to

$150
$300
$700
$2,000

31% of unpaid balance to $500
18% or j
13% of unpaid balance to $3,000

Greater of 18%
or 6-month
T-bill rate + 6%

18% or no limit
w hen 2-year T-bill
rate remains above
15% for 5 consecutive
Thursdays**

Greater of 23%
or rate on
2-year or 6-month
T-note + 6%

•Rate lim its often vary by type of lend er. Lim its shown are highest perm itted for any lend er. U nd er the 1980 M onetary Co ntro l A ct,
banks, S&Ls, and credit unions may charge the greater of the Federal R eserve discount rate plus t percent or the highest rate perm itted any
state lender for the type of loan in question.
••T h e operative lim it has been 18% since the law becam e effective N ovem ber 1,1981.

companies located in Arkansas and that state
has a much larger number of pawnbrokers
than Illinois, Wisconsin, or Louisiana, which
have more lenient ceilings on consumer
credit. In addition, a survey of merchants in
the adjacent cities of Texarkana, Texas and
Texarkana, Arkansas [1] revealed that there
were many more automobile, furniture, and
appliance dealers on the Texas side of the
border than on the Arkansas side. Further
more, 84 percent of the merchants inter
viewed indicated that Arkansas’ usury ceiling
had been an important factor in their deci
sion to locate in Texas.
Differences in state usury regulations
also were cited in recent decisions to relocate
the credit card operations of Citibank, First
National Bank of Maryland, Philadelphia
National Bank, and the First National Bank of
Chicago.10* In addition, banks in Seattle and
Detroit are reported to be considering relo
10See Wall Street Journal, Decem ber 5 and 15,1981
and The Am erican Banker, September 30 and October
30,1981. The ability of banks to take advantage of inter
state differences in ceilings on credit card lending
derives from a 1978 Supreme Court ruling. In Marquette
National Bank v. First of Omaha Service Corporation, the
Court determined that national banks may charge out-

cating credit card operations to other states
because of usury limits.11
The m acroeconom ic impacts o f usury ceil
ings. When usury ceilings make it unattractive

to make loans in a particular state, the adverse
impact of the ceilings falls most heavily on the
credit-sensitive sectors of the state's econ
omy. The health of a state's residential con
struction industry, for example, can be
seriously affected by its usury regulations. As
Ostas and Robins showed, housing starts and
permits are sensitive to ceilings on mortgage
rates. Furthermore, the New York State Bank
ing Department concluded that New York's
restrictive usury ceiling contributed to the
depressed condition of the housing market in
that state during the late 1960s and early
1970s.
Similarly, there is evidence that restric
tive usury ceilings on automobile loans and
of-state credit customers the rate permitted by the law of
the bank’s home state. See Federal Reserve Bulletin, vol.
67 (February 1981), p. 181 fn. The same option does not
apply to department stores, gasoline companies, or other
issuers of retail or sellers’ credit cards.
11See The Am erican Banker, May 6,1982.

Econom ic Perspectives

other forms of consumer credit can affect the
level of consumer purchases and retail trade.
Thesurvey of merchants in Texarkana, Arkan
sas, and Texarkana, Texas [1] revealed that
approximately 38 percent of credit sales
among merchants on the Texas side of the
border were to customers from Arkansas.
This substantial out-of-state shopping, which
is presumably due to the 10 percent usury
ceiling in Arkansas, represents a significant
loss of potential business revenues for
Arkansas-based retailers. Furthermore, as the
authors of the study concluded, it represents
a loss of jobs and local tax revenues.
A state's usury ceiling is likely to have
far-reaching consequences for the state's real
economy. Its effects can be expected to show
up first in the level of credit-financed expen
ditures and eventually in levels of state
employment and income. A study by Richard
Gustely and Harry L. Johnson, described by
Harold Nathan [14], used an econometric
model of Tennessee toexaminethe impact of
that state's comprehensive 10 percent usury
ceiling. According to Nathan, the authors
found that Tennessee's economy grew faster
than the national economy except at times
when market interest rates exceeded the
state usury ceiling. The ceiling was estimated
to have cost the state annually between 1974
and 1976 $150 million in output, $80 million in
retail sales, and 7,000 jobs. Thisstudy indicates
how restrictive usury ceilings may deprive a
state of the credit needed to keep its econo
my expanding. All residents of the state are
affected, not only those borrowers who find
credit difficult to obtain.
Usury ceilings and com petition

As the foregoing discussion has shown,
the impacts of usury ceilings extend well
beyond simply holding a lid on interest rates.
The adverse effects on the economy as a
whole may even be sufficient to outweigh the
benefit to those who are able to borrow at
below-market interest rates. However, a
common argument is that without usury laws
borrowers would be forced to pay exorbitant

Federal Reserve Bank o f Chicago

interest rates, or at least rates that were
unreasonable in relation to the cost of supply
ing credit. Thus, evaluation of usury laws is
not complete without a consideration of the
consequences of not having usury ceilings.
According to economic theory, a com
petitive market is sufficient to prevent lend
ers from exercising power over pricing or
earning more than a normal return. The price
established in a competitive market reflects
suppliers' costs of providing the given amount
of the good. To be sure, removing a binding
usury ceiling will result in higher interest
rates. However, if credit markets are competi
tive, the resulting market rate of interest will
not exceed lenders' cost of providing credit.
It is when competition is absent that consum
ers may face unreasonable interest rates.
Thus, the consequences of not having usury
ceilings depend importantly on the competi
tiveness of credit markets. Indeed, the ab
sence of competition is the only clearly
defensible theoretical reason for imposing a
usury ceiling.
We might argue that U.S. credit markets
today are fairly competitive. Many types of
institutions—banks, finance companies, credit
unions, thrift institutions, and retailers—make
up the supply side of the credit market and
frequently offer credit in closely substitutable
forms. Moreover, in many (but not all) local
market areas, consumers can choose among
several lenders of any particular institutional
type. However, competition in credit markets
may be hampered by the fact that lending
institutions have become specialized accord
ing to the types of credit they offer and/or the
types of borrowers they serve. In the area of
personal consumer credit, for example, banks
and other depository institutions primarily
offer cash credit to lower risk borrowers
while finance companies specialize in servic
ing higher risk customers. Thus, the question
of whether credit markets are sufficiently
competitive to protect consumers from un
reasonable interest charges is one which must
be answered empirically. Unfortunately, stud
ies of the extent of competition in credit
markets do not provide a definitive answer to

the question.
Smith [22] concluded from a study of the
structure of rates on personal loans at com
mercial banks that there is a considerable
degree of interbank competition for the more
profitable type of loans, but that this does not
extend to the small high-risk loan where the
social problems of credit regulation are most
acute (p. 524). He also found evidence of
interinstitutional competition in the influence
of consumer finance companies on bank loan
rates and portfolio composition. On the other
hand, Geer's analysis of the NCCF data on
personal loan rates [5] did not allow him to
conclude firmly that finance companies and
commercial banks compete vigorously.
The NCCF Report provided some evi
dence of the existence of competition in its
findings regarding the pattern of interest
rates across states. The Commission's 50-state
survey revealed that rates on auto loans and
unsecured loans at banks clustered within a
rather narrow range (the market rate?) re
gardless of state usury ceilings.12 Also, aver
age observed interest rates for these loans
were in the same range even in states with no
ceiling at all.13 In contrast, in the finance
company loan market, the Commission
noticed a much closer correspondence
between observed rates and the state usury
ceilings.
The conflicting findings of these few stud
ies illustrate the difficulty in reaching a defini
tive conclusion about the extent of competi
tion in credit markets. The studies described
here suggest that competitive behavior may
vary considerably among different segments
of the credit market. Rates on finance com
pany personal loans, for example, appear to
be set less competitively than rates on auto
12O f course, it could simply be that the state usury
ceilings were above the optimum price for an oligopolis
tic competitor. Even if that were the case, however, the
situation i ndicates that the rate oligopolist lenders estab
lish is below what most legislatures consider usurious.
13ln addition, an investigation by the Federal Reserve
Bank of St. Louis revealed that mortgage rates in the
Chicago, M inneapolis, and Pittsburgh SMSAs did not rise
to state ceilings when these usury limits were allowed to
float. See Lovati and Gilbert [11].

loans or personal loans extended by banks.
Another factor which makes an overall
assessment of competition difficult stems from
the potentially great differences in local
market conditions. Lending institutions
located in urban areas may face much greater
competitive pressures than lenders in smaller
cities or towns.
What can be stated definitively, how
ever, is that from the point of view of protect
ing borrowers from unreasonable interest
charges, competition is desirable, and the
more the better. To the extent that competi
tive pressures arise from the presence and
ready entry of many firms into the market,
consumers are best served by policies that
foster these conditions in credit markets.14
There is some evidence that usury ceil
ings, rather than fostering these conditions,
tend to restrict competition in some parts of
the credit market. The NCCF found, for
example, a strong inverse relationship be
tween statewide finance company concentra
tion ratios and the average level of legal rate
ceilings on personal loans. (Higher concen
tration ratios are usually associated with lower
levels of competition.) The relationship was
even stronger within the group of states hav
ing low rate ceilings. The findingthat lending
firms tend to be more highly concentrated in
states with lower rate ceilings can be attrib
uted to several factors. First, low usury ceil
ings drive inefficient firms out of the market,
thereby increasing concentration [6, p. 1377].
In addition, low usury ceilings create barriers
to entry making it difficult for new firms to
compete during the start-up phase [15, p.
137].
14The literature on the structure of banking markets
has established that firm entry and concentration have
highly significant, although quantitatively small, effects
on competitive pricing behavior. See Stephen Rhoades,
Structure-Perform ance Studies in Banking: A Summary
and Evaluation, Staff Economic Studies 92 (Board of G ov
ernors of the Federal Reserve System, 1977); Harvey
Rosenblum, “ A Cost-Benefit Analysis of the Bank Hold
ing company Act of 1956/' Proceedings o f a C onference
on Bank Structure and C om petition (Federal Reserve
Bank of Chicago, 1978); and George Benston, “ The
Optimal Banking Structure: Theory and Evidence,”
Journal o f Bank Research, vol. 3 (Winter 1973), pp. 220-37.

Econom ic Perspectives

Rate ceilings may impede competition in
various other ways. The NCCF argued that
different rate ceilings for different types of
consumer lenders tend to segment the market
artificially and restrict interinstitutional com
petition [15, p. 147 and 5, p.60]. A recent study
by Sullivan for the CRC [23] supports this
argument. She found that the extent of com
petition between banks and finance compan
ies for consumer loans depended on whether
the two types of lenders operated under the
same or different rate ceilings. In a local per
sonal loan market in Illinois, which differen
tiates ceilings by type of institution, borrow
ers from banks had significantly different risk
characteristics than borrowers from finance
companies. Such segmentation was not found
in a comparable local loan market in Louisi
ana where all lenders are treated equally.
Another difficulty with usury ceilings,
suggested by Shay’s findings, is that rate ceil
ings may offer convenient focal points for
setting rates higher than they might other
wise be set, when lenders already have some
power to set prices [21, p. 457]. Finally, the
Treasury Department’s Interagency Task Force
on Thrift Institutions [24] recently argued that
very low usury ceilings discourage thrift insti
tutions from adding consumer loans to their
portfolios and from actively competing with
finance companies by offering consumer
loans. According to all of these arguments,
the removal or easing of usury ceilings would
tend to make credit markets more competitive.
Knowledgeable, informed borrowers also
foster competition in credit markets. When
consumers do not know or cannot compare
rates being charged by various lenders, each
lender has more scope to charge whatever
rate he chooses. Thus, a high level of bor
rower awareness can place a natural con
straint on interest rates, in lieu of the external
constraint of a usury ceiling. Indeed, as the
NCCF pointed out, “ Not all consumers need
beawareof the APR [annual percentage rate]
or shop for credit to bring about effective
price competition. A significant marginal
group of consumers who are aware and do
shop is sufficient to 'police' the market’’ [15,

Federal Reserve Bank of Chicago

p. 175].
It is difficult to say exactly what the size of
that group needs to be, but the Commission
suggested that one-third to one-half of all
borrowers is certainly sufficient. By this criter
ion, today’s consumers seem to exert a rather
effective pressure on lenders. A 1977 Consum
er Credit Survey sponsored by the Board of
Governors of the Federal Reserve System [4]
classified 65 percent of consumers as aware of
APRs on revolving credit. The awareness level
on bank credit cards was 71 percent, and on
closed-end credit it was 55 percent.
Consumer awareness levels were not
always this high. Surveys comparable to the
1977 one were conducted in 1970 and 1969.
Only 38 percent of credit users were found to
be aware of APRs on closed-end credit in 1970
and only 15 percent in 1969.15 Awareness lev
els on retail revolving credit and bank credit
cards were only 35 and 27 percent, respec
tively, in the 1969 survey, although they stood
at 56 and 63 percent by 1970.
At least some of the improvement in con
sumer awareness since 1969 revealed by these
surveys is probably attributable to the con
sumer protection legislation enacted in the
late 1960s and 1970s. The Truth-in-Lending
Act (Title I of the 1968 Consumer Credit Pro
tection Act) was passed only shortly before
the 1969 survey, and its impact seems evident
in the 1970 survey results. This association of
improved consumer awareness with the pas
sage of Truth-in-Lending suggests that, in the
absence of usury ceilings, such legislation
could effectively ensure consumers of reason
able interest rates by fostering more intense
price competition in the credit market.
Policy action and options

Over the past few years there has been a
spate of legislative activity affecting usury
15ln analyzing the results of the 1970 survey, the
NCCF found awareness levels in the “ general market” —
the market comprised mainly of higher income, more
highly educated, white, homeowning borrowers who
live in nonpoverty areas and use mostly cash credit—
sufficient to police the market. The high-risk market, on
the other hand, had disturbingly high levels of un
awareness.

regulations at the national and state levels.
Probably all of these legislative changes have
helped to ease the adverse economic effects
of binding usury ceilings during the recent
period of high market interest rates. How
ever, the specific policies implemented have
differed greatly in the extent of their move
toward deregulation; not all have involved
completely removing legal price constraints.
For example, some states have acted to
raise, but not eliminate, ceilings when they
have impinged on credit availability and eco
nomic activity. This approach preserves fixed
statutory interest rate limits and whatever
protection they might afford consumers from
outrageously high interest charges. But, if
state legislatures intend to avert the negative
economic impacts of fixed usury ceilings,
they must act deliberately and quickly to
adjust ceilings limits in response to changes in
market rates—a task made more difficult by
the increased volatility of rates in recent
years.
Asecond approach, tying ceiling limitsto
market interest rates, avoids this problem and
at the same time preserves the protection
afforded by statutory limits. Some states have
instituted legislation to allow ceilings to float,
usually by stipulating limits several percent
age points above certain specified interest
rates—such as Treasury bill yields or the Fed
eral Reserve discount rate—over which
neither borrowers nor lenders have control.
These usury ceiling limits, then, adjust auto
matically at frequent intervals to changes in
the market interest rate. While floating rate
ceilings are designed to be nonbinding with
respect to the rates charged on the vast major
ity of loans, they prevent lenders from charg
ing rates which are out of line with the
market.
The difficulty with floating ceilings is in
choosing a tie-in formula which will keep the
ceiling above the average market rate over
time. In a 1979 study of floating ceilings in the
mortgage market, the Federal Reserve Bank
of St. Louis [11] concluded that ceiling rates
set 2.5 percentage points above yields on tenyear U.S. Treasury bonds or 5 percentage

points above the discount rate were high
enough not to distort the flow of credit to
housing. Other floating rate schemes, how
ever, continued to bind mortgage rates and
impede housing activity.
Action by state legislatures has not been
limited to partial easing of controls, by raising
limits or implementing floating ceilings. Many
other states have completely eliminated their
usury ceilings. These states can and still do
regulate lenders in other ways, of course.
In addition to these changes on the state
level, the federal government has also acted
recently to remove legal constraints on inter
est rates. The 1980 Monetary Control Act
temporarily preempted state usury limits on
mortgage loans and on large business and
agricultural loans. The same act also overrode
state interest ceilings on loans by national and
state banks, S&Ls, and credit unions when the
state ceiling is below the local Federal Reserve
discount rate plus 1 percent. Proposals to
extend federal preemption to include con
sumer credit were considered during the
1981 congressional session.16
This move by the federal government to
supplant state usury regulations raises an
important and difficult issue. From an eco
nomic point of view federal action has an
advantage over states acting individually. It
would impose uniformity on credit markets,
eliminating legislatively created differentials
in interest rates that artificially distort credit
flows among states. (Uniformity could be
achieved, of course, whether the federal
government imposed its own fixed usury ceil
ing, instituted floating ceilings, or eliminated
ceilings altogether.) From another point of
view, however, federal action may not be so
desirable. The economic advantage of uni
form treatment needs to be weighed against
the political implications of the federal
government stepping into an area—usury
regulation—which has traditionally been
under the jurisdiction of the states. Thus, the
16A Senate bill was introduced by Senator Lugar and
incorporated in S. 1720 by Senator G arn; House bills were
sponsored by Representatives John La Falce and William
Alexander.

Econom ic Perspectives

question whether deregulation of usury ceil
ings should be left to individual states or
whether it is best accomplished by federal
preemption should not be answered on the
basis of economics alone.
Sum m ary

Economic research clearly supports the
current legislative moves toward deregula
tion of usury ceilings. The evidence on the
impact of usury ceilings shows that they have
not achieved their objectives. According to
the empirical studies surveyed, usury ceilings
have significantly reduced the availability of

credit and created hardships for those who
were supposed to be protected. Ceilings have
encouraged lenders to usesuch credit rationingdevicesas higher down payments, shorter
maturities, and higher fees for related non
credit services, which increase the effective
interest rate. They have curtailed the amount
of credit available to lower income and higher
risk borrowers, harming primarily those indi
viduals whom the ceilings are intended to
benefit. Finally, the lack of uniformity of
usury laws across states has distorted credit
flows and economic activity, favoring those
states and regions which are less regulated.

R e fe re n ce s
1. Blades, Holland C ., Jr. and Gene C . Lynch. Credit Policies and Store

Locations in Arkansas Border Cities: Merchant Reactions to a 10
Percent Finance Charge Ceiling. M onograph 2, Krannert Graduate
School of M anagem ent, Purdue U niversity, 1976.
2. Blitz, Rudolph C . and M illard F. Long. "T h e Economics of Usury Regula
tio n ,” journal ol Political Economy, vol. 73 (Decem ber 1965), pp.
608-19.
3. Dahl, David S., Stanley L. Graham , and A rth u r). Rolnick. "M inneso ta’s
Usury Law : A R eevaluation, ” Ninth District Quarterly, vol. 4
(Spring 1977), pp. 1-6.
4. D urbin, Thomas A. and Gregory E. Ellichauser, 7977 Consumer Credit
Survey. W ashington: Board of G overnors of the Federal Reserve
System, 1978.
5. G re e r, Douglas F., Jr. "A n Econom etric Analysis of the Personal Loan
C red it M ark et,” in Douglas F. G reer and Robert P. Shay, eds.. An

Econometric Analysis ol Consumer Credit Markets in the United
States. T echnical Studies Volum e IV. W ashington: The National
Com m ission on Consum er Finance, 1974.
6. G re e r, Douglas F. "R ate Ceiling s, M arket Structure, and the Supply of
Finance Com pany Personal Loans,” journal ol Finance, vol. 29
(Decem ber 1974), pp. 1363-82.
7. G re e r, Douglas. "R ate Ceilings and Loan Turnd o w ns,” journal ol
Finance, vol. 30 (Decem ber 1975), pp. 1376-83.
8. Johnson, Robert W . and A. Charlene Sullivan. Restrictive Effects of Rate

Ceilings on Consumer Choice: The Massachusetts Experience.
W orking Paper No. 35, Credit Research C enter, Krannert Graduate
School of M anagem ent, Purdue U niversity, 1980.
9. K eleh er, Robert E. State Usury Laws: A Survey and Application to the
Tennessee Experience. Processed. W orking Paper Series, Federal
Reserve Bank of Atlanta, January 1978.
10. K o h n, Ernest, Carm en J. C arlo , and Bernard Kaye. The Impact ol New
York's Usury Ceiling on Local Mortgage Lending Activity. Pro
cessed. New York State Banking Departm ent, January 1976.1
11. Lovati, Jean M . and R. Alton G ilbert. "D o Floating Ceilings Solve the
Usury Rate P roblem ?" Federal Reserve Bank ol St Louis Review,
vol. 61 (April 1979), pp. 10-17.

13. M ors, W allace P. Consumer Credit Finance Charges. New York:
National Bureau of Economic Research, 1965.
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